Morio Kuninori 1 & Masayuki Otaki 2

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1 Environment an Natural Resources Research; Vol. 7, No. 1; 2017 ISSN E-ISSN Publishe by Canaian Center of Science an Eucation A Theoretical Inquiry of the Offset Mechanism in Mitigating Global Warming: Economic Welfare Implications of the Clean Development Mechanism Investment Morio Kuninori 1 & Masayuki Otaki 2 1 Faculty of Sustainability Stuies, Hosei University, Tokyo, Japan 2 The Institute of Social Sciences, The University of Tokyo, Tokyo, Japan Corresponence: Morio Kuininori, Faculty of Sustainability Stuies, Hosei University, , Fujimi, Chiyoaku, Tokyo, Japan. kuninori@hosei.ac.jp Receive: December 27, 2016 oi: /enrr.v7n1p76 Accepte: February 11, 2017 Online Publishe: February 27, 2017 URL: Abstract This stuy attentively examines the role of the offset mechanism like the Clean Develop Mechanism (CDM) in mitigating global warming problems an consiers its economic welfare implications in a theoretical offset environment. The CDM is a kin of offset traing scheme of carbon ioxie (CO 2 ) emissions between avance an eveloping economies. Formulating the essence of the offset market into a simple moel, we interpret the right to trae CO 2 emissions at an ieal price as rewars to avance economies for investing in more CO 2 saving technologies an/or factories in eveloping economies. Our moel shows that uner some conitions the CDM can succee in suppressing CO 2 emissions an become a secon-best measure to mitigate global warming. Nevertheless, we also clarify that the prices of carbon offset in avance economies are not generally sustainable without the help of the outsie agencies such as the governments. This fact suggests that offset mechanism like the CDM incurs an aitional buren, such as taxes to avance economies for preserving the scheme, although the resultant transfer eviently equalizes the international income istribution. Keywors: Offset mechanism, Clean Development Mechanism, global warming problem, aitionality, baseline 1. Introuction Whether the Clean Development Mechanism (CDM) uner the Kyoto Protocol substantially mitigates the excess CO 2 emissions is quite obscure. This is not merely because the structure of the CDM scheme is rather complicate to unerstan, but also because the offset traing system oes not seem to reuce total CO 2 emissions in reality. This stuy offers a simple moel of an offset mechanism like the CDM scheme that captures its important characteristics an analyzes the economic welfare implications of this scheme (Hereafter, we call an offset mechanism as the CDM since the CDM scheme carries most of the offset characteristics we want to eal with). The carbon market uner the CDM scheme traes reuction creits of CO 2 emissions originating from nascent an/or prevailing emission-saving technology in eveloping economies (Note 1). This stuy clarifies that the CDM contributes to mitigating excess emissions of CO 2 as long as the carbon price is set properly, following the moifie Samuelson rule (Note 2). In aition, since the CDM presumes voluntary transactions, it is apparent that eveloping economies becomes better off by joining this scheme. That is, if it works, the CDM coul achieve mitigation of income isparity between avance an eveloping economies. The secon concern of this stuy is the income reistribution effect of the CDM scheme. There is no object that esignates proper carbon price in the CDM scheme in itself. Accoringly, a kin of rationing of allowable CO 2 emissions to each firm is unavoiable if one consiers that the control of CO 2 emissions is effective. Nevertheless, as long as the actualize aggregate emissions of avance economies stay within the amount of the acquire reuction creit by the CDM, the price of carbon cannot remain at ieal levels. As such, the economic value of the carbon creit is heavily impaire. This makes the CDM scheme ysfunctional. If the governments of avance economies inten to sustain a suitable positive carbon price, the governments, by themselves, must intervene in the market, by purchasing the corresponing amounts of reuction creits. 76

