Discussion Papers No. 521, November 2007 Statistics Norway, Research Department

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1 Dscusson Papers No. 521, November 2007 Statstcs Norway, Research Department Cathrne Hagem * The clean development mechansm versus nternatonal permt tradng: the effect on technologcal change Abstract: The clean development mechansm of the Kyoto Protocol may nduce technologcal change n developng countres. As an alternatve to the clean development mechansm regme, developng countres may accept a (generous) cap on ther own emssons, allow domestc producers to nvest n new effcent technologes, and sell the excess emsson permts on the nternatonal permt market. The purpose of ths artcle s to show how the gans from nvestment, and hence the ncentve to nvest n new technology n developng countres, dffer between the two alternatve regmes. We show that the dfference n the gans from nvestment depends on whether the producers n developng countres face compettve or noncompettve output markets, whether the nvestment affects fxed or varable producton costs, and whether producers can reduce emssons through means other than nvestng n new technology. Keywords: Clmate Polcy, Technology Adopton, Emsson Tradng, Clean Development Mechansm, Technologcal Change, Cournot Competton JEL classfcaton: L13, Q54 Acknowledgement: Comments from Ger Ashem, Mads Greaker, Knut Enar Rosendahl, Sjak Smulders, two anonymous referees and partcpants at the Centre for Advanced Study (CAS) workshops are much apprecated. Address: Cathrne Hagem, Statstcs Norway, Research Department. E-mal: cathrne.hagem@ssb.no * Most of the work on ths artcle was conducted whle I was employed by the Department of Economcs, Unversty of Oslo, and partcpated n the project Envronmental economcs: polcy nstruments, technology development, and nternatonal cooperaton sponsored by the CAS at the Norwegan Academy of Scence and Letters n Oslo n 2005 and The fnancal, admnstratve, and professonal support of CAS s much apprecated.

2 Dscusson Papers comprse research papers ntended for nternatonal journals or books. A preprnt of a Dscusson Paper may be longer and more elaborate than a standard journal artcle, as t may nclude ntermedate calculatons and background materal etc. Abstracts wth downloadable Dscusson Papers n PDF are avalable on the Internet: For prnted Dscusson Papers contact: Statstcs Norway Sales- and subscrpton servce NO-2225 Kongsvnger Telephone: Telefax: E-mal: Salg-abonnement@ssb.no

3 1. Introducton Accordng to the Kyoto Protocol, developng countres have no quantfed emsson targets for the frst Kyoto perod ( ). However, ndustralzed countres wth quantfed emsson targets are allowed to partly meet ther reducton commtments through nvestments n emsson-reducng projects n developng countres (the CDM). The emsson reductons generated by CDM projects can be used to offset the nvestor s own emsson reducton oblgatons. Accordng to the Kyoto Protocol, the purpose of the CDM s twofold (see UNFCCC (1998), artcle 12). It s a means of reducng complance costs for ndustralzed countres, and t s a means of assstng developng countres n achevng sustanable development. Through spn-off effects from technologcal mprovements n some producton unts, the CDM may ncrease the use of envronmentally frendly technologes n developng countres. A condton for the approval of a CDM project s that the reducton acheved by the project shall be addtonal to any that would occur wthout project actvty (see UNFCCC (1998), artcle 12). 1 The addtonal requrement ensures that the certfed emsson reducton unts (CERs) are based on real emsson reductons such that the CDM does not lead to hgher global emssons. However, the problem wth ths crteron s that t must be based on a counterfactual baselne for emssons. Furthermore, both the nvestor and the host have ncentves to overstate the baselne emsson to make the project more proftable 2. The problems connected wth baselne estmates and the potentally hgh transacton costs of CDM projects are arguments for alternatvely ncludng developng countres n a cap&trade regme. 3, 4 In a cap&trade regme, developng countres accept bndng caps on ther emssons. Countres receve emsson allowances (or permts) correspondng to ther caps on emssons and are allowed to partcpate n permt tradng. If the cap for emssons s generous, a developng country gans from partcpatng n ths regme by mplementng low-cost abatement optons, and sell permts on the permt market. In ths artcle, we compare the cap&trade and CDM regmes n ther ablty to promote frms n developng countres to nvest n more envronmentally frendly technologes. Hence, we address the 1 An executve board s desgnated to approve CDM projects and ssue certfed emsson reducton unts (CERs). 2 Fscher (2005) evaluated how dfferent baselne methodologes affect the effcency of the CDM when there s asymmetrc nformaton between the certfyng agent and the partcpants n CDM projects. 3 The necessary effort used n preparng CDM proposals, and the resources used to verfy and certfy emsson reductons may lead to qute hgh transacton costs for acqurng CERs. See, among others, Mchaelowa et al. (2003) for an overvew of estmated transacton costs for varous knds of CDM projects. 4 Ths argument was made by, e.g., Bohm (2002). 3

