analysis of unilateral co₂ control in the european community and...

Analysis of Unilateral C02 Control in the European Community and OECD*

John Pezzey**

Whalley and Wigle (1991b) use a static, six-region, perfect competition, general equilibrium model to explore various global carbon tax policies designed to cut C02 emissions. Their program is used here to model unilateral carbon taxes applied by large regions such as the EC or the OECD. Sample model results suggest that a 20% unilateral cut in EC carbon-based energy consumption achieves a 0. 7% cut in world consumption in equilibrium; the EC's production of energy-intensive goods falls by 8.3%; but EC welfare is hardly changed, thanks to a shift in consumption towards nonenergy-intensive goods and to cheaper carbon-based energy imports. Unilateral action, even by large economies, therefore seems to be environmentally ineffective but economically neutral overall. However, international leadership effects or induced technical progress might change these conclusions. Also, Perroni and Rutherford (1991) find less extreme results for similar policies , probably because they model world energy markets very differently.

INTRODUCTION

Gradually rising concentrations of carbon dioxide (COJ in the atmosphere, the resulting increase in the greenhouse effect, and the harmful

The Energy Journal , Volume 13, Number 3. All Rights Reserved.

*1 am grateful to ICI pic, the Kleinwort Foundation and the Dulverton Trust for financial support of my research at Bristol; to IBM UK Ltd for computing support; to Jos Delbeke of the Environment Directorate of the European Commission for helpful advice; and to the U.K. Department of Trade and Industry for commissioning a study on the international competitiveness effects of COj control, from which this paper is lately drawn. An earlier version of the paper was presented at the Annual Meeting of the European Association of Environmental and Resource Economists, Stockholm, June 1991 . My especial thanks go to John Whalley and Randy Wigle for generously sharing their data and program code. None of these bears any responsibility for the content of this paper, and all views expressed are mine alone.

**UK CEED Research Fellow, Department of Economics, University of Bristol, 8 Woodland Road, Bristol BS8 1TN, U.K.

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160 / The Energy Journal

global warming that this increased greenhouse effect is widely (if uncertainly) expected to cause, are all truly global problems. C02 emissions occur in all economic sectors in all countries of the world, but eventually are thoroughly mixed in the global atmospheric system to affect only the global concentration of C02. Any benefit of a unilateral reduction in C02 emissions by one country is therefore scaled down by a factor equal to the proportion of global C02 emissions coming from that country, and the biggest such proportion is only 23% for the largest single emitter (the USA).1 In the face of such a global tragedy of the commons, it is therefore not surprising that many of the best- known studies of the economics of controlling C02 emissions have concentrated on coordinated policy action at the global level (see, for example, Edmonds and Barns, 1990, Manne and Richels, 1991 and Nordhaus, 1991). It is perhaps more surprising that many other studies model the effects of unilateral C02 control by small countries- see, for example, Glomsrod et al (1992) for Norway (0.2% of global C02 emissions), Bergman (1991) for Sweden (0.3%), and Proost and Van Regemorter (1991) for Belgium. The direct effects on both the global climate and global economy of such small C02 emitters individually controlling their emissions will be negligible, so apart from any demonstration effects and the warm glow of pure altruism, the economics of unilateral control would depend on just the direct effects of C02 control on the country's economy.

What has received little attention so far, and what forms the subject of this paper, is unilateral C02 control by large countries or economic groups such as the USA or the European Community (EC), where the effects of control on both the global climate and economy are likely to be more significant. There now follows a brief qualitative discussion of the general issues raised by unilateral control, and then a more detailed presentation and discussion of numerical results obtained from the multiregional computable general equilibrium (CGE) model used by Whalley and Wigle (1991b), referred to hereafter as WW.

ISSUES IN THE ECONOMICS OF UNILATERAL C02 CONTROL

Unless otherwise specified, "C02 control" is taken to entail three things throughout this paper. Firstly, control measures are substantial, rather than mainly "diplomatic" measures such as making small shifts in existing energy taxes towards more carbon-intensive fuels like coal, and calling the resulting

1. COj emission data are derived from Markandya (1990) and are based on 1987 emissions from fossil fuel burning only. There are small differences between these data and the 1982 benchmark data set used in Whalley and Wigle (1991b).


