Climate protection through CO2 prices – the role of emerging and developing countries

Limiting global warming and climate change requires a substantial reduction of CO2 emissions. Industrialized countries and oil-producing states have a special responsibility and importance in this regard due to their longstanding high per capita emissions.

However, an effective and efficient climate policy also requires these countries to include newly industrializing and developing countries in their emission reduction strategies.

International climate targets

At the Rio Conference in 1992, the principle of “common but differentiated responsibilities” of states in protecting the climate was established for the first time.

The United Nations Framework Convention on Climate Change adopted there stated that industrialization is the central driver of climate change and that industrialized countries, therefore, have a particularly large responsibility for causing climate change and thus also for coping with it.

The two major international climate change agreements based on this – the Kyoto Protocol of 1997 and the Paris Agreement of 2015 – attempt to concretize this responsibility.

Under the Kyoto Protocol, 37 industrialized countries and Eastern European economies in transition, and the European Union pledged to meet quantified emissions caps or reductions for their respective economies.

What the Kyoto Protocol lacked, however, was the setting of an overall global target, i.e., an emissions limit for the world economy.  This was introduced with the Paris Climate Agreement. All 190-plus member states of the treaty pledged to work together to achieve emissions levels that would limit the rise in average global temperatures to well below 2 degrees Celsius, and preferably to 1.5 degrees Celsius compared with the pre-industrial era.

All countries must make nationally determined contributions (NDCs) to reduce emissions – but only as a voluntary commitment.

Climate protection through CO2 prices

Many industrialized countries, and the European Union, in particular, are increasingly using the pricing of CO2-intensive products as a particularly effective and efficient instrument for achieving jointly defined climate targets.

A CO2 price makes emission-intensive products and activities more expensive. As a result, consumer demand for these products and activities declines. Companies adapt to the lower demand. CO2 is synonymous with all man-made greenhouse gases that are harmful to the climate.

In addition, companies respond to a higher CO2 price by pushing technological progress and developing low-emission technologies and products. This allows a given quantity of goods and services to be produced with lower emissions of climate-damaging greenhouse gases.

However, if only a small number of countries worldwide pursue this approach to reducing CO2 emissions, two important challenges arise. A study by the Kiel Institute for the World Economy (IfW) commissioned by the Bertelsmann Stiftung has examined in greater detail.

Greater effectiveness: Avoiding carbon leakage

If an industrialized country unilaterally increases its carbon price, domestic companies may lose their international competitiveness. Therefore, there is an incentive to relocate emissions-intensive economic activities to countries with less stringent climate policies.

This shift reduces production, employment, and income domestically. On the other hand, for those economies that have no or only a low carbon price, this means an increase in their economic activities.

As a result, production, gross domestic products (GDP), income, and employment increase – and so do CO2 emissions. This shift in emissions is called carbon leakage. As a result, emissions savings in industrialized countries are at least partially wiped out.

Theoretically, it is even possible that there will be a net increase in global emissions. This is to be feared if production is carried out abroad using more environmentally harmful technologies and if the transport of products produced abroad is also associated with high emissions.

Simulation calculations can estimate the extent of these emission increases. A study by the Kiel Institute for the World Economy (IfW) commissioned by the Bertelsmann Stiftung shows that if the price of CO2 were to rise by 50 dollars within the EU, emissions from European countries such as Algeria and Libya would increase by more than two percent, and by more than one percent in Turkey.

In emerging economies such as China and India, emissions would actually increase only very slightly in percentage terms. However, due to the size of their economies, this would mean additional emissions of 13.6 million metric tons of CO2 per year in the case of China alone.

Overall, this results in a carbon leakage rate of 14.9 percent, i.e., 14.9 percent of the emissions saved in the EU are simply shifted to other countries, especially developing and newly industrializing countries. With an even further increase in CO2 prices in Europe and their expansion to more products, the figures would rise even further – a scenario that is not unrealistic given the EU’s growing climate policy ambitions.

Nevertheless, this should not stop the EU from taking action to reduce its emissions and lead by example, becoming a role model for climate protection.

