Article 17 of the Kyoto Protocol allows Annex B parties to meet their commitments by trading greenhouse gas emissions reductions "supplemental" to domestic emissions control. We demonstrate that implementing supplementarity by imposing concrete ceilings on imports of allowances in a market for tradable emissions rights gives rise to monopsonistic effects, even with price-taking behavior by both buyers and sellers. We assess the importance of this finding for Annex B emissions trading, in the context of the import and export provisions of the recent EU Proposal on supplementarity. Our results show that the proposal would reduce efficiency, and could significantly alter the distribution of the gains from trade in an Annex B tradable permits market.

Since the introduction of motorized transportation systems, economic growth and advancing technology have allowed people and goods to travel farther and faster, steadily increasing the use of energy for transportation. Modern transportation systems are overwhelmingly powered by internal combustion engines fueled by petroleum. Emissions of carbon dioxide (CO₂), the principal greenhouse gas (GHG) produced by the transportation sector, have steadily increased along with travel, energy use, and oil imports. In the absence of any constraint or effective countermeasures, transportation energy use and GHG emissions will continue to increase.

In the U.S. economy, transportation is second only to electricity generation in terms of the volume and rate of growth of GHG emissions. In terms of carbon dioxide, which accounts for 95 percent of transportation's GHG emissions, transportation is the largest and fastest growing end-use sector.¹  Today, the U.S. transportation sector accounts for one-third of all U.S. end-use sector CO₂ emissions, and if projections hold, this share will rise to 36 percent by 2020. U.S. transportation is also a major emitter on a global scale. Each year it produces more CO₂ emissions than any other nation's entire economy, except China. Given its size and rate of growth, any serious GHG mitigation strategy must include the transportation sector.

This report evaluates potential CO₂ emission reductions from transportation in the United States. Measures considered include energy efficiency improvements, low-carbon alternative fuels, increasing the operating efficiency of the transportation system, and reducing travel. Highway vehicles should be the primary focus of policies to control GHG emissions, since they account for 72 percent of total transportation emissions. Passenger cars and light trucks together account for more than half of total sectoral emissions.

The international allocation of responsibilities for reductions in greenhouse gas emissions, as foreseen in the Kyoto Protocol, would create a public good. Yet the 1990 level of emissions that is used in the Protocol, as the base from which the reductions would be made, and the reductions targets themselves, are quite arbitrary and not based on a specific target for the future world climate. In addition, the particular allocations of greenhouse gas emissions restrictions among countries do not have a principled logic. This arbitrariness has led to allocations that impose sharply different costs on the participating countries that have no consistent relation to their income or wealth.
        Calculations are presented of the implications of alternative allocations of emissions reductions that do have a plausible ethical basis: equal per capita reductions, equal country shares in reductions, equalized welfare costs, and emulation of the allocations of the United Nations budget. All of these would reach the overall Kyoto target at lower overall costs than the emissions allocations in the Protocol itself. This would be achieved through the participation of the developing countries, in which the costs of emissions reductions are relatively low. In addition, use of any of the alternative allocations analyzed here would eliminate the wholly capricious accommodation given to the countries of the Former Soviet Union and Eastern Europe.
        The additional costs to the developing countries, for most of the alternative allocations, are so low that the Annex B countries could pay them to accede to a new emissions reduction schedule and still have lower costs than those imposed by the Kyoto allocations. This conclusion puts the Annex B countries in the anachronistic position of advocating an arbitrary and relatively high cost allocation of emissions reductions. The lower cost alternative is to make such an unequivocal commitment for reimbursement to the non-Annex B countries that they would be persuaded to reduce their own emissions. Everyone would gain from that.

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 As a result of the allocation of emissions reductions, and the differential willingness of countries to ratify, it turns out that Russia is a central player in the Kyoto Protocol. With the U.S. out and Japan and the EU ratifying, the Protocol cannot enter into force without Russian ratification. In part, U.S. rejection of the Kyoto Protocol resulted from the fact that, had the U.S. been in, its least costly road to implementation would have involved large purchases of emissions credits from Russia. With the U.S. out, Russian credits are worth much less but Russia may be able to exploit monopoly power to increase the value of those permits, or Russia could bank permits on the expectation that prices will rise in the future, perhaps as a result of the U.S. reentry into the Protocol in later periods. The Russian decision is more complex, however, in that it is also a major fossil fuel exporter. To the extent it withholds permits from the market, fossil energy prices are depressed further, and the value of its exports of energy are reduced. Thus, Russia faces a tradeoff between maximizing its permit revenue and its revenue from fossil energy exports. We develop this problem as a simple dynamic optimization problem and calibrate the model to the results of two CGE models (EPPA and GEMINI-E3) that fully capture interactions of energy trade, permit trade, and permit and energy prices. We show that carbon prices are relatively insensitive to Russia's behaviors when the U.S. is assumed to participate. It also shows that, in the absence of U.S. participation, the impact of market power by Russia and Ukraine is largely dependent on the elasticity of demand for permits. Finally, we focus on the uncertainty about the supply of CDM by developing countries. It is shown that permit prices are relatively insensitive to CDM supply in the short run but not in the long run.