DISCUSSION PAPER. Environmental Protection for Sale. Strategic Green Industrial Policy and Climate Finance. C a r o l yn F i s c h e r

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1 DISCUSSION PAPER Aprl 206 RFF DP 6-3 Envronmental Protecton for Sale Strategc Green Industral Polcy and Clmate Fnance C a r o l yn F s c h e r 66 P St. NW Washngton, DC

2 Envronmental Protecton for Sale: Strategc Green Industral Polcy and Clmate Fnance Carolyn Fscher Abstract Industral polcy has long been crtczed as subject to protectonst nterests; accordngly, subsdes to domestc producers face dscplnes under World Trade Organzaton agreements, wthout exceptons for envronmental purposes. Now green ndustral polcy s ganng popularty as governments search for low-carbon solutons that also provde jobs at home. The strategc trade lterature has largely gnored the ssue of market falures related to green goods. I consder the market for a new envronmental good (such as low-carbon technology) whose downstream consumpton provdes external benefts (such as reduced emssons). Governments may have some preference for supportng domestc producton, such as by nterest-group lobbyng, ntroducng a poltcal dstorton n ther objectve functon. I examne the natonal ncentves and global ratonales for offerng producton (upstream) and deployment (downstream) subsdes n producer countres, allowng that some of the downstream market may le n nonregulatng thrd-party countres. Restrants on upstream subsdes erode global welfare when envronmental externaltes are large enough relatve to poltcal dstortons. Clmate fnance s an effectve alternatve f poltcal dstortons are large and governments do not undervalue carbon costs. Numercal smulatons of the case of renewable energy ndcate that a modest socal cost of carbon can mply benefts from allowng upstream subsdes. Key Words: green ndustral polcy, emssons leakage, externaltes, nternatonal trade, renewable energy, subsdes JEL Classfcaton Numbers: F3, F8, H2, Q5 206 Resources for the Future. All rghts reserved. No porton of ths paper may be reproduced wthout permsson of the author. Dscusson papers are research materals crculated by ther authors for purposes of nformaton and dscusson. They have not necessarly undergone formal peer revew.

3 Contents Introducton... Model Framework... 5 Optmal and Strategc Subsdes... 8 Strategc Upstream and Downstream Subsdes... 0 Strategc Subsdes wthout Envronmental Benefts... 0 Strategc Subsdes wth Envronmental Benefts... 2 Contrbutons to Clmate Fnance... 3 A Numercal Applcaton to Renewable Energy... 5 Scenaros... 7 Results... 7 Concluson References Appendx... 30

4 Fscher Envronmental Protecton for Sale: Strategc Green Industral Polcy and Clmate Fnance Carolyn Fscher Introducton Green ndustral polcy (GIP) s the use of government nterventons to support domestc ndustres that have envronmental benefts. GIP has emerged as a prmary polcy tool to develop clean energy alternatves that can help reduce relance on energy sources that emt greenhouse gases. Ratonales for GIP are manfold: the development of new technologes and ndustres can create jobs and economc opportuntes and combat clmate change at the same tme. Furthermore, such ndustres may need assstance to become compettve, both because they are nfant ndustres stll nnovatng, developng support networks and scale economes, and also because ther envronmental benefts are not properly prced by the market (Rodrk 204). Carbon doxde (CO 2 ) n partcular s an underprced externalty. As of 205, only 2% of global emssons were ncluded n a carbon prcng scheme (World Bank 205), and of those, the average prce was $8 per ton, well below common estmates of the socal cost of carbon (SCC), whch the US Envronmental Protecton Agency puts n the range of $40 per ton. At the same tme, fossl fuels enjoy substantal subsdes n most parts of the world (IEA 205). The general polcy preference for subsdes over emssons prces s evdent n renewable energy polces: nearly 00 countres and countless subnatonal jursdctons offer fnancal ncentves for renewable energy (IEA/IRENA 205), whereas fewer than 40 countres and roughly 20 subnatonal jursdctons all of whch also rely on renewable energy support are usng or plannng to mplement carbon prcng (World Bank 205). Resources for the Future, Gothenburg Unversty, FEEM, and CESfo Research Network. Malng address: RFF, 66 P Street NW, Washngton, DC Emal: fscher@rff.org. Fscher would lke to acknowledge the European Communty s Mare Skłodowska-Cure Internatonal Incomng Fellowshp, STRATECHPOL Strategc Clean Technology Polces for Clmate Change, fnanced under the EC Grant Agreement PIIF-GA , and the hosptalty of the Fondazone En Enrco Matte (FEEM). The numercal smulatons are made possble by pror work funded by US Envronmental Protecton Agency Grant # and the Swedsh Foundaton for Strategc Envronmental Research (MISTRA) INDIGO program. Own calculatons based on data from World Bank (205).

