Kyoto2 a framework for an effective, efficient, equitable Climate Agreement
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3. The Kyoto2 proposals

3.1 Introducing Kyoto2

The approach advocated in this paper unashamedly appropriates key features of existing and proposed approaches to carbon regulation, and re-assembles them into a new structure aimed at achieving the best of those approaches, while avoiding the problems.

The key ideas behind Kyoto2 are:

3.1 The Global Cap

The reason to set a cap on global GHG emissions is, simply that this is the only way to be sure that GHG emissions do not continue to rise as they may well do - even with other excellent policy measures in place - in the absence of a cap, as has happened under the Kyoto Protocol. The cap would need to be global as the global climate responds to global GHG emissions.

A series of annual caps reaching far into the future would need to be set by parties to the UNFCCC in order to facilitate the necessary long term decisions and investments. The caps should, once agreed, only be adjusted in the light of overwhelming scientific evidence as to the need so to do. It is envisaged that firm caps should be in place for a decade ahead, creating market certainty, while less accurate ranges would be defined for the years beyond.

Ideally the caps would be set in accord with expert scientific advice from the Inter-Governmental Panel on Climate Change (IPCC). The next challenge is then to determine how rights to emit GHGs should be allocated.

3.2 Auction

A broad base of economic theory, amply confirmed by empirical evidence, suggests that auction is the most optimal means of allocating a scarce resource with many competitive buyers. This approach tends to guarantee the best return to the seller, and allocate the resource - in this case GHG production Rights - to where it will be used to the greatest economic advantage.

In the matter of the form and process of auction, the arguments of Crampton & Kerr set out in 2.8 above are broadly accepted. The use of Ascending-Clock Auction seems entirely appropriate.

The question of a hybrid mechanism is also one to consider: that is a hybrid between the "quantity-based" auction (in which the quantity is limited) and a price-based system (effectively a tax which is at a fixed level). The economic theory of such hybrid instruments was first presented in 1976 by Marc Roberts & Michael Spence ("Effluent Charges and Licenses Under Uncertainty", Journal of Public Economics 1976) and was recently expanded by Cameron Hepburn (Oxford Review of Economic Policy Vol. 22 No. 2, summer 2006) in "Regulation by prices, quantities or both: a review of instrument choice" with specific application to environmental regulation.

In this scenario, the auction could be subject to floor and ceiling prices. That is to say, that if the auction price fails to achieve the floor price, the quantity of Rights on offer is reduced until that floor price is achieved. If the ceiling price is achieved, the quantity of Rights on offer is increased until demand is no longer sufficient to maintain the ceiling price.

The advantages of this approach are severalfold:

Any "excess" allocation of Rights in one year could be corrected in subsequent years by an equivalent reduction in quantity offered in future years. This may be justified since the greater than anticipated revenue would be invested in reducing demand for Rights in future years.

Such are the benefits of using a hybrid auction mechanism that this approach now forms part of the Kyoto2 proposals. However suitable floor and ceiling price levels have yet to be determined

A further key question is that of who would need to buy Rights, or at what stage in the GHG production chain audit and verification is to take place. The principle applied is to go upstream to reduce the number of control points. In the case of GHGs derived from the burning of fossil fuels, which accounts for most GHG emissions, the best points to use are at or close to fossil fuel production, such as coal-washing plant, or oil refinery. This involves a relatively small number of players each producing on a large scale, so greatly simplifying the task of ensuring regulatory compliance. This also avoids the need for carbon audit and accounting at subsequent points in the supply chain.

Accordingly the main auction participants needing to acquire Rights would be fossil fuel producers who would need to acquire sufficient Rights to match the carbon equivalent of their production. Secondary participants would be cement producers, the aviation industry and Potent Industrial Greenhouse Gas (PIGG) producers.

We also need to consider a further category of GHG emissions: those avoidable (excluding, for example, emissions from natural ecosystems) GHG emissions from non-industrial sources, such as

It is proposed that a proportion of the total GHG cap is allocated to National Governments to cover such emissions, on a per capita basis in accord with C&C principles. This would mean that poor countries would in general not need to find cash with which to purchase Rights at auction, but might even have a surplus for sale. All Governments would be incentivised to put in place policy measures for the reduction of their non-industrial GHG emissions, while also devising systems to ensure that the actual emitters, where possible, paid their share of the cost.

