Funding for greenhouse gas mitigation projects in developing countries is crucial for addressing the global climate change problem. This paper indicates that current climate change-related financial mechanisms and their limitations. The clean development mechanism (CDM) could offer great potential in helping mobilize foreign direct investment towards climate mitigation.
Funding for greenhouse gas mitigation projects in developing countries is crucial for addressing the global climate change problem. This paper indicates that current climate change-related financial mechanisms and their limitations. The clean development mechanism (CDM) could offer great potential in helping mobilize foreign direct investment towards climate mitigation.
Funding for greenhouse gas mitigation projects in developing countries is crucial for addressing the global climate change problem. This paper indicates that current climate change-related financial mechanisms and their limitations. The clean development mechanism (CDM) could offer great potential in helping mobilize foreign direct investment towards climate mitigation.
Towards a privatepublic synergy in nancing climate
change mitigation projects ZhongXiang Zhang a,b, *, Aki Maruyama c a Faculty of Law and Faculty of Economics, University of Groningen, P.O. Box 716, 9700 AS Groningen, The Netherlands b Centre for Environment and Development, Chinese Academy of Social Sciences and China Centre for Regional Economic Research, Peking University, Beijing, China c Institute for Global Environmental Strategies, 1560-39 Kamiyamaguchi, Hayama, Kanagawa 240-0198, Japan Received 28 December 2000 Abstract Funding for greenhouse gas mitigation projects in developing countries is crucial for addressing the global climate change problem. By examining current climate change-related nancial mechanisms and their limitations, this paper indicates that their roles are limited in aecting developing countries future emissions, and argues for the necessity of stronger private sector engagement in nancing mitigation projects. In this regard, the clean development mechanism (CDM), one of the exibility mechanisms incorporated into the Kyoto Protocol, could oer great potential in helping mobilize foreign direct investment towards climate mitigation, by providing commercial incentives for the private sector to invest in mitigation projects and internalizing externalities associated with mitigation projects. However, due to additional risks and barriers involved in CDM projects, we believe that appropriate publicprivate linkage would be necessary in order to bring the CDM into full play. To this end, we suggest that public funds could be used to complement private investment via the CDM, thus enhancing market functions of such an investment. Moreover, in so doing, we think that it would be necessary to examine a host of factors, such as risk sharing, private sector investment behaviour, types of technologies to be transferred, and co-ordination with the commonly practiced trade and investment rules. r 2001 Elsevier Science Ltd. All rights reserved. Keywords: Clean development mechanism; Climate change; Foreign direct investment; Kyoto Protocol; Ocial development assistance 1. Introduction In recent years, there has been growing concern about changes in the global climate resulting from increased atmospheric concentrations of the so-called greenhouse gases (GHG) and the resulting socioeconomic impacts. Given the global characteristics of climate change, this promotes the necessity of taking international co- operative eorts to reduce global GHG emissions. Given that GHG emissions in the Asian developing countries are already high and are expected to grow rapidly in line with their industrialization and urbaniza- tion, these countries will, in particular, require signi- cant nancial assistance from developed countries in order to reduce their future GHG emissions. To date, assistance for climate change mitigation has been coming mainly from public nancing. Despite some eorts, little progress has been made in investments in the so-called climate-friendly projects that generally entail higher risks and initial costs than conventional projects. Under these circumstances, the introduction of the clean development mechanism (CDM) is expected to facilitate private sector investments in GHG-reducing, climate-friendlier projects in developing countries. No doubt, the CDM as an innovative market mechanism will provide the private sectors investment incentives, thereby addressing externalities related to GHG reduc- tions. However, due to additional risks and barriers involved in CDM projects, appropriate publicprivate linkage would be necessary in order to bring the CDM into full play. To this end, public funds could be used to complement private investment via the CDM by removing barriers, reducing implementation costs and *Corresponding author. Tel.: +31-50-363-6881; fax: +31-50-363- 7101. E-mail addresses: z.x.zhang@rechten.rug.nl (Z. Zhang), maruyama@iges.or.jp (A. Maruyama). 0301-4215/01/$ - see front matter r 2001 Elsevier Science Ltd. All rights reserved. PII: S 0 3 0 1 - 4 2 1 5 ( 0 1 ) 0 0 0 3 8 - 6 reducing long-term technology costs associated with the CDM projects, thus enhancing market functions of such an investment. Against this background, this paper examines relevant issues from a nancial point of view, in order to construct wider, more ecient nancial mechanism options for climate change mitigation projects. In so doing, special attention is paid to the Asian region. Sections 2 and 3 rst provide an overview of current climate change-related nancial mechanisms and their limitations, arguing for the stronger private sector involvement in climate mitigation. Sections 4 and 5 then analyse the potential and barriers of the CDM as a nancial mechanism to facilitate private sector invest- ments in climate mitigation. Finally, Sections 6 and 7 consider the complementary roles of public funds and private investments via the CDM, and point out some of the issues that need further consideration. 2. Current climate change-related nancial mechanisms Funding for GHG mitigation projects in developing countries is crucial for addressing the global climate change problem. It is important to recognise that industrialised countries are responsible for the majority of both historical and current greenhouse gas emissions and, thus, must demonstrate once and for all that they are really taking the lead in reducing their emissions. On the other hand, in the light of expected rapid growth of GHG emissions in developing countries, co-operation by developing countries is also essential. From the industrialised countries perspective, the lack of devel- oping countries involvement in combating climate change aggravates their short-term concerns about international competitiveness. Non-participation of developing countries also increases emissions leakage that could arise in the short term, as emissions controls lower world fossil fuel prices, and in the long term, as industries relocate to developing countries to avoid emissions controls at home. In addition, it raises the spectre of developing countries becoming locked in to more fossil fuel intensive economy and eliminates the Annex I countries opportunity to obtain low-cost abatement options. To date, several steps have been taken to assist developing countries in nancing GHG mitigation related activities. Article 4 of the United Nations Framework Convention on Climate Change (UNFCCC) adopted in 1992 species some of the funding needs of developing countries, and for that purpose, the Global Environment Facility (GEF) was identied as a nancial mechanism of the Convention on an interim basis. At the rst Conference of the Parties to the UNFCCC, the implementation of the pilot phase of activities implemented jointly (AIJ) up to the year 2000 was endorsed in order to achieve emissions reductions in a more cost-eective manner. Although there is no crediting allowed from the AIJ, it is a co- operative mechanism between Annex I (developed) and non-Annex I (developing) countries through which developed countries carry out mitigation projects in developing countries based on the approval of each involved party. AIJ projects utilise funds additional to the ocial development assistance (ODA) and contribu- tions to the GEF, aiming to mobilise resources from the private sector. Furthermore, the Kyoto Protocol adopted at the third Conference of the Parties to the UNFCCC in 1997 incorporates emissions trading, joint implementation (JI) and the CDM to help Annex I countries to meet their legally binding Kyoto emissions targets at a lower overall cost. While many Annex I countries have put and continue to put pressure on developing countries to take on emissions limitation commitments, the CDM so far is the only mechanism with an authentic global reach. It aims to contribute to the sustainable development of developing countries while assisting Annex I countries in meeting their emissions targets. Although the rules governing the CDM are unclear at this point, what has been agreed on is that CDM projects can generate the so-called certied emission reductions (CERs) from 2000 on, making available a stock of CERs for Annex I countries to full part of their national GHG emission reduction require- ments for the rst commitment period (20082012). With its main source of nance being expected to come from the private sector, the CDM will have signicant implications for future options for nancial mechanisms aiming at GHG mitigation in developing countries. In what follows, we will examine the status and size of current climate change-related nancial mechanisms, with special attention being paid to the Asian region. 