Establishing and Operating the Clean Development Mechanism Michael Toman September 2000 • Climate Issues Brief No. 22 Resources for the Future 1616 P Street, NW Washington, D.C. 20036 Telephone: 202–328–5000 Fax: 202–939–3460 Internet: http://www.rff.org Climate Issues Briefs are short reports produced as part of RFF’s Climate Economics and Policy Program to provide topical, timely information and analysis to a broad nontechnical audience. The preparation of these briefs is funded in part by The G. Unger Vetlesen Foundation. © 2000 Resources for the Future. All rights reserved. No portion of this paper may be reproduced without permission of the authors. 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 ii 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. 1 Resources for the Future Toman 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). 2 Resources for the Future • Toman 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 3 Resources for the Future Toman 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. 4 Resources for the Future Toman 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. 5 Resources for the Future Toman 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. 6 Resources for the Future Toman 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 7 Resources for the Future Toman 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 8 Resources for the Future Toman 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. 9 Resources for the Future Toman 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 10 Resources for the Future Toman 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. 11 Resources for the Future Toman 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 12 Resources for the Future Toman 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). 13 Resources for the Future Toman 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 14 Resources for the Future Toman 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 15 Resources for the Future Toman 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. 16 Resources for the Future Toman 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. 17