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The Clean Development Mechanism:
Key issues for Southern Africa

by Randall Fecher, Khorommbi Matibe, Justice Mavhungu, and Gillian Simmonds
Energy and Development Research Centre
University of Cape Town

Summary

The Kyoto Protocol to the United Nations Framework Convention on Climate Change (UNFCCC) created a new possibility for North-South co-operation in mitigating climate change through joint projects. The Clean Development Mechanism (CDM), described in Article 12 of the Protocol, allows industrialised countries to purchase "certified emissions reductions" (CERs) from projects in developing countries which mitigate climate change. The CDM follows from the concept of Joint Implementation, whereby investors exchange capital and technology for emissions reductions from joint projects in developing countries. This paper analyses a number of key issues around the CDM from the perspective of developing countries, and Southern Africa in particular.

Much work remains to be done to clarify whether and how the CDM can meet the twin goals of contributing to sustainable development in developing countries and assisting industrialised countries to meet their commitments to emissions reduction and limitation. The issues presented here will be debated in the coming months and at the Fourth Conference of the Parties in Buenos Aires. These issues echo many of the points raised by the G77 and China in their submission to the UNFCCC Secretariat (FCCC/SB/1998/MISC.1/Add.5).

Although many of these issues are controversial, a Southern African perspective suggests several conclusions. Firstly, to prevent a bias between the flexible mechanisms, banking must be applied to all or none. Given the potential abuse, it may be better to exclude banking but introduce other measures to promote early action. Caps of the use of flexible mechanisms will almost certainly be required to satisfy developing countries’ desire to see industrialised countries take significant domestic action to mitigate climate change (and to reduce leakage), even if this could theoretically limit the number of CDM projects. Developing countries may be more willing to consider their own commitments if caps are in place.

Similarly, mechanisms must be put in place to raise funds for adaptation and to ensure a better regional distribution of projects than in the Activities Implemented Jointly (AIJ) pilot phase. For the former, it may be more appropriate to place an "adaptation levy" on all flexible mechanisms so that CDM projects are not at a disadvantage. For the latter, if regional quotas for projects are too cumbersome, then the COP must put in place aggressive programmes to build the enabling environment and project guidelines which promote projects in under-served regions like Africa. An independent, critical review of the AIJ pilot phase would illuminate what the barriers were to these projects, with the goal of widening access to the CDM. The principle of financial additionality from the AIJ pilot phase should also be examined, given the importance of securing new and additional funding for the CDM.

At a minimum, the CDM as an institution should serve as a clearinghouse of projects and funding proposals and a certifying body for CDM activities. To promote investment in regions such as Africa, however, a more systematic approach will be necessary, which may involve the CDM serving as a broker or proactively seeking out projects. These two approaches could operate in parallel, with "certification only" for regions with high investor interest and a funding or brokerage role in regions such as Africa.

Baselines and verification will provide the technical basis for CDM project assessments. As with JI (and AIJ), standard methodologies for baselines, and clear links between national and project baselines will make the process easier and more credible. Independent certification is also critical to the credibility of any trading system; a network of accredited auditors under the authority of the COP is likely to be more cost effective than having all projects verified by the CDM Executive Board or similar body. For credit sharing, basic guidelines or principles will be useful to prevent unproductive competition between developing countries for projects, but it is unclear how these can be implemented in practice because of the possibility of side payments and differing investment levels by industrialised country partners in CDM projects.

Introduction

The objective of the CDM, as stated in the Protocol, is to contribute to sustainable development and the overall objectives of the Convention, as well as to assist industrialised countries in meeting their emissions reduction targets.

The CDM provides an overarching accord for organising, structuring and financing initiatives which involve North-South collaboration with the objective of treating the global problem of climate change with mutual benefit to participating countries. If it is well constructed the CDM will be able to focus on sustainable development in developing countries through an emphasis on avoided future emissions, while contributing to emission reduction in Annex I countries. To achieve such a role, the CDM would need to be clearly defined, such as the criteria for baselines, and take into consideration the status quo of the collaborating Parties while not compromising the underlying principles in the UNFCCC. The CDM was defined only loosely in the Kyoto Protocol, and many questions on how it would operate and what the role of developing countries would be were left unanswered. Many of these issues will be decided at the Fourth Conference of the Parties (COP4) in Buenos Aires in November 1998. This paper presents an analysis of the key issues that must be addressed before the CDM can operate effectively and for the benefit of both developing countries and industrialised countries.

The background for any discussion of "flexible mechanisms" such as the CDM should be the larger question of equity in dealing with global climate change. Not only are per capita and total greenhouse gas emissions from developing countries far lower than those of industrialised countries, but the cumulative impact of industrialised country emissions in this century dwarfs the impact which developing countries have had on the global atmosphere. Since 1950, for example, the cumulative carbon emissions from industrialised country emissions account for more than 85% of the carbon dioxide build up in the atmosphere (Sari 1998). Even more striking is the fact that, despite their limited responsibility for climate change, in some cases developing countries are making more progress to change their development paths than are industrialised countries. Several studies presented at the 1997 climate change negotiations by the World Resources Institute, Woods Hole Research Center, and Environmental Defense Fund, demonstrated the efforts of developing countries. One even concluded that that "developing countries may be achieving equivalent or greater CO2 emissions savings than OECD countries in absolute terms and, since they are starting from a lower baseline, significantly greater savings as a percentage of their emissions" (Ramakrishna & Jacobsen 1997).

