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EUROFORUM
Within the ‘Euroforum’ framework, KU Leuven academics present policy papers on the Europe 2020 targets
(employment, social inclusion, climate, education and innovation) and the Eurozone’s design problems, in
interaction with policymakers from the European Commission and international experts.
Policy papers by Euroforum KU Leuven:
1.
Paul De Grauwe, ‘Design Failures in the Eurozone: Can They Be Fixed?’ (April 2013)
2.
Maarten Goos, Anna Salomons & Marieke Vandeweyer, ‘Job Polarization During the Great
Recession and Beyond’ (April 2013)
3.
Frank Vandenbroucke, Ron Diris & Gerlinde Verbist, ‘Excessive Social Imbalances and the
Performance of Welfare States in the EU’ (April 2013)
4.
Koen Decancq & Erik Schokkaert, ‘Beyond GDP: Measuring Social Progress in Europe’ (April
2013)
5.
Paul Schoukens, ‘From Soft Monitoring to Enforceable Action: A Quest for New Legal
Approaches in the EU Fight against Social Exclusion’ (April 2013)
6.
Bart Muys, Karel Van Acker, Han Vandevyvere, Erik Mathijs, Axel Marx, Nicole Van Lipzig &
Peter Tom Jones, ‘Transition to a Climate Neutral Society: From Innovation Niches to
Institutional Reform’ (June 2013)
7.
Stef Proost, ‘Climate Change Policy in a Non-Cooperative World’ (June 2013)
8.
Ron Diris & Erwin Ooghe, ‘Financing Higher Education in Europe’ (June 2013)
9.
Ides Nicaise, Kristof De Witte, Carl Lamote, Jeroen Lavrijsen & Georges Van Landeghem,
'Towards a Basic Qualification for All in the EU: A Social, Educational and Economic Agenda'
(June 2013)
10. Reinhilde Veugelers, ‘How to Turn on the Innovation Growth Machine in Europe?’ (June
2013)
Euroforum is part of the interdisciplinary think-tank Metaforum, which aims to strengthen the KU Leuven's
involvement in societal debate by supporting multidisciplinary working groups in which researchers from
different disciplines combine their academic expertise and discuss relevant societal issues from different angles.
Metaforum KU Leuven
Interdisciplinary think-tank for societal debate
Holland College
Damiaanplein 9 bus 5009
3000 Leuven
[email protected]
www.kuleuven.be/metaforum
www.kuleuven.be/euroforum
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ABSTRACT
This paper2 shows first that the world is unlikely to reach a broad and effective climate agreement.
The EU is likely to be one of the few continents to be ready to take responsibility for all the climate
damage it does to the world. This requires a rethinking of the EU climate policy, as simply minimizing
emissions within Europe is not cost effective. Indeed the green paradox may imply that oil and gas
savings within Europe are merely postponing emissions Reducing emissions in a non-cooperative
world requires promoting emission reduction in the rest of the world, even if this world is not really
motivated to reduce emissions. The main implications for the EU are more emphasis on coal than on
oil and gas, favouring technological developments above behavioural adaptations and focusing on
technologies that are cheap and reduce emissions in the rest of world instead of achieving a carbon
free society in the EU.
2
I thank Erik Schokkaert, Frank Vandenbroucke, Ronnie Belmans, Wim Benoot, Lotte Ovaere en Joris Morbee
for comments on earlier versions en Veerle Achten for her help in the realization of this paper.
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CONTENTS
Euroforum............................................................................................................................................................... 2
Abstract ................................................................................................................................................................... 3
1.
Introduction ..................................................................................................................................................... 5
2.
What is the Climate Policy Issue? .................................................................................................................... 5
3.
The EU Climate Policy Orientation and its Effects ........................................................................................... 7
4.
International Energy Markets & Carbon Leakage .......................................................................................... 14
5.
Which Way Forward? .................................................................................................................................... 17
6.
Conclusions .................................................................................................................................................... 23
7.
References ..................................................................................................................................................... 25
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1.
INTRODUCTION
Climate policy is one of the most important EU policy domains. All EU policy initiatives, whatever
their field of application, are tested on their relevance for its climate policy goals. Climate change is a
typical public ‘bad’ that does not stop at national borders. It is therefore a policy issue that is much
better managed at the EU than at Member State level. The issue we address in this paper is whether
the present policy objectives and choice of instruments are indeed optimal.
As climate policy deals with all types of sectors (industry, transport, households) using different
instruments, our analysis will focus more on the broad objectives than on the choice of particular
policy instruments.
In section 2, we present a very brief layman's introduction to the climate policy problem. Section 3
describes the EU policy line. Section 4 discusses EU policy in an international climate negotiation
setting. Section 5 analyses the implementation of climate policies in the energy markets, and section
6 discusses policy orientations for the EU. Section 7 draws policy conclusions.
2.
WHAT IS THE CLIMATE POLICY ISSUE?
The climate can best be understood as the long term trend in the average weather. It is a function of
average and extremes in temperature, precipitation, wind conditions etc. The climate is a complex
function of the interaction between the sun, the atmosphere, oceans and biological and human
activity. For a detailed description of the science of the climate problem one can consult the reports
of the Intergovernmental Panel on Climate Change (Group I report, 2007). Cutting many corners,
there are four key relations that are important:
1. Human activity and specifically the use of fossil fuels emits greenhouse gasses (of which CO2 is the
most important) and this increases the concentration of greenhouse gasses in the atmosphere –
how much the emissions increase depends on the world economic growth that determines energy
needs, on the fossil fuel intensity of this energy growth needs, and on the type of fossil fuel used
(generating electricity using coal emits twice as much CO2 as gas, and oil is in between the two).
2. Greenhouse gas emissions accumulate in the atmosphere and stay there for 100 to 300 years. The
concentration of greenhouse gasses leads to an increased “greenhouse effect” and a “global
warming”. These climate effects appear with a delay of 30-50 years because of the thermal inertia of
the oceans.
3. The change in climate has effects that differ from region to region: reduced masses of ice and
snow, sea level rise, extreme weather events, average temperature, rainfall etc.
4. These effects can be beneficial (colder regions warm up), but also very costly (floods, storms,
migration flows, loss of agriculture output). The precise effects can vary widely over the world.
