Climate Change: Policy Mix for a Brave New Kyoto? (ARI)

Climate Change: Policy Mix for a Brave New Kyoto? (ARI)

Theme: Moderate optimism for some and overt scepticism for others, spurred after Bali, will continue to highlight the inevitable winding road of climate–change negotiations. Despite the long way ahead, reflecting on the policy instruments that could make the journey safer, cheaper, more equitable and politically feasible, is interesting given the lack of free lunches in the climate–change menu. This ARI looks at the basic features of the main policy instruments at our disposal for the post–Kyoto era.

Summary: It is too soon to forecast any final policy mix for any particular country in the battle against climate change. The discussion below, nevertheless, offers insights into the main features of the policy instruments that can be used to achieve efficient outcomes that help us abide by the IPCC’s recommendations of limiting GHG emissions to ensure that temperature increases remain within the 2°C range. Hybrid policy approaches have been pursued by European Climate Change Programmes as well as by national governments, such as Spain’s, and it is likely for this to continue to be the case in the future.

An overview of the economics of pollution control is put forth with regards to the main policy instruments. Interventionist instruments, such as command and control regulations, environmental taxes and cap–and–trade tradable permit systems, are discussed. Non–interventionist instruments, such as moral suasion and voluntary regulation, are also succinctly analysed as part of the potential policy mix for greenhouse gas–emission reduction. These instruments are evaluated in terms of their environmental effectiveness and static and dynamic efficiency, as well as in terms of political considerations.



Policy instruments implemented to deal with environmental problems are becoming increasingly sophisticated. In the EU, the publication of the Delors ‘White Paper on Growth, Competitiveness and Employment’ in 1993 spread the discussion of market–based instruments (MBIs) in all sectors of society.[1] This has not meant, however, abandoning traditional command and control policies, but it has widened the scope for market–based instruments. Global environmental problems such as climate change pose a world–wide policy challenge that will continue to be tackled by a wide portfolio of policy tools. The various sectors of the economy, a country’s stage, national interests, the lobbying power of the various stakeholders, etc, will shape the policies to be implemented.

The criteria against which the different policy tools to tackle climate change will be evaluated include: environmental effectiveness, efficiency, equity considerations and feasibility. When we analyse environmental effectiveness, we will look into the extent to which the policy under evaluation achieves the environmental goal. When analysing efficiency, we will refer to static efficiency (ie, will the instrument achieve an efficient level of pollution and will the abatement costs be minimised within the industry?). Dynamic efficiency (ie, the incentives for innovation) will also be analysed. Equity issues, whether the policy will affect those who are worse off , will be discussed. The feasibility of each policy will then be considered from a Public Choice approach, as policy usefulness will be determined by whether it is feasible to implement a given tool in a certain context.

Interventionist Instruments: Command and Control

Historically, the first ‘and still most commonly used’ policy instruments for controlling pollution and resource use are command and control regulations. When using command and control regulations, authorities simply mandate a certain behaviour (eg, maximum pollution levels or speed limits) and use enforcement tools such as fines, courts, etc, to ensure all agents meet the requirements. At a European level, examples of different types of command and control measures include standards on products (eg, Directive 96/57/EC, that determines the energy efficiency of domestic appliances), emission standards for sulphur dioxide and nitrogen oxides (regulated in Spain by Royal Decree 430/2004) and technology standards that specify the technology or process to be followed by polluters in their production processes. Examples of the latter type of standards include the mandatory use of catalytic converters.

The basic characteristics of command and control measures include the theoretical certainty obtained by the standards set, and thus the possibility of achieving a set environmental goal. They are also apparently simpler in their design and implementation, although the bargaining process between the regulated agents and the government might erode the outcome of the process, increasing the costs of implementing these measures. They have a long history and thus all actors are used to the process. They are also morally close to the ethical sense of right and wrong (ie, if something is bad it should be banned rather than allowed to take place for those agents who can afford to pay for damaging activities).

