WPS4761


Policy ReseaRch WoRking PaPeR                        4761




        Carbon Markets, Institutions, Policies,
                             and Research

                                 Donald F. Larson
                                 Philippe Ambrosi
                                    Ariel Dinar
                             Shaikh Mahfuzur Rahman
                                  Rebecca Entler




The World Bank
Development Research Group
Sustainable Rural and Urban Development Team
October 2008

Policy ReseaRch WoRking PaPeR 4761


 Abstract

 The scale of investment needed to slow greenhouse gas                                 price outcomes from newly formed markets and point
 emissions is larger than governments can manage through                               out areas where markets have preformed as predicted and
 transfers. Therefore, climate change policies rely heavily                            areas where markets remain incomplete. Overall the scale
 on markets and private capital. This is especially true                               of carbon-market investment planned exceeds earlier
 in the case of the Kyoto Protocol with its provisions                                 expectations, but the geographic dispersion of investment
 for trade and investment in joint projects. This paper                                is uneven and important opportunities for abatement
 describes institutions and policies important for new                                 remain untapped in some sectors, indicating a need for
 carbon markets and explains their origins. Research                                   additional research on how investment markets work.
 efforts that explore conceptual aspects of current policy                             How best to promote the development and deployment
 are surveyed along with empirical studies that make                                   of new technologies is another promising area for study
 predictions about how carbon markets will work and                                    identified in the paper.
 perform. The authors summarize early investment and




 This paper--a product of the Sustainable Rural and Urban DevelopmentTeam, Development Research Group--is part of
 a larger effort in the department to understand and assess policies related to climate change.The research was supported, in
 part, by a grant from the Knowledge for Change Program. Policy Research Working Papers are also posted on the Web at
 http://econ.worldbank.org.Theauthorsmaybecontactedat dlarson@worldbank.org,pambrosi@WorldBank.org,adinar@
 worldbank.org (adinar@ucr.edu starting December 1, 2008), mahfuz2020@gmail.com and rebecca.entler@gmail.com.




          The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development
          issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the
          names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those
          of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and
          its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.


                                                          Produced by the Research Support Team

       Carbon Markets, Institutions, Policies, and Research
                    Donald F. Larsona, Philippe Ambrosia, Ariel Dinara,
                      Shaikh Mahfuzur Rahmanb and Rebecca Entlerc




aWorld Bank; Texas Tech University; Penn State University.
            b                      c

1 Introduction

There is a longstanding debate about how countries should manage their greenhouse gas emissions.

And, for more than a decade, much effort has been given to reaching an agreement among countries

that would coordinate their actions. This has had several practical consequences. For one, the broad

process of debate has led to a large body of research and a specialized set of institutions that

influence how the predictions of physical and social outcomes from climate change are assessed.

Additionally, an international treaty aimed at slowing global warming and a complex set of

implementing rules are in place.

         The influence institutions have on carbon policy and related markets is considerable and

cascading. The special characteristics of the climate change ­ that the potential effects of climate

change are global and that the greenhouse gas emissions that contribute to climate change matter in

the aggregate irrespective of their source ­ creates a need for a coordinated international response,

and new institutions have evolved to organize debate and establish a common set of objectives. At

the same time, because of uncertainty about the natural, economic and social consequences of

climate change, a widely-shared understanding of the science of climate change is needed as a starting

point for a coordinated strategy. In response, organizations and procedures have been built up in

recent years to develop informed judgments ­ for example, dedicated research centers, non-

government organization and panels under United Nations sponsorship. Another key characteristic

of the international policy framework currently in place is its reliance on markets, which is due in part

to the scale of investment needed to significantly reduce global emissions. In turn, this has given rise

to a related set of market institutions, including those that certify tradable permits and support

private investment flows.

         In this paper, we describe important institutions that shape climate change policies together

with a set of key market-reliant instruments. We selectively review the related research, emphasizing

empirical studies that assess the effects of current policies and that evaluate the markets upon which

current policies depend. To date, much of the empirical analyses relating to climate change policies

have been forward looking and anticipatory. This is changing as new markets emerge and as a history

of project investment builds and we indicate areas where future work is anticipated.

         Following this introduction, the remainder of the paper is organized as follows. Section 2

briefly describes the process by which scientific predictions of climate change are incorporated into

policy and policy evaluations. The following section delineates key features of the climate change

framework and the related debate over the framework's design, with special attention to the

amendments and rules related to the Kyoto Protocol's flexibility mechanisms. Section 4 examines


                                                         2

alternative evaluations of expected outcomes. Section 5 discusses market-based domestic policies in

Australia, the European Union and the United States. Section 6 looks at the current state of carbon

markets. Finally, Section 7 concludes and indicates areas for future research.1


2 Science and policy

Motivation for a treaty limiting greenhouse gas emissions stems from evidence that the global climate

is warming and the strengthening inference that human activity is a significant contributing factor. In

turn, the degree to which interventions are required depends firstly on an evaluation of both points,

and secondly on an assessment of the damages caused by global warming and the costs and benefits

of altering its mutable components.

         The conceptual foundation for the contribution of human activity to global warming is not

controversial in itself and relates to the greenhouse effect. Briefly, as the earth constantly receives

energy from the sun and radiates energy back into space, water vapor, clouds and long-lived gases,

including carbon dioxide, work to reduce the outflow of radiated light, creating an energy imbalance

known as the greenhouse effect. In 1861, John Tyndall speculated that the accumulated release of

carbon dioxide from combustible fossil fuels might increase the energy imbalance, resulting in a

warming of the earth's surface. Later, the Swedish physicist, Svante Arrhenius (1896) provided a

formal model of the phenomenon. Arrhenius predicted a gradual warming of the climate, but did not

view the consequences as threatening. Later, as global consumption of fossil fuels increased and the

earth's cooling and warming mechanisms became better understood, the subject was further revived.

In 1957, an important paper by Revelle and Suess (1957) suggested that the oceans' capacity to

absorb carbon dioxide from the atmosphere was more limited than previously thought. The authors

went on to stress the potential risks and uncertainties associated with a continuing buildup of

greenhouse gases. In the ensuing years, measurements of atmospheric carbon dioxide taken at the

Mauna Loa Observatory starting in 1958 revealed increasing concentration of carbon dioxide in the

atmosphere. Later on, corroborating evidence from ice-core analysis suggested a trend of building

accumulations going back to the Nineteenth Century (Siegenthaler and Oeschger 1987).

         Nevertheless, predicting the consequences of increased concentrations of atmospheric

carbon dioxide and induced global warming proved a difficult task. Hurdles included inexact historic

climatic measures and an incomplete understanding of the complex natural relationships among the

mechanisms that heat and cool the earth's oceans and atmosphere.2 By the close of the 1970s, no


1Language describing the objectives and workings of the Climate Change Treaty is ladened with acronyms and
we include a glossary in the annex to this paper to help frustrated readers.
2See, for example, Lindzen (1990) for a discussion.


                                                             3

consensus had emerged among scientists as to the effects increased concentrations of greenhouse

gases might have on climate and no formal mechanism existed to reach one. By extension, economic

analysis of the consequences of climate change lacked a common starting point.3

         A series of conferences sponsored by the World Meteorological Organization (WMO), the

United Nations Environment Program and the International Council for Science led to the

establishment of an Advisory Group on Greenhouse Gases in 1985 and ultimately the establishment

of the Intergovernmental Panel on Climate Change (IPCC) in 1988, which is the formal mechanism

by which studies concerning human-induced climate change are reviewed by experts with the goal of

providing an objective evaluation to policy makers. The first panel report was submitted to the UN
                                                         4

General Assembly in 1990 and was instrumental in the eventual negotiation of an international treaty,

the United Nations Framework Convention on Climate Change (UNFCCC), intended to protect the

global climate by limiting greenhouse gas emissions.5 Significant additions to the treaty, known as the

Kyoto Protocol, were negotiated in 1997 and entered into force in February 2005, following IPCC

reports in 1995, 1997 and 2001. The most recent IPCC report was issued in 2007.

         Of special interest for this paper is the structure of the IPCC and the topics it is designed to

review, since much of the literature cited here directly addresses questions posed by the IPCC. As a

practical matter, the work of the IPCC is carried out by separate groups of experts aligned around

three general topics. The first working group is concerned primarily with evaluating the drivers of

climate change and evaluating on-going evidence of global warming. Much of the evaluation of

physical models of climate change takes place within this group. The remaining groups deal with

predicted consequences. Working Group II assesses current knowledge about and predicted effects

of climate change on nature and on human welfare, vulnerability and adaptability. Much of the

economic analysis evaluated by this group concerns an accounting of economic gains and losses due

to climate change. The third working group focuses on mitigation. Related economic studies

reviewed by the group include both general equilibrium studies and sectoral studies of mitigation

costs. The effects of market mechanisms are also reviewed by this group. Experts who draft and

review initial reports are chosen by member governments and governments participate in the reviews

of final drafts. As a general practice, draft summaries intended for policy makers are closely reviewed

by national representatives external to the working groups and actively debated before their release.

The panel is not the only group engaged in assessing the likely economic impact of climate change


3For an early example of integrated analysis and a related discussion, see Nordhaus (1977).
4See IPCC (2004) for a history of the panel.
5The first IPCC report was instrumental in the negotiation of three treaties, which formed the basis for the Rio
Earth Summit in 1992. In addition to the UNFCCC discussed here, the Rio Conference also resulted in the
Convention on Biological Diversity and the United Nations Convention to Combat Desertification.


                                                            4

and other summary evaluations exist, most notably the Stern Review on the Economics of Climate

Change issued by the British Government in November 2006.

         Before proceeding to the next section, it is useful to draw some parallels between the

physical and social sciences as they relate to climate change. In both instances, expected outcomes lie

largely outside current experience. For this reason, numerical models of highly complex relationships

­ either climatic or economic are relied upon. While a discussion of climate models falls outside the

scope of this paper, we return to modeling issues later in the paper.


3 Features of the climate change framework

The broad international legal framework that most shapes international carbon markets and national

policies includes the United Nations Framework Convention on Climate Change, additions to the

Convention under the Kyoto Protocol, and related decisions taken by Parties to the Convention and

the UNFCCC Secretariat. The set of agreements and rules have built up over time and the full set of

rules pertinent to a given policy instrument is usually spread over sets of decisions. For convenience,

we use the term climate change framework, or simply the framework, to refer to the full set of

components.

         As mention, the objective to limit greenhouse gas emissions is set out in the UNFCCC,

which entered into force in March 1994. In particular, Article 2 of the treaty calls for the

"stabilization of greenhouse gas (GHG) concentrations in the atmosphere at a level that would

prevent "dangerous anthropogenic interference with the climate system (...) within a time-frame

sufficient to allow ecosystems to adapt (...), to ensure that food production is not threatened and to

enable economic development to proceed in a sustainable manner." The UNFCCC covers six

greenhouse gases: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons,

and sulphur hexafluoride. There are standard rates of conversion among the gasses and most

reporting and rule-making is done in terms of carbon equivalents.6 Following its adoption, the treaty

evolved through a series of decisions taken by treaty participants, known as UNFCCC Conferences

of the Parties (COP).

         At the third Conference of the Parties, held in Kyoto Japan, additions to the treaty, known

as the Kyoto Protocol, were negotiated that delineated an international mechanism for reducing

greenhouse gas emissions.7 Key features of the Kyoto Protocol relate the notion of common but

differentiated responsibility. Commonality comes from the physical property that greenhouse gases


6For example, one ton of nitrous oxide is equivalent to 281 tons of carbon dioxide.
7As of September 2006, 166 countries had ratified the treaty, including 34 Annex I countries that represent
about 62% of 1990 emissions.


                                                           5

have a uniform effect on global warming independent of the source of emission; differentiation

stems from the historical nature of current levels of accumulated anthropogenic greenhouse gases,

which are primarily the consequence of emissions from developed countries. This guiding principle,

along with recognition of differentiated abatement costs and impacts, gave rise to the climate change

framework's unusual structure.

Obligations under the framework

Currently, the framework sets out three levels of obligation among party participants. Over the first

commitment period 2008 to 2012, industrialized countries, generally referred to as Annex I countries

in reference to the annexed list in the Kyoto Protocol, obligate themselves to take specific steps to

bring their overall carbon emissions below a 1990 baseline.8 Commitments are listed in Annex B of

the Kyoto Protocol and vary among the countries. By way of example, targets for the European

Union and many transitional economies are set at 8 percent below 1990 levels, Russian targets are set

at 1990 levels and Australian emission targets are 8 percent above 1990 levels. In addition, a wealthier

subset of the Annex I countries, known as Annex II Parties, pledged to provide new and additional

financial resources to facilitate and finance technology transfer and cover the costs of compliance

incurred by developing country Parties.9 Developing countries, known as Non-Annex I Parties, are

obliged to develop and periodically update their national inventories of greenhouse gas emissions by

sources and removals by sinks, but are not committed to reduce emissions during the first

commitment period.     10


         To complete some key definitions associated with the framework, the amount to which an

Annex I Party must reduce its emissions over the commitment period is known as its "assigned

amount." These Parties are allocated "assigned amount units" (AAUs) up to the level of their

assigned amount, corresponding to the quantity of greenhouse gases they can release in accordance

with the Kyoto Protocol (Article 3), during the first commitment period. One AAU equals one ton

of emissions, expressed as a carbon-equivalent (tCO2e). Parties may offset their emissions by

enhancing greenhouse gas sinks in the land use, land-use change and forestry (LULUCF) sector.

Greenhouse gases removed from the atmosphere through eligible activities within this sector

generate credits known as "removal units" (RMUs).



8Not all Annex I countries ratified the Kyoto Protocol, so it is a slightly different group of countries, known as
Annex B countries, that are obligated to reduce emissions. Moreover, for some transitional economies,
commitments are based on years other than 1990.
9Current Annex II countries that have ratified the Protocol are: Australia, Austria, Belgium, Canada, Denmark,
Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, Netherlands, New Zealand,
Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.
10Sinks are natural or man-made systems that absorb and store more greenhouse gases than they emit.


                                                            6

Flexibility mechanisms

In addition to domestic actions, the Kyoto Protocol allows for three flexibility mechanisms intended

to reduce the overall cost of the treaty. First, countries facing emission limits can purchase AAUs

from other Annex B countries under the International Emission Trading provision (Article 17). In

addition, countries can contribute to projects that reduce carbon emissions abroad. The Protocol

distinguishes between projects hosted in Annex B countries and non-Annex I countries ­ that is,

between countries that have pledged to limit emissions and those that have not. Though conceptually

similar, there are differences in how the programs are administered and implemented. The two

programs are authorized under separate articles of the Protocol, Articles 6 and 12, respectively. The

mechanism for projects in Annex B countries is referred to as Joint Implementation (JI); the

mechanism for projects in developing countries is referred to as the Clean Development Mechanisms

(CDM). Offsets (credits) arising under JI are known as Emission Reduction Units (ERUs), while

credits generated by CDM are known as Certified Emissions Reductions (CERs). CERs and ERUs

can be used to meet treaty obligations. Each CER and ERU represents one tCO2e of greenhouse gas

emission reductions and both can be traded.11

         Solving pollution problems through international cooperation had several precedents prior

to Kyoto, but key aspects of the framework having to do with project credits were unique and have

been controversial.12 To start, credits emanating from projects are based on a hypothetical baseline

of emissions that would have occurred absent the CDM or JI investment. Judging an appropriate

counter-factual is difficult at best and entails both economic and engineering challenges. As a

practical consequence, the rules and procedures for approving and implementing CDM and JI

projects has grown complex. In addition, CDM projects are expected to also advance development

objectives. The criterion is loosely defined and judging whether it is met is difficult. Moreover, the

twin objectives imply tradeoffs, since setting a high development objective for CDM projects can

slow investment transfers and hamper the scope of the flexibility mechanisms to lower

implementation costs. And finally, the flexibility mechanisms are expected to be supplemental to

domestic action and this has prompted debates about domestic policies governing the use of offsets.

