Establishing and Operating the Clean Development Mechanism Michael Toman

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Establishing and Operating the Clean
Development Mechanism
Michael Toman
September 2000 • Climate Issues Brief No. 22
Resources for the Future
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Contents
Introduction ............................................................................................................................. 1
Purpose and Organization of the CDM................................................................................. 2
CDM Design Issues.................................................................................................................. 4
Basic Structure of the CDM ................................................................................................ 4
Evaluating Projects and CERs............................................................................................. 6
CDM Project Implementation and Crediting ...................................................................... 8
Providing Development Benefits............................................................................................ 9
CDM and Broader Climate Agreements............................................................................. 13
Concluding Remarks............................................................................................................. 16
Further Readings................................................................................................................... 16
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Establishing and Operating the Clean Development Mechanism
Michael Toman, Resources for the Future*
Introduction
The negotiation of the December 1997 Kyoto Protocol to the UN Framework Convention
on Climate Change (FCCC) represented a significant development in international environmental
policy. Not only had a large group of industrialized “Annex I” countries agreed in principle to
quantitative limits on their net greenhouse gas (GHG) emissions; all the participants agreed in
principle to the development and implementation of novel “flexibility mechanisms” for
international compliance with the numerical targets. In addition to mechanisms for emissions
trading among Annex I industrialized countries, a “Clean Development Mechanism” (CDM) also
was created in Article 12 of the Protocol. (For a broad overview of the Kyoto flexibility
mechanisms, see the paper by Wiener in Further Readings.) The CDM would allow for the
creation within non-Annex I developing countries of units of certified emissions (CERs) that
could be traded and used within Annex I to comply with Kyoto emissions limits.
Operationalizing the CDM requires carrying out a number of distinct steps. They
include: (i) project identification; (ii) assessment of a project’s net GHG emissions reduction;
(iii) assessment of a project’s economic and social effects; (iv) project financing; (v) creation and
certification of CERs through project implementation, with monitoring and independent
verification of project performance; and (vi) distribution of development benefits as well as
CERs from the project.
Decisions made with regard to each of these elements will influence the CDM’s capacity
to fulfill the multiple aims of Article 12, and thus to satisfy the concerns of both Annex I and
non-Annex I countries. Fundamentally, these choices will determine the extent to which the
CDM is oriented more toward (a) a market-based mechanism, in which nongovernmental actors
take the lead in CER creation, subject to certain basic and general rules to ensure that the CDM
is cost-effective, environmentally responsible, and fair; or (b) a multilateral governmental
*
Much of the material in this paper draws upon joint work with Marina Cazorla and a workshop summary prepared
with Jean-Charles Hourcade of CIRED. However, I am solely responsible for the points made here.
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institution with substantial regulatory involvement in the operational details of project and credit
creation. In my view, option (a) is strongly preferable for meeting the needs of both Annex I and
non-Annex I countries, as I attempt to explain below.
The next section of the paper introduces the CDM’s purposes, mandate, and institutional
structure as authorized in the Kyoto Protocol. The third section focuses on some of the principal
technical and administrative issues that will arise as the CDM is designed and implemented. In
the fourth section, I address some of the main issues that arise in considering how the CDM can
contribute to the development goals of non-Annex I countries. The last section briefly considers
the relationship of the CDM to broader questions about international climate agreements.
Purpose and Organization of the CDM
Like “joint implementation” investments in GHG control among Annex I countries, the
CDM is a project-based mechanism. Under the CDM, emission reductions can be generated in
non-Annex I countries and then transferred to Annex I countries for use in meeting the latter
countries’ Kyoto targets. CERs can be generated through joint ventures between entities in the
host developing country and partners from developed countries; through activities undertaken
within developing countries that lead to credits which can be sold on an open market; or through
the intermediation of multilateral institutions like the World Bank. And unlike the Annex I
mechanisms, the Protocol states that CDM activities and credits can be initiated as early as 2000
(versus 2008), though there is controversy about what “early” projects (those coming online prior
to formal implementation of the CDM) would be allowed to generate credits.
Article 12, paragraph 2 identifies three purposes of the CDM, which are given equal
weight in the Protocol text. These are (in order of appearance):
•
To assist non-Annex I countries in achieving sustainable development.
