University of Massachusetts Amherst Department of Resource Economics Working Paper No. 2006-6 http://www.umass.edu/resec/workingpapers Enforcing ‘Self-Enforcing’ International Environmental Agreements David M. McEvoy 1 and John K. Stranlund 2 Abstract: Theoretical analyses of international environmental agreements (IEAs) have typically employed the concept of self-enforcing agreements to predict the number of parties to such an agreement. The term self-enforcing, however, is a bit misleading. The concept refers to the stability of cooperative agreements, not to enforcing these agreements once they are in place. Most analyses of IEAs simply ignore the issue of enforcing compliance by parties to the terms of an agreement. In this paper we analyze an IEA game in which parties to an agreement finance an independent enforcement body with the power to monitor the parties’ compliance to the terms of the IEA and impose penalties in cases of noncompliance. This approach is broadly consistent with the enforcement mechanism of the Kyoto Protocol under the Marrakesh Accords. We find that costly enforcement limits the circumstances under which international cooperation to protect the environment is worthwhile, but when IEAs do form they will involve greater participation than IEAs that do not require costly enforcement. Consequently, costly enforcement of IEAs is associated with higher international environmental quality. Moreover, under certain conditions, aggregate welfare is higher when IEAs require costly enforcement. These conclusions are accentuated when monitoring for compliance to IEAs is inaccurate. Keywords: International environmental agreements, self-enforcing agreements, compliance, enforcement. JEL Classification: Q5, H41, C72, F53 ________________________ 1David M. McEvoy, Department of Resource Economics University of Massachusetts, Stockbridge Hall, 80 Campus Center Way, Amherst, MA 01003 E: [email protected] P: 617-671-8147 F: 413-545-5853 2John K Stranlund, Department of Resource Economics University of Massachusetts, Stockbridge Hall, 80 Campus Center Way, Amherst, MA 01003 E: [email protected] P: 413-545-6328 F: 413-545-5853 August 2006 Enforcing ‘Self-Enforcing’ International Environmental Agreements DAVID M. McEVOY∗ Department of Resource Economics University of Massachusetts-Amherst JOHN K. STRANLUND Department of Resource Economics University of Massachusetts-Amherst Acknowledgements: The authors acknowledge funding for this project from the Center for Public Policy and Administration, University of Massachusetts, Amherst, and the Cooperative State Research Extension, Education Service, U. S. Department of Agriculture, Massachusetts Agricultural Experiment Station, and the Department of Resource Economics under Project No. MAS00871. James Murphy provided valuable comments in the early stages of this work. ∗ Correspondence to: David M. McEvoy, 80 Campus Center Way, 404 Stockbridge Hall, Amherst, MA 01003, USA, Phone: 617-671-8147, Fax: 413-545-5853, E-mail: [email protected]. Enforcing ‘Self-Enforcing’ International Environmental Agreements Abstract: Theoretical analyses of international environmental agreements (IEAs) have typically employed the concept of self-enforcing agreements to predict the number of parties to such an agreement. The term self-enforcing, however, is a bit misleading. The concept refers to the stability of cooperative agreements, not to enforcing these agreements once they are in place. Most analyses of IEAs simply ignore the issue of enforcing compliance by parties to the terms of an agreement. In this paper we analyze an IEA game in which parties to an agreement finance an independent enforcement body with the power to monitor the parties’ compliance to the terms of the IEA and impose penalties in cases of noncompliance. This approach is broadly consistent with the enforcement mechanism of the Kyoto Protocol under the Marrakesh Accords. We find that costly enforcement limits the circumstances under which international cooperation to protect the environment is worthwhile, but when IEAs do form they will involve greater participation than IEAs that do not require costly enforcement. Consequently, costly enforcement of IEAs is associated with higher international environmental quality. Moreover, under certain conditions, aggregate welfare is higher when IEAs require costly enforcement. These conclusions are accentuated when monitoring for compliance to IEAs is inaccurate. Keywords: International environmental agreements, self-enforcing agreements, compliance, enforcement. JEL Codes: Q5, H41, C72, F53 1. Introduction International environmental agreements (IEAs) made between sovereign nations seeking to manage shared environmental and natural resources are susceptible to two sources of free-riding. First, because participation to IEAs are voluntary, countries can decide at will whether to become a party to an