emissions trading with nonsignatories in a climate …lessman/slides/wcere2010.pdfkai lessmann,...

Kai Lessmann, WCERE 2010 Montreal 1

Emissions trading with non­signatories in a climate agreement 

An analysis of coalition stability

Kai Lessmann*Ottmar Edenhofer*Robert Marschinski*Michael Finus♦

WCERE 2010, Montreal

* Potsdam Institute for Climate Impact Research♦ University of Exeter Business School

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Kai Lessmann, WCERE 2010 Montreal 2

International Environmental Agreements (IEA)

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coalitionpermittrade

CDMcredittrade

non-member

• Coalition formation: two stage game– Stage 1: Membership game

● Players either sign the IEA or do not

● CDM credit supplier remains impartial

● Internal/external stability (  Carraro/Siniscalco 1993)→

– Stage 2: Emission game● Players decide on 

investments (  emission trajectories)→and trade (  allowances choice)→

● Partial Agreement Nash Equilibrium (  Chander/Tulkens 1995)→

● Our aim:Design permit trade with non­members (“CDM”) to improve the IEA

CDM credit supplier

Kai Lessmann, WCERE 2010 Montreal 3

Modeling Endogenous Allowance Choices

● Trading allowances: net permit exports = allowances ­ emissions

● Choose

–  q > e to sell CDM credits

–  q < e to import CDM credits

–  q  low to reduce global warming, as total allowances cause damages

● Additionality – CDM trader must reduce below “no trade” baseline no “hot air”→

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coalitionpermittrade

CDMcredittrade

non-member

CDM credit supplier

time

allowances,emissions allowance choice q

tradable credits xemissions e

Cf. Helm (2003) JPE, Carbone, Helm and Rutherford (2009) JEEM

Kai Lessmann, WCERE 2010 Montreal 4

Model of International Climate Agreements (MICA)

welfare

consumption

output

labor capitallaborefficiency

mitigation

emissionintensity

● Model builds on Lessmann et al. 2009, Lessmann/Edenhofer 2010

● Economic dynamics: 

– Regions maximize intertemporal welfare(cf. Nordhaus' RICE)

– Trade in one good and emission allowances

– Eight symmetric regions + CDM supplier

● Climate dynamics:

– emissions   concentration   temperature→ →

– climate change damages

● Data: global aggregates calibrated to common scenarios

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coalitionpermittrade

CDMcredittrade

Kai Lessmann, WCERE 2010 Montreal 5

Impact on Coalition Stability

● Stability Function: inside payoff – outside payoff

● Largest stable coalition: 2

Stability Functions

No CDMbaseline

Coalition Size

Kai Lessmann, WCERE 2010 Montreal 6

Impact on Coalition Stability (2)

CDM

No CDM

Stability Functions

● Stability Function: inside payoff – outside payoff

● Largest stable coalition: 2

● Introduction of CDM 

– stability decreased

– coalition size 2 remains 

● Why?

Coalition Size

Kai Lessmann, WCERE 2010 Montreal 7

Impact on Coalition Stability (3)

CDM

No CDM

Stability Functions Global Emissions

CDM

No CDM

● More abatement in coalition   reduced global emissions→

● Stronger incentive to free­ride

Coalition Size Coalition Size

Kai Lessmann, WCERE 2010 Montreal 8

Improving CDM Design

● Two approaches to (maybe) overcome this negative result:

– Selling targets● Idea: Shift the gains from CDM trade to the coalition● Impose more stringent upper bounds on CDM-trader’s allowance choice

– CEA CDM trade● Idea: Negotiate CDM trade after coalition formation● CDM trade ensure cost effectiveness

(but is not part of the cost/benefit trade-off in the allowance choice)

time

CDM traderallowances

no tradeselling target

allowance choicetradable credits

no trade

time

Coalitionallowances

no trade

“no lower than no trade”

CEA constraint

Kai Lessmann, WCERE 2010 Montreal 9

Selling targets: Welfare effects

● No selling targets: 

– welfare gains from CDM­trade for● CDM-trader (––) ● Non-member (––)

● Selling targets 

– shift welfare gains from CDM trader to Members, leaving Non­members unaffected

– free­riding incentive remains high

● CDM­trader gain < 0:not profitable   no trade→

● Trade­off: profitability vs. stability

fixed coalition size of 6

Kai Lessmann, WCERE 2010 Montreal 10

Selling targets: Stability vs. Profitability

Coalition Size

Selling Target

profitable CDM trade

stable coalitions

→ Selling targets work in principle, but are restricted by non-profitability

Kai Lessmann, WCERE 2010 Montreal 11

CEA CDM: Coalition Stability

Stability Functions

● Stability is improved, but the effect remains small

● This may be due to relatively small volume of CDM trade

 → Boost CDM trade by introducing some heterogeneity

CDM No CDM

CEA CDM

Coalition Size

Kai Lessmann, WCERE 2010 Montreal 12

CEA CDM: Introducing Heterogeneity

Abatement

Coalition (all members) CDM-trader

MCi

MBC

MBi

Abatement

MCi

MBi

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MM

ET

RIC

SY

MM

ET

RIC

CDMContributionto Abatement

17%

AN O – T R A D E for a 5 playercoalition

Kai Lessmann, WCERE 2010 Montreal 13

CEA CDM: Introducing Heterogeneity

Abatement

Coalition (all members) CDM-trader

MCi

MBC

MBi

Abatement

MCi

MBi

Abatement

MCi

MBC

MBi

Abatement

MCi

MBi

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RIC

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RIC

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GE

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CDMContributionto Abatement

17%

67%

for a 5 playercoalition

AN O – T R A D E

Kai Lessmann, WCERE 2010 Montreal 14

CEA CDM: Results from heterogeneous players

Stability Functions Stability and profitability of trade

profitable CDM trade

stable coalitions

Coalition SizeCoalition Size

Sel

ling

targ

etCDM

No CDMbaseline

CEA CDM

Kai Lessmann, WCERE 2010 Montreal 15

CEA CDM: Welfare implication of hot air

● Positive effect of CDM trade on treaty participation increases with traded volume (heterogeneity)

● Net­effect of “hot air” ambiguous: 

– dillutes the agreement and thus causes welfare loss

– improves participation – which may outweigh the welfare loss

with additionalitywith “hot air”

Degree of Heterogeneity

% o

f soc

ial o

ptim

um

Kai Lessmann, WCERE 2010 Montreal 16

Summary

1. Depending on its design, 

– CDM may discourage participation (CBA) or

– CDM may foster participation (CEA)

2. Selling targets may help the agreement in two ways:

– by shifting welfare gains of CDM trade to coalition members (CBA)

– by stabilizing a dilluted agreement by allowing “hot air” (CEA)

3. Large enough differential, large credit trade volume necessary

Kai Lessmann, WCERE 2010 Montreal 17

Thank your for your time.