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FORES Study 2012:8

Market mechanisms

- from CDM towards a global

carbon market

Ulrika Raab


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FOREWORD ............................................................................. vii

EXECUTIVE SUMMARY .......................................................... xi1. INTRODUCTION ................................................................... 1

2. WHAT ARE FLEXIBLE MECHANISMS? ............................ 7

3. THE CDM - OPERATION AND EXPERIENCES SO FAR 15

4. WHAT ARE FLEXIBLE MECHANISMS EXPECTED TODELIVER? .................................................................................. 29

5. THE FUTURE OF THE CDM .......................................... 41

6. POSSIBLE FUTURE FLEXIBLE MECHANISMS ............ 47

7.THE FUTURE LANDSCAPE ................................................ 71

8. CONCLUSIONS ................................................................... 81

COMMENT ............................................................................... 87

REFERENCES ........................................................................... 93


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About the study

The establishment of the Clean Development Mechanism hasbeen one of the successes of the Kyoto Protocol. It has helpedto build experience, capacity and comfort with the use ofmarket mechanisms to reduce emissions. This will be usefulwhen implementing future market mechanisms.

This study looks into the principles behind the flexible

mechanisms of the Kyoto Protocol with a focus on the CDM,but also towards the future of flexible mechanisms. Itconcludes that flexible mechanisms will continue to play a rolein a post-2012 climate change regime. The CDM will be moredirected towards the less developed countries, can play a roleas a channel for mitigation finance and CDM-credits mayprovide a receipt for mitigation action. New and scaled-up

mechanisms will require stronger governance arrangementson the host country level. A lesser degree of detailed controlthan in the current CDM has to be accepted.

Finally, it is fundamental to remember that flexiblemechanisms themselves do not lower emissions. First thereneeds to be a commitment either to reduce emissions or toprovide finance for reducing emissions.


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About the Author

Ulrika Raab is Senior Advisor for Climate Change Policy at theSwedish Energy Agency. Educated at the Royal Institute ofTechnology in Stockholm, she holds a MSc degree in ChemicalEngineering with a major in Environmental Engineering. Shehas been involved in climate change policy development onnational and international level since 1998 and as a negotiatorfor Sweden since 2001. She has been a member of the CDM

Executive Board and was the chair of the CDM EB Small ScaleWorking Group 2007-2008. Currently she is working for theSwedish governmental CDM and JI purchase programme.

Ulrika Raab has written this report for FORES in her personalcapacity while on leave from her regular employment. Theideas expressed in this report are those of the author and do

not necessarily represent the views of the Swedishgovernment.

The Author would like to express her thanks to FORES formaking the writing of this report possible and to the friendsand colleagues who have shared their knowledge and helpedimprove it.


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About FORES

FORESForum for Reforms, Entrepreneurship andSustainabilityis a think tank that seeks to renew the debatein Sweden with a belief in entrepreneurship and opportunitiesfor people to shape their own lives.

Environment and the market economy, migration,entrepreneurship and civil society, integrity, gender equality,

global democratisation and modernisation of welfaretheseare some of the issues on which we focus. FORES is an openand independent forum for civil society, academics and policymakers throughout Sweden and Europe. Together with peoplein Sweden and abroad, we will find solutions to better meet thechallenges that globalisation and climate change brings.

We function as a link between the civil society, entrepreneurs,policymakers and academia. FORES produces research papersand books, and organises seminars and debates.

Visit our webpage www.fores.se


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FOREWORD

A useful plan for the market mechanisms

for the international

market mechanisms whereby it is possible for an emitter in onenation to credit climate emission reductions in another.

The idea behind the CDM and the other UN-sponsoredflexible mechanisms is as simple as it is elegant; sinceemissions of carbon emissions affect the climate equallyirrespective of the point of emission, those with high costs for

emissions cuts can sponsor cuts where it is less costly.Businesses and governments in developed countries have beenpaying for reductions in developing countries and emergingmarkets and offsetting them against their own emissions.

But the system has been under heavy criticism and beingaccused of being used by developed countries as a letter of

indulgence and not leading to real emissions reductions. Inaddition, the CDM was created under the Kyoto Protocol, atreaty whose first commitment period will soon expire.Meanwhile, during the economic crisis developed nations havebeen able to reach their unambitious emission targets almosteffortlessly, so that no recourse has been necessary topurchasing emission reductions elsewhere.


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Therefore a big debate is currently taking place among expertsand in the UN negotiations about what will come next. How toimprove the CDM and make it relevant also after the firstcommitment period of the Kyoto Protocol, and what otherflexible mechanism should be introduced are two equallyimportant issues to address. The CDM is entering a new phase,where its focus is likely to shift away from emerging economiessuch as China, India and Brazil, to the least developedcountries in sub-Saharan Africa. Should a new market

mechanisms include more emission sources and possibly bebased on whole economic sectors rather than individualprojects? Where is the boundary between CDM and regularemission markets such as the EU has, and China is planning tointroduce?

Despite the momentous importance for climate change action,

and despite vocal criticism by NGOs against many aspects ofthe CDM, this debate has long been narrowly confined toexperts, negotiators and lobbyists. There have been few plansby independent experts or researchers to set out basic ideas ofhow this system could be best designed and improved.

FORES asked Swedens leading expert Ulrika Raab to put herideas into print. Ulrika Raab has been working with the flexiblemechanisms for 15 years, as a field expert, negotiator andmember of the CDM executive board. Ulrikas paper is aremarkable blueprint, accessible to experts and policymakersalike, with a long list of practical and relevant principles andproposals. It shows that the CDM is no panacea, rich countriescannot magically avoid emission cuts by reducing emissions inpoorer countries, but flexible mechanisms remain a very useful


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additional track to help developing countries reduceemissions.

FORES is grateful to Ulrika for taking the time to write thislong-awaited paper. We also wish to thank the Swedish EnergyAgency, Energimyndigheten, for allowing for Ulrika to taketime off for the project.

In addition, we would like to thank a number of people who

assisted FORES during the process of this report. We wouldlike to thank the members of FORES experts group onemissions trading for taking part in a work shop where aninitial draft of this paper was presented. In particular, thankyou to Johannes Stripple from Lunds University, Martina Bosiat the World Bank and Olle Bjrk for reading and commentingon earlier drafts. Olle has also provided a written comment

that can be found at the end of this publication. A specialthanks also to professor Michael Grubb, Climate Strategiesand University of Cambridge, for his intellectual support andintroduction to Ulrika Raabs work.

Martin dahl, director FORES


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EXECUTIVE SUMMARY

Key findings:

Flexible mechanisms themselves do not loweremissions. First there needs to be a commitment eitherto reduce emissions or to provide finance for reducing

emissions. The clean development mechanism, CDM, will

continue to be important in a post-2012 climate changeregime but its role will change. The CDM is alreadymoving in the direction of less developed countries andfrom large projects to smaller projects andprogrammes. It can also play a role as a channel for

mitigation finance and CDM-credits may provide areceipt for mitigation action.

The post-2012 climate change regime will consist ofseveral different flexible mechanisms. For thegovernance of new mechanisms it seems rational todraw upon the experience from the flexiblemechanisms of today and the systems for accreditationetc. already established.

Host country governments will play a stronger role ingoverning new mechanisms and will have to provideincentives for private sector participation in newmechanisms. These incentive structures are to-daylargely unexplored.

If flexible mechanisms are to be scaled up from projectlevel to a sectoral level or to incorporate larger parts of


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the economy, a lesser degree of detailed control than inthe current CDM has to be accepted.

A mechanism with many purposes to fulfil is not likelyto deliver equally well on all of them and a marketmechanisms is likely to deliver optimally onparameters that are monetized. Therefore, it would bewise to focus the mechanisms objective on one aspect,rather than trying to create multi-purpose tools.

The challenging exercise of setting baselines in asectoral crediting system will be useful in laterdiscussions on caps.

Standardised baselines can be seen as a bridge betweensingle projects and more comprehensive, sectoralapproaches, eventually leading on to economy-widecaps. It is, however, difficult to anticipate a linearevolution beginning with project-based mechanisms,

moving on to sector based mechanisms, finally leadingup to economy-wide cap and trade. Perhaps it will bemore efficient not to go through all these stages butrather go straight from project-based mechanisms tocap and trade.


