Prepared statement of

W. David Montgomery Ph.D.

Vice President, CRA International

before the

Committee on Foreign Affairs

U.S. House of Representatives

May 15, 2007

 

 

Mr. Chairman and Members of the Committee

 

I am honored by your invitation to appear today, as the Committee addresses how the United States could most effectively engage in international action to manage the risks of climate change.  I am Vice President of CRA International, co-head of CRA’s global energy and environment practice, and an economist by profession and training.  Much of my work for close to 20 years has dealt with the economics and policy of climate change, on both the national and international level.  Most recently my research and publications have focused on design of policies that can most effectively stimulate technology innovation and reduce or reverse the growth in emissions from developing countries.   My statements today are my personal conclusions and opinions, and do not necessarily represent positions of CRA International or any of our clients.

 

Key Points

 

My testimony contains eight key points.

 

  • The Kyoto Protocol is a flawed approach to global action on climate, and with or without the United States is unlikely to achieve anything close to the goal of stabilizing greenhouse gas concentrations in an acceptable range.

 

  • Mandatory U.S. greenhouse gas controls and any version of the Kyoto Protocol will impose a significant cost on the U.S. economy and will lead to a shift of investment away from the U.S. and toward countries like China and India that are not willing to undertake similar efforts.

 

  • By creating these competitive advantages, adherence to the Kyoto Protocol by industrial countries will actually strengthen the incentives for countries like China and India to resist controls.  

 

  • Because China, India and other developing countries will be responsible for the majority of global emissions over the next century, any prospect for halting global warming depends crucially on inducing these countries to cut their emissions.

 

  • The immense potential for cost-effective emission reductions in developing countries can only be unlocked if those countries adopt the deep institutional reforms that are necessary for the efficient functioning of markets and sustained economic growth.

 

  • Designing an international agreement that can accomplish this will be difficult, and the greatest U.S. contribution would be to convince the rest of the world to recognize and confront those difficulties in a realistic manner.

 

  • A new framework is needed to replace the Kyoto Protocol.  To be effective, negotiations for a post-2012 framework should be confined to the top 13 to 20 emitting countries.  The framework should include cooperative R&D and mechanisms to address institutional change, investment climates, and technology transfer in the rapidly growing developing countries.

 

  • Although the ultimate objective of stabilizing greenhouse gas concentrations at some level needs to be kept in mind, it is pointless to negotiate specific concentration goals until a framework conducive to technological advance and developing country participation is created.

 

Costs to the U.S. economy

 

Mandatory U.S. greenhouse gas controls and any version of the Kyoto Protocol will impose a significant cost on the U.S. economy and will lead to a shift of investment away from the U.S. and toward countries like China and India that are not willing to undertake similar efforts.

 

Any industrial country that sets a mandatory cap on carbon dioxide emissions will have to incur higher energy costs to meet that cap.  The tighter the cap, the greater that cost will be.  In previous studies that have looked at a range of proposals for U.S. emission caps set at varying levels, we have estimated annual losses that range from 0.3% to about 1.9% of GDP in 2020.[1]  For proposals that apply a constant or declining cap, or provide for a rising carbon tax, these costs would increase over time.  In every case, we see exactly the same mechanisms at work.  The need to adopt more costly methods of electricity generation, to invest in producing more expensive, low-carbon fuels and to undertake more intensive energy conservation measures diverts resources that would otherwise be available to produce the goods and services that make up GDP.   Higher energy costs raise the costs of U.S. manufacturing relative to competitors in countries that do not adopt limits on greenhouse gas emissions.

 

Due to these higher energy costs, there will be an even greater shifting of investment from the United States (and other industrial countries) into countries like China and India.  Emissions in the United States will fall, especially as our share of energy intensive industries shrinks, but they will grow even faster in China as factories rise there that would otherwise have been built here.  Moreover, given the much lower level of energy efficiency in countries like China, the leakage of emissions will be much greater than the leakage of investment.

 

Deficiencies of the Kyoto Protocol

 

The Kyoto Protocol is a flawed approach to global action on climate, and with or without the United States is unlikely to achieve anything close to the goal of stabilizing greenhouse gas concentrations in an acceptable range.  It gives developing countries inadequate incentives to participate, and even the industrial countries that ratified the Protocol are unlikely to meet their targets without resort to purchasing credits that are not backed by real reductions.  