We return to these topics below.




11Only sovereign entities can trade AAUs, while both private and public entities can trade and own CERs and
ERUs.
12Examples of international cooperative action include the 1976 Convention Concerning the Protection of the
Rhine River against Pollution by Chlorides and the 1985 Vienna Convention for the Protection of the Ozone
Layer (Hanafi, 1998).


                                                           7

Emission allocations and the choice of policy instruments

By all accounts, the decision to employ quantitative controls among industrial countries took place

early in the process of negotiating the Kyoto Protocol. This was formalized at the first Conference of

the Parties in 1995 as part of the "Berlin Mandate", which called for binding emission limits while

excluding developing countries from new commitments. Subsequent negotiations focused on a

proposal for uniform reduction rates favored by the European Union and a proposal for

differentiated reductions favored by Australia, Iceland and Norway, among others. The differentiated

proposal won out, based on the argument that the burden of limiting greenhouse gas emissions

should be equally shared, rather than the reductions themselves (Fisher, Tulpule and Brown 1998).13

         Still, the early consensus among negotiators has not stalled the debate about burden-sharing

under future agreements and a number of approaches have been proposed.14 In general, proposed

allocations are based on historical responsibility (Pinguelli, Luiz, and Ribeiro 2001), population (Baer

et al. 2000; Bode 2004), single or multiple measures of development or economic need (Jacoby, Prinn

and Schmalensee 1998; Gupta and Bhandari, 1999; Aslam, 2002; Ringius, Torvanger and Holtsmark,

1998). Moving emission targets, based on overall or sector-specific intensity targets have been

proposed as well (Lutter 2000; Kolstad 2006). How allocations are made have implications for equity

because they imply uncertain transfers of wealth. And adaptation associated with on-going climate

change generates an added set of uncertain certain costs. This makes it hard to judge the overall costs

and benefits of the climate change framework. It also makes it difficult for countries or groups of

countries to decide which competing targets and design features associated with the framework best

match their own interests. Additional discussions of these topics are included in Panayotou, Sachs

and Zwane (2002), Leimbach (2003), Vaillancourt and Waaub (2004), Tol and Verheyen (2004) and

Halsnæs et al. (2007). We return to this topic later when we discuss model measures of the benefits

and costs of competing policies.

         In the lead-up to the Kyoto Protocol another debate emerged that still endures, centering on

a choice of a coordinating policy instrument, with carbon taxes and tradable permit systems emerging

as the primary candidates. Pearce (1991) provides an early and still relevant discussion of the

advantages and problems of using a carbon tax to limit greenhouse gas emissions that reflects the

state of the debate at that time. Cooper (1998) and Pizer (1998) provide additional arguments as does




13Bertram (1992) and Rose, Stevens, Edmonds and Wise (1998) provide early reviews. See Whalley and Wigle
(1991) for an early quantitative assessment of policies under debate.
14Gupta et al. (2007) provides an extensive and recent review.


                                                            8

Nordhaus (2007) more recently. Ellerman (2005) provides a good introduction to a cap-and-trade

systems and tradable permits.15


Permit systems versus carbon taxes

Depending on how they are implemented, the tradable permit and carbon tax systems share many of

the same benefits and suffer many the same problems. The chief advantage of both approaches is

that they result in a cost to emitting greenhouse gases that encourages a switch to low-emission

technologies and activities, and encourages the development of emission-reducing technologies. In

turn, these general equilibrium effects create opportunities for cost-savings over command-and-

control approaches.

          Both systems can be used to raise revenues. In the case of carbon tax, this comes directly

through collections, while raising revenue in a permit system requires that emission allowances be

sold or auctioned. Revenue raised under either system can be used to displace economically less-

efficient taxes on productive factors, potentially leading to a positive welfare externality. This is

known as a "double-dividend", a topic discussed later in section 4. Revenue could also be transferred

among countries to encourage wider international participation in the climate framework.

          To work well, either system should lead to a common price for emissions, which requires a

harmonization of policies among countries and also across sectors within economies. Otherwise

problems of spillovers and leakages arise through trade. In practice, both systems are open to

domestic capture when important sectors vie for tax breaks or for preferential permit allocations. We

return to this topic in section 4 as well.

          Both systems generate administrative and related transaction costs. To a degree, carbon-tax

systems can make use of existing tax collection mechanisms and require less intensive emission

monitoring, both of which reduce implementation costs. However proponents of permit systems will

counter that measuring emissions is required in either case in order to judge the environmental

efficacy of the policy. Moreover, costs of financial monitoring can be high. For example, Victor

(2001) points to the difficulty in determining net carbon taxes, especially when other taxes are levied.

          There are substantive differences between the two instruments that have to do with the

effects of different types of uncertainty. Both systems require some prior judgment about the desired

level of emission reductions either instrument is expected to accomplish. The optimal level is


15Hybrid trading systems have been discussed as well, including cap-and-safety-value systems where the
regulatory authority stands ready to issue new permits should permit prices exceed some threshold. In a guide-
rail system, regulators also intervene to buy-up permits when prices fall below a threshold. See, among others,
McKibbin and Wilcoxen (2002), Pizer (2002), Jacoby and Ellerman (2004), and Aldy, Barrett and Stavins
(2003).


                                                            9

uncertain and Nordhaus (2007) points out that this dynamic uncertainty works against permit

systems. With economic growth and changes in technologies, base-year emissions of the type often

used in permit systems, become increasingly irrelevant. Making adjustments to allocations implies

welfare transfers and this reopens equity issues, although the same can be said about changes to tax

rates or transfers.

         In principle, carbon tax systems effectively fix the price of emissions while permit systems

fix emission levels and uncertainty. Consequently, permit systems result in price variability while tax

system results in emission variability. In turn, this has implications for two other types of uncertainty:

uncertainty about the relationship between emissions and climate change and uncertainty about the

relationship between tax rates and emission levels. If only the first type of uncertainty was present, a

preference for one instrument over the other could be made based on the relative nonlinearities in

costs and benefits, with costs that are nonlinear relative to benefits favoring price systems

(Weitzman, 1974).

         Because both types of uncertainty are present, the choice may be less clear. Pearce (1991)

and subsequent authors have argued that a fixed price for carbon has an uncertain effect on the

environment, the safest approach is to directly target the proximate cause of carbon accumulation,

emissions, rather than rely on relationships between price and emissions that are imprecisely

understood. This is especially important because damages from climate change are potentially large

and irreversible. At the same time, Nordhaus (2007) points out that carbon taxes generate stable

incentives for investment and for the development of new technologies, which are key to long-term

success.

         Evidence from the commodity storage literature, suggests another less-discussed difference

between carbon taxes and permit systems that has to do with the pricing of uncertainty. In tradable

permit systems, forward and futures markets evolve in order to determine a price at which

inventories of unused permits are carried forward. These markets can be utilized to provide an

implicit market-driven evaluation of evolving risks profiles, information that is not provided under

carbon-taxes. Moreover, while uncertainty creates incentives to delay irreversible investments that

reduce emissions, uncertainty also drives up the shadow price of permits held in inventory, thereby

reducing current emission levels and partly reducing the negative effects of uncertainty on

investment.16




16See Larson (2007) in the context of commodity markets and Considine and Larson (2006) in the context of
the US sulfur dioxide permit markets.


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Current instruments

In the lead-up to the Kyoto Protocol, most country experience related to carbon emission abatement

focused on command-and-control style regulations; however a few countries had experimented with

carbon taxes. Those efforts were not encouraging and the inability of European governments to

implement a uniform carbon tax across sectors may have influenced the preference for a permit

system.17 In contrast, proponents of permit systems could point to the success of the US cap-and-

trade program for sulfur dioxide, which led to a rapid decrease in emissions and a transparent pricing

market for SO2 permits (Kruger and Dean, 1997; Ellerman et al., 2000). Tradable permit systems had

been applied successfully to other problems as well. For example, a related system of individual

transferable fishing quotas had been introduced in New Zealand in 1986 and similar approaches had

been adopted subsequently in Australia, Canada, Iceland, Italy, the Netherlands, South Africa and the

United States (Larson and Parks, 1999; Newell, Sanchirico and Kerr, 2005). Positive experience with

tradable permits also came from the phase-out of lead gasoline in the United States, limits on

emissions from electricity producers in the Netherlands, and a regional air pollution program in the

Los Angeles basin.18 Taken together, favorable prior experience with tradable permit systems and

difficulties with current carbon tax efforts appeared to sway policy makers and from the Berlin

Mandate forward, negotiations focused on a tradable permit system supplemented with and the

project-based components. Even so, the system that would eventually be codified in the Kyoto

Protocol differed from prior experience in that new permits could be generated through project

investment.

          The logic behind the project-based flexibility mechanisms rests on the observation that the

cost of reducing emissions varies greatly among countries, though the effects of greenhouse gas

emissions on climate change are uniform regardless of where the gases are emitted. Countries where

greenhouse gas emissions were already low were particularly interested in finding ways to lower the

cost of treaty emission goals. In the course of negotiation, the Government of Norway suggested a

mechanism to allow those countries facing emission limits to receive credit for investments made

elsewhere that reduce global emissions (Carraro, 1999; Dixon and Mintzer, 1999). The concept came

to be known as joint implementation and was subsequently adopted into the treaty negotiating

documents (articles 4.2 and 3.3 of the UNFCCC) and eventually, as discussed, into the Protocol.19



17For discussions of the Danish and the Norwegian experiences with carbon taxes, see respectively Andersen
(2005) and Bruvoll and Fæhna (2006).
18Lambert (1996) and Hahn and Hester (1989) discuss the leaded gas phase-down. Klaassen (1996) discusses
the Dutch covenant; Prager, Lier and Matton (1996) discuss the Regional Clean Air Incentives Market.
19As discussed, the term Joint Implementation refers to a specific set of partnerships in the Kyoto Protocol.
This is different from the more general use of joint implementation, which leads to some confusion.


                                                          11

         The notion of supplementing emission constraints through bilateral project-based

investments was untried and controversial among negotiators and non-government organizations. To

demonstrate that the approach was practical, advocates proposed a coordinated group of country

pilots under the UNFCCC. The pilots, known as Activities Implemented Jointly (AIJ) were meant to

provide practical experience about baselines and other practical design features related to the creation

of project-based financed. The agreement to do so, known as Decision 5 of the UNFCCC, provided

broad guidelines for establishing a voluntary AIJ program and also established a common reporting

system.20 By design, early crediting was prohibited during the AIJ pilot phase. Nevertheless,

Schwarze (2000) notes that many of the AIJ projects had project lives extending well into the CDM

and JI crediting periods and surmises that many AIJ investors hoped to receive credits for offsets

generated after the close of the pilot phase. Even so, given the contrast in incentives between AIJ

projects and current Kyoto mechanisms, the AIJ experience is most informative about the process of

government project approval and transaction costs related to bilateral investments and the practical

lessons learned about baselines.21

Project rules

As discussed, the Kyoto Protocol established two mechanisms by which countries facing emission

limits to meet those obligations by investing in projects that reduce emissions elsewhere. Very

broadly, credits generated by CDM and JI projects are calculated by comparing the emissions or

reductions from each project against a business-as-usual scenario, or baseline. Consequently, a

significant portion of the project cycle entails developing arguments about why low-emission

outcomes would not occur without investments associated with the project. Because this process is

rule-based and because there are arguably incentives for both investor and host to exaggerate the

environmental consequences of the project, the mechanisms were viewed with suspicion. Delegates

and observers worried that weak controls and imprecise baselines might allow countries that had

pledged reductions to purchase water-downed credits cheaply from developing countries, thereby

attenuating the environmental benefits of the treaty and forestalling the development of new

technologies. In addition, delegates from developing countries expressed concern that donor

countries would meet emission reduction targets by redirecting existing aid flows to joint


20Convention participants assigned an advisory committee, the Subsidiary Body for Scientific and
Technological Advice (SBSTA) to establish reporting guidelines and to compile and publish the reports on an
on-going basis.
21Michaelowa, Dixon and Abron (1999) look at early AIJ participation and Lile, Powell and Toman (1998)
describe the US programs. Michaelowa, Begg, Parkinson and Dixon (1999) examine the application and
approval process for AIJ projects in eleven investor countries. Heister, Karani, Poore, Sinha and Selrod (1999)
discuss concurrent World Bank experiences with baselines. Selected projects are reviewed by Schwarze (2000)
and by Barrera and Schwarze (2004). Larson and Breustedt (2007) discuss how policy preferences and
transaction costs affected the location of AIJ projects.


                                                           12

implementation projects (Ghosh and Puri, 1994; Parikh, 1995).22 One consequence was an extended

period of rule making and details of the programs were left unfinished until the announcement of the

Marrakesh Accords in 2001.        23The concerns also affected the design of the programs and have given

rise to a specific set of national and international institutions that, in turn, shape private markets for

carbon projects.

          In particular, the final rules called for a centralized project-by-project review process and a

conservative approach to validation. Less specific language in the treaty and in the implementation

rules calls for projects to promote sustainable development and asks developed countries to ensure

that Overseas Development Assistance (ODA) is not diverted to finance CDM projects. Language

calling on countries not to depend too heavily on project-derived credits to meet treaty obligations,

and specific rules limiting the use of credits from sinks reflects the qualified support given to the

CDM by negotiators.


The CDM project cycle

In order to generate certified credits, projects located in developing countries must materially reduce

or remove atmospheric greenhouse gas emissions and also contribute to sustainable development. In

practice, most aspects of the CDM project cycles fall under the supervision of host national

regulatory agencies ­ known as Designated National Agencies in UNFCCC parlance. And, in general,

it is up to the host government to determine whether projects meet its sustainable development

goals. This determination is part of the CDM project cycle and is signaled by a project-specific letter

from the host country to the UNFCCC.24

          In contrast, the environmental integrity of a CDM project is subject to specific supervision

rules and a series of checks along the project cycle by the UNFCC Secretariat. To start,

methodologies for establishing baselines must be approved on behalf of the UNFCCC by an

international supervisory group, known as the CDM Executive Board. Approved methodologies are

published and these can be drawn on by project developers. However, projects relying on new



22 Lecocq and Ambrosi (2007) provide a good historical account of the CDM. Gulbrandsen and Andresen
(2004) discuss the role played by nongovernmental organizations in this debate Grubb, Vrolijk and Brack
(1999) provide a good account of the negotiations. See also criticisms in Cullet and Kameri-Mbote (1998).
Chomitz (1999) discusses moral hazard problems relating to baselines.
23 Werksman (1998) gives an account of the CDM negotiations. den Elzen and de Moor (2002) discuss rules
emerging from the Marrakesh Accords.
24 Of course, additional criteria can be applied. For example, the Gold Standard Foundation requires additional
stakeholder consultations for projects to qualify for its voluntary certification. In February 2008, the British
government announced plans for a voluntary certification for CDM projects that conform to its Code of Best
Practice for Carbon Offsetting. The Code is voluntary is administered by an Accreditation Board. The Code
may be extended to Voluntary Emission Reductions soon (DEFRA 2008).


                                                             13

methods face the additional task of gaining approval. In either case, whether new or established

methods are employed, developers must also convince the CDM board that their project

methodology has been appropriately applied.

