A basic assumption of our analysis is that CDM projects will not enjoy any form of public or multilateral subsidy. Hence, the decisions of private actors to participate in the projects will be based solely on the expected additional economic return and commercial opportunities provided by the new opportunities created by a GHG offset market.

Investors committing funds to a project base their decision on the expected returns on the investment: cash flows resulting from the project plus any increase in the market value of the project assets. Investors look for projects with expected rates of return that compare favorably with other investment opportunities available to them in the market, and for returns that are high enough to compensate them for the particular risks borne in any specific project. It is a well-established fact that higher risk projects attract investment only if they promise a correspondingly higher return sufficient to compensate investors for the risk borne by committing their funds to a project. In facing the decision to allocate a limited supply of investment funds among competing project options, companies generally establish a "hurdle rate" ⁽³⁸⁾, which is the minimum expected return below which the company will not commit investment funds to a project.

Similarly, banks will extend financing only if project appraisal suggests that the expected cash flows will be sufficient to repay the debt and cover debt service payments on terms that are profitable to the syndicate of banks extending the project loan. When financing projects, banks are also careful to guard against the risks of project failure, and consequent loan default, by demanding from the developer guarantees against contingent failure and risk mitigation measures for particular risks borne by a project. In general, the cost of financing available to a project will be lower the more effectively the project can be hedged against risks.

To illustrate how these concepts apply to projects with a CDM GHG offset component, consider for example a new power plant that is expected to sell both power (the base project) and produce GHG offsets (the CDM project sub-component). In appraising the viability and attractiveness of the project, investors and lenders will assess:

• The financial soundness of the base project (the power plant in this example) including the cash flows to be generated and degree of risk associated with the future power sales, as well as the plant’s construction, operation, and management costs in order to derive an expected return.
• What is the contribution of the GHG offset component to the cash flows expected to be generated by the overall project. What is the degree of risk associated with the cash flows deriving from the GHG offset component over the project’s lifetime?

In the event that the uncertainties or risks associated with the unexpected cash flows from the GHG offset component are judged to be very large as they are very likely to be in any inchoate market, these cash flows will be heavily discounted in the project’s appraisal. In this case, the overall project will go forward only if the base project is financially sound and profitable enough to justify investment on its own.

The risks of producing GHG offsets are likely to be perceived as high by investors because GHG offsets (aside from normal project risks) face three additional forms of uncertainty: baseline risk, inchoate market price risk, and transaction cost risks. Baseline risk is due to the possibility that changes in the baseline could invalidate the "additionality" ⁽³⁹⁾ and therefore the "certifiability" of the GHG offsets deriving from a project. Market price risk is due to the uncertainty of the market value that the GHG offsets will command once produced, since the price of offsets is likely to fluctuate based on their actual supply and demand at any point in time, like any other commodity. Risks also arise from transaction costs due to uncertainties inherent in the costs of offset verification, monitoring, certification, trading and other requirements that CDM rules might impose. High transaction costs might erode the marginal abatement cost advantage that make GHG offset production in Non-Annex I countries a potentially lucrative proposition for investors in the first place.

The important point to realize is that the mere existence of CDM will not alter business-as-usual investment decisions unless CDM rules and operating modes can accommodate various possibilities for private investors to protect themselves against the perceived risks of a GHG offset market and derive attractive returns on the projects. ⁽⁴⁰⁾ Since Article 12 of the Kyoto Protocol leaves most of the CDM operational details to be negotiated later, a tremendous opportunity exists to complete the design of the CDM framework in a way that creates the conditions to attract private funds to these new investment opportunities. Negotiators need to design CDM institutions and rules to mitigate project risks and overcome other barriers that might stand in the way of CDM projects realizing a positive market return adjusted for risk on investment. ⁽⁴¹⁾ In short, a strong market for CDM projects will emerge only if the rules and institutional framework of the CDM provide the conditions for these projects to compete successfully with other investment opportunities in the international capital markets.