5 Fscher The polces range from downstream measures to support deployment to upstream ncentves for R&D and manufacturng. Downstream measures create markets for upstream ndustres to serve; upstream measures support domestc ndustres drectly. The dstncton s mportant, both from an economc and legal perspectve. Wth nternatonal trade, the polces have dfferent effects on global clean technology prces, and thus on the deployment opportuntes for export markets (Fscher, Greaker and Rosendahl, forthcomng). The World Trade Organzaton (WTO) agreements create restrctons on ndustral polces that dstort trade, partcularly subsdes. Although downstream subsdes can generally be desgned n a nondscrmnatory fashon, upstream polces by defnton offer preferental treatment to domestc producers. The WTO attests that ts rules do not mpede supportng the deployment and dffuson of green technologes (WTO 20), but multple dsputes have come to WTO panels over the solar PV, wnd power equpment, and bofuel sectors, partcularly regardng subsdes or local content requrements for deployment benefts (Charnovtz and Fscher 204, Cosbey and Mavrods 204). 2 Importantly, the Agreement on Subsdes and Countervalng Measures (Subsdes Code) lacks exceptons for envronmental reasons; thus, subsdy polcy may have less leeway than tarff-related measures, snce the General Agreement on Tarffs and Trade (GATT) does carve out specfc exceptons for transboundary externaltes lke human health or resource conservaton (Rubn 202). Economsts have long made a strong case aganst ndustral polcy, notng the potental for beggar-thy-neghbor protectonsm, opportuntes for rent seekng, and the dffculty n pckng wnners (Rodrk 204). Should exceptons be made n the Subsdes Code for addressng global envronmental challenges? Or can alternatve polces lke encouragng technologyproducng countres to extend clmate fnance to develop markets for deployment n developng countres substtute for upstream measures? Ths paper extends the work on strategc subsdes by Fscher (206) to look specfcally at the queston of poltcally motvated green ndustral polcy and clmate fnance as an 2 Examples: European Unon Certan Measures on the Importaton and Marketng of Bodesel and Measures Supportng the Bodesel Industry (Complanant: Argentna, 203); Inda Certan Measures Relatng to Solar Cells and Solar Modules (Complanant: Unted States, 203); European Unon and Certan Member States Certan Measures Affectng the Renewable Energy Generaton Sector (Complanant: Chna, 202); Canada Measures Relatng to the Feed-n Tarff Program (Complanant: European Unon, 20); Canada Certan Measures Affectng the Renewable Energy Generaton Sector (Complanant: Japan, 200); Chna Measures Concernng Wnd Power Equpment (Complanant: Unted States, 200). 2

6 Fscher alternatve. Ths ntersecton s hghly novel. Export and producton subsdes have been studed n the strategc trade lterature, largely buldng on early work by Spencer and Brander (983) and Brander and Spencer (985), who demonstrate that countres wth mperfectly compettve ndustres that export to a thrd market can rase ther jont profts f they commt to lmtng producton by agreeng to avod subsdes. These studes tend to focus on the strategc nterest of the producer countres, gnorng questons of global welfare or correctng market falures. Fscher (206) ponts out that from a global welfare perspectve, strategc countres tend to underprovde producton subsdes that can correct upstream market falures (lke mperfect competton or network externaltes) and downstream externaltes. 3 In an applcaton to renewable energy, she fnds that the global emssons externaltes are far more consequental than market power by technology frms. Ths framework thus does not make a case that restrctng the use of upstream subsdes enhances global welfare. By contrast, the protecton for sale theory ntated by Grossman and Helpman (994, 995) explans excess protectonsm wth a model of ndustry group lobbyng that dstorts the government s objectve functon away from pure welfare. Ths poltcal dstorton does set the stage for multlateral agreements lmtng subsdes to mprove global welfare. However, ths lterature has tradtonally gnored transboundary envronmental spllovers. 4 Renewable energy s an nterestng applcaton because of ts central role n green ndustral polcy, ts potental to generate spllover benefts, the multple polcy levers brought to bear, and the multple objectves expressed (Fscher and Preonas 200). The European Parlament, n adoptng the 20/20/20 Drectve, justfed the renewable energy targets as promotng the securty of energy supply, promotng technologcal development and nnovaton and provdng opportuntes for employment and regonal development, especally n rural and solated areas, [ncreasng] export prospects, socal coheson and employment opportuntes 3 Fscher, Greaker and Rosendahl (204, 206) consder strategc subsdy polces wth envronmental consequences n somewhat dfferent frameworks among Cournot duopoles (wth no thrd market). Other well-known studes n the envronmental economcs lterature have consdered strategc polcy responses to trade and market structure (e.g., Barrett 994, Conrad 993), and a recent study by but they have gnored the mportant dstncton between upstream provders of abatement technologes and downstream sectors deployng them (Greaker and Rosendahl 2008). 4 An excepton s Margols et al (2005), who look at nvasve speces ssues. 3

7 Fscher [for small] ndependent energy producers (EU 2009, 6). 5 In 202, the value of EU nterventons for renewable energy exceeded the value of all the emssons tradng allowances allocated for the year. 6 Renewable energy s also contentous n trade: n addton to the abovementoned dsputes, both the Unted States and the European Unon have ntated antdumpng measures aganst Chnese solar panels n recent years. Meanwhle, clmate fnance plays a growng part n nternatonal archtectures: the Pars Agreement ncluded commtments to delverng clmate fnance to developng countres of at least $00 bllon per year by 2025, wth a large porton devoted to low-carbon energy. 7 The next secton descrbes the model framework. Theoretcal results solate the envronmental and poltcal market falures. Then the model s parameterzed to represent global producton and deployment of renewable energy technologes and explore optmal polcy strateges. Both sectons reveal mportant trade-offs between allowng and restrctng the use of upstream subsdes. For green goods, allowng upstream subsdes may be useful, especally f poltcal dstortons are large relatve to the envronmental benefts. For brown goods, restrctons on upstream subsdes are ether useful, f poltcal dstortons are large, or neffectual, as strategc countres may not want to use them otherwse. These restrctons can be costly, however, when external envronmental benefts are mportant, and clmate fnance may only be a successful alternatve f clean technology exportng countres have strong specal nterests lobbyng ther governments to support foregn markets. 5 As further evdence of the broad lnk between GIP and employment objectves, durng the Great Recesson, the European Unon devoted 59% of ts stmulus to green projects, whle ndvdual member states and the Unted States each allocated on average about % of ther stmulus packages, and Chna spent 38% on green projects; globally, 9% of green stmulus was spent on renewable energy specfcally (Robns et al 2009). 6 Alberc et al (204) fnd that n 202, the total value of publc nterventons n energy (excludng transport) n the EU-28 s bllon, wth bllon for renewable energy (p. -). For 202, the annual allocaton of allowances was 270 mllon; at an average annual prce of roughly 7, the value of the annual cap was just over bllon. Sources: and (Also cted n Fscher 206). 7 Clmate fnance s dstnct from the technology transfer envsoned n the Kyoto Protocol. Glachant, Ing and Ncola (206) explore strategc ncentves to transfer less pollutng technologes to trade partners when the downstream ndustres adoptng them compete (albet mperfectly) through nternatonal trade. 4

