0219-B1

The Role of Forest Carbon Sequestration in International Climate Change Policy

Gordon Lee^[1] and Tim Williamson

ABSTRACT

Climate regulation services provided by the global atmosphere are non-exclusive and non-rival and therefore possess the basic features of a pure public good. A simple game theory model is developed that shows that the dominant strategy of nations is to delay, minimize or refuse to take actions to reduce greenhouse gas emissions (i.e. a non-cooperative result). It may, however, be possible to change or modify the game by including options such as forest carbon sequestration that provide positive incentives for unilateral action and/or cooperative action.

Introduction

This paper discusses the global warming issue from a basic public goods theory perspective and uses a simple game theory construct to illustrate the challenges faced in finding a cooperative solution to the problem in an international context. The paper also argues that the opportunity to claim credits for carbon sequestered in forests (as well as other mechanisms such as emissions trading) might help to change the fundamental dynamics of the game in a way that moves toward a more cooperative approach to GHG emission abatement and toward a more socially optimal level of GHG emission.

Greenhouse gas abatement: a global public good

Public goods are differentiated from private goods by two characteristics. First, they exhibit the property of being non-exclusive. That is, it is difficult or impossible to prevent individuals from consuming the public good. A second property of pubic goods is that they are non-rival. Therefore, consumption of the public good by one person does not reduce the amount of utility that a second person can obtain from the public good. Provision of public goods requires the collective actions of all those individuals in society who demand the public good. However, because public goods are non-exclusive and non-rival, competitive markets are unable to provide socially optimal levels of public good provision. Thus, provision of public goods requires a mechanism for ensuring that each individual in society pay his or her fair share for providing the public good.

The global atmosphere provides a diversity of services to the world’s populations that have economic value. One service is to regulate climate. The climate regulation function is both non-rival and non-exclusive and therefore can be characterized as a pure public good (Sandler and Sargent 1995). Another service of the atmosphere is to assimilate the secondary outputs of economic development. Since there are limits on the ability of the atmosphere to assimilate wastes without affecting other atmospheric services (such as climate regulation), the assimilative services of the atmosphere are rival and subject to congestion. In the case of GHG emissions, congestion is not measured in terms of reduced capacity to assimilate more GHG but in terms of reductions in climate regulation (i.e., reductions in a public good). Thus, increased concentrations of GHG into the atmosphere have externality characteristics. Assuming reduced emissions lead to a more stable climate, and assuming that the net benefits of a more stable climate are positive, then the abatement of greenhouse gas emissions prevents the reduction of climate regulation capacity, which can be considered to be a pure public good. In this context, therefore, reduced emissions can be viewed as externality correcting actions that lead to the creation of a pure public good (Bruce et al. 1996).

There is no international agency with the power to assign responsibilities for emission limitation to individual nations and, in effect, require payment for the public good. Thus the problem must be addressed by trying to find a solution through the cooperative actions of nations as has been done through the UNFCCC process. The Kyoto Protocol attempts to facilitate a strengthened collective response to deal with global warming through a long-term process of negotiations on targets involving a growing number of countries, including developing countries. It is clear that current commitments only address the issue of climate change in a limited way, and the success of the long-term vision of the Protocol will only be known in time. Thus, for the foreseeable future it is likely that there will be under provision of climate regulation services. There may be a number of reasons for this, but among them is the public good nature of the issue. Economic theory suggests that non-cooperation may be the dominant strategy of nations relative to issues such as global warming that involve a pure public good (Sandler and Sargent 1995, Barrett 1994). The result will be under provision of the public good. Nash equilibrium in a two-player game occurs when the dominant strategy of both players is to be non-cooperative even when cooperation is in both parties’ best interests (Nash 1953). The tendency for Nash equilibrium (using a simple game theory model) and alternative equilibriums based on assumptions regarding conjectural variation is discussed in the following section.

A Two-Player Game

The selection of a policy action for global warming involves strategic interactions between nations. Thus, the choice of a policy can be modeled by using game theory. A nation knows that any unilateral action will impose costs and benefits to itself. However, since the problem has the characteristics of an international public good, each nation knows that its benefits and costs associated with any policy choice depend critically upon the actions of other nations. The policy choice of any nation produces benefits and costs that spill over to other nations. The costs of policy inaction also are accrued by many nations.

