Trade And Environment: Theory And Policy in the Context of Eu Enlargement And Economic Transition (The Fondazione Eni Enrico Mattei (Feem) Series on Economics and the Environment)

Trade and Environment

THE FONDAZIONE ENI ENRICO MATTEI (FEEM) SERIES ON ECONOMICS AND THE ENVIRONMENT Series Editor: Carlo Carraro, University of Venice, Venice and Research Director, Fondazione Eni Enrico Mattei (FEEM), Milan, Italy Editorial Board Kenneth J. Arrow, Department of Economics, Stanford University, Stanford, California, USA William J. Baumol, CV Starr Center for Applied Economics, New York University, New York City, USA Partha Dasgupta, Cambridge University, Cambridge, UK Karl-Göran Mäler, The Beijer International Institute of Ecological Economics, The Royal Swedish Academy of Sciences, Stockholm, Sweden Ignazio Musu, University of Venice, Venice, Italy Henry Tulkens, Center for Operations Research and Econometrics (CORE), Université Catholique de Louvain, Louvain-la-Neuve, Belgium The Fondazione Eni Enrico Mattei (FEEM) was established in 1989 as a non-profit, nonpartisan research institution. It carries out high-profile research in the fields of economic development, energy and the environment, thanks to an international network of researchers who contribute to disseminate knowledge through seminars, congresses and publications. The main objective of the Fondazione is to foster interactions among academic, industrial and public policy spheres in an effort to find solutions to environmental problems. Over the years it has thus become a major European institution for research on sustainable development and the privileged interlocutor of a number of leading national and international policy institutions. The Fondazione Eni Enrico Mattei (FEEM) Series on Economics and the Environment publishes leading-edge research findings providing an authoritative and up-to-date source of information in all aspects of sustainable development. FEEM research outputs are the results of a sound and acknowledged cooperation between its internal staff and a worldwide network of outstanding researchers and practitioners. A Scientific Advisory Board of distinguished academics ensures the quality of the publications. This series serves as an outlet for the main results of FEEM’s research programmes in the areas of economics, energy and the environment. Titles in the series include: The Endogenous Formation of Economic Coalitions Edited by Carlo Carraro Climate Change and the Mediterranean Socio-economic Perspectives of Impacts, Vulnerability and Adaptation Edited by Carlo Giupponi and Mordechai Shechter Game Practice and the Environment Edited by Carlo Carraro and Vito Fragnelli Analysing Strategic Environment Assessment Towards Better Decision-Making Edited by Pietro Caratti, Holger Dalkmann and Rodrigo Jiliberto Trade and Environment Theory and Policy in the Context of EU Enlargement and Economic Transition Edited by John W. Maxwell and Rafael Reuveny

Trade and Environment Theory and Policy in the Context of EU Enlargement and Economic Transition

Edited by

John W. Maxwell Kelley School of Business, Indiana University, USA and ZEI, Germany

Rafael Reuveny School of Public and Environmental Affairs, Indiana University, USA

THE FONDAZIONE ENI ENRICO MATTEI (FEEM) SERIES ON ECONOMICS AND THE ENVIRONMENT

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© John W. Maxwell, Rafael Reuveny, 2005 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. 136 West Street Suite 202 Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library

ISBN 1 84542 164 7 Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall

Contents vii ix xi xii

List of figures List of tables List of contributors Acknowledgements 1 Introduction John W. Maxwell

PART I THE TRADE–ENVIRONMENT DEBATE IN CONTEXT: THE US DECISION ON KYOTO 2 The Kyoto Protocol: a flawed concept Richard N. Cooper 3 You’re getting warmer: the most feasible path for addressing global climate change does run through Kyoto Jeffrey A. Frankel

PART II TRADE AND ENVIRONMENTAL POLICIES 4 Trade, the harmonization of environmental policy and the subsidiarity principle Charles Perrings

5 Trade and the environment in the perspective of EU enlargement Alexey Vikhlyaev

6 Can environmental regulations be compatible with higher international competitiveness? Some new theoretical insights Savas Alpay

113

PART III

Contents

ENVIRONMENTAL POLICY CONCERNS IN THE CONTEXT OF EU ENLARGEMENT

7 Environmental implications of EU enlargement: lessons from the southern member states and preliminary evidence from Poland 143 Onno J. Kuik and Frans H. Oosterhuis 8 Strategic environmental policies with foreign direct investment: implications of European enlargement M. O¨zgür Kayalica and Sajal Lahiri

167

9 External actors and their prospective roles in environmental cleanup in Central and Eastern Europe Matthew R. Auer and Rafael Reuveny

182

10 How can economies in transition pursue emissions trading or joint implementation? Fanny Missfeldt and Arturo Villavicenco

207

PART IV ECONOMIC AND ENVIRONMENTAL POLICIES IN TRANSITION ECONOMIES 11 Energy and sustainability in Central Europe: a decade of transition in review Diana Ürge-Vorsatz, László Paizs and Radmilo Pesic 12 Reorganization of environmental policy in Russia: the decade of success and failures in implementation and prospective quests Vladimir Kotov and Elena Nikitina

227

265

13 Policy in transition: a new framework for Russia’s climate policy 293 Vladimir Kotov Index

339

Figures 7.1 Indices of economic activity and emissions in Poland 9.1 Twenty largest point sources of arsenic pollution in the Czech Republic, 1993–97 9.2 Standardized mortality due to malignant neoplasm in the Czech Republic, 1996–99 average 9.3 Long-term unemployment as a percentage of total unemployment in the Czech Republic (31 December 2000) 9.4 Average monthly gross wages (kroons) in Ida-Viru County versus all Estonian counties

160

191 192 193 195

10.1 Carbon intensities in EITs in 1999 10.2 Public versus private perspectives on CO2 reduction costs

214 218

11.1 Per capita SO2 emissions in selected countries, 1989 11.2 CO2 emissions per unit of economic output in selected countries and OECD, 1980, 1989 and 1999 11.3 Per capita primary energy supply in selected countries and country groups, 1989 11.4 Energy intensities in selected countries and country groups, 1989 11.5 The development of electricity prices for industry in selected countries and OECD, 1990–2000 11.6 The development of electricity prices for households in selected countries and OECD, 1990–2000 11.7 GDP of Hungary, Poland, the Czech Republic and Russia 11.8 The development of primary energy supply in selected CEE countries, 1985–98, as a percentage of 1989 values 11.9 TPES per capita in selected countries and country groups 1989–98 11.10 The development of electricity consumption in selected CEE countries, 1985–99 11.11 Index of industrial production in selected CEE countries 11.12 The development of energy intensities in CEE countries, 1989–98

228

vii

230 231 232 243 244 245 246 247 247 248 250

viii

Figures

11.13 The development of energy intensities in selected countries and other country groups, 1983–97 11.14 The development of energy intensities in selected countries and OECD, 1983–99 11.15 Development of the structure of TPES in Poland, 1988–99 12.1 New Russian environmental facilities, 1976–2000 12.2 Sources of capital investments in environmental protection and natural resources conservation in Russia, 2000 (%)

251 251 255 283 285

Tables 7.1 Macroeconomic and environmental indicators for southern accession countries in 1975 and ACs in 1990, in relation to the EC-9 and EU-12, respectively 7.2 Growth of Greek agricultural activity by enterprise prior and post accession 7.3 Annual GDP growth (%) in Greece, Portugal, Spain and the EC in constant 1990 prices 7.4 Revealed comparative advantages by sector, 1997 7.5 Foreign direct investment in Cohesion countries, 1987–96 7.6 Growth of the economy and environmental pressures in Spain, 1985–93 7.7 GDP per capita and regional disparities, purchasing power standards (EU-15=100) 7.8 Share of main sectors in value added and employment in Poland and the EU-15 7.9 Selected environmental indicators for Poland and the EU-15 7.10 Composition of household consumption by major spending categories (as % of total household expenditure), 1997 9.1 Environmental characterization of FDI inflows to CEE in 1997 and 1998 (%) 9.2 Rate of increase in unemployment in fourth quarter 2000 versus November 1997 across Polish Voivodships 10.1 Fulfilment of eligibility requirements for the Kyoto Mechanisms 10.2 Quantifying ‘hot air’ 11.1 Policy agenda to reduce high energy intensities and unsustainable energy practices in CEE 11.2 The status of the implementation of the policy agenda outlined in Table 11.1 in the three CEE countries discussed 12.1 Dynamics of environmental indicators and GNP in Russia 12.2 Dynamics in greenhouse gas emissions in Russia ix

147 150 151 152 153 155 156 158 159 161

186 196

210 213

239 257 271 272

Contributors Savas Alpay, TOBB Economy and Technology University, Turkey Matthew R. Auer, Indiana University, USA Richard N. Cooper, Harvard University, USA Jeffrey A. Frankel, Harvard University, USA ¨ zgür Kayalica, Sakarya University, Turkey M. O Vladimir Kotov, Russian Academy of Sciences, Russian Federation Onno J. Kuik, Vrije Universiteit, The Netherlands Sajal Lahiri, University of Essex, UK John W. Maxwell, Indiana University, USA and ZEI, Germany Fanny Missfeldt, Risø National Laboratory, Denmark Elena Nikitina, Russian Academy of Sciences, Russian Federation Frans H. Oosterhuis, Vrije Universiteit, The Netherlands László Paizs, Central European University, Hungary Charles Perrings, University of York, UK Radmilo Pesic, Belgrade University, Serbia Rafael Reuveny, Indiana University, USA Diana Ürge-Vorsatz, Central European University, Hungary Alexey Vikhlyaev, UNCTAD, Switzerland Arturo Villavicenco, Risø National Laboratory, Denmark

Acknowledgements We would like to thank FEEM, Milan and ZEI, University of Bonn for financially supporting the two workshops that led to this volume. We thank Marialuisa Tamborra for ogranizing these two workshops and for her early efforts in developing this volume. We also thank the following individuals for their copy-editing assistance: Andrea Burtaski, Clara Cao, Dong Chen, Susan Chen, Keith Larsen, and Jing Li. We especially thank Luisa Rovetta for her administrative assistance.

xii

Introduction John W. Maxwell

The discovery of the ozone hole over Antarctica in 1982 and its subsequent connection to the production and use of Chloroﬂuorocarbons (CFCs) represented an important link between industrialization and its impact on the global environment. Today, the debate over how best to manage the interplay between trade, industrialization and their impacts on our global environment (known as the trade–environment debate) is commonplace in the academic and popular press. Much of this debate has been concerned with the scientiﬁc evidence on the impact of industrialization on the environment, the economic evidence concerning the creation of wealth and its impact on the demand for a cleaner environment, and the ethics concerning how burdens should be shared by industrialized and developing nations. Given the multiplicity of issues and perspectives, this debate could be endless. The 1997 Kyoto Protocol has brought some immediacy to the trade– environment debate. The Protocol, concerning the reduction of greenhouse gas emissions, placed in a speciﬁc context all of the issues of the general debate. The European Union nations became the chief advocates of the Protocol, while the United States, under the administration of George W. Bush, became its chief opponent. A sufficient number of nations have pledged to ratify the proposal, and a number of nations are presently debating ratiﬁcation. Even if the protocol fails the ratiﬁcation stage, it is unlikely that the European Union will abandon its greenhouse gas emission reduction targets.1 Thus, the situation now faced by the European Union (EU) provides us with a concrete example of how policy must be developed in order to constrain the impact of industrial production on the natural environment while at the same time ensuring acceptable rates of economic growth. Indeed, in the context of the trade–environment debate, the European Union provides us with a microcosm of the world. With the accession of Central and Eastern European (CEE) countries to the EU, the union now contains both developed and industrializing nations. As such, EU policy must adapt to the different realities of these two types of economies.

Trade and environment

In the initial phases of the Protocol, the EU might beneﬁt from their industrializing members. The collapse of the Soviet Union, and the subsequent collapse of CEE economies, means that those economies are likely to produce fewer emissions than their targeted levels. This should ease the burden on the developed EU economies, which are already exceeding their targeted emissions levels. The Protocol, however, is simply an initial step in achieving what scientists argue are required emissions reductions. Consequently, the pressures of rapid economic development and continued development of large economies, in the face of a goal to reduce their environmental footprints, must be met by EU policy. This volume contains a series of essays that deal with numerous issues in the trade–environment debate, with a particular focus on EU enlargement. Two non-EU-based perspectives, American and Russian, are included as well. The papers in this volume have been selected from several papers presented at the Fondazione Eni Enrico Mattei (FEEM) in Milan, Italy in the summer of 2002 in two workshops on Trade, the Environment and Carbon Flows in Europe. The sessions, co-sponsored by FEEM and the Centre for European Integration Studies (ZEI) in Bonn, Germany, produced lively debates and important feedback for the presenters. The papers selected for this volume have been revised and updated so as to incorporate this feedback and incorporate present policy conditions. The book begins with articles from two prominent American scholars who present each side of the debate over the Kyoto Protocol. With this debate ﬁrmly in mind we turn, in Part II, to a review of the broader trade–environment debate by undertaking a critical analysis of the interplay between current World Trade Organization (WTO) and EU economic policies and how those strategies conﬂict with courses of action aimed at environmental protection. In Part III we focus on the economies of the EU accession countries. Several articles provide an economic and environmental history of these economies, while others provide policy suggestions regarding how EU policies and actions can best strike a balance between necessary environmental improvements while at the same time promoting trade and economic development. Part IV is devoted to three papers detailing various impacts of economic transition on environmental institutions, policies and outcomes of CEE nations and Russia. While not an EU member, Russia will play an important role vis-à-vis the EU in the area of trade and the environment. As a means of meeting its Kyoto obligations, it is likely that the EU will rely on imports of natural gas from Russia. Recent large investments from EU energy companies, most prominently BP, will help to fully develop Russia’s energy potential. In addition, the Soviet collapse has left Russia producing greenhouse gas emissions that are well below its Kyoto targets. While reliance on foreign nations to meet one’s own national Kyoto obligations,

Introduction

through the use of, say, tradable emissions credits, is less popular in the EU than with other large greenhouse gas emitting nations (such as the US, Canada, Australia and Japan), reliance on Russia’s ‘emissions gap’ may grow in popularity if internal solutions fail and if targets become more stringent. The ﬁnal paper in this volume, however, offers a warning in this regard. In Russia the ﬁnancial attractiveness of the Protocol is fading, and with it the chances of ratiﬁcation. Finally, the precarious state of Russia’s environment is of great importance to the EU as Russia is now a neighbouring country. This fact is illustrated by the general unease within the EU at suggestions that Russia may engage in the development of nuclear power generating facilities along its western boarder in order to free up natural gas reserves for sale to EU nations.

THE TRADE–ENVIRONMENT DEBATE IN CONTEXT: THE US DECISION ON KYOTO The ﬁrst two chapters in this volume provide different American perspectives on the US government’s decision not to support the Kyoto Protocol. The chapters are included in this volume since they help to illustrate, in context, the broader debates over the science and economics of environmental policy and its interplay with economic development. In his chapter, Richard N. Cooper outlines the case against the Kyoto Protocol. After stating that the Bush administration’s decision not to participate in the Protocol was unnecessarily vague, he goes on to argue that failure of the Protocol would constitute no great loss for society. In short, Cooper argues that the Protocol is ﬂawed in several aspects, including its limitation on participants, its vagueness concerning the means by which nations should achieve their goals, and the fact that the Protocol’s design delivers short-term political costs with gains occurring only over the longer term. Cooper begins his condemnation of the Protocol by noting that the problem of global warming is, as its name suggests, global in scope. He argues that the problem must be tackled globally, and is particularly critical of the exemption of larger developing countries such as China and India from the Protocol. He argues that in its present form the Protocol is weak and unlikely to contribute signiﬁcantly to solving the global warming problem. Next, he argues that at the time of the supposed entry of developing nations into the Protocol, they will surely demand further concessions, further weakening it. The vague nature of the Protocol is noted in relation to supposed markets for tradable emissions permits. At present it is unclear who the

Trade and environment

participants in these markets will be. Will they be national governments or the multitude of ﬁrms residing in the nations that sign the Protocol? If it is the latter, how will trade between ﬁrms be monitored and required emissions reductions be appropriately enforced? The imposition of a trading system also brings to light problems with excluding some nations from the Protocol. It may be the case that trade involving ﬁrms residing in nations that are non-signatories is the most efficient course to achieve greenhouse gas emissions reductions. Other problems associated with any possible trading system include how to deal with ﬁrms that have been grandfathered into the system and then go bankrupt. Cooper closes by suggesting the alternative approach of having nations commit to actions rather than targets. In particular, he suggests a universal agreement to impose a carbon tax. Although nations may face differing degrees of opposition to such a tax, Cooper argues that taxes carry the political beneﬁt of generating short-term gains for governments in the form of general revenues. The idea of a common carbon tax could then be extended to other greenhouse gasses such as methane. Finally, Cooper notes that in light of the fact that some nations may fail to pass taxes on greenhouse gasses, all nations should position themselves for adaptation to climate change in the event that the world fails to coordinate sufficient actions to avoid impending global warming. Jeffrey A. Frankel defends the Clinton administration’s version of the Kyoto Protocol in dealing with global warming through his own experiences as a member of President Clinton’s Council of Economic Advisers on global climate change. He starts with the scientiﬁc evidence (for example, the IPCC report) showing that the Earth is getting warmer, and argues that the approach to addressing global climate change must be multilateral due to the free-rider problem. Frankel then reviews the speciﬁc US principles upon which the Clinton administration’s proposal presented at the third conference of the UN Framework Convention on Climate Change (UNFCCC) in 1997 in Kyoto were based. First, he believes that the traditional cost–beneﬁt methods such as Integrated Assessment Models and Business as Usual path were constrained in the Kyoto Protocol application, because of tremendous uncertainties involved in any model and difficulty in assigning probabilities on catastrophic scenarios. The economists at the Council of Economic Advisers used estimates by Alan Manne and Rich Richels and found that the most efficient paths involved heavy cuts below current levels of emission only in the second half of the 21st century. Second, Frankel notes the importance of the political environment in which the Kyoto Protocol was set up. Any US policy to address climate change has to contend with four political chasms: (1) the gap between

Introduction

environmentalists and the Congress in understanding the climate change issue and willingness to bear some economic costs to address it; (2) the gap between the US and the European Union; (3) the gap between the US and developing countries; and (4) the chasm between engineers and economists. Third, Frankel emphasizes the ﬂexibility mechanisms embedded in the Kyoto Protocol, namely, ‘when ﬂexibility’, ‘what ﬂexibility’ and ‘where ﬂexibility’. ‘When ﬂexibility’ refers to the fact that countries are allowed to average over the ﬁve years of the budget window (2008–12) and to bank any reductions beyond the target for future budget periods. ‘What ﬂexibility’ implies that individual numerical targets for six different gases were replaced by a numerical target of a linear combination of the six. ‘Where ﬂexibility’ is the most contentious issue. It loosened the constraint regarding within whose borders physical reductions in emissions occurred. Speciﬁcally, it allowed international trading of emission permits, and includes developing countries. Fourth, Frankel explains the Council of Economic Advisors (CEA) estimates of the economic costs of the policy to show the legitimacy of allowing the international trading of emission permits. Lastly, he explains why the Kyoto Protocol set quantitative targets rather than relying on the price mechanism: the price mechanism is not politically feasible.