8 Fscher Model Framework The model focuses on the market for a green manufactured good, such as a wnd turbne or solar panel. There are three regons, all of whch are consumers of the good, n the sense of deployng the technology n ther downstream electrcty sectors. Two of the regons are also home to producers of the good. Markets are decentralzed, and the products are assumed to be dentcal. Ths statc, partal equlbrum model s kept smple to capture the essental features of the trade and envronmental problem. 8 Governments n each producng regon {,2} may offer to subsdze downstream deployment by and/or to subsdze the producton of the upstream technology frms by. The thrd regon s government makes no nterventons (for example, a developng country wthout clmate polcy oblgatons), leavng 3 0 that s, unless the producer countres agree to subsdze deployment there by f (such as through contrbutons to clmate fnance or clean energy foregn ad), n whch case 3 f f2. Ths latter polcy opton wll be consdered as an alternatve when upstream polces are dsallowed. Note that contrbutons dffer from export subsdes, snce they apply to all consumpton n the thrd market, not just the exports of the country offerng the support. The demand sde of the model follows Fscher (206), as repeated here. Let us assume the followng lnear demand functons for the technology n each country, where m s a measure of downstream market share of regon (and m ). 9 a( P ) x m b X x Total demand s x2 x3, whch gves us an nverse demand functon facng the upstream producers of P ABX, where the slope equals the dentcal ndvdual slopes B b, and the ntercept equals the weghted average ntercept Aa, where m. 8 Snce a green good represents a relatvely small sector n the economy, we declne to model general equlbrum effects. Brander and Spencer (985) show that wth an addtve utlty functon ncludng a perfectly compettve numerare good, the results carry through n a general equlbrum model wth terms of trade. We also avod dynamc effects; polces that stmulate upstream nnovaton, lke R&D subsdes, generally have the same costreducng effect as upstream subsdes, over the longer term. We dscuss some mportant caveats related to unmodeled scale economes and learnng spllovers n the concluson. 9 One could vary other demand parameters by country, as we do n the numercal smulatons, but the strategc ssues related to heterogeneous downstream demand are captured suffcently by the parameter m. 5

9 Fscher Consumer surplus s the area under each lnear demand curve above the consumer prce: CS m a ( P ) 2 2b The upstream market s characterzed by prce-takng frms wth an upward-slopng aggregate supply curve n each producer country. Ths framework dffers from the Cournot competton assumed n Fscher (206) and the earler strategc trade lterature; t allows us to focus on the market falures related to the downstream external benefts and the poltcal economy, rather than mperfect competton. 0 Snce we want to thnk about an nternatonal trade context wth multple producer regons and allow for asymmetrc polces and thereby asymmetrc costs, a market structure that gves postve producer surplus s requred. Wth perfect competton and prce-takng frms, one cannot use constant margnal costs, as n Fscher (206), because profts would be zero and the least-cost producer would serve the entre market. Thus, let us assume upward-slopng margnal costs of domestc producton, such as can arse from producton lnes of heterogeneous producers wth lmted capactes (as n Laffont and Trole 996). Consder a representatve, prce-takng frm n each country; margnal costs are lnear wth ntercept c and slope 2h. Domestc ndustry profts (for d {,2}, f {2,} ) are P ( c hy ) y d d d d From the frst-order condtons for each frm / y P ( c 2 hy ) 0; wth P A B( y y ), we have n equlbrum d f y d d d d d B ( d f) ( A c d ) h 2 Ac ; Y 2( B h) B h where ( 2) / 2 s the smple average upstream subsdy. The equlbrum prce s 0 Fscher (206) explores the nteractons wth mperfect competton and fnds the welfare costs from that market falure to be small relatve to the costs of the downstream externalty. An alternatve structure would be heterogeneous frms wth mperfect substtutablty (as n Meltz 2003). However, representatve supply curves are n better keepng wth our numercal parameterzaton, whch reles on lnear demand functons and the assumpton of dentcal products. The mportant aspect s smply that we have postve producer surplus, whch makes strategc countres want to engage n ndustral polcy, n order to nfluence the terms of trade. 6

10 Fscher B h P c A B h B h b h c ( a) b h b h (Note that an equlbrum wth both countres producng requres that one does not fll all global demand by drvng the prce below the margnal cost at zero producton n the other country: h( A c ) / B. Snce we wll look at symmetrc equlbra, ths always holds, but n f d d general t requres a postve h.) Governments place a value on domestc upstream profts, ; domestc downstream surplus, CS ; net revenues, TR ; and global downstream externaltes, E G. However, they may undervalue the external benefts relatve to a global planner ( v v ). Furthermore, governments may have heghtened concerns about the clean technology ndustry s success because of the assocated jobs, wages, and exports. Let us model ths concern by addng weght n the domestc objectve functon to total domestc producton of the technology. Though we wll not model the underlyng nfluences explctly, preferences for establshng and mantanng global market share may arse from a model of lobbyng by ndustry nterest groups, as was well establshed by Grossman and Helpman (994). We use upstream output, rather than profts, as the metrc of nterest for the governng poltcans 2 ; ths choce does not change the results qualtatvely but does render them more transparent. Total revenues are the cost of the upstream and downstream subsdy payments for a producer country: TR Y x. The external benefts are proportonal to consumpton of the product, and we allow dfferent countres to have dfferent global benefts from the envronmental good: EG x 2x2 3x3. For example, renewable energy use can dsplace emssons from fossl energy by factor n country. The objectve functon for the government of producer regon s W CS TR v EG y From the perspectve of a global socal planner, however, welfare s W TR TR CS CS CS v E G G G G 2 For example, labor nterest groups and assocated ndustres n the supply chan may be more nterested n the scale than n the proftablty of producton. 7