The Kyoto Protocol provides only the shell of the possible CDM. It gives a rough outline and then in Article 12.7 it states, "The Conference of the Parties serving as the meeting of the Parties to this Protocol shall, as its first session, elaborate modalities and procedures with the objective of ensuring transparency, efficiency, and accountability through independent auditing and verification of project activities." ⁽⁴²⁾ Thus, although the CDM is formally part of the Kyoto Protocol, there is still a great deal of uncertainty regarding how it will be interpreted and implemented. Several contentious legal issues will need to be addressed in the design and implementation of the CDM. These include:

• The Context of the Kyoto Protocol and Equity Concerns
• Institutional Structures and Control of the CDM Mechanism
• Treatment of Sinks, Including Forest Conservation Projects
• Market-Based Requirements
• Incentive Structures and Forest Preservation
• Project Additionality, Accounting, and Baselines
• Leakage of Carbon Benefits

 

THE CONTEXT OF THE KYOTO PROTOCOL & EQUITY CONCERNS

The ongoing debate regarding the CDM and its implementation is happening within the overall context of highly politicized negotiations over the other diverse climate change issues which assail FCCC member nations’ representatives. Although in this analysis we are assuming that other elements of the Protocol are constant, it is critical to note that many of the overall issues of contention with the Kyoto Protocol directly affect the CDM. Above all, it is important to remember that the Kyoto Protocol is an agreement made by voluntary assent. As explained in an article by Jonathan Weiner, "Global environmental regulation occurs under a different legal framework [than national regulation] in which regulation is essentially adopted by a voluntary assent [treaties bind only those that consent to be bound] voting rule and is implemented through intermediary political jurisdictions." ⁽⁴³⁾ Thus, under international law, the notions of regulation, coercion, responsibility and enforcement are dramatically changed. International treaties must depend upon national governments for enforcement, monitoring and evaluation, and overall accountability. In addition, within this "voting rule", voluntary consent implies that countries will need to be faced with significant incentives to comply with costly and difficult treaty commitments. This leads to the need for general consensus among Party members in order to avoid the economic costs of sub-global coverage and leakage. ⁽⁴⁴⁾

Thus, in the context of the climate change negotiations, Party members who have made commitments to reduce emissions have done so because of a number of incentives including the future costs of climate change, international pressure, and a feeling of responsibility to future generations. Other countries which have not agreed to make reductions commitments, mainly developing countries, will need to be provided with further economic and/or political incentives in order to avoid an overall failure of the Kyoto Protocol without which, of course, there will be no CDM.

…The Kyoto Protocol failed to employ side payments to engage developing countries in quantitative GHG emissions limits. The prospect is that GHG emissions will grow in those countries (perhaps even perversely spurred by uncapped JI/CDM subsidies), emissions-intensive activities will "leak" from constrained to unconstrained countries, and the treaty will have to be renegotiated with a new simultaneous assignment of allowances to industrialized and developing countries that caps global emissions while conferring compensatory side payments on developing countries. ⁽⁴⁵⁾

Thus, the CDM can only successfully meet one of its primary requirements (to "contribute to the ultimate objective of the Convention…" ⁽⁴⁶⁾ which is to mitigate climate change) if it is within an overall Protocol framework which is conducive to the market trading of emissions while ensuring that these market based incentives are not loopholes allowing the continued global GHG accumulation.

Furthermore, the issue of total quantified global limits, brings to the fore a very contentious, yet highly critical issue which can have an important impact on the design and/or acceptance of the CDM. This is the participation of developing countries. As mentioned before, the developing countries or non-Annex I countries are not faced with any limitations, more than voluntary reductions. The main reason behind their non-participation is based on equity. The industrialized world has been "polluting" since the dawn of industrialization and since carbon emissions may have a life of approximately 200 years, the greenhouse gases emitted by the industrialized countries over the course of the last hundred years, has accumulated and is thus disrupting the important balance that has been maintained for millions of years before the "industrial age." Thus, the problem that the globe faces today is directly attributable to those countries of the "developed" world. The dilemma is that the problem that those countries have caused is not local, but global and there is global pressure for all countries to assist in the solution–including those countries that have little hand in the cause.

To make the context even more complicated, those same countries which were polluting over a hundred years ago, are also the same countries which enjoy higher standards of living, economic wealth and political strength. And the developing world has a strong argument that they should not have to sacrifice their economic growth to pay for the errors of the past. They insist that the past cannot be grandfathered in and that any agreement should allow for the continued and sustainable economic growth of the developing world. By contrast, the Annex I countries balk at the specter of the rapid population growth within much of the developing world, the higher per capita emissions and the prospect of unfettered emissions within this context. In particular, China and India cause most to doubt the potential success of an agreement which does not include them. ⁽⁴⁷⁾ The solution to this problem would be a Protocol which would recognize the inequitable situation, while providing incentives to make it economically feasible for developing countries to participate. Such a Protocol might include measures which:

• Configure emission rates based on a weighted formula with several variables, for example: Emissions Allowance = B + B₂ Past Emissions + B₃ Population + B₄ Population Employed in Industry Emitters + B₅ GDP + … + E
• Support continued and sustainable economic and social development of the non-Annex I nations.
• Recognize that the protection of the environment is a "luxury good" which most developing countries don’t have the income to pay for.