TRADE AND ENVIRONMENT POLICIES Part II contains three chapters. The ﬁrst two chapters offer overviews of the interplay between supranational policies governing international trade, and supra- and subnational policies governing environmental protection. The ﬁnal chapter offer theoretical investigations of this policy interplay. Charles Perrings examines the linkage between trade and environmental policies, and the role of harmonization of environmental policy. From the discussion, useful implications about trade and environmental policies in the enlarged EU and WTO are provided. Perrings ﬁrst reviews the literature on the linkage between trade and environment. In particular, the author discusses a strand of literature which explores the impact of trade liberalization on the environment. The common view is that as a result of the composition effect, liberalization of global markets is environment-improving. The counter-argument, that liberalization increases environmental damage, is also presented. Perrings claims that the impact of trade liberalization is an empirical question, and that it depends on people’s preferences between environmental quality and consumption possibilities.

Trade and environment

Perrings then considers the importance of country differences. Differences in economic structures, income levels, labour market conditions, technological development and environmental resource endowments create an incentive to negotiate the linkage between environmental institutions and trade pacts, given that environmental policy may be used as a surrogate for trade policy in place of subsidies or tariffs. Next, the discussion focuses on issues related to coordination, harmonization and subsidiarity within the EU. In particular, the characteristics of the Sanitary and Phyto-Sanitary Measure (SPS) and Article XX measures associated with trade pacts are considered. Perrings indicates that harmonization of environmental policy is driven by a trade agenda, and that it will be inefficient if environmental conditions and preferences are different between different locations. Harmonization also tends to be incompatible with the subsidiarity principle. Coordination of policy, instead of harmonization, is needed in the above setting. The above arguments are illustrated by a particular problem, the problem of invasive alien species (IAS). Perrings uses the speciﬁc case of foot-andmouth disease (FMD) to extend the discussion on the linkage between trade and environmental policy. The chapter concludes that it is inappropriate for environmental policy to be driven by trade policy. Harmonization induces an inefficient and environmentally inappropriate use of local resources in that it ignores local conditions and local preferences. Perrings claims that it would be a mistake, for both economy and the environment, to apply harmonization to countries with very different socio-economic and environmental conditions across the enlarged EU. In Chapter 5, Alexey Vikhlyaev examines how various trade measures relate to domestic health, safety and environmental protection policies in the context of a multilateral trading system and regional integration arrangements. Based on the discussion, he provides valuable recommendations for policy makers. First, he reviews broad issues concerning trade measures for environmental purposes in the WTO and EU. In general, not only do international instruments address risk, lack of certainty and action, but also regional integration agreements incorporate the notion of precaution in situations of uncertainty. In detail, he reviews issues related to two core trade and environment concerns in both the WTO and the EU: (1) different balance between market access, and (2) environmental protection and regulatory tensions between jurisdictions with differing environmental standards. In particular, he focuses on domestic, extra-jurisdictional and institutional aspects of trade and the environment in the WTO and the EU.

Introduction

WTO, Article XX, the SPS and the Technical Barriers to Trade (TBT) determine the levels of domestic health, safety and environmental protection. The evolution of these three sets of rules is also discussed with applications. The discussion of extra-jurisdictional activities deals with the scope of trade measures for environmental purposes. Finally, the WTO institutions have very limited directives on domestic health, safety and environmental protection, and the relationship between the provisions of the multilateral trading system and trade measures for environmental purposes. Conﬂicts in the process of trade–environmental rule making between developed and developing countries are speciﬁed as well. The EU adopts similar rules to restrict imports from other member states that do not comply with domestic levels of health, safety and environmental protection. In contrast to the WTO, the EU offers upward harmonization of domestic standards at a high level of protection. The EU also goes further than the WTO on extra-territorial activities and provides a regime of minimum production process or methods standards (PPMs) and a large number of directives to address air, water, waste and chemicals. Furthermore, the absence of a unanimity requirement contributes to better environmental standards and harmonization in the EU, compared with the WTO. In conclusion Vikhlyaev argues that trade and environmental rule making is a function of economic integration that cannot succeed without each other. The comparative discussion on trade and environmental issues within the GATT/WTO and the EU indicates a rationalization of trade and environmental rule making. Savas Alpay explores the Porter hypothesis, which has not been given much credit in the academic environmental economics literature. The Porter hypothesis concerns the relationship between environmental regulations and international competitiveness of the domestic ﬁrms subject to higher environmental standards. Speciﬁcally, it argues that environmental regulation can augment regulated ﬁrms’ international competitiveness under the conditions that these ﬁrms engage in innovation and that the environmental regulation is incentive-based. This view is contrasted to the conventional one that claims stricter environmental regulations at home have an unambiguously negative effect and regulate ﬁrms’ international competitiveness. Alpay’s theoretical work is of interest because the considerable amount of empirical work in this literature has not been able to generate evidence for either of these two views. Alpay presents a two-country model which incorporates a Tradable Emissions Permit system as the environmental regulatory regime. He starts with a closed economy, where two Cournotoligopolists produce a good that causes pollution. In such a model, ﬁrms

Trade and environment

subject to stricter environmental regulation can offset regulatory costs through innovation and/or permit revenues by abating more and selling extra permits, conditioned on the features of the permit market, such as the price elasticity of permit demand and ﬁrms’ R&D behaviour. For example, if the permit market is sufficiently inelastic and investment in R&D results in innovation with some known probability, stricter policy may lead to increased competitiveness for the regulated ﬁrms. Alpay extends the model into the open economy case where there is a second country with two Cournot-oligopolists producing the same good. He presents the conditions for when regulation decreases international competitiveness (the conventional view) and when it does not (the Porter hypothesis). Similar to the closed economy case, the main determinants are the probability of innovation, the cost of R&D, returns to innovation and the price elasticity of permit demand.

ENVIRONMENTAL POLICY CONCERNS IN THE CONTEXT OF EU ENLARGEMENT In Part III we examine the trade–environmental debate in the context of EU enlargement with a particular emphasis on how development and environmental policies will impact economic growth and environmental conditions in CEE accession countries. Onno J. Kuik and Frans H. Oosterhuis examine how the accession of Greece, Spain and Portugal to the EU in the 1980s affected their natural environment. Their analysis helps us understand the impact of present-day eastern enlargement of the EU upon entrants’ environment, since certain economic and environmental characteristics of Greece, Spain and Portugal were comparable to these new entrants from CEE countries. In analysing the environmental dimensions of southern enlargement, Kuik and Oosterhuis focus on the impact of the economic changes that took place in Greece, Spain and Portugal after their accession to the EU. Speciﬁcally, the authors analyse the changes in foreign trade, the composition of agricultural production, the share of agriculture in GDP and employment, and foreign direct investment. The authors use the framework often used in studies of the impacts of trade liberalization on the environment and decompose the environmental effects into scale, composition and technique effects. The authors ﬁnd, ﬁrst, that the opening-up of trade raised the levels of economic activity in these countries, which led to growth in transport and air pollution. Second, trade liberalization affected the relative prices of ﬁnal and intermediate goods in different sectors to such an extent that capital and labour may

Introduction

be induced to shift between sectors, thereby affecting the structure or composition of industry within these countries. Moreover, rising incomes and more consumption goods from the EU have affected the spending patterns of households in these countries. Finally, trade liberalization inﬂuenced production methods. All three countries exhibited improvements in the technical aspects of production and consumption due to the application of EU policies and standards, and these countries’ autonomous modernization of products and technologies. As a check of the validity of their analysis to Central and Eastern European countries, the authors also present evidence concerning the environmental impact of Poland’s process towards accession. The analysis of environmental changes during the accession process is also taken up by M. Özgür Kayalica and Sajal Lahiri. The question these authors consider is whether easier access to EU markets actually helps bring environmental policies closer to each other. To answer this question, the authors develop a Cournot Oligopoly model, where a number of identical foreign ﬁrms located in a host country compete with a domestic ﬁrm for the market of a hom*ogeneous product in a consuming country. According to the model, the host country represents a candidate for EU membership and the consuming country is viewed as the EU. Pollution is created as a by-product of production in both countries. Pollution from the host country is also transmitted across the border to the consuming country as a spillover. For simplicity, the model only considers an emission standard in the form of a maximum amount of pollution that a ﬁrm is allowed to emit per unit of its output. The consuming country charges a tariff for each unit of imported good produced in the host country. Both countries set their own emission standards to maximize their respective welfare. The ﬁrms maximize their proﬁt net of production cost, pollution abatement payment and tariff. In the benchmark model, the number of foreign ﬁrms in the host country is exogenous. Unemployment in the host country is assumed, and the host country beneﬁts from FDI only through the employment generated by foreign ﬁrms. The analysis of the optimization problem shows the following. A larger market implies a stricter emission standard by the government of the host country. The same is true in the consuming country if the marginal disutility from pollution is signiﬁcantly greater than the unit abatement cost in that country. A reduction in the tariff leads to a stricter emission standard in the host country. The same is true in the consuming country if the spillover parameter for cross-border pollution is sufficiently large. Compared to the non-cooperative equilibrium, a small uniform reduction in the emission standards in the two countries makes the host country unambiguously better off. The same is true for the consuming

Trade and environment

country if the marginal disutility of pollution there is sufficiently high. With free entry and exit of foreign direct investment (FDI) captured by allowing the number of foreign ﬁrms to be endogenous, similar results to those from the benchmark model are obtained. Matthew R. Auer and Rafael Reuveny examine the issue of where foreign ﬁnancial aid to accession countries should best be directed. The authors contend that external public sector actors, such as international ﬁnancial institutions and the EU, need to shift attention and ﬁnancial aid from preventing prospective pollution to cleaning up past pollution in Central and Eastern Europe. The authors begin by describing the patterns of FDI inﬂows to CEE countries. These inﬂows grew steadily in the 1990s, but only 15 per cent of them were directed to pollution-prone industries, much less than the more than 30 per cent share in industrializing Asian countries. Next they summarize the costs and beneﬁts of FDI in general and in the context of CEE. The authors note that FDI has failed to promote environmental quality in CEE as expected; a large fraction of FDI went to greenﬁeld investments, partly because of investors’ concerns about liability for past pollution. In response to the liability concern, the CEE governments established generous liability schemes as incentives to reassure investors. But this led to various problems and failed to accelerate FDI inﬂows to pollution-prone industries and areas. The authors thus argue that liability schemes were not sufficient to reactivate the brownﬁelds in CEE. Why? The authors contend that enduring economic problems and persistent environmental ills occur in concert in CEE. Thus economically and environmentally poisoned areas of CEE are distinctly disadvantaged and deserve attention from external actors. The authors thus suggest that multi-faceted western-style brownﬁeld revitalization programs be adapted to solve the above problems in CEE. It is noted, however, because of ﬁnancial constraints, that CEE governments will not be able to exactly copy the Western counterparts to play a major role in paying for cleanup. In this case, external actors, such as private investors, bilateral aid agencies and international ﬁnancial institutions, are the most promising sources of ﬁnancing for brownﬁeld revitalization. The authors propose a prospective plan to revitalize depressed sub-regions of CEE, and explain why and how the four external public actors, that is, the International Finance Corporation (IFC), the European Bank for Reconstruction and Development (EBRD), the Instrument for Structural Policies for Pre-accession (IPSA), and the Objective 1 funds at EU, can help expedite cleanup of past pollution in CEE. The main thrust of their arguments is that funds from these sources, and others, should be directed more to cleanup of past pollution instead of prevention of future pollution in CEE.

Introduction

Chapter 10 examines the allocation of FDI via joint implementation projects under the Kyoto Protocol and the role that they could play in improving the environment of transition economies. The sale of tradable emissions permits by these economies is also examined. Under the Kyoto Protocol, economies in transition are eligible for both emission trading and joint implementation. It is expected that these countries may beneﬁt substantially from those mechanisms if they are implemented appropriately. These beneﬁts include additional revenue, project ﬁnance, knowledge and technology transfer, and synergies with existing policies. Fanny Missfeldt and Arturo Villavicenco suggest that a key criterion on whether a country should undertake emission trading is the comparison of their projected emissions up to 2012 with their targets under the Kyoto Protocol. Only if there exists a sufficiently wide gap between the projections and the target should the country undertake emissions trading mainly because of the high level of uncertainty in the economic development in transition economies. The prospect for ﬁnancial gain from emission trading for transition economies became less encouraging with the departure of the US, the largest potential buyer of emission permits, from the agreement. To increase revenue, it is suggested that transitional economies reserve their emissions quota until the second commitment period rather than selling quota at a low price in the ﬁrst period. The authors argue that for successful joint implementation projects, the domestic investment climate and the emission reduction potential of speciﬁc projects are of particular importance. A country’s investment climate is reﬂected in the general performance of the economy and also the enforcement of business laws, and so on. It is suggested that setting up a clear institutional structure is important for the success of joint implementation. Speciﬁcally, an organization solely in charge of joint implementation is necessary.

