FORES Study 2012:8

Market mechanisms
- from CDM towards a global carbon market

Ulrika Raab  
 

FOREWORD............................................................................. vii EXECUTIVE SUMMARY ..........................................................xi 1. INTRODUCTION ................................................................... 1 2. WHAT ARE FLEXIBLE MECHANISMS? ............................ 7 3. THE CDM - OPERATION AND EXPERIENCES SO FAR 15 4. WHAT ARE FLEXIBLE MECHANISMS EXPECTED TO DELIVER? ..................................................................................29 5. THE FUTURE OF THE CDM .......................................... 41

6. POSSIBLE FUTURE FLEXIBLE MECHANISMS ............ 47 7.THE FUTURE LANDSCAPE ................................................ 71 8. CONCLUSIONS ................................................................... 81 COMMENT ...............................................................................87 REFERENCES ........................................................................... 93

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About the study
The establishment of the Clean Development Mechanism has been one of the successes of the Kyoto Protocol. It has helped to build experience, capacity and comfort with the use of market mechanisms to reduce emissions. This will be useful when implementing future market mechanisms. This study looks into the principles behind the flexible mechanisms of the Kyoto Protocol with a focus on the CDM, but also towards the future of flexible mechanisms. It concludes that flexible mechanisms will continue to play a role in a post-2012 climate change regime. The CDM will be more directed towards the less developed countries, can play a role as a channel for mitigation finance and CDM-credits may provide a receipt for mitigation action. New and scaled-up mechanisms will require stronger governance arrangements on the host country level. A lesser degree of detailed control than in the current CDM has to be accepted. Finally, it is fundamental to remember that flexible mechanisms themselves do not lower emissions. First there needs to be a commitment either to reduce emissions or to provide finance for reducing emissions.

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About the Author
Ulrika Raab is Senior Advisor for Climate Change Policy at the Swedish Energy Agency. Educated at the Royal Institute of Technology in Stockholm, she holds a MSc degree in Chemical Engineering with a major in Environmental Engineering. She has been involved in climate change policy development on national and international level since 1998 and as a negotiator for Sweden since 2001. She has been a member of the CDM Executive Board and was the chair of the CDM EB Small Scale Working Group 2007-2008. Currently she is working for the Swedish governmental CDM and JI purchase programme. Ulrika Raab has written this report for FORES in her personal capacity while on leave from her regular employment. The ideas expressed in this report are those of the author and do not necessarily represent the views of the Swedish government. The Author would like to express her thanks to FORES for making the writing of this report possible and to the friends and colleagues who have shared their knowledge and helped improve it.

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About FORES FORES—Forum for Reforms, Entrepreneurship and Sustainability—is a think tank that seeks to renew the debate in Sweden with a belief in entrepreneurship and opportunities for people to shape their own lives. Environment and the market economy, migration, entrepreneurship and civil society, integrity, gender equality, global democratisation and modernisation of welfare—these are some of the issues on which we focus. FORES is an open and independent forum for civil society, academics and policy makers throughout Sweden and Europe. Together with people in Sweden and abroad, we will find solutions to better meet the challenges that globalisation and climate change brings. We function as a link between the civil society, entrepreneurs, policymakers and academia. FORES produces research papers and books, and organises seminars and debates. Visit our webpage www.fores.se

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FOREWORD
A useful plan for the market mechanisms
A crucial m om ent has now com e for the international market mechanisms whereby it is possible for an emitter in one nation to credit climate emission reductions in another. The idea behind the CDM and the other UN-sponsored “flexible mechanisms” is as simple as it is elegant; since emissions of carbon emissions affect the climate equally irrespective of the point of emission, those with high costs for emissions cuts can sponsor cuts where it is less costly. Businesses and governments in developed countries have been paying for reductions in developing countries and emerging markets and offsetting them against their own emissions. But the system has been under heavy criticism and being accused of being used by developed countries as a letter of indulgence and not leading to real emissions reductions. In addition, the CDM was created under the Kyoto Protocol, a treaty whose first commitment period will soon expire. Meanwhile, during the economic crisis developed nations have been able to reach their unambitious emission targets almost effortlessly, so that no recourse has been necessary to purchasing emission reductions elsewhere.

