Financing mechanisms

Three instruments to finance the South's incremental costs beyond its obligation-to-pay have been canvassed widely. These are carbon taxes, traceable permits, and trade in abatement services. Below, I examine the role that each might play in transferring financial resources on a large scale.

The reader should note that I treat all three mechanisms as a means to an end: each of them is a way to ensure that reduction targets are achieved at least cost, from a global perspective. Minimizing the global cost of reduction (that is, efficiency) per se is not the overriding priority in this study, however. Rather, I aim to see how carbon emission reductions might be achieved efficiently in an equitable carbon reduction strategy. Equity has been defined here with respect to an overarching goal, the creation of a strategy to achieve the necessary emission reductions in accordance with obligation-to-pay as defined above. Taxes, permits and trade, therefore, are enlisted to minimize the costs of promoting an equitable and ecologically sustainable emissions strategy. As is proper, means have been subordinated to ends - however strange this relationship appears to some in the economic profession.

The reader should be alert that the numbers that follow are indicative and are used to explore the contours of the terrain rather than to provide precise answers. The results should not be interpreted as the 'real' figures. In short, I aim only to sketch the landscape rather than to produce a map with pinpoint accuracy.

Carbon tax

Many analysts have explored the possibilities of using a carbon tax to reduce demand to accord with emission quotas or an emission target. Here, I do not examine the pros and cons of different levels and types of carbon taxes. Rather, I determine the level of carbon tax in the North that would raise the necessary revenue needed for the transfer to cover the costs of the South that are the North's obligation-to-pay.

Carbon tax transfer

A. Assuming high abatement cost curve and redistributed cost, case 1 (billions $)

Annuity of North-South transfer according to obligation-to-pay index = 34 billion/ year
Net present value of carbon tax on projected northern emissions to finance the transfer annuity, after north has achieved own required reductions = 518 billion
Annuity of carbon tax revenue to fund transfer = 34 billion
Carbon tax level to achieve transfer annuity = 13$/T-C emitted

B. Assuming medium abatement cost curve and redistributed cost, case 3 (billions $)

Annuity of North-South transfer according to obligation-to-pay index = 29 billion/ year
Net present value of carbon tax an projected northern emissions to finance the transfer annuity, after north has achieved own required reductions = 445 billion
Annuity of carbon tax revenue to fund transfer = 29 billion
Carbon tax level to achieve transfer annuity = 11 $/T C emitted

Table 6.2 UN scale of payments

Column one does not sum to 100 per cent due to rounding error and errors in source data
Source United Nations, Administrative and Budgetary Coordination of International Atomic Energy Agency, A/45/798, November 27, 1990, pp 23-27

In the box opposite, I show the carbon tax needed in our scenario to raise the revenue in the North to finance the transfer to the South. To calculate the tax, the North's total 'post-reduction' emissions (projected emissions minus required reductions, in the efficiency scenario in Chapter 5) are multiplied by the tax rate per tonne of emitted carbon in each year. The carbon tax that amasses an annuity based on the present value of this stream of future tax revenues, that equals the transfer implied by the obligation-to pay indice, is the tax adopted.

Two tax levels are derived, one for the high marginal abatement cost, Case 1, and one for the medium abatement cost, Case 3. (Each case generates a different estimate of the target transfer annuity, namely, $34 and $29 billion respectively). Carbon taxes of between $13 and $11 per tonne of carbon emitted achieve these target annuities. These tax levels are quite small compared with the carbon taxes that are computed by economists as necessary to dampen carbon emissions to a significant degree (according to which taxes of $20-120/T-C abated are required for reduction ratios of from 20 to 80 per cent).

Tradeable permits

Many analysts have argued for traceable permits instead of or to supplement carbon taxes. Based on limited US experience, traceable permits are argued to create flexible market incentives to reduce emissions at low administrative cost and lesser social cost. The system requires that total emissions be limited or that a cap be placed on the total number of permits issued. A mix of buyers and sellers must also exist with access to markets for permits. Trade must not be allowed above the total limit or without permits if permits are to maintain their value.

