An economic assessment of the Kyoto Protocol using a global model based on the marginal abatement costs of 12 regions

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1 MPRA Munch Personal RePEc Archve An economc assessment of the Kyoto Protocol usng a global model based on the margnal abatement costs of 12 regons ZhongXang Zhang East-West Center November 2001 Onlne at MPRA Paper No , posted 4. February :26 UTC

2 An Economc Assessment of the Kyoto Protocol Usng a Global Model Based on the Margnal Abatement Costs of 12 Regons ZhongXang Zhang Research Program East-West Center 1601 East-West Road Honolulu, HI , USA Tel: , Fax: ZhangZ@EastWestCenter.org Summary: The Kyoto Protocol ncorporates emssons tradng, jont mplementaton and the clean development mechansm to help Annex 1 countres to meet ther Kyoto targets at a lower overall cost. Usng a global model based on the margnal abatement costs of 12 countres and regons, ths paper estmates the contrbutons of the three Kyoto flexblty mechansms to meet the total greenhouse gas emssons reductons requred of Annex 1 countres under the three tradng scenaros respectvely. Our results clearly demonstrate that the fewer the restrctons on the use of flexblty mechansms the gans from ther use are greater. The gans are unevenly dstrbuted, however, wth Annex 1 countres that have the hghest autarkc margnal abatement costs tendng to beneft the most. Our results also ndcate that restrctons on the use of flexblty mechansms not only reduce potental of the Annex 1 countres effcency gans, but also are not benefcal to developng countres because they restrct the total fnancal flows to developng countres under the clean development mechansm. JEL classfcatons: Q28; Q25; Q48; Q43 Keywords: Margnal abatement costs, Emssons tradng, Clean development mechansm, Jont mplementaton, Kyoto Protocol, Greenhouse gases.

3 2 Z. X. Zhang 1 Introducton The Kyoto Protocol to the Unted Natons Framework Conventon on Clmate Change (UNFCCC), agreed n December 1997, Kyoto, s the frst nternatonal envronmental agreement that sets legally bndng emssons targets for a basket of sx greenhouse gases and tmetables for Annex 1 countres (.e., the OECD countres and countres wth economes n transton). Together, Annex 1 countres must reduce ther emssons of sx greenhouse gases by 5.2% below 1990 levels over the commtment perod (UNFCCC, 1997). Reflectng the underlyng prncple of the UNFCCC, whch states polces and measures to deal wth clmate change should be cost-effectve so as to ensure global benefts at the lowest possble cost, the Kyoto Protocol ncorporates a varety of provsons for flexblty mechansms through whch the costs of abatng emssons can be lowered. Artcle 6 authorzes the transfer or acquston of emsson reducton unts from jont mplementaton (JI) projects among Annex 1 Partes. Artcle 12 establshes the so-called clean development mechansm (CDM). Through the mechansm, Annex 1 countres wll be able to obtan the certfed emsson reductons from clean development projects jontly mplemented wth non-annex 1 countres (.e., developng countres), and use them to count towards meetng ther commtments under the Kyoto Protocol. In addton to the two project-based mechansms, the Kyoto Protocol accepts the concept of emssons tradng n prncple, under whch one Annex B (an annex to the Kyoto Protocol that lsts the quantfed emsson lmtaton or reducton commtment per Party) country or ts sub-natonal enttes would be allowed to purchase the rghts to emt greenhouse gases (GHG) from other Annex B countres or ther regulated enttes that are able to cut GHG emssons below ther assgned amounts or ther targets. Currently, nternatonal clmate change negotatons are fnalzng the rules, procedures and nsttutons needed to make these flexblty mechansms fully operatonal. To what extent Annex 1 countres complance costs can be lowered depends on the extent to whch the flexblty mechansms wll be allowed to contrbute to meet ther Kyoto targets. Under the Kyoto Protocol, each of the Artcles defnng the three flexblty mechansms carres wordng that the use of the mechansm must be supplemental to domestc actons. Whether the supplementarty clauses wll be translated nto a concrete celng, and f so, how should a concrete celng on the use of the three flexble mechansms be defned reman to be determned. At the June 1999 Sessons of the Subsdary Bodes of the UNFCCC, the EU (European Unon, 1999) has tabled a proposal for concrete celngs on the use of flexblty mechansms. The EU proposal calls for the lmts on both buyng countres and sellng countres. For a buyng country, the maxmum purchase for GHG emsson reducton unts va all three flexble mechansms can not exceed the hgher of the followng two alternatves:

4 An Economc Assessment of the Kyoto Protocol 3 (1) 5% of {(ts base year emssons multpled by 5 + ts assgned amount)/2}; (2) 50% of the dfference between ts annual actual emssons n any year between 1994 and 2002, multpled by 5, and ts assgned amount. The EU proposal s based on quanttes already agreed upon or emssons that wll be observed before the proposed restrcton becomes applcable (Ellerman and Wng, 2000). The dfference between the two alternatves s that the frst s based manly on the Kyoto Protocol s quantfed emsson lmtaton or reducton commtments, whereas the second takes the actual emsson reducton efforts of buyng countres as ts bass. One reason behnd the two alternatves s that ndustralzed countres whose emssons are already very hgh on a per capta bass should take the lead n reducng ther own emssons so that developng countres are encouraged to follow sut and take on emssons commts at a later date. Another reason has been to urge Annex 1 countres to stmulate techncal nnovaton domestcally by rasng margnal abatement costs of buyng countres, although t s unclear to what extent a stmulus of ncreased techncal nnovaton n buyng countres would reman. Motvated by allevatng the concern about hot ar, the EU proposal also sets the rule for a sellng country. Smlar to the frst alternatve for a buyng country, the EU proposal specfes that the maxmum allowed sale for GHG emsson reducton unts va all three flexble mechansms can not exceed the amount calculated by: 5% of {(ts base year emssons multpled by 5 + ts assgned amount)/2}, referred to hereafter as Alternatve 1. Ths proposed restrcton on transfers provdes an ndrect way of mplementng supplementarty snce the hgher market prce as a result of the restrcton on the amount of hot ar for sale restrcts the acqustons from what would otherwse have occurred. Under the EU proposal, however, the celng on net acqustons and on net transfers can be ncreased to the extent that an Annex B Party acheves emsson reductons larger than the relevant celng n the commtment perod through domestc acton undertaken after 1993, f demonstrated by the Party n a verfable manner and subject to the expert revew process to be developed under Artcle 8 of the Kyoto Protocol. (European Unon, 1999). Ths s the so-called however clause. It allows an mportng (exportng) country to purchase (sell) more than the amount defned by the above alternatves f verfable domestc abatement by the mportng (exportng) country can be demonstrated. Thus, the however clause effectvely rases the mportng celng and allows an mportng country to purchase emsson reductons from abroad up to 50% of the emsson reducton requrement, provded that the country can verfy a smlar volume of domestc abatement undertaken after Gven the emssons reductons requred of Annex 1 countres, part of the needed reductons wll take place domestcally, whereas the rest wll come from emssons tradng and JI wth other Annex 1 countres, and acqustons of the certfed CDM credts from non-annex 1 countres. Usng a global model based on margnal

5 4 Z. X. Zhang abatement costs of 12 countres and regons, ths paper ams to examne the mplcatons of the dfferng extent of use of these flexblty mechansms for both Annex 1 countres and non-annex 1 countres as well as for the market prce of permts under the no lmts scenaro, under the EU celngs wth the however clause scenaro, and under the no hot ar scenaro. Secton 2 descrbes the 12- regon s margnal abatement cost-based model used n determnng the dvson of abatement actons at home and abroad. Secton 3 dscusses the data used. Secton 4 presents the results. Fnally, Secton 5 draws up the man conclusons. In wrtng the paper, we have taken a balanced approach combnng the calculatons wth polcy analyss n order to put the numbers nto perspectve and thus facltate the understandng of what the numbers say. Wherever necessary we have compared our estmates wth those from a varety of economc modellng studes. Although not amed to provde a completely rgorous explanaton for the dfferences between these estmates, such a comparson wll ndcate the range of such estmates and dentfy the sources of the dfferences, thus provdng the broad perspectve on the ssues examned. 2 The Global Model Based on Margnal Abatement Costs of 12 Countres and Regons Gven the emssons reductons requred of Annex 1 countres, part of the needed reductons wll take place domestcally, whereas the rest wll come from emssons tradng and JI wth other Annex 1 countres, and acqustons of the certfed CDM credts from non-annex 1 countres. The relatve dfferental between the margnal cost of domestc abatement and the nternatonal prce of emssons permts would apporton the total emssons reductons nto domestc reductons and the demand for GHG offsets. Thus, n order to dvde up abatement actons at home and abroad, we need to determne the margnal abatement costs for all the countres. Because t s a dauntng task to estmate the margnal abatement cost for each ndvdual country, we do so at a regonal level. We dvde the world nto twelve regons. The acronyms for the twelve regons are gven n Table 1. The frst sx regons are Annex 1 regons, whereas the other sx are non-annex 1 regons whose emssons are unconstraned under the Kyoto Protocol. In defnng these regons, we have attempted to employ the mnmal level of dsaggregaton necessary for the purpose of ths study.

6 An Economc Assessment of the Kyoto Protocol 5 Table 1: Defntons of Countres and Regons. Annex 1 countres and regons 1. US: Unted States 2. JP: Japan 3. EU: European Unon 4. OOE: Other OECD Countres 5. EE: Eastern Europe 6. FSU: Former Sovet Unon Non-Annex 1 countres and regons 7. EEX: Energy Exportng Countres 8. CN: Chna 9. IN: Inda 10. DAE: Dynamc Asan Economes 11. BR: Brazl 12. ROW: Rest of the World Now let us descrbe the model for determnng the dvson of abatement actons at home and abroad. To start wth, we assume that the margnal abatement cost functon for regon s of the quadratc form: MCA = a Q + b Q 2 where MCA s the margnal cost of domestc abatement for regon, Q s the amount of greenhouse gas abatement undertaken domestcally n mllon tons of carbon, and a and b are coeffcents. By ntegraton, the total cost of domestc abatement, TCD, s: Q ( ) 1 2 = + = TCD a q b q dq a Q b Q for every. (1) Denotng the total emssons reductons requred of the Kyoto-constraned Annex 1 regon by D and the amount of hot ar that s allocated to regon by H, the total autarkc abatement cost, that s, the total abatement cost n the absence of emssons tradng (.e., n the no tradng case), TCA, s calculated as D H ( ) ( ) 1 ( TCA = a q + b q dq = a D H + b D H 2 ) (2) for = US, JP, EU, OOE, EE. Emssons tradng helps a regon wth hgh autarkc margnal cost to lower ts complance cost by avodng the undertakng of more costly domestc actons. In ths case, the regon undertakes domestc abatement Q (Q < D ) at the margnal cost aq + bq = MCA for = US, JP, EU, OOE, EE, (3) 2 and meets the remanng demand (D - Q - H ) va purchasng the rght to emt at the nternatonal prce p. So, the total remanng demand of all purchasng regons, TD, s:

7 6 Z. X. Zhang TD = ( D Q H) = US, JP, EU, OOE, EE. (4) Measured as percentages of the total abatement costs n the absence of emssons tradng, the reductons n abatement costs for purchasng regon s: G ( ( )) TCA TCD + p D Q H = = US, JP, EU, OOE, EE (5) TCA where G s the gans from emssons tradng for purchasng regon. On the other hand, for the Kyoto-unconstraned regon wth lower margnal cost, emssons tradng provdes an ncentve for t to undertake otherwse no domestc abatement actons and sell the permts generated to those hgher cost regons at the nternatonal prce p aq + bq = p for = FSU, EEX, CN, IN, DAE, BR, ROW. (6) 2 Thus, the total amount of emssons permts avalable for sale, TS, are: TS = Q = FSU, EEX, CN, IN, DAE, BR, ROW, (7) of whch, the value of the total non-annex 1 countres sales for permts to the Annex 1 regons, that s, the value of the CDM market, VCDM, s: VCDM = pq = EEX, CN, IN, DAE, BR, ROW. (8) Subtractng ther own abatement costs, the net value of the CDM market, or the net gan of non-annex 1 regons, NCDM, s derved as NCDM = ( pq TCD ) = EEX, CN, IN, DAE, BR, ROW. (9) At the equlbrum, the total amount of demand for emssons permts are equal to the total supply so that we have H + TS = TD = US, JP, EU,OOE, EE, FSU. (10) Ths completes the summarzed descrpton of the general model. When t s used to examne the followng cases, some specfc settngs are nvolved.

8 An Economc Assessment of the Kyoto Protocol 7 Case A. No Lmts Scenaro Even f no lmts are mposed on the use of flexblty mechansms, t s stll n the nterest of a purchasng country to abate ts own emssons up to the pont where the margnal cost of dong so s equal to the prevalng prce of permts. Thus, Eq. (3) merges wth Eq. (6) so that we have aq + bq = MCA = p for every. (11) 2 Ths mples that the margnal cost of domestc abatement for each regon s the same and that there s no dstncton between the nternatonal prce and domestc prces. Case B. Supplementarty Restrctons Scenaros When a unform formula defnng the restrctons on the use of flexblty mechansms s appled to all the regons, some regons mght be allowed to purchase more than needed. Put another way, t s more costly for the regons to purchase part of the allowed acqustons than to abate them domestcally. To remove the unnecessary part, we set Eq. (3) nto aq + bq = MCA p for = US, JP, EU, OOE, EE. (12) 2 As a result, a regon s gong to purchase permts only f t becomes more costly to undertake emssons abatement on ts own. By contrast, for a regon that s allowed to meet part of ts commtments va the purchase of emssons permts, t must rely on domestc abatement capabltes. The lesser extent t s allowed to purchase permts abroad, the hgher the domestc prces, and hence the larger the dstncton between the nternatonal prce and domestc prces. Case C. No Hot Ar Scenaro Under no hot ar scenaro, tradng n hot ar s not allowed. Thus, Eq. (10) becomes TS = TD. (13)

9 8 Z. X. Zhang 3 Data To run the above model, we frst need the aggregate magntude of emssons reductons requred of each Annex 1 regon and the sze of hot ar n The former represents the amount of the mandated reductons from projected busnessas-usual (BAU) emssons levels, whereas the latter represents those assgned amounts under the Kyoto Protocol that exceed antcpated emssons requrements even n the absence of any lmtaton. The two types of data are derved from the ndvdual natonal communcatons (to the UNFCCC) of the followng 35 Annex 1 countres wth emssons targets: Australa, Austra, Belgum, Bulgara, Canada, Czech Republc, Denmark, Estona, Fnland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Latva, Lthuana, Luxembourg, the Netherlands, New Zealand, Norway, Poland, Portugal, Romana, Russa Federaton, Slovaka, Slovena, Span, Sweden, Swtzerland, Ukrane, the Unted Kngdom, and the Unted States. Ths nvolves three steps. The frst step s to determne GHG emssons for each Annex 1 country n the base year. The second step s to determne the Kyoto target for each Annex 1 country n The thrd step s to estmate baselne GHG emssons for each Annex 1 country n By addng up the amount of the mandated reductons from projected baselne emssons levels for each Annex 1 country, the aggregate magntude of emssons reductons requred of Annex 1 countres n 2010 s estmated to be mllon tons of carbon (MtC) equvalent, as gven n Table 2. Smlarly, the sze of hot ar n 2010 s calculated to be MtC. 1 See Zhang (1999) for detaled dscusson on procedures and results. Table 2: Annex 1 Regons Emssons Reductons Requred and the Sze of Hot Ar n Annex 1 regons Unted States Japan European Unon Other OECD Countres Eastern Europe Former Sovet Unon Annex 1 Total Source: Zhang (1999). Emssons reductons requred n 2010 (MtC) The sze of hot ar n 2010 (MtC) Note that n some regons there s the co-exstence of hot ar and the requred emssons reductons wthn the same regon. Ths s smply because of the sums across countres wthn each of these regons. For an ndvdual Annex 1 country, t s ether requred to reduce ts emssons to meet the Kyoto targets or not requred f t has hot ar.

