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Climate change policy and global trade (CCGT)

Exploitable results

For the baseline development, extensive data work has been performed. It had been decided to use the latest and updated version of the GTAP database. This change to the large GTAP5 database comprises the benefit that all partners will have access to an updated, GTAP5 based version of the model database. This will save time for all parties in future research. The new database includes the representation of post-Uruguay Round tariff rates, representation of the China and Taiwan WTO accession package, representation of the Multi-Fibre Arrangement /ATC phaseout (i.e. textile and clothing Non Tariff Barriers), applied and bound rates for bindings that were set by the WTO, macroeconomic projections, and price-cost markups for the implementation of imperfect competition.
If some world regions unilaterally constrain emission intensive activities, the associated changes in relative prices and shifts in trade patterns may increase emissions elsewhere, partially offsetting the primary emission reductions. This is due to three types of effects. First, in energy markets, tighter emission policies lead to a reduction of demand for fossil fuels and thus a price drop in world energy prices, which in turn leads to an increase of energy inputs and carbon emissions in other regions. Second, tighter environmental policies lead to a relocation of energy intensive industries. They move to less regulated countries, and emissions tend to be increased there. Third, there is a Heckscher-Ohlin effect: with tighter policies, domestic supply of energy-intensive goods is reduced; this leads to an increase in their prices, and to an increase in their supply by foreign producers, who increase their energy use. The simulation results, which were received with a stylised model, show that the leakage effect induced by the energy market is substantial, whereas the other two effects are rather small. The small impact of these other effects can be explained by the (empirically) low production elasticity of energy. Therefore, it is advisable to combine the taxation of domestic energy use with a subsidy on energy imports. This will lead to an increase of international energy prices and, thus, tend to reduce foreign energy demand. An instrument equivalent to the trade intervention is a tax on domestic production of fossil fuels. This would also raise world energy prices and mitigate leakage. Note that this policy recommendation to tax energy use and domestic supply of fossil fuels is in obvious contradiction to most national tax policies that subsidise domestic production of fossil fuels. On final-goods markets, the optimal instruments in the presence of leakage are import tariffs or export subsidies. Both instruments lower the world market price and reduce foreign incentives to produce energy-intensive commodities. It was shown that optimal tariffs on final goods markets are rather small. The reason for this result is the small size of leakage through final goods markets. The basic results carry over to the case of the non-competitive goods market, where leakage effects are very small, too. With respect to international environmental agreements like the Kyoto Protocol, it can be said that a stabilisation of such an agreement through trade restrictions is unlikely. However, as the above results make clear, import subsidies or export taxes should be in the self-interest of countries implementing greenhouse-gas reducing policies, and these instruments would probably not be interpreted as sanctions by non-compliant countries.
A qualitative analysis was performed on current and future trade liberalisation initiatives and agreements with a focus on regional integration outside Europe (ASEAN, AFTA, ANZCERTA, CACM, CARICOM, MERCOSUR, NAFTA) and on developments in world trade. One major finding was that intra-regional trade increases faster than world trade. In the literature there are two explanations for this phenomenon. One is the "natural factor of geographical approximity" (Krugman), the other the "artificial factor of preferential trade policy" (Bhagwati Panagariya). In order to capture different degrees of possible future liberalisation of world trade, four scenarios have been set up. The Business-as-Usual (BaU) scenario is specified according to the decisions of international agreements valid today. It includes regional agreements, WTO Uruguay round commitments and China and Taiwan accession. CLUB-A assumes further integration of the CEECs in the EU. CLUB-B is based on CLUB-A, but takes further trade liberalisation between the EU, Russia and Ukraine in to account. The GLOBAL scenario assumes fully liberalised world trade, in which all tariff and non-tariff barriers are abolished after 2010.