 

The failings of the Kyoto Protocol are unavoidable in any approach based on future targets and timetables.  The complete lack of definition for targets beyond 2012 undermines any reasonable expectation that investments made today for the purpose of reducing future emissions would generate any predictable return.  This problem cannot be fixed by getting started on negotiations for the Second Commitment Period, because the Protocol provides no enforcement mechanisms or other incentives to induce reluctant parties to sign the treaty and continue their participation in emission targets and timetables. This lack of enforceability stems not from poor drafting of the treaty, but from the fundamental fact that an agreement on future targets and timetables among sovereign countries is in principle unenforceable and therefore unstable. [2]

 

The Kyoto Protocol’s fatal flaws were outlined succinctly by Professor Scott Barrett of Johns Hopkins SAIS. He wrote:

 

… The Kyoto Protocol has failed to create the incentives needed to promote global participation, to reduce emissions both substantially and in the long term, and to implement these reductions in a cost-effective manner. Moreover, it is difficult to see how the Kyoto approach could be modified to create the needed incentives. A different, more radical approach is required.

Sovereign countries are unable to make binding commitments, because the Protocol deals with targets rather than observed actions. Moreover, there are no consequences under the Kyoto Protocol for failure to participate or to comply with an agreed target. Any country can avoid its commitments de jure by withdrawing with two years notice, or de facto by rolling any violation of a target into future periods.  The Kyoto Protocol fails to define emission targets beyond 2012, and negotiations on the Second Commitment Period (2013 – 2017) are just beginning.

The only enforcement provisions in the Protocol provide that any failure to meet a target in a given period must be made up with a penalty in a future period. However, the lack of definition of targets beyond the first commitment period makes these penalties meaningless. No country that is likely to be in violation of its first commitment period target needs to agree to a second commitment period target, until that second target is increased sufficiently to avoid the penalty.  Since no commitments are defined for any future period, any country that expects to exceed its target can negotiate a sufficiently high future commitment to cover the excess, without requiring any real action to make it up. A country that wishes to do so is in a good bargaining position, because its fallback is to withdraw completely. In short, the hard caps of the Protocol become soft when violations can be rolled into yet-to-be-negotiated future targets.

 

By lurching from one short run goal to the next, the Kyoto process gives countries (and their industries) no credible expectation that there will be stable, progressively more ambitious future commitments. Therefore it creates no incentive to make large investments (in R&D or different energy supplies) that will only pay off if the agreement holds together.

 

Thus it is not surprising to see that even the EU and Japan are not achieving the emission reductions required to meet their targets through domestic action.  The figure below shows the lack of progress made by the EU15 since they signed the Kyoto Protocol in 1997.  Their CO2 emissions have risen, and only one-time success in controlling non- CO2 greenhouse gases has held total greenhouse gas emissions constant.   Both levels remain far above the targets to which the EU15 agreed.  A similar picture characterizes Japan. 

 

 

Source:  Data submitted by the EU to the UNFCCC; units are in 1000 metric tons CO2 equivalent

 

Reports for the EU25 appear to show more progress, but this is only because the entry of Eastern European countries into the EU has given the original 15 EU members the benefit of emission reductions already achieved by their new members.  Thus data for the EU25 obscure the inability of the original EU parties to the Kyoto Protocol to meet their reduction targets.

 

Both the EU and Japan intend to rely on purchasing credits from CDM or Russian “hot air” to meet their obligations.  Credits from Russia are simply a way of buying out of the obligation, since they are the ‘hot air’ that Russia skillfully extracted as a condition of agreeing to the Protocol, and represent no actual emission reductions.

 

CDM was intended to provide a mechanism under which the Kyoto parties could fund real emission reductions in developing countries when those opportunities are more cost-effective than domestic reductions.   The CDM, however, is not working out that way.  Rather than engaging the developing countries in reducing emissions, CDM is encouraging them to game the system and increase emissions so that they can subsequently get credit for reducing them.  Thus reliance on CDM may also replace real emission reductions with credits that represent no real reduction from what would have happened without the Kyoto Protocol.  The unintended consequences of the CDM have received considerable attention in the press recently.

 

Contrary to expectations when the CDM was created, relatively few of the credits have been generated from projects involving new energy sources or long term improvements in energy efficiency.  Rather, they have been concentrated in non-CO2 greenhouse gases that provide very large amounts of credits because of their exceptionally large effect on global warming (see figure below).  Although there is no question that releases of these gases must be stopped, the CDM rules have not always led to true reductions. 

 

According to Michael Wara of Stanford University:

 

The CDM fails as a market because it has animated accounting tricks that allow participants to manufacture CERs at little or no cost.

 

…there is relatively strong evidence that HCFC-22 producers participating in the CDM have behaved strategically to direct a greater share of the subsidy to themselves by artificially inflating their base year production...”[3]

Source: Michael Wara, Is the Global Carbon Market Working, Nature, Vol 445, No. 8 February 2007

 

More recently, the British Sunday Times reported that

 

“While British companies use the credits instead of cutting their own pollution, [the seller of emission credits from burning CFCs] plans to reinvest its windfall in building a new plant producing another refrigerator gas called HFC-134a - 1,300 times more damaging than carbon dioxide.”[4]

 

Technology and developing countries are key to managing climate risks

 

Technology innovation and participation by developing countries are indispensable to managing climate risks at an acceptable economic cost, and the approach of the Kyoto Protocol cannot accomplish either one.