In principle, traceable permits favour technological innovation due to the continuing incentive for users to avoid having to pay for additional permits. Tradeable permits would permit states to enter voluntarily into an arrangement whereby one reduces its emissions in return for value provided by another which continues to emit, provided the sum of the two national limits combined is not exceeded. Whereas the major deficiency of a carbon tax is that policymakers will not know the tax level needed to achieve a given reduction level, a major inadequacy of a traceable permit system is that the price of the permits - and thus the cost of achieving limits on emissions cannot be determined in advance. The initial allocation of traceable permits as well as the administrative and enforcement mechanisms needed to implement a global regime based on permits (in the absence of world government) are two other major difficulties with the scheme.

I do not address the political feasibility of allocating permits in this study, although I did suggest a combined set of criteria in Chapter 5 with which to set a limit on national emissions. Thus, the cap on emissions was determined by setting emissions at a target level that was defined as 'sustainable' in terms of atmospheric carbon concentration and rates of temperature and sea level rise. I assume here, therefore, that the South is simply issued with an additional amount of saleable emission permits over and above those needed to meet its target required reduction trajectory (that is, it received en 'excess entitlement' that it can sell without being required to offset each sale with equal and additional abatement in the South); and that the same volume of emissions are deducted from the North's permits, forcing the North either to abate emission further, to meet its reduction targets, or to buy permits from the South.

I suppose further that the North would only buy permits from the South when a major price differential makes it attractive relative to its own marginal abatement cost in a given year of the abatement scenario. The upper limit on the permit price is set therefore by the North's marginal abatement cost. In principle, the South could sell excess permits at any price below that upper limit as it obtains marginal rent for any price above zero. (Of course, the lower the price, the more sales are needed to generate the requisite financing of the South's 'excess' incremental costs relative to its obligation to pay.) However, I assume that the South sells its permits only when the price offered is above its own marginal abatement cost, thereby setting a lower limit for the permit price.

This assumption reflects my belief that the supply of low-cost abatement in the South is not unlimited, and that development pressures in the South will push it to exceed its own emission permits in our abatement scenario. Thus, even if it is allocated 'excess permits' et the outset, the South may have difficulty in financing its requisite emission reductions via traceable permits because each 'excels' permit that it sells incurs an opportunity cost worth its own marginal abatement cost. For illustrative purposes, the permit price is assumed to settle at the South's marginal abatement cost plus half the difference between the North's and the Souths' marginal abatement cost in any year in the scenario.

Tradeable permits, Case 1
In Figure 6.4,1 show the high marginal cost curve from Case 1 in Chapter 5 in which the North and the South face the same shaped curve, but travel over it at different rates due to divergent required reduction ratios in each year.

In Case 1, both the North and the South pay the same $50/T-C abated until 1997, so I assume no trade in emission permits before this year. (It is as cheap for the North to reduce another tonne of carbon emissions as it is to buy a permit to emit that tonne from the South). But then the North moves up to $160/T-C abatement cost while the South remains at only $50/T-C abated until it too attains $160/T-C abated in 2002 when it reaches the 20 per cent required reduction ratio. From 1998 to 2002, therefore, I posit that the price of a permit to emit carbon will fall half way between the South's ($50) and the North's ($160) marginal abatement cost - that is, at $105/T-C emitted.

Figure 6.4 Tradeable permits transfer, Case 7

Sales fall to zero over the next two years as the cost curves have converged at $160. Then in 2004, the North moves rapidly up to a $250/T-C-y^-1 abatement cost passing a required reduction ratio of 50 per cent. Consequently, the permit price increases to halfway between the North's own marginal abatement cost and that of the South ($160/T-C-y^-1 abated) or $205/T-C emitted. As the South's cost never exceeds $160/T-C-y^-1 abated in the rest of the scenario, the permit price does not change thereafter.

Having determined the permit price path, it is possible to derive the volume of permits that must be sold to finance the transfer annuity to the South. The volume of permits that generates a present valued stream of traceable permits sold at the posited, upwardly ratcheting permit prices that equals the transfer annuity of $34 billion is 280 million tonnes per year in each 'trading year' (see box, page 161). Relative to the North's average annual required reduction of 1.7 billion tonnes per year in our abatement scenario, Case 1 offers a plausible way to transfer resources to the South required to effect its abatement commitments.)