agreement. If an IEA only requires a subset of countries to join before entering into force, as is typically the case, then incentives exist for some countries to stay out of the agreement and free-ride off the provision of the cooperating others. Second, if compliance with the terms of the agreement are not enforced well, parties to an IEA will have an incentive to violate the terms of the agreement and free-ride off those countries that do comply. Previous theoretical analyses of IEAs have usually investigated the impact the first form of free-riding has 1 on the effectiveness of IEAs, while avoiding altogether the possibility that member countries may not fully comply with their commitments. In this paper, we deal directly with the issue of noncompliance within IEAs by constructing and analyzing a game in which parties to an IEA finance an independent enforcement body with the power to monitor parties’ compliance behavior and impose penalties in cases of noncompliance. There is ample evidence that many existing IEAs experience significant problems with noncompliance. For example, the Convention on International Trade in Endangered Species (CITES) has witnessed hundreds of infractions every year since its inception in 1979 (Swanson and Johnston 1999; Finus 2004). Similarly, customs officers throughout the world frequently intercept flows of CFC products even though these substances have been banned under the Montreal Protocol since 1991 (Finus 2004). As a more recent example, although the performance of the Kyoto Protocol cannot formally be evaluated until the end of the first commitment period (2008-2012), many countries are currently on pace to significantly exceed their quotas (Friends of the Earth 2006).1 Not surprisingly, many IEAs include provisions for enforcement. The critical element of these enforcement mechanisms is that they must be negotiated and included as part of the agreement. In addition, as Hovi and Areklett (2004, pg 3) point out, “… enforcement must either be carried out by the parties themselves, or by some institution erected, accepted and empowered by the parties.” An example of the first approach is contained in the Montreal Protocol, which enforces compliance by threatening the use of trade sanctions on defecting parties (Benedick 1 Although it is universally accepted that some level of noncompliance with IEAs exists, there remains debate as to the magnitude and consequences of noncompliance. On one end of the debate, Chayes and Chayes (1991) argue that high levels of compliance are often observed in IEAs without formal enforcement mechanisms and therefore enforcement is not a real concern. On the other end, Downs et al. (1996) argue that high levels of compliance may result because the lack of enforcement motivates parties to form shallow agreements to begin with. 2 1998; Heister 1997). It is one of an estimated 19 IEAs that uses trade sanctions as a mechanism for motivating compliance (United States International Trade Commission 1991).2 An example of an “institution erected, accepted and empowered by the parties” to enforce compliance with an IEA has been implemented within the Kyoto Protocol under the Marrakesh Accords. An independent Compliance Committee, consisting of members elected by the parties, has been formed to oversee monitoring for compliance and applying sanctions in cases of noncompliance. If a party to the Kyoto Protocol is found in violation, the Compliance Committee has the power to impose a penalty in the form of a reduction in next period’s greenhouse gas emissions quota (UNFCC 2002). Although it is too early to evaluate the effectiveness of this type of enforcement mechanism, its structure is unique in the sense that parties have agreed to invest in an institution with the power to monitor and sanction noncompliance. Conceptually, IEAs have often been modeled with the equilibrium concept of a self- enforcing agreement. A self-enforcing agreement made between agents, as first proposed by D’Aspremont et al. (1983) and later coined by Barrett (1994) for use in his analysis of international environmental relations, is defined as a single coalition from which no member wishes to withdraw (the coalition is internally stable) and no nonmember wishes to join (the coalition is externally stable). 3 The term self-enforcing is a bit misleading, however, because it does not address the problem of enforcing compliance by parties to a cooperative agreement. In fact, most authors who use this equilibrium concept simply assume that parties to a self- enforcing agreement comply fully with the terms of the agreement (e.g. Barrett 1994, 2003; 2 Barrett (2003) estimates that a much larger number of IEAs make provisions for trade sanctions, however, many of those agreements use bans on traded items as part of the agreement’s goal, not its method of enforcement. 