The significance of transaction costs for the flexible mechanisms JI, CDM and emissions trading have been analysed. Concerning the project based mechanisms (JI and CDM), it turned out that the factor that most determines the influence of transaction costs on the implementation of a project is the size of the project. For some projects, transaction costs amount up to over 1000€/ton carbon reduced, which proves the necessity of streamlining procedures, as recognised in the Marrakesh Accords. A reduction of transaction costs can be achieved through the bundling of projects, streamlining of information and the development of standardised procedures. For international emissions trading, it will be of high importance to build on experience with past national emissions trading schemes in order to keep transaction costs low. However, international trading schemes of the type envisaged under the Kyoto Protocol are likely to have significant issues, e.g. design of the permit allocation mechanism, that have not been addressed in the same way in previous national experience. This underlines the importance of operating a European permit market in order to get acquainted with such a system before the Kyoto period 2008-2012, since transaction costs are expected to decline due to learning effects. In addition to transaction costs, projects in different sovereign states may attract different risk premia, owing to the perceived level of risk of default or project failure due to micro-level or macro-level factors. Country risk premia have been determined, however, there is the need to determine project type risk premia in future research.
Simulation studies to investigate the economic effects of GHG abatement policies indicate substantial efficiency gains from where-flexibility. In particular, the developing world exhibits a large potential for low-cost abatement that could be exploited through the extensive use of the CDM mechanism, providing benefits to both industrialised as well as developing countries. Yet, many simulations neglect risks and uncertainties associated with project-based emission credits from the developing world, where risk refers to the possibility that the ex-post credits deviate from the ex-ante nominal value. Therefore, a quantitative assessment was provided for the question as to how investment risks implicit to CDM projects can change the economic impacts of GHG abatement. The results show that the sole incorporation of expected risks in CDM projects produces rather small deviations from the risk-free optimal abatement pattern even for ambitious Annex B emission reduction targets: Total efficiency gains slightly decline, whereas the share in domestic emission abatement for Annex B countries, with respect to their overall emission reduction commitment, slightly increases. Furthermore, the simulations provide an insight into the distributional consequences of risk to developing countries. The incorporation of risk makes high-risk developing countries worse off, whereas low-risk countries can gain comparative advantage by selling emission credits compared to a situation where risk aspects are neglected.
Simulations of Kyoto emission reduction configurations were performed in order to analyse the effects of US withdrawal from the Kyoto Protocol and the emergence of "hot air" on the FSU. In addition to this, results on market power in international emissions trading were presented. For competitive permit trade, the withdrawal of the U.S. would lead to a reduction of environmental effectiveness to zero. This is due to the fact that without the US demand for permits, the total permit supply (due to hot air from the Former Soviet Union) will exceed the total demand for permits. This will drive permit prices down to zero. However, as there are few suppliers for permits, it can be expected that they will use their market power. Monopolistic permit supply on behalf of the Former Soviet Union will assure some environmental effects of the Kyoto Protocol. It will drive up the permit prices compared to a scenario with competitive permit trade and US withdrawal. However, prices will still be far below the ones without hot air. The exclusion of "hot air" from the FSU would imply big welfare losses for Annex B abatement participants while producing poor environmental results because of high carbon leakage effects. Given FSU monopoly power, U.S. withdrawal provides some cost reduction to complying non-U.S. OECD countries because reduced overall permit demand drives down the permit price.
The Kyoto Protocol allows for the supplementary use of flexible instruments to exploit cheaper emission reduction possibilities elsewhere. Instead of meeting its reduction target solely by domestic action, countries can undertake projects within the framework of Joint Implementation or the Clean Development Mechanism. Concerning the modelling, the rationale behind JI/CDM and emissions trading is the same: cost-effectiveness requires that measures to limit greenhouse gas emissions should be taken where they are cheapest. It turns out that such programs provide a possibility for developing countries to equip their electricity industry with scarce capital goods, yielding large welfare gains through more efficient power production and lower electricity prices. The technology improvement for CDM countries leads to an increase in the capital stock especially in the electricity sector, a reduction of the electricity price, and a reduction of the productivity gap in the developing industries with respect to the developed regions. This leads to a substantial increase in welfare. This result may be important for ongoing negotiations, as it may help to reduce the developing countries� reservations against JI or CDM.
