A Strategic Explanation for Unilateral GHG Regulation

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Peter Davis (10593)

2 Introduction: As the international climate conference in Copenhagen approaches, the difficulty of negotiating and implementing a comprehensive international agreement for climate change mitigation has become apparent. There has been considerable progress over the last decade towards the formation of an international climate protection regime. However, for those who see climate change as a cataclysmic and potentially irreversible crisis, progress at an international level has been frustratingly slow. This frustration is often perceived to be the driving force behind the proliferation of numerous national and sub-national climate change mitigation policies. The causes and impacts of sub-global voluntary action to reduce the emissions of greenhouse gases (GHGs) is increasingly a subject of interest to social scientists. Whether these programs will ultimately have a significant and durable impact on climatic change depends on the underlying rationale that is driving their development. If these programs are irrational anomalies, as they are sometimes depicted by the economic literature, then they might be predicted to peter out as their costs rise. If, however, these programs are locally rational—not requiring costly philanthropic behaviour—then these programs might be dynamically stable or even dominant. The first contribution of this paper to the existing literature is to formally model a category of individual behaviour that directly or indirectly reduces the individual’s GHG emissions. The behaviour of interest in this paper is the decision to divest from long-term capital stocks that might be exposed to regulatory risks under a global climate change regime. The divestment behaviour explained by this model is reinforced by ancillary benefits to the investor from emissions reductions, and by a signalling effect, which can help investors resolve the principal agent problem. The second contribution of this paper extends the results from the private sector to consider the implications for local and regional public policy decisions. This section introduces the possibility of local ancillary benefits from GHG emission reduction. Alone, these benefits from emission reduction could justify limited local climate protection programs, especially if other regions have enacted similar programs. But,

3 if the private sector is known to deal poorly with systematic risk and long time horizons, then the local public sector has an even greater incentive to intervene. The conclusion of this analysis is not that decentralized GHG regulation is a substitute for a comprehensive climate change regime. Because of carbon leakages, these unilateral initiatives will have a limited direct impact on short term global GHG emissions. Nonetheless, decentralized GHG regulation is a significant and growing phenomenon. As the proliferation and intensification of decentralized GHG regulation gains momentum these programs can be expected to have an increasing impact on country level payoffs from an internationally negotiated regulatory regime. Furthermore, in a finite world, the carbon leakages from a marginal regulator can be expected to decrease as the proportion of regulators increases. For these reasons, decentralized GHG regulation is nontrivial; rather it is the driving force of global climate change mitigation.

Literature Review: The majority of political and economic scholarship on climate change mitigation deals with the issue of negotiating, implementing and enforcing a comprehensive international regime. Contributions to this debate generally focus on the problem of designing an efficient, yet feasible, mechanism for achieving a socially optimal level of GHG emissions: one which distributes costs and benefits ethically and efficiently across space and time. The emphasis on the international level has overshadowed a marginal scholarship on the local decision making processes that can directly, or indirectly, influence GHG emissions and global climate change negotiations. Even among economists who consider unilateral regulation, it is commonly argued that local action to reduce GHG emissions will have negligible, or even perverse, effects on aggregate global emissions. This argument is formalized by Hoel (1991). The game theoretic model Hoel uses is two representative individuals who make decisions regarding a purely public good, given the expected responses of the other individual. The conclusions of this game theoretic approach to public goods were strongly pessimistic for unilateral emissions regulation.

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Not only would the degree of unilateral regulation be below the globally optimal level, but the effects of unilateral emissions reduction on global emissions would be diluted by international carbon leakage. Hoel also argued that unilateral emissions reductions would reduce the bargaining power of the regulating country in international negotiations, thereby diluting the future global regulatory regime. Hoel’s bargaining power argument is perhaps an oversimplification of the process of international negotiations and that allowing for costly punishment can strengthen the unilateral regulator’s bargaining position. On the subject of carbon leakages, however, a number of empirical studies demonstrate the significance of this phenomenon. In a simulation, Felder and Rutherford (1993) found that marginal leakages to be in the order of 25 percent. Babiker (2005) empirically measured carbon leakages and found them to as large as 50 to 130 percent. Weiner (2006) attributes such large leakages to the unexpectedly fast shift of emissions towards Asia. This shift is visually presented below in Figure 1, while Figure 2 shows the insignificant impact of European regulation on global GHG emissions.