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Therefore a big debate is currently taking place among experts and in the UN negotiations about what will come next. How to improve the CDM and make it relevant also after the first commitment period of the Kyoto Protocol, and what other flexible mechanism should be introduced are two equally important issues to address. The CDM is entering a new phase, where its focus is likely to shift away from emerging economies such as China, India and Brazil, to the least developed countries in sub-Saharan Africa. Should a new market mechanisms include more emission sources and possibly be based on whole economic sectors rather than individual projects? Where is the boundary between CDM and regular emission markets such as the EU has, and China is planning to introduce? Despite the momentous importance for climate change action, and despite vocal criticism by NGO’s against many aspects of the CDM, this debate has long been narrowly confined to experts, negotiators and lobbyists. There have been few plans by independent experts or researchers to set out basic ideas of how this system could be best designed and improved. FORES asked Sweden’s leading expert Ulrika Raab to put her ideas into print. Ulrika Raab has been working with the flexible mechanisms for 15 years, as a field expert, negotiator and member of the CDM executive board. Ulrika’s paper is a remarkable blueprint, accessible to experts and policymakers alike, with a long list of practical and relevant principles and proposals. It shows that the CDM is no panacea, rich countries cannot magically avoid emission cuts by reducing emissions in poorer countries, but flexible mechanisms remain a very useful

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additional track to help developing countries reduce emissions. FORES is grateful to Ulrika for taking the time to write this long-awaited paper. We also wish to thank the Swedish Energy Agency, Energimyndigheten, for allowing for Ulrika to take time off for the project. In addition, we would like to thank a number of people who assisted FORES during the process of this report. We would like to thank the members of FORES experts group on emissions trading for taking part in a work shop where an initial draft of this paper was presented. In particular, thank you to Johannes Stripple from Lunds University, Martina Bosi at the World Bank and Olle Björk for reading and commenting on earlier drafts. Olle has also provided a written comment that can be found at the end of this publication. A special thanks also to professor Michael Grubb, Climate Strategies and University of Cambridge, for his intellectual support and introduction to Ulrika Raab’s work. Martin Ådahl, director FORES

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EXECUTIVE SUMMARY
Key findings:
• Flexible mechanisms themselves do not lower emissions. First there needs to be a commitment either to reduce emissions or to provide finance for reducing emissions. The clean development mechanism, CDM, will continue to be important in a post-2012 climate change regime but its role will change. The CDM is already moving in the direction of less developed countries and from large projects to smaller projects and programmes. It can also play a role as a channel for mitigation finance and CDM-credits may provide a receipt for mitigation action. The post-2012 climate change regime will consist of several different flexible mechanisms. For the governance of new mechanisms it seems rational to draw upon the experience from the flexible mechanisms of today and the systems for accreditation etc. already established. Host country governments will play a stronger role in governing new mechanisms and will have to provide incentives for private sector participation in new mechanisms. These incentive structures are to-day largely unexplored. If flexible mechanisms are to be scaled up from project level to a sectoral level or to incorporate larger parts of

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the economy, a lesser degree of detailed control than in the current CDM has to be accepted. A mechanism with many purposes to fulfil is not likely to deliver equally well on all of them and a market mechanisms is likely to deliver optimally on parameters that are monetized. Therefore, it would be wise to focus the mechanism’s objective on one aspect, rather than trying to create multi-purpose tools. The challenging exercise of setting baselines in a sectoral crediting system will be useful in later discussions on caps. Standardised baselines can be seen as a bridge between single projects and more comprehensive, sectoral approaches, eventually leading on to economy-wide caps. It is, however, difficult to anticipate a linear evolution beginning with project-based mechanisms, moving on to sector based mechanisms, finally leading up to economy-wide cap and trade. Perhaps it will be more efficient not to go through all these stages but rather go straight from project-based mechanisms to cap and trade.

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A new landscape for flexible mechanisms
For the atmosphere it does not matter where emission reductions are made. Different types of flexible mechanisms provide the possibility of undertaking emission reductions at a lower costs as well as providing flexibility across time and place. Flexible mechanisms are therefore important tools in the struggle to reduce global greenhouse gas emissions. The flexible mechanisms, in particular the Clean Development Mechanism (CDM), were vital in creating the necessary conditions for the agreement of the Kyoto Protocol. Since 2005 the Clean Development Mechanism has helped to reduce global emissions by more than 1 billion tonnes of carbon dioxide equivalents through more than 4600 projects, and has in total generated more than $150 billion of private investments in emission reducing projects. Before the end of 2012, another billion CDM credits are expected. However, the landscape for flexible mechanisms is changing. There will be a different landscape between 2012 and 2020 most likely governed by the rule agreed under a second commitment period of the Kyoto Protocol, for those who have ratified it. Subsequently, the post-2020 climate change regime will consist of a spectrum of commitments and means of implementation. Countries with emission caps under the Kyoto Protocol will also have caps in a post-2020 regime. However, to curb global emissions, it will be necessary to encompass all countries and all sources (and sinks) in one way or another. In this new landscape there is need for a