•
To assist non-Annex I countries in contributing to the ultimate objectives of the FCCC as
described in Article 2 (to stabilize GHG concentrations in the atmosphere at a level that
would prevent dangerous anthropogenic interference with the climate system within a timeframe sufficient to allow ecosystems to adapt naturally to climate change, to ensure that food
production is not threatened, and to enable economic development to proceed in a sustainable
manner).
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to assist Annex I countries in achieving compliance with their quantified emissions limitation
and reduction commitments under Article 3 of the Protocol.
In practice, the third objective emphasizes the provision of cost-effective emission control
opportunities.
Meeting the aims of Article 12 explicitly requires “environmental additionality” (see
paragraph 5 of the Article). This refers to generating GHG reductions additional to any that
would occur in the absence of the project and would provide real, measurable, and long-term
benefits related to the mitigation of climate change. There is, however, enormous controversy in
practice about what constitutes environmental additionality.
Notions of financial and development additionality are implicit in the aims of Article 12.
Broadly, this refers to limiting global emissions without unacceptably restricting the
development options of developing countries. Specifically, many countries take financial
additionality to imply that financial resources provided by the investor country should be
additional to official development aid (ODA) and funding through the Global Environment
Facility (GEF). In addition, the argument goes, for the investment to be additional it should not
have occurred anyway under business-as-usual conditions, in the absence of an international
GHG control regime. Yet another set of proposed constraints would involve minimum
conditions on the performance of technologies transferred to developing countries as a
consequence of CDM projects. As with environmental additionality, enormous controversy
surrounds the practical determination of financial and development additionality.
Article 12 establishes three bodies to oversee the CDM: the representatives of the
Conference of Parties (COP), an executive board established by the COP, and independent
auditors to verify project activities. However, the Protocol provides almost no guidance on what
exactly the CDM would do or how it would operate. Instead, the structure and authority of
supervisory bodies and the CDM are left for future negotiation.
The principles governing this institutional development themselves are subject to debate.
Nevertheless, I suspect that the following general points would garner support in many quarters:
The institutions developed should be effective at promoting shared opportunity. As in
any trade dispute, it is always possible to imagine some constraint that generates a short-term
advantage for one set of parties (nations or sectors) over others. The challenge is to ensure that
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the mechanisms do not degenerate into profit-seeking without gaining real material advantages in
facilitating environmental protection and sustainable development.
The institutions should be credible, in particular with respect to environmental
performance. If environmental goals are subverted by a poorly designed or operated flexibility
mechanism, neither economic nor environmental interests will be served. Attending to this
concern raises technical and legal issues as well as economic issues.
The institutions should be internally efficient and adaptable. This puts a high premium
on linking the CDM (and the other Kyoto mechanisms) as closely as possible to existing markets
and other institutions, while recognizing the legitimate role of governments in ensuring the
credibility of the mechanisms and in evaluating where their own sovereign interests lie with
respect to participation. This last point links in turn to the first item: countries should be free to
decide the degree to which they wish to participate in the Kyoto mechanisms, but the structure of
the mechanisms should not unduly cater to special interests.
CDM Design Issues
Implementing the CDM requires a basic structure that identifies the responsibilities for
operating the mechanism and rules for defining, measuring, and certifying emission reductions.
Also required is the establishment of both general compliance mechanisms within the Kyoto
Protocol that would induce Annex I countries to demand CERs in order to meet emission
reduction targets and sanctions for the misrepresentation or misuse of CERs. In addition, to
make the mechanism acceptable to developing countries, issues related to the distribution of
benefits and their authority over the mechanism need to be clear.
Basic Structure of the CDM
The CDM is a novel international legal and institutional structure that will involve both
governmental and nongovernmental actors. A number of specific questions remain regarding the
basic legal and institutional structure of the mechanism. These relate to the functioning of the
CDM Executive Board and its relation to both member countries and the “operational entities”
carrying out the daily mission of the CDM; the way in which developing countries can expand or
restrict their participation in the mechanism (from initiating projects to blocking access to certain
potential investments); the criteria for project eligibility and certification; and the role of the
CDM itself in collecting and disbursing funds.