         The project cycle also contains checks carried out by an independent firm or organization

that has been accredited by a CDM Board. This entity, known as a Designated Operational Entity

(DOE), initially validates the baseline design and the project's plan to monitor and measure

outcomes.25 This occurs before the project is registered -- that is officially recognized by the CDM

Board. For large CDM projects, a separate independent entity carries out the project's monitoring

protocol, the process by which emissions or sequestrations are measured. The DOE is also

responsible for certifying all emission reductions, although it is the CDM Board that issues and tracks

the ownership all CERs. To boost the contribution of the CDM to sustainable development, a two

percent levy on CERs goes toward an Adaptation Fund, designed to cover the CDM's administrative

costs and to fund projects that help the poorest countries adapt to climate change.26


The JI project cycle

Conceptually, Joint Implementation, the second project-based mechanism established by the Kyoto

Protocol is less controversial since, because of an overall cap on allowed emissions from the JI host,

any projects that abates greenhouse gases potentially leads to tradable units of carbon. Domestically

financed projects do so by creating more headroom under the cap of allowed emissions, potentially

contributing to a surplus that could be traded to other countries in the form of AAUs. The JI

program provides an additional mechanism for foreign investment projects that directly create

tradable carbon units in the form of ERUs. At the end of the Convention's accounting period, all

types of carbon units are balanced, so the primary distinction between traded AAUs and traded

ERUs has to do with how the underlying projects were financed.

         Notionally, the practical hurdles of implementing JI projects are also lower. Since Annex I

countries have pledged to cap domestic emissions, national guidelines used to measure emissions

from wholly domestic projects can be applied to JI projects as well. Moreover, in contrast to the

CDM project cycle, the JI program is designed to place full responsibility for the environmental

integrity of the projects in the hands of hosting countries. In practical terms, Annex I countries that




25The overall design of the project is laid out in a Project Design Document (PDD).
26The levy is not assessed against projects hosted by developing countries.


                                                             14

have the necessary national guidelines in place to track, measure and report emissions and reductions

are able to issue and transfer ERUs without recourse to an international body for approval.           27


           As a practical matter however, many Annex I countries do not currently have in place the

domestic institutions needed to fully comply with UNFCC JI eligibility rules.28 And, rather than

preclude projects in countries that have pledged emission ceilings while permitting them in countries

that have not, the UNFCCC devised a second Track Two procedure for JI similar in structure to the

CDM project cycles. Track Two projects are monitored by the Article 6 supervisory committee, also

known as the Joint Implementation Supervisory Committee (JISC), which plays a role similar to the

CDM Board. ERUs generated by track-two projects are measured against a baseline, whose

methodology has been approved, as determined by an accredited independent entity (AIE)

recognized by the JISC. In practice, several of the firms certified to validate CDM baselines (as

DOEs) are also certified as to validate Joint Implementation baselines (as AIEs).


Land management projects

Rule-making for sinks and land-use projects proved difficult and it was not until the Bonn

Conference of the Parties in 2003 that guidelines for LULUCF CDM projects emerged. The projects

are complex and involve measuring the net change in carbon stocks for particular sites and any

related increases in emissions off-site, taking into account above-on-and-below-ground biomass and

soil organic carbon. The projects are also long-lived and subject to reversibility because of human

activity such as logging or natural events such as forest fires or disease. Because of these

characteristics, many feared that the projects would not deliver sound environmental benefits. Added

to this was a concern that CDM-market economics would favor projects based on fast-growing

industrial plantations, crowding out projects that are community-based and that promote

biodiversity.29 Consequently there was opposition to allowing land-use projects under CDM and the

rules that eventually emerged are cautious and restrict the scope for land-use projects.

           In particular, current rules permit afforestation and reforestation projects but exclude

projects designed to slow deforestation. Moreover, rules limit the total amount of land-use CERs that

can be used to meet Kyoto obligations during the first commitment period.30 To address

reversibility, net removals from the project are certified every five years. Certified reductions from


27To be eligible for participation in either project-based mechanism, Annex I countries: ratify the Kyoto
Protocol; calculate their assigned amount; establish a national system for estimating emissions and removals;
put in pace a national registry to record and track the creation and movement of related tradable assets.
28As of February 2008, only the Czech Republic, Greece, Japan, New Zealand and Slovakia had met UNFCC
eligibility requirements.
29Hunt (2008) reports that this may be the case for tropical Australia.
30An Annex B party's use of LULUCF CERs cannot exceed 5 percent of their base-year emissions.


                                                              15

land-use projects are given a different status and project developers can choose between two types of

CERs: Long-term CERs (lCERs), which expire at the end of the project's crediting periods, or

temporary CERs (tCERs) that expire at the end of the next commitment period.31 (For example,

tCERs issued during the first commitment period would expire at the end of the second

commitment period.) If the project performs as planned, new tCERs are issued to replace expiring

ones until the end of the project's crediting period. However, Annex B countries that use tCERs

during the first commitment period have to replace them during the next commitment period with

so-called permanent credits: AAus, ERUs, RMUs or CERs from non-LULUCF projects. The same

restriction does not apply to the use of lCERs; however if the accumulated stocks of stored carbon

from a projects for which lCERs have been issued declines during the five-year certifications, Annex-

B countries must replace a proportional share of the lCERs that they used. If a project fails to submit

a certification report, all lCERs issued to the project must be replaced.

         Even though IPCC reports note the large potential for enhancing or preserving sinks,

especially in Latin America, few CDM projects have been proposed to date.32 And, as a practical

matter, the limit on their use during the first commitment period has not been binding; less than 2.5

percent of the allowed amount has been contracted so far by governments with Kyoto obligations.33

Additionality, diversion, supplementarity and carry over

Supplementarity

As discussed, there is a long-standing concern that the flexibility mechanisms will weaken the

environmental efficacy of the climate change framework. In turn, these have led to safeguards in the

project cycles and explicit or implied constraints on how tradable carbon permits can be traded. A

principal concern relates to emission trading and a belief that reduction pledged under the Kyoto

Protocol are, in the aggregate, not significantly different from the level of emissions that would

otherwise occur. This concern stems chiefly from a large supply of excess allowances resulting from a

restructuring of transitional economies since 1990. These allowances are referred to as "hot air" and

modeling results suggest that the availability of excess allowances will lower the overall price of

tradable permits. The issue also relates to credits arising from projects since these can add to the

overall supply of tradable permits.




31To complicate matters, project developers can chose two types of project crediting periods: one with a set
crediting period of 30 years, and a 20-year crediting period eligible for two renewals (for a maximum of 60
years.)
32In their IPCC report, Fisher et al. (2007) note studies indicating that 15-40 percent of total cumulative
abatement of the next century could be provided by land-use mitigation options.
33See Pedroni (2005) for a general discussion. Olschewski et al. (2005) provides a case study from Patagonia.


                                                             16

         While lower carbon prices would reduce many of the economic costs of the treaty, lower

prices would also lead to fewer emission reductions in Annex B countries. Moreover, lower prices

would provide lower incentives to develop and use new technologies. During negotiations, moral and

equity arguments were put forward as well against relying on traded permits (Lecocq and Ambrosi

2007).

         As discussed, negotiators reached agreement on emission allocations well before deciding on

how the flexibility mechanisms would work. Consequently, as concerns rose over the aggregate

supply of first-period allowances, negotiators chose to focus on restricting how the allowances might

be used, rather than revisiting the allocation decision. In particular, although the treaty places no

explicit restrictions on the combination of instruments that Annex B parties can use to meet their

obligations, there is ample language in the climate change framework that implies restrictions on the

use of credits overall and on the use of project credits. For example, Article 17 of the Kyoto Protocol

states that the use of emissions trading to meet Kyoto commitments shall be "supplemental to

domestic actions." Article 6 says that credits from joint implementation projects shall be

`supplemental to domestic actions' for the purpose of meeting reduction commitments. And Article

12 says that parties can use credits from the clean development mechanism to meet "part of their

quantified emission limitation and reduction commitments." The uncertain question of how

substantially countries can depend on traded credits is referred to as supplementarity, based on the

language of Article 17, and remains controversial. The role of excess allowances factor into most of

the modeling efforts discussed later in the paper. Studies that focus especially on "hot air" include

Ellerman and Wing (2000); Victor, Nakienovi and Victor (2001); Böhringer and Löschel (2003);

Maeda (2003); Klepper and Peterson (2005); and Böhringer, Moslener and Sturm (2007).

         As will be discussed in more detail in section 4, there is political resistance in several Annex

B countries to rely significantly on emission trading and policies that limit the use of tradable units

are in place. As the term "hot air" connotes, there is a view that some AAUs do not contribute

materially to emission reductions. From the perspective of countries holding surplus AAUs, this

undermines their value. In response, countries like Bulgaria, Latvia and the Ukraine have developed

green investment schemes (GIS), where proceeds from the sale of AAUs are invested in to other

projects with environmental integrity. Blyth and Baron (2003) provide an overview.


Additionality and baselines

A related concern with the flexibility mechanisms has to do with environmental gains arising from

project investment. Here the concern is that project outcomes may not be different from business-

as-usual outcomes. Language in the Kyoto Protocol (Article 12) states that reductions in emissions



                                                        17

from CDM projects should be "additional to any that would occur in the absence of the certified

project activity" (Para 5c), and this has given rise to the notion of baseline additionality.

         There are several types of additionality discussed in the literature on carbon projects that

potentially have a bearing on CDM baselines and approval by the CDM Board. The ones that relate

most closely to baselines are environmental additionality, technology additionality and investment

additionality. Technology additionality is implies using the best available technologies. This relates to the

CDM in that the mechanism is expected to facilitate technology transfer. Environmental additionality is,

at least conceptually, straight-forward and implies that project emission outcomes are lower when

compared to a business-as-usual baseline. Investment additionality is a related baseline concept that

means that the project in question would not be profitable without additional funding ­ presumably

obtained in return for offsets. This means that any investment project that meets certain profitability

standards falls within the business-as-usual scenario, even if the project displaces emissions. In this

sense, investment additionality precludes a re-labeling of existing projects as CDM projects. It also

addresses the emergence of new technologies that are, in and of themselves, profitable and emission-

reducing. Even so, finding the appropriate measure of profitability is difficult. Moreover, establishing

a too-stringent standard would exclude projects that can deliver off-sets at low cost, while setting lax

standards can undercut the project's environmental additionality.34

         Another type of additionality, financial additionality, has to do with the use of bilateral aid. The

term was originally used in connection with the AIJ program and has to do with a fear that Annex B

countries would simply divert existing overseas development assistance (ODA) into AIJ projects.35

More recently, financial additionality is addressed in the Marrakesh Accords, which state that public

funding for clean development mechanism projects should not "result in the diversion of official

development assistance and is to be separate from and not counted towards the financial obligations

of Parties included in Annex I." (Preamble of Decision 17/CP.7, UNFCCC, 2001: 20). As Dutshke

and Michaelowa (2006) point out, financial additionality would appear to rule out the use of ODA

funds for the direct purchase of CERs and the authors note that the OECD's Development

Assistance Committee has proposed rules that would deduct publicly financed CERs from official

ODA. However, CDM projects are intended to contain a sustainable development element and a

case can be made that public funds spent to bolster the development impact of CDM projects should

count as ODA. Similarly, there may be good reasons to ODA on public goods such as building the

institutions that support and monitor CDM markets. Even so, controversy surrounds the whether



34Asuka and Takeuchi (2004) discuss environmental, investment and financial additionality. Greiner and
Michaelowa (2003) provide a good discussion of the debate concerning investment additionality rules.
35See discussions in Ghosh and Puri (1994) and Parikh (1995).


                                                           18

such spending is additional or a diversion of existing funds and the practical problem of how to

measure financial additionality remains.

         As discussed, the decision by delegates to require project level reviews of project level

baselines was prompted by a desire to safeguard the environmental integrity of the climate change

framework. Even so, several authors have advocated setting sectoral or industry level baselines. For

example, Zhang, Heller and May (2005) discuss how this might be accomplished for electricity

producers in China. Largely, the arguments for doing so are based on arguments that project

baselines are costly, arbitrary and unlikely to fully safeguard environmental integrity.36 Moreover,

project-by-project approval precludes the potential for the restructuring of transport systems, which

may have substantial positive spillover effects in the long-run. In contrast, the environmental

safeguards associated with sectoral baselines may be second best, but may substantially lower costs

and regulatory uncertainty and could potentially play a large role in establishing low-emission

development pathways.


Managing tradable units inventories under Kyoto

The Kyoto Protocol and a series of rules issued as part of the Marrakesh Accords govern how

countries manage their inventories of measured emissions and tradable permits. For one, in order to

participate in emission trading, Annex I countries must create a national registry to keep track of

their tradable units and must file annual reports on emissions. In addition, a series of rules govern

how countries must mange their inventories within a reporting period and across reporting periods.

How countries manage their inventories within the first commitment period is governed by the

commitment period reserve rule. This rule is designed to address concerns that incautious sales of excess

permits would leave some parties unable to meet their targets. Keeping in mind that the current

commitment period spans five years while greenhouse gas inventories are reviewed annually, each

Annex I Party must maintain in its national registry a "commitment period reserve," which cannot be

below 90 percent of the Party's assigned amount or five times its most recently review inventory,

whichever is lowest.37

         How inventories can be managed between commitment periods are governed by the banking

rule, the suspension rule and the restoration rule. The banking rule is straightforward and set out in



36Geres and Michaelowa (2002) and Shrestha and Timilsina (2002) discuss indirect leakages related to project
baselines. Transaction costs and barriers that may not be fully accounted when investment additionality is
determined are discussed by Renz (1998); Heller (1998); Michaelowa and Fages (1999); Woodward (2000); and
Brechet and Lussis ( 2006).
37Net holdings of ERUs, CERs, AAUs and RMUs for the relevant commitment period comprise the
commitment period reserve.


                                                           19

Article 3 of the Kyoto Protocol, which states that any difference between emissions and assigned

amounts can be carried forward into the next commitment period. Borrowing from future

commitment periods is limited by the suspension rule and penalized by the restoration rule. The

suspension rule, based on Article 17 of the Protocol, states that parties that are in deficit at the end of

the first commitment period cannot export additional transfers until the deficit is eliminated. What's

more, the restoration rule states that each unit deficit during the first commitment period will be

matched by a reducing second period allowances by 1.3 units.

          Even so, because compliance is voluntary and because the cost of rebalancing inventories is

low, the combined rules are not expected to greatly influence the overall cost of the treaty or

ultimately affect compliance. See, for example, Godal and Klaassen (2006) who use a numerical

model to assess the role of the four rules on costs to treaty participants individually and collectively

and also Hovi, Froyn and Bang (2007), who discuss the determinants of treaty compliance.

Compatibility with the trade agreements38

Generally, parties to the UNFCCC are also members of the World Trade Organization and language

in the climate change framework urges compatibility between the two.39 Even so, the basic principles

underlying the treaties differ and there are potential areas for conflict.40 As discussed, the Kyoto

Protocol is built around a principle of common but differentiated responsibilities. In contrast, the

WTO promotes trade based on the principle that national policies will not discriminate against goods

based on national origin. Moreover, for the most part, the international trade system characterizes

goods based on physical description, while the processes by which goods are produced are central to

greenhouse gas accounting. At the same time, Brewer (2003) makes the point that the two are, from a

narrow legalistic point of view, compatible because the climate change framework has no

enforcement mechanism that would conflict with WTO judgments. Additionally, Werksman (1999)

argues that the system of emission trading established under the Kyoto Protocol should be

unaffected by the WTO agreement, since emission allowances are licenses or permits rather than

goods or services under WTO law. Still, there are potential conflicts. As discussed, differences in

how greenhouse gas emissions are regulated terms-of-trade effects that create advantages to countries

that face lower constraints on emissions. The resulting trade diversion can affect incomes and can

also lead to increased emissions elsewhere, a problem known as "leakage" in the climate change



38Brewer (2003) and the World Bank (2008) provide good overviews.
39As Brewer (2003) points out, Article 2.3 of the Kyoto Protocol and Articles 3.5 and 4.2 of the UNFCCC
urges parties to implement policies that minimize adverse effects on international trade and refrain from
arbitrary restrictions on trade.
40For example, Green (2006) argues that the WTO Agreement in its current form precludes some types of
beneficial subsidies.


