An Economic Analysis of the Kyoto Protocol

The Park Place Economist The Park Place Economist

Volume 10 Issue 1 Article 19

4-2002

An Economic Analysis of the Kyoto Protocol An Economic Analysis of the Kyoto Protocol

Alexis Manning '04

Illinois Wesleyan University

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An Economic Analysis of the Kyoto Protocol An Economic Analysis of the Kyoto Protocol

Abstract Abstract

Global climate change represents a serious im pending issue that must be addressed in the present, not

the distant future, in order to avoid irreversible, adverse consequences. Due to externalities—

intertemporal and locational—markets will not reach an e6cient outcome. Present generations bear the

cost of reducing greenhouse gas (GHG) emissions and do not experience the negative repercussions of

global climate change, while future generations reap the bene5ts of avoiding global warming without

enduring the initial monetary cost of emission reductions. Also, since the stratosphere is a public good for

the entire world, the free rider problem occurs on a global scale (Rao, 2000). Each country has an enticing

incentive to allow other nations to reduce GHG emissions without contributing to emission reduction

efforts themselves. Due to these inevitable externalities, government intervention and international

cooperation is not only justi5able but a necessity.

This article is available in The Park Place Economist: https://digitalcommons.iwu.edu/parkplace/vol10/iss1/19

The Park Place Economist Volume X

I. Introduction

lobal climate change represents a serious im

pending issue that must be addressed in the

present, not the distant future, in order to

avoid irreversible, adverse consequences. Due to ex-

ternalities—intertemporal and locational—markets will

not reach an efficient outcome. Present generations

bear the cost of reducing greenhouse gas (GHG) emis-

sions and do not experience the negative repercus-

sions of global climate change, while future genera-

tions reap the benefits of avoiding global warming with-

out enduring the initial monetary

cost of emission reductions. Also,

since the stratosphere is a public

good for the entire world, the free

rider problem occurs on a global

scale (Rao, 2000). Each country

has an enticing incentive to allow

other nations to reduce GHG emis-

sions without contributing to emis-

sion reduction efforts themselves.

Due to these inevitable externalities, government in-

tervention and international cooperation is not only

justifiable but a necessity.

The Kyoto Protocol reflects an attempt to

correct these externalities by imposing GHG emis-

sion reduction standards upon current generations,

thereby combating global climate change. Unfortu-

nately, this treaty fails to present a valid solution to

global warming. The Kyoto Protocol neglects eco-

nomic as well as scientific realities, and therefore,

qualifies as a fundamentally flawed treaty. Neverthe-

less, global warming represents an inevitable, formi-

dable threat to human welfare that merits a pro-ac-

tive approach characterized by efficiency, cost-effec-

tiveness, flexibility, and equitability.

II. Background

Global climate change results, according to a

widely accepted scientific consensus, from the accu-

mulation of GHG’s in the atmosphere, which absorb

infrared radiation, causing global temperature to rise.

Scientists hypothesize with a considerable amount of

evidence that the burning of fossil fuels, which emit

carbon dioxide (CO

), contributes to the increasing

concentrations of GHG’s in the atmosphere and,

therefore, creates global climate change (Rao, 2000).

The exact effect of increasing average global tem-

peratures remains uncertain, but

simulations project rising of the sea

level, unstable weather patterns,

extension of climate-sensitive dis-

eases, and disruption of agricultural

productivity (Chandler, 1999).

The scientific community predicts

that the mean global temperature

will rise 3°C to 4°C over the next

century if GHG emissions continue

to increase unabated (Easterbrook, 2001).

Considering the potential for drastic, irrevers-

ible consequences, international policy should reflect

the precautionary principle, which implies society is

risk-averse and ensures against the possibility of a

global warming catastrophe (Kellow, 1998). There-

fore, despite the lack of complete scientific evidence,

global warming represents a formidable threat to hu-

man welfare and merits global action.

As a result of this growing, widespread con-

cern of global climate change, developed nations met

in December of 1997 and formed the Kyoto Proto-

col, a treaty intended to counteract the trend of glo-

bal warming by instituting legally binding GHG emis-

sion reduction standards. Under the Kyoto Proto-

col, Annex I nations, which encompass 39 high in-

An Economic Analysis of the Kyoto

Protocol

Alexis Manning

“The Kyoto Protocol ne-

glects economic as well

as scientific realities, and

therefore, qualifies as a

fundamentally flawed

treaty.”