2.1. Existing nancial mechanisms 2.1.1. Global Environment Facility While international agencies have vast experience of development aid, none of them have previously ad- dressed the issues of funding projects aimed to secure a global benet. Hence, the GEF 1 was set up as a pilot US$ 1.3 billion trust fund in 1991 to support developing 1 The GEF is managed by 3 implementing agencies: United Nations Development Programme (UNDP), United Nations Environment Programme (UNEP) and the World Bank. Each implementing agency contributes its particular expertise to GEF operations: the UNDP is primarily responsible for implementing technical assistance and capacity building programmes; the UNEP takes the lead in advancing environmental management at regional and global levels within GEF- nanced activities and in catalysing scientic and technical analysis; and the World Bank helps to develop and implement investment projects and seeks to mobilize resources from the private sector. Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1364 countries for projects and activities that protect the global environment and to promote sustainable devel- opment. It was restructured and replenished with over US$ 2 billion from 34 countries in 1994 to support its 4 focal areas: climate change, biodiversity, international waters and conservation of the ozone layer. An additional US$ 2.75 billion was pledged in March 1998, and its member countries now number 165. GEFs nancial assistance is to cover the dierence (or increment) between the costs of a project undertaken with global environmental considerations and the costs of an alternative project that the country would have implemented under the normal circumstances. During the period 19911998, the GEF has funded more than 500 projects in 120 countries, with the total funding of more than US$ 2 billion. Co-nance for GEF projects from other sources, public as well as private, exceeds US$ 5 billion. Of these investments, the GEF has allocated US$ 753 million to climate change-related projects, accounting for 38% of the total number of projects, matched by more than US$ 4.3 billion in co- nancing (GEF, 1999a). There are currently 4 Opera- tional Programmes 2 in the climate change portfolio: removal of barriers 3 to energy eciency and energy conservation (OP#5); promoting the adoption of renew- able energy by removing barriers and reducing imple- mentation costs (OP#6); reducing the long-term costs of low GHG emitting energy technologies (OP#7); and promoting environmentally sustainable transport (OP#11). The breakdown of nance allocation by programme is shown in Table 1, with Asia and the Pacic accounting for 47% of the total funding. With its limited resources, the GEF cannot signicantly aect GHG emissions in the short term; rather, the GEF promotes the development and use of technologies that are critical for addressing the climate change problem in the long term (Martinot, 2000). 2.1.2. Activities implemented jointly The rst Conference of the Parties to the UNFCCC in Berlin in April 1995 endorsed the AIJ as a pilot programme. During the AIJ pilot phase, emission reductions achieved are not allowed to be credited to current national commitments of investor countries. Currently, approximately 160 AIJ projects have been established worldwide mainly in energy-related (energy eciency improvement, fuel-switching, and renewable energy), forest conservation and aorestation elds. The countries with economies in transition host most of these projects. As of July 1999, 7 projects were implemented in the Asian countries and reported to the UNFCCC Secretariat. As shown in Table 2, the costs of these projects vary signicantly, depending on the types and scale of a project. Because much of cost information is either unclear or unavailable, it is thus very dicult to derive the aggregated investment in all AIJ projects. The AIJ pilot phase aims at introducing private funds and technologies. However, it is dicult to say that it has played a signicant role in leveraging private sector nance. This is because of factors such as the absence of credits as yet for emissions reductions, and the lack of international consensus on providing appropriate Table 1 GEF nancing in the climate change area and its ow to Asia and the Pacic, 19911998 (in million US$) a Total 1991 1992 1993 1994 1995 1996 1997 1998 Total OP#5 0.00 29.40 15.90 0.00 6.40 55.08 38.19 42.91 187.07 OP#6 40.30 49.00 14.60 0.00 6.90 62.80 46.48 60.23 280.31 OP#7 0.00 0.00 8.12 0.00 0.00 53.50 40.84 0.33 102.79 Enabling 0.00 16.00 6.90 0.00 19.49 5.43 8.85 11.67 68.34 Short-term 19.80 45.00 7.20 0.00 6.26 4.70 10.21 21.39 114.56 Total 60.10 139.40 51.91 0.00 39.05 181.51 144.58 136.53 753.08 Asia/Pacic OP#5 0.00 16.50 0.00 0.00 1.00 32.80 22.00 17.16 89.46 OP#6 30.00 49.00 0.00 0.00 0.00 43.20 8.83 37.12 168.15 OP#7 0.00 0.00 0.00 0.00 0.00 49.75 0.00 0.00 49.75 Enabling 0.00 11.50 1.50 0.00 0.47 3.39 0.59 0.88 18.34 Short-term 10.00 10.00 0.00 0.00 6.26 0.00 0.00 9.19 29.19 Total 40.00 87.00 1.50 0.00 1.47 129.15 31.42 64.36 354.90 a Information on OP#11 is unavailable here because it became operational since 1999. Source: Vaish (1999). 2 Operational programmes, which consist of the majority of GEF nancial assistance, are conceptual and planning framework for implementation of a set of projects. In addition, the GEF has other nancial assistance categories: enabling activities; short-term response measures; project development facility; small grants programme (for grants up to US$ 50,000); and medium-sized projects requiring no more than US$ 1 million in GEF nancing. 3 The barriers here refer to incremental expenditure for winwin nance ows. These include regulatory barriers and biases, lack of information, insucient management capability, inability to analyse non-traditional projects, higher perceived technology risk of the alternative, high transaction costs, and high initial costs (GEF, 1996). Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1365 incentives for the private sector, thus leading to a lack of incentives other than a little public image-improvement. Moreover, the limited number of AIJ projects that have been implemented in developing countries to date means that most of non-Annex I countries have not experi- enced an AIJ project within their own countries and thus provides insucient details to draw conclusions. This led to the decision at the fourth Conference of the Parties to the UNFCCC held in November 1998, Buenos Aires, to continue the AIJ pilot phase. Although more countries might gain experience from a new round of AIJ projects, however, the future of AIJ is likely to be limited. This is partly because of lack of adequate incentives for the private sector participation in AIJ project nancing. It is partly because of the adoption of the Buenos Aires Plan of Action, an ambitious 2-year work programme intended to make the Kyoto Protocol operative. With the work programme in place, attention has since focused on how the CDM, JI and emissions trading would work, with priority being given to the CDM. Therefore, it is generally acknowledged that the interest of potential investors in project-based coopera- tive mechanisms is likely to focus on the CDM and JI rather than the AIJ. 2.2. Other multilateral and bilateral programmes and activities Developing countries can also seek nances for climate change mitigation projects from other sources including multilateral and regional banks, bilateral aid as well as multinational agencies. Since these organisa- tions often aim to nance more general socio-economic activities, the aggregate ows specically supportive to the Convention are very dicult to disentangle from their total funding portfolios, due to a lack of accounting/reporting for that purpose. Here, we look at programmes/projects by major nancing actors which specically address climate change. 