                                                           20

literature. Modeling results suggest this problem can be significant, a topic we return to later in the

paper.

          While the best approach is to reach a satisfactory policy treatment for climate change

separately, remedies involving trade policy have been discussed. For example, Biermann and Brohm

(2005) argue that there is scope under trade law for border-tax adjustments that would penalize

imported goods that embody higher emissions, but concede that the related rules are far from clear.

Stiglitz (2006) suggests using the WTO appeals process to force wealthy countries to adequately

regulate greenhouse gas emissions since failing to do so creates trade advantages.41 Zhang and

Assunção (2003) point out potential areas of conflict regarding subsidies, energy efficiency standards,

eco-labeling, government procurement, and carbon taxes.

          Separate from potential conflict, several authors point out that there is ample scope for

reducing greenhouse gas emissions by removing trade obstacles. For example, a World Bank study

(2008) concludes that removing trade barriers to clean energy technologies among 18 developing

countries would significantly boost related trade, result in technology transfers and reduce

emissions.42 Reducing restrictions on goods and services related to the CDM project cycle is another

example. Brewer (2003) provides additional examples.


4 Expected outcomes from the climate change framework

Negotiators faced the practical tasks of deciding upon the objectives of the climate change

framework and devising instruments that achieves those objectives in a fair and efficient way. Both

tasks are steeped in uncertainty. Even so, decisions have been taken based on informed expectations

about the relationships between greenhouse gas emissions and climate change and based on

expectations about how the provisions of the treaty will work, including the Protocol's innovative

flexibility mechanisms. In particular, the flexibility mechanisms are expected to lessen the cost of

meeting the environmental objectives of the treaty. Incentives and new markets related to the treaty

are expected to mobilize private capital. For developing countries, the treaty is expected to generate

inflows of capital and technology and contribute to sustainable development. Early project

investments through JI and CDM are expected to set countries on a lower carbon path, by

supplanting commonly used technologies in long-lived and irreversible investments with carbon-

saving alternatives. In this section, we briefly discuss the literature related to evaluating the benefits


41 Article XX of GATT 1994 allows for trade interventions to protect necessary to protect human, animal or
plant life or health or exhaustible natural resources as long as they are not arbitrarily or inconsistently applied.
Whether this provides an endorsement of process and production related criteria for trade interventions is
subject to debate. See Ahn (1999) and Jackson (2000) and the discussion in Zhang and Assunção (2003).
42 The studied technologies are clean coal, wind power, solar power and efficient lighting.


                                                              21

and costs of limits on greenhouse gas emissions and evaluations of how the flexibility mechanisms

might work.

Policy evaluations and predictions

Most often in economics, evaluations of policy are based on historical assessments. In the case of

integrated evaluations of climate change and its economic impact, evaluations are forward looking

and rely heavily on models built up from current and historical physical, technical, institutional and

economic relationships. For the most part, the model predictions are against hypothetical

alternatives, some of which are unlikely to occur. Still, the models used to evaluate climate change

policy contain predictions about the scale of carbon markets and how markets they might work.

There is a substantial literature on how to model climate change policies. It is well reviewed

elsewhere and this section draws on that work. Comprehensive surveys are given in Weyant (1999,

2004), Löschel (2002), Springer (2003), Sands (2004) and most recently in Working Group III

contribution to the Fourth IPCC Assessment (IPCC 2007a).


Model structures and technology

Springer (2003) broadly categorizes the reviewed models into five groups. The first is made up of

integrated assessment models, where physical and human activities are jointly modeled. As Springer

notes, there is some overlap between this group and the remaining, since the economic components

of the integrated models employ CGE or energy system models. Examples of integrated models are

discussed in Manne and Richels (1999), Nordhaus and Boyer (2000), Nordhaus (2001), Jacoby et al.

(2006). Another common approach relies on marginal abatement cost curves to examine the effects

of trade. Examples include Jotzo and Michaelowa (2002), Löschel and Zhang (2002) and Stevens and

Rose (2002). A less common approach focuses on macroeconomic tradeoffs between monetary

policy and employment. See, for example, McKibbin, Shackelton and Wilcoxen (1999). An

alternative approach is to employ technical engineering models of sectors or energy systems. These

bottom-up models are sometimes integrated with other sectors via a CGE model. IPCC (2007a)

contains a review of several bottom-up sector models.

         An important distinction among the models is whether greenhouse gas concentration is

exogenous to the model.43 Optimization models let the economic sectors maximize profits while

adjusting the level of emissions endogenously. This can be done either by adjusting levels of

production and the mix of sectoral output, or by introducing and endogenously selecting production

technologies with different greenhouse gas intensities. The other approach is to exogenously impose

a level of greenhouse gas concentration on the model and to find the most cost effective way to


43See Manne and Rutherford (1994) for a discussion.


                                                        22

reach it. Both approaches can be either static or dynamic. While endogenous technology adoption

can be part of the model, CO2 concentration can also be addressed via level of production only.

          Springer notes a variety of common outcomes from most modeling exercises. For example,

most models find that trade in permits substantially lowers the cost of meeting Kyoto objectives,

while trade restrictions increase costs and potentially lead to market power concerns. The withdrawal

of the US is expected to substantially lower the environmental efficacy of the climate change

framework. Dynamically, most modeling exercise reveal what Nordhaus (2007) describes as a

climate-policy ramp, whereby policies aimed at slowing climate change tighten over time.

          Another important modeling dynamic involves the treatment of technical change.44 In most

modeling efforts, technical change most often enters climate change policy models exogenously. In

bottom-up models technical change consists of optimizing among a fixed set of engineering technical

relationships. The same can be said of some of the models that rely on abatement cost curves built

up from information on the energy structure of economic regions. In top-down models, technology

is reflected in the parameters of the modeled economic relationships, which are expected to change

with shifting technologies. The most straightforward way is to think in terms of the parameters of a

production function where the parameters imply an underlying technology. For this reason, Löschel

(2002) argues that endogenous technical change is more easily modeled within a top-down structure.

Still, shifting production function parameters are also consistent with the endogenous adoption of

existing technologies (Mundlak 1993).45 Moreover, efficiency gains can also come about because of a

changing input composition as capital levels change over the longer term (Sands 2004).

Consequently, what distinguishes the endogenous technology change models is a structural link

between research expenditures and innovation. Endogenous technical change models that take into

account research and development investments include Goulder and Schneider (1999), Buonanno,

Carraro and Galeotti (2003) and Nordhaus (2002).

          One primary purpose to which models have been put is the development of a schedule of

carbon prices that are consistent with different carbon concentration levels and that lead to stable but

different long-run climates. Estimates gathered for the Fourth IPCC Assessment suggest a carbon

dioxide price of from $US 20 ­ 80 per ton by 2030 and rising to $US 30-155 by 2050 is consistent

with scenarios that stabilize atmospheric carbon concentrations at 550 ppm, a level thought to be

consistent with moderate climate change. Importantly, models that allowed for endogenous technical

change suggested that the same level of atmospheric concentration levels could be obtained at


44See Carraro and Galeotti (1997), Löschel (2002) and references therein.
45The diffusion of known technologies is well illustrated by Oda, Akimoto, Sano and Tomoda's (2007)
bottom-up study of the Japanese steel industry.


                                                           23

significantly lower carbon prices (IPCC 2007b). The modeling results, which suggest a significant role

for new technologies, are reflected in a set of policy proposal aimed at funding global research. We

take up this topic in the section below. The same models are used to measure any adverse impacts of

economic growth resulting from Annex B emission reductions. For comparison purposes, the costs

are often expressed in terms of reduced GDP. Model predictions of 2050 GDP reductions reviewed

by the IPCC (2007b) associated with stabilization around 550 ppm range from near zero to 4

percent.  46


          The numeric models have also been relied upon to provide estimates of the potential

benefits of the Kyoto Protocol's flexibility mechanisms. As Springer (2003) notes in his review, a

common finding is that the costs of reaching greenhouse reduction goals are greatly reduced by rules

that allowed spatial and temporal flexibility. By way of example, early model results by Bernstein,

Montgomery and Rutherford (1999) suggest that flexible trading rules could reduce the price of

carbon permits ­ which can be seen as the marginal cost of emission reductions ­ by a factor of

seven in the European Union and by a factor of sixteen in Japan.47

          Early results indicating the importance of trade and project investment countries have held

up with time; however, recent modeling efforts have illustrated how the cost-savings from the

flexibility mechanisms depends on the stringency of emission reduction targets. For example, under

scenarios consistent with earlier assumptions, den Elzen and Both (2002) estimate that the Kyoto

flexibility mechanisms reduce the overall cost of meeting the first commitment period targets by 40

percent. However, the authors also show that the withdrawal of the United States from the

agreement greatly reduces the need for the provisions; predicted trade under the provisions is cut in

half as aggregate abatement levels drop significantly without demand for offsets from the US.

          Global averages of the costs of mitigation mask differences in the distributional effects of

climate change. As Mendelsohn, Dinar and Williams (2006) note, early models of climate change

suggested that the effects of climate change would fall uniformly among the rich and poor. More

recent results suggest that this is not the case and that the world's poor will be disproportionately

affected. The study suggests this result comes about primarily because of where the poor live. In the

already mentioned paper by Mendelsohn, Dinar and Williams, the authors develop sectoral response

functions and country specific measures of geography, population and income to develop country-



46Sathaye et al. (2007) provide a survey of alternative welfare indicators.
47See Nordhaus and Boyer (2000), Springer (2003), Weyant (2004), Sands (2004) and Working Group III's
contribution to the Fourth IPCC Assessment (IPCC 2007) for additional reviews of modeling approaches and
results. Painuly (2001) reviews numerical models that address project-based investments in developing
countries; Muller and Mestelman (1998) review related laboratory-based experiments.


                                                             24

specific measures of climate change. They conclude that the poorest half of the world's nations will

suffer most from climate change while the net consequences for wealthy countries are mild. Based on

current income, land use and population distributions, Dasgupta et al. (2007) conclude that the

countries mostly likely affected by rising sea levels are poor. Bosello, Roson and Tol (2007) reach a

similar conclusion based on modeling results. In a related paper, Bosello, Roson and Tol (2006), the

authors conclude that adverse health consequences from climate change will also fall most heavily on

poor countries.


Market power

As discussed, the supply of excess AAUs available in the economies that have restructured to
become more energy efficient since 1990 has spurred a set of policy discussions around the topic of
supplementarity. More recently, authors have argued that the concentration of excess allowances in a
handful of countries, especially in Russia and the Ukraine, conveys a degree of market power that
might encourage countries to withhold AAUs from the market, resulting in a higher price than
competitive models might suggest (Baron, 1999). This possibility raises the question of whether or
not there is a practical way to exercise this latent market power. As Klepper and Peterson (2005)
point out, the climate change framework is not explicit about the relative roles that governments and
private firms play in emission trading, so it is possible for governments to restrict trade in a
cooperative way that extracts rents and the prices of tradable permits. Hagem and Maestad (2006)
analyze optimal strategies for a country that has market power in an international market for
emission permits and at the same time is an oil and gas exporter. In applying the analysis to the case
of Russia, they show that a country can benefit from coordinating the permit and oil and gas exports,
depending on the level of substitution between the types of fuels exported. They conclude that
strategic behavior affects decisions that lead to market power and may impose inefficiencies on
carbon trading, either directly or indirectly

          Market power can arise from the buyer's side as well. Carlén (2003) uses a laboratory

experiment to explore this question, but doesn't "observe that the dominant buyer country exerts

market power by withholding demand from the market as predicted by standard economic theory.

...the outcome casts doubt over the validity of assessment of market power effects in international

carbon emission trading that indicate substantial efficiency losses"(Carlen 2003:23).

         Several authors have also explored whether issues of market power, raised initially in the

context of international trading arise in the context of domestic market regulations. For example,

.Kuik and Mulder (2004), in their analysis of alternative regulatory approaches to emissions in the

Netherlands assert that the trading schemes will lead among to different market clearing permit

prices, the effects of which will differ depending upon the scale of the firm. Firms in sectors such as

agriculture will be disadvantaged, because the sector is composed of relatively many small units that

face higher transaction costs under trading schemes. Using a static game theory model applied to a


                                                         25

regional electricity market, Lise et al. (2006) find that a reduction in the market power of large

producers may benefit both the consumers and the environment. Taken together, the two studies

indicate the importance of domestic structure on policy outcomes and suggest that more work is still

needed to better understand the relationship between market power and the efficiency of the carbon

market and its impact on global emissions.


Leakages, ancillary benefits and crowding out

A practical concern arising from differentiated obligations has to do with the interaction between

those who have assumed obligations and those who have not. The set of secondary effects, known as

carbon leakage, can come about because economic activities shift due to changing prices and terms

of trade. Leakage can occur because of differences in a variety of policy instruments, but the term

most often refers to the set of secondary effects that result in increased emissions in countries

without emission limits that partly or fully offset the environmental gains from limiting emission in

Annex B countries. As discussed, this has to do in part with trade rules and their compatibility with

climate change obligations.

         General equilibrium models are well suited for analyzing carbon leakages and this literature is

reviewed in Burniaux and Martin (2000) and in Baker et al. (2007). These studies find evidence of

leakages of ranging degrees. For example Paltsev (2001) reports a leakage rate of around 10 percent,

while Babiker (2005), looking at energy-intensive activities reports scenario outcomes ranging in

global leakage rates between 25 and 130 percent ­ that is, under some scenarios emission limits

increased net emissions. At the same time, studies suggest that leakages are likely to vary greatly

among subsectors. For example, in a detailed study of the cement industry, Szabo et al. (2006)

suggest leakage rates of 29% in the EU. More recently, Di Maria and van der Werf (2008) develop a

conceptual model that suggests that the terms-of-trade effects captured by most CGE models ignore

the offsetting effect of induced technological change and consequently over-estimate leakages.

         Other secondary effects, often referred to as ancillary effects in the climate change literature,

have to do with positive welfare gains that accrue from greenhouse gas mitigation. One example is

associated with the double-dividend welfare gain arrived at by taxing a negative externality instead of

economic goods and services (Terkla 1984; Lee and Misiolek 1986). The "double dividend" stems

from the recovery of dead-weight welfare losses related to taxing productive economic activity. In

the case of climate change policy, a positive effect on economic growth is accomplished by using

revenue raised by a carbon tax or by auctioned permits to displace distortionary factor taxes, such as

payroll taxes or taxes on capital assets, thereby generating both environmental and economic

benefits. A series of numerical studies showing that factor market distortions swamped the positive



                                                          26

effects of marginal tax cuts cast doubt on the potential for a double dividend (Bovenberg and de

Mooij 1994; Parry 1995; Bovenberg and Goulder 1996; Koskela, Schon, and Sinn 1998). Later,

Williams (1999, 2002) and Parry and Bento (2000, 2001) described special situations that might lead

to a double dividend. Most recently, Bento and Jacobsen (2007) use a conceptual and numeric model

to show that, when rents related to the use exhaustible resources are not fully taxed, net welfare gains

constituting a double dividend can be generated when environmental taxes are used to cut pre-

existing labor taxes. Country studies include; McKitrick (1997), Canada; Garbaccio, Mun and

Jorgenson (1999), China; Edwards and Hutton (2001), UK; Ibarraran, Viniegra and Boyd (2001),

Mexico; Roson (2003), Italy; and Takeda (2007), Japan.

