Economic Mechanisms in Global Climate Policy

Per Callesen, Ministry of Finance

INTRODUCTION

The climate change problem is basically a scientific phenomenon, but taking steps to curb global warming also makes good sense econom ically and in terms of energy. Its solution represents a unique economic-policy and global coordination task. It involves elements of disciplines as diverse as taxes, subsidies, financial markets, development aid, research, structural policy in a wide range of sectors, including industry, transport, construction, agriculture and forestry as well as global governance. The essence of the CO₂ problem is that it is global and that emissions have the same effect no matter what countries or sectors they come from. Real global climate policy has been insufficiently examined; so far it has had no major effect and it has indisputably been inefficient. There are no existing global cooperation systems that are capable of handling solutions to the climate problem of the necessary nature and scale. But with a combination of political will, major reforms and international cooperation it is possible to perform the task at reasonable cost and with quite a few additional bonuses.

1. MAGNITUDE OF THE TASK

Given the great scientific uncertainty, global warming as such cannot be controlled. The increase in greenhouse gas concentrations that has already taken place and is certain to continue is bound to result in substantial global warming. Visions expressed in global discussions therefore revolve around reducing future emissions to an extent that may stem the risk of substantial or unchecked increases in temperature. Many seek to translate this into a vision where annual greenhouse gas emissions should be reduced to 50 per cent of the 1990 level.

The size of the task can best be illustrated by the following perspec tives:

From 1990 and up to the present time, global annual emissions have been steadily increasing without slowing down, cf. Chart 1. In 2009, emissions are 30-40 per cent higher than in 1990. Any positive effects of the global discussions and political initiatives over the last two decades have been dominated and outweighed by higher living stand ards, population growth and emission-increasing policies in other areas.

Global population will grow by 50 per cent up to 2050, and the global vision implies that emissions must be reduced from 6-7 tons to about 2 tons per capita per year, cf. Chart 2. In comparison, the current level is 6 tons in China, 10 tons in Europe and more than 20 tons in the USA. In India emissions amount to approximately 2 tons per capita, but they are rapidly increasing.

At the same time continued strong economic growth must be ex pected in countries which accounted for limited CO₂ emissions up to 1990, but which contain 80-90 per cent of the global population. Even if CO₂ emissions in the OECD countries were to cease completely – which is quite unrealistic – expected growth in a business-as-usual ref erence scenario for the rest of the world would make it impossible to solve the problem.

GLOBAL CO₂ EMISSIONS	Chart 1

Source: OECD, Environmental Outlook, 2008.

CO₂ EMISSIONS PER CAPITA IN SELECTED COUNTRIES	Chart 2

Source: OECD, CO₂ Emissions from Fuel Combustion, 2008.

Development of new technology is imperative, but it is not enough. Existing technology, often simple measures such as insulation and auto mation, is only implemented to a limited extent at the global level. Nor is it enough to increase the efficiency of known, typical production and consumption as there is no limit to potential additional energy con sumption for air conditioning, helicopter flights, desalination of sea water, etc. The problem can only be solved by a combination of ad equate pricing and regulation and closely coordinated participation of all countries.

2. COSTS

Many engineers and economists have tried to estimate the economic costs of meeting the global vision described. These exercises have been useful, although there are major limitations to the theoretical assump tions. For example, on the one hand, the economically favourable po tential of abolishing existing inefficient policies is often disregarded. On the other hand it is assumed that reduction initiatives will be cost effective, but historically policies have proved to be rather inefficient.

Estimates typically indicate an isolated output loss from cost-efficient measures to limit climate change in accordance with the global vision of 1-4 per cent of the gross domestic product, GDP. In a macroeconomic context this may be considered as a moderate loss compared with other economic events (such as financial crises) and measures (such as pension reforms) and the expected global increase in prosperity of many hundred per cent between 1990 and 2050 in particular. The magnitude may best be demystified by translating the expected politically deter mined CO₂ price of 40-80 dollars/ton over the next 10 years into the corresponding increase in fuel and electricity prices of 8-16 eurocents/litre and 4-8 eurocents/kWh, respectively. In terms of oil prices this corresponds to just over 15-30 dollars per barrel. The GDP effect, a growth slowdown of about 0.1 percentage point per year, will be the consequence of the additional structural adjustment caused by a revenue-neutral tax reorganisation at such CO₂ prices. Euro peans will hardly find CO₂ prices at this level disturbing, but the situation is rather different in the rest of the world, cf. section 3, and higher CO₂ prices will be necessary in the longer term.