The modelling of imperfect competition is not only important for the goods markets, but also for the permit markets, as the considerations above already made clear. A distinction has to be made between intergovernmental and inter-source emissions trading. On the supply side, imperfect competitive supply behaviour seems very plausible for both cases, as the majority of inexpensive emission rights is concentrated in the Eastern European and former Soviet Union countries. It can be expected that even with inter-source emissions trading these countries will act as monopolists. On the demand side, however, competitive trade seems appropriate, as firms in OECD countries are allowed to take part in emissions trading, so that the number of participants will be large. Three scenarios are suggested for the analysis of imperfect competition on permit markets: one in which FSU and EEC coordinate their permit supply to maximise joint profits forming a sellers' cartel, one in which FSU and EEC constitute a duopoly competing in quantity and - the most realistic one- a scenario where only the FSU acts as a monopoly, whereas the EEC is treated as price taker.
The key effects from trade liberalisation can be divided into static and dynamic effects. Traditional theory emphasises static welfare effects. Perfect competition allocation effects on the sectoral level are trade creation, trade diversion and terms of trade effects. Both trade creation and trade diversion result from a fall in the market price as tariffs are abolished. With regard to the EU eastern enlargement, for example, the welfare effects from higher imports from the EU (as well as to the EU) will be captured by the trade creation effect. Its magnitude depends on the size of adjustment costs in the CEEC industries and distributional effects emerging from changes in factor prices. On the other hand, the availability of lower price imports from the new members of the customs union might cause trade diversion from the former supplier to the new member countries. Under imperfect competition, the reduction of tariffs leads to increased competition, which forces firms with market power that set prices above marginal costs down to competitive pricing. The reduction of the prices of foreign varieties will lead to an increase of varieties and therefore a better choice. Another source of gains from trade is the firm exit effect. Free entry drives profits to zero and with the opening of trade, some firms will exit due to negative profits. Fewer firms will then produce the same output with lower average costs.
The Eastern European Associates have committed themselves to reducing their emissions of greenhouse gases in 2010 according to their targets set in the Kyoto Protocol. Furthermore, since 1993, trade liberalisation has taken place between all associated countries and the EU as agreed in the Europe Agreements. In this study, the impacts of different environmental policies in the process of the EU enlargement have been analysed. The calculations show that large gains are at stake for the CEECs, while integration holds only modest efficiency gains for the EU member states. Integration shows very slight impact on environmental policies and marginal abatement costs. The price of the carbon penalty is almost unchanged. However, integration mitigates the welfare losses caused by environmental policy to a large extent. Under domestic carbon abatement policies, the EU energy intensive industry loses competitiveness, and accordingly energy intensive production rises in CEA and falls in EUR. This comparative advantage disappears with lower carbon prices under Annex-B trading and global trading. Carbon leakage rates mimic the effects of carbon abatement policies on energy intensive production. As expected, emission trading provides substantial benefits mainly to the main seller of permits i.e. the former Soviet Union and the central and eastern European associates. Those regions also benefit from further trade liberalisation. On the other hand, the welfare losses of the EU under the trading regimes are very small. Trade liberalisation even offsets part of it.
When national economies are linked through international trade, adjustments of economic activities in one country will spill over to other countries via changes in export and import quantities. The associated change in international prices implies an indirect secondary burden or benefit for all trading countries. General equilibrium effects have been decomposed in a way to reflect policy intervention in trade models. The decomposition splits the overall welfare effect into a domestic market effect, holding international prices constant, and international market effects as a result of changes in international prices (terms of trade). Decomposing the overall welfare effect into these component parts conveys important economic information as to why a country will benefit or loose from adjustments on international markets. The decomposition represents a general concept, is intuitively appealing, and its numerical implementation within the GE framework is straightforward. The usefulness of this decomposition approach was demonstrated in the context of an applied welfare analysis of international carbon abatement policies.