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How these issues are resolved will substantially influence the performance of the CDM in
meeting its various goals. One approach would involve substantial ongoing involvement by
governments and operational entities in the functioning of the CDM. In this approach, the
entities would be charged not just with auditing project performance and calculating CERs (see
below), but also with project organization and financing. Governments would retain substantial
involvement and discretion in reviewing the findings of operational entities as well as exercising
their sovereign self-interest with respect to the hosting of CDM projects. In addition, certain
types of projects or technologies would be favored or rejected as a matter of principle, quite
separate from the details of the project’s ability to generate development benefits and CERs. For
example, certain renewable energy or energy efficiency technologies could be favored, and
performance standards for transferred technologies could be mandated in advance.
However, the CDM will operate in the context of broader market forces that affect energy
use and investment. Constraints on project eligibility and laborious project assessment and
approval procedures built into the legal structure of the CDM will limit the flexibility of entities
trying to form transactions, reducing the number and increasing the financial costs of CDM
investments. This will have the additional implication of reducing the amount of developing
country benefits from the CDM, and possibly aggravating concerns about the distribution of
these benefits as investments flow more disproportionately to those countries with large numbers
of “prime” targets for investment. These drawbacks need to be traded off carefully against
whatever perceived environmental or other benefits may flow from more constraints on the
operation of the CDM.
An alternative, and in my view superior, perspective for the structure of the CDM starts
from the premise that the private sector in investor and host countries needs to take a proactive
role for the mechanism to be most effective in meeting the needs of developed and developing
countries. In particular, private market institutions can bring an irreplaceable expertise in project
evaluation and financial and risk management services. The need for effective market
institutions is especially high if, as one would hope from the perspective of encouraging both
cost-effective emissions limitation and sustainable development benefits, the scale of CDM
activity grows to be substantial. A vibrant and competitive market for CERs encourages
efficient pricing of these credits, so that suppliers of lower-cost opportunities can enjoy a surplus
return over that gained from more marginal investments. Thus a well-functioning market can
protect developing countries from “predatory” underpricing of CERs in transactions with Annex
I entities, just as it protects buyers from the possibility of seller market power.
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Some rules are needed to ensure the integrity of the mechanism. But integrity can be
promoted if (a) the CDM executive board promulgates clear and logical criteria for project
evaluation to promote the consistency of projects with the aims of the CDM; and (b) public
authorities of host countries carry out their responsibilities to mitigate undesired side effects and
to facilitate projects with the most favorable development outcomes. In this model, operational
entities serve as needed auditors in the enforcement of project performance standards but do not
have to be involved in market transactions. Participation by multilateral organizations in CDM
project development and financing to assist the least developed countries can be pursued, but it
does not become the norm for CDM transactions. Choices of investment types, terms, and
conditions are determined largely by negotiation and competition, not by one-size-fits-all rules.
It is also important when establishing the CDM’s legal structure to prohibit rules for national
participation and project eligibility from becoming tools for obstructing legitimate transactions
as a form of rent-seeking or limiting the entry of new sellers.
Evaluating Projects and CERs
A key issue in balancing environmental additionality and cost-effectiveness is
establishing how many emission credits are generated by a particular CDM activity, and over
what time frame the credits are being created. Establishing these characteristics of the flow of
CERs requires a counterfactual baseline, as well as an estimate of the emissions change relative
to that baseline (discussed below). Since a counterfactual baseline is inherently subjective, and
since participants will have incentives to convince less well-informed monitoring bodies that
emission reductions are larger than in actuality, this element of project-based credits is
controversial.
Gauging the number of CERs from a project requires a counterfactual assessment of what
net emissions would have been in the absence of the project – for example, what technology and
fuel for electricity generation might otherwise have been used. Broadly speaking, this
assessment can be done project-by-project or through the use of more or less standardized
baselines that may vary across sectors, technologies, countries, and geographical regions. An
important distinction to maintain in evaluating ways to address these options is the interplay
between uncertainty and dynamic change. There is inherent uncertainty at the time a project is
being designed about what the “right” baseline might be. In addition, views about the
appropriate baseline may change over time as technological and market circumstances evolve.