 

New technological solutions are required to make stabilization an economic possibility

 

Technology innovation and participation by developing countries are both indispensable to managing climate risks at an acceptable economic cost. The Kyoto Protocol cannot accomplish either one nor could any approach modeled on Kyoto.

 

One of the clear implications of climate science is that stabilizing atmospheric concentrations of greenhouse gases will require the world (not just the U.S.) to reduce greenhouse gas net emissions to near-zero levels. – that is, the rate at which emissions are put into the atmosphere must equal the rate at which they are removed.  That cannot be done at affordable cost with today’s technology or with incremental improvements in that technology.  Halting climate change is possible only if large-scale greenhouse gas emission reductions can be implemented at costs that are both politically and economically acceptable.  Therefore, R&D to create new technological options is a necessity if that stabilization goal is to be economically feasible. 

 

The challenge is huge.  One study estimates that getting on a path toward zero net emissions will require that, within the next 50 years, the world must produce carbon free energy at twice the level of today’s output of all energy.[5]    The magnitude of possible reductions in the next decade or two achievable with today’s technology is dwarfed by the magnitude of reductions that are required and that successful innovation would supply.  A massive program of R&D focused on breakthrough discoveries leading to new approaches and technologies is required.  Even mandatory limits on emissions over the next decade or two will not provide a sufficient, credible incentive for that R&D.[6] 

 

Hoffert et al. identify an entire portfolio of technologies requiring intensive R&D, suggesting that the solution will lie in achieving advances in many categories of research.  They conclude that developing a sufficient supply of technologies to enable near-zero carbon intensity on a global scale will require basic science and fundamental breakthroughs in multiple disciplines.  This kind of R&D effort appears to be the only way to hope to achieve meaningful reduction of climate change risks.  Emission limits that do not simultaneously incorporate specific provisions that directly support a substantially enhanced focus on energy technology R&D will not effectively reduce climate risks.

 

Development and transfer of new technology is also critical to preventing increases in emissions from developing countries.  Although significant, cost-effective emission reductions are possible in these countries in the near term with today’s technology,  ultimately their emissions will still grow rapidly unless new, low cost technologies are developed.

 

Climate risks cannot be managed without China, India and other large developing countries

 

Because China, India, and other developing countries will be responsible for the majority of global emissions over the next century, any prospect for halting global warming depends crucially on inducing these countries to cut their emissions.  These countries are expected to continue rapid population and economic growth which, combined with essentially wasteful energy use, leads ultimately to emission far surpassing our own.  China is a good example.  Its rate of economic growth has exceeded 8% per year for the past decade, and every added dollar’s worth of output in China increases greenhouse gas emissions by double the amount associated with a dollar’s worth of output in the United States.  Energy-related technology used in most of China still lags far behind the United States.[7]  Thus China’s greenhouse gas emissions are expected to exceed ours within the next year or two, and to keep on increasing from there.  India is a similar story, though at this time a smaller economy. 

 

The Kyoto Protocol’s inability to bring China and India within the system of mandatory emission reductions dooms the agreement, or any similar agreement to environmental ineffectuality.    Even if all the countries that originally signed the Protocol were to meet those targets, the result would fall far short of what is required to stabilize global temperatures.  MIT researchers have estimated that the Kyoto Protocol, if all its signatories were to continue forever to keep emission at or below its targets, would produce a reduction of 0.5° C in global average temperatures by 2100 (about a 14% reduction from uncontrolled temperatures).[8]  Other mainstream climate scientists have estimated that it would take 30 Kyotos to achieve what they consider acceptable concentrations of greenhouse gases in the atmosphere,[9] and that the targets for the 2008-2012 period would reduce global average temperatures in 2050 by just 0.07° C.[10]

 

A few years ago researchers at MIT determined that to reach a commitment of holding CO2 concentrations below 550 ppmv while allowing non-Annex 1 country emissions to grow unchecked, the OECD countries would, by 2035, have to reach negative emissions, i.e. net removal of greenhouse gases from the atmosphere.[11]

 

All these estimates assume that parties to the Protocol actually meet their targets.  It is not just the United States that will have emissions in excess of the Kyoto Protocol target.  At this point, Australia, Japan, Canada, and the European Union itself appear likely to fail to reduce emissions sufficiently to meet their targets.  The European Union may be able to comply with its obligation, but only if it purchases large quantities of “hot air” from Russia, an action with leads to no net decrease in global emissions.

