Cooperation to reduce developing country emissions

Suzi Kerr (Motu) and Adam Millard-Ball (McGill)

Motu climate change economics workshop, March, 2012

The challenge• We need DCs to mitigate to meet targets• We want DCs to mitigate to lower costsBut• DCs have insufficient concern and capability /

capacity • Need to transfer resources• Existing instruments – e.g. offsets - have serious

flaws

How can we do better?

Outline• Cooperation within a repeated game• Mitigation instruments• Challenges• Straw man• Future Research Directions

Gains from cooperation

MICMDC

H

MBDC

MBIC

MBIC+DC

MCICMCDC MCIC+DC

Most gains to industrialised countryMost cost to developing country

Can we achieve this?• Nash equilibrium (e.g. Barrett) very negative• More optimistic in a repeated game

– Experimental evidence that people are altruistic and conditional cooperators – states?

– Good monitoring, low discount rates make cooperation possible

– Some countries will lead to generate trustbut

– Bargaining will generate delay – difficult to identify bargaining space and agree on an equilibrium

• Need flexibility in cost sharing to find mutually beneficial deals.

A Continuum of Mechanisms

6

Tradable creditsE.g. CDM

Grants and loansE.g. GEF

GHG reductions only

Integrated with cap-and-trade

Results based

Ex-post monitoring and payment

Broader development goals

No link to cap-and-trade

Effort based

Ex-ante assessment and payment

Non-financial approaches: technology transfer, capacity building

Common Challenges

• Leakage• Adverse selection• Risk and moral hazard• Incomplete contracts/underinvestment• Negotiation• Integration with cap and trade

Most challenges apply to all instruments on the continuum, not just offsets

Adverse Selection

• Information asymmetries between ‘regulator’ and offset provider combined with voluntary participation

Adverse Selection

Adverse Selection• Considerable evidence that adverse

selection is a major problem in CDM• Admissions by project developers• Manipulation of Internal Rate of Return• Non-credible claims about barriers• Implausibility of aggregate claims• Simulation / econometric models• Technology diffusion models

Adverse Selection

Possible solutions:• Reduce private information• Conservativeness and discounting• Adjust the cap or fund size – or give

up and reward all• Scale up

• e.g. Domestic cap and trade in DC with binding cap

Risk and moral hazard

baseline

response

emissions

baseline

response

emissions

Baseline risk1. Improve baseline2. Allow baseline to

change• If fn(DC action) leads

to moral hazard

Moral hazard: when contract is insufficiently precise (possibly because of unobservable effort) so that what the parties explicitly agree to do in the contract is not exactly the intention of both parties.

baseline

response

emissions

Response risk

3. Improve responses4. Reward actions rather

than emissions• Offset cost of actions• No incentive for

‘invisible’ actions

Other risk management options5. Industrialised country direct investment

• IC takes some response risk• If brings extra resources makes response

larger and reduces relative baseline risk

6. ‘No loss’ baselines• Removes risk of absolute liability only• Makes effective price θp – where θ = prob

of reward• Response is lower and relative risk higher.

Hold-up and underinvestmentEffective mitigation requires:

• long-term investment, • innovation, • policy change and • structural change

Once investments are made, the DC has little bargaining power during renegotiation

they will be unwilling to invest.

Solutions to hold-up

1. IC makes direct equity investments in mitigation• Directly addresses under-investment• Bargaining becomes more balanced• Commitment is visible so less under-

investment• Has benefits for risk sharing also

2. Build IC credibility for cooperation

Straw man1. Monitor (and model to assess effort)

2. Differentiate policies depending on the DC

For ‘strong’ countries – based on governance not income• Agree (bi- or multilaterally) combination of

target/pledge and investment package• Pay (in cash or tradable credits with

commitment to purchase) relative to target

For ‘weak’ countries• If possible create regional or sectoral targets

with results-based agreements• Invest in policy, technology, capital and

infrastructure• Try to get maximum benefit for funds• Be clear about aid objectives• Do not link to cap and trade markets• Make graduation to national emissions

contracts attractive • Internalise carbon costs from IC end –

through capital and consumer markets

Future Research DirectionsPotential

• Model realistic mitigation instruments rather than ideal

Leakage• Estimates of intertemporal leakage/persistence

Future Research DirectionsRisk and additionality

• Better estimates of real uncertainty in emissions projections for DCs and the drivers of that uncertainty

• More out-of-sample tests of predictions

Integration with cap and trade• Evaluate costs and benefits of linking markets

under uncertainty

Future Research Directions

Develop new mitigation instruments• More rigorous evaluation of actual mitigation

investments and policies in developing countries• Theory-based design and simulation of complete

policies under uncertainty• ‘Experiments’ in small countries/regions