There is enormous uncertainty in each of these four key relations. Unfortunately, we are learning
slowly as we observe only the short-term variations in weather patterns that are generated by a
system we do not fully understand. This can be illustrated by the estimates of the effects of a
doubling of the GHG (Green House Gasses) concentration in the atmosphere. According to Stern
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(2008), if no action is taken one could end at a concentration of 550 ppm CO2 in the atmosphere in
2050 and the 90% confidence interval would be an average rise of the temperature between 1.5 and
5°C. The damage estimates vary by at least a factor 10 as the damage function is probably
exponential. Assessing the damage caused by climate change is necessary to determine what policy
actions can be justified.
Estimating and monetizing the damage raises three interesting methodological and value issues.
First, there is the huge uncertainty. Climate change may bring about catastrophic events and we
tend to attach a high value on avoiding such events. This insurance dimension of the climate policy is
the most powerful argument for a strong climate policy. But how to best incorporate the low
probability/high damage events in policy design is still a matter of academic debate.
Second, the damage will occur in 50 to 300 years from now. So it will mainly affect our grandchildren
and their descendants. This is at the heart of the discount rate debate. A high discount rate (3%)
means that 100 Euro of damage 100 years from now counts for only 5.2 Euro now. A very low
discount rate (0%) means that a future damage of 100 Euro remains a damage of 100 Euro now.
There are two considerations that play a role in determining the discount rate: a purely economic
consideration and an equity consideration. Economists tend to discount future damage and costs
(use a rate of 3 to 5%), as using resources now rather than tomorrow has an opportunity cost, i.e.
one could have used the same resources for other productive investments But these economic
considerations tends be less credible for comparisons over a long period, as it is difficult to judge
productivity of assets transferred to the next generation. The equity consideration is also important
as future generations tend to be richer, even accounting for climate damage. Should the poorer
present generation then make sacrifices for the richer future generation? Should our greatgrandfather have decreased his consumption of wood or coal so that we could have started with a
lower concentration of GHG? If one wants to maximize inter-temporal welfare, future populations
that are richer leads to higher discount rates3.
Third, damage can be spatially very diverse: some countries may even benefit from a better climate
as it a change in climate may be beneficial for say agriculture in some areas. But it could very well be
that the most extensive damage will be experienced by the poorer parts of the world. When we care
for the poor in the world, this means that their damage counts more heavily.
Humankind can react in different ways to climate change. Of course, we need to understand the
system better by investing more in climate research, but this may take a long time and it may be
wise to already take action now. In terms of action, one needs a combination of prevention and
adaptation. Prevention is possible by reducing the emissions of greenhouse gasses that are at the
origin of the global warming problem or by influencing the climate effects themselves by geoengineering techniques (Barrett, 2009). Adaptation means to minimize the costs of climate change
by increasing dikes, managing water resources, adapting crops etc. This is a decision problem under
uncertainty and the optimal strategy is a combination of learning, prevention and adaptation. In an
3
This reasoning is based on the Ramsey formula that results from maximizing inter-temporal utility. The
consumption discount rate then becomes equal to the inter-temporal discount rate (often assumed 0) and
the product of the growth rate of consumption and the elasticity of the marginal utility of consumption. For
example, if growth rate of consumption is 1% and the elasticity of marginal utility of income is 2 (a value
commonly found in the literature) one obtains an ‘optimal discount rate’ of 2%.
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international context, we need to worry more about sufficient prevention than about adaptation.
The reason why we need to be more concerned about prevention than about adaptation is simple.
Every region or country that is expecting climate change damage will be fully motivated to minimize
the effects of the damage for itself. The incentives for a country to decrease emissions and
contribute to prevent climate change are much smaller. Each country is only responsible for a small
share of the total emissions, so it gets only a small share of the total benefits of decreasing
emissions. So preventing climate change by reducing emissions is an international problem, while
adapting to climate change is more a problem at the regional level.
The main focus of current policy discussions is thus the prevention of greenhouse gas emissions. This
raises many policy issues: the international division of efforts over continents; the choice of policy
instruments by the EU; and the distribution of efforts over different member countries. We will not
discuss the distribution of efforts over EU Member States. Instead we focus on global EU policy lines.
3.
EU CLIMATE POLICY ORIENTATION AND ITS EFFECTS
The EU has short term objectives for 2020 and long term objectives for 2050. We discuss each of
them in turn.
THE 20/20/20 OBJECTIVES FOR 2020
The EU aims to cut GHG emissions by 20% compared to the 1990 emission level4, meet 20% of its
final energy needs by renewable sources, and wants to improve energy efficiency by 20%. The 20%
reduction in 2020 is a prolongation of the commitments of the international Kyoto agreement. The
EU has been world leader in the implementation of the Kyoto protocol.
Different policy instruments are used by the EU for the big polluters (industry, power generation)
and for the smaller polluters. For industry and power generation, a system of tradable permits5 has
been implemented since 2005. This system has been gradually adapted from a purely grandfathered
system to a system in which a large part of the emission rights are auctioned. For the smaller
polluters, one relies on policy initiatives from the Member States and on emission standards for the
more standardized goods like cars and some appliances.
The costs and benefits of this 2020 strategy have been assessed by different authors. External
assessments (Böhringer, Rutherford, Tol, 2009) using models not financed by the European
Commission agree that this policy has been effective in reducing emission in the EU, but that its
costs could have been lower. According to Böhringer et al., the most efficient policy mix to reduce
emissions of GHG in the EU by 20% in 2020 (compared to 1990) would cost between 0.5 and 2% of
GDP. The separation of the policy between an ETS (emission trading sector) used for industry and a
non-ETS sector could have increased costs by 50%. Adding a renewable obligation of 20% raised the
4
For CO2, the main greenhouse gas, this is relatively easy as it is sufficient to know the total use of fossil fuels
by type to estimate the total emissions in a sector and country.
5
In a tradable emission permit system, the government decides first on an absolute limit of emissions in a
sector or country. It then distributes the permits to pollute to polluters, often in proportion to their historic
pollution, called ‘grandfathering. In the final phase, the polluters trade the ‘rights to pollute’ and this results
in a market for permits with a market price.
Page 8 of 26
cost of emission reduction by 90%. The reason is that renewables, even if they generate carbon free
energy, are very costly and much more expensive than policies in which coal is replaced by gas.