Tradeable permits, Case 3
Case 3 is a little more complicated as the North and the South are on different cost curves, but the principle is the same. The North's abatement cost is far below that of the South until 2004 when the North's required reduction ratio reaches 47 per cent and its abatement cost jumps to $294/TC-y^-1 abated well above the South's $77/T-C-y^-1 abated (which it never exceeds in the rest of the scenario). At the 'split the difference' permit price of $147/T-C-y^-1 emitted, about 200 million tonnes of permitted emissions sold each year by the South to the North would fund the obligated annual transfer of $29 billion (see Figure 6.5). However, unlike Case 1, the underlying cost curves in Case 3 ensure that no trade occurs for the first decade, indicating that traceable permits may not set in motion a scheme that achieves transfers justified by the obligation-to-pay indice - an essential characteristic of a workable scheme.

Figure 6.5 Tradeable permits transfer, Case 3

Tradeable permit transfer, Cases 1 and 3

I. Tradeable permits, case i, high cost curve

Annuity of North-South transfer according to obligation-to-pay index, assuming
Nordhaus cost curve in all areas = 34 billion/year
phase 1:^a North and South have same marginal abatement cost, no trade between 1995-1997
phase 2:^a North buys South's abatement between 1998-2002 at $80/T-C abated
phase 3:^a North and South have same marginal abatement cost, no trade between 2003-2004
phase 4:^a North buys South's abatement between 1998-2002 at $205/T-C abated

Volume of sales to reach annuity of transfer according to South's obligation-to pay = 290 million T-C/year Net present value of sales at this level = 516 billion Annuity of sales at this level = 34 billion/year

II. Tradeable permits, case 3, medium cost curve in South, low cost curve in North/East

Annuity of North-South transfer according to obligation-to-pay index, assuming medium cost curve in South, low cost curve in North/East cost curve in all areas
= 29 billion/year

phase 1:^a marginal abatement cost in North is less than in South, no sales by South to North
phase 2:^a North buys South's abatement between 1998-2025 at $147/T-C abated

Volume of sales to reach annuity of transfer according to South's obligation-to-pay = 250 million T-C/year Net present value of sales at this level = 443 billion Annuity of sales at this level = 29 billion/year
a See Figures 6.4 and 6.5

These two cases demonstrate how the relative cost curves drive the hypothetical North-South trade in permits. It is likely that a big relative cost difference would impel massive innovation in carbon abatement technologies in the North if the South's abatement costs set the price of traded permits well above the North's marginal abatement cost. If the North's and South's marginal abatement costs are approximately equal, trade will be very slow. Either way, however, the fact that the North's marginal abatement cost eventually greatly surpasses that of the South suggests that buying permits from the South would become increasingly attractive to the North.

How exactly the market would operate and where the clearing price would settle would depend on the rate of innovation driving down the permit price, and the oligopolistic behaviour of the rent-seeking southern owners of the permits and monopsonistic behaviour of the rent-avoiding northern buyers.)

Emission abatement services

Another possible financing technique involves the South selling low cost abatement services to the North. This scheme assumes that the South has a large stock of inefficient energy-using equipment in its buildings, industries, and transport systems plus forestry related carbon fixing potential that exceeds its own responsibility to reduce emissions. This 'surplus' abatement potential endows the South with cheap abatement options relative to those in the North. Ironically, the highly wasteful energy economy of many southern states endows them with competitive abatement opportunities if an international market can be created for such activities.

Such services can be provided by private entities and do not require interstate agreement as is usually assumed to be required for traceable permit schemes. (Indeed, the first such project by a US utility which invested in carbon fixing reforestation in Guatemala, was led by private organizations.) Rather, it requires: (1) that abatement targets be adopted by states and that these states devolve responsibility to meet the abatement commitments onto public and private entities within these countries; and (2), that parties to the Convention adopt rules recognizing that abatement paid for by such an emission-reducing entity, but achieved at a saving relative to its own abatement costs in another country, can be debited from the emissions of the investor's country.

Here, I determine the volume of abatement services that would have to be sold by the South to the North to finance the South's incremental costs. Table 6.3 shows the calculation for the high and medium marginal cost curves used to calculate the transfers.

The abatement services market would be analogous to that in traceable emission permits. Polluters seeking a cheap abatement option relative to either the emission permit price or their own abatement cost would bargain with sellers of abatement services over the cost savings represented by their marginal abatement cost differential. However, abatement prices would be pegged to only this cost savings rather than the North's total marginal abatement cost. Thus, a smaller value is obtained by the South from the North for each sale of a tonne of carbon abatement versus a tonne of carbon permitted emission. Here, I posit that the abatement services price would settle at half the difference between the North's and the South's marginal abatement cost in our scenario.