3 Models of self-enforcing IEAs have included provisions for trade sanctions (Barrett 1997a; 1997b), side payments (Carraro and Siniscalco 1993; Carraro and Botteon 1997 and Hoel and Schneider 1997), issue linkage (Folmer 1993; Carraro and Siniscalco 1997; Botteon and Carraro 1998) and minimum participation requirements (Barrett 1998a; 2003 and Carraro et al. 2003). For a review of many of these extensions see Wagner (2001). 3 Carraro and Siniscalco 1993, 1998; Hoel 1992). A few studies do include costly enforcement mechanisms within the framework of a repeated IEA (Barrett 1994, 2003; Finus and Rundshagen 1998). These models use reciprocal punishment strategies in which parties to an agreement may punish violators in future rounds by jointly reducing the level of the international public good. We take a different approach to the study of compliance and enforcement of IEAs that is motivated by the enforcement mechanism of the Kyoto Protocol under the Marrakesh Accords. We maintain the concept of a self-enforcing agreement to determine the equilibrium number of parties to an IEA. However, to counteract the incentive that parties have to violate the terms of an IEA, they finance and empower an independent enforcement agency with monitoring and sanctioning capabilities. Our efforts yield a number of new results. First, the range of international environmental problems within which a self-enforcing IEA can form is smaller when enforcing cooperation is necessary and costly. This follows because enforcement increases the cost of cooperation, which in turn limits the set of situations under which a treaty can actually increase international welfare. Second, when an IEA is expected to form, it will have more members when enforcement is costly, hence, costly enforcement of IEAs is associated with higher environmental quality. Greater participation in IEAs that are costly to enforce occurs because the additional cost of being a party to an IEA must be offset with an increase in the level of environmental quality, which is realized through an increase in the number of parties to the agreement. In addition, provided that the number of countries involved is sufficiently large, social welfare will be greater under an IEA that is costly to enforce. If the number of countries involved is large enough, the aggregate benefit from increased participation levels the parties’ costs of enforcing their agreement. Finally, we find that when monitoring for compliance is not perfectly accurate, the 4 principal results of our model are accentuated. That is, monitoring errors further reduce the set of situations in which multilateral cooperation is welfare enhancing and thus limit the opportunities for an IEA to form. However, when an agreement does form it will involve a higher level of participation. The paper proceeds as follows: Section 2 presents the basic model of a self-enforcing IEA without enforcement costs. In section 3 we introduce the endogenous enforcement mechanism, and in section 4 draw conclusions about the effects of costly enforcement on the equilibrium number of parties to an agreement and on aggregate welfare. In section 5 we extend the model to allow for errors in monitoring. In section 6 we provides some concluding remarks. 2. The basic model of a self-enforcing IEA In this section we present a standard model of a self-enforcing IEA in order to review the structure of these games and to provide a baseline for determining the effects of costly enforcement on the outcomes of these games in later sections. Following Barrett (2003), consider a situation where N identical countries each emit a uniformly mixed transboundary pollutant. Country i’s welfare is w = A+b(q +q )−cq , [1] i i −i i whereq is equal to one of i abates its emissions and is zero if it does not, q is the sum of the i −i abatement decision by all other countries, b is the constant marginal benefit of abatement, c is the cost of abatement, and A is a positive constant. Assume that the underlying structure of the countries’ interactions with each other is an N-player prisoners’ dilemma. That is, all countries have a dominant strategy to not abate in a noncooperative Nash equilibrium. This will be true 5 when b<c. However, the countries’ joint welfare will be maximized when they all abate their emissions. This requires Nb>c. Recognizing the benefits from jointly agreeing to abate their emissions, the countries have the incentive to form an international environmental agreement to do so. Because participation in an IEA is voluntary, countries can join or not join the agreement at will. In this section, however, parties to any IEA that forms will comply with the terms of the agreement, that is they will abate their emissions, without the need for an enforcement mechanism. Let s denote the number of parties to an IEA. Moreover, let wp(s)denote the common welfare of each of the parties to the IEA, and let wnp(s) denote the common welfare