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development of the existing mechanisms, such as the CDM, as well as of different types of new market mechanisms. This report aims to highlight the potential role of flexible mechanisms in combating climate change. The ambition is also to pose relevant questions and to stimulate debate on what we want from future mechanism and how to best design them to fulfil the set targets. Based on the past experience of the CDM development and operation, the report identifies and discusses new principles that can be incorporated into any, current or new, market-based instruments. The report also points to the need to strike a balance between detailed control and the flexibility to incorporate larger parts of the economy or sectors. Before discussing the different mechanisms, it is vital to understand that flexible mechanisms themselves do not lower emissions. First there needs to be a commitment either to reduce emissions or to provide finance for reducing emissions.

The future of the CDM
It is likely that the CDM will continue to evolve and that the mechanism will play a different role in a future climate change regime. The CDM is already moving in the direction of less developed countries and from large projects to smaller dispersed projects and programmes. Some of the possible developments of the CDM could include:

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Programme of Activities Lately there has been a transition from the traditional projectby-project-based CDM to more comprehensive approaches. Programme of Activities, PoA, allow for an unlimited number of CDM programme activities over a wide area to be run under one single administrative umbrella. PoA increases the attractiveness of a range of smaller, more dispersed, CDMprojects, such as installing cook stoves, solar water heaters and other small-size renewable energy generating systems. These are projects particularly suitable for Least Developed Countries, where the CDM will continue to play an important role after 2012. Standardised baselines As a result of the many projects developed during the first years of the CDM a need for greater standardisation of baselines has emerged both for calculating emission reductions and for assessing additionality. The development of standardised baseline, also within the CDM, could be a stepping stone from project based mechanisms towards more comprehensive approaches, including new market mechanisms. A receipt for finance Finance is likely to take a more dominant part in a future climate change regime, not least in the light of the establishment of the Green Climate Fund and developed countries’ commitment to provide $100 billion annually by 2020 to support developing countries’ climate efforts.

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Certified emission reductions, CERs, from a CDM project are not per se offsets. It is the use of these CERs that determines whether or not a CDM project is offsetting, not the mechanism itself. If the CER is retired or not used, it is effectively mitigation in developing countries. A CER can then be seen as a “receipt” for an emissions reduction that has taken place and the financial contribution through the CDM as payment for performance.

Possible future flexible mechanisms
The post-2020 climate change regime will most likely consist of a spectrum of commitments and means of implementation and there have been several proposals outlining a wide range of new mechanisms. The different proposals are being discussed under different agenda items in the UN negotiations, but they do resemble one another to the extent that they are attempts to take a broader grasp on mitigation, possibly through the use of markets. A key difference appears to be the degree of international (UN) oversight foreseen. Examples of potential flexible mechanisms are the NAMA (Nationally Appropriate Mitigation Action) of developing countries under the Climate Convention, which may prove to be a flexible mechanism if the NAMAs, for example, result in credits sold to fund emissions mitigation. Another mechanism that could play a role in a post2012 -regime is REDD+, where developing countries could receive credits for reducing emissions from deforestation and forest degradation.

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Another interesting proposal is a Japanese idea for a bilateral offsetting crediting mechanism (BOCM). The idea behind such a mechanism is to transfer and disseminate low carbon technologies through bilateral agreements. Eligibility is determined in terms of emissions reduced by accelerating deployment of low carbon technologies, products and services. A Joint Committee formed by the two countries involved sets the rules and guidelines, and companies implement the projects. The BOCM may be described as a “streamlined and simplified CDM”, since it moves away from difficult concepts of additionality and reduces monitoring costs by using benchmarks for different technologies. New market mechanisms In Durban in December 2011 parties decided to initiate a work programme to elaborate modalities and procedures for a new market mechanism. During 2012, countries have submitted proposals on what form the new market mechanism should have and how it should operate, and discussions are still in progress. At this stage it seems reasonable to believe that a new market mechanism will, to a certain extent, contain elements recognizable from existing mechanisms. According to the guidelines from the COP-16 decision, a new market mechanism should stimulate mitigation action across broad segments of the economy. The mechanism should safeguard environmental integrity and ensure a net decrease/avoidance of greenhouse gas emissions. In this context, it is important to note that a mechanism with many objectives to fulfil is not likely to deliver equally well on all of