Alexis Manning

The Park Place Economist Volume X

come, developed countries, must reduce their emis-

sions of six GHG’s, including CO

, methane, nitrous

oxide, hyrdoflorocarbons, polyflorocarbons, and sul-

fur dioxide by an average of 5% from 1990 levels.

The treaty stipulates that this reduction occur during

the commitment period extending from 2008-2012.

The Kyoto Protocol will become effective once 55

participating parties, representing at least 55% of CO

emissions, ratify the treaty (Rao, 2000)

III. Benefit-Cost Analysis of the Kyoto

Protocol

Despite the treaty’s many flaws, the Kyoto

Protocol allows several innovative, theoretically cost-

effective approaches to attaining the emission reduc-

tion quotas instead of relying upon the standard com-

mand and control approach. Unfortunately, many of

these strategies remain dangerously vague, and the

treaty compromises economic theory in favor of poli-

tics. In theory, the Protocol permits a considerable

amount of flexibility in achieving these emission re-

ductions. This flexibility, in turn, could greatly reduce

the total cost of obtaining the desired emission reduc-

tions. However, in practice, potentially flexible mecha-

nisms become inflexible due to restrictions and regu-

lations (Tol, 1998).

The treaty allows an international emission

reduction trading system, which creates a limited glo-

bal market for emission reduction units among Annex

I countries (Rao, 2000). Countries with a lower mar-

ginal cost (MC) of reduction will reduce their emis-

sions and sell their excess emission reduction credits

to countries with a higher MC of reduction. There-

fore, MC’s will equalize; countries will engage in mu-

tually beneficial transactions to achieve emission re-

ductions in the most cost effective method possible.

The existence of tradable emission reduction units

potentially could drastically reduce the total cost of

Kyoto’s standards.

However, considering that Kyoto only legally

obligates developed nations to alter GHG emissions,

the treaty limits permit trading to Annex I nations (Rao,

2000). Since most Annex I countries have relatively

similar MC’s of emission reduction, the benefits of an

international trading system cannot be fully realized.

Although this theoretically cost effective system dem-

onstrates a less expensive method than a standard

command and control approach, this diluted permit

trading system will not approach the least cost

method. According to a study conducted by William

Nordhaus (1998), a complete international emission

reduction trading system could reduce the massive

cost of Kyoto by a factor of nine. However, a trad-

ing system restricted only to Annex I nations produces

a less impressive decline in cost, and reduces the to-

tal cost of Kyoto by less than a factor of two. Clearly,

a globally inclusive trading system could achieve GHG

emission reduction goals in a more cost efficient man-

ner, thereby lessening the financial burden of Kyoto.

In addition, the international emission reduc-

tion trading system could drastically impact individual

economies. Due to the increasing costs of produc-

tion in Annex I countries, companies may elect to shift

production to developing nations, which will have a

substantial lower MC of production. This shift will

negate Kyoto’s efforts to reduce global GHG emis-

sions, because firms will be able to pollute freely in

these non-Annex I nations. Goods produced in An-

nex I nations will become more expensive, while non-

Annex I goods will become comparatively less ex-

pensive. Consequently, Annex I nations will experi-

ence a comparative disadvantage. Also, these per-

mits may discourage development in certain coun-

tries. Russia and Eastern Europe will possess an ex-

cess of emission reduction credits due to the collapse

of the Soviet Union that occurred after 1990 (Tol,

1998). Consequently, these countries will experience

a windfall and reap unearned profits. These coun-

tries will benefit more from selling emission reduction

permits than developing efficient, environmentally

friendly policies. Consequently, total output will de-

crease significantly, though their income will actually

increase due to large transfers from Annex I countries

(Nordhaus, 1998). Although their GDP may reflect

prosperity, the reduction of output has serious impli-

cations for their economy.

