Peter Neilson wants the US with China and the EU, to encourage most countries to charge for carbon emissions, and adopt border carbon charge adjustments, so action on climate change is fair, effective and inclusive

By Peter Nielson*

Earlier this year President Obama made it clear that he sees action on climate change as his most enduring legacy. At home, his Clean Power Plan to cut power plant emissions is weaving its way through the courts. Last December at the Paris Climate Change talks, he also achieved an international breakthrough. After the deep disappointment following the Copenhagen Climate talks, in Paris President Obama, with the crucial support of China was able to get more than 190 countries to agree that action was required to significantly reduce the level of carbon emissions being released into the atmosphere.

While there was wide agreement to target a maximum, 2-degree C increase in average global temperatures and both developed and developing countries needing to take action, each country was left to take their own domestic actions and report every 5 years on progress.

After nearly 25 years of negotiations on climate change we still do not have a price on most of the world’s greenhouse gas emissions.

Economists have long suggested that a global agreement, which caps the growth of carbon emissions and puts a price on emissions, is likely to be the most cost effective way to manage climate change.

Greenhouse gases released into the atmosphere create the problem of rising temperatures and charging for those emissions at the right price can bring a reduction in emissions to an agreed target level. The price can be introduced in the form of a carbon tax or a price set by an emissions trading system, where emission rights up to a set cap, are bid for. So if we have a mechanism that would work why can we not get a global deal? Nature does not care which country, the increased or reduced emissions comes from. Countries however do care who is paying for the reductions. 

For a global agreement to cap and then reduce emissions to work, almost every country needs to agree, to take responsibility for a share of the globally reducing cap and live with the consequences of eventually lowering its own domestic emissions level or paying someone else to reduce theirs. Countries with a big share of the world’s emissions such as the USA, China and the EU don’t want to end up paying all the costs of fixing the problem but smaller countries know they can’t fix it all on their own so they need the bigger countries to participate. The small countries individually or collectively, lack the leverage to make anything happen. No one individual country therefore, has any incentive to take early action. The effect of most countries holding back on making a serious commitment means that no global agreement gets off the ground. This is called, the “free rider” problem.

The second barrier to action is the effect on its trade for any country taking early action. If one country puts a price on carbon emissions created by its domestic producers and they export, they face lower returns for their goods and services compared with their competitors in countries who do not put a price on carbon emissions. The producers may threaten to relocate their production to a country that has not imposed a price on carbon. This is called the “carbon leakage” problem.

The twin result of these two problems is that no country has the incentive to go first, since the likely effect is that production will leak and that countries also have an incentive to hold-out, in the hope of getting a better deal.

There are two ways in which to solve the combined problems of free-riding and carbon leakage.

The first, which has been the focus of international efforts to date, has been to seek a universal agreement that all countries will impose a uniform price on carbon.  This has proved politically impossible.

The second, which is the focus of this article, is to devise a system that would firstly allow a group of countries that represented a significant share of global emissions to take concerted actions in advance of a global agreement that will not involve either free-riding or leakage, but which would both provide an incentive for other countries to join as well as providing a dis-incentive for those trying to hold-out.

In sum, we need a new starter agreement with the potential to grow into a global agreement.

Fortunately, we have an example from the world of international trade, known as border price adjustment, which when combined with the experiences of the Kyoto Protocol on emissions trading, holds out the prospect of a practical solution to the problems that have bedeviled climate change negotiations to date.     

Having failed to date to get a majority of countries to put a charge on emissions, the most relevant question now is what sort of arrangement, with the smallest number of parties could bring about real progress in reducing global emissions?

The only three parties that would constitute half of the world’s emissions are China, the US and the EU. What sort of arrangement could be embraced by these parties that would have an open architecture, thereby enabling other countries to join? Such a foundation arrangement would need to recognise the differences between the parties as well as their shared destiny. This means the foundation agreement needs to be sensitive to the domestic politics of each of the three parties. It also needs to have compliance procedures that could be extended to other countries that have varying levels of administrative capacity.

The foundation arrangement would include:

• An agreed target limit for global temperature increases.
• An agreed pathway for future global emissions that is compatible with the temperature increase.
• An agreed emissions pathway for each party that would also be their responsibility target for the party.
• An agreement to eventually cover all sectors and all gases – including the fuels used to import or export products – on a timetable that was sensitive to each party’s domestic priorities.
• Agreement that each party would put a price on carbon but this price could be set as a carbon tax or could arise out of a cap and trade regime. Setting a price directly would not necessarily mean that each partner had to use the same price as other partners.
• Agreement on an open architecture, enabling other countries to become a member of the scheme on the same rules as for the foundation countries.
• Agreement that within each member country, domestic production and imports would pay the same carbon price.   

The mechanism for this to work would be a border carbon adjustment on traded goods and services that did not discriminate between domestic producers in the foundation members and those producers in the countries that are exporting goods and services to the foundation members. This would operate in a similar way to a value added tax under the WTO rules.

