implementation until after they had accepted a GHG emissions budget could actually result in developing countries' finding it more difficult to accept such budgets.

By the same token, allowing developing countries to reap the benefits of engaging in GHG emissions trading even before they agreed to GHG emissions budgets could enhance the effectiveness of the incentive created by the promise of participation in trading following the imposition of a GHG emissions budget. Direct experience in the international GHG emissions trading market and direct enjoyment of the benefits of participation in the market could help persuade developing countries to move into the budget regime and to do so more quickly.

At first blush, this would seem to be a paradoxical result. Presumably, developing countries would be only too happy to reap the rewards of emissions trading without bearing the burden of a GHG emissions budget. In fact, participation in the emissions trading market under these circumstances inevitably will be significantly less advantageous and less lucrative for the exporting country than it would be for those countries that engage in trading while subject to a GHG emissions budget. It is this differential, which inevitably will be substantial, that will create the incentive for developing countries to adopt GHG emissions budget; yet, it is initially allowing countries to participate in emissions trading in the first place that will make the incentive more vivid and compelling.

This differential will arise from the contrast in transactions costs associated with trading where both affected sovereigns are subject to budgets and those associated with trades where the exporting nation is not subject to a budget. In the former case, as discussed at length above, the universal accounting and reporting system, backed by the discount and debt-carryover mechanisms, for countries subject to GHG

emissions budgets will render all transacted reductions surplus. As a result, firms and sovereigns engaging in such trades will have to incur few if any costs related to demonstrating that the reduction in question is surplus.

In the case of reductions exported by countries without GHG emissions budgets, however, the trading participants will be forced to incur significant costs in establishing that the reductions in question are truly surplus and can be used to offset emissions subject to GHG emissions budget requirements. This will be the case no matter how liberal the protocol may be or how dominant the constituencies seeking to encourage or facilitate joint implementation may be. In addition to meeting tests that may seek to establish not only "additionality" but "but for" causality as well, joint implementation projects may be required to demonstrate also that their emissions reductions are not merely the result of shifting emissions generation to other firms or activities. Proponents of joint implementation transactions will also incur the costs associated with seeking the approval of as many as three authorities--that of the host country, that of the country against whose compliance requirements the reductions are being offered and possibly that of an international body that may be created for the purpose by the protocol itself.

Meanwhile, thanks to the certification that reductions are surplus that is built into the very mechanics of reporting, parties to GHG trading in the emissions budget context will face none of these burdens and costs. As a result, they are likely to seek reductions from countries subject to GHG emissions budgets as a first preference and offer prices commensurate with the reliability and minimization of transactions costs characteristic of that context. In competing against that preference, sovereigns and firms without budgets will suffer smaller demand and lower prices for their reductions.

With experience, these nations will come to identify an economic advantage that the emissions trading market can confer on those that accept budgets.

To facilitate developing countries' response to this incentive, the protocol should specify a fixed formula to be universally applied to developing countries when they elect to adopt a GHG emissions budget. While the formula can include an advantage for those nations that act more quickly, applying a pre-established set of specifications, and thus eliminating case-by-case negotiations, will ensure the integrity of the system of budgets imposed on developing countries. As a result, this approach can be tailored to address the pressing demand of developing countries: that the perceived need for rapid economic growth, comparable to that enjoyed by industrialized nations earlier in their economic history be accommodated. Specifically, for the initial budget period or periods developing countries can be subject to "growth budgets" calculated, for example, as a function of current emissions with a small-percentage margin for increase over a certain time horizon. At the end of the horizon, which can be set at a length that would be greater for those nations that begin their budget commitments earlier, they would be subject to the same reduction path applicable to all nations.

This paper has attempted to articulate the framework for an international greenhouse gas trading regime and to elucidate the importance of the elements of that framework for its effective functioning. As the international community rapidly moves toward the adoption of a protocol to limit greenhouse gas emissions, building an international understanding of the practicality and desirability of emissions trading is

essential if agreement is to be reached in Kyoto. Only a system of international emissions trading can effectively span the diversity of national interests, legal systems, norms, implementation strategies, and preferences represented among the community of nations. The very essence of emissions trading is choice - the ability to choose when, where, and how much.

At the same time, only emissions trading has the capacity to modulate both total cost as well as the distribution of costs among nations. Economic analyses of greenhouse gas control are remarkably uniform in ascribing huge cost savings to emissions trading. The key to delivering these cost savings is the creation of a framework for trading which reduces transactions costs, provides environmental and financial credibility, and rewards innovation. This paper has identified the minimum elements necessary.

FOF

ENVIRONMENTAL
DEFENSE FUND

January 13, 1998

The Kyoto Protocol on Climate Change: Issues and Analysis

On December 11, 1997, in Kyoto, Japan, over 150 nations adopted the Kyoto Protocol to the United Nations Framework Convention on Climate Change. The Protocol, whose text is available electronically at www.unfccc.de, committed nations, for the first time ever, to place legally binding limits on their emissions of greenhouse gases ("GHG"). By trapping heat in the atmosphere, GHG have already begun to warm the Earth; their uncontrolled emissions are predicted to cause significant and dangerous interference with the world's climate system.

The Kyoto Protocol establishes two innovative mechanisms for implementing these emissions caps - trading of portions of nations' "assigned emissions amounts" (i.e., total GHG emissions limits) among nations that have adopted legally binding targets; and project-based emissions reduction credit trading, among nations that have adopted legally binding targets and also between such nations and those that have yet to adopt targets. These two mechanisms have the potential to create a global marketplace in cost-effective emissions reduction opportunities. If these innovative approaches are brought to fruition, they can ensure that the Protocol's environmental performance will be fueled, rather than stymied, by the power of economic forces. However, at least some additional steps will likely need to be completed before a global emissions trading system becomes fully effective. The Parties to the Framework Convention will meet in Buenos Aires, Argentina, in 1998 to elaborate rules and guidelines for these several types of trading under the Protocol. The Buenos Aires rules may facilitate or hamper the operation of emissions trading, and consequently enhance or diminish the environmental and economic effectiveness of the Protocol. In addition, emissions trading is not well understood, and not well accepted, in a number of regions of the world, in particular in Europe. With increased international understanding of the principles and mechanisms by which trading can improve environmental performance, reduce costs and expand economic opportunity, however, these features of the Protocol will be welcomed more broadly in the international community.

Emissions trading may be especially important in creating incentives for developing nations to adopt emission caps. The Protocol creates these incentives in two ways. First, the Protocol provides that developing nations can attract foreign investment in GHG-reduction activity, and earn transactable emissions reduction credits, by participating in cooperative emissions reduction projects through a "clean development mechanism." At the same time, developing nations can reduce the relatively higher

**Copyright © The Environmental Defense Fund, 1998. All Rights Reserved.** This preliminary analysis is subject to revision.

50-343 99-7