The effect is partial because the economic gains from preventing global warming that exceeds the risk limit have not been taken into account. According to many estimates, those gains exceed the costs of the CO₂ reduction. As such gains are global, they involve a free-rider problem – as some countries may speculate in others making the effort. Furthermore, the gains are not likely to be sufficiently compelling polit ically in some countries, e.g. because gains and losses are unevenly distributed between countries and sectors.

Another factor that has not been taken into account is the potential gains for oil-importing countries as a result of the dampening effect on prices in the world market caused by reduced demand for oil. In other words, the oil-importing countries have never succeeded in counter balancing supply-side cartelisation. A coordinated increase in carbon taxes in the largest importing regions would to a large extent have a modest effect on the final price paid by energy consumers, but it would shift a large import bill into revenues for domestic Treasuries, providing corresponding relief to taxpayers as a whole.

Climate action is predominantly discussed as a cost challenge, which is of course neither surprising nor irrelevant, but such discussions also exaggerate the problems and disregard the economic gains that many countries would achieve by reducing their CO₂ emissions. A few examples:

The parallel to the trade negotiations in the World Trade Organiza tion, WTO. They are, with only some exaggerations, conducted along the following lines: "I won't stop using tariff rates and subsidies (in a climate context: too much CO₂) that are bad for my own economy un less you do the same".

The focus of the developed countries on carbon leakage, i.e. the possible relocation of carbon-intensive industries. These industries only account for 1-2 per cent of the developed economies, but subjecting them to CO₂ regulation is often construed as a macroeconomic prob lem of competitiveness. However, the costs of action will be higher if carbon-intensive production is exempted as regulation of relatively less carbon-intensive production will have to be tightened accordingly¹.

The poor countries' right to growth. The right to growth is indisput able, but it should not be exaggerated as a CO₂ issue. The rich coun tries did not get rich by using a lot of fossil fuel. Rather, consumption of fossil fuels has been driven by increases in prosperity – in combin ation with inappropriate regulation and pricing.

The energy exporters' demand for compensation. Exporters have been quicker than importers to see (and complain about) how increased CO₂ efficiency may affect their export prices and volumes. But before con cerns about burdening energy exporters arise, it should be kept in mind that action against climate change will most likely imply a more modest increase rather than a reduction in expected additional income as the global economy grows.

Obviously, the necessary restructuring of the global economy will no doubt require unprecedented political action and willingness to invest. But the barriers to an effective CO₂ policy seem to be political rather than macroeconomic. Good explanations and information may remedy this to some extent, and there is a need for a paradigm shift from seeing CO₂ as a particularly dynamic production factor to seeing it as a cost that typically swallows up 5-10 per cent of a country's GDP – expenditure that could be better spent on other purposes. So necessary restructuring is possible without jeopardising growth and welfare. But international solutions on such a scale are unprecedented, and conversely there are many examples showing that structural policy is difficult to implement due to established interests and in spite of general economic gains.

3. THE POLICY PURSUED SO FAR

Surprisingly little international information is available about actual climate policies being pursued. Good technical information on CO₂ con sumption and intensity, etc. is available, but there is no global overview of national prices and energy and CO₂ regulation or the private and public funds spent on energy and CO₂ policy, let alone the development of these factors over time. Nor has global cooperation been examined to a significant extent. For example, no price statistics of the purchase of CO₂ credits from developing countries are available. This information gap is a major unsolved problem for international organisations.

