Allocation of carbon permits within regions and its regional economy impact: a multi-regional general equilibrium analysis

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1 Allocation of cabon pemits within egions and its egional economy impact: a multi-egional geneal equilibium analysis Wu Jie, Xia Yan Cente fo Enegy and Envionmental Policy Reseach, Institute of Policy and Management, Chinese Academy of Sciences 1. Intoduction In the 12th Five-Yea Plan of China poposed in 2011, China caied out the taget to educe its economy s cabon intensity by 17 pecent by 2015 compaed to 2010 levels. To achieve this goal, seven cabon emissions tading pilots have been established to find a way fo the unified national cabon tading maket. In China, egional diffeences and inteegional economic linkages have played key oles in China s egional economy development and spatial stuctue fomation. To get a national taget, each egion will have a diffeent contibution. Diffeence of initial quota allocation and emission eduction cost among povinces in China is the diving foce of unified national cabon tading maket. The initial quota allocation of cabon pemits will have impotant effects on egional economic development, industial stuctue and inteegional tading. Theefoe, the allocation of the emission eduction taget at the povincial level may not only take egional economic development into consideation, but also the egional eduction potential to achieve the goal, while at the same time emphasizing egional equity and a egional development stategy. CO2 emissions allowance tading is an effective mechanism fo emission contol, and the initial emission allowance allocation is the key to and pemise of this tading. In geneal, thee ae vaious possible allocation schemes. Fist, the gand-fatheing scheme whee pemits ae allocated fee in popotion to companies emissions in a base yea, and ae esaleable. But such scheme makes moe sense whee those paticipating in the scheme ae the only ones who face economic penalties fo polluting. An altenative is benchmaking, whee fims ae allocated pemits accoding to an emissions taget based on a egulato s judgement of best-pactice fo that industy. This would be faie in tems of ensuing all that companies pay fo cabon use, but difficult to apply in less homogeneous sectos, fo example it is ae fo emissions tading schemes to allocate pemits to new entants (Tietenbeg, 1990). Possibly the faiest method would be the thid scheme--a public auction, which would also aise evenues, which would be ecycled in vaious ways. Fo a global pollutant, such as cabon dioxide, a system of auctionable pemits woks in many ways like a cabon tax, although it is the total volume, athe than the maginal abatement cost, which is fixed. Howeve, a pemit scheme has vaious advantages, paticulaly if it allows fo intenational tading. Unlike a cabon tax, pemits can be saved fo futue use which makes sense given that cabon is a long-lasting global pollutant allowing uses geate choice ove the intetempoal path of consumption, and making possible a futues and options maket (Camton and Ke, 1998.). This pape attempts to simulate the unified national cabon tading maket though povinces with a multi-egional CGE model in China. It concens diffeent initial quota allocations and thei effect on egional economic. Commonly thee ae thee pinciples in initial quota