          In their review of country studies, Barker et al. (2007) conclude that the benefits associated

with revenue recycling (replacing current taxes with revenues raised through climate policy) can be

significant. Taken in combination with other ancillary benefits, this greatly expands the scope for

low-cost and no-regrets outcomes. We return to this topic later in this section.

         Another set of positive externalities, referred to collectively as co-benefits, include collateral

health benefits that are realized when other types of pollutants are reduced together with greenhouse

gases. Both top-down and bottom-up models have been employed to measure such effects. For

example, Li (2002, 2006) looks at health benefits associated with greenhouse gas emissions in

Thailand and Burtraw et al. (2003) examine the potential for positive health gains associated limits on

US greenhouse gas emissions. Dudek., Golub and Strukova (2003), Dessus and O'Connor et al.

(2003) and Aunan et al. (2003) examine the same issue in Russia, Chile and in China, respectively. A

series of papers, including Gundimeda (2004), Plantinga and Wu (2003), Feng and Kling (2005),

Yemshanov et al. (2005), look at forestry and carbon sequestration co-benefits. These benefits are

tied to both the environmental services generated by sustained forests and incomes associated with

payments for environmental services. Pendell et al. (2007) provide an example related to soil fertility.

         In their synthesis, Barker et al. (2007) note that conservative studies of the ancillary health

benefits associated with climate change policy can equal 30-50 percent of estimated mitigation costs,

while some studies, especially studies of developing countries, indicate that health benefits can exceed

mitigation costs. They also note that several studies suggest that a large share of business-as-usual

emissions that can be reduced without welfare loss: 13-23 percent in India (Bussolo and O'Connor,

2001); 15-20 percent for China (O'Connor, 2003); and 20 percent for Chile (Dessus and O'Connor

2003). Other studies suggest savings could be had on other types of air pollution controls as well. For

example, Burtraw et al. (2003) estimate that a 31 percent reduction in CO2 emissions in the United

States would drive the price of SO2 permits to zero.




                                                         27

          A potential negative externality recently identified by Nordhaus (2007) has to do with the

consequences of large inflows of carbon financing into small economies. Potentially, large inflows of

investment tied to one sector can lead to a currency appreciation changing domestic relative prices to

the disadvantageous of parts of the economy and crowding out economic activity in those sectors.

This phenomenon is known as the Dutch Disease and is most often explained in terms of

commodity booms (Corden, 1984; van Wijnbergen, 1986.).48 There is also a body of research that

suggests that economic growth in resource-rich developing countries has been slow because of

related rent-seeking, corruption, violence, fiscal mismanagement and a crowding out of other

economic activities.49 While crowding-out stems from a general equilibrium trade effect, the

remaining problems relate to weak institutions. To date, the most significant investment flows under

CDM have gone to large economies and few studies have considered the possible consequences of

project-based investment flows. In one innovative study focusing on two large economies,

Bohringer, Conrad and Loshel (2003) look at a joint model of Germany and the Indian electricity

sector and find large welfare gains for both countries.50


Uncertainty, discounting and intergenerational tradeoffs

How best to model the uncertainties associated with climate change remains an unresolved challenge.

The recent IPCC assessment reviews the potential for abrupt climate change with catastrophic

results, including raising sea levels, droughts, and an increased intensity of tropical typhoons (Meehl

et al. 2007). Moreover, because greenhouse gases are long lived policy decisions have cumulative and

irreversible effects. Wirl (2006, 2007) provides a conceptual approach to model types of

environmental irreversibility under uncertainty in a stochastic setting and provides a brief review of

the related literature. Still, little is known about the point at which a particular extreme climate event

would occur or, for that matter, about the associated probabilities. Even so, decisions are taken

sequentially and this provides some scope for developing and incorporating new information

through time (Valverde, Jacoby and Kaufman, 1999). As Pindyck (2007) points out, the practical

consequence of limited information on probabilities is that uncertainty is handled in the context of

specific models.




48There is a related literature having to do with aid flows as well. See Agénor, Bayraktar and Aynaaoui (2008)
for a recent discussion.
49For an early discussion of the "resource curse" see Gelb and associates (1988). See also Mehlum, Moene and
Torvik (2006), Auty (2007) and references therein.
50Advocates also argue that administrative and other transaction costs would be lower under a carbon tax. See
Hahn and Hester (1989) and Stavin (1995) for early general discussions of tradable permits and transaction
costs.


                                                             28

         In terms of numeric modeling efforts to assess policy outcomes, the consequences of

uncertainty come into play largely through discounting rates used to value future events. Since the

consequences of near-term policies persist in accumulations of greenhouse gases in the atmosphere

and in accumulations of capital and technologies, advantages or disadvantages gained by one set of

policies over another are difficult to reverse as time goes by. For this reason, the rate of comparing

early costs to future benefits is crucial to modeling efforts. Halsnaes et al. (2007) review the risk and

uncertainty literature as it relates to climate change and describe out how the issue affects IPCC

assessments.

         Arguments about appropriate rates of social discounting relate to positive conceptual and

empirical studies as well as more controversial normative approaches. Studies of past returns to

capital (financial and human) suggest positive rates of return, which imply positive discount rates for

future benefits arrived from present investments. This finding is not controversial in its self and is

discussed in Arrow et al. (1996) as background to the second IPCC assessment. In contrast,

normative arguments over whether market-based rates are indicative and an appropriate measure for

discounting future welfare are controversial and pivotal for policy assessments.

         Generally, assessments of climate change policy are based on positive and often constant

discount rates. In some instances these are based on observed market rates, based on the notion that

policy tradeoffs reflected in climate change scenarios should use the same metric as other policy

tradeoffs related to trade or debt. Critics argue that, because of market imperfections, such rates are

biased upwards and that lower rates should be employed. Even so, separate from arguments

concerning appropriate levels, an important consequence of positive discount rates is that the welfare

of future generations has little present value. Some writers find this objectionable based on moral

grounds and argue that the approach for valuing inter-generational transfers should differ from the

approach taken for capital. To take this into account, studies sometimes distinguish between the rate

used to reflect the time-value of capital and the rate used to discount future welfare, sometimes

referred to as the pure rate of social time preference. While rates measuring returns to capital have an

empirical basis, arguments concerning an appropriate way to discount the interests of future

generations are philosophical and subject to stark dissonance. Yet the assumption matters critically

for numerical models of the cost and benefits of climate change policies. For example, Nordhaus

(2007b) maintains that the use of a near-zero social time-preference rate explains why the Stern

Review (Stern 2007) calls for stronger early mitigation interventions than does the general literature.

         Most studies use positive and constant rates to discount future welfare, but several authors

propose that discount rates should fall with time. For example, based on uncertain returns to capital,

Weitzman (2001) argues for a declining discount rate as do Gollier (2002), Newell and Pizer (2004).


                                                         29

Weitzman (1998) argues in favor of using a zero discount rate for half century time horizons and, as

mentioned, the Stern Review relies on a near-zero discount rate. Portney and Weyant (1999) provide

a good review of the related literature. Dasgupta (2005, 2007) looks at the discounting issue. The

ethical and conceptual bases for the discount assumptions of the Stern report are discussed by

Beckerman and Hepburn (2007), Dasgupta (2007) and Nordhaus (2007).

Technology development and transfer as a policy instrument

As discussed, modeling outcomes point to the importance of new technologies in affecting the cost

of meeting emission reduction goals. However, several studies indicate that past investments in

related research and development has been insufficient, suggesting that markets for new technologies

will need non-market support. For example, Margolis and Kammen (1999) show, using data from the

US, that there has been a long-term pattern of underinvestment in R&D in the energy sector,

compared to other sectors and they conclude that a deployment effort for increased research in the

energy sector is needed. Subsequent authors conclude that, while additional research in energy

technologies is necessary to improve energy efficiency, a broader approach is needed. For example,

Sagar (2000) argues that development and deployment efforts should focus on additional sectors as

well as energy. Sagar and van der Zwaan (2006), using data from OECD countries, demonstrate a

lack of correlation between energy efficiency level and energy R&D. They conclude that energy R&D

is sufficient but not a necessary condition for improved energy efficiency. They identify roles for

institutions, deployment and learning as necessary conditions for transfer of energy R&D

innovations to the market.

          Modeling results indicating a strong role for technology and that carbon prices will be lower

than expected, following the US decision not to ratify the Kyoto Protocol have also worked to focus

attention on policy instruments that support technology development and technology transfer. This

interest is reflected in the climate change literature and in actions taken by the UNFCCC delegates.

Institutionally, a framework was developed during the Marrakesh Conference of the Parties to

enhance the implementation of Article 4.5 of the Convention, which recognizes the importance of

technology development and transfer in battling climate change and allowing steady growth in

developing countries. The framework includes 5 activities/requirements, namely: technology needs

and needs assessments; available technology information; enabling environments in developed and

developing countries; capacity building in developing countries; mechanisms for technology transfer.

To date, there are three special funding mechanisms under the UNFCC: the Least Developed

Countries Fund, the Special Climate Change Fund and the already mentioned Adaptation Fund.51 To



51In addition, funding for mitigation and adaptation efforts is available under the Global Environment Facility.


                                                           30

a degree, the three funds offer ways to promote technology transfer, although the emphasis of the

funds is on adaptations and also on specific areas, including agriculture, health, water resources and

disaster protection that are expected to promote development objectives. Additionally, as discussed,

CDM and JI are expected to promote technology transfer. Still, policy makers and researchers have

suggested that current incentives and funding is unlikely to generate significant new technologies and

have proposed additional funds emphasizing research and development.52 Worth noting as well is a

Clean Technology Fund, managed by the World Bank and backed by donor pledges of $US 5 billion

(World Bank, 2008b). The Fund, viewed as an interim measure until a future financing architecture

can be established under the UNFCCC, is aimed at finding policy instruments that can accelerate the

deployment, diffusion and transfer of low-carbon technologies.

         Buchner and Carraro (2005) review proposals for an international agreement for the

development and diffusions of new technologies.53 Such an agreement can be supplemental to

emission controls; however, using a conceptual model Barrett (2006) argues that agreements to limit

emissions are likely to be ineffective, leaving an agreement to promote technologies as the most

practical approach to climate change. At the same time, numerical models provide evidence that the

secondary effects of induced technology are small relative to the direct effects of a carbon tax and

generate lower welfare gains than an equivalent control on emissions (Nordhaus 1998; Goulder and

Mathai 2000; Parry, Pizer and Fischer 2003). The previously mentioned study by Buchner and

Carraro concludes that a self-enforcing agreement to cooperate on technological innovation and

diffusions is more likely than a cooperative agreement on emissions, but also concludes that

technological cooperation by itself will be insufficient to meet reasonable abatement goals.


Technology transfer and project financing

Various approaches have been used in the literature to incorporate technology transfer in models that

deal with country policies and carbon offset markets. Approaches used include country and regional

case studies, optimization approaches such as growth models and CGE models, and negotiation and

strategic approaches such as Game Theory. Some of the papers are process oriented and some

provide estimates of economic savings.

         Irrespective of the approach used, the repeated messages from the literature are similar,

namely, a need for enabling local and global institutions and other arrangements that are directly and



52Within the UNFCCC framework, discussion at the Bali COP focused on new funding mechanisms for
adaptation and mitigation research and the Expert Group on Technology Transfers was asked to make
recommendations on develop a strategic plan to scale up investment in technology transfer
(FCCC/CP/2007/L.2).
53Examples include Benedick (2001) and Barrett (2003).


                                                         31

indirectly related to technology development, adjustment and transfer. Both the case studies

(Forsyth, 1999; Duic et al., 2003; Forsyth, 2005;), the partial equilibrium (Kemfert, 2003), the general

equilibrium (Sahlén and Aronsson, 2006), and the strategic approaches (Matsuhashi, Chang and

Ishitani, 1999; Millock, 2002) suggest that there is no one policy that addresses similarly the issues

countries face, but rather, each country or partnership that collaborates in the CDM setting needs a

specific solution to allow technology and its transfer. Finally, an econometric study of the reported

technology transfer by project types and countries suggests also a more microscopic analysis and

understanding of the differences between determinants of technology transfer (Haites, Duan and

Seres, 2006).

         Present policies to technology transfer are criticized for not taking advantage of private

sector capacities and international trade. Distinction is made between long-term technology sharing

policies, used at present, that ignore the potential benefits of the globalization of technology

investment and ownership (Forsyth, 1999). The present policy is claimed to be heavily subsidized and

deterrence of private investors. Rather than having the state focus on the direct innovation

development process, states could better impact development and transfer of technologies by

improving fair trade policies, protect intellectual property rights, and increase public access to

information about, technologies (Forsyth, 2005; Millock, 2002).

         Early on, researchers noted that abatement costs and the shape of the marginal abatement

curves play a crucial role in rates of technology transfer. For example, based on a comparison of

input-output tables, Matsuhasi, Chang and Ishitani (1999) conclude that the potential for technology

transfer between Japan and China is large under CDM; however, using game-theory and sensitivity

analysis, they also show that small changes in underlying assumptions about the structure of

abatement costs have significant consequences for predicted rates of transfer. They point to expected

lower price of the technology and the potential for lower financial cost for the technology transfer

and its positive impact on the economy as key factors affecting the economic viability of CDM

technologies. Similarly, Duic et al. (2003) show that small changes in cost can dramatically change

incentives to switch to new renewable energy technologies, even in a small economy of island nations

such as Santiago and Cape Verde where carbon intensity is low but fossil fuel prices are high.

         The global (both partial and general equilibrium) models demonstrate the importance of

indirect effects of trade on the transfer of clean energy technologies and hence, on economic growth.

Using a partial equilibrium model, Kemfert (2003) shows that trade barriers, would not only damage

the economy, but could also deter investments in climate friendly technologies. Using a general

equilibrium model, Sahlén and Aronsson (2006) add also labor barriers into the market of factors of

production to account for north economies (capital intensive) and south economies (labor intensive).



                                                        32

The effects of trade barriers (including labor) imply that for a CDM setting with allowed flows of

factors of production--no borders, a technology transfer from the North to the South is clearly

desirable from the perspective of a `global social planner', since the welfare gain for the South

outweighs the welfare loss for the North. However, if the regions impose trade barriers, then the

incentives to introduce the technology transfer appear to be relatively weak from the perspective of

the North. Finally, by imposing the Kyoto emission reductions on the otherwise uncontrolled market

economy, the technology transfer leads to higher welfare in both regions.

         The literature reviewed above employs models and normative assumptions to predict the

rate of clean technology transfer between investor and host countries in the CDM-JI operations.

However, looking at specific projects provides additional insights. Haites, Duan and Seres (2006)

examine claims of technology transfer in the project proposal documents of 854 early CDM projects.

As the authors point out, the CDM does not have an explicit technology-transfer mandate, even

though several provisions of the overall Climate Change Convention commit developing-country

parties to promote and finance such transfers. Even so, the authors find that about one-third of the

CDM projects they examined made claims of technology transfer, where technology transfer takes

the form of use of equipment or knowledge, not previously available in the host country. On average,

more large projects claimed to transfer technology, so that two-thirds of the emission reductions

from the studied projects were associated with transfer claims. Technology transfer claims also varied

by technology type. In general, few projects in hydro and energy-efficiency claimed to transfer

technology (less than 15 percent) while most projects in agriculture, wind and biomass claimed to

promote technology transfer (81, 41 and 21 percent of the projects in each class). About half of the

projects studied do not have foreign partners. Only about a quarter of these "unilateral" projects

made technology transfer claims; within this group transfer claims were higher among larger projects.

This leads the authors to conclude that the probability of technology transfer increases with project

size and with foreign participation.


