In 1997 Canada, along with most other industrialized countries, signed the Kyoto agreement under which they agreed to collectively reduce their aggregate emissions of greenhouse gases (GHGs) to a specified target by 2012 subject to the agreement being ratified by at least 55 of its signatories representing at least 55 percent of the greenhouse gas (GHG) emissions of those countries. Now that Canada has ratified the agreement, and it is likely that the critical numbers will be reached, the policy question in Canada should now be: How can we best meet our obligations?

One option is to implement the agreement through an integrated system of international and domestic emissions- reduction trading. The Kyoto protocol already allows for emissions-reduction trading between countries; an integrat- ed system would allow emissions-reduction trading between firms within Canada " indeed, the creation of such a sys- tem is part of the federal government’s strategy as presented in Climate Change Plan for Canada (2002). As the govern- ment acknowledges, however, the plan remains a ”œwork in progress,” and the role that emissions trading will play in the overall policy will continue to be debated.

What policy is best for achieving the required emissions reductions depends on the policy’s objective. The principal purpose of reducing GHG emissions, of course, is to slow the process of global warming and avoid its potential long-term consequences. This reduction in the expected long-term con- sequences of global warming is often referred to as the avoid- ed damages or primary benefits of GHG-emissions reduction. In addition to these primary benefits, GHG-emissions reduction may also generate substantial indirect benefits in the form of improved air quality and, consequently, health (from less res- piratory illness, for example). These indirect benefits are often referred to as co-benefits or ancillary benefits.

Co-benefits affect the Kyoto debate in two major ways. First, they potentially lower the net cost to Canada of imple- menting the agreement, since any costs from lost produc- tion would be mitigated by the health benefits. Second, they might also affect Canada’s policy for implementing the agreement. In particular, these co-benefits call into question the wisdom of purchasing emissions-reduction credits from overseas, if smaller domestic reductions lead to smaller improvements in air quality.

In this article we are concerned with the question of how the presence of co-benefits affects what would be the best policy for implementing Canada’s obligations under Kyoto, with particular reference to the extent to which Canada should avail itself of the opportunity to purchase emissions-reductions credits from other countries. Our conclusion is that a system of integrated internation- al and domestic emissions-trading remains the best way of implementing the agreement even when co-benefits are taken into account, provided other policies are put in place to address the question of air quality.

Under the Kyoto agreement, partic- ipating countries accepted certain GHG-emissions-reduction targets. The targets are supposed to be met by the year 2012. For Canada, the Kyoto tar- get is an aggregate emission level 6 per- cent below the 1990 value. It has been estimated that, in comparison with a scenario under which the Canadian economy continues to grow but no measures are implemented to reduce GHG emissions, the target corresponds with a 26 percent reduction by 2010.

The Kyoto Protocol provides for international trading of emissions rights. That is, it provides for a maxi- mum level of GHG emissions for all the participating countries together, but individual countries do not have to reach their specific targets. Instead, a country can exceed its original target and still fulfil its obligation by buying a sufficient number of permits from another participating country, which then has to reduce its emissions by more than implied by its individual target.

The rationale for these credit- transfer provisions is that from the viewpoint of slowing down global warming, it doesn’t matter where or how GHG emissions are reduced. A system of credit transfers, which allows one country to purchase emis- sion-reduction credits from another at a price that makes it beneficial for both countries, provides an incentive for GHG emissions to be reduced in the countries where the cost of achieving those reductions is lowest " thus min- imizing the total world-wide cost of reaching a given global emissions reduction, while also compensating those countries that take on more than their share of the emissions reduction.

Within this framework, Canada faces two policy questions concerning the implementation of its obligations. First, what is the least expensive way to achieve a given level of emissions reduction? Second, what level of emis- sions reduction should the country choose to implement internally, and, hence, what amount of emissions- reduction credits should it buy in the international market? The answer to the second question will presumably depend on how much those credits cost (or how much can be earned by selling credits) compared with the cost of reducing emissions domestically. This in turn will depend on the answer to the first question. In the absence of health co-benefits, a system of domestic tradeable emissions permits integrated into the international permit market could be an efficient way both to determine the answer to these questions and to implement the appropriate policy.