2 allocation: equity pinciple, auction pinciple and cuent poduction pinciple. In the model, fou scenaios ae designed: one is fee allocation by gandfatheing, that is, a egion eceives quotas based on histoic pefomance accoding to equity pinciple; the second is auctioning of quotas with evenues ecycled as lowe VAT, this model assumes the govenment budget balances, so the exact amount ebated in lowe VAT will also patly eflect changes in economic output and the tax base; the thid is allocation of quotas elative to cuent poduction, which means disguised subsidies and will encouage egions to impove poduction efficiency; the last one is allocation of quotas accoding to the pe-given emission eduction taget in the 12th Five-Yea wok pogam of enegy consevation and emission eduction, though compaing with othe thee scenaios, we can evaluate the feasibility of this policy. 2. Liteatue eview: emission quota allocation eseach Emissions tading theoy has matued in 1980s, and then many studies focus mainly on pactice. Montgomey (1972) and Tietenbeg (1985) indicated that the emissions tading system is supeio to the taditional envionmental policy, with the chaacteistic of contolling pollution at the lowest cost. Howeve, the monopolistic emissions tading maket may be even less efficient, compaed with the Command-and- Contol. Hahn (1984) believed that in the impefect competitive maket, both the tading volume and cost depend on the initial allocation of emissions allowance. In addition, the maket powe would also influence the design and opeation of the emissions tading system (Misiolek and Elde,1989; Svendsen and Moten,2002). Tietenbeg (1990) find that it is due to the inceased tansaction costs caused by the govenment contol. The tansaction costs of emissions tading include the costs fo negotiation, appoval, monitoing, and enfocement. High tansaction costs educe the cost efficiency of emissions tading (Foste and Haln,1995; Stavins,1995). Given the tansaction costs existing in emissions tading Stavins (1995), believed that tansaction costs will affect the tading system, and thus ceate a new cost-efficient equilibium. Theefoe, the initial emissions allocation plays an impotant ole in detemining the contol efficiency. Cason and Gandgadhaan (2003) demonstates Stavins s opinion, and points out the tansaction costs will boost the pice of an emission pemit. The allocation of emissions is the basic pemise of emissions tading, which decomposes the total emission allowance to each pollution souce accoding to some ule. Thee ae thee majo citeia o methods of allowance allocation: auction, citeia exogenous to the fim eceiving the pemits, and output-based allocation (Boemae and Quiion,2002; Pesson et al.,2006). Gandfatheing is the most common citeion in pactice (Camton and Ke, 2002). Howeve, gandfatheing has two negative effects: it educes the incentive of egulated fims to develop envionmental innovations to educe the value of the pemits, and it ceates a bias against new fims enteing the poduct maket (Boemae and Quiion, 2002; Howe, 1994; Milliman and Pince,1989). Lod Mashall s epot (Mashall, 1988) said that a pemit scheme is that potential intenational tading could allow exta cutbacks in pollution to be made in those counties which have the lowest maginal abatement costs, and sold to counties with highe maginal abatement costs. In theoy, this should educe the total abatement cost. Thee is a consideable liteatue on both the theoy and pactice, fo example Pay et al. (1997) estimated that the costs of educing US emissions by 10% wee moe than thee highe unde a gandfatheed pemit system than with a cabon tax, due to the inability to ecycle evenue. Smith (1998) quotes a study by Ballad et al. (1985) estimating that tax eceipt in the USA had a deadweight welfae cost of 20-50% at the

3 magin, and discussed the potentially lage evenues involved in cabon taxes, and the fact that gandfatheing means the loss of the possibility of ecycling these to educe the welfae distotions. Camton and Ke (1988) pointed to the likely costs of political lobbying and legal challenges to any system which allocates pemits fee to some fims but not othes. The thee allowance allocation methods, auctions in theoy ae consideed to be the most cost effective (Camton and Ke,2002). Reseaches suggest that the auction method is the most cost-efficient method, by which its evenue can be used to cut pe existing distotion taxes (Fulleton and Metcalf,2001; Goulde etal.,1999). The emissions-based fee allocation is theeby moe costly than the output-based allocation ule, since it distots fims' choice of both output levels and emissions ates (e.g. Böhinge et al., 1998; Böhinge and Lange, 2005). Goulde et al. (1999) have also shown that the efficiency of pollution abatement can be impoved in the second-best wold if evenues fom auctioning ae used to educe pe-existing taxes. A elated but distinct concen that is intended to be tackled by means of fee allocation is the isk of cabon leakage which efes to the elocation of emissions fom abating to non-abating counties instead of thei eduction (Böhinge and Ruthefod, 2002; Kuik and Hofkes, 2010; van Asselt and Bewe, 2010). With the deteioating envionmental contadiction in China, moe attention has been paid to emissions tading and discussion of Chinese emissions tading with the total amount contol (Lin,1990; Ma and Du,1999; Wang and Yang,2002) and the initial allocation of emission pemits (Yang and Fu,2002; Shi and Huang,2005), which is egaded as a solution to the emission eduction. Raufe and Li (2009) hold that emissions tading maket designs based upon US o Euopean appoaches ae not necessaily elevant fo the conditions found in China, and poposes a thee-component ai quality management appoach of emissions tading pogam. Studies on China s emissions tading ae fuitful, especially, some papes ae mostly focused on the powe industy analysis, fo example Chang and Wang (2010) indicated that the powe industy often has numeous othe policy objectives, theefoe, the design and implementation of an emissions tading pogam in the secto have to give consideation to the compatibility of existing industial policies. Lin et al.(2011) studied focus on the SO2 emissions tading in the powe industy in Fujian povince in China, compaed fou diffeent allocation methods fo sulphu dioxide allowance. Liu et al. (2012) examined the pefomance of the Jiangsu SO2 emission tading maket unde diffeent allowance allocation methods and tansaction costs. The emainde of the pape is stuctued as follows. Section 3 and 4 descibe the methodological appoach and the data used fo the multi-egional CGE model in China with 4 kinds of initial quota allocation scenaios. Section 5 pesents empiical findings on the diffeent initial quota allocations and thei effect on egional economic in 30 povinces, and addesses the issues of altenative model specification and sensitivity analysis. Section 6 concludes. 3. Desciption of multi-egional CGE model Fo this study we build a multi-egional computable geneal equilibium (CGE) model, which includes 30 egions in China and 21 sectos in each egion. Though labo flow, capital flow, enegy flow and commodity tade, 30 egions fom a unified domestic maket. Thee ae 2 poduction factos: labo and capital, and 2 epesentative households by aea: uban and ual. The multi-egional CGE model is compised by poduction block, tade block, institution block,

