Karsten Neuhoff 25.1.2010 Climate Policy after Copenhagen At the UN conference in Bali (December 2007), States agreed on a two-year negotiation process, the ‘Bali road-map’. The roadmap was designed to culminate in an agreement on future international climate co-operation in Copenhagen in December 2009. Yet the Copenhagen Accord, three pages that were merely acknowledged by the UN General Assembly, did not live up to this expectation. The set of possible reasons include internal EU disputes constraining European leadership, objections of the US to international commitments prior to the passage of US domestic legislation, and the reluctance of emerging economies to put their cards on the table in the absence of US commitments. More broadly, it was even questioned whether UN negotiation procedures, developed to tackle armed or political conflicts between countries, were well suited to foster global treaties. However, possibly the major challenge for the negotiations in Copenhagen was a conceptual one. The rapidly evolving scientific, economic, and political landscape has resulted in a paradigm shift on the mechanisms for international climate co-operation, which had emerged during the climate discussions at UN, G8, G20, and major economies’ meetings leading up to Copenhagen. A shared understanding of the new approach will be essential to facilitate future co-operation. The following five aspects contributed to the paradigm shift: (i) (ii) (iii) (iv) Draft the perspective of the 1990s, as reflected in the Kyoto Protocol, was focused on marginal mid-term emissions reductions in developed countries. Improved climate science and the rapid growth of some developing countries require ambitious emissions reductions in the medium term and a transformation of our economies to reduce future emissions to fractions of today’s levels. International negotiations now discuss medium term objectives and strategies that are consistent with agreed long-term temperature stabilisation objectives; 20 years of global climate co-operation and national and regional climate policy frameworks demonstrate that absolute emissions targets must be supported by low-emission development strategies to: ensure consistency across sectors; ensure short-term actions are compatible with long-term objectives; identify trigger points for public programmes and policies; and outline opportunities for the private-sector; the focus on carbon pricing that emerges from global emissions trading schemes has been expanded. While exposing actors to the social cost of carbon is essential, it is insufficient, by itself, to shift innovation and investment towards low-carbon technologies, projects and activities. Hence comprehensive policies and programmes also address institutional requirements, evolve regulatory frameworks and provide technology support to facilitate low-carbon transformation; and this is reflected in the requirement to report national actions emerging from the Copenhagen accord; the emphasis upon supporting mitigation action in developing countries has shifted from carbon markets towards public finance mechanisms. This reflects the need to for clear, credible and long-term policies, as pointed out by the Copenhagen declaration of 186 investment institutions, representing assets of US$13trillion. Markets are an essential component – but they must be anchored in domestic 1 Karsten Neuhoff (v) 25.1.2010 policy frameworks, rather than imposed by international mechanisms which try to limit engagement with domestic institutions; the scope of monitoring and reporting is significantly increased. Medium-term emissions targets in developed countries and off-setting (CDM) projects in developing countries have resulted in a focus on the measurement of annual carbon emissions. The new objective of low-emission transformation of our economies can only be achieved with detailed information on the structure and implementation of policies and programmes and private-sector response. Thus governments can manage the implementation of policies and programmes, and rapid international learning is facilitated. While some of the objectives and approaches of international climate policy co-operation have changed, co-operation remains essential for creating a shared sense of action and responsibility, to provide outside commitments to translate longer-term objectives into short-term actions, to provide support for mitigation and adaptation action in developing countries and to ensure that the various parts of the global effort add up to achieving the global climate objectives. The reminder of this paper explore how the evolving experience and assessment of domestic implementation of climate policies in general, and carbon pricing as one specific example, is reflected in emerging frameworks for global climate co-operation. 