complying nations, and invest effort in ensuring that reductions they acquired were from countries in compliance or on a course for compliance. Thus, by sending a market signal back to nations that fail to manage their emissions reduction obligations, this discount provision fulfills the capacity of the "compliance triangle" to impose a discipline both on these sovereigns and their firms and on their emissions trading partners.

Because one critical attribute of the automatic discount is its shifting of some risk - and, therefore, incentive - to buyers, the discount enhances the integrity of the emissions trading system in another way. Buyers' preference will be for reliable trading partners who can deliver CEUs that will retain their full value in offsetting emissions in the context of buyers' own compliance obligations. As a result, a preponderance of the CEUS transacted in the global emissions trading market may be those that in the first instance are highly likely to represent truly surplus reductions.

At the same time, in contrast to a regime in which non-compliers were excluded from the emissions trading market de jure, the fact that it would be the market, in exercising its preferences, that produced the effective exclusion of non-compliers from emissions trading comports with an overall strategy of using the market to elicit compliance. In this instance, the loss of economic opportunity resulting from this exclusion could act as a spur to drive non-compliers to take the actions necessary to achieve compliance. In fact, firms and other entities seeking to generate surplus GHG emissions reductions and sell them in the global market would become constituents for compliance within their own countries. In the face of the limitations that characterize an international enforcement regime, the protocol must rely on using the incentives inherent in a global GHG emissions trading market to mobilize constituents in favor of compliance.

From a superficial perspective, an approach, such as an automatic discount, which exposes buyers to uncertainty as to the use-value — in this case, the emissions-tonnage value of their acquisition would seem to be incompatible with an active exchange market. However, a simple comparison to currency markets, or, for that matter, to any transaction involving currencies that are "foreign" to one of the parties, and which regularly fluctuate in value in comparison to the party's "domestic" currency, demonstrates that this uncertainty is a routine part of international commerce. Moreover, it is easy to imagine that transaction partners and intermediaries would find a variety of hedging or insurance instruments readily available to manage such uncertainty. Only if it resulted in the full confiscation of a CEU's offset value would a discount system fatally inhibit the development of an international emissions trading market.

In this case, no such confiscation would be necessary. The concurrent presence of the debt-carryover mechanism would render surplus, at least eventually, exported reductions, even from initially non-complying countries. Consequently, the emissions-offset value of such reductions would not have to be discounted to zero. By the same token, the discounting would be applied only for those CEUs presented for

use in meeting the buyer's compliance obligations after the selling nation's budget exceedance emerged in annual reporting. CEUs that had been used prior to that time would not be discounted, thus avoiding the imposition of retroactive liability for purchasers of a sort that could inhibit emissions trading activity.

Without both an automatic debt-carryover to subsequent budget periods and an automatic discount applied within each budget period for CEUs exported by nations demonstrably exceeding their budgets, an international GHG protocol would lack adequate mechanisms for ensuring both nations' accountability for compliance and its own credibility. Without the ability to rely, in any but the most extreme circumstances, on the kinds of remedies, sanctions or other coercive measures typical of domestic pollution control laws such as the U.S. Clean Air Act or, in some instances, the general system of international commercial trade, a GHG protocol must develop a fully integrated set of incentives to motivate compliance.

That is why implementing nations' GHG emissions obligations through a system of emissions trading is so indispensable to the success of a GHG protocol. An emissions trading market is virtually the only mechanism that can provide such incentives. At the same time, the emissions trading and compliance regime must be carefully designed to hone these incentives. Just as the opportunity to create early reductions and "save" them for future use intensifies incentives for early action and for the development of environmental innovations, features like a discount applied to the GHG emissions reduction exports of non-compliers are essential to perfecting those incentives that can effect nations' -- and their firms' - preference for compliance. Moreover, such a discount does more than provide a tangible instrument for delivering such incentives. Without a discount, the emissions budget and trading regime will lack important mechanisms that can be readily usable in the first instance to perform the function - traditionally served by penalties and similar remedies in domestic legal programs of disciplining sovereigns that stray from the path of compliance.

