Final exam

• The material for the final exam will begin with our
coverage of incentive based instruments: emission
taxes and cap and trade

• Thus, there will be slight overlap with the material

covered on the midterm
Back to climate change
The closest thing to a climate agreement
currently in place is the Paris agreement,
which was established in 2015

“By comparison to what it could have been,

it’s a miracle. By comparison to what
it should have been, it’s a disaster.”

-- The Guardian
Paris Agreement
• Negotiated by 196 UN countries in December 2015;
goes into effect in 2020
• 176 countries have signed the agreement, though US
dropped out in 2017
• At the time, the agreement was viewed as a
tremendous success, in part because expectations
were very low
Paris Agreement

• Intent is to keep temperature rise“to well below 2 °C

above pre-industrial levels and to pursue efforts to
limit the temperature increase to 1.5 °C above pre-
industrial levels”
• Nevertheless, country scale commitments to not add
up to nearly enough to ensure this
Main Economic Critique
• From an economic perspective, biggest limitation is
that emission reduction commitments (Nationally
Determined Contributions) are voluntary—thus, no
consequence if a country falls short
• Nevertheless, the agreement that exists is probably the
best that could have been achieved given political
constraints at the time
• As time has progressed, many countries have failed to
meet initial commitments
Limits of sub-global climate policy
• Given challenge of achieving an effective global climate agreement, it
is worth considering the potential to achieve desired outcomes
without a fully global treaty
• Two big problems with sub-global action:
1. Costs are higher
2. Leakage
1. Costs Higher

• Suppose the world consists of two countries with the

same marginal abatement costs
• Compare abatement costs when a 50 percent global
reduction in emissions is achieved by both countries
working together compared to case when it is
achieved entirely by one country
Estimate from Nordhaus (2008)
2. Leakage
2. Leakage

Carbon leakage (IPCC): “the increase

in CO2 emissions outside the countries
taking domestic mitigation action
divided by the reduction
in the emissions of these countries.”

CAUSES
• Price effect
• Firms relocate
• Industries relocate
A global market for coal
16 16 16
14 EU 14 China 14 Combined
12 12 12
10 10 10
8 8 8
$

$
6 6 6
4 4 4
2 2 2
0 0 0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 0 10 20 30
Tons of coal Tons of coal Tons of coal
 Coal market with unilateral policy

15 15 15
EU China Combined
10 10 10

$
5 5 5

0 0 0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 0 10 20 30

BEFORE: equilibrium price was

$7.50, China demanded 7.5 tons

AFTER: equilibrium price was

$5.00, China demanded 10 tons

Leakage rate is 50%

How big is leakage in practice?
• Most studies suggest the true leakage rate is between 5 and 25
percent

• Tends to be larger when

• Jurisdiction with policy is small
• Policy is ambitious
• When look over long time periods
Options to reduce demand-side leakage
Options to reduce demand-side leakage

Global policy

Go easy on high leakage sectors

Border tax adjustment

Even with high leakage, sub-global
action still has value through
creating incentives for innovation
Example: Newell et al., 1999,
Quarterly Journal of Economics
 Example: Newell et al., 1999,
Quarterly Journal of Economics

• Prior to 1973, most innovations in air conditioning technology led to

cheaper units, but not to more energy efficient units
• In contrast, with higher energy prices after 1973, most innovations
favored more energy efficient units

Clean energy innovation will only happen on

large scale if the products have a market; only
true if carbon emissions are regulated
How can we make the cooperative outcome
in the prisoner’s dilemma game self-
reinforcing? how to overcome free-rider? country interest to act in cooperation
• Add penalties for not participating?
• But there is no international agency to enforce, so the
penalty has to come from the other players
• It must be a penalty that countries can levy on each
other while finding it in their interest to follow
through when the time comes to do so
economically valuable: access to free trade
word trade org: strict rules --> follow the rules if you want to join

Linking to trade agreements is most compelling avenue

Clubs
Characteristics of economic goods

Nonrival Club good Public good

(Vaccinations)
(Fitness center)

Private good Open access resource

(Slice of pizza) (Ocean fishery)
Rival

Excludable Nonexcludable
Clubs

o A club is a voluntary group deriving mutual benefits from sharing the cost of
producing an activity that has public-good characteristics (non-rival)

o The gains from a successful club are sufficiently large that members will pay
dues and adhere to club rules in order to gain the benefits of membership

o EXAMPLES:
o Country club
o Fitness club
o World Trade Organization
o NATO
Conditions for a successful club
1. There is a public-good-type resource
that can be shared
(whether a fitness club or a military alliance)
2. The cooperative arrangement, including
the dues, is beneficial for each member
3. Non-members can be excluded or penalized
at relatively low cost to members
4. Membership is stable in sense
that no one wants to leave
The Climate Club
The Climate Club linking to trade