In principle, finding the least-cost way of achieving a given level of emis- sions reduction in Canada requires a decision on which GHGs to reduce and by how much, and which firms or activ- ities should be responsible for doing so. This is an extremely complicated prob- lem that has been considered by the Analysis and Modelling Group (AMG), one of the sixteen Issue Tables set up by the federal government as part of the National Climate Change Process.

The informational problems here are such that the government should not see its job as finding the exact answer to the questions of what GHG emissions to reduce, by how much, and by whom, but rather as implementing a system by which the answers to these questions would be determined in large part by the individuals with the most information. Whether a system of domestic tradeable emissions permits could be used for this purpose was part of the AMG’s report which was tabled in April 2000.

Such a system is based on the same principle as the intercountry emissions trading provided for in the Kyoto agree- ment. Emissions are monitored, and a firm is only legally allowed to emit an amount equal to the total quantity specified in all the permits it holds. Assuming the law is enforced, govern- ment can control the aggregate nation- al amount of emissions by restricting the quantity of permits it issues. If domestic permits can be traded, a mar- ket-clearing price will be established, and each firm can then decide whether to buy a permit or to reduce emissions.

A permit system is likely to lower the cost of meeting an aggregate emis- sions target than a system of specific lim- its imposed by governments on individual firms (command and control regulation). A system of the latter type will only minimize the economy-wide cost of reaching a given emissions target if governments know exactly how much it costs each individual firm to reduce emissions to different levels. With a sys- tem of tradeable permits, governments don’t need this information. Instead, the firms themselves decide which of them will reduce emissions and by how much, based only on information about their own cost conditions and the market price for permits. The resulting pattern of emissions reduction will tend to mini- mize the aggregate cost to all the firms as a group of meeting a given nationwide emissions reduction target.

The question of the extent to which Canada should meet its Kyoto obligations by reducing its GHG emissions domestically amounts to asking whether the cost of an international permit is lower than the cost to Canada of achieving the same amount of reduction within its borders. Specifically, the cost-minimiz- ing strategy for achieving the target level of emissions reduction would be to reduce emissions domestically by the cheapest means available up until the point where the cheapest way of mak- ing a reduction of one more unit of GHG exceeded the cost of an interna- tional permit.

One of the positive aspects of a sys- tem of domestic emissions permits is that, in principle, the market price of the permits conveys information about the cost to each firm and hence to the country of the last unit of emissions reduction, since a firm will only pur- chase emissions permits as long as the benefit that the firm receives from the permit exceeds the cost. This provides a simple rule for whether Canada should purchase emissions-reduction permits from other countries " as long as the price of international permits is less than that of domestic permits, it should purchase the international ones and issue a corresponding additional quantity of domestic ones. It should do this until sufficient permits have been issued to equalize the two prices.

Based on this logic, economists have suggested that the two kinds of trading systems should be integrated, in the sense that international and domestic permits should be considered equiva- lent: A firm that wanted to emit a certain quantity of CO2 equivalent could be allowed to do so on the basis of either a domestic or an international permit. Allowing firms the choice between inter- national and domestic permits would obviously guarantee that their market prices would be the same (since if the price were different firms would only buy the cheaper permit and either drive up its price or drive down the price of the more expensive one). With an inte- grated system of permits like this, the optimal number of international permits would be purchased without any need for the government to enter the interna- tional permit market directly.

The federal government’s climate change plan does allow for inte- grated permit trading to some extent. However, although the plan does make reference to health benefits from an improvement in air quality, it does not address a key issue: whether, as some critics have suggested, the existence of co-benefits invalidates the logic on which the preceding argument is based.

Unfortunately, the interdepend- ence between the choice of climate change strategy and other policies to protect air quality has not been suffi- ciently recognized in the Canadian debate. In particular, we believe that a more detailed analysis is needed of what policies would be pursued in addition to those specifically targeted to GHG-emissions reduction. Failure to consider other policies that would like- ly be used to protect air quality under an integrated system of international and domestic emissions trading has led to an overestimate of the co-benefits that would be lost under such a strate- gy, and thus to an overstatement of the air quality benefits of strategies involv- ing restrictions on international permit trading. Let’s review the argument.