2.2.1. Multilateral development banks (MDBs) 2.2.1.1. Asian Development Bank (ADB). The ADB has been actively promoting climate change-related technical assistance (TA). In particular, a $10 million Asia Least Cost Greenhouse Gas Abatement Strategy (ALGAS) project, which was carried out during 1995 1998 in 12 Asian developing countries 4 was noteworthy. ALGAS has the objective of assisting participating countrys capacity building for the preparation of GHG inventory as well as identifying mitigation options and preparing a portfolio of abatement projects in line with national development goals. ALGAS has identied 81 TA and investment projects (ADB, 1999a), which were presented to potential investors including donor country aid agencies, multinational organisations and represen- tatives from the private sector in July 1999. Identied projects were selected via governments of participating countries and this exercise is therefore helpful, with regard to building experience relevant to the future CDM. Moreover, the ADB has launched another TA targeted at policy makers in the Asian developing countries with regard to capacity building for imple- mentation of Kyoto mechanisms since September 1999. Recently, the ADB has launched another TA project, called Regional Technical Assistance for the Promotion of Renewable Energy, Energy Eciency and Green- house Gas Abatement (PREGA) in April 2001, to facilitate investment in renewable and energy eciency in the region. Furthermore, according to a press release by the ADB (dated on 3 April 2001), the Canadian Table 2 UNFCCC AIJ projects in Asia a Project Type Host country Investing country Cost (thousand US$) Lifetime of the activity (year) Installation of a coke dry-quenching facility EEF China Japan (AIJ) 26,798 20 Integrated agriculture demand-side management AIJ pilot project EEF India Norway 4,600 20 The model project on eective utilization of energy in re-heating furnace in steel EEF Thailand Japan Cost not xed yet 10 Reduced impact logging for carbon sequestration in East Kalimantan FPR Indonesia USA 180 40 Kilung-Chuu Micro Hydel, Bhutan REN Bhutan Netherlands (AIJ) 412 4 Renewable energy training/ demonstration project REN Indonesia Australia (Project) 234 (AIJ) 92 20 SELCO-Sri Lanka rural electrication REN Sri Lanka USA Not available 29 a Type: REN=renewable energy; EEF=energy eciency; FPR=forest preservation. Source: available from the UNFCCC Secretariats web site at http://www.unfccc.de. 4 Bangladesh, China, India, Indonesia, Mongolia, Myanmar, Pakistan, Philippines, Republic of Korea, Thailand, Viet Nam, Democratic Peoples Republic of Korea (ADB, 1999a). Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1366 Government has agreed to establish a fund on climate change to reduce the growth of greenhouse gas emissions in the Asia and Pacic region. The Canadian Cooperation Fund will have an initial Can$ 5 million (US$ 3.2 equivalent) and will be administered by the Asian Development Bank (ADB). This will be the rst Canadian trust fund at a multilateral development bank from which grants will be provided on an united basis. The fund will assist projects with potential access to treaty mechanisms, including the Global Environment Facility and Clean Development Mechanism. It will also support activities relating to carbon sequestration and adaptation to climate change. Grants from the fund will be used for project preparation, training and advisory services, institutional support or other technical assis- tance services. Although all the ADBs developing members are eligible for the fund, priority will be given to the Peoples Republic of China and India to reduce greenhouse gas emissions; Indonesia for carbon seques- tration; and to the Pacic Islands for operations to adapt to climate change. The fund reects Canadas aim to contribute towards poverty reduction in the region through policy dialogue and collaborative programming with the ADB supporting in managing climate change. 2.2.1.2. World Bank. The World Bank Group is also promoting a variety of climate change-related activities. Among them, the most important activities include serving as one of the 3 implementing agencies of the GEF, involvement of some AIJ projects, and the establishment of Prototype Carbon Fund (PCF) which will be closely related to the future CDM and joint implementation. AIJ projects at the World Bank are carried out in conjunction with other Bank Group investment projects which meet AIJ criteria of the UNFCCC. The conces- sional funding (the amounts available from a single donor in the range of US$ 25 million) comes from donors who are interested in contributing to the development of AIJ. The Bank aims at identifying a diverse portfolio, providing nance and technological assistance and facilitating relevant research. Currently, there are 8 such AIJ projects (most of which receive nancial contributions from the Norwegian govern- ment), with only one project (in India) being imple- mented in Asia. The PCF was endorsed by the Banks Executive Directors on 20 July 1999 and launched on 18 January 2000 as a pioneering model to catalyse a carbon market in project-based emission reductions. It is a trust fund with contributions from governments and private sector participants. 5 The PCF will invest in 1520 GHG mitigation projects in developing countries or in countries with economies in transition during the next 3 years, with the primary focus on renewable energy projects that would not be protable without revenues from emission reductions sold to the PCF, and will then distribute its return to investors in the form of emissions reduction certicates as per their pro rata investment in the Fund. The size of the PCF is capped at US$ 150 million. It is designed to be capable of being adjusted to operate within the UNFCCC regulatory framework as it develops. 2.2.2. Bilateral aid programmes In addition to AIJ projects, the OECD countries, such as Germany, Japan, the UK, the US 6 and Australia, have carried out projects which contribute to climate change mitigation in the Asian developing countries through respective bilateral aid programmes. The scopes and objectives of these programmes as well as their budgets vary greatly, ranging from a research project to a concessional nancing and to building relative demonstration facilities. In particular, Japans coopera- tion in this region is prominent in terms of nancial assistance. First of all, main nancial assistance in this area by the Japanese government is through special environmental ODA. Such an assistance, which was announced in September 1997, applies specially lower interest rate (special environmental rate 7 ) for loans to a category of environmental projects designed to improve the global environment including those for climate change mitigation (e.g., forestry, energy conservation, new energy sources and public transportation) and anti-pollution measures. Special environmental projects in scal year (FY) 1998 numbered 27, and the loan amount associated with these projects totals Yen 277.3 billion on an agreement basis (record high), with all loans but one going to the Asian countries (in total Yen 272.2 billion) (OECF, 1999). Besides, although not a programme specically aimed at addres- sing climate change in a strict sense, the Green Aid PlanFa technical and nancial assistance to pollution and energy-related problem targeted at 6 Asian countries 8 provided by the NEDO/MITIFhas a component contributing to climate change mitigation. Under the Green Aid Plan, the MITI allocated above 5 The required contributions for public sector and private sector participants are US$ 10 million and US$5 million, respectively (World Bank, 1999b). 6 For instance, the US Country Studies Program has provided technical and nancial assistance to GHG inventory preparation and vulnerability assessment of 56 developing and economies in transition countries since 1992. 7 As of August 1999, the interest rate is 0.75% with 40 years of grace period (which is the same terms used by the World Banks International Development Association, the most preferential condi- tions in the world; for middle-income countries the applied rate is 1.8% with 25 years of grace period). 