Consequently, an assessment of current climate policies can only be based on fragmentary and anecdotal information with the addition of information provided by the Ministry of Foreign Affairs and the Danish embassies. These fragments are interesting, but nevertheless the enter tainment value of the following examples may make up for concerns about the effects only in the short term:

By all accounts the global implicit CO₂ price is negative. Only Europe and Japan have introduced substantial indirect taxes and allowance prices. The revenue from European energy taxes amounts to approxi mately 210 billion dollars, cf. Table 1. On the other hand, there are estimates of global subsidies and grants for the use of fossil fuels of up to 600 billion dollars, of which 75 per cent in developing countries (including the Middle East). Several South East Asian countries spend 5-10 per cent of their GDP on public subsidies to keep down the prices of petrol, etc. In comparison, global development aid amounts to about 120 billion dollars.
A "snapshot" of petrol prices measured in euro per litre a few years back shows a variation of 1.07-1.2 euro in Europe, 0.5 euro in the USA, 0.4 euro in China, 0.2 euro in Indonesia and about 0.07 euro in oil countries such as Iran and Venezuela. Similar variation is seen for electricity prices.
In large parts of the world, rather than paying for their actual heating consumption, consumers pay an amount per square metre. In reality this means zero pricing (no marginal price) of consumption. The con sumption-increasing effect is aggravated in the many cases where consumers' only access to heat regulation during cold winters is to open and close the windows while the radiator is on.

In rich countries individual regulation of heating and air-conditioning consumption is often not possible in office buildings; the marginal price of petrol for users of company cars is zero; the marginal price of electricity and heating is kept down by connection fees; and until recently the EU imposed high punitive tariffs on cheap energy-saving light bulbs.

Domestic biofuels with an efficiency level (the share of the final fuel that is not set off by the energy consumption related to its production) of a few per cent are subsidised, but duties are imposed on imported biofuels with high levels of efficiency.

In tropical areas palm oil is widely produced for fuel purposes in a production process which, including the clearing of rainforest for cultivation, causes emissions of up to 30 times the amount of CO₂ displaced in ultimate consumption.

ECONOMIC INDICATORS, 2006		Table 1
	Billion dollars	Per cent of global GDP
Subsidies for fossil fuels (energy consumption)	600	1.2
Energy taxation, total income, EU	210	0.5
Development aid (ODA)	105	0.22
Subsidies for renewable energy	(25)	(0.05)
OPEC oil exports	605	1.3
Total oil market at 100 dollars/barrel	3000	6.2
OPEC current-account surplus	340	0.7
USA current-account deficit	810	1.7
CO₂ allowance trading, offsets, etc. global	31	0.05
CDM projects, etc.	7	0.02
Sub-Saharan Africa, fuel imports (2005)	23	0.05
Source: Global Subsidies Initiative, IMF, IEA, The World Bank State and Trends of the Carbon Market, 2008.

The effects of such policies, involving both economic and environmental losses, are not trivial. Estimates have shown that 5-10 per cent of global CO₂ emissions could be avoided by phasing out fossil fuel subsidies only, implying environmental as well as economic gains. And while only about 20 per cent of the developing countries' current energy consumption is attributable to households, the growth potential in this sector is very large, and pricing and regulating practices are therefore automatically widening to include an increasing share of total consumption.

There is no doubt that markets and price signals (also) affect energy and CO₂ consumption substantially. It is no coincidence that CO₂ con sumption per capita is about twice as high in Australia, Canada and the USA as in Europe and Japan. Nor is it a coincidence that electricity consumption in Norway is four to six times higher than in Denmark (the price of electricity is about a fourth of the Danish price). While it is often difficult to demonstrate high price elasticities in energy consumption through estimation on time series, a simple cross-section analysis shows an elasticity between price indicators and CO₂ intensity of 0.6-0.7.

Presumably, international cooperation in this area has had a historical effect, including the Kyoto Protocol and related trade mechanisms, etc., in the sense that without such cooperation, CO₂ emissions might have been even higher. But this cooperation has included, and been ratified by, too few countries, and targets have been fulfilled only to a modest degree. Furthermore, considerable scepticism of the effects so far of cooperation on measures to reduce CO₂ emissions in developing coun tries is justified.