ECONOMIC AND ENVIRONMENTAL POLICIES IN TRANSITION ECONOMIES In Part IV three chapters provide us with an inside look at economic transition and its impact on the national environments and environmental policy institutions of CEE countries and Russia. In chapter 11 Diana ÜrgeVorsatz, László Paizs and Radmilo Pesic note that post-communist countries and CEE countries have some of the most obsolete, polluting, economically and environmentally inefficient energy industries in the world. The purpose of their chapter is to review the progress that has been achieved in selected CEE countries’ energy sectors during the 1990s and to

Trade and environment

develop a policy agenda aimed at establishing a sustainable restructuring of the energy sector in these countries. The authors describe the major characteristics of the national energy sectors in CEE in the post-communist era. Key features include: energy intensities, wasteful production and use of energy, and high environmental emissions. The authors believe that the key to a more sustainable energy sector in CEE is the reduction of the high energy intensities by restructuring the sector. They go on to identify the weak points of the centrally planned economy that led to intensive energy usage. These include: no reward for efficiency, no penalty for inefficiency, highly subsidized energy prices, ﬂat rates independent of actual energy consumption, and dominance of heavy industries in the economic structure. The authors also note several aspects of the centrally planned economy that can be viewed as environmental strong points, such as efficient public transport, the high share of district heating and high levels of reuse and recycling, and argue that these should be preserved. Based on these observations, the authors develop a concrete policy agenda aimed chieﬂy at a reduction in the intensity of energy usage. The authors then summarize the progress that has been made over the ﬁrst decade of transitions, using the electricity industries in Hungary, Poland and the Czech Republic as examples and Russia as a contrast. Their analysis concludes that, overall, there is no signiﬁcant improvement in the energy efficiency gap between the EU and CEE. It is shown that Poland has achieved the most signiﬁcant progress in energy efficiency among the above four countries, while the energy efficiency gap between the EU and Russia has only broadened. The authors demonstrate that, although economic reforms and energy sector restructuring are keys to the improvement of energy intensities, they are not sufficient alone. Other reasons, such as the understatement of previous energy intensities data and a gradual change in consumer behaviour and technical organization, explain the lack of progress. The authors argue that in order to reach the levels of energy efficiency in the current EU, CEE countries need to consistently implement energy efficiency policies and establish or reinforce the relevant institutional and educational reforms. The ideal timing for pursuing these reforms is the beginning of the transition process. In conclusion, the authors note that even if the most radical policy, legislative and institutional reforms, are implemented, it will still take time for the energy efficiency gap to close. In Chapter 12 Vladimir Kotov and Elena Nikitina provide us with a history of the economic and environmental changes that have been undertaken in Russia since the early 1990s. Since then Russia has seen a series of changes in its environmental policies. These include the adoption

Introduction

of new environmental legislation, the creation of domestic environmental management systems, the decentralization of environmental management with the transfer of authority from the central government to the regional level, the introduction of economic mechanisms as a tool of environmental management, and participation in international environmental agreements. These new policies deﬁned a framework to address the environmental degradation that was largely inherited from the Soviet period of extensive and unsustainable use of the environment. The authors note, however, that the implementation of these policies was not successful. Several factors are identiﬁed as barriers to new policy implementation. First, due to institutional reorganization, Russia’s environmental agencies were gradually degraded to a weak position in the Russian power structure. This led to poor enforcement of environmental legislation, difficulty in acquiring funds and the subjugation of environmental concerns in the face of economic objectives. Second, the decentralization of environmental management caused overlaps of control and power at the federal and regional levels, which led to a state of confusion over enforcement obligations. Third, serious misapplication of economic mechanisms occurred. In particular, pollution taxes were not set at appropriate levels and their collection was often poorly enforced because of the pressure from economic development. Hence, these taxes failed to provide the polluting ﬁrms with the right incentive to invest in environmentally efficient technologies. Fourth, the general lack of funding severely affected the capability of environmental agencies to carrying out their programs. Major reasons leading to the under-ﬁnancing of environmental programs include the economic crisis that Russia experienced in the 1990s and the utilization of environmental funds for other purposes by local administrations. The authors conclude with the observation that the main lesson learned from Russia’s experience in the 1990s is that the success or failure of environmental policies depends not only on the design of the policies as such, but also on the domestic economic and political institutions. In the ﬁnal chapter of this volume Vladimir Kotov discusses the present state of Russia’s climate policy. Russia’s climate policy was formed in the 1990s during the period of economic transition. This fact has impacted some of the basic characteristics of Russia’s climate policy as well as its evolution. Kotov notes that Russia’s climate policy is currently going through some fundamental institutional changes. The organization in charge of Russia’s climate policy, The Interdepartmental Commission on Climate Change (ICC), is undergoing a transition of its basic functions and method of management. Due to Russia’s transition to a market economy, the old methods

Trade and environment

that ICC used (based on a planned economy) were no longer appropriate and new methods had to be developed. Corresponding to ICC’s low position in the Russian national power hierarchy, the legal support that is essential for the implementation of climate policy is still absent. While the emission trading promised by the Kyoto Protocol has turned Russia’s climate policy into a potentially huge business, the institutional capacity building has been delayed partially due to the lack of a balance in interests between different agencies for the control of future climate business. Due to the prolonged recession, economic development has become the Russian government’s number one priority in its political agenda. As a consequence, climate policy is subordinate to the policy of economic growth. As such, Russian climate policy is determined by economic goals, rather than environmental constraints. The main parameters determining the greenhouse gas emissions in Russia are largely beyond the control of Russia’s climate policy institutions. Instead, they are under direct control of the institutions controlling Russia’s economic growth policy and its energy policy. These institutions are also undergoing a great deal of change. With this institutional backdrop in mind, Kotov speculates on the likelihood of passage of the Kyoto Protocol by the Russian government. He is sceptical for two main reasons. First, the absence of the United States has considerably diminished the economic attractiveness of the Protocol for Russia. This attractiveness is being driven mainly by the sale of emissions rights to US companies or the US government. Second, the increase in Russia’s rate of economic growth has brought with it more industrial and consumer-driven pollution. As such, the amount of pollution rights at Russia’s disposal for sale has diminished, further reducing the economic attractiveness of the protocol.

NOTE 1. Indeed, even in the United States, the main non-signatory, major corporations are in the process of documenting their reductions in greenhouse gas emissions so as to obtain early reduction credits should laws mandating emissions reduction be passed.

PART I

The Trade–Environment Debate in Context: The US Decision on Kyoto

The Kyoto Protocol: a ﬂawed concept Richard N. Cooper

In 2001 the Intergovernmental Panel on Climate Change (IPCC) issued its Third Assessment Report on the prospects for and likely impact of increases in global average temperature over the next century. The summary report of Working Group 1 (WG 1), on science, widened the range of likely temperature increase, compared with the IPCC’s Second Assessment Report ﬁve years earlier, to 1.4–5.8 degrees centigrade, with the increase in the upper end of the range receiving wide public attention. The summary report of Working Group 2, on impacts, sketched a somber picture of how both human settlements and non-human ecologies might be adversely affected by the rise in temperature and an accompanying rise in sea level. A close reading of the WG 1 Report, however, reveals that the wider range, and in particular the increase in the upper end of the range, was not at all due to a reassessment of the scientiﬁc evidence accumulated and closely studied since the mid-1990s. Rather, it was due to a change in the way that emissions over the next century of greenhouse gases (GHG), mainly carbon dioxide (CO2) from fossil fuel consumption and deforestation, and methane (CH4) from agriculture and waste disposal, were characterized. Instead of the single ‘business as usual’ emissions trajectory used in the Second Assessment Report (SAR), the Third Assessment Report (TAR) produces six different scenarios, depending on the evolution both of the world economy and of its energy system over the next 100 years. This reﬁnement is in some respects an improvement over the single assumed trajectory, but to present the outlook as likely more serious than the previous assessment is, to say the least, misleading. The judgment about the likely temperature effect of a given GHG ‘forcing’ was actually narrowed modestly in the Third Assessment Report, not widened. Shortly after the release of the latest IPCC summaries, but presumably not because of them, newly elected President Bush of the United States

The trade–environment debate in context

announced, in an especially clumsy way, that his Administration would not support the Kyoto Protocol to the Framework Convention on Climate Change (FCCC) adopted in 1992. The Kyoto Protocol, negotiated in late 1997, established emissions ceilings on six speciﬁed greenhouse gases for 38 countries, with the 15 members of the European Union treated as a single unit, to be reached on average in the ﬁve-year accounting period 2008–12. It is not yet in force, in that the requisite countries (55, covering at least 55 per cent of the established ceilings) have not yet ratiﬁed it. But it established a speciﬁc framework and timetable for the countries covered (those listed in Annex B) to reduce their GHG emissions. The Protocol contained a number of other features, such as possibilities for emissions trading, cooperation across national boundaries in emissions reduction, and sequestration of GHG in ‘sinks’, some of which will be described further below. But it lacked many operational details, which were left to be worked out following Kyoto, and over which there was still substantial disagreement at a follow-up conference in the Hague in November 2000, three years after Kyoto. President Bush gave as his reason for dropping Kyoto that achieving the targets would be too costly to the American economy, and to American workers, without elaboration or analysis. He left entirely open how his administration would approach the problem of global climate change, or indeed whether it considered this to be a problem that needed to be addressed. Bush’s rejection of Kyoto caught off guard both foreign governments and American environmentalists, including some of his own senior officials, since when campaigning for the presidency he had signaled his concern with global climate change and his commitment to limiting emissions of CO2. However, for reasons I hope to make clear, dropping the Kyoto Protocol represents no great loss to the international community, since it is fatally ﬂawed as an instrument to deal substantively (as distinguished from symbolically) with the potential problem of global climate change. The faster this is recognized, the better, so work can begin on alternative, prospectively more successful, approaches. The chapter is organized as follows: the next section analyzes the basic structure of the task of mitigating global warming. The following section evaluates the Kyoto Protocol in terms of the structural issues. Then comes a section on the advantages of permit trading, combined with the conditions that must be met to achieve it. This is followed by sections on an alternative approach to that embodied in the Kyoto agreement, and on contingency plans for action in case the international community discovers that it has moved far too slowly to deal with climate change. A ﬁnal section offers brief conclusions.

The Kyoto Protocol

STRUCTURE OF THE PROBLEM Concerns about global climate change have led to pleas and indeed to some national commitments to slow or reverse the growth of greenhouse gas emissions. It is useful to identify the structural characteristics involved in attempting to mitigate global warming through formal collective action. There are three key features. First, climate change brought about through an increased atmospheric concentration of greenhouse gases is a global issue, since whatever their earthly origin the gases are widely dispersed in the upper atmosphere, and CO2 is long-lived. Effective restraint must therefore involve all (actual and prospective) major emitters of greenhouse gases. The rich industrialized countries account for most of the emissions today, but the Soviet Union was a major contributor before its dissolution and economic collapse in 1991, and with economic growth its successors can be expected again to become a major source. Rapidly growing developing countries will become major contributors within a time frame that is relevant for managing the issue. Second, the rewards from restraints on greenhouse gas emissions will come in the (politically) distant future, while the costs will occur in the political present. Moreover, the rewards are highly uncertain. Much controversy still surrounds the expected impact of further greenhouse gas emission on the earth’s ecological system, and in particular on conditions of habitability for humans. The residents of some of today’s states, for example, Canada, Russia, and perhaps the United States, may even expect to beneﬁt from moderate climate change. It will thus be difficult to persuade publics that they should make sacriﬁces in living standards in the near future for the sake of uncertain gains to their grandchildren and greatgrandchildren, much less for the grandchildren of people living at remote distance. The wide distribution of expected but distant beneﬁts in response to collective action today provides an incentive for every country to encourage all to act, but then to avoid acting itself – the so-called free-rider problem. Third, the pervasive sources of greenhouse gas emissions – notably use of fossil fuels, rice cultivation and raising cattle – imply that restraint will involve changes in behavior by hundreds of millions if not billions of people, and not merely restraints by 180 or fewer governments, as in the typical treaty. Thus the most important part of an effective regime to limit climate change involves not the relationships among states, but the effective inﬂuence of governments on the behavior of their domestic publics. Moreover, the pervasive sources of CO2 and methane are at the heart of modern economies, which depend intimately on productive agriculture and on non-animate sources of energy.

The trade–environment debate in context

No major legally binding regulatory treaty involves all of these characteristics to the same degree. Typically either governments themselves, or a few ﬁrms in a handful of countries, as in the cases of halting nuclear testing or limiting production of CFCs are the major actors. These three structural factors make collective decisions regarding actions to mitigate global climate change exceptionally difficult. The beneﬁts of mitigation actions encompass the adverse impacts of climate change that are thus avoided. Serious mitigation necessarily involves major reductions in the actual and prospective consumption of energy based on fossil fuels (especially coal-ﬁred electricity generation and use of oil products for heat and motive transportation). Since such consumption is at the very heart of modern industrialized economies, the costs of mitigation are both the economic and the psychological adjustments that must be made to move away from current energy systems; and, secondarily, the adjustments that must be made to move away from wet rice and cattle production, the main man-made sources of methane (in addition to methane leaks from gas and oil reﬁning and distribution systems). Moreover, the likelihood that the distribution of costs and beneﬁts will be greatly uneven across nations complicates further the task of reaching international agreement.

EVALUATION OF KYOTO The emissions targets of the Kyoto Protocol, as noted above, cover only 23 countries, plus the 15 members of the European Union taken together. These countries in 1996 accounted for nearly 64 per cent of world emissions of carbon dioxide, leaving over one-third uncovered.1 Moreover, the uncovered portion is expected to grow more rapidly in the coming decades than the covered portion. By 2010 developing countries are expected to contribute 45 per cent of total greenhouse gas emissions, and China and India together will experience greater growth in emissions than all OECD countries combined. China alone in 1996 accounted for over 13 per cent of CO2 emissions, second after the United States, and on plausible projections for the two economies can be expected to reach US emissions in 2013, with no allowance for US compliance with the Kyoto Protocol; sooner if the US attempts to comply. The rest of Asia (minus Japan) exceeded China in emissions; Latin America and Africa, taken together, emitted about half as much as China. Thus effective action cannot be taken by a small group of countries alone, as was possible for example with agreement to cease atmospheric testing of nuclear weapons. Here, while the same requirements need not be imposed

The Kyoto Protocol

on all countries from the beginning, the agreement needs to be structured so that all countries will eventually participate. On one estimate, for example, full implementation of the Kyoto Protocol and continuation at the prescribed lower emission levels of Annex B countries would, on IPCC SAR (1996) main assumptions, reduce the increase in average global surface temperature in 2050 by approximately 0.05 °C, from an increase of 1.4 to 1.35.2 It was such considerations that led the US Senate, which must ratify treaties for the United States by a vote of two-thirds, to insist before the conference at Kyoto, by a vote of 95–0, that there must be ‘meaningful participation’ by developing countries in any treaty to limit GHG emissions. Lack of comprehensive coverage creates another potential problem: economic activities might re-locate from countries with GHG emission ceilings to countries without ceilings. Through such ‘leakage’ even the impact on GHG concentrations of effective action by the Annex B countries would be reduced. Apart from weakening the effectiveness of the Kyoto agreement on climate change, such leakage would also involve costly adjustments by workers, ﬁrms and towns that would be brought about not by changes in economic efficiency, but by a regulatory system with incomplete coverage. Proponents of the Kyoto Protocol would not deny the fundamental point that key developing countries must eventually participate. They would argue, however, that someone must start the process, and it is natural that the world’s richest and most heavily emitting countries do so. Kyoto is only a ﬁrst step toward a serious approach to the problem. If Kyoto is acknowledged to be only a ﬁrst step, we must anticipate what the next step might be. For those covered in Annex B, the natural next step is to lower the emissions ceilings now set for 2012, to achieve, for example, 80 per cent of 1990 emissions by 2022. But if the Kyoto targets are reached, developing countries as a group (those not covered by Annex B) on plausible assumptions will have CO2 emissions equal to those of the Annex B countries by 2013, while continuing to grow. How are these countries to be brought into the Kyoto framework, as they must be if climate change is to be avoided? The answer, in brief, is that they cannot be brought into the Kyoto framework without compromising its purpose. The Kyoto framework for setting national targets is base-weighted, focused on emissions in 1990. This is in fact standard practice when allocating quotas, to choose a ‘representative’ year and allocate them according to the activity of the relevant agents (for example, ﬁshermen, banana importers) in that year. Kyoto deviated slightly from normal practice in that the target reductions are modestly differentiated among agents, ranging from 92 per cent of 1990 emissions for the European Union and some Eastern European countries to 108 per cent for Australia and 110 per cent for

The trade–environment debate in context

Iceland. This differentiation reﬂected in part special circ*mstances in 1990 (for example, recent uniﬁcation of West Germany with the collapsed East German economy), in part different reliance on fossil fuels (for example, heavily geothermal in Iceland, which cannot easily be used for mobile transport), and in part different expected growth trajectories (for example, recovery of the collapsed Russian and Ukrainian economies). Moreover, Kyoto involved the usual political bargaining, with targets adjusted to ensure adherence of each of the Annex I countries of the 1992 FCCC. Developing countries insisted at Kyoto on their exemption from targets, as already foreshadowed in the FCCC; a provision of the Kyoto Protocol actually prohibits targets being set for developing countries. Base-weighted targets, even with some differentiation, are completely unacceptable to poor countries with high aspirations for economic development. It is well-known that modern economies rest on the consumption of much energy, and in practice most of this energy is provided by fossil fuels. Even major sources of non-fossil fuel energy, such as hydro and nuclear generation of electricity, have become controversial, at least among some environmentalists in rich countries. Indeed, those given to conspiracy theories suggest that the modern environmental movement in Europe and America purposefully wants to keep poor countries poor – a position given credence by the apparent environmentalist opposition to all forms of inexpensive energy accessible on any scale. Developing countries insist that their ﬁrst priority should be economic development. They are not against environmental improvement, and indeed some island countries are fearful of global climate change, particularly if it entails higher sea levels or more serious storms. But relative priority is accorded development, and indeed developing countries insisted that the Rio conference, which was seen by its initial supporters as a follow-on to the Stockholm conference on the environment of 1972 (which established the UN Environmental Program, UNEP), be devoted to development as well as to environment. This raises the question of whether the priorities of the developing countries can be accommodated in the next step after Kyoto. A natural way to do this would be to agree on ‘business as usual’ (BAU) emissions trajectories for each developing country, which would of course reﬂect the process of development with its dependence on higher energy consumption. Targets could then be deﬁned in terms of agreed reductions from each national BAU trajectory. If the trajectories themselves adequately reﬂected the special circ*mstances of each country, the targeted reductions could even be uniform, for instance, 2 per cent a year. At Kyoto the European Union negotiated an overall target for the EU. But it faced the problem of how to allocate this target among agents within