 

This reality poses a fundamental dilemma for U.S. climate policy. On the one hand, America and the other OECD countries cannot solve the problem of climate change without the help of countries like China and India, and would incur serious economic costs in proceeding with GHG controls without the participation of those countries. On the other hand, the U.S. has very little ability to influence Chinese and Indian willingness to adopt GHG limits.  

 

The Kyoto Protocol provides insufficient incentives for new technology

 

Some have suggested that by putting a price on carbon emissions, the Kyoto Protocol would induce industry to develop the new technologies to drastically reduce GHG emissions. A price on GHG emissions would encourage further refinement and commercialization of new abatement technologies. Unfortunately, a price is a poor tool for encouraging the more basic R&D needed to effect very large reductions in GHG abatement costs. Edmonds and Stokes convey the essence:

 

For technologies that are “on the shelf” or technologies that are near commercialization, this argument is largely undisputed. But putting technologies on the shelf is another matter. That requires R&D and R&D suffers from the problem of inappropriability. That is, private actors cannot capture the full economic benefits of the R&D they conduct and therefore there is a systematic underinvestment in that activity. Moreover, the more basic the R&D, the harder its fruits are to appropriate. The difficulty then lies in getting the technologies to the point where they can be put on the shelf. At the very least, there is a problem in laying down the foundations upon which new technologies can be built. All of this speaks to the problem of the public-private interface in the creation of a climate policy. There is a clear need for R&D that goes beyond that which even the best market economies would foster in the private sector.

Montgomery and Smith point out that even if the appropriability problem were solved, it is impossible for governments to make a credible commitment to future carbon prices high enough to motivate private sector R&D.  The only substitute is a set of public policies to provide additional direct incentives and funding for R&D, policies that are completely missing from the Kyoto Protocol. 

 

International cooperation on R&D has at least three advantages over uncoordinated national approaches. 

 

  1. If every country knows its efforts will be matched by others and the accomplishments of R&D are shared, each country will gain greater benefits for every dollar it agrees to spend.  Thus internationally coordinated research should be able to achieve far greater total funding than the sum of funding that countries would be willing to undertake on their own.

 

  1. Cooperative R&D and international exchanges of students and researchers can create additional capabilities worldwide by providing advanced training for scientists and engineers from developing countries that do not have their own world-class research establishments. 

 

  1. R&D in which developing countries are actively involved can better identify innovations and technology most appropriate to the resources, markets and skill levels in those countries, and thus more rapidly and effectively develop technologies that will bring down the cost of reducing emissions in developing countries.

 

Barrett’s findings about the instability of an agreement based on targets and timetables do not apply to agreements dealing with cooperative R&D.  He finds that an agreement on R&D is both feasible to negotiate and capable to address the critical problems in practice: “it does not require that compliance be enforced, and it provides positive incentives for participation.” [12]

 

 

The Kyoto Protocol is not motivating engagement or effective action on the part of developing countries

 

It is not the lack of U.S. participation that makes the Kyoto Protocol fall short of achieving sufficient reductions in emissions to achieve climate goals.  The reason for the ineffectiveness of the Kyoto Protocol – and this would still be the case if the U.S. were to undertake unilaterally a standard equal to Kyoto or tighter -- is that developing countries are not only outside of the agreement but are benefiting from the competitive distortions that it creates.

 

Developing countries have shown no interest in adopting emission limits and becoming part of the global system envisioned under the Kyoto Protocol.  These countries consistently give higher priority to economic growth and its ability to ameliorate much more pressing social problems.  Their point of view, and its implications, are well described by David Victor and Danny Cullenward of Stanford University:

 

The rub, though, is that developing countries have refused to accept limits on their emissions. Their interests are different from the industrialized world—they seek development and are wary of any scheme that would impose immediate economic costs for the more distant benefit of reduced climate change

 

Luring developing countries into an emissions trading system would require printing large number of extra permits—headroom to grow. Such a strategy, while well-intentioned, would actually undercut serious efforts to control emissions elsewhere in the world by flooding emission permit systems with extra permits. Exactly such a deal was struck to get Russia and Ukraine to join the Kyoto Protocol; both countries refused to join Kyoto unless they were given generous headroom that was akin to printing a huge windfall of free extra permits.

 

The target and timetable approach in the Kyoto Protocol, even if coupled with international emission trading, forces developing countries to trade off emission reductions and economic growth.  As a result, there are only two paths forward:  industrial countries act alone, suffering competitive disadvantages and strengthening the incentives for countries like China and India to remain outside the agreement, or the industrial countries make immense cash payments to those countries, over and above current trade deficits, to induce them to participate.