Analysis of Unilateral C02 Control / 161

package a "carbon tax." Secondly, only C02 emissions from the burning of commercial carbon-based energy sources (coal, oil or gas), hereafter referred to as "carbon energy," are considered, and emissions from deforestation are ignored. Thirdly, it is assumed that control is applied to carbon energy consumption rather than production, a distinction which WW show is crucial.

Now it is conceivable that, even ignoring environmental benefits, C02 control may in itself produce a net financial benefit, either because it causes a powerful induced increase in energy-saving technical progress (after Kennedy, 1964) which gives the controlling country a profitable lead in world markets, and/or because even with current technology, existing market failures mean that newly-induced energy conservation measures actually save more resources than they cost (i.e. have no regrets). Now "induced technical progress, " "first mover advantage" and "no regrets measures" are all complex phenomena which may well be very important, and certainly need further research in the context of C02 control economics; but one has to ask why, if they are significant, have major C02 control measures not already been introduced, long before the current awareness of the global warming problem? For most of this paper, this controversial debate is set aside, and it is assumed that the world is perfectly competitive, that no technical progress occurs, and that energy conservation measures which are cost-effective at current prices are already fully exploited. Also, it is assumed that C02 control is carried out by economic instruments (such as carbon taxes) which raise the domestic cost of C02 emissions, and that any tax revenues generated are returned to the economy through reductions in other taxes or increased public expenditure.

Given all the assumptions of the previous two paragraphs, the effect of unilateral C02 control in a small , industrial, energy-importing country will almost certainly be to drive up the internal opportunity cost of energy use inside the country. In turn this will cause a loss of international competitiveness in energy-intensive industries and a loss of economic welfare, essentially because the country is denying itself the advantage of using carbon energy at the prices used by its competitors. Trying to prevent the loss of sectoral competitiveness by giving large subsidies to energy conservation measures will reduce the adjustment costs of contraction in its energy-intensive industries, but may increase the long-run welfare costs by effectively thwarting the restructuring of its economy needed to shift consumption away from goods which are inherently C02-intensive. Because the country is small, there will be next to no effect on the world prices of traded goods.

If, however, a large industrial country or coalition of countries introduces unilateral C02 control, the outcome could be quite different in some ways. Assuming that the coalition is a large net importer of carbon energy (in practice mainly oil), a reduction in C02 emissions will significantly reduce its demand for carbon energy imports, and hence exert downward pressure on



world carbon energy prices. This could of course result in retaliatory policies by carbon energy exporters, for example in a strengthening of the OPEC cartel as prices decline and oil production again becomes more concentrated in low- cost OPEC countries. However, over the several decades which are appropriate for considering global warming problems, it seems not unreasonable to assume (although no justification is given here) that the average state of competition in world carbon energy markets will remain about the same. A reduction in import demand by the C02-controlling coalition will then, indeed, cause a significant reduction in the relative world price of carbon energy, compared to the no- policy baseline.2

This fall in carbon energy prices is in effect an improvement in the coalition's terms of trade, since it is assumed to be exporting manufactured products in exchange for carbon energy imports. Cheaper imports will allow it to divert some manufacturing output from exports to consumption, thus improving welfare, while its trade remains balanced. If the coalition is very large, this terms of trade benefit can be very significant, effectively because the coalition is exploiting its market power to apply something approaching the theoretically optimum import tariff (see Karp and Newbery, 1991, for a recent study in this area). However, the fall in world carbon energy prices will also induce countries outside the coalition to increase their carbon energy consumption and hence C02 emissions, which will offset some of the emissions reduction achieved by the coalition. It is this effect in particular which is estimated here, using a multiregional CGE model which explicitly allows for terms of trade effects.