Tol (2012) analyses different cost estimates for the 2020 objectives and compares them with the
distribution of the marginal social cost of carbon: the sum of discounted expected climate damage
that is avoided in the world by a small reduction of emissions. There is a considerable uncertainty on
the cost and on the benefit side. The marginal costs of emission reduction are increased by three
factors. First, they will be higher whenever carbon prices are not equalized across polluters (sectors,
countries) as this means that shifts between sectors could still reduce total costs of abatement. A
second reason for higher costs of emission reduction is the pursuit of other policy objectives at the
same time (like a minimum share of renewable energy). A third reason why emission policy becomes
more costly than necessary is the negative interaction with pre-existing tax distortions6.
For the benefit side of emissions reduction, the discount factor is important. Tol finds a mean of
5€/ton of CO2 for a 3% discount rate and up to 76€/ton of CO2 for a 0 % discount rate. For a 0%
discount rate, the marginal damage can be high, but not infinite, because the fossil fuel use itself and
the associated damage is finite as GHG concentration decays in the atmosphere. Extreme events
(95% percentile or higher) have a very high damage rate and this drives the mean higher, because
the mode of the distribution is much smaller.
Tol finds for all discount rates higher than 1% that the policy is not justified in cost benefit terms.
Both the costs of emission reduction and the benefit of emission reduction are uncertain. But he
finds that for a 0% discount rate, there is a 40% probability that the cost is higher than the benefit.
For a 1% probability, he finds that the probability that the cost is higher than the benefit equals 74%
and for a 3% discount rate, he finds a 95% probability that the cost is higher than the benefit. The
benefit cost ratio increases whenever climate policy becomes more efficient (one could decrease
costs by 50%) and whenever there are important ancillary benefits (reduced conventional air
pollution, improved energy security...) to be taken into account.
The main weak point in the whole cost benefit analysis is the use of marginal damage estimates for
the world. The EU represents a shrinking share of world GDP and is not particularly vulnerable to
climate damage. This means that the marginal damage avoided within the EU could be less than 20%
of the world damage estimates, so that the efforts made for the short term 2020 objectives can
never be justified by the avoided damage in the EU itself. Of course, the EU is still partly responsible
for climate damage in the world, but it will be increasingly difficult to step up efforts to the much
stronger reductions that are foreseen in the Energy Roadmap of the EU for 2050 where reductions of
80 to 90% are promised.
6
An easy example is the effect of additional taxes (or the cost of emission rights) on the price of consumer
products. Pprice increases imply that the overall purchasing power of one’s wage decreases and this will
reduce labour supply. But labour is already heavily taxed, so one ends up increasing the tax wedge on the
labour market even more and this generates additional efficiency losses. The efficiency losses can be much
higher for tradable permit systems than for carbon taxes, because grandfathered permits do not generate
any tax revenues that can be used to reduce existing labour taxes (see Goulder et al., 1999)
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THE 2050 OBJECTIVE
For 2030, the EU has proposed an additional effort of -30% if the other continents follow, but this
has not happened up to now. The EU has also considered strengthening the target for 2020 to -30%
as the current recession has reduced the costs of meeting the initial -20% target for 2020. The main
long term objective is, however, the reduction of emissions by 80 to 90% in 2050 compared to 1990
(COM 2011). This decarbonisation objective is in line with the Stern report (2007), which proposed
an overall global emissions reduction by 2050 of 50%, but wants to allow some room for growth in
emissions for developing countries and counts on proportionally larger efforts from the rich
countries. Figure 1 shows the emissions per capita for a sample of countries in the world. It shows
clearly that there are at least three categories of countries: the group of very large emitters (US and
a few others), the group of large emitters (most EU countries, Germany serves as example) and a
group of poorer countries that have a much lower level of emissions per capita. Inside the latter
group there are still large variations: China, for example, has 3 times more emissions than India).
Figure 1: International comparison of emissions per capita (in tons) (source: BP Statistical Review of World
Energy, source of population data: UNPD, 2010 (WPP Rev. 2010))
How this EU objective for 2050 is to be reached is not yet clear. Scenario studies point to different
combinations of technology paths that can reach this objective, counting mainly on renewables and
strongly reducing (more than 50%) the role of oil and coal.
The main conclusions of the assessment of the energy roadmap (Com 2011) are first, that an energy
supply with very low carbon emissions is possible and less costly in the long run than current policy
initiatives. Second, the energy system will rely much more on capital costs than on fuel import costs,
so import dependence decreases strongly. Third, energy consumers will have to strongly reduce
their energy consumption via intensive energy saving programmes incentivized by strict regulations
and high-energy prices. Fourth, this is seen as an opportunity for EU industry to be a forerunner for
the world.
The commitment to the Energy 2050 Roadmap is not explicitly linked to the efforts of the other
continents. All that is mentioned is to protect the competitiveness of EU industry. Marginal carbon
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abatement costs would be of the order of 250 to 310€ (as of 2008) in 2050. These orders of
magnitude have to be compared to the marginal cost of 5 to 20€ per ton of C02 paid in industry over
the last years.
INTERNATIONAL NEGOTIATIONS AT WORK
International climate negotiations started in Rio de Janeiro (1992) and led to a first agreement in
Kyoto (1997). These negotiations are an on-going process and the last rounds thereof were based on
reports like the Stern report. For an outsider, an international agreement is a logical step in an
efficient approach to climate change. Up to now the success of the climate negotiations has been
rather limited. The Kyoto agreement has not been ratified by some of the key emitters (USA) and left
out some of the important emitters (China, India). In addition, many of the signatories did not
comply with their promises. In the follow up conferences – e.g. Copenhagen – it also proved
impossible to achieve full agreement on a climate agreement that would more or less limit the
expected concentration of GHG to 550 ppm.
In theory, it is possible to make an international agreement in which it is beneficial for all countries
to sign and in which one reaches an optimal level of abatement. All one needs is a correct
computation of costs and benefits by country and transfers among countries so that all parties gain.
This is the idea of the grand coalition (Eyckmans & Tulkens, 2003). Unfortunately, according to
economic theory reaching a wide agreement on an environmental issue at a global scale is very
difficult. Contrary to environmental problems at the country scale, there is no global authority that
can enforce international environmental agreements. One country might introduce trade sanctions
or send fighter jets, but such enforcement actions are also costly for that country and will not be
easily undertaken.