Kyoto also permits other methods of achiev-

ing GHG emission reductions. Through “joint imple-

mentation,” Annex I countries can achieve their emis-

sion reduction quotas by undertaking projects in other

Annex I countries to reduce GHG emissions (Chan-

dler, 1999). However, the MC of reductions lack

significant variability among these nations, and this strat-

egy will not radically mitigate the costs of Kyoto. In

addition, the treaty provides Annex I nations with the

opportunity to fulfill emission reduction requirements

in developing nations, under the “clean development

mechanism” (CDM). The MC of reduction is signifi-

cantly lower in developing nations that will allow de-

veloped nations to capitalize off these lower cost op-

An Economic Analysis of the Kyoto Protocol

The Park Place Economist Volume X

portunities. Developed nations can undertake projects

in developing nations, which will reduce emissions,

while encouraging technological innovation and eco-

nomic development in these underdeveloped areas

(Chandler, 1999). Kyoto also

allows emission reduction flex-

ibility, because the treaty allows

countries to achieve emission

reduction credits through refor-

estation. Forests qualify as emis-

sion reduction units, because

they are CO

“sinks,” which absorb CO

and prevent

GHG’s from entering the stratosphere. Therefore,

the presence of forests can significantly mitigate glo-

bal climate change (Sutherland, 2000).

Kyoto contains several innovative approaches

to combating global climate change that encourage

flexibility, thereby lowering total costs. However, the

Protocol states many of these emission reduction

mechanisms in very vague terms and limits the use of

these alternative methods. Regardless of varying MC

of reduction, international efforts and reforestation

projects may only supplement domestic efforts

(Nordhaus, 1998). Therefore, the Kyoto Protocol

will not achieve an efficient outcome.

Perhaps the most fundamental flaw of Kyoto

involves the lack of mandatory participation of devel-

oping nations. The treaty fails to impose legally bind-

ing emission reduction standards upon Non-Annex I

countries, which encompass 134 developing nations

(Tol, 1998). Some proponents of Kyoto argue that

the developed world, specifically the US and Europe,

pioneered the use of fossil fuels during industrializa-

tion and therefore, created the current global warm-

ing predicament. Also, developed nations account

only for 20% of the global population yet emit 60%

of the world’s CO

emissions (Easterbrook, 2001).

Even more alarming, the US composes only 5% of

the world population yet accounts for 30% of CO

emissions. According to per capita calculations, a

Chinese person generates 1/10 of the GHG emis-

sions of an American. Nevertheless, even the most

ardent supporters of Kyoto admit that the treaty can-

not stabilize GHG emission without meaningful par-

ticipation of developing countries, which represent

80% of the global population (Tol, 1998).

As developing nations advance, their GHG

emissions will rapidly increase due to industrial de-

velopment, which relies heavily upon high CO

emit-

ting fossil fuel sources, including coal. According to

widely accepted projections, China will surpass the

US as the largest CO

emitter by 2015, and the de-

veloping world will overtake the developed world in

emissions by 2020 (Tol, 1998). Therefore, the

actions of 39 Annex I nations

cannot significantly counteract

the trend of global climate

change, while 134 non-Annex I

nations continue to exponentially

increase GHG emissions

(Nordhaus, 1998). Any

progress accomplished by developed nations will be

more than offset by increasing emissions of develop-

ing nations. According to Nordhaus, Kyoto will only

decrease global mean temperature by 0.13°C from

the projected baseline temperature increase during

the next century. This insignificant decrease in aver-

age global temperature cannot mitigate the global

warming trend. Therefore, the Kyoto Protocol lacks

scientific validity. Kyoto cannot possibly achieve its

ultimate goal of reversing the global climate change

trend.

In addition, the chosen emission reduction

targets lack any scientific or economic foundation.

The Protocol stipulates that each Annex I nation re-

duce GHG emissions by an average of 5% from 1990

levels. These historical baseline targets lack any rela-

tion to global CO

concentrations, projected tempera-

ture increases, or MC of emission reduction (Kellow,

1998). The Kyoto Protocol sets completely arbi-

trary emission reductions quotas, which prevent an

efficient, effective outcome. Efficient emission reduc-

tion standards would reflect economic and scientific

factors, including GHG concentrations and MC’s of

emission reduction.

Also, the impending emission reduction tar-

get deadlines approach economic and scientific im-

possibility. Kyoto requires the US to reduce GHG

emissions by 7% of 1990 levels. According to pro-

jections, if emissions continue to increase at the cur-

rent rate, the US will be over 20% above 1990 CO

levels by 2008 (Tol, 1998). Consequently, the US

must reduce it emissions by 27% of its projected level

in less than a decade. The European Union (EU)

faces similar, though not quite as daunting, emission

reduction challenges as the US. The next few years

do not constitute sufficient time to institute such dras-

tic emission reductions.

The presence of relatively uniform emission

reduction standards, without the mitigating presence

“...the US composes only

5% of the world population

yet accounts for 30% of

emissions.”