5 Domestic policies in the European Union, the United States and Australia

As discussed, while Kyoto Protocol obligations ultimately fall to governments, the architecture of the

agreement relies on markets to mobilize capital, technology and foreign direct investment. Doing so

is expected to reduce the cost of meeting the framework's environmental objectives. Still, while

project cycle rules for CDM and track-two JI projects are explicit and apply to all parties, domestic

rules and policies are relevant. Because tradable permits have value to private firms primarily because

they can be used to meet regulatory rules, differences in domestic rules can also lead to price

differences for otherwise equivalent offsets. In the case of the United States, which has not ratified



                                                       33

the Protocol, and Australia, which only recently ratified the Protocol, separate voluntary and regional

markets have evolved that are not be entirely distinct from Kyoto markets. We discuss policies

related to carbon markets for these three countries in anticipation of the market discussion in the

next section.

EU Emissions Trading Scheme

The European Union's Emissions Trading Scheme (EU ETS) is one of the principle instruments that

the EU relies on to meet its GHG emissions reduction requirements under the Protocol ­ an 8

percent reduction compared to 1990 levels by the first commitment period. Presently, the plan

covers carbon dioxide emissions from more than 10,000 installations from the EU's 27 Member

States plus, as of 2008, Norway, Iceland and Liechtenstein, members of the European Economic

Area.  54Together the installations account for about 40 percent of the EUs greenhouse gas

emissions. Legislation that eventual launched the EU ETS in 2005 was approved by the European

Council and the European Parliament in 2003.55

          To date, the policy has covered two periods. Phase 1 (2005-2007) of the cap-and-trade

program was intended as a trial prior to the first commitment period of the Kyoto Protocol, which

coincides with Phase 2 (2008-2012). Emission allowances, called EU allowances (EUAs), are permits

equivalent to one ton of emitted carbon dioxide. During the first two phases, Member States

allocated allowances to their regulated installation in accordance with a National Allocation Plan

(NAP). At the end of each year, regulated installations must surrender allowances equivalent to their

emissions. Surplus and short-falls can be matched through sales and purchases.

          Under current rules, NAPs are subject to European Commission oversight and the

Commission can (and has) reduced the number of overall EUAs under national plans if the plans

appear inconsistent with business-as-usual scenarios and climate change framework obligations. The

back and forth between national planners and the Commission has generated delays and regulatory

uncertainties.56 Moreover, differences and inconsistencies in the process by which national

governments allocated allowances created distortions and inefficiencies, which are discussed later in

this section. Under a current proposal national plans would be abolished and replaced with an EU-

wide cap based on harmonized rules. The proposal would also extend the system beyond 2012 and



54Currently, the sectors covered include energy activities (e.g. electric-power generation greater than 20
megawatts), ferrous metals industries (iron and steel), mineral industries (cement, glass, ceramics, oil refineries,
etc.), and pulp and paper industries.
55For background information on the EU ETS see Watanabe and Robinson (2005), Convery and Redmond
(2007) and Europa (2007).
56For example the Commission's review of Member NAPs required for the start of Phase II in January 2008,
did not conclude until the fourth quarter of 2007.


                                                            34

cover additional industries and two additional greenhouse gases, nitrous oxide and perflurocarbons.

Proposed rules would also allow Phase II EUAs to be carried forward into future periods.

         Although the second phase of the EU ETS has only recently begun, a growing literature

assesses the early effects of the policy. The research focuses primarily on the two-stage process by

which overall levels of national allowances were set and distributed to regulated installations. One

area of study focuses on the bureaucratic process itself and the motivations for decisions. For

example, the volume edited by Ellerman, Buchner and Carraro (2007) looks at the process of setting

Phase I allowances and decisions taken by the EC. The volume also contains country case studies.

         During the first phase of the EU ETS, exchanges emerged to trade contracts derived from

Phase I and Phase II. As the first phase ended, contracts based on Phase I allowances drifted down

to near-zero values after a dramatic price collapse in April 2006. The low ending price for Phase I

contracts is taken as an indication of an over-allocation; the structural break in the contract pricing

has been attributed to a poorly developed system for measuring emissions and uncertain policy

(Ellerman and Buchner, 2007). As discussed in Alberola, Chevallier and Chèze (2008), allocations

were based on emission projections rather than verified emission data and when initial results on

verified emissions became public, demand expectations for Phase I EUAs were revised downward.

Moreover, an initial decision by France and Poland to allow firms to carry over (bank) Phase I

allowances for use in Phase II was reversed during the planning of Phase II NAPs, further reducing

the value of Phase I EUAs.

         The sequential nature of EU policy making creates moral hazard problems when firm

behavior can affect future permit allocations. This topic is discussed in the case of power generation

by Neuhoff, Keats-Martinez and Sato (2006). Along a similar line, Demailly and Quirion (2006)

contrasts the affects of allowance allocation rules based on historic emissions (grandfathering) with

the effects of output-based rules for the cement industry. Not all industries fall within the EU ETS

and differences in regulatory rules between firms inside and outside the EU ETS creates distortions

as discussed in the context of German regulations by Böhringer, Hoffmann and Manrique-de-Lara-

Peñate (2006). The free allocation of permits creates wealth transfers and these are measured in the

context of power generators by Keats-Martinez and Neuhoff (2005). They argue in favor of

increased permit auctions, a topic also discussed by Hepburn et al. (2006).




                                                        35

Integration with the climate change framework

The EU ETS is intentionally designed to work well with rules established under the Kyoto Protocol

and the Marrakesh Accords.57 In general, CERs or ERUs generated by Kyoto projects can, be

exchanged one-to-one with EUAs, although offsets generated from nuclear energy projects and,

importantly, land-use projects are excluded. However, as discussed, most greenhouse gas emissions

in the EU are regulated outside of the trading scheme and these rules work to limit the extent to

which firms can rely on Kyoto project offsets under Phase II. For one, under EC rules on

supplementarity, Member States must meet at least 50 percent of their emission reductions

domestically. In practice, Member States have placed additional (and varying) limits on the share of

total emission reductions that can be met by purchasing tradable units, ranging from 8 percent (i.e.

the Netherlands) to 50 percent (i.e. Spain and Ireland). Moreover, recall that countries must keep

inventories of offsets in line with the commitment period reserve rule. This creates complications for

managing Kyoto-projects offsets since these national supplementarity targets could be exceeded if

firms regulated under the EU ETS were allowed to purchase CERs and ERUs without limit. As a

way of managing supplementarity, Phase II NAPs under the EU ETS place explicit caps within the

national plans. In the aggregate, the national plans allow member states to supplement their allowed

emissions under the EU ETS by no more than 13.36 percent. The limits vary among countries,

ranging from zero (Estonia) to 20 percent (Lithuania, Norway and Spain). In addition, in order to

avoid direct and indirect "double counting", ERUs allowed into the EU ETS must originate in

sectors not covered by the EU ETS.58 These limitations potentially affect price arbitrage

opportunities among the tradable permits, a topic we return to later in the paper.

Regional initiatives and the US voluntary market

In the absence of federal regulation, alternative state, municipal and corporate initiatives to manage

greenhouse gas emission in the US have emerged. The programs encompass a range of standards for

environmental and investment additionality. In general, comprehensive and binding regulations of

the type found among countries that have ratified the Kyoto Protocol are absent. Nevertheless, large

regional schemes are under discussion and some innovative programs predate the EU ETS. Even so,

in contrast to the European trading system, studies of US systems are not well represented in peer-

reviewed economic journals.


57Legislation known as the "Linking Directive" lays out the relationship between EUAs and the Kyoto-system
tradable units
58Direct double counting can occur when ERUs are issued after a firm reduces emissions relative to a baseline
and also receives EUAs based on historical emissions. Indirect double counting can occur when a JI project
earning ERUs displaces a firm that still receives EUAs. Both concepts are distinct from actual double counting
when two firms surrender identically coded EUAs against their emissions ­ a problem that occurred repeatedly
during Phase I of the EU ETS.


                                                          36

         One example stems from experience with offsets tied to the Oregon Carbon Dioxide

Emissions Standard for New Energy Facilities, enacted in 1997 by Oregon, the first State to regulate

GHG emissions. The statute requires all new power plants (and large energy facilities) to meet a

carbon dioxide emissions target that is 17% better than the most efficient base-load gas plant

currently operating in the U.S. Any emissions exceeded that standard must be matched by financed

or purchased project offsets or by a fee of US$0.85 per short ton of CO2 paid into The Climate

Trust, a non-profit group established to manage offset projects on behalf of its members. There are

no limitations on the geographic location or type of project providing the offsets. So far, the Climate

trust manages a portfolio of 15 projects that will offset 2.7 MtCO2e (of which 1.5 MtCO2e are linked

to the compliance with the Oregon Standard). In addition to common offset classes such as energy

efficiency (supply side), renewable energy and sequestration, the Climate Trust has sponsored more

innovative projects, especially in the transportation sector. Some of its portfolio has besides been

sold to the voluntary market.

         The Chicago Climate Exchange (CCX) is a voluntary cape-and-trade scheme, where

members make a voluntary but contractually binding commitment to reduce GHG emissions. By the

end of Phase I (December, 2006) all Members were to have reduced direct emissions 4% below a

baseline period of 1998-2001. Phase II, which extends the CCX reduction program through 2010,

will require all members to reduce GHG emissions 6% below baseline. There are more than one

hundred members in the exchange, from all sectors of the economy (including entities such as

universities or municipalities). Not all (though most) are based in the US. Their baseline emissions

amount to some 230 MtCO2e ­ a few percent of US GHG emissions. As new regional initiatives

began to take shape in the United States, CCX attracted new members (both compliance members

and offset providers), who expressed their interest in familiarizing themselves with emissions trading.

New participants joining in the scheme can directly assume the target for the end of phase II, viz. 6%

reduction in emissions below baseline by 2010. Post 2006 vintages (2007, 2008, 2009 and 2010) were

listed from mid-April onwards and while activity has increased on the CCX, trading has been

concentrated in the post 2006 vintages (69% of volumes from April `06 to Dec `06), reflecting

growing carbon market interest in the United States.

         CCX trades the six Kyoto gases, converted along one currency, the Chicago Financial

Instrument (CFI), which represents 100 tCO2e. CFIs can be either allowances issued to members

according to their baseline and emissions reduction commitment, or offset credits, from third-party-

verified projects. Offset categories include the following: agricultural methane, landfill methane, coal

mine methane, agricultural soil carbon, rangeland soil carbon management, forestry, renewable




                                                        37

energy and energy efficiency and fuel switching.59 Renewable Energy Certificates and CERs can also

be traded. A limited activity for CERs trading (futures) has been reported in the second half of 2007,

with prices on average slightly higher than those observed in Europe. CFIs come primarily from soil

management projects (60%) and coal mine methane (15%). For the most part, projects are based in

North America.

         Two regional efforts are worth mentioning as well. The Regional Greenhouse Gas Initiative

(RGGI) is the US cape-and-trade scheme closest to operation. It targets CO2 emissions from electric

power generators (25MW or more and which burns 50% or more of fossil fuel) in ten Northeastern

States: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New

York, Rhode Island, and Vermont. In addition, the District of Columbia, Pennsylvania, the Eastern

Canadian Provinces, and New Brunswick are observers in the process and could opt-in at some

point. Initial discussions started in April 2003 and after a two-year design process that included

extensive stakeholder and expert input and detailed and comprehensive technical analyses by the

states, the governors of seven states agreed in December 2005 to move forward with the

implementation of RGGI in their states.60 The Model Rules, first issued in August 2006, are to be

adapted by each participating state in its own legislation.61 NY was the first to do so by December

2006. Burtraw, Kahn and Palmer (2006) describe the regional program and analyze its potential effect

on electricity prices.

         The second regional initiative, the Western Regional Climate Action Initiative, was formed in

February 2007, through a coalition uniting Oregon, California, Washington, New Mexico and

Arizona to establish a regional target for reducing GHG emissions by fall 2007 and to design by fall

2008 a cape and trade scheme to this end. Among these states, California may take unilateral action

before the initiative is fully designed. In August 2006, the state passed the California Global Warming

Solution Act, which calls for a reduction in greenhouse gas emissions to 1990 levels by 2020.

Permit markets in Australia

Australia has only recently ratified the Kyoto Protocol but in recent years a number of initiatives to

reduce GHG emissions have emerged at the state level, mostly based on the mandated use of

renewables. However, there have also been trade-based programs as well. For example, since 2003,

Australia's New South Wales (NSW) has operated a program based on tradable permits, called the

NSW Greenhouse Gas Abatement Scheme (GGAS), which is intended to reduce greenhouse gas


59Young (2003) discusses soil sequestration and US agricultural policy.
60The states are Connecticut, Delaware, Maine, New Hampshire, New Jersey, New York, and Vermont
61An interesting feature of the program is that permits will be auctioned in some states, a departure from past
precedents in the US where allowances are traditionally based on past emission levels.


                                                            38

emissions from the power sector. Under the program, retailers and large electricity customers in

NSW (and since 2005 in the Australian Capital Territory) are required to meet mandatory intensity

targets to reduce (or offset) the emissions of GHG arising from the production of electricity they

supply or use. They can meet their targets by purchasing certificates (NSW Greenhouse Abatement

Certificates or NGACs). NGACs are generated through the following activities: low-emission

generation of electricity and improved generator efficiency, activities that result in reduced

consumption of electricity or on-site generation of electricity and carbon sequestration into biomass.

Renewable Energy Certificates are also eligible62. No other form of credit (e.g. JI or CDM) is eligible

at this time. A buy-out penalty applies, set at AU$11.50 (currently approximately US$9) for

compliance year 2006. So far, all participants have been in compliance (eventually by carrying

forward part of the shortfall ­ up to 10% of the benchmark). After the EU ETS, the NSW GGAS is

the second largest greenhouse gas abatement market with about 20.2 million certificates exchanged

through 2006 for a value estimated at US$225.4 million. The 2006 market represented a 3.3 times

increase over the volumes transacted in 2005 and about 3.8 times increase in the value for 2005.

          As of end of February 2007, 201 projects were accredited, for the most part under the

"generation" and "demand side abatement" rules. Credits issued from carbon sequestration also

entered the scheme in 2005. Over 40 million NGACs had been created by the end of March 2007,

with "generation" certificates dominating at 70% of volumes followed by "demand side abatement"

certificates at 25%. So far, taking into account the certificates that have been surrendered, there is

currently an oversupply of over 13 million NGACs. Participants expect that the demand may exceed

supply by 2009; however, the demand supply balance could quickly reverse as some participants may

decide to hedge their position forward. In addition, there is growing interest in the voluntary market

for the NGACs. The key to the supply/demand balance may in fact reside in the eligibility of

NGACs under the future national scheme under discussion (see below). As long as no firm decision

is made upon transition arrangements, some volatility is to be expected as has been the case in recent

months.

          Looking ahead, a national trading scheme is under discussion, to start no later than 2010

with the detailed design to be finalized by the end of 2008. Key inputs will be provided by the

Garnaut Climate Change Review (with a final report due by end of September 2008). Meanwhile, an

interim report released in February 2008, stated that Australia should promote strong global action

on climate change and be prepared to match the commitments of other developed nations. Among



62Their share in the total number of certificates surrendered for compliance tends to decrease from 29% in 2003 to 11% in
2006.



                                                                  39

other interim recommendations, one could read that nations should move ahead on unilateral and

regional climate agreements before a post-Kyoto deal and calls for a South Pacific regional emissions

trading scheme that helps prevent deforestation in Indonesia and Papua New Guinea.

         As with the US programs, the analytic literature is not well represented in peer-reviewed

journals. With Australia's recent ratification of the Protocol, this is likely to change as current

programs are accommodated within a national and international system.