The argument about contribution to, and ability to deal with, global climate change is the origin of the concept of "common but differentiated responsibilities" under the Convention, and should be a reference for other debates about responsibility for mitigating climate change. For each of the issues below, for example, it is important to ask what options reflect appropriate responsibilities for developing country and industrialised country parties to the Kyoto Protocol.

CDM Issues

Competition between flexible mechanisms

The Kyoto Protocol established a legally binding obligation on Annex B countries (subject to entry into force) to reduce emissions for six greenhouse gases (GHGs) in total by approximately 5% below 1990 levels by the years 2008 to 2012 (IEA 1998b). To assist them in meeting their negotiated commitments, Annex B countries argued for the inclusion of a variety of flexible instruments in the Kyoto Protocol. Four flexible mechanisms were included:

  • Joint fulfilment or bubbling (Article 4): Allows for Annex I countries to come together and negotiate a reallocation of quantified commitments on a regional basis ("within a bubble") on the proviso that the total combined commitment to emissions reduction of the Annex I Parties remains the same (Matsuo 1998).
  • Joint implementation (Article 6): Allows Annex I countries to transfer to, or acquire from, other Annex I Parties emission reduction units (ERUs) resulting from individual projects which can be demonstrated to reduce emissions beyond what would have occurred otherwise. Joint implementation must be supplemental to domestic action (Kyoto Protocol 1997).
  • Clean development mechanism (Article 12): Has dual objectives of assisting non-Annex I countries in achieving sustainable development and assisting Annex I countries in meeting their commitments. Annex I countries can achieve certified emissions reductions (CERs) for individual projects which reduce GHG emissions beyond what would have occurred in the absence of the project. Those CERs achieved between 2000 and 2008 can be credited against commitments during the first commitment period (2008 to 2012) (IEA 1998b).
  • Emissions trading (Article 17): Allows Annex B countries (ie those with emissions reduction commitments under the Protocol) to trade surplus emissions. Emissions trading must be supplemental to domestic actions to achieve commitments.

The latter three mechanisms allow for the trading of emission reduction titles. While these instruments of co-operative implementation will be operating and competing in the global market, the linkages between the mechanisms are not clearly defined in the Protocol. How compatible are the three mechanisms? To what extent does the Protocol ensure their co-existence? How should the CDM be designed to ensure that non-Annex I country participation is not jeopardised by within-Annex B instruments (JI and Emissions Trading)? Observers have identified several inconsistencies between the three mechanisms, which prejudice or advantage the different mechanisms. While it is not always clear to what extent these inconsistencies are intentional or mere omissions, their implications need to be carefully thought through and if necessary addressed at COP4 in Buenos Aires.

  • Early crediting or banking: Article 12, paragraph 10 of the Kyoto Protocol makes allowances for banking of CERs achieved through CDM activities. CERs achieved between 2000 and 2008 can be used to achieve compliance in the first commitment period. No such allowances are made for JI, so the Protocol creates an inherent bias in favour of CDM. Proponents of banking argue for its inclusion on the basis that early crediting encourages early action. If, however, the motivation is purely to encourage early action, is it not then appropriate to include banking for both JI and domestic action as well? Parties with economies in transition, such as the Eastern European countries, have argued for the inclusion of early crediting in Article 6 as they want to encourage early JI to assist them in their economic reconstruction. Others argue, however, that banking has been omitted from Article 6 because of the inherent potential for abuse where both Parties have emission reduction commitments (Jepma 1998). Still others have argued for the exclusion of banking between 2000 and 2008 on the basis that banking has the potential to relax targets in the commitment period (Parkinson 1998). There are two options for ensuring the compatibility of the mechanisms. Firstly, allowances can be made to include banking under JI while putting checks in place to prevent system abuse. This will, however, give JI and CDM a competitive advantage over domestic action in Annex I countries and, where countries have similar emission reduction cost curves, it would be more beneficial to co-operate through JI projects (Jepma 1998). Secondly, banking could be excluded from Article 12, and other mechanisms to encourage early action could be explored. Regardless of banking provisions, Annex I countries are obliged to have shown "demonstrable progress" by 2005 (Article 3, para 10).
  • Sinks: Allowances are made under Joint Implementation (Article 6) for Annex I countries to meet their commitments through enhancing sinks of GHGs. No such allowances are made under CDM. It is not clear whether this discrepancy was a result of a political decision taken at Kyoto or whether it was an omission. It is clear, however, that it could disadvantage those non-Annex I countries that have an advantage in forestry projects. At a workshop held in Latin America, the overwhelming response from non-Annex I countries was that this inconsistency is grossly unfair and that sinks should be included under Article 12 as well (IEA 1998a). Other forums have been more circumspect. Forestry projects have been under debate due to the difficulties in monitoring and verifying absorption and setting baselines, as well as the difficulties in guaranteeing the long-term conservation of these environments. At a workshop on carbon credit sharing held in the Netherlands, it was agreed that sinks should be included only if emissions reductions from those types of projects could be measured. The level of certainty around measuring emissions reductions of different types of forestry projects would need to be established by the scientific bodies of the UNFCCC.
  • Transaction costs: Provision is made for an adaptation fund under Article 12, where it is stated that "a share of the proceeds from certified project activities is used to cover administrative expenses as well as to assist developing country Parties that are particularly vulnerable to the adverse effects of climate change to meet the costs of adaptation (Kyoto Protocol 1997). Gupta (1998) argues that, while the adaptation fund is essential, the levy acts as an implicit tax on CDM, raising the transaction costs of these project activities and making them less attractive. This will be especially true after 2008, when the CDM will no longer have the advantage afforded from the early crediting which is written into the Protocol text at present. A possible solution would be for all three mechanisms to contribute to the Adaptation Fund. Transaction costs and the adaptation levy are discussed in more detail below.

