Monday, July 21, 2008

Primer - Part 2. Critical Aspects to Post-Kyoto Negotiations

It’s been over a month since my last posting, and I feel a little ashamed of it. However, it’s summer, and I’ve needed a break from the professional Me. Over the past year, I’ve been building up a pile of (non-energy related) books that I’ve only now had the chance to read. I’m also visiting my home country, Finland, and friends and family take up half of my time here. I love every moment of being here, but I know I have to return to the real world soon. Finland is a country that doesn’t share most of the real world’s problems. The education, health care, and social security systems are some of the most lavish of any country in the world. Our economy and geopolitical security are on par with the rest of EU-15, and according to some (very narrow-minded) studies we’re one of the few countries to even benefit from climate change. And yet, we’re leading the global statistics in violence, suicides and depression. I guess when you don’t have problems; you have to make them up. Or perhaps Albert Camus was partly right: maybe the struggle itself is necessary (though not enough, as he claimed) to fill a man’s heart. What makes the Finns depressed and violent is the lack of struggle.

I’ll continue with my primer to the blog, and I’ll briefly discuss the main aspects of global equity in GHG emissions and energy consumption, and take a look at different pricing mechanisms for CO2. These are enormous issues, and I plan to return to them many times again in this blog. For now, I just want to raise up the most central aspects to them. Next time, I’ll wrap up this primer series with a look at where electricity market deregulation has been going in different areas of world, and what we’ve learned from the experience.

There’s hardly a more important and challenging global policy issue at our hands than the Post-Kyoto negotiations for a new global climate treaty. The UN Conference in Copenhagen in late 2009 will be the critical point, but the drafting of the text for the new framework is planned to begin this summer. Nicholas Stern has been writing extensively on the subject of the new treaty, and his views should be taken very seriously. After all, at the moment he’s probably the most influential economist on the subject, and his opinions weight heavily on policy makers’ decision making. His recent paper, Key Elements of a Global Deal on Climate Change outlines some of the critical issues that need to be considered in the process, but his policy implications change quite dramatically, if one assumed more strict emissions cuts. His paper is based on calculations of bringing GHG emissions down by 50 % by 2050 relative to 1990 levels, leading to a CO2 concentration of 500 ppm. However, the recent studies of one of our leading climatologists, Jim Hansen, suggest that the goal should be as low 350 ppm, implying global emissions reductions on the scale of 80-90 %. The latter target would require reducing emissions in the OECD countries practically by 100 %, throwing one of Stern’s basic principles, efficiency (reduce emissions where they’re cheapest) out the window. If one is to believe Hansen, we need to reduce emissions everywhere, regardless of the costs.

In addition to the required level of global emissions reductions, the two other major issues of debate in the climate treaty include equity in emissions allowances and the optimal pricing mechanism for CO2. Since I’m not a climatologist, I should have more to say about these issues than about the required level of CO2 abatement. After realizing the magnitude of the required emissions reductions, global equity in energy use and emissions might sound like a mere philosophical question. But to policy makers it’s a real issue, which must be solved in the Post-Kyoto negotiations. If the people in the developing countries are entitled to the same living standards as the people in the West, it means that people in the West have to change their living habits tremendously to reduce their emissions – and they do. To abate the equity dispute, Stern proposes binding emissions reductions for developed countries immediately post-2012, while developing countries would not have to commit to binding reductions until 2020. The point of binding commitment could also be tied to certain “graduation criteria”, such as a given per capita GDP, beyond which binding commitments would have to be taken. Until 2020, developing countries would benefit from a one-sided trading system, in which they could sell emissions credits, but would not be required to buy them. In other words, they would be rewarded for mitigating emissions, but they would not be punished for failing to do so. In light of the current emissions, projected GDP growth rates, and the required abatement figures, this all sounds a little too lax to me. I’d rather remain a realist regarding what must be done, and inspire optimism in policy makers for what can be done. After all, China is already emitting 5 tons of CO2 per capita today, and the Chinese economy is projected to grow by 10-16 fold by 2050. Even in Stern’s conservative 500ppm scenario, the global average per capita CO2 emissions should be as low as 2 tons per annum by 2050. China must start decarbonizing its energy system at the same time as developed countries, as do India, Brazil and the rest of the developing world. I don’t see any way around this fact, if we are to seriously mitigate climate change – we simply cannot rely on non-binding commitments. Coal is just too cheap to burn to leave it in the ground without a real opportunity cost. As the only robust and real opportunity cost, I see an immediate (post-2012), universal and binding price for carbon. The compensation for developing countries must be dealt with in other ways than encouraging them to increase emissions until 2020, and we’ll discuss those ways in more detail later. Needless to say, they are financial.

So what is the optimal pricing mechanism for CO2 emissions? An efficient pricing mechanism for carbon emissions would involve low transaction costs, it would minimize additional negative market distortions, avoid perverse incentives and protectionism, and furthermore it should be transparent, credible, durable, and lastly: effective. I’m inclined to think that such a system is a global carbon tax, and not a cap-and-trade system which now seems to end up being the ultimate choice of the global community. The better transparency, credibility and effectiveness of the carbon tax can hardly be disputed, but there are other reasons, as well. First of all, the tax would dismiss most of the debate on distributing emissions, because no allowances would be allocated. France with its history of “clean” electricity production would face the same marginal cost of emissions as would Germany. Trust me; this is not a trivial issue even among developed countries. Secondly, a tax-based system would remove negative market distortions by making it possible to lower taxes on capital and labor. Every country could choose how to use its tax revenues the best way it saw fit. The transaction costs of a cap-and-trade system would also be much higher than a tax-based system, something that the global financial sector would welcome with open arms. But however important the liquidity improving role of the financial markets is in other cases, I just cannot see liquidity as a decisive factor in CO2 pricing. After all, we need to decrease emissions by 80-90 %, which means decreasing them everywhere. Furthermore, the social cost of CO2 emissions is the same universally, and individuals and firms alike should pay their full marginal cost.

We’re living in exciting times as decisions regarding these issues are about to be made. Our children and grand-children will one day judge, if there was one thing we managed to do right. I hope so.

To be continued.