8 China, India, Indonesia, Malaysia, Philippines, and Thailand. Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1367 US$ 280 million between 1993 and 1997 for projects aiming at the diusion of energy conservation technol- ogies (Evance, 1999a). Furthermore, the MITI and the Environment Agency of Japan have been providing the Japanese entities with nancial assistance for feasibility studies of potential JI and CDM projects to identify potential projects and accumulate know-how and expertises. 2.2.3. Activities by other regional/international organisations In addition to the above eorts, several regional/ international organisations oer TA related to climate change mitigation. They include capacity building, research and technical assistance activities by the UNEP, and the AsiaPacic Climate Change Seminar for policy makers organised jointly by the United Nations Economic and Social Commission for Asia and the Pacic and the Environment Agency of Japan. Being non-nancial entities, the main activities of these organisations in the climate change arena are not, in principle, related to investment but informa- tion dissemination and capacity building, the budget and scope of which for this purpose vary from year to year. 3. The limitations of conventional public nance 3.1. Problems with current options Current nancial mechanisms for climate change mitigation projects have several problems. For example, problems associated with GEF funding include: the limited funding sources available for achieving the ultimate objective of the Convention and for transfer- ring the necessary environmentally sound technologies to developing countries; a typically lengthy process of project identication and approval for funding; con- sultant-driven project identication that risks leading to projects which do not take regional or country needs into consideration (Porther et al., 1998; TERI, 1998; ECON, 1997). Moreover, unequal geographical distributions of project implementation and non-existence of nancial assistance mechanisms for adaptation for countries/ regions particularly vulnerable to climate change are the two major issues that require special consideration. Diculties involved in taking concrete and ecient co- operative measures at national, regional and interna- tional levels because of uncertainty with the outcomes of the future international negotiations are a major obstacle to strengthening the supporting eorts. As mentioned earlier, multilateral development banks as well as bilateral aid agencies carry out some activities related to climate change mitigation. However, it is dicult for them to strengthen their eorts or prescribe particular policies at this point when rules and modalities of the Kyoto mechanisms are yet to be decided. Thus, early formation of international con- sensus is essential for strengthening necessary support- ing measures. 3.2. Necessity of private investment Generally speaking, investments in climate-friendlier projects are dicult, due to the higher initial costs, risks and externality of GHG reductions. Thus, the UNFCCC looked to the GEF to ll the cost gap (incremental cost) in order to leverage private funds. However, as reviewed in a GEF overall performance study, there has been comparatively little mobilisation of capital from private nancial institutions (GEF, 1998). The private sectors involvement has been limited to providing procured equipment and services or advisory capacity. The GEF attributes the causes of this obvious obstacle to such factors as the private sectors low awareness of the GEF, a lengthy approval process, private sectors fear for the disclosure of valuable business information, and vague tangible benets resulting from a partnership with the GEF (GEF, 1999b). However, the limited involvement of the private sector at this moment does not prevent huge private ows from going to climate-relevant conventional projects in developing countries in the future, provided that favourable investment conditions are created. Given the fact that the role of nancial assistance (from the GEF or ODA) for mitigation projects is limited in aecting future GHG emissions, it has been recognised that the mobilisation of private sector investment is the key to achieve global GHG emissions reductions, particularly in developing countries. 3.2.1. Size and the importance of the foreign direct investment (FDI) A ve consecutive year fall in the ODA ended with rise to US$ 51.5 billion in 1998, while the net private ows to developing countries fell drastically to approxi- mately US$ 200 billion, 9 due to loss of condence in emerging markets triggered by the recent nancial crisis that led to the withdrawal of short-term bank ows and portfolio investments (DAC, 1999; World Bank, 1999a). Still, private ows to developing countries are running at 35 times the size of the ODA. The FDI has been more resilient than other forms of private capital ows in the face of the nancial crisis, because it is motivated largely by the investors long-term prospects for making 9 According to the DAC statistics, the net private ows from OECD countries in 1998 were US$181 billion, of which the FDI amounted to US$110 billion. Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1368 prots in production activities that they directly control. By contrast, foreign bank lending and portfolio invest- ment are not invested in activities controlled by banks or portfolio investors, which are often motivated by short- term prot considerations. These dierences are high- lighted, for instance, by their investment patterns in the Asian countries stricken by nancial turmoil in 1997. FDI ows in 1997 to the ve most aected countries remained positive in all cases and declined only slightly for the group, whereas bank lending and portfolio equity investment ows declined sharply and even turned negative in 1997 (Mallampally and Sauvant, 1999). Developing countries are becoming increasingly attractive destinations for investment, accounting for two-thirds of the increase in global FDI ows from the late 1980s to the 1990s. The FDI is likely to remain the dominant source of long-term nance for developing countries in the foreseeable future (World Bank, 1999a). The majority of the US$ 96 billion net long-term ow to the East Asian region in 1998 was dominated by the FDI of US$ 61 billion, while ocial ows were US$ 19 billion (IMF credit not included) (World Bank, 1999a). Not only can the FDI add to investible resources and capital formation, but, perhaps more importantly, it is also a means of transferring advanced technologies to local industry, and introducing institutional frameworks of the market economy, such as industrial organisations, contractual concepts, transaction know-how, nancial systems, and labour markets, as well as of accessing international marketing networks. In this respect, the FDI is potentially a strong vehicle to activate developing economies (Ohono, 1996). Furthermore, even when the ODA or other public funds are available for mitigation projects, project replication and sustainability often depend on creating conditions for similar investments by the private sector (GEF, 1999b). In this respect, green- ing the FDI in climate relevant sectors, such as energy sector, is essential for climate change mitigation. 3.2.2. Private sector investment in the electricity sector Electricity generation, a primary cause of climate change, is one of the leading infrastructure sectors in attracting private investment. According to Izaguire (1998), the private sector took on the management, operation, rehabilitation or construction risk of 534 projects, with total investments of US$131 billion between 1990 and 1997. Of these, the East Asian and the Pacic countries won 165 contracts, representing a total investment of about US$50 billion (see Table 3). Independent power producer (IPP) projects account for nearly 60% of all new private generation capacity nanced in the developing world, and the East Asian countries show a pronounced trend towards introducing private participation in this form. Among the contracts brought to fruition during 1990 1997, large green eld IPPs (exceeding 100 MW) comprised 137 projects worth US$ 65 billion, of which the IPPs mobilised US$ 51 billion in private funds (Babber and Schuster, 1998). On the other hand, loans to the energy sector (electricity generation and gas projects) provided by MDBs or bilateral credit agencies active in the Asian region (namely, the ADB, the World Bank, and the Japan Bank for International CooperationFthe latter created from a merger of the Overseas Economic Co-operation Fund (OECF) and ExportImport Bank of Japan (JEXIM)) totalled approximately US$ 6 billion in 1998 (see Fig. 1). Although these nancial institutions provide loans on concessional terms, the basic principle of evaluating the Table 3 Private electricity projects in developing countries by region, 1990 1997 a Region Projects Total investment with private participation (million US$) East Asia and the Pacic 165 49,741 Europe and Central Asia 112 10,436 Latin America and the Caribbean 169 45,311 Middle East and North Africa 10 6,721 South Asia 57 16,799 Sub-Saharan Africa 21 2,040 Total 534 131,048 a Source: Izaguirre (1998). Fig. 1. Loans to energy sector in 1998. Note: measured in million US$ at the exchange rate 1 US$=Yen 130.89. Sources: ADB (1999b); OECF (1999); World Bank (1999c); Dengen Chiiki Shinko Center (1999). Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1369 project economics based on loan repayment is the same as that of commercial banks. Without relevant environ- mental regulation in place, and with subsidized energy prices, promoting climate-friendlier investments that are not internalised in economic appraisals of the projects is even more dicult in developing countries than in developed countries. Thus, the cost gap for considera- tion of GHG emissions reductions has been addressed by using public funds with more preferential terms, such as GEF funds or Japans special environmental ODA. However, as the sizes of these funds show clearly, the impact of this type of support has been limited in leveraging private investments. From the preceding discussion, it thus follows that current nancial ows for mitigation projects in the Asian developing countries are a tiny part of relatively small ocial ows. The trend toward privatisation of state- owned electric utilities means that decisions about the carbon intensity of power plants will be made on the basis of economic criteria. Given that the private sector investments in climate-related areas will shape the future of developing countries economic growth and environ- ment, such as those in the energy sector, our task is to nd ways to direct private ows to investments that contribute to both economic growth and climate change mitigation. 3.3. Barriers to climate-friendly investments in developing countries What risks and barriers are associated with climate change mitigation projects in developing countries, in addition to those of conventional projects? Table 4 shows risks and barriers from the point of view of nanciers/investors, according to project type (i.e., those associated with conventional projects (left column), climate change mitigation projects (middle column), and CDM projects (right column)). As shown in Table 4, projects in the area of climate change mitigation have additional barriers/risks on top of those associated with conventional projects in developing countries. These include risks related to technologies (performance risks of unconventional technology itself), management (risks associated with the use of unfamiliar technologies) as well as country risks related to domestic regulatory and economic aspects (regulation on invest- ment and import of climate-friendly technologies, and uncertainty over energy pricing and subsidy schemes). Furthermore, there are risks of non-conventional alter- native project itself, such as uncertain rates of return, incapability of analysing non-conventional projects, higher initial investment cost, or small project size and implicit transaction costs (GEF, 1996; EIC, 1999; APEC, 1998). In order to attract more private investments in climate-friendlier projects, it is important to create a transparent and stable market where investors have realistic expectations of future returns. To this end, developing country governments should strive for reduction of investment risks and introduction of policy measures to promote mitigation technology transfer. In parallel, new nancial mechanisms and measures to address incentives and risks of private investors will be necessary. In this connection, the CDM could oer great potential in directing the FDI to climate-friendlier Table 4 Risks associated with mitigation/CDM projects in project nance a Conventional projects Mitigation projects CDM projects Project performance (completion, operational) Increased risks due to Ratication of the Kyoto Protocol Technology Non-conventional project Rules and design of the CDM design Sponsor Non-conventional technology Insecurity of energy source Amount of CERs (baseline, leakage, eligibility) Management Cost-eectiveness (high transaction cost, adaptation fee) Force majeure (natural disasters, etc.) Uncertainties associated with the market (price, behaviour) Market (quantity, price) Delivery of CERs Country Institutional arrangement for CDM Regulatory (underdeveloped regulatory system in assets and nance) Unfavourable regulation on investment and import of climate friendly technologies Political (war, nationalisation) Energy pricing/low conventional energy price Economic (foreign exchange, currency transfer, local nancing, creditworthiness of local partner and clients) Social and institutional High initial costs Uncertain (usually low) rate of return Small project size and implicit transaction costs a Sources: adapted from Ohara (1996); APEC (1998); GEF (1996); Mundy (1999); Maruyama (1999). Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1370 investments by providing market-based incentives and internalising externalities associated with mitigation projects. 4. The potential of the CDM 4.1. Signicance of the CDM as an innovative nancial mechanism The exibility mechanisms incorporated into the Kyoto Protocol provide the prospect of GHG emission reductions (surplus to the compliance needs) being treated as a commodity with monetary value. Like environmental taxes, the Kyoto mechanisms are inno- vative nancial tools which internalise externalities. They could send price signals to the market and facilitate energy-related cost savings and cost recovery of climate-friendly investments, thereby reducing some of the barriers associated with nancing of mitigation projects. Although the details of CDM are as yet unclear, by carrying out mitigation projects in develop- ing countries the mechanism has the potential to help developed countries to meet their national emissions reduction targets cost eectively, while contributing to sustainable development in developing countries. Although the ultimate responsibility for fullling the national reductions commitments rests with each government, the Kyoto mechanisms open the door for participation by private entities. Therefore, provided that appropriate domestic mea- sures provide the private sector incentives for invest- ments (such as, the introduction of domestic emissions trading systems, early reductions rewarding schemes, voluntary reduction agreements, regulations, or tax breaks, etc.), the CDM could oer cost-eective abatement options and new business opportunities. In addition, the sale of the credits generated from the CDM projects (namely, the CERs) oers the prospect of recovering the high investment cost associated with climate-friendly investments, thereby reducing some of the barriers associated with nancing mitigation pro- jects. Besides, there could potentially be a variety of exible-nancing tools, ranging from conventional FDI or project nance to mutual funds similar to the PCF advanced by the World Bank. Furthermore, the CDM would allow each country to take region- and country- specic institutional elements into consideration, de- pending on their project-screening ability. In other words, given proper identication of potential CDM projects by developing country governments, CDM ows could provide a substantial source of income, which can bring co-benets, addressing not only GHG mitigation, but also other social development goals, such as local and regional environmental problems, rural development, poverty alleviation, and employment generation, etc. 4.2. Potential size of the CDM market Estimates of the potential of CDM market (see Table 5) are very sensitive to the rules governing the CDM and other exibility mechanisms. Assuming the contribu- tions from domestic abatement actions and hot air and dividing the remaining demand between emissions trading and JI among Annex I countries and the CDM within non-Annex I countries in proportion to the estimated potential of supply, Haites (1998) esti- mates that the size of the CDM market in 2010 