6 Carbon markets63

As discussed, the flexibility mechanisms of the Kyoto Protocol are designed to bring about the same

type of market efficiencies that are generally associated with trade. Moreover, they are expected to

mobilize private capital on a scale that public transfers cannot. Through price discovery, private

markets associated with the flexibility mechanisms are expected to reveal whether current regulations

place a value on greenhouse gases emissions that is consistent with what modeling efforts suggest are

need to curb global warming.

         In this section, we discuss what can be broadly termed carbon financial markets. These are

the markets that are motivated directly by greenhouse gas policies. As the discussion of national

policies in the preceding section suggests, the markets operate across a heterogeneous set of public

and private institutions. Regulatory uncertainty associated with some markets is high and basic

information can be scarce. Even so, the scale, sophistication and pace of growth in these markets and

derived risk markets are remarkable. Project investment levels supported by these markets are likely

to be larger than anticipated by model studies.

Model studies of potential size of the market for the flexibility mechanisms

Several estimates of the potential demand for emissions reductions as well as the size of the CDM

market are listed in Table 1. The estimates of the potential demand for GHG offsets ranges from 600

to 1713 MtCO2e (million tons of CO2 equivalent) per year over the first commitment period, 2008-

12. The estimates differ substantially mainly due to uncertainties involved with the projection of

emissions growth in Annex I countries and alternative macroeconomic model specifications

(Springer, 2003). The estimates of the size of the CDM market ranges from 0 to 520 MtCO2e per

year.

         The wide range is due primarily to alternative assumptions about the supply of Kyoto

allowances (AAUs) from Russia and Ukraine, which can serve as an alternative for project credits. In

many of the modeling exercises, the combination of US withdrawal from Kyoto markets and the


63This and the following two sections draw heavily on Capoor and Abrosi (2007).


                                                        40

unconstrained sales of allowances from Russia and former Soviet countries drive CER prices to zero

and supplies of project credits to zero. Nevertheless, as discussed, market incentives may encourage

Russia and the Ukraine to withhold some of their allowances, and this creates opportunities for

project credits in several model scenarios. By way of example, Haites (2004) suggests that if Russia

and Ukraine restrict the supply of their surplus Kyoto units to about 40 percent, the market demand

for CERs would be about 1250 MtCO2e CDM units over the first commitment period. However,

most modeling exercise suggest that emission trading and project credits are likely to meet only a

small portion of the demand for the emission reduction units (Zhang 2000).

         Nevertheless, early indications from project registrations suggest greater levels of investment

than anticipated by the modeling exercises. As is discussed in greater detail below, the number of

CDM projects submitted for validation has grown exponentially from 5 in 2003 to 58 in 2004, 499 in

2005, 885 in 2006, and 1,480 in 2007. Projects already in the CDM pipeline by February 2008 could

potentially produce about 499 MtCO2e annually, which is close to the top-end of the model

projections reported in Table 1.

The evolution of carbon project financing

In a broad sense, carbon markets began in the late 1990s, when corporations, non-government

organizations and governments began experimental programs in market-based regulations ­

including pilots under the already discussed AIJ program.64 Moreover, because of a provision

allowing for early action, the CDM market emerged before the rules governing the CDM were

finalized. In fact, when Russia agreed to ratify the Protocol in October 2004, thereby making it

certain that the Kyoto Protocol would enter into force, more than 120 CDM transactions had already

been recorded.

         The participants in the Prototype Carbon Fund (PCF), six governments and fifteen private

companies, were the first investors in the CDM. The PCF is a closed $180 million mutual fund

managed by the World Bank to purchase emission reduction credits under JI and the CDM. The

PCF was established in 1999, became operational in April 2000, and signed its first emission

reduction purchase agreement for a CDM project in Chile in 2002.

         Another key player in the early market was the Government of the Netherlands, which

decided early on to purchase emission reductions through flexibility mechanisms as part of a

comprehensive strategy to meet its Kyoto target. In addition to participating in the PCF, the

Government of the Netherlands also developed the first carbon tenders for CDM and JI in 2001. In



64For a discussion of early greenhouse gas market-based programs see Sonneborn (1999) and Sandor,
Bettelheim and Swingland (2002).


                                                         41

2004, the two original players in the CDM market--the Government of the Netherlands and the

World Bank (whose carbon finance activity had by then grown to include new funds besides the

PCF)--still represented about a third of the total volume of project-based transactions. The adoption

of the Marrakesh Accords in December 2001 led more players to move in. Private firms from Japan

started to enter the market in 2002 and 2003, despite the absence of a domestic climate policy in

Japan; the Japanese climate policy was approved only at the end of 2005. European firms followed

about a year later, when it became clear that the EU Emissions Trading Scheme would become

operational and that CERs would become eligible at least in part, under the EU-ETS. Around 2005,

other Annex B governments came into the market as the Kyoto Protocol entered into force. By

2007, a number of secondary market participants had entered the market, including banks and

investor funds that do not need CERs or ERUs for compliance.

         The first CDM transaction was struck in early 2002 followed by more than one hundred

transactions during the next two years. Still, three years elapsed between the adoption of the

Marrakesh Accords and the registration of the first CDM project by the Executive Board in 2004.65

Moreover, by the close of 2005, only 63 projects were registered by the Board, despite a growing

number of projects entering the pipeline. Still, as the number of CDM projects entering the pipeline

grew steadily, the average number of days between the start of the public comment period and

submission for registration began to decline; from January 2006 to July 2007, start-up delays at the

validation stage decreased from about 250 days to less than 30 days.

         The slow start and high initial transaction costs for early projects are consistent with

experience in other tradable schemes.66 This generally comes about because of the time and costs

associated with building public and private institutions. In the particular case of CDM, a project

enters the CDM pipeline at the start of the 30-day public comment period, which is the first step of

the validation phase of the project cycle. During this phase a third-party designated operational entity

(DOE) reviews and validates the project's baseline and monitoring plans. As discussed, new baseline

technologies must be approved by the CDM Board. Early on, capacity constraints among the small

number of designated third-party validators (DOEs), drawn-out rule making by the CDM Board, and

a low stock of approved methodologies all worked against speedy registration. Conversely, start-up

costs declined as the stock of approved baseline and monitoring methodologies accumulated and as

project managers, third-party entities and regulators gained experience.




65The first project registered was the Brazil NovaGerar Landfill Gas to Energy Project.
66Hahn and Hester (1989) and Gangadharan (2000) provide examples from US air pollution markets.
Michaelowa et al. (2003) discuss transaction costs from early AIJ and Prototype Carbon Fund projects.


                                                           42

         In 2006, developing countries supplied nearly 450 MtCO2e of primary CDM credits for a

total market value of US$4.8 billion. The carbon market and associated emerging markets for clean

technology and commodities have attracted a significant response from the capital markets and from

experienced investors, including those in the United States. Analysts estimated that US$11.8 billion

had been invested in 58 carbon funds as of March 2007 compared to US$4.6 billion in 40 funds as of

May 2006, half of which is managed in the UK (Bulleid, 2006; New Carbon Finance, 2007). By

August 2007, the CDM Board had registered 760 projects expected to deliver about 1 billion CERs

by 2012. In addition, 1,500 projects were at the validation stage or ready for registration. Together,

these 2,260 projects could deliver close to 2.2 billions CERs by 2012.

         Joint Implementation shares the same origins as CDM, since early treaty negotiations

concerning project credits made no distinction between projects located in transitional or developing

countries. Consequently, some exploratory project investments hosted in Annex I countries were

made in 2001 -- before the first CDM transaction -- by public buyers. Nevertheless, as separate

mechanisms evolved, JI project development stalled -- due in large part to a decision to allow early

crediting only under CDM. Delays among Annex I countries to meet JI eligibility requirements along

with uncertainty together with delays associated with establishing track-two project-cycle rules further

dampened investment. Nevertheless, as UNFCCC and host country domestic rules evolved, projects

began to enter the JI pipeline, beginning in late 2006 and by February 20008, pipeline projects

represented a potential of 188 MtCO2e by 2012 (UNEP RISOE, 2008).


Evaluations of mitigation potential and project investment

As discussed earlier, bottom-up and top-down methods have been employed to provide an

understanding of how emission trading might affect abatement activities. To start, the viability of a

given offset project has to do with basic physical and economic characteristics. Bottom-up studies in

particular take stock of the potential for different types (asset classes) of investment over a range of

potential market prices for carbon. For example, reducing emissions by switching fuels might be

economically viable at lower prices for carbon, while investing in alternative sources of energy may

be viable at higher prices. In the aggregate, the distribution of viable technologies also has

implications for the geographic distribution of investments. Both the geographic and asset class

distribution of potential projects are important for policy makers. For one, different types of

abatement activities are associated with different costs and the relative potential supply of low or

high cost mitigation opportunities will affect the costs of meeting the policy emission goals. Different

types of abatement activities also have different implications for additional spillover benefits such as

health or biodiversity co-benefits and technology transfer. Where projects locate is important as well,




                                                         43

since it determines who benefits from any economic, developmental or spillover effects associated

with the project.

         A number of studies have looked at the composition of project location under alternative

policy settings; Haites (2004) provides a review as do recent IPCC evaluations.67 These studies

roughly indicate country or regional potential for Kyoto-project offsets since they are driven by

abatement costs. In general, most models suggest that Asia has the largest potential for CERs. For

example, Jakeman et al. (2000) place about 62 percent of the predicted CDM market in Asia, Sijm et

al. (2000) suggest 71 to 78 percent and Jotzo and Michaelowa (2002) estimate 72 percent. For studies

that provide country detail, China is usually the largest source of potential offsets.68 Asia's dominance

is partly due to the large population but also because of the composition of the region's industrial

base and its reliance on coal and oil.

         There is less agreement as to differences in sectoral potential. In their synthesis of sector

studies, Barker et al. (2007) suggest large potential savings in all regions based on improving energy

efficiencies in residential and commercial buildings, accomplished through, for example, improved

lighting and insulation, gains in small appliance efficiency, and the use of alternative coolants. Sijm et

al. (2000) suggest that potential gains in energy efficiency account for most potential emission

reductions. In developing countries, agriculture and forestry projects are significant when carbon

prices remain under $20 per tCO2e. This includes the use of better soil management techniques to

improve soil sequestration and adding to sinks through afforestation and reforestation projects. At

higher prices, the composition of potential projects expands to include more industry-based (the use

of more efficient equipment, the control of non-carbon-dioxide emissions, etc.) and energy-supply

projects (renewables, fuel-switching, etc.)

The geographic distribution of Kyoto-project credits

To date, the supply of issued and potential CERs remains firmly centered in Asia. Nearly 75 percent

of the pipeline projects accounting for about 79 percent of potential first-period CERs are hosted in

Asia.69 This is largely due to population and also the relatively high consumption levels of oil and

coal in Asia. Latin America accounts for 21 percent of the projects and 15 percent of pipeline CERs

and, on a per capita basis, hosts a larger share of the first-period pipeline than Asia. Sub-Saharan

Africa accounts for about 2.6 percent of the pipeline potential. Across all regions, the least-developed

countries host few projects and account for about 1 percent of potential first-period CERs. A


67See especially Barker et al. (2007).
68For example, Chen (2003) estimates that roughly 55% of the potential for CDM projects is in China alone,
with another 10 percent in India.
69UNEP/RISOE, March 2008.


                                                         44

relatively small set of countries account for most of the CDM pipleline; most of the potential CER

supply comes from China (53.2 %); India ranks second (15%) Brazil third (6%) and South Korea

(4.1%). Similarly, the JI first-period pipeline is dominated by Russia (61%) and the Ukraine (26%).

           Capoor and Ambrosi (2006) provide estimates of market activity based on interviews with a

range of market participants and voluntary reporting of emission reduction purchase agreements.

They estimate that, in 2006, developing countries supplied nearly 450 MtCO2e of primary project

credits for a total market value of US$4.8 billion, up from $2.4 billion in 2005. China accounted for

61 percent of transacted volumes, down slightly from 73% in 2005. Next was India at 12%,

increasing from 3% in 2005. Asia as a whole led with an 80% market share. Latin America ­ an early

pioneer of the market ­ accounted for 10% of CDM transactions overall with Brazil alone at 4%.

The share for Africa remained constant, at about 3%; however African volumes transacted increased

proportionally to the increase of overall volumes transacted. The smaller market for credits from JI

projects also grew in 2006, with 16.3 MtCO2e transacted, up 45 percent over 2005 levels. Russia,

Ukraine and Bulgaria provided more than 60 percent of transacted volumes­ for a value of US$ 141

million.

           Ukraine, Russia and Bulgaria accounted for 20% each of the ERUs supply traded through

2003-2006 (44 M tCO2e transacted, or about 10% of the primary CDM market in 2006). Other

countries ­ and not only in Eastern and Central Europe, but also New Zealand for instance ­ have

also taken part in the market, although to a lesser extent. Transactions in the second half of 2006 and

the first quarter of 2007 already exhibit a trend with fewer emission reduction purchase agreements

(ERPAs) signed in Europe (as was historically the case) and more in Russia and Ukraine. This is no

surprise as the biggest potential is expected to lie in these two countries associated with large projects

in the oil and gas as well as the power sector (refurbishment and energy efficiency improvements as

well as methane capture). In addition, the EU decision on double counting discussed earlier means

that the JI potential can only be realized from projects outside the sectors covered by the EU ETS,

particularly restricting opportunities in the newer members of the EU.70 It remains to be seen what

portion of the JI potential in Russia and Ukraine may however materialize, given remaining

uncertainties with regard to issuance procedures and a limited five-year crediting period that may not

be sufficient to get many projects up and running.




70In addition, several of these opportunities in the EU newer Member States countries may already have been secured by
early public procurement programs.



                                                                45

Balance across asset classes

By project count, most projects involve renewable energy sources. For example, as of February 2008,

hydro 26%), biomass (16%) and wind projects (12%) accounted for 54 percent of the CDM pipeline.

However the largest source of CERs (31%) are derived from a small number of industrial gas

projects, considered the low-hanging fruit of greenhouse gas projects. These projects involve

reducing the emissions of very concentrated greenhouse gases, or converting them to less harmful

gases. The projects are straightforward from an engineering and baseline point of view and can

deliver CERs at low risk for a limited upfront investment with a short lead-time. In 2005, HFC23

destruction projects account for two-thirds of CERs entering the CDM pipeline and in 2006 projects

for the destruction of N2O captured a 13% market share of volumes transacted. This type of project

has been heavily criticized as delivering few additional development benefits and may work to slow

the phase-out of ozone-reducing gases (Pearson 2007).71 In the case of China, concerns prompted

interventions, and most proceeds from related CER sales into a clean development fund to finance

mitigation projects in priority sectors (World Bank 2006). Moreover, proposals have been advanced

under the UNFCCC to limit credits from new facilities.

          Separately, there is some indication that new opportunities for these types of projects may be

tapering off. For example, by February 2008, the supply of pipeline CERs for renewables had grown

considerably, representing about 30 percent of first-period CERs. Moreover, Capoor and Ambrosi

(2006) conclude that CDM projects have been successful in jump-starting clean energy projects in

developing countries. They estimate that financial flows to developing and transition countries

through Kyoto projects grew to about US$7.8 billion in 2006 (signed contract value). By some

estimates, carbon finance - in 2006 alone - leveraged approximately US$10 billion in clean technology

investments in developing countries, about 48 percent of their total investments in clean

technologies.

          The share of transactions from energy efficiency projects and fuel switching projects

increased dramatically from 1% in 2005 to 9% in 2006. Together, these types of projects now

comprise over 19 percent of the CDM pipeline and are mostly energy efficiency projects at industrial

facilities. Despite their overall potential demand-side management energy-efficiency projects are held

back by methodological challenges (additionality requirements for activities that are considered

economically rational or because of issues with monitoring) and as of February 2008 make about 1

percent of the pipeline.