The overall conclusion is that in terms of its scope and nature neither the action taken by the rich countries nor international cooperation has efficiently prevented or reduced CO₂ emissions. This does not mean that it has been a waste of effort. It is now possible to base the design of the new systems that are needed on both good and bad historical experi ence.

4. FUTURE POLICIES

International climate cooperation revolves around two main elements: setting binding reduction targets – i.e. putting a cap on total national CO₂ emissions – for the rich countries and a coherent system with a framework of reduction initiatives in the developing countries based on their own policies combined with support for further action.

Reduction targets in rich countries
The advantage of reduction targets is simplicity, comparability and that, in principle, other countries and the world community need not be interested in whether the reduction initiatives are efficient or whether they incur substantial costs, as long as the target is met. In that case the principle of subsidiarity (as defined in the EU) may be applied in full with a view to the reduction initiatives.

In practice the rich countries' reduction initiatives are likely to be based mainly on allowance systems with plans to link trade in such allowances between systems and to purchase offset credits in the developing coun tries. This places new and much heavier demands on international coord ination.

On the face of it, CO₂ allowance trading among rich countries appears to be simple and useful. Once their reduction commitments have been determined, trading will always reduce the costs of total action because the market will direct the reductions to wherever they are cheapest. Before the reduction commitments are determined, the situation is much more complex. If a country with unambitious targets can persuade an other country (or region) with tight targets to link their allowance trad ing, it would create a cash cow for itself and its enterprises. The net direc tion of CO₂ allowance trading is thus determined by the reduction com mitments undertaken.

This is complicated by the fact that certain interest groups in countries with ambitious targets may still be expected to aim for linkage. Those (i.e. finance ministries) who are charged with meeting a specific target set by others (i.e. climate ministries) will want to keep the economic costs as low as possible, and on the surface it appears to be almost an advantage to trade with countries with unambitious targets, because it means that the price of purchasing reductions is correspondingly low. This is a very partial view, however, disregarding the global context. The global reduction initiatives should sum up to a whole. The more lenient the targets set by other countries, the tighter a country's own targets will be within the framework of the global vision.

Similarly, it is important not to give other countries incentives to set lenient targets. So it is positive that the EU and the USA have both emphasised that linkage of allowance trading should be between systems with comparable levels of ambition.

Many professionals ask why at least the developed countries do not use carbon taxes instead of an allowance system with a complexity and potentially unintended side-incentives at par with that of financial regu lation. The answer may presumably be found in the political logic that prefers visible effects with less visible prices and incidence to visible prices and more invisible effects.

Both carbon taxes and allowance systems work by ensuring a CO₂ price that encourages savings (achieving the same output and comfort by other means), substitution to renewables, and development of less carbon-intensive technology. The higher price is paid by end-users. The immediate difference is that in the allowance system the price is created by a separate market creating a price at a level that displaces CO₂ to such an extent as to meet the reduction target.

In principle, the effects of allowance systems may be made to almost resemble the effect of carbon taxes, but this requires in particular that three assumptions are met: a) the system must cover the entire economy (this is technically very difficult – the EU allowance trading system covers only about half of EU emissions); b) the allowances must be determined once and for all to prevent speculation (in systems where allowances are free or partially free of charge) in pumping up emissions in period 1 to earn more allowances in period 2 (this is unrealistic); and c) the allow ances must be fully auctioned and not allocated freely or "grand fathered" (this has proven very difficult politically).

If the allowances are grandfathered– typically to established enter prises with historically high emissions – revenue from the intended higher CO₂ price for ultimate users will go to the enterprises that are subject to allowances rather than to the Treasury. This will have the effect of a subsidy on corporate earnings, and the subsidy will replace the reversal of revenues to the ultimate users in the form of lower taxes and levies in other areas. It can be argued – and this happens much more than the argument can bear – that energy-intensive enterprises cannot pass on the CO₂ price to the ultimate users if they are subject to intense competition from third countries without a CO₂ price. On the other hand, in favour of granting allowances to enterprises it is em phasised that this would make an otherwise sceptical group interested in maintaining and developing CO₂ regulation.

