I investigate the natural resource rent in the Kyoto flexibility mechanisms. .... discovery costs for the resource that have to be subtracted from the rent. The.
Natural Resource Use, Resource Rent, and the Kyoto Flexibility Mechanisms Adrian Muller
Environmental Economics Unit (EEU) Department of Economics, Göteborg University PO Box 640, 40530 Göteborg, Sweden phone: 0046-31-773 47 59 fax: 0046-31-773 41 54 e-mail: adrian.muller[at]economics.gu.se
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Abstract I investigate the natural resource rent in the Kyoto flexibility mechanisms. Three resource use situations can be distinguished: The use of the atmospheric greenhouse gas (GHG) absorption capacity in any GHG emitting activity, the use of various “classical” or “new” resources in activities to reduce GHG emissions and to subtract GHGs from the atmosphere. The resource use in these activities is explained and the corresponding resource rent is discussed. The resource rent perspective clarifies the property and use rights and costbenefit structure of climate change mitigation projects. The resource rent should be extracted for economic reasons. It is part of a property right that the proprietor has rights on the property’s revenues. Rent extraction also helps reflecting the true value of a resource and thus works towards more efficient resource allocation. It can further serve to internalize external costs incurred in the context of the resource use. Among the different possible rent extraction schemes, the resource rent tax performs best regarding the economic criteria allocative and cost efficiency and flexibility. Due to political reasons, rent extraction is difficult to implement in established resource use contexts, but it should be a topic for new resources or changes in resource use that become valuable due to climate change mitigation activities. Keywords: natural resource rent, rent extraction, profit tax, emissions trade, Kyoto protocol, Clean Development Mechanism
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Acronyms AAU aGHG-AC CDM CER COP EAU ERU ET GHG JI KP LULUCF RMU
assigned allowance unit atmospheric greenhouse gas absorption capacity clean development mechanism certified emissions reduction conference of the parties emissions allowance unit emissions reduction unit emissions trade greenhouse gas joint implementation Kyoto protocol land use, land use change, and forestry removal unit
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1 Introduction The Kyoto Protocol (KP) and the activities to curb climate change aim at stabilizing the atmospheric greenhouse gas (GHG) concentration. This restricts GHG emissions and makes the atmospheric greenhouse gas absorption capacity (aGHG-AC) a scarce resource. In consequence, this hitherto price-less natural resource becomes valuable. The KP provides the institutional framework to allocate the use rights to this resource and allows for trading those on a market. This is done by setting caps on the GHG emissions of industrialized countries and by establishing the so-called Kyoto flexibility mechanisms. These are the Emissions Permit Trade (ET), regulating the trade in the use rights on the resource aGHG-AC, the Clean Development Mechanism (CDM) and Joint Implementation (JI), regulating how reductions made abroad can be accounted for the reduction goals of countries subject to emissions caps. The aGHG-AC is a renewable resource in the sense that there are natural processes that replenish its stocks and that operate at the same time scale as the natural and anthropogenic processes using it up. All processes that extract GHGs from the atmosphere and sequester or destroy them are such renewing processes, most notably dilution of CO2 in the oceans and storage in biomass by photosynthesis. As any kind of GHG extraction from the atmosphere increases the stock of the aGHG-AC, it is possible to engage in business activities to increase the resource stocks rather than running them down - e.g. by extracting CO2 from the combustion gases of a power plant and storing them in geological formations such as old oil fields or by setting up special forest plantations to sequester CO2 by photosynthesis. The aGHG-AC has thus a complex double role as a resource and a production good. The aGHG-AC being a valuable resource, using less of it than would be possible due to use rights allocated, or engaging in activities increasing its stocks becomes potentially profitable business. The KP allows public or private entities to engage in such and sets the framework how to do this. For any productive activity employing natural resources, the resource rent is the residual equaling the difference between the market price of the output good and its production costs. It occurs due to heterogeneous firms employing different technologies and facing different production costs competing in a free market where the price is set by the marginal producer. This residual reflects the value of this resource (for this productive activity). Usually, the firm is not the owner of the resource, and it is thus generally agreed on that it should pay for the resource use. To determine a price for this resource is also necessary for its efficient allocation. The proprietor, often the state, should thus extract part of the resource rent by a rent sharing mechanism such as a tax or a fixed fee. In the context of GHG emissions reductions, not only the resource aGHG-AC plays a role, but depending on the type of the business activity reducing its use or replenishing its stocks, the use of other resources not used earlier or in other than traditional ways may become profitable. Setting up a solar or wind power plant on hitherto useless and unvalued barren land can generate rents that reflect the value of this land for this specific activity, the rent thus being