A key aspect of enforcement here would be a global network of strategically located monitoring stations, including satellite observatories, which would collect data on atmospheric levels of key GHGs and land use.

3.3 Trade

It is essential that Rights be tradeable in order that those holding surpluses be able to sell them to those in deficit, so ensuring their efficient allocation in a secondary market. Participation in both auction and secondary market should not be limited to any particular category of trader, in order to allow a trading system to develop similar to that existing in financial markets.

However it is proposed that the application of a small "Tobin tax" of under 1 percent should be considered for levy on secondary Rights trades to pay for the cost of administering the trading system and to yield additional revenue.

3.4 Regulatory questions

A number of regulatory questions will need to be addressed, for example:

It is proposed that:

However there is scope for debate on these points. See, for example, "Managing Permit Markets to Stabilize Prices" by Richard Newell, William Pizer, and Jiangfeng Zhang (Resources for the Future, June 2003), which establishes that the ability to borrow Rights from future years, subject to payment of interest (also denominated in Rights) can have a stabilising effect on markets.

3.4 Kyoto1 Flexibility Mechanisms

The Clean Development Mechanism (CDM - http://cdm.unfccc.int) and Joint Implementation (JI), the most important of the Kyoto Protocol's "flexibility mechanisms", have proved to be a powerful means of mobilising investment to reduce GHG emissions, from both fossil fuel and other sources. This is demonstrated by the number of Certified Emissions Reductions (CERs) expected to be delivered by 2012: 660 million, equivalent to reductions in CO2 emissions of 660 million tonnes.

However these mechanisms would play no direct part Kyoto2, since they rely on the differing status under the Kyoto Protocol of Annex 1 and other nations. Under Kyoto2 there is no such distinction and all countries are on an equal footing.

However that does not mean that organisations involved in the CDM / JI will not be able to put their experience and expertise to good use. There may also be opportunities to continue a re-configured CDM / JI if this is seen as desirable. First, let us consider the two forms of CDM / JI projects - those that reduce emissions from:

Energy and industrial projects

Under Kyoto2 the main incentive to stop burning fossil fuels, and to reduce production of other industrial GHGs, would come from the increased cost under the global GHG production cap. Any CDM / JI -like projects aimed at reducing fossil fuel consumption and other industrial emissions would, accordingly, have no effect on global emissions.

However they would achieve targetted reductions in fossil fuel demand, so reducing the price of fossil fuels within the cap - in effect, producing "Certified Demand Reductions" rather than the current "Certified Emissions Reductions" or "Emission Reduction Units" (ERUs). This would ease the transition process towards a lower carbon economy. In the case of projects targetted at poor people, it would also create social and economic benefits for them, helping to offset the impact of higher fossil fuel costs.

Funds might therefore be allocated from auction proceeds for the purchase of CERs / ERUs, not for any reduction in carbon emissions, but for the other resulting benefits.

Non-industrial projects

Under Kyoto2 National Governments would be responsible for avoidable GHG emissions not otherwise controlled, such as methane which is emitted from numerous and diverse sources. It would be advantageous for them to reduce their need for Rights - either reducing their need to buy them or producing a surplus from their allocation for sale. Accordingly there is scope for a market in which companies bring about such reductions by way of CDM-like projects - for example to capture methane emissions at pig farms. The Government of the territory in question might, for example, pay the company a proportion of the Rights saved. Or it might agree to the sale of the Rights liberated by such a scheme within its territory, and take part of the sale value as a commission.

3.5 Invest

Current carbon dioxide production from fossil fuels (2004, IEA) is 26,583Mt. If the current spot price for EU-ETS allowances (12.15/tCO2) is indicative of the price of GERs under Kyoto2 the sum realisable at global auction is 323 billion. However it is generally accepted that 20-25/tCO2 is sustainable. Even at the lower end of this range at 20/tCO2 we find that in excess of 500 billion per year could be raised.

Some would want these revenues to be redistributed directly to member states. If the funds were allocated to national governmments on a per capita of population basis this would be, in effect, an economically efficient implementation of Contraction & Convergence.

However this approach would neglect a substantial opportunity to address positively:

Accordingly it is proposed that a number of investments and expenditures be made from the sums raised from the GER auction. These should arguably include:

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