This is in keeping with the suggested "side payments" discussed above in reference to the voluntary assent of Party members.

This issue has further implications for the CDM because it questions the ethics of the mechanism. There are many discussions surrounding the "passing off" of the developed world’s problems onto the developing world. Many Party members representing the developing nations question whether the industrial world should be able to "pay off" their environmental debt to the rest of the world by buying cheap emissions credits. However, often left behind in the discussion is that the host countries could likely benefit from CDM projects as well. The notion of the Clean Development Mechanism is that it is to be designed in order to offer win-win solutions. Host countries currently have an asset that is of little monetary value to themselves while being recognized as invaluable to many industrialized nations. From an economic perspective, these developing nations could have a great deal to gain from the "sale" of these assets. ⁽⁴⁸⁾

In addition, developing countries fear the possibility of losing the "low-hanging fruit" to the developed world just because they are ready to pick it. In other words, many developing countries fear that nations of the developed world will take the cheapest and easiest alternatives to meet their own carbon emissions limits and when the developing nations themselves are confronted with the need to reduce emissions, they will have fewer alternatives, and will be faced with much higher reduction costs. However, it should also be noted that there are a myriad of arguments which contradict this assumption. Most of these arguments depend upon the notion that developing countries will be able to leap-frog past this clumsy learning while reducing phase based on the gained experience of the industrialized countries. Conceivably, when developing nations are faced with limits themselves, there will be just as many "low-cost" alternatives if not more CO₂ reduction technologies that will help adjustment in the future. Still, "the loss of low-hanging fruit is a risk, but it is impossible to make a generic assessment of the expected costs and benefits. Host partners/countries’ assessments must be done on a case by case basis. After making such assessments, host partners/countries and investors might find themselves differing on the merits of the project." ⁽⁴⁹⁾ In other words, each CDM project is different and host countries, instead of rejecting the CDM as a whole, should make an active assessment of the costs and benefits of a specific project, including the possible cost of future emissions reductions, in order to make a decision about participation.

In addition, developing countries that are potential host countries are concerned about the possibility that CDM projects will have adverse effects on other sectors. First of all, they seem concerned that CDM funds will count against other Overseas Development Assistance. Many nations are worried that the flow of CDM funding will not be additional, but instead will replace already existing sources of international development aid, thus negating any national benefit that would be gained from hosting a CDM project. Some of these concerns are based on the fact that existing Overseas Development Assistance "ODA" has many ‘environmental conditions’ which must be achieved in order to receive ODA. However, these conditions, it should be noted, are related to local environmental issues while CDM is strictly directed towards climate change.

To alleviate concern about the perceived loss of ODA, the Convention and the Parties should agree that prospective host countries will not lose any ODA assistance because of CDM. …and because of the intrinsic differences between CDM and ODA, discussion about the two types of programs should be decoupled. ... In particular, [investor countries] should not favor ODA for countries that cooperate with CDM nor penalize those that do not. ⁽⁵⁰⁾

Secondly, there is a general fear that with the CDM will come a further push for developing nations to implement their own emissions limits, stifling their newly begun economic growth. This concern seems highly justified in light of the many arguments surrounding the CDM which suggest that the only way to make it an effective climate change mechanism -- instead of an international loophole -- is to implement universal emissions limits for all countries. Many developing nations are uneasy about supporting any mechanism which would bring up the difficult issue of limits for developing nations. ⁽⁵¹⁾

Thirdly, Developing countries, despite the explicit statement in the Kyoto Protocol regarding the requirement of CDM project to support sustainable development in host countries, continue to be concerned about a mismatch of their national priorities and needs with the priorities and effects of the CDM project. This is understandable given, in many cases, the problems that they face with low per capita income, high population growth rates, high rates of mortality and infant mortality, internal conflict and civil war, and frequent natural disasters such as droughts, floods, hurricanes, and mudslides. For instance, few would doubt that Nicaragua, though it could conceivably be an ideal place for a CDM project, would be prepared to negotiate any such project. Similarly, many African nations are currently dealing with so many complex problems that they cannot afford to bear the burden of the environmental problems of the developing world. This goes back to the concern that environmentalism is a "luxury good" for which few developing nations have the time or financial ability to address. However, it is because of the aforementioned problems that the international community has other forms of assistance, and the Kyoto Protocol should once again make it clear that any gain from the CDM would be in addition to financial and technical gains from ODA which is designed explicitly to address some of the other issues which face developing nations.