The Kyoto Protocol

the EU. Instead of adopting a uniform policy for all ﬁrms within the EU, as it might have done, the EU members elected to allocate the overall EU target to member states, leaving each member state the task of achieving its target in its own way, within constraints imposed by EU policy. The result of this European negotiation was even greater differentiation than at Kyoto, with national targets ranging from 72 (Luxembourg) and 79 per cent (Denmark and Germany) to 125 (Greece) and 127 per cent (Portugal) of 1990 emissions. Again, the differentiation reﬂected different initial conditions and different expected growth trajectories for member states. Luxembourg steel production was already in extensive decline. Germany could accept a deep cut because of its artiﬁcially high 1990 base, including the collapsed high-energy-intensive East German economy; and Denmark wanted to demonstrate its green credentials by accepting a similarly deep cut. Acknowledgement was given to high initial reliance on nuclear power by France (no cut required) and by Sweden, which was committed to phasing out its nuclear power (a 4 per cent increase over 1990 was allowed). The poorest members of the EU – Ireland, Spain, Greece and Portugal – were all allotted generous increases in emissions over 1990 levels, of 13, 15, 25 and 27 per cent respectively, all higher than any country received at Kyoto itself. A similar negotiation at the global level, outside a common framework for discussion and deciding on economic policy, presents a mind-boggling challenge. The suggestion that uniform reduction targets from differentiated BAU trajectories be established is easy to state, hard – probably impossible – to execute, at least while preserving the ultimate objective of Kyoto, which is to forestall serious climate change by controlling GHG emissions. The problems are twofold. First, given the high priority accorded to development, developing countries will want to ensure that under no circ*mstances will the targets impede their development. They will insist on a generous BAU trajectory, either by pleading special circ*mstances or by aspiring to an ambitious rate of growth, or both. Several countries in East Asia have demonstrated an ability to grow in excess of 8 per cent a year for several decades. Many countries would like such success, even though few will achieve it. But they will certainly not agree to forego the possibility in the name of their contribution to mitigating global GHG emissions. To gain their agreement, they must be given generous BAU trajectories. Yet if all developing countries are given generous trajectories, the objective of limiting atmospheric concentration of GHGs, which is necessary to forestall serious climate change, will not be achieved. Some hypothetical but plausible numbers can be associated with the argument above. Suppose, as suggested above, emissions from developing countries equal those of Annex B countries in 2013. Suppose further that

The trade–environment debate in context

they insist as a condition for accepting national targets that they have growth trajectories of 8 per cent a year; and suppose that the GDP-growth elasticity of demand for primary energy is 0.75 (historically it has been closer to unity), implying an allowable growth in emissions of 6 per cent a year.3 Assume further that the Annex B countries hold to their Kyoto targets in subsequent years, that is, they continue to grow economically without any increase in GHG emissions. Under these circ*mstances, CO2 emissions will be 10.9 billion metric tons (bmt) a year by 2025, 83 per cent above global emissions in 1996, the year before Kyoto.4 Reduction targets could be set from this level for both Annex B and developing countries, but given their priorities developing countries are not likely to agree to severe targets – unless new technologies make possible rapid growth without GHG emissions – and political ‘equity’ will then prevent the Annex B countries from agreeing to severe targets for themselves. In short, the ultimate objective will not be achieved, either without the participation of developing countries, or with participation on such terms as are likely within the Kyoto framework. There is a second problem with the Kyoto framework. It envisages establishing a market for emission rights (more on this below), a necessary condition within the framework of national targets for reducing GHG emissions at lowest real cost. Such a market should be established and in effective operation well before 2008, the ﬁrst year of the agreed ﬁve-year accounting period. Emission permits will command a value in the market, and will be traded. Firms or countries that ﬁnd it more costly than the price of the permit to reduce emissions further will buy permits from other Annex B countries that have reduced their emissions below their targets. Firms or governments will plan their actions taking into account this market, and their estimates of future prices of permits. If in a post-Kyoto phase II many more countries are to be admitted to the scheme, with targets yet to be negotiated but likely to be generous, that will lower the prospective value of emission permits and discourage ﬁrms (or governments) from investing aggressively to reduce their future emissions. Firms will be discouraged from holding unused permits. Kyoto is base-weighted, as noted. But the problem of allocating valuable resources through global negotiation is a more general one. Emission rights will have value – not just hypothetical value, but an actual money value under a system of tradable permits. This value is created by virtue of placing binding limits on emissions. The value commanded will of course depend on how severe the limits are, on the real costs of reducing emissions and on any conditions imposed on the tradability of the permits. We require some principle for allocating scarce resources. Kyoto elected the principle of a historical base, but as we have seen that is unsatisfactory

The Kyoto Protocol

to countries with high aspirations for growth and development. In sharp contrast to reliance on recent history, some observers have suggested that simple distributive justice would require that emission rights be based on population. Such an allocation would favor heavily populated poor countries such as China, India, Indonesia, Bangladesh and Nigeria. To be meaningful in limiting climate change they would require drastic cutbacks in emissions by today’s rich countries, implying radical reductions in living conditions there if implemented quickly. Targets based on population would of course be insensitive to varying resource endowments (for example, for hydro-electric power) and to the fact that countries depend on vastly different fuel mixes as well as different levels of fuel consumption. Reductions in living standards could be mitigated, but not avoided, by the sale of unused emission rights from poor to rich countries. Trading emission rights will be discussed further below. But the ﬁnancial transfers involved if emission rights were based on population would be immense relative to foreign assistance today, far more than is likely to be politically tolerable. If carbon emissions were to take a plausible value of $100 a ton, for instance, a typical American family of four would have to pay $2000 a year to sustain its current (direct and indirect) average level of emissions of about 24 tons a year, 20 tons over its per capita allocation (roughly 6 billion tons of carbon emissions a year divided by a world population of roughly 6 billion people). Total US transfers to the rest of the world would amount to $120 billion a year, roughly ten times current US foreign aid expenditures. Moreover, the transfers in practice would be made to governments, not individuals, despite the underlying moral rationale for basing targets on population, and many these days would question the desirability of transferring large sums to governments whose responsiveness to the needs of their own citizens has been indifferent or worse (think of contemporary Iraq or Burma). A natural compromise has been suggested: base the national targets on GDP (or recent past emissions) initially, and gradually convert them to targets based on population over, say, 25 years, to avoid the wrenching impact on life styles in the rich countries and the implausibly large transfers to governments of developing countries. Here, however, we encounter some unpleasant arithmetic with respect to population-based emission rights. In 1995 India’s per capita income (on a purchasing power basis) was about 5.2 per cent that in the United States. Suppose that per capita income in India grows at 5 per cent a year over the next 25 years, and per capita income in the United States grows at 1 per cent a year (this is a plausible scenario, although in reality the gap in growth rates is not likely to be so wide). Under those assumptions, Indian per capita income 25 years later (in 2020) would still equal only 14 per cent of per capita income in the United States, and

The trade–environment debate in context

per capita consumption of energy would be many times higher in the United States than in India. Thus under national emission targets converging on population after 25 years either India would not be effectively constrained or the United States would be very tightly constrained or (under tradable emission permits) there would be huge transfers from the United States and to India. The sense of global community is not likely to be great enough by 2020 to sustain such large transfers – it is not that great within the United States today – and in any case such large transfers either to governments or directly to citizens, by fostering a rentier mentality, would probably not be desirable, as some of the highly oil-dependent countries have discovered. My general conjecture is that there is no widely acceptable basis for allocating scarce resources – here, emission rights – among all countries by international negotiation. The fact that the resource is known to be valuable will lead many countries to hold out for generous treatment as a condition for their binding agreement, and the sum of such generous treatment will undermine the purpose of the agreement, namely to limit signiﬁcantly the growth in atmospheric concentration of GHGs.

INTERNATIONAL TRADING While climate change is indifferent to the source of GHGs, because of rapid mixing through the upper atmosphere, the costs of reducing emissions of CO2 and other GHGs differ greatly from one place to another, and from one activity to another. So long as resources are scarce, we need to be concerned with the costs of GHG mitigation, and in particular we should reduce emissions at least cost, wherever that might be. Thus, if the costs of CO2 reduction are higher in Sweden than in Poland, there should be some way for Sweden to help achieve its national target by reducing emissions in Poland, so long as Poland is within its national target. Indeed, Kyoto envisions the possibility of ‘Joint Implementation’ to take account of such possibilities, without, however, specifying how joint implementation is to be implemented. This notion of cross-border cooperation in reducing emissions, so long as the targets are met collectively, is an excellent one. But to be effective it requires careful accounting. One way to achieve joint implementation automatically is to create a market in emission rights. Kyoto is couched in terms of setting national ceilings for GHG emissions; but the same framework can be interpreted as allocating emission rights to the Annex B countries, not to be exceeded. Each country ‘owns’ the right to emit a certain maximum of greenhouse gases. Then Sweden, in the example above, can buy some of these emission rights from Poland; Poland’s rights would of course decline by the amount it sold to Sweden.

The Kyoto Protocol

Creating an effective trading regime in emission rights poses a host of practical problems. First, who exactly is to participate in the market? In particular, should it be 38 governments, or should it be thousands of ﬁrms? Markets work best if there are many participants, none of them dominant. But if ﬁrms are to trade, each relevant ﬁrm needs to have a clear and unambiguous right to emit GHGs.5 Thus each country with an emission quota under Kyoto needs to develop a system for allocating these rights to participating ﬁrms. Three principles of allocation are known (and of course combinations among them): on the basis of historical emissions (the principle used for countries at Kyoto, with modest differentiation), on the basis of political favoritism (with the strong temptation to bribe, directly or indirectly, the officials who control the process of allocation), and competitive auction, whereby the highest qualiﬁed bidders acquire the emission rights, and the sales revenues accrue to the government, or to some party designated by the government. If the principle of allocation is based on historical performance, as it almost always is in practice, should the historical basis last forever? The issue of global climate change is a long-term issue, not a transitory one; a scheme to deal with it must have great durability. Are those with emission rights based (say) on 1990 emissions to keep their rights forever? Even if they go out of business? Indeed, if the permits command a sufficiently high price, it may make economic sense for some of the owners to go out of their original (emitting) business, and sell all of their permits. They, and their distant descendants, could become rentiers, living off the earnings of sales of perpetual emission rights, earned on the basis of activity way back in 1990. If the emission rights are not to be perpetual, that is, they are to decay over time, how often should they be reallocated, and what should be the principle of reallocation? Simply re-basing the allocation, for example, from 1990 to 2000, would create a perverse incentive not to reduce emissions. In short, public authorities will be allocating valuable resources (emission rights) within countries, either forever or from time to time, and any historical basis will have some perverse or anti-social effects. These can be avoided by auctioning the rights, with revenues accruing to the government. So as to mitigate the economic costs to those parties who will be required to have emission rights, the revenues could initially be used in some form of compensation, so long as the compensation is not based on actual emissions. The compensation could then be gradually phased out over time, for example, a decade.6 Of course, similar problems of allocation and reallocation arise among countries, as discussed above. Bringing new countries into the scheme will require a principle of allocation to new entrants. And even Annex B countries will require a new allocation beyond 2012: should it still be based on 1990, or should a new principle be introduced, and if the latter what should it be?

The trade–environment debate in context

A market in emission permits would establish a price for them, for example, per ton of carbon emissions. That price would then provide useful information for all emitters covered by the scheme: if they can reduce emissions at a cost below the permit price, they should do so, and sell their rights in the market. If the costs of reducing emissions by a particular ﬁrm exceed the permit price, the ﬁrm will be better off continuing to emit, and buying a permit to do so. The price of the permits would ﬂuctuate with overall net demand for them. Various estimates have been made of the price of such permits. The estimates inevitably involve much conjecture, particularly about the schedule of costs associated with different levels of reduction of emissions. Because costs can plausibly be expected to differ sharply from one country to another, the price of the permit will also depend on the nature of the trading scheme, and in particular on what countries are included and what restrictions are placed on trading – as well as on the severity of the overall emissions target.7 In general, the more countries that are included, the lower will be the price for any given overall target; and the tighter the restrictions on trading, the higher will be the price. The US Council of Economic Advisers (1998) estimated that the price per ton of carbon under the Kyoto targets would be about $200 in 2012 if the trading scheme were conﬁned to the United States, but would decline to $56 if all Annex B countries were included in the scheme, and to $23 if China, India and other key developing countries could be brought in under reasonable terms.8 Under the latter two conditions, Americans would not meet their Kyoto target in the United States, but would buy permits from other Annex B countries, or from developing countries if they were brought into the scheme. One concern with this arrangement is that Russia and Ukraine were granted emission rights at Kyoto that they are unlikely to use fully. (Kyoto was negotiated before Russia’s ﬁnancial crisis of 1998, which set back Russia’s prospects for economic growth by several years. Even then, the Russian and Ukrainian targets were on the generous side, designed no doubt to ensure the participation of those two countries in the Kyoto commitments.) If this is so, an unrestricted trading regime would lead to higher emissions by the Annex B countries in 2012 than would occur if all countries met their targets domestically. The European Union has therefore proposed that countries be allowed to buy from abroad permits no greater than the GHG abatement they have actually achieved, in effect allowing trading for no more than half of a country’s target (with an analogous rule to apply to sellers). Ironically, under the intra-EU country allocation reached in 1998, 10 of EU’s 15 members would violate the rules the EU proposes for other countries (CEA, 2000, p. 271). Moreover, the EU proposal could have the consequence, by restricting the trading market,

The Kyoto Protocol

of much lower permit prices than would obtain without the restriction, thus discouraging some abatement that would occur under an unrestricted trading regime (see Victor, 2001, p. 115). Cross-border purchases of emission permits of course would involve corresponding transfers of funds from the buying country to the selling country, or from ﬁrms in the buying country to ﬁrms in the selling country. Assume that the EU proposal was adopted, and that American ﬁrms purchased from Russia and Ukraine permits amounting to half the reductions the United States required to meet its Kyoto target. At the CEA estimated price, that would imply transfers from Americans to Russians and Ukrainians in excess of $13 billion annually to buy emission rights. Given the recent history in those two countries, the allocation of emission rights to domestic ﬁrms is likely to be riddled with corruption. Foreign purchasers would be complicit in sustaining and (given the values involved) possibly enhancing this corruption. Would such transfers, or even the prospect of them, be politically acceptable in the United States, or in Europe? I strongly doubt it. So here is another ﬂaw of Kyoto: the ceilings are too stringent to be applied nationally – at least in the United States, given its rapid growth in 1990–2000; but the ﬂexibility allowed by Kyoto is likely to result in politically unacceptable large transfers among countries, in particular to Russia and Ukraine. The Kyoto Protocol requires a system for monitoring emissions of GHGs, and for enforcing compliance with the targets. Monitoring fossil fuel emissions in the Annex B countries perhaps poses no insurmountable problems. But monitoring net CO2 emissions from other sources (for example, soils and forests), and emissions of the other ﬁve GHGs will be much more problematical, as Victor (2001) has emphasized. How will we know whether or not the targets have been reached? Suppose a country by its own acknowledgement has not reached its target, or, worse, claims to have reached its target but on impartial assessment has not? What, if anything, will be done about it? The problem arises especially with a trading regime, under which a country has sold some of its permits to others, and then claims unconvincingly to have cut its own emissions below its target by the amount of the permits sold. How can the money be recovered? Again, Russia and Ukraine come to mind, but the problem could arise with any selling country. Suppose in the meantime the selling ﬁrms have disappeared? Should the government be liable? Can we anticipate future analogues of the debt crises of the 1980s and 1990s, in which country debts were rescheduled, under painfully negotiated conditions? Victor (2001) ingeniously suggests that the buyers should be liable, implying that the permits would be continually labeled by the seller (like bonds). Thus some permits could sell at a discount to others, depending on

The trade–environment debate in context

the reputation of their source. But he does not explain how past wrongdoing would be rectiﬁed. And buyer liability would fragment and make much less liquid the market in emission permits, which at least in its early years might be fatal to its basic purpose. Taken together, the ﬂaws of the Kyoto Protocol – incomplete coverage, inappropriate basis for allocation of valuable emission rights, inadequate provision for monitoring and enforcement, politically unacceptable transfers under (necessary and desirable) trading – render that agreement fatally ﬂawed, and therefore functionally moribund.