In terms of efficiency, command and control will only ensure static efficiency in the unlikely event that all firms affected by the regulation have the same marginal abatement cost curve. The lack of cost–efficiency is a strong argument in opposing this type of regulation from an economic standpoint; but, as we will see when analysing the feasibility of the different instruments, there are wider considerations that shape the policy mix. Regarding dynamic efficiency, emission standards can foster some innovation (compared to technology standards), although incentives to innovate beyond regulation requirements are said to be, at best, weak. In terms of equity considerations, command and control can be seen as treating all agents alike, although negotiations with the government and exemptions for big polluters might result in a differential treatment for polluting agents.

Command and control policies are suggested when the optimal level of emissions is zero or very small, when monitoring costs are very high and when there are emergency events (eg, the spillage of a highly polluting substance in high seas) that might alter the damages caused by the pollution emitted, and when firms are not responsive to price instruments, as in non–competitive settings.

Interventionist Instruments: Market–based Instruments or More Broadly Economic Incentives

These are defined as ‘any instrument that provides continuous inducements, financial or otherwise, to encourage responsible parties to reduce their releases of pollutants or make their product less polluting’.[2] Within this category, environmental taxes and tradable permits will be discussed.

Environmental Taxes
In the case of climate change, these can be defined as a levy on each unit of CO2.[3] They are the most often used market mechanism world–wide. According to the OECD,[4] there are currently approximately 375 environmental taxes in operation in OECD countries, which are mainly levied on energy products and motor vehicles and mainly fall on households and transport. They are normally set at very low levels and are generally implemented for non–environmental reasons (ie, to raise revenues for the government rather than to achieve environmental goals). Additionally, tax exemptions are granted to certain industries and thus the effectiveness of the tax in controlling, for instance, GHG emissions is reduced.

The main characteristic of this price mechanism is that, at least in theory, it achieves both static and dynamic efficiency. All agents are faced with the same tax and adjust their production and pollution levels accordingly, producing until the tax rate equals the marginal abatement costs. This implies the satisfaction of the equimarginal principle. Additionally, as each unit of pollution is taxed, firms have an incentive to innovate and reduce pollution (provided the costs of innovation are lower than the benefits from the reduced payment in taxes).

The flexibility of environmental taxes and the possibility of reaping a double dividend from their implementation (reducing pollution and using this revenue to lower distortive taxes over labour and capital, thus fostering growth and overall welfare) are their core assets. These strengths, coupled with their revenue–raising potential (especially for goods with a low price elasticity of demand), and the fact that they can be administered using the existing fiscal system, make environmental taxes a highly attractive tool from an economic perspective. These instruments are also uniquely suited to reach dispersed sources such as transport and households that would be very difficult to include in, for example, tradable permit systems.

The main drawbacks of implementing a tax system include the information needs, the potential loss of competitiveness of industries subject to the tax, the potentially regressive effects of taxes and the lack of certainty about the amount of pollution reduced. The optimal tax design would need information on the marginal damage curve, which would in turn require data on the firms’ outputs, pollution produced, any cumulative damages of pollution, etc. This information could be very costly to obtain and, therefore, establishing the optimal tax rate is difficult. A further problem in the use of environmental taxes is the potential to hinder competitiveness. If a tax is levied unilaterally in one country and not in others, national industries can lose out. Although this is a legitimate concern, the generally low environmental tax rates and the small percentage of these taxes in the cost structures of firms ‘plus the exemptions granted to major polluters’ have provided scant evidence of this effect.[5] Environmental taxes are also accused of being potentially regressive, disproportionately affecting agents who are less well off, although this depends on which goods and services are taxed and which policies are implemented to counteract the policy’s regressive effects.

Although past European initiatives to levy an EU–wide CO2/energy tax have not succeeded, several countries have implemented some form of CO2/energy tax (eg, Finland, Sweden, Denmark, the Netherlands, Germany, France and the UK). Simulations of the possibility of implementing a green tax reform in Spain have been analysed[6] and the conclusion reached that there is a potential for reaping a double dividend from implementing such a reform.