10 An Economc Assessment of the Kyoto Protocol 9 The second set of data are the maxmum allowed acqustons and the maxmum allowed transfers n Applyng the two EU celng alternatves to each Annex 1 country, and assumng that countres would wsh to use the hgher allowed acqustons n 2010, we have calculated the maxmum allowed acqustons n 2010 for those Annex 1 countres whose emssons targets n 2010 are below ther projected BAU emssons (as gven n Table 3) wthout consderng the however clause. When the however clause s factored n, the above celngs on the allowed acqustons are relaxed up to 50% of the dfference between projected baselne emssons and the Kyoto targets n Followng the same procedure as one n calculatng the maxmum allowed acqustons, we have calculated the maxmum allowed transfers n 2010 for those Annex 1 countres whose emssons targets n 2010 are above ther projected BAU emssons. See Zhang (1999) for detaled dscusson on procedures and results. Table 3: Annex 1 regons Unted States Japan European Unon Other OECD Countres Eastern Europe Former Sovet Unon Annex 1 Total Source: Zhang (1999). Allowed Acqustons and Transfers of GHG Emsson Reducton Unts Under the Two EU Celng Alternatves. Maxmum allowed acqustons n 2010 wthout consderng the however clause (MtC) Maxmum allowed transfers n 2010 (MtC) The thrd set of data are coeffcents of the margnal abatement cost functon for each of the above twelve regons. They are taken from Ellerman and Decaux (1998) who have estmated the margnal abatement cost (at 1985 US$ per ton of carbon) functons for the above twelve regons runnng the Emssons Predcton and Polcy Analyss (EPPA) model under progressvely strngent carbon constrants for the year 2010 and then econometrcaly estmatng the EPPA runs for the amount of abated carbon emssons and the correspondng margnal abatement costs. The results are gven n Table 4. It can be seen that the assumed cost functons ft very well to the results from the EPPA runs because R 2 s very close to one.

11 10 Z. X. Zhang Table 4: Coeffcents of the Margnal Abatement Cost Functons of the 2 Form: MCA = a Q + b Q. Regon a b R 2 USA JPN EEC OOE EET FSU EEX CHN IND DAE BRA ROW Source: Ellerman and Decaux (1998). 4 The Economc Effects of the Three Tradng Schemes n 2010 How the total emssons reductons requred of Annex 1 countres wll be met depends on the extent to whch the flexblty mechansms wll be allowed to contrbute to meet ther Kyoto targets. Ths s the area that remans to be decded by the clmate change negotators. For the purpose of llustraton, we examne three tradng scenaros here. No lmts scenaro: no caps are mposed on the use of all three flexblty mechansms so that one Annex 1 country can trade as much as t wshed untl t becomes more costly for the country to trade than to abate domestcally; The EU celngs wth the however clause scenaro: just as the name mples, the scenaro follows the EU proposal for concrete celngs on the use of all three flexblty mechansms, as dscussed n Secton 1. For an mportng country, the maxmum acqustons from all three flexblty mechansms are allowed up to 50% of the dfference between projected baselne emssons and the Kyoto targets n 2010, provded that the country can verfy a smlar volume of domestc abatement undertaken after We smply assume that such a verfcaton s possble wthout ncurrng sgnfcant transacton costs. On the export sde, we assume that unconstraned countres (those wth hot

12 An Economc Assessment of the Kyoto Protocol 11 ar) would be lmted to exportng only the amount of hot ar, whch s defned by the alternatve 1 under the EU proposal; and No hot ar scenaro: tradng n hot ar s not allowed, ndcatng that any effectuated tradng n GHG emssons must represent real emssons reductons. Under the above three scenaros, tradng of emssons permts s assumed to take place globally among all the countres. But, under the Kyoto Protocol non-annex 1 countres currently have no oblgatons to reduce ther GHG emssons. Thus, n our modellng exercses, these countres are treated as f they agreed to constran ther emssons n such a manner that they are allocated permts equal to ther projected baselne emssons. As such, non-annex 1 countres only reduce ther emssons by an amount equal to the number of permts they wsh to sell. Followng the defnton of the certfed credts from CDM projects, the amount of emssons reductons below the country-wde baselne trend s termed as the supply of the certfed CDM credts from each non-annex 1 countres Contrbutons of the Kyoto Flexblty Mechansms For countres whose emssons targets specfed under the Kyoto Protocol are expected to exceed ther antcpated emssons requrements even n the absence of any lmtaton, Secton 3 ndcates that these countres n 2010 wll have surplus assgned amounts of MtC avalable for sale. Because hot ar s avalable at zero abatement cost, hot ar s assumed to be used to the maxmum extent allowed, except for under the no hot ar scenaro. Ths means that, of the aggregate demand of MtC n 2010, hot ar contrbutes to MtC under the no lmts scenaro, and to 70.2 MtC under the EU celngs wth the however clause scenaro. Then, the remanng demand wll be met va domestc abatement actons and three flexblty mechansms. Insertng the aggregate magntude of emssons reductons requred and the sze of hot ar n 2010, the maxmum allowed acqustons and the maxmum allowed transfers n 2010, and the estmated coeffcents of the margnal abatement cost functon for each of the above twelve regons, we solve the 12-regon s margnal abatement cost-based model for determnng the dvson of abatement actons at 2 Ths mples that n our modellng exercses we treat the CDM synonymously wth emssons tradng as many other modellers do (Weyant, 1999). In real practce, the CDM s a project-based mechansm. Unlke homogenous permts under emssons tradng, concerns about addtonalty and the nherent dffculty of establshng counterfactual baselnes for heterogeneous CDM projects and montorng emssons reductons below the baselnes may mpose hgh transacton costs and thereby lmt the supply of CDM credts from non-annex 1 countres (Ellerman and Decaux, 1998; US Admnstraton, 1998).