ESTIMATING THE GENERAL EQUILIBRIUM EFFECTS OF UNILATERAL C02 CONTROL IN THE EC AND OECD

The Policy and Empirical Contexts

There is much continuing debate over the possibility of unilateral C02 control by the EC. No details of this debate are given here but some of the issues raised can be seen from Table 1, which quotes selectively from the Commission of the EC (1990). The Commission's general argument was clearly that oil-exporting or other developing nations will not take action to curb C02 emissions until industrialized nations have given a clear lead, so that unilateral actions are important as a precursor for effective worldwide action on global

2. Measuring from this baseline is important because depletion effects may cause the relative price of carbon energy to rise over time in the absence of policy.



Table 1. Indication of European Commission Thinking on Unilateral EC Control of C02 Emissions

Extracts from Commission of the EC (1990):

"... the international competitiveness of European companies can also go hand in hand with the protection of the environment. If a reinforced policy of environmental protection leads European companies to an adaptation of their marketing and R&D efforts ahead of others, these companies will in the future be better placed on world markets (first mover advantage). This might also induce an accelerated renewal of the capital stock, i.e. additional investment." (p2)

"The Community has a responsibility to assume a leadership role, both within the Community and internationally" (p3)

"... the EC's C02 emissions represent only about 13% of the world's overall C02 emissions. The external dimension of the CO; problems must therefore be of great concern to the Community. The reluctance of the USA to adhere to the stabilisation objective is a major drawback . . . care should be taken that its bad example is used as little as possible by others as pretext for non-action. Consequently, the Community has an overwhelming interest to induce through its proper action policy changes in third countries." (p3)

"The essential political policy options for specific taxes consists of:

taking all (excluding renewable) energy sources as base (general energy tax)

taking the carbon content as base (COj or carbon tax)

a combination of the two." (p6)

"On the one hand, a CQj tax provides a more specific economic incentive to reduce COj emissions than a general energy tax. On the other hand, the C02 tax puts a relatively high burden on coal, the most secure energy supply and it does not burden nuclear energy at all. Moreover, both taxes have a quite different impact on Member States. In view of the above, the Commission favours a combination of a CQ tax with an energy tax." (p7)

warming. The Commission seemed prepared for the EC to give this lead by bringing in control policies even if the rest of the world does not immediately follow suit.

This raises important questions about the economic effects of unilateral EC control measures. In the sense of the preceding section, is the EC a "small" or a "large" coalition with regard to unilateral C02 control? It accounts for about 13% of global C02 emissions, and more importantly for nearly half the world's net imports of carbon energy products from the oil-exporting countries



(Whalley and Wigle 1991b, Table 7.5B), so it seems likely that the EC has enough market power to affect its own terms of trade. What the balance of competitiveness and terms of trade effects will be, and how much of the EC's reduction in C02 emissions would be offset by increases in non-EC emissions, are interesting questions that can be answered only by empirical modelling, to which we now turn.

The Whalley-Wigle Model

A multiregional, computable general equilibrium (CGE) model is clearly necessary to include the effects on world carbon energy prices and terms of trade that were discussed above. The most suitable model to use- although not without its limitations, as will be seen- is WW's because it is the only relevant global model that treats the EC separately (see Pezzey, 1991, Chapter 5). WW's program code is adapted here to estimate the differences in economic effects among no action, unilateral action by the EC or other large coalitions such as the OECD, and global (universal) action. The only parameters in the program that are changed are the exogenous policy variables determining which region controls C02 emissions, and by how much.

WW's model is a static, perfect competition model of global general equilibrium which distinguishes three types of energy (carbon energy, i.e. coal, oil and gas; non-carbon energy, i.e. hydro, nuclear and solar power; and a composite of the first two); and two types of industrial output (energy-intensive goods and other goods). Final consumption goods are composite energy, energy-intensive goods and other goods, while there is free worldwide trade in carbon energy, energy-intensive goods and other goods. The world is divided into six regions: the EC, North America, Japan, Other OECD, Oil Exporters and Developing/Centrally Planned Countries.3 Oil, gas and coal are not distinguished, so interfuel substitution, which is probably one of the most important domestic ways of reducing C02 emissions, is not considered. Another crucial assumption, and also one which clearly could be improved upon, is that not only is the same technology set available to all regions, but also all regions use inputs in precisely the same proportions as those in the 1982 benchmark equilibrium data set used by the model.

