Global Climate Change: Lowering Cost Estimates through Emissions Trading -- Some Dynamics and Pitfalls

Order Code RL30285

CRS Report for Congress

Received through the CRS Web

Global Climate Change:

Lowering Cost Estimates through Emissions

Trading — Some Dynamics and Pitfalls

August 20, 1999

(name redacted)

Specialist in Energy and Environmental Policy

Resources, Science, and Industry

Congressional Research Service ˜ The Library of Congress

ABSTRACT

With the negotiation of the Kyoto Protocol, international emissions trading has become the

centerpiece of efforts to minimize costs of reducing greenhouse gas emissions. A review of

existing cost analyses of U.S. compliance with the Kyoto Protocol indicates consensus that

the potential for international emission trading to reduce compliance cost is substantial and

indisputable. However, this report also indicates that potential for turning that potential into

fact is problematic and that other alternatives may deserve a hearing. Further information on

global climate change is available from the CRS Electronic Briefing Book at

http://www.congress.gov/brbk/html/ebgcc1.html. This report will be updated as circumstances

warrant.

Global Climate Change: Lowering Cost Estimates through

Emissions Trading — Some Dynamics and Pitfalls

Summary

A major element in the debate about global climate change has been how to

minimize costs by selecting the most economically efficient strategies to reduce

greenhouse gases. With the negotiation of the Kyoto Protocol, international

emissions trading has become a focal point of attention. Indeed, the Administration

believes that the goals of the Kyoto Protocol can not be achieved without effective

emissions trading. International emissions trading is one of four “flexibility

mechanisms” contained in the Kyoto Protocol (article 17).

A review of existing cost analyses of U.S. compliance with the Kyoto Protocol

indicates consensus that the potential for international emission trading to reduce U.S.

compliance cost under the Kyoto Protocol is substantial and indisputable. However,

whether the potential for international emissions trading can be turned into fact is

more problematic. This analysis suggests that implementing international emissions

trading under Kyoto would represent uncharted territory for U.S. environmental

policy.

First, an international emissions trading scheme has to function very efficiently

to achieve the savings projected by analyses. For example, the Administration’s

analysis relies on an unprecedented amount of international trading to achieve the

substantial cost reduction it projects. Under its most aggressive scenario, 82%-88%

of the U.S. reduction requirement would be bought from foreign sources. The

magnitude of transactions not only raises questions of its feasibility, but also may

conflict with the intent of the Kyoto Protocol, which states that international

emissions trading is to be “supplemental” to domestic actions.

Second, besides the amount of trading estimated, the sources of these reductions

raise additional questions. For example, according to an analysis by Charles River

Associates, half the estimated savings from international emissions trading would

come either from so-called “hot air” credits that countries of the former Soviet Union

have available because of their economic difficulties, or from transactions with Third

World countries that are not required to participate in the program.

Third, while the U.S. acid rain emissions trading program is cited as a model for

international carbon trading, in fact, unlike an international carbon trading program,

the acid rain program does not have to operate particularly efficiently to achieve

substantial cost savings. The simplest trades — those between a company’s own

plants — achieve the greatest cost savings under the acid rain program. Thus, the

U.S. acid rain emissions trading program provides little guidance to any future

international carbon trading program.

The complexity presented by international emissions trading suggests that

alternatives may deserve a hearing.

Contents

Overview: Importance of Emission Trading to Kyoto Compliance . . . . . . . 1

Review of Analyses: the Dynamics of Trading . . . . . . . . . . . . . . . . . . . . . . 5

Implementation Pitfalls: Comparison with Acid Rain . . . . . . . . . . . . . . . . . 9

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

List of Tables

Table 1: Climate Change Perspectives and Policy Parameters . . . . . . . . . . . . . . 3

Global Climate Change: Lowering Cost

Estimates through Emissions Trading — Some

Dynamics and Pitfalls

Overview: Importance of Emission Trading to Kyoto Compliance

United States concerns about implementing the Kyoto Protocol focus on three

interlinked issues: (1) the considerable uncertainty and risk of substantial cost from

carbon dioxide (CO2) abatement; (2) the competitive impacts of compliance, both

domestically and internationally; and (3) the comprehensiveness of the Protocol’s

scope, in particular, the exclusion of third world countries from any CO2 reduction

program.1

These implementation concerns, along with perceived scientific

uncertainty, have prevented any serious effort by the Administration to seek Senate

ratification of the Kyoto Protocol.

