Will the landmark climate agreement between the U.S. and China reached in November spur progress towards a global deal in Lima? (Feng Li, Getty)

Three weeks ago, the U.S. and China announced a landmark bilateral agreement to cut greenhouse gas emissions.  Secretary of State John Kerry heralded the agreement as a key step toward reinvigorating international negotiations on climate change.

His theory will be tested this week, when diplomats will converge on Lima, Peru to negotiate the next steps of the climate change regime.  Although there is some optimism, the prospects remains highly uncertain.  The Kyoto Protocol expired in 2012, and so far, only a handful of countries have renewed their commitments, comprising only 12 percent of global emissions.  Countries have set themselves a deadline of December 2015 to agree to Kyoto’s successor, but agreement appears a long way off.  For starters, countries have not yet decided upon what the legal form of such an agreement would be, let alone agreed upon substantive commitments.

At the same time, states are developing national responses to climate change.  Increasingly, these include carbon markets.  The World Bank states that there are currently 18 active emissions trading schemes, functioning at the regional, national and sub-national levels, and 11 more are in the pipeline.  The conventional wisdom suggests that climate change is a collective action problem, where states will only act jointly for fear of others free-riding.  The explosive growth in domestic markets suggests that this is no longer a rigid constraint on action.

The relative gridlock at the international level, coupled with the patchwork of national and sub-national carbon markets, has prompted many to suggest that a bottom-up approach to international climate policy might be a potential solution.  Individual markets could link together, creating an ever-larger set of jurisdictions that price carbon, ideally culminating in a global carbon market.  Such an approach has the advantage of allowing states to set their own targets, consistent with domestic constraints, rather than subjecting them to international negotiation.

Economic theory dictates that linkage should lower the overall costs of reducing carbon emissions.  Linked carbon markets will allow money to flow to those investments where marginal costs of emissions reduction are lowest—providing the most bang for the buck.  In all likelihood, this would facilitate the movement of capital from the developed to the developing world, where costs of emissions reductions are generally lower.  Although the benefits of such an approach would be unevenly distributed (and more on that below), the overall costs of reduction would fall.

Accordingly, optimists suggest that linking carbon markets will be a “key element of emerging international climate policy architecture.”  If one adds in the possibility of linkage with the additional dozen jurisdictions that have implemented carbon taxes, the prospects for a global market are even more robust.

If only it were that easy.  I argue in a new article in the journal Nature Climate Change that successful linkage—which reduces net long-term greenhouse gas emissions—may be more elusive than it seems ( the article is co-authored with Thomas Sterner and Gernot Wagner) .

At the domestic level, states must resist the temptation to change policy in the face of rising costs.  Cap-and-trade markets are built around a cap: the amount of allowable emissions, which determines the level of reductions, and therefore, the ambition of the policy.  Once linked, the total number of allowances grows, but so too do the number of regulated entities.  Whether this raises or lowers the prices will depend on the cap set in each jurisdiction.  Countries must fight the temptation to hedge against future costs by setting overly generous caps.  These will drive down the price of individual allowances, but also lower the level of ambition of the policy.  Second, they must also avoid raising caps mid-stream.  If country A has a generous (i.e. unambitious) cap and links to country B with a stringent one, then prices for country A may well rise, since allowances become relatively more scarce.  One logical response would be for country A to raise its cap, thus increasing the overall number of allowances and lowering prices.  This would not only lower the efficacy of the policy, but would deflate the value of allowances throughout all linked markets, interfering with the ability of the markets to send credible price signals.

While linkage may provide a cost-effective way to reduce emissions, there will undoubtedly be winners and losers within each market.  Large emitters may benefit if the cost of compliance declines.  But smaller emitters, who may have allowances to sell, will see less demand for their product, and may object to the prospect of lost revenue.   The same logic holds across states, where net sellers will face increased competition.

Since countries inevitably have multiple policy goals, linkage faces yet another domestic obstacle: it must be compatible with these other objectives.  Linkage is premised on the assumption that states want to lower the cost of reducing emissions.  For some, cheaper allowance prices may not further other policy goals, such as transitions away from fossil fuels.   Conversely, some may wish to pursue linkage irrespective of its effects on prices.  For example, California and Quebec have recently linked their nascent carbon markets.  Given that abatement costs are roughly similar in these two jurisdictions, the economic benefits are likely to be small.  However, both have clearly indicated their desire to be policy leaders in the linkage approach.  Each appears more interested in demonstrating the feasibility of linkage than reaping its economic benefits.

