permits circulating, but it also considerably increases the cost of participating in the trading system. This in turn reduces the incentive to trade and raises the overall cost of compliance. Different countries and stakeholders are taking different positions on this tradeoff between compliance cost and environmental assurance. Environmental Improvement or "Hot Air"? In 1990, prior to the break-up of the former Soviet Union (FSU), the emissions of GHG gases by the member states of the FSU were high. After the break-up and the severe decline in economic activity that followed, emissions fell and are today at quite low levels relative to 1990. The Protocol sets the commitments for Russia and Ukraine at 100% of their 1990 emission levels. Projections to 2010 suggest that FSU emissions will still be below 1990 levels by then. This means that these countries could have a considerable block of surplus permits to sell - if they were permitted to do so. This block of allowances has been termed "hot air" by critics, including many in Europe, who are eager that it not be traded on a global basis. The US and some other countries argue that the assigned amounts were agreed upon by all Parties, and therefore that permits based on these amounts are as good as any others for trade. As noted previously, this is as much as debate over the targets themselves as it is over the mechanism. Raymond Kopp is a senior fellow in the Quality of the Environment Division. Michael Toman directs RFF's Energy and Natural Resources Division. The Clean Development Mechanism (CDM) is one of several "flexibility mechanisms" authorized in the December 1997 Kyoto Protocol to the 1992 United Nations Framework Convention on Climate Change (signed at the Rio de Janeiro "Earth Summit"). The Kyoto Protocol specified legally binding commitments by most industrialized countries to reduce their collective greenhouse gas (GHG) emissions by at least 5% compared to 1990 levels by the period 2008-2012. With the goal of reaching these targets at the lowest possible cost for countries that committed to reductions, the Protocol created two flexibility mechanisms, GHG emissions trading and CDM. The CDM is also intended to be an opportunity for developing countries that did not accept binding emissions reductions at Kyoto to be involved in GHG mitigation. The second section of this paper introduces the CDM's purpose, mandate and institutional structure as authorized in the Kyoto Protocol. The third section focuses on the principal technical and administrative issues that will arise as the CDM is designed and implemented. The last section discusses some of the main unresolved issues with the CDM that confront the Conference of Parties to the Framework Convention. II. The Kyoto Protocol and Article 12: Organization and The CDM was created as a successor to "Joint Implementation" (JI). JI consists of a bilateral agreement between two entities to complete a GHG mitigation project. The investor is from an "Annex B" industrialized country that must reduce its emissions under the Framework Convention. JI potentially can provide credit for emissions abatement to the investor at a lower cost than domestic abatement. In other words, JI is a form of "emissions trading." At the same time, a developing country host can benefit from new investment that increases economic productivity and may reduce local environmental problems. Under the Kyoto Protocol, JI projects still can be undertaken between entities in Annex B industrialized countries (as specified in Articles 3 and 4). However, collaborative projects to reduce emissions or sequester carbon in developing countries are now to occur through the CDM. Article 12 of the Kyoto Protocol identifies three specific goals for the CDM: (1) to assist in the achievement of sustainable development, (2) to contribute to the attainment of the environmental goals of the Framework Convention, and (3) to assist Annex B parties in complying with their emissions reduction commitments. In particular, Article 12 specifies that developing countries are to benefit from CDM projects resulting in "certified emission reductions" (CERS) and that industrialized countries may use CERS to comply with their quantified emissions reduction commitments under the Kyoto Protocol. Essentially, this allows for voluntary projects similar to previous JI projects between Annex B and non-Annex B countries. The difference is that unlike previous JI projects, CERS are specifically authorized to apply to Annex B emissions reduction targets. 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. III. CDM Design Issues In order for CERS to be created from CDM projects, a number of overlapping technical, regulatory, project finance finance and administrative functions must be performed. Before any CDM project can be established, there must be demand for CDM projects and CERS; developing countries' concerns about uneven bargaining positions during project contract negotiations must be addressed; liability must be assigned, and insurance procured; project financing also must be obtained; and the benefits of projects must be allocated among participants. It is important to bear in mind that the CDM is a form of market, one in which valuable goods and services are to be bought and sold. Many of these functions may be most effectively undertaken by private markets or existing international institutions; the key question is what functions need to be undertaken by new CDM institutions. Criteria for selection of projects. CDM projects must presumably fulfill certain criteria in order to be certified upon completion, but these criteria have not yet been established. Possible criteria include: method or extent of technology transfer; specific performance or design standards for transferred technology; capacity and willingness of both national and local governments to host the project; existence and nature of agreements for sharing project benefits (CERS and financial returns) and project liability between investor and host; and limits on local environmental or other social impacts. A particularly important question is what criteria might be established for determining "sustainable development" and other benefits for host countries. Another important question is whether references to "emission reductions" in Article 12 are interpreted as allowing or precluding carbon sequestration projects under the CDM. Project review and CER calculation (before implementation). Prior to the initiation of projects, the "baseline" or previous amount of carbon emissions from the project facility or area in question must be established. The baseline is used to show that purported GHG reductions are "additional" to what otherwise would have occurred. One practical question that arises in assessing additionality is the issue of "project leakage" - when a particular project lowers emissions, but emissions rise in other parts of the host country economy (or elsewhere). This could happen, for example, if a reforestation project in one location was accompanied by greater deforestation elsewhere. There are a variety of options for defining project-level baselines to assess additionality. These include detailed project-level review of projected emissions with and without the project, and streamlined formula-based approaches that estimate emission reductions based on easily observed project characteristics (for example, conversion of a coal power plant to natural gas). Another approach would involve the host country establishing and enforcing "top-down" national or sectoral baselines in an effort to limit leakage, and then assigning shares of the baseline to different emission sources much as emission allowances are allocated in the US program for sulfur dioxide trading among power plants. In this case the validity of the CERS generated from a specific project would depend in part on overall sectoral emissions. Project monitoring and CER assessment (after implementation). Related to the issue of additionality are technical questions regarding how to measure, monitor and verify the outcomes of individual projects. Both emission reduction and carbon sequestration projects pose their own measurement and monitoring challenges. In either case, some independent entity must intermittently monitor the emissions or sequestration of the project in order to ensure that the benefits of the project accrue over time as represented by project participants. In turn, standards for the accreditation of the certifiers are needed in order to ensure certifier objectivity and credibility. Rules for CER validity and project liability. For CERS to be credible, there must be rules defining when CERS can be used and assigning legal responsibility in the event that a CDM project is found not to generate the amount of emission reduction promised (either because of misrepresentation before the fact or less than expected performance after the fact). Liability is of less concern if CERS can be used only after an independent (and honest) auditor has certified their existence. If this were the case, prospective credits would be held in abeyance between certifications; the project participants would have to trade off the value of more rapid certification against the cost. If, however, credits can be used in advance of certification, as is the case in some US emission credit trading programs, then questions of after-the-fact liability do arise. Under the Kyoto Protocol, Annex B countries have ultimate responsibility for noncompliance if credits are disallowed. In practice, the assignment of liability to Annex B investors/CER buyers is likely to be efficient since buyers have a financial and reputational stake in CDM projects, possess the resources for effective project oversight, and face enforceable emission ceilings in their own countries. CERS could be transferred to subsequent purchasers without reassignment of liability in order to protect incentives for trading. Recording of CER exchanges and resulting changes in Annex B parties' accounts. Some institution must be responsible for accounting for newly created CERS, CER exchanges or transactions, and the application of CER credits to Annex B parties' GHG emissions obligations. Marketing, information, financing, and insurance services. If the |