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the land rent that was not present before (see Financial Times (2005) for on recent example). Such facilities could be profitable options for sun-rich countries in Africa in particular in combination with hydrogen production. Aggregate profits in such activities may be large although still very uncertain. Clear rules on how these potential profits should be divided between different parties are not always given and should be established. In the presence of resource rents, this is especially important in the light of the crucial role the quality of institutions play for the provision of public goods and to avoid the resource curse (see e.g. Mehlum et al. 2005). The resource rent for aGHG-AC itself is currently only discussed for the initial allocation of the use rights, i.e. of GHG emission allowances. Initial allocation by grandfathering distributes the rent to the firms, while an auction extracts it for the state (Haites and Hornung 1999a, 1999b). The aim of this paper is to systematically discuss the resource rent and its potential extraction for all resources and actions potentially involved in GHG emissions reduction. Rose et al. (1999) view pollution absorption capacity as a natural resource and describe its dynamics with models inspired by the Hotelling approach. They model the effects of the Kyoto flexibility mechanism on developing countries’ reduction costs and show that cumulative abatement effects can increase those, but that technological change, market power of the host countries or direct compensation can avoid this. The presence of the resource rent can be linked to these results, as it could be one way to finance support of technological progress or such compensation. Market power for the total of host countries could emerge if they set rules extracting parts of the resource rent in an internationally coordinated manner thus avoiding dynamics analogous to fiscal competition among themselves. Section 2 discusses the concept of the natural resource rent. Section 3 addresses the resource use and the corresponding resource rent in the Kyoto flexibility mechanisms. The double role of aGHG-AC as a natural resource and an output good is clarified. Section 4 discusses rent extraction for the different resources involved and section 5 concludes.
2 Natural Resource Rent In an free market equilibrium situation where all the actors are price-takers but exploit scarce natural resources of different quality, the rent reflects the “true economic value” of the natural resource exploited and is a residual value given by the difference between the market price and the production cost. 2.1 Types of Economic Rent Economic rent can be divided into three types: differential, scarcity, and quasi-rent (see Tietenberg (2003) and van Kooten and Bulte (2000) for overviews). Differential rent arises because of innate differences of production sites. Some firms operate on more ideal conditions, while others build their plants in locations with more difficult base characteristics. They will thus have higher investment and operation costs for a given output. Scarcity rent emanates from excess demand for the good, which is only available in restricted supply, due to natural or political circumstances. Both kinds of rent arise from the characteristics of the natural resource and their sum is therefore called “(natural) resource rent”. These two kinds of rent can also be described
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by scarcity rent alone, as the differential rent accrues due to the relative scarcity of high-quality resource stocks what makes lower quality stocks profitable to exploit. Differential and scarcity rent do not vanish in free market equilibrium for the final good produced. The presence of the resource rent is not due to a socially sub-optimal situation. Prices are exogenous and if they are high, then not because of high rents, as in the monopolistic case. Rather the opposite is the case and rents are high because of high prices (Amundsen et al. 1992). Prices are determined by the industries marginal cost curve and the demand curve and are thus set by the costs of the marginal producer that does not earn any rent. In contrast, quasi-rent is defined as an economic value, which can be attributed to a firm’s extraordinary wise investments by advertising, specific training of the employees, visionary choice of technologies and so forth. These expenses can result in higher prices (brand) or lower costs. Quasi-rents accrue due to managerial investments in the products and are independent of any natural resource use. In a competitive market, quasi-rents are expected to disappear as competitors adopt such profitable strategies and technologies. It is often difficult to decide on which levels and types of investments are “natural” or “extraordinary” and thus to decide on which part of the rent is a quasi-rent. To determine the rent, prices and costs have to be known. Prices are observable in the case of a free output market. The resource rent then reflects the economic value of the resource as a firm would still be profitable also after paying this amount to be able to use the resource. If market prices are regulated by the government or influenced by oligo- or monopolistic behavior, the rent concept is less useful, since it does not reflect the true economic value of the resource. In case of a monopoly, part of the rent would be monopoly rent not attributable to resource use. To determine the production costs, it has to be decided which cost components to include. As the resource rent is defined, profit-related taxes must not be included. Costs should however include some “reasonable” rate of return for outside and company capital as well as “reasonable” depreciation (Luchsinger 2005). To