4 sustanable development role of the CDM, rather than ts role n mnmzng ndustralzed countres costs of achevng targets for global emsson reductons. We assume that, under a CDM regme, emsson reducton credts can only be generated f a fxed nvestment occurs. Hence, n our model, CDM projects cannot be based on emsson reductons that occur only because of output reductons, for nstance 5. We suggest that fxed nvestment n new technology represents a reasonable requrement for a CDM project. Ths s because the CDM s meant to promote sustanable development n developng countres 6. In our analyss we take nto account how the market envronment on the output market for the goods produced by the frms n the developng countres affect ther ncentves for nvestment n new technology 7. In the case of nvestment projects sutable for CDM fundng t s relevant to consder both compettve and non- compettve output markets. Because of the hgh transacton costs of ntatng and mplementng CDM nvestment projects, t s large emtters whch attract CDM nvestors. 8 At Unted Natons Framework Conventon on Clmate Change s homepage there are descrptons of the varous CDM projects regstered 9. Some of these projects are nvestments n energy effcency mprovng technologes n captal ntensve manufacturng ndustres. The output market for some of these ndustres can be characterzed as mperfectly compettve. There are for nstance several projects amng at emsson reducton from the cement producton. Cement producton nvolves hgh fxed costs, and the regonal cement markets are characterzed by a relatvely small number of supplers. 10 The alumnum ndustry s another ndustry, sutable for hostng CDM projects, where studes have ndcated some degree of market power (see for example Lndqust (1994) and Yang (2001)) 11. Furthermore, electrcty provders are also lkely canddates for hostng CDM projects. The electrcty markets are lkely to face market power abuse 5 However, f an nvestment occurs, we assume that the emsson credts acqured equal the dfference between estmated busness-as-usual emssons and ex post emssons, regardless of whether some of the emsson reductons are due to reduced producton. Ths s accordng to the UNFCCC s gudelnes for estmatng the emsson reducton of a CDM project actvty (see 6 Fscher (2005) consdered stuatons n whch undertakng a fxed nvestment s not a requrement for partcpaton n a CDM project. 7 Note that t s only the output market for goods produced by potental CDM hosts (frms n developng countres) that are analyzed. We do not take nto account that the agents fnancng the CDM projects also may produce goods exchanged at mperfectly compettve markets. 8 Although hgh transacton costs assocated wth the CDM s an argument n favor of a cap&trade regme, we gnore transacton costs n our theoretcal model For nstance, one CDM project s to substtute bomass for fossl fuels n the cement manefucturng process of Lafarge Malayan Cement Berhard. Lafarge Malayan Cement Berhard s a leadng producer of the Malayan cement ndustry and a major player n the Asan export market. 11 For nstance replacng the old Söderberg cell technology wth the new Prebake cell technology n alumnum smelters mples lower energy use, n addton to lower local emssons of hazardous gases and partcles. The alumnum ndustry s used as an example of an ndustry subject to strategc trade polcy n Greaker (2003). 4

5 nter ala due to physcal constrants on the transmsson system and the capacty of nterconnectors between regons and countres. To evaluate the mpact of mperfectly compettve output markets, we compare our results wth the nvestment decsons for hosts operatng n perfectly compettve output markets. In the paper we show that there are two effects whch nfluence the dfference n nvestment ncentves under the two types of regmes (cap&trade and CDM): Frms n developng countres have access to the permt market whether or not they nvest n new technology under the cap&trade regme, whereas the frms must host an nvestment project to obtan emsson credts, and hence get access to the permt market, under the CDM regme. The strategc effect of an nvestment on the output market may dffer between the two regmes f the frms n developng countres face mperfectly compettve output markets. We refer to the frst effect as the permt market access effect, and the latter effect as the strategc effect, of an nvestment. Note that f nvestment were not a prerequste for a CDM project, there would be no permt market access effect. We show that the permt market access effect favors nvestment under the CDM regme, whereas the strategc effect favors nvestment under the cap&trade regme. We also descrbe stuatons n whch the strategc effect domnates the permt market access effect and vce versa. The strategc effects of nvestment are, among others, analyzed n Brander and Spencer (1983). The relatonshp between technologcal change and envronmental polcy nstruments has been wdely analyzed n the lterature. (See, e.g., Jaffe et al. (2002) for an overvew.) Montero (2002) and Requate (1998), among others, analyzed the ncentves of mperfectly compettve frms to nvest n new technology. However, n those studes, emsson permts and standards were examned. There are apparently no studes n whch dfferences n the strategc effect of nvestment under the cap&trade and CDM regmes are analyzed. In the next secton, we defne the two clmate polces that are avalable to developng countres. In Secton 3, we derve the dfference n nvestment ncentves under the two regmes when frms n the developng countres operate n mperfectly compettve output markets. In Secton 4, we derve correspondng results for perfectly compettve frms. Concludng remarks are gven n the fnal secton. 5

