Institutional framework: elements

Institutions, as the general principles and rules adhered to in society, are fixed but malleable.

Ownership rules are most basic and well developed in a market based society, ultimately depending also on court rules and their implementation. Liability rules are a core part of them and have been developed to also cover environmental liability, with efforts to also apply them for climate liability, see the survey of options and constraints analyzed by (Faure and Peeters 2011).

Though applicable in principle, the practice is difficult as yet: there are billions of emitters, at a global level, with effects at a global level, with a substantial delay in time of effects coming up, and with many options for adaptation to avoid damages. Strict and several liability has widened the legal options, making major actors in the chain responsible, but have effectively been applied only in clean-up of toxic waste sites, especially in the US (Superfund) and the Netherlands, and play an important supporting role in toxic emissions. Though already relevant in the insurance domain these options will not be analyzed further here.

Ownership and liability rules create markets, with additional rules on specific markets. Also these are mainly fixed but malleable in time. They are of central importance for markets where new

low emission technologies are to function. Electricity markets belong to the most strictly regulated markets, also after privatization in most OECD countries, due to the monopolistic nature of transmission and distribution. The EU Unbundling Directive sets a more or less binding principle for national regulations in the electricity market domain, reducing the monopolistic and oligopolistic power of large fossil electricity producers. The specifics of renewables in terms of intermittency and dischargeability may lead to market adaptations as being detailed below, see Section 4.4. Markets may be designed in different ways and their domains may be restricted.

Slaves cannot be traded anymore, and international trade in toxic waste is prohibited mostly.

Most economic activities in the market domain have a direct bearing on climate emissions.

Restricting the market domain seems hardly possible; ordering the market domain through climate relevant markets design seems a core of long term climate policy, involving both opening up of markets, like for electricity in the EU, and restricting markets, as in allowing only air conditioners on the market with a certain minimum energy efficiency, depending on strategies followed.

The principles-based detailing of institutional rules is the normal way of adapting the institutional framework of society, reckoning with economic and social developments and re-interpreting principles and stating new ones. When environmental policy came up in the Seventies of last century, some order as to instrumentation was created internationally by establishing the Polluter Pays Principle, supported by all OECD countries (OECD 1972). That principle has two elements: the polluter should pay for emission reduction and he should pay for the damages remaining, according to Pigovian or Baumol-type reasoning. Emission standards make the polluter pay for emission reduction but not for the damages remaining, as do freely allocated emission permits. Auctioned permits and emission taxes cover the Polluter Pays Principle fully.

Internalization of External Cost is another way of stating the Polluter Pays Principle, with a slightly broader domain, as it may cover other effects than emissions. For principles to be valid operationally, they need to be filled in with more detailed rules, as on what the costs are the polluter should pay and what the external costs are, and how they should be internalized.

One option for partial internalization, not reckoning with damages remaining, is to reckon with an assumed environmental damage price, equal in all environmental policy, in public investment in infrastructure and regulations regarding private actors. This implicit emission price may be attributed to specific policies or private actions. Some estimates of implicit emission prices reflected in the Great Britain feed-in tariffs for some solar PV technologies were in the range of 800 Euro per tonne of CO2, with German feed-in tariffs slightly lower (OECD 2013). These subsidies might be seen as subsidies not-to-pollute, hardly in line with the Polluter Pays Principle. However, the reasoning behind these subsidies was of a different nature, making the implicit price not so relevant. These subsidies were temporary to create learning curves, allowing for future lower cost prices of these technologies. This dynamic aspect makes this implicit emission price mostly irrelevant for long term considerations. Such instruments may be relevant for short term considerations, reducing emission levels next years. Feed-in tariffs of several decades of duration, as considered for the new nuclear installations in the UK, of course are not learning curve payments but part of long term climate (and energy) policy. Furthermore, an implicit price might be established for technology-specific regulations intended to reduce climate emissions, then amongst other emissions however, as with coal fired power stations. This is mostly difficult as other emissions and other external effects will then have to be valuated as well, which mostly is

not well possible, and certainly not in a dynamic way. For long term transitions such implicit emissions prices give limited guidance to policy makers and to society. The principles are to be more firmly embedded in general rules to effectively hold. So more generic pricing rules are to come to the aid in redirecting market activities dynamically.