AN ALTERNATIVE APPROACH9 There is an important alternative to setting national emissions targets. That is to agree internationally on a set of actions, calibrated to achieve the desired emissions (ultimately, as stated at Rio, set to stabilize the atmospheric concentration of greenhouse gases, an objective that is too radical for speciﬁcation in the near future). Since to accomplish their quantitative objectives governments must in any case create the appropriate behavioraltering incentives for their citizens, and since, as we have seen, setting a national allocation of global emission rights is likely to prove so contentious as to be impossible, it may be far easier simply to agree on a common use of instruments. For problems such as reducing emissions, the favorite instrument of economists is to tax the offending activity. All countries would agree to impose a common carbon tax, which would increase the price of fossil fuels in proportion to their carbon content (with possible tax exemptions for uses that do not produce carbon dioxide, such as production of some plastics). Such a tax would have at least two major advantages. First, it would encourage reduction of emissions to take place where that can be done at least cost, since all emitters would have the same incentive to reduce emissions, but only those who saved more in tax payments than it cost to reduce emissions would undertake reductions; others would simply pay the tax. It would provide encouragement everywhere for fuel switching toward natural gas, and more importantly to conserve generally on the use of fossil fuels. Second, it would generate revenues for governments. All governments have trouble ﬁnding sources of revenue that do not have negative effects on economic incentives to work, save, or undertake commercial risks. Here is a tax with the right incentives. That should make a carbon tax attractive to ﬁnance ministries everywhere. Where the revenues are large, as they eventually would be, the new tax should be phased in gradually, and growth

The Kyoto Protocol

could be encouraged by reducing other taxes, for example those on foreign trade or on earnings. Taxes on fossil fuels would of course have some undesirable effects, such as delaying the switch from fuel wood to fossil fuels in poor countries. But it would be impractical in most cases to tax fuel wood. In principle, it would be possible to extend the idea of a common carbon tax to methane as well, covering wetland rice production, decomposable refuse, gas pipeline losses and cattle raising, but that more difficult step could perhaps wait until a later stage, or even be treated in a different way (see Victor, 2001, chapter 4). Differential treatment could be extended to developing countries by allowing them more time to phase in the carbon tax, although those with a growing need for revenue might choose to introduce it earlier than required by the agreement. The imposition of a common carbon tax would be easy to monitor. Enforcement of the tax would also be possible to monitor, since 183 countries (which, however, exclude Taiwan, Hong Kong, North Korea and Cuba) hold annual consultations with the International Monetary Fund on their macroeconomic policies, including the overall level and composition of their tax revenues. The IMF could by agreement provide reports on energy revenues collected to the monitoring agent of the treaty governing greenhouse gas emissions. Such reports could if necessary be supplemented by international inspection both of the major tax payers (for example, electric utilities) and the tax agencies of participating countries. Large emitters such as generating stations could be monitored by satellite. Imposition of taxes by international agreement imposes a major problem for democratic countries, however, since taxation goes to the heart of parliamentary prerogative, and most will not welcome taxation by international agreement, even with a requirement for parliamentary ratiﬁcation. Moreover, as 1993 experience in the United States with a British thermal unit (BTU) based energy tax illustrates, even modest energy taxes can be politically unpopular. In 1992 the European Commission proposed a somewhat more ambitious tax for energy, rising to the equivalent of about $10 a barrel (roughly 50 per cent) of oil by 2000. That tax was never enacted. Moreover, the EU proposal paradoxically but not surprisingly gave special preference to coal (which is produced at high cost in a number of EU countries), the most carbon-intensive of the fossil fuels, and would also have levied a tax on nuclear power, the least carbon-intensive major source of energy. Several European countries have introduced energy taxes, usually, however, taxing industrial uses at signiﬁcantly lower rates (see, for example, Kirkpatrick et al., 2001, on Germany, and parallel OECD studies on energy policies in other European countries).

The trade–environment debate in context

But this political calculus could change dramatically. If we are to act seriously to reduce GHG emissions, a rise in the price of emitting activities is necessary to encourage large-scale conservation. It is better that the revenues from the price increase go into the hands of governments that represent the entire public than into unnecessary economic inefficiency, such as would be brought about by a command and control system, or into the hands of the owners of large corporations that are allocated emission quotas. Furthermore, the imposition of carbon taxes would not necessarily imply additional revenues for governments. One possible disposition of revenues from emission taxes would be to reduce other taxes, such as income taxes or payroll taxes, that arguably discourage useful economic activity. Each country would be free to dispose of the emission tax revenues as it judged best. In the United States, introduction of emission taxes would be easier if coupled with the reduction of other taxes. Other countries, particularly developing countries, might need the additional revenue and welcome these taxes in lieu of having to raise additional revenues in other ways. Negotiation along these lines has no assurance of success. But since the national target approach of Kyoto has no prospect of accomplishing its ultimate purpose, it is better to abandon the impossible for the merely difficult. We do not know how responsive economies will be to any given tax level. The cuts in emissions could be either greater or less than initially projected. Thus a regime based on mutually agreed emissions taxes must allow for subsequent adjustment in tax levels, up or down, as new scientiﬁc evidence on the signiﬁcance of GHG emissions for climate change becomes available, and as we learn how effective a given level of taxation is in reducing emissions. The latter effects will become clear only after the passage of some years, so the taxes could be adjusted, by mutual agreement, at ﬁve-to ten-year intervals. That is not a decisive disadvantage when the objective concerns decades and perhaps centuries.

CONTINGENCY PLANS Many adverse developments could occur as a result of global climate change. It is much more difficult – today, impossible – to forecast with conﬁdence what will happen. Some analysts have projected benign effects from global warming, and easy adaptation to the adverse effects – especially for those whose income is enough above subsistence to give them room for maneuver. Thus for this among many reasons developing countries give higher priority to economic development than to averting climate change if the latter in any way inhibits development.

The Kyoto Protocol

The great uncertainty about impacts, the prospect of serious gainers as well as losers, the high apparent cost of near-term actions to reduce emissions signiﬁcantly, for beneﬁts both more distant in time and more uncertain in magnitude, and the need for eventual wide participation by countries with substantially different initial circ*mstances and hence greatly different priorities – all these factors make early action to stop growth of greenhouse gas emissions, much less to lower them, highly problematic. Suppose the best guesses about climate change turn out to be too optimistic; or suppose that despite accurate forecasts the international community is unable to reach agreement on costly, effective mitigation actions; or suppose that despite international agreement countries prove unable to implement the agreements. What then will the community of nations do if accumulating experience suggests the climate change is likely to be great and clearly adverse? This possibility suggests the need for some contingency planning to supplement research to develop cheap low-emitting sources of energy and ways to satisfy human wants with lower requirements for energy. Such contingency planning can take two broad paths. The ﬁrst concerns how best to adapt to more serious climate change. It means inter alia pushing ahead with both the basic science and applied research for genetic engineering in many areas, especially agriculture, but also providing potential substitutes for possible useful species that may be lost. That could be supplemented by a systematic program for collecting, cataloguing and storing genetic material, mainly but not exclusively from plants, in the form of seed banks and DNA. The second concerns how to slow further warming as rapidly as possible. One route involves sequestration and even withdrawal of greenhouse gases, mainly carbon dioxide, from the atmosphere on a scale at least equal to continuing emissions. That will involve good stack absorbers and storage depositories of carbon dioxide. But it also might involve mobilizing the biosphere. Rapidly growing trees could be planted on a massive scale, especially as climate change extends the areas that can support them, for example by dropping seeds by air. More unconventionally, barren portions of the oceans could be fertilized with the requisite minerals (the main deﬁciency is thought to be iron) so that microscopic carbon-loving plants can thrive. A different approach would involve reducing the incidence of sunlight on the earth’s surface, for example by placing reﬂecting surfaces in space or by increasing the albedo by altering cloud formation or by placing particulates in the atmosphere, for example, through jet engine exhaust or by using cannons or rockets from the surface.10 Other possibilities will no doubt emerge over time. It is of course premature to commit to any particular method for rapid mitigation. Some suggestions will be impossibly expensive, and others will have unacceptable

The trade–environment debate in context

side effects. The point here is merely to encourage imaginative work on possible emergency actions.

CONCLUSIONS Proposition 1 The problem of global warming cannot be solved without the cooperation both of China and of the United States, where ‘China’ here is a metaphor for all large, growing developing countries, and ‘USA’ is a metaphor for all large and prosperous rich countries. Proposition 2 There is no formula for quantitative national targets for GHG emissions, under existing technology and knowledge about global climate change, that will be acceptable both to China and the USA that will address satisfactorily the problem of global climate change, where that issue is deﬁned by preventing atmospheric GHG concentrations from rising above, say, 720 ppm carbon dioxide equivalent (⫽ 2.5 times pre-industrial levels, and twice current levels, implying an increase in global average surface temperature of 2.1–6.6 °C based on current scientiﬁc knowledge). Proposition 3 If propositions 1 and 2 are correct, no scheme based on binding national targets can succeed in dealing with the problem, at least in the next decade or two. Therefore if anything is to be done soon at the international level, an alternative approach to Kyoto is required. Proposition 4 The approach most likely to succeed is international agreement on common actions, in particular agreed taxes on GHG emissions. Proposition 5 Tax policy is sensitive in every country; success at negotiating common actions based on taxation is not assured of success. Proposition 6 In view of proposition 5, countries should position themselves for adaptation to climate change; and the world should position itself for emergency actions, mainly involving the rapid sequestration of GHGs, if climate change seems to seriously threaten society.

NOTES 1.

Detailed quantitative information is not available for the other GHGs, which together accounted for an estimated 30 per cent of the increase in atmospheric GHG concentration since the beginning of the industrial era. Figures here will focus on CO2, and on its major sources in fossil fuels, deforestation and cement making, as is usually done. But

The Kyoto Protocol

2. 3. 4.

8. 9. 10.

the other GHGs should not be neglected. CFCs are also important greenhouse gases, but are not covered by Kyoto because they were already being phased out under the Montreal and London Protocols dealing with stratospheric ozone depletion. Private communication from Fred Singer. An elasticity of 0.75 seems to be implied in the EU target for Greece, based on Greece’s actual growth in the 1990s. It is about 0.5 for Portugal. The literature on GHG emissions is confusing with respect to units of measurement. GHGs other than CO2 are usually converted into CO2 equivalents in terms of their warming potential, itself a somewhat uncertain exercise because of imperfect knowledge of the atmospheric lives of different gases. CO2 is then measured in metric tons. But some sources (for example, the Kyoto Protocol) use the weight of CO2, while others (for example, the work of the IPCC) use the weight of the carbon in the CO2. I will adopt the latter practice. Oxygen is heavier than carbon: the carbon content in CO2 is about 27 per cent, such that the 1990 base of the Kyoto Protocol (Annex B) is 14.5 billion metric tons (bmt) of CO2 from fossil fuels, which translates into 3.96 bmt carbon content. This measurement ambiguity must be borne in mind when addressing carbon taxes. The US Administration under President Clinton made clear its intention to create a domestic market for tradable permits by 2008, and urged other countries to do likewise, arguing that an international mixture of permit trading in some countries and command and control systems in others could signiﬁcantly weaken the efficiency advantages of a system of permit trading. See CEA (2000), pp. 270–72. Ironically, one of the advantages alleged for the national targets set at Kyoto is that they would allow each country to pursue the common objective in its own ways. Under the US sulfur dioxide (SO2) emissions control program, tradable and bankable permits were allocated initially to 263 high emission generating units at 110 power plants (with fewer owners), on the basis of energy use in 1985–87, adjusted through the very political process of congressional negotiation. Phase II, covering 2000–2009, which extended coverage to all fossil fuel generating units over 25 MW, also involved allocation on the basis of a formula focused on historical emissions as adjusted by political bargaining, with a consciousness that valuable permits were being issued. Emission permits are issued annually, but can be saved for future use. The SO2 trading system so far has worked well within the United States, with permit prices being much lower than originally estimated. See Ellerman et al. (2000). See Dean and Hoeller (1993), p. 153, where the results of several studies of a hypothetical reduction of GHGs by 2 per cent a year from BAU trajectories are compared, across ﬁve regions of the world. The cost of a further reduction in 2050 ranges from a low of $67 (1990$) per ton of carbon (in China) to $2245 (in the Former Soviet Union). These differences suggest both major uncertainty (across models) in the costs of mitigation, and major efficiency gains (across regions) from allowing cross-border permit trading. These prices are per ton of carbon; the equivalent price per ton of CO2 would be about 27 per cent of these prices. This and the following section draw on Cooper (2000). A study by the National Research Council (1991) suggested that placing reﬂectors in space would be very costly compared with alternative ways to reduce the incidence of sunlight, but relative costs might be very different in three or four decades.

REFERENCES Cooper, Richard N. (2000), ‘International Approaches to Global Climate Change’, World Bank Research Observer, 15 August, 145–72. Council of Economic Advisers (1998), ‘The Kyoto Protocol and the President’s Policies to Address Climate Change: Administration Economic Analysis’, processed.

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Council of Economic Advisers (2000), Economic Report of the President, Washington: US Government Printing Office. Dean, Andrew, and Peter Hoeller (eds) (1993), The Costs of Cutting Carbon Emissions, Paris: Organization for Economic Development and Cooperation. Ellerman, A. Denny, Paul L. Joskow, Richard Schmalensee, Juan-Pablo Montero and Elizabeth M. Bailey (2000), Markets for Clean Air: the US Acid Rain Program, New York: Cambridge University Press. Kirkpatrick, Grant, Gernot Klepper and Robert Price (2001), ‘Making Growth More Environmentally Sustainable in Germany’, Economics Department Working Paper No. 276, Paris: OECD. National Academy of Sciences (1991), Policy Implications of Greenhouse Warming, Washington: National Academy Press. Victor, David G. (2001), The Collapse of the Kyoto Protocol, and the Struggle to Slow Global Warming, Princeton, NJ: Princeton University Press.

You’re getting warmer: the most feasible path for addressing global climate change does run through Kyoto Jeffrey A. Frankel

When I ﬁrst arrived at the White House in September 1996, I had no idea that one of the issues on which I would spend a great deal of time during my period as a member of President Clinton’s Council of Economic Advisers was global climate change. But Under Secretary of State Tim Wirth had the month before announced a major change in policy: that the United States would in multilateral negotiations now support ‘legally binding’ quantitative targets for the emission of greenhouse gases. This left less than 16 months for the US Administration to decide what kind of speciﬁcs it wanted, at the Third Conference of Parties of the UN Framework Convention on Climate Change (UNFCCC), scheduled for December 1997 in Kyoto. Because other countries take their cue from the superpower (whether it is to support or oppose US positions), this countdown engendered a certain amount of suspense: what speciﬁcally would the US propose at the Kyoto Conference, most notably regarding how the numerical targets should be determined? Outsiders demanded to know – with particular tenacity in the case of the US Congress, who feared the worst. I was a member of a large inter-agency group that worked intensively on what was to become the Kyoto Protocol. I never thought that the agreement had a large chance of being ratiﬁed by the US Senate or of coming into force in a serious way. There were too many unbridgeable political chasms, as I will explain. Furthermore I understand the reasons why almost all economists, at least in the United States, disapprove of the Kyoto Protocol. Nevertheless, I am prepared to defend the Clinton version of the treaty, and I believe it was a step in the right direction. I will begin by noting that the weight of scientiﬁc opinion seems indeed to have concluded that the Earth is getting warmer, that increasing concentrations of carbon dioxide and other greenhouse gases are the major cause, and that anthropogenic emissions are in turn responsible. I am not 37

The trade–environment debate in context

a scientist. But the latest IPCC report concludes, ‘The globally averaged surface temperature is projected to increase by 1.4 to 5.8 degrees Celsius’ over the period 1990 to 2100, and ‘global mean sea level is projected to rise by 0.09 to 0.88 metres’.1 The evidence has become clearer over the last ten or twenty years. President George Bush, the Second, made a big mistake when he initially allied himself with the minority of disbelievers. It was a political mistake if nothing else. Even granting that the incoming administration in 2001 did not want to pursue Kyoto, it was foolish and unnecessary for the White House to dismiss the climate change problem. This chapter will take as given that the problem of global climate change is genuine, and is sufficiently important to be worth addressing by steps that are more than cosmetic. Because the externality is purely global – a ton of carbon emitted into the air, no matter where in the world, has the same global warming potential – the approach must be multilateral. Individual countries will not get far on their own, due to the free-rider problem.2 Multilateral negotiations have since the Rio Summit of 1992 proceeded speciﬁcally under the UNFCCC. The chapter will summarize major decisions that the Clinton Administration had to make, and why it made them. What were the quantitative limits on emissions to be? How would greenhouse gases other than carbon dioxide be treated? Would trading across time or across countries be permitted? And so on. In my time in the government, I was surprised to discover that policy makers often must make such decisions with relatively little help from the body of technical knowledge and opinion outside the government. It is not just that academic research is too abstract to be of much direct help with the minutia of speciﬁc policy decisions. The pronouncements of think tanks and op-ed writers also ignore practical complexities, because they seek to make big points for general audiences. We were largely on our own. Some years from now, the world may be politically ready for a more serious treaty, one that requires some sacriﬁce of sovereignty and wealth. Those who design this future treaty will have to grapple with some of the same issues that we did. An explanation of the thinking that went into Kyoto might help. As I see it, the Kyoto Protocol, particularly its ﬂexibility mechanisms, is a good foundation on which to build. The subtitle of this chapter is: ‘The most feasible path for addressing global climate change does run through Kyoto’. This is also the second meaning of the chapter’s main title, ‘You’re Getting Warmer’. In the American game, a child looks for a hidden object, being told ‘you’re getting colder’ whenever he or she looks in the wrong vicinity, and ‘you’re getting warmer’ when coming closer to the objective. Kyoto was a step closer.