Removal of any one of the three interlinked issues might significantly improve

the prospects for approval of the Kyoto Protocol, or some other regime to control

greenhouse gas emissions. For example, if the cost of Kyoto compliance could be

shown to be not as burdensome as some have suggested, the competitive impact

would be weakened and the concern about comprehensiveness would lessen. Such

concerns, along with scientific doubt, would not be eliminated; however, they would

be attenuated.

Such a task would not be easy. Estimates of costs to reduce CO2 emissions vary

greatly, and focus attention on an estimator’s basic view about the problem and the

future, rather than on simple, technical differences, in economic assumptions.2 Some

of these “lenses” through which people view the problem and their effects on cost

analysis are summarized in Table 1. Based on these perspectives, the cost of

complying with Kyoto can appear to range from “none” (or indeed, a positive

benefit”) to an estimate so high as to potentially bankrupt the economy. For example,

the American Petroleum Institute, in summarizing the results of several studies

concludes that Kyoto compliance would require “heavy taxes or high carbon permit

prices” to be achieved, resulting in “sharp declines in domestic demand”, “encourage

1

For a analysis of U.S. policy, see Larry B. Parker and John E. Blodgett, Global Climate

Change Policy: From “No Regrets” to S. Res. 98, CRS Report RL30024, January 12, 1999.

For a summary of the Kyoto Protocol, see (name redacted), Global Climate Change Treaty:

The Kyoto Protocol, CRS Report 98-2 ENR, updated June 23, 1999.

2

For a further discussion, see: (name redacted) and (name redacted),

Global Climate Change:

Three Policy Perspectives, CRS Report 98-738, August 31, 1998. It identifies three “lenses”

through which people can view the global climate change issue, and their influence on cost

analysis.

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imports and reduce exports,” and a “significant loss of jobs” in energy related

industries.3 In contrast, a study by a coalition of public interest groups concludes that

new energy policies can “cut energy costs, increase employment, and protect the

environment.” Such a path is seen as reducing energy costs by $530 a household

while exceeding the reduction requirements of Kyoto.4 None of the perspectives on

which these analysis are based is inherently more “right” or “correct” than another;

rather, they overlap and to varying degrees complement and conflict with each other.

People hold to each of the lenses to some degree. The uncertainties about the risk of

global climate change and the critical impacts of differing assumptions about the

nature of the problem effectively preclude predictions of the ultimate costs of

reducing greenhouse gases.

As a result, attention has focused on how to minimize costs by selecting the most

economically efficient strategies to reduce CO2 emissions. With the negotiation of the

Kyoto Protocol, the mechanism that has become the centerpiece of this attention is

emissions trading. Indeed, Janet Yellen, Chair of the President Council of Economic

Advisors has stated that the “promise of Kyoto can not be achieved without effective

emissions trading.”5

Emissions trading is one of four “flexibility mechanisms contained in the Kyoto

Protocol (article 17).6 Under the Kyoto Protocol, developed countries are given

greenhouse gas emissions “budgets” for the compliance period 2008-2012 based on

a percentage of their 1990 or 1995 emissions levels (depending on the particular

greenhouse gas). If a country determined that it would exceed its emissions limit

during the compliance period, emissions trading would permit it to purchase emissions

reductions (i.e., “credits”7) from another country that determined it would have

achieved more emissions reductions than necessary to comply. With emissions

trading, countries that can make relatively inexpensive emissions reductions have an

incentive to reduce emissions below the level required by the Kyoto Protocol, and sell

the extra credits to other countries whose emissions control costs are more

3

Rayola Dougher, The Impact of the Kyoto Protocol on Allied Industry Output, Employment,

and Trade, American Petroleum Institute, 1999. For a rebuttal of the type of studies on which

the API conclusions are based, see Howard Geller, “On Impacts of the Kyoto Protocol on

U.S. Energy Markets and Economic Activity.” Testimony before the House Science

Committee, October 9, 1998.

4

Alliance to Save Energy, American Council for an Energy-Efficient Economy, Natural

Resources Defense Council, Tellus Institute, and Union of Concerned Scientists, Energy

Innovations: A Prosperous Path to a Clean Environment, Tellus Institute, June 1997. For

a rebuttal of the type of studies on which these conclusions are based, see Ronald J.

