Climate Change 2001:
Working Group III: Mitigation
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8.3 Interface between Domestic Policies and International Regimes

For every country, the costs of achieving a given level of abatement will be dramatically affected by the interface between its domestic policy and international regimes. Since a co-ordination on the basis of simple reporting mechanisms has not be adopted from the outset because it would not have been stringent enough for UNFCCC objectives, some studies were devoted to clarifying the differences between the two main tools for co-ordinating climate policies: country emissions quotas or agreed carbon taxes.

Theoretically, both solutions are equivalent in a world with complete information (the optimal quota leads to the same marginal abatement cost as the optimal level). However, Pizer (1997), building on a seminal work by Weitzman (1974), demonstrated that this is not the case if uncertainties about climate damages and GHG abatement costs are considered. Indeed, welfare losses due to an error of anticipation are not the same in these two approaches, depending upon whether the steepness of marginal abatement cost curve is higher or lower than the steepness of the damage curve. If the marginal abatement cost curve is steeper, then it is preferable to agree on a pre-determined level of taxation because if this level is either too low or too high, the resulting welfare losses trough climate impacts will not be dramatic. This is the case in most modelling efforts as long as there is no large probability of dramatic non-linearity in climate systems over the middle term. This policy conclusion can be reverted if one considers a high level of risk-aversion to catastrophic events (which makes the damage curve steeper), or a large proportion of “no regret” policies (which make the mitigation cost curve flatter). The main message, however, is that in a tax harmonization approach, the costs of complying with commitments on climate policies are known in advance (but the outcome is not predictable), while in a quota approach the outcome is observable but there is an uncertainty about the resultant costs. In this respect, emissions trading is logically a companion tool to a system of emissions quotas, to hedge against the distributional implications of surprises regarding abatement costs and emissions baselines.

After the Berlin Mandate (1995), a quota co-ordination approach was implicitly adopted and the focus of analysis was placed on linkages between emissions trading regimes and national policies. Contrary to the preceding period, very few works were devoted to the case of co-ordinated carbon taxes. Hourcade et al., (2000a) confirmed that, because of the existing uneven distribution of income, discrepancies in pre-existing taxation levels, and differences in national energy and carbon intensities, a uniform carbon tax would result in very differentiated losses in welfare across countries, unless appropriate compensation transfers operated. However, a differentiated taxation does not minimize total abatement expenditures (rich countries would have to tap more expensive abatement potentials) and creates distortions in international competition. The suggested solution, a uniform tax for carbon-intensive industry exposed to international competition and a differentiated taxation for households, has to be at least adapted to the Kyoto framework which does not preclude the use of carbon taxes but changes the condition of their applicability. However, the underlying issue of how to minimize abatement expenditures while guaranteeing a fair distribution of welfare costs still remains.

Under the Kyoto framework, the interface between domestic policies and the international regime passes through three main channels: the impact of international emissions permit trading (under Article 17), international trading in project-related credits (under Articles 6 and 12 (Read, 1999)) on abatement costs, and spillover effects across economies through commercial and capital flows.

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