The signing of an environmental agreement is a complex process. Preparation by technical experts,
the political process inside each country that determines its negotiation position, the treaty
negotiation process itself, and finally ratification all contribute to this complexity. Each of these steps
matters for the final outcome, but most analyses have represented the negotiation process as a
simple game between countries. We rely mainly on this simple representation and discuss briefly the
intra country policy making step later.
SIMPLE REPRESENTATION
In the simplest representation, each country can reduce its own emissions at a certain cost and will
benefit from the abatement of emissions in the whole world. Barrett (1994) reaches firm conclusions
using a simple model with identical countries and constant marginal benefits of abatement. He
defines self-enforcing international environmental agreements as agreements that are such that
every country that joins the agreement is better off within the agreement than outside the
agreement and vice versa for those outside the agreement.
Barrett (1994) uses a model with identical countries and finds that the equilibrium number of
signatories in an international environmental game that is played only once equals 3, whatever the
number of countries in the world. We can illustrate the issue using a simple graph. Figure 2 presents
a problem whereby 10 identical countries face an environmental issue that is caused by the sum of
the emissions of the 10 countries.
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Each of them faces a marginal damage function (MB) that is horizontal and equals 1. The marginal
damage curve integrates all the damages associated to an emission of 1 ton of CO2 now, so the
damage in the whole world and over the whole period where the CO2 molecules are active. We have
seen that according to Tol (2012), this ranges from 5 to 76 Euro/ton, depending on the discount rate.
The total benefit of an emission reduction of 2 units equals 2 for one country (the area under the MB
curve) but equals 20 when we consider the benefits for the world of 10 countries.
Every country can also reduce emissions, but at increasing marginal abatement cost: this is the MAC
curve that is taken equal to the 45° line. The first unit of emission reduction costs 1, the second unit
of emission reduction is more expensive and costs 2 etc. The total cost of an emission reduction of 3
units is then 1+2+3= 6.
$/ton
10 MB
Total abatement effort
Nash: 1x10 = 10
Int Agreem 3x3 + 7= 16
Full cooperation (FB)= 10x10=100
MAC
3MB
Int agreement
1
MB
nash
1
3
10
abatement
Figure 2: Illustration of an international environmental negotiation problem
Consider first what the ideal solution would be for the world. This comes down to reducing
emissions in every country up to the point where MAC equals the sum of the marginal damage of all
the country victims, so MAC=10 MB and this implies a total abatement effort of 100 units. This is the
solution where each polluting country is responsible for all the damages of its emissions, as GHG
emissions cause damage to the whole world, every country should push efforts up to the point
where the cost of making more efforts becomes higher than the damages that are avoided. This can
also be called a fully cooperative solution: which could be reached if one could make a binding
international agreement where every country would make an effort of 10 units of abatement.
Consider now the other extreme in which there is no cooperation at all. In such a case, every country
compares its marginal abatement cost with the marginal damage in its own country. This is called
the Nash “non-cooperative” solution. Every country takes the actions of the other countries as given
and selects its own preferred level of abatement, in equilibrium; every country will limit its efforts up
to the point at which the MAC equals its MB and the total abatement effort equals 10 times 1 = 10.
Consider country 1 made much more effort, say 10 units of abatement. This would be beneficial for
all the other countries, but will not be an equilibrium as for country 1; the total cost would be the
area under the MAC curve (0.5x2=0.5(10)2=50) and the benefit would be only 10x1=10. As long as all
Page 12 of 26
countries maximize the sum of the difference between their own total benefits and their own total
costs, countries will ultimately end up in the Nash equilibrium with minimal abatement efforts7.
The other solution is an international agreement that satisfies the following stability requirement: a
country is as well off when it signs the agreement as when it does not sign the agreement. The group
that signs the agreement maximizes its group welfare so it considers the damage of its members.
The equilibrium for this game is 3 signatories8 and the total abatement effort is here 3 countries that
make an effort (MAC=3MB so 3x3) plus 7 others that work non- cooperatively (MAC=MB so 7x1) and
take the effort of the others as given. In total, this gives 16 units of abatement. As can be seen the
“self-enforcing” requirement for international agreements is a serious handicap and limits what can
be achieved by an international agreement.
THE EU HAS BEEN TRYING A COOPERATIVE STRATEGY
Up to now we have been discussing a “one shot game”, i.e. a game that is played over and over
again, in which players do not take into account the past or future behaviour of the other players.
One could also think about the behaviour of countries as more consistent over time. The game could
be seen as a repeated game, in which each country starts by cooperating and announces that it will
stop making efforts forever if the others do not cooperate. When the future is sufficiently important,
the sanction of stopping cooperation forever is important for the other countries and Barrett proves
that more performing international agreements become possible. At present, the EU is deploying
such a cooperative strategy in the hope that the others will follow: it promises to do more by 2030 if
the other countries follow. Nevertheless, one could also argue that a one shot game is the right
concept given that the political majorities in countries can change and that a new government is not
responsible for what the previous government did (think about blaming Obama for the poor climate
negotiations behaviour of Bush).
CATASTROPHIC CLIMATE EVENTS
The simple Barrett model uses smooth damage functions, but climate change damage is highly
uncertain and may not be smooth. Indeed, it may even be catastrophic. The risk of very high,
catastrophic damage is the main motivation for the calls for stringent climate policies by Stern
(2008) and many others. Modelling a catastrophe is difficult. In negotiation, therefore, it is important
to know what is the threshold of global emissions that triggers the catastrophe. Barrett (2013)
models a catastrophe with a damage function that jumps when the threshold is exceeded. Assume
first that there is no uncertainty on the exact threshold (say 3°C warming should not be exceeded)
and the damage of the catastrophe is extremely high compared to the abatement cost per country,
7
In a model with countries of different sizes, Eyckmans et al. (1993) found, that the non-cooperative
equilibrium does not sustain more than 16% of optimal abatement. So having larger countries helps, but
overall the level of abatement that is reached in this type of equilibrium remains very low.