ranges from 265 million tons of carbon (MtC) under the 50% reduction from business as usual (BAU) emissions scenario to 575 MtC under the no limits scenario. The size of the market estimated by the four economic modelling studies examined ranges from 397 MtC with the OECD GREEN model (Van der Mensbrugghe, 1998) to 723 MtC with the EPPA model (Ellerman and Decaux, 1998). Austin et al. (1998) argue that such estimates derived from these global modelling exercises tend to overestimate CDM ows because, in practice, political limitations and transaction costs will probably keep CDM activities at the lower end of such estimates. Based on the national communications from 35 Annex I countries and using the global model based on the marginal abatement costs of 12 regions, Zhang (2000, 2001) have estimated the contributions of three exibility mechanisms to meet the total emissions reductions required of Annex I countries under four alternative trading scenarios * No limits scenario: No caps are imposed on the use of all three exibility mechanisms so that one Annex I country can trade as much as it wished until it becomes more costly for the country to trade than to abate domestically; * The EU ceilings without the however clause scenario: At the June 1999 Sessions of the Subsidiary Bodies of the UNFCCC, the European Union (EU) has put forward a proposal for concrete ceilings on the use of exibility mechanisms (European Union, 1999). 10 The EU proposal calls for the limits on both importing countries and exporting countries. This scenario follows the EU proposal without consider- ing the however clause; * The EU ceilings with the however clause scenario: For an importing country, the above EU ceilings are relaxed to the extent that the maximum acquisitions from all three exibility mechanisms are allowed up to 50% of the dierence between projected baseline 10 See Zhang (2001) for a detailed discussion on the EU proposal for concrete ceilings. Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1371 emissions and the Kyoto targets in 2010, provided that the country can verify a similar volume of domestic abatement undertaken after 1993. On the export side, we assume that unconstrained countries (those with hot air) would be limited to exporting only the amount of hot air, which is dened by the alternative 1 under the EU proposal; and * No hot air scenario: Trading in hot air is not allowed, indicating that any eectuated trading in GHG emissions must represent real emissions reductions. From Tables 5 and 6, it can be seen that our estimates of the potential size of the CDM market in 2010 are in the range of 132358 MtC in terms of certied emission reductions, 11 and of US$ 4574513 million in value terms. With respect to the geographical distribution of the CDM ows, the Asian region has the largest potential of GHG emission reductions and hence attracting the CDM ows, with China and India accounting for about three-quarters of the total devel- oping countries CDM opportunities. It should be pointed out that the above value of the CDM market corresponds merely to the incremental carbon abatement cost from CDM projects. Therefore, if the total project investment including additional FDI that would not have occurred otherwise is taken into account, it is fair to say that the CDM would leverage even larger ows from developed to developing coun- tries than the incremental cost alone suggests (Austin et al., 1998). 5. Barriers to private sector investments in the CDM: from the perspective of risks Despite its huge potential, there are currently several obstacles to implementation of the CDM. 12 Even provided that the CDM becomes fully operational, it may be unable to deliver the perfect solution to Table 5 Estimates of the size of the CDM market in 2010 a Size of the CDM market (MtC) Total emissions reductions required of Annex I countries (MtC) Contribution of the CDM (%) EPPA 723 1312 55 Haites 265575 1000 2758 G-Cubed 495 1102 45 GREEN 397 1298 31 SGM 454 1053 43 Vrolijk 67141 669 1021 Zhang 132358 621 2158 a Sources: Zhang (2000, 2001). Table 6 The value of the CDM market and the geographical distribution in 2010 under the four trading scenarios a No limits EU ceilings without the however clause EU ceilings with the however clause No hot air CDM market (million US$) of which 2795.6 456.9 1103.4 4512.8 China 60.28% 59.63% 60.00% 60.36% India 15.08% 15.92% 15.52% 14.86% Energy Exporting Countries 6.07% 5.38% 5.69% 6.28% Dynamic Asian Economies 4.91% 4.34% 4.59% 5.09% Brazil 0.25% 0.20% 0.22% 0.26% Rest of the Developing World 13.41% 14.53% 13.98% 13.14% 11 In absolute terms, our estimates are at the low to middle end of the range of the studies examined in Table 5. This is mainly because our estimate of total emissions reductions required of Annex I countries, which is based on compilation of the national communications from 35 Annex I countries, is lower than those estimates from the economic modelling studies. As discussed in Zhang (2000), the main reason is that the ocial projections of baseline GHG emissions in 2010 by most EU member countries are very close to their targets, thus leading to low demand for emissions reductions. In percentage terms, our estimates of the contribution of the certied CDM credits are broadly in line with other estimates. Our upper bound estimate comes from the no hot air scenario. If the supply of hot air is included as other estimates from the economic modelling studies do, then our upper bound estimate comes down to 47.1% under the no limits scenario. 12 A discussion on the rules and design of the CDM goes beyond the scope of this paper. We recommend readers to consult IGES (1999), Grubb et al. (1999), and UNDP (1998). Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1372 nancing mitigation projects. Although the CDM could help to leverage relevant FDI towards climate-friendlier investments, the CERs to be generated from the CDM may be just one of the elements in a project negotiation. To illustrate this point, Table 4 summarises various risk factors from the nanciers/investors point of view. As discussed in Section 3.2.2, climate-friendlier mitigation projects have nancing barriers in terms of risks and costs. In addition to those barriers, CDM projects have their own risks and barriers. These include (see right column of Table 4): possible disadvantages over other Kyoto mechanisms arising from the design of the CDM that could aect cost-eectiveness and the amount of CERs to be generated, uncertainty over the ratication of the Kyoto Protocol; and uncertainty associated with the CDM market in terms of price and behaviour. There are also risks associated with the delivery of CERs. Institutional arrangements for the CDM by dierent host governments could be another concern. Thus, CERs could remain just one of the key factors in a project negotiation. Therefore, in ensuring project-level viability of risk management, considerable attention needs to be paid to developing appropriate publicprivate sector linkages to mobilise additional private sectors nancial sources (Mundy, 1999). 6. Publicprivate synergy in nancing climate mitigation projectsFtowards construction of ecient nancial mechanism options From the preceding discussion, it thus follows that investments in climate mitigation projects should make the best use of private ows to the extent possible, complementing them with public funds. In this regard, utilisation of the CDM, complemented by public nance, could be an ideal model to facilitate private sector investments in mitigation projects. In this regard, at least the following, interrelated issues need to be addressed in considering a better framework for overall nancial mechanism options. 6.1. Financial additionality and the use of public funds Article 12 of the Kyoto Protocol does not stipulate the so-called nancial additionalityFi.e., the nancial resources of the CDM as additional to existing ODA and GEF funds, although it does refer to additionality of emissions reductions (meaning that resulting emis- sions reductions must be additional to those that would have occurred in the absence of the CDM projects). 