Global Economic Impacts of Carbon Emission Reduction of Korea

Global Economic Impacts of Carbon Emission Reduction of Korea

Hyun Joon Chang[1], Gyeong Lyeob Cho[2], and Jaekyu Lim[3]

I. Introduction

Focusing on the Clean Development Mechanism (CDM), this paper analyzes the global economic impacts of the participation of Korea in the global effort to reduce carbon emission. In order to do that, this paper develops a multi-sector and multi-region CGE model with realistic implementation of “flexibility mechanisms”. Ignoring “supplementarity” and “additionality” based on project based CDM, a previous work(Bernstein et al 1999) has treated CDM as a form of limited global trading with a single world price for carbon emission in all countries. In order to focus on “supplementarity” and “additionality” which is one of the key issues at the current climate change negotiation, however, we investigate various scenarios, covering unrestricted and restricted CERs trading regimes. Furthermore, we investigate economic impacts of project based CDM with/without transaction cost. Under each emission trading regime, such as no trading, trading among Annex B countries, and full global trading, we allow Korea to be able to participate in trading and the CDM project like Annex B countries. While each Annex B region is assigned emission limits for 2010 consistent with its obligation under the Kyoto agreement, Korea is arbitrary assigned emission reduction targets with 30% against BAU in 2010.

Section II first explains the basic framework about CDM and provides brief description of the CGE model employed for analysis. In Section III, the impacts of emission reduction by Annex B countries, under various situations regarding emission trading and CDM, are analyzed by focusing on the changes of the marginal cost of abatement and welfare represented by Hicksian Equivalent Variation in income. Under assumption of Korean participation in emission reduction, Section IV analyses the impacts of emission reduction and compares the results with that generated in Section III. Finally, Section V provides conclusions and policy implications.

II. Modeling the CDM

One of the most important provisions of the Kyoto Protocol is Article 12 offering the potential to generate benefits for both developed and developing countries. The CDM allows non Annex B countries to benefit from project activities resulting in certified emission reductions (CERs) which can be used by Annex B Parties to compliance with the Kyoto Protocol. The CDM would allow Annex B countries to work with local development needs, and gain credits from such actions. The CERs are created by certified project activities satisfying the criteria for "additionality" to ensure that CERS represent actual reductions. The CDM is compatible with the concept of emission trading which is a market based instrument aimed at providing flexibility and choice for achieving the most cost effectiveness compliance, since CERs could ultimately be traded in such a system. Though being conceptually similar, the CDM shifted away from the concept of freely global or bilateral trading towards a potentially more centralized and controlled form of project based crediting. Therefore, the CDM would appear to have higher transaction costs than the emission trading mechanism.[4]

The CDM is still to be defined: Article 12 states that CERs will only contribute to “part” of compliance. This kind of “supplementarity” issue is currently being discussed in the FCCC negotiation. The European Union supports “limit or cap”, ensuring that developed countries take some aggressive action at home to reduce emissions. The U.S. and the other industrialized countries have opposed them. Advocates of quantitative limits argue that ensuring some minimal level of domestic action in industrialized countries would have multiplier effects in terms of technological, institutional, and policy innovations, which developing countries could then emulates (See Filho 1998; Dessus 1998; Pachauri 1998). On the other hand, critics argue that limits on the Kyoto mechanism could harm substantially the overall efficiency of the emission market, and dramatically increase the price of GHG emission trades (See Yellen 1998).[5]

In order to investigate issues mentioned above, we develop the multi-region, multi-sector dynamic general equilibrium model largely dependent on the MS-MRT model developed by Bernstein et al (1999). A limit on how much the CDM can be used to meet reduction target would similar to on a trading quota. Thus, we set import quota for each Annex B country by 10% of reduction target. The CERs in this paper is assumed to be created by non-Annex B countries’ electric sector only.

The model in this paper divides the world into 13 regions. Each region has 16 industries including 5 energy sectors: crude oil, refined products, coal, natural gas, and electricity. According to the Kyoto Protocol, we divide the region into two different groups, Annex B with carbon reduction target and non-Annex B regions with no restrictions. Annex B region consists of the U.S. (USA), the European Union of 15 countries (EUR), Japan (JPN), Eastern Europe (CEA), the Former Soviet Union (FSU), and the other OECD countries (OOE). OOE contains major coal exporters: Australia, Canada, New Zealand. We divide Non-Annex B region into 7 groups: Korea (KOR), China (CHN), India (IND), Brazil (BRA), rest of Asia (ASI), Mexico and OPEC (MPC), and rest of world (ROW). In order to facilitate the impacts of participation of Korea in the emission reduction effort, we treat KOR differently with the other non-Annex B countries. In this paper, KOR is included into Annex B group if Korea is arbitrary assigned emission reduction targets, otherwise, it is included in non-Annex B group.