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A new landscape for flexible mechanisms

For the atmosphere it does not matter where emissionreductions are made. Different types of flexible mechanismsprovide the possibility of undertaking emission reductions at alower costs as well as providing flexibility across time andplace. Flexible mechanisms are therefore important tools inthe struggle to reduce global greenhouse gas emissions.

The flexible mechanisms, in particular the Clean DevelopmentMechanism (CDM), were vital in creating the necessaryconditions for the agreement of the Kyoto Protocol. Since2005 the Clean Development Mechanism has helped to reduceglobal emissions by more than 1 billion tonnes of carbondioxide equivalents through more than 4600 projects, and hasin total generated more than $150 billion of private

investments in emission reducing projects. Before the end of2012, another billion CDM credits are expected.

However, the landscape for flexible mechanisms is changing.There will be a different landscape between 2012 and 2020most likely governed by the rule agreed under a secondcommitment period of the Kyoto Protocol, for those who haveratified it. Subsequently, the post-2020 climate change regimewill consist of a spectrum of commitments and means ofimplementation. Countries with emission caps under theKyoto Protocol will also have caps in a post-2020 regime.However, to curb global emissions, it will be necessary toencompass all countries and all sources (and sinks) in one wayor another. In this new landscape there is need for a


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development of the existing mechanisms, such as the CDM, aswell as of different types of new market mechanisms.

This report aims to highlight the potential role of flexiblemechanisms in combating climate change. The ambition is alsoto pose relevant questions and to stimulate debate on what wewant from future mechanism and how to best design them tofulfil the set targets. Based on the past experience of the CDMdevelopment and operation, the report identifies and

discusses new principles that can be incorporated into any,current or new, market-based instruments. The report alsopoints to the need to strike a balance between detailed controland the flexibility to incorporate larger parts of the economy orsectors.

Before discussing the different mechanisms, it is vital to

understand that flexible mechanisms themselves do not loweremissions. First there needs to be a commitment either toreduce emissions or to provide finance for reducing emissions.

The future of the CDM

It is likely that the CDM will continue to evolve and that the

mechanism will play a different role in a future climate changeregime. The CDM is already moving in the direction of lessdeveloped countries and from large projects to smallerdispersed projects and programmes. Some of the possibledevelopments of the CDM could include:


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Programme of Activities

Lately there has been a transition from the traditional project-by-project-based CDM to more comprehensive approaches.Programme of Activities, PoA, allow for an unlimited numberof CDM programme activities over a wide area to be run underone single administrative umbrella. PoA increases theattractiveness of a range of smaller, more dispersed, CDM-projects, such as installing cook stoves, solar water heaters andother small-size renewable energy generating systems. Theseare projects particularly suitable for Least DevelopedCountries, where the CDM will continue to play an importantrole after 2012.

Standardised baselines

As a result of the many projects developed during the first

years of the CDM a need for greater standardisation ofbaselines has emerged both for calculating emissionreductions and for assessing additionality. The development ofstandardised baseline, also within the CDM, could be astepping stone from project based mechanisms towards morecomprehensive approaches, including new marketmechanisms.

A receipt for finance

Finance is likely to take a more dominant part in a futureclimate change regime, not least in the light of theestablishment of the Green Climate Fund and developedcountries commitment to provide $100 billion annually by2020 to support developing countries climate efforts.


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Certified emission reductions, CERs, from a CDM project arenotper se offsets. It is the use of these CERs that determineswhether or not a CDM project is offsetting, not the mechanismitself. If the CER is retired or not used, it is effectivelymitigation in developing countries. A CER can then be seen as areceipt for an emissions reduction that has taken place andthe financial contribution through the CDM as payment forperformance.

Possible future flexible mechanisms

The post-2020 climate change regime will most likely consistof a spectrum of commitments and means of implementationand there have been several proposals outlining a wide range ofnew mechanisms. The different proposals are being discussedunder different agenda items in the UN negotiations, but theydo resemble one another to the extent that they are attemptsto take a broader grasp on mitigation, possibly through the useof markets. A key difference appears to be the degree ofinternational (UN) oversight foreseen. Examples of potentialflexible mechanisms are the NAMA (Nationally AppropriateMitigation Action) of developing countries under the Climate

Convention, which may prove to be a flexible mechanism if theNAMAs, for example, result in credits sold to fund emissionsmitigation. Another mechanism that could play a role in a post-2012 -regime is REDD+, where developing countries couldreceive credits for reducing emissions from deforestation andforest degradation.


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Another interesting proposal is a Japanese idea for a bilateraloffsetting crediting mechanism (BOCM). The idea behindsuch a mechanism is to transfer and disseminate low carbontechnologies through bilateral agreements. Eligibility isdetermined in terms of emissions reduced by acceleratingdeployment of low carbon technologies, products and services.A Joint Committee formed by the two countries involved setsthe rules and guidelines, and companies implement theprojects. The BOCM may be described as a streamlined and

simplified CDM, since it moves away from difficult conceptsof additionality and reduces monitoring costs by usingbenchmarks for different technologies.

New market mechanisms

In Durban in December 2011 parties decided to initiate a workprogramme to elaborate modalities and procedures for a new

market mechanism. During 2012, countries have submittedproposals on what form the new market mechanism shouldhave and how it should operate, and discussions are still inprogress. At this stage it seems reasonable to believe that a newmarket mechanism will, to a certain extent, contain elementsrecognizable from existing mechanisms.

According to the guidelines from the COP-16 decision, a newmarket mechanism should stimulate mitigation action acrossbroad segments of the economy. The mechanism shouldsafeguard environmental integrity and ensure a netdecrease/avoidance of greenhouse gas emissions. In thiscontext, it is important to note that a mechanism with manyobjectives to fulfil is not likely to deliver equally well on all of


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them, and that a market mechanism is likely to deliveroptimally on parameters that are monetized. Therefore, itwould be wise to focus the mechanisms objective on oneaspect, rather than trying to create a multi-purpose tool.

The discussion on the new markets mechanisms uncoversaspects worth exploring further, and that are discussed below.

Sectoral trading and crediting

One can distinguish at least two types of market basedapproaches covering broad segments of the economy -sectoral trading and sectoral crediting.

In a sectoral trading system, emissions allowances are issued inaccordance with a defined absolute emission target for theincluded segments. If emissions are lower than the issued

allowance, excess allowances can be sold. If emissions exceedthe issued allowances, additional allowances need to bepurchased to comply with the target agreed for the broadsegment.

In a sectoral crediting system existing emissions in a sector arechecked against a baseline set in advance. If emissions fall

below this baseline, emissions credits are issued which can besold to at least partly cover the costs of mitigation activities. Ifemissions do not fall below the baseline, no penalty is applied(a so called no-lose target).

A sectoral crediting mechanism gives the opportunity to coverdifferent target areas. Experiences with existing market-based


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instruments have shown that agreeing on workable definitionsof sectors and boundaries is challenging. So far, there is noagreement on what is meant by broad segments of theeconomy, but some important considerations for theselection of target areas could be; mitigation potential andcosts; sectors with high share of emissions; capital intensivenew term investments; data availability, monitoring, financialincentives to stimulate net reductions; and responsiveness toprice signals.

Baseline setting

One of the greater challenges when establishing a creditingmechanism is to decide on a crediting threshold, as a sectorsfuture emissions are difficult to predict, since they relate toeconomic growth, fuel prices, technological innovation andmore. Hence, there is a risk that the crediting threshold will be

set too high or too low. With a very ambitious threshold, thefinancial incentive for the host country to engage in reductiondecreases. If the threshold is not ambitious enough, credits canbe awarded for very little action. It may, at the same time, leadto an oversupply of credits, low prices and low financialrevenues for host countries. Another challenge for baselinesetting is how to account for existing as well as new policies

and measures. An inclusion of policies and measures thatfavours the reduction of emissions into the baseline provides amisguided incentive for the host country to hold off onmeasures so as not to lose out on crediting.

Baselines can either be established at an absolute level orindexed to one or several parameters (physical metrics of


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sector like per kWh or economical metrics like GDP). A furtheroption is to use a technology penetration baseline. A potentialsolution to the problem of how to set the crediting thresholdcould be to give certain financial/technical support at a levelbelow where crediting starts. Although desirable, it is difficultto see the principles for the ambition agreed at an internationallevel.

