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Faced with paying for their emissions of carbon, firms in all countries start changing technology, moving away from carbon-intensive inputs. Households alter their consumption patterns, also moving away from carbon-intensive goods. With higher carbon prices raising costs for firms, productivity and output fall. Aggregate investment falls because the average marginal product of capital is lower, and consumption follows declines in real incomes. To the extent that some firms and households are forward looking, they would react immediately to the anticipated future prices, which makes policy more effective. Although the levels of real activity fall permanently relative to the baseline, the shock has only a temporary effect on GNP growth rates: over time, they return to the baseline levels. Current accounts tend to improve in countries that considerably reduce emissions, because declines in investment in such countries outweigh declines in savings.

The total abatement costs vary across countries, depending on how efficient they are in reducing emissions and by how much they reduce them. The costs are the highest for China—by far the least efficient economy in the use of energy (producing nine times more emissions per unit of output than Japan and five times more than the United States). China can reduce emissions at the lowest incremental cost by improving the efficiency with which firms and households use energy. The net present value of consumption in China declines by about 1#/4 percent from the baseline levels by 2040 (see Chart 2). For other economies, and the world as a whole, the decline in the net present value of consumption is about !/2 percent for the same period. When measured in terms of the bundle of goods produced, the costs are higher, with the net present value of world GNP declining by about 2 percent from the baseline by 2040. But this would still leave world GNP two-and-a-half times higher in 2040 than in 2007. (The study focused on GNP as a measure of output because, in contrast to GDP, GNP takes into account the value of transfers between countries, which may occur particularly under the cap-and-trade policies.)

The total costs of mitigation in G-cubed are higher than in many other studies (see, for example, U.S. CCSP, 2007), but within the range of estimates reported by the Intergovernmental Panel on Climate Change (2007). The main reason for higher estimates is that this study assumes relatively strong emissions growth in the baseline and uses conservative assumptions about the availability of the so-called backstop technologies, which allow output to be produced without any emissions of GHG.

Cap-and-trade policy. Next, the study compared the effects of the price-based policies to those of a global policy that requires countries to agree on an initial allocation of emissions rights and international trade of these rights. Each economy receives emissions rights for each year from 2013 onward, which are proportional to its share of global emissions in 2012. Emissions permits can be traded internationally, which establishes a common price. Economies with higher incremental (or marginal) abatement costs (MACs)—that is, the costs of an incremental reduction in emissions—buy permits from economies with lower MACs, compensating them for undertaking more abatement than implied by their share of emissions. Hence, the actual emissions paths of individual economies differ from their initial allocations of permits, whereas the world emissions path is consistent with the targeted profile.

For most economies, transfers are small and the macroeconomic effects of the cap-and-trade policy are similar to those of the carbon tax and the hybrid. For China (a recipient), other emerging and developing economies (payers), and economies in the Organization of the Petroleum Exporting Countries (recipients), transfers reach 6 percent, 1!/2 percent, and !/2 percent of GNP, respectively, by 2040. China receives the largest transfers because it is comparatively inefficient in its use of energy and can reduce emissions at a much lower cost than other economies. Advanced economies, as well as other emerging and developing economies, buy emissions rights from China because emissions reductions are highly costly for these countries. The costs for economies paying transfers (Europe, Japan, Russia, and other emerging and developing economies) are higher under the cap-and-trade scheme than under the carbon tax and the hybrid policy, whereas the costs for the economies receiving transfers (China, OPEC, and the United States) are lower.

Although most studies predict that advanced economies—especially Western Europe and Japan—would have to pay for emissions permits, there is no consensus about international transfers for emerging market economies. Such countries have high growth potential, which implies high future demand for emissions rights, but they also emit a large amount of carbon dioxide per unit of output, suggesting much room for efficiency gains and the ability to sell emissions rights.