4 flow block, emission block and system constaint block. The key featues of the model ae outlined below. 3.1 Poduction block In the poduction, we teat enegy as a special esouce athe than an intemediate input and combine it with value-added as KLE bundle. In this model, thee ae five types of enegy, namely coal, cude oil and natual gas, petoleum poducts, gas and electicity. Thus, fo each secto ( j 1,, I, i j ) in each egion ( 1,, R, s ), goss output ( QA ) ae poduced using inputs of labo ( L ), capital ( K ), enegy ( E ) and intemediate input ( INTA ): QA CES ( KLE ( L, K ; E ), INTA ) (1) We use constant-elasticity-of-substitution (CES) functions to chaacteize the poduction technologies and nesting stuctues fo poduction of all industies. All industies ae chaacteized by constant etuns to scale and ae taded in pefectly competitive makets. 3.2 Tade block The poducts ( QA ) of sectos in each egion not only supply to local maket ( QRD ), but also to othe egions in China ( QRRE ) and expot maket ( QE ). As the same, demands ( QQ ) of intemediate and final consumption commodities ae diffeentiated among local maket QRD ), othe egions domestically ( QRRM ) and impot ( QM ( ). Both of the total supply and demand of good j in egion is CES composite of domestic vaiety and foeign vaiety, and domestic vaiety is epesented by nested CES function. The supply function follows CET (constant-elasticity-of-tansfomation) function and demand function follows the Amington assumption as follows: QA CES ( QDS, QE ) (2) QDS CES ( QRRE, QRD ) (3) QQ CES ( QDC, QM ) (4) QDC CES ( QRRM, QRD ) (5) QDS is the supply of good j in egion to domestic maket and demand of good j in egion fom domestic maket. 3.3 Institution block and flow block QDC is the

5 In the institution block, thee ae 30 egional govenments and one cental govenment in the model, tax income is allocated to egional govenments and cental govenment accoding to cetain popotions. In the flow block, we depict the labo migation, capital flow and enegy flow among egions. We assume wage diffeence is the main cause of labo migation, and it decides the migation amount though a distotion coefficient. Afte the migation among the egions, fo each egion, we use a CES function to allocate the labo to sectos with an objection that minimize the labo cost in each egion. MigL f ( WLR, WLR, TL ) (6) s s WLR CES ( WLR,, WLR ) (7) 1 MigL s is the labo migation amount fom egion to s, of egion befoe migation, WLR is the wage level of egion, and TL is the labo endowment WLR is the wage level of industy j in egion. The handling of capital and enegy ae simila to labo. 3.4 Emission block We calculate the cabon emission by cabon intensity and the output value of each egion. Cabon intensity is an exogenous vaiable which is fom emission amount in benchmak yea. It is also an integated coefficient accoding to emission of 13 enegy types when we calculate the benchmak emission, fo diffeent scenaios we can change it. EMISS ems GDP (8) EMISS is the total cabon emission of egion, is the goss domestic poduct of egion. 4. Data and policy scenaios ems is the cabon intensity, GDP The data set of this model is based on the 2002 China inte-egional input-output table published in the book of Input-output model and economic link between Chinese povinces. Cabon emission data is based on data fom China Enegy Statistical Yeabook and Povincial Statistical Yeabook of 30 povinces. We design thee scenaios to compae the economic impact of diffeent appoaches to allocate initial quota in each egion. Fo these thee scenaios, the total quotas ae the same, 85% of the benchmak emission, i.e. total emission will be educed by 15%. Scenaio 1: quotas ae allocated feely by gandfatheing, that is, a egion eceives quotas based on histoic pefomance accoding to equity pinciple, we collect the histoic data fom yea 1987 to 2001 due to that Hainan has been an independent povince since 1987.

