1. The Limits of (International) Cap and Trade Thomas C. Heller Stanford University June 18, 2009 Venice

2. Carbon Abatement Paradigm Common pool resources and inclusive governance Optimization –Stern report and cost-benefit analysis Regulatory mandates –Cap & trade or taxes to set carbon quantity or price (at point where MC = MB) –Commitments and targets key (accession to markets) General institutions and rules –Property rights and Hard law –Global carbon markets (to minimize costs of optimal solution) –Low specific institutional demands

3. Facts on the Ground Subsidies and PAMs (regulation) –Annex I Countries EU –Renewable Mandates, Energy Efficiency, Non-ETS US –Stimulus, Sectoral Policies, State measures (CA) –Non-Annex I Countries China National Action Plan and Fund Resistance to legal caps (enforceable?) Framework is not commitments, but current (supported) implementation of paths to low carbon growth –Role of prices and markets in operationalizing?

4. Source: McKinsey Global GHG Abatement Cost Curve v2.0 Abatement potential and cost - 2020 McKinsey Gobal abatement cost curve, 2020 (up to costs of €60 per tonne abated) 101520 Abatement potential Gt CO 2 e 0 10 20 30 40 50 60 70 -10 -100 -20 -30 -40 -50 -60 -70 -80 Cars aerodynamics improvement Cars internal combustion engine improvement Retrofit building envelope (commercial) New waste recycling Electricity from landfill gas Shift coal new build to gas Rice management Reduced deforestation from slash-and-burn agriculture conversion Reduced deforestation from pastureland conversion Grassland management -90 Organic soil restoration Pastureland afforestation Nuclear Onshore wind Biomass Offshore wind Solar conc. Reduced intensive agriculture conversion Solar photovoltaic Cost of abatement €/tonne Average cost of opportunities up to 17 Gt = €0 per tonne abated (if benefits from negative cost on left-hand side fully captured) Breakdown by abatement type 9 Gt for terrestrial carbon (forestry and agriculture) 6 Gt for energy efficiency 4 Gt for low carbon energy supply

5. Market Limitations Inadequacy of price signals for + NPV (left side of curve) –Information, finance, capacity and mandates Gaming, perverse incentives and sub-prime assets for – NPV (middle of curve) –Marginal differences small and regulated prices Barriers analysis prevails in CDM CDM (outside HCFC-22) is wind, hydro, landfill gas, oil & gas (flaring), industrial efficiency in steel and cement (last 3 left side) –Local environment, industrial policy, energy security and (- NPV) on economic costs alone –Forestry, land use and uncapped sectors (offsets issues) Inadequate price signal (right side of curve) Behavioral changes (cognitive psychology)

6. Supplemental Technology Policies? Innovation policy over carbon price + patents? –Carbon price too low and uncertain over time –Optimal price sets up high inframarginal rents If patents effective, subsidy needed to counter monopoly constraints If patents weak, sub-optimal production of innovation requires subsidy –Enforceability/uncertainty –Returns are slow to limited uptake in early period –Uncertainty about future vintage improvements –Pricing: Ramsey, competition both in given technologies and in energy services, branding

7. Value in mixed systems? Impact of policies and subsidies on demand for permits –Getting the allocation right –Linkage effects between markets with politically driven prices –Volatility, investment and expectations of enforcement Low market prices (low commitments or over- allocation): technology signals and sources of international funding High market prices (deeper commitments): cost containment, rents Price collars as remedies

8. Subprime assets (regulation) HFC-23 (1 st generation) –Baselines vs. efficient industrial procedures –Price –New facilities return? Landfill gasses (2 nd generation) Tariffs: (2 nd generation) –Wind and hydro facilities –Gas flaring –Dual regulation and the politics of gaming Relative learning: market players vs. regulators –Concentrate and reduce support decisions –Relative regulatory competence by instrument type

9. Political rents Markets clear at a single price –If supply curve is normally sloping, a selling party receives rents equal to the difference between market clearing price and its incremental costs of supply –Tons purchased at 1:1 ratio Markets as information revelation: price discovery mechanisms –Trade off of national infra-marginal rent transfers for efficient allocations (with redistribution possible) –How much do we know about the shape of the marginal carbon abatement cost curve? –Many of the elements of cost are not economic (technical) information, but available political or organizational (principal-agent; inertia) information, more responsive to administration than price