of each of the countries that are not party to the agreement. Throughout, the superscript p signals that the country in question is a party to an IEA, while the superscript np signals that the country is not a party to the agreement. From [1] we have: wp(s)= A+bs−c; wnp(s)= A+bs. [2] Let snc denote the equilibrium number of parties to an IEA. (The superscript nc identifies snc as the equilibrium number of parties when the terms of an IEA are not costly to enforce). The definition of a self-enforcing voluntary agreement in this setting is: Definition: An IEA consisting of snc countries that can enforce the IEA without cost is self- enforcing if and only if: (i) wp(snc)≥wnp(snc −1) (ii) wnp(snc)≥wp(snc +1).4 [3] 4 Although the concept of a self-enforcing agreement is most often adopted for analyses of international environmental agreements, it was first developed to study the stability of cartels by D’Apremont et al. (1983). See 6 Requirement (i) of a self-enforcing IEA is that no party has an incentive to leave the agreement; that is, the agreement is internally stable. Requirement (ii) is that no non-party wishes to join the IEA; that is, the agreement is externally stable. The equilibrium value of snc follows easily from these two conditions. Using the welfare functions [2] and the external stability condition (ii), wnp(s)−wp(s+1)=c−b≥0. Since we have assumed that b<c, the external stability condition is always satisfied. Determining the values of s that satisfy the internal stability condition (i) involves examining the consequences of two possible outcomes of a single country that leaves an IEA. The first is when this single defection does not cause all the other parties to the IEA to also defect. In this case, using [2] and the internal stability condition (i), wp(s)−wnp(s−1)=b−c≥0, which violates our assumption that b<c. This implies that if the number of parties to an IEA is such that it would remain intact if one party defected, then the IEA is not internally stable. Thus, the self-enforcing number of parties to an agreement must be such that one defection would make the agreement collapse. In this case, the internal stability condition (i) is written as wp(s)−wnp(0)=bs−c≥0. The self-enforcing number of parties to an agreement that is enforced without cost is the minimum size coalition that satisfies this inequality. Formally: snc =mins|wp(s)−wnp(0)≥0=mins|s≥c/b. [4] Our assumption that b<c implies that snc >1, while the assumption that Nb−c>0 implies that [4] will be satisfied for some snc ≤ N. Condition [4] indicates that participation with an IEA is increasing in the cost of abatement, c, and decreasing in the individual benefit of abatement, b. Diamontoudi (2005) for a recent contribution to this literature. Dawson and Segerson (2003) have used the concept of a self-enforcing agreement to model voluntary domestic environmental policies. 7 Thus, Barrett’s (1994, 2003) claim that international cooperation to protect the environment will be greatest when it is needed least is easily verified. It is clear that the concept of a self-enforcing agreement applies to the stability of a cooperating coalition, not to parties’ decisions to comply with the terms of the agreement once they’ve joined. However, Barrett (1998b, pg 36) claims: “The binding constraint on international cooperation is free-rider deterrence, not compliance enforcement. Once free-riding [nonparticipation] can be deterred, compliance can be enforced free of charge.” This is a very strong statement that follows if countries are able to observe each other’s compliance decisions perfectly and without cost. In this setting a country has no incentive to join an agreement and then not comply with its requirements. If it did so all the other participating nations would automatically observe this violation, would realize that they would then be worse off if they stayed with the agreement, and therefore would leave the agreement. Under perfect information a party to an IEA would not violate the terms of the agreement, because this violation would cause the agreement to collapse. Realistically, however, nations cannot observe each other’s abatement perfectly and without cost, nor can a country's abatement decision be inferred from an aggregate measure (e.g., the global concentration of a pollutant). In these cases, a country may be motivated to join an agreement and then decide to violate its terms. If the other participating countries are not able to observe this act of noncompliance, they will not automatically leave the agreement. The violator, then, is able to escape the cost of compliance while enjoying the benefit of cooperation of those that remain with the agreement. Asymmetric information among parties to an IEA about their compliance decisions motivates the implementation of some enforcement mechanism to counteract the incentive to violate the terms of the agreement. 8