It has long been recognized that international trade in emission quota can reduce mitigation costs. This will occur when countries with high domestic marginal abatement costs purchase emission quota from countries with low marginal abatement costs. This is often referred to as “where flexibility”. That is, allowing reductions to take place where it is cheapest to do so regardless of geographical location. It is important to note that where the reductions take place is independent of who pays for the reductions.

Table TS.5: Energy Modeling Forum main results. GDP loss in 2010 (in % of GDP; 2010 Kyoto target)
	No trading				Annex I trading				Global trading
Model	US	OECD	Japan	CANZ	US	OECD	Japan	CANZ	US	OECD	Japan	CANZ
ABARE-GTEM	1.96	0.94	0.72	1.96	0.47	0.13	0.05	0.23	0.09	0.03	0.01	0.04
AIM	0.45	0.31	0.25	0.59	0.31	0.17	0.13	0.36	0.20	0.08	0.01	0.35
CETA	1.93				0.67				0.43
G-CUBED	0.42	1.50	0.57	1.83	0.24	0.61	0.45	0.72	0.06	0.26	0.14	0.32
GRAPE		0.81	0.19			0.81	0.10			0.54	0.05
MERGE3	1.06	0.99	0.80	2.02	0.51	0.47	0.19	1.14	0.20	0.20	0.01	0.67
MS-MRT	1.88	0.63	1.20	1.83	0.91	0.13	0.22	0.88	0.29	0.03	0.02	0.32
Oxford	1.78	2.08	1.88		1.03	0.73	0.52		0.66	0.47	0.33
RICE	0.94	0.55	0.78	0.96	0.56	0.28	0.30	0.54	0.19	0.09	0.09	0.19
Note: The results of the Oxford model are not included in the ranges cited in the TS and SPM because this model has not been subject to substantive academic review (and hence is inappropriate for IPCC assessment), and relies on data from the early 1980s for a key parametization that determines the model results. This model is entirely unrelated to the CLIMOX model, from the Oxford Institutes of Energy Studies, referred to in Table TS.6.

“Where flexibility” can occur on a number of scales. It can be global, regional or at the country level. In the theoretical case of full global trading, all countries agree to emission caps and participate in the international market as buyers or sellers of emission allowances. The CDM may allow some of these cost reductions to be captured. When the market is defined at the regional level (e.g., Annex B countries), the trading market is more limited. Finally, trade may take place domestically with all emission reductions occurring in the country of origin.

Table TS.5 shows the cost reductions from emission trading for Annex B and full global trading compared to a no-trading case. The calculation is made by various models with both global and regional detail. In each instance, the goal is to meet the emission reduction targets contained in the Kyoto Protocol. All of the models show significant gains as the size of the trading market is expanded. The difference among models is due in part to differences in their baseline, the assumptions about the cost and availability of low-cost substitutes on both the supply and demand sides of the energy sector, and the treatment of short-term macro shocks. In general, all calculated gross costs for the non-trading case are below 2% of GDP (which is assumed to have increased significantly in the period considered) and in most cases below 1%. Annex B trading lowers the costs for the OECD region as a whole to less than 0.5% and regional impacts within this vary between 0.1% to 1.1%. Global trading in general would decrease these costs to well below 0.5% of GDP with OECD average below 0.2%.

The issue of the so-called “hot air”¹⁷ also influences the cost of implementing the Kyoto Protocol. The recent decline in economic activity in Eastern Europe and the former Soviet Union has led to a decrease in their GHG emissions. Although this trend is eventually expected to reverse, for some countries emissions are still projected to lie below the constraint imposed by the Kyoto Protocol. If this does occur, these countries will have excess emission quota that may be sold to countries in search of low-cost options for meeting their own targets. The cost savings from trading are sensitive to the magnitude of “hot air”.

Numerous assessments of reduction in projected GDP have been associated with complying with Kyoto-type limits. Most economic analyses have focused on gross costs of carbon emitting activities¹⁸, ignoring the cost-saving potential of mitigating non-CO₂ gases and using carbon sequestration and neither taking into account environmental benefits (ancillary benefits and avoided climate change), nor using revenues to remove distortions. Including such possibilities could lower costs.

A constraint would lead to a reallocation of resources away from the pattern that is preferred in the absence of a limit and into potentially costly conservation and fuel substitution. Relative prices will also change. These forced adjustments lead to reductions in economic performance, which impact GDP. Clearly, the broader the permit trading market, the greater the opportunity for reducing overall mitigation costs. Conversely, limits on the extent to which a country can satisfy its obligations through the purchase of emissions quota can increase mitigation costs. Several studies have calculated the magnitude of the increase to be substantial falling in particular on countries with the highest marginal abatement costs. But another parameter likely to limit the savings from carbon trading is the very functioning of trading systems (transaction costs, management costs, insurance against uncertainty, and strategic behaviour in the use of permits).

Policies aimed at mitigating greenhouse gases can have positive and negative side effects on society, not taking into account benefits of avoided climate change. This section assesses in particular those studies that evaluate the side effects of climate change mitigation. Therefore the term “ancillary benefits or costs” is used. There is little agreement on the definition, reach, and size of these ancillary benefits, and on methodologies for integrating them into climate policy. Criteria are established for reviewing the growing literature linking specific carbon mitigation policies to monetized ancillary benefits. Recent studies that take an economy-wide, rather than a sectoral, approach to ancillary benefits are described in the report and their credibility is examined (Chapter 9 presents sectoral analyses). In spite of recent progress in methods development, it remains very challenging to develop quantitative estimates of the ancillary effects, benefits and costs of GHG mitigation policies. Despite these difficulties, in the short term, ancillary benefits of GHG policies under some circumstances can be a significant fraction of private (direct) mitigation costs and in some cases they can be comparable to the mitigation costs. According to the literature, ancillary benefits may be of particular importance in developing countries, but this literature is as yet limited.

The exact magnitude, scale, and scope of these ancillary benefits and costs will vary with local geographical and baseline conditions. In some circumstances, where baseline conditions involve relatively low carbon emissions and population density, benefits may be low. The models most in use for ancillary benefit estimation – the computable general equilibrium (CGE) models – have difficulty in estimating ancillary benefits because they rarely have, and may not be able to have, the necessary spatial detail.

With respect to baseline considerations most of the literature on ancillary benefits systematically treats only government policies and regulations with respect to the environment. In contrast, other regulatory policy baseline issues, such as those relating to energy, transportation, and health, have been generally ignored, as have baseline issues that are not regulatory, such as those tied with technology, demography, and the natural resource base. For the studies reviewed here, the biggest share of the ancillary benefits is related to public health. A major component of uncertainty for modelling ancillary benefits for public health is the link between emissions and atmospheric concentrations, particularly in light of the importance of secondary pollutants. However, it is recognized that there are significant ancillary benefits in addition to those for public health that have not been quantified or monetized. At the same time, it appears that there are major gaps in the methods and models for estimating ancillary costs.

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