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Much of the policy discussion concerning baselines has focused on the tradeoffs between
using relatively generic benchmarks for gauging reduced emissions versus project-specific
assessment. Using generic average benchmarks runs the risk of crediting some “paper tons” in
the absence of a project-specific assessment. Critics also argue that experience to date with
voluntary pilot projects has revealed many instances of excessive optimism in assessing
emissions reductions because the project baselines did not build in trends toward lower
emissions under business-as-usual conditions. But reported experiences also demonstrate that
project-specific assessment does not necessarily rule out risks of fictitious abatement. A
benchmark approach may make dubious claims about incremental abatement more easy to
identify and control statistically, while also providing a crucial benefit in keeping “transactions
costs” (all the overhead costs of setting up and implementing projects) affordable. That is
important not just for Annex I countries but also for developing countries seeking to expand
project opportunities—especially small projects in smaller economies that cannot afford high
overhead costs.
Expectations of trend improvement over time in energy efficiency (if any) once a project
is in place could be built into specifications of baselines and benchmarks for project performance
in an effort to limit over-crediting of projects. These specifications should reflect realistic
prospects before the fact for ongoing improvements with in-place investments. It would not be
appropriate simply to use ongoing improvement in energy efficiency of new investment to
penalize the GHG savings of previous investment (except insofar as this improvement might
reduce the utilization of older plants over time or shorten their economic lifetimes); the previous
investment still displaces even less energy-efficient investment that otherwise would have been
made before. On the other hand, in assessing environmental additionality it is necessary to
consider whether a more energy-efficient investment is simply being accelerated. The
assumption of no technical advance in a developing country’s energy system could overstate
CDM credits, since a new energy-efficient plant might have been built anyway in a few years.
Baselines also could be defined over shorter periods than the life of projects and
subsequently revised (upward or downward) in some transparent way based on new or more
accurate information about efficiency improvements for in-place investment. Investors would
recognize these uncertainties up front in their decisions and build them into their project
planning. Changes over time in judgments about appropriate baselines can be incorporated in
revision of baselines for new projects. Retroactive revisions in past baselines and CERs for
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existing projects should be avoided; they create unproductive investment uncertainty beyond the
control of project investors that hampers project finance and implementation.
Whether baselines are set project-by-project or through more generic benchmarks, they
need to be realistic given the circumstances of the investment. There is an assumption that no
technical advance in a developing country’s energy system could overstate CDM credits (a new
energy-efficient plant might have been built anyway in a few years). Indeed, the use of an
“internationally best available” standard for evaluating efficiency improvements will understate
CERs if the prevailing norm is less advanced technology. Such standards not only are too
stringent in terms of assessing environmental additionality; they also can hinder, rather than
advance, the spread of advanced technology to developing countries. Faced with higher costs
and fewer CERs as a result of such technology standards, investors will reduce and redirect their
investment.
CDM Project Implementation and Crediting
In addition to establishing a baseline, calculating CERs requires an assessment of what
reductions the project generates relative to the baseline. Here there is concern about the
difference between after-the-fact and before-the-fact project performance because of a variety of
considerations. These include unpredicted deviations in technical performance, and issues
related to project implementation—for example, the power plant achieves the promised energy
efficiency but only operates half as much as expected.
As is the case when defining baselines, there is an overarching tension between the need
for greater environmental quality and a desired distribution of benefits on the one hand, and for
market transactions to occur in a flexible, adaptable milieu without onerous transactions costs on
the other. Even if there is no uncertainty about the net emissions reduction of a project if it is
completed, the fact that both host and investor entities possess more information about project
performance than their governments (or the CDM authority and its operational entities) creates
potentially significant incentives and opportunities for misrepresenting the amount of emissions
reductions generated by CDM projects.
Many observers have argued that in the interest of environmental integrity, only credits
that have resulted from direct observance of project performance after the fact should count
toward compliance with Annex I emission targets. Annex I governments might even require
their own legal entities to use only such “prime quality” credits for compliance in order to ensure
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that the Annex I governments would not be embarrassed by unanticipated national
noncompliance due to disallowed CERs. Speculative forward sales of pre-certified credits could
be allowed, but the buyer would need to be aware of the risk of nonperformance after the fact.
A certain amount of after–the-fact certification based on direct monitoring and
verification by independent bodies under the control of the executive board of the CDM would
be necessary to ensure the integrity of the CDM. However, requiring direct monitoring and
verification of all reductions before certification would imply larger monitoring costs and delay
in project returns. This in turn would discourage project development—especially for small
projects—and limit the evolution of some projects that would be cost-effective and beneficial to
the host country in certain regions and domains.
