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...and compare the importance of many different second-best factors on economic outcomes. As will be clear, we suggest that credibility is paramount. Indeed, while this topic is rarely discussed among analysts of climate policy, this is a long-standing topic in other fields of regulation and regulatory risk. Studies of foreign investment, for example, have shown that countries that have more credible regulatory policies tend to be more attractive locations for investors who are risk-averse and fear that unpredictable changes in regulatory results will lead to expropriation of their fixed assets [Vernon, 1971; Woodhouse, 2006]. The daily business of diplomats, such as those crafting global warming treaties, is a constant fretting about credibility because international legal Politics and Economics of Second-Best Regulation of Greenhouse Gases / 5 2. A thorough description and a list of related papers and applications are available at http:// www.witchmodel.org. mechanisms, on their own, are usually not very strong. Credibility is a scarce resource in international law. AN INTEGRATED ASSESSMENT MODEL To examine this second-best world—where geometry, trading rules, sectors and credibility all vary—w...

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... control greenhouse gases from all sectors of their economies as soon as possible. That ideal outcome would give firms time to anticipate regulation. It would also help prevent “leakage” of emissions that would occur if emission-intensive activities shifted from tightly regulated sectors and countries to the more lax zones [e.g., Aldy and Pizer, 2009]. Indeed, from the pioneering work on the economics of regulating greenhouse gases to the present day, the standard result confirms that a global, economywide and long-term approach is the most cost-effective method for controlling warming gases [Manne and Richels, 1992], [Nordhaus, 2005] and [Jacoby at al, 2008]. The economic benefits of this approach are particularly large when countries aim to make deep reductions in emissions, as implied with increasingly popular goals such as limiting concentrations of CO2 and other warming gases at 450 ppm or even 350 ppm. Indeed, meeting such goals is essentially impossible without immediate and comprehensive limits that cover nearly all nations and economic sectors [Clarke et al. 2009, Bosetti et al. 2008, Edmonds et al. 2007, Keppo and Rao, 2007, OECD Policy Brief, 2009]. While the ideal world is elegant and efficie...

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...so those of the more advanced nations that hope to link their emission trading schemes to the many low-cost opportunities for emission controls in the developing world. They will be wary about allowing trading links to sectors that are impractical to monitor and enforce [Rai and Victor, 2009; Wagner et al., 2008]. Even in those sectors where regulation is feasible, developing countries will demand delays and compensation before they impose limits on their activities, just as they secured delays and special funding in other major international accords, such as on protection of the ozone layer [Benedick, 1998; Parson, 2003]. The ideal world of greenhouse regulation is one of a seamless regulation that spans all sectors globally. The real world is a messier second-best landscape of fragmented efforts that run at many different speeds [Victor et al., 2005; RiPolitics and Economics of Second-Best Regulation of Greenhouse Gases / 3 1. In the real world, membership in these categories varies as countries learn about climate dangers and come under varying degrees of political pressure to act or drag their feet. For simplicity, for the modelling runs in this paper we assume the enthusiastic countries are...

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... daily business of diplomats, such as those crafting global warming treaties, is a constant fretting about credibility because international legal Politics and Economics of Second-Best Regulation of Greenhouse Gases / 5 2. A thorough description and a list of related papers and applications are available at http:// www.witchmodel.org. mechanisms, on their own, are usually not very strong. Credibility is a scarce resource in international law. AN INTEGRATED ASSESSMENT MODEL To examine this second-best world—where geometry, trading rules, sectors and credibility all vary—we use the WITCH model [Bosetti et al, 2006].2 WITCH is a regional integrated assessment model that is designed to analyse optimal responses of world economies to climate damages and to identify the impacts of climate policy on global and regional economic systems. It is a hybrid of “top-down” (macroeconomic) and “bottom-up” (technology) assessment models. Its top-down component consists of an inter-temporal optimal macroeconomic growth model in which the energy input of the aggregate production function has been expanded to provide a bottom-up like description of the energy sector. The bottom-up attributes include detailed treatment o...

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...of global warming but not much real investment in building capable institutions—suggests that most governments don’t yet take these issues seriously. For illustration, we briefly examine one strategy that might boost credibility: pre-commitment. One difficulty with all the strategies already mentioned is that they require collective action and formal negotiations. Pre-commitment is something that a country can do on its own—much like tacit bargaining in arms control where a country can boost the credibility of efforts to cut arms by unilaterally cutting arms on its own [Downs and Rocke, 1990; Schelling, 1963]. A country could, by similar logic, boost the credibility of international warming regulations on its own soil by committing to cut emissions even in advance of a binding international obligation. If such actions increased credibility—by making firms within a nation’s borders more likely to anticipate future international regulations and by making those regulations more likely—then pre-commitment (as we will call it) could be in a country’s narrow self-interest even without formal cooperation by others. 20 / The Energy Journal Table 4: Change in Policy Costs for the Three Groups for Differen...