And finally, there is a general concern that CDM projects will result in a loss of, or at least will undermine the national sovereignty of a country. Many countries have voiced their apprehension over the possible loss of authority over their land and domestic resources. This concern is particularly acute when it comes to projects that deal with forest preservation, afforestation, and reforestation due to the issue of ownership and responsibility over the "saved" CDM project area. Especially in cases where the investing country could conceivably argue for retaining ownership for many carbon tonnes-years. Although the Protocol states that all CDM projects are to be based on the voluntary participation of all parties, it should make explicit the need to involve the host country in all phases of the project, to share information with the host country, to ensure that the host country is included in negotiations and that there are explicit rules and decisions regarding the duration of CDM projects and the responsibility for those same projects following the termination of a CDM project. ⁽⁵²⁾

 

INSTITUTIONAL STRUCTURES & THE CDM

The Kyoto Protocol has made few guidelines regarding the structure and the organization of the Clean Development Mechanism. The Protocol simply states that there will be an "Executive Board" for the CDM and operational entities which will certify the emissions reductions resulting from each project activity, but it fails to define these organizational structures or create parameters within which they will be created. Furthermore, among the responsibilities, beyond emissions certification, is the role in arranging funding of certified project activities as necessary, in providing guidance in the implementation of CDM projects, and in ensuring that a share of the funds is to be used for administration fees, as well as adaptation assistance for those countries threatened by possible climate change. Much of the structural definition was to be provided at the negotiations in Buenos Aires. As noted by the "Statement of Austria: Clean Development Mechanism", the European Union recognized the need to address some of the more critical issues. "The EU wishes to stress the importance of making substantial progress at this [COP-4] session to agree on key principles and for the COP to set out terms of reference and a timetable for further work leading to the necessary decision by COP/moP1" ⁽⁵³⁾ However, the discussions failed to achieve the kind definition which was needed. Thus, the organization and the structure of the CDM are still unknown.

First of all, it is as yet unclear what exactly the CDM will cover. It could either be a bilateral or multilateral project fund or even a project clearing house or project exchange, all of which have their own advantages and disadvantages. The multilateral fund, in which several investing countries make contributions to an independent fund, allows countries to offer up CO₂ reduction projects and compete for the funds resources. In this option, the projects would be selected based on the emission reduction efficiency and positive externalities. The multilateral option, however, does not allow investor countries to choose a project based on their own preferences and could lead to the preferential treatment of large projects, which reduce project variety, because of the lower overall administrative costs. Nonetheless, one advantage of the multilateral fund is that risk is spread among all the investors.

The alternative approach would be a clearinghouse or project exchange in which the CDM would broker CO₂ reduction deals between investor and host countries. The clearinghouse CDM would "accept and evaluate project proposals and invite tenders for projects. This approach differs from the fund approach in that projects are not bundled together in a portfolio." ⁽⁵⁴⁾ Thus investors would send their applications in for approval and would be put in contact with the project proposals that they applied for. At the end of the project, if successful, the emissions reductions would then be credited to the investor country. This is closely related to the original bilateral Joint Implementation projects in that it is implemented by the two countries, however the service that the CDM would provide as a central exchange institution would help reduce the administrative costs of finding suitable partners as well as reduce market entry barriers. ⁽⁵⁵⁾ In addition the exchange solution would help increase the variety of projects and would not give preferential treatment to larger or smaller projects.

The Executive Board, which is to be the supervising body of the CDM, whether it be a multilateral fund or clearinghouse, requires definition as soon as possible. Regardless of the type of institutional structure that the CDM takes, they will be providing much of the "guidance" for implementation, will be responsible for the "operational entities" and thus the certification of emissions reductions, as well as acting as the central command center for the money both coming in and going out. In the case of a multilateral fund, the Executive Board would be required to select the projects which would receive the funds, possibly determine the price per carbon tonnes-year, finance all administrative and implementation costs and verify the success of the project. In the case of the clearinghouse, the Executive Board would also need to supervise verification of carbon reductions, set standards, and contract or act as an independent auditor or an operational entity. ⁽⁵⁶⁾ In all cases, monitoring and verification is absolutely essential for the success of the CDM and consequently also the Kyoto Protocol. Without absolute assurances that projects have provided the required reductions in carbon emissions, the agreements have done little good. ⁽⁵⁷⁾