1. The role of a climate policy mix Carbon emissions from energy production and industrial processes are deeply entrenched in our economies. To mitigate the risk of catastrophic climate change, these emissions need to be reduced to a fraction of today’s levels. In 2007, the Intergovernmental Panel on Climate Change (IPCC) concluded, based on the scientific evidence it collected, that global CO2 emissions must be reduced to half of today’s levels by 2050, to limit the risk of temperatures increasing above 2 degrees Celsius (IPCC 2007). The challenge is now to implement policy instruments to deliver the necessary emissions reductions. Many of the past climate policy discussions focussed on marginal emissions reductions. To achieve these, economists recommend exposing producers and consumers to the environmental cost of carbon, thus creating incentives for efficiency improvements and for less carbon-intensive production and consumption choices. The theoretical foundation of this approach is in the first fundamental theorems of welfare economics: The ‘invisible hand’ of the market will result in efficient production and consumption decisions. It requires that a set of assumptions is satisfied, including market participants' exposure to the costs of environmental externalities. Carbon taxes or emissions trading therefore received much of the attention in public debate. The objective of climate policy has now shifted, from delivering marginal emission reductions, to facilitating a low-carbon transformation of our economies. This requires revisiting whether all the assumptions required for the first fundamental theorem of welfare economics are still satisfied: e.g. whether internalising the cost of carbon will result in efficient market outcomes. Ample evidence and analysis has demonstrated: that innovation and learning by doing create non-convexities in cost functions; interactions between actors and technologies Draft 2 Karsten Neuhoff 25.1.2010 create network effects that result in non-convex benefit functions; and historic infrastructure creates additional path dependency. All of these instances violate the fundamental assumptions of the welfare theorem and therefore there is no theoretical foundation for claims that carbon pricing on its own will result in efficient outcomes. The Stern Review (2006) on climate change points to three sets of instruments which are necessary to facilitate a low-carbon transition: (i) putting a price on carbon; (ii) technology policy and targeted regulation, with transparent and shared information; and (iii) targeted measures to engage individuals and firms in low-carbon opportunities. The design of any such public policy intervention risks distorting economic incentives, creates agency costs, has distributional implications and might intervene in private-sector decision processes. Hence it is essential carefully to assess the specific situation of sector, country and industry structure when designing the policy mix for the low-carbon transformation. Changes to policy frameworks, in particular if a change directly changes relative prices of products and services, have distributional implications that shift costs and wealth between poor and rich, rural and urban parts of society. As a result, implementation of individual climate policy instruments can increase or reduce fuel poverty or inequality in a society. The more ambitious the objectives of climate policy instruments are, the more likely it is also that they will result in significant distributional impacts that affect equity issues and political support. With careful analysis, it is possible to anticipate many of these impacts, and to use complementing policy measures to balance the implications, or to support individuals and firms during a transition. To illustrate the type of analysis that is necessary for any policy instrument, we briefly explore the carbon pricing. Carbon pricing increases the price of processes, products and services that are carbon-intensive, thus creating incentives for the use and innovation of more carbon-efficient technologies, and inducing substitution towards lower-carbon fuels, products and services by industry and final consumers. The price signal feeds into individual decisions that would be difficult to target with regulation. Pricing also makes it profitable to comply with carbon-efficiency regulations, thus facilitating their implementation. Carbon prices can be delivered with a carbon tax or cap-and-trade schemes. As much as the theoretical features are essential, the real analytic and policy challenge evolves around the process of implementation of the relevant policy instruments and the design of detailed provisions. 2. The delivery of investment responses. Low-carbon transformations require diffusion of existing and new technologies, infrastructure, and business models. A group of 186 investment institutions, representing assets of US$13 trillion, announced in Copenhagen that this requires clear, credible, and long-term policies. Over recent years, the paradigm on the framework, process, and mechanism to deliver this low-carbon investment framework has rapidly evolved: International discussions, for example of the Kyoto protocol, focused on emissions targets, initially for developed countries. The expectation was that clear commitments to such targets allow private actors to anticipate future opportunities, for low-carbon processes, products and services, as well as constraints for carbon-intensive investment choices. The emission targets for Draft 3 Karsten Neuhoff 25.1.2010 countries obviously must be translated into policy instruments if they are to affect investment choices of private actors. Cap-and-trade schemes directly translate emissions targets into economic incentives for private actors. This can limit the uncertainty of policy design and implementation and thus strengthen the low-carbon investment framework. The first example of this approach – the EU ETS – has succeeded in focussing the attention of carbon-intensive industries and their investors on exposure to carbon costs and on low-carbon opportunities. When evaluating individual projects, many investors remain concerned that the carbon price signal is not sufficiently robust and carbon prices might drop in response to economic and political developments. It is therefore often argued that the risk of extremely low carbon prices must be reduced, if low-carbon projects are to be facilitated. It was suggested