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Figure 1: Global CO2 Emissions Centre of Gravity (1970-2005)

Figure 2: The Impact of European Emission Reductions on Global Emissions Nonetheless, the last decade has seen a proliferation of unilateral actions to reduce GHG emissions. Since its inception in 1993, the Cities for Climate Protection (CCP) campaign has grown to involve more than 650 local governments, representing 15 percent of global GHG emission.1 Lutsey and Sperling (2008) estimated that 53 percent of the U.S. national population lived in a state or city that had a target for GHG emission reduction in 2007. In China, plans are underway for a new city of half a million people in Dongtan that will generate zero contribution to global warming (Keohn, 2008). Further evidence of the scale of unilateral actions is available from a number of sources including Rabe (2004), Betsill and Bulkeley (2004), and Collier and Löfstedt (1997). Given that unilateral GHG emission reduction will not have a significant, or could even have a perverse, effect on the level of global GHG emissions; how can the

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6 proliferation of unilateral actions be explained? There are two categories of solutions to this puzzle. The first category of solutions specify that for unilateral climate change action to be rationalized it must have an expected impact on global GHG emissions. These solutions take two forms possible forms: individuals could have systemically incorrect expectations; or individual behaviour could have indirect impact on global GHG emissions through influencing the behaviour of others. These solutions require either that unilateral actors be purely irrational agents, or quasi-rational normative agents. Schreurs and Tiberghien (2007) present such a solution to the puzzle of consistent European Union leadership in climate change mitigation. The second category of solutions specify that for unilateral climate change action to be rationalized it must have an expected utility benefit to the actor, regardless of the impact on global GHG emissions. Do individual actors have an incentive to reduce GHG emissions, independent of the climatic impacts of these actions? And do cities and regions have an incentive to regulate GHG emissions in the absence of an international climate change regime? A solution to the puzzle of unilateral GHG regulation that falls within the category of individually rational behaviour is much more desirable than a solution that falls in the category of quasi-rational behaviour. Quasi-rational behaviour fails to resolve the free-rider problem, because the appearance of emissions reductions can be as effective as actual reductions. transformations. A purely rational explanation for unilateral emissions reduction is one that, in evolutionary terms, improves the fitness of the unilateral actor. In evolutionary models, a behavioural strategy which improves the fitness of an individual can be expected to be dynamically stable, or even dominant. If this is the case for unilateral climate change action, then this behaviour can be expected to replicate itself over time. The argument of Schreurs and Tiberghien, while eloquently articulated and heuristically interesting, fails to satisfy this condition. This creates the perverse incentive for corporations and governments to “green-wash” their practices, rather than making real costly

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There are few existing rational actor models that explain unilateral climate change mitigation. Urpeleinen (2009) skirts the issue in his two-level game that shows how experimentation by lower levels of government, like the State of California, reduces the uncertainty of political costs and benefits at the national level. The national leadership might therefore prefer sub-national policies. This is an effect that the International Energy Agency has termed the Real Options Approach (IEA, 2007). Urpeleinen fails, however, to address the root causes of what he calls the “Schwarzenegger phenomenon”. Urpeleinen’s only rigorous support for unilateral action is to recognize that GHG emission reduction is an impure public good— meaning that some benefits of abatement accrue directly to the region. Several other authors have also commented on the ancillary benefits from reducing GHG emissions. Koehn (2008) emphasizes the importance of explicitly bundling cobenefits of climate change action in promoting local climate change initiatives. Koehn explores several examples of how reducing GHG emissions could potentially have ancillary benefits at a local and regional level. These benefits include reduced environmental degradation, diminished resource consumption and depletion, and health-related effects. These all constitute rational explanations for why a local or regional government would choose to regulate GHG emissions unilaterally. But, not taking into account global aggregate emissions means that the level of regulation due to ancillary benefits will always be sub-optimal. The contribution of this paper is to introduce the concept of corporate sustainability— or the risks associated with corporate insustainability—as a rational solution to the puzzle of unilateral GHG regulation. Richardson (2009) charts the emergence and evolution of the concepts of corporate social responsibility, socially responsible investment and corporate sustainability. Richardson is pessimistic, however, about the potential of corporate sustainability to have a significant impact on global warming. This is because he perceives the movement to have lost its ethical/ideological/normative foundation:
“For most investors, global warming is (at most) mainly a matter of financial risk or investment opportunity. With decision-making in financial institutions dominated by fund managers and other investment professionals focused on the ‘bottom line’, any notion that such institutions are a forum