The experiences from setting baselines, sectoral no-lose

targets and sectoral crediting will most likely prove useful infuture discussions on economy-wide caps. Standardisedbaselines can be seen as bridge between single projects andmore comprehensive, sectoral approaches, eventually leadingon to economy-wide caps. It is however difficult to anticipate alinear evolution beginning by project-based mechanisms,moving on to sector-based mechanisms, finally leading up to

economy-wide cap and trade.

Governance in a future landscape

Compared with the flexible mechanisms of the Kyoto Protocol,new market-based mechanisms will require much strongergovernance arrangements on the host country level. Thegovernance structure of new market mechanisms will need to

strike a balance between the sovereignty of the participatinggovernments and the outside control needed to build trust.The detailed control possible in the CDM will not be possiblein scaled-up mechanisms such as sectoral crediting.

The current debate focusing on governance systems, at leastthe one at UN level, seems unaware of the crucial question of


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how to create incentives for participation by those who are toimplement the mitigation action. Private sector entities underreduction obligations will likely be facing a number of differentsystems under different rules.

The incentive for the actual emission reduction needs to becreated at host country level. For this to emerge, the incentivestructure on this level needs to be carefully tailored. In asectoral agreement the action to reduce emissions has to be

taken at individual installation level, but the issuance of creditsdepends on the performance of the sector as a whole. One wayof directly involving sector entities in the carbon market wouldbe to combine a national emissions trading scheme with asectoral agreement.

The role of governments also becomes increasingly more

important with more comprehensive (or sectoral)mechanisms. This is not only true for the supply side but alsofor the demand side. Companies under an emission cap areunlikely to enter into negotiations with the government ofanother country to buy credits from a sectoral creditingscheme. Intermediate levels are therefore necessary.

There are a number of examples of regional trading systemslinking, either through direct linking or through the use of thesame type of offsets. This is likely to continue and in somecases also create demand for credits. For example, the EU ETShas been the prime source of demand for certified emissionreductions from CDM.


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1. INTRODUCTION

where emissionreductions are made (i.e., the impact is the same whether thereductions take place in Stockholm or in Tokyo, or inJohannesburg), but it is vital that they are made. However, thecosts of reducing emissions can vary significantly betweencompanies, sectors, regions and countries. Therefore, the use

of flexible mechanisms, which provides flexibility wheremitigation is taking place, as well as facilitating more costefficient reductions, is of great interest to anyone interested inmitigating climate change.

Climate change is a global problem that can only be solvedthrough international co-operation. The ultimate objective of

the UN Framework Convention on Climate Change(UNFCCC) is stabilization of the concentrations ofgreenhouse gas in the atmosphere at a level that will preventdangerous anthropogenic interference with the climatesystem. The Kyoto Protocol, adopted under the Conventionin 1997, has been acknowledged as an important first step tomeet this objective. One of the results from the Kyoto Protocol

was the establishment of flexible mechanisms, of which theClean Development Mechanism (CDM) is the perhaps mostwell-known. The modalities and procedures of themechanisms were adopted in Marrakech in 2001.


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The flexible mechanisms were decisive components thatassisted in the conclusion of the Protocol as well as inencouraging nations to ratify the Kyoto Protocol. The KyotoProtocol entered into force in 2005, after Russia had ratifiedthe agreement. It has now been ratified by 191 governments.The USA initially signed the protocol but has not ratified it,whilst Canada withdrew in December 2011.1

The first commitment period of the Kyoto Protocol started in

2008 and ends in 2012, and there is a general understandingthat in the near future deeper reductions are necessary.Currently, negotiations on a second commitment period aretaking place at UN level. Simultaneously, there are on goingnegotiations on a more comprehensive global climate changeregime that will commence in 2020 and must include furtherfar-reaching mitigation action from a broader set of countries.

As negotiations on a future, more comprehensive and far-reaching climate change agreement progresses, it is apparentthat flexible mechanisms will have a role to play in a newclimate regime as well. Hence, discussions on the design onnew flexible mechanisms are intensifying.

The future landscape of flexible mechanisms to operate in willbe radically different from the one in which the currentmechanisms were established. The Kyoto Protocol is a top-down approach under which a number of industrialisedcountries have taken quantified emission reductionobligations, whereas the agreement at the UN climate meeting

1 For more information on the Kyoto Protocol, visit the UNFCCC websitewww.unfccc.int


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in Durban in December 2011 opens up the possibility ofdeveloping a system of bottom-up pledges taken byindustrialised, emerging and developing countries.

This report is about international flexible mechanisms and therole they can play in combating climate change. In Durban,countries agreed upon establishing a new market basedmechanism. However, the details are still unknown and willhave to be decided over the coming years. Some of the current

proposals are presented in this report. The intention is not togive a full description of the current situation or completeanswers about what the future will bring, but rather to poserelevant questions and to stimulate debate and discussion.

Based on the learning from the development and operation ofthe project-based Clean Development Mechanism, the report

identifies and discusses principles that can be incorporated inany, current or new, market-based instruments with apotentially larger scope, such as sector based mechanisms. Inthis regard, the report also discusses the need to strike abalance between detailed control and the flexibility toincorporate larger parts of the economy or sectors.

The report is divided into two parts; the first (chapter 2-3)begins with a short description of what flexible mechanismsare, the rationale behind them and a description of the flexiblemechanisms of the Kyoto Protocol. A full chapter (chapter 3) isdevoted to the most well-known of the flexible mechanisms,the Clean Development Mechanism, and its achievements sofar. The aim of the chapter is to utilise the experience gainedfrom CDM when considering future mechanisms. Fuller,


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comprehensive,insights from the CDM can be found in theliterature2.

This first part serves as a background and is primarily directedtowards those readers who feel they need the basics of flexiblemechanisms. Those readers who are familiar with the KyotoProtocol and its flexible mechanisms can skip this part of thereport and instead turn to the second part (begins at page 29).

The second part of the report focuses on the future of flexiblemechanisms. After a chapter on what the flexible mechanisms,old and new, are expected to deliver in a future climate changeregime, it continues with a chapter on the future of the CDM.In chapter 6 different proposals for new mechanisms, inparticular the sectoral crediting mechanism (also known assectoral no-lose target) are described and discussed. It also

includes a brief design comparison. The report concludes witha chapter on the future context of market-based mechanismsand some conclusions on ways forward.

2 See for example the World Bank publication 10 Years of Experience in CarbonFinance: Insights from working with the Kyoto Mechanisms, published May2010, or the research reports produced for the High-Level Panel on the CDMPolicy Dialogue, 2012


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PART 1- The Background


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2. WHAT ARE FLEXIBLE

MECHANISMS?

in combating climatechange were first introduced in the early 1990s. The flexiblemechanisms of the Kyoto Protocol, in particular the CDM, arethe most well-known. They can be seen as policy instruments

for international co-operation in the climate change thatprovide the possibility of undertaking emission reductions at alower cost as well as providing flexibility across time and place.

The availability of mechanisms may increase willingness totake on deeper, more ambitious commitments, even ifdomestic low cost options have already been exhausted. They

can also give other benefits that extend beyond climate change,such as contributing to sustainable development.International mechanisms contrast with domesticmechanisms such as the EU ETS that deal with reducingemissions within a country or region based upon domesticlegislation.

Furthermore, flexible mechanisms can assist countries inchanging their development track towards a society with lowergreenhouse gas emissions and give insights into the matter ofclimate change mitigation and the challenges and possibilitiesit offers. Flexible mechanisms may also protect the globalcompetitiveness of nations and companies, and stimulatetechnical innovation. A concrete benefit of using flexiblemechanisms is to accelerate the earlier replacement of less


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efficient technologies and to avoid lock-ins. In addition,flexible mechanisms, or levies on them, can be a source ofrevenue used for climate finance.

One crucial point to bear in mind when reading this report isthat flexible mechanisms themselves do not lower emissions.An emission reduction commitment has to be the startingpoint after which flexible mechanisms, within a framework,can utilize the market to facilitate that the reductions are

carried out in a cost efficient way. A crediting mechanism onlyprovides an incentive to reduce emissions if there is areasonable global carbon price and can only be assured ifdemand is larger than the supply of credits and allowances inthe market.