that, for example, carbon taxes would be more predictable in the short-term, and could thus increase investment certainty for investors operating with short investment horizons. In the long term, however, carbon taxes are more difficult to predict, as they are subject to continued political negotiation. Even where carbon taxes are fixed in the long term, this might increase rather than reduce exposure for low-carbon investors, who are competing in a world with uncertain fuel, commodity and technology costs. The discussion illustrates that the variety of participants in our economies might well respond differently to policy instrument that delivers a carbon price. Hybrid cap-and-trade schemes, combining a price floor with an emissions cap, could target the needs of heterogeneous groups of investors. The evolving focus of climate policy, from marginal emissions reductions towards lowcarbon transformation of economies, is also reflected in discussions about low-carbon investment frameworks. Investment in new technologies, production processes, products, and services can only succeed with appropriate infrastructure, institutional setting and social acceptance. It often requires government support for research, development and early deployment, and adjustments to regulatory frameworks, and administrative standards and procedures. The co-ordination of all these activities requires a shared vision of a country's lowemission development trajectory. For this reason, the international discussions leading up to Copenhagen increasingly emphasised the importance of low-emission development plans for developed and developing countries. The plans characterise industrial and technological development, energy use and emissions across different sectors of the economy. They can therefore ensure that initial mitigation efforts are consistent with long-term objectives (e.g. understanding the implications of efficiency improvements of coal power stations relative to other mitigation options). They can also ensure consistency of mitigation strategies across sectors, for example by testing whether available bio-mass resources is consistent with their anticipated use in steel, cement, transport, heating, industry and power sectors, and by assessing whether electricity use in transport, industry and for heat pumps is consistent with anticipated generation and network structure. In addition they allow national governments to prioritise actions according to long-term relevance and lead-times, and signal a consistent overall strategy to facilitate private-sector investment. Low-emission development plans are therefore essential, not as a bureaucratic instrument, but as a process to create a shared vision and platform to discuss and initiate the appropriate policy actions and thus facilitate low-carbon investments. These actions might well differ across countries that differ in their social preferences, industry structures, finance sectors, and institutional settings. Countries might vary in their emphasis on short-term insurance of robust Draft 4 Karsten Neuhoff 25.1.2010 carbon prices, mid-term emissions targets translated into emissions trading schemes, technology support schemes and institutional design choices and administrative standards 3. Opportunities for international climate co-operation The discussion of domestic policy frameworks to facilitate a low-carbon development points to the various opportunities for international climate co-operation. An adequate response to climate change requires action on a global scale. The objective of holding the increase in global temperature to less than 2 degrees Celsius (Copenhagen, 2009) requires a reduction of global carbon emissions globally by at least 50% (G8 statement at TÅyako, 2008). Thus the main driver for global climate co-operation will remain the engagement of all nations, in supporting emissions reductions with their domestic efforts. Sometimes the need to act on global scale, to achieve the 2 degrees Celsius target, is interpreted to mean that individuals and countries have no responsibility to act individually in the absence of adequate action at global scale. This is wrong – every tonne of carbon emissions accelerates climate change and increases the risks and costs for our societies. Domestic mitigation action does not require the justification or motivation of international co-ordination. Some economists argue that individuals only consider the damage their carbon emissions create and impose on themselves. According to this argument, national governments would, equally, only choose mitigation action to the extent that these reduce future damage for their own country. This line of argumentation would imply that climate change can only be tackled if a comprehensive and enforceable global contract is signed. However, if this assumption of economists would really be true, then we should observe that the only punishment constrains individuals from stealing from their neighbours and only fear of retaliation restrains nations from initiating wars. Fortunately, individuals and nations usually have a sense of empathy, responsibility or morality and we often observe behaviour and climate change action, which undermine this self-interest argument. If international agreements are not essential to facilitate action of individuals and nations, they can nevertheless be important to enhance the effectiveness of domestic action in developed countries and, as will be discussed in the next section, to initiate international support for low-emission development in developing countries. First, global co-operation can enhance the level of understanding of