Environmental taxes, however, work best in combination with other policy instruments and they are rarely used in isolation. Implementing taxes in a gradual manner, allowing economic agents time to adapt and ensuring the stability of the tax can be the key to a fruitful implementation of an environmental tax. As the latter do not ensure the quantity of pollution that will be reduced, they work better when there is no quantitative reduction needed and when the damage function is relatively flat.

Tradable Permits (TP)
This market–based instrument (MBI) can be defined, in the climate change area, as an allowance to discharge pollution. Their use, more common in the US than elsewhere a decade ago, has spread around the world, while the use of TPs in the Kyoto Protocol has brought the instrument even further into the spotlight. Tradable permits are still implemented less than command and control regulations[7] and have traditionally been used only after other policy instruments have failed. The functioning of the cap–and–trade tradable permit system for climate change mitigation will require the determination of an overall ceiling for the emission of GHG, and the allocation of tradable permits (also known as transferable discharge permits) among the actors that are allowed to participate in the trading system.[8] It is therefore a quantity instrument that fixes the overall pollution level, allowing economic agents to adjust their emission reduction efforts according to their cost structures, innovative capacity, etc, in a market interchange.

The basic characteristics in terms of efficiency include the satisfaction of the equimarginal principle, by which firms with different marginal abatement costs trade emission permits until their abatement costs are equal to the permit price. This requires a single market for the permits in which economic actors interact openly with minimum transaction costs. In this optimally functioning market, a single price for permits should emerge, and agents with low abatement costs will reduce their emissions, freeing their allowances for the market exchange. Dynamic efficiency is also fostered by tradable permit systems. Incentives to innovate arise from the reduction in abatement costs through innovation and the possibility of exchanging permits in the market (provided the investment in innovation yields benefits to the firms).

One potential problem of tradable permits is likely to arise in their initial distribution. Even though an efficient level of emissions will be achieved, no matter the initial allocation of rights, the distributional consequences might seem unfair to firms that have initially been assigned fewer permits. A compromise will have to be reached that is acceptable to the agents allowed to participate in the permit market. Tradable permit systems will also need to establish a clear set of rules defining who can act in the scheme, how interaction takes place and the procedures for solving any problem that might arise.[9] As with environmental taxes, the predictability and stability of the trading system will increase its efficiency, favouring long–term investment strategies that favour cost–efficient pollution control. Setting clear trading rules, and allowing the market to develop, is therefore advisable to help minimise the transaction costs of tradable permit systems. A final caveat is the potential damages that could arise due to the non–uniform impacts of emissions. The possibility of encountering pollution hot spots could favour the implementation of trading coefficients among sources that might restrict trade and therefore reduce economic efficiency. This, however, will not take place in the CO2 emission exchange, as the damage caused by the emission of one tonne of CO2 is the same, no matter where it is emitted.

Kyoto’s novel flexibility mechanisms (the European Emission Trading System or EU–ETS),[10] the clean development mechanism, and the joint implementation mechanism[11] can, according to the EU, reduce the cost of compliance with the commitments established in the Kyoto Protocol by 20%.[12] The unprecedented geographical coverage, the vast amount of participants and the potential of the EU–ETS to cover a wide range of emissions are the key innovations presented by the KP. The possibility that climate change can turn out to be the greatest niche for tradable permits can be justified in terms of the above–mentioned advantages. This will, however, be subject to the successful negotiation of future GHG emission limits, as well as to the implementation of adequate monitoring and enforcement mechanisms, not only on behalf of developed countries, but also of less developed countries that might enter the trading system in the future.

The use of tradable permit systems is favoured when the damage cost function is steep, when we need precise control over the pollution emitted and where the marginal abatement costs vary among sources. This might well be the case for future damage–cost curves in the climate–change challenge. Abandoning the emission trading system therefore seems unlikely thus far.