Alternative allocation rules. The pattern of international transfers and the macroeconomic effects of cap-and-trade schemes are highly sensitive to how emissions rights are allocated. Suppose each economy receives emissions rights not according to its initial share of emissions, but according to its share of world population in each year from 2013 onward. This would change the pattern of international trade in permits and the macroeconomic effects substantially, with other emerging and developing economies now selling permits and receiving transfers, in the amount of !/2 percent of GDP in 2040, which reduces the cost of mitigation for these countries.

Guiding principles

What lessons can we glean for policymakers trying to contain the potentially adverse macroeconomic effects of mitigation? Carbon-pricing policies must

· Be long-term and credible. It is important to establish a steadily rising time path for carbon prices that people and businesses believe in. Increases in world carbon prices then need not be large—say a 1 cent initial increase in the price of a gallon of gasoline that rises by an additional cent every two years. Such gradual increases, if started early, would allow the cost of adjustment to be spread over a longer period of time.

· Require all groups of countries—advanced, emerging market, and developing—to start pricing their emissions. Any policy framework that does not include emerging and developing economies (particularly, large and fast-growing economies such as Brazil, China, India, and Russia) would be extremely costly and politically untenable, because 70 percent of total emissions during the next 50 years are projected to come from these and other emerging and developing economies.

· Establish a common world price for emissions. This would ensure that emissions are reduced where it is least costly to do so. Emerging and developing economies, in particular, are likely to be able reduce emissions much more cheaply than advanced countries. For example, if China and India have access to technologies similar to those available in Japan and Europe, they could cut emissions dramatically by improving the efficiency with which they use energy and by reducing reliance on coal. The difference in costs can be significant—for the world as a whole, costs will be 20–40 percent lower if carbon prices are common across countries. Countries would have to harmonize the rate of carbon tax, coordinate trigger prices for the safety valve under a hybrid policy, or allow international trading of emissions permits under a cap-and-trade scheme.

· Be sufficiently flexible to accommodate cyclical economic fluctuations. In periods of high demand, it would be more costly for firms to reduce their emissions, whereas the opposite would be true when demand is low. Abatement costs would be lower if firms could vary their emissions over the business cycle. That would allow achievement of a given average level of emissions reductions over the medium term. In contrast to carbon taxes and hybrid policies, cap-and-trade could prove restrictive in periods of higher growth because of increased demand and prices for emissions permits, unless provisions are made to control price volatility.

· Distribute the costs of mitigation equitably across countries. Some mitigation policies—for example, a uniform tax, a cap-and-trade scheme where permits are allocated based on countries’ share of emissions, or a hybrid policy—would impose high costs on some emerging market and developing economies. Substantial cross-border transfers may be needed to encourage them to participate and to help them deal with the negative impact. Using border tax adjustments to induce countries to join could elicit a protectionist response that would detract from mitigation efforts.

In addition, countries may need to complement carbon pricing with appropriate macroeconomic and financial policies. For example, under a global cap-and-trade regime, transfers from industrial countries that buy permits to emerging and developing economies that sell them could be potentially large—several percentage points of GNP. Such transfers would reduce the costs of carbon pricing policies for emerging and developing countries and would encourage them to participate. However, the transfers might also cause real exchange rates in the recipient countries to appreciate considerably, making some sectors of the economy less competitive. Such macroeconomic effects can be reduced if countries save a portion of these inflows, continue to improve the business environment, and, depending on their exchange rate regime, allow appreciation to take place at least partly through the nominal exchange rate rather than through inflation.

Finally, capital and technology flows can help reduce the costs of mitigation by helping allocate abatement to the least costly destinations while making abatement easier to achieve through the use of modern technology. And initiatives by major advanced economies to subsidize the transfer of clean technologies to emerging and developing countries can usefully complement a global commitment to contain carbon emissions through a broadly accepted global carbon-pricing framework.

Concluded

Tamirisa is a Deputy Division Chief in the IMF’s Research Department.

Source: IMF