13 Whether projects are nancially additional could be important because nancial additionality, 14 together with environmental additionality, might determine whether projects are eligible for the CERs under the CDM. Closely related to this, a controversy exists over the use of the ODA, due to the fact that the nancial additionality was a condition attached to the AIJ, and developing countries concern about a possible shift of current ODA funds towards climate change mitigation, which is not a high priority on their current develop- ment agenda. The ODA is dierentiated from other public funding on concessional terms according to the grant element as dened by the Development Assis- tance Committee of the OECD. Without explicit denition of the term, it is unclear whether the so-called nancial additionality refers only to the ODA and GEF funds, or to the use of public funds in general to ensure that CDM funding comes entirely from private investments. As discussed earlier, the use of public funds could be essential for mitigating country risks associated with conventional projects in developing countries, let alone CDM projects. As far as CDM projects that require large investments are concerned, they are likely to involve some public sector nancing that includes the ODA for project development, project nancing, country risk insurance or other purposes. Moreover, expected high transaction costs associated with CDM projectsFi.e., those related to project identication, host government approval, project validation, baseline calculation, monitoring and verication etc.Fcould outweigh benets from CERs particularly from small- scale renewable energy projects. With its more prefer- ential terms of concessionality, the ODA could broaden the scope of possible CDM projects, improving eco- nomic viability and addressing externalities more exibly. Without appropriate privatepublic partner- ships to ensure project level risk management, there is a danger of signicant ows going into conventional projects. Therefore, at least nancial additionality should be interpreted in such a way to allow the complementary use of public nance including the ODA. On the other hand, acquiring the CERs from the use of the ODA to complement private nance in a CDM project is another issue, requiring further consideration. In this regard, the EU takes the stance that the ODA should not necessarily be excluded from CDM projects, but should not be used to acquire the CERs. The EU suggests that the part of the CERs equivalent to the portion of ODA funding in the projects could be used to reinvest in the same projects or in any case used for other development purposes (EC, 13 See Baumert (1999) for a variety of interpretations of nancial additionality. 14 The debate about additionality is further complicated by another derived concept of investment addtionality which supposedly means that only those projects which are uneconomic in the absence of CERs are eligible for the CDM. Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1373 1999). This principle seems appropriate in light of the spirit of the ODA that aims at helping the development of developing countries. However, it cannot be denied that countries like Japan, whose ODA activities historically show a strong presence in the eld of social infrastructures including energy and environment, could face diculties because of the budgetary constraints. This suggests that further careful discussions on the use of public funds including ODA would be necessary in order to reect real investment practices, while main- taining environmental integrity. 6.2. Publicprivate complementary roles in project risk mitigation Risk mitigation measures for conventional projects in the setting of project nance include contractual agreements, nancial design of the project, and insur- ance and guarantees provided both by the private and public nancial institutions (see left column of Table 7). In considering possible future supporting measures to address risks specic to investments in mitigation projects or those of the CDM, it would be eective to examine and categorise various types of risks. We distinguish those best covered by multilateral/regional banks by reinforcing existing risk coverage measures, those best addressed by development of new nancial products developed by the private nancial institutions, or those to be covered by government guarantees or bilateral export credits. Table 7 summarises possible risk coverage measures for mitigation/CDM projects. 6.3. Privatepublic complementary roles: other considerations In considering the use of public fund to complement private investment in mitigation project, attention needs to be paid to using public funds to address the issues that private investment could not address via the CDM. These issues include the transfer of technology, the creation of an enabling investment environment, the regional balance of future CDM project, and technical innovation. 6.3.1. Technology transfer entailing high transaction cost In order to introduce private funds and technologies, domestic policy measures to provide the private sector incentives and nancial mechanisms for technology Table 7 Risk mitigation measures for mitigation/CDM projects Conventional projects Mitigation projects CDM projects Contract GEF grant Cost recovery through CER Completion ODA Reduction of transaction costs through CDM design Turnkey rump-sum EPC Other bilateral/multilateral programmes Withholding osets as buer and insurance to address CERs delivery risk Price CDM Capacity payment and energy payment GEF non-grant nancing a Price hedge (forward sale, portfolio) Long-term purchase Contingent grants/performance grants Reinforcement of risk coverage measures by MDBs Take or pay/take and pay contract Contingent or concessional loan Mutual Fund Performance and operational Partial risk or credit guarantees Reinsurance Warranties, etc. Reserve fund, etc. Financial design Cash ow control, reserve fund, deferred payment, oshore escrow account, cash deciency support, oor price escalation, etc. Insurance Property, business Interruption, liability, etc. Country risk mitigation Co-nancing, guarantees, insurance by export credit agencies, governmental institutions, MDBs(e.g., WB, MIGA, IFC, ADB) Host government guarantees Domestic policy and measures to reduce barriers/risks in developing countries a GEF non-grant nancing is a new scheme currently being examined at GEF (EIC, 1999). Sources: adapted from Ohara (1996); APEC (1998); GEF (1996); Mundy (1999), Maruyama (1999). Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1374 transfer should match the kind of technologies to be transferred and corporate investment behaviour. For example, Forsyth (1999) categorises technology transfers into vertical (point-to-point relocation of technology by foreign investors) or horizontal (sharing technology with local producers) according to owner- ship of a technology, and further classies by presence or absence of competition between domestic and international producers (see Table 8). He argues that the state of art technologies that fall into Category 2 are likely to attract most investment and their transfer may be accelerated if the CDM is used to encourage this type of investment, even though the ownership of the technology remains in the foreign investors hands. 15 On the other hand, the technology transfer currently discussed in the climate change negotiations, which represents horizontal transfer of Category 4, is unlikely to attract much investment, because of extra costs required in sharing technologies and setting up joint ventures and transfer of intellectual property rights. In this category, therefore, public funds might nd the best scope for value-added. Public funds including nancial assistance by the GEF or the ODA could be used to cover the high transaction costs associated with this type of technology transfer. They can also be used to diuse the state of the art technologies already transferred (vertically) by the CDM to local industry. In current practice, there seem to be broadly two ways of providing grants to support technology transfer: one is providing funds to construct demonstration facilities; the other is to cover the license feeFthough the latter is a very rare case (there is an example in the GEF OP#5: China industrial boiler project where it covered license fee to obtain energy ecient industry boilers from developed countries). However, companies usually prefer demonstration facilities as a reference case to enter into a new market, thus putting them at an advantageous position in international competitive bidding (Evance, 1999b). Therefore, technology trans- fers that require setting up a joint venture, license for sharing technologies or a process of training would be dicult and costly for private companies, without nancial support from public sources. Thus, it is necessary to take the types of technologies to be transferred and investment behaviour into account in examining nancial mechanisms and policies to provide incentives for the private sector. 