Non–interventionist Instruments

Leaving aside the assignment of property rights and Coasean–type bargains (due to their limited applicability in the climate–change challenge), this final sub–section on instruments will briefly analyse moral suasion and voluntary agreements as the last and ‘softer’ instruments for pollution control. These instruments entail either the provision of information by the government to persuade agents to behave in a certain way or voluntary compliance (such as reducing GHG emissions) when not required by law.

The role of the government in providing information and trying to persuade agents to behave in environmentally ‘friendly’ ways is assessed as generally positive. Examples of this include advertising campaigns on the importance of using public transport to reduce GHG emissions from the use of cars, and the adverts on the relevance of separating household waste for recycling. Although the flexibility of moral suasion initiatives is significant, the extent to which actual individual behaviour changes is debatable. The incentives to free–ride in large societies often overtake any incentive to change the agents’ behaviour, and thus environmental objectives can fail to materialise.

Voluntary agreements by which firms undertake pro–environmental initiatives that are not required by law can be unilaterally established by polluting firms and communicated to stakeholders (eg, the 3M’s Pollution Prevention Pays programme), they can be established by environmental agencies and adhered to by polluters (eg, the US 33/50 programme to reduce the release of 17 toxic chemical substances). These agreements can also be negotiated between the public authorities and the industry (eg, the National Environmental Policy Plan established in the Netherlands to reduce GHG emissions). Fostered by the 5th EU Environmental Action Plan, in 1999 there were over 310 voluntary agreements in operation in the EU and over 350 in OECD countries to reduce CO2 emissions.[13] This large volume of voluntary regulation has been favoured by the increasing cost of other forms of direct regulation, the lengthy legislative processes needed to approve new regulations and the strong support of the industries themselves. Support is based on the flexibility and potential cost efficiency of voluntary initiatives, and the possibility of improving the firms’ public image due to their proactive approach.

The attainment of environmental goals by voluntary agreements can, however, be questionable due to the alleged low ambition of the targets set, and the possibility of breaching commitments in the absence of third party verification, monitoring and sanctions. The incentives for innovation of voluntary agreements are dependent on the returns of these investments and the stringency of the targets set by the firms.

The implementation effectiveness of voluntary regulations is, nevertheless, favoured by setting clear objectives and obligations by third parties, independently of the firms adhering to the agreements, including reporting requirements to evaluate the performance of the firms, mechanisms for dispute resolution and, finally, the possibility of threatening sanctions or the implementation of more stringent regulations. Thus, the voluntary nature of voluntary agreements is rightly disputed and the alleged departure from ‘business as usual’ can be more of a marketing strategy than a reality.

In Europe, voluntary agreements are very popular in Germany and the Netherlands, and interest for these instruments is growing in many other countries. Voluntary agreements work best when firms are unsure about pollution abatement technology and when pollution abatement is homogeneous across firms.

Feasibility: A Further Criterion for Understanding Policy Choices

The efficiency gains brought about by market–based instruments are, according to a Public Choice approach, of little interest to bureaucrats and regulated industries that generally prefer command and control regulations to MBIs, if a policy is to be implemented. The significant weight of these actors in shaping policy outcomes might therefore explain the continued prevalence of command and control policies.

Given the above analysis, firms should theoretically favour cost–efficient MBIs; but in practice they will at best be hesitant regarding these. Firms have the scope for negotiating limits imposed by command and control regulations. This bargaining margin is based on the information held by firms regarding their emissions (and costs to reduce these emissions), and also on the entrepreneurial threat that can be exercised on the government in terms of job losses and the relocation of polluting activities if overly stringent regulations are imposed. The fact that firms either have to pay for every pollution unit emitted (under tax) or face an opportunity cost for the tradable permits used (under tradable permit systems) can imply that command and control regulations are cheaper for them, as a certain amount of pollution (or resource use) is allocated ‘for free’, providing an extra rent for the firm. The lobbying power exercised by firms involved in regulatory processes, as well as their financial backing and visibility in the media, have traditionally tipped the balance in favour of command and control.

