Internationally-Tradable Permits Can Be Riskier for a Country than an Internally-Imposed Carbon Price

Abstract

This paper compares internationally-tradeable permits with a uniform carbon price, as seen through the lens of an individual country. To ensure a level playing field, these two approaches are initially calibrated to be welfare-equivalent for the country in a deterministic setting. While both price and quantity instruments have identical consequences under perfect certainty, outcomes differ substantially when uncertainty is introduced. The uncertainty analyzed here takes the reduced form of idiosyncratic country-specific abatement-cost shocks. Then, because of cross-border revenue flows, internationally-tradable permits can expose a country to greater risk than the imposition of a uniform carbon price (whose revenue proceeds are domestically retained). This result is formalized in a very simple model that highlights the core essence of the argument. Some implications are discussed. I suggest that this relative-riskiness result may be a pertinent consideration in choosing between negotiated price-based approaches and negotiated quantity-based approaches for controlling worldwide carbon emissions.

Martin L. Weitzman, Harvard University