WW use their model to investigate various global strategies to reduce emissions of C02. All strategies are equivalent to carbon taxes, but choosing whether producers or consumers are taxed and whether tax revenues are

3 . The last category includes formerly centrally planned countries. A preceding paper (Whalley and Wigle, 1991a) treated the OECD as one unit rather than as four separate parts.



nationally or globally redistributed, causes wide differences in international tax incidence. Specifically, they find (p259):

"...carbon taxes [at the level necessary to make 50% cuts in C02 emissions relative to baseline] .... could well account for 10% of global income over the period we consider (1990-2030)

of the tax will largely determine what international incidence effects will likely occur. Under global taxes collected supranationally (say, via the UN) and redistributed to countries on a per capita basis, developing countries benefit. Under national production-based taxes, energy exporters (OPEC) do well. Under national consumption-based taxes, energy importers (OECD) do well."

Modelling Unilateral C02 Control

Two initial equilibria are used here: the original 1982 benchmark data used to calibrate the model, and "projections" for the 1990-2100 period4 which allow both for differential rates of economic growth (with faster growth in the Third World) and for discounting at a 5 % real discount rate in order to reduce all flows over the 110-year period to present value capital sums. For both of these timeframes, five policies have been investigated:

1 . a 20 % cut in carbon energy consumption in the EC alone;

2. a 50% cut in carbon energy consumption in the EC alone;

3. a 20% cut in OECD Europe and Pacific (which together account for about half of the OECD's energy consumption);

4. a 20 % cut in the whole OECD (i.e. including North America);

5. a 20% cut worldwide.

There turns out to be little qualitative difference between the two timeframes. The greater influence of the non-oil developing countries over the

4. The published version of WW uses projections for the 1990-2030 period but the program code obtained from Wigle contains 1990-2100 projections. The only difference is that the scalars used to convert from the benchmark data to 1990-2100 are about 50% higher for the non-oil- developing countries than for the OECD and oil-exporting countries, whereas for the conversion to 1990-2030 the scalars are about 10% higher.



longer time period can be seen, but it is not dramatic. Selected results for the EC and the world are given in Table 2 for 1990-2100 only.

As can be seen, unilateral C02 control policies (either by the EC alone, or by a bigger group including the EC) have many similar effects. The direct effect of unilateral policies on world carbon energy consumption (and hence on the greenhouse effect, the original purpose of policy action) is small: for example, a 20% unilateral cut in EC consumption achieves only a 0.7% cut in world consumption ; similarly, a 20% unilateral cut in OECD consumption achieves only a 2.8% cut in world consumption. It thus appears that unilateral action by industrial countries is largely ineffective in controlling global warming.

There are two quite distinct causes of this pessimistic conclusion. The first is simply the size of the coalitions' consumptions in relation to the world total. In WW's 1982 benchmark data, the EC accounts for about 15% of total world carbon energy consumption, and the OECD for about 50%; 20% cuts in each coalition's total will therefore represent only 3% and 10% of global consumption, to begin with. The second cause is the general equilibrium trade effect discussed earlier. Because there is free trade in carbon energy among all six regions, reduced demand for carbon energy imports in some of the regions causes a fall in world carbon energy prices, and hence increases in carbon energy consumption in non-coalition countries, which offset the coalition's savings. As can readily be calculated from Table 2, in the WW model these increases offset about 80% of the carbon energy saved by unilateral EC action, or 70% of the carbon energy saved by OECD unilateral action. If this is a reliable result, unilateral action will therefore succeed in curbing global C02 emissions significantly only if other countries are persuaded to follow suit and abandon any free rider advantage. The need for international coordination of policy action on C02 therefore appears to be acute.