Caps and limits on CDM

  1. While both ERUs achieved through project activities under JI and traded emissions must be supplemental to domestic actions to achieve commitments, CERs accruing through project activities under CDM can be used to contribute to compliance with part of Annex I quantified emissions limitation and reduction commitments. While the wording of paragraph 3 of Article 12 of the Kyoto Protocol does suggest limits to the extent to which ERUs can be used by Annex I countries to meet their commitments, the ratio of domestic compliance to CDM still needs to be negotiated.
  2. The demand for quotas which would guarantee a minimum amount of domestic action originally came from developing countries which feared that industrialised countries would use flexible mechanisms as a means of buying their way out of their own climate obligations. Developing countries have contributed very little to the threat of climate change and argue that it would thus be unfair if they were to be expected to shoulder the "burden" of emissions reduction. While it is agreed that the CDM will assist Annex I Parties in meeting their commitments, Davidson (1998) makes an important point that the operative word in CDM is development not environment. Consequently, the CDM cannot be expected to achieve the environmental objectives of the UNFCCC on its own.
  3. From an environmental perspective, quotas can provide a solution to certain loopholes in the Protocol. Leakages in an open trading system, particularly one which includes Parties with no binding commitments as in the case of CDM, are difficult to police. In a closed system, for example in the case of domestic action where Parties have defined baselines and binding commitments, leakages can be more easily accounted for at a macro-level. Thus, the greater the proportion of commitments fulfilled through domestic action, the greater the potential for achieving the environmental objectives of the UNFCCC.
  4. There has been increasing pressure in the international negotiations for non-Annex I countries to take on voluntary commitments. Considering these countries have contributed very little to the threat of climate change and still have very low per capita emissions, they are reluctant to take on commitments until the Annex I countries have demonstrated progress toward meeting their targets. To what extent is "demonstrable progress" tied up with the CDM? On the one hand, some Annex I countries may look to the CDM and other flexible mechanisms to demonstrate progress by 2005 as required by the Protocol. On the other hand, non-Annex I countries are likely to require Annex I Parties to show progress in reaching their targets through domestic actions before they will be willing to consider voluntary commitments. Quotas or caps are one method of ensuring that Annex I Parties undertake domestic action. This, in turn, will potentially increase the willingness of non-Annex I Parties to take on voluntary commitments.
  5. Parties to the Convention remain widely divided with regard to the proportion of domestic action to action undertaken through flexible mechanisms. While most developing countries have called for the majority of emissions reductions to be fulfilled through domestic action, some Eastern European countries are in favour of a small domestic commitment. Michaelowa and Dutschke (1998) argue that quotas themselves could potentially lead to problems. Firstly, they argue that credits from a CDM project could only accrue until the quota is filled and secondly, they argue that there is a risk that all credits from CDM projects could lose their value if the quota had already been filled through emissions trading and JI within Annex I countries. Furthermore, they argue that if developing countries continue to push for quotas, emissions trading and Annex I JI will reduce the transfers to non-Annex I countries and exclude these countries from the climate change negotiations.

Contribution to Sustainable Development

As discussed above, what separates the CDM from other flexible mechanisms is the focus on sustainable development as well as cost-effective emissions reduction. Assuming that all parties accept these goals, the task is then to define what is included within sustainable development (or a process to define it) and develop tools to measure progress on a project and country basis.

One of the leading climate change NGOs in Africa, ENDA Tiers Monde in Senegal, points out that the CDM can, if properly designed, make a decisive contribution to sustainable development in Africa, primarily through the implementation of desperately needed large-scale infrastructure development projects and programmes. To achieve this, however, the certification criteria will have to include socio-economic and other development indicators. (Sokona, Humphreys & Thomas 1998) Although Africa is a minor contributor to climate change, it is the most vulnerable region to its impacts; infrastructure development can significantly alleviate those impacts. Professor Ogunlade Davidson of Sierra Leone argues that Africa has an opportunity therefore to link mitigation to development, and by doing so integrate environmental and developmental issues, increase national capacity, and negotiate the transfer of technical and financial resources (Davidson 1998).

