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Energy Policy 29 (2001) 13631378

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. In this regard, the resumed sixth
Conference of the Parties to the UNFCCC in July 2001
is considered to be of a paramount importance for
seeking to put the CDM in operation as well as for the
Kyoto process itself.
Acknowledgements
This paper was presented at the International Work-
shop on Enhancing GHG Mitigation through Interna-
tional Cooperative Mechanisms in Asia, Kanagawa,
Japan, 2627 January 2000. The authors would like to
thank participants in the above workshop and an
anonymous referee for useful discussions and comments
on an earlier version of the paper. The views expressed
here are those of the authors, and do not necessarily
reect the positions of the organisation with which the
authors are aliated.
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