8
Barrett (1994) proves that for identical countries and constant marginal damages, the equilibrium number of
signatories is 3 whenever there are 3 or more countries. So whether there are 10 or 100 countries, only 3
will cooperate. The fact that the number is very small (3) is not related to the slope of the MAC curve, it is
the result of the possibility that each country can always step out of the agreement and free-ride on the
efforts of the countries that signed the agreement. Barrett has more general results (non-constant MB etc.)
but also these are very pessimistic in the sense that when an agreement is most needed, it is unlikely to
exist.
Page 13 of 26
then an agreement in which all countries coordinate to avoid the catastrophe can be self-enforcing.
To illustrate this case, consider again 10 identical countries and start with an international
agreement whereby all countries share the effort to avoid the catastrophe equally. If one country
defects, it knows it may be responsible for a catastrophe and this means that there are far higher
chances for a successful international agreement.
Uncertainty about the extent of the catastrophe is not crucial as long as the damage is high enough.
Unfortunately, Barrett (2013) shows that uncertainty about the threshold itself is more problematic
for international negotiations. Assume that one starts with a division of efforts among all countries
such that the catastrophe is certainly avoided. A country defecting and reducing its abatement
efforts is now only responsible for an increase in the probability of a catastrophe and the expected
sanction of defecting is therefore less important. This acts as an incentive not to comply with the
agreement and to free-ride on the others.
WHY DOES THE EU MAKE MORE EFFORT THAN THE OTHER CONTINENTS?
If we believe the game-theoretical results of Barrett (and many others), it is rather odd to see the EU
making more effort than the other continents. In addition, one expects that the EU will not
experience more climate damage than the others9. There are two kinds of explanation: either we
have modelled the process of climate negotiations wrongly or the EU is pursuing other objectives
than we have assumed.
The process of reaching an international agreement is complex and a representation using simple
objective functions for governments is simplistic. Some authors have tried to integrate the national
political process into the international agreement process. Buchholz et al. (2005), for example,
suppose the median voter determines the negotiation position of a country, followed by an
international bargaining phase between countries. Their central result is that a low environmental
target allows the median voter in a country to receive a larger share of gains from the bargaining
game between the two countries. The result is pessimistic: despite the presence of bargaining
(cooperation) between countries, the outcome is an even weaker environmental agreement than
predicted by the Nash non-cooperative outcome. Roelfsema (2007) proposes an alternative model,
showing that a decisive voter who cares sufficiently about the environment gains from delegating
policy making to a politician who cares more about the environment than him or herself. Such
delegation mitigates the risk of an outcome like the one predicted by Buchholz et al. Glazer & Proost
(2012) look at international treaties as a way to allow a minister in one country to learn about the
beliefs held by a minister in another country, so allowing each to make better decisions. When the
net benefits of environmental policy are uncertain, a country that participates in negotiating an
environmental treaty, or that supports strong environmental action, thereby provides information to
another country that such action can be worthwhile. This dimension of international environmental
agreements helps to explain why countries negotiate treaties, why agreement to a treaty by a
country deemed not particularly favourable to it can strengthen environmental action, and why
treaties may invoke a minimum participation clause. In conclusion, bringing in national politics does
not easily explain the EU position.
9
Ciscar, Saveyn & Van Regemorter (2012) find that climate damage in the EU varies significantly between the
North and the South of Europe. In aggregate terms, the North is gaining at the expense of the South and
effects on agriculture, coastal systems and river floods are the most important.
Page 14 of 26
The second explanation relies on another objective function for the EU citizen. If this EU citizen feels
responsible for his or her climate damage in the world (in Figure 2, every ton of emissions creates 10
units of damage to the world and 1 country feels responsible for this total damage) and he or she
does not care about how the rest of the world deals with it, this is itself a justification for increased
effort (10 instead of 1 unit of abatement effort in Figure 2). Strong efforts are then the optimum for
this country because he or she draws satisfaction from being a responsible world citizen. There is
certainly an element of truth in this more altruistic motivation, but when we transplant this
behaviour to other world-order problems (development aid, poverty, catastrophe’s etc.) the very
generous European citizen is not so much in evidence.
In conclusion, the cooperative attitude of the EU, which consists in promising to make more effort if
the other big players follow, is the most plausible explanation for the increased effort made by the
EU at present. If the other players do not follow, it is difficult to envisage an EU continuing its climate
policy voluntarism with the same vigour.
4.
IMPLEMENTING CLIMATE POLICY IN INTERNATIONAL ENERGY MARKETS
Any reduction of CO2 emissions (the main GHG gas) always requires either a reduction of fossil
energy use or the switch to less carbon intensive forms of fossil fuel (gas instead of coal). There are
two recent events that need our attention and one long term issue. The two recent events are the
collapse of the permit prices on the European market and the success of shale gas. The long term
issue that we need to consider is the green paradox.
For the big emitters, the EU has chosen to restrict the number of permits to pollute such that the
2020 target of emission reduction is gradually met. Because of the economic recession, the need for
polluting permits has decreased significantly and this has resulted in a price below 5 Euro/ ton of
CO2, far below the expected 20 Euro/ton. The strong price fluctuations are inherent to a system of
tradable permits where the supply is inelastic. The main disadvantage of the low prices is that they
decrease the return on all carbon saving investments. One can try to pump up the carbon prices by
decreasing supply or one can consider it as a time out in the climate policy. A time out allows some
more reflection on longer term objectives.
The development of shale gas production (and to a lesser extent the development of nonconventional oil) has been triggered by the high gas prices in the last decennium. Shale gas
production in the US will gradually take over from conventional gas production and make the US a
natural gas exporter. The substitution of coal for gas in electricity production will decrease the
carbon emissions of the US, but this is more a coincidence than a deliberate environmental policy
action of the US.
THE GREEN PARADOX AT WORK IN THE OIL AND GAS MARKETS
Sinn (2008) has drawn attention to the dangers of the green paradox. There are many versions of
this paradox, but we will interpret it in our own context, where the EU is one of the few to pursue a
vigorous climate policy. We distinguish between two types of fossil fuel: those without large rents
Page 15 of 26
(coal, non-conventional oil) and the fossil fuels that involve large rents10. The main question is the
following: what is the net effect on global emissions of a reduction in the consumption of coal, gas
and oil by the EU?