In many developed countries there is a preference for regulation, even including in areas such as energy efficiency standards for cars where the price mechanism is suitable, and subsidies for renewable energies. This involves higher costs than the use of indirect taxes. A simple explanation is that unlike indirect taxes, energy efficiency standards for cars do not affect the way we drive or the size of car we choose. Contrary to carbon taxes, subsidies for renewable energy do not raise the price of using energy. Consequently, the result is only a change of energy source and not a concurrent reduction of energy consumption or an incentive to create production and comfort in other ways. By subsidising renewable energies rather than introducing a tax on fossil fuels, governments can be said to choose technology rather than providing a choice between energy savings and renewable energy on market terms. The preference for subsidies presumably has to do with the fact that the expenditure is distributed on all taxpayers and not on visible major energy consumers.

Finally, there has been a lot of international debate during the current economic slowdown on the use of fiscal expansion for climate-friendly purposes. This may have the desired effect in the short term, but it is hardly wise to base a strategy for climate action on expenditure and economic-policy measures. On the contrary, a 5-10 year period of sig nificant fiscal policy tightening is likely to be required when the econ omy picks up again in order to restore public finances in almost all coun tries. On the other hand it is quite conceivable that such tightening may include taxes on CO₂, etc.

Measures in developing countries
The discussion of reduction initiatives in the developing countries fo cuses on establishing and presenting low carbon development strategies (LCDS) and specific action. As a result, the initiatives do not focus on reduction targets. They may include a country's own unsupported meas ures, internationally supported measures and measures financed by the sale of offset credits (the carbon market).

For such a system to be politically sustainable there is a need for, on the one hand, the developing countries' guarantee of financing for specific measures and, on the other hand, the developed countries' guarantee that specific financing contributions will lead to the intended reductions and not be set-off by a lenient CO₂ policy elsewhere in the economy.

The absence of national reduction targets makes it difficult to measure whether additional action is taken. Nor will the scope and distribution of global reduction initiatives be guaranteed in advance in the absence of targets for all countries. But the developing countries, depending on their stage of development, have good reason to show reluctance in setting national targets. While it is relatively simple for developed countries to predict longer term economic growth and energy effi ciency trends, this is very difficult for the developing countries. Will the growth rate be 5 or 10 per cent per year, and for how long will it remain at that level? A national target may thus turn out to be much too tight or loose. If it is too tight, it will cost the developing country money. If it is too lenient, the developed countries' support schemes may inadvertently become cash cows subsidising reduction targets that could easily be met.

One of the consequences is that within the framework of an overall global vision a developing country will in effect pass on an otherwise assumed reduction contribution to other countries if it has a higher growth rate than anticipated. But if this is due to economic growth alone, it is not unreasonable either as the mutual scope of the chal lenges thus turns out to be different than anticipated.

Box 1 describes possible compositions of the global reduction initia tives. Obviously, the figures are only examples. Firstly, the reference scenario is uncertain. Secondly, it is not possible to predict the extent to which a reduction target can be met by purchasing credits, as this is dependent on the choices made by private enterprises. Thirdly, the effect of credits and international public support to developing coun tries need not necessarily deliver on a ton by ton basis, but may to some extent be based on the developing countries' own efforts – as many of them get richer – and mechanisms may be designed to encour age the countries to make an extra own effort.

REDUCTION NEED AND DISTRIBUTION

Box 1

In its project catalyst work McKinsey has provided an instructional example of requirements in respect of global reduction efforts. Significant caveats apply with regard to the overall challenge and the mutual magnitude of the possible con tributions. In 2020, global emissions measured in gigatons, Gt CO₂, are to be reduced from 61 Gt in a reference scenario (business as usual, BAU) to 44 Gt, i.e. by 17 Gt, cf. Table 2.