6 Scenaio 2: allocation of quotas is elative to cuent poduction, which means disguised subsidies and will encouage egions to impove poduction efficiency. Scenaio 3: quotas ae allocated accoding to the pe-given emission eduction taget in the 12th Five-Yea wok pogam of enegy consevation and emission eduction. Though compaing with othe thee scenaios, we can evaluate the feasibility of this policy. 5. Numeical esults China is chaacteized by significant egional heteogeneity in enegy use, labo and capital demand, cabon emissions, and cabon emission intensity as descibed above. So we anticipate that policy impacts will vay acoss povinces, and also expect diffeent esponses unde the fou scenaios modeled. Below we analyze the impact of diffeent initial quota allocations on cabon emissions, GDP pe capita and welfae outcomes at the povincial level. 5.1 Cabon emission Figue 1 shows the cabon emission in the baseline without eduction and unde the fou scenaios. It shows that in the baseline, the developed egions in coastal aea and egions which ae industial aggegations hae lage amount of cabon emission, such as Shandong, Jiangsu, Guangdong and Hebei. Cabon emission in Shandong is the lagest among all egions, about 9.9% of national cabon emission. In scenaio 1 and scenaio 2, GDP is the main standad to allocate the initial quota, so it can be obviously seen that developed egions get moe emission quotas and the cabon emission doesn t change much compaed with the baseline, such as Jiangsu, Guangdong, Zhejiang. In geneal, based on equity pinciple, the lage the histoical o cuent emissions, the geate the emission ights available, and theefoe developed egions will eceive moe cabon emission quotas in scenaio 1 and 2. Regions with high emission but not so high GDP get moe eduction in scenaio 1 and 2. Compaed with othe scenaios, quota allocation unde scenaio 3 seems moe aveage among all egions baseline scenaio1 scenaio2 scenaio Figue 1 Cabon emission (Mt) 5.2 GDP change

7 A compaison of the GDP in each egion unde the fou scenaios eveals some significant diffeences (see Figue 2). It can be seen that thee egions with high emission have the geatest GDP change unde scenaio 2 and scenaio 3 compaed with baseline and scenaio 1, which is Jiangsu, Guangdong and Shandong. It indicates that initial quota allocation consideing cuent output o composite allocation will inspie the economics of developed egions. Some of othe egions will have slight GDP decease unde the emission eduction, such as Beijing, Shanghai, Hunan baseline scenaio1 scenaio2 scenaio Figue 2 GDP in each egion (10 7 yuan) 5.3 welfae outcomes Figue 3 shows the welfae change of each egion unde the fou scenaios, elative to no cabon eduction scenaio. In this pape, welfae change is measued as the equivalent vaiation of household income elative to the no policy benchmak. Based on the simulation esult, we can find that Jiangsu, Shandong, Guangdong, Gansu and Xinjiang will bea a elatively obvious bunt of cabon emission eduction in welfae unde scenaio 1 and scenaio 2. It shows egions which is quite developed o economically backwad ae much easie to be attacked by emission eduction policy. Nevetheless, welfae outcome of almost all the egions unde scenaio 3 doesn t change much. That means the pe-given emission eduction taget in the 12th Five-Yea wok pogam of enegy consevation and emission eduction will not affect esidents welfae seiously.

8 6 5 4 baseline scenaio1 scenaio2 scenaio Figue 3 welfae outcomes (10 7 yuan) 6. Conclusions This pape has descibed a multi-egional CGE model of China and applied it to assess the impact of fou initial quota allocations, which follows ules of gandfatheing, auctioning, cuent poduction and the pe-given taget in the 12th Five-Yea wok of China. Accoding to the simulation esult, this pape can make following conclusions: 1. Unde the fou scenaios of allocation, developed egions eceive moe quotas and esouces-intensive but no so developed egions get stict eduction and fewe quotas in tems of equity pinciple (scenaio 1 and scenaio 2). Quotas ae moe aveage in quantity among egions unde scenaio 3, which is a composite allocation. 2. All the scenaios affect much moe on developed egions in coastal aea and backwad westen, especially gandfatheing scenaio and cuent output scenaio. 3. Compaing with othe scenaios, the pe-given taget in the 12th Five-Yea wok of China (scenaio 3) has the least affect on economic of egions and is quite pio to the othe thee allocation policies. Refeences Adam R, Bandt S. The Efficiency and Equity of Maketable Pemits fo CO2 Emissions. Resouce and Enegy Economics 1993; 15: Cason TN, Gandgadhaan L. Tansactions cost in tadable pemit makets: an expeimental study of pollution maket designs. Jounal of Regulation Economics 2003; 23(2): Chang YC, Wang NN. Envionmental egulations and emissions tading in China. Enegy Policy 2010; 38(7): Edwads TH, Hutton JP. Allocation of cabon pemits within a county: a geneal equilibium analysis of the

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