International greenhouse gas marketsThe establishment of an international greenhouse gas market,putting a price on greenhouse gas emissions across the globe, isone of the most important achievements of the KyotoProtocol. Through its flexible mechanisms, it provides a pricesignal in all countries, including those where greenhouse gasemissions are not capped. However, the continued

development of the greenhouse gas market is uncertain due toconcerns over the long-term climate framework post 2012. It isimportant to bear in mind that a greenhouse gas market is aregulations-based market; supply and demand have beencreated by political decisions setting up a framework, a well-defined emissions cap and subsequent regulations. To achieve


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a long-term stability of the market, participants need torecognise that there is a clear political commitment.

Governments bear the responsibility for creating confidence ingreenhouse gas markets, by setting rules that are perceived tobe of long-term nature and stable, and by providing businesswith confidence to plan ahead and take actions. There shouldalso be provisions for review, in order to take into accountlearning whilst ensuring that those that have taken actions are

not disadvantaged. Market information has to be transparentfor the formation of a well-functioning market and an effectiveprice signal. High liquidity and a sufficiently large number ofplayers in the greenhouse gas market are needed if the marketis to perform efficiently and generate cost efficient reductions.

The flexible mechanisms of the KyotoProtocol

Three flexible mechanisms were introduced in the KyotoProtocol International Emissions Trading (IET) in allocatedemission allowance units (AAUs) between countries withemission caps, and the two project-based mechanisms, JI(Joint Implementation) and the CDM (Clean Development

Mechanism). The common feature of these three mechanismsis that they enable a country with emission limitationcommitments to be credited for reduction measures that havebeen taken in other countries; the flexible mechanisms of the


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Kyoto Protocol can be used for offsetting3 the emissions incountries with emission limitation commitments.

CDM - Clean Development Mechanism4

The Clean Development Mechanism (CDM, Article 12 of theKyoto Protocol) provides the possibility for countries withemission limitation commitments under the Kyoto Protocol togain credits for emission reductions by investing in project

activities in countries without such commitments5

. Theemission reductions are calculated in relation to a baseline andmust be additional, i.e. have to exceed those that would havetaken place without the project. Countries can authorizecompanies to participate in the CDM, and CDM projects cantherefore be implemented both by countries and bycompanies.

The CDM has two equally important purposes: to contribute toemissions reductions beyond those that would have otherwiseoccurred and that can be used by developed countries to meeta part of their commitments, and to contribute to sustainabledevelopment in host countries. For the latter, the host countryhas to approve the project and issue a Letter of Approval thatcertifies that the project contributes to sustainable

development. This is required in order for the project to beregistered as a CDM project by the CDM Executive Board. The

3 For a general discussion on offsetting see chapter 44A more thorough discussion on the CDM follows in chapter 35 The Kyoto Protocol divides countries into two groups roughly in the same waythat the UNFCCC did. Throughout this report the terminology developed anddeveloping countries is used for sake of simplicity.


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additionality the project resulting in emission reductionsthat are real and go beyond what would otherwise haveoccurred is controlled by detailed procedures and a systemset up at UN level.

Through the CDM, emission-reduction projects in developingcountries can earn certified emission reduction (CER) credits,each equivalent to one tonne of CO2. They are issued ex-post(afterwards) and hence the CDM contributes to the economy

of the project primarily once it becomes operational. The CERscan be traded, and used by developed countries to meet a partof their emission limitation commitments under the KyotoProtocol. The CDM is also the main source of income for theUNFCCC Adaptation Fund, which is financed by a 2% levy onCERs issued by the CDM. The Adaptation Fund financesadaptation projects and programmes in developing countries

that are particularly vulnerable to the adverse effects ofclimate change.

JI - Joint Implementation

Whereas the CDM is a co-operation between countries withand without mitigation commitments, Joint Implementation(JI, Article 6 of the Kyoto Protocol) is also a project-based

mechanism, but one where total emission allocations are beingredistributed between two countries with emission limitationcommitments. A country with emission limitationcommitments under the Kyoto Protocol can be creditedemission reduction units by investing in emission-reductionprojects in another country with emission limitationcommitments. The emission reductions in both JI and the


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CDM are calculated in relation to a baseline and must beadditional, i.e. must exceed what would have taken placewithout the project.

IET - International Emissions Trading, trade ofAAUs between countries

International Emissions Trading (IET, Article 17 of the KyotoProtocol) enables Parties with quantitative commitments in

accordance with the Protocol to purchase and sell emissionrights from/to one another. The Kyoto Protocol deals only withtrading amongst countries. The possibility of internationaltrading in emission allowances under the Kyoto Protocolbegan in 2008. There have only been a handful of trades inAAUs and, therefore, no established market price exists.International Emissions Trading under the Kyoto Protocoloperates according to the seller beware principle, i.e. the

traded AAUs remain valid for the buyer independently ofwhether the seller subsequently defaults on its Kyotoemissions obligation. A Commitment Period Reserve, wherecountries are required to maintain a reserve of allowances inits national registry, is designed to prevent over-selling ofAAUs.

Regional emission trading systems

In addition to the flexible mechanisms of the Kyoto Protocol,the Protocol has assisted in providing the rationale for thedevelopment of regional emissions trading systems. These areestablished domestically, not as part of the UN system andtypically form a key element of a country or regions overall


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mitigation action. These are systems that enable companiescovered by a domestic emissions "cap" to trade surplusallocations with those that are "short" of allocation. The mostimportant one, in number of participants and traded volumes,is the European Union Emission Trading Scheme (EU ETS). Itcovers more than twelve thousand installations across theEuropean Union and encompasses half of the EUs carbondioxide emissions and 40 % of its total greenhouse gasemissions.6

Regional emissions trading systems can link to a global carbonmarket through the use of offsets from project basedmechanisms. Until a new global climate regime comes intoforce, regional markets, determined by domestic or regionallegislation, will be the main source of the demand for offsets.The EU ETS has been the main driver for the international

carbon market and source of demand for CDM credits. This isabout to change. The common EU policy on climate and energyand the EU Emission Trading Scheme has a direct impact onthe market for CDM. The EU ETS Directive restricts whichtypes of emission reduction units companies can use in the EUETS in Phase 3, from 2013 to 2020. This, together withspeculation regarding further restrictions on types of projects,has created some turbulence in the CDM market. TheEmissions Trading Directive stipulates that for CDM projectsregistered after 2012 only CERs from projects in leastdeveloped countries (LDCs) can be used for compliance.

6 http://ec.europa.eu/clima/policies/ets/index_en.htm (retrieved October 2012)


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A number of countries and regions have adopted or areintroducing carbon pricing mechanisms or emissions tradingschemes. These include Australia, which has a carbon pricingmechanism that will transform into an emissions tradingscheme in 2015. The Australian ETS allows for its participantsto cover 12,5 per cent of its emissions through CDM-credits. Ithas been announced that the Australian scheme will link withthe EU ETS.7 In addition, emissions trading schemes are inoperation or will be introduced in New Zealand, Korea, the

Regional Greenhouse Gas Initiative (RGGI) in the North-eastern parts of the U.S., California and Quebec. Moreover,seven provinces/cities in China are also introducing pilotemissions trading schemes (see also map on page 75). The useof offsets within these schemes varies in both types permittedas well as quantity.

7 Australian and European Commission agree on a pathway towards full linking Emissions

Trading Systems, Press release 28 August 2012,http://www.climatechange.gov.au/en/media/whats-new/linking-ets.aspx


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3. THE CDM -OPERATIONAND EXPERIENCES SO FAR

is the CDM,

which actors in developed countries can use to contributefinancially to projects in developing countries and useemission reductions to comply with their targets. Since 2005,the CDM has reduced global emission by more than 1 billiontonnes of carbon dioxide equivalents through more than 4600projects, and has in total generated more than $150 billion ofprivate investments in emission reducing projects. The CDMhas built experience, capacity and comfort with the use ofmarket mechanisms and has been instrumental for manydeveloping countries when considering domestic marketmechanisms.

The first CERs were issued on the 20th of October 2005 and onthe 7th of September 2012 the billionth CER was issued.According to estimates8, another billion CERs are expected to

have been issued towards the end of 2012. That means that ittook almost 7 years to reach the first billion but only monthsthereafter to reach the second.