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of enlightened ethical deliberation among climate-conscious investors would be naive. (Richardson, 2009:602)

Echoing Richardson, the Dow Jones Sustainability Index (DJSI) maintains that “a growing number of investors perceive sustainability as a catalyst for enlightened and disciplined management, and, thus, a crucial success factor”. Klaus Wellershoff, global head of UBS Wealth Management Research, adds:
“Whether or not you agree with the view that human activity is influencing the climate system is largely irrelevant to the investment thesis. What is important is that numerous policies to combat the threat of global warming are converging to influence people’s behaviour, alter the risk profile of various businesses, and improve the investment outlook for others” (Baue, 2007)

This paper demonstrates that the conception of “sustainable” as it relates to the corporate bottom-line can have greater consequences for international climate change mitigation than conceptions that concentrate on corporate philanthropy or altruism. The rational expectations of firms regarding future regulation can create an incentive for investors to unilaterally divest from carbon-intensive industries before international negotiations are concluded. The rest of this paper formalizes the microeconomic principals of this argument and explores the impact of divestment on the incentives for local and global GHG emissions regulation. When local externalities and imperfections in capital markets are considered, a strong case emerges for unilateral GHG regulation, irrespective of the impact of such regulation on global GHG emissions.

A Microeconomic Model of Unilateral Climate Change Mitigation: This section presents a simple micro-economic model of individual behaviour resulting in GHG emissions in a large society of N individuals. Babiker (2007) provides a similar, but more complex, model of GHG emissions. In this model, a representative firm produces output Y using two technological processes:

The inputs in both processes are capital (K) and carbon (C). The first process is carbon intensive, while the second process is capital intensive. Carbon is a purely variable input that must be purchased in each period and is totally consumed in the

9 production process. Capital purchases spill-over into the next period. Ownership of capital stock represents a flexible store of wealth for an investor in the firm because they can be divested to increase consumption at a rate:

The total wealth (W) of the investor at time t is therefore:

Investors tailor their investment portfolio to reflect their preference for carbonintensive and low-carbon capital investment. The investor’s utility gained from investment is a function of the net present value (NPV) of future wealth, but also a function of the expected variance or risk associated with different investment decisions. The investor’s utility function can therefore be described by:

The Ω parameter of the utility function represents the individual’s risk preferences. To make rational decisions about long-term investment the investor must have a set of expectations about the future prices of capital in the two sectors. These expectations can be described by three vectors:

There are several factors that determine these prices and are therefore taken into the consideration of a rational investor. The price of carbon is determined by environmental scarcity, by demand, and by government regulation. A rise in the price of carbon could be triggered, for instance, by the implementation of an international climate change mitigation regime; or by a sudden decrease in the availability of hydrocarbons. As a baseline, it is useful to consider the relative price of the two capital goods in a society that does not consider future price expectations. Prices are therefore

10 determined by the equilibrium condition that the marginal revenue products of K1, K2, and C are all equal:

Or

Given

In a static environment, therefore, an investor will be indifferent between different portfolio compositions. There are, however, a number of external shocks that can influence the relative prices of capital-goods in the future. Firstly technological advancement in the production of low-carbon capital can cause the relative price of low-carbon capital to fall. This creates a bleeding edge effect of early adaptors paying unreasonably high costs. The bleeding edge effect might be offset by subsidies, regulatory incentives, or by intellectual property rights that enable early adaptors to earn rents from future technological advances. Another potential shock to the relative price of capital-goods would be a rise in the price of carbon. The resulting technical substitution to low-carbon technology would cause demand for carbon-intensive technology to evaporate. The higher the ratio of carbon-intensive capital in the individual’s investment portfolio, the more exposed the individual is to the impacts of a change in carbon prices. A risk adverse investor may choose to divest from carbon-intensive capital, if he expects the price of carbon to rise in the future. This is analogous to a forward looking individual divesting from a pyramid scheme or market bubble before its inevitable collapse. As the international community approaches a comprehensive climate change agreement and uncertainty in low-carbon technology decrease, the number of investors divesting from carbon-intense capital should increase and the demand for carbon-intense capital should begin to decline. As the price of carbon-intensive capital decreases, risk preferring or myopic investors will increase their portfolio

11 share of carbon-intense capital and earn temporary economic rents on the cheap capital. Figure 3: Price and MRP of Carbon Intense Capital

P
MRP (Cheep Carbon)

MRP (Costly Carbon)

Probability of GHG Regulation
This process may not lead to drastic reductions in aggregate GHG emissions in the short term, but it has the beneficial effect of discouraging new investment in carbonintense capital, because the supply of new capital is determined purely by its production costs. The other effect of this process is to concentrate carbon-intensive industries in the portfolios of risk-preferring individuals. The combination of this This effect is factor with the existence of ancillary benefits from reducing GHG emissions creates a strong incentive for regulation at the local and national levels. demonstrated by a game theoretic model in the following section. Local and Regional Regulation: This section illustrates a dynamic model of local and regional GHG emissions regulation. It finds that regions have an incentive to regulate GHG emissions before the implementation of a comprehensive climate change mitigation regime. Furthermore—contrary to the public goods model—when other regions increase their regulation of GHGs the appropriate response is not to decrease regulation. Because of

12 the nature of the ancillary benefits, there is a strong first mover advantage in tougher regulation. Societal intervention in the market is efficient when the interests of individual actors diverge from the interests of society as a whole. The function of societal intervention is to force actors internalize the social costs of their behaviour. Intervention is called for in the case of GHG emissions for a number of reasons. Firstly, because the expected costs of anthropogenic climate change exceed the costs of mitigation. This is the global public goods argument. But, this potential benefit of regulation is diffused at the global level, so local community leaders will not internalize the full benefits of averting climate change into their decision making process. There are, however, a number of social benefits from regulation that can be internalized at the local level and regional level. These externalities are not limited to the ancillary benefits mentioned previously. Drawing from the previous section, it is feasible that there will be costs associated with a sudden loss of wealth that are not internalized by the owners of capital. If a large percent of a community’s wealth and productive capacity evaporated overnight, jobs would be lost and the community could potentially fall into a recession. For this reason carbon-intensive investments can be seen as having societal risks that are not internalized by the private investor. The divergence of private and public interests is exacerbated when investors expect to be compensated for their investments in the event of regulation. There is a well established norm of compensation to avoid regulation that is unfairly punitive and to smooth the transition into the new regulatory regime, avoiding some of the aforementioned costs. This norm has been respected to some extant by most landreform programs, by the emancipation of serfs and slaves, and by various alcohol prohibition programs. The pragmatic explanation for this norm is that, without compensation, the capital interests harmed by regulatory reform have an incentive to use their political clout to obstruct the reforms. If this is the case then private investors may not even fully internalize the private risks of their investments.