An alternative is to rely on a degree of self-certification for compliance coupled with spot
monitoring and the threat of significant sanctions if project performance is less than claimed. If
the monitoring system is active enough and the sanctions for nonperformance are substantial
enough, this approach has the potential to provide adequate performance. In particular, buyers
can be held liable for nonperformance of purchased credits so that they have an incentive to
police the conduct of sellers and buy insurance in the form of extra credits (see the paper by Kerr
for further discussion of liability issues surrounding the Kyoto mechanisms). It would also be
possible to build in incentives for improved monitoring and reporting by allowing relatively
more before-the-fact certification for projects supported by higher-quality monitoring and
reporting capacity.
CDM projects could involve either direct reductions in GHG emissions (in particular
through energy-related projects) or projects to enhance carbon sequestration (like reforestation
initiatives). Carbon sequestration projects give rise to several special considerations, including
those related to measuring carbon storage from the project. These considerations are beyond the
scope of this paper and are addressed in the paper by Sedjo, Sohngen, and Jagger.
Providing Development Benefits
Many experts from developing countries have expressed the concern that CDM projects
may not meet (or even could contradict) their development priorities. A related but distinct
concern is that some developing countries could be left at a serious disadvantage given their own
limited capacities to generate and negotiate projects that would meet eligibility requirements and
attract investment.
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The Kyoto Protocol provides that the decision to participate in the CDM rests with
governments; hence host country public authorities will have the authority to decide if particular
CDM projects are consistent with their development and environmental priorities. Attention
should be placed on ensuring that the institutions of the CDM provide the best possible
opportunities for developing countries facing differing economic and environmental
circumstances. Because this capacity may be undermined in some host countries by financial
pressures and risks of corruption, some observers have suggested that a set of internationally
implemented indicators might be utilized to gauge the benefits to host countries and ensure that
the interests of these countries are protected. An even stronger position would give the CDM
authority the power to judge whether projects provided sustainable development benefits.
However, the set of potential indicators is vast, addressing a variety of economic and social
issues, and the assessment of any CDM project depends very much on the specific circumstances
of the project. Moreover, imposing mutually acceptable international standards that would
restrict the sovereign discretion of countries would be very difficult.
There is a continuing concern that the CDM will simply result in a reallocation of official
overseas development assistance (ODA). However, some degree of crowding out probably is
inevitable, given the continued downward trends in ODA across the world. It may be more
relevant to focus on how the CDM can provide tangible sustainable development benefits that
might otherwise not be reaped at all. There may also be synergies between CDM and ODA that
need to be better developed. For example, spending ODA in part to help develop capacity for
CDM in developing countries might be useful—even though nominally it is a form of crowding
out—because this may have positive impacts in terms of general capacity building for
development policies.
Concern over the development benefits of CDM also is part of a larger and longerstanding debate over the nature of benefits from private foreign direct investment (FDI). There
is concern that developing countries will not effectively capture a share of benefits from FDI in
CDM projects, or that the projects selected will not necessarily advance the development
interests of the host country. Such concerns about sustainable development vis-à-vis a market
mechanism can be addressed in several ways.
Non-Annex I countries can generate CERs on their own or through some kind of
international financial pooling (a sort of mutual fund, like the World Bank’s Prototype Carbon
Fund) and sell them in the international GHG credit market, rather than just participating in
individual joint ventures. These approaches could allow developing countries to compete
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effectively as CER suppliers, rather than be subject to the exercise of market power by a single
partner/credit buyer. In fact, different kinds of transactional arrangements (for example, service
contracts with technologically advanced partners) can be structured to meet the interests of
project proponents. It is also important that developing countries be allowed to bank CERs they
create, so that they can compete over time for the best contract terms rather than being in a “sell
or lose” position with undeveloped credits.
Proposals have been made for the CDM to include rules for the sharing of CERs between
the international investor and the host country, both at a moment in time and over time. In
particular, CERs could revert to the host country after a fixed period of time or if and when the
host country assumes its own national GHG control obligations. However, there are inherent
tradeoffs between project returns in cash and CERs, and insistence on a greater share of CERs
will reduce the financial benefits an international investor is prepared to offer. Moreover, fixed
rules for sharing credits over time or at a moment in time will only by accident replicate the
circumstances that best suit the interests of the transacting entities and the overall costeffectiveness of the mechanism. These terms should be left to the entities involved to negotiate.1
Another possibility is using the CDM to provide leverage in encouraging public
infrastructure policies or domestic policy reforms that would trigger GHG-reducing investments
even if the policies or reforms reflect primarily policy aims other than climate objectives.