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...more advanced nations that hope to link their emission trading schemes to the many low-cost opportunities for emission controls in the developing world. They will be wary about allowing trading links to sectors that are impractical to monitor and enforce [Rai and Victor, 2009; Wagner et al., 2008]. Even in those sectors where regulation is feasible, developing countries will demand delays and compensation before they impose limits on their activities, just as they secured delays and special funding in other major international accords, such as on protection of the ozone layer [Benedick, 1998; Parson, 2003]. The ideal world of greenhouse regulation is one of a seamless regulation that spans all sectors globally. The real world is a messier second-best landscape of fragmented efforts that run at many different speeds [Victor et al., 2005; RiPolitics and Economics of Second-Best Regulation of Greenhouse Gases / 3 1. In the real world, membership in these categories varies as countries learn about climate dangers and come under varying degrees of political pressure to act or drag their feet. For simplicity, for the modelling runs in this paper we assume the enthusiastic countries are OECD countrie...

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...l commitments. We show that China, for example, can justify unilateral, emission controls because such pre-commitment would encourage Chinese firms to invest with a clearer eye to the future. 2 / The Energy Journal INTRODUCTION In the ideal world all governments would control greenhouse gases from all sectors of their economies as soon as possible. That ideal outcome would give firms time to anticipate regulation. It would also help prevent “leakage” of emissions that would occur if emission-intensive activities shifted from tightly regulated sectors and countries to the more lax zones [e.g., Aldy and Pizer, 2009]. Indeed, from the pioneering work on the economics of regulating greenhouse gases to the present day, the standard result confirms that a global, economywide and long-term approach is the most cost-effective method for controlling warming gases [Manne and Richels, 1992], [Nordhaus, 2005] and [Jacoby at al, 2008]. The economic benefits of this approach are particularly large when countries aim to make deep reductions in emissions, as implied with increasingly popular goals such as limiting concentrations of CO2 and other warming gases at 450 ppm or even 350 ppm. Indeed, meeting such goals is ...

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... and long-term plan for expenditure of capital it does not assume that most of its managers are asleep, ignorant or otherwise unable to tune their individual efforts to the common plan. But the assumption that agents can anticipate the future is deeply troubling at the international level. International law is weak and easy to disregard. Often its strictures are vague and hard to translate into meaningful efforts that every country or firm should implement. To be sure, there is a raging debate on the questions of why international law exists and whether it works reliably [e.g., Keohane, 1984; Chayes & Chayes, 1995, Goldsmith and Posner, 2005; Guzman, 2008]. But even the most ardent enthusiasts of international law do not see those regulatory instruments as reliable guides for investment when compared with the strict planning, monitoring and enforcement system that is typical of well-administered corporate budget planning or of a properly monitored and enforced scheme of national law. International laws, to different degrees, are not fully credible—especially when their mandates are inconvenient for powerful states. To explore the importance of credibility we vary the extent to which the model allows fo...

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...antage point would be meaningless. WITCH includes two breakthrough technologies, one in the electric and one in the non electric sector, that necessitate dedicated innovation investments to become economically competitive, even in a scenario with a climate policy. We follow the most recent characterisation in the technology and climate change literature by modelling the costs of the breakthrough technologies with a two-factor learning curve in which their price declines both with investments in dedicated R&D and with technology diffusion. Similar approaches are also reported, for example, in [Kouvaritakis et al., 2000] and [Klassen et al, 2007]. For our analysis, a key attribute of the WITCH model is the ability to adjust the extent to which governments and firms are forward-looking. If global policies such as binding limits on emissions and concentrations of warming gases will be credibly enforced then each region’s policy maker (and by implication, firms that follow the dictates of the policy maker) can reliably anticipate the arrival of policy mandates. Anticipation allows firms and governments to invest in new energy technologies in a manner consistent with the commercial life-time of the energy stock,...

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...e importance of many different second-best factors on economic outcomes. As will be clear, we suggest that credibility is paramount. Indeed, while this topic is rarely discussed among analysts of climate policy, this is a long-standing topic in other fields of regulation and regulatory risk. Studies of foreign investment, for example, have shown that countries that have more credible regulatory policies tend to be more attractive locations for investors who are risk-averse and fear that unpredictable changes in regulatory results will lead to expropriation of their fixed assets [Vernon, 1971; Woodhouse, 2006]. The daily business of diplomats, such as those crafting global warming treaties, is a constant fretting about credibility because international legal Politics and Economics of Second-Best Regulation of Greenhouse Gases / 5 2. A thorough description and a list of related papers and applications are available at http:// www.witchmodel.org. mechanisms, on their own, are usually not very strong. Credibility is a scarce resource in international law. AN INTEGRATED ASSESSMENT MODEL To examine this second-best world—where geometry, trading rules, sectors and credibility all vary—we use the WITCH m...