define what “reasonable” means in this context clearly poses its own problems. The presence of quasi-rents, finally, may hinder the usefulness of the resource rent to identify the value of the resource as clear distinction between the rent types might be impossible. This discussion is based on a short-term, e.g. annual basis referring to the market value of resources when sold. The resource rent can alternatively be captured on a long-term basis by the present value of future net income from extractions (Santopietro 1998). This latter requires assumptions about future prices and extraction costs, discount rates, quantities extracted and the like. This is the discounted free cash flow (DFCF) method to determine the net present value (NPV) of the income flow from a resource over the whole extraction period. It is equivalent to the former view if this is summed over all sales, which requires the same information. Santopietro (1998) points out that the absence of perfect future markets makes any values for resource rents based on the parameters of current markets imperfect. He also discusses other methods to determine the rent. They are based on assumptions on
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sustainability explicitly identifying part of the rent as a depletion allowance to be used to invest in some replacement option, or on proxies for valuation like stock values of the exploiting firms, or on the importance to discern some discovery costs for the resource that have to be subtracted from the rent. The latter is no topic in the climate context and the former options will not be discussed as I want to focus on a purely economic definition of the rent. 2.2 Rent Extraction The resource rent is a surplus value attributable to the resource itself. This is tightly linked to property and use rights, as an important aspect of property rights is the right to extract some income from the property (Barzel 1989). In the resource use sector, proprietor and user often do not coincide and at least partial extraction of the rent on behalf of the proprietor is in place. Rent extraction is also motivated on grounds of efficient allocation, as free resources act as a subsidy for a production process employing those as opposed to other technologies employing other resources that might be subjected to payments. Economically, full extraction of the rent would be optimal and in principle be feasible, as the firm would still operate efficiently, the cost being covered by the price also after the rent extraction. However, full extraction could only take place with complete information and perfectly enforceable contracts. As this is not the case in reality, a reasonable sharing mechanism has to be found, which redistributes part of the rent to the owner of the resource without destroying the incentives for the firm to operate efficiently. The determination of the rate has to pay attention to political economy aspects like the fairness of such a measure as perceived by the different groups affected. Luchsinger (2005) collected a set of nine criteria that are most adequate to assess the performance of rent extraction schemes. These are allocative efficiency (no distortion of investment patterns) and cost efficiency (not destroying incentives for cost reductions), administrative simplicity, transparency (about who pays how much and for what) and flexibility (towards changing environments like volatile market prices), stability of extraction rates (a vital interest of the firms) and of revenues (of great interest for the authorities), risk-sharing aspects and equity issues (similar firms are subject to similar extraction (horizontal equity) and firms that are better off are subject to correspondingly higher extraction (vertical equity)). I add political economy aspects as a criterion, such as the preferences of interest groups for certain mechanisms (Dijkstra 1999). As the rent is determined by the price of the good and the production costs, extraction can take the form of revenue sharing (only related to the price and quantity), profit sharing (related to the price, quantity and the costs) or a fixed fee (related to quantity, but neither to the price nor to the costs - it can also be independent of the quantity as well) (Luchsinger and Muller 2005). Another approach is to extract the resource rents in advance by auctioning the use rights. Clearly, combinations of these different mechanisms are possible. From an economic point of view (i.e. regarding allocative and cost efficiency and flexibility), a resource rent tax performs best, (i.e. a profit sharing scheme, where the costs include some “reasonable” return on capital, “reasonable” depreciation, but no profit taxes - and the difference between price and costs
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thus equals the resource rent). Theoretically, such a scheme does not affect the firms’ decisions on how to operate. It also avoids making almost marginal, but still profitable firms unprofitable, as it may happen with a fixed fee. To shed against large uncertainty, e.g. due to volatility of the market prices for the output good, a resource rent tax could however be combined with a fixed fee. This discussion is strictly adequate only in the case no quasi-rent is present what may be reasonably assumed for a long-term perspective over several decades. Due to uncertainties of the future GHG regulations after 2012 but also to the pace of innovation in new energy and other technologies, some resource use has considerably shorter time horizons. Authorities could perform sector-wise econometric cost-estimations to determine the costs and rent of a “normally” efficient firm (Shleifer 1985). With regard to this benchmark, quasi-rent and also inefficiency could be detected and taken into account for the rent extraction.