6 2. The CDM regme versus the cap&trade regme We consder a developng country that has the opton to choose between two clmate polces. It can ether jon the Kyoto Protocol on equal terms wth ndustralzed countres, n whch case, t enters the cap&trade regme, or the country can allow domestc frms to host CDM projects, n whch case, t enters the CDM regme. Under the CDM regme, a foregn nvestor fnances (some of) the cost of mplementng the new technology. The host s emsson reductons relatve to baselne emssons generate CERs, whch can be used by the nvestor to offset ts own emsson reducton oblgatons. The value of each CER thus equals the nternatonal permt prce. We assume that emssons and emsson reductons can be correctly calculated. The problem of baselne estmates and ex post emssons calculatons s not the 12, 13 ssue of ths artcle. Hence, baselne emssons equal busness-as-usual (BaU) emssons, and the CERs accrung from a CDM project equal the dfference between the BaU emssons and the ex post emssons followng mplementaton of the project. Furthermore, we also gnore nformatonal asymmetres between the host and nvestor under the CDM regme. 14 Havng made these smplfcatons, we can show how nvestment decsons by frms n developng countres are affected by the clmate polcy chosen by ther governments CDM regme or cap&trade regme even n the case wth no asymmetrc or ncomplete nformaton. If the developng country partcpates n emsson tradng, all domestc frms must hold permts correspondng to ther emssons. In addton, all frms can trade ther permts on the nternatonal permt market. To facltate comparson of the nvestment ncentves under the two regmes, we assume that the emsson reducton requrement of the cap&trade regme s no strcter than that of the CDM regme, whch s zero by defnton: the country s not oblged to acheve any emsson reductons. Hence, a 12 The mplcaton of ths assumpton s brefly dscussed n the concludng remarks. 13 Developng countres have been reluctant to accept bndng commtments. One reason for ths s that uncertanty about the busness-as-usual (BaU) emssons may ncur less beneft than expected. If the BaU emssons turn out to be hgher than expected when acceptng the emsson cap, the cost of the cap&trade regme may become hgher than that of a CDM regme, n whch emssons reductons are calculated based on project-specfc baselnes. Kallbekken and Westskog (2005) explored the costs and benefts of developng countres makng bndng commtments. They found that the effcency gan from jonng the emsson tradng regme compared wth the CDM regme mght not be very large compared wth the rsk ncurred. We gnore problems related to uncertanty about BaU emssons. 14 The host for the nvestment project may have more nformaton about the effect of nvestment on producton costs and emssons than do the nvestors. Such asymmetres may lead to neffcences. Ths s dscussed by Hagem (1996) and Wrl et al. (1998), among others. Mllock (2002) showed how technologcal transfer, as a part of the CDM contract, can create ncentves for mtgatng the neffcency loss from asymmetrc nformaton. 6

7 country that accepts a cap s granted permts that cover the BaU emssons. Furthermore, we assume that the country redstrbutes ts permts to the emttng frms based on ther BaU emssons. The latter assumpton, whch s made only for smplcty, does not affect our results. The presence of an endowment of tradable permts represents a pure wndfall gan and does not nfluence frms nvestment decsons (assumng that pure changes n wealth do not affect these nvestment decsons). 15 Our assumptons about the cap on emssons and the dstrbuton of the free permts mply that f frms do not act to reduce emssons, ther ncomes are dentcal under both regmes. As stated n the ntroducton, we assume that, under a CDM regme, emsson reducton credts can only be generated a fxed nvestment occurs. We consder the ncentves for nvestment n energy effcency mprovng projects. Such projects could typcally lead to lower margnal and/or fxed producton costs n addton to generatng value n the form of emsson reducton. In the followng secton, we consder nvestment n a (captal ntensve) ndustry n whch there are few producers, so that each producer has market power n the output market. A compettve output market s analyzed n Secton An mperfectly compettve output market To determne the effect of mperfect competton n output markets, we consder two symmetrcal frms that operate n a developng country and engage n Cournot competton n the output market 16. We apply the standard assumpton that the reacton functons are downward slopng,.e., ncreased supply by one of the frm leads to a decrease n the optmal supply from ts compettor. We gnore any welfare effects arsng from changes n the consumer surplus by assumng that the good produced are sold n a foregn country 17. The frms are denoted 1 and 2, but we sometmes refer to frms and j. Producton s energy ntensve. Each frm can reduce ts use of energy per unt of output by nvestng n new technology. In Secton 3.1, we analyze the case n whch nvestment ncreases the productvty of a varable (energy-ntensve) producton factor. In Secton 3.2, we examne the case n whch nvestment reduces the energy ntensty of a fxed producton factor. 15 The property of free tradable permts s dscussed by, e.g., Hagem (2002). 16 For smplcty we consder a model wth only two frms. However, the man conclusons from our model stll holds f there are more frms supplyng the same market. The crucal assumpton s that the frms n queston have some degree of market power. 17 See a bref dscusson of the mplcaton of ths assumpton n the concludng remarks. 7

8 3.1. Investment ncreases the productvty of a varable nput factor In ths secton, we consder the case n whch emssons are caused by the use of a varable nput factor. We gnore all producton costs except the cost of the carbon-based energy used n producton. Throughout, we use captal letters to denote the levels of physcal varables under the cap&trade regme, and use small letters to denote the correspondng levels under the CDM regme. Hence, let E denote the use of energy measured n CO 2 unts, let X denote output, and let K denote the technology parameter for the cap&trade regme. Let e, x and k denote the correspondng varables under the CDM regme. To smplfy the analyss we consder a lnear relatonshp between producton and emssons, for a gven level of captal 18 : (1) ( ) E = 1 K X = 1, 2 (Cap&trade-regme) and ( ) e = 1 k x = 1,2 (CDM-regme). Furthermore, we assume that there s (only) one nvestment opton;.e., = 0 does not nvest, and = K K ( = ) K ( = 0) k K f the frm does nvest. 19 Note that 0< K < 1. k f the frm To fnd the Nash-equlbrum nvestment decsons of frms, we consder a two-stage game. In the frst stage, frms choose whether to nvest or keep the old technology. (Under the CDM regme, nvestment nvolves the frm enterng nto a CDM contract.) In the second stage, frms choose outputs. When frms make ther nvestment decsons n stage 1, t s assumed, followng Dxt (1980) and Brander and Spencer (1983), that they correctly antcpate the Nash-equlbrum outputs that emerge n stage 2. The Nash equlbrum at stage 2 s a functon of both frms nvestment decsons from stage 1. We solve the model backwards. In the next secton, we derve the Nash-equlbrum outputs (stage 2). In Secton 3.1.2, we compare the nvestment decson from stage 1 made under the two regmes The second stage: the output market The cap&trade regme For each frm, proft ( Π ) s the sum of net ncome from permt sales and net ncome from the output market, mnus the nvestment cost (f the frm mplements the new technology), as follows: 18 Although we use a very smple producton functon, t s suffcently complex to llustrate how nvestment ncentves dffer under the two regmes. 19 Havng more than one nvestment opton makes the comparson between the two regmes much more complcated wthout addng anythng to the man result of our paper. The mplcaton of havng more than one nvestment opton s dscussed n the concludng remarks. 8