Sutherland, The Feasibility of “No Cost” Efforts to Reduce Carbon Emissions in the U.S.,

American Petroleum Institute, Issue Analysis #106, May 1999.

5

Statement of Janet Yellen, Chair, President’s Council of Economic Advisers, House

Committee on Commerce, Subcommittee on Energy and Power, March 4, 1998.

6

The other mechanisms are Bubbles (Article 4), Joint Implementation (Article 6), and the

Clean Development Mechanism (Article 12).

7

A credit would generally represent the reduction of one metric ton of carbon equivalent

emissions.

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Table 1: Climate Change Perspectives and Policy Parameters

Seriousness of

Problem

Risk in developing

mitigation program

Technology

Is agnostic on the

merits of the

problem. The focus

is on developing

new technology that

can be justified

from multiple

criteria, including

economic,

environmental and

social perspectives.

Believes any reduction

program should be

designed to maximize

opportunities for new

technology. Risk lies

in not developing

technology by the

appropriate time.

Focus on research,

development, and

demonstration; and on

removing barriers to

commercialization of

new technology.

Viewed from the

bottom-up. Tends to

see significant

energy inefficiencies

in the current

economic system

that currently (or

projected) available

technologies can

eliminate at little or

no overall cost to the

economy.

Economic

Understands issue

in terms of

quantifiable costbenefit analysis.

Generally assumes

the status quo is the

baseline from which

costs and benefits

are measured.

Unquantifiable

uncertainty tends to

be ignored.

Believes that

economic costs should

be examined against

economic benefits in

determining any

specific reduction

program. Risk lies in

imposing costs in

excess of benefits.

Any chosen reduction

goal should be implemented through economic measures such

as tradeable permits

or emission taxes.

Viewed from the topdown. Tends to see

a gradual

improvement in

energy efficiency in

the economy, but

significant costs

(quantified in terms

of GDP loss)

resulting from global

climate change

control programs.

Typical loss

estimates range from

1-2% of GDP.

Ecological

Issue understood in

terms of potential

threat to basic

values, including

ecological viability

and the well-being

of future generations. Values

reflect ecological

and ethical considerations; attempts

to convert them into

commodities to be

bought and sold

seen as trivializing

the issue.

Rather than economic

costs and benefits or

technological

opportunity, effective

protection of the

planet’s ecosystems

should be the primary

criteria in determining

the specifics of any

reduction program.

Focus of program

should be on altering

values and broadening

consumer choices.

Views costs from an

ethical perspective in

terms of the

ecological values

that climate change

threatens. Values

such as intergenerational equity

should not be considered commodities

to be bought and

sold. Costs include

aesthetic and environmental values

that economics cannot readily quantify

and monetize.

Approach

Costs

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expensive. Thus, both the seller and the buyer would have lower costs by virtue of

the seller’s profit and the buyer’s savings.

This mechanism, however, comes with significant restrictions under the Kyoto

Protocol. First, emissions trading is restricted to countries that have legally binding

greenhouse gas emission limitations. Commonly called Annex 1 parties, only

developed, industrialized countries are included.8 This restriction also applies to two

of the other three mechanisms — bubbles and joint implementation projects. Only the

Clean Development Mechanism (CDM) can be employed for transactions between

Annex 1 countries and countries without legally binding requirements — i.e.,

developing countries. The specifics of this mechanism are yet to be defined.

A second restriction to trading is the requirement that it “be supplemental to

domestic actions for the purpose of meeting quantified emission limitations and

reduction commitments...”9 However, the Protocol is vague as to what

“supplemental” means, and the term is subject to continuing negotiation.

Some parties have suggested a third restriction on trading with respect to how

reductions are accomplished. Specifically, some have argued that trading be restricted

to transactions where the traded carbon credits are the result of explicit controls that

reduce greenhouse gases, and not because of economic downturns or other events

separate from the Protocol. This issue arises as several countries of the former Soviet

Union are projected to have sizeable amounts of credits available for sale because of

current economic difficulties. Proponents of trading restrictions argue that such “hot

air” reductions would have occurred anyway and would weaken the Protocol’s

targets. These concerns are heightened by the failure of Russia and seven other

members of the former Soviet Union countries to comply with the Montreal

Protocol10 because of “economic difficulties” — the same difficulties that would

create the hot air credits. However, the Kyoto Protocol places no restriction on the

means countries may use to comply with reduction requirements; thus, this position

may be difficult to sustain in negotiation.