11 Fscher Optmal and Strategc Subsdes The strategc subsdy choce s modeled as a two-stage game. In the frst stage of the game, a regon chooses whether and how much to subsdze downstream and upstream. We may thnk of ths cost subsdy as the net effect of a range of polces, such as drect subsdes, tax breaks, and low-cost land or fnancng. In the second stage of the game, nternatonal supply and demand fnd equlbrum. We compare the optmal subsdy strategy of a global planner wth the Nash equlbrum among the regonal governments. In essence, although the frms are prce takers, ther governments have market power, and they compete lke a duopoly. Each actor maxmzes ts welfare functon wth respect to the polcy levers t controls, recognzng the market equlbrum response to subsdes, and takng as gven the polcy choces n the other regon. Specfcally, the global planner would maxmze global welfare wth respect to choosng upstream and downstream subsdes n each producng regon; that s, W / 0, W / 0, W / 0, W / 0. We wll consder the case of G G G 2 G 2 symmetrc producer regons and thus restrct the optmal upstream subsdes to be symmetrc, to allow better comparson wth the noncooperatve equlbrum. We also consder the case n whch upstream subsdes are restrcted to zero, but contrbutons to deployment n the thrd market can be made: 0, 0, W / 0, W /, W / f 0, W / f. 2 G G 2 G G 2 In the Nash game, each producng country maxmzes ts own welfare, takng as gven the subsdy choces of the other actor and knowng the subsequent effects on the nternatonal market equlbrum. In equlbrum, W / 0, W / 0, W / 0, W / 0 all must hold. In the case where upstream subsdes are restrcted, we consder 0, W / 0, W / f 0, 0, W / 0, W / f The subsdes have drect and ndrect effects on welfare through changes n output and consumpton. Note that from the decentralzed problem, / y 0 and CS / x 0, holdng prces fxed, and all prce changes amount to global transfers on the margn ( W / P / P CS / P y x 0). Consder the planner s problem wth G respect to regon. Dfferentatng global welfare n ts general form wth respect to the upstream subsdy, we see 8

12 Fscher dw TR TR dx TR dy TR dx TR dy E dx v d x d y d x d y d x d G G G 2 2 dx dx dy dy dx y y v G d d d d d dx dy ( v ) 0 G d d Smlarly, wth respect to the downstream subsdy, dw CS TR TR dx TR dy TR dx TR dy E dx v d x d y d x d y d x d G G G dx dy dx dy dx x x v 2 2 G d d d d d dx dy ( vg ) 0 d d Thus, the planner wants a combnaton of subsdes to nternalze the envronmental externalty, such that the last bracketed term equals zero. Note that snce the planner s ndfferent to the locaton of revenue transfers, a choce of contrbutons for deployment n the thrd regon wll look lke dwg / d 3. From the ndvdual regon s perspectve, the subsdy choces are somewhat dfferent: dw dp CS dp TR dx TR dy E dx dy y y v d P d P d x d y d x d d G dp dx dx dy ( y x ) v ( ) 0 d d d d dw dp CS dp TR dx TR dy E dx dy x x v d P d P d x d y d x d d G dp dx dx dy ( y x ) v ( ) 0 d d d d dw dp CS dp TR dx TR dy E dx dy x v dg P df P df x df y df x df df G 3 P dx dx dx dy ( y x ) x v g f df df df df In each case, the frst term reflects ncentves to nfluence the terms of trade, to the extent the regon s a net exporter. These terms dffer across the polces, snce dp / d 0 whle dp / d 0 and dp / df 0. The remanng terms reflect the regon s value of the addtonal 9

13 Fscher envronmental benefts relatve to the addtonal revenue costs as quanttes adjust, as well as any perceved beneft from expandng producton. Notably, n the case of the contrbutons, the lost revenue to the government from the transfer abroad mposes a drect negatve term; thus, for contrbutons to be postve, there must be suffcent benefts n terms of trade, envronmental mprovement, and/or havng a larger market. Strategc Upstream and Downstream Subsdes To begn, let us gnore the opton of contrbutons to foregn deployment and consder optmal strateges targetng only domestc producton and deployment. All results are derved n the Appendx usng our lnear functonal forms, whch provde straghtforward relatonshps for the equlbrum prce and quantty responses embedded n the prevous equatons. For the most part, we consder equlbra wth symmetrc producer countres to focus on the role of the thrd market and the dfferent market dstortons. Strategc Subsdes wthout Envronmental Benefts Frst, we consder the strategc ncentves n the absence of envronmental spllovers. These benchmark subsdes can then be compared wth subsdes n the presence of global envronmental externaltes. Proposton (a): If vg 0, then the optmal polcy s to have no subsdes * * ( 0). In the absence of any market falures, no nterventon s necessary. (Ths obvous result s stated formally only for symmetry wth the subsequent results.) Proposton (b): If vg 0, and 0, then the Nash equlbrum has producer countres taxng upstream and subsdzng downstream by an equvalent amount, to the extent that they are net Nash Nash exporters to the thrd market:, {,2}, v 0, 0, v 0, 0. Wthout a downstream externalty and wthout any dstorton to the domestc welfare functon, governments stll have an ncentve to ntervene n the market for green goods. Both taxng upstream and subsdzng downstream serve to drve up global technology prces and capture rents from the thrd regon. Furthermore, snce margnal producton costs are ncreasng wthn a country, there may be some ncentve to shft the cost of producton to the other 0