Alexis Manning

The Park Place Economist Volume X

of significant market incentives, creates very cost in-

effective results. Standard emission reductions among

Annex I nations neglect to consider the individual cir-

cumstances of each country under the guise of equal-

ity. Kyoto ignores factors which significantly affect a

nation’s ability to reduce domestic emissions, includ-

ing level of wealth, population growth rate, type of

energy supply, transportation system, rate of economic

growth, past investment selections, and existing infra-

structure (Kellow, 1998). For example, the treaty

allows Eastern Europe, as well as nations included in

the former Soviet Union to benefit from their histori-

cally incredibly inefficient energy systems by using

1990 levels as a baseline (Nordhaus, 1998). These

countries could easily reduce emissions at a minimal

cost. Also, the collapse of the Soviet Union, which

greatly affected industry and therefore, reduced GHG

emission from 1990 levels, allows Russia a huge wind-

fall. Russia would be able to meet its target without

any modifications of its current emission level.

Also, enforcement of the Kyoto Protocol re-

mains a perplexing, unresolved problem. Due to the

extremely high projected cost of Kyoto, countries will

have a strong incentive to cheat. As a result, high

transaction costs to ensure en-

forcement will add to the al-

ready burdensome cost of

Kyoto. The treaty fails to ad-

dress the specifics of enforce-

ment and consequently, pun-

ishment. Even more problem-

atic, there is no precedence for

a global enforcing agency of the

magnitude Kyoto requires. Doubts arise as to the

practical possibility of implementing and enforcing

Kyoto.

More than any other factor, the unbelievably

high cost of implementing Kyoto effectively eradicates

any possible value of the treaty. Nordhaus estimates

the global cost of Kyoto to total $828 billion (1998).

Annex I nations bear this economic burden, while non-

Annex I countries benefit, albeit comparatively insig-

nificantly. Eastern Europe and Russia emerge as ben-

eficiaries. However, these gains are merely transfers

from the US, due to the tradable emission reduction

credits, and do not represent true economic benefits.

If implemented, the US will bear the brunt of

Kyoto’s massive cost, paying over 2/3 of the total

global cost, which reaches approximately $517 bil-

lion (Nordhaus, 1998). The treaty requires 2-5% of

the US’s GDP annually (Murkowski, 2000). Imple-

menting Kyoto will cause serious economic ramifica-

tions. By 2050, the US will transfer over $40 billion

annually to Russia and Eastern Europe to purchase

emission reduction permits (Nordhaus, 1998). This

large transfer of wealth will deplete funds for capital

investment within the US and discourage domestic

growth of the economy.

In addition, energy prices will dramatically

increase. In order to achieve Kyoto’s emission re-

duction standards domestically, the US will need to

decrease energy consumption by raising prices, which

will eventually decrease demand. However, the in-

elastic demand for energy predicts that prices must

drastically increase before consumers respond. En-

ergy prices will increase by 33% by 2010. Imple-

menting Kyoto will impose a tax on carbon exceed-

ing $250 per ton by 2050 (Nordhaus, 1998). Kyoto

will consume an average of $2,728 of household in-

come annually, eradicate 2.4 million jobs, and de-

crease the US living standard (Murkowski, 2001).

Proponents of the treaty argue that the high

costs of global climate change justify the extremely

large price tag of the treaty. Although the estimated

total cost of unabated global cli-

mate change varies, relatively

conservative estimates total

$1.8 trillion, which clearly vali-

dates the devotion of resources

to combat this environmental

problem. However, as stated

earlier, Kyoto does not effec-

tively mitigate global warming.

Kyoto’s benefits only total $0.12 trillion, while the

costs total more than $0.8 trillion. Therefore, the

Kyoto Protocol clearly fails the benefit-cost test; the

benefit-cost ratio equals 1/7 (Nordhaus, 1998). The

Kyoto Protocol is an extremely inefficient, cost inef-

fective approach that fails to produce results.

IV. Conclusion

Although the dynamics of global climate

change necessitates both government intervention and

international cooperation, the Kyoto Protocol lacks

the ability to counteract the global warming trend but

retains a prohibitively high price. Both the economic

and ecological ramifications of Kyoto raise concern.