Finally, the Executive Board will need to take responsibility for investigating cases in which projects have failed to result in the forecasted reduction in GHG, handing out some form of punishment in the cases of wrongdoing. ⁽⁵⁸⁾ It should first be determined with whom the responsibility of project success lies. It could be determined that the entire responsibility lies in the hands of either the host or the investor country. Both cases would make the risks so high that there would be few interested parties. In the former situation, if the project failed, the financial cost would lie solely upon a nation which in most cases is unable to pay for the failure. In the latter, the investor country would be fully responsible for failure and have little control over the project itself. In the case of joint responsibility, both parties would be responsible for the possible failure of a CDM project. This would encourage investors to take a vested interest in the success of the project and in the veracity of declared carbon reductions. Similarly, the host country, if they were also financially liable, would be less inclined to falsify accounting information. However, in the case of accidental failure caused by any number of unexpected problems, all parties in the exchange would lose, increasing the risk of CDM and thus its attractiveness. One alternative suggested is a form of carbon reduction insurance. "A central insurance system can produce more economical conditions for the individual contract partners. By spreading the insurance risk across all CDM projects and by standardizing procedural analysis, cost reductions can be achieved which will probably lead to lower premiums than could be offered by an individual insurance company." ⁽⁵⁹⁾ Still, in this world of market-based incentives and competition, it could just as easily be argued that the lack of competition could engender inefficiencies, high costs and an over-dependence upon one central insurer. In cases where there is a market for private insurers, there is seldom a lack of interested providers.

 

 

TREATMENT OF SINKS, INCLUDING FOREST CONSERVATION PROJECTS

The role of land use changes and forestry (LUCF) within climate change mitigation efforts outlined by the Kyoto Protocol is ambiguous and thus, has led to a broad debate about its inclusion. There are few instances in which the LUCF sector is directly referred to. It is incorporated into Article 3.3 in which it is noted that both emissions sources and sinks should be included in the accounting of net changes in emissions against a nation’s other GHG emissions. "The net changes in greenhouse gas emissions by sources and removals by sinks resulting from direct human-induced land-use change and forestry activities, limited to afforestation, reforestation and deforestation since 1990, measured as verifiable changes in carbon stocks in each commitment period, shall be used to meet the commitments under this Article…" ⁽⁶⁰⁾ Thus, the Article, although it does not include sources and sinks into the original baseline figures of the national inventories, allows carbon fluxes based on these LUCF sources and sinks to offset some of the national emissions reductions requirements. For those countries whose net LUCF sector carbon changes represent a net source, the Protocol makes an exception thus allowing those nations to include LUCF net changes within the calculation of their 1990 national baseline. ⁽⁶¹⁾ Furthermore, Article 6 of the Kyoto Protocol allows for the crediting of emissions credits for projects which either reduce anthropogenic sources or increase carbon sinks as long as they meet the additionality requirement. ⁽⁶²⁾ These credits could then be exchanged between Annex I countries.

The Protocol, however, does not specifically state that LUCF sector changes would be incorporated into the CDM which links the developed and developing world. Although the CDM does provide for crediting for "certified emissions reductions", it does not explicitly define the types of projects which could be incorporated. Thus, there has followed an intense debate surrounding the inclusion of LUCF changes in the structure and organization of the CDM. ⁽⁶³⁾ The omissions of specific reference to the land use changes and forestry sector sinks and sources from discussion in the CDM has led to diverse and often contradictory opinions. Many argue that its general provision, allowing the inclusion of carbon emissions reduction projects to offset emissions reductions in other nations, implicitly includes the LUCF sector. This is supported, some argue, by the inclusion of the LUCF sector in other references to emissions offsets and credits, in particular in Article 6. However, others argue the exact opposite, suggesting that because there was specific reference to LUCF sector inclusion in previous Articles, the omission of any such reference in Article 12 on CDM is all the more pertinent. In order to resolve some of this ongoing conflict between the supporters of LUCF sector inclusion and those in opposition, the Parties of the climate change negotiations have requested that the IPCC undertake a study of the issues surrounding LUCF sector inclusion. The report of this study is to be submitted for evaluation to the Parties to the UNFCCC. In the absence of which, many of these issues continue to permeate further discussion of the Clean Development Mechanism, in particular issues of emissions markets, incentives, additionality, accounting procedures and mechanisms, baselines, and limits on offsets for Annex I countries.