8 CDM in numbers, http://cdm.unfccc.int/Statistics/index.html retrieved 23 Sept 2012.


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The majority of the demand from certified emission reductionunits (CERs) from the CDM comes from companies within theEU ETS, but also Japanese companies have been major buyers.Initially, multilateral funds and governmental purchaseprogrammes played an important role in developing themechanisms at a time when there was considerableuncertainty about whether the Kyoto Protocol would enterinto force or not. Not unlike the situation of today, where thepost-2012 regime remains undecided.

FIGURE 1

Source: CDM http://cdm.unfccc.int/Projects/MapApp/index.htm (Illustrationreplica made by FORES)


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BOX 1 - What the CDM has achieved

Attracted over $150 billion of private investment

Reduced to date over 1 billion tonnes of greenhouse gasemissions in 79 countries.

Provided price signalling and marginal abatement costdiscovery in unexpected sectors such as the landfill andindustrial gas sector.

Exponentially increased the greenhouse gas accounting,

monitoring and reporting expertise. Positively influenced the awareness and understanding of

clean technologies, emissions trading and future actionfor climate change both in the private and public sector.

Enabled developing countries to gain first-handexperience and to enhance their local human capacity andinstitutions for managing and controlling GHGmitigation.

Built significant carbon market infrastructures for projectdevelopment, verifications, and finance services.

Attracted financing for clean technology transferimproving livelihoods of millions, reducing local airpollution and biodiversity loss, increasing gender equalityand access to electricity.

Source: UNFCCC (2011) Benefits of the CDM, access athttps://cdm.unfccc.int/about/dev_ben/pg1.pdf; UNFCCC (2010)


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The CDM Operational learning

Understanding how the CDM has functioned and changed overthe years provides some valuable lessons for the establishmentof new market based measures. Below is an overview of someof the areas that have been discussed during the first years ofthe CDM.

Project types

Since participation in the CDM is voluntary on both sides, thedevelopment of projects is driven not only by rules regardingwhich activities are eligible but also by costs, risk-return ratioand the (changing) eligibility of which credits can be used forcompliance.

The early CDM market was dominated by industrial gas

projects with low abatement cost and high returns. Theseprojects, while being criticised for overly high returns and lowsustainable development benefits, rapidly provided the earlymarket with volumes and liquidity. These mitigationopportunities had been virtually ignored before they weremobilized under the CDM. Thus the CDM stimulated costefficient action to curb extremely potent greenhouse gas

emissions. This resulted in large profits for host countries andalso provided the Adaptation Fund with early and significantrevenues.

Regional/national acceptance of credits from specific projecttypes can also have a major impact. Forestry and land-useprojects, which could have provided low abatement costs


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albeit higher transaction cost and large volumes, account formerely nineteen of the more than 4600 registered projects.This mainly because such projects have not been eligible foruse within the EU ETS.

In total, thirty-three project types have received issuance sofar. The ten largest project type categories have contributed toninety-three per cent of the issued volume. In the future, thebulk of the issued CERs will stem from a much larger number

of projects and around half of the volume is projected to comefrom renewable energy projects.

Countries and regional distribution

The CDM is a market-based mechanism; hence projects will beimplemented where the collective conditions for cost efficientmitigation are found, within the limits created by policy

decisions. So far this has led to a situation where the CDM-projects have largely been centred in a few countries. Morethan 50 per cent of the projects have been developed in China.Another 20 per cent have been developed in India. Countriesthat have been successful in attracting investors to CDM-projects are those who have a low country risk and an enablinginvestment environment. To a great extent these are also

countries with rapidly growing economies and greenhouse gasintensive baselines, i.e. where there are high emissions that canbe reduced. Through the CDM, a less carbon intensivedevelopment path has been offered.

About two per cent of the world's registered CDM projects are


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in the African continent.9 The development of the AfricanCDM market has been hampered by a generally unfavourableinvestment climate. Attracting investors and lenders toprojects is often difficult since investments have beenperceived as too risky. Limited industrial activity andinfrastructure in several countries have also put obstacles inthe way of the development of the more successful categoriesof CDM-projects. Small projects are particularly affected byhigh transaction costs, which has also hampered CDM

development on the African continent where small-scaleprojects are dominant.

A change, however, seems to be emerging. Least DevelopedCountries as well as Small Island Developing States, have beensubject to efforts at UN level to enhance regional distribution.Least Developed Countries also get a favourable treatment by a

change in the EU ETS rules regarding projects registered after2012. This has led to a considerable shift towards projects inLDCs in recent years, which in turn has also increased thenumber of projects on the African continent.

Eight of the 37 Programme of Activities (PoAs)10 registered arein African countries. This gives hope that PoA will better cater

9 There are however funds and purchase programmes that have a larger percentage ofprojects in Africa than the global average, for instance, about a fifth of the bilaterallycontracted projects of Swedish governmental purchase programme are in Africa.10 Programme of Activities, PoA, often called Programmatic CDM is a voluntarycoordinated action by a private or public entity which coordinates and implements anypolicy/measure or stated goal (i.e. incentive schemes and voluntary programmes), whichleads to anthropogenic GHG emission reductions or net anthropogenic greenhouse gasremovals by sinks that are additional to any that would occur in the absence of the PoA. APoA allows an unlimited number of CDM programme activities (CPAs) over a wide area to

be run under a single administrative umbrella.


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to project types such as small renewable energy and energyefficiency, project types that are likely to fit these countries.See also chapter 5 for a more comprehensive description ofPoA.

Technology transfer and diffusion

Technology transfer is an important aspect in both theUNFCCC and the Kyoto Protocol. It is not specifically defined

but can relate to the transfer of specific technical equipment. Itcan also be any systematic knowledge for the manufacture of aproduct, for the application of a process or for the rendering ofa service. It needs not necessarily be an entirely newtechnology, but can just as well concern the increased use of atechnology that is common practice in one geographical areabut not in another, or the use of existing technology in a newway. Technology transfer may also entail the transmittal of

technical knowledge and experience.

Studies11 have shown that roughly a third of the CDM projectshave involved technology transfer. Judging by project designdocuments, the highest rates of technology transfer can befound for industrial gas (over 90 per cent) and methaneavoidance (about 85 per cent) projects whereas technology

transfer for biomass energy (about 35 per cent) and renewableenergy (just over 20 per cent) projects account for less.12

11 Haites, Duan, Seres (2006) Technology transfer by CDM projects. Climate Policy 6, 327-344 and Seres, Haites, Murphy (2009) Analysis of technology transfer in CDM projects: Anupdate. Energy Policy 37, 4919-492612 Benefits of the Clean Development Mechanisms 2011, UNFCCC


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One example where the CDM has led to transformation on alarge scale is wind power in China. Feed-in tariffs incombination with CDM revenues have led to 40 million tonnesof emission reductions in this sector. This has made China theworld-leading wind power producer. When the first Chinesewind CDM project started its approval process in 2004, theChinese capacity was less than 100 MW installed capacity.

FIGURE 2

Source: data retrieved from UNEP RISOE http://cdmpipeline.org* 2012 includes January - October


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Private sector participation

Since the Kyoto Protocol entered into force and the launch ofthe EU Emissions Trading Scheme in 2005, the private sector,principally in Europe and Japan, has been the forerunners inthe development of the CDM. The interest of EU industry inthe CDM has grown primarily because companies that haveinstallations covered by the EU ETS can use CERs to meettheir quota obligations.

The diversity of projects and methodologies put before theCDM Executive Board is a clear sign of the ingenuity of theprivate sector in finding different mitigation possibilities.Furthermore, companies with new climate-efficienttechnology have often become involved in the CDM as a way ofdisseminating their products in the market. The CDM hasbrought business to a whole new line of service providers;

project developers, brokers and independent verifiers.

Banks and financial institutions have also become interested inthe CDM market. In addition to coordinating some of thenational funds and purchasing programmes, some of thefinancial players have launched their own private funds for theacquisition of CDM and JI credits. These funds have succeeded

in attracting a relatively large amount of capital from theprivate sector.

