Project monitoring and CER assessment (after implementation). 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 investors are likely have access to market financing for well-designed CDM projects. In some cases, however, institutions like the World Bank might need to provide assistance in identifying and providing financing. Insurance against project failure is another important financial or brokerage service, which again could be provided by the private sector or in some cases by multilateral institutions. Finally, market institutions need to be developed for facilitating transactions in CERs as well as "derivative" transactions, such as options to buy or sell CERs in the future. These institutions would serve as a clearinghouse for secondary trades by matching buyers and sellers, and could also be a repository for "banked" or unused CERS. Such institutions would also facilitate exchanges between CERs and emission permits emerging from Annex B trading. Providing negotiating support for non-Annex B countries. Some developing countries might avoid participation in CDM projects out of fear of possible exploitation by investors due to lack of capacity to negotiate fair contracts. These countries are concerned about the relationship between the CDM and international development assistance, the under-development of the private sector in some developing countries, the lack of developing country capacity to monitor and verify projects independently, and the possibility that investors will take advantage of their lack of technical expertise in project evaluation. The CDM or other institutions could assist by providing access to experienced negotiators and offering training or capacity-building services. However, undertaking these tasks requires a resolution of potential conflicts of interest among the roles of project promoter, host country advocate, and neutral market supporter. CDM fund administration. Article 12 stipulates that "a share of proceeds from certified project activities [should be] used to cover administrative expenses as well as to assist developing country Parties that are particularly vulnerable to the adverse effects of climate change to meet the costs of adaptation." The COP must still determine how funds will be drawn from CDM projects or CER trading, how large the fund should be, and how proceeds would be disbursed. The question of how funds are raised is of particular interest. If the funding mechanism is based on the proceeds of the project (either direct financial payment or diversion of a share of CERS to a central fund), then in negotiation investors will reduce their willingness to provide benefits to the host country accordingly in order to ensure that the net return on the project remains commensurate with other rates of return throughout the global capital market. In this case the CDM fund would simply be redistributing proceeds among non-Annex B countries. An alternative would be to levy a fixed annual registration fee on any investor interested in being eligible for participation in the CDM. IV. Key Decisions on CDM Structure and Function There are several ways the CDM could be structured to address project selection, finance and implementation. The CDM could be more centralized and active in CER market operation, playing a role similar to that of the World Bank or the Global Environment Facility (GEF) in screening, selecting, financing, and assisting in implementation of projects. The CDM also could be a market maker, seeking out host countries from whom to acquire credits and reselling them. However, a key question with a more centralized alternative is the extent to which the CDM would have a comparative advantage in carrying out all these functions, especially if by international agreement it became the only entity eligible to carry out these various functions. Experience suggests that many of the functions enumerated above can be carried out more efficiently by the private sector, and that exclusive control over the functioning of a market does not promote market efficiency or adaptability. Another alternative would be very similar to Joint Implementation, in which an industrialized country and a developing country agree to collaborate on a CDM project which is later certified by an independent auditor. This arrangement would imply a much smaller role for the CDM, one mostly involving definition of basic criteria for project selection and implementation, general oversight of audits and recording of CER exchanges. This system likely is the most dynamic and flexible, with individual actors in the market (investors, financiers, and others) defining the functioning of the CER market through "learning by doing." How successful this approach would be in terms of accountability would depend on the criteria used for project selection and implementation and the quality of oversight applied. There is a broad debate over the issue of "supplementarity." The Kyoto Protocol refers to the use of international emissions trading (and by extension the CDM) as being "supplemental" to domestic actions. Supplementarity constraints reflect a concern by some Annex B countries that participation in international flexibility mechanisms 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 the Kyoto goals. The other side of that argument is that limits on trading and CDM are blunt instruments to improve the credibility of a nation's commitment to the Kyoto Protocol, and that by increasing the overall cost of compliance with the Protocol the restrictions also contribute to lack of willingness to achieve the target reductions. Finally, there are inherent tensions among the goals for the CDM articulated in Article 12 of the Kyoto Protocol. For example, a more formulaic approach to project review would lower "transactions costs," but it might also decrease the accuracy of the assessment of additionality. Greater efforts to extract benefits for non-Annex B countries or to reduce uncertainty in the measurement of CERS will increase participation costs for Annex B countries and thereby reduce their interest in participation. To illustrate, requiring selection of the best available abatement technologies might facilitate technological "leapfrogging" by LDCs but would also raise the cost of the project. These tradeoffs and their consequences are the reason why the design of CDM institutions and projects must be considered carefully before implementation. Since early (pre-2008) reductions through the CDM are possible under the Protocol starting in 2000, there is little time to spare in settling some of these basic issues. Michael Toman directs RFF's Energy and Natural Resources Division. Marina comments. weathervane FEATURE International Emissions Trading By Raymond Kopp and Michael Toman OCTOBER 1, 1998 -- Emissions trading is one of the key "flexibility mechanisms" built into the Kyoto Protocol negotiated among 168 governments in December 1997. Supporters of trading argue that it will greatly reduce the overall costs of complying with the reductions in greenhouse gas emissions that the Kyoto Protocol would require. But the rules for a trading system have yet to be worked out, and skeptics question its potential efficacy. The issue is likely to be one of the main subjects at the next international negotiation session on global warming, which begins Nov. 1 in Buenos Aires. In the United States, the Clinton administration has said that it will not send the Kyoto Protocol to the Senate for ratification until, among other conditions, the provisions for trading are explicit. In addition to technical issues of administration and enforcement, Emissions trading is a mechanism for use among the "Annex B" industrialized countries, basically the OECD (minus South Korea and Mexico) plus the countries of the former Soviet Union and Eastern Europe. All of these countries have numerical emission limits in the Kyoto Protocol to be reached by 2008-2012. Another flexibility mechanism in the Kyoto Protocol, the "Clean Development Mechanism" (CDM), involves transactions between Annex B countries and developing countries that do not have |