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...use some emitting sectors are easier to regulate than others [e.g., Rai and Victor, 2009]. We also explore a fourth and much less studied aspect of the real, secondbest world: credibility. When policies are highly credible then investors can make reliable plans; in turn, the cost of emission controls is lower than it would be otherwise because new technologies can be ordered and installed with the normal turnover of the capital stock [e.g., Philibert, 2007]. Very few studies have looked at the effect of policy anticipation on the costs of climate change regulation. The few exceptions include [Blanford et al, 2009] and [Bosetti et al 2009b], both of which assess the negative effect of myopic behaviour on latecomers as well as on climate agreement early participants. A study by [Reinelt and Keith,2007] has examined the consequences of regulatory uncertainty on incentives to invest in carbon capture, which is one widely discussed technological option that could help societies lower emissions. Still other studies have looked at how credibility affects markets. An analysis by [Paltsev at al, 2009], for example, has explored the effect of policy credibility on the banking of carbon permits, concluding that ...

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...ch is the most cost-effective method for controlling warming gases [Manne and Richels, 1992], [Nordhaus, 2005] and [Jacoby at al, 2008]. The economic benefits of this approach are particularly large when countries aim to make deep reductions in emissions, as implied with increasingly popular goals such as limiting concentrations of CO2 and other warming gases at 450 ppm or even 350 ppm. Indeed, meeting such goals is essentially impossible without immediate and comprehensive limits that cover nearly all nations and economic sectors [Clarke et al. 2009, Bosetti et al. 2008, Edmonds et al. 2007, Keppo and Rao, 2007, OECD Policy Brief, 2009]. While the ideal world is elegant and efficient, the real world is not nearly so accommodating. Developing countries have been famously reluctant to accept caps on their emissions. Efforts to entice them by offering more generous caps— so-called “headroom allowances”—are exciting for theorists to discuss, but have been politically impossible to achieve in real diplomatic discussions. The experience with Russia (which was given a particularly generous cap to entice its participation in the Kyoto treaty) suggests that providing generous caps to reluctant treaty members...

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...ansport and buildings, are regulated with different instruments. Developing countries are also exploring policies that would vary by sector, not least because some emitting sectors are easier to regulate than others [e.g., Rai and Victor, 2009]. We also explore a fourth and much less studied aspect of the real, secondbest world: credibility. When policies are highly credible then investors can make reliable plans; in turn, the cost of emission controls is lower than it would be otherwise because new technologies can be ordered and installed with the normal turnover of the capital stock [e.g., Philibert, 2007]. Very few studies have looked at the effect of policy anticipation on the costs of climate change regulation. The few exceptions include [Blanford et al, 2009] and [Bosetti et al 2009b], both of which assess the negative effect of myopic behaviour on latecomers as well as on climate agreement early participants. A study by [Reinelt and Keith,2007] has examined the consequences of regulatory uncertainty on incentives to invest in carbon capture, which is one widely discussed technological option that could help societies lower emissions. Still other studies have looked at how credibility affe...

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...d allow regulation, first, in particular sectors where they are confident of their ability to administer emission controls; other, less well-regulated sectors would be brought into a regulatory scheme later on [Victor, in press]. That sectoral approach reflects not only the interests and capabilities of these countries, but also those of the more advanced nations that hope to link their emission trading schemes to the many low-cost opportunities for emission controls in the developing world. They will be wary about allowing trading links to sectors that are impractical to monitor and enforce [Rai and Victor, 2009; Wagner et al., 2008]. Even in those sectors where regulation is feasible, developing countries will demand delays and compensation before they impose limits on their activities, just as they secured delays and special funding in other major international accords, such as on protection of the ozone layer [Benedick, 1998; Parson, 2003]. The ideal world of greenhouse regulation is one of a seamless regulation that spans all sectors globally. The real world is a messier second-best landscape of fragmented efforts that run at many different speeds [Victor et al., 2005; RiPolitics and Economics of...

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...rst, in particular sectors where they are confident of their ability to administer emission controls; other, less well-regulated sectors would be brought into a regulatory scheme later on [Victor, in press]. That sectoral approach reflects not only the interests and capabilities of these countries, but also those of the more advanced nations that hope to link their emission trading schemes to the many low-cost opportunities for emission controls in the developing world. They will be wary about allowing trading links to sectors that are impractical to monitor and enforce [Rai and Victor, 2009; Wagner et al., 2008]. Even in those sectors where regulation is feasible, developing countries will demand delays and compensation before they impose limits on their activities, just as they secured delays and special funding in other major international accords, such as on protection of the ozone layer [Benedick, 1998; Parson, 2003]. The ideal world of greenhouse regulation is one of a seamless regulation that spans all sectors globally. The real world is a messier second-best landscape of fragmented efforts that run at many different speeds [Victor et al., 2005; RiPolitics and Economics of Second-Best Regulati...