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Natural Resource Mechanisms
Rent
and
the
Kyoto
Flexibility
The Kyoto protocol (UNFCCC 1997) and the more detailed regulations from the “Marrakesh-accords” (UNFCCC 2001) and further documents provide a legisl framework to fight climate change. It came into force in February 2005, but notably, the biggest emitter USA and also Australia have not ratified the protocol. 3.1 The Kyoto Flexibility Mechanisms The KP sets binding targets on the emissions (in CO2-equivalents) of all industrialized and transition economies countries ratifying it. The targets range from -8 to +10% (in total -5%) with reference to 1990 emissions levels, to be achieved in the “first commitment period” 2008-12. This means, that the cumulated emissions during these five years have to be less or equal to the target agreed on times five. Each country is then free in how to achieve these reductions in accordance with the rules of the KP and further legislations. Each country can thus decide if voluntary agreements, taxation, technology standards or other policy instruments or combinations thereof are best suited. Sector-wise and other discrimination is possible as well. Considerable freedom exists in the KP also regarding the initial allocation of the allowances corresponding to each country’s target (the “assigned allowance units” (AAU)) to the emitting entities within its national boundaries. The KP defines three mechanisms allowing flexibility on how and where to achieve the necessary reductions. These are the Clean Development Mechanism (CDM), Joint Implementation (JI) and Emissions Trade (ET). It is expected that the flexibility mechanisms will increase the efficiency of climate change mitigation activities and lead to least-costs emissions reductions. 3.1.1 Clean Development Mechanism and Joint Implementation The CDM is defined in Article 12 of the KP (UNFCCC 1997) and regulated in more detail in the Marrakesh accords (UNFCCC 2001, Decisions 15/Cp.7 and 17/Cp.7) and some other additional documents negotiated in subsequent “conferences of the parties” (COPs). Under the CDM, countries without binding targets (i.e. developing countries) can benefit from emissions reduction or GHG removal activities leading to “Certified Emissions 8
Reductions” (CER), as the CDM allows countries facing emissions targets to use these reductions achieved abroad to contribute to their compliance. CDM activities can be financed by the countries themselves or by private and public entities. The countries can subsequently buy CERs from a CDM project or they can directly invest in such projects and get the CERs as part of the return on investment. Since February 2005 unilateral projects are eligible as well (UNFCCC 2005). These are projects without involvement of an Annex-I country and the CERs produced are then sold on the market. There is a tax of 2% on the CER production by each project to collect revenues to support countries particularly vulnerable to the adverse effects of climatic change (Decision 17/Cp.7, 15, UNFCCC 2001). CDM projects in least developed countries are exempted from this tax. A fee to cover administrative expenses of the CDM has yet to be agreed on. An important aspect of CDM activities is the fact that CERs are only granted for emissions reductions in addition to any that would occur in a “business as usual” scenario, i.e. in the absence of the certified project activity. Theoretically, this additionality requirement would be reflected in that the activities would not be profitable without the cap on emissions, i.e. without emissions permits being a valuable good. To set this baseline is a complex and controversial task with crucial consequences on the profitability and the actual mitigation effects of single projects. For the further discussion, I will however assume that this has been settled as it does not qualitatively affect the rent discussion. Non-additional projects however are likely to have lower costs than truly additional ones and thus generate a potentially bigger rent. JI is subject of Article 6 of the KP and regulated more detailed in the Marrakesh accords (Decisions 15/Cp.7 and 16/Cp.7) and subsequent decisions of the COPs. It refers to the possibility for any country subject to emissions targets to transfer to, or acquire from any other such country “Emissions Reduction Units” (ERU) resulting from projects aimed at reducing emissions from sources or enhance removal by sinks. As in the CDM, any legal entity can participate in the generation, transfer or acquisition of ERUs under the JI framework. It is expected that most JI activities will take place between industrialized countries and economies of transition. Similarly to the CDM, a baseline is requested for JI activities as well, so as to guarantee them to be of additional character. There are no quantitative limits regarding the amount of reductions that can be achieved by the CDM or JI. The KP only states that they should be of supplementary character regarding domestic reductions. The EU Linkage Directive (EU 2004) leaves it to the member states to further regulate the use of CDM credits and according to the National Allocation Plans (EU 2005) none of these seems to have taken a decision to restrict those. The KP regulates, however, some activities related to removal by sinks (leading to “Removal Units” (RMU)), both in the context of CDM and JI and genuine domestic reductions. Currently, removals by land use, land use change and forestry (LULUCF) are eligible for CDM activities only if they comprise in afforestation or reforestation. For the first commitment period of