9 (2) ( 1 ) 0 Π = t E K X ( ) ( ) j ( ) + p X + X q 1 K X Q K = 1,2 j = 1,2 j, where 0 E s the frm s BaU emssons (whch s equvalent to the allocaton of free permts), q s the prce of energy measured n CO 2 unts, t s the nternatonal permt prce, ( j + ) prce (as a functon of total supply), and Q( K ) s the nvestment cost. ( ) and equals Q when = K K. The prce of output s decreasng n quantty ( < 0) p X X s the output Q K equals 0 when K = 0, p. From (2), maxmzng Π wth respect to X gves the followng frst-order condton: p X + p q+ t 1 K = 0 = 1,2. (3) ( ) ( ) From (3), each frm s optmal output level s a functon of ts own technology parameter and the other frm s output ( (, j) X K X ) 20. The Nash equlbrum n the output market s found by solvng the two equatons gven by (1). Let (, ) and (, ) X K K X K K denote the Nash-equlbrum output levels n the output market The CDM regme In what follows, we assume that the CDM contract s desgned to maxmze the jont total proft of the nvestor and host, whch s the sum of proft from producton and proft from the generaton of emsson permts (CERs). Ths mples that we assume there s no conflct of nterest between the nvestor and the host when t comes to the mplementaton of the CDM project. Furthermore, we assume that no contract s sgned unless t gves a non-negatve ncrease n jont total proft. In the followng we also assume that the proft of the CDM project goes to the host such that the nvestor s equally well off wth the contract as wthout 21. Another rule for proft sharng between the nvestor and the host would unambguously make t less proftable for the host to enter nto the CDM contract (see concludng remarks). However, by assumng that the proft goes to the host we are able to show how the two regmes dffer regardng nvestment decsons even n the case where the frms n developng countres are able to capture all proft from the nvestment project under both regmes. 20 To nsure the exstence of a unque, pure strategy Nash-equlbrum, we assume that p + p X < These two latter assumptons ensure that both the nvestor and host are at least as equally well off wth the contract as wthout. 9

10 Gven that we also have assumed that nvestment s a prerequste for a CDM contract, the proft (π ) of a frm that enters nto a CDM contract s gven by (4) 0 ( 1 ) ( ) ( ) π = t E K x + 1 p x + xj q K x Q = 1,2 j = 1,2 j, and s dentcal to the proft functon of a frm that nvests under a cap&trade regme. Although the new technology reduces the need for energy per unt of producton, we assume throughout that nvestment s not proftable unless the frm can sell emsson permts. Hence, a frm that does not enter nto a CDM contract does not mplement the new technology, and thus has the followng proft functon: (5) ( ) 1, 2 1, 2 π = + p x x q x = j = j j If a frm has entered nto a CDM contract, the frst-order condton for maxmzng proft s obtaned from maxmzng (4) wth respect to x. Ths frst-order condton s gven by p x + p q+ t 1 K = 0 = 1,2, (6) ( ) ( ) whch corresponds to the frst-order condton under a cap&trade regme. If the frm does not enter nto a CDM contract, the frst-order condton s obtaned by choosng x to maxmze (5). In ths case, the frst-order condton s gven by (7) p x + p q= 0 = 1,2. From (6) and (7), each frm s optmal output level s a functon of ts nvestment decson (.e., ts decson to enter a CDM contract) and the output of the other frm. Let (, j) to (6) and let ( 0, j) The terms ( + ) ( 1 ) x x denote the soluton to (7). x K x denote the soluton q t K and ( q) n (6) and (7), respectvely, express the margnal cost of producng x. Comparng (6) and (7), we see that the margnal cost of producton decreases wth nvestment f ( q+ t) ( 1 K) < qand ncreases wth nvestment f ( ) ( 1 ) q+ t K > q. The Nash equlbrum n the output market, as functon of the nvestment decsons, follows from (6) and (7). Let (, ) and (, ) x k k x k k denote the Nash-equlbrum outputs under the CDM regme An nvestment s sad to have a postve (negatve) strategc effect f other producers responses to the acton ncrease (decrease) the proft of the producer takng the acton. (See, e.g., Trole (1988), 10

