Climate Change, Strict Pareto Improvements in Welfare and Multilateral Financial Transfers

Recent climate change negotiations have emphasised the need for developing countries to take the lead by undertaking economy-wide absolute emission reduction targets but also the obligation of developed countries to provide financial resources to assist them in their mitigation efforts. This paper explores the role of such financial resources in achieving strict welfare gains (Pareto improvements) when emission targets deviate from the global welfare optimum, and there are impediments to international trade. Using a general equilibrium model of international trade with global emission externalities, it is shown that strict Pareto improvements in welfare may arise from multilateral financial transfers when either trade or carbon taxes are constrained away from their Pareto optimal levels. The purpose of financial transfers is then to account for the impact on emissions of trade distortions and inappropriate carbon pricing. Importantly, such transfers exist if and only if a generalized normality condition is violated. Numerical examples illustrate the financial transfer mechanism