10. Source: McKinsey Global GHG Abatement Cost Curve v2.0 Abatement potential and cost - 2020 McKinsey Gobal abatement cost curve, 2020 (up to costs of €60 per tonne abated) 101520 Abatement potential Gt CO 2 e 0 10 20 30 40 50 60 70 -10 -100 -20 -30 -40 -50 -60 -70 -80 Cars aerodynamics improvement Cars internal combustion engine improvement Retrofit building envelope (commercial) New waste recycling Electricity from landfill gas Shift coal new build to gas Rice management Reduced deforestation from slash-and-burn agriculture conversion Reduced deforestation from pastureland conversion Grassland management -90 Organic soil restoration Pastureland afforestation Nuclear Onshore wind Biomass Offshore wind Solar conc. Reduced intensive agriculture conversion Solar photovoltaic Cost of abatement €/tonne Average cost of opportunities up to 17 Gt = €0 per tonne abated (if benefits from negative cost on left-hand side fully captured) Breakdown by abatement type 9 Gt for terrestrial carbon (forestry and agriculture) 6 Gt for energy efficiency 4 Gt for low carbon energy supply

11. Political rents National vs. international rents –Domestic redistribution options –Political controls over use of rents –Resource rent effects International Competitiveness –Profits retained in firms (even if baseline correct) –Chinese taxes and sectoral markets –Limit purchase to international public good

12. Economic rents Quantity of tons needed is scientific with a political definition of budget –Assume world needs 17 GT for 2 degree path –Assume 25% reductions in Annex I = 9 GT –Assume availability in Annex I to 2020 = 5GT –Assume non-Annex I countries reduce 3 GT due to self-interest –17 GT = 3 self-financed Non-Annex I +5 domestic in Annex I + 9 to be financially supported by Annex I in non-annex I

13. Economic rents Quantity of tons needed is scientific with a political definition of budget –If you buy tons 1:1 in an unmediated market, Annex I parties pay for 4 GT of offsets and acquire 4 GT of reductions (fixed budgets) –Buying nation meets its target, but the world is short mitigation by at least 5 GT (17- [5+4+3]=5) –Problem is to sell 4 GT in one market to acquire the funds to finance the incremental costs of 9 GT in another market (9+3+5=17)

14. Economic rents Need for arbitrage between paying (Annex I) markets and supplying (Non-Annex I) markets Re-invest surplus of funds acquired over incremental costs in additional tons needed Arbitrage vs. conventional carbon markets –Carbon market: buy and sell at single clearing price across integrated (linked) markets –Fund: governments provides budgetary resources that are allocated by fund at (incremental?) cost –Hybrid carbon financing system: commitment by Annex I parties to sell in their domestic markets international offsets at prices set by defined financing needs and use funds to support the incremental costs of non-Annex I mitigation –

15. Economic rents Multiple mechanisms for arbitrage –Fund (Amazon fund for forestry) –Segment markets to restrict conventional carbon market to high cost or flatly sloped areas of cost curve (EU) –Discount tons purchased (US) –Set baselines to fund incremental costs (Japan) –Market at 1:1 with rents taxed and reinvested by developing country host (China) –Intermediary (carbon) bank or ISO-like standards Portfolio of these mechanisms possible

16. Economic rents Principle of incremental costs –Ramsey pricing (differentiated prices by compensated demand) –Auction markets or tendering (public expenditure or property sales) –Convention on agreed incremental costs –No consumer (buying nation) surplus with full investment of proceeds in additional mitigation; global public goods maximized

17. Effective mitigation Efficiency of carbon prices? –Political limits on prices in Annex I produce lower than optimal price –Technical and behavioral change with sub- optimal incentives –Cost reductions through offsets magnify need for supplemental subsidies for technology innovation and learning

18. Effective mitigation Cost containment and displacement of available tons –Offset markets motivated by cost containment in domestic systems tend to: (1) supply expansion and (2) acquisition of low priced tons that are more likely to be self-financed by non-Annex I nations (on left half of curve) US bill seeks 1 (1.5) GT at 1:1.25 (after 2018) EU and Green Investment schemes –Global system output reduced by potential for discounted tons, displaced self-financed tons and inadequate domestic mitigation Low value for small expenditure

19. Looking forward Integrated over time, nations and sectors –Timing dilemma in early period Forestry and land use (concentrated) Capital stock turnover and new technologies Climate compatible growth plans for all countries Multiple actions by advanced industrial states –Domestic mitigation by marginal cost potential –International transfers for incremental costs above self- interest (+ credit facility for impaired capital amrkets) –Technology development facility (reverse auction) Standardized methodology (MRV as emergent) Efficient and arbitraged financial mechanisms International support and coordination for national growth plans