Politics and Economics of Second-Best Regulation of Greenhouse Gases: The Importance of Regulatory Credibility

Abstract

Compared with economically ideal policies, actual limits on global warming gases are likely to be “second-best” in many ways. Most studies focus on “second-best” approaches such as delaying emission controls in developing countries, constraining international emission trading, or regulating gases piecemeal by sector rather than equally across the whole economy. We show that another second-best approach—lacking of regulatory credibility—imposes up to six times the extra costs on the economy when compared with all other “second-best” factors combined. When regulatory rules are not believable then firms and other agents become short-sighted and unable to make optimal investments in research and development as well as long-lived technologies. Although analysts have largely ignored this issue, low credibility is commonplace when governments tackle international problems because international institutions such as treaties are usually weak and fickle. Governments can help solve credibility problems with strategies such as “pre-committing” regulations into domestic law that is usually more credible than international commitments. We show that China, for example, can justify unilateral, emission controls because such pre-commitment would encourage Chinese firms to invest with a clearer eye to the future.