A recent meeting sponsored by Climate Network Africa laid down potential areas and criteria for the sustainable development contribution of CDM projects. They include:

  • sustained economic growth;
  • poverty eradication;
  • social development;
  • meeting basic needs;
  • reduction/elimination of foreign debt;
  • real and meaningful technology transfer;
  • awareness and capacity building;
  • intra- and inter-generational equity. (Climate Network Africa 1998)

Measuring sustainable development is one of the most difficult areas for CDM projects, because there is not universal agreement on definitions or methods for measurement. A critical question is whether sustainable development must be defined across all CDM projects, or whether individual host countries should be responsible for their own definitions. The trade-off here is that, while individual countries should be setting their own priorities, individual governments do not necessarily choose projects which are the most beneficial for society in the long run for a variety of reasons. Whether it is possible or useful to impose standards is an open question.

On a national level, the United Nations Development Programme’s Human Development Index provides one broad measure of development. Certain countries have also instituted measures of development or, more importantly, policies and plans to achieve economic and social development. How well CDM projects fit into those development plans could be one measure of their contribution to sustainable development. In the AIJ pilot phase, for example, it was generally the host country’s decision whether the project fit with their development priorities, and they accepted or rejected the project on that basis. This re-emphasises the need for national baselines that reflect national policy priorities.

Institutional structure and the Executive Board

The Kyoto Protocol alludes to the institutional structure of the CDM in Article 12, paragraphs 4 and 5 stating that the CDM will be administered through three bodies:

  • the COP/MOP, which provides authority and guidance;
  • the Executive Board, a supervising body; and
  • operational entities to certify emissions reductions.

The roles of and linkages between these three bodies are, however, not clearly defined in the Protocol and have been prioritised for clarification at COP4. Observers to the Protocol have identified three possible roles for the Executive Board (see Sokona, Humphreys and Thomas 1998):

  1. A certification body for projects involving transfer of emissions reductions: The CDM acts as a regulatory body only, ensuring transparency and standards of application and crediting.
  2. A project clearing house: The CDM will act as a contact point, bringing together private or public actors with projects and programmes to implement and those with the means to implement them.
  3. A project co-ordinating body and funding agency: The CDM acts as a broker, actively seeking and accumulating funds and actively eliciting projects and programmes. The CDM would define criteria for the acceptance of projects and the allocation of funds, which meet the objectives of both emissions reduction and sustainable development and ensure an equitable distribution of activities and finances on a geographical basis.

Under scenario one, the role of the CDM will essentially be to establish guidelines to monitor and evaluate the contracts between Parties and joint action will continue to take place on a bilateral basis, as was the case under the AIJ pilot phase. Some argue that economically this is the most appropriate function for the CDM, as it can reduce the transaction costs to the investors and raise the attractiveness of CDM projects for private actors (Michaelowa & Dutschke 1998). From an African perspective, however, scenario one is viewed as severely limiting. Sokona, Humphreys and Thomas (1998) argue that Africa was largely excluded from the AIJ pilot phase because of the focus of AIJ on emissions reductions, on the one hand, and because of the reliance largely on market forces, on the other. Africa contributes little currently to global emissions and, therefore, stands to benefit little from CDM if the focus is not expanded to include avoided future emissions. Furthermore, Africa's comparatively small and weak markets do not make it attractive to investors and, therefore, Africa will stand to be excluded from CDM, as was the case in the AIJ pilot phase, if the emphasis remains purely on market forces. Furthermore, a CDM that promotes bilateral activities will not encourage investment in the large-scale and regional-based infrastructure projects (such as energy supply, transport and communications) which are required to stimulate nascent markets and facilitate sustainable development in Africa. It is argued, therefore, that under scenario one, emissions reductions will be emphasised over and above sustainable development, and equity considerations are unlikely to be addressed.

Scenarios two and three both allow the CDM to function as a multilateral body. Scenario three, however, expands the role of the CDM to one that is more visionary and proactive. As a co-ordinating and funding body, the CDM could set criteria and apply standards to ensure geographical equity considerations are taken into account (see section 2.5), ensure that the CDM dual objectives of emission avoidance and sustainable development are given equal weight, and that funding is available for projects initiated by host countries (Sokona, Humphreys & Thomas 1998). The obvious disadvantage of this approach is that a relatively large bureaucracy would be needed within the CDM to carry out all of these functions and monitor them. This could delay projects and reduce the total number of projects. On the other hand, it might mean that only those projects that truly meet both goals of the CDM were implemented rather than others focused mainly on emissions.

While the African position would appear to favour the CDM as a broker, there are differing perspectives within the G77 and China bloc. At a recent workshop held in Latin America, participants largely agreed that the Executive Board should not be responsible for the functions of project identification and defining sustainable development, as these functions should rest with the host countries (IEA 1998a). This viewpoint would appear to favour the CDM as a clearing house rather than as a project co-ordinator and funding agency, where equity and sustainable development considerations would require the Executive Board to set and apply criteria and standards to choice and efficiency of projects. The solution may be for the CDM institutions to operate both as a clearing house and as a fund or broker. While some CDM activities with significant investor interest would pass through for certification only, the Executive Board and other institutional structures could actively seek out and package projects and funding for under-served regions such as Africa.

