Policy Instruments for Climate Change: How Can National Governments Address a Global Problem?

There continues to be a great debate about the desirability of taking actions to limit carbon dioxide (CO2) and other greenhouse gas emissions, but it is important to consider policy instruments that can be employed to meet targets that may eventually be forthcoming. The theoretical advantages of market-based instruments,, such as carbon taxes and systems of tradable carbon rights, are striking In the U.S. domestic context, grandfathered tradable permits will probably be the preferred approach (if any) in the short run, although revenue-neutral carbon taxes will hold greater promise in the long run. In the international context, a system of international tradable permits could provide important advantages over alternative approaches, but it is difficult to imagine what existing international institution could adminster such a system. Hence, despite the great theoretical advantages of market-based approaches to addressing global climate change, neither domestic political barriers nor international institutional impediments to implementing these and other instruments should underestimated.

There are a variety of factors that nations will need to consider to identify their optimal (and feasible) portfolios of greenhouse policy instruments. Countries differ dramatically in their institutional structures, their resource endowments, and their levels of industrialization; and their policy makers will inevitably consider alternative instruments in intensely political environments.

On the domestic level, even the most cost-effective greenhouse policy instrument will be desirable only if the national target it seeks to achieve is part of an accepted set of international mandates. By virtue of the fact that unilateral action will inevitably be highly inefficient, a necessary precondition for any domestic program is the existence of an effective international agreement, if not indeed a set of international greenhouse policy instruments. This returns us to the international context, where we are faced with the awesome task of identifying (or, more likely, creating) an institutional framework for achieving agreement among nations and for credibly administering any program.

Tremendous uncertainty characterizes both the future damages of greenhouse warming and the costs of avoiding or adapting to such a warning. Because much of this uncertainty may be resolved gradually over time, it is important to consider alternative time-paths of public policies, rather than simple, static end-points. Furthermore, since the creation of a satisfactory institutional framework is a precondition for the successful implementation of any international policy instrument (and for the enactment of a serious domestic program), it is also important to consider time-paths for developing institutions that can implement such policies.

There are compelling arguments for beginning with broad-based (if not global) agreements that require only low-cost measures to achieve moderate goals with relatively unsophisticated instruments. As appropriate institutions develop and as more is learned about the benefits and costs of addressing climate change, there might be an evolution toward more ambitious goals, requiring higher-cost measures, achieved (cost effectively) with more sophisticated policy instruments. This approach has been described as a "broad, then deep" policy architecture by Schmalensee (1996).

Reasonable first steps might involve the broad participation of many nations (presumably including, at the very least, the OECD countries, China, Russia, and India) in low-cost agreements, which could later be made more ambitious (and costly), as appropriate. The default alternative appears to be to begin with narrow participation by a limited set of countries (most likely, some subset of the OECD) in a relatively ambitious agreement that involves considerable costs and hence requires fairly sophisticated policy instruments. Examples of this approach include some proposals for ambitious harmonized taxes and JI programs among European nations.

Potentially severe free-rider and emissions-leakage problems, together with other implementation concerns discussed in this paper, are among the reasons why a default, "deep, then broad" strategy would have a low probability of success. Emissions leakage induced by a bilateral or narrowly multilateral greenhouse agreement means that the very existence of an effective multilateral agreement can make the formulation of a global agreement more difficult. This is because such an initial greenhouse agreement would cause non-participant countries to increase their economic specialization in carbon-intensive production, and thus to be even more resistant than previously to joining any future agreements.

This suggests that despite the great theoretical advantages of market-based approaches to addressing global climate change, in terms of static cost effectiveness, dynamic efficiency, and distributional equity, the domestic political barriers to this set of policy instruments should not be underestimated; nor should the severe institutional challenges that characterize the international domain. The ultimate test of any greenhouse policy instrument— whether domestic or international— will be whether it is scientifically effective, economically rational, and politically feasible.