President-Elect Barack Obama has recently indicated that he will support a cap-and-trade regime for mitigating climate change. On a national basis, such a regime would put a price on carbon emissions and enable firms to trade with each other, thus creating a market that would encourage emissions cuts to be made in the most cost-effective way.
American legislation would be an essential component of effective action on climate change, a global solution will be required. In particular, fast-growing economies such as those in Asia will need to be part of the regime, so that they have incentives also to reduce emissions. In turn, these incentives will depend both on these relatively poor countries receiving payments and technological assistance from wealthy countries, and on carbon emissions being priced in these economies. The best way to accomplish this task will be either to create a global cap-and-trade regime or to construct linkages among national regimes so that trading is facilitated on an international basis.
The Kyoto Protocol is important as a building-block because it sketches some elements of such a regime, but its constraints are too mild, it does not include caps on developing countries, and the United States has not ratified the Protocol and is therefore not even subject to the limits that it does impose. These problems have been much-discussed, but a less-discussed problem is equally important: the Kyoto regime contains no credible provisions to assure compliance with agreed-upon limits.
The fundamental problem of compliance in world politics is that it is virtually impossible to enforce international rules against powerful states. This in turn generates a lack of credibility of such rules ex ante. This is not a feature specific to global climate change; it is a general feature of the existing system of sovereign states. Even where sovereignty has been curtailed, as in the European Union, it remains very difficult to enforce international rules externally.
The Kyoto Protocol nonetheless contains compliance provisions built around the idea of external enforcement. States that violate the caps on emissions can in essence “borrow” emissions from the next commitment period with a 30% penalty. As a response to sudden fluctuations that are beyond the control of states that are genuinely committed to meet their long-term targets, this approach makes some sense. But it does not constitute an effective enforcement mechanism. Since states have yet to negotiate those future limits they can build the “penalty” into their future allocation. Moreover, as in many international treaties the Kyoto Protocol permits any party to exit at will. As a result, the Kyoto arrangements are akin to requiring homeowners who default because they cannot afford their mortgage payments to pay a higher interest rate next year, without any provision for foreclosure but with the opportunity for the borrower, in the future, to reset the terms of the loan or simply walk away largely unscathed.
Buyer Liability: the Roles of States and Enterprises
A better compliance system would make buyers liable for the quality of the permits they purchase, just as buyers of international bonds bear the risks of fluctuations in their quality. In such a regime, actual trading would take place between enterprises, whether private or state-controlled. Enterprises in permit-short countries would buy permits from enterprises in permit-long countries to cover their shortfalls during specific periods of time. For example, Duke Power in the U.S. might purchase Chinese-denominated permits from Xian Electric Power in China to cover its anticipated excess emissions in 2010. Trading on secondary markets could also take place among enterprises in various developing countries, or within countries. For example, if in the middle of 2010 Duke Power discovered that it held more permits than it would need to meet its legal cap, it could sell the Chinese-denominated permits that it had purchased from Xian Electric Power to enterprises anywhere in the world.
Buying and selling will largely be between enterprises, but states are nonetheless crucial making a cap-and-trade system work. Permit validity would be assessed on a national basis and permits will discounted on a national basis as well. Hence all permits emanating from a given jurisdiction in a given year would ultimately be assigned the same validity: permits issued in 2010 by the Xian Electric Power Company and Shanghai Electric would have the same value. Permits would be “jurisdiction-equal.”
Under this system, buyers who hold valid permits that do not sum to the excess of their own emissions over their cap at the end of the budget period would need to reenter the market to purchase more permits or engage in further internal reductions. These buyers would be held to their commitments by national law in their countries of operation, which in general would be the wealthy democracies of Europe, North America, and Australasia.
But if buyers bear the liability for invalid permits, what incentives do sellers have to ensure that the permits they sell are backed by real emissions reductions at the national level? Under the system outlined here, the first consequence of public discovery that some permits lacked full validity would be a depreciation of their value on secondary markets, with the loss borne by buyers that held the permits at that time. The second consequence, however, is that buyers would stop paying full value for permits issued by these sellers, and might stop buying them at all. So the stream of revenue received by seller governments would dry up. In other words, expectations of an ongoing market would create an incentive for sellers to ensure the quality of their permits, and to generate and maintain reputations for selling valid permits. In sum, the beauty of this potential buyer liability system is that it could be self-enforcing. It does not require that an international organization ensure compliance with international commitments.
Many questions can be raised about such a regime. It requires an accurate and prompt ex post assessment of permit quality, which would be difficult and complex. But if assessment is difficult, think how much harder assessment plus enforcement is – against strong countries that guard their sovereignty! Under this system, sellers would have incentives to accept impartial assessment since such assessments would be conditions for maintaining high values for their permits.
A buyer liability-based system could provide the basis for a politically realistic cap-and-trade regime not doomed by enforcement problems. It could therefore contribute to effective regulation of greenhouse gas emissions.
- Robert O. Keohane, Woodrow Wilson School of Public and International Affairs, Princeton University.
* This commentary, written originally for the European Weekly, is based on a paper by Robert O. Keohane and Kal Raustiala, “Toward a Post-Kyoto Climate Change Architecture: a Political Analysis (June 2008). Discussion paper 01-08, Harvard Project on International Climate Agreements. See the website of the Harvard Project on International Climate Agreements: http://belfercenter.ksg.harvard.edu.
** Robert O. Keohane is a guest contributor to the GEG blog, and a Visiting Research Fellow at the Centre for International Studies, Oxford University.
December 7th, 2009 at 11:06 am
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