2 enrr.ccsenet.org Environment an Natural Resources Research Vol. 7, No. 1; 2017 Because government expeniture is ultimately finance by tax, such purchases reistribute incomes from tax payers unrelate to the CDM scheme to participants. While one coul encounter many ifficulties in juging the fairness on income istribution, it shoul be note acutely that ebt finance is unesirable because this isturbs the income istribution of future generations who are not responsible for the state of current economies. Thus, it is quite important where to set the baseline of the CDM scheme that is the reference point that etermines the volume of tax creit of CO 2 emissions. This stuy also analyzes this problem. The rest of this stuy is organize as follows. Section 2 constructs a static moel of CO 2 emissions control by the CDM scheme an shows that the CDM can enhance wellbeing in both an avance economy an a eveloping economy. Section 3 explains the income reistribution effect associate with our CDM moel, an iscusses the role of the carbon finance alongsie the trae of emissions rights. Section 4 provies brief concluing remarks. 2. The Moel 2.1 The Laissez-Faire Economy As a reference case, let us consier the laissez-faire worl economy in which there is no regulation on CO 2 emissions an emission ecisions are segregate from the calculation of associate amages. It is assume that there are n economies of type k ( k = a, : a an refer to avance an eveloping economies, respectively). Let k the economic benefits of an economy be enote by α F ( e i ), where e k i is the volume of emissions of the i -th economy of type k.α is a parameter that represents the efficiency of the fossil fuel combustion. Figure 1 illustrates k the shape of the function F ( e i ). It shoul be note that it is assume there is an upper limit of the benefits from α F e ). the combustion for a given α (i.e., ( ) Figure 1. The prouction function For simplicity, the amage function Ψ of global warming for an economy via fossil fuel combustion is assume to be the same linear homogenous quasi-convex, non-negative, strictly increasing an symmetric function enote ' ' Ψ(, e k,, k ' ) (, k ',, k l el Ψ el el ), k, k', l, l'. (1) The symmetry represente in Equation (1) implies that the amages of global warming are unrelate to the locations where CO 2 is emitte. Since the emissions ecisions are assume to be segregate, the maximal emissions e are actualize in the laissez-faire economy. Consequently, the resultant welfare of an economy is α F e Ψ e, e,, e,, e, e. (2) ( ) ( ) 77

3 enrr.ccsenet.org Environment an Natural Resources Research Vol. 7, No. 1; Economic Welfare uner the CDM Scheme This subsection examines whether economic welfare is improve by applying the CDM scheme to a pair of one avance an one eveloping economy where both economies are in laissez-faire situation. This stuy captures the CDM scheme as follows. (i) ε units of goos are require for capital investment in a eveloping country. Which of the two economies finance the associate fun is not essential for evaluating the economic welfare as is iscusse in Section 3. (ii) If an only if the capital investment is aitional (the term aitional is strictly efine below), the project is certifie. (iii) Such a certifie investment is reware by an emission right whose value is θ [ ê e]. θ enotes the unit carbon price that is esignate by governments. ê is the baseline of emissions associate with this investment, an e represents the actual emissions. (iv) Whenever the carbon market falls into isequilibrium, the government of the avance economy briges the gap (Note 3). The necessary funs for this compensation are finance by taxes in the avance economy. The sum of the gains obtaine by applying the CDM scheme of the i -th pair of avance an eveloping economies is written as a a a a αf( ei ) + αf( ei ) 2 Ψ( e1 ei en, e1 ei en ) ε. (3) Equation (3), which is funamental in our moel, becomes the objective function of the CDM scheme. One must note that the transaction amount of the emissions right, θ e ˆ e i, oes not appear in Equation (3). This is because the carbon market between an avance an a eveloping country functions only as an income transfer mechanism an oes not relate to efficient carbon allocation although such an amount is vital for capital investment to become aitional in the CDM scheme. While the conitions for aitionality uner the actual CDM scheme are very complicate an there are many requirements in reality, this stuy focuses on the following two properties. Definition 1. A plan to invest capital in a eveloping economy is aitional whenever the following two conitions are satisfie. (i) Financially aitional: the investment is feasible in that the irect benefits from emissions traing are privately beneficial an the revenues from the traing, θ [ ê e], excees the associate costε. That is, the following shoul hol (Note 4): θ e ˆ e i ε (4) (ii) Socially aitional: the maximize value of social welfare function (3) takes a larger value than that in the state of laissez-faire efine by Equation (2). Conition (i) prescribes that the capital investment shoul be compatible with the private motive. Conition (ii) requires that the CDM scheme shoul enhance the economic wellbeing of the conjoining two economies in reality. The problem to be solve in this subsection is to maximize Equation (3) on ( a ei, e i ) uner the constraint of Equation (4). One must also ascertain whether the maximize value satisfies the requirement of being socially aitional (Conition (ii) in Definition 1). For the first step, the following lemma is use. Lemma 1. For any fixe θ e ˆ e i, there is a sufficiently small ε that satisfies Equation (4). Conversely, for any fixe ε, there is a sufficiently large ê that satisfies Equation (4). Lemma 1 implies that the constraint in Equation (4) becomes reunant as long as the investment cost ε is sufficiently small relatively to the benefits obtaine from traing emissions rights, an this is attainable by setting the baseline ê to be high enough. Since the baseline ê is irectly unrelate to the maximization problem in Equation (3), we can separate the maximization problem from the ecision of where to set the baseline ê. Accoringly, the necessary an sufficient conition for the maximization of the social utility function in Equation (3) becomes a Ψ Ψ αf' ( ei ) = 2, αf' ( ei ) = 2, i (5) a By the symmetry assumption in Equation (1), we obtain 78