The EU’s public bureaucracy is also said to be clearly opposed to the use of MBIs. Its opposition is due to the fact that command and control measures are perceived to further strengthen their position. As more resources are needed for the negotiation and implementation of command and control measures ‘compared to their market–based counterparts’, they thereby increase their budgets. The new skills and more flexible approaches needed to implement MBIs are also generally lacking in the bureaucracy. These factors again lead to favouring command and control policies over the more cost–efficient and innovative policies.

The Policy Mix: The EU and Spain

The EU has, since 1991, launched a wide variety of initiatives to tackle climate change. These initiatives, analysed under the European Climate Change Programme, have included, among others, voluntary agreements with car manufacturers, provision of information on CO2 car emissions (Directive 1999/94/EC), taxing energy, promoting renewable energy production (Directive 2001/77/EC), promoting R&D on climate change (eg, Decision 1513/2002/EC), implementing the EU–ETS (Directive 2003/87/EC), setting energy performance standards for buildings (Directive 2002/91/EC), preventing GHG emissions from industrial and agricultural installations (Directive 96/61/EC), etc. The initiatives already undertaken, plus the planned policies, include a hybrid policy approach, and are said to hold the potential to limit the EU’s contribution to global warming significantly, although the final emission reductions achieved at the end of the first commitment period (2008–2012) remain to be seen.

Spain, as one of the EU’s most vulnerable countries to climate change, should be one of the most active in limiting GHG emissions. The lag in the effective implementation of measures to arrest climate change has been notorious and the recent approval of Spain’s Climate Change Strategy (Cabinet Meeting, 2 November 2007), plus the urgent measures announced by the government on 20 July 2007 have paved the way for Spain’s effort in this area. The policies included in these initiatives reflect the above EU Directives and therefore provide a hybrid policy–mix to respond to GHG emission reduction efforts. Spain’s participation in the EU–ETS, the building performance standards covered by Royal Decree 314/2006, the promotion of information, awareness campaigns and the implementation of environmental taxes, such as the tax on atmospheric pollution first levied in Galicia in 1996, and the tax on activities that affect the environment put forth by Castilla–La Mancha in 2000, are examples of Spain’s policy instruments to respond to climate change.

Having analysed the basic features of the different policy options to controlling pollution in the climate change field, a hybrid policy approach seems to emerge as a way forward in a low–carbon future.


Multiple Approaches to Meet Low–Carbon Future Demands

The wealth of policy instruments at our disposal has evolved from relatively inefficient command and control approaches to more efficient economic incentives and, finally, to voluntary agreements. The trend, however, has been far from linear, and the increasing use of market–based instruments for GHG emission control has not displaced the prominent use of command and control regulations.

The distinctive features of the main policies to arrest climate change that have been discussed throughout this ARI include:

  • Command and control policies that set emission levels and directly lead to overall higher compliance costs compared with market–based instruments and limiting (especially when using technology standards) innovative capacity. Their widespread use is, however, fostered by the interests of powerful actors, such as firms and bureaucrats.
  • Environmental taxes and charges. Their environmental performance depends on their ability to induce changes in behaviour. They can bring about both static and dynamic efficiency, but can be regressive. Overall they are unpopular, and the implementation of environmental taxes is met with strong opposition by stakeholders.
  • Tradable permits are theoretically able to bring about any desired cut in emissions, provided the cap on emissions is adequately set and there is broad participation and compliance. Efficiency will also depend on the characteristics of the market, and the behaviour of sectors invited to engage in market exchanges. Problems with the initial allocation of emission rights are a concern, and no initial allocation rule is likely to satisfy all agents. Although opposition is less than for environmental taxes, well functioning markets and a process of ‘learning by doing’ is likely to improve the performance of tradable permit systems.
  • Information campaigns by the authorities can raise awareness and promote individual behavioural changes, although their environmental effectiveness is questionable. Their use as part of a broader set of policies is perceived to increase their effectiveness. Opposition to these initiatives is generally low.
  • Voluntary agreements can bring about environmental improvements, especially when there are clear targets to be met, when these imply a significant shift from ‘business as usual’ performance and when there is third–party involvement in the design and monitoring of the agents’ performances. The overall support for these initiatives makes them easier to implement than market–based instruments.