Following the MS-MRT model, we calibrate the model to the benchmark year 1995. Then, it solves in 5-year intervals spanning the period over 2000 – 2030 with assumption of perfect foresight ensuring that agents anticipate changes in future prices and take these into account in saving and investment decisions. Unlike the theoretical model, numerical models can only be solved for a finite number of periods. In order to approximate the infinite horizon choice, we impose a steady state condition on capital accumulation in the last period of 2030.[6]

The model in this paper is benchmarking the model to the GTAP-EG data set constructed by the University of Colorado at Boulder.[7] The calibration methods in this paper are consistent with those in the MS-MRT model.[8] Unlike the MS-MRT, for Korea, we use the different reference level of GDP growth and energy consumption. For GDP and energy consumption of Korea forecasts, the model is calibrated to the values in <Table 1> projected by the Korea Energy Economics Institute.

<Table 1> GDP and Energy Consumption of Korea

Source: Long-Term Energy Outlook and Strategy Development for the 21st Century in Korea, 2000, Korea Energy

Economics Institute

III. Impacts of the Kyoto Flexible Mechanisms

<Table 2> shows the carbon emission target of Annex B countries agreed at the Kyoto Protocol. The United States have commitment to reduce GHG emissions to 7 percent below 1990 levels in the first commitment period (2008-2012), which is projected for the United States to reduce emission by 585 million metric ton of Carbon (MMTC) of carbon in 2010. The last two columns in <Table 2> show the CDM quotas imposed to Annex B countries. Under given assumption that only 10% of emission reduction target can be achieved through CDM project(s), USA, JPN, and EUR are projected to reduce emissions by 58.5MMTC, 10.1MMTC and 24.2MMTC respectively with CDM projects.

<Table 2> Carbon Emission Target for 2010 in Annex B Countries according to Kyoto Protocol

III.1 Impacts of Emission Trading

Under independent abatement without emission trading, the marginal cost of abatement are projected to be US$527/MTC (metric ton of carbon), US$297/MTC and US$270/MTC for Japan, the United States and the European Union respectively (Table 3).[9] As Bernstein et al. (1999) emphasized, the marginal cost of abatement varies depending on the pre-existing energy price structure, the share of coal in total energy use, the amount of energy produced domestically, the required amount of emission reduction and so on.[10]

<Table 3> Economic Impacts of Emission Trading without CDM (1995 US$/metric ton)

With emission trading between Annex B countries, the marginal cost of abatement (= the price of permit) in Annex B countries is projected to decline to US$89/MTC in 2010. Under global emission trading, it is projected to decrease further to US$41/MTC in 2010. The increased supply of permits in the market contributes to this further reduction under global emission trading.

The emission reduction under Kyoto Protocol is project to deteriorate welfare level of every Annex B countries. In contrast, non-Annex B countries such as South Korea and China tend to enjoy higher welfare level. Annex B countries reduce their energy consumption to meet their emission reduction targets. This leads to lower energy prices in international market. The production of energy intensive goods becomes more expensive in Annex B countries as emissions are penalized. This leads to increased demand for energy intensive exports from non-Annex B countries (i.e. an improvement of international competitiveness of energy intensive industries for non-Annex B countries). However, this positive effect for non-Annex B countries is offset at some extent by the decreased Annex B demand for imported goods from non-Annex B countries. Based these two contrasting effects, ASI, MPC, and ROW are projected to incur losses in welfare, while other non-Annex B countries such as South Korea and China stands to gain. The main impacts on energy exporting countries (MPC) including OPEC and Mexico are likely to arise from lower Annex B energy demand, resulting bigger negative welfare impacts relative to Annex B countries.

The introduction of emission trading between Annex B countries is projected to reduce significantly the welfare cost to Annex B countries of meeting their Kyoto commitments, while the welfare gain in non-Annex B countries is projected to be lower than the case of independent abatement. The lower marginal cost of abatement in Annex B regions under Annex B emission trading reduces the competitive advantage gained in the production of energy intensive products by non-Annex B over Annex B countries. This results in smaller export earnings from these products for non-Annex B countries with emission trading compared with independent abatement. Otherwise, the lower marginal cost of abatement under emission trading decreases the price of non-Annex B imports from Annex B countries and decreases the decline in non-Annex B energy exports. On the whole, the introduction of Annex B emission trading reduces the cost of Annex B countries and the gain of non-Annex B countries compared with independent abatement. In particular, FSU is projected to enjoy the significant improvement of welfare level with Annex B emission trading through the sale of emission permits in the market.