11 Chapter 8.) When there s Cournot competton n the output market, each frm s optmal output and proft are decreasng functons of ts compettors output levels. Thus, f nvestment n new more envronmentally frendly technology ncreases the nvestng frm s output, such nvestment has a postve strategc effect. If, on the other hand, the nvestment causes the frm to decrease ts producton, the nvestment has a negatve strategc effect. By comparng the mpact of nvestment under the cap&trade and CDM regmes, we derve the followng proposton. Proposton 1 Investng n a technology that ncreases the productvty of the varable nput factor has always a postve strategc effect under the cap&trade regme. Under the CDM regme, the nvestment has a postve strategc effect f t causes the margnal costs of producton to decrease (( q 1) ( 1 K ) q ) + <, and has a negatve strategc effect f t causes margnal costs of producton ( q K q ) to ncrease ( 1) ( 1 ) + >. Proof. See appendx Investment has two effects on the margnal cost of producton under the CDM regme. On the one hand, nvestment ncreases the margnal cost of producton because enterng nto a CDM contract also mples that emssons have become costly. Each unt ncrease n emsson gves one unt less of CDM credts and, hence, decreases the beneft of the CDM project by the unt cost of the permts. On the other hand, nvestment ncreases energy effcency and thus decreases the use of energy per unt of output, whch, ceters parbus, lowers the margnal cost of producton. If the former effect domnates the latter (( + ) ( 1 ) > ) q t K q, the net margnal cost of producton ncreases followng nvestment 22. In the next secton, we explore how the dfference n the strategc effect of nvestment under the two regmes nfluences the dfference n nvestment ncentves The frst stage: the nvestment decson In the frst stage, each frm decdes whether to nvest/enter nto a CDM contract. Let Π ( K, K ) denote frm s proft under the cap&trade regme and let (, ) 1 2 π k k denote frm s proft Bulow et al. (1985) showed how an ncrease n proft from one market may reduce the frm s proft n another (mperfectly compettve) market. In our model, t s the (voluntary) partcpaton n the permt market (through the CDM contract) that may reduce the frms proft n the output market (f the CDM project causes an ncrease n margnal cost of producton). 11

12 under the CDM regme. Under each regme, there are four dfferent combnatons of nvestment decsons and, hence, four dfferent potental proft levels for each frm. For the cap&trade and CDM regmes, respectvely, n Tables 1 and 2, we summarze the nvestment game that takes place n stage 1, and summarze the payoffs that follow from the dfferent outcomes n stage 2. Table 1. Investment decsons and payoffs under the cap&trade regme Frm 2 Frm 1 K K Do not nvest ( K = ) Invest ( = 1 ) Π1 Invest ( K, K ) ( 2 ) Do not nvest K = ( ) 2 0 Π1 ( K,0) Π ( K K ) 2, Π2 ( K,0) ( K ) Π1 0, Π 1 ( 0,0) 1 0 ( K ) Π2 0, Π 2 ( 0,0) Table 2. Investment decsons and payoffs under the CDM regme Frm 2 Frm 1 k K Do not nvest ( k = ) Invest ( = 1 ) π1 Invest ( K, K ) ( 2 ) Do not nvest k = ( ) 2 0 π1 ( K,0) π ( K K ) 2, π 2 ( K,0) ( K ) π1 0, π 1 ( 0,0) 1 0 ( K ) π 2 0, π 2 ( 0,0) In what follows, we explan how the two regmes may lead to dfferent Nash-equlbrum nvestment decsons even though frms have dentcal nvestment optons and producton functons under both regmes 23. To fnd the soluton to the frst-stage games under the two regmes, we must rank the payoffs of the dfferent outcomes of the games. 23 There may not be unque Nash-equlbrum solutons of the games. See, e.g., Rasmussen (1989, chapter 1) for a dscusson of the Nash equlbrum for dfferent rankngs of payoffs. 12

13 Because both frms have dentcal producton functons, t follows that (8) ( K K) ( K K) π ( K K) π ( K K) Π, =Π,,, =,, ( ) ( ) π ( ) π ( ) Π 0,0 =Π 0,0, 0,0 = 0,0, ( K) ( K ) π ( K) π ( K ) ( K ) ( K) π ( K ) π ( K) Π 0, =Π,0, 0, =,0, Π,0 =Π 0,,,0 = 0, In the followng we restrct the attenton to the rankng of the payoffs for frm 1, as any rankng of the payoffs for frm 1 determnes a symmetrc rankng of the payoffs for frm 2, gven by (8). From the frst-order condtons gven by (3) and (6), t follows that f both frms nvest, the Nashequlbrum outputs are dentcal under both regmes;.e., (9) Π 1(, ) =π1 (, ) K K K K. To llumnate the consequences of the dfferent strategc effects of nvestment under the two regmes, we consder an nvestment project for whch, under both regmes, both frms prefer an outcome n whch both nvest to one n whch no frm nvests. Ths mples that (10) Π (, ) >Π ( 0,0) and π (, ) > π ( 0,0) KK KK It follows from Proposton 1 that each frm under the cap&trade regme s better off f the other frm does not nvest. Hence, gven (10), the only possble rankng of the outcomes under the cap&trade regme s as follows: (11) Π 1(,0) >Π 1(, ) >Π 1( 0,0) >Π1( 0, ) K KK K. For ths rankng, Invest s the domnant strategy for both frms, and the unque Nash equlbrum n stage 1 s for both frms to nvest under the cap&trade regme. Under the CDM regme, the rankng of the dfferent outcomes depends on whether the strategc effect of nvestment s postve or negatve. If the strategc effect s postve, the rankng of the outcomes s the same as under the cap&trade regme. Hence, for ( ) ( 1 ) possble rankng of the outcomes s: (12) π1 (,0) > π1 (, ) > π1 ( 0,0) > π1 ( 0, ) K KK K, q+ t K < q, and gven (10), the only and the Nash equlbrum n stage 1 s for both frms to nvest under the CDM regme. Let us now consder the case n whch nvestment gves a strategc dsadvantage,.e., ( ) ( 1 ) q+ t K > q. 13