 

MARKET BASED REQUIREMENTS

The Clean Development Mechanism is based on an overall concept of the free market system. It relies on two major factors; that reductions in emissions anywhere can offset emissions elsewhere because of the global nature of the problem; and that the cost of emissions reductions can vary across products and countries. In other words, an emissions trading market assumes that for some countries, reductions in sources would be more costly than in other countries and that the overall global effect would be the same regardless of where reductions were made. Therefore, if trading of the certified emission reductions credits is allowed, then a country A who faces a US$30 per tonnes-year of carbon, could choose to invest in an emissions reduction project in Country B which would provide credits against emissions limits at cost of US$10. ⁽⁶⁴⁾ Country A would obviously choose the more inexpensive alternative, given the same externalities of both options. In essence, the function of the CDM would be to assist the trade of carbon credits and offsets between Annex I and non-Annex I countries as a market would assist in the exchange of other types of commodities. As long as the CDM option was competitively priced, relative to domestic reductions, Annex I countries would see it as a viable option. The cost-benefit analysis would have to include other factors, including the environment (apart from climate change issues), human and animal health, and social, political, economic impacts before it can truly be deemed a win-win situation for all participating countries.

Thus, the trading of greenhouse gas emission offsets under the CDM represents a cost effective and flexible, market-based means for achieving overall targets for reductions in GHG emissions. Emissions trading has had a successful history for the environment. The United States in 1976 implemented an emissions trading system for the Clean Air Act. However, in order to make the Clean Development Mechanism function properly, a true market must be developed. Firstly, the certified emissions reductions credits must be viewed as viable and secure alternatives to domestic reduction. A transparent set of standards and procedures must be defined, as with any commodity, to ensure the actual value of the good. Furthermore, the procedures for exchange must be defined. "If this trade is to be allowed under FCCC, the starting point would be to agree on one currency and strengthen regulatory institutions in the south." ⁽⁶⁵⁾ It is essential to have these basic procedural elements in order to facilitate the exchange of offsets.

In addition, there can be no market without the demand for the available good. There is already significant demand for GHG offsets as a consequence of the national commitments to carbon emissions reductions. It will be the demand which determines the success of the CDM. As mentioned previously, this demand will remain high as long as it is competitively priced relative to the alternatives. In the case of LUCF sector market for offsets, all of the previously mentioned issues are relevant; however, the problems are often more acute. LUCF sector markets face even more grave technical challenges in terms of the accountability, verifiability and the poor reputation that they have gotten in the past with leakage and temporal problems. LUCF sector offsets will need to compete with other forms of offsets as well as the non-offset alternatives. ⁽⁶⁶⁾ LUCF sector offsets will only be competitive on the market if they can establish themselves as viable alternatives and can be priced competitively.

The role of competition is essential in the success of the CDM because it helps ensure a win-win solution. From the demand side, investors will be able to most cost effectively meet their emissions limits while the host country would benefit from the additional funding emanating from CDM projects and from the possible transfer of new technologies and other positive externalities. In effect, the mere competitive nature of the CDM helps to respond to any fears that participating countries would have. A market-based system would make the project itself compete with other alternatives so that the total costs and benefits would have to be summed and compared, and only following such an analysis would any nations agree to participate. Thus, developing nations will only agree to participate if the benefits from undertaking a CDM project would surpass not only the costs of doing that project, but also the opportunity costs of using those resources for something else. For example, in a forest preservation project, the benefits might include biodiversity conservation, watershed protection, enhanced eco-tourism potential, and expanded marketing of non-timber forest products. These benefits would be added to the financial gain from selling the carbon offsets gained from the enhancement of a carbon sink and would need to outweigh the costs of the diminished timber sales, alternative agricultural uses, employment opportunities, and other indirect effects. As a consequence, the actual price of the carbon offset would need to more than balance the cost; thus ensuring that participation of the host country is worthwhile. ⁽⁶⁷⁾

Similarly, an investing country would need to face a carbon offset price, as previously stated, which is competitive with other alternatives. Thus as most market dynamics will illustrate, the offset will be in demand until that point in which they are no longer a competitive alternative to actual domestic reductions. In this way, competition answers yet another concern which has hindered the passage of CDM. There was much concern over the incentive for reduction innovations. There were arguments which suggested that because CDM was providing an alternative, industrial nations would not be encouraged to create the innovations which could ultimately respond to the actual global need for emissions reductions. This, however, is shown to be an erroneous conclusion if you follow the economic logic. It is true that initially the costs may be considerably lower to undertake CDM projects, however as more nations are interested in offsetting carbon emissions and the number of nations willing to host them changes over time due to the changing opportunity costs and benefits from each project, it is more likely that prices per carbon offset will increase over time in order to attract host countries. Eventually, the prices will reach an equilibrium such that there is little difference between purchasing offsets and investing in carbon reduction technologies and thus making actual domestic reductions in source emissions. "Additionally, emissions trading recognizes that polluters responsible for reducing their emissions, rather than regulators, have the greatest incentive to minimize costs and therefore will seek new and innovative methods to reduce emissions if given the opportunity." ⁽⁶⁸⁾ Therefore, innovations will occur, as over time, economic necessity will require such innovation.

