Should Canada join a climate club?

ABSTRACT

Climate change is a global problem and beyond the ability of any single country to meaningfully address. To do so requires collective action, and efforts to date to mobilize such actions have failed (e.g., the 1997 Kyoto Protocol) or been less successful than needed (e.g., the 2015 Paris Agreement). The growing concentration of carbon emissions in the atmosphere increases the urgency of successful actions. The concept of a climate club has been advanced as a mechanism to provide both the incentive and the discipline to collectively address climate change. Canada has recently been invited to participate in a climate club. Is this initiative worthwhile for Canada to participate in?

RÉSUMÉ

Le changement climatique est un problème mondial qui dépasse la capacité d'un seul pays à y faire face de manière significative. Y parvenir nécessite une action collective, et les efforts déployés à ce jour pour mobiliser de telles actions ont échoué (par exemple, le protocole de Kyoto en 1997) ou ont été moins fructueux que nécessaire (par exemple, l'accord de Paris de 2015). La concentration croissante des émissions de carbone dans l'atmosphère accroît l'urgence d'actions fructueuses. Le concept d'un club climatique a été proposé en tant que mécanisme assurant à la fois l'incitation et la discipline pour s'attaquer collectivement au changement climatique. Le Canada a récemment été invité à participer à un club climatique. Cette initiative vaut-elle la peine que le Canada y participe ?

KEYWORDS:

• Carbon border adjustment mechanisms
• carbon clubs
• carbon pricing
• climate change
• climate clubs

Introduction

In 2015, William Nordhaus, Sterling Professor of Economics at Yale University, used his presidential address to the American Economic Association to outline his concept of a climate club as “a voluntary group deriving mutual benefits from sharing the costs of producing an activity that has public-good characteristics” (Nordhaus, 2015, p. 1340). Much of Nordhaus’s work has focussed on analyzing the effects of climate change policies on the climate and on the economy, and in 2018 he was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to “integrating climate change into long-run macroeconomic analysis”. His Nobel Prize Lecture elaborated on his work on climate change economics and policies and concluded with a reiteration of his climate club concept (Nordhaus, 2018, December 8).

Nordhaus’s initial article on climate clubs appeared in the same year as the United Nations Framework Convention on Climate Change (UNFCCC) parties created the Paris Agreement, a climate change strategy with voluntary commitments by countries to limit average global temperature increases to “well below 2^oC” (and preferably 1.5°C) and achieve a “climate-neutral world” (including decarbonized energy systems) by 2050. Nordhaus sees the Paris Agreement and its predecessor, the Kyoto Protocol, as flawed arrangements because they rely on uncoordinated voluntary responses that are susceptible to being undermined by free-riding and therefore unlikely to succeed.

This article will describe the rationale for and nature of a climate club, discuss some of the merits and challenges of implementing a climate club and conclude with a discussion of the recently stated aim of the G7 to establish a climate club.

Addressing global negative externalities

To economists, climate change is a global negative externality. Private markets cannot efficiently allocate use of the atmosphere because the atmosphere is a public good which no person owns or is excluded from using, rather than a private good for which both the benefits and costs are exclusively those of the owner/buyer and the producer/seller. The atmosphere is shared globally by all citizens and countries. We know that climate change is caused by emissions of greenhouse gases (GHGs) – principally CO₂ – emitted into the atmosphere by the combustion of fossil fuels. And we know that cumulative climate change can cause increasingly costly disruptions to human and natural systems. Any incremental GHG accumulation in the atmosphere will add to climate change and will affect everyone, making climate change a global phenomenon. While there is a price on the fossil fuels we consume, traditionally consumers have been able to emit GHGs into the atmosphere at no cost.

While the aggregate effects of GHG emission on climate change are negative, the costs of climate change are unevenly distributed across countries and individuals. The contribution of any individual’s emissions to climate change will generally be far less than the benefits to that individual of the activity that generates those emissions (in the absence of an appropriate price for emitting GHGs to the atmosphere). Similarly, the benefits to any country from its actions in reducing GHG emissions will be small relative to the costs of those actions (Ricke, Drouet, Caldeira, & Tavoni, 2018) (although China might be an exception, as its share of global GHG emissions exceeds its shares of global population and global Gross Domestic Product). This creates a strong incentive for non-cooperation, or what Nordhaus refers to as “free-riding”. Individuals and countries have an incentive to rely on the emissions reductions of others without proportionately reducing their own emissions, thereby benefiting from climate change abatement without contributing to the associated costs.

Free-riding countries put their own national interests ahead of addressing global climate change, consequently undermining the effectiveness of climate agreements in reaching their goals. No international institutions exist that can compel actions to address a global negative externality like climate change, as may occur with a national negative externality. A key rationale for a climate club is to create an international structure to address climate change more effectively by eliminating the free-riding incentive.