13 A final point is that even if private capital was to internalize the cost of future price shocks, there would still be a case for societal intervention. This is because societal risk and time preferences may differ from those of the private sector. This argument may be controversial with classical economists. Baumol (1968), for example, argued that public and private discount rates should be equal. Recent scholarship, however, appears to accept the idea that society should be more patient and risk adverse than the private sector (Caplin and Leahy, 2004; Farhi and Werning, 2007). Societies therefore have an incentive beyond the typical ancillary benefits to regulate GHG emissions. The societies that choose not to regulate do so either because increased risk and pollution is seen as an acceptable trade-off for increased activity, because of a lack of information regarding the true costs and risks associated with carbon-intensive capital, because of inefficient political markets, or because the administrative costs of regulation exceed the technical capacity of governance. Together, these barriers create a frictional cost that tends to discourage smaller and less politically developed societies from adopting GHG regulations. The existence of such frictional costs is confirmed by Robinson and Gore’s (2005) work on barriers to municipal regulation in Canada; and by Collier and Löfstedt’s (1997) work on the experience of municipal governments attempting to regulate GHG emissions in Sweden and in the United Kingdom. But, how will the utility of regulation change when a neighbouring society implements stricter regulations? The classical approach suggests that the probability of an international regime should be inversely related to the proportion of societies with GHG emissions regulations. Hoel’s bargaining power argument suggests that when a society regulates unilaterally it gives up emission reductions that could have been used in negotiations to obtain concessions from other parties. I argue contrarily, that an increase in the number of regulating societies will not only increase the likelihood of an international regime, but will also strengthen the incentive of nonregulating societies to introduce their own regulation. When a society regulates unilaterally it accepts a loss of productivity relative to nonregulating societies. This creates an economic transfer between the regulating and

14 non-regulating societies, until an international agreement is reached that forces all societies to regulate. Regulating societies therefore have an incentive to hasten an international agreement by punishing non-regulating societies. Assume x percent of societies unilaterally regulate GHG emissions, and x-1 percent of societies remain unregulated. The total economic costs of carbon leakages are a strictly increasing function of x, because marginal carbon leakages are assumed to be strictly positive. A coalition of regulators would therefore choose a punishment level λ that would be strictly increasing in x. The costs of this punishment will be divided between regulators and non-regulators:

This conceptualization creates a critical point for x (in the preceding functional form it is found at x=0.5). Before this point, punishment is irrational because it will incur a greater cost to the marginal regulator than to existing non-regulators; in effect deterring regulation. After the critical-mass of regulators is reached the punishment of a large number of regulators is concentrated on a small number of non-regulators. From this point onwards, the incentive for non-regulators to join the coalition of regulators is strictly increasing in x. The process may be amplified by increasing ancillary costs of non-regulation as carbon-intense capital moves into the remaining non-regulating regions. As x becomes large, the few non-regulators will be flooded with dirty, risky, carbonintense capital. Once the ball is rolling, this system should eventually produce the stable Nash equilibrium where all societies regulate GHG emissions (with or without an international regime) and the societies that adapt last pay the highest price. Concluding Remarks: This paper proposed a possible rational explanation for local and regional governments to unilaterally regulate their GHG emissions. Both investors and the regions in which they invest have an incentive to minimize their exposure to regulatory risk. Ancillary costs to society from the emission of GHGs encourage

15 governments to regulate GHG emissions beyond the private sector equilibrium. The incentive to regulate unilaterally is even stronger if the private sector does not adequately internalize systemic risks or if the private sector’s risk and time preferences differ from those of the society. --The trajectory should follow an S-curve. 1st Technology is Uncertain.. Carbon Leakages are High. Low Carbon Market is small.. options. 2nd Critical Mass of Low Market is formed. Pollution problems emerge in nonregulating regions. Low carbon technologies stabilize. The implication of this result is that as the negotiation of an international climate change regime, the more countries, municipalities and individual investors will divest from carbon-intensive capital stocks. In perfectly competitive markets with good information this behaviour should follow a continuous s-curve of divestment over time. This behaviour will yield a comparative advantage for these regions and individuals in the future low-carbon economy. The trade-off is that risk preferring investors will earn rents from the risky carbon-intensive capital until an agreement is reached. Non-regulating municipalities and regions will benefit from increased economic activity, but these benefits will eventually be eclipsed by the external costs and the risk associated with carbon-intense capital. Still, the governments of these regions might be unable to regulate due to inefficient political markets, lack of technical capacity, insufficient awareness of the risks associated with GHG emissions, or other barriers to regulation. This understanding of carbon leakages demands the question: where will the carbon intense economy leak to when China regulates GHG emissions? And then where? Clearly, there is no long term advantage from engaging in an environmental race to the bottom. Eventually, the world must make the transition to low-carbon technology. This is the fundamental flaw in models that conceptualize emission abatement as a pure global public good. The scholarship addressing regime theory and institutional Few societies unilaterally regulate.. some societies develop real position

16 design is interesting and important, but it should not disregard the potential significance of complex individual and regional behaviours in the absence of an international regime. More theoretical work is needed to understand the determinants of unilateral abatement, and also to understand the impacts of unilateral abatement on international negotiations.