In the case of global emission trading participated by both Annex B and non-Annex B countries, non-Annex B countries selling the emission permits are projected to experience the welfare improvement. On the other hand, because of the reduction of income from the sale of emission permits to other countries, the welfare level of FSU is projected to be lower than the case of Annex-B emission trading.

III.2 Impacts of Clean Development Mechanism (CDM)

III.2.1 Impacts of CDM without Restriction

Assume that Annex B countries (= investor countries) except FSU obtain CERs through CDM projects, by undertaking emission abatements in non-Annex B countries (= host countries). This section ignores transaction, monitoring and compliance costs and assumes no restriction on the amount of emissions abated through CDM projects. It also allows CDM in conjunction with an international emission trading. Under this circumstance, since the price of CERs generated from CDM is lower than the marginal carbon tax rate under independent abatement and the price of permit under an international emission trading, the emission abatement with CDM will be more cost effective than with independent abatement and emission trading. In this case, the emission abatement with CDM projects will be expanded. As a result, without restriction on CDM, the price of CERs from CDM, the marginal carbon tax rate under independent abatement and the price of permits from emission trading will be equalized eventually. The trade in CERs from CDM in conjunction with emission trading is projected to lead to a decline in the marginal cost of abatement compared with emission trading in the absence of CDM. The projected marginal costs of abatement in <Table 4> and <Table 3> also support this argument.

Korea is projected to export CERs by 16.9MMTC to Annex B countries (Table 4). The United States is projected to abate emission by 152MMTC through CDM projects which is approximately 26% in total amount for emission reduction required by the United States’ Kyoto commitment. For Japan where tends to pay the highest marginal cost of abatement in Annex B regions, the reduction of emission by 60% through CDM in total emission reduction is projected to be most cost effective. For central eastern Europe (CEA) where its marginal cost of abatement is low, on the other hand, the emission abatement with only domestic policies and measures is projected to be more cost effective than using the Kyoto flexible mechanisms

such as CDM and emission trading.

<Table 4> Optimal CERs under CDM Project without any Restriction

Note: The domestic carbon tax rate for CEA is 17$/metric ton in non-trading system.

<Table 5> shows the trade balance of CERs under CDM without restriction. Korea, following China and India in terms of the amount of CERs, is projected to host CDM projects. Without emission trading, the United States and Japan are projected to generated CERs by 13.9MMTC and 2.7MMTC respectively through CDM investment to South Korean electricity sector.

The introduction of CDM with Annex B emission trading is projected to reduce the marginal cost of abatement to 65$/MTC, which is lower by US$24/MMT than emission trading without CDM. The total amount of traded CERs is projected to be 154MMTC, which is lower than the case of independent abatement with CDM. The United States is projected to achieve the cost-effectiveness by reducing 16% of total emission reduction with CDM and the remains with emission trading. It is interesting result that, with global emission trading, Japan and other OECD countries (OOE) are projected to achieve the cost-effectiveness without participation in CDM projects.

In the independent abatement case, the CDM makes all of countries in the world be better off compared with the case in the absence of the CDM (Table 3, Table 6). The reason for this result is that Annex B countries benefit from lower marginal abatement cost and non-Annex B countries benefit from the sales of CERs. In this case, therefore, the CDM tends to offer a “win-win” opportunity to both Annex B and non Annex B countries.

<Table5> Balance for CERs under CDM without any Restriction (Million Metric Ton)

None Trading

<Table 6> Impacts of CDM without any Restriction on Hicksian Equivalent Variation in income (% of present value consumption)

Under Annex B trading with CDM, the welfare of every country except FSU and CEA is projected to be higher than Annex B trading without CDM, partly because developing countries such as South Korea and China earn extra income from the sale of CERs (Table 6). Since the introduction of CDM decreases the price of permits, the welfare levels of FSU and CEA where sell the permits in the market without participation in CDM are projected to decline compared with the case of Annex B trading without CDM. Under global emission trading, however, the introduction of CDM is projected to decrease the welfare of South Korea and China relative to the case without CDM, while Annex B countries except FSU and CEA enjoy the improvement of welfare level. This result is mainly caused by a decline of the permit price, allowing Annex B countries to purchase permits at lower costs and reducing income of South Korea and China earned from the sale of permits.

<Table 7> Optimal CDM Project with Transaction Cost

Note: The domestic carbon tax rate for CEA is 17$/metric ton in non-trading system.