The same economic logic responds effectively to the concerns that industrial nations should only be able to use CDM for part of their carbon emissions reduction commitments. Such a statement is included in the Kyoto Protocol itself, "Parties included in Annex I may use the certified emission reductions accruing from such project activities to contribute to compliance with part of their quantified emission limitation and reduction commitments under Article 3…." ⁽⁶⁹⁾The basis of this argument is linked to the concern over incentives for innovation, as well as equity concerns about the ethics of industrial nations passing off their commitments to developing nations. However, the economics of the emissions market should effectively address any concern over this mainly because the cost of carbon offsets will increase rapidly as the demand for such offsets increases. Once it reaches equilibrium, many nations will have discovered that domestic reductions are actually economically advisable.

 

 

 

INCENTIVE STRUCTURES & FOREST PRESERVATION

One of the most prominent concerns among environmentalists with respect to the Clean Development Mechanism is the incentive for environmental degradation, which is incorporated into the current structure of the Protocol. The accounting methodologies suggested by the Inter-governmental Panel on Climate Change (IPCC) 1997 guidelines regarding deforestation and reforestation actually encourage possible deforestation. It is clear that under the current procedural structure, developing nations are actually faced with positive incentives to clear cut forests and reforest the land at a later date. This could be one of the conceivable results of the fact that the clear cutting would not be counted, while the carbon sequestration potential would be. This problem is particularly acute because there is to be no inclusion of net carbon fluxes up until 2008. "We are extremely concerned with the need to avoid unnecessary loopholes and the creation of perverse incentives. This would include cutting down old growth forest, rich in biodiversity, and replanting with fast growth mono-culture." ⁽⁷⁰⁾ Thus, countries would be encouraged to clear cut prior to that period for the financial gain of selling "regrowth carbon offsets." ⁽⁷¹⁾ The lack of combined conditions or incentives which would help protect forest biodiversity and/or forest sustainability thus undermine the total global environmental benefit. ⁽⁷²⁾

Secondly, there are incentives which help to prevent forest degradation and which can also result in considerable emissions. This is closely linked to the omission of any provision which addresses the problematic shift from primary to secondary forests. Such a shift is also a considerable problem in terms of climate change while adversely affecting other sectors within the environment. The maintenance and care for the health of a forest, while helping to preserve biodiversity and "old growth" benefits could alleviate much of the carbon emissions problems as the degradation of forest have been found to be almost on equal footing with outright deforestation.

 

PROJECT ADDITIONALITY, ACCOUNTING & BASELINES

Even if a country, out of respect for the environment or for forest preservation, chooses not to act upon the incentives which the CDM currently provide, there are other issues to consider. One issue is particularly contentious in the discussions referring to LUCF sector inclusion. This is the problem of additionality; it is a hard condition to prove. It requires that the CDM project is a project that would not have happened in the absence of the Clean Development Mechanism. In other words, policy makers are arguing that a nation who intends to preserve a certain amount of land for national forests should not then utilize that space for CDM project forest preservation. This, while in the best interest for the national government of the host country, would effectively undermine the ultimate goal of the CDM. The host government would then be using CDM funds for something that would have been done regardless and which regardless would have created a net benefit in terms of climate change mitigation. "Providing carbon certificates on an endless hypothetical deforestation would be the best way to ensure that CO₂ emissions from developed countries will continue -- that means business as usual or perhaps worse. Should that be considered an admissible political behavior?" ⁽⁷³⁾

Furthermore, closely related to this subject, there is the problem that the CDM project would not take the place of another project which may -- in the case of the LUCF sector -- lead to deforestation, but rather would merely move the problem area to another location. For example, if an industry wishes to clear-cut a forest and the nation uses that opportunity to preserve the forest through CDM, that gain will only provide a net benefit to goal of forest preservation and climate change mitigation if the industry does not simply relocate the plans for clear-cutting.