Additionality

Additionality is a central concept in the CDM and refers towhether the emission reductions would have taken place evenwithout the CDM-project. Additionality is usually proven in


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one of two ways: either through financial (or investment)analysis, i.e. the proceeds from the sale of certified emissionreduction units means that the project becomes financiallyfeasible, or that CDM helps the project to overcome barriers,known as barrier analysis.

Implementing and evaluating additionality under the CDM hasproven to be challenging. The CDM experience has shed lighton the inherent and practical challenges and uncertainties of

determining the scenario representing what would haveoccurred otherwise thus making it difficult to proveadditionality with absolute certainty.

The diversity of factors considered and approaches taken inindividual investment decisions by different entities in avariety of circumstances has made the task of assessing a

projects additionality based on investment analysis verychallenging from a global perspective. This has contributed tomaking additionality the main point of much of the criticismthat has been directed towards the CDM. This has contributedto a high CDM regulatory risk13, which in turn has made itdifficult to use expected carbon finance revenues tostrengthen the financial viability of projects and to helpincentivize potential financiers and lenders to leverage thenecessary underlying finance.

13 Regulatory risk is the exposure to financial loss arising from the probability thatregulatory agencies will make changes in the current rules (or will impose new rules) that

will negatively effect the already-taken action.


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BOX 2 Additionality assessment in the CDM

Additionality is a central concept in the CDM and means that emissionreductions would not have taken place without a CDM-project. Theconcept was already introduced in the Kyoto Protocol in 1997, but was thensubmitted to the CDM Executive Board for definition. The additionalityrequirements differ for small scale and large scale projects. For small scalemethodologies it is common to present the additionality requirements aseligibility critera, i.e. the methodology specifies exactly which conditions

must be met for the project to qualify as a CDM project.

The CDM Executive Boards way to review projects and ensureadditionality has changed through the years. At first, it was up to eachproject proponent to find a way to show additionality, but in 2004 the CDMExecutive Board published the first additionality tool which set thestandard for how additionality is proven. Over time the additionality toolhas been enhanced with added flowcharts, questions to be answered and

more required steps in order to specify and clarify different requirements.

The "Validation and Verification Manual" first released in 2008, has furtherhelped to ensure a transparent and homogeneous treatment of projectsand enabled non-additional projects to be discharged early in theprocess. In 2008, the benchmarks for additionality were introduced. Theconcept was first applied for energy-efficient refrigerators. In thismethodology the identified benchmark represents a certain percentage ofthe most efficient refrigerators available on the market. If a refrigeratorfalls into this category it is considered additional and its emissionreductions can be credited in a CDM project. This procedure means that astechnology advances and more efficient refrigerators come on the market,higher efficiency is required to be considered additional.

A possible further development in the field of additionality is to a greaterextent use technical criteria that are objective and easier to verify thanproject-specific conditions. It is also possible to work on designing

eligibility criteria, such as for projects in certain regions, and thus to definein advance what is to be regarded as additional.


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Governance and predictability in decisions

The CDM is governed by the CDM Executive Board, consistingof ten members and ten alternates serving for a period of twoyears.14 The CDM Executive Board reports to the Parties to theKyoto Protocol. The CDM has been criticized for beingadministratively overly cumbersome and small projects havebeen particularly affected since they are less able to carry hightransaction costs.

Another, and more serious, concern is lack of transparency andpredictability in the decision making. This is partly due to thefact that the CDM is a bottom-up-process and the detailedrules and the application of these has developed over time.Decisions are also part of the policy making process as someissues are pushed from the Parties to the Kyoto Protocol to theCDM Executive Board to handle. Although several steps have

been taken over the years to increase transparency andconsistency in the rulings of the Executive Board, thoseinvesting in CDM are still exposed to considerable regulatoryrisk.

14The Executive Board consists of ten members from Parties to the KyotoProtocol, as follows: one member from each of the five United Nations regionalgroups; two other members from the Parties included in Annex I; two othermembers from the Parties not included in Annex I; and one representative of thesmall island developing States, They are nominated by the relevantconstituencies listed above and elected by the COP/MOP. (Decision 17/CP.7,Modalities and procedures for a clean development mechanism as defined inArticle 12 of the Kyoto Protocol)


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PART 2- Future flexible mechanisms


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4. WHAT ARE FLEXIBLE

MECHANISMS EXPECTED

TO DELIVER?

of benefits that thecurrent and potential future flexible mechanisms could bringto the future international climate change regime andprinciples to which they should adhere. This chapter presentsthe expectations that usually are voiced in discussions onflexible mechanisms.

When designing a flexible mechanism, one central question to

keep in mind is whether some principles or benefits are moreimportant than others. It is unlikely that a mechanism withmany purposes delivers equally well on all of them, so it isimportant to be clear on the objectives. The experiencesgained from the CDM, as well as those from the establishmentof regional and national trading schemes, provide valuableinsight into the development of future market-based systems

to support a new climate regime. It must, however, clearly bestated that flexible mechanisms themselves do not solve theclimate change problem. They are tools to help meet emissioncommitments cost-effectively, and need to be underpinned bymitigation commitments. Their effectiveness in contributingto addressing climate change depends upon this target.


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Environmental integrity

Maintaining environmental integrity, that is, making sureactions taken are indeed contributing towards solving theclimate change problem, is important for the overall climateregime, as well as for providing confidence and credibility tocarbon markets and flexible mechanisms. Furthermore,environmental integrity is essential to secure political andpublic support for a mechanism.

Environmental integrity needs to be maintained on a systemlevel, but on a project level absolute certainty should beweighed against transaction costs. One of the lessons learnedfrom the CDM is the need to strike a balance between seekingto measure every single tonne of greenhouse gas reduced (ateach project site) and estimating - with proper accuracy,

justification and conservativeness - the total greenhouse gasimpact of a creditable activity. Striking such a balance isnecessary for keeping transaction costs manageable whilesafeguarding environmental integrity. Too high transactioncosts erode the carbon price signal and thus the impact ofmarket mechanisms.

In spite of the detailed control that is exercised over CDMprojects, the additionality and environmental integrity ofemission reductions have been questioned and formed the keycritique of the CDM in the public debate, as well as being acause for developing new mechanisms. However, new marketmechanisms will not put such concerns at ease; if flexiblemechanisms are to be scaled up from project level to a sectoral


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level or to incorporate larger parts of the economy, a lesserdegree of detailed control has to be accepted.

Cost efficiency and flexibility across timeand place

Putting a price on greenhouse gas emissions is an efficientdriver for mitigation action. Such a price signal can be created

either by rewarding emission reduction or by making thepolluter pay for the emissions that take place. Flexiblemechanisms have been established that operate according toboth methods.

Flexible mechanisms make use of the fact that the mitigationcosts vary across sectors and nations. As a result, actors otherthan nations can contribute towards meeting nationalcommitments and obligations. But cost difference is not theonly rationale; the flexibility across time which emissiontrading provides is perhaps more important. The globaleconomy may go up or down, but the economic conditionsexperienced by different types of producers in differentregions will vary. Emission reduction obligations are usuallyset with a time horizon of up to ten years and it is difficult to

predict the prevailing conditions at the time when they are tobe met. With access to a greenhouse gas market suchobligations will be easier to meet and thus to accept.

This is equally true for a country considering taking onmitigation commitments as it is for a company adhering to acompliance regime. For example, if an individual company is


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experiencing a period with high economic growth andtemporary higher emissions, it can buy allowances on themarket (matching the cost of purchase against increasedproduction) and remain in compliance. Such flexibility withinan emission trading system allows the company to efficientlycarry out (not change) its own emission reduction strategy, forexample, the orderly introduction of its own emissionreducing investments at its facilities.

The role of offsetting

Offsetting is as an activity that compensates for the emissionof carbon dioxide or other greenhouse gases by providing foran emission reduction elsewhere. The main reasons foroffsetting are cost efficiency and to gain flexibility across timeand place. 15

The moral aspects of offsettingThe use of offsetting cannot be considered withoutconsidering the context in which it is used. For example, itneeds to be considered if a country took reductioncommitments with the understanding that they would achievethese domestically or whether they took ambitious

commitments because they could use offsetting to achieve apart of them in a more cost-effective manner. In the formercase, the morality behind outsourcing the emission reductionwork may be questioned. In the latter case the possibility to useoffsetting may have facilitated a more ambitious commitment.