Because trading is a central feature of costs analyses of the Kyoto Protocol, this

paper analyzes some of the dynamics and pitfalls of carbon trading, based on various

analyses done on U.S. compliance with the Kyoto Protocol. As the analysis

conducted by the Administration has become the focus of much of the cost debate,

it receives special emphasis here.

8

Although called “Annex 1" countries in reference to Annex 1 of the Framework Convention

on Climate Change (FCCC), the correct reference is to Annex B of the Kyoto Protocol. The

lists of countries in Annex 1 and Annex B are very similar, but not identical. CRS uses the

common usage term, Annex 1, in this report.

9

Article 17, Kyoto Protocol.

10

The Montreal Protocol is an international environmental treaty designed to protect the

stratospheric ozone layer by phasing out the global production of ozone-depleting chemicals,

such as chlorofluorocarbons.

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Review of Analyses: the Dynamics of Trading

Several attempts have been made to estimate the cost of U.S. compliance with

the terms of the Kyoto Protocol. Seventeen estimates by eight different organizations

are shown in Figure 1.11 In terms of the discussion in table 1, these estimates are the

result of “top-down” analyses, although some have more aggressive assumptions

about market penetration rates for new, more energy efficient technologies than

others. Several “bottom-up”, technology-oriented analyses of potential carbon

reductions under various scenarios have been conducted. However, these analyses

rely on assumed availability and penetration of various energy-efficient and low

carbon technologies, not international emissions trading, to achieve their cost savings,

and so are not reviewed here.12 Indeed, a recently released “bottom-up” analysis

conducted by the Tellus Institute expresses concern that the flexibility mechanisms

contained in the Kyoto Protocol could threaten environmental integrity and result in

misguided policies that could actually increase costs in the long term.13

Most analyses of the Kyoto Protocol either exclude emissions trading or limit

trading to the developed countries covered by the Protocol (Annex 1 countries). The

latter assumption is consistent with the intent and language of the Protocol —

developing countries’ participation in emission trading is restricted to a “Clean

Development Mechanism,” the parameters of which are yet to be sorted out.14 Only

three estimates incorporated a global trading scenario. Despite the wide range of

estimates plotted in Figure 1 for each trading scenario, the differences between the

three trading scenarios strongly suggest that emission trading would significantly

11

The organizations are the Energy Information Administration (EIA), WEFA, Inc., Charles

River Associates (CRA), Pacific Northwest National Laboratory (PNNL), Massachusetts

Institute of Technology (MIT), Electric Power Research Institute (EPRI), Data Resources

Institute (DRI), and the Clinton Administration. A summary of the first seven analyses can

be found in Energy Information Administration, Impacts of the Kyoto Protocol on U.S.

Energy Markets and Economic Activity, prepared for the U.S. House, Committee on Science,

U.S. Govt. Print. Office, SR/OIAF/98-03, October 1998, pp. 137-151. Additional scenarios

from the CRA analysis are available in Paul M, Bernstein and W. David Montgomery, How

Much Could Kyoto Really Cost? A Reconstruction and Reconciliation of Administration

Estimates, prepared for the American Petroleum Institute, 1998. The Administration’s

analysis is contained in The Kyoto Protocol and the President’s Policies to Address Climate

Change: Administration Economic Analysis, July 1998.

12

Indeed, the best known of these studies, the “Five-Lab Study,” used carbon taxes of $25 and

$50 a ton in developing its scenarios. It should also be noted that the “Five-Lab Study

examined technology-oriented strategies to achieve stabilization of U.S. carbon emissions at

1990 levels — not the 7% below 1990 levels required under Kyoto. See: Interlaboratory

Working Group on Energy-Efficient and Low-Carbon Technologies, Scenarios of U.S.

Carbon Reductions: Potential Impacts of Energy-Efficient and Low Carbon Technologies

by 2010 and Beyond, September 1997. For a critique of the analysis, see: Energy Information

Administration, Impacts of Kyoto Protocol on U.S. Energy Markets and Economic Activity,

prepared for the House Committee on Science, October 1998, pp. 146-151.