An additional problem is related to the creation and calculation of baselines. The baseline is the static scenario against which the success of a CDM project must be measured. It has been argued that for CDM projects, baselines should be established at the national level, however this has proved a challenging task given the numerous technical constraints. Nonetheless, "the essential issue is that a CDM project needs to have clear system boundaries (in space, in economic sectors, and in time) in order to evaluate the impact of greenhouse gas emissions.

Closely related to the issue of baselines is the matter of accounting. One of the real problems with inclusion of the LUCF sector in the CDM is that it presents many with some considerable technical accounting obstacles. "There are tremendous difficulties in measuring the uptake by sinks in a scientifically accurate manner. I have been told in fact that the most certain way to measure exactly how much carbon a tree has absorbed is to keep track of it from the time it is a seedling to the time it is cut down. It can then be weighed…of course, at that point, the tree will absorb no more carbon." ⁽⁷⁴⁾ It has been suggested that the best methods for measuring the actual benefit of sinks are merely estimates with nearly 60% uncertainty ⁽⁷⁵⁾ that may or may not be capable of passing a statistician’s scrutiny.

Furthermore, this problem is exacerbated by the fact that there are many different areas which should undergo estimates, including both above-gound and below-ground biomass (roots), "necromass" (woody coarse debris, litter, soil organic matter), and wood products. Very few complete inventories exist of national carbon stocks and flows, and even fewer have included the organic layer, the underground biomass and associated flora. In particular, for the IPCC report, "the inventory need only consider the top 30 cm of the mineral soil." ⁽⁷⁶⁾ However, for most forest inventories, such an estimate would fail to accurately measure the stores of carbon. In addition, little information is provided on carbon stores further than 100cm below the surface, while many roots systems for trees are on average extend to more than 4 meters below ground surface. Finally, one cannot fail to address the additional problem of vegetation and environment variability which also effects the carbon sequestration capacity for a specified area.

None of these issues has been adequately addressed to allow for immediate implementation of LUCF sector CDM projects, however, it has been suggested that through long-term periodic inventories on a statistical basis which covers all of the aforementioned carbon store areas, in combination with frequent "micrometerological measurement" of individual stands, one could allow a realistic estimation of terrestrial sources and sinks.

Once that inventory has been undertaken, and successfully completed, there is still the issue of how some sources and sinks will be accounted for in the national inventories. In other words, whether the accounting will follow the flows or the stocks. For example, when an area of land has been cut, it must be determined if the country which actually cuts the lumber should be sourced in terms of the change in stocks, or if (since the lumber still holds much of the carbon to be released over time) the second country which ultimately takes the wood on, should be sourced for the slow release of carbon as the wood oxidizes within their national boundaries. Many argue that the former accounting method is the simplest way to follow the fluxes in carbon globally. "…The most practical accounting, and the one that supplies the most appropriate incentives for minimizing net carbon emissions, is to account for changes in stocks of renewable carbon-bearing materials." ⁽⁷⁷⁾

 

LEAKAGE OF CARBON BENEFITS & TEMPORAL ISSUES

Finally, an additional argument against LUCF sector inclusion in the CDM is based on leakage and temporal issues. Some argue that there is a "fundamental difference between reducing greenhouse gas sources and increasing greenhouse gas sinks. When sources are reduced the challenge is to account for the amount of reduction, but once reasonable accounting is completed, the emission reduction is undeniable and permanent." ⁽⁷⁸⁾ However, the same is not necessarily true for sinks. Sinks represent a change in the custody of carbon from the atmosphere into the tree. Thus the tree must be monitored for the atmospheric life of any carbon which it has been used to offset–nearly two hundred years. The offset must, therefore, be maintained, otherwise that nation risks the subsequent release of that stored carbon into the atmosphere. Some argue that such maintenance is more difficult than it was previously thought. "The use of the term sinks is very appropriate. Sinks get clogged up and overflow, and cracks often appear through excessive use. A forest grows old, stops absorbing carbon and it can burn down. A forest can experience the phenomenon of carbon saturation. Thus, a forest has a finite and limited contribution to make in terms of being a carbon sink. At some stage it ceases to be a sink. But once fossil fuels have been burned, they stay burned." ⁽⁷⁹⁾ In other words, emissions from the combustion of fossil fuels would then be offset by the creation of sinks whose lifetime can rarely be guaranteed over several centuries. This risks that carbon will be released again following a few decades and would permit the continued release of carbon emissions from the industrial sector.