What is a climate club?

A climate club is an agreement among participating countries to undertake harmonized policies to achieve GHG emission reductions. The major conditions required for a successful climate club are (Nordhaus, 2021, p. 290):

• existence of a public-good-type resource whose benefits and harms are shared by all;

• membership in the club, including the costs or dues, benefiting each member;

• ability to exclude or penalize non-members at relatively low cost; and

• stable membership, with no member wanting to leave.

The harmonized policy envisioned by Nordhaus is a carbon price using a mechanism of choice — carbon tax, cap-and-trade or a hybrid mechanism. That price should be the social cost of carbon (i.e., a price that reflects the marginal damages from carbon emissions). Nordhaus believes a harmonized carbon price is a more effective policy instrument for the climate club to adopt than attempting to harmonize emissions reduction targets. Prices provide a simpler instrument for international arrangements because they have a single dimension, whereas emissions reductions have the dimensionality of the number of regions in the club. Also, the administrative aspects of taxes are more easily understood than marketable emissions allowances and thus are less amenable to corruption.

Participation in a climate club would require a country to have a domestic carbon price at least as high as the minimum international target carbon price. The carbon price will result in abatement costs being incurred in the country up to the level set by that price. These costs must be more than offset by the trade benefits resulting from tariff-free trade with other climate club members and the tariff-penalty that would be imposed on non-members.

A penalty imposed on non-members is a critically important aspect of the climate club that complements the carbon price. The incentive for a country to join the climate club is the ability to trade with other club members without penalty. The harmonized penalty advocated by Nordhaus is a uniform percentage tariff on imports from non-members in the club. An alternative might be a tariff on the carbon content of imports, such as the European Union’s currently proposed carbon border tax. Nordhaus dismisses the carbon border tax because of its administrative complexity, limited scope and less effective impact.

Can a climate club work?

Progress towards the Paris Agreement goals is lagging, with the UNFCCC’s most recent assessment indicating global climate change policies “may lead to a temperature rise of about 2.7°C by the end of the century” (UNFCCC, 2022). Achieving the Paris Agreement goals will be challenging. Climate clubs could help by incentivizing compliance, but are they realistic and feasible? Will they attract broad enough membership to meaningfully drive policies to address climate change?

There appears to be increasing interest among academic researchers on the potential role and efficacy of climate clubs. Rather than attempting a wide literature review, this brief paper will focus on a few recent papers that draw on and assess much of the relevant literature to date, as well as consider the merits of a climate club and some initiatives toward establishing one.

Based on an extensive review of the literature on climate clubs, Unger & Thielges (2021) adopt an analytic approach based on three criteria:

1. Club membership and size: to advance climate change mitigation efforts, a club must include “relevant members”. For their analysis, this includes:

   • capability to address the problem (e.g., share of GHG emissions or size of the economy);

   • legitimacy, in terms of including key affected parties; and

   • a common objective of addressing climate change.

2. Benefits to the public: governance activities to create positive social externalities by mitigating climate change as the main objective of a climate club, as indicated by:

   • adoption of policies that reduce emissions;

   • support in the development of policies and tools that advance climate mitigation among the members;

   • activities that raise awareness and increase support for the common objective; and

   • enhanced cooperation among members.

3. Benefits of club membership: in addition to the common goal of climate governance, such as:

   • financial advantages to members;

   • dissemination of knowledge, methodologies and technologies;

   • reputational benefits to members, bringing prestige and recognition by stakeholders;

   • building trust among participating club members; and

   • co-benefits that are positive side effects from the club’s mitigation activities (e.g., for sustainable development).

These criteria are broad and qualitative, less specific and possibly less onerous than those suggested by Nordhaus. Nordhaus proposes a harmonized carbon tax as the single climate change mitigation policy and a comprehensive tariff on imports as the penalty on non-members. Nevertheless, Unger & Thielges (2021) apply these qualitative criteria to three international governance bodies to assess the effectiveness of their climate change initiatives.

• G20 – a forum for international economic cooperation, which now includes climate-related issues such as climate finance, adaptation, mitigation and clean energy transition.

• CCAC (Climate and Clean Air Coalition) – its central objective is slowing the rate of near-term global warming through the reduction of short-lived climate pollutants, such as black carbon, methane, hydrofluorocarbons and tropospheric ozone.

• U2C (Under2 Coalition) – a coalition of sub-national governments that aims to achieve GHG emissions mitigation.