13

Tellus Institute, America’s Global Warming Solution, a study prepared for the World

Wildlife Fund and Energy Foundation, August 1999, pp. 18-20.

14

The EPRI analysis included above includes some participation in the CDM.

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reduce the projected costs of U.S. compliance with the Kyoto Protocol. The

“promise” of international emissions trading appears to be indisputable, based on

existing analyses.

Figure 1

Cost Estimates for Kyoto Compliance

(Year 2010)

400

350

348

300

250

295

280

266

265

200

221

193

175

171

150

119

114

110

100

61

100

50

50

23

14

0

No Trading

Annex 1 Trading

Global Trading

Source: U.S. Energy Information Administration, Charles River Associates, Administration Economic Analysis.

To examine this a little further, two organizations conducted cost analyses for

three different trading scenarios. Those estimates, calculated by the Administration

and by Charles River Associates (CRA) are provided in Figure 2. As indicated,

moving from a no trading posture to an Annex 1 trading posture lowered the cost

estimates by 60% (CRA) to 68% (Administration). According to these analyses, if

the Kyoto Protocol permitted full global trading, the costs would be lowered by 83%

(CRA) to 88% (Administration). These analyses agree on the potential cost

reductions presented by emissions trading; a potential that increases as the pool of

potential participants increase. This agreement on trading’s effect on costs is evident

despite the significant disagreement on what the actual compliance costs under the

Kyoto Protocol might be.15

15

The difference in costs between the Administration’s and CRA’s analyses is primarily the

result of two factors. First, the Administration assumes a higher energy efficiency

improvement rate than CRA. Second, the Administration assumes a higher elasticity of

substitution between coal and natural gas. These more aggressive assumptions by the

Administration are consistent with its “technological view” of Kyoto implementation. For

more on that view, see Table 1.

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Figure 2

Another important dynamic with respect to trading illustrated in figure 2 is the

importance of “hot air” credits to reducing costs. As noted earlier, “hot air” credits

is a rather pejorative term used to describe a potentially large pool of CO2 credits

available from the former Soviet Union. This pool of perhaps 200 million metric tons

of carbon, according to DOE estimates, results from the substantial reduction in

economic activity in the former Soviet Union since 1990 (the baseyear for the Kyoto

Protocol). If these credits are dumped on the market during the five-year compliance

period (2008-2012), credit prices would be depressed, reducing compliance costs as

indicated in the CRA analysis. Likewise, without the availability of these credits, the

cost of U.S. compliance under Kyoto could be substantially higher.

This substantial cost savings projected under the CRA analysis illustrates why

the Administration opposes any restriction on hot air credits. An increase in the

available pool of credit for sale would tend to reduce the price of credits in the trading

market. For a country like the United States, which is projected to be very active in

the trading market, lower credit prices would translate into lower compliance costs,

all else being equal.

Indeed, the lower cost estimates of the Administration’s analysis is partially the

result of a trading system that is assumed to be very free and unconstrained. In

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essence, the Administration assumes the trading system will work very well indeed.

Just how well is indicated by Figure 3. In order to gain the 68% cost reduction from

emission trading between Annex 1 countries discussed above, 61% of the necessary

carbon credits must be bought from other Annex 1 countries. In order to gain the

88% reductions in costs from global trading, 82% of the necessary carbon credits

must be bought from other countries. In a maximum trading scenario developed by

the Administration, up to 88% of carbon credits would be purchased from other

countries.

Figure 3

This scale of potential trading may put any resulting U.S. implementation

strategy in conflict with restrictions contained in the Kyoto Protocol, and with the

negotiating position of other parties to the Protocol. As noted earlier, according to

the Protocol, international emissions trading is to be a “supplemental” implementation

tool to domestic efforts. According to the latest European Union position,

supplemental means no more than 50%. If the European standard was adopted in

negotiation, the estimated savings from trading would be substantially reduced.

Two conclusions emerge from this review. First, there is little debate among the

analyses that emission trading could reduce U.S. compliance cost under Kyoto.