EXAMPLE OF REDUCTION NEED IN 2020			Table 2
	2005	BAU, 2020	Reduction scenario, 2020
Developed countries	18	21	16
Developing countries	27	40	28
Total, reference scenario	45	61	44
Source:Project Catalyst (www.project-catalyst.info).

McKinsey estimates that a reduction of 5 Gt in the developed countries is feasible at a cost of less than 60 dollars/ton, and that the developing countries themselves can carry out a reduction of 3 Gt at no cost or with economic gains. The estimates are based on cost curves ranking specific initiatives according to their additional (negative or positive) technical costs.

EXAMPLE OF DISTRIBUTION OF REDUCTION EFFORTS IN 2020			Table 3
	1. Limited offset		2. Considerable offset
Developed countries' commitment in relation to the reference scenario	8		11
Reduced in developed countries (own reductions	5		5
Covered by offset credit purchases	3		6

Offset credits in developing countries	3		6
Reduced in developing countries at economic cost	6		3
Reduced in developing countries at economic gain	3		3
Initiatives in developing countries, total	12		12
Global reductions in relation to reference scenario	17	(17)	17	(17)
Source: Project Catalyst (www.project-catalyst.info).

In the first example developed countries undertake a reduction commitment of 8 Gt in relation to the reference scenario, of which 3 Gt is purchased as credits. The last 6 Gt is to be achieved through the developing countries' own efforts, including with support from international public finance. In the other example the reduction commitment of developed countries is increased to 11 Gt in relation to the reference scenario with 6 Gt purchased as credits. This leaves 3 Gt to be achieved by means of the developing countries' own efforts and support from international public finance.

Finally, it is not possible to establish good operational estimates for the developing countries' need for international public finance. Such estimates involve technical and time-related uncertainties, and the costs depend on the efficiency of the action. If need be, estimates should be calculated as additional expenditure in relation to revenue-neutral in vestment calculations and not as disbursement of capital costs, which is a different, though often very important, financial question of lending. Estimates are often presented in aggregate form. This is equivalent to additional costs of increasing the efficiency of Chinese power plants being partially offset by the investments in oil-producing countries saved due to lower oil consumption. The safest conclusion seems to be that it would be useful to scale up and develop support over time in step with capacity building and the development of absorption capacity and op portunities for efficient action. The design of efficient support schemes is a central question of far-reaching significance to the climate nego tiations that is beyond the framework of this article.

5. ISSUES IN RELATION TO OFFSET-BASED PURCHASES OF CO2 CREDITS IN DEVELOPING COUNTRIES

The offset system may become a central element in the international financing system for climate action. The system works by enterprises or governments in developed countries paying for a CO₂ emission reduc tion in a developing country; this reduction can then be deducted from ("credited against" or "offset against") the developed countries' own reduction commitments. It is generally expected that offsets will be the main driver of financial flows among the countries.

The purpose of purchasing CO₂ credits in developing countries is not to reduce CO₂ emissions, but to ensure that reduction commitments in the developed countries can be met more cheaply by picking the low-hanging fruit in the developing countries rather than undertaking more costly measures in the developed countries themselves. The offset system will only contribute to global reductions if it allows tighter reduction commitments in the developed countries or if it provides an incentive for the developing countries to make an extra own effort.

On the face of it, the offset system does seem to be a cheaper way for a developed country with certain reduction commitments to meet those commitments. Within the framework of a coherent global reduction effort the question of whether the method actually provides cost effi ciency is much more complex. The offset system implies that the de veloped countries deduct the purchase of credits from their domestic efforts. The real question regarding efficiency is whether developed countries may best support reductions in the developing countries by direct public support or by undertaking more substantial reduction commitments than they would otherwise have done, thereby encour aging private enterprises to purchase credits. For example, the same contribution to the global reduction effort is achieved if a developed country undertakes a reduction commitment of 20 per cent with access to purchase credits for 10 percentage points or if it sets a reduction target of 10 per cent and then supplements it with international public support that may purchase extra reductions in the developing countries corresponding to an additional 10 percentage points. Which of the op tions is cheaper is not obvious in advance.