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the KP, LULUCF activities are restricted to maximal 1% of the base-year emissions of each country. 3.1.2 Emissions Trade The KP also establishes an emissions trade system where all the different types of reduction certificates, allowances or units as described above (AAU, CER, ERU, RMU) can be traded (KP, article 17; Marrakesh accords, Decisions 15/Cp.7 and 18/Cp.7; further documents from later COPs). For the reminder of this paper, I will use “emissions allowance unit” (EAU) as an overall term for these different types as the holder of one of these is allowed to emit a unit (i.e. a ton) of CO2-equivalents in GHGs and they are thus essentially the same with respect to resource use and permit trade. The KP sets no quantitative restriction on trade volumes, but it states that trading should be of only “supplementary” character to achieve compliance. A crucial aspect of ET is the initial allocation of EAUs to the sectors and firms subject to emissions reduction targets within each country. The total amount of EAUs allocated corresponds to the national reduction target, the intranational sector- and firm-wise distribution is subject to national negotiations. In the European Union Emissions Trading System (EU-ETS), at least 95% of the emissions permits have to be allocated for free, i.e. by some type of grandfathering mechanism, while the remaining 5% may be auctioned (EU 2003). Each firm can use the EAUs allocated to it to emit a corresponding amount. If emissions are higher, it has to buy more EAUs on the permit market or get them from other activities like CDM, if its emissions are lower, it can sell the EAUs it does not use. 3.2 Natural Resource Use in CDM, JI and Emissions Trade The caps on the national emissions make the natural resource “atmospheric GHG absorption capacity” (aGHG-AC) scarce. The possibility of ET assigns a market-price to this hitherto price-less resource. It thus becomes a part of the cost-function of any production process emitting GHGs. A firm has the possibility to reduce the demand for this input, i.e. to reduce its GHG emissions, or to buy the input on the market, i.e. to buy GHG emission allowances. The presence of the market allows selling unused emissions allowances to participants short of compliance. In addition, the CDM and JI create the opportunity to actually “generate” emissions allowance units. They are a good that potentially is profitable to produce. The possibility to generate the traded units is a new aspect of the trade under the KP not present in existing ET systems (e.g. the US SO2-trade, Burtraw and Palmer 2004). This suggests the following three types of involvement of the aGHG-AC and other resources in productive and GHG emissions reduction activities: a) Any productive activity emitting GHGs exploits the resource “atmospheric GHG absorption capacity”. Two types of producers have to be distinguished - such with and such without emissions caps. The resource is scarce and EAUs are a costly input for the former only. Clearly, other resources may be employed in addition. b) Genuine reduction of GHG emissions is possible, either domestic or abroad (CDM and JI). Several natural resources can be involved in such activities to produce new resp. to use less of the allocated EAUs.
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The main output of such projects can be any consumption good (e.g. electricity), which to produce the facility is designed while the EAUs are a side product. c) Domestic actions, CDM and JI can also subtract GHGs from the atmosphere and sequester them. Different resources can be involved in such EAU production. The EAUs are the main product, other goods produced in such projects are of secondary interest. The first activity uses the resource aGHG-AC, while the second and third add to its stock. The aGHG-AC is thus used as a resource in the first case while it is an output good in the other two. Other resources may be used as well. For the CDM and JI, the additionality requirement means that absent any GHG regulation, in the second and third activity, the projects would produce an output good at prices too high to be competitive, or they would sequester GHGs from the atmosphere and produce EAUs, for which no market would exist. The aGHG-AC has thus very special properties. On the one hand, it is a natural resource which is exploited for production processes, on the other hand it is itself a good that can be produced. This complicates the first type of resource use listed above: when bought on the market, the EAUs are an input to the production process as any other and they stand for a good, not for a resource. If, however, EAUs corresponding to the assigned emissions target are used, they stand for a genuine resource use the unit holding the EAU has use rights on. Physically, the use of EAUs always involves the use of the resource, as the EAUs used stand for actual emissions made. A further characteristic of this resource is its physical homogeneity. The aGHG-AC is the same everywhere, unlike other resources that, for example, differ in concentration (mineral ores) or composition (oil). As the demand for EAUs is no physical necessity but politically set, only the quantity of EAUs counts. Some regulations exist restricting the use of EAUs from LULUCF and countries are free to apply some stricter regulations such as requesting a certain percentage of reductions to be achieved by domestic actions (cf. section 3.1.1). But basically, there is no further quality aspect of the EAUs the consumers and producers are interested in, and one self-enforcing control mechanism of goods markets is thus missing (Repetto 2001). 3.3 The Resource Rent in CDM, JI and Emissions Trade Generally, resource rent becomes a topic in the Kyoto-context, as the regulations make the aGHG-AC scarce and this in turn makes any activity to reduce its use or to add to its stock potentially profitable. This is a new business field and these activities open up new profitable use for “classical” resources or for hitherto valueless and unexploited “new” resources. First, I look at the productive activities emitting GHGs. Besides the aGHGAC, they may employ other natural resources, but many input factors will actually be bought on a market and it is thus possible that the aGHG-AC is the only natural resource employed (car companies buy sheet steel and are not engaged in iron-ore extraction, for example). By definition, the total rent generated is the difference between total revenues and total costs. Assuming