Indeed, the percentage reductions resulting from increased trading do not differ

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greatly. Rather, the dispute is over how well such a program would work. Second,

it is the assumption of the Administration’s analysis that trading will work extremely

well, resulting in substantially lower costs for the United States. This possibility may

be difficult to achieve given restrictions contained within the Kyoto Protocol, the

negotiating position of some of the other parties, and the sources from which many

of the credits are projected to come. Moreover, current efforts to devise a workable

trading system suggest that it will be a difficult and lengthy process, at best.

Implementation Pitfalls: Comparison with Acid Rain

The importance of trading to cost estimates, and the scope to which it is

employed by the Administration in its analysis has no direct parallel in any existing

environmental program. The closest example of such a trading program is the acid

rain program under title IV of the 1990 Clean Air Act Amendments. However,

significant differences between acid rain and possible global warming limit the

usefulness of title IV as an analogy for an international carbon trading system. For

example, the acid rain program involves up to 3,000 new and existing electric

generating facilities that contribute two-thirds of the country’s sulfur dioxide (SO2)

and one-third of its nitrogen oxide (NOx) emissions (the two primary precursors of

acid rain). This concentration of sources makes the logistics of emissions trading

manageable and enforceable. However, CO2 emissions are not so concentrated.

Although over 95% of the CO2 generated comes from fossil fuel combustion, only

about 33% comes from electricity generation. Transportation accounts for about

33%, direct residential and commercial use about 12%, and direct industrial use about

20%. Thus, small dispersed sources in these other areas are far more important in

controlling CO2 emissions than they are in controlling SO2 emissions. This creates

significant administrative and enforcement problems for an international emissions

trading program if it attempts to be comprehensive. These concerns multiply as the

global nature of the program is considered, along with the number of greenhouse

gases that would be included in it.

In addition to the substantive differences in the problems, the trading dynamics

of national SO2 trading and international CO2 trading are different. As indicated by

Figure 4, the largest projected saving from emission trading under the SO2 program

is from permitting relatively simple and uncomplicated trading between a utility’s own

facilities. An additional ten percent can be gained by permitting intrastate trading.

However, expanding the boundaries of the trading to interstate trading does not result

in as dramatic cost reductions as for intra-company trading. For implementation

policy, this is very significant, as it suggests that the SO2 trading program does not

have to work very efficiently to achieve a large proportion of the economic benefits

that have been estimated. Given the increasing regulatory and administrative

complexity of expanding the scope of trading to regional levels, the trading dynamics

suggest that such complexity can be avoided at little loss of economic efficiency.16

16

For a further discussion, see: Larry B. Parker, Robert D. Poling, and John L Moore, “Clean

Air Act Allowance Trading,” 21 Environmental Law, 4, 1991, pp. 2023-2068,

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Figure 4

However, although the positive effects of trading have been borne out in the first

few years of the SO2 program, it is not necessarily a harbinger of the potential cost

savings from an international carbon trading program. First, the baselines for

measuring cost savings are different. For the acid rain program, a unit-by-unit

allocation of reduction with absolutely no trading is the baseline from which cost

savings from trading are measured. For a carbon trading program, the baseline is an

interstate (or intra-country) trading scenario from which cost savings from

international trading is measured. Thus, the maximum trading scenario estimated

under the acid rain program (interstate trading) is the baseline scenario for measuring

the effect of inter-country trading under carbon trading. In essence, the “no trading”

scenario of the carbon trading program is the “interstate trading” scenario of the acid

rain program. Thus, the scope of international carbon trading is well beyond that of

the title IV program.

Second, the trading dynamic under the SO2 program discussed above contrasts

strongly with that projected under an international carbon trading program. As

indicated in Figure 5, under an international carbon trading program, only half the

anticipated savings from trading occur in transactions between developed Annex 1

countries. About a fifth of the savings projected by Charles River Associates is the

result of “hot air” credits. Finally, about a quarter to a third of the anticipated savings

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results from transactions with countries not currently covered by the Protocol. Thus

about half the total savings from trading would come from sources whose credits are

either contested in some quarters, or from countries who are not required to

participate in the reduction program at all.17

Figure 5

Conclusion

The potential for international emission trading to reduce U.S. compliance cost

under the Kyoto Protocol is substantial and indisputable. Whether that potential can

be turned into fact is more problematic. The analysis presented here suggests that

implementing international emissions trading under Kyoto would represent uncharted

territory for U.S. environmental policy.