14 Fscher producng regon. 3 For these reasons, the tax/subsdy shft s ncreasng wth the thrd-party market share and, up to a pont, wth the slope of the supply curves. Proposton (c): If vg 0, and 0, then n the Nash equlbrum, symmetrc producer countres subsdze downstream and may tax or subsdze upstream; the sum of the upstream and downstream subsdes equals the extra weght on producton n the objectve functon. Nash Nash v0 v0 The desre to subsdze upstream producers comes from carng more about upstream producers than about downstream consumers. Thus, governments are wllng to let global prces be drven down to some extent because the upstream subsdy drectly benefts the producng Nash frms at home. For the net effect to be postve, the upstream subsdy requres v, 0, 0. Corrollary: In a symmetrc-country duopoly wth no thrd market, strategc downstream subsdes are zero, and strategc upstream subsdes are. If nether country s a net exporter, there s no ncentve to nfluence the terms of trade, only an ncentve to make transfers to the upstream producers. Note that f 0, the symmetrc duopoly replcates the socal optmum wth no subsdes. However, f the downstream demand functons dffer, the duopoly equlbrum wll devate from the socal optmum. For example, f one country has a larger downstream consumpton market share ( m m ), all else equal, t wll tax downstream and set an equal d f subsdy upstream, whle the exportng country wll do the opposte but at dfferent levels. The net effect of the taxes/subsdes s to reduce total output. It s worth notng that n ths framework, upstream subsdes are negatve unless there s a sgnfcant dstorton n the regonal government s objectve functon. Ths result dffers from that wth mperfectly compettve frms wth Cournot competton upstream, as case n whch strategc upstream subsdes are postve (Fscher 206). However, the common pont among the frameworks s that regons tend to provde upstream subsdes that are lower than optmal (because of the lack of concern for the thrd-party regon), and a dstorton lke overweghtng 3 Ths result stands n contrast to that wth Cournot-competng producers wth constant margnal costs, where a postve upstream subsdy s strategcally optmal (Fscher 206). In that case, the upstream subsdy helps expand market share and profts, wthout rasng producton costs. Here, capturng more market share ncurs a deadweght loss from hgher total producton costs.

15 Fscher producton n the government s objectve functon s requred for a prohbton of postve upstream subsdes to be welfare enhancng from a global perspectve. Strategc Subsdes wth Envronmental Benefts Now suppose that the consumpton of the product downstream has an external beneft of v per unt, as n the case of an envronmental good. At the socal optmum, we want the prce to G equal the margnal socal cost n each downstream country: P c hy v. Snce the * D, G externalty s downstream, ths would suggest mplementng the subsdes downstream * ( v, ). However, f a thrd-party country does not have these polcy levers at ts G dsposal, the optmum cannot be acheved wth downstream subsdes alone. If the margnal benefts of the good are equal across all countres (, ), then upstream subsdes of v alone suffce to acheve the optmum. But when margnal benefts dffer, a * * 2 G combnaton of upstream and downstream subsdes s needed to maxmze welfare. We fnd the followng results wth strategc subsdes: Proposton 2: The globally optmal polcy s to subsdze upstream at the rate of the thrdcountry margnal beneft, and to subsdze consumpton n the producer countres accordng to the dfference n the margnal beneft from that of the thrd country: * * * * v ; v ( ), {,2}. 2 G 3 G 3 Wth an external envronmental beneft from downstream consumpton, the planner wants the total subsdy n each country to equal the socal margnal beneft; that s, * * v,. If subsdes cannot be mplemented n the thrd-party country, the optmal G strategy s to use the unform upstream subsdy to reflect the thrd country s external beneft, whle downstream subsdes (or taxes) are used n the producer countres to adjust net subsdy. Proposton 3: In the Nash equlbrum, the sum of the subsdes equals the margnal beneft as valued by that country, plus the government s weght on producton: Nash Nash v, {,2}. The ndvdual subsdes combne the cost-shftng components defned n the subsecton above wth an external beneft component that s postve and ncreasng n proporton to v. Snce the upstream and downstream cost-shftng components offset each other, t s the sum of the external beneft components that equals the valued margnal beneft. In other words, for {,2}, Nash ( v) Nash (0) up ( v); Nash ( ) Nash (0) down up down v ( v); and v. 2

16 Fscher Corollary: Wthout a thrd country, n a symmetrc Nash equlbrum, the noncooperatve subsdes replcate the socal optmum f each country values envronmental changes at the global margnal beneft and 0. Ths follows from Proposton 3; under these condtons, nether county s a net exporter and does not want to dstort the terms of trade. Thus, f v vg, then Nash Nash * * v. To nternalze the externalty, the countres combne upstream and G downstream subsdes n such a way that the total subsdes equal those desred by the planner for each regon, assumng they adopt the global valuaton of the externalty. In ths case, the planner s ndfferent as to where to target the subsdes because only the sum matters. Proposton 4: Wth a thrd country, a symmetrc Nash equlbrum provdes lower envronmental gans than s optmal to the extent that m3 0 and 3 0, even f v vg, unless s suffcently large. Although strategc countres may care about the global costs of foregn emssons, the ncentve to mantan hgher export prces remans (through hgher downstream subsdes and lower upstream subsdes than the planner would prefer), resultng n global underprovson of the green good. Ths underprovson s further exacerbated to the extent that global gans are undervalued locally. The excepton s f the preference for domestc producton s suffcently strong that t drves upstream subsdes hgh enough to nduce more global reductons. In ths sense, the poltcal economy dstorton can be a frend to the envronment. Contrbutons to Clmate Fnance If upstream polces are prohbted, an alternatve mechansm s to encourage the producer regons to contrbute to fnancng deployment n the rest of the world (ROW). In a sense, contrbutons subsdze exports; however, they also subsdze the exports of the compettor, so another type of free-rdng problem exsts. We derve the followng results: Proposton 5: The socal planner s ndfferent between subsdzng deployment n ROW and subsdzng upstream manufacturng. The socal planner merely seeks to ensure that the net subsdy n each regon equals the margnal external beneft. If the planner cannot set that subsdy drectly n the thrd regon, t can do t ether through the upstream subsdy or through clmate fnance. 3