 

Given developing countries’ perceptions of the conflict between economic growth and emission reductions, it is naïve in the extreme to believe that adopting mandatory limits will automatically cause developing countries to follow our lead.  Instead, limits on emissions from industrial countries will cause a shift in investment toward those developing countries, so that our emission reductions will be offset by greater increases in emissions outside the United States. 

 

Finally, and this point is widely misunderstood, the competitive advantage that China and India would gain from unilateral emission limits in the United States makes those countries even less likely to agree to future limits on emissions.  Moreover, once China and India build industries that depend on a difference in energy cost to succeed, it will become politically even more difficult for those governments – and others in the same position -- to undertake policies that threaten those activities.[13]   Thus far from providing a moral example that will bring countries like China into an international agreement, naïve unilateral action will create economic disincentives for those countries to limit their emissions.  Thus, if the U.S. were to ratify the Kyoto Protocol, it would simply further deepen the incentives for China and India to stay out of the agreement.

 

There have been, as Victor and Cullenward mention, proposals to provide China and other developing countries with sufficiently generous allocations of allowances to provide both headroom for growth and sufficient extra permits that the sale of those permits could compensate them for any perceived losses.  As they mention, the precedent for this is the “hot air” given to Russia to induce it to agree to the Kyoto Protocol.  This approach would entail wealth transfers from the United States and other industrial countries far larger than current aid budgets.  Moreover, these payments would go almost exclusively to two countries, China and India, whose rapid economic growth makes them unlikely candidates for our aid. 

 

For example, the International Energy Agency predicts that by 2020 China’s emissions will be about 6 billion tonnes (CO2 equivalent).  At a carbon price of $50 per tonne, an allocation sufficient to cover China’s projected 2020 emissions (to give “headroom” for growth) would be worth $300 billion dollars per year.  Should China find ways to prevent growth in emissions through 2020 by exploiting what appear to be cost-effective changes in technology and energy efficiency, it would be able to sell about 1.5 billion of those allowances per year, adding $75 billion per year to its trade surplus, all at the expense of industrial countries who would be providing the overallocation of allowances.

 

Recent research suggests that China and India with their massive coastal plains may be the countries that would suffer the largest share of world damages from climate change.[14]    These countries should therefore be motivated to participate in an international agreement to reduce greenhouse gas emissions for their own national interest, and not need any additional inducements.  They are also far from being the poor countries to whom we want to send our aid.  By offering —even implicitly—to pay these countries to join a global trading system in which their current and expected emission rates would be grandfathered, we give them an incentive to eschew actions that would be in their unilateral interest if we took a more hardheaded approach. 

 

The remedies for the unwillingness of developing countries to undertake significant emission reductions are not easy to find, but it is clear they are not being provided by the Kyoto Protocol or its Clean Development Mechanism.  China and India are claiming most of the money going into the CDM, as I discussed earlier by building factories that produce exotic greenhouse gases and then earning CDM credits for destroying those same gases.  All of the major developing countries have expressed their opposition to any form of mandatory cap on their carbon dioxide emissions, because of valid concerns that in their current state of institutional development such caps would interfere with their industrial growth. 

 

An alternative approaches to an international agreement can reconcile growth with declining emissions

 

There is in fact an immense potential for cost-effective emission reductions in developing countries, but that potential can only be unlocked if those countries adopt the deep institutional reforms that are necessary for the efficient functioning of markets and sustained economic growth.

 

There are in fact immense opportunities for reducing emission in these countries in ways that would improve their prospects for economic growth – if the governments of China and India could muster the political strength and will to end market distorting policies even though these policies may have the support of important constituencies.  If they are able to meet this challenge, a dollar spent in developing countries could be expected to create much larger emission reductions than the same dollar spent in the United States or any industrial country. 

 

These opportunities exist because of the outmoded technology used in China and other developing countries, and the lack of market institutions to create effective incentives for efficient energy use.  The technology of energy use in developing countries embodies far higher emissions per dollar of output than does technology used in the United States; this is true of new investment in countries like China and India as well as their installed base (See figure below).  The technology embodied in the installed base of capital equipment in China produces emissions at about 4 times the rate of technology in use in the United States.  China’s emissions intensity is improving rapidly, but even so its new investment embodies technology with twice the emissions intensity of new investment in the United States.  India is making almost no improvement in its emissions intensity, with the installed base and new investment having very similar emissions intensity.  India’s new investment also embodies technology with twice the emissions intensity of new investment in the United States. 

 

Thus large emission reductions can be achieved in developing countries through introduction of technologies that are now the standard in industrial countries, and at the same time improve their productivity and prospects for economic growth.  The situation is exactly the opposite in the United States, where our generally efficient markets and advanced technology means that we must incur substantial additional costs to reduce emissions.  The United States is a good benchmark of technology that is economic at today’s energy prices, without any additional incentives or regulations that would lead to adoption of more costly technologies for the purpose of reducing greenhouse gas emissions. 