14 When nvestment leads to a strategc dsadvantage, each frm s better of f the other frm nvests. If the strategc dsadvantage of nvestment s suffcently large, each frm prefers the strategy Do not nvest, whatever the other frm chooses;.e., π1 ( 0, K ) > π1 ( KK, ) and π1 ( 0,0 ) π1 (,0) case, Do not nvest s the domnant strategy, and outcomes are ranked as follows: (13) π1 ( 0, ) > π1 (, ) > π1 ( 0,0 ) > π1 (,0) K K K K. Ths rankng leads to a unque Nash equlbrum n whch no frm nvests. > K. 24 In that We can now state the followng proposton. Proposton 2 Consder the case n whch the outcome under whch both frms nvest s preferred to the outcome under whch no frm nvests under both regmes. In ths case, there s a unque Nash equlbrum n whch both frms nvest under the cap&trade regme. However, under the CDM regme, there may be a prsoner s dlemma outcome n whch no frm nvests. Proof. See appendx The dfference n the gans from nvestment between the two regmes arses because nvestment n cleaner technology affects the margnal proft of producton n dfferent ways. As stated n proposton 1, the strategc effect of nvestment may be negatve under the CDM regme, but s unambguously postve under the cap&trade regme. Note that the permt market access effect favors nvestment under the CDM regme rather than nvestment under the cap&trade regme. Under the cap&trade regme, frms may beneft from reducng emssons wthout nvestng because they can sell surplus permts on the market. It s assumed that ths s not an opton under the CDM regme. Hence, the permt market access effect ncreases the gans from nvestng under the CDM regme (gven that both frm nvest). 25 In the example gven n the proof of proposton 2, the strategc effect outweghs the permt market access effect ( π1 ( 0, K ) > π1 ( KK, ) and π1 ( 0,0 ) π1 (,0) > K ). The prsoner s dlemma s less lkely to occur the more energy effcent s the nvestment opton (the hgher s K ). There are two reasons for ths. () The strategc dsadvantage (advantage) of an 24 If the strategc dsadvantage of nvestment s lower, there may be other outcomes for the rankng of the payoffs. 25 Π ( K, K) =π ( K, K ) but Π ( 0, 0) > π ( 0, 0), so that Π (, ) Π ( 0,0 ) < π (, ) π ( 0,0) K K K K

15 nvestment s decreasng (ncreasng) n K. 26 () The gans from usng the permt market are ncreasng n K. (From (4), for any gven producton level, ncome from permt sales s ncreasng n K.) From (4), for any gven producton level, ncome from permt sales s ncreasng n the permt prce (t). Hence, an ncrease n t ncreases the gans from usng the permt market. However, the strategc effect of an ncrease n t s negatve. Ths s because an ncrease n t decreases the nvestng frm s optmal output. 27 Hence, the mpact of an ncrease n the permt prce on the lkelhood of there beng a prsoner s dlemma stuaton s ambguous. In the next secton, we consder an abatement opton that does not affect frms margnal profts of producton. We show that, n that case, the dfference n nvestment ncentves between the two regmes depends only on the permt market access effect Investment affects the emssons from a fxed producton factor The dfference n the strategc effect of an nvestment between the two regmes, dscussed n the prevous secton, s due to the fact that emssons are correlated wth producton. Consder the case n whch the fxed producton factor, rather than the varable producton factor, generates emssons. Ths s, for nstance, the case f emsson s only generated by the heatng or coolng of the producton plant, (and the need for heatng/coolng s ndependent of the producton level). In that case, there s no dfference n strategc effect of nvestment under the two regmes. If the only relevant abatement opton s to nvest n new less pollutng (heatng/coolng) technology, there s no dfference n ncentves for nvestment due to the permt market access effect ether, as frms must nvest n new technology to sell permts under both regmes. If, on the other hand, t s proftable for frms to reduce emssons from the fxed producton factor wthout nvestng n new technology under the cap&trade regme, the permt market access effect favors nvestment under the CDM regme rather than nvestment under the cap&trade regme. We can hence state the followng proposton. ( ) ( ) x K, x 26 j q+ t We fnd from total dfferentaton of (6) that = > 0. K p x + 2 p ( ) ( ) x K, x 27 j 1 K We fnd from total dfferentaton of (6) that = < 0. t p x + 2 p 15

16 Proposton 3 Gven that nvestment s a prerequste for a CDM project, and gven that the only possblty for abatement s to reduce emssons from a fxed producton factor, the gans from nvestment under the CDM regme exceed (or equal) those under the cap&trade regme. Proof. See appendx Furthermore, f nvestment were not a prerequste for a CDM contract, nvestment ncentves would be the same under the two regmes. 4. Compettve output markets In the prevous sectons we consdered stuatons n whch frms faced an mperfectly compettve output market. When nvestment affects the margnal cost of producton, t also affects frms strategc postons n the output market (secton 3.1). If we assume that frms only produce small shares of world output, ther prces are ndependent of ther output levels and thus unaffected by ther nvestment decsons. Investment only affects the nvestng frm s output, and does not change the equlbrum output prce. Ths mples that each frm consders ts beneft from nvestment ndependently of the actons of other frms. There s no strategc effect of nvestment when frms face compettve output markets. The only dfference n ncentves for nvestment between the two regmes follows from the permt market access effect. Hence, the case of compettve output markets correspond to the case n whch the fxed producton factor, rather than the varable producton factor, generates emssons, as dscussed n secton 3.2. We can hence state the followng proposton: Proposton 4 Gven that nvestment s a prerequste for a CDM project, and gven that frms are perfectly compettve, the net gans from nvestment under the CDM regme exceed (or equal) those under the cap&trade regme. Proof. See n appendx If nvestment were not a prerequste for a CDM contract, or f abatement were not proftable unless the frm had nvested under the cap&trade regme, nvestment ncentves would be the same under the two regmes (as there would be no dfference n nvestment ncentves due to the permt market access effect). 16