The politics of linkage become even thornier when considering the international effects.  Linked jurisdictions must accept the reduced regulatory autonomy that accompanies open markets.  This is not terribly problematic if A and B jointly decide to link on agreed-upon terms.  However, if A subsequently decides to link to C, B is now indirectly linked – through terms it did not explicitly approve.  In addition to diminishing autonomy, indirect links could also compromise the integrity of the system, if regulatory systems are weak in any one of the three markets.  After all, carbon markets are premised on the assumption that states have both the regulatory capacity and the political will to enforce property rights; the same is true for linkage.  If any state within the system lacks these capabilities, there are additional risks of inundating the market with cheap allowances that do not represent meaningful reductions.   This will have repercussions throughout all linked jurisdictions.

Finally, linkage may be the victim of its own economic success.  Cost-effective linkage will result in large transfers of money from North to South, lowering the cost of compliance for the developed world, and promoting investment in the developing world.  However, as these transfers grow in size, it is likely that political objections will too.  The Clean Development Mechanism of the Kyoto Protocol serves as a cautionary tale.  At one point, the majority of investments originated in the European Union (EU) to support industrial gas projects in China.  Least developed countries, which were in the greatest need of investment, received a fraction of the total financial flows.  The EU has since changed its rules to redirect funds to underserved regions.  While this promotes one set of EU policy goals, it undermines the economic effectiveness of linkage.

How linkage can work

Carbon markets are now big business, estimated at almost $50 billion this year.

They provide a promising avenue for moving beyond the gridlock that has beset the Kyoto negotiations.  They are not going away.

So the question remains: how can linkage promote effective action on climate change – i.e. real and meaningful emissions reductions?  We advise that linking markets proceed with caution.  They must balance the benefits of economic efficiency with political feasibility.  Specifically, we have five suggestions for an incremental approach to linkage.

1)     Linking states should start small. Informal linkages through memoranda of understanding will promote learning and provide flexibility to work out any unanticipated problems.  It will also allow a test-run to ensure that domestic regulatory institutions are up to the task.  Once a pilot phase is successful, relationships can be further institutionalized through law.

2)     Linkage should start in the developed world.  This is so for several reasons.  First, the most mature markets—including, among others, the EU Emissions Trading Scheme and the Regional Greenhouse Gas Initiative—are located in the developed world.  Quite simply, they have the most experience with cap-and-trade markets.  Second, and related, these are most likely to have robust regulatory capacity to support and enforce a trading system.  Finally, there will be smaller differences in marginal costs of abatement between developed nations.  While this will sacrifice some of the efficiency gains, it may also mitigate political objections associated with large transfers of wealth.

3)     Indirect linkage should be kept to a minimum.  Indirect linking—where two states are linked through a third—reduces regulatory autonomy and creates another layer of coordination requirements.  In other words, it can create problems both politically and in terms of policy design.  As such, we suggest that markets linked through a third party explicitly agree with each other on the terms.

4)      Banking and borrowing should be kept to a minimum. Banking and borrowing are designed to help smooth out prices over time by providing clear signals about future markets.  But they can also be gamed, and may propagate any flaws in the market into the future.  Linked markets should limit the number of allowances that can be banked or borrowed across time periods.

In sum, linkage will require extensive regulatory coordination.  And that coordination will invariably involve politics.  Thus, at the outset, simpler systems are better, both for the purposes of learning how to design working systems, and for reducing opportunities for political objections.

Linkage is not a panacea for climate change.   Indeed, if the current patchwork of carbon markets evolves into a global, or even a semi-global market, the associated political challenges may be on a par with a global agreement like Kyoto.   But if done slowly and deliberately, linkage can be one tool among many to help move states toward a lower-carbon future.

 Jessica F. Green is an assistant professor of political science at Case Western Reserve University. Her  book, Rethinking Private Authority: Agents and Entrepreneurs in Global Environmental Governance, was published by Princeton University Press in January 2014.