Equity and regional distribution of projects

Another key concern of developing countries particularly in the construction of CDM is how to create a mechanism which distributes funding and other benefits with a measure of equity not previously achieved with other flexible mechanisms. Most of the early AIJ projects, for example, were in Eastern Europe and Central America, with only two in Africa as of 1997. Most foreign direct investment in developing countries is also heavily concentrated in a few countries, none of which are in Africa (French 1996). Tapping this investment for sustainable development and influencing it through mechanisms such as the CDM poses a major challenge.

Some have argued that the CDM should incorporate a regional quota for projects to ensure a fair distribution of projects among regions and also ensure that the benefits of projects implemented under its umbrella are equitably shared between participants (Sokona, Humphreys & Thomas 1998). Participants in the recent Climate Network Africa meeting in Kenya (CNA 1998) went a step further to argue that equity not only involves numbers and people, but also how these people or groups are empowered. Suggestions were that equity in the CDM could entail the following:

  • representation on various bodies (eg executive board);
  • equal opportunities to participate in projects;
  • capacity and resources to be able to participate; and
  • economic development resulting from projects.

The arguments against such quotas or representivity would be that they raise the costs of projects and create a large central bureaucracy that makes project decisions rather than providing incentives for innovation and private investment. Investors would argue that any restrictions will reduce the pool of tradable projects and push up the transaction costs of projects (Heller 1998). There is a need to explore creative mechanisms for ensuring that the benefits of CDM accrue to a broad range of developing country parties rather than only a few. An assessment of the AIJ pilot phase should address this issue critically for AIJ projects and suggest alternatives for the CDM.

Adaptation and transaction costs

  1. In the early discussions about the CDM at Kyoto, Brazil proposed that industrialised countries which did not meet their obligations under the Protocol should contribute to a fund which would compensate the social and economic losses in developing countries from climate change impacts. Although the CDM in the end went beyond this concept to provide for the sale of "certified emissions reductions", the Protocol still states that part of the funds raised should be used for adaptation (Article 12, para 8).
  2. Some have argued that including a provision for adaptation costs (or even excessive administrative costs) will raise the price of using the CDM, making it less attractive to investors. Including adaptation costs in the price of a CDM project or fund raises the transaction cost for both buyer and seller. This could potentially discourage investment, particularly when JI projects will not be required to make provisions for adaptation. As discussed above, this begs the question of why all emissions trading should not be taxed to contribute to adaptation and the costs of vulnerability. If JI, CDM and Emissions Trading all had a small levy, then the issue would not prejudice one mechanism over the other. While the conditions for JI and Emissions Trading do not specifically state that they must contribute to sustainable development in the way that the CDM does, this is a central goal of both the Convention and the Protocol.
  3. Whether the transaction costs result in fewer CDM projects depends on what the cost of reducing emissions in developing countries is compared to the costs in industrialised countries and countries with economies in transition, who will be engaging in JI. If the project cost in developing countries is sufficiently low, then adding a small "adaptation levy" to the cost of the project is unlikely to discourage the investment relative to other mechanisms. While analysis of the climate change mitigation opportunities in industrialised countries has shown that there are significant "no regrets" options (eg Lovins & Lovins 1991), research in developing countries also shows a wide range of "no regrets" and low-cost options (eg Praetorius & Fecher 1998; UNEP 1994).
  4. For Africa, the issue of funding for adaptation is crucial. Most African countries have very low emissions currently, so do not contribute significantly to global GHG emissions. In contrast, however, those same nations often have delicately balanced or even severely degraded ecosystems vulnerable to desertification, flooding, or other extremes in climate. A recent IPCC report on the regional impacts of climate change concluded that Africa would be hit the hardest (IPCC 1997).
  5. If an adaptation levy were applied to CDM projects, the remaining decision would be how the funds are collected and allocated. Will they be collected on a project-specific basis, or through a clearing house or brokerage house for credits as a tax? Clearly this depends on the institutional structure of CDM and the Executive Board. In addition, will adaptation funds be dedicated to the same countries that have CDM projects, or will these funds be distributed across all developing countries according to some criteria? This question is linked to the regional distribution of CDM project, because the mechanism used for making those decisions on distribution could also apply to adaptation funds. The Protocol implies that funds for adaptation should go to those countries most vulnerable to impacts of climate change, rather than those that have the most CDM projects.

Participants in CDM projects

Based on the language of the Kyoto Protocol, the CDM could function as a multilateral body that serves as a vehicle to channel funds for large-scale projects. The question of who actually implements CDM projects and who funds them depends on the institutional structure of the mechanism, and could theoretically include governments, business, NGOs and multilateral organisations.

  • The first option may take the form of government-to-government business wherein an Annex 1 Party directs public funds to finance a project/program in a non-Annex 1 country. The governments could in turn designate implementing agents within countries, but essentially the climate change funding would be moving between governments only.
  • Option two would be a direct government project investment initiative in which the government of an Annex 1 Party channels funds directly to a private project operating in a non-Annex 1 country. The authorisation of the project would come from the recipient country, and the role that the Annex I government plays in the project would probably be larger than in the first option.
  • Option three is private to private sector involvement in which a company in an Annex 1 country gets authorisation and/or an incentive from its own country and channels those financial resources to a project in a non-Annex 1 country. Presumably the private sector partners would make the operating decisions for the project with minimal intervention from governments other than certification of emissions reductions and other CDM requirements.
  • Option four would be for an independent broker to facilitate the movement of funds from the Annex 1 country to a project operating in non-Annex 1 country. The broker would also play an important role in the certification of the project.