However, the 70% result here differs dramatically from that in Perroni and Rutherford (1991), who find that the proportion of the C02 savings from a unilateral OECD carbon tax which is offset by rising energy use elsewhere ranges from about 2.5% to a maximum of less than 10%. This order-of- magnitude difference no doubt reflects the very different modelling assumptions that Perroni and Rutherford make about world energy markets, as well as different data on energy supply elasticities.5 A detailed comparison of the two models is not given here but one obviously important difference is that in contrast to WW's assumption of perfect competition and free trade in world energy markets, Perroni and Rutherford assume no trade at all in coal and gas,

5. WW note that the elasticity of carbon energy supply is a crucial parameter in their model, and show results for elasticities of 0. 1 and 1 .5 as well as the central assumption of 0.5 which is used here. Similar sensitivity analyses of the unilateral control results in Table 2 would be an important part of the further investigation that is needed.


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and "allow for upper and lower bounds on trade in oil and carbon rights. " This gives rise to significant regional variations in oil prices and implicit carbon taxes in both pre- and post-policy equilibria, and to much less sensitivity of oil prices in a non-controlling region to reduced energy demand in another region. Other features such as WW's lack of regional variation in energy intensities, and its assumption of no policy reactions by oil-exporting countries, may also be significant. One of the key results of this paper is therefore that further investigation is clearly needed into this large difference in such an important result.

There are several other noteworthy features in Table 2. Not surprisingly, unilateral EC carbon taxes cause production of non-carbon energy to rise, but there is a much larger fall in composite energy consumption reflecting much lower EC imports of carbon energy. Other goods production declines slightly, but production of energy-intensive goods declines much more. Translating these absolute changes into relative changes, note that unilateral action causes the EC's international competitiveness (defined as its share of world production6) to increase slightly in carbon energy production, and significantly in non-carbon energy production. EC competitiveness declines greatly in energy-intensive industries, but less so as the coalition applying the carbon tax widens; competitiveness in other goods production declines slightly.

However, the lower world price of carbon energy improves the terms of trade of industrialized nations and, together with substitution in consumption away from energy-intensive goods, this largely offsets any effects in unilateral scenarios of lower competitiveness on consumer welfare , as measured by Hicksian equivalent variations. The offset happens to be exact for the EC when the OECD applies the 20% consumption cutback. If control becomes universal rather than unilateral, and the whole world reduces C02 emissions by 20%, the terms of trade effect is strong enough for EC welfare actually to rise by 0.8%. So the EC and the OECD are "medium-sized" in relation to the rest of the

world: they are small enough to suffer lost competitiveness in some sectors if they apply unilateral C02 control, but large enough to offset any welfare losses by the general equilibrium effect of improved terms of trade.

CONCLUSIONS, AND DIRECTIONS FOR FURTHER WORK

Preliminary results using the multiregional, CGE model in Whalley and Wigle (1991b) suggest that unilateral C02 control by a coalition of countries such as the EC, or even by the whole OECD, will be largely environmentally

6. See Pezzey (1991, Chapter 2) for a detailed discussion of alternative definitions of competitiveness .



ineffectual because world C02 emissions (and hence global warming) are reduced by only very little, and sectorally disruptive because of reduced competitiveness in the coalition's energy-intensive industries, but harmless overall because the improvement in the coalition's terms of trade avoids, or even reverses, any welfare losses by its consumers. These conclusions, which reflect the fact that the greenhouse effect is after all a tragedy of the global commons, could be significantly altered in two main ways. Firstly, if induced technical progress results from higher energy costs, it could give the coalition's energy- intensive industries a first-mover advantage in world markets in the future, reversing the disruptive contraction predicted here for some sectors. Secondly, if the political effect on other, non-coalition countries of the leadership shown by unilateral action is powerful enough, such action could stimulate effective worldwide action to tackle the global warming problem. Further objective research on these issues is therefore a priority, but it will need very different approaches to the CGE modelling approach used here.