15 It should be noted that this is a discussion about offsetting, not about the flexiblemechanisms of the Kyoto Protocol per se, although they can be used for offsetting.


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In the negotiations on a future climate change regime, manygovernments have introduced pledges that are conditional onthe use of offsets.

Levels of offsettingMost systems have a limit on the amount of offsetting that isallowed; for the industrialised countries that are part to theKyoto Protocol, the use of flexible mechanisms has to besupplemental to domestic action. This was later specified to

mean that a considerable part of the effort to meet obligationswas to be made domestically. For businesses in the EU ETSthere is a quantified limit per installation on the amount ofemission reductions from CDM and JI that can be used.

Concerns over competitivenessThe use of offsetting in form of project-based mechanisms,

in particular the CDM, has resulted in infrastructureinvestments in developing countries, paid by developedcountries. There is concern, voiced especially by trade-exposed industry, that by improving infrastructure indeveloping countries one may, however, be harming thecompetitiveness of the industry in the industrialised countries.There is little documented evidence to demonstrate this atpresent. There are many factors affecting competitiveness andthe risk of the CDM seriously affecting the level playing field isprobably small.

Is the low hanging fruit being picked?There is concern that offset projects will result in thecheaper reduction possibilities (low hanging fruit) beingused up in developing countries. From a mitigation point of


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view it is most important that the fruit are being picked, notwho does it. From time to time you will hear concerns that thelow abatement opportunities, the low hanging fruit, will all bepicked through the CDM16 and that this might force hostcountries to invest in more expensive measures to meet theirfuture reduction targets. This argument has been examined,with Castro17 finding that the CDM is not yet capturing a largeportion of the identified abatement potential in mostcountries. The study concludes that although the costs of most

emissions reduction opportunities grasped are below theaverage credit price, there are still plenty of available low-costopportunities to be tackled by future processes.

Finance

Substantial mitigation is needed to limit global warming. Theestimated incremental cost for mitigation in developingcountries ranges from US$140 billion to US$175 billion per yearin 2030.18 As part of the Copenhagen Accords from COP 15 in2009, the international community has agreed to mobilize US$100 billion per year by 2020.

The UN Secretary Generals High Level Advisory Group on

Climate Change Financing reported in 2010 that US $30 billion

16 Any CDM project requires host country approval so the host country has the ultimateauthority over which projects are implemented as CDM projects.17 Paula Castro 2012. Does the CDM discourage emission reduction targets in advanceddeveloping countries? Climate Policy 12 (198-218)18 Susanne Olbrisch, Erik Haites, Matthew Savage, Pradeep Dadhich & Manish KumarShrivastava, Estimates of Incremental Investment for and Costs of Mitigation Measures inDeveloping Countries, Climate Policy, Volume 11, Issue 3, June 2011, pages 970-986s


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to US $50 billion annually could be generated in increasedcarbon market flows to developing countries, if and whencarbon markets are further developed and deepened. Thereport emphasizes that instruments based on carbon pricingare particularly attractive because they can provide bothincentives for mitigation as well as raise revenues.

Achieving carbon market flows of this magnitude would rely onambitious mitigation commitments from developed countries

and the introduction of new mechanisms.

According to OECD, public finance for climate changemitigation reached more than US$ 13 billion in 2010. This canbe compared to investment in CDM projects that, in the sameyear, was US$ 47 billion.19 The capacity for investment andfinance through carbon markets is potentially much larger

than what can be collected through public funds. This wouldespecially appeal to governments as the source of fundingwould not come directly from governments budgets.

Sustainable development and other benefits

Flexible mechanisms can bring benefits that extend beyond

climate change mitigation, such as contributions tosustainable development.20 Mechanisms can assist countries

19 UNFCCC (2011) Benefits of the CDM, access athttps://cdm.unfccc.int/about/dev_ben/pg1.pdf; UNFCCC (2010)20 In the case of CDM, sustainable development is an explicit aim of themechanisms and a requirement to be taken into account by the host countrygovernment


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in changing their development track towards a society withlower greenhouse gas emissions. This is particularly importantat a point in time when many developing countries build long-lasting infrastructure like electricity generation systems. Aconcrete benefit of using flexible mechanisms is theacceleration of the replacement of less efficient technology.

Contribution to sustainable development, or rather how toenhance contribution to sustainable development, is an

important factor in the development of new marketmechanisms. Since contribution to sustainable developmentcan take different forms it is not easy to define or quantify in auniform way. The example of CDM shows the difficulties ofevaluating the extent to which an individual project hascontributed to sustainable development. It is even harder tosay that one project has contributed more than another. In

contrast, at least with present day mechanisms, the emissionreductions are clearly monetized and therefore easier toevaluate. In the case of CDM, sustainable developmentbenefits are to some extent taken into account in the marketprice of emission reductions; in some cases, projects with clearsustainable development benefits can gain a premium.

In discussing the development and evolution of the KyotoProtocol project-based mechanisms, as well as thedevelopment of future flexible mechanisms, the issue on howto promote benefits besides mitigation needs to be betteraddressed. It is evident that it is hard to ensure those benefits ifthey are not quantified or indexed, and in order for a market-based mechanism to deliver well on parameters they should bemonetized.


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It seems highly unlikely that countries could agree on commonsustainable development priorities or to adopt someone elsesstandards but inspiration could, for example, be sought in theMillennium Development Goals. It may be possible, based onthe host country prerogative to decide, to ask host countries tospecify their own sustainable development priorities andsuggest indicators for how the contribution to those prioritiescould be evaluated.

Increase acceptability of a climate changeregime

As flexible mechanism have the potential to lower the cost ofclimate change mitigation and provide flexibility in how thiscan be achieved, which may increase the likelihood thatcountries will commit to reducing greenhouse gases. Theflexible mechanisms were a decisive component in theconclusion of an agreement in Kyoto and also encouragednations to ratify the Kyoto Protocol; similar can be expected ina future climate change regime. In the case of the KyotoProtocol, developed countries were attracted to the flexiblemechanisms as they provided cost efficiency in complying

mitigation commitments. In a new climate regime, mitigationis not the only important aspect. Adaptation and finance islikely to play a larger role and flexible mechanisms can act as avehicle for financing mitigation or as a source of revenue foradaptation.

Another aspect of the tools is that they enable countries that


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are themselves no major emitter or have a demand for offsetsto make a greater contribution to the global goal through usingmechanisms and by contributing to their overall development.This is for instance one of the aims of the Swedishgovernmental CDM and JI purchase programme. This can alsobe linked to "results-based" financing and moving the CDMaway from offsetting.

The benefits and expectations identified above are clearly

applicable in varying degrees both to the post-2012 CDM as wellas any new market-based mechanisms that are developed. Thenext chapter concentrates on the future of the CDM and thefollowing chapter on new market mechanisms.


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5.THE FUTURE OF THECDM

and the project types havechanged over time. It is likely that the CDM will continue to

evolve and that the mechanism will play a different role in afuture climate change regime. The CDM is already moving inthe direction of less developed countries and from largeprojects to smaller projects and programmes. Its use foroffsetting is also likely to change and other features may gaingreater dominance, such as the contribution to sustainabledevelopment or as a channel for climate finance.

Governments have, in many UN meetings, stressed the needfor the CDM to continue as a mechanism. After a number ofyears of operation and learning, there is clearly a need tocontinue its development to enable the mechanism to fitwithin a post-2012 climate regime. If new mechanisms,targeted at the more advanced members of the developingcountry group, are developed in a way that allows for more

flexibility in implementation and less bureaucracy, it is alsoimportant, from a fairness perspective, to streamline themechanisms that are targeted mainly at less developedcountries. Some of the possible developments of the CDMcould include:


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Programme of Activities

Lately, there has been a transition from the traditional project-by-project-based CDM to more comprehensive approaches.Programme of Activities, PoA, often called ProgrammaticCDM allows for an unlimited number of CDM programmeactivities (CPAs) over a wide area to be run under a singleadministrative umbrella.

PoA is a voluntary coordinated action by a private or publicentity which coordinates and implements any policy/measureor stated goal (i.e. incentive schemes and voluntaryprogrammes) that leads to greenhouse gas emissionreductions or net greenhouse gas removals by sinks, which areadditional to those that would occur in the absence of the PoA.