17 Fscher Proposton 6: In the Nash equlbrum, wth no envronmental externalty and no polcy restrctons, strategc countres would subsdze upstream but tax downstream f they could also tax ROW deployment. Taxng ROW deployment s essentally a way of rasng revenues and returnng rents from the thrd regon. The domestc downstream tax s perfectly offset by the upstream subsdy. To the extent that governments overweght producer surplus, the upstream subsdy wll be even hgher. Obvously, such a polcy (taxng foregn consumpton) s not feasble, but t llustrates the strategc ncentves. The followng set of propostons reveals that producng countres do not have an nherent nterest n subsdzng foregn deployment, just as they wll not provde postve upstream subsdes, unless the poltcal dstorton or external beneft s suffcently large. Furthermore, when that s the case, they stll prefer to subsdze at home rather than abroad, to keep more rents at home. Proposton 7(a): If upstream nterventons are not allowed and there are no poltcal or envronmental dstortons, strategc countres n the Nash equlbrum would tax downstream consumpton at home to the extent that the ROW has market share, and they would also lke to tax ROW consumpton. Proposton (b) found that n the absence of other market falures, strategc countres would lke to tax upstream producton to the extent that the ROW has market share. Thus, when that upstream polcy lever s removed, the countres would lke to tax all downstream consumpton, although n ths case they are restrcted to home and ROW. Wth that desre, and the addtonal ncentve of shftng more rents from ROW through the tax drectly, the strategcally optmal domestc downstream subsdy s negatve. Proposton 7(b): If upstream nterventons are not allowed, symmetrc strategc countres wll subsdze both downstream consumpton at home and n ROW only f the overweghtng of producton or ther value of the external beneft s suffcently large. Both concern about domestc producton and concern about the global envronment lead the producng country to want to expand the global market for ts upstream producers. However, these concerns must be suffcently large to overcome the ncentves from Proposton 7(a) to tax downstream deployment. The Appendx demonstrates ths result for the case n whch the margnal external benefts of deployment are equal across countres; from that pont, ncreasng alone would ncrease foregn contrbutons and decrease domestc deployment subsdes, n 3 order to shft more deployment where t s more valuable. 4

18 Fscher Proposton 7(c): Domestc downstream subsdes are strctly larger than foregn contrbutons f the margnal external benefts are equal. Strategc countres would prefer to subsdze at home more than abroad, for the same envronmental effects. However, f the external benefts n ROW are suffcently large, more support wll be allocated to foregn contrbutons. To summarze the theoretcal results, we have found that for goods wthout envronmental benefts, restrctons on upstream subsdes are ether useful (f 0 ) or N neffectual (f 0). For green goods, allowng upstream subsdes may be useful, especally f 0. Clmate fnance, on the other hand, wll only be a good substtute measure f 0 and producng countres do not undervalue the global external benefts. A Numercal Applcaton to Renewable Energy The theoretcal analyss draws ntuton for stuatons n whch strategc trade partners may underprovde producton subsdes n the presence of market falures. In ths secton, we explore these results quanttatvely n a parameterzed applcaton to the renewable energy technology sector. The downstream sde of the numercal model s dentcal to that of Fscher (206). It represents the producer-consumer regons of Europe, the Unted States, and Chna, as well as and consumpton n the rest of the world. Each regon has a downstream market for electrcty generaton that s closed to nternatonal trade (ths framework could be appled equally to renewable fuels n transportaton). The downstream markets consst of representatve frms located and owned n the correspondng regons, and competton s perfect. 4 Electrcty generaton wth conventonal fossl-fueled technologes (coal, ol, and gas-fred generaton) leads to emssons of CO 2, a global pollutant. Renewable energy technologes, such as solar panels and wnd turbnes, produce electrcty wthout emssons. Hydropower and nuclear capacty are avalable but are assumed not to beneft from the subsdy polces (although they may beneft ndrectly from CO 2 taxes f mplemented). All technology demand functons are lnear and based on smplfed statc versons of the calbrated electrcty sector models n Fscher, Newell, and Preonas (203) for the Unted States 4 The prmary assumpton s that the fossl supply curve s upward slopng and cost ncreases are fully passed through. Ths assumpton s less realstc for Chna, where prces are regulated and adjusted nfrequently. 5

19 Fscher and n Hübler, Schenker, and Fscher (205) for the European Unon. 5 The data represent annual electrcty producton n a near-term horzon of Nonhydro renewables (wnd, bomass, solar, etc.) are aggregated, wth wnd beng the domnant source. These renewables represent 7% of EU electrcty demand and 7% of US demand n the baselne. Incremental renewables also dsplace fossl energy to dfferent extents; the margnal emssons rates from dsplacng nonrenewable sources are twce as hgh n the Unted States as n the European Unon. For Chna and ROW, the model uses as the baselne supply mx the projectons for 2020 n the 203 Internatonal Energy Outlook (EIA 203). The slopes of the supply curves are calbrated to match the same supply elastctes as n the Unted States, n the absence of data to calbrate them drectly, and Chna and ROW have levels of fossl fuel relance more lke US than EU levels. We note that by 2020, the US and EU electrcty markets are projected to be smlar n sze to each other, whle the Chnese power sector wll be nearly twce as large, and ROW almost four tmes as large, makng t also the bggest market for renewable energy. The model ncorporates the downstream subsdes n the nonhydro renewable energy demand functons, ncludng,,, and f f f. 6 The result s a seres of EU US CN ROW EU US CN lnear downstream demands for renewable energy technology, as a functon of the after-subsdy prces. The upstream market follows that of the analytcal secton, whch dffers from Fscher (206). Snce wnd s the domnant technology, the allocaton of the upstream renewable technology supply s stylzed on the global wnd turbne manufacturng sector. Nne of the top ten producers are from the Unted States and Chna (one s from Inda), and they provde 70% of global producton (REN2 203). Of these ten producers, Europe has roughly twce the market share of the Unted States and Chna. Thus, the model allocates half of baselne global renewable energy supply to the European Unon and one quarter each to the Unted States and Chna. The baselne technology prce (measured n $/kwh generated) s assumed to equal the lowest of the electrcty prces among the downstream markets, such that renewable energy s compettve n the baselne. The supply curves are assumed to begn at the orgn and run through the baselne supply quantty at the baselne technology prce. 5 These models were desgned for lookng at endogenous techncal change across two stages; to create a statc model, we use the frst stage only. 6 The model can allow carbon prces that vary across regons, but these scenaros are not explored n ths paper. 6