You’re getting warmer

TARGETS AND TIMETABLES The economist’s approach to designing a strategy to address an environmental problem, of course, is to take into account economic costs. In principle, cost–beneﬁt analysis is the right way to do this, along the lines of the Integrated Assessment Models pioneered by Bill Nordhaus.3 The prescription that often emerges is a very long-term plan of emission reductions relative to the Business as Usual path (BAU) – with cuts that are very small initially, but that become larger late in the 21st century – implemented by a price mechanism such as a global carbon tax. Although academic research can and should proceed with such models, the problem faced by policy makers in 1997 was more constrained in a number of ways. In practice, full cost-beneﬁt analysis in the case of global climate change is less helpful than is at ﬁrst apparent, for two major reasons. The ﬁrst reason is the tremendous uncertainties involved in any model. The range of uncertainty about the proper discount rate, alone, can give every answer from large immediate cuts to a path that begins with no cuts.4 Further, it is impossible to put probabilities on the catastrophe scenarios (an end to the Gulf Stream current, melting of the Antarctic ice shelf, an unstable feedback loop through release of methane from thawing permafrost, and so on). One is thus led to accept an arbitrary environmental goal, such as limiting the increase in carbon dioxide to twice pre-industrial levels by 2100 (from 270 ppm to 550 ppm), and to seek the cost-minimizing path to achieve this goal. We at the Council of Economic Advisers used estimates by Alan Manne and Rich Richels.5 According to their estimates, the most efficient paths involved heavy cuts below current levels of emission only in the second half of the 21st century. It was assumed that new technologies, now unknown, could be developed so far into the future. In the early decades, the most efficient path featured emissions that would continue to rise, though at a rate modestly below the BAU path. To see why heavy cuts in the early decades would be too expensive, consider electric power generation. Today’s fuel mix relies heavily on the dirtiest fuel, coal. Power plants have a natural life of at least 40 years. To cut domestic emissions of carbon dioxide heavily in the ﬁrst two decades would require shutting down coalﬁred power plants before the end of their useful lives, at great expense, replacing them for example with natural gas. Waiting three or four decades to begin the heavy cutting below the BAU path is far cheaper, provided ﬁrms know that they need to begin planning for the change now. The Manne–Richels least-cost path for achieving the speciﬁed goal of 550 ppm showed global emissions peaking in the decade 2040–50, and rich-country emissions peaking several decades earlier.6

The trade–environment debate in context

As we became more familiar with the politics, we soon realized that even the cost-minimization solution would not serve. These 100-year paths were of little use to political leaders. Politicians have short horizons, for very good (electoral) reasons. Once in a great while, a leader can try credibly to commit to a project with a ten-year horizon, even though the public knows he will not still be in office to see its completion. President Kennedy, for example, committed the US to reach the moon by the end of the 1960s. Some attempts have been made to ‘ﬁx’ social security on a ten-year horizon. But it is out of the question for political leaders to commit to policies 100 years in advance. Even 30 years is too long a horizon. A president who proposed to cut emissions 30 years in the future would be laughed out of Washington. Everyone would think ‘it’s just words’, and they would be correct. None of the countries participating in Kyoto, neither the Europeans and others who were arguing for very ambitious targets, nor those arguing for gradualism, proposed setting targets far into the future. All the discussion concerned targets for the period 2008–10. Most of those participating (though not all) understood that, for this reason, the cuts under discussion would make only minute contributions to reducing greenhouse gas concentrations, temperatures, and sea-level rises later in the century. We estimated that if participation were limited to the countries undertaking commitments at Kyoto, then the effect of the agreement would be to reduce the temperature in 2050 by only roughly 1/10 of one degree Celsius (relative to a baseline increase of 1.15 degrees). Even so, the longest journey begins with a single step.7 The implication of these considerations is that the targets had to involve a concrete non-fudgeable commitment of some sort within a horizon of ten years or so. My personal choice was a commitment that emissions should reach a peak – that is, that they be observed to level off – in the decade 2010–20, with absolute reductions to follow in later decades. Climate mitigation under this proposal was almost the same as the plan to return to 1990 levels by 2010, and yet the impact on energy prices would be only about one eighth as much. But peaking two decades hence was not a sufficiently ambitious goal for the environmentalists and was thought – correctly, I am sure – to be a non-starter with the Europeans. They were all thinking in terms of the (voluntary) goals that had been set at Rio, which were phrased in terms of 1990 levels of emissions. The Europeans thought they would achieve 1990 levels by 2000, that is, that they were already peaking (as called for at Rio). True, the United States could have told the Europeans ‘take it or leave it’; but President Clinton wanted an agreement. A good solution, in terms of economics, would have been an early ‘downpayment’ policy measure to demonstrate sincerity, such as a substantial energy tax. But such tax increases are extremely unpopular, and were ruled

You’re getting warmer

out on political grounds. The Clinton Administration had proposed a BTU tax in its ﬁrst year, and felt severely burned by the experience. An alternative, if the desire to be more ambitious was genuine, would have been to set a target path in which emissions peaked in some year earlier than 2010. But such proposals were too concrete and immediate; they ran into the paradoxically simultaneous brick walls of being too ambitious economically and insufficiently ambitious environmentally.8 In October 1997, the President decided that the US position going into Kyoto would be to return carbon emissions to 1990 levels by 2008–12. In the end, in order to break a negotiating deadlock at Kyoto in November, the US gave some ground, agreeing to reduce a combination of six gases to 7 per cent below 1990 levels. The US team ﬁgured that the ﬂexibility inherent in tradeoffs among the six gases made the cost almost equivalent to that of the President’s October position. Other countries agreed to similar cuts, some larger and some smaller, totaling 5 per cent relative to BAU.

POLITICAL CHASMS The small inter-agency group that met frequently in the White House office of the Director of the National Economic Council developed its own ways of speaking of the political constraints of climate change policy. It was decided that nobody around the table was allowed to dismiss someone else’s proposal on the grounds that ‘it is politically impossible’. All options were politically impossible. Rather, you had to identify an alternative proposal that was less politically impossible than the one you were arguing against. I also noticed that an option where the political impossibility was immediate and certain would be dominated by another that was also ‘politically impossible’ but where the constraint would be encountered in the more distant future and with less certainty. In Butch Cassidy and the Sundance Kid, Butch (Paul Newman) proposes that the only way out for the two outlaws, who are trapped on a rock ledge, is to jump off the cliff into the river far below. Robert Redford confesses, ‘I can’t swim’. Paul Newman replies, ‘Are you crazy? The fall will kill you anyway!’ Any US policy to address climate change had to contend with four political chasms. Each was so deep as to be virtually unbridgeable, and also so wide that the constituents living on the opposite sides were barely communicating with each other. Each of the gaps remains wide today, although some progress has been made. (1) The ﬁrst was the gap between environmentalists and the Congress on understanding of the climate change issue and willingness to bear some economic costs to address it. The Congress in 1997 passed the Byrd–Hagel

The trade–environment debate in context

resolution, which opposed a treaty along the lines of Kyoto, by a vote of 95–0. At the same time, environmentalist NGOs considered the agreement and related Clinton policies inadequate. Many environmentalists pronounced the Administration a profound disappointment, and support for the Green Party’s Ralph Nader in the year 2000 election turned out to be (one of many things) great enough to deny the presidency to Al Gore, the candidate with the most knowledge and concern regarding the environment of any political leader in US history. Where did the median American citizen stand? On both sides of the chasm. On the one hand, polls say that a heavy majority of Americans are concerned about the environment in general, and global warming in particular, and want to do something about it.9 On the other hand, I think most of them could not answer correctly whether global warming is scientiﬁcally the same phenomenon as the greenhouse effect, stratospheric ozone depletion or acid rain. In a poll, 59 per cent responded that it was either deﬁnitely true or probably true that the greenhouse effect was caused by a hole in the earth’s atmosphere, while only 26 per cent thought this was probably or definitely not true.10 The polls also show that the median American voter opposes substantial energy taxes to address climate change.11 The United States will not address the issue seriously until public awareness rises. The negotiation and debate over the Kyoto Protocol itself has helped raise the visibility of the issue a great deal. A very hot summer, and some natural catastrophes, would help more. Some say the American public will never accept a substantial increase in the price of energy, whether in the form of taxes or otherwise. But I would not completely rule out a major shift in attitudes at some point in the future. It may have to be tied in part to other objectives such as other environmental goals, and reducing dependence on oil for national security reasons. Political saleability of an energy tax would be enhanced if it came at a time of falling world energy prices (because avoiding a decline in price is much less damaging politically than causing an increase), and if the tax revenue were visibly seen to be recycled directly back to the public in another, popular, form. (2) The second wide political chasm lay between the United States and the European Union. The EU, correctly pointing out that it had already reduced the ratio of energy use to GDP while the United States had continued its proﬂigate policies, insisted that cuts in domestic emissions be sufficiently severe to impose economic costs on the United States. In the negotiations, this translated both into support for aggressive targets for reductions in emissions, and opposition to schemes whereby members could pay other countries to do the cutting for them. The United States favored ‘ﬂexibility’ mechanisms such as international trading of emission permits, to reduce the economic costs of achieving a given target. Many Europeans felt that such

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trading was immoral. The US response was that if the Europeans opposed such market-oriented mechanisms to reduce the economic costs of achieving a given environmental goal, they must have a sinister ulterior motive. Their goal must be scoring debating points with their domestic green parties or inﬂicting pain on the United States for its own sake,12 rather than achieving an agreement that would lead to a better environment. The gulf between the EU and US became even clearer in the wake of Kyoto, never more so than at the Sixth Conference of Parties at the Hague in November 2000. The EU made a mistake symmetric in nature and comparable in magnitude to the mistake made a few months later by the incoming Bush Administration in rejecting Kyoto out of hand. The EU refused to agree to the Clinton–Gore position on ﬂexibility mechanisms (particularly unrestricted international trading of emission permits, and use of sinks), even though the known alternative was dealing with the far more hostile Republicans. The symmetry arises in that both the EU and Bush passed up the chance to offer apparent concessions, secure in the knowledge that the other side would not agree, and thereby able to pin the blame for the failure of multilateral negotiations on the unreasonableness of the other. (3) The third political chasm lay between the United States and the developing countries. Many Americans opposed taking any costly steps unless the developing countries were participating as well.13 This was also the gist of the Byrd–Hagel resolution. After Kyoto, industry ran prominent advertisem*nts that showed a map of the world with the non-participating countries cut out, as giant holes in the system. The most commonly articulated reason why the absence of developing countries was considered fatal was the adverse impact on American economic competitiveness. Although competitiveness is not the proper way to articulate the concern, I will argue below that we do indeed need the developing countries in. The developing countries, for their part, argued, quite reasonably that the rich countries should have to go ﬁrst, since they created the problem and the poor countries should not be forced to forego their own industrialization to solve it. In this they were supported by the Berlin Mandate, wherein the UNFCCC negotiators had already agreed in 1995 that the developing countries would be exempted in the ﬁrst round. (4) The fourth chasm was intellectual rather than political – between the engineers and the economists. Engineers promised that new technologies were already available that could save energy and save money at the same time, and that reducing emissions thus need not entail any economic costs. Their favorite example was so-called ‘green light bulbs’, though many other technologies had their proponents (low-ﬂow shower heads, fuel cells, solar and wind power, cogeneration, and so forth). The engineers used so-called

The trade–environment debate in context

‘bottom-up’ models, essentially large-scale linear programming exercises that used technical coefficients from laboratory experiments, with little allowance for human behavior. A prime example was the ‘ﬁve-labs’ study that the Department of Energy (DoE) produced to back up claims that the Kyoto reductions could be achieved at very little economic cost.14 They called ‘lemon-suckers’ those who argued that an increase in the price of carbon was necessary to induce the desired shift in the amount and composition of energy that consumers and ﬁrms use. The economists – the lemon-suckers – in turn called their opponents techno-optimists. They asked why such energy-saving technologies were not already in use, if they were so proﬁtable.15 It is probably in fact a poor tactic for economists to deny the possibility that any money-saving technologies could exist unused. The claim that everyone is rational alienates non-economists unnecessarily. But there are other problems with the argument that technologies already exist that have the potential to save us. One is the difficulty in knowing which of the many candidate technologies are the winners. Another is in overcoming whatever social barriers currently exist to the use of the techniques – some of which result from irrational or inefficient ‘market barriers’ (incomplete information, incorrect discount rates), but others of which may be perfectly rational given the absence of economic incentives (many consumers are genuinely averse to ﬂuorescent light, low-ﬂow shower heads and small toilet tanks, no matter how much environmentalists wish the truth were otherwise). In either case, it is foolish to think that people will start using new technologies that they were not previously using merely because the President gives a speech, the Senate ratiﬁes a treaty or Economic Planning Agency (EPA) bureaucrats hand out leaﬂets on street corners. People need incentives to change their ways. In this light, it makes little difference whether the people have been acting fully rationally or not. It should go without saying that technology is part of the solution. But technology is not a policy lever. Only measures like taxes, tax breaks, research subsidies, permit requirements and other forms of regulation are policy levers. To make an analogy, we can agree scientiﬁcally that burning calories is the way to lose weight. But this is not a prescription for avoiding the hard work of getting exercise. Exercise is the policy lever and burning calories is the intermediating variable, to cut weight. Similarly, creating incentives to save energy is the policy lever and use of cleaner techniques is the intermediating variable, to cut energy use. The economists’ models were called ‘top-down’ models, because they relied on econometric equations estimated from aggregate data on energy use, income, price and so forth. It was not precisely correct to say that these models were pessimistic. The models said that little progress could be made

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reducing carbon emissions if there were no increase in the price of carbon, especially in the short run. But, based on the data of past history such as the response to the 1970s oil shocks, the models predicted that substantial adjustments were possible in response to an increase in price, especially in the long run. The patterns of behavior implicit in the estimated equations included the development and implementation of new technologies not currently contemplated, given generous enough incentives, and in that sense could actually be more optimistic than the engineers’ approach. Why do I list the conceptual gap between techno-optimists and economists as one of the chasms that needs to be bridged if climate change is to be seriously addressed? I do not believe that it does the environment any service to pretend that greenhouse gases can be reduced without raising the price of emissions, without paying any economic costs or without making any special effort. If it is so easy, then why would we need a treaty? An agreement that resulted from such a pretense would prove to be cosmetic. People need to realize that there will be some price, even if it is only a moderate one, and need to decide that it is worth paying, not just because it is the truth, but also because the effort will not be sustained if it is based on unrealistic promises.

FLEXIBILITY MECHANISMS Techno-optimism might be good enough for the DoE or the EPA, or even, if the truth be told, the President and Vice President. But the White House wanted the Council of Economic Advisers (CEA) to be able to testify to Congress that the economic costs of Kyoto would be modest. There was pressure on the economists, from some parts of the government, to accept estimates made by the bottom-up modelers, that technology would achieve large reductions in domestic emissions at low cost. The CEA was not prepared to accept these estimates, or to testify at all to any propositions that were contradicted by the leading economic models. In the aggregate models, the parameter under dispute was the rate of improvement of the Autonomous Energy Efficiency Index. We considered a trend of 1.0 per cent a year plausible, a small increase above the 0.9 per cent number in the Energy Information Agency’s Annual Energy Outlook. We did not consider it wise to assume that such initiatives as the $6.3 billion ﬁve-year package of tax cuts and R&D that President Clinton proposed in the 1999 ﬁscal year budget would over the short span of ten to ﬁfteen years have a payoff greater than this. There was only one way we could see to reconcile the models with the claim that the quantitative targets of Kyoto need not imply large economic costs.

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This was to give full sway to the ﬂexibility mechanisms: the treaty had to specify the environmental goals in an aggregate way and let the market decide how to achieve them most efficiently. We identiﬁed provisions falling under three kinds of ﬂexibility: ‘when ﬂexibility,’ ‘what ﬂexibility’, and ‘where ﬂexibility’, all of which were in the end accepted by the other parties at Kyoto. (1) ‘When ﬂexibility’ loosened up the constraint whereby a given country might otherwise have had to hit a given target precisely in a given year. That would have been very difficult, given the imprecision of measurement and in particular, the unpredictabilities of the weather and the business cycle. Rather, countries are allowed to average over the ﬁve years of the budget window, 2008–12, and to ‘bank’ any reductions beyond the target for future budget periods. (2) ‘What ﬂexibility’ loosened up the constraint whereby a country might otherwise have had to hit individual numerical targets for carbon dioxide, methane and four other greenhouse gases. The other gases were considered important enough sources of global warming to include, as scientists have a relatively good idea of their contribution to the greenhouse effect. But we will not know which gases ﬁrms will ﬁnd it easiest to cut back on until we try. Thus a linear combination of the six was speciﬁed, rather than separate targets for each. The protocol also speciﬁed a role for sinks – sequestration of carbon, particularly into growing forests – though how exactly countries would receive credits for sinks was to some extent left for future negotiation. (3) ‘Where ﬂexibility’, the most contentious set of issues, loosened the constraint regarding within whose borders physical reductions in emissions occurred. It is far easier for some countries to cut emissions relative to the BAU path than for others. It is far cheaper for China to refrain from building a coal-ﬁred power plant that it would otherwise have built, using natural gas in its place, than for the United States to tear down an existing coalﬁred plant. The latter can pay the former for the trade, and both come out ahead. At the insistence of the United States – and allies within the ‘umbrella group’, which included Japan, Canada, Australia and New Zealand – the text agreed at Kyoto allowed international trading of emission permits. The United States was careful to allow that trading could be undertaken by individual entities within a country and need not go through the government; it wanted to be able to respond to charges that US taxpayers were being asked to pay other sometimes-corrupt countries for the right to use energy, by arguing that trading would only take place if private individuals voluntarily wished it. The language speciﬁed that countries pay others for emission reductions ‘supplemental’ to those achieved domestically. Left for future negotiations was the deﬁnition of ‘supplemental’ – Europeans insisting on