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absence of quasi-rents, the rent is due to the resources employed in the production. If this is only the aGHG-AC, it equals the rent corresponding to the use of this resource and reflects thus its value for the specific process investigated. The quasi-rent can play an important role, though (cf. above) what poses major conceptional and informational challenges. These problems may partly be solved by benchmarking approaches as suggested above. To determine the rent in genuine reduction activities is also intricate. Due to the additionality criterion, the main business activity would not be profitable, so there is no rent generated in that. Only the additional output of EAUs makes the activity profitable. But the EAUs are not produced independently of the main output - on contrary. It can also be argued that the higher production costs of the main output are due to the possibility to generate EAUs. Therefore it is not necessarily possible to claim that all the rent generated is due to the EAUs only. As the resource rent refers to the input and not to the output, total revenues only need to be known to calculate the rent. In case more than one resource is employed, the problem of assigning due shares of the rent to the different resources remains. Clearly, the reservations regarding quasi-rents made above apply here as well. The rent generated in sequestration activities is more straightforward. EAUs are produced at certain costs, employing certain natural resources, and they are sold on the market, thus at least covering the costs but most likely also generating some resource rent. This rent accrues to the resources employed. The problems of how to assign the rent in case of multiple resource use and of potential quasi-rents arises again. An applied modeling study is Newell and Stavins (2000), using the DFCF method (they call it “levelization”) to determine the NPV for various models of forest sink sequestration activities in US counties. Average sequestration costs range in the order of 20-25 Euro/tCO2. Employing case-study data from Ecuador, Olschewski and Benitez (2005) find that sequestration by forestry becomes a profitable alternative to pastures at permit prices of 4-6 Euro/tCO2. Besides motivating the rent discussion in these three resource use situations, pricing the aGHG-AC changes the relative profitability of productive processes for the same good that employ much or few of it, as e.g. electricity generation based on fossil fuels or hydropower. This likely increases output prices and thus the rent accruing to the often “classical” resources employed in production processes emitting relatively few GHGs. Banfi et al. (2005) calculate these effects for the hydropower sector in Switzerland and find that a 10% price increase would lead to 25% higher rents. If this was due to carbon regulation, mostly storage plants (i.e. peak-load producers) would benefit from this as fossil fuel using plants mainly serve this production segment. Modeling studies of Sijm et al. (2005) similarly identify considerable new rents generated in the electricity sector due to 13-39% higher electricity prices because of the EU-ETS. CDM and JI activities can involve some GHG emissions as well (e.g. due to fossil fuel use). Expectedly rather few in sequestration projects, in potentially considerable amounts however in some reduction projects (e.g. if a coal-fired plant is replaced by a gas-fired one). These have to be offset with EAUs in the case of JI, as the host country also faces emissions caps. In CDM, this is not
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the case, as the host country does not face emissions targets, but nevertheless, the resource aGHG-AC is used in the process and some rent may be generated due to this resource use. Joint production and multiple resource use poses no problem as long as the focus lies on the aggregate rent. However, it can be a major problem if it comes to assigning the rent to the different resources and outputs. This could be necessary if different proprietors are involved (e.g. municipalities and the state). It is a problem of the cost side only, given output prices are observable in the market and total revenue can thus be assigned to the single outputs.
4 Natural Resource Rent Extraction in the Kyoto Flexibility Mechanisms “Classical” natural resources use to be subject to traditionally evolved rent extraction. When a “new” resource is exploited, there is no pre-existing extraction scheme and an optimal solution can be sought. Therefore it is of particular importance to make rent extraction a topic for the “new” resources exploited in climate change mitigation measures. The discussion on resource use and rent in the foregoing sections has been organized along the different productive activities in the context of emissions reductions and sequestration. The discussion on rent extraction is best organized referring to the different types of resources employed: the aGHG-AC, “classical” resources and “new” resources. The first is also a “new” resource, but I discuss it separately due to its twofold character as a resource and a good. The 2% tax on EAUs generated from CDM (section 3.1.1) can be seen as a way to extract a part of the rent. However, earmarking the revenues from this tax to support the adaptation of particularly vulnerable countries is in conflict with the arguments to extract the rent for the resource owner, and being a revenue tax, it is less optimal than a resource rent tax taking costs into account as well. 4.1 Atmospheric GHG Absorption Capacity In the context of the Kyoto flexibility mechanism, only the rent extraction related to the use of the aGHG-AC is systematically discussed in the literature. This is done in the context of initial allocation in emissions trading systems. The rent is fully extracted if the initial allocation is organized as an auction. This would pay undistorting government revenues. In practice, however, often no extraction takes place, as most countries choose to allocate by grandfathering, reflecting an explicit political decision to let firms use the corresponding amount of the resource for free (in the EU-ETS, at least 95% of all permits have to be allocated for free in the first period (2005-2007), EU (2003)). Grandfathering can be tied to the historic values of different variables, most commonly past emissions or past output. Other possibilities are to differentiate according to environmental or other performance standards. Output or emissions based grandfathering allows mimicking closely the situation before the ET came into force and it would compensate the firms for capital losses (sunk costs) due to the carbon regulations (Haites and Hornung 1999a, 1999b). How big these losses are is a controversial issue, though. Besides auctions and grandfathering, other initial allocation schemes such as selling the EAUs at a fixed price are in principle possible. Any system that involves some compensation for the initial allocation can be see as a rent 13