17 5. Concludng remarks The purpose of ths artcle was to compare the ncentves for nvestng n new technology under two dfferent clmate regmes. We showed that f producers n a developng country face a compettve output market, or f nvestment does not nfluence margnal producton costs, the gans from nvestng under a clean development mechansm (CDM) regme exceed (or equal) those from nvestng under a cap&trade regme. When producers face an mperfectly compettve output market, nvestment may gve the frm a strategc dsadvantage n the output market under a CDM regme. Ths effect makes t less proftable to nvest under a CDM regme than under a cap&trade regme. Welfare comparsons of the two regmes are not n general trval under olgopolstc output markets. Ths s because clmate polces affect the already-dstorted output market. However, because we assumed that frms produce output for a foregn market, we can gnore the effect of polcy on the consumer surplus. In that case, a developng country s socal surplus equals the sum of the producers surpluses. Thus, an nvestment opton that mproves both frms profts, and hence ncreases total welfare, would be mplemented under a cap&trade regme, but would not necessarly be under a CDM regme (see Proposton 2). Furthermore, f frms face compettve output markets, or f an nvestment opton does not affect output, the frm s more lkely to nvest under a CDM regme than under a cap&trade regme f nvestment s a prerequste for CDM credts. Hence, for a developng country seekng to promote nvestment n new technology, choosng a CDM regme may be better than partcpatng n a cap&trade regme. However, because mplementng nvestment through a CDM contract confers access to the permt market, a CDM regme may lead to the mplementaton of neffcent nvestment projects n the sense that t would be more cost-effectve to undertake abatement efforts that dd not requre fxed nvestments. We consdered a stuaton n whch there was only one nvestment opton. However, there may be a range of dfferent technologes that can reduce emssons or ncrease the energy effcency of the frm. Because nvestment affects the frm s strategc poston n the output market dfferently under the two regmes we consdered, frms may choose dfferent levels of nvestment under the two regmes. We also assumed that a host for a CDM project receves all the net ncome from the project. However, t s lkely that nvestors seek to proft from ther nvestments. In that case, producers n the developng countres have a lesser ncentve to nvest n new technology under a CDM regme than under a cap&trade regme (when they do not have to share the proft wth foregn nvestors). We assumed that busness-as-usual (BaU) emssons can be correctly calculated. We also assumed that emsson credts under a CDM regme are equvalent to the dfference between the BaU emssons and 17

18 those followng mplementaton of a CDM project. Any mscalculaton of the BaU emssons (denoted by E 0 n the text) mples that emsson credts do not correspond to real emssons reductons. Furthermore, overstatng (understatng) BaU emssons ncreases (decreases) ncentves for nvestment under a CDM regme, relatve to those under a cap&trade regme. 28 Accordng to the Kyoto Protocol, one opton for complance s to nvest n specfc projects n other countres wth quantfed emsson targets so-called jont mplementaton projects. For our model specfcatons, the ncentves for nvestment would be dentcal whether a frm hosted a jont mplementaton project or whether t partcpated n emsson tradng. The reason for ths s that, n a country wth a bndng emsson target (a cap on emsson), t s assumed that all frms are allowed to trade n permts. Ther shadow cost of emssons s therefore equal to the nternatonal permt prce whether they host a jont mplementaton project or whether they partcpate n emsson tradng. A jont mplementaton project therefore gves no permt market access effect. The strategc effect of an nvestment would also be dentcal whether a frm hosted a jont mplementaton project or whether t partcpated n emsson tradng. Furthermore, n our model, the host and nvestor are assumed to cooperate to maxmze the proft of the nvestment project, and all proft s assumed to go to the host. Hence, the host s proft from an nvestment s dentcal whether t s fnanced by a foregn nvestor or funded by the host See Fscher (2005) for a dscusson of the effect on effcency of over-allocatng baselne emssons under a CDM regme. 29 See, e.g., Breton et al. (2006) for an analyss of the merts of jont mplementaton n a game-theoretc settng wth dfferent model specfcatons to ours. 18