Limiting the types of participants in CDM projects could reduce the number and effectiveness of projects. Clearly, however, all participants must be bound by the same rules and would be required to report on all CDM project requirements. Specifying these requirements will be more important than limiting project participants.

A more interesting question is the role of regional organisations in CDM projects, and the opportunities for regional development project finance. The Southern African Development Community, African Development Bank, and other African organisations could use CDM funding as an opportunity to develop stronger regional infrastructures, policy co-ordination, and regional economic integration. These large-scale initiatives would arguably do more for both local sustainable development and the global environment and a host of micro-level project initiatives.

Baselines

  1. Under the Kyoto Protocol, CDM projects are required to demonstrate "reductions in emissions that are additional to any that would occur in absence of the certified project activity" (Article 12, para 5(c)). An essential element of CDM projects, therefore, is the definition of baselines, against which the emissions additionality of projects will be measured and certification subsequently applied. The baseline of a specific CDM project defines the scenario that would have occurred in the host country in the absence of CDM. It is the necessary foundation for calculating, by way of comparison, the global environmental benefits that would accrue if the project were successfully completed and determining how much of the impact can be attributed to the CDM investment.
  2. Not only do possible baselines differ according to the underlying assumptions about economic growth and its environmental impacts, but are also based on how closely the future fits past trends. An "historical" baseline might simply project past emissions trends forward in time, while a "business as usual" baseline would reflect future emissions based on current policy guidelines. A third baseline type, the "most likely" scenario would take into account not only current policies but likely changes in policy and the economy in the future, based on underlying socio-economic shifts in the country (eg growing involvement in international trade). There is a direct link between how ambitious the baseline is in terms of environmental protection, and how cost effective a CDM (or JI) project is. If countries set very lenient baseline projections, then even poorly performing CDM projects will appear to produce large, cost effective emissions. This leads to the ironic conclusion that emissions reductions may be the cheapest in countries that lack a national sustainability policy (Michaelowa & Dutschke 1998).
  3. Setting standards for project and national baselines – or, rather, standards for how they are generated – will be necessary to lay the foundation for credible emissions reductions. National baselines could be linked to National Communications or the Climate Change Country Studies being carried out in many developing countries. Project-specific baselines could also incorporate standard assumptions about technologies, emissions factors (modified with local data where available), and the impact of certain policy interventions. While standards are desirable for consistency, in practice they may be difficult to determine. The impact of a given policy or programme on energy consumption in the national baseline, for example, will vary widely depending on the details of the policy, how it is implemented, and the socio-economic and cultural environment in which it is implemented.

Certification and verification

  1. Article 12 of the Kyoto Protocol refers to "certified emission reductions" and certified project activities (para.6). Certified emission reductions (CERs) are essential components and incentive for private sector involvement. CERs also form the basis for emission credits for Annex I countries. There is no hope of a CDM or successful JI without a credible certification and verification system. Many questions remain, however, about who should be responsible and carry out such certification and what they should certify. At a technical level, verification must "establish whether the measured GHG reductions actually occurred, similar to an accounting audit performed by an objective certified party" (Vine & Sathaye, 1997). In contrast to AIJ or JI projects, for the CDM not only the GHG reductions but also the sustainable development impacts must be included in the certification process.
  2. As models for how a certification regime could be implemented, two approaches are possible: a decentralised approach similar to professional accreditation, or a centralised approach similar to monitoring international weapons or election inspections. In the former, a central body would license individuals or firms to serve as accredited certification services, much the way certified accountants or lawyers have professional associations which accredit them. The advantages of this approach are that the central body does not have to be responsible or involved with every audit and individual auditors have incentives to do their job effectively (so that they do not lose their licence) and efficiently (so that they can afford to operate or make a profit if a private firm). The disadvantage is the risk of individual auditors "cheating" under pressure from project partners and not being picked up by the accrediting authority. A centralised approach would be analogous to United Nations election inspectors of nuclear weapons who are under direct control of the central body in each case. The advantage of this approach is that the centre has tight control over the outcome and process of each audit. The disadvantages are the potentially high costs of doing a large number of inspections around the world from one location, the costs of creating a new firm where capable organisations may already exist, and the lack of incentive to operate more efficiently.
  3. Some private firms with experience in other areas of verification have already initiated plans to develop a GHG certification programme (pamphlet?). NGOs are also involved with many of the current AIJ projects. Building on the skills available to develop an international network of qualified auditors under strict guidelines from the COP is likely to be the most cost-effective approach for certification and verification, particularly if the results of the audits are publicly available.

Liability and enforcement

The inclusion of trading in emissions reduction titles through flexible mechanisms introduces new complexities with regard to enforcing compliance of Annex I countries with their obligations under the Protocol. The introduction of CDM raises the question, which Party - the buyer or the seller - bears responsibility if a GHG project falls short of its expected emissions reductions, resulting in non-compliance?