With an analysis for the GLOBAL scenario, it was examined whether after the extensive liberalisation and regional integration of the last two decades there is still potential for meaningful gains from the abolition of all duties on international trade. The answer is yes. The modelling results showed increasing values for welfare, GDP, employment, private consumption and investment on a global level, compared to BaU, with an increase of the trading activity. The main beneficiaries of full trade liberalisation would be the less developed regions, opposing arguments that these countries would be the losers of globalisation. They have positive changes in shares of value added for all sectors except for transport equipment. The biggest change is listed for the textile industry. These positive changes are mainly due to the expansion of trade within the less developed countries, as the biggest increase of trade is in this part. The evaluation of the sectors shows that the more "traditional" sectors such as textiles, agriculture and food register the highest increases of up to 8% change in global value added, compared to an average of 4% for the other sectors. A positive relation between abolished tariff rates and global value added changes is given. With regard to CO2 emissions, the simulation results showed an increase of emissions. However, the evidence obtained from the analysis so far does not suggest that trade liberalisation or more perfect competition enhance or impede significantly the ability to abate.
The modelling framework used for the analysis is a multi-regional and multi-commodity computable general equilibrium model. In comparison with partial equilibrium models, this model has the advantage that it includes market spillover and feedbacks and has closed income cycles. Different degrees of trade liberalisation, various assumptions on capital mobility and imperfectly competitive markets are incorporated into this model. The CCGT model is a comparative-static model and measures the costs of implementing Kyoto as compared to a BaU reference point in 2010 in which no emission requirements exist. Benchmark data is obtained from the updated GTAP5 database, providing input-output tables and bilateral trade data. The GTAP-disaggregation uses 57 sectors (20 of which are food and agricultural sectors, 22 are manufacturing sectors and 15 services sectors) and 66 regions (including 16 European countries and -new to GTAP5- an explicit representation of Hungary and Poland). The energy sector distinguishes between coal, oil, gas, electricity and refined oil products. The forward calibration is targeted to the year 2010 (as this is the central year of the Kyoto commitment period). It combines baseline estimates for GDP growth, energy demand and future energy prices as given in the International Energy Outlook with information on trade restrictions as described above.
In order to account for industrial organisation effects, a model featuring imperfectly competitive supply behaviour and increasing returns to scale is required. Yet, once the clear-cut world of perfect competition is abandoned, a vast range of a priori plausible alternative specifications of firm conduct and market structure crops up. A synopsis of alternative specifications of imperfectly competitive supply behaviour was provided. Intra-industry product homogeneity across firms was considered, as well as intra-industry product differentiation. Moreover, it was distinguished in both cases between (i) Bertrand- and Cournot-type behaviour, including conjectural variations extensions of each, (ii) international market integration and market segmentation regimes, and (iii) alternative assumptions about agents' preference relations among goods of different regional origin. A sensitivity analysis was performed using a miniature prototype model. The results made clear that the important factor for the model implementation is not the choice of the "right" oligopolistic model, but rather the careful calibration of the substitution elasticities. This result was confirmed by model simulations that used the same elasticities in different models of oligopolistic interaction. From this, the practical implication can be derived that it is more important to give careful consideration to the numerical specification choices at the calibration stage than to perform extensive structural sensitivity analyses across a wide spectrum of different oligopoly models within the large-scale model.
The international climate change agreement that is dealt with in the project is the Kyoto Protocol, which was set up in 1997. In this protocol, the industrialised countries agreed on a reduction of their emissions by a fixed percentage of their emissions in 1990. These reductions will have to be made over the period 2008-1012. In march 2001, the U.S. declared their withdrawal from the protocol, reasoning that the costs to the U.S. economy would be too high and exemption of developing countries from binding emission targets would not be acceptable. As the agreement is to enter into force only if it has been ratified by at least 55 countries, and if the ratifying countries have contributed at least 55 percent of the industrialised world's CO2 emissions (the most important GHG) in 1990, the U.S. withdrawal provided a great deal of bargaining power for some countries. This played an important role in such open issues as sink credits and the selling of surplus emission rights (hot air) and led to very generous settlements on these points. There have, for example, not been set any concrete caps on the share of emissions reductions a country can meet through the purchase of permits from other industrialised countries, nor on the amount of permits it can sell. This means, that Russia, Ukraine and Eastern Europe will be able to sell all their hot air, which would reduce the environmental effectiveness of the Kyoto Protocol to zero, as the supply of permits would exceed overall demand. However, as there are so few sellers, it is highly probable that they will use their market power, which would lead to an increase of the permit price as well as real emission reductions, compared to a scenario with competitive permit markets.