For a fossil fuel that has no large rents, the price is close to marginal extraction costs as the reserves
of these fossil fuels are rather large. This certainly holds for coal and to a lesser extent for nonconventional oil. A deliberate decrease of the consumption of coal by the EU will not affect the
world market price very much and, if one forgets about carbon leakage via relocation of production
(some 20% of each ton that is reduced by the EU pops up in the rest of the world), this implies a net
reduction of CO2 emissions in the world.
For fuels like oil and gas, the rent for the producers is important as there is a large difference
between the extraction cost and the market price. The main reason is that the cheap reserves are
limited. We study the price formation of these fossil fuels via a simple Hotelling model. Take a fixed
stock S of a fossil fuel resource that is cheap to extract (extraction cost c) and assume that these
reserves are spread over a few suppliers so that there is perfect competition. The world demand
function for the fossil fuel is given. This world demand function has a maximum willingness to pay
for the fossil fuel (or “choke price”) P*, which is the cost of a backstop technology (renewable
electricity etc.) that can substitute for the fossil fuel. Every producer of fossil fuel will compare the
profits they can make by selling today rather than tomorrow or than in 10 years etc. When the real
interest rate equals r, the inter-temporal arbitrage by profit maximizing suppliers results in an
equilibrium profile of prices such that the rent (price – extraction cost) increases at the rate of
interest. In Figure 3, the solid curve 1 is an equilibrium price profile. A second characteristic is that
the reserves are fully used in the last period when the choke price P° is reached. So the choice of the
initial price P° and the inter-temporal arbitrage condition lead to the price profile. These conditions
hold at any moment in time, so that whenever new information comes available the price profile is
adapted.
10
There is a growing literature on the green paradox. One can consult Fisher & Salant (2013) who review the
literature and offer a model that has different types of fossil fuel resources, and only part of the world
making emission reduction efforts. The different types of oil and gas reserves differ in the extraction costs
and the price is set by the higher cost reserves. We use a simpler model where we distinguish between coal
(low rent) and oil and gas (higher rent) but the insights are very similar. .
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Figure 3: Effect on world fossil fuel equilibrium prices of a climate effort of the EU (from 1 to 2) and of an
improvement of the backstop technology (from 1 to 3)
Consider now a significant, deliberate and long lasting decrease of oil use by the EU. A decrease in
the world demand implies that one needs a new price profile over time. The current price of oil will
decrease and with the new equilibrium price profile (2), the world will use oil for a longer period.
The total quantity of carbon emissions will not decrease, emissions will only be delayed11.
Consider now an improvement of the backstop technology of oil, brought about by strong R&D
efforts. Again this will imply a new inter-temporal price profile. The maximum price at which oil can
be sold will decrease, working back to an initial price and taking into account that all the reserves
must be used, this implies a drop in the oil price now and total emissions will not increase but come
earlier.
Our model is simplistic, of course, but the mechanisms are real. There has been much more
attention for the leakage effects of relocation of carbon-intensive production outside of Europe.
Leakage means that when the carbon emissions in the EU are reduced by 1 ton, the rest of the world
will compensate this reduction partly by emitting somewhat more. Estimates for the leakage
through relocation are of the order of 20% (Babiker & Rutherford, 2005). The EU has already
foreseen mechanisms to counteract this type of leakage. Leakage via the green paradox mechanism
is less clearly recognized, but can be much more important. In theory, it can be 100% for the oil and
gas reserves.
11
Still another policy option is that the climate conscious countries buy the deposits of fossil fuels in other
countries in order not to use them (Harstad (2012)). They would buy the reserves that are the most costly to
extract.
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5.
WHICH WAY FORWARD?
The EU has embarked on a vigorous course of action to reduce carbon emissions. Its ambitious
targets will require large long term investments by consumers and producers of energy. Of course,
the EU, like all countries, is responsible for the damage brought about by its carbon emissions to the
whole world. This in itself can be a valid reason to be ambitious in terms of carbon reduction. For the
EU roadmap 2050 to be effective, two conditions need to be fulfilled. First, the strategy put forward
should be credible, and second it should be cost-effective in terms of carbon emission reduction.
CREDIBILITY ISSUES
It will be increasingly difficult to establish the credibility of the roadmap 2050. There are four serious
hurdles. First the policy is ambitious and requires very significant adaptation from the users of
energy. The marginal cost of achieving the objective is of the order of 300 Euro/ ton of CO2 , to be
compared with the 20 Euro/ton of CO2 that was expected for the 2010-2020 period. Of course, this is
a marginal cost and the total cost is much lower. Still this implies high user prices for all forms of
energy. Nijs and Van Regemorter (2012) show how, for the residential sector, these high energy
prices are needed to incentivize the energy users to adopt the massive energy efficiency investments
needed in power stations, buildings, cars etc.
Second, the climate damage that is avoided is real but diffuse, uncertain and delayed. It is diffuse
and uncertain: we don’t know enough about the climate to predict what exactly will happen and
where. In addition, the reward for abatement efforts comes with a delay of 30 to 50 years because
of the thermal inertia of the oceans. When compared with the very limited effort our society is
prepared to make in solving the current longer term problems of our society (for example: aging), it
is difficult to imagine politicians mobilizing their voters to solve an uncertain problem when the
rewards of their effort can only be expected 50 years later.
Third, there is the objective of technological leadership for Europe. But if the rest of the world does
not get onboard, it would seem that nobody is waiting for such new technologies.
Fourth, even if the other continents are also important polluters, it is difficult to keep the polluters
motivated in Europe when the others do not make similar efforts and even partly compensate our
efforts via important carbon leakage effects.
These four factors make it difficult to defend the credibility of the roadmap 2050. A non-credible
roadmap 2050 will make consumers and producers of energy, as well as the regional governments,
hold back on investment as they know that governments will probably step back when there is no
visible benefit of the climate policy.