20 Fscher Scenaros The scenaros explore three man polcy combnatons:. upstream and downstream subsdes are both avalable; 2. upstream nterventons are restrcted and only downstream subsdes are avalable; and 3. downstream subsdes are combned wth contrbutons to clmate fnance for deployment n ROW. The optmal and Nash subsdes are solved for a range of values of the SCC. Snce Chna does not fnd t n ts nterest to make clmate fnance contrbutons unless t uses a carbon value n excess of $00/ton CO 2, we assume contrbutons are made by the Unted States and the European Unon alone, also more n keepng wth oblgatons under the Pars Agreement. Each case s valued assumng ether no poltcal dstorton or assumng = $0.0/kWh, whch s a smlar scale to addng the total value of sales to the government s objectve functon. Results To focus on the role of upstream subsdes, let us frst compare the optmal subsdes to the Nash subsdes wthout and wth the overweghtng of producton. Then, the effects of restrctons on upstream subsdes and the effectveness of contrbutons to ROW deployment as an alternatve wll be analyzed. In the next cases, the results assume that regons value CO 2 at the global SCC. Ths assumpton avods the ssue of undervaluaton and keeps the focus on the dstorton from overweghtng. Fgure depcts the optmal upstream subsdes (denoted *) and the Nash subsdes, both wthout any poltcal dstorton (no addtonal notaton) and wth the overweghtng of producton (denoted +), as a functon of the SCC, when the three producer countres are free to choose both and. Note that the European Unon, the largest net exporter, pcks the lowest subsdy, followed by the Unted States and Chna. The optmal subsdes are unformly hgher than the Nash subsdes n the absence of overweghtng (as predcted by the theory). Wth the degree of overweghtng chosen, the Nash subsdes are hgher than the optmal subsdes untl the SCC gets very large ($200/ton CO 2 ). 7

21 $/kwh Resources for the Future Fscher Fgure. Optmal and Strategc Upstream Subsdes as Functon of SCC SCC EU US Chna EU+ US+ Chna+ Optmal Thus, overweghtng can be a frend to the envronment, but t can n a sense be too frendly: at lower values of the SCC, the optmal subsdy s closer to zero than the Nash subsdes. Thus, we see that absent a global externalty, the WTO has a strong case to place restrctons on upstream subsdes. To what extent, then, are contrbutons a useful alternatve to addressng an externalty when upstream subsdes are restrcted? Frst, consder the ncentves to provde them. Fgure 2 plots the Nash contrbutons when they are completely unconstraned. We see that wth the excepton of the European Unon when t overweghts producton the producer countres would lke to tax foregn deployment unless the SCC s qute hgh. (Ths behavor allows them to transfer rents from export markets, rasng revenues and offerng larger subsdes at home.) Chna n partcular, as the smallest net exporter, does not want to contrbute to clmate fnance unless the SCC s well over $00. For ths reason, n subsequent scenaros, we restrct Chna s contrbutons to zero. 8

22 $/kwh Resources for the Future Fscher Fgure 2. Strategc Contrbutons to ROW Deployment g EU US CN EU+ US+ CN SCC We can understand these results by explorng the net subsdes n the varous equlbra. Fgure 3 shows the total effectve subsdes ( ) for the European Unon and ROW n the standard, overweghtng, and optmal cases, as a functon of the SCC, when upstream subsdes can be freely chosen and no drect contrbutons are made to foregn deployment. At these SCC levels, optmal total subsdes for the relatvely clean European Unon are smaller than the Nash combnatons, especally wth overweghtng of producton, whle optmal total subsdes for ROW are hgher than n the standard Nash equlbrum but lower than wth overweghtng of producton. 9

23 $/kwh Resources for the Future Fscher Fgure3. Total Effectve Subsdes when Upstream Subsdes Are Unconstraned avg SCC Fgure 4 shows the total subsdes when only downstream subsdes and clmate fnance are allowed (, n ths case). Wth these restrctons, the Nash subsdes for the producer regons are below the optmal subsdes, even wth overweghtng, because of the loss of the upstream subsdy. Wth overweghtng, however, contrbutons can lead to hgher-than-optmal subsdes n ROW. EU ROW EU+ ROW+ EU* ROW* 20

24 $/kwh Resources for the Future Fscher Fgure 4. Total Effectve Subsdes wth Downstream Subsdes and Contrbutons to ROW Deployment SCC EU ROW EU+ ROW+ EU* ROW* What are the welfare consequences of restrctons on upstream subsdes or the use of contrbutons? Fgures 3, 4, and 5 compare the welfare change from no polcy of the Nash equlbra, as a share of the welfare mprovement from optmal subsdes, for an SCC of $30, $00, and $200, respectvely. In Fgure 3, wth an SCC of $30, we observe a large welfare loss from regons freely choosng subsdes when they overweght producton. In that case, dsallowng upstream subsdes elmnates the loss and leads to a small welfare gan. On the other hand, n the absence of the poltcal dstorton, the restrcton on subsdy polcy leads to a loss of nearly half the gans from the unrestrcted Nash polcy response. Contrbutons n ths fgure are made by the European Unon only when t overweghts producton, resultng n a small mprovement over downstream subsdes alone. 2