The EU, through the development of the European Climate Change Programmes and the start up of the EU–ETS, and Spain, through the development of the Climate Change Strategy, have fostered a hybrid policy mix with the goal of reducing GHG emissions. Although all instruments have their drawbacks, the EU’s leading role in implementimg policies to arrest climate change widely recognised as a significant and decisive step in the right direction.

The future success of climate change mitigation and adaptation strategies will inevitably involve developing countries. China and India will lead the way towards future GHG emissions.[14]A fair burden–sharing agreement, that limits developed countries’ emissions and increases the pay–off for developing countries to reduce their own emissions, lies at the heart of a bearable climate regime. Although it is too soon to forecast the policies to be implemented in developing countries in the post–Kyoto era, current energy efficiency strategies and the participation in clean development mechanism projects could be enhanced by the participation of developing countries in a broader emission–trading system. This would, however, require a fair redistribution of TPs that is likely to be opposed by countries like the US. Copenhagen should shed some light onto these thorny issues. Broadening the reach of the different policy options and overcoming the resistance of powerful stakeholders is the challenge lying ahead for a brave new Kyoto.

Lara Lázaro–Touza
London School of Economics

[1] EEA (2000), Environmental Taxes: Recent Developments in Tools for Integration, European Environment Agency, Copenhagen. See also ;; and–report/ar4/wg3/ar4–wg3–chapter13.pdf.

[2] US EPA (2005), International Experiences with Economic Incentives for Protecting the Environment, Environmental Protection Agency, Washington DC, p. i.

[3] R. Swart (2001), Policies and Measures as a Tool to Achieve the Objectives of the Convention and the Kyoto Protocol, Workshop on Good Practices in Policies and Measures, Copenhagen, 8–10 October.

[4] OECD (2006), The Political Economy of Environmentally Related Taxes, OECD, Paris.

[5] OECD (2006).

[6] See, for instance, X. Labandeira, J.M. Labeaga & M. Rodríguez (2005), ‘Análisis de eficiencia y equidad de una reforma fiscal verde en España’, Cuadernos Económicos del ICE, nr 70, p. 207–225.

[7] US EPA (2005).

[8] In the European Emission Trading System (EU–ETS) the sectors that are allowed to participate in the market according to article 2 of Directive 2003/87/CE are detailed in annex one and they basically include firms in the ceramics, pulp and paper, glass, oil refining, smelting and steel industries.

[9] The basic legislation regulating the EU–ETS includes Directives 2003/87/EC, that establishes the scheme for GHG emission trading, and 2004/101/EC.

[10] The first international system for emission trading.

[11] According to the Kyoto Protocol, the flexibility mechanisms include the clean development mechanism (CDM), by which Annex–I parties can implement projects in non–Annex–I countries to reduce emissions or increase the absorption of CO2 by obtaining certified emission reductions (CERs). The second mechanism is Joint Implementation (JI), whereby an Annex–I country can implement projects to reduce emissions or increase the absorption of CO2 in other Annex–I countries, obtaining emission reduction units (ERUs) in exchange. The emission trading system (ETS) is the final flexibility mechanism that enables the exchange of emission allowances among the agents allowed to take part in the trading system.


[13]C. Carraro & F. Lévêque (eds.) (1999), Voluntary Approaches in Environmental Policy, Kluwer Academic Publishers, Dordrecht.

[14] See Pablo Bustelo (2007), ‘China and India: Energy and Climate Change’, ARI nr 136/2007, Elcano Royal Institute.