An exporter in a country that is a member of the scheme would get a credit for the carbon charges that were incurred in the production chain prior to export. In effect the origin country would take off the carbon charges that it had already applied to the products. When these products went into a member country as imports the emissions content of the imports would be multiplied by the domestic carbon price of the destination country and this levy would be applied to the products. In other words the destination country would apply its own carbon charges to the imports. If the destination country was not charging for emissions for particular domestic products, it would not apply charges to imports of these products from other countries.

The same approach, would be used by member countries for trade with non-member countries. A member country would remove its own carbon tax from exports as they left the country. And a member country would apply its own carbon charges to imports from a non-member country.  

This approach allows each country to have the carbon price it wants to apply but without discriminating against the producers of its imports, or its own producers. This approach should minimise carbon leakage, where producers feel they have to relocate production to a country that has a lower, or non-existent, carbon charge. It is likely that over time carbon prices will converge at a higher level as governments recognise the revenue that is being foregone by having a carbon price that is lower than those of their trading partners.

Having eventually, all sectors and gases covered would make the border adjustment process easier to apply. So it is also likely that over time there will be convergence on coverage – to a full coverage approach.

Emissions made by international transport would be treated similarly to those made by other industries. All aircraft and ships leaving a country would receive a rebate for any carbon levies that were on the fuels that they purchased while in that country. All aircraft and ships arriving in a country would be levied at that country’s carbon price on the fuel that they used in transporting their passengers and goods to that country. This will ensure that all arrivals will have paid the destination country’s carbon price, which is the same price that will have been paid on internal movements within the destination country.

Governments of exporting countries would need to certify the carbon production content of its exports to countries that are parties to the agreement. Over recent years work has been undertaken on devising ways to make the estimation of production emissions easier for businesses. One possible approach is as follows. The exporting enterprise calculates the emissions arising from three sources: its own emissions, the emissions embodied in the inputs that it imports, and the emissions that are embodied in the inputs it purchases from domestic suppliers. For the purchases from domestic suppliers, the exporter focuses on the supplies from high-emitting industries. The embodied emissions in domestic supplies are either obtained directly from suppliers or calculated using pre-estimated embodied emission rates from an input-output model. The exporter apportions emissions from each of three sources to the exports that it produces. 

Since most countries would wish to export to either the EU, the US or China it is likely that within a relatively short time most traded products and services would include, in their total price, a price for their carbon content. So producers and consumers will face incentives to reduce the carbon intensity of what they produce and consume.    

Next Steps:

To progress this proposal the US Administration along with China and the EU should establish, a Task Force of working groups to answer over the next 100 days the following questions.

1. Could such an approach be politically acceptable for the foundation parties?
2. Can the proposed Border Carbon Adjustment system be implemented?
3. Is the proposed use of Input/Output analysis feasible?
4. Would the administrative costs of establishing and implementing such a system be reasonable?

For 25 years the perfect approach – a global cap and trade scheme for pricing greenhouse gas emissions which covers all sectors and most countries – has failed to materialise.

It is time for the perfect to no longer be the enemy of the good. A foundation arrangement that most countries could over time sign up to, and supported by China, the EU and the United States – would be a game changer and would bring real action on climate change. For the first time ‘free riding’ would no longer be the default option. An arrangement that will see a carbon price on most of the world’s emissions, even if starting from a low base, is needed to put us on the pathway for really fixing climate change. The economic superpowers need to lead now for this to happen.

When the then Senator Obama secured the Democratic Nomination back in 2008 he said “this was the moment when the rise of the oceans began to slow and our planet began to heal”

President Obama can use the next 100 days to ensure his successor has a practical plan to address climate change globally following their inauguration on the 20^th of January 2017. 

Peter Neilson is currently a trustee of WWF in New Zealand and is a former chief executive of the New Zealand Business Council for Sustainable Development which successfully campaigned for an Emissions Trading Scheme in New Zealand. In that role attended the COP11 meeting in Montreal and COP15 in Copenhagen. An economist and consultant, Peter Neilson is a former cabinet minister in the 1984-1990 New Zealand government. He was also the chief executive of the NZ Financial Services Council. The views expressed in this article are his own and do not represent the position of any organisation he is currently or has previously been associated with. He can be contacted at peter@neilson.net.nz or on twitter @PeterNeilson4

Table 1 Impact of a foundation agreement on economic sectors     

Figure 1 Shares of total emissions for China, the USA, and the EU

Proportion of global GHG emissions

Source: WRI; covers all GHG emissions in 2012.

Figure 2 Emissions intensity (i.e. emissions/real GDP) for China, US, and the EU

MTCO₂ equivalents/real GDP in $US billions

Sources of data: Emissions data is from the World Resources Institute and excludes emissions from land use changes and forestry. GDP data is from IMF’s WEO database April 2015 and has been rebased on 2012 US dollars.