6.3.2. Creation of an enabling environment for private sector investments Creating an enabling environment for private sector investments is also an area where public funds show clear advantage over private ows. Eorts in this area may include helping to establish regulatory and institu- tional capacity of developing countries to regulate, identify, assess, validate and implement CDM projects as well as to foster education and relevant information dissemination. Funding feasibility studies for the identi- cation of potential CDM projects, similar to the approach taken by the Japanese government, or maintenance of a projects surrounding environment, would be another eective means to facilitate private sector investments (Maruyama, 1999). 6.3.3. Regional balance By the time (30 June 1998) of the UNFCCCs second synthesis report on the AIJ, 95 projects were listed as AIJ projects (UNFCCC, 1998). These projects are located in 24 host countries, with Africa hosting only one certied AIJ project. AIJ experiences (Dixon, 1999) suggest the possibility of an inequitable distribution of future CDM projects. This would be a serious problem for regions such as Africa that are already facing diculties in attracting private ows, by virtue of the fact that they are less industrially developed and have fewer emissions reductions potential. Projects in regions with poor infrastructure for private investment are accompanied by higher risks, and are dicult to attract private partners for GHG reduction business opportu- nities. Thus, it is important for such regions to put in Table 8 Dierent investment niches for technology transfer a Expertise and economic base in technology exist locally Expertise and economic base in technology do not exist locally Vertical technology transfer (ownership remains with investor) 1: associated with high competition and low prot margins 2: most attractive to new foreign investor Horizontal technology transfer (ownership is shared with local producers) 3: least attractive to new foreign investor 4: associated with high transaction costs and potential loss of competitiveness a Source: Forsyth (1999). 15 In this case, although host countries could not share technologies, encouraging this type of investment is still in the interest of host countries because it generates benets, such as employment opportu- nities, job training and accumulation of knowledge. However there is a need for domestic/international measures so that the CDM could not damage competing industries in developing countries by rewarding the growth in market shares (Forsyth,1999). Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1375 place as soon as possible national mechanisms to identify, monitor, verify, and certify investments in emissions reductions. In order to foster their participa- tion in the CDM, it is also helpful that CDM projects in the least developed countries (LDCs) should be exempt from the share of proceeds for adaptation, and that smaller LDCs could bundle together their smaller projects to attract nance. Moreover, public funds could be used to cope with regional imbalances, for instance, by creating a fund dedicated to implementa- tion of GHG reduction projects in a particular region. 6.3.4. Technological innovation Another area where public nance has a comparative advantage is support for RaD of GHG reduction technologies in developed countries and implementation of demonstration projects. Support in this area would not only promote innovation of GHG reduction technologies needed to make more stringent future emissions targets aordable, but also contribute indir- ectly to future technology transfer of these technologies via the CDM. 7. Conclusion It has been recognised that the role of current nancial mechanism options for climate mitigation projects in developing countries is limited in addressing risks and externalities of required climate-friendly technology transfers to developing countries and aect- ing these countries future GHG emissions. Given the huge potential of climate-related private ows to developing countries, this promotes the necessity of shifting the focus of current climate-related nancial mechanisms from technology transfer and nancing from the public sector to mobilising resources from the private sector in order to achieve the UNFCCCs ultimate objective of stabilising GHG concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system. In this regard, the CDM as an innovative nancial mechanism would oer great potential in helping direct FDI in relevant sectors towards climate mitigation, by providing commercial incentives for the private sector to invest in climate mitigation projects and thereby facilitating internalisation of externality of climate- friendlier investment. However, due to additional risks and barriers involved in CDM projects, appropriate publicprivate linkage would be necessary in order to bring the CDM into full play. To this end, public funds could be used to complement private investment via the CDM by establishing regulatory and institutional capacity of host developing countries, removing barriers to CDM investors, reducing implementation costs and reducing long-term technology costs associated with the CDM projects, thus enhancing market functions of such an investment. In so doing, relevant parties should examine a host of factors, such as private sector investment behaviour, risk sharing, types of technolo- gies to be transferred to developing countries, and other areas where the private sector is dicult to address. Past experience shows that the involvement of public funds is often confronted with the dangers of bureau- cracy and abuse of power in a lengthy process of project identication and approval for funding. Whether the limited public funds for addressing the climate change problem can avoid the dangers needs to be tested. Besides, careful consideration should be given to such issues as the relationship between the public nancial supporting measures and the OECD investment rules 16 and the rules of the World Trade Organisation. From a long-term perspective, climate concerns could be in- corporated as one of the important factors in formulat- ing industrialised countries aid strategies. At the same time, it is perhaps more important for developing country governments to strive for eliminating invest- ment risks and introducing policy measures aimed to promote climate-friendlier technology transfer and energy sector reforms. Finally, it should be pointed out that, at the time of this paper going to the press, the ratication of the Kyoto Protocol faces considerable uncertainty, due largely to the recent political development in the United States where Bush administration in April 2001 expressed that it will not support the Kyoto Protocol. Although the analysis of the complex political situations is beyond the scope of the paper, some experts argue that as long as the climate change problem is real, CDM-like mechanisms for technology/funds transfer to developing countries could be realised, even without the Kyoto Protocol, for instance, under the UNFCCC itself, or through other channels. The Dutch governments recent announcement on the closure of the rst ve JI contracts under the ERUPT scheme 17 can be regarded as an example of such a view. Currently, there are also 16 In particular, the Helsinki package agreed by the OECD countries in 1991 which bans the use of aid and tied export credit together in nancing projects in developing countries, with the exception of commercially non-viable projects. 17 On 17 April 2001, the Dutch Minister of Economic Aairs, Mrs. Jorritsma, signed the rst contracts relating to joint implementation. With these contracts, the Netherlands buys reductions in emissions of greenhouse gases realised by investing in Central and Eastern Europe. The purchases involve a sum of NLG 79 million (EUR 35.3 million), including the procurement of more than 4 million tons of reductions in CO 2 emissions in 5 years. These reductions will take place at the following sites: a 60 Megawatt wind-power park in Poland; a hydro- power plant in Romania; a series of biomass-fuelled boilers in the Czech Republic; and two urban heating projects in Romania (see The Hague-based Senter Internationals press release on 17 April 2001, Jorritsma buys Kyoto reductions in Central and Eastern Europe). Z. Zhang, A. Maruyama / Energy Policy 29 (2001) 13631378 1376 active discussions on the possible ratication scenario without the US. 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