climate change impact and options to tackle it, bringing together experts and allowing policymakers and industry actors to a discussion of equals. Second, joint global action reinforces a sense of individuals' and countries' own responsibility based on perceptions of individuals' and countries' own behaviour and behaviour they observe. Third, international co-operation can contribute to comprehensive reporting, so as to allow rapid international learning on best practice policymaking, to facilitate measurement of the performance of policy instruments, and to enhance accountability of policymakers and to enhance transparency for private-sector investors. International co-operation can furthermore provide a platform for commitments towards emissions targets and specific actions, for example with regard to deployment of renewables. Such commitments provide time frames and quantitative reference levels that subsequently can help to overcome domestic political barriers. External commitments can also enhance the Draft 5 Karsten Neuhoff 25.1.2010 credibility of longer-term strategies for private-sector investors, reducing capital costs and enhancing the scale of low-carbon investment. This leads to the question of whether different countries should implement a joint emissions trading scheme. Such a scheme can allow traders to identify the least-cost emissions-reduction opportunities in a bigger market, and could therefore offer the benefit of reducing costs of climate policy. A joint scheme also has some political attractions: it might reflect increasing commitment of participating countries and could create momentum to drive implementation through adverse political circumstances. Yet these benefits of a joint scheme must be weighed against three potential drawbacks: First, if two countries have a joint scheme, but negotiate future emissions targets separately, then industry in the more ambitious country will end up buying allowances issued from the less ambitious country. This creates strong incentives to negotiate less ambitious targets at any future negotiations. Second, emissions reductions require a multitude of domestic policies, such as information provision, performance standards, and suitable regulatory frameworks for new technologies. The responsibility of governments for these policies is clearly defined, if targets are defined for the same jurisdiction over which governments have responsibility. This allows governments to measure and manage policy success more effectively, which is more difficult in the case of joint schemes which extend beyond the boundary of their jurisdiction. Third, if domestic support in a country allows for a more ambitious climate policy, this directly translates into a tighter cap for a regional scheme, and results in higher carbon prices. The region will benefit from accelerated low-carbon innovation and transformation. As the new low-carbon processes, products and policies diffuse to other regions, they contribute to accelerated global decarbonisation. With a joint scheme, an individual country's more ambitious target only will have a marginal impact in the scarcity of a global scheme, and thus have a less significant impact on technology development and transition. Rather than designing a joint emissions trading scheme, countries could initially develop individual schemes that are subsequently linked. Currently, separate emissions trading schemes are evolving in Australia, New Zealand, and the US, while EU countries have implemented a joint trading scheme. Several approaches are available that could result in direct and indirect linking of these schemes. It is for policymakers to decide whether to pursue early integration, for example in 2015, as proposed by the European Commission, or to delay such linking until 2020. 4. A world of different carbon prices If national emissions trading schemes are not linked until the next decade, and if some developing countries are slow in even implementing some level of carbon prices, then we are facing, a world of differentiated carbon prices. Asymmetric prices frequently raise concerns about carbon leakage: higher carbon prices might induce some industries to shift production or investment to countries with low or no carbon pricing. Rather than reducing emissions, the climate policy would result in a relocation of emissions to another jurisdiction, a phenomenon typically described as carbon leakage. The direct environmental impact would likely be negligible unless significant transport emissions are implied, as the new production location is likely to have similar or better carbon intensity as old facilities. However, there are three indirect effects which are quite disconcerting. First, if emissions that are initially covered under a cap are relocated to another Draft 6 Karsten Neuhoff 25.1.2010 jurisdiction, this creates space under the cap for additional emissions, resulting in a net emissions increase. Second, as the relocated production facility will not face the carbon price, prices for carbon-intensive products will not increase and thus incentives for innovation and substitution to low-carbon alternatives are suppressed. Finally, given the coincidence of negative social, economic and environmental impacts associated with such relocation, policymakers are likely to address any potential risk of leakage by subsidies through free allowance allocation or direct financial support, thus further undermining incentives for de-carbonisation and potentially creating administrative barriers for any change to low-carbon processes, products and services. However, it is important to note that cost increases