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...mpliance effort—a scenario we will call “15% cap”. In adding transaction costs, we envision that efforts to reform the CDM create a much tighter administration that imposes a $10 per ton CO2 extra cost. (That number is at the high end of current estimates for administrative costs but not implausible.) Because the results from these constraints are most interesting when combined with other second-best constraints we report them later. Sectors We also explore second-best policies that might vary by sector. A few analysts have examined such scenarios, often focusing on the electric power sector [Sawa 2008]. Such sectoral approaches are important to analyse because even when governments are keen to regulate emissions due to internal political pressure or external incentives such as carbon credits, it can often be administratively difficult for governments to control activities in all sectors. Moreover, the politics of regulation often vary by sector. For simplicity, we divide the world into two broad sectors: electricity and the rest. We assume that enthusiastic countries require equal regulatory effort in all sectors. But the rest of the world varies its effort by sector. This reflects that in...

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...tion about the dangers of global warming but not much real investment in building capable institutions—suggests that most governments don’t yet take these issues seriously. For illustration, we briefly examine one strategy that might boost credibility: pre-commitment. One difficulty with all the strategies already mentioned is that they require collective action and formal negotiations. Pre-commitment is something that a country can do on its own—much like tacit bargaining in arms control where a country can boost the credibility of efforts to cut arms by unilaterally cutting arms on its own [Downs and Rocke, 1990; Schelling, 1963]. A country could, by similar logic, boost the credibility of international warming regulations on its own soil by committing to cut emissions even in advance of a binding international obligation. If such actions increased credibility—by making firms within a nation’s borders more likely to anticipate future international regulations and by making those regulations more likely—then pre-commitment (as we will call it) could be in a country’s narrow self-interest even without formal cooperation by others. 20 / The Energy Journal Table 4: Change in Policy Costs for the Three Gr...

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...re easier to regulate than others [e.g., Rai and Victor, 2009]. We also explore a fourth and much less studied aspect of the real, secondbest world: credibility. When policies are highly credible then investors can make reliable plans; in turn, the cost of emission controls is lower than it would be otherwise because new technologies can be ordered and installed with the normal turnover of the capital stock [e.g., Philibert, 2007]. Very few studies have looked at the effect of policy anticipation on the costs of climate change regulation. The few exceptions include [Blanford et al, 2009] and [Bosetti et al 2009b], both of which assess the negative effect of myopic behaviour on latecomers as well as on climate agreement early participants. A study by [Reinelt and Keith,2007] has examined the consequences of regulatory uncertainty on incentives to invest in carbon capture, which is one widely discussed technological option that could help societies lower emissions. Still other studies have looked at how credibility affects markets. An analysis by [Paltsev at al, 2009], for example, has explored the effect of policy credibility on the banking of carbon permits, concluding that incredible policies have ...

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...3, causes a very modest 3% increase in total policy costs. However, in the short term the increase in costs in this scenario can be substantial; in 2020 total economic costs are 50% higher than the first-best regulated baseline, and the costs for the OECD nations are double those in the first-best world. (However, since early costs are modest in absolute terms the overall impact on total integrated costs is not severe.) In addition, the early increase in efforts is rewarded by a faster technological progress that pays off when, in later periods, the cuts in emission are more substantial (see [DeCian and Tavoni, 2009] for a detailed description of the effects of trade restriction on the cost of climate policy). These results are consistent with those reported by other scholars who have found that restrictions on trade are not too costly so long as they are not so severe to prevent at least some forms of trade—for example the studies by [Jaffe et al., 2005] and [Jaffe and Stavins, 2007]). The effect of second-best limits on sectors is also relatively small. We implement this approach by allowing trade in emission credits only in the power sector (fourth scenario in figure 3). The small (less than 4%) incre...

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...include black carbon and its potentially large but uncertain warming properties. it is widely discussed and has been the subject of extensive modelling and thus our results can readily be compared with others. We do not claim that this goal aligns the costs and benefits of climate regulation, which is an important and controversial matter, but not the focus of the present analysis. This scenario is less aggressive than some of the scenarios that are now popular—among climate modelers and activists, if not real politicians who might implement them—such as stabilising concentrations at 350ppm. [Monastersky, 2009] Most models find that such aggressive scenarios are impossible to achieve with second-best policy that excludes some countries and sectors, such as for example [Clarke et al, 2009]. The regulated baseline shown in figure 2 and table 1 is a “first-best” response. Costs are minimised because policy makers and firms have perfect 8 / The Energy Journal Figure 2: Abatement Efforts in the “First Best” World of Optimal Regulation Main chart shows emission levels (below the BAU scenario in figure 1) for each of our three groups of countries. The inset shows the resulting stabilization of CO2 concent...