71In the case of projects involving the destruction of HFC-23, a bi-product of producing HCFC-22, used in
coolants and the production of Teflon, there are also concerns that income generated from the projects create
incentives to delay the phase-out of HCFC-22 coolants under the Montreal Protocol (Schwank, 2004)


                                                          46

          Similarly, carbon assets from land use (LULCF) projects are rare in the CDM market; their

cumulative market share, in terms of volumes transacted, hardly reaches 0.2%.72 This is largely due to

their exclusion from Europe's ETS.73 Even so, this is striking and viewed by many as a failure of

current policies since emissions from deforestation and land degradation account for an estimated 18

to 25 percent of all global greenhouse gas emissions.74

          To a degree, obstacles for including forestry projects under the Kyoto mechanisms have

given rise to projects in the voluntary markets that emphasize additional biodiversity benefits and

other positive spillovers. Examples include the World Bank's Forest Carbon Partnership Facility, the

Australia Global Forest Fund and Carbon Neutral Norway among others.

          Carbon credits from clean energy projects comprise the greatest share of the JI market, with

slightly less than two thirds of volumes transacted over 2003-2006. ERUs from energy efficiency

improvement and fuel switching projects came first at 28%, followed by biomass, wind and hydro

with respectively 13%, 12% and 10% of the market. N2O projects from industrial installations

account for 8%. This picture could change notably in the coming years as Russia and Ukraine bring

opportunities from the oil, gas and power sectors. The pipeline for JI indicates expected credits by

2012 from reducing fugitive emissions will come from pipelines (44%), emission reductions from

energy efficiency improvement and fuel switching (32%) and coal mine methane (12%).75 Unlike in

developing countries, where green-field projects have long lead times, many such opportunities in JI

countries are associated with existing facilities and sites and have relatively shorter lead times. Many

such projects are likely to be implemented within the 2012 time-frame provided financing is available

before the window of opportunity starts to close.

Who is buying project credits?

European buyers dominated the primary CDM and JI market with 86% market share (versus 50% in

2005) with Japanese purchases sharply down at only 7% of the primary market in 2006 (versus 46%

in 2005). Within Europe, the United Kingdom had a 50% market share of volumes transacted (up

from 15% in 2005) consolidating its leadership position as the carbon finance hub for the world.

Many companies, including project developers and players with an eye on the secondary market, have

opened accounts on the U.K. national registry. Private sector players were the main buyers of CDM

assets in 2006, with about 90% of purchases coming from the European private sector in 2006. In


72See Neeff et al. (2007) for a recent and exhaustive review of the market for forestry offsets.
73See a related discussion by Schlamadinger et al. (2005).
74As of end of January 2008, the UN reported fifteen land-use projects in the CDM pipeline.
75The term "fugitive emissions" refers to pollutants released to the air other than those from stacks or vents.
They can be occur due to equipment leaks, evaporative processes, and windblown disturbances.



                                                            47

contrast, the JI market has long been dominated by public buyers (mainly the Netherlands, Denmark

and Austria), representing 92% of those transactions in 2006 (up from 80% in 2004 and 2005).

          By the end of first quarter 2007, EU governments had purchased 143 MtCO2e, about 30%

of the assets identified for purchase from the flexible mechanisms (CDM, JI and AAUs).76 506

MtCO2e, about 45% of the expected demand for CDM and JI credits from EU ETS installations in

Phase II, have already been contracted by European entities, either directly, by natural compliance

buyers and the funds in which they are participants, or indirectly, by entities planning to sell back

these credits on the secondary market.77 As far as Japan is concerned, 266 MtCO2e credits purchased

by Japanese entities so far account for around half of the expected shortfall for Japan (use of Kyoto

Mechanisms by the Government and share of the burden borne by the private sector).78 Together,

these sources of demand could add up to at least one billion tCO2e in the next year or so. Even

without factoring in any potential demand from Australia, Canada and the United States, there is still

significant potential demand for CDM and JI from Japan and the EU before 2012.

          The carbon market and associated emerging markets for clean technology and commodities

have attracted a significant response from the capital markets and from experienced investors,

including those in the United States. Analysts estimated that US$11.8 billion had been invested in 58

carbon funds as of March 2007 compared to US$4.6 billion in 40 funds as of May 2006, half of

which is managed in the UK (Bulleid 2006; New Carbon Finance 2007).

Markets and the pricing of project credits

Though nascent, formal market for pricing emission reduction units are quickly forming for Kyoto

project-based offsets, CERs and ERUs. Exchange-traded futures and options contracts for CERs

were launched in late 2007 on the Chicago Climate Futures Exchange and the Norwegian exchange

Nord Pool and in March 2008 on the European Climate Exchange (ECX) and the European Energy

Exchange (EEX). Similar contracts are in place for allowance under the EU ETS. When traded

volumes are sufficiently large, exchange-based contracts offer the most transparent form of pricing.

The contracts are of standard quality and the exchange stands behind delivery. For example, the

exchange guarantees the delivery of any CERs purchased for future delivery. Behind the exchange




76Based on Fourth National Communications from EU Members States, the 2006 European Environment
Agency report on GHG emissions trends and projections and updates from the NAPs, one may estimate a 450
MtCO2e demand for CDM and JI over 2008-12.
77Using a 1.25 billion tCO2e estimate for CDM and JI demand over 2008-12 by EU ETS installations, an average across
assessments by Fortis, Merrill Lynch, New Carbon Finance, Point Carbon, Société Générale and UBS.

78This is based on estimates from the 4th National Communication in the "with existing measures" scenario.



                                                              48

markets are a range of related markets, differentiated by quality or by risks associated impediments to

their delivery.

           Prices for project-based offsets have increased regularly in recent years and the pricing

process has become more transparent and market-driven, largely because the rules governing how

they can be used in Annex B countries has become more clear and because of the development of

formal markets for European allowances. The largest class of CDM transactions involves the direct

purchase of CERs from registered projects. According to Capoor and Ambrosi (2007), weighted

average prices for these primary CERs reached about US$10.90 in 2006, representing a 52% increase

over 2005 levels.79 Still, these average prices mask a range (US$6.80-US$24.75) related to the

heterogeneity of the underlying projects and contracts.

           Transactions on the primary market involve forward streams of credits and therefore the

buyer faces a number of risks, linked to project performance and to the eligibility of the generated

credits for its compliance purposes. Some risks are project specific ­ for example, risks related to the

variability of rainfall feeding a small scale hydro-power project--while others may be country specific

­ for example, risks related to the performance of the national Designated National Authority. And,

since most projects are related to an underlying business ­ for example, the production of electricity

­ vagaries associated with that side of project can affect emission performance as well. In addition,

uncertainties about policy can affect how useful the credit is for meeting regulatory or even

contractual obligations. By way of example, credits from land-use CDM projects are ineligible for

delivery against CER future contracts sold on the EEX and the ECX.

           CERs that have already been issued sell at a significant premium, since they are without

project performance risk. To date, nearly xxx CERs have been issued by the CDM board, but many

of these were sold under existing contracts so pricing information is scarce. Still, Capoor and

Ambrosi note that issued CERs can trade at nearly double the prevailing price for primary CERs.

Still, even issued CERs are not without risk, in part because the International Transaction Log ­ a

system for tracking and affecting the transfer of tradable Kyoto units ­ including CERs ­ is not yet

fully implemented. Consequently, since title of the CER cannot be transferred, some element of

counter-party risk remains. Additionally, there may be an eventual requirement to become a project

participant to enter a primary transaction, a time-consuming process that does not come without

risks of legal or public exposure.




79All prices in US$ per tCO2e, unless otherwise indicated.



                                                            49

         Another strategy for managing performance risk relates to a secondary market, which grew

to 25 MtCO2e in 2006. The market draws on portfolios of guaranteed-delivery CERs,, with most if

not all delivery risk assigned to the seller. Players on this market are primarily financial institutions,

large energy players and investors' funds. Buying on the secondary market certainly has some

advantages: the buyer is purchasing a near compliance-grade asset with firm volumes deliveries and

guarantees and the buyer also does not have to create an infrastructure or team to source and

structure carbon transactions. There is increased standardization of contracts in the secondary market

and this standardization considerably facilitates the trade of CERs for compliance purposes, for

hedging purposes and for arbitrage purposes.

         As discussed above, exchange-based instruments for managing risk are developing to round

out the range of markets developing around the Kyoto flexibility mechanisms. In addition to futures

and options contracts, which open the door to a range of traditional hedging techniques, some

insurance products have emerged as well. An example is a recent MIGA guarantee against certain

sovereign and non-commercial risks related to a CDM project involving Luxembourg and El

Salvador.

         To date, many of the developments in the CDM market are motivated in part the EU ETS

and a clarification of rules concerning the use of CERs and ERUs within the significantly large

European system (1,100 MtCO2e in 2006 transacted volume.) Still, the same set of supporting

markets is not yet as developed for JI markets. The prices at which ERUs transacted in 2006

increased to an average of US$8.70, representing a 45% year-on-year rise, but ERUs remained

cheaper than CERs on average. JI assets traded in a range from US$6.60 up to US$12.40, which is

lower than the range at which primary CERs (US$6.80-US$24.75) were transacted. In many cases,

host country rules and laws are unclear, and this sovereign risk may translate into a discount

compared to the CDM price. Market players report that the key to closing JI deals is the ability to

bring upfront financing (up to 50% of ERPA value). The price of ERUs is often discounted in

transactions to reflect the cost of providing upfront finance.


7 Conclusions and areas for future study

To date, there is concern that the set of climate change policies currently in place are insufficient to

slow anticipated climate change. This is because the growth rate in current emissions appears

inconsistent with trajectories that scientists predict would stabilize the global climate. At the same

time, most governments have expressed their intent to slow or reverse emission rates. Moreover,

parties to the UNFCCC are committed to finding ways to reach a cooperative strategy that extends




                                                          50

beyond the Kyoto Protocol's first commitment period and the Bali Roadmap agreed upon at the

most recent conference of the parties provides a process for doing so.

         Beneath the overarching unease about the efficacy of current policies is an on-going debate

about whether current market-based policies deliver expected environmental benefits. In the specific

case of voluntary and Kyoto project-based emission reductions, there are a variety of issues. For one,

policy makers worry that safeguards built into the respective project cycles are not sufficient to

guarantee delivery of the combination of environmental and developmental benefits the projects

promise. One consequence is that EU member states have placed limits on how related tradable

permits can be used. In addition, a variety of supplemental private and public quality certifications

have emerged in order to further distinguish among UNFCCC-approved offsets. Stalled efforts to

solve project design obstacles in forestry projects that would allow project-based investments to go

forward are another area of concern. At present, investments in reforestation and afforestation are

meager and international agreement on how to slow deforestation is missing. In addition, problems

about how to accurately gauge emission reductions from sector-wide projects and current

implementation rules for CDM and JI appear to leave identified sources of mitigation untapped in

transport and energy systems and inefficient buildings. Even so, the ability of private markets to

mobilize capital in other areas has proved much greater than originally anticipated. Moreover, in the

case of Australia and possibly the United States, domestic tradable permit programs will become

better integrated with Kyoto's international system. These points are encouraging, because they

suggest a strengthening of the markets needed for effective policy, but they also raise questions about

how voluntary and regional systems in those countries will transform under new rules and how they

will influence present markets for framework-based credits and projects.

         All of this can be expected to influence the future direction of policy research. As has been

discussed, much of the economic literature to date has been predictive and focused on evaluating

alternative policy proposals; this is reflected in the large portion of the associated economics

literature devoted to numeric models and methods. Looking forward, this type of research will

certainly remain important for several reasons. First, an on-going analysis of related proposals will be

needed within and outside the IPCC process. For this, policy makers will want to focus increasingly

on explaining the relationships among carbon-market policy, research and technology diffusion and

capital formation. In addition, the most recent research on vulnerability suggests large differences in

the geographic distribution of climate change effects. For this reason countries will want to develop

greater detail on differences specific policies have on their own vulnerability. These areas of research

will require further advances in modeling approaches and a greater level of specificity than current




                                                          51

models can manage. An increase in the use of country-specific modeling is also anticipated as

countries will want to evaluate the adaptation policies and the effects of tradable instruments.

         In addition, the growing number of project-based investments, together with the emergence

of formal markets for tradable permits and derived financial products, will open up new areas for

applied research. By way of example, project-based studies are likely to address questions concerning

environmental additionality, spillovers and technology transfer that have in the past been addressed

using modeling methods. In addition, while models typically suggest that CDM and JI projects will

locate where abatement costs are lowest, project-based studies might better be able to examine the

role institutions and other determinants of transaction costs play in investment decisions.

Observations from formal exchanges can be used to examine the performance of market efficiency

and integration. This is especially useful since current policies sometimes limit how tradable

instruments can be used. Information across markets and among derivative markets can also be

exploited to reveal how market participants price the risks associated with potential policy reversals,

guarantees of quality, and performance risk related to specific types of contracts.




                                                        52

Table 1: Study estimates of the demand for emission reductions and the size of the CDM market.

                                               Annex I countries' demand
                                                  for emission reductions      Potential size of the CDM

                                                 under the Kyoto Protocol                market

Study                                                                MtCO2e per year
Blanchard, Criqui, and Kitous (2002)a                    688-862                         0-174
Eyckmans et al. (2001)a                                 1414-1713                       261-499
Grutter (2001)a                                         1000-1500                        0-500
Haites (2004)b                                          600-1150                         50-500
Halsnaes (2000)b                                        600-1300                         400-520
Holtsmark (2003)b                                       1246-1404                        0-379
Jotzo and Michaelowa (2002)a                               1040                          0-465
Vrolijk (2000)b                                         640-1484                        300-500
Zhang (2000)b                                               621                         132-358
Range                                                    600-1713                        0-520
Note: Model ssumes that only the United States does not ratify the Kyoto Protocol; Model assumes that
      a                                                                           b

Australia and the United States do not ratify the Kyoto Protocol.
Sources: Haites (2004); Zhang (2000).




                                                           53

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Annex I: Glossary of acronyms

  Acronym                                           Meaning
    AAU                                     Assigned Amount Unit
     AIJ                                 Activities Implemented Jointly
     AIE                                Accredited Independent Entity
    CCX                                   Chicago Climate Exchange
    CDM                                 Clean Development Mechanism
    CER                                  Certified Emission Reduction
     CFI                                 Chicago Financial Instrument
    CGE                                Computable General Equilibrium
    COP                                UNFCCC Conference of the Parties
    DOE                                 Designated Operational Entity
   ERPA                            Emissions Reduction Purchase Agreement
    ERU                                    Emission Reduction Unit
   EU ETS                      The European Union Emission Trading Scheme
   GGAS                               Greenhouse Gas Abatement Scheme
    GHG                                         Greenhouse Gas
    IPCC                          Intergovernmental Panel on Climate Change
     JI                                      Joint Implementation
    JISC                         Joint Implementation Supervisory Committee
    lCER                               Long-term CER under LULUCF
  LULUCF                            Land Use, Land-Use Change and Forestry
    NAP                                    National Allocation Plan
   NETS                      National Greenhouse Gas Emissions Trading Scheme
   NGAC                    New South Wales Greenhouse Gas Abatement Certificate
    ODA                                Overseas Development Assistance
   OECD                  The Organization for Economic Co-operation and Development
   MtCO2e                               Million tons of CO2 equivalent
    PCF                                     Prototype Carbon Fund
    PDD                               Project Design Document, for CDM
   RGGI                                Regional Greenhouse Gas Initiative
    RMU              Removal Unit, for GHG removal from the atmosphere through LULUCF
   SBSTA                    Subsidiary Body for Scientific and Technological Advice
    tCER                               Temporary CER under LULUCF
   tCO2e                                    Ton of CO2 equivalent
  UNFCCC                  United Nations Framework Convention on Climate Change




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