Common Tragedies

Thoughts on Environmental Economics

A deal to help ozone and climate

Posted by Daniel Hall on October 5, 2007

Catching up on some news from a couple weeks back:

Nations have come to agreement on an accelerated phase-out schedule for hydrochlorofluorocarbons, a group of ozone-depleting substances that also contribute to climate change:

A deal by 191 nations to eliminate ozone-depleting substances 10 years ahead of schedule is a “pivotal moment” in the fight against global warming, Canadian Environment Minister John Baird said on Saturday.

Delegates at a U.N. conference in Montreal struck the deal late on Friday. The agreement will phase out production and use of hydrochlorofluorocarbons (HCFCs) for developed countries to 2020 from 2030 and to 2030 from 2040 for developing nations.

This is significant because it should help reduce a perverse incentive that the Kyoto Protocol was creating in its attempt to incentivize emissions reductions in the developing world through the Clean Development Mechanism (CDM).

The CDM allows projects to be conducted in the developing world that reduce emissions and generate offset credits that can be purchased by countries with binding Kyoto targets. One of the categories of projects — accounting for ~40% of currently registered CDM reductions and about one-quarter of the current expected total “pipeline” of CDM reductions — consists of destroying a manufacturing byproduct of one of the most common hydrochlorofluorocarbons, HCFC-22. This byproduct is a potent greenhouse gas, about 12,000 times more potent than carbon dioxide. Several commentators, particularly Michael Wara, have noted that there is a strong possibility projects to destroy this byproduct are creating a perverse incentive to expand or maintain HCFC-22 production: given current prices for CDM credits and the low abatement costs for the byproduct, the profits from selling the CDM credits are greater than the value of the HCFC-22 production itself.

The CDM has rules that should prevent this from being much of a problem… for now. Firms can only claim credits based on historical production levels prior to the entry into force of the Kyoto Protocol. This means that in the current round the CDM is not providing an incentive to ramp up production, because entities can’t claim credits on any new production.

But there have recently been an increasing number of calls for the CDM to extend crediting to new production of HCFC-22, including from the UN Environment Programme [gated news story]. China in particular would benefit if this happened, because it has a large portion of new developing world HCFC-22 production, and because it has become a popular place for offset project investors due to increasing government familiarity with conducting CDM projects. Further, China’s government is pocketing a substantive tax on all of these emissions reductions projects. (They can do this because prices for CDM credits are so substantially higher than actual abatement costs.) It’s not as if there is no environmental benefit to be had from allowing these new production sources into the CDM process either: it would at least ensure that a potent greenhouse gas wasn’t getting emitted.

The problem is that changing the rules in the middle of the game also changes the incentives. In this case, updating the rules to allow new production is effectively a (large) subsidy to production, and could encourage further strategic manipulation down the road. (If new sources start getting allowed in every five years there are going to be lots of new HCFC-22 producers.) This is why in general economists often prefer lump sum transfers, transfers not based on current or future behavior, because of the complicated — and frequently perverse — incentives that arise when the payoffs can be manipulated by the behavior of participants.

This makes it all the more impressive that nations came to an agreement that is mainly about bringing down developing world HCFC-22 production levels sooner than under the previous schedule. I would have thought beforehand that a deal was unlikely, because it seems that several countries — particularly China — are leaving a large potential pot of CDM money on the table. I understand that there were some “international credibility” reasons for China to go along with a proposal that the U.S. and Europe were strongly behind… but when the money gets big enough it seems to me that narrow self-interest usually trumps softer considerations in international relations.

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