  • Seller liability: Under this scenario, the seller is held solely responsible. The buyer can thus retain and use the units purchased, regardless of whether the GHG project has fallen short of its expected emissions reductions (Goldberg et al 1998). A disadvantage of pure seller liability is that, if it is unrestricted, there is a potential incentive for the seller to sell emission units aggressively for financial gain. This may be of particular risk in the case of CDM, where non-Annex I countries have no commitments and, therefore, sanctions for exceeding assigned amounts are not applicable to them.
  • Buyer liability: The buyer is prevented or restricted from using the purchased units towards meeting its commitment unless or until the implementation of the GHG project has been fully successful (Goldberg et al 1998). Under this scenario, there is a stronger incentive for sellers to implement successful projects so as to attract buyers. Furthermore, the buyer will insist that sellers take effective measures to achieve the expected emissions reductions. However, pure buyer responsibility could have a negative impact on the development of an efficient market for emission reduction titles.

While this question of liability applies to both Annex I JI and emissions trading as well, under CDM accountability issues become more difficult to enforce. As a result, some have argued for a buyer liability scheme. Goldberg et al (1998) argue, however, that the threat of suspension from participating in the CDM could be used to hold host countries accountable. Furthermore, CERs could be issued only after emissions reductions are realised and certified, thus reducing the need to assign responsibility. The concern of baseline or leakage problems emerging after CERs have been issued could be overcome if the emissions reduction potential of CDM projects was conservatively estimated.

Shared responsibility for the fulfilment of obligations can be achieved with periodic evaluation of the Annex I Party’s implementation of its emission reduction and other commitments and non-Annex I Party's implementation of the CDM project. In this scenario, the seller would bear responsibility for ensuring successful project implementation initially. Periodic review would determine that a Party is deemed to have actual or potential implementation problems. Buyers would be warned and would not be able to use the units in their compliance calculation until the seller's implementation problems had been resolved. The buyer would thus be liable for the purchase of emission units with a weak reputation. Auditing of such projects and certification of emission reductions would need to be stringent.

Financial additionality

  1. The concept of financial additionality was introduced in the decision to establish AIJ, to prevent industrialised countries from diverting development assistance toward AIJ, or from reducing previous obligations to contribute to the Global Environment Facility (GEF). For the pilot phase, AIJ funding was supposed to be additional to other official development assistance or obligations under the Convention. Although financial additionality for the CDM is not mentioned in the Kyoto Protocol, developing countries have raised it as a key issue in determining how the CDM will work (FCCC/ G77 position).
  2. In practice, financial additionality is difficult to determine because ODA has been declining for some years, particularly to regions such as Africa (Sokona, Humphreys & Thomas 1998; French 1997). In 1992, countries at the Rio Earth Summit agreed that industrialised countries would devote 0.7% of their gross domestic product to foreign aid. The UNFCCC and the Kyoto Protocol both say that the industrialised countries will pay the incremental costs the developing countries incur to comply with the Convention. Yet few industrialised countries have fulfilled these commitments. Indeed, some countries, notably the United States, have cut their foreign aid budgets since 1992.
  3. While the guidelines for several countries for AIJ refer explicitly to financial additionality (CC:INFO/AIJ 1997), this criterion was generally not used as a basis for rejecting projects because it was so difficult to determine. Several AIJ projects have received ODA or even GEF funds, so it is not clear how this criterion has actually been applied to date. One argument is that private sector funding in climate change projects is almost by definition additional to government action (unless companies fund projects from tax cuts that reduce government ODA), so private sector participation should be encouraged. Foreign Direct Investment in developing countries has increased rapidly, but is generally concentrated in a few countries (French 1996). In summary, while financial additionality is an important principle for the CDM, work will be necessary to provide a suitable definition and mechanism for determining whether CDM projects meet this criterion.

Credit sharing

If CDM projects can create CERs, how should these reductions be shared among the participants in the project – in particular between the two (or more) countries which participate? The major issues here is whether there is a need for guidelines on credit sharing which apply to all CDM (and JI) projects, or whether this should be negotiated on a case by case basis with the parties involved.

The main reason for establishing guidelines is the concern that individual developing countries will not get a "fair" share of the credits from a project because of their weak negotiating position vis-ą-vis industrialised countries or multinational corporations. Worse yet, without guidelines developing countries would have to compete against one another to provide a greater share of cheap credits to investors: it is difficult to see how this would meet the sustainable development objectives of the CDM. Some investors have argued, however, that introducing guidelines for credit sharing could raise the price of the credits and make CDM projects more expensive. In addition, many have questioned what the basis would be for a standard sharing formula. Does each participant get an equal share? Is the share of credits related to share of investment? Or would it relate to the share of the "incremental cost" of a climate-friendly project.

Credit sharing cannot be separated from the cost of credits, since the cost is based on both the investment and the credits received in return for that investment. Jepma (1998) provides a useful example of this issue using the coal-to-gas conversion AIJ project in Decin, Czech Republic. For this AIJ project, three US utilities provided US$600 000 out of a total project cost of $9 058 000. The total emissions reduction from the project were 608 952 tons CO2, with 133 829 tons from the fuel switch and 475 125 from setting up co-generation.