Before describing the game, however, it is important to note that the strategic interactions among nations in the context of global warming are truly complex. The benefits and costs accrue over time, and there are significant uncertainties as to the magnitude of these benefits and costs. These uncertainties are enhanced by the non-market characteristics of many of the benefits and costs of controlling the emissions that lead to global warming. Global warming involves many quality of life and biodiversity issues for which market prices either do not exist or do not reflect true social values. Finally, the number of nations involved and the heterogeneity of these nations also make analysis complex.

Nevertheless, analyzing the global warming problem in the setting of a two-nation game can yield some useful results. Similar to Sandler (1997) and Jeppesen and Anderson (1998), this paper will begin with a static model. Consider a two-nation game. Each nation can either reduce its CO₂ emissions or choose not to reduce. Initially, suppose that the policy tool to reduce emissions is strictly domestic. Each nation knows the benefits and costs of its policy choice and the benefits and costs resulting from the other nation’s choice.

Table one provides a hypothetical payoff matrix for the international GHG emissions problem. The entries in this payoff matrix represent the net present value of benefits associated with the nation’s choice given the choice of the other nation. Thus, if nation X reduces emissions and nation Y also reduces, the net present value of benefits to nation X is X_R. The present value of Nation Y’s benefits is Y_R. If nation X and Y do not reduce, then their respective net present values are X_NR and Y_NR.

The usual expectation with the global warming issue is that X_R > X_NR and Y_R > Y_NR. That is, as a group both nations do better if they both reduce emissions than if they both do not reduce emissions.

Often, when considering international environmental agreements, the possibility of a nation free riding must be considered. In this situation, it is possible for one nation to free ride off the policy action of the other. Suppose nation Y reduces its emissions of CO₂. Then nation Y incurs the costs of its action as well as some of the benefits. If nation X chooses not to reduce, then it is attaining the benefits of nation Y’s policy action without incurring any costs. In the payoff matrix above, nation X would free ride off of nation Y if X’_NR > X_R. Similarly, nation Y would choose to free ride if Y’_NR > Y_R.

Table 1. Theoretical payoff matrix for a bilateral game for reducing GHG emissions

Note: The values in the brackets are relative measures of net present values.

Now, suppose that X_NR > X’_R. Here, nation X has greater net benefits if it does not reduce when nation Y also does not reduce. This condition implies that a nation is better off with no policy action than by taking unilateral action to reduce emissions. That is, a nation should not take positive policy action alone.

Given the above conditions on the entries of the payoff matrix, nation X’s dominant strategy clearly is to not reduce emissions regardless of what choice nation Y makes (i.e., in the row where Y reduces, X is better off not reducing. In the row where Y does not reduce, X is better off not reducing). Similarly, nation Y’s dominant strategy is to not reduce emissions. Thus, the outcome of this game, the Nash equilibrium, is for both nations not to reduce their emissions. This result is typical of a prisoners’ dilemma game.

However, the outcome of the game is not consistent with the optimal choice for the two nations as a group - reduce emissions. The result of this game suggests that a long term and effective international agreement on CO₂ emission reduction may be difficult to achieve. In this scenario, a nation would likely choose a ‘wait and see’ policy and delay decisions to reduce their emissions until they are certain other countries are prepared to make a substantial commitment. All nations would follow a similar logic and the expected outcome will be some difficulty in attaining a long-term international agreement that requires individual nations to incur significant costs to their national economies.

Changing the game

The question then arises, how can the non-cooperative result be reversed? How can the game be changed to ensure that the dominant strategy of a country is to cooperate and not delay action?

One possible solution is for countries to adopt strategies that change the entries in the payoff matrix. Changing the values of the entries could change the Nash equilibrium so that the prisoner’s dilemma result does not occur. For example, if the entries in the payoff matrix are such that X_R > X’_NR and X’_R > X_NR, then there is an incentive for unilateral action by country X, independent of what country Y does. Moreover, if country Y has access to other ways of reducing emissions in ways that return positive net benefits from unilateral actions, then it also will have an incentive to act.