Innovation is a key long term issue for climate policy. However, the innovative capacity of society is not specific for climate policy and its instrumentation. Innovative capacity substantially depends on culture, including local culture and broader institutions, not related to climate policy.

See (Mazzanti and Antonioli 2013), also on the issue of broader embedding of climate policy, as in using techno-organizational training efforts, and (Mazzanti, Antonioli et al. 2014) on the financing of innovation, with generic financing institutions the main route, while bottlenecks to be resolved maybe, like related to the exceptionally long term nature of some climate investments. What climate policy can do is to shift the direction of innovation, with generic incentives dominant in the long run and technology-specific incentives in the short and medium term, the latter to avoid crowding out of other innovative actions and developments.

Pricing instruments in the form of taxes and subsidies tend to be technology-specific, from a long term perspective mostly relevant for temporary inducing innovation but not for normal functioning from then on, then preferably being subject of long term dynamic incentives. Main examples of such temporary support are publicly funded demonstration projects and feed-in tariffs and premiums and investment subsidies to create learning curves. Subsidies require some sort of funding which then cannot be spent otherwise. There are many taxes with climate relevance, more distant like differentiated value added taxes and more direct like fuel excises for transport fuels. Fuel excises have a serious volume effect, as shown in the extreme differences in gasoline and Diesel use between roughly twice as high excises in countries like Europe and Japan as compared to low excise countries like the USA (with China following suit), leading to roughly half the fuel use per person. These excises had been set up however for reasons of funding and traffic reduction and hence are difficult to interpret in terms of transport based emission tax. They might be set up that way, as a complement to a cap or carbon tax in non-transport domain. In terms of strategic design the logic would then be to apply the generic pricing principle to transport fossils as well and leave the fuel excises to the national domain with country specific reasoning for their functioning and with substantial differences in what they are intended to finance.

Subsidies tend to be technology specific, also the relatively open tax reduction mechanisms. Also taxes can be technology-specific, as in taxing specific types of coal fired power stations, for example only the least efficient ones. Such instruments belong to the domain of directing private actions, instrument type 4.2. There are gradations towards more generic mechanisms. The tax on coal fired power stations may be based on actual CO2emissions. It may cover all coal fired power stations, and also all gas fired power stations, and all oil fired power generation. A next step may be to also cover non-electricity related emissions from fossil combustion processes, also for heating. At a certain level of uniform encompassingness, the CO2emission pricing rules become so general that they become part of the institutional framework. Then the general rule is emission pricing, with maybe some exceptions, like combustion of fossils in heavy non-road going transport, for practical reasons. This then would be a temporary exception with also covering such heavy transport emissions under emission pricing rules when circumstances allow. There then is no technology-specific relation with emission pricing any more. This would be a major step in practically implementing the polluter pays principle, and in a way internalizing external climate

effects. The current ETS is in the middle domain, applied nearly fully on electricity production and energy intensive industry, but not on smaller industrial emissions and not on heating of buildings, and not on transport, with the exception of inland aviation. Its overall GHG emission coverage is now around 45% and will decline if CO2 emissions in its domain are reduced and other emissions not.

One further institutional domain concerns the financing of the very substantial investments in low emission energy production and energy use systems. The institutional framework for financing is there, evolving dynamically for its own reasons. Lifting out the domain of low carbon energy by creating a generic energy related institutional structure for funding would require specific reasons: issues not solved by the general financial institutions regarding investments.

There are specific domains where financing does not work properly, as in household investments in low emission systems. When financial markets fail on such issues, specific measures, like combined subsidies and financing for insulation programs would be appropriate, not changing general framework conditions in the financial system. Changing these general framework conditions of course may be urgent for non-climate reasons, like improved transparency and stability, and better serving small borrowers.

The two major institutional framework conditions, emission pricing and electricity markets will be detailed, surveying a number of variants, in Sections 4.3 and 4.4.