 

Greenhouse Gas Emissions Associated with Existing and New Investment

(Million tons C per $Billion GDP)

Source:  Bernstein, Montgomery, and Tuladhar

 

Priorities for Economic Growth

 

Developing countries have made it clear that their highest priorities are dealing with poverty, disease, famine, unemployment and violent conflict, and that sustained economic growth is a prerequisite for dealing with these problems.  Therefore, nearly all developing countries have refused to accept caps on their greenhouse emissions and have expressed no interest in becoming part of a global emission trading system—at least on terms acceptable to the industrial countries.  China’s commitment to what might be described as growth at any price is clear.  These countries see the targets and timetables approach to climate change policy as threatening their ability to grow and deal with their more pressing problems.  Therefore, only approaches to climate policy that combine greater economic growth with reductions in emissions intensity have any chance of attracting the interest of developing countries.

 

The Importance of Technology Transfer

 

Technologies that offer lower CO2 intensity have largely been developed in the industrial countries.   Therefore technology transfer, which occurs largely through foreign direct investment, is required to replace carbon-intensive technology. 

 

Technology transfer and increased investment have the potential for achieving large reductions in emissions. The potential from bringing the emissions intensity of developing countries up to that currently associated with new investment in the United States is comparable to what could be achieved by the Kyoto Protocol.[15]  These are near term opportunities, from changing the nature of current investment and accelerating replacement of the existing capital stock.  Moreover, if achieved through transfer of economic technologies it is likely that these emission reductions will be accompanied by economic benefits for the countries involved.

 

Causes of High Carbon Intensity and Effective Remedies

 

In a highly developed economy such as the United States, characterized by efficient markets, pricing relatively undistorted by government policies or government-owned enterprises, free trade and free flows of capital, and strong legal institutions and protection of property rights, it is likely that there are few opportunities to improve carbon intensity without causing reductions in economic performance and income per capita.  If technologies offering such opportunities exist, market forces and individual economic interest will lead to their adoption.  This is not the case in many developing countries, which have economic systems characterized by a lack of incentives for efficient energy use, due to institutional and market failures, and an investment climate that discourages foreign investment and technology transfer.  Remedying these institutional and market failures offers the prospect of reconciling economic growth and emissions reduction.

 

The modern literature on economic development emphasizes the role of legal, market and governmental institutions in economic development.  The concept of “economic freedom” summarizes a wide variety of conditions that are found to be conducive to individual initiative and economic growth.[16]   Indices of economic freedom are based on comprehensive surveys of conditions around the world.  The broad indices of economic freedom include specific institutional problems that can lead to high carbon intensity:

 

·        Pricing systems that make efficient technologies unprofitable

 

·        Institutions and policies that make markets inhospitable to foreign investment with world class technology

 

§         Rule of law and protection of intellectual property

§         Role of state owned enterprises

§         Access to foreign capital

 

·        Lack of required infrastructure, education and skills to utilize technology

 

Lack of these components of economic freedom is clearly associated with high levels of energy use per dollar of GDP.  The figure below plots scores on the Economic Freedom of the World Index compiled by the Frasier Institute against energy use per dollar of GDP, measured at market exchange rates. 

 

Association Between Economic Freedom and Energy Intensity

 

 

Energy intensity is used as a measure because it is directly connected to greenhouse gas emissions from energy use. For example, three of the countries with the relatively poor scores on economic freedom, Russia, China and India, have high energy use and carbon emissions per dollar of GDP.  At the other end of the scale, countries like South Korea, Singapore and Namibia with relatively free economies have much lower carbon intensities, similar to that of the United States.

 

The curved line represents the results of a statistical analysis of the association, which shows that about one-third of the variation in energy intensity is explained by differences in scores on economic freedom.  This is an unusually clear relationship for this type of cross-sectional data.  The literature on economic development also shows that the economic freedom index is very closely associated with per capita income and rates of economic growth. 

 

In more recent work I have focused on specific aspects of the institutional setting that can be expected to have a direct effect on either the efficiency of energy use or the transfer of economic technologies. [17]  This research reveals that both China and India have significant institutional shortcomings in such areas as the rule of law and administration of justice, protection of intellectual property, excessive bureaucracy and corruption, a dominant role of state enterprises in the economy, and inadequate infrastructure.  In both countries, continued economic reform is recognized as being necessary to sustain current rates of economic growth.   We have also found that the same institutional problems are directly connected to wasteful energy use, by diminishing or eliminating incentives for efficient use of resources, and discourage foreign direct investment of the type that leads to effective technology transfer.

 

 

Design of Policies that Can Be Effective and Engage Developing Countries

 

The evidence that high emissions intensity is closely associated with fundamental market and institutional failures leads me to conclude that the highest priority in international negotiations should be to facilitate the process of removing market and institutional failures in China and India.