The entries in the payoff matrix can be changed by several policies. Three such polices involve the use of carbon sinks, the clean development mechanism, and transferable discharge permits. Consider first the use of the clean development mechanism to reduce CO₂ emissions. One common theme is that Annex I nations would attain emissions credits by aiding developing nations in reducing their CO₂ emissions. Hence, an Annex I nation could choose to provide a relatively low cost emissions reduction program in a developing nation as opposed to applying the program at a higher cost domestically. Another option is emissions trading in transferable discharge permits. Many studies have discussed the advantages of using permits as a solution to the global warming problem. Tietenberg (1995) notes that the use of permits might result in cost savings of over 30% relative to using regulations. Like permits, the use of carbon sinks, clean development mechanisms, and emissions trading might lower the costs of reducing CO₂ emissions and thus might change the entries in the payoff matrix.

In the context of this game the application of any of these policies does not ensure a way of escaping the prisoners’ dilemma result. The use of these policies changes the size of X_R, X’_R, Y_R, and Y’_R. If X’_NR > X_R and X_NR > X’_R still remain after the application of these policies, the prisoners’ dilemma result would still occur.

However, permits, carbon sinks or the clean development mechanism might change the size of the entries so that the benefits of taking unilateral action outweigh the benefits of no action. This still leads to a rather pessimistic conclusion. Unless both nations have the incentive to unilaterally take action, a cooperative equilibrium where both players reduce emissions might not be achieved.

Alternatively, getting both nations to reduce emissions might be accomplished with intense bilateral diplomatic negotiation. Each nation might reduce if it feels that its actions will cause the other nation to also reduce or if it is confident that the other nation will fulfill its commitments as agreed upon in a bilateral agreement. This result occurs if there is a positive conjectural variation, the belief that the actions of one nation will lead to positive actions on the part of another nation. This positive conjectural variation may be the result of a desire for a nation to be seen as a “fair player”. The result may be a “fairness equilibrium” (See Jeppesen and Andersen 1998). Diplomatic negotiations might be highly effective in the case of bilateral environmental public good issues, but they become more difficult to bring to conclusion as the number of negotiating parties increases (Olson 1965, Cornes and Sandler 1984). Nevertheless bilateral discussions do have a key role, even in global negotiations, because they can help in creating alliances and providing assurances about the intentions and commitment of countries.

Conjectural variation can also have a negative side. If one nation believes that its actions will result in the other nation free riding, then this nation may choose not to reduce. The prisoners’ dilemma outcome occurs.

The use of policies such as permits or carbon sinks may work as a positive signal. These polices would indicate a commitment to CO₂ reduction. This commitment then would assure the other players in the negotiation process, inducing these players to also make commitments. In the repeated game, the cooperative equilibrium of all players reducing emissions can be achieved.

Obtaining carbon credits from the management of forests as carbon sinks is an example of an option that could help to induce country X to take positive actions. Under favorable circumstances, forest management can result in an increase in the steady state amounts of carbon stored in forests (Sedjo et al. 1998, Griss 2002). Increasing the steady state amount of carbon permanently stored in a carbon sink is equivalent to reducing the level of emissions. More generally, the Intergovernmental Panel on Climate Change has concluded that even if conservation and sequestration of carbon are not permanent, they offer significant climate change mitigation potential because they allow time for options for emission reduction, such as the development and implementation of new technologies. In doing so they can reduce the overall long-run cost of reducing emissions.

If the net benefits of investment in forest carbon sinks are positive (i.e., the combined net present value of timber rents, non-market benefits and carbon rents), then this increases the likelihood of unilateral action, at least up to the point where the net benefits remain positive. This is not to suggest that forest carbon sequestration can provide a complete solution. However, it is an example of one option that can be used to improve the incentive for countries to take action, irrespective of their expectations regarding the strategic behaviors of other countries.

It is possible, and perhaps probable, that the net present value of forest sequestration (or other positive incentive options) may not be large enough to escape the prisoners’ dilemma result (i.e., X_NR >X’_R). However, the use of carbon sequestration may provide a strong positive signal to other nations that nation X is committed to CO₂ reduction, which, again, may provide the incentives for other nations to also reduce their emissions. Finally, there are many other factors and considerations that will go into a particular country’s decision to take action, a number of which are intangible. For forested nations, the opportunity to make investments to sequester carbon may increase X’_R thereby narrowing the gap between X_NR and X’_R. This will tend to improve the motivation for countries to take action to reduce net GHG emissions into the atmosphere.

Acknowledgements

We are grateful for the significant contributions and suggestions provided by Tony Lempriere (Canadian Forest Service).

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