25 Fscher Fgure 5. Welfare Change (as Share of Change wth Optmal Subsdes) by Polcy Tools and Poltcal Dstortons; SCC = $30 Standard welfare Weght upstream Nash wth upstream subsdes Nash wth only downstream subsdes Nash wth contrbutons to ROW Wth an SCC of $00 (Fgure 6), restrctons are stll benefcal wth our poltcal dstorton and costly f not. In ths range, the Unted States and the European Unon both provde postve clmate fnance n both the standard and poltcal dstorton cases. Those contrbutons to foregn deployment mprove global welfare by more than a thrd when governments do not overweght producton, and nearly double t when they do. Recall from Fgure that n ths stuaton, upstream subsdes are too hgh wth poltcal dstortons and too low wthout; Fgure 3 showed that foregn contrbutons are stll too low wth an SCC of $00, but the welfare gans are larger wth foregn contrbutons than wth upstream subsdes when the poltcal dstorton s present. Absent that dstorton, however, welfare s hgher allowng for upstream subsdes. 22

26 Fscher Fgure 6. Welfare Change (as Share of Change wth Optmal Subsdes) by Polcy Tools and Poltcal Dstortons; SCC = $ Standard welfare Weght upstream 0 Nash wth upstream subsdes Nash wth only downstream subsdes Nash wth contrbutons to ROW Wth an SCC of $200 (Fgure 7), restrctng the use of upstream subsdes dmnshes welfare whether or not governments overweght producton. However, contrbutons to clmate fnance more than offset the loss when governments overweght, but less so when they do not. In ths case of very hgh global external benefts whch the governments value fully clmate fnance and upstream subsdes lead to more smlar outcomes for global welfare. 23

27 Fscher Fgure 7. Welfare Change (as Share of Change wth Optmal Subsdes) by Polcy Tools and Poltcal Dstortons; SCC = $ Standard welfare Weght upstream 0 Nash wth upstream subsdes Nash wth only downstream subsdes Nash wth contrbutons to ROW All of the precedng scenaros assume that governments value global emssons at the global SCC; suppose they undervalue the global benefts of the green technologes? Fgure 8 consders ths case when the SCC s $00 but countres value the benefts at $30. Wth undervaluaton, Nash strateges usng upstream subsdes acheve most of the potental welfare gans from subsdes, whether or not there s a poltcal dstorton. Restrctng the use of upstream subsdes forgoes a majorty of those welfare gans, and clmate fnance only recaptures a small fracton, snce at a carbon value of $30, only the European Unon s wllng to contrbute modest support to deployment n ROW. 24

28 Fscher Fgure 8. Welfare Change (as Share of Change wth Optmal Subsdes) by Polcy Tools and Poltcal Dstortons; SCC = $ Standard welfare Weght upstream 0.0 Nash wth upstream subsdes Nash wth only downstream subsdes Nash wth contrbutons to ROW Concluson Green ndustral polcy rases mportant questons about the nteracton between envronmental and free-trade goals as appled to goods wth global external benefts. In partcular, ths analyss reveals ratonales both for allowng and for restrctng the use of upstream subsdes. In the absence of unnternalzed envronmental benefts, restrctng upstream subsdes ether does no harm (snce strategc countres may not want to use them anyway) or provdes global welfare benefts by mpedng domestc poltcal dstortons from nterferng wth trade. On the other hand, such restrctons can do more harm than good f the envronmental benefts outwegh the poltcal dstorton. Indeed, f governments undervalue the global external beneft, the poltcal dstorton can be a frend to the envronment, f countres are free to use all subsdy tools. Gven restrctons on upstream subsdes, an alternatve polcy n whch producer countres fnance deployment n thrd-party markets can recoup some of the lost welfare. However, ths opton s most effectve when those producer countres both perceve a hgh value n the global envronmental beneft and have a hgh degree of poltcal dstortons to ther trade polces. 25

29 Fscher These ssues are partcularly relevant for clmate polces and markets for low-carbon technologes. The Pars Agreement codfes an nternatonal system of dfferentated and voluntary clmate polcy formaton, and the slow progress of emssons prcng means that most emssons are not nternalzed by energy markets. In the face of carbon leakage, countres that take nto account the SCC may contnue to eschew carbon prcng n favor of technology polces, whch beneft from much greater publc support. Toward that end, the most valuable polces are those that wll lower the cost of low-carbon technologes for the entre world, but partcularly for developng countres whose energy demand growth far outstrps that antcpated among developed natons. Here, upstream subsdes clearly meet that objectve, as can contrbutons to clmate fnance as well. The dsadvantage of clmate fnance s that such contrbutons beneft domestc ndustry only n part, and n practce, these shares are further dluted by the large portfolo of actvtes foreseen by the Green Clmate Fund, of whch clean energy deployment s just a part. Strategc countres thus prefer upstream subsdes, and the key queston s whether some leeway for green ndustral polcy should be provded n trade rules, n an attempt to harness these selfsh ncentves for the global good. Underlyng ths analyss s the standard assumpton that global supply curves for the green good are upward slopng and that downstream demand for the good s downward slopng. As such, the qualtatve results should be robust to other applcatons. However, some aspects relevant to emergng clean technologes have not been ncluded. In partcular, characterstcs that mght render the supply curve downward slopng such as scale economes, learnng-by-dong, and nternatonal nnovaton spllovers would change the results, as then downstream subsdes can have the effect of lowerng global prces as well. These aspects wll be the subject of future analyss. 26