These initiatives have in common with Nordhaus’s climate club “that their activities on climate change mitigation were a response to the perceived failure of the UNFCCC process and a conviction that extra action would be necessary to cope with climate change” (ibid., p. 14). However, their role was to “prepare the playing field” rather than put the members on a clear path to achieving the Paris Agreement goals. Unger & Thielges found that all three have contributed positively to climate change mitigation efforts and “the central value-added of these three initiatives in climate governance has been that of strengthening a strategic dialogue through influencing political agendas and raising awareness in specific contexts and communities” (ibid.). They were found to incentivize policy planning and capacity building for the implementation of policies and creation of networks, leading to deeper cooperation. They all contributed to progress in climate change mitigation without adopting the full Nordhaus model.

Elkerbout, Bryhn, Righetti, & Chapman (2022) provide a broad and rigorous overview of different approaches to carbon pricing, assessing their effectiveness as climate policy tools and addressing frequently raised concerns about carbon leakage risk and effects on international competitiveness. They conclude with a discussion on the concept of climate clubs as a potential mechanism for cooperating on climate policy beyond just carbon pricing. They note that climate clubs can provide a way for faster progress among a group of like-minded countries than for an individual country to adjust its own carbon pricing policies relative to the rest of the world in the context of the Paris Agreement’s differentiated, bottom-up structure. They suggest three priorities for a climate club: “[t]he first priority could be to boost the deployment of low-carbon technology. The second could be to cooperate on various carbon standards and benchmarks to measure and drive down embedded carbon contents. The third could be to align on carbon pricing approaches” (ibid., p. 28).

In Canada, and perhaps even more so in the United States, implementing a carbon tax is challenging, let alone getting it to the level of the social cost of carbon. Imposing a uniform tariff on imports may be even more problematic. Nordhaus notes “an important aspect of the proposal will be a set of “climate amendments” to international trade law, both internationally and domestically. The climate amendments would explicitly allow uniform tariffs on non-participants within the confines of a climate treaty; it would also prohibit retaliation against countries who invoke the mechanism” (Nordhaus, 2015, p. 1349). It is not clear how easily, or whether, these amendments would be achieved. Without them, it would be very problematic for Canada or the United States to impose uniform tariffs on each other, or on Mexico, and presumably similar problems would arise within the European Union if all members did not join the club.

A departure from the Nordhaus climate club model that may be necessary is to build the club around a carbon border adjustment mechanism (CBAM) rather than a uniform tariff on all imports. This has been recently proposed and referred to as a “carbon club” (Bethan, Axelsson & Parr, 2022). These authors are strong advocates for CBAMs and find the prospects for implementing CBAMs among the G7 countries to be promising, potentially leading to a G7 carbon club.

Chancellor Scholz’s climate club advocacy

The need for closer international cooperation to address climate change has been recognized by German Chancellor Olaf Scholz. With the risk of putting energy intensive industries at a competitive disadvantage from unilaterally adopting ambitious climate change policies, Scholz has advocated the creation of a climate club of countries adopting a CBAM. A climate club could exploit the current momentum in developing climate change policies, leading to the collaboration necessary for successful climate change policies.

Scholz envisages a club comprising countries with the highest climate policy ambitions, initially centered around the European Union, which is currently considering a common CBAM. Scholz is using his 2022 G7 Presidency to encourage G7 countries to participate in a climate club and subsequently to extend membership to include the G20 countries (Federal Government of Germany, 2022). Three European G7 countries are already committed to the same targets as Germany, so Scholz’s proposal is aimed at Canada, Japan, the United Kingdom and United States.¹ Developing countries with high ambitions would also be encouraged to join, with their limited capacities taken into consideration, possibly through differentiated targets and financial support for their climate policies and capacity building to reflect their limited economic capacities for mitigation efforts. “If the climate club is large enough and manages to agree on WTO-compliant joint rules, it could have a strong appeal to other countries globally” (Federal Ministry of Finance of Germany, 2021).

The Scholz club would be:

• Ambitious – admitting all countries committed to adopting ambitious and intensified GHG reduction measures to meet the Paris Agreement targets (i.e., complementing and strengthening the Paris Agreement, not competing with it), including realistic interim targets for 2030 and beyond.

• Bold – members committing to work cooperatively and swiftly on:

  • o decarbonization policies and strategies for energy intensive industries such as steel, cement and petrochemicals;

  • o developing a roadmap towards joint measurement and pricing of CO₂, including similar or uniform (minimum) carbon prices; and

  • o coordinating their measures to prevent carbon leakage (e.g., energy intensive industries relocating to jurisdictions with lower standards for climate change measures) such as adopting a joint carbon border adjustment mechanism.