A WORLDWIDE PERSPECTIVE ON COST EFFICIENCY
Taking as granted that the different blocks of the world are to a large extent on a non-cooperative
equilibrium path, are there better ways to address the climate issue then via the current roadmap
2050? Are there more cost-effective approaches? One of the dimensions largely missing in the
roadmap is the world dimension. The focus is on promising significant efforts within the EU to reach
an ambitious very low emission objective. Whenever there are much smaller efforts involved
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abroad, one would expect that there are opportunities to reduce emissions much more cheaply in
the rest of the world (ROW). As an extreme example, take the generation of 1 mWh of electricity
with coal, a very carbon intensive product, and compare the marginal production cost in the EU and
in another continent. One mWh of electricity in a coal power plant costs, in the EU under the
roadmap 2050 scenario, 30 Euro/mWh (fuel) +300 Euro/mWh in emission permits. In another
continent, where there is no climate policy, the same mWh costs 30 Euro/mWh to produce. This
means there is an enormous difference in prices between continents that will give rise to very
different marginal costs of emission reduction. In the EU, one would go for a maximum of electricity
savings as every mWh saved means saving 330 Euro. In the other continents, the drive for saving on
electricity consumption is largely absent as the reward for saving one mWh is only 30 Euro/mWh.
The main idea of the Clean Development Mechanism is that there are investment options abroad to
reduce emissions more cheaply. The main issue is monitoring: because the other continent is not
very involved in climate policy, it is difficult to assess the real emission reduction effect of the CDM.
Of course, if a foreign country also has an absolute cap on emissions, one could trade emission
rights. This would be a less glamorous but more cost-effective approach.
The next table illustrates the possibilities of cooperation in emission reduction at a less ambitious
scale for 2020 and 2030. This issue has been studied using the GEM-E3 general equilibrium model.
This model studies economic development in the world by considering 10 or so economic blocks in
the world linked via trade and modelling their emissions of GHG as well as the costs of reducing
these emissions. Two scenarios are illustrated: a cooperative scenario in which the rest of the world
joins an agreement and also agrees to make efforts, and a “unilateral” scenario in which only the EU
commits to emission reductions.
Table 1: Simulation of costs of different EU strategies (source GEM-E3)
In the cooperative scenario, the assumption is that the US commits to an identical reduction as the
EU (-30% in 2020 and progressively more in 2030)) and that the new industrializing countries commit
to monitor their emission/output ratios so that they cannot sell emission reduction efforts by first
increasing their emission levels. A second important assumption is that there is full trade of carbon
permits in the world. This means that the emission reductions in the EU and the US are realized
Page 19 of 26
largely in China and Brazil, but paid by the EU and the US. The overall reduction in the world would
be 25,9% and the gross economic cost (before accounting for climate damage reduction) would be
1.2% of GDP in 2020. The price of a carbon emission permit would be of the order of 45 $/ton of
CO2. The cost for the US is lower than for the EU, because the US starts from a higher level of
emissions per capita and can therefore more easily reduce emissions than the EU.
It is also interesting to see what strategy could be followed to realize the 20% in 2020 for the EU if
the rest of the world does not sign any climate agreement at all. In that case, it would pay for the EU
to set up a monitoring system in a country like China, where emission reductions are cheap. The EU
set up an emission trading programme with China and although China does not commit to an
emission reduction, it will be eager to step into the emission trading program as there are important
gains from trade in emission reduction. Permits would be traded at 6 Euro/ton and the EU would
comply with its promises in a cheap way.
To conclude, reducing emissions cost-effectively in a non-cooperative world probably implies having
the bulk of the effort located abroad rather than in the EU.
TECHNOLOGY POLICIES
Realizing emission reductions abroad also has several implications for technology policy.
The first idea is that the balance between behavioural efforts and technology efforts may have to
change. Reducing emissions at minimum cost usually involves an optimal mix of reducing the level of
the polluting activity and making the activity cleaner. Figure 4 illustrates this trade-off. In the
absence of climate policy, one has an activity level Q° as the price of the activity is P°. This is the
price in the absence of regulation or taxation of the climate damage. Assume now that the
consumers and producers of the polluting activity (say cars) are confronted with the full climate
damage d per unit of activity (Euro of discounted climate damage per car mile). Assume this is done
via a pollution tax. There will be a double reaction on the (perfectly competitive) car market. Those
manufacturers that can offer a less polluting model at a low cost will offer a car that will be
somewhat more expensive to produce but also less polluting. As long as the total cost for the user is
lower than P°+d°, the manufacturer will do so. Competition between manufacturers will lead to a car
that, for the user, will cost Peff+d* (the cost of the more efficient car Peff and the smaller pollution tax
d* as the car is cleaner). Implementing an efficient climate policy leads to a reduction of activity
levels from Q° to Q*. The total pollution damage will be reduced from the rectangle d° times Q° to
the rectangle d* times Q*. There is thus a reduction of pollution damage via two mechanisms: a
“behavioural mechanism” under the form of a reduction of the activity level from Q° to Q* and a
“technological mechanism” under the form of a shift to a cleaner production or consumption of the
activity (from d° to d* per unit of activity). Emission permits and emission taxes minimize the total
cost of emission reduction by balancing optimally these two ways of pollution reduction.
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Figure 4: Optimal combination of activity reduction and cleaner production techniques
Through its environmental policy, the EU can push manufacturers to develop cleaner, more efficient
appliances. The knowledge developed to design and produce the more efficient appliances is a cost
element for EU manufacturers, but it also has an important beneficial side effect: it reduces the cost
of emission reduction for all other producers in the world. A multinational firm, active in the EU and
in the rest of the world, will be able to produce cleaner appliances in the EU but also in the ROW.
Barla & Proost (2012) argue that, in a non-cooperative world, this may shift the balance between
emission reduction by better technology and by reducing the polluting activity. Simply using a
cleaner production technique without any reduction of the level of activity would already decrease
emissions in Figure 4 with an amount (d°-d*) times the level of activity (Q° or Q°* depending on
whether one contributes fully in the additional production costs or not). Intuitively, the noncooperating ROW will never reduce the level of its polluting activities as it is not interested in
emission reduction. But it does not mind using more fuel efficient techniques if it does not involve
an extra cost for the user. The reduction of emissions associated to technological innovation when
its use is spread over the world can be far more important than behavioural emission reduction at
home. Take cars by way of illustration. The EU market represents 25% of the world car market. If the
EU can make the other 75% of the world car market adopt somewhat more fuel efficient cars, this
may be far more important than the total emission reduction for cars in the EU itself12. The only
concern is that there may be a rebound effect: when the ROW has more fuel efficient appliances at
its disposal, its variable cost decreases and the appliances will tend to be used more intensively,
taking away part of the gains.
