Introduction

Ⅱ. Model Set Up

Ⅲ. Non-Cooperative Model

Ⅳ. Cooperative Model V . Conclusion

Key words: transfrontier pollution, environmental investment, uncertainty, option

I. Introduction

It has been well recognized among economists that free riding incentive prevails especially when externality is caused by transfrontier pollution like acid rain or particulate unidirectionally moving over adjacent countries. One suggestion to resolve unidirectional externality is to rest on `Victim Pays Principle (VPP)' as implied by Coase (1960). Under the rule, a cooperative agreement or contract is established among the involved countries so that a

* Associate Research Fellow, Korea Energy Economics Institute

** Research Fellow, Korea Energy Economics Institute

Hojeong Park & Gyeong-Lyeob Cho

victim country provides technological or financial transfer to a polluter country so to abate pollution. It is generally agreed that, by implementing VPP to control transfrontier pollution, the involved countries can improve upon their current welfare (Kaitala and Pohjola (1998) and Mäler and de Zeeuw (1998)).

However, inter-country cooperations to control transfrontier pollutants are less often observed. According to Mäler (1990), emission source country has less incentive to abate its pollution at the optimal level, while expecting non-necessarily larger side payments. This results in a victim country to hesitate its environmental investment in the polluter country, in response to the polluter country's deliberate strategy. One way to overcome the low incentive of the victim country's investment is to link concerned flow pollutant problem (i.e. transfrontier pollutants in current context) with other issues by which the investment donor country can be partially rewarded.

A notable example for the reward mechanism is emission credit as postulated in the Joint Implementation (JI) and Clean Development Mechanism (CDM) in the Kyoto Protocol. As for CDM, Article 6 of the Protocol authorizes an Annex I country, or a private entity from that country, to invest in a climate change mitigation project in another Annex I country. With approval by the host country, the investing country can receive "emission reduction units'', which it can add to its allocated permits. Similary Article 12 authorizes an Annex I country to invest in a climate change mitigation project to contribute sustainable development of non-Annex I country. If it is approved, the investing country can add "certified emission reduction'' to its allocated permits. This latter case corresponds to JI.

Under these rules, a donor country can gain appropriately evaluated emission credits when it finances environmental projects in a host country and thereby it is widely believed that JI/CDM can contribute to enhancing cooperations to curb regional transfrontier pollutants as well as global

Does Credit Transfer Reduce Emission Transfer?: Real Option Game Perspectives

pollutants.

Recent environmental cooperation between Finland and Estonia provides a good example for JI/CDM. The famous debates over acid rain problem between Finland and Eastern European countries was launched by late 1980s.

But, the acid rain game was finally resolved at least partially in the late of 1990s when Estonia signed to the mutual agreement with Finland. According to this agreement, Finland finances environmentally clean projects in Estonia while Estonia is obliged to reduce SO2 emission by the year 2005 by 80% as compared with 1980 base emission. Furthermore, more recently, they signed an agreement on December 2002 to participate in JI projects under which Finland is supposed to attain emission credits for the exchange of financing construction of heating power plants in Estonia.

Obviously, it is important to establish such environmental cooperation in North East Asian countries. In this region, it is increasingly evident that the transfrontier acid rain and yellow dusts from China are causing serious environmental and health problems in South Korea and Japan. Despite of consecutive discussions and regional forums held in those countries, effective cooperation to curtail acid rain and yellow dusts has not yet been implemented.

The purpose of this paper is to show that environmental cooperations can be facilitated by linking underlying transfrontier pollution problem to other global pollutant via an emission credit transfer mechanism. One property of acid rain or yellow dusts is that they are directly or indirectly related to global warming issues. Since acid rain is caused by acidic pollutants such as SO2 and NOx that are mostly byproducts of fossil fuels, pollution abatement activity to reduce SO2 and NOx can be taken into account as an effort against global warming. In addition, forest management such as afforestation to recover acidified forest has practical implications for North East Asian

Hojeong Park & Gyeong-Lyeob Cho

countries.¹⁾

The present model analyzes this issue using non-cooperative and cooperative game. In a non-cooperative framework, a victim country's investment, or interchangeably, technological transfer is not linked to CDM. Hence, there is no reward for the investment. On the other hand, a cooperative strategy allows the host country to transfer emission credits to the victim country when the latter undertakes an investment. Depending on which strategy is employed, the sequence of investment could be substantively affected. The transfrontier pollutant is assumed to be flow (e.g., acid rain, yellow dust, and particulates) while the global pollutant is stock pollutant (greenhouse gases).

The game proceeds in a dynamic context to accomodate dynamic features of global pollutants.

The vast majority of the previous literature on cooperative games analyzes in deterministic framework (Dockner and Long (1993), Mäler and de Zeeuw (1998)). In the following analysis, environmental damage caused by a transfrontier pollutant is subject to uncertainty as in Pindyck (2002). By combining real option model with cooperative game, uncertainty is relatively easily incorporated. We show that, although environmental cooperation can improve every participants' welfare but uncertainty acts as a source of delay of international environmental agreement.²⁾ Although the effect of uncertainty on investment is not a peculiar property restricted to only environmental

1) Karp and Liu (2000) discuss the efficacy of JI/CDM in establishing international environmental cooperation. As for forest management as a part of CDM, Rotter et al. (1998) emphasize the potential role of afforestation in developing countries and Satyanarayana (2003) provides several pilot projects being in practice around the world.

2) Matsueda (2000) shows that information asymmetry between victim and polluter countries play an important role to delay international environmental cooperation. In the present paper, however, we do not analyze such asymmetric problem and we assume the damage cost uncertainty is common factor to both countries.

Does Credit Transfer Reduce Emission Transfer?: Real Option Game Perspectives

economics, it has an important implication because voluntary implementation of environmental agreements can be significantly hampered by uncertainty.

The paper is organized as follows: section 2 provides basic set up of the model. Analysis starts with non-cooperative game in section 3 and then section 4 extends the model to cooperative game. Section 5 concludes the analysis.