from carbon pricing, relative to other cost components, are trivial for all but 1-2% of economic activity. As the cost increase is concentrated in a narrow set of economic activities, in our analysis 24 sub-sectors, it is possible to make a sector-specific analysis to assess whether the increase is really substantial. Due to transportation costs, product differentiation, and sunk-investment costs, there is no concern about leakage in several of these sub-sectors. Thus only a few sub-sectors, such as basic steel and cement production, are likely to require targeted measures to address leakage concerns. These measures can differ across sub-sectors and can include conditional free allowance allocation, direct financial subsidies and border adjustments. Frequently a fourth option, sectoral agreements, is proposed as a means of delivering a global carbon price for individual industrial sectors; this also addresses leakage concerns prior to the establishment of a global carbon price. All options have significant negative side effects, and should therefore be applied as restrictively as possible. If these measures are implemented as components of an internationally co-ordinated approach, some of these negative effects can be reduced. Close international co-operation will therefore be essential to ensure any response to leakage protects the environmental effectiveness of carbon pricing. The sector-specific analysis of leakage concerns leads to the conclusion that it is possible for countries to pursue ambitious emissions targets and make use of the full carbon price as part of their policy mix. Thus leading by example, they can help to accelerate technology development and diffusion, and contribute to international experience with low-carbon policy frameworks. Individual action, however, is not a substitute for an international agreement that reflects common but differentiated responsibility for climate mitigation and thus creates the opportunity, and where necessary support, for all countries to contribute to emissions mitigation action. 5. International support for low-carbon growth in developing countries Developing countries are in a particular situation. Fewer historic emissions are reflected in less current infrastructure and resources, while there are other pressing priorities, such as poverty alleviation, education and health. In recent years, the Clean Development Mechanism has been the major mechanism for international support of low-carbon action in developing countries. It is a project-based offset mechanism which allows industrialised countries to acquire emission-reduction credits generated through projects in developing countries. It has the double aim of generating lowcost emissions reductions and promoting sustainable development in the countries hosting projects. With financial flows directed towards developing countries, it has provided tangible Draft 7 Karsten Neuhoff 25.1.2010 evidence of the importance attributed to climate policy in Europe and Japan. It has succeeded in supporting initial projects and has been effective in creating awareness, interest, and expertise in both private and public sectors. The CDM offsetting mechanism has also put a price on carbon. However, it acts as a subsidy for low-carbon options, as opposed to providing a disincentive to choose carbon-intensive options. As each tonne of avoided carbon emissions receives the same CDM price, the mechanism creates profits for actors in energy- and carbon-intensive sectors in developing countries, contributing to a lock-in of energy- and carbon-intensive activities, rather than facilitating a shifting towards low-carbon development. The mechanism exemplifies the paradigm of delivering marginal emissions reductions through global mechanisms, largely circumventing the involvement of domestic policymakers and institutions. It even creates incentives for policymakers in developing countries not to implement effective domestic policy frameworks for low-carbon investments: China does not receive further support for wind power projects after the national government implemented a feed-in tariff. Experience and analysis from developed countries show that effective domestic policy frameworks are essential to facilitate a low-carbon transition. Hence discussions on international co-operation on climate policy in 2009 have increasingly focused on shifting to a new approach (see e.g. the text of the ad hoc working group on long-term co-operative action, discussed at Copenhagen). This comprises four distinct components: (i) Low-emission development plans were initiated by South Africa and subsequently also developed by India, Brazil, China and Mexico. They outline the intended economic, energy, and emissions trajectories for their respective countries. They cannot, and should not, be the basis for any financial support (other than technical assistance for their development) or definition of emissions targets for developing countries. The purpose of the overall strategy is to identify trigger points for policy intervention. To initiate such policy intervention, lowemission development plans must be anchored in domestic policy frameworks and must be developed with full domestic ownership. The shared ownership of low-emission development across ministries provides information, capacity, and co-operation to identify and implement NAMAs. (ii) Nationally Appropriate Mitigation Actions (NAMAs) comprise a set of projects, programmes and policies to shift a domestic sector or technology onto a low-carbon development trajectory. This allows for a set of actions to be pursued in parallel to facilitate a shift to lowcarbon