Implementing Kyoto would result in both economic

and ecological disaster. Kyoto would cause an in-

credible amount of strain upon the US and other An-

“...enforcement of the Kyoto

Protocol remains a perplexing,

unresolved problem. Due to

the extremely high projected

cost of Kyoto, countries will

have a strong incentive to

cheat.”

An Economic Analysis of the Kyoto Protocol

The Park Place Economist Volume X

nex I economies. In addition to the inevitable eco-

nomic crisis, the global climate change would con-

tinue to occur at an alarming rate, aiding a possible

ecological disaster. However, the world would lack

necessary resources to devote to combating global

climate change due to the high costs of Kyoto. Ironi-

cally, implementing the Kyoto Protocol, a treaty de-

signed to reduce global warming, would actually in-

crease the severity of this environmental problem,

because large quantities of valuable resources would

be devoted to a fundamentally, flawed, ineffective

treaty. Kyoto imposes a large opportunity cost upon

the world. The financially depleted world would lack

the necessary resources to solve global climate change.

Achieving an efficient global climate change

policy is a very challenging goal, but several funda-

mental guidelines exist. Global climate change ne-

cessitates decisive global action. Each country will

not individually elect a globally optimal policy, be-

cause the stratosphere is a public good. Therefore,

global climate change requires enforceable, binding

worldwide cooperation. Both developed and devel-

oping countries must play active, meaningful roles.

Without the participation of developing nations, any

policy will be rendered ineffective. Obviously, or

perhaps not so obviously, total benefits must outweigh

total costs. In order to achieve a globally optimal

policy, each country must individually experience a

positive net gain. Any successful policy must create

the proper incentives for participation, which implies

positive net benefits. Logically, global participation

will not occur, in the absence of prohibitively high en-

forcement costs, unless each country experiences

positive benefits. Efficiency and cost effectiveness

constitute important goals. Ideally, the marginal cost

of emission reduction should equal the marginal ben-

efit emission reduction, which indicates efficiency.

However, practicality eliminates the possibility of com-

plete efficiency. Nevertheless, global warming poli-

cies should strive towards efficiency. Flexibility in

achieving reductions in GHG emission will lessen the

cost of implementing the policy and result in a more

efficient outcome. International tradable emission

permits will promote efficiency by minimizing mar-

ginal cost as well as encouraging technological inno-

vations. Also, reduction standards should reflect sci-

entific findings, which indicate that any policy must

actually reduce global warming, thus producing ben-

efits. A scientifically ineffective policy wastes valu-

able resources.

Fortunately, the US faced economic and sci-

entific realities, and President George W. Bush termi-

nated Kyoto Protocol negotiations in March of 2001.

However, many Annex I nations remain in the nego-

tiations. Although some environmentalists and politi-

cians view the US’s rejection of the treaty as short-

sighted and ignorant, the rejection of Kyoto appears

logical and prudent, in terms of both the short and

long run. Allocating additional resources to Kyoto, a

profoundly flawed treaty, would represent waste of

limited, valuable resources. The US now possesses

the opportunity to pursue an economically and scien-

tifically valid alternative to the Kyoto Protocol. As

the largest CO

emitter and an influential world power,

the US has an obligation to take a pro-active stance

towards climate stabilization in order to ensure the

welfare of future generations across the globe.

References

Chandler, Parkash, et al. “The Kyoto Protocol: An Eco-

nomic and Game Theoretic Interpretation.” University

Catholique de Louvain CORE Discussion Paper (May 1999).

Easterbrook, Gregg. “Climate Change.” The New Republic

225 (July 23 2001) : 22-25.

Kellow, Aynsley, et al. “The Political Economy of the Kyoto

Protocol.” Agenda 5 (November 1998) : 289-298.

Murkowski, Frank H. “The Kyoto Protocol is not the An-

swer to Climate Change.” Havard Journal on Legislation

37 (Summer 2000) : 345-367.

Nordhaus, William D. and Joseph G. “Requiem for Kyoto:

An Economic Analysis of the Kyoto Protocol.” Yales Cowles

Foundation Discussion Paper (October 1998).

Rao, P. K. The Economics of Global Climatic Change.

Armonk, NY: Sharpe, 2000.

Sutherland, Ronald J. “No cost efforts to reduce carbon

emissions in the U.S.: An economic perspective.” Energy

Journal 21 (2000) : 89-112.

Tol, Richard S. J. “Kyoto’s Mistakes.” Institute for Envi-

ronmental Studies 10 (1998) : 503-507.