12
We simplify the issue very significantly here as a correct treatment of this issue requires the modelling of a
game with several layers: between governments that decide on instruments and between firms in an
imperfect competition setting. The imperfect competition setting is needed to model R&D investments.
Strategic governments anticipate two types of spillover: knowledge spillovers as well as climate damage
spillovers, see Benoot & Proost (2013).
Page 21 of 26
Dechezlepètre et al. (2011) show, using patent data, that those countries who signed the Kyoto
treaty (Kyoto Annex 1) were indeed much more active in terms of climate mitigation innovation than
non-signatory countries like the USA. Figure 5, taken from Dechezlepètre et al., shows the build up
of the share of the climate-mitigation innovation activity in Kyoto Annex 1 countries in total
innovation activity in the EU. This demonstrates that innovation is strongly stimulated by the climate
policy objectives. Observe the special case of China, which also has an increase in innovation activity
from 2000 onwards. This may be due to the implementation of stricter domestic environmental
policies, but it could also be due to the strong demand for highly subsidized renewable energy (solar,
wind) in the EU, in particular in Germany.
Figure 5: Share of climate related inventions by different types of countries over time (source:
Dechezleprêtre et al. (2011))
Figure 6 shows that most technological developments still originate in the OECD countries. In
addition, since the late nineties there is a stronger export of technological knowledge related to
climate technologies from OECD to non-OECD countries. Both types of evidence show the role of
innovation and the export of innovation in addressing the climate issue in worldwide context.
Page 22 of 26
Figure 6: Share of North South flows in technology measured by the patents that originate in OECD countries
and are also registered in non-OECD countries (source: Dechezleprêtre et al. (2011))
The second idea is that one may have to push less ambitious technologies than we plan now in the
framework of Roadmap 2050. Once one starts with the idea that emission reduction abroad is as
important as the emission reduction at home, there are three dimensions of technology that
become more important. The first is that the “climate-efficient” technology has to compete with
traditional technologies in the absence of a strong local environmental policy. This simply means
that it has to pay for itself at the level of the ROW user. Consider again Figure 4. The new technology
with cost Peff has to compete with traditional technologies with cost P° and this means limiting one’s
ambitions in terms of performance and associated costs.
The second technology characteristic that becomes important is the local absorption capacity. A
large part of the world has a lower level of technological development than the EU. The less
developed countries will more easily adopt technologies with which they are more familiar. Take, for
example, car engine technologies. Table 2 presents the potential to reduce emissions per mile using
standard gasoline & diesel technologies and using hybrid, hybrid plug-in and electric vehicles. The
emission performances of the different technologies are compared using an index in which the
emission index for the current new car in the OECD is set equal to 100. The total emission reduction
achieved with hybrid and electric engines is clearly higher, but it is also much more expensive and
more complex than traditional gasoline and diesel engines. An efficient and cheap gasoline engine is
probably more useful to the world’s climate than the hybrid technology.
Page 23 of 26
Technology
Gasoline
Diesel
Hybrid gasoline
Hybrid diesel
Plug-in Hybrid
Electric
Index of GHG emissions per mile
(well to wheel)
(average OECD 2010=100)
80-45
80-45
60-34
50-34
30-19
45-14
Additional costs per vehicle
0 to 2000 $
0 to 2000 $
2000 to 4000 $
2000 to 4000 $
7500 $
10 000-20 000 $ + additional discomfort
(range, refuelling
Table 2: Comparing alternative car engine technologies for GHG emission reduction (source: Proost & Van
Dender (2012), using IEA data)
Thirdly, there is no certainty that the promotion of ambitious climate technologies is a guarantee for
a successful European industrial policy. The massive support focused on renewables in the EU has
generated a renewable industry, but it is one that is very dependent on massive subsidies. In
addition, the first mover advantage for renewables did not really materialize as other parts of the
world have taken over as primary producers of renewable equipment (Frondel et al. (2010)). This
can be seen as a failure of industrial policy, but it can also be considered as a successful transfer of
carbon free technologies if they are used intensely outside the EU.
In sum, climate policy needs to be geared more to technology development when the rest of the
world does not cooperate. Reducing emissions via technological improvement can indeed have
beneficial spillovers in the rest of the world. These spillovers are missing for behavioural efforts to
reduce emissions. As an important part of technological improvements needs to be passed to the
ROW that has much more restricted climate policy objectives, one should not opt for the most
efficient technologies. The ROW is not waiting for fancy technologies that achieve the Energy
Roadmap 2050 objectives.
6.
CONCLUSIONS
This paper looked into the broad climate policy lines for Europe. The EU has ambitious goals for 2020
and is even more ambitious in its Energy Roadmap for 2050. Discussing the broad lines implies we
left out the fine tuning of the policy choices inside the EU. Instead, we focused on the international
setting. Up to the present, the EU is the only region to have committed to a firm reduction of its
GHG emissions. We argued that this is likely to remain unchanged. The character of global warming
as a global ‘public bad’ is an important handicap for international climate treaties. Surprisingly, this
implies that we need to devote more attention to international cooperation in a world in which
there is no international agreement.
As long as the EU is the only region to take firm climate action, there is an additional hurdle to be
cleared on the international energy markets. For fossil fuels like oil and gas, which are nonrenewable resources with a significant scarcity component in the price, all deliberate reductions of
fossil fuel by the EU could result in postponing rather than reducing carbon emissions, because the
available resource stock will be used anyway by the rest of the world. This implies that reducing coal
Page 24 of 26
use in an absolute sense (replacing it with renewable electricity) or substituting coal by gas could
lead to a more effective carbon emission reduction than a reduction of oil or gas use.
When one considers the Energy Roadmap 2050 in a world perspective, there are more cost-efficient
policies to reduce or at least postpone climate emissions than to absolutely want to achieve a
carbon free Europe. Many actions that can be taken in the rest of the world are probably cheaper
than the extremely ambitious efforts we are planning in the EU. This has two major implications in
terms of policy. The first is that technological developments have an advantage compared to
behavioural efforts within Europe because technological efforts spill over to the rest of the world.
The second is that the transferred technologies need to be usable and cheap if we want them to be
used.
Finally, as cooperation is unlikely in the field of climate policy, efforts in most of the world, including
the EU, will shift to adaptation rather than prevention.
Page 25 of 26
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