extraction mechanism. The general distributive and welfare properties of the initial allocation depend essentially on the concrete scheme finally chosen and the auction is in theory the most efficient (Cramton and Kerr 2002, Harrison and Radov 2002, Palmer and Burtraw 2004). The aGHG-AC is used as a resource in any activity emitting GHGs. Besides in case initial allocation takes place by an auction, at least partial payments for the use of the aGHG-AC occur if the firms buy additional EAUs on the market. The beneficiaries of the payments differ in this case as payments are not for resource use but to buy an input good on the market. With an auction, the payments are made to the state. With grandfathering, the use rights are given out for free. In the market, the payments are made to other market participants, expectedly private companies. This reflects the double nature of the aGHG-AC as a resource and a traded good. In the first case, the proprietor of the resource extracts the rent or decides deliberately to leave the rent with the resource users, while in the second, the seller of a good gets payed for it by the buyer, as in any market goods exchange. The seller however has either produced this good by adding to the resource stock, e.g. by the CDM, or got the use right on the resource by the initial allocation or by itself buying it. Resource rent in the context of the aGHG-AC only emerges in case climate change mitigation is implemented by means of a permit trading scheme. With an alternative system such as a tax, there would not be a market for the resource and the concept of the rent would thus become meaningless. 4.2 “Classical” Resources Rent extraction for “classical” resources is well-established in resource economics. “Classical” natural resources are usually subject to existing regulations concerning exploitation charges. However, the appearance of new potentially quite profitable business opportunities employing “classical” resources motivates a renewed discussion of the rent extraction that might be perceived as being too low in face of these new profits. Two situations can be discerned. New uses of “classical” resources on the one hand, like land use for GHG sink projects that under certain circumstances may be more profitable than growing crops. And changed marked conditions on the other, i.e. increased rent due to increased market prices. This case occurs when the GHG regulations make GHG free production relatively more profitable by increasing the costs of the marginal producer and thus the market price (c.f. 3.3). The capability of the resource rent tax to adjust to changes in costs and prices makes this instrument most adequate for rent extraction in such situations. The corresponding additional profit on land use, for example, would be accounted for by a resource rent tax on land but not by a fixed fee per area. The flexibility of the resource rent tax regarding prices is especially important in an environment with still uncertain and potentially volatile prices as it is present in the current permit market, where prices tripled form January to July 2005 (from less than 10 to 30 Euro/tCO2) and fell by 30% since then (PointCarbon 2005). Volatility and uncertainty in this market can be expected to prevail as long as the future of climate policy is not clear for considerable
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longer periods than today, where existing regulations are still subject to discussion and only cover the period up to 2012. 4.3 “New” Resources “New” resources that become valuable only in the context of GHG reduction measures and that have not been valuable resources before are of particular interest. The resources have to be identified, property and use rights have to be clarified, and the rent generated and potential rent extraction schemes have to be discussed. Currently, there are many options for “new” resource use. Many of them are connected to various carbon-sink activities. Large-scale projects include storage in geological formations and in the oceans (Bode and Jung 2004). Old oil and gas reservoirs, deep saline aquifers and coal seams become valuable resources (IEA 2003). Injection of CO2 into the oceans makes the storage capacity of those a valuable resource. Other than sink activities can be a topic as well, e.g. large-scale solar power or wind farms on barren land that has no other use or on off-shore sites. Here as well, rent extraction by a genuine resource rent tax performs best regarding the many uncertainties involved. Combination with a fixed fee is an option to hedge against these risks. Finally, the rents in CDM activities that do not employ “new” resources but hitherto valueless “new” inputs have to be discussed as well. Examples are projects using methane from landfills, biogas projects burning agricultural waste or energy crops. If high profits can be made in such projects, it is due to the prices on the EAU market reflecting relatively higher costs of the marginal EAU supplier to meet the demand. One would expect that such high profits could not pertain for long, either due to more EAU-producers entering the market or due to rising prices for the newly valuable inputs. This argument builds partly on the presence of markets for these inputs. Depending on the nature of these latter, such markets may not emerge and the resource rent discussion should be taken up for the resources producing these inputs instead (e.g. for the land of coffee- or rice-plantations where coffee- or rice-husks are newly used in biofuel-plants). In this context, the presence of quasi-rent is clearly an issue and the absence of some markets complicates the discussion. 4.4 Rent Extraction, Equity and External Costs Rent extraction in the context of the “new” resources and a renewed discussion of it in the context of “classical” ones, especially if employed in CDM and JI, would help an open discussion on keeping a fair share of the profits in the host country. This would address some of the criticism against the CDM (Ott and Sachs 2002, Equity Watch 2002), as it would work against the potential sell-out of cheap reduction opportunities to the industrialized countries. It would lead to emissions reduction projects where the host country would get revenues more likely to reflect the true value of the project. Rent extraction would also work in support of projects that are truly additional as those tend to have lower profit margins. The extraction of a considerable part of the rent in highly profitable projects would decrease differences in these margins and thus make truly additional projects relatively more competitive. A clear tradeoff exists between rent-extraction and profitability. If only few