Meanwhile, improvements to the WW model which are obviously desirable for investigating unilateral policies are to improve the production data used, so as better to reflect technology differences between the six world regions; to model coal, oil and gas as separate sectors; and to include a wider range of ways of returning carbon or energy tax revenue to the economy, for instance as reductions in income or value-added taxes, as well as the lump sum refunds to consumers that are implicitly modelled here. Lastly, even with the existing model, it would be useful to do further calculations, analogous to those reported in WW's Table 7. 10, with elasticities of carbon energy supply different to the 0.5 value assumed here. The differences between the approaches of WW and Perroni and Rutherford would also benefit from closer scrutiny, particularly

with regard to which has the more defensible assumptions on the world trade in energy.

The first two features and a great deal else besides (such as a dynamic instead of static approach) are already included in the large GREEN model reported in Burniaux, Martin et al (1991), but results for the EC alone are not readily obtainable because GREEN uses the OECD Europe region rather than the EC. The third feature may be easier to include in a relatively simple model like WW's than in other more complex models because iteration will be required to find revenue-neutral combinations of tax rates and tax reduction rates, so

short computer run times will be an advantage. Allowing for different ways of returning carbon tax revenues will be of considerable policy interest since unilateral C02 control by the EC will probably entail, given the subsidiarity principle, freedom for individual countries to choose their own policy instruments.



REFERENCES

Bergman, Lars (1991). "General Equilibrium Effects of Environmental Policy: A CGE-Modeling Approach." Environmental and Resource Economics 1 (1): 17-42.

Burniaux, Jean-Marc, John P. Martin et al. (1991). GREEN - A Multi-Region Dynamic General Equilibrium Model for Quantifying the Costs of Curbing C02 Emissions: A Technical Manual. Working Paper No. 104. Paris: OECD Economics and Statistics Department (June).

Commission of the EC (1990). "Policy Options in View of the Community's CC^ Emission Stabilisation Target." Working Paper of the General Secretariat of the Council No. CONS/ENV/90/13. Brussels: European Commission (December).

Edmonds, Jae and David W. Barns (1990). Estimating the Marginal Cost of Reducing Global Fossil Fuel C02 Emissions. Richland, WA: Pacific Northwest Laboratory (September).

Glomsrod, Solveig, Haakon Vennemo and Torgeir Johnsen (1992). "Stabilization of Emissions of C02: A Computable General Equilibrium Assessment. " Scandinavian Journal of Economics 94 (1): 53-70.

Karp, L. and D.M. Newbery (1991). "OPEC and the US Oil Import Tariff." The Economic Journal 101 (March): 303-13.

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Nordhaus, William D. (1991). "To Slow or Not to Slow: The Economics of the Greenhouse Effect. " The Economic Journal 101: 920-37 .

Perroni, Carlo and Thomas F. Rutherford (1991). "International Trade in Carbon Emission Rights and Basic Materials: General Equilibrium Calculations for 2020." Waterloo, Ont.: Department of Economics, Wilfrid Laurier University.

Pezzey, John (1991). Impacts of Greenhouse Gas Control Strategies on UK Competitiveness: A Survey and Exploration of the Issues. Report to the UK Department of Trade and Industry. London: Her Majesty's Stationery Office.

Proost, S. and D. Van Regemorter (1991). "The Carbon Tax as Principal Ecotax: Implementation and Effects in the Case of Belgium." Leuven: Department of Economic Studies, Catholic University of Leuven.

Rutherford, Thomas F. (1989). "General Equilibrium Modelling with MPS/GE." London, Ont.: Department of Economics, University of Western Ontario (April).

Whalley, John and Randall Wigle (1991a). "Cutting COj Emissions: The Effects of Alternative Policy Approaches." The Energy Journal 12(1): 109-24.

Whalley, John and Randall Wigle (1991b). "The International Incidence of Carbon Taxes." in R. Dornbusch and J. Poterba, eds., Economic Policy Responses to Global Warming. Cambridge, Mass: MIT Press.


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