Examples include public sector energy-efficiency improvements or investments in transportation
and financial inducements to reduce energy subsidies. Making more attractive those carbonabating investments that are in synergy with development targets would broaden the potential for
CDM projects, whose attractiveness would in turn be reinforced by the revenue from CERs.
Including these options would require further work on how to assess their environmental
additionality. This involves not just the technical assessment of potential changes in emissions,
but also the politically controversial determination of whether to view such changes as already
occurring in a business-as-usual situation. One does not want to create incentives for developing
country decisionmakers to retard beneficial reforms in the search for financial benefits from the
CDM. But the limited real-world success of policies to promote better energy pricing and more
1
I am grateful to Urvashi Narain and Klaas van ‘t Veld for sharing with me the results of their ongoing work on
these issues.
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efficient public infrastructure in some countries would support a more generous view about
allowing CDM credits for such shifts where improved practice otherwise seems unlikely.
The CDM cannot be asked to rectify all the problems of either international equity or
capacity shortfalls. Broadening opportunities for host countries themselves to take a more active
role in project identification and implementation would also respond in part to the concerns
about the potential for an uneven geographical distribution of benefits. Smaller economies
would be more able to attract investments consistent with their development priorities by
lowering the search and transaction costs for foreign (and domestic) investors.
Attempting to more directly mitigate distributional concerns through project eligibility
criteria will reduce total investment and development benefits, even if it does transfer some
benefits to the countries with the least CDM potential. A similar concern arises with a plan to (in
effect) tax CDM transactions to raise money for a fund to redistribute project investments, as
well as to cover CDM administration costs. This may lead to some perverse outcomes
distributionally, in that Annex I investors will seek to protect their project returns by shifting part
of the tax to their host country partners. Consequently, the financing of the redistribution fund
will in effect involve a shift of resources from some developing countries to others. Moreover,
the greater the CDM tax is, the greater the advantage of Annex I emissions trading or joint
implementation over the CDM. Some of this tax shifting could be ameliorated if other Kyoto
flexibility mechanisms for Annex I also are taxed, but it is not clear whether and how such an
extension of project excise taxes could be justified.
Other revenue-raising options need to be explored in order to address these concerns.
One possibility would be a set of national-level contributions to a CDM fund by Annex I
countries that do not inherently affect the returns to specific projects. Such contributions could
be thought of as payments for the option to participate in CDM, and they could be scaled in a
variety of ways.
While this approach would be more economically efficient than taxing specific projects,
it also would be politically challenging. And the thorny questions of who controls the fund and
how it is used would still have to be addressed. What particular sustainable development criteria
would be used to govern the allocation of the fund? Would it be used to support additional CDM
projects, presumably those that did not pass the test of the CDM market, or distributed in some
other way such as grants? How could the allocations be made in a way that did not invite
excessive bureaucratic inefficiency, rent-seeking, and corruption? In the end, the least developed
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countries may benefit as much or more from more institutional kinds of support—the availability
of technical assistance in project development and implementation and the creation of general
project eligibility criteria that increase their opportunities for participation in a market-oriented
CDM.
CDM and Broader Climate Agreements
Experience suggests that any project-based mechanism will have higher transactions
costs than a system of trading in homogeneously defined emissions permits, as in the sulfur
dioxide trading program used in the U.S. power sector. The use of project-based credits also
raises questions about what is actually happening to aggregate emissions and “carbon leakage,”
as already noted. Moreover, project-based crediting only can address discrete emissions
reductions beyond some minimum size. A project-based approach cannot so easily capture a
variety of options for emissions savings that are more dispersed but still important in the
aggregate, such as industrial process changes and increases in household energy efficiency.
An alternative to project-based crediting is the voluntary assumption of national
emissions caps by non-Annex I countries. These countries then could engage in emissions
trading like Annex I countries. The Kyoto Protocol provides for such actions by non-Annex I
countries, though the conditions under which accession could take place have not been fully
spelled out.