13 12 Z. X. Zhang home and abroad usng GAMS, a wdely dstrbuted nonlnear programmng package (Brooke et al, 1996). Accordng to our calculatons, even f no lmts are mposed on the use of all three flexblty mechansms, not all the emssons reductons requred of an Annex 1 country wll take place abroad. Ths s because even f no account s taken of ancllary benefts of reducng GHG emssons, t s stll n the nterest of any buyng country to reduce ts own emssons as long as the margnal costs of dong so are lower than the prevalng prces of permts. Based on the margnal costs of domestc abatement for the twelve regons, t s estmated that a reducton of MtC, or 27.7% of the total needed emssons reductons n 2010 wll be met through domestc actons of Annex 1 countres under the no lmts scenaro (see Table 5). Ths s broadly n lne wth the fndng of the IPCC (1996) that reducng emssons by 20% from 1990 levels n developed countres wthn the next two or three decades can be acheved domestcally through no-regrets optons. When tradng n hot ar s not allowed, the nternatonal prce of permts ncreases n comparson wth the no lmts scenaro (see Table 6). As a result, the demand for permts abroad decreases, and more and more domestc abatement s undertaken. Ths s confrmed n Table 5, whch ndcates that a reducton of MtC, or 32.8% of the total needed emssons reductons n 2010 wll be met through domestc actons of Annex 1 countres under the no hot ar scenaro. Under the EU celngs wth the however clause scenaro, the amount of abatement through domestc actons n 2010 s estmated to be MtC, or 50.8% of the total emssons reductons requred of Annex 1 countres n The reason why the Annex 1 countres as a whole abate slghtly over 50% domestcally under ths EU celng scenaro s that Eastern Europe abates 68.7% domestcally (Zhang, 2001). Ths n turn s because ts low margnal abatement cost allows t to beneft from exportng permts up to the extent that ts domestc abatement cost equals the nternatonal prce of permts. Table 5: Scenaros No lmts EU celngs wth the however clause No hot ar The Contrbutons of Three Flexblty Mechansms Under the Three Tradng Scenaros n 2010 (MtC). Domestc actons Hot ar Emssons tradng and JI CDM Total supply Table 5 summarzes estmates of the contrbutons of three flexblty mechansms under the three tradng scenaros. It can be seen that the supply of certfed CDM credts n 2010 ranges from MtC under the EU celngs wth the however clause scenaro to MtC under the no lmts scenaro and to MtC under the no hot ar scenaro, respectvely. In comparson wth the no lmts scenaro, the

14 An Economc Assessment of the Kyoto Protocol 13 EU celngs wth the however clause restrcton would reduce the sze of the CDM market by 33.1%. Although such a restrcton s much relaxed n terms of ts mpact on the sze of the CDM market, n comparson wth the EU celngs wthout the however clause scenaro under whch the sze of the CDM market s cut by 54.9% (Zhang, 2001), ts mpact on the sze of the CDM market s stll very severe. Of the total emssons reductons requred of Annex 1 countres n 2010, the supply of the certfed CDM credts accounts for 31.5% under the EU celngs wth the however clause scenaro, 47.1% under the no lmts scenaro, and 57.6% under the no hot ar scenaro, respectvely. Table 6: Scenaros No emssons tradng No lmts EU celngs wth the however clause No hot ar Autarkc Margnal Abatement Costs n the No Tradng Case, and Domestc Prces and the Internatonal Prces of Permts n 2010 Under the Three Tradng Scenaros (at 1998 US$ per ton of carbon). Unted States Japan European Unon Other OECD Internatonal prce When there are no lmts mposed on the use of flexblty mechansms, the margnal cost of domestc abatement for each regon equalzes, and there s no dstncton between the nternatonal prce and domestc prces. Based on the model, the nternatonal prce of permts n 2010 s calculated to be US$ 9.6 per ton of carbon. Ths prce s pushed up to US$ 12.6 per ton when tradng n hot ar s not allowed. The ncrease n the nternatonal prce s partly because any sales for permts by the former Sovet Unon are generated by no cost-free abatement undertaken to earn export permts addtonal to the amount of hot ar, and partly because preventng tradng n hot ar ncreases the OECD countres demand for the certfed CDM credts. When the supplementarty restrcton as specfed under the EU proposal s mposed on the acqustons, the purchases of permts are restrcted. Ths wll push down the market prce. Thus, the nternatonal prce of permts s much lower under the EU celngs wth the however clause scenaro than under the no lmts scenaro. Moreover, because no account s taken of the dfferences n the margnal costs of domestc abatement among the Annex 1 countres, all the countres are requred to comply wth the same supplementarty rule. Ths could lead to a dstncton between the nternatonal prce of permts and domestc prces of buyng countres. The lesser extent t s allowed to purchase permts abroad, the hgher the domestc prces, and hence the larger the dstncton between the nternatonal prce and domestc prces. As ndcated n Table 6, because the autarkc margnal abatement cost for Japan s hghest, the EU proposed restrcton leads to the largest dfferental between the domestc prce n Japan and the nternatonal prce of permts. On the other hand, because the