PoA increases the attractiveness of a range of smaller anddispersed CDM projects, such as those installing efficient cookstoves, solar water heaters, biogas digesters and other small-size renewable energy generating systems. These are projecttypes that may be particularly suitable for Least DevelopedCountries, countries where the CDM will continue to play animportant role post 2012.

One of the rationales behind PoA was a desire to capturesmaller, more dispersed emission sources, as well as thepossibility to start small and then scale up. The rules of PoAwere based on the modalities and procedures for CDMalthough PoA differs in two significant ways; its modularfeature and the possibility to extend with time. In particular,the monitoring requirements can be challenging when


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covering a number of small and dispersed units. There mighthave been unforeseen changes over time which wereimpossible to predict at the registration of the first units.

Increased standardisation

The project-based mechanisms of the Kyoto Protocol aredeveloped in a bottom-up process. As a result, a wide variety of

project-types have evolved, including disparate approaches,which in turn has emphasized a need for standardisation.Through greater standardisation there is a potential tocalculate emission reductions and assess additionality in amore homogenous and consistent way. In addition,transaction costs for the individual project proponent can belowered.

Standardised baselines can be established for a country or asector within a country. Projects within that country or sectorcan use the standardised baseline and thus save the expense ofdeveloping a project specific baseline. A standardised baseline,being developed centrally without the potential bias of theproject proponent, could also better guarantee environmentalintegrity. The standardised baseline may be either qualitative,

e.g. the baseline for new electricity generation is a gasturbine, or quantitative; e.g. the baseline emission factor forgrid connected electricity generation in country X is Z kgCO2/kWh.

Standardised baselines have been possible within JI since itsonset. Recently, this is also possible within the CDM, and the


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CDM Executive Board has launched work in this area. Thedevelopment of standardised baselines could be a steppingstone from project-based mechanisms towards morecomprehensive approaches, including new marketmechanisms.

A role for the CDM beyond offsetting areceipt for finance

The Kyoto Protocol set up a system focusing on mitigation; in afuture climate change regime finance is likely to take a moredominant part. At the COP 15 in Copenhagen in December2009, a Green Climate Fund (GCF) was established.Developed countries then pledged to provide US$100 billion ofprivate and public sources annually by 2020 to supportdeveloping countries climate policy efforts. These decisionsmean that a new role for the CDM can be envisaged.

With additional demand for finance to support mitigationcomes an increased need to make sure that the finance alsodelivers real emission reductions. Certified emissionreductions, CERs, from a CDM project are notper se offsets. Itis the use of these CERs that determines whether or not a CDM

project is offsetting, not the mechanism itself. If the CER isretired or not used, it is effectively mitigation in developingcountries. A CER can then be seen as receipt or proof that anemissions reduction has taken place and the financialcontribution through the CDM as payment for performance.Furthermore, there are possibilities to ensure net mitigationthrough the CDM, even in the case where the resulting CERs


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are used for offsetting other emissions, for example; in theconservativeness of the methodologies and in the setting oflength of the crediting periods, further emission reductionscan be achieved than those credited for in the terms of CERs.The rigorous control systems that have been built up for theCDM could be used to ensure that finance is targeted towardsdelivering mitigation action.

An objective of the Green Climate Fund is to promote the

paradigm shift towards low-emission and climate-resilientdevelopment pathways by providing support to developingcountries to limit or reduce their greenhouse gas emissionsand to adapt to the impacts of climate change. One possibleway for the Green Climate Fund to do this would be to supportcurrent and future projects in the CDM by buying, and retiringCERs21. Such an approach would ascertain that the financial

support would result in real reductions.

21 CDM Policy Dialogue: Recommendations from the High-Level Panel inClimate Change, Carbon Markets and the CDM: A call to action.


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6. POSSIBLE FUTURE

FLEXIBLE MECHANISMS

istremendous and the international community is currentlyseeking ways to address this challenge. One outcome of the UNclimate change meeting in Durban 2011 was to extend the

Kyoto Protocol with a second commitment period. Anotherone was to launch a process to develop a protocol, anotherlegal instrument or an agreed outcome with legal force underthe Climate Change Convention applicable to all countriesfrom 2020. This process is taking place under the DurbanPlatform and work should conclude as soon as possible but nolater than 2015. The aim is to raise the level of ambition and to

ensure the highest possible mitigation effort by all countries.The post-2020 climate change regime will most likely consistof a spectrum of commitments and means of implementation.

Flexible mechanisms such as emissions trading, the CDM andJI will have a role to play in a future climate change regime aswell. Emissions trading is the simplest form of levelling outcost over time and space, and project-based mechanisms areways of channelling mitigation action to specific areas.Moreover, emissions trading and Joint Implementation arealternative ways to redistribute emission reductions under acap. The CDM differs from the two in that it brings aboutemission reductions from within an uncapped environment.The CDM also has the unique feature of being able to introducea carbon price signal to the private sector in a country even


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though it does not have a limitation on emissions. In that waythe CDM can build awareness about the economic importanceof reducing emissions to companies well before the hostcountry has imposed restrictions on emissions of greenhousegases.

In UN climate change negotiations, parties have agreed toestablish a new market-based mechanism under theauthority of the Conference of the Parties (COP) and to

consider a framework for various approaches includingmarkets22.A key difference between the two appears to be thedegree of international (UN) oversight foreseen. Thisdifference can be illustrated by the EU proposal for newmarket based mechanism with strong UN oversight and theJapanese proposal for a bilateral offsetting creditingmechanism that could fit under a framework for various

approaches. It is too early to say if there will be just one newmarket mechanism or perhaps several under a commonframework.

One over-arching aim for many governments is to ensure thatthe new market based mechanisms give a net mitigationcontribution. As such, there is an underlying assumption thatnot all emission reductions achieved through the mechanismwill be credited, subsequently traded and used for offsetting.The scientific rationale behind this thinking is that in order tomeet the challenge of limiting global temperature rise to 2C,in addition to ambitious emission reduction commitments by

22 Outcome of the work of the Ad Hoc Working Group on Long-term Cooperative Actionunder the Convention, Decision 2/CP.17,http://unfccc.int/resource/docs/2011/cop17/eng/09a01.pdf


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developed countries in the order of 25-40% by 2020, there is aneed for substantial deviations of 15-30% by 2020 fromcurrently projected emissions in developing countries,especially more advanced developing countries.

FIGURE 3

Source: Greenhouse gas production pathways in the UNFCCC process up to2025, CNRSLEPII-EPE, RIVM, MNP,KCS-NTUA, CES-KUL(2003)


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There have been several proposals outlining a wide range ofnew mechanisms. These include emissions trading systems,sectoral trading, sectoral crediting, crediting for nationallyappropriate mitigation actions (NAMAs), market-basedmechanisms for reducing emissions from reducingdeforestation and forest degradation in developing countries(REDD+) and a Bilateral Offset Credit Mechanism (BOCM).

These are diverse proposals and discussed under differentagenda items in the negotiations. But they do resemble oneanother to the extent that they are attempts to take a broadergrasp on mitigation, possibly through the use of markets. Table1 at the end of this chapter makes a comparison of some of thecurrent proposals.

NAMA - Nationally Appropriate MitigationAction

NAMA refers to a set of policies and actions that countriesundertake as part of a commitment to reduce greenhouse gasemissions. The term recognizes that different countries maytake varying nationally appropriate action on the basis of

equity and in accordance with common but differentiatedresponsibilities and respective capabilities. The Bali Actionplan from 2007 first speaks of Nationally appropriatemitigation actions by developing country Parties, supported and

enabled by technology, financing and capacity-building, in a

measurable, reportable and verifiable manner.


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The Copenhagen Accords from 2009 invites parties to notifytheir NAMAs and states that NAMAs seeking internationalsupport will be recorded in a registry along with relevanttechnology, finance and capacity building support. Thoseactions will be added to the list in an appendix to theCopenhagen Accords and these nationally appropriatemitigation actions will be subject to internationalmeasurement, reporting and verification in accordance withguidelines adopted by the Conference of the Parties. So far,

forty-four developing countries have submitted NAMAs thathave been incorporated in Annex II of the CopenhagenAccord

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