More efficiency: saving CO2 where it costs the least

In principle, greenhouse gas emissions should be saved where there are the lowest emission avoidance costs. As a result, the cost of a particular targeted emissions reduction can be reduced. Alternatively, more climate-damaging emissions can be avoided with the same amount of resources.

Highly developed industrial nations have already implemented emission-reducing production technologies in many areas. Further emission reductions may only be possible through financially costly innovations, which means correspondingly high costs for research, development, and subsequent investment.

On the other hand, emerging and developing countries often use technologies that cause higher greenhouse gas emissions but can be converted to low-emission technologies more cost-effectively.

With such differences in emissions abatement costs, it makes sense from a global perspective for emitters from industrialized countries to implement or finance abatement measures in less developed economies. At the same time, industrialized countries must push ahead with their own efforts to develop lower-emission or even neutral technologies because, without such technological advances, the agreed-upon long-term climate targets cannot be achieved.

However, this creates a financing problem: Developing countries generally do not have the financial resources needed to implement lower-emission technologies. As a result, they continue to produce using outdated technologies with low energy efficiency and use fossil fuels, led by low-cost coal.

Policy recommendations 

Fortunately, there are options for solving both of the problems outlined.

The relocation of emission-intensive production processes from industrialized countries with high CO2 prices to emerging and developing countries can be prevented with the help of a so-called border adjustment mechanism (“Carbon Border Adjustment Mechanism“).

It works with two basic instruments. First, products imported from abroad are subject to an emissions levy or CO2 tariff. The amount of this levy corresponds to the domestic CO2 price. Second, exports by domestic companies are exempt from the applicable CO2 price. This removes the incentive to relocate emissions-intensive activities to countries with a lower emissions price – the associated price advantage is eliminated by combining the two measures mentioned.

Our study conducted by the IfW also shows the consequences of such a border adjustment mechanism for emissions shifting. If, as planned, the EU only introduces a CO2 tariff for energy-intensive imported products, i.e., foregoes full border adjustment by additionally subsidizing exports, the carbon leakage rate already falls from 14.0 to 10.8 percent.

By joining forces with other major emitters in a climate club that also levies an import duty, this rate can be reduced even further. However, such a club always leads to economic losses for non-members, as their products now become more expensive.

As long as developing countries remain outside the club, the question of financial burden-sharing or additional support for the ecological transformation of their economies will therefore always arise.

The second problem mentioned here can be tackled with the help of the Clean Development Mechanism (CDM) or the Sustainable Development Mechanism (SDM). These instruments were established in the Kyoto Protocol and the Paris Agreement, respectively.

Industrialized countries can finance projects to reduce greenhouse gas emissions in developing countries and receive credit for the resulting emission reductions. For example, suppose Germany invests in the construction of a wind turbine in India that subsequently generates electricity that would be provided by a coal-fired power plant without this investment.

In that case, this investment reduces greenhouse gas emissions in India. Under the CDM, certificates are issued for the emission reductions achieved in India (Certified Emission Reductions). These emission credits are transferred to the investor in Germany and can be used or sold by him as emission rights.

This instrument makes good business sense for companies if the emission avoidance costs in their own country are higher than in a developing or emerging country. It should also be noted that this mechanism also contributes to sustainable development in developing countries. It gives them access to climate-friendly, forward-looking technologies and know-how.

Outlook

Climate change is a global problem that ultimately requires a global solution. National solo efforts to reduce CO2 emissions are necessary but insufficient and may even have a negative impact due to carbon leakage.

The best solution, therefore, remains a global CO2 price. Our simulation calculation carried out with the IfW shows, for example, that long-term savings of almost 40 percent of global emissions would be possible if all countries raised their CO2 prices by $50.

By contrast, an increase in CO2 prices by the EU alone would save only 2.5 percent of global emissions. At the same time, however, it is also true that waiting for a global solution is not an option, so rapid national or European action on climate protection is necessary.

For more extensive international cooperation to come about in the long term, developing countries must be supported with technical know-how and financial resources, at least for a limited period of time.

This is because such an increase in CO2 prices hits poorer countries particularly hard, especially low-income households. Only with the help of industrialized countries and rich emerging economies can these countries make a socially responsible contribution to climate protection.