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them, and that a market mechanism is likely to deliver optimally on parameters that are monetized. Therefore, it would be wise to focus the mechanism’s objective on one aspect, rather than trying to create a multi-purpose tool. The discussion on the new markets mechanisms uncovers aspects worth exploring further, and that are discussed below. Sectoral trading and crediting One can distinguish at least two types of market based approaches covering broad segments of the economy sectoral trading and sectoral crediting. In a sectoral trading system, emissions allowances are issued in accordance with a defined absolute emission target for the included segments. If emissions are lower than the issued allowance, excess allowances can be sold. If emissions exceed the issued allowances, additional allowances need to be purchased to comply with the target agreed for the broad segment. In a sectoral crediting system existing emissions in a sector are checked against a baseline set in advance. If emissions fall below this baseline, emissions credits are issued which can be sold to at least partly cover the costs of mitigation activities. If emissions do not fall below the baseline, no penalty is applied (a so called no-lose target). A sectoral crediting mechanism gives the opportunity to cover different target areas. Experiences with existing market-based

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instruments have shown that agreeing on workable definitions of sectors and boundaries is challenging. So far, there is no agreement on what is meant by “broad segments of the economy”, but some important considerations for the selection of target areas could be; mitigation potential and costs; sectors with high share of emissions; capital intensive new term investments; data availability, monitoring, financial incentives to stimulate net reductions; and responsiveness to price signals. Baseline setting One of the greater challenges when establishing a crediting mechanism is to decide on a crediting threshold, as a sector’s future emissions are difficult to predict, since they relate to economic growth, fuel prices, technological innovation and more. Hence, there is a risk that the crediting threshold will be set too high or too low. With a very ambitious threshold, the financial incentive for the host country to engage in reduction decreases. If the threshold is not ambitious enough, credits can be awarded for very little action. It may, at the same time, lead to an oversupply of credits, low prices and low financial revenues for host countries. Another challenge for baseline setting is how to account for existing as well as new policies and measures. An inclusion of policies and measures that favours the reduction of emissions into the baseline provides a misguided incentive for the host country to hold off on measures so as not to lose out on crediting. Baselines can either be established at an absolute level or indexed to one or several parameters (physical metrics of

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sector like per kWh or economical metrics like GDP). A further option is to use a technology penetration baseline. A potential solution to the problem of how to set the crediting threshold could be to give certain financial/technical support at a level below where crediting starts. Although desirable, it is difficult to see the principles for the ambition agreed at an international level. The experiences from setting baselines, sectoral no-lose targets and sectoral crediting will most likely prove useful in future discussions on economy-wide caps. Standardised baselines can be seen as bridge between single projects and more comprehensive, sectoral approaches, eventually leading on to economy-wide caps. It is however difficult to anticipate a linear evolution beginning by project-based mechanisms, moving on to sector-based mechanisms, finally leading up to economy-wide cap and trade. Governance in a future landscape Compared with the flexible mechanisms of the Kyoto Protocol, new market-based mechanisms will require much stronger governance arrangements on the host country level. The governance structure of new market mechanisms will need to strike a balance between the sovereignty of the participating governments and the outside control needed to build trust. The detailed control possible in the CDM will not be possible in scaled-up mechanisms such as sectoral crediting. The current debate focusing on governance systems, at least the one at UN level, seems unaware of the crucial question of

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how to create incentives for participation by those who are to implement the mitigation action. Private sector entities under reduction obligations will likely be facing a number of different systems under different rules. The incentive for the actual emission reduction needs to be created at host country level. For this to emerge, the incentive structure on this level needs to be carefully tailored. In a sectoral agreement the action to reduce emissions has to be taken at individual installation level, but the issuance of credits depends on the performance of the sector as a whole. One way of directly involving sector entities in the carbon market would be to combine a national emissions trading scheme with a sectoral agreement. The role of governments also becomes increasingly more important with more comprehensive (or sectoral) mechanisms. This is not only true for the supply side but also for the demand side. Companies under an emission cap are unlikely to enter into negotiations with the government of another country to buy credits from a sectoral crediting scheme. Intermediate levels are therefore necessary. There are a number of examples of regional trading systems linking, either through direct linking or through the use of the same type of offsets. This is likely to continue and in some cases also create demand for credits. For example, the EU ETS has been the prime source of demand for certified emission reductions from CDM.

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Emission trading systems and crediting mechanisms are currently being implemented and planned both at international and national level. Some, but not all, are part of the UNFCCC framework. This diversity of mechanisms could lead to a variety of unit types using different standards and under different forms