17 Bibliography: Babiker, Mustafa (2005) Climate Change Policy, Market Structure, and Carbon Leakage. Journal of International Economics, 65(2):421-45. Baue, Bill. Citigroup, Lehman Brothers, and UBS Report on Climate Risks and Opportunities for Investing. Sustainability Investment News, February 27th, 2007. Available at: <http://www.socialfunds.com/news/article.cgi/2237.html> Baumol, William (1968). On the Social Rate of Discount. The American Economic Review, 58(4):788-802. Betsill, Michele and Bulkeley, Harriet (2004). Transnational Networks and Global Environmental Governance: The Cities for Climate Protection Program. International Studies Quarterly, 48(2):471-93. Brown, Marilyn (2001). Market Failures and Barriers as a Basis for Clean Energy Policies. Energy Policy 29(14):1197-207. Caplin, Andrew and Leahy, John (2004). The Social Discount Rate. Journal of Political Economy, 112(6) Collier, Ute and Löfstedt, Ragnar (1997). Think Globally, Act Locally? Local Climate Change and Energy Policies in Sweden and the U.K. Global Environmental Change, 7(1):25-40. Farhi, Emmanuel and Werning, Iván (2007). Inequality and Social Discounting. Journal of Political Economy, 115(3):365-402. Felder, S. and Rutherford, T.F. (1993). Unilateral CO2 Reductions and Carbon Leakage: The Consequences of International Trade in Oil and Basic Materials. Journal of Environmental Economics and Management, 25(2):162-76. Hoel, M. (1991). Global Environmental Problems: The Effects of Unilateral Actions Taken by One Country. Journal of Environmental Economics and Management 20, 55–70. International Energy Agency (2007). Modeling investment risks and uncertainties with real options approach—a working paper for an IEA Book: Climate Policy Uncertainty and Investment Risk Keohn, Peter (2008). Underneath Kyoto: Emerging Subnational Government Initiatives and Incipient Issue-Bundling Opportunities in China and the United States. Global Environmental Politics, 8(1):53-77. Lutsey, Nicholas, and Daniel Sperling. (2008). America’s Bottom-Up Climate Change Mitigation Policy. Energy Policy 36 (2): 673–685.

18 Schreurs, Miranda A., and Yves Tiberghien. (2007). Multi-Level Reinforcement: Explaining European Union Leadership in Climate Change Mitigation. Global Environmental Politics 7 (4): 19–46. Rabe, Barry G., Mikael Roman, and Arthur N. Dobelis. (2005). State Competition as a Source Driving Climate Change Mitigation. New York University Environmental Law Review 14 (1): 1–53. Richardson, Benjamin (2009) Climate Finance and its Governance: Moving to a Low Carbon Economy Through Socially Responsible Financing?. International and Comparative Law Quarterly, 58:597-624. Robinson, Pamela, and Gore, Christopher (2005). Barriers to Canadian Municipal Response to Climate Change. Canadian Journal of Urban Research, 14(1):102-120. Schreurs, Miranda and Tiberghien, Yves (2007). Multi-Level Reinforcement: Explaining European Union Leadership in Climate Change Mitigation. Global Environmental Politics, 7(4):19-46. Urpelainen, Johannes (2009). Explaining the Schwarzenegger Phenomenon: Local Fruntrunners in Climate Policy. Global Environmental Politics, 9(3):82-105 Wiener, Jonathan (1998) On the Political Economy of Global Environmental Regulation. Georgetown Law Review, 87(1):749-794. Wiener, Jonathan (2006). Think Globally, Act Globally: The Limits of Local Climate Policies. Duke Law School Faculty Scholarship Series. Paper 93 Velasquez-Manoff, Moises (2009) Companies Desert the Climate Deniosphere. The Christian Science Monitor, August 28th. Available at: <http://features.csmonitor.com/environment/2009/09/28/companies-desert-theclimate-deniosphere/>

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