Assuming a reasonably accurate national inventory of GHG (or at least CO2) emissions—
a reasonably big “if” for some developing countries— a voluntary but binding national baseline
could help increase the accuracy of carbon accounting, diminish concerns about the
environmental additionality of any particular GHG reduction activity, increase opportunities for
GHG savings, and lower transactions costs by making the commodity exchanged (emission
permits) more homogeneous. For this approach to succeed, however, the non-Annex I country
must perceive more benefit than cost from the assumption of a national baseline. The baseline
must not constrain economic growth and associated increases in energy use by more than the
value of increased revenues from expanded emissions trade under the more efficient emissions
trading system – assuming some constraints on CDM projects in the absence of the baseline out
of concern for environmental additionality. One possibility to this end is a “growth baseline”
that seeks to limit the carbon intensity of economic activity without limiting the total volume of
carbon emissions (see the paper by the Center for Clean Air Policy in Further Readings).
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Just as implementing the CDM itself requires some kind of project-level or sectoral
agreements on what are normal and above-normal practices in matters such as the energy
efficiency, implementing a voluntary national baseline would require agreement on a grander
scale about what is an appropriate business-as-usual standard for the GHG emissions of the
developing country. There is a fear in some developing countries that a commitment to the
CDM—and even more so the further commitment to a voluntary set of aggregate emissions
baselines—could prejudice their position in future negotiations. Ultimately, as argued in the
paper by Wiener (see Further Readings), successful international climate policy to limit GHG
would require global participation. The distribution of burdens in a longer-term global
agreement remains very contentious, with developing countries understandably arguing that their
long-term development opportunities should not be constrained by the developed world’s
historic levels of GHG emissions. Developing countries need concrete reassurances that their
options in future negotiations are not foreclosed by the project, sectoral, or national baselines
established under the CDM.
There also is concern that developing countries could end up supplying too many “low
hanging fruit” projects early in the CDM. These are projects with low GHG abatement cost
which developing countries might prefer to retain for later when they are negotiating
requirements for GHG reduction. However, such disadvantages are not pre-ordained. A wellfunctioning competitive market for CERs, in which suppliers of credits can bank CERs for future
sale, can engender an efficient spread of CDM investment over time. (To this end, the
negotiation of terms for a second commitment period beyond the Kyoto Protocol would provide
greater clarity for the development of future price expectations for CERs.)
Host countries also can exercise their sovereign authority to limit the approval or restrict
the term of projects they believe should be retained for future domestic use. However, there are
costs to such constraints that need to be considered. Economic and environmental returns on
CER-generating investments can be lost if the investments are delayed. This is illustrated by a
delay in upgrading existing industrial or power plant facilities whose energy efficiency and
pollution performance are poor; a delay implies continued pollution and higher energy
expenditures, and the same investment made in the future may not satisfy future additionality
tests if improved technology has become the norm. Moreover, the supply of such projects is not
necessarily exhausted by early investments, so long as there remains a continuing differential in
the state of technology between North and South. Further work is needed to reassure developing
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countries that with appropriate structuring of the CDM, tangible and environmentally responsible
development benefits are possible.
Developing countries also have an interest in the evolving debate over the operation of
the Annex I flexibility mechanisms. This interest encompasses both short-term economic
impacts and longer-term institutional structure. Large volumes of Annex I trading may reduce
the demand for CDM projects. Therefore, developing countries have an interest in pushing to
ensure that the mechanisms are credible (not just loopholes).
On the other hand, actions that weaken the efficiency of the mechanisms themselves, like
“supplementarity” constraints, are not likely to serve the interests of developing countries as
suppliers of emission credits. The Kyoto Protocol refers to the use of international emissions
trading (and by extension the CDM) as being “supplemental” to domestic actions. Support for
specific “supplementarity constraints” on the use of international flexibility mechanisms reflect a
concern by some countries that “excessive” importation of emissions permits or credits by other
countries will limit the scope and stringency of domestic policies, thus retarding the long-term
development of technology and improved energy efficiency needed to achieve and go beyond
Kyoto goals.
However, limits on CDM and international trading will reduce demand for CERs, thus
directly reducing the inflows of financial resources and technology that could help increase
environmentally sound economic development in developing countries. It is not even clear how
the CDM and other flexibility mechanisms would effectively operate under supplementarity
constraints, since transactions would be contingent on whether the constraints were binding.
