Geopolitics: Commitments through Financial Options: A Way to Facilitate Compliance with Climate Change Obligations

Karsten Neuhoff, University of Cambridge

This paper has shown that states can overcome both the internal and the external commitment problem and thus credibly promise to foreign governments and to investors in low-carbon technologies to maintain the carbon price at or above a certain level. If states take measures that reduce the carbon price, e.g. through issue of more allowances, they are “punished” by the financial markets: the holders of the options exercise their options and receive a payment amounting to the shortfall of the carbon price under the commitment level. They are protected by the domestic property guarantee and by an international arbitration clause which allows them to obtain title against a state seeking to default on its obligations. Once in place, the mechanism thus largely prevents non-compliance. The approach can be “fine-tuned”, in the sense that states can, through the number and duration of options issued and the determination of the strike price, select a desired level of commitment from a continuum of choices. More research seems warranted on the exact structure of the options scheme, as well as on possibilities for the actors to abuse the scheme.

The mechanism has the advantage of compatibility with the Kyoto process, while also addressing concerns regarding free-riding and ability to commit, as well as ease of monitoring and predicting compliance. It is also simple and dynamically flexible. In short: the proposed mechanism gives decision-makers the choice as to how much of a commitment they wish to make.

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