Rules vs. Targets: Climate Treaties under Uncertainty

We demonstrate the advantages of a climate treaty based solely on rules for international permit markets when there is uncertainty about abatement costs and environmental damages. Such a ‘Rules Treaty’ comprises a scaling factor and a refunding rule. Each signatory can freely choose the number of permits it allocates to domestic firms. For every permit so issued, an international agency is allowed to issue additional permits in accordance with the scaling factor. The agency auctions all additional permits and refunds all the revenues to the signatories according to the refunding rule. Our main finding is that for a sufficiently large scaling factor, the Rules Treaty approximates the globally optimal outcome in every state of the world. In this sense, newly arriving information is optimally processed. This is in stark contrast to treaties based on emission targets, even if countries fully comply with such targets. If countries are sufficiently homogeneous there exists, moreover, a refunding rule under which every country that abates more under the treaty than in the status quo ante can be compensated, so that all countries will participate voluntarily. If, however, countries are rather heterogeneous, some may decline to participate.