And a limit on use of the CDM and other flexibility mechanisms is a blunt instrument to improve
the credibility of a credit-buying nation’s commitment to GHG limitation. By increasing the
overall cost of compliance with GHG control targets, the restriction would add to a lack of
willingness to achieve target reductions.
Finally, attacks on “hot air” also need to be carefully considered. This is the pejorative
term that has been applied to the likely surplus of emission allowances in Russia under the Kyoto
Protocol. Clearly the sale of such a surplus to other Annex I countries implies less aggregate
emissions control than if such a surplus did not exist, as well as less demand for CDM credits.
However, the same mechanism – otherwise known as “providing headroom for growth” – could
figure prominently in longer-term negotiations to increase developing country participation in
emissions targets. Future climate negotiations doubtless would benefit from more explicit
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consideration of economic, environmental, and distributional tradeoffs, but the allocation of
tradable surpluses to some countries should not be precluded.
Concluding Remarks
The CDM is an inherently imperfect mechanism. Even the most ardent proponents of the
CDM concede that it will have higher transactions costs, greater monitoring difficulties, and
lower overall efficiency than other options like a full-blown permit trading system. But it is a
good place to start. CDM projects can provide
•
acceptably tangible GHG reductions
•
concrete information on GHG control opportunities and costs in developing countries
•
cost-saving benefits in developed countries
•
economic and local environmental benefits in developing countries.
Specific institutional measures, like a liability system that holds international investors at
least partly responsible for project shortfalls, can improve credibility. The “leakage” problem
with a project-based approach is vexing, but it can be addressed by defining rules of thumb for
different project categories that attempt to adjust for leakage, which can be updated over time. It
can also be addressed by encouraging the voluntary adoption of credible growth baselines in
developing countries. To protect the longer-term bargaining positions of developing countries, it
must be absolutely clear that such interim baselines are for defined periods, with no prejudice as
to future divisions of GHG responsibilities.
Further Readings
Center for Clean Air Policy (CCAP). 1998. Growth Baselines: Reducing Emissions and
Increasing Investment in Developing Countries. Washington, DC: CCAP.
Grubb, Michael, with Christiaan Vrolijk and Duncan Brack. 1999. The Kyoto Protocol: A Guide
and Assessment. London: Earthscan and Royal Institute of International Affairs).
Hagem, Cathrine. 1996. Joint Implementation Under Asymmetric Information and Strategic
Behavior. Environmental and Resource Economics 8(4):431-447.
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Hahn, Robert W., and Robert N. Stavins. 1999. What Has Kyoto Wrought: The Real
Architecture of International Tradeable Markets. Discussion Paper 99-30. Washington
DC: Resources for the Future, March.
Haites, Erik, and Farhana Yamin. 2000. The Clean Development Mechanism: Proposals for Its
Operation and Governance. Global Environmental Change 10(1):27-45.
Jacoby, Henry, Ronald Prinn, and Richard Schmalensee. 1998. Kyoto’s Unfinished Business.
Foreign Affairs 77(4, July/August):54-66.
Joshua, Frank, et al. 1998. Greenhouse Gas Emissions Trading: Defining the Principles,
Modalities, Rules and Guidelines for Verification, Reporting & Accountability. United
Nations Commission on Trade and Development. August 1998. (Paper available at
www.weathervane.rff.org/negtable/unctad.html.)
Kerr, Suzi. 1998. Enforcing Compliance: The Allocation of Liability in International GHG
Emissions Trading and the Clean Development Mechanism. Climate Issues Brief #15.
Washington, DC: Resources for the Future, October. (Paper available at
www.weathervane.rff.org/archives/climate_briefs.html).
Sedjo, Roger, Brent Sohngen, and Pamela Jagger. 1998. Carbon Sinks in the Post-Kyoto World.
Climate Issues Brief #12. Washington, DC: Resources for the Future, October. (Paper
available at www.weathervane.rff.org/archives/climate_briefs.html).
Tata Energy Research Institute (TERI). 1999. The CDM Maze: The Way Out. New Delhi: Tata
Energy Research Institute. (Paper available at www.teriin.org.)
Wiener, Jonathan B. 1999. Global Environmental Regulation: Instrument Choice in Legal
Context. Yale Law Journal 108(4):677-800.
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