The AMG scenario analysis includes a report in which co-benefit esti- mates are presented for several scenar- ios (Environmental and Health Impacts Subgroup 2000). According to the report, if Canada were to undertake all its emissions reduction domestically the value to Canadians of the environmental and health co-benefits would be substantial " between $300 and $600 million per year " but if Canada were to purchase emissions-reduction permits from other countries, about a quarter of these benefits would be lost.

Let us now consider how the pres- ence of such co-benefits might change the analysis of the desirability of imple- menting the accord through an integrat- ed system of international and domestic emissions-reduction permits. First, since not all GHGs are equivalent in their impacts on health, the true net costs of reducing some GHGs (taking into account the health co-benefits) will differ from the gross costs of lost production by more for some GHGs than for others. Second, unlike the effect on global warm- ing, the health costs of emissions do depend heavily on where the emitters are located. In general the health costs of air pollution are greatest when the emis- sions are in heavily populated areas that already have a high level of pollution. Finally, health benefits to a country from reduced emissions are not a direct gain to the firm making the emissions reduction, and so those benefits will not be taken into account in the actions of firms and hence in the market price of permits.

These considerations greatly com- plicate the issue of which GHGs should be reduced, by which firms or activities, and whether emissions reductions should be purchased from overseas rather than achieved domesti- cally. It also calls into question whether a market-based system of tradeable per- mits is the most appropriate tool for making that determination.

The Tradeable Permits Working Group report did not take account of co- benefits, something that environmental groups (and some economists) have crit- icized. In particular, they have argued that it would be entirely inappropriate for Canada to let the market decide the extent to which our Kyoto obligations would be met by domestic emissions reductions by allowing private firms to buy emissions permits in the interna- tional market without restrictions. This argument is based on the calculation that about a quarter of the potential environmental and health co-benefits could be lost if Canadian firms were allowed to avoid reducing domestic emissions by buying foreign emissions permits. For this reason, environmental- ists have advocated placing limits on the amount of international permits that Canadian firms should be allowed to buy. Similarly, they have noted that in a system of unrestricted domestic emis- sions permits the incentive for firms to reduce particular types of emissions will be proportional to their GHG content, even though domestic emissions with the same GHG content may have vastly different impacts on environment and human health, for example, because of toxic co-pollutants, or because some occur in close proximity to densely pop- ulated areas. We refer to these objections as the ”œenvironmentalist critique.”

Another way of putting this criti- cism is to say that, because individual firms would buy permits only as long as the cost of the permits was less than the lost profit to them from not hav- ing the emissions that the permits would allow, the decision on how many permits to buy would be based purely on the lost production that the lost profit represented. Socially, how- ever, we would want the decision on the extent to which Canada avails itself of the option to buy emissions reductions from overseas to be based not just on lost production, but rather on the net cost to society, which would be the lost profit to firms less any health benefits. This is an example of what economists term an externality " i.e. a situation where individual firms or consumers operating in an unregulated market choose a socially sub-optimal level of some activity because effects of the activity on third persons are not reflected in the prices that they face in the market.

The environmentalist critique is that because of this market failure in the pric- ing of permits Canada should choose to eschew the option of buying emissions reduction credits from other countries. Although this argument has merit, we believe that the best response to the pres- ence of co-benefits is not to avoid using an integrated system of domestic and international emissions permits, but rather to supplement that system with a separate set of air quality controls.

This is for the two rea- sons stated above " not all GHGs are equal in their health impact, and the health costs of emissions tend to be local rather than global. Simply increasing the amount of GHG reduction in Canada by restricting international permit purchasing without supplementing the policy with specific measures directed to air quality would not guarantee that the increased emis- sions reductions in Canada were targeted to where the total cost net of health ben- efits was minimized. Indeed, it is possible that in some cases the lowest-cost way for a firm to comply with a target GHG- emissions reduction would be to take actions that worsen local air quality.

Although it is likely that restricting international trading would be better than allowing unrestricted trading, in the absence of any other policies to improve air quality, there are other alter- natives. An optimal policy would be to implement measures directed specifical- ly to improving air quality in areas where there would be the greatest gain from doing so. If such measures were put in place, however, there wouldn’t be any need to restrict international trading of GHG-emissions-reduction permits.

