The political economy of negotiating international carbon markets

International carbon markets are a cost efficient instrument for achieving a given CO2 emissions target. This paper identifies the conditions under which participating governments benefit from the establishment of such a market through Coasean cooperation, in the presence of strategic considerations in the negotiations. While negotiations internalize cross-border spillovers, governments have incentives to send delegates who value environmental damages less than they do themselves. We find – for benefit and damage functions typically assumed in the literature on international environmental agreements – that even though total emissions are lower than in a non-cooperative regime, high cost savings from trading permits are not sufficient for all participating governments to benefit from an international market. An international market constitutes a Pareto improvement in particular if i) marginal damages substantially differ across countries, ii) marginal damages and marginal abatement costs are sufficiently similar across countries. Bilateral carbon markets among the large emitters China, the EU and the US would not be Pareto improving. What is more, bilateral agreements with non-tradable emissions caps may be better suited to establish mutually beneficial cooperation in such cases. We conclude our analysis with a robustness check for different functional forms.