Basically, the offset system involves three major challenges:

Double counting. As credits cover part of the developed countries' own commitments and are purchased in the developing countries, there is an incentive to take ownership of the same reduction twice. The developed countries claim with some justice that credit purchases can also be seen as a form of support to the developing countries. But since offsets have so far been explained as part of the developed coun tries' own reductions, wanting credit purchases to be recognised as support is a significant political challenge. It only makes sense if the reduction targets are sufficiently tight. However, it is not possible to assess how tight the developed countries' reduction commitments would have been if there was no offset option. So the only possible way to control for the risk of double counting is to ensure that total global reduction commitments are ambitious enough. The commit ments announced by the developed countries so far are not sufficient to meet that challenge, even though a number of developed countries expect it to be easier to set tighter targets – with access to purchasing offsets – than to obtain ongoing parliamentary approval of public support for the developing countries.

Environmental integrity. The question is whether single actions actually lead to larger reductions in the developing countries. This is very difficult – or impossible – to establish in the existing project-based CDM (Clean Development Mechanism) system in countries with no overall objectives. The problem is that the products traded in this part of the carbon market are unobservable. The credit is granted, often on a company basis, for the difference between the actual scenario and a baseline scenario that cannot be observed, only estimated. At the same time the incentive for a real effect is inconsistent with the joint interest of the purchaser and the seller in establishing a CO₂-intensive baseline scenario creating a figure indicating the largest "reduction" possible. The purchaser and the seller choose their own agents to make this assessment from among a number of enterprises approved by the UN to make such verification. In addition, restructuring towards less CO₂ intensity in an individual enterprise does not prevent any of the following: that the problem is passed on to other enterprises in the same sector; that the country concerned uses the fuel released for additional emissions in other sectors; or that the CO₂ intensity increases again at a later time.

Rents or overnormal earnings by middlemen or in the developing countries. Rents occur if the price paid for the credit (e.g. measured in dollars per ton) is significantly higher than the actual reduction costs. For example, China has considered it necessary in several cases to im pose a special tax on enterprises that have sold CO₂ credits in order to prevent overnormal earnings. The system gives reason to expect such rents. The incentive for the credit purchase is thus driven by the marginal reduction costs in developed countries that are much higher than the costs of the reduction paid for. Although enterprises in de veloped countries have a strong incentive to get approval for as many tons of "reduction" as possible in connection with the project, they have no incentive to pay a higher price per ton than necessary. But rents occur in combination with considerable excess demand for credits. Excess demand is caused by a combination of bottleneck problems in the verification units, problems with capacity to offer projects in the developing countries and an opaque market without effective competition between projects.

It is not likely that these problems can be completely solved, but large improvements may be made by moving towards sector-based and programme-based systems (e.g. policy initiatives in a broader area of the economy) where credit is granted for reductions in relation to a baseline scenario that is more ambitious than just business as usual. The baseline scenario can be analysed on the basis of historical data and benchmarks in other countries, etc. Furthermore, the development of markets with real competition between programmes and projects would be an advan tage. Transition to sector level would also be necessary if the offset-based market is to be scaled up to the expected extent. As is the case with CDM projects, it is of vital importance to establish a reliable inter national body to verify "additionality" and prevent adverse effects from a coalition of joint interests between enterprises and authorities in the two countries concerned benefiting from counting towards CO₂-inten sive reference scenarios.

Public finance for reduction initiatives in the developing countries – support that cannot be offset against the developed countries' own commitments – involve a number of similar issues. One drawback is that the know-how of private enterprises cannot be included. On the other hand, it may be easier to avoid rents as they are driven by the political desire for reductions in tons rather than savings driven by their own reduction costs. Moreover, the impact of public finance would have to be subjected to direct parliamentary control.

[1] Furthermore, the OECD has calculated that the CO₂-related leakage effect would amount to 12 per cent of the CO₂ reduction in the event of a general CO₂ tax in the EU and only 2 per cent of the reduction in the event of a coordinated tax in all OECD countries.

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