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a cap on trading such as 50 per cent of targeted reductions, and Americans thinking anything up to 99 per cent was fair game. Other details of the trading scheme were also left to be worked out in the future, such as whether buyers or sellers would face legal liability, and whether there would be penalties for abuse. (In my view, if a country sells several years’ worth of emission permits in the ﬁrst year of the budget period, it should then have to make good with accounted-for domestic cuts before it can sell any more. This was called an ‘empty-tank provision’.) Besides international trading, the other key geographical ﬂexibility provision was the inclusion of developing countries. As already noted, the Kyoto Protocol followed the Berlin Mandate in specifying targets only for the so-called Annex I countries – the industrialized countries and some of the formerly industrialized countries of the former Soviet bloc. In practice, this meant that the United States and other rich countries would compete to buy permits from Russia and the Ukraine. (The latter two would ﬁnd it easy to reduce emissions relative to 1990 levels, for two reasons. First, they consume six times as much energy per dollar of output as does even the United States. Second, their economies had collapsed in the intervening decade. Thus some, but certainly not all, of the reductions they would be paid for would be ‘paper tons’ or ‘hot air’, that is, reductions that would have occurred even in the absence of an agreement.) President Clinton signed the Kyoto Protocol one year later, November 1998, at the time of the Fourth Conference of Parties in Buenos Aires. But, at the same time, the Administration adopted the position that it would not submit the treaty to the US Senate for ratiﬁcation – knowing that it would face certain and overwhelming rejection – unless and until negotiations achieved ‘meaningful participation’ by developing countries. That meant not necessarily that all developing countries need participate fully (the Byrd–Hagel position), but that at least a majority of the key large countries – China, India, Korea, Brazil, Mexico, Argentina – must participate. ‘Participation’, in turn, meant adoption of targets, and participation in the voluntary permit trading system. The Kyoto Protocol included a version of the already existing Joint Implementation, dressed up under the name ‘Clean Development Mechanism’ (CDM) to sound like a resource-transfer proposal that came from Brazil. These provisions looked much like emissions trading, except that, divorced from the benchmarks provided by targets, countries were in essence selling permits without the existence of property rights. The idea was to pay Costa Rica to preserve forests or to pay China to switch to clean energy sources. The difficulty was knowing what the benchmark was, what these countries would have done otherwise. Proponents agreed that every effort should be made to ensure ‘additionality’, but in my view gave few real

The trade–environment debate in context

grounds for hope that additionality would in practice be much greater than zero. A caricature version of the proposal would have each of a billion Chinese citizens stepping forward, in turn, to explain that he or she had been thinking of building a dirty power plant or chopping down a forest, but that if paid a modest sum he would agree not to do so. My personal view was that the CDM would do more harm than good, by bringing the valuable principle of international permit trading into disrepute. Others thought that it was better than nothing. In any case, the Clinton Administration position was that it would not submit the treaty to the Senate until major developing countries agreed to targets of the same nature as the countries that had signed Kyoto. Even assuming that these countries could be persuaded – and most were adamantly opposed even to discussing the issue – this would require either side agreements with individual countries or negotiating some new parallel agreement. CEA Estimates of the Economic Costs of the Policy In response to insistent demands from the US Congress, the White House produced a set of CEA estimates regarding the economic effects of achieving the Kyoto targets.16 These estimates relied on the Second Generation Model (SGM), of Battelle Labs, with the help of Jae Edmonds.17 The key ﬁndings were as follows: (i) international trading, even if just among the Annex I countries, reduced costs by an estimated 50 per cent. If the EU countries chose to forego trading, then the opportunity to buy and sell emission rights within the umbrella group alone (including Russia and some other transition economies) would reduce costs by 60–75 per cent; (ii) inclusion of major developing countries in the target and trade system reduced costs further, to a total saving of 80–87 per cent; and (iii) with these ﬂexibility mechanisms, costs became quite modest, approximately $7–12 billion a year, or only 0.1 per cent of GDP. While predicted economic costs (lost real income) is the relevant statistic for an economist, the public instinctively considers those numbers less real than predictions of the increase in the price of energy; (iv) our prediction was that energy prices would rise modestly: $14 to $23 per ton of carbon equivalent. This translated into increases of 5–9 per cent in fuel oil prices, 3–4 per cent in the price of electricity, and 3–4 per cent in gasoline prices (around 4–6 cents per gallon). For the typical household, it would mean an increase of 3–5 per cent in overall energy prices, or an increased energy bill of $70–$110.18

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It followed from the second point, above, that without international trading, the costs of Kyoto would be ﬁve to eight times higher, and thus in excess of $100 per ton of carbon avoided. But we did not include this statistic explicitly in the report, because it would have given hostile opponents a sentence to quote. Some reacted to our report by suspecting that we must have used a model biased to give low estimates. But in fact the SGM model is roughly in the middle of the pack of economic models (and a fortiori more conservative than the techno-optimist models). Subsequently, ten leading models that participate in the Energy Modeling Forum of Stanford’s John Weyant (EMF-16) showed a median prediction of costs in terms of permit prices of Kyoto quite close to ours, both in the case of no international trading and in the case of Annex I trading. With full global trading, the SGM results were a bit below the median, but far from the lowest of the models. The others predicted gains of 70 to 91 per cent from full global trading, consistent with our estimates.19 There was one respect in which our estimates were very optimistic. That was the assumption that there would be effective and unlimited international trading and participation by developing countries, when the EU had not yet agreed to the former and the developing countries were adamantly opposed to the latter. But we were completely explicit about this, and did not offer any estimation that attaining the necessary conditions was politically likely. Better yet, by repeating these estimates and the necessary conditions endlessly in testimony and other public fora, the Administration in effect became completely locked in to the position that it would not submit the treaty for ratiﬁcation unless or until these conditions were met. There were also respects in which our estimates were pessimistic. First, as noted, we did not rely on the possibility of immediate technological breakthroughs. Second, we made no allowance for the potentially very important global role of sinks in removing carbon from the atmosphere at relatively low cost, in part to be conservative and in part because the speciﬁcs were not available. Third, we did not explicitly include auxiliary beneﬁts: the relative price shifts necessary to reduce emissions should produce non-climate beneﬁts in three areas – traffic congestion, highway accidents and air pollution – that we estimated could offset approximately a quarter of the resource cost of climate change policy. And the most important factor that we left out of the assessment was the long-term beneﬁt of beginning to mitigate climate change itself. On the other hand, as the date gets later, as 2008 approaches and no real action has been taken, it gets harder and harder to attain the Kyoto targets. Already by 1998, US emissions of CO2 were something like 12 per cent

The trade–environment debate in context

above 1990 levels (and emissions of all greenhouse gases 22 per cent above). By now they have risen substantially more. Thus the cuts envisioned at Kyoto were very large relative to the current path that we were – and still are – on. I have not seen any recent estimates, but as of 2002, I would guess that by now, for the United States, attaining the targets would be so economically ruinous as to be almost out of the question, unless perhaps one were able to make generous interpretation of the sinks provision.

TREATY DESIGN Why did the Kyoto Protocol set quantitative targets, instead of the price mechanism favored by many economists? 20 A global carbon tax, while meritorious in theory, would be an instance of ‘common policies and measures’, which was rejected by the parties. The main explanation, again, is that it is not feasible politically. To dictate to each country the instruments to be used to achieve a shared environmental goal is too large an invasion of national sovereignty. Also a uniform tax would require a far higher sacriﬁce by the United States, relative to the status quo, than Europe or Japan, because the latter already have high taxes on some forms of energy, so it is not sensible to expect the US government to support such a thing. To address the latter problem, the version proposed by Richard Cooper is a uniform incremental carbon tax. But then Europe and Japan would have a strong incentive to substitute the additional carbon tax for existing energy taxes. Skeptics will say that monitoring and enforcement problems are sufficiently great that quantitative targets are meaningless. They are correct that monitoring and enforcement problems are large, but not that the targets are of no use for this reason. The precedent of the successful Montreal Protocol on stratospheric ozone depletion is somewhat encouraging. Compliance problems would inevitably be greater with global climate change than with ozone, because the number of emitters and range of activities is so much greater. The enforcement clause was left blank at Kyoto, to be ﬁlled in later, given a lack of good ideas. In practice, countries would miss targets sometimes – some explicitly, pointing to factors beyond their control such as natural disasters, civil wars, economic hardship, and so forth, and others hiding behind a mask of shameless accounting. But the more egregious cheaters would feel strong moral suasion from others, and when all was said and done, some progress would be accomplished. Unfortunately, the power of moral suasion diminishes sharply if the countries participating know that they are heavily outnumbered by the countries not participating. An excellent idea that might have helped persuade cost-conscious countries was the safety valve: supplementing quantitative targets with a

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provision that if the shadow price of carbon (the price of tradable permits) goes above a pre-arranged level, then it is capped by an arrangement that some authority will sell an unlimited number of additional permits at that price.21 The selling authority could be national governments in one version, or a multilateral authority in another version, with proceeds earmarked for agreed-upon uses. One attractive feature of this idea is that it ‘calls the bluff’ of the techno-optimist environmentalists. If they are right that there are lots of opportunities for reducing emissions cheaply, then they should have no objection to a safety valve that would kick in only at a relatively high price. The proposal is also called an escape clause or, in trade-policy language, a tariff-rate quota. Even after the Kyoto Protocol was written, there was still scope for incorporating such a provision under the compliance section, as a monetary penalty for non-compliance. The safety valve idea had more potential support than most ideas that we economists come up with. If the economic team in the Clinton Administration had been even better prepared, we might have been able to get a safety valve accepted as part of the Administration position. Still, it would have been a difficult ‘sell’. As soon as one names a speciﬁc number for the mechanism to be triggered, the number is too high – in that you are admitting to industry the possibility that costs might go that high – and simultaneously too low – in that the environmentalists worry that you are abandoning the objective of putting a ceiling on emissions. Many regard the absence of the developing countries as the most serious and most intractable shortcoming of the Kyoto Protocol. This is right in the sense that we need these countries in the system. We need meaningful participation by developing countries for three reasons: (1) although the industrialized countries created the climate problem, the developing countries are nevertheless the source of the big increases in emissions in coming years under the BAU scenario. (2) If an international regime is implemented without the developing countries, their emissions are likely to rise even faster than BAU, due to the problem of ‘leakage’. And (3), as is apparent in the model results, the opportunity for the United States and other industrialized countries to buy emission reductions from developing countries is crucial to keep the economic cost low. It is also correct that the obstacles to bringing the developing countries in are very large. This was the third of the political gaps identiﬁed above. I would disagree with people like my friend and colleague Dick Cooper who claim that the approach of setting quantitative targets does not lend itself to bringing in the developing countries. Before Kyoto, one would reasonably have thought that it would be impossible for countries to agree on differentiated quantitative targets. But the Annex I countries did precisely that. But how, you will ask, could the developing countries now be brought in?

The trade–environment debate in context

In the ﬁrst budget period, the developing countries should be asked to commit to quantitative targets closely related to their BAU paths. These would not be cuts in absolute terms, which it would be completely unreasonable to ask of developing countries, but would rather constitute ‘growth targets’. I have explained elsewhere ideas for how speciﬁcally to determine these targets.22 To address problems of both equity and uncertainty, targets could be set by a formula based on countries’ past emissions, income levels and population. Persuading the developing countries to participate should not be quite as difficult as many assume, because they stand to gain from the system, not only environmentally but economically as well, that is, from the opportunity to sell emission credits. As a measure that can offer gains to all parties, both rich and poor, the proposal to add the developing countries to Kyoto by granting them BAU-related paths surely is more likely to be adopted than measures that ask them to make sacriﬁces. Here I will add a few words on how I propose setting the targets in subsequent budget periods, after the developing countries are in the system and targets for the ﬁrst budget have been agreed. For the second budget period, participants should again negotiate targets, according to one formula for Annex I countries and another for developing countries. The formula for the Annex I country targets should incorporate small additional cuts in per capita emissions by taking a step in the direction of the worldwide average of per capita emissions. Meanwhile, the formula for developing countries should incorporate small additional cuts (again, relative to existing growth paths) by taking a step in the direction of their 1990 per capita levels. In the third budget period, the formula for Annex I countries would again place a bit less weight on the Kyoto targets and a bit more weight on the global per capita average; and the formula for developing countries would place a bit less weight on the BAU path and a bit more weight on 1990 levels. In the long run, all countries could converge on a common formula for per capita emissions, as a function of each country’s 1990 emission levels and per capita income levels. With a long-term framework of this nature, Kyoto would truly turn out to have been the ﬁrst step on the path toward seriously addressing global climate change.

NOTES 1. 2. 3.

Working Group I of the IPCC (2001), p. 13–16. A few will try, which is commendable. But absent a commonly agreed set of rules or incentives, voluntary individual efforts are unlikely to add up to much, and rather to remain a matter of ‘private virtue’ (a phrase of Vice President Dick Cheney’s). Nordhaus (1994).

You’re getting warmer 4. 5. 6. 7.

9. 10. 11.

12. 13.

14. 15. 16. 17. 18.

19.

20. 21. 22.

For example, William Cline (1992). For an introduction to the discount rate issue, see Goulder and Stavins (2002). For a more recent and general review of the timing issues, see Aldy et al. (2001). Manne and Richels (1997). Subsequently, Hammett (1999) estimated that the least-cost emissions path for stabilizing at 550 ppm lies below the fully optimizing path of costbeneﬁt analysis, until 2024, and then crosses above it. Wigley et al. (1996) had earlier proposed a path to this goal (which Manne–Richels found to be almost as cost-efficient as theirs), showing Annex I emissions peaking in 2010, developing countries peaking in 2050 and the global average peaking in 2030. I want to be clear that it still makes sense for most academic models to work in terms of long-term paths. But it is also important to realize that no given policy maker gets to choose a long-term path. The job of each, at most, is to choose the size of one link in the chain. The economic adviser who insists on talking about 100-year paths is making the common mistake of refusing to answer the question that the policy maker has hired him to answer. On several occasions, I would try to explain an intermediate value theorem to my colleagues: Before emissions returned to 1990 levels, their rate of growth would have to turn negative, and before that, their ﬁrst derivative would have to fall to zero. But nobody wanted to discuss the leveling off date. Awareness is also increasing over time (Kull, 1998, pp. 3–6). The source is a survey conducted by the National Opinion Research Center, for the US Council for Energy Awareness, in 1993. Only 48 per cent favor increasing the tax on gasoline by 10 cents a gallon, according to a Mellman Group poll in August 1997, although a majority is willing to pay more for gasoline in an unspeciﬁed way, if it will signiﬁcantly reduce global warming (73 per cent will pay 5 cents a gallon, and 60 per cent will pay 25 cents), according to a Pew Poll in November 1997 (Kull, 1998, p. 12). Some others share this feeling as well, for example, Sandel (1997). Forty-four per cent said the US should refuse to sign the Kyoto Treaty until all the lessdeveloped countries committed to limits, while 53 per cent said the industrialized countries should proceed with as many countries as would commit to limits (Kull, 1998, p. 10). US Department of Energy (1997). Al Gore’s book on climate change repeats the old joke about a man not wanting to pick up a $20 bill on the sidewalk, under the theory that it couldn’t be real because somebody else would have already picked it up (Gore, 1993, p. 186). The Kyoto Protocol and the President’s Policies to Address Climate Change: Administration Economic Analysis, White House, July 1998. Summaries included Yellen (1998); and Frankel (1998). Edmonds et al. (1992, 1997). We made adjustments for the effect of the six-gas objective, as the existing economic models focused on carbon dioxide alone. Joe Aldy was the CEA staff economist who worked with the model. A majority of 52 per cent of Americans say they would oppose signing the treaty at a presumed cost level of $50 a month for an average household (Kull, 1998, p.11). Although the White House did not use or have polling data at the time the policy was formulated, the politically minded aides had a notion of what the public would support that turned out to be about right, judged by subsequent data. Three models were (substantially) more optimistic than SGM: FUND, G-Cubed (McKibbin–Wilcoxen) and RICE. In the case of global trading, six models were more pessimistic than SGM: MIT, AIM, MRT, CETA, MERGE3 and Oxford (the latter few models were substantially more pessimistic). For example, Nordhaus (2001); Cooper (1998), and Chapter 2, this volume. For example, Pizer (1997); Kopp et al. (1999). The Brookings Institution (1999). The targets could be set slightly below the BAU estimates, comparable – controlling for income levels – to the pattern of reductions implicit in the targets agreed by the industrialized countries at Kyoto.