As Table 1 shows, the cost of the credits depends on which investment generates which credits. The investor might argue that, without their incremental investment, the project would not have happened. They should receive all of the credits, which results in a cost of $0.99/ton. The host, on the other hand, might argue that credits should go in proportion to investment. If $9 million dollars produces 600 000 tons of emissions reduction, then every ton costs $14.87. For their $600 000, US investors should only receive 40 336 tons of emissions reduction credits. To make matters more complicated, if the global "market price" for carbon is $3 ton of CO2, then investors in this case would want at least $600 000 / $3 = 200 000 tons of emissions reduction credits, which is much greater than the amount based on share of investment.

Table 1: Credit sharing example (from Jepma 1998)

 
 

Project costs in US$

 

Total costs

US investors’ contribution

CO2 emission reduction (tons)

9 058 000

600 000

608 952 (total)

14.87/t

0.99/t

133 827 (due to fuel switch)

67.68/t

4.48/t

475 125 (due to co-generation)

19.06/t

1.26/t

40 336 (share based on investment)  

14.87/t

T

 

 

 

 

 

Because developing countries (non-Annex I countries in the Kyoto Protocol) do not have quantified emissions limitation of reduction objectives (QELROs), it is not clear what they would do with their share of the certified emissions reductions under a CDM project. Currently there is no language in the Protocol which would allow developing countries to "bank" credits for use against future commitments in the way that Annex B countries are allow to do under Article 12. Some stakeholders in South Africa, for example, have raised the concern that, by giving away all of the credits for inexpensive projects, developing countries will face greater difficulty meeting any future commitments (Hirst & Fecher 1998). Another possibility is that developing countries could sell their share of certified emissions reductions on the world market, assuming that CDM credits could be traded. This raises again the importance of setting strong baselines and providing for independent certification, to reduce the risk of host countries which have no emissions limits from inflating the CERs from a project.

An issue related to credit sharing is the discounting of credits to reflect the risk of project default. Some authors have argued that all CDM credits should be discounted to reflect the risk of non-performance (Parkinson et al; Tattenbach?*) or that certain project types that are more risky should have heavily discounted credits (Michaelowa and Dutschke 1998). A key question here is what risks can be insured against, and what risk can not. If insurance is provided and is compulsory, then discounting is not necessary. Whether such an insurance scheme can be set up within the CDM remains to be seen, but deciding how much to discount credits is likely to be very contentious if this issues is raised in negotiations.

Conclusions

Much work remains to be done to clarify whether and how the Clean Development Mechanism can meet the twin goals of contributing to sustainable development in developing countries and assisting industrialised countries meeting their commitments to emissions reduction and limitation. This paper has raised a number of issues which will be debated in the coming months and at the Fourth Conference of the Parties in Buenos Aires. These issues echo many of the points raised by the G77 and China in their submission to the UNFCCC Secretariat (FCCC/SB/1998/MISC.1/Add.5).

Although many of these CDM issues will undoubtedly be controversial, a Southern African perspective suggests several conclusions. Firstly, to prevent a bias between the flexible mechanisms, banking must be applied to all or none. Given the potential abuse, it may be better to exclude banking but introduce other measures to promote early action. Caps of the use of flexible mechanisms will almost certainly be required to satisfy developing countries’ desire to see industrialised countries take significant domestic action to mitigation climate change (and to reduce leakage), even if this could theoretically limit the number of CDM projects. Developing countries may be more willing to consider their own commitments if caps are in place.

Similarly, mechanisms must be put in place to raise funds for adaptation and to ensure a better regional distribution of projects than in the AIJ pilot phase. For the former, it may be more appropriate to place an "adaptation levy" on all flexible mechanisms so that CDM projects are not at a disadvantage. For the latter, if regional quotas for project are too cumbersome, then the COP must put in place aggressive programmes to build the enabling environment and project guidelines which promote projects in under-served regions such as Africa. An independent, critical review of the AIJ pilot phase would illuminate what the barriers were to these projects, with the goal of widening access to the CDM. The principle of financial additionality from the AIJ pilot phase should also be examined, given the importance of securing new and additional funding for the CDM.

At a minimum the CDM as an institution should serve as a clearing house of projects and funding proposals and a certifying body for CDM activities. To promote investment in regions such as Africa, however, a more systematic approach will be necessary, which may involve the CDM serving as a broker or proactively seeking out projects. These two approaches could operate in parallel, with "certification only" for regions with high investor interest and a funding or brokerage role in regions such as Africa.

Baselines and verification will provide the technical basis for CDM project assessments. As with JI (and AIJ), standard methodologies for baselines, and clear links between national and project baselines will make the process easier and more credible. Independent certification is also critical to the credibility of any trading system; a network of accredited auditors under the authority of the COP is likely to be more cost effective than having all projects verified by the CDM Executive Board or similar body. For credit sharing, basic guidelines or principles will be useful to prevent unproductive competition between developing countries for projects, but it is unclear how these can be implemented in practice because of the possibility of side payments and differing investment levels by industrialised country partners in CDM projects.

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