4 enrr.ccsenet.org Environment an Natural Resources Research Vol. 7, No. 1; 2017 Ψ Ψ Ψ = =, i. (6) a a e1 Substituting Equation (6) into (5), it is ascertaine that k Ψ αf' ( ei ) = αf' ( e ) = 2, ki,. (7) a e1 Since the right-han sie of Equation (7) represents the social marginal cost of CO 2 emissions, the price of carbon θ shoul be etermine at the level of θ. That is, Ψ θ = 2. (8) a e1 Equation (8) implies that the price of carbon shoul be equal to the sum of the marginal nuisance of the emissions of the economies that are partners in the CDM scheme. This is a form of Samuelson s (Samuelson, 1954) rule in the sense that the price of public bas (goos) shoul be etermine by the sum of marginal isutility (utility) of sufferers (beneficiaries). As iscusse above, we confirm that the capital investment satisfies the conition (i) for aitionality if ε is small enough, an that the carbon price subues the rule in Equation (8). Finally, what remains to check is whether the resource allocation esignate by the rule in Equation (8) is consistent with conition (ii) in Definition1. Concerning this question, the following theorem hols. Theorem 1. Since αf ( e ) Ψ( e e e, e e e ) > αf( e) Ψ( e e e, e e e), (9) the CDM scheme that satisfies Equation (7) improves economic welfare in both avance an eveloping countries in comparison with the laissez-faire state in Equation (2). Proof. Because F F' e n Ψ Ψ = n < 0, α e e e e e = 1 e = 1 α Ψis strictly concave an ( ) a a a a 1 1 Accoringly, (9) hols. Ifε is sufficiently small, ε exists such that αf ( e ) Ψ( e e e, e e e ) ε > αf( e) Ψ( e e e, e e e). (10) Equation (10) implies that economic welfare in both economies is improve by the CDM regarless of which economy has incurre expense for the capital investment, as long as the investment costs are not so expensive. QED. Consequently, it has been ascertaine that the CDM scheme that obeys optimal carbon pricing rule (8) satisfies the conitions for capital investment aitionality in the sense of Definition Determination of the Baseline an Associate Change of Income Distribution 3.1 Relationship between the Baseline an Domestic Income Distribution The iscussion about the CDM scheme in Section 2 neglects the income reistribution effect into the omestic economies. This is because the etermination of the baseline ê is not concerne with the optimal emissions allocation, an relates only to the income reistribution in conjunction with the achievement of the CDM scheme. This section eals with how the level of ê affects income istribution within an avance economy. While traing in emissions rights is limite to the bilateral case, the essence of the iscussion is also applicable to the case of the international an open market in which an economy in excess supply of the emissions rights exports its rights to economies with excess eman for such rights. Excess supply emerges in an economy when ê is locate at θ ê e > θ e. (11) The left-han sie of Equation (11) is the supply of the emissions right that is obtaine from the emissions-saving capital investment for a eveloping economy. The right-han sie is the eman for the emissions right of the omestic inustry. Insofar as Inequality (11) is maintaine, the emissions right market cannot sustain the carbon price in market θ at the esignate price θ because of the existence of excess supply, which amounts to θ e ˆ 2e. Such an amount of emissions right may well be purchase by the government in orer to sustain the equilibrium market price atθ. Because the government expeniture is finance by taxation, θ e ˆ 2e amounts of income, e e. 79