In the high cost, Case 1- when the North and the South start out on the same cost curve - there is initially no cost difference, followed by a four year stretch of relative cost advantage to the South and a subsequent twenty year stretch of even greater advantage after 2005 (see Table 6.3).

Table 6.3 Abatement services transfer, Cases 7 and 3

A. CASE 1, HIGH MARGINAL COST TRANSFER OF 34 BILL $/Y Sale of Abatement Services to fund North's Transfer to South, and N-S transfer = l/2 price difference at time of sale

A1. Assume sale occurs when MCsth<MCnth, and transfer = 1/2 of versus North, with saving split 50:50 between North/South

A2. Annuity-OTP N-S Transfer = 34.0 Bill$/y

A4. Required Sales to generate Annuity OTP? NPV trade 523.2 Annuity Trade 34.0 Sales volume = 1.2 BillT/y

A5. Total South Req Reduction is only 24.7 Bill T C 1995-2025
A6. Trade to fund total transfer 1995-2025 is 30 y x sales/y = 35.9 Bill T C 1995-2025
or 1.5 times South's required reduction over same period

B. CASE 3, MEDIUM MARGINAL COST TRANSFER OF 29 BILL $/Y
Sale of Abatement Services to fund North's Transfer to South, and N-S transfer
= 1/2 price difference at time of sale

B1. Assume sale occurs when MCsth<MCnth, and transfer = 1/2 of versus North, with saving split 50:50 between North/South

B2. Annuity-OTP N-S Transfer = 29.0 Bill$/y

B4. Required Sales to generate Annuity OTP?

B5. Total South Req Reduction is only 24.7 Bill T C 1995-2025
B6. Trade to fund total transfer 1995-2025 is 30 y x sales/y = 30.0 Bill TC 1995-2025
or 1.2 times South's required reduction over same period

With the price trajectory specified, the volume of abatement services needed to fund the South's annual 'excels' incremental cost of $34 billion can be calculated. After discounting and annuitizing the volume of trade at the posited prices, the required sale of abatement services is no less than 1.2 billion tonnes per year. Thus, the South would have to find more than 150 per cent more abatement potential than its own required reduction at these relatively low costs over the thirty year scenario. Applied to the medium cost, Case 3, the same method demands only a slightly smaller volume of trade to achieve the smaller obligated funding in the South of $29 billion.

It is apparent that unlike traceable permits - and granted all the assumptions stated earlier as to the South's net profit earned on sale of abatement services the sale of abatement services cannot be relied on to finance the whole of the South's 'excess' incremental costs. It is highly unlikely that such large volumes of abatement opportunities exist in the South, abatement that must be achieved to the credit of other nations and over and above the reductions required on the South's own behalf. However, the forestry related carbon fixation opportunities in the South (either forestry maintenance or reforestation) may be much greater than those obtained by abating carbon dioxide from fossil fuel, and entrepreneurs may identify many new ways to provide competitive abatement services in the South.

I conclude that trade in abatement services - especially if supplemented by a scheme related to the South's forestry carbon fixation - would be useful within and between states in responding to emission limits or targets. Northern marginal abatement costs will also increase faster in the North than in the South as Northern states move up the required reduction curve calculated in Chapter 5 (see Figure 5.11). With each year that passes, therefore, it is likely that the price of traceable permits and abatement services will increase substantially, offering increasing opportunities for the South to reap benefits from their initial endowment of traceable permits that could thereby finance their own required reductions.

Using these instruments in combination to implement a global carbon reduction strategy may also be productive, as would introducing them at different phases of a strategy. Carbon taxes might be spent best at a national level, thereby stimulating a new wave of technological innovation and driving down the marginal cost of abatement for everyone. Trade in abatement services might be used effectively early on in a reduction strategy to enable the North to take advantage of lower marginal abatement costs in the South, even if the South has few or no excess permits. And traceable permits might be used later rather than earlier, thereby avoiding the possible perverse outcome that the South would self 'excels' emission rights at the outset of a reduction strategy to finance development that expands greenhouse emissions - which is what the world is trying to avoid.