THE IMMUTABLE IDENTITY BETWEEN TRADING AND

COMPLIANCE

In a GHG emissions budget and trading system, the mechanics of accountability must be carefully designed. Fortunately, it is possible to create a unified system through which sovereigns can effectuate emissions trading and, at the same time, to design it so as to establish their accountability for meeting their GHG emissions budgets.

The key specification for each budget period is setting the numerical value of each nation's decadal budget. Presumably, since the initial commitments of the industrialized nations under the FCCC were expressed in terms of 1990 emissions levels, the protocol will establish each nation's initial budget as a function of its 1990 emissions. For purposes of setting the initial budget as well as each subsequent budget, the Parties should rely on the resources of international institutions such as the Intergovernmental Panel on Climate Change, under the direction of the Secretariat, to focus on three major components.

First, as the IPCC has done continuously since before the signing of the FCCC in 1992, the IPCC should provide an ongoing assessment of all scientific developments relevant to climate change. Inevitably, this will include a dual focus on tolerable concentrations of GHGs in the atmosphere and tolerable rates of climatic change. Second, technological advances and innovations are likely to progress at an accelerated pace in the wake of the establishment of a GHG protocol and in response to the incentives it engenders. These, as well as technological costs and limitations, should also be carefully assessed. Finally, nations' performance under the protocol as that performance develops needs to be assessed as well.

These assessments should inform the setting of the budget for the immediate subsequent period as well as projected reduction trajectories over a

multi-budget-period horizon. An equally critical element of the budget-setting process is timing. Specifically, each budget should be established and announced no later that the end of the fifth year of the current budget period. By following this schedule, the protocol's budget-setting process will afford nations and firms the time necessary to

anticipate their upcoming compliance obligations and to integrate them with their overall economic responses.

This budget-setting schedule also contributes to the protocol's ability to establish a credible system of accountability. A five-year separation between the establishment of the ensuing period's budget and the application of remedies such as an automatic debt-carryover can help ensure that the budget-setting process will not be compromised by efforts to ease non-complying nations' obligations under the debt-carryover provision. As a result, the carryover will represent a true net deduction from a budget that is not inflated to defeat the effect of the carryover.

Mechanics of Reporting, Accounting and Trading

One of the innovations introduced by the SO2 emissions trading program under the U.S. Clean Air Act was that the SO2 emissions "allowance" served - all at the same time as i) the currency of trading, ii) the instrument of compliance for affected sources and iii) the regulatory mechanism applied by the U.S. EPA for ensuring sources' accountability and for "tracking" emissions trades. Similarly, the protocol can establish a single, simple sovereign accounting system that performs the same multiplicity of functions for an international GHG emissions budget and trading regime. At the same time, this system would be able to succeed without relying on the allocation of emissions "allowances" or marketable permits.

This is critical, since in the context of a GHG protocol a compliance accountability infrastructure must be designed to meet several constraints as well as

the demand that it work. First, the protocol, and its compliance and trading accounting method, must be able to accommodate every possible policy approach - e.g., pollution taxes, technology standards, research and development subsidies, marketable permits - available to sovereigns in adopting their respective domestic strategies to meet their GHG emissions budget obligations. A system that presupposed the adoption of certain measures and the exclusion of others would be untenable to the extent that it would necessitate the forfeiting by sovereigns of at least a portion of their own policy-making prerogatives.

By the same token, reliance on the creation of elaborate or powerful new international institutions for the purpose of implementing a protocol could doom such a protocol, for, here, too, demanding that sovereigns surrender significant elements of their authority may be a prospect even more daunting than inducing them to agree to curb their GHG emissions. Finally, an international system for accounting for, and tracking trades in, each nation's GHG emissions must be simple, reliable and durable.

Fortunately, the FCCC itself already has laid the foundation for such a system in its existing requirements that countries file annual reports of their GHG emissions. To implement each nation's GHG emissions budget requirements and effectuate the application of GHG emissions trading they may have engaged in in meeting their respective emissions budgets, the protocol should require each nation to file an annual report with the following information:

1. Emissions Budget, expressed in annualized terms by multiplying its decadal GHG emissions budget by 0.1.

2. Actual Domestic Emissions Reported in Total and By Sector.