19 References Bohm, P. (2002): Improvng Cost-effectveness and Facltatng Partcpaton of Developng Countres n Internatonal Emsson Tradng, Internatonal Envronmental Agreements: Poltcs, Law and Economcs 3, Brander, J. A. and B. J. Spencer (1983): Strategc Commtment wth R&D: The Symmetrc Case, Bell Journal of Economcs, 14, No. 1, Breton, M., G. Zaccour and M. Zahaf (2006): A Game-theoretc Formulaton of Jont Implementaton of Envronmental Projects, European Journal of Operatonal Research, 168, Bulow, J., J. Geanakopolos and P. Klemperer (1985): Multmarket Olgopoly: Strategc Substtutes and Complments, Journal of Poltcal Economy 93, Dxt, A. (1980): The Role of Investment n Entry-Deterrence, The Economc Journal, 90, No. 357, Fscher, C. (2005): Project-based Mechansms for Emsson Reductons: Balancng Trade-offs wth Baselnes, Energy Polcy 33, Greaker, M. (2003): Strategc Envronmental Polcy; Eco-dumpng or a Green Strategy? Journal of Envronmental Economcs and Management 45, Hagem, C. (1996): Jont Implementaton under Asymmetrc Informaton and Strategc Behavor, Envronmental and Resource Economcs, 8, Hagem, C. (2002): A Note on the Kyoto Protocol, Tradable Quotas, and Frm Survval, Envronmental and Resource Economcs 22, Jaffe, A. B., R. G. Newell and R. N. Stavns (2002): Envronmental Polcy and Technologcal Change, Envronmental and Resource Economcs 22, Kallbekken, S. and H. Westskog (2005): Should Developng Countres Take on Bndng Commtments n a Clmate Agreement? An Assessment of Gans and Uncertanty, Energy Journal, 26, No. 3, Lndqust, K.-G. (1994): Testng for market power n the Norwegan prmary alumnum ndustry, Dscusson paper, Statstcs Norway, No.132 Mchaelowa, A., M. Stronzk, F. Eckerman and A. Hunt (2003): Transacton Costs of the Kyoto Mechansm, Clmate Polcy, 3, September, Mllock, K. (2002): Technology Transfer n the Clean Development Mechansm: An Incentves Issue, Envronment and Development Economcs 7, Montero, J.-P. (2002): Permts, Standards, and Technology Innovaton, Journal of Envronmental Economcs and Management 44, Rasmussen, E. (1989): Games and Informaton An Introducton to Game Theory, Blackwell Publshers, Cambrdge, USA. 19

20 Requate, T. (1998): Incentves to Innovate under Emsson Taxes and Tradable Permts, European Journal of Poltcal Economy 14, Trole, J. (1988): The Theory of Industral Organzaton, The MIT Press, Cambrdge, USA. UNFCCC (1998): The Kyoto Protocol to the Conventon on Clmate Change, ( Wrl, F., C. Huber and I. O. Walker (1998): Jont Implementaton: Strategc Reactons and Possble Remedes, Envronmental and Resource Economcs, 12, Yang, S.-P. (2001): Measurng Market Power n the U.S. Alumnum Industry: A Resdual Demand Approach, Revew of Industral Organzaton 19,

21 Appendx Proof of Proposton 1 We see from (1) that nvestment ncreases the productvty of emssons ( e, k ) 2 x e k 2 X ( E, K ) E K > 0. It follows from the standard lterature that the strategc effect of an nvestment under Cournot competton s postve (negatve) f the nvestment leads to hgher (lower) output from the nvestng frm. The frst-order condton under cap&trade, gven by (3), mples that (, ) > ( 0, ) X K X X X. It thus follows from downward-slopng reacton functons that j j (, ) > ( 0, ) X KK X K. Comparng the two frst-order condtons (6) and (7) under the CDM regme, j j we fnd that: x ( K, xj) > x ( 0, x j) f ( q+ t) ( 1 K) < q and (, j) < ( 0, j) x K x x x f ( q+ t) ( 1 K) > q. Downward-slopng reacton functons ensure that, for ( ) ( 1 ) > 0 q+ t K < q, t follows that x ( Kk, j) > x ( 0, k j). For ( q+ t) ( 1 K) > q, we fnd that (, j) < ( 0, j) x Kk x k. Proof of Proposton 2 From the prevous dscusson, f Π ( KK, ) >Π ( 0,0) 1 1, the unque Nash equlbrum n stage 1 s for both frms to nvest under the cap&trade regme. To show that the same nvestment opton may lead to a stuaton n whch no frm nvests under the CDM regme, despte the fact that π (, ) > π ( 0,0) KK, 1 1 we use a numercal example. Let the demand functon for the commodty produced by the two frms be p( x) = 30 x. Note that x = x + x under the CDM regme, and x = X + X under the cap&trade regme. Furthermore, let q = 1, t = 2 and E 0 = 29/3. For K = 1/5 and Q = 3, we fnd that ( ) ( ) ( ) ( ) j Π K,0 ( 105) >Π K, K 101 >Π 0,0 100 >Π 0, K 97 and that ( ) ( ) ( ) ( ) π 0, K 103 > π K, K 101 > π 0,0 93,4 > π K,0 92,6. Hence, the domnant strategy s to nvest under the cap&trade regme. However, the domnant strategy under the CDM regme s to not nvest. Proof of Proposton 3 As there s no strategc effect of nvestment when the frm does not affect the margnal cost of producton, ths corresponds to the stuaton where Π (, ) =Π (,0), Π ( 0, ) =Π ( 0,0) KK K K and j 21

22 (, ) = (,0), ( 0, ) = ( 0,0) π KK π K π K π (See Table 1 and 2). A dfference between the two regmes arses only because of the permt market access effect. Hence, the gans from nvestment cannot be lower under the CDM regme than under the cap&trade regme. (That s, (, ) ( 0, ) π (, ) π ( 0, ) Π K K Π K K K K ) Proof of Proposton 4 As there s no strategc effect of nvestment when frms face compettve output markets, the proof of proposton 4 s dentcal to the proof of proposton 3. 22