Climate Policy with a Global Refunding System

Cumulated carbon dioxide emitted by the burning of fossil fuels is leading to warmer surface temperatures that are likely to have a significant and adverse impact on the functioning of ecosystems and the well-being of future generations. As greenhouse gases tend to disperse uniformly around the globe, emissions reduction is a global public good, and international coordination is crucial. It is, however, difficult to achieve. The Kyoto Protocol promises only modest progress in slowing global warming. Various other approaches to international coordination have been suggested (see Aldy, Barrett, and Stavins (2003) and Nordhaus (2006)).

I propose an alternative international framework called the Global Refunding Scheme (referred to hereafter as GRS) that would enable countries to determine their climate policy at a national level while simultaneously creating powerful incentives for abatement by means of global refunding, which would work as follows:

• Countries decide whether they want to join the GRS. A country can join the GRS if it accepts the rules and levies a minimal carbon emission tax. Industrial countries pay an initial fee.
• In each period, every country belonging to the GRS independently determines its level of taxes on CO2 emissions. Emission taxes are the sole policy instrument a country is allowed to adopt.2 All tax revenues are collected in a global fund.
• In each period, the GRS refunds a share of the accumulated wealth to the participating countries.3 Each participating country receives an annual refund in proportion to the share of total CO2 emission reductions it achieves in the period under consideration.4
• Non-refunded wealth of the GRS is invested in order to maintain funds for future refunding activities.
• In each period a country is allowed to exit. If a country leaves the GRS, it loses its right to refund.
• Decisions within the GRS are governed by majority rule.

In evaluating the pros and cons of the system, I proceed from the notion that an efficient climate policy would require all countries to participate, with each country mitigating its emissions to the point where its own marginal abatement costs equal the sum of marginal benefits globally.5

The main advantage of the GRS is that, once they have joined, countries are motivated to set socially desirable tax rates. While higher emission taxes are costly for a country, it will benefit simultaneously from higher refunds. The core idea of the proposal is to make the latter effect sufficiently strong. This is achieved (a) by levying initial fees when countries join, such that the global fund starts with an appropriate amount of money that can potentially be refunded, and (b) by making the annual refund to a country proportional to its share in total emission reductions achieved within a particular period. A formal model incorporating these requirements is developed in Gersbach and Winkler (2007). In a stylised setting we show that, once countries have joined, a first-best allocation can be achieved by an appropriate GRS.

The second main advantage is that countries will not want to exit as a country loses all its refund claims if it does. The third is built-in redistribution to developing countries. Such countries not only tend to have higher marginal damages; they also lack access to clean technologies. Moreover, programmes to combat deforestation have to take place mainly in these countries. The GRS can support developing countries in two ways. First, only rich countries pay an initial fee into the fund, thus increasing future refunds for all countries and benefiting developing countries. Second, refunding formulas can be designed in such a way that developing countries can benefit.6

The fourth advantage of GRS is its flexibility, as no targets or prices have to be negotiated at the international level. The two parameters that govern the system are the minimal tax rate and the refunding formula, which can be used to strengthen or weaken the incentives for member countries to reduce emissions.7

Finally, participation will be encouraged, as developing countries are allowed to join the GRS without paying any initial fee. It is thus in the interests of such countries to join, as they can expect to be net receivers in the system. The distribution objective discussed before goes hand in hand with motivating developing countries to participate.

Of course, GRS requires data on emission taxes and per-capita carbon emission levels in member countries. These data are difficult to assemble and leave scope for attempts to manipulate data for political reasons. This will ultimately require the creation of an international authority that both controls and supervises data from member countries and handles the refunding procedure.

Moreover, GRS requires that countries share tax sovereignty for greenhouse gases with the international authority in the sense that countries can determine tax rates, while net revenues depend on the combination of own emission reductions and emission reductions of other countries through refunding. The partial surrender of tax sovereignty is a substantial hurdle from a political-economic perspective. This problem may be alleviated by increasing the initial fees or by requiring periodic fixed payments while countries would be allowed to keep the revenues from taxing emissions. In such a system, countries should also be free to choose their policy instruments to reduce emissions.

Finally, like other international frameworks addressing climate policy, the GRS requires an agreement on the policy instrument and in particular on a carbon tax. Achieving such an agreement among a large number of countries is a considerable challenge. The flexibility of the GRS, which gives countries discretion over their emission tax beyond the minimal tax rate, may be helpful in achieving a broader consensus on this issue.

Aldy, J.E., Barrett, S. and Stavins, R.N. (2003), “13 + 1: A Comparison of Global Climate Change Policy Architectures”, Discussion Paper no. 03-26, RFF, Washington, DC.
Boehringer, C. and Vogt, C. (2003), “Economic and Environmental Impacts of the Kyoto Protocol”, Canadian Journal of Economics, 36(2), 475-494.
Gersbach H. and Requate, T. (2004) “Emission Taxes and Optimal Refunding Schemes”, Journal of Public Economics, 88(3-4), 713-725.
Gersbach, H. and Winkler, R. (2007), “An Economic Analysis of Global Refunding and Climate Change”, CEPR Discussion Paper, No. 6379.
Goulder, L.H. and Pizer, W.A. (2008), “The Economics of Climate Change”, New Palgrave Dictionary of Economics, 2nd edition, Macmillan, Basingstoke (forthcoming).
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Nordhaus, W.D. (1999), “Requiem for Kyoto: An Assessment of the Economics of the Kyoto Protocol”, Energy Journal, Special Issue, 93-130.
Nordhaus, W.D. (2006), “After Kyoto: Alternative Mechanisms to Control Global Warming”, American Economic Review, 96(2), 31-34.
Schelling, T.C. (2002), “What Makes Greenhouse Sense? Time to Rethink the Kyoto Protocol”, Foreign Affairs, 81(3), 2-9.
Stern, N. (2006), The Economics of Climate Change - The Stern Review, Cambridge University Press, Cambridge.
Tol, R.S.J. (2006), Why Worry About Climate Change? A Research Agenda, Nota di Lavoro 136. 2006, Fondazione Eni Enrico Mattei, Milano.

1 See e.g. Boehringer and Vogt (2003), Goulder and Pizer (2008), McKibbin and Wilcoxen (2002), Nordhaus (1999), Schelling (2002), Stern (2006), and Tol (2006).
2 Over time it may be useful to abolish this requirement. Moreover, one could allow countries to keep the revenues from taxing emissions as outlined in the concluding paragraphs.
3 Emission payment refund schemes for particular industries in a given country have been developed by Gersbach and Requate (2004). We propose a global refunding scheme for countries.
4 To account for catching-up processes by developing countries and to avoid growth-harming policies, one should adjust or normalize CO2 emissions by GDP growth.
5 As there is high uncertainty regarding the estimation of the benefits and costs of global climate change, assessing efficiency at a general level is impossible. Accordingly, weaker criteria, such as the Kaldor-Hicks criterion, are more appropriate in practical policy analysis.
6 Developing countries can benefit from the system if population weights and emission reductions per value added are used in the refunding formula.
7 The question of the “optimal level of emission reductions” is the most difficult and controversial issue in the economics of climate change, and estimates for appropriate price penalties vary considerably (see e.g. Nordhaus 2006).