The trade–environment debate in context

REFERENCES Aldy, Joseph, Peter Orszag and Joseph Stiglitz (2001), ‘Climate Change: An Agenda for Global Collective Action’, conference on The Timing of Climate Change Policies, Pew Center on Global Climate Change. Cline, William (1992), The Economics of Global Warming, Washington, DC: Institute for International Economics. Cooper, Richard N. (1998), ‘Toward a Real Global Warming Treaty’, Foreign Affairs, March/April, 66–79. Edmonds, J.A., S.H. Kim, C.N. McCracken, R.D. Sands and M.A. Wise (1997), ‘Return to 1990: The Cost of Mitigating United States Carbon Emission in the Post-2000 Period’, Paciﬁc Northwest National Laboratory, Operated by Battelle Memorial Institute. Edmonds, J.A., H.M. Pitcher, D. Barns, R. Baron, and M.A. Wise (1992), ‘Modeling Future Greenhouse Gas Emissions: The Second Generation Model’, in Lawrence Klein and Fu-chen Lo (eds), Modeling Global Climate Change, Tokyo: United Nations University Press, pp. 295–340. Frankel, Jeffrey (1998), ‘Economic Analysis of the Kyoto Protocol’, After Kyoto: Are there Rational Pathways to a Sustainable Global Energy System?, Aspen Energy Forum, Aspen, 6 July, Colorado: White House. Gore, Al (1993), Earth in the Balance: Ecology and the Human Spirit, New York: Plume, Penguin Books. Goulder, Lawrence, and Robert Stavins (2002), ‘How and Why Economists Discount the Future’, Nature, 419, 17 October, 673–4. Hammett, James (1999), ‘Evaluation Endpoints and Climate Policy: Atmospheric Stabilization, Beneﬁt–Cost Analysis, and Near-Term Greenhouse Gas Emissions’, Climatic Change, 41, 447–68. Kopp, Raymond, Richard Morgenstern, William Pizer and Michael Toman (1999), ‘Domestic Trading: A Credible Early Action’, Washington, DC: Resources for the Future. Kull, Steven (1998), ‘Americans on Global Warming: A Study of US Public Attitudes’, Program on International Policy Attitudes, University of Maryland, pp. 3–6, 10–12. Manne Alan S. and Richard G. Richels (1997), ‘On Stabilizing CO2 Concentrations – Cost-Effective Emission Reduction Strategies’, Stanford University and Electric Power Research Institute. National Opinion Research Center (1993), Survey for the US Council for Energy Awareness. Nordhaus, William (1994), Managing the Global Commons: The Economics of Climate Change, Cambridge, MA: MIT Press. Nordhaus, William (2001), ‘After Kyoto: Alternative Mechanisms to Control Global Warming’, American Economic Association, Atlanta, GA, 4 January. Pizer, William (1997), ‘Prices vs. Quantities Revisited: The Case of Climate Change’, Resources for the Future Discussion Paper 98–02, October. Sandel, Michael (1997), ‘It’s Immoral to Buy the Right to Pollute’, New York Times, 15 December, p. A29; reprinted in Robert Stavins (2000), Economics of the Environment: Selected Readings, 4th edition New York: Norton, pp. 449–52. The Brookings Institution (1999), ‘Greenhouse Gas Emissions’, Policy Brief No. 52, June, Washington, DC: The Brookings Institution.

You’re getting warmer

US Department of Energy (1997), ‘Scenarios of US Carbon Reductions: Potential Impacts of Energy-Efficient and Low-Carbon Technologies by 2020 and Beyond’. Wigley, Thomas, Richard Richels and Jae Edmonds (1996), ‘Economic and Environmental Choices in the Stabilization of Atmospheric CO2 Concentrations’, Nature, 379. Working Group I of the Intergovernmental Panel on Climate Change (2001), Climate Change 2001: The Scientiﬁc Basis, Summary for Policymakers Report, United Nations Framework Convention on Climate Change, United Nations, New York, pp.13–16. Yellen, Janet (1998), ‘Testimony before the US House of Representatives Committee on International Relations’, The Kyoto Protocol and the President’s Policies to Address Climate Change: Administration Economic Analysis, 13 May, Washington, DC: White House.

PART II

Trade and Environment Policies

Trade, the harmonization of environmental policy and the subsidiarity principle Charles Perrings

INTRODUCTION Enlargement of the European Union implies increasing heterogeneity amongst member states. This raises important questions about the connections between trade and environmental policy in the enlarged EU and in particular, about the role of harmonization in environmental policy. The question posed is the following: what should be the nature of the linkages between common trade and environmental policies, and to what extent should a common environmental policy imply the harmonization of environmental standards? Although the chapter is concerned with the European Union, and with the differences between current and accession states, these turn out to be essentially the same questions being raised at the global level in connection with an environmental analogue to the World Trade Organization (WTO). The institutional implications are somewhat different, but the principles at issue are the same. Given this, the chapter begins with a discussion of the global debate about the linkages between trade and the environment, and the importance of differences between countries for those linkages. This debate is normally considered in terms of North–South differences, but enlargement faces the European Union with qualitatively similar problems. For example, the current concerns of the South about the role of environmental standards as trade protection devices have echoes in the concerns of accession countries over harmonized environmental standards. Globally, the failure of trade liberalization to yield promised development beneﬁts has hardened attitudes in the South against environmental cooperation. The fact that the South’s share of world exports has been steadily declining in the years since the conclusion of the Uruguay Round has made the countries of the South more suspicious than ever of the hidden agendas in environmental negotiations. Within Europe, similar concerns have affected attitudes both to 59

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regional commitments under multilateral environmental agreements (MEAs) and to environmental directives that enforce common standards. The points at issue in the debate are then illustrated through a particular problem – the problem of alien invasive species (IAS). This is not a problem that has yet become a general source of concern, although speciﬁc cases of invasive pests and pathogens, such as the current foot and mouth (FMD) epidemic or the AIDS epidemic attract both attention and resources. Indeed, FMD is taken as an exemplar for purposes of discussion. It is a problem that nicely reveals the trade-offs at issue in the linkage between trade and environmental policy, and the case for harmonization.

TRADE–ENVIRONMENT LINKAGES The issue is not whether trade and environment are linked, but how they are linked. To be sure the issue has been blurred by the heated debate over the inclusion of environmental considerations in the WTO.1 But the frequently repeated assertion that trade measures are blunt instruments to deal with environmental problems that are better addressed through dedicated environmental measures does not mean there is or should be no linkage between trade and the environment. The environmental effects of economic activity are frequently not reﬂected in national or international market transactions – they are external to the market. But environmental externalities exist precisely because there are physical linkages between non-marketed environmental processes and marketed goods and services. Internalization of environmental externalities implies recognition of the physical linkages between economic and environmental processes. The way we choose to do this varies with the nature of those linkages – whether they involve public or private goods, whether the effects are unidirectional or reciprocal, whether they consist of stock or ﬂow pollutants, and whether they cross national boundaries. The speciﬁc options open at the international level may be different from those at the national level, but the generic features of those options are the same. There are examples of the internalization of externalities through the assignment or negotiation of property rights at both national and international levels. Safe minimum standards exist for transboundary effects just as they do for domestic effects. Taxes, subsidies or penalties have both national and international analogues, and in both cases efficiency requires that the scale of the intervention is proportionate to the failure of the market concerned. It is related to the marginal damage cost of the external effect. It is certainly possible to pose the question as to whether negotiated changes in the trade regime generate sufficient gains that the new regime is

Trade, harmonization of environmental policy and subsidiarity

superior to the old regime by the compensation principle, irrespective of the welfare costs of environmental externalities. Even if one uses this rather limited test of efficiency, however, the compensation mechanisms for distributing the gains from changes in the trade regime are natural elements of trade negotiations. Indeed, the idea that those who stand to carry increasing environmental costs from a change in the trade regime should negotiate rules without reference to compensation mechanisms is fanciful. The more important question is whether trade agreements exacerbate environmental externalities, and if so how they should be addressed. There has been a long and not particularly helpful debate as to whether trade liberalization is ‘good’ or ‘bad’ for the environment. A common argument is that liberalization of global markets is likely to be environmentimproving as a result of the composition effect. This is, for example, because removal of explicit or implicit agricultural and energy subsidies is thought to reduce the incentive to over-exploit marginal lands and to encourage the adoption of energy-saving technologies, both of which reduce pressure on the environment (cf. Munasinghe and Cruz, 1995). In the same vein, it has been argued that trade liberalization would both lower the cost of environmental protection, and facilitate the diffusion of environmental protection technologies (Anderson and Blackhurst, 1992). Against arguments such as these is the fact that the reallocation of effort on the basis of comparative advantage can lead to greater concentration of activities in particular locations, increasing the environmental impact in those locations. The change in developing country share in world production and trade in the smoke-stack industries, for example, is partially due to changes negotiated in earlier rounds of the General Agreement on Tariffs and Trade (GATT). To the extent that specialization in polluting activities is driven by a set of prices that exclude environmental costs, liberalization has been argued to be ‘bad’ for the environment (Daly and Goodland, 1994; Young, 1994). There are similarly conﬂicting stories told about the environmental implications of the scale effect. On the positive side, the literature stimulated by Grossman and Krueger’s (1993) study of the environmental implications of NAFTA – the Environmental Kuznets Curve literature – has supported the view that the growth induced by trade liberalization may improve certain measures of environmental quality. This is partly because of the composition effect. The point has already been made, for example, that high income countries have tended to shift out of the most polluting industries such as pulp and paper, iron, steel and non-ferrous metals, petroleum reﬁning and chemical products (Panayotou, 1997; de Bruyn, 1997). But it has also been argued to follow from the fact that growth in incomes induces a proportionately greater growth in environmental expenditures.

Trade and environment policies

That is, one reason to expect a positive relation between the scale effect and environmental quality is that environmental quality is in the nature of a luxury good (McConnell, 1997). Environmental expenditures are income-elastic. On the other side of the coin, if liberalization stimulates demand for the products of environmentally damaging activities, then it follows that it will increase environmental damage, other things being the same (Anderson, 1992; Barrett, 2000). Of course other things will not necessarily be the same. Feedback mechanisms such as the price system will induce changes in technology and demand. But if there exist no feedback mechanisms, or if the existing feedback mechanisms are blind to environmental effects, then as Daly (1973) has long observed, economic growth will indeed be environmentally harmful. Economic growth is likely to push economies closer to the assimilative or carrying capacity of their environment. As activity levels rise, the environmental constraints to growth may become more and more binding. In extreme cases, environmental impacts may threaten the resilience of the ecological systems on which economic activities depend (Arrow et al., 1995). The main point here, as Barrett (2000) remarks, is that whether liberalization is good or bad for particular environments is an empirical question. At the international level it depends on people’s willingness to trade off environmental quality in different locations, and this involves complex decisions. It may, for example, be possible to relieve an environmental constraint to the growth of industrial output by relocating industry from areas where the assimilative capacity of the environment is fully stretched to those where it is barely tested. This will involve both beneﬁts and costs for people in both areas, and the balance struck will reﬂect their preferences between environmental quality and the consumption possibilities associated with industrial decline or expansion. It may also be possible to relieve an environmental constraint to industrial growth by enhancing the assimilative or carrying capacity of the environment. Growth in carbon emissions in one location may, for example, be balanced by increasing carbon sequestration in other locations. In this case, the costs of enhancing the assimilative capacity of the environment include the foregone development options of committing land to carbon sequestration. The pertinent questions at the national or international level are: (i) whether the externalities induced by the composition and scale effects of changes in the trade regime outweigh the gains from that change, (ii) whether there exist interventions to internalize the externalities resulting from the change, and (iii) if the change yields potential net beneﬁts excluding externalities, whether there exist compensation mechanisms to ensure that it is welfare improving for all.

Trade, harmonization of environmental policy and subsidiarity

At the international level, the answers to these questions depend on both the physical and institutional linkages between economic and environmental processes. The environmental externalities associated with trade expansion are a function of the physical interactions between economic and environmental processes, given the set of property rights that underpin market transactions, and given the measures taken to deal with problems posed by the incompleteness of markets. That is, externalities exist because of the failure of institutions to match the physical linkages. Environmentalists’ concerns with the WTO stem from the perception that it limits the extent to which transboundary externalities (spillovers) may be internalized. The exceptions allowable under Article XX of the GATT, along with the Sanitary and Phytosanitary Agreement (SPS Agreement), do authorize countries to impose restrictions on trade in order to protect human, animal and plant life. Moreover, it is recognized that tariffs may substitute for Pigouvian taxes in the internalization of international environmental externalities, albeit imperfectly (Markusen, 1975; Brander and Taylor, 1998). But there is a (well-grounded) perception that the exceptions allowable under Article XX and the SPS measures are narrowly interpreted, and that the WTO’s predisposition to see environmental measures as protectionist measures limits their effectiveness. The WTO has in fact been very cautious in granting exceptions to individual countries under Article XX. Aside from Article XX and SPS exceptions, trade sanctions have been successfully included as mechanisms for encouraging participation in and discouraging non-compliance with multilateral environmental agreements (MEAs), the best example being the Montreal Protocol on Substances that Deplete the Ozone Layer (Barrett, 1999). In some cases these have been recognized by the WTO, although in others like the Cartagena Protocol on Biosafety and Genetically Modiﬁed Organisms, it is more sceptical (Runge, 2001). The consensus is now that the WTO may not be the place to negotiate cooperative environmental measures (Bhagwati, 2000; Barrett, 2000). Indeed, the WTO itself makes the same point, arguing that international economic integration reinforces the need for international environmental cooperation (Nordstrom and Vaughan, 1999). This had led to growing pressure for the establishment of an environmental analogue to the WTO – either a World Environment Organization (WEO) (Whalley and Zissimos, 2000) or a Global Environment Organization (GEO) (Runge, 2001). The case for either a WEO or GEO has several elements. The ﬁrst is that the WTO as presently constituted is not the place to address transboundary environmental externalities. The alternative to date has been to negotiate speciﬁc MEAs, each covering a particular transboundary issue. This has led to a plethora of agreements – more than 200 so far. In some instances

Trade and environment policies

these have been linked in the sense that agreement on one issue has been associated with agreement on other issues. The reasons for this are now well understood. Issue linkage turns out to be one of the main mechanisms for assuring the viability and stability of environmental coalitions (Carraro, 1999; Xepapadeus, 2000). There is, however, no mechanism for the general coordination of MEAs. The Global Environment Facility (GEF) may be interpreted as a compensation mechanism for a select number of MEAs, especially the Convention on Climate Change and the Convention on Biological Diversity. But most agreements are both negotiated and then implemented in isolation. Given the physical interdependence of the issues covered by different agreements, this is an important lacuna. Moreover, while not all agreements involve trade sanctions, enough do so for coordination with the WTO to be a problem. Runge (2001) argues that the primary role of a GEO would be coordination of the MEAs, and liaison between MEAs and the WTO. In particular, he regards a GEO as taking responsibility for negotiating Article XX exceptions. A secondary role would be to offer the same sort of dispute resolution function as the WTO. Whalley and Zissimos (2000), by contrast, see the role of a WEO as being explicitly to internalize global environmental externalities. Arguing that the cause of global environmental externalities lies in the lack of well-deﬁned property rights at the global scale, they claim that a primary function of a WEO would be to establish markets for global environmental goods and services. Very few existing MEAs involve markets or compensation mechanisms, so this vision goes well beyond coordination. A key point here is that global environmental externalities are evidence of global market failure, and their internalization implies a mechanism that can operate at the global scale. It does not follow that a WEO or GEO should operate only at the global scale. Most MEAs do not have a global reach, and most transboundary environmental disputes involve a relatively small number of countries. In a similar vein, most disputes brought to the WTO disputes panel – and all of the disputes brought under Article XX – involve a small number of countries. Nonetheless, there is a link between the scale of an environmental externality and the scale of the institutional framework suggested for its internalization. Regional trade agreements typically involve parallel environmental agreements. The form of these differs from one case to another. NAFTA includes an environmental side agreement, the North American Agreement on Environmental Cooperation (NAAEC), which is implemented by the North American Commission for Environmental Cooperation (CEC). The EU includes a much broader array of region-wide environmental policies administered partly through the Environment Directorate and partly

Trade, harmonization of environmental policy and subsidiarity

through other Directorates. But in both cases there are environmental institutions with the same potential reach as the trade pact.

THE IMPORTANCE OF COUNTRY DIFFERENCES The point made at the outset is that enlargement of the EU involves the accession of countries that are different in a number of respects from current member states. The differences may not be as dramatic as North–South differences involved in the enlargement of NAFTA, but they are qualitatively similar and are important. The accession countries are characterized by different economic structures, income levels, labour market conditions, technological development and environmental resource endowments. At the global level, North–South differences have been well enough studied that we can draw some general conclusions about the implications of enlargement for institutional linkages. The most frequently made argument is that agreements which facilitate capital mobility tend to induce a ‘race to the bottom’ as ﬁrms in high income countries seek to remain competitive by relocating to countries where labour and environmental conditions are more relaxed (Wheeler, 2000). The race to the bottom implies that a locally relaxed environmental protection regime is maintained in order to induce inward investment. If trade agreements make it impossible to protect domestic agriculture or industry through trade policy, countries may be encouraged to use other policies to the same effect. By this argument, enlargement would be accompanied by increasing levels of activity in accession countries as ﬁrms relocate to take advantage of local labour market and environmental regulatory conditions, with resulting impacts on both the local and regional environment. The corollary is that other countries would use environmental regulation as protectionist measures against the accession states. Furthermore, because trade agreements can create both winners and losers, they create the conditions in which side payments or issue linkages can be invoked to improve the stability of the coalition. Differences between current member states and the accession states create an incentive to negotiate linkage between institutions. At the root of the race to the bottom argument is the proposition that competition within a trade pact will drive ﬁrms to locate where costs – including the costs of compliance with environmental regulations – are minimized. The empirical evidence for this is mixed. The relocation of polluting industries from high-income to low-income countries is an important part of the explanation for changes in environmental indicators observed in the EKC literature (Barbier, 1997; Cole et al., 1997). However,

Trade and environment policies

studies of the incentive effects of environmental regulation have concluded that the costs of compliance with environmental regulations are a sufficiently small proportion of total costs and that they do not generally turn location decisions in high-income countries (Jaffe et al., 1995; Levinson, 1996). Labour costs, raw material costs and taxes tend to be more important than

Trade And Environment: Theory And Policy in the Context of Eu Enlargement And Economic Transition (The Fondazione Eni Enrico Mattei (Feem) Series on Economics and the Environment) - PDF Free Download (2024)