• Cooperative — focussing on cooperation among participating countries to prevent competitive disadvantages to their economies because of decarbonization measures while respecting World Trade Organisation (WTO) rules; this will include assisting emerging economies and developing countries in their low carbon transition and eventually becoming club members.

Relying on a CBAM rather than the uniform tariff on imports from non-participants proposed by Nordhaus to penalize free-riders may result in the proposed climate club being less than optimal by Nordhaus’s modeling analysis, but as a more practical approach it may also make establishment of a climate club more realistic and more likely. If politics is “the art of the possible”, this adaptation may be necessary to make a climate club possible.

At their meeting in March 2022, Prime Minister Trudeau and Chancellor Scholz “agreed to cooperate to further advance the adoption of carbon pricing policies globally, including through Canada’s Global Carbon Pricing Challenge and Germany’s Climate Club” (Prime Minister of Canada, 2022).

G7 climate club statement and advocacy

Chancellor Scholz used his G7 Presidency to continue his climate club advocacy. Energy and climate were important issues addressed at the G7 June 28, 2022 Leaders’ Summit in Elmau (Germany), and the G7 Leaders’ Communiqué from this meeting reaffirmed their “unwavering commitment to the Paris Agreement” and to fully play their part in urgently implementing the Glasgow Climate Pact (G7 Germany, 2022a, p. 1). The leaders also agreed to creating an open and cooperative international climate club to support the effective implementation of the Paris Agreement.

In a separate statement (G7 Germany, 2022b), the leaders stated that their proposed climate club would:

1. Advance ambitious and transparent climate mitigation policies to reduce emissions intensities of participating economies on the pathway towards climate neutrality, including sharing best practices and ways of assessing the effectiveness and the economic impacts of emission mitigation policies such as explicit carbon pricing.

2. Jointly transform industries to accelerate decarbonization through mechanisms such as the Industrial Decarbonisation Agenda, the Hydrogen Action Pact, and expanding markets for green industrial products.

3. Boost international ambition through partnerships and cooperation to encourage and facilitate climate action, unlock socio-economic benefits of climate cooperation and promote a just energy transition.

The G7 leaders committed to developing comprehensive terms of reference and to work with partners outside the G7 towards establishing an open, cooperative international climate club by the end of 2022. The terms of reference would need, among other things, to set out specific criteria and objectives for carbon pricing and CBAM policies and whether there would be any additional trade benefit arrangements among members. To meet the essential criteria for a climate club as set out by Nordhaus, these provisions would need to establish key mechanisms for tackling climate change and provide both incentives for participation and penalties for non-participation in the club. Working with partners outside the G7 would potentially expand the membership of the climate club, thereby increasing its effectiveness.

Should Canada join a climate club?

Canada has expressed strong commitment to meeting the targets of the Paris Agreement. Canada has very ambitious carbon pricing intentions (Environment and Climate Change Canada, 2022) and is contemplating a form of CBAM (Department of Finance Canada, 2021). These policies are consistent with those of the climate club proposed by Chancellor Scholz.

Many Canadians are critical of Canada’s climate change policies, and a common criticism is that Canada will damage its own economy by aggressively pursuing these policies when other countries are not. Canada’s Output-Based Pricing System (OBPS) is intended to protect the global competitiveness of emissions-intensive and trade-exposed (EITE) sectors of Canada’s economy. Wide membership in a climate club would contribute to the level global playing field Canada’s OBPS is seeking to create. The CBAM would not completely obviate the need for its OBPS, as the level playing field Canada is seeking to achieve is for its export industries (including oil and gas exports), not for domestic producers that compete with imports. But it would enable a broader scope for Canada’s carbon price and increased effectiveness of its climate policies.

The reality is that even if Canada reaches all of its goals, the goals of the Paris Agreement will not be achieved if other countries are not similarly motivated and similarly successful. As a G7 member, Canada was party to the climate club discussions at the June 2022 Leaders’ Summit and to the Leaders’ Communiqué and Statement on Climate Club. A climate club with wide membership would increase the likelihood of the world reaching the goals of the Paris Agreement and reduce the risk of Canada damaging its own economy by acting alone. This climate club initiative is an important step towards realizing the goals of the Paris Agreement, and Canada’s full commitment and active engagement will provide a valuable contribution towards bringing an international climate club to early fruition.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Additional information

Notes on contributors

Paul Precht

Paul Precht is an independent energy economist in Edmonton. He has consulted across Canada and internationally for clients including the World Bank, the International Monetary Fund, the African Development Bank and the Commonwealth Secretariat. He is an executive fellow at the University of Calgary School of Public Policy.

Notes

1 A climate club composed of Canada, the European Union, Japan, the United Kingdom and United States would cover 44% of global international trade and about 28% of global GHG emissions.