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countries decided to extract these rents, it is likely that they would loose these investments as other countries could offer higher profits. This race to the bottom would be an instance of the mechanisms behind the pollution haven effect for which considerable empirical support exists (Copeland and Taylor 2004). To avoid this, such rent extraction should be coordinated internationally. The institutional context to do this exists due to the international character of the KP. A detailed assessment of these issues in the context of the CDM is given in Muller (2005). A distinction can be made between payments to internalize external costs of GHG emissions and payments to use a resource for a productive activity (resource rent extraction). For a firm, both these issues result in higher costs. Regarding property rights, the two payments are also similar - they are based on the decision that the firm does not hold the property rights to the resource but only is granted use rights it has to compensate for. But from a conceptional and motivational viewpoint, these two payments are different and can be discussed independently. The first is based on the social damage caused by the resource use, say of aGHG-AC, the second reflects the value of this resource for a firm as an input to a productive process. These values need not coincide, as the latter is determined by the market price of the output good while the former is not. Ideally, the permit price equals the Pigovian tax level given by the social optimum regarding emissions reductions and external cost internalization. In reality, the emissions caps are rather set on account to political reasons than the social optimum and differentiation between rents and external costs internalization is necessary.
5 Conclusion This paper discusses the natural resource rent in the context of the Kyoto flexibility mechanisms. The resource use in these mechanisms is of considerable complexity, especially as the aGHG-AC plays the double-role of both a natural resource exploited and a good produced and sold on a market. The resource rent perspective helps to clarify the ownership relations on the different resources and on the profits accruing due to their use, especially in the case of “new” resources being exploited only in the context of climate change mitigation measures. This is important both because of economic and political reasons. Knowledge of the rent and an at least partial extraction are necessary for efficient resource allocation. This is so as the use of resources for free bears the potential of substantial profits on behalf of the firm and can act as a hidden subsidy with respect to other activities subject to payments for resource use. Rent extraction on behalf of the proprietor of the resource also reflects that a property right includes rights on the revenues that flow from this property. Of particular political concern are the related equity issues. These influence the distribution of profits from the resource use. This is so especially in the CDM, where industrialized countries realize cheap emissions reductions in developing countries. A systematic discussion of the rent involved and a potential extraction of it may help rewarding the host countries for the true value of such projects.
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Especially in the context of climate change, rent extraction could be understood as both payments for the resource use and as internalization of external costs. For developing countries in particular not only mitigation of but also adaptation to climate change becomes a necessity. Revenues from these resources could provide at least part of the necessary financial means for this. On the other hand is it important not to impede investments that mainly benefit the poor and support sustainable livelihood projects. The aim of discussing the resource rent is not primarily to extract it but to understand the true cost-benefit structure of climate change mitigation projects and to discuss potential rent extraction on these grounds. To avoid a race to the bottom regarding strictness of additional regulation of resource use, e.g. in the CDM context, international coordination of such is necessary. Due to the international character of the CDM the international institutional framework necessary for this already exists. For more applied discussions, many practical obstacles have to be overcome. First, there are several strong assumptions involved in the concept of the resource rent, foremost the assumption of free markets for the outputs. In absence of such markets, the estimation of the rent is next to impossible. Separating quasi-rent form the resource rent is also far from being a simple task and the same applies to the assessment of real cost functions. Yardstick competition resp. benchmarking to estimate efficient cost functions and to identify potential quasi-rents may offer a solution here. Although a resource rent tax, i.e. a sharing mechanism of the rent performs best according to economic criteria, an ordinary revenue tax or a fixed fee might be preferable on grounds of the simpler administration, in particular in light of the several potential complications any determination of the resource rent might face. Second, resource rent extraction is a delicate political topic and any concrete suggestions to change existing tax systems in such a direction are likely to face strong opposition. However, in cases where new rules have to be defined, it is promising to make rent extraction a topic and it could, for example, be brought up to be included in the rules for the second commitment period of the KP. This discussion is of particular importance in case potentially large new resources are located in countries with weak institutions (e.g. solarpowered hydrogen production in sun-rich African countries) thus facing the danger of some kind of resource curse.
Acknowledgments Many thanks to Thomas Sterner and the Environmental Economics Unit at the Göteborg University for their hospitality. Financial support from the Swiss National Science Foundation is gratefully acknowledged. The usual disclaimer applies.
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