An agreement by participating countries to impose a target carbon price

(for example, all countries could agree to implement
a minimum domestic carbon price of $25 per ton CO2)

To punish nonparticipants, all club members impose a tariff on the

imports of nonparticipants into the club region

Importantly, the club overcomes the free rider problem by creating a

strategic situation in which countries acting in their own self-interest will
choose to enter the club and undertake high levels of emission
reduction because of the structure of incentives
Uniform Tariffs as Penalty
• Participating countries levy a uniform percentage tariff
(perhaps 2 percent) on all imports from nonparticipants
• The approach is simple and transparent, though in no way linked
to the carbon content of imports
Coalition DICE (or C-DICE)
• Extension of the multi-region DICE model used to
study the incentives for different regions to join a
coalition of high-abating countries
• Model has 15 regions: US, EU, China, India, Russian
Federation, Japan, Canada, South Africa, Brazil,
Mideast and North Africa, Eurasia, Latin America,
tropical Africa, middle-income Asia, and the ROW
(rest of world)
Coalition DICE (or C-DICE)
• The model has region-specific damages and region-
specific abatement costs
• Includes effects of international trade and tariffs on
economic welfare of each region
• Accounts for both the benefits and costs (to itself and
others) when a country imposes a tariff on others
Gains and losses from participation
Gains and losses from participation
• When an individual country chooses whether or not to participate, it
compares the added abatement cost from joining (net of the
domestic reduction in damages) to the trade benefits from joining
• The trade benefits depend critically on how many other regions are
participating in the club and the target tariff rate
Results: A first example
Results: A first example
• Suppose the target carbon price is
$25 per ton CO2
• The penalty tariff rate is 4 percent
• All high-income countries are in the club
• The US is considering whether or not
to participate
The no-sanction regime (row 1) is akin to the Paris Agreement
(or Kyoto Protocol)

Note: “Damages” are a benefit

What is new?
• What distinguishes the club design from typical
international treaties is a mechanism that effectively
sanctions nonmembers (by imposing a tariff on other
countries)
• Nordhaus arrives at the quantitative conclusion that free
rider incentives are too strong to provide adequate
amount of climate policy without meaningful punishments
on nonmembers
• In DICE, the “Nash equilibrium” amount of climate policy
(countries sign treaty with voluntary participation) is ~12
percent of optimal abatement level!
Simulations
• The model is run for four different target carbon prices: $12.5, $25,
$50, and $100 per ton CO2
• For each, tariff rates ranging from 0 percent to 10 percent are
considered
• Specifically, 0%, 1%, 2%, 3%, 4%, 5%, 6%, 7%, 8%, 9%, 10%
• For each “regime” (carbon price and tariff), the model determines
how many countries participate in the stable coalition
Corresponding emission reductions
• With 100 percent participation, emissions reduction
for each carbon price are as follows:

Carbon price Emission reduction

$12.5 9 percent
$25 18 percent
$50 36 percent
$100 72 percent
Higher reductions would require technical change or a higher tariff (which Nordhaus
argues would place an implausible burden on the trade and enforcement systems)
Analysis of Kyoto Protocol
• Nordhaus uses the model to study coalition stability under the terms
of the Kyoto Protocol: Only the Annex 1 countries have binding
emission commitments to start with non penalty for noncompliance
(0% tariff)

All simulations collapse to the noncooperative equilibrium

Conclusion: “The Kyoto Protocol was doomed from

the start. It did not contain sufficient economic glue
to hold a cooperative coalition together.
How would a climate club come about?
 How would a climate club come about?

• Two options:
• A top down treaty signed by many countries
• A club that starts small with a handful of key players, then grows from there
• Either option could work
• History of international regimes (e.g., gold and dollar standards,
cholera conventions, WTO, European Union, and the internet) show
that paths are often unpredictable
• Similarly, there could be many possible paths to a successful
climate club
 The incentive to free ride inherent in the Kyoto Protocol and the Paris
Agreement are critical obstacles that cannot be ignored

Achieving a climate agreement in which it is in the interest of participants to

follow through with it will require linking climate policy to something else of
substantial value to them – most likely access to free trade

Current international debates on climate policy are just starting to seriously

consider the importance of linking a climate agreement with trade

Progress in this direction will likely require that citizens and politicians move on
from questioning the science and develop sufficient “economic literacy” to
understand why this type of approach is needed