 

Without remedies for the fundamental institutional problems that underlie poor scores for economic freedom, the continuation of two unfortunate current conditions can be expected:

 

·        A hostile economic environment in China and India will prevent technology that is introduced through projects that the Partnership might support from spreading throughout the economy

 

·        Emission caps will remain costly, because without new technology, emission reductions will require diverting resources that could otherwise be used for growth

 

If remedies are found for fundamental institutional problems, two kinds of results can be expected:

 

·         Projects that transfer economic technologies will take place without further incentives and will lead to spillover effects and significant emission reductions

 

·        The root causes of both poverty and high carbon intensity will be addressed together

 

The actions required to create fundamental institutional reform must take place within the developing countries themselves, and be designed and carried out by their governments, businesses and citizens. What is needed is a process in which all these countries can work together to identify the needs for institutional reform in China and India, understand the benefits that institutional reform would provide in enhancing economic growth and reducing greenhouse gas emissions, and take on appropriate responsibilities for bringing about those changes.  But to do this, engagement with these countries must make institutional reform the highest priority.

 

Finding approaches to engaging these developing countries is critical to managing climate risks, and these approaches must directly address technology transfer and institutional reform.  Although the Kyoto Protocol offers little hope of doing so, these can be addressed in future negotiations involving a more limited number of parties under a different architecture than the target, timetables and emission caps that the developing countries find unacceptable.  I now turn to how these negotiations might be structured

 

Engagement in a global process

 

The Committee on Foreign Affairs has a particular interest in the principles that might guide the U.S. in international negotiations to develop a framework for managing the risks of climate change.   The climate problem will not be solved by U.S. ratification of the Kyoto Protocol, for the reasons I have discussed already.   Designing an effective international architecture is in fact very difficult, and the greatest U.S. contribution would be to convince the rest of the world to recognize and confront those difficulties in a realistic manner.  Effective action on climate risks requires that the U.S. challenge those who would be satisfied with cosmetic changes or tinkering with the Kyoto Protocol, and instead insist on a new approach that can deal effectively with the critical challenges of enforceability, technology and developing countries. 

 

The experience of the Kyoto Protocol, both in its formulation and in its execution, suggests five guiding principles for a realistic and effective architecture:

 

  • Avoid creating unintended incentives that lead to perverse consequences of an agreement. 

 

This has been one of the clear failings of the Kyoto Protocol.  In broad, its architecture encourages developing countries to remain outside of the agreement as long as possible, and its short-term focus fails to provide incentives for either innovation or large capital investments.  In detail, the design of the CDM has wasted resources on projects that garner credits for destroying high-GWP gases that would never have been produced in the first place without the perverse incentives of the CDM.

 

  • Be clear about foreign policy objectives and focus benefits on those in need

 

There is no question that for both moral and foreign policy reasons, we should be concerned about alleviating poverty around the world.   The rise of China is also a major foreign policy concern.  The CDM directs most of its funding toward China and other countries already embarked on rapid economic growth, and leaves the poorest out completely.   A global emission trading regime would require massive wealth transfers to convince China to join, and again provide almost nothing to the poorest.   Since China is likely to be one of the countries most affected by climate change, its gains from participating in a global effort to limit emissions are likely to exceed its costs.  Although there are legitimate arguments that industrial countries should bear the cost of protecting the poorest, it is difficult to see why we have any moral obligation to pay China to participate.  A focus on the connection between institutional change and economic growth would aid the poorest, and help to put them on a path toward sustained and environmentally sound economic growth.

 

  • Concentrate on promoting the most important changes in the proper order

 

For the Annex B countries, the highest priority should be development of technologies that can make long term goals of stabilizing global temperatures economically feasible for all countries.  The largest cost-effective opportunities for near-term emission reductions are in developing countries.  To achieve these reductions, and to slow and ultimately reverse the growth in emission from developing countries, the focus must be on promoting institutional change to create efficient markets and a favorable investment climate.  Timing of reductions in emissions from industrial countries needs to be paced by technology and developing country participation.

 

  • Negotiate only incentive-compatible agreements

 

As the work of Barrett and others has shown, there is no incentive under the Kyoto Protocol for countries to join or to adhere to their agreements.  This is an inherent problem of the targets and timetables approach to an agreement among sovereign states.  To create an agreement in which parties have an incentive to live up to their commitments, some form of “pledge and review” is required.  This involves a discussions of concrete actions that can be monitored effectively and entail credible consequences for failure.  An example might be reform of electricity pricing in India in exchange for transfer of specific U.S. technologies on concessionary terms, with the credible threat that the technology transfer will cease if India fails to make specified changes on an agreed timetable.  Discussions of internationally harmonized carbon taxes might also be compatible with a pledge and review approach, whereas emission trading requires targets and timetables.