17

Indeed, it is not clear that developing countries can participate in the CDM unless they

assume reduction obligations. For more on the CDM, see United Nations Development

Programme, Issues & Options: The Clean Development Mechanism, United Nations

Publications, 1998.

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First, an international emissions trading scheme has to function very efficiently

to achieve the savings projected by analyses. For example, the Administration’s

analysis relies on an unprecedented amount of international trading to achieve the

substantial cost reduction its projects. Under its most aggressive trading scenario,

82%-88% of the U.S. reduction requirement would be bought from foreign sources,

resulting in domestic CO2 reductions of only 66 to 99 million metric tons, compared

with an estimated 550 million metric tons if all reduction were achieved

domestically.18 Even restricting trading to Annex 1 countries results in 61% of the

country’s reduction requirement coming from foreign sources. The magnitude of

transactions not only raises questions of its feasibility, but may also conflict with the

intent of the Kyoto Protocol — and with the positions of some other countries —

which states that international emissions trading is to be “supplemental” to domestic

actions.

Second, besides the amount of trading estimated, the sources of these reductions

raise additional questions. For example, according to analysis by Charles River

Associates, half the estimated savings from international emissions trading would

come from either “hot air” credits from the former Soviet Union, or from transactions

with Third World countries that are not required to participate in the program.

Trading with these sources does not have the certainty that trading with most Annex

1 countries would have in terms of monitoring, enforcement, and integrity of

transactions. With respect to the former Soviet Union, current problems with

achieving compliance with the Montreal Protocol, a far simpler international treaty,

does not bode well for the Kyoto Protocol. That “economic difficulties” are

proffered by these countries as grounds for non-compliance and non-enforcement of

the Montreal Protocol is particularly disturbing, as those same difficulties are the

source of the “hot air” credits.

The situation may be more uncertain with Third World transactions as

developing countries generally have neither the incentive of a binding obligation under

the Protocol, nor the infrastructure to monitor, enforce, and protect the integrity of

transactions. In addition, there may be complications resulting from the Kyoto

Protocol itself. As currently written, transactions with Third World countries are to

be funneled through a “Clean Development Mechanism,” an institution whose role

and parameters have yet to be worked out. How much this “middle man” mechanism

would affect trades is unclear.

Third, the situation with international carbon trading is not analogous to the acid

rain program, often cited as a model.19 The acid rain program involves domestic

trading in one pollutant from about 3,000 relatively large stationary sources. As such,

it has been administratively manageable, enforceable, and successful. The Kyoto

Protocol involves 6 pollutants, millions of small, medium, and large sources, and

18

For further information on the projected U.S. reduction requirement under the Kyoto

Protocol, see: (name redacted) and (name redacted),

Global Climate Change: Reducing

Greenhouse Gases — How Much from What Baseline? CRS Report 98-235 ENR, March

11, 1998

19

For example, see: Council of Economic Advisors, Economic Report of the President, U.S.

Govt. Print. Off., February 1997, pp. 208-213.

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international trading. The maximum trading scenario under the acid rain program —

interstate trading — is the baseline for international trading under the Kyoto Protocol.

While electric generating facilities — the focus of the acid rain trading program —

account for two-thirds of U.S. sulfur dioxide emission, they account for only 29% of

the six greenhouse gases emitted in the U.S. (mostly carbon dioxide). Other more

dispersed energy uses, such as transportation, make up most of the rest. Add the

international scope of carbon trading to this mix, and it is clear that implementation

challenges would be on a different level than that encountered with the acid rain

program, a level to which the implementation of the acid rain program provides little

guidance.

Besides questions raised by the scale of carbon trading, the trading dynamics of

carbon trading differ from those of the acid rain program. Unlike an international

carbon trading program that must operate very efficiently to achieve much of its cost

savings, the acid rain program does not have to do so. The simplest trades — those

between a company’s own plants — achieve the greatest cost savings under the acid

rain program, not interstate trades between unassociated parties. That there have

been relatively few interstates trades so far under the acid rain program means once

again that the program provides little guidance to any future international carbon

trading program.

In short, to expect trading to reduce costs by the 80%-90% suggested by some

analyses seems at the current time to be unrealistic. Indeed, the complexity presented

by international emissions trading suggest that alternatives may deserve a hearing.

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