Hot Air as an Implicit Side Payment Arrangement : Could a Hot Air Provision have Saved the Kyoto - Agreement ?

The purpose of this paper is to analyse whether the presence of Hot Air trading jeopardizes the environmental target of an international environmental agreement. We argue that Hot Air can be used as an implicit side-payment mechanism to actually bring about higher environmental protection compared to the situation without the trade option. We point to the existence of a fundamental trade-off between costs of compliance and the creation of dynamic incentives to develop cheaper reduction technologies. Implicit side-payments, in terms of Hot Air provision, may be needed in order to establish a compromise between these opposing demands. We identify the shortcomings and benefits of allowing fully flexible permit trading including the allocation rule of grandfathering. JEL Classification: Q28; H2; H4.