5 enrr.ccsenet.org Environment an Natural Resources Research Vol. 7, No. 1; 2017 which correspons to the subsiy pai for participating in the CDM scheme, are transferre from unrelate (taxe) iniviuals to the participants of the CDM scheme within the avance economy. Thus, the baseline, ê, acutely affects the income istribution within the avance economy. While employers are encourage to participate into the CDM scheme by an increase in the baseline, ê, the associate costs are burens for other taxpayers. Thus, the evaluation of income reistribution is quite a ifficult problem. There is, at least, one thing of which to be cautious. Since CO 2 emissions remain in the atmosphere over time an aggravate the stanar of living of our escenants, the associate costs for encouraging the CDM scheme shoul be levie not from future generations but from the present generation. This is because only irect taxation from the present generation coul warn a legitimate price for which they shoul pay for their own emissions. In this sense, ebt finance for the subsiy is prohibitive since this proceure is accompanie by no pain to the present generation. 3.2 Carbon Financing an Government Intervention In this subsection, the function of carbon finance is formatte an reveals the necessity for the government intervention analyze in the subsection 3.1. Carbon finance in this stuy is regare as a type of finance in which money is lent to a eveloping economy for a capital investment in emissions-saving technology an/or factories in exchange for the trae in those emissions savings. Accoringly, the first conition for the capital investment being aitional, that is, Inequality (4), is equivalent to the viability conition of such finance. Thus, to make financial intermeiaries confient in the result of carbon financing, the confience in the government s intervention to equilibrate the carbon market at the esignate price θ must be acutely ecisive. As such, carbon finance is a fragile concern without government help, as epicte by Lovins an Cohen (2011, p. 227). 4. Concluing Remarks In a highly simplifie offset scheme, this stuy esignates the CDM as an acquisition mechanism of carbon creits for returns from emissions-saving capital investments in eveloping economies, which are conitional on aitionality. The requirements for a project to be aitional are efine clearly. It shoul be note that our theory is also applicable to the case in which a eveloping country constructs an emissions-saving facility an sells the acquire carbon creits to an avance economy. This is because the ifference between the former an the latter case is only the ifference to who owns the property rights of the emissions-saving capital an associate carbon creits. In the former case, these property rights belong to the avance economy, an the converse is true in the latter. By the Coase theorem (Coase, 1960), the efficient allocation of public goos (bas) through a bargaining process is achievable without conferring the location of property rights. Therefore, our moel is also applicable to the case in which a eveloping economy irectly accesses the CDM scheme (Note 5). This stuy also fins that the optimal carbon price, which shoul be esignate in the carbon market, is the sum of the marginal isutility of the two economies erive from CO 2 emissions. This is a variant of Samuelson rule concerning the allocation of public goos (bas). Finally, the role of the baseline is iscusse in conjunction with the role of the government intervention to equilibrate the carbon market uner the esignate price. Whenever the baseline is set above the equilibrium transaction volume, an excess supply of carbon creits appears, an the government purchases such resiues in orer to sustain the esignate price. Such purchases subsiize an enhance the CDM projects but ultimately become the burens of taxpayers who are unrelate irectly to the CDM projects. Thus, we fin that the location of the baseline from the viewpoint of economics strongly relate to the income reistribution problem provoke by CDM projects. References Brohé, A. (2014). Whither the CDM? Investment outcomes an future prospects. Environment, Development an Sustainability, 16, Coase R. (1960). The problem of social cost. Journal of Law an Economics. 3(1), Lovins, L. H., & Cohen, B. (2011). Climate capitalism: Capitalism in the age of climate change. New York, NY: Hill an Wang. Mas-Colell A., Whinston, M. D., & Green, J. R. (1995). Microeconomic theory. New York, NY: Oxfor University Press. 80

6 enrr.ccsenet.org Environment an Natural Resources Research Vol. 7, No. 1; 2017 Samuelson, P. A. (1954). A pure theory of public expeniture. Review of Economic Statistics, 36(4), Schneier, L. (2009). Assessing the aitionality of CDM projects: Practical experiences an lessons learne. Climate Policy, 9(3), Unite Nations Framework Convention on Climate Change. (2012). TOOL01, Methoological tool: Tools for the emonstration an assessment of aitionality (Ver ). Retrieve from methoologies/pamethoologies/tools/am-tool-01-v7.0.0.pf Unite Nations Framework Convention on Climate Change. (2014). CDM Methoology Booklet (6th E., Information Upate as of EB 79, November). Retrieve from Documentation/1411/Meth_Booklet_2014_Name.pf Notes Note 1. Typical types of actual CDM projects an their methoologies are explaine in Unite Nations Framework Convention on Climate Change [UNFCCC] (2014). Note 2. It is often state that an offset mechanism oes not generate aitional carbon reuction globally (e.g. Brohé, 2014). It shoul be note, however, that appropriate carbon pricing enables the total carbon reuction worlwie in our moel. Note 3. In our moel, the market consists of only carbon creits from the CDM scheme in orer to highlight the offset mechanism. Note 4. This is a half of the notion of aitionality. The other half inicates that, without the CDM project, the capital investment must not be feasible. Since most of the profitable investment projects woul be feasible even without the revenue from the CDM project, aitionality conition rules out these profitable projects. Although UNFCCC has been trying to satisfy the aitionality conition, issuing methoological tools such as UNFCCC (2012), various stuies, incluing Schneier (2009), have claime that many CDM projects often fail to pass the aitionality test, thereby, losing the environmental integrity of the CDM creit program. In our stuy, one of the sufficient conitions of aitionality may be expresse as αfe ( i ) < ε. However, hypothetically speaking, there woul be other kins of barriers in preventing the project when the revenue is unavailable. Some of the barriers are iscusse in UNFCCC (2012). Note 5. See Mas-Colell, Whinston, an Green (1995, pp ) for a concise explanation about the Coase theorem. Copyrights Copyright for this article is retaine by the author(s), with first publication rights grante to the journal. This is an open-access article istribute uner the terms an conitions of the Creative Commons Attribution license ( 81

Florent Pratlong ERASME, Ecole Centrale Paris. EUREQua and PRISM LASI, Université Paris 1. Abstract

Environmental regulation inciences towars international oligopolies: pollution taxes vs emission permits Florent Pratlong ERASME, Ecole Centrale Paris. EUREQua an PRISM LASI, Université Paris 1. Abstract