Fighting global warming requires ambitious global policies. To have a chance to keep world temperature under 2ºC and avoid severe consequences of global warming, carbon emissions need to be cut by a factor of four or five in the next decades. One of the preferred policy instruments to solve this climate externality is to impose a carbon tax on fossil fuel consumption: in the Pigouvian framework, one would set a carbon tax equal to the Social Cost of Carbon, a measure summarizing the cost of emitting one additional ton of CO2 due to future costs of climate change.
However, the world faces policy inaction. One of the main explanations is the presence of free riding in climate policy: the benefit of fighting climate change is global, while the costs of reducing emissions are local. As a result, countries have incentives to free ride on the rest of the world without implementing ambitious carbon policies themselves.
Moreover, this free-riding problem is exacerbated because the carbon policy has strong redistributive effects. First, it affects rich and poor countries differently as emerging economies face challenges in reducing fossil fuels necessary for their economic development. Second, different regions are differentially affected by global warming. Third, phasing out fossil fuels has a substantial impact on energy markets, affecting the surplus of energy producers. Lastly, imposing a carbon tax in one country reallocates economic activity and emissions toward other countries through international trade – called the “carbon leakage” effect.
The traditional answer to solve the free-riding problem has been to push for international cooperation through climate agreements, like the United Nations’ COP. More recently, Nordhaus (2015) suggested the idea of a Climate Club, a voluntary agreement in which members set a carbon tax on their emissions and impose trade tariffs on non-members. His argument is that trade sanctions are necessary to foster countries’ participation in a climate agreement.
In my paper, The Optimal Design of Climate Agreements, I am studying the optimal design of the climate club. I analyze what should be the optimal level of the carbon tax and tariffs, and the optimal choice of countries in the agreement.
This problem reveals a trade-off between an intensive and an extensive margin. At the intensive margin, we could design a small club with a high carbon tax and large individual emissions reductions. However, that would not be enough to stop climate change, as it requires reducing global emissions. In contrast, we could build a more extensive climate club with more countries, but that necessitates lowering the carbon tax to incentivize participation and prevent free-riding.
I am studying this question in a climate economy framework – or Integrated Assessment Model – with heterogeneous countries and international trade. I am accounting for many redistributive aspects of global warming and climate policy in a quantitative framework replicating many dimensions relevant to the countries’ decisions to join a climate agreement. I am solving the problem of a social planner or social designer who maximizes world welfare by jointly choosing the optimal level of the carbon tax and trade tariffs and the choice of countries when participation is endogenous.
In this setting, I find that the optimal climate club gathers all the countries in the world, with the exception of Russia and former Soviet countries. The optimal tax is $100 per ton of CO2, which is $50 lower than the globally optimal carbon tax when free riding is absent. Moreover, moderate tariffs of 50% are important to incentivize participation. In the figure, the participation of different regions is displayed as a function of the level of the carbon tax within the club and the value of the retaliatory tariffs against non-members. The higher the carbon tax, the higher the countries’ tendencies to deviate – creating a Laffer curve for carbon taxation due to free-riding incentives.
Figure: Participation in the Climate Agreement for different carbon taxes and tariffs.
As a result, we still need to lower the tax from $150/tCO2 to $100 because some countries would never joi
n an agreement regardless of the value of the tariffs. Indeed, the choice of joining the climate club relies on a balance between the cost of distortionary carbon taxation, on the one hand, and the cost of tariffs and gains from trade, on the other hand, which we know are bounded and small for many countries.
Consequently, reducing the carbon tax is key to inducing the participation of several regions, like Middle Eastern oil and gas exporters, or South Asia, which consumes a large share of coal. However, if one wished to include Russia and former Soviet countries, which are cold, large fossil fuel exporters, and relatively closed to trade, we would need to lower the carbon tax so much that it would not be enough to curb global emissions. Such an agreement allows for an increase in welfare by 5% and a reduction of emissions by 33%, despite free-riding incentives, which marks a pivotal breakthrough in the fight against climate change.
References
Nordhaus, William. “Climate Clubs: Overcoming Free-riding in International Climate Policy.”
American Economic Review 105, no. 4 (2015): 1339-1370. https://www.aeaweb.org/articles?id=10.1257/aer.15000001