To see this, suppose that other policy instruments are used to regulate those emissions that have significant air quali- ty effects. Such policies could take many forms. For example, certain kinds of emissions might be prohibited in certain locations, even for firms with valid GHG- emissions permits. Alternatively, emis- sions in some locations, or of specific kinds of pollutants, might be controlled through a second permit system, so that firms would require two separate permits for such emissions. In such cases, a firm that chose to purchase international per- mits to be able to continue to emit GHGs could do so only as long as it also com- plied with local air-quality policies. As long as these additional policies passed the full cost of reduced air quality on to firms, they would only purchase interna- tional emissions-reduction credits if the net benefit to them exceeded the com- bined cost of the international permits plus the cost of complying with the air- quality policies. That is, additional local measures to improve air quality would eliminate the externality described above, hence the market failure that would otherwise have led to too many emissions- reduction credits being purchased from overseas.

Note that we are not rejecting the view that the least-cost way of implementing Canada’s Kyoto obligations will involve fewer purchases of international emissions-reduction permits if there are health co-benefits than if there are not. Rather, we are saying that, when accompa- nied by specific policies directed to air quality, an integrated market system of international and domestic GHG-emissions permits would achieve that end without fur- ther restrictions being imposed.

The discussion above constitutes what economists call a ”œfirst-best” argument. That is, it asks what would be the optimal policy assuming that opti- mal conditions exist elsewhere. One can still make an argument for restricting Canada’s use of international emissions trading if one assumes that optimal additional policies with respect to air quality would not be followed. One rea- son for this view is the Canadian system of divided federal-provincial jurisdiction for environmental protection.

Because climate change is a global issue and the Kyoto agreement is an international one, the federal govern- ment has played a major role in formu- lating a Canadian negotiating position and in organizing the debate regarding ways to implement it. The main respon- sibility for environmental protection and hence air quality in Canada, how- ever, rests with the provinces. One argu- ment, then, for favouring restrictions on the purchase of international emission- reduction credits would be a belief that provincial governments undervalued air quality. In this case, a federal regulatory strategy that effectively tied implemen- tation of the Kyoto agreement to meas- ures that also improve local air quality may seem desirable. The argument here, of course, rests not only on an assess- ment of various governments’ commit- ment to air quality, what the desirable level of air quality is, and of how effec- tive using Kyoto-implementation meas- ures to target air quality would be, but also on a belief that it is appropriate for the federal government to intervene in an area of provincial jurisdiction in this way. This is obviously a political ques- tion that goes well beyond the scope of economic analysis.

Even if one takes the view, howev- er, that it is appropriate for the federal government to act to improve air qual- ity within a province, there is still a case to be made for our proposed policy of implementing the first-best policy with respect to achieving the Kyoto emis- sions-reduction targets and trusting to other targeted policies to deal with issues of air quality: We noted in the introduction that one of the ways in which the presence of co-benefits inter- acts with the determination of optimal policy with respect to Kyoto is that they lower the cost of implementing Kyoto, and thus make it more attractive to gov- ernments to honour their commitment and to push for further GHG-emissions reductions in the future. It is important, however, to note that the converse is also true: an existing commitment to implement Kyoto lowers the cost of tak- ing local action to improve local air quality. Even if one believes that in the past the provinces have been insuffi- ciently concerned about air quality to bear the economic cost of improving it, this reduction in costs may be all the incentive that is needed, without incur- ring the efficiency and jurisdic- tion-confusion costs implied by trying to use one policy to achieve two objectives.

Whatever one’s views on this question, it is clear that to some extent consideration of co- benefits when discussing how to implement Canada’s Kyoto obli- gations has been successful in raising awareness about air-qual- ity policies. The issue of environ- mental and health impacts of air pollution has received increased public attention as a result of the debate on climate change strategy, and the work on co-benefits has significantly improved the information base avail- able to those decision-makers " federal and provincial " who will formulate future policies with respect to air quali- ty. Whether or not Canada ultimately achieves the GHG-emissions reductions it is committed to under the Kyoto accord, this work will be a valuable lega- cy of the debate and will serve as a building block for continued research.  

 

Much of the early work on this paper was done while the authors were working at Health Canada.