 

  • Limit negotiations to the nations that make a difference

 

One of the reasons that so little has come out of the Kyoto and UNFCCC negotiations is that they include nearly 200 parties, most with primary agendas completely unrelated to climate issues, in an unwieldy and inconclusive consensus process.   Since 75% of global emissions come from just 13 countries,[18] limiting future negotiations to the “big emitters” would be much more likely to produce a workable agreement.   Getting out from under the UN’s processes is particularly important to allow the discussions to address different architectures for the post-2012 period, but even if the goal remains to agree on future targets and timetables, negotiations need to be confined to the big emitters.  Regional and bilateral discussions, such as the Asia-Pacific Partnership and the U.S.-India Strategic Partnership, can supplement these negotiations and provide examples of how to achieve effective engagement with developing countries.

 

 

 

 

 

 



[1] Prepared statement of Dr. Anne E. Smith before the Committee on Energy and Natural Resources,

United States Senate, Washington, DC September 20, 2005

[2] Scott Barrett, “U.S. Leadership for a Global Climate Regime,” a paper done for the Climate policy Center, March 2003. Barrett’s book Environment and Statecraft: The Strategy of Environmental Treaty-Making, Oxford University Press, 2003 provides a clear and complete exposition of how the lack of enforcement and participation incentives leads to the ultimate breakdown of the Kyoto Protocol and failure to motivate effective action. 

[3] Measuring the Clean Development Mechanism’s Performance and Potential Michael Wara

Working Paper #56 July 2006 The Program on Energy and Sustainable Development at Stanford University

[4] From The Sunday Times, April 22, 2007 “Indians make cool £300m in carbon farce”

[5] M. I. Hoffert, et al. “Advanced Technology Paths to Global Climate Stability: Energy for a Greenhouse Planet”  Science, Vol. 298, November 1, 2002, p. 981-7.

[6] W. D. Montgomery and A. Smith, “Price, Quantity and Technology Strategies for Climate Change Policy,” Chapter 27 in M. Schlesinger, H. Kheshgi, et. al, eds. Human-Induced Climate Change: An Interdisciplinary Assessment, Cambridge University Press, forthcoming 2007.

[7] P. Bernstein, W. D. Montgomery and S. Tuladhar, “Potential for Reducing Carbon Emissions from Non-Annex B Countries through Changes in Technology,” Energy Economics, Vol. 28, Issues 5-6, November 2006, pp. 742-762.

[8] J. Reilly et. al.  “Multi-Gas Assessment of the Kyoto Protocol,” Nature 401: 549-555 (1999)

[9] D. Malakoff, Science 278, 2048 (1997)

[10] T. M. L. Wigley, Geophys. Res. Lett. 25, 2285-2288 (1998)

[11] Zili Yang and Henry D. Jacoby  “Necessary Conditions for Stabilization Agreements” This paper was presented at the International Conference on “International Environmental Agreements on Climate Change,” held on May 6–7, 1997, in Venice, Italy p.5

 

[12] Scott Barrett, "Towards a Better Climate Treaty" (July 2002). FEEM Working Paper No. 54.2002. Available at SSRN: http://ssrn.com/abstract=318681 or DOI: 10.2139/ssrn.318681

[13] H. D. Jacoby, R. Prinn et al.  Kyoto’s Unfinished Business, Foreign Affairs Vol 7, No. 4.

[14] David Anthoff and Richard S.J. Tol, On International Equity Weights And National Decision Making On Climate Change, February 13, 2007 Working Paper FNU-127, Free University of Amsterdam.

[15] These calculations are provided in Bernstein, Montgomery and Tuladhar

[16] Economic Freedom of the World (EFW) index is published by The Frasier Institute (http://www.freetheworld.com/release.html) and measures the degree to which a country is supportive of economic freedom. The EFW summary index is constructed from five different policy areas: (i) size of government; (ii) legal structure and protection of property rights; (iii) access to sound money; (iv) international exchange; and (v) regulation.  Index of Economic Freedom is published by the Heritage Foundation/Wall Street Journal (http://www.heritage.org/research/features/index/) and reports 10 broad measures of economic freedom for 161 countries.

[17] W. D. Montgomery and S. D. Tuladhar, “The Asia Pacific Partnership: Its Role in Promoting a Positive Climate for Investment, Economic Growth and Greenhouse Gas Reductions.”  International Council for Capital Formation, June 2006.

[18] In order, the U.S., China, EU25, Russia, India, Japan, Brazil, Canada, S. Korea, Mexico, Indonesia, Australia.  Adding Ukraine, Iran, and S. Africa brings to total to 80% of global emissions.