development of a sector or technology, including: training, capacity building, evolving institutional and regulatory structures, and initial access to finance. The design and implementation of NAMAs require local knowledge and political support from local stakeholders The actions and associated politics for a low-carbon transition in any one sector or technology are complex. Therefore it is desirable to define one NAMA for each transition in a sector or technology, rather than further increasing the scope of a NAMA, as this could delay delivery. Draft 8 Karsten Neuhoff 25.1.2010 (iii) International support mechanisms can provide tailored support for individual actions. They must be easily accessible by motivated domestic stakeholders, to allow domestic and international actors to structure support. This ensures that the support is demand-driven, incorporates local insights, and tackles the specific needs of the country and sector or technology. Different support mechanisms can create synergies for the implementation of a NAMA: Capacity-building enhances skills to manage, construct, maintain, and operate new technologies and practices which receive regulatory, financial and technical support. International support can enhance the scale, scope and speed of implementation of NAMAs. If support is linked to individual NAMAs, it creates an additional driver for the domestic implementation of the actions required for success. Linking the support to continued NAMA implementation enhances the stability of regulatory and policy frameworks. For example, a feed-in tariff is more likely to be stable if international support contributes to the incremental cost over time. This attracts domestic and international manufacturing and investment. Technology co-operation can support the development of an enabling environment for lowcarbon technologies, encompassing technology innovation, human and institutional capacity, markets and regulatory frameworks, availability of finance, and focussed national policies. The type of support must be tailored to the state of development and diffusion of the technology, and to the country's needs. While the mechanisms often focus on cooperation between governments, their ultimate objective is usually the creation of an enabling environment for private-sector innovation, deployment and use of the technologies. Financial instruments matching the needs of actors and sectors facilitate the implementation of NAMAs. Grants, loans, credit guarantees or equity funding can thus support public and private actors in dealing with the risks of new technologies and policy frameworks, and create opportunities to acquire new skills and develop business models. International support for individual NAMAs can facilitate their implementation and enhance their long-term credibility. Public finance is therefore an essential catalyst to shift large volumes of private-sector investment to low-carbon technologies. The choice of financial instruments needs to reflect institutional capacity and available resources. Experience of bilateral and multilateral co-operation for specific financial instruments can inform the choice of institutions for their provision. The resource base of multilateral institutions can be strengthened with revenue from carbon pricing on international aviation and shipping. Commitment to hypothecation of domestic carbon revenues can create the public funds necessary for bilateral co-operation. If all support provided across all instruments were measured in grant-equivalent terms, developed countries’ contributions could be evaluated against their commitments (the Copenhagen accord indicated US$ 100 billion). (iv) Expanding monitoring and reporting beyond greenhouse gas emissions can enhance the implementation of an action or policy, facilitate international learning, and create transparency to support private-sector investment and innovation. This requires detailed quantitative and qualitative evidence. It reflects the experience from industry and other Draft 9 Karsten Neuhoff 25.1.2010 sectors that points to the need to link outcome measures (like changes in greenhouse gas emissions) to a combination of input, process and output indicators. One conceptual challenge for the year 2010 will be the design of transition from a CDM mechanism to a broader support framework for low-emission development. A clear and shared vision of such a transition is necessary, to avoid CDM interest groups delaying new approaches that are not in their specific interest, while failing to attract investment for their own projects during a time of policy uncertainty. Well handled, the expertise and structures that were developed to explore, pursue, monitor and finance low-carbon projects under the CDM mechanism can be redirected towards the design and implementation of NAMAs and the pursuit of low-carbon investment in the new framework. 6. Conclusion National and international climate policy rapidly evolved in 2009. From a static analysis, focussed on delivering marginal emissions reductions, the focus has expanded to facilitating a low-carbon transition. This requires an extension of policy instruments, from simple carbon pricing towards policy packages tailored to the specific needs of countries and sectors. The importance of low-carbon transformation as part of an adequate response to climate change is reflected in international climate negotiations. The focus has shift from a top-down approach, of target-setting to trigger domestic action, to a bottom-up approach that explores how domestic policy design and implementation can be supported through international cooperation. Draft 10