15 14 Z. X. Zhang offcal projectons of baselne GHG emssons n 2010 by most EU member countres are very close to ther targets, the EU only needs to purchase a vey small amount of permts to meet ts targets. 3 As a result, the supplementarty restrcton examned here on the EU s much less severe than on Japan and the US. Consequently, domestc prce for the EU s very close to the nternatonal prce of permts. Because autarkc margnal abatement costs for the OECD countres excludng the EU are much hgher than the market prce of permts, tradng can help these countres to lower ther complance costs by avodng ther undertakng of more costly domestc actons. The extent to whch the complance costs can be lowered depends on the relatve dfferental between the autarkc margnal cost of the country n queston and the nternatonal prce of emssons permts. In percentage terms, the countres whose autarkc margnal costs are much hgher than the market prce wll beneft more than those countres whose autarkc margnal costs are closer to the market prce. As ndcated n Table 7, because Japan and the US have the hghest autarkc margnal abatement costs, the two countres beneft the most from tradng both under the no lmts scenaro and under the no hot ar scenaro. Measured as percentages of the total abatement costs n the no tradng case, the abatement costs of Japan and the US are cut by 93.1% and 85.2% under the no lmts scenaro, and 91.0% and 81.0% under the no hot ar scenaro, respectvely. By contrast, because the autarkc margnal cost for the EU s very close to the market prce, t acheves only small gans from tradng under the above two scenaros. Besdes, the restrcton on the use of flexblty mechansms tends to lower the gan from tradng. For the OECD as a whole, the reducton n abatement costs, namely, the gan from emssons tradng, decreases from 86.5% under the no lmts scenaro to 78.4% under the EU celngs wth the however clause scenaro. Table 7: Scenaros No lmts EU celngs wth the however clause No hot ar The Reductons n the Total Abatement Costs n 2010 Under the Three Tradng Scenaros (%). Unted States Japan European Unon Other OECD OECD The low EU baselne projectons are attrbutable n large part to nternal burden sharng of the Kyoto commtments among the member countres, havng ncorporated the mpacts of energy polces that are currently beng ether mplemented or negotated n response to clmate change, and to the choce of base year. See Zhang (1999, 2001) for detaled dscusson.

16 An Economc Assessment of the Kyoto Protocol The Sze of the CDM Market and the Shares of Chna and Inda Multplyng the endogenously-determned, nternatonal prce of permts by the supply of certfed CDM credts from each non-annex 1 country and summng over all the correspondng product, we can derve the value of the CDM market n As ndcated n Table 8, our estmate ranges from US$ mllon under the EU celngs wth the however clause scenaro to US$ mllon under the no hot ar scenaro. Subtractng ther own abatement costs, the net value of the CDM market n 2010, or the net gan of non-annex 1 countres s estmated to be n the range of US$ mllon under the EU celngs wth the however clause scenaro to US$ mllon under the no hot ar scenaro. The fndng that the net gan of non-annex 1 countres s hghest when tradng n hot ar s not allowed ndcates that to prevent tradng n hot ar, although n practce t s very dffcult to dstngush real emssons reductons from hot ar, s benefcal to the expandng of the CDM market as well as to the global clmate. Wth respect to the geographcal dstrbuton of the CDM flows, because of a great deal of low-cost abatement opportuntes avalable n the energy sectors of Chna and Inda and ther sheer szes of populaton, the two countres are expected to emerge as the domnant host countres of CDM projects. Ths s confrmed n Table 8, whch shows that about three-quarters of the total CDM flows go to Chna and Inda, respectvely. Because of relatvely hgh abatement costs and relatvely small sze, the remanng four non-annex 1 regons account for only 25% of the total flows channelled to developng countres through the CDM. Table 8: The Value of the CDM Market and the Shares of Chna and Inda n 2010 Under the Three Tradng Scenaros. CDM market (mllon US$) of whch: Chna Inda No lmts % 15.1% EU celngs wthout the however clause % 15.5% No hot ar % 14.9% Net CDM market (mllon US$) of whch: Chna Inda % 15.5% % 16.0% % 15.3% Because the CDM has an mportant role n helpng Annex 1 countres to meet ther Kyoto targets at a lower overall cost, some studes have estmated the potental sze of the CDM market. As ndcated n Table 9, these estmates vary. Assumng the contrbutons from domestc abatement actons and hot ar and dvdng the remanng demand between emssons tradng and JI among Annex 1

17 16 Z. X. Zhang countres and the CDM wthn non-annex 1 countres n proporton to the estmated potental of supply, Hates (1998) estmates that the sze of the CDM market n 2010 ranges from 265 MtC under 50% reducton from BAU emssons scenaro (under whch the maxmum allowed acqustons from all three flexblty mechansms are lmted to 50% of the dfference between projected BAU emssons and the Kyoto targets n 2010) to 575 MtC under the no lmts scenaro. The sze of the market estmated by the four economc modellng studes examned ranges from 397 MtC wth the OECD GREEN model (Van der Mensbrugghe, 1998) to 723 MtC wth the EPPA model (Ellerman and Decaux, 1998). Austn et al. (1998) argue that such estmates derved from these global modellng exercses tend to overestmate CDM flows because, n practce, poltcal lmtatons and transacton costs wll probably keep CDM actvty at the lower end of such estmates. Of the studes examned n Table 9, the estmate by Vroljk (1999) s at the low end of the range. In absolute terms, our estmate s at the low to mddle end. Ths s manly because, as ndcated n Table 9, our estmate of total emssons reductons requred of Annex 1 countres, whch s based on complaton of the natonal communcatons from 35 Annex 1 countres, s lower than those estmates from economc modellng studes. As dscussed n Zhang (1999), the man reason s that the offcal projectons of baselne GHG emssons n 2010 by most EU member countres are very close to ther targets, thus leadng to low demand for emssons reductons. In percentage terms, our estmate of the contrbuton of the certfed CDM credts s broadly n lne wth other estmates. Our upper bound estmate comes from the no hot ar scenaro. If the supply of hot ar s ncluded as other estmates from economc modellng studes do, then our upper bound estmate wll come down to 47.1% under the no lmts scenaro. Table 9: Estmates of the Sze of the CDM Market n EPPA Hates G-Cubed GREEN SGM Vroljk Our projecton Sze of the CDM market (MtC) Total emssons reductons requred of Annex 1 countres (MtC) Contrbuton of the CDM (%) Sources: Edmonds et al. (1998); Ellerman and Decaux (1998); Hates (1998); McKbbn et al. (1999); Van der Mensbrugghe (1998); Vroljk (1999); Zhang (2001). Can the CDM actually produce the amount of certfed credts as we estmate here? Ths s not that easy to answer, but experence wth actvtes mplemented jontly (AIJ) mght gve us some ndcatons. The frst Conference of the Partes to

18 An Economc Assessment of the Kyoto Protocol 17 the UNFCCC n Berln n Aprl 1995 endorsed a plot AIJ phase. Durng the AIJ plot phase, emsson reductons acheved are not allowed to be credted to current natonal commtments of nvestor countres under the UNFCCC. By the tme (30 June 1998) of the UNFCCC s second synthess report on AIJ, 95 projects were lsted as AIJ projects (UNFCCC, 1998). These projects are located n 24 host countres, wth Afrca hostng only one certfed AIJ project. If all the projects were fully mplemented and operatng as desgned, they would generate a combned GHG offset of 162 mllon tons of CO 2 equvalent, namely, 44 MtC equvalent, over an average lfetme of 16.5 years (UNFCCC, 1998). Translated nto an annual GHG offset, t amounts to 2.7 MtC. By contrast, the projected contrbuton of the certfed CDM credts mples as much as a 100-fold ncrease n ths type of project-based actvtes. Although lack of adequate ncentves for the prvate sector partcpaton n AIJ project fnancng lmts the role of the AIJ, to acheve such a substantal scale of ncrease n the quantty of emssons reductons, although not mpossble, poses great nsttutonal challenges for developng countres, gven that most non-annex 1 countres have not experenced an AIJ project wthn ther own countres. 5 Conclusons The Kyoto Protocol ncorporates emssons tradng, jont mplementaton and the clean development mechansm to help Annex 1 countres to lower the costs of meetng ther Kyoto targets. To what extent ther complance costs can be lowered depends on the extent to whch the flexblty mechansms wll be allowed to contrbute to meet ther Kyoto targets. Takng the year 2010 as representatve of the frst commtment perod, and usng a global model based on margnal abatement costs of 12 countres and regons, ths paper estmates how many of the emssons reductons requred of Annex 1 countres n 2010 wll be met through domestc abatement actons, emssons tradng and JI, and acqustons of the certfed CDM credts under the no lmts scenaro, under the EU celngs wth the however clause scenaro, and under the no hot ar scenaro. Our results suggest that, of the total emssons reductons requred of Annex 1 countres n 2010, domestc actons account for 27.7% under the no lmts scenaro, 32.8% under the no hot ar scenaro, and 50.8% under the EU celngs wth the however clause scenaro. The contrbutons of the certfed CDM credts n 2010 are estmated to range from 31.5% under the EU celngs wth the however clause scenaro to 47.1% under the no lmts scenaro and to 57.6% under the no hot ar scenaro. In absolute terms, the supply of the certfed CDM credts n 2010 ranges from MtC under the EU celngs wth the however clause scenaro to MtC under the no lmts scenaro and to MtC under the no hot ar scenaro, respectvely. Although t s at the low to mddle end of those

19 18 Z. X. Zhang estmates derved from economc modellng studes, our projected contrbuton of the certfed CDM credts mples as much as a 100-fold ncrease n the type of project-based actvtes n comparson wth an annual GHG offset through the AIJ of 2.7 MtC. No doubt, to acheve such a substantal scale of ncrease n the quantty of emssons reductons, although not mpossble, poses great nsttutonal challenges for developng countres. Wth respect to the geographcal dstrbuton of the CDM flows, we found that Chna and Inda account for about three-quarters of the total flows channelled to developng countres through the CDM. Besdes, our results clearly ndcate that the use of flexblty mechansms helps to lower the OECD countres complance costs by avodng ther undertakng of more costly domestc actons. However, the magntude of reductons n complance costs dffers substantally among the OECD countres. In percentage terms, the countres whose autarkc margnal abatement costs are much hgher than the market prce of permts wll beneft more than those countres whose autarkc margnal abatement costs are closer to the market prce. Furthermore, our results demonstrate that restrctons on the use of flexblty mechansms not only reduce potental of the Annex 1 countres effcency gans, but also are not benefcal to developng countres because they restrct the total fnancal flows to developng countres under the CDM. Thus, from the perspectve of husbandng the world s lmted resources, the fewer the restrctons on the use of flexblty mechansms the gans from ther use are greater. Acknowledgements Ths paper formed part of the presentatons at the Asan Development Bank/Unted Natons Envronment Programme s Workshop for Polcymakers on the Insttutonal Desgn of the Kyoto Protocol Cooperatve Implementaton Mechansms, UN Conference Center, Bangkok, October 1999; the Internatonal Workshop on Enhancng GHG Mtgaton through Internatonal Cooperatve Mechansms n Asa, Kanagawa, Japan, January 2000; Chna-US Workshop on Economc and Envronmental Modelng, Bejng, 5-6 March 2000; the 3 rd Bennal Conference of the European Socety for Ecologcal Economcs, Venna, 3-6 May 2000; the 10th Annual Conference of the European Assocaton of Envronmental and Resource Economsts, Crete, Greece, 30 June 2 July 2000; the Jont Meetng of the Energy Modelng Forum and the Internatonal Energy Workshop, Stanford Unversty, June 2000; the 40 th Congress of the European Regonal Scence Assocaton, Barcelona, 29 August - 1 September 2000; the Workshop on Emprcal Modelng of the Economy and the Envronment, Mannhem, Germany, June 2001; and at the Internatonal Expert Meetng on Clmate Change and Sustanable Development, Seoul, 6-7 September 2001; as well as at semnars at Tsnghua Unversty, Bejng, 17 March

20 An Economc Assessment of the Kyoto Protocol and East-West Center, Honolulu, 16 Aprl The author would lke to thank partcpants n the above Workshops and Conferences, J.R. Bhatt, A. Denny Ellerman and Adam Rose for useful dscussons and comments on an earler verson of the paper. Fnancal support from the Asan Development Bank s gratefully acknowledged. The vews expressed here are those of the author, and do not necessarly reflect the postons of the Asan Development Bank. All errors and omssons are my own. References Austn, D., P. Faeth, R.S. da Motta, C.E.F. Young, C. Ferraz, J. Zou, J. L, M. Pathak and L. Srvastava (1998), Opportuntes for Fnancng Sustanable Development va the CDM: A Dscusson Draft. Presented at a Sde-Event of the Fourth Conference of the Partes to the UNFCCC, 7 November, Buenos Ares. Brooke, A., D. Kendrck and A. Meeraus (1996), GAMS Release 2.25: A User s Gude, GAMS Development Corporaton, Washngton, DC Edmonds, J., C. MacCracken, R. Sands and S. Km (1998), Unfnshed Busness: The Economcs of the Kyoto Protocol, Pacfc Northwest Natonal Laboratory, Prepared for U.S. Department of Energy. Ellerman, A.D. and A. Decaux (1998), Analyss of Post-Kyoto CO 2 Emssons Tradng Usng Margnal Abatement Curves, MIT Jont Program on the Scence and Polcy of Global Change, Report No. 40, Massachusetts Insttute of Technology. Ellerman, A.D. and I.S. Wng (2000), Supplementarty: An Invtaton to Monopsony?, MIT Jont Program on the Scence and Polcy of Global Change, Report No. 59, Massachusetts Insttute of Technology. European Unon (1999), Communty Strategy on Clmate Change: Councl Conclusons, No. 8346/99, 18 May, Brussels. Hates, E. (1998), Estmate of the Potental Market for Cooperatve Mechansms 2010, Margaree Consultants Inc., Toronto, Canada. IPCC (1996), Clmate Change 1995: Economc and Socal Dmensons of Clmate Change, Contrbuton of Workng Group III to the Second Assessment Report of the Intergovernmental Panel on Clmate Change (IPCC), Cambrdge. McKbbn, W.J., M.T. Ross, R. Shackleton and P.J. Wlcoxen (1999), Emssons Tradng, Captal Flows and the Kyoto Protocol, Presented at the Intergovernmental Panel on Clmate Change Workng Group III Expert Meetng on the Economc Impacts of Annex 1 Mtgaton Polces on non-annex 1 Countres, May, The Hague. Tulpulé, V., S. Brown, J. Lm, C. Poldano, H. Pant and B.S. Fsher (1998), An Economc Assessment of the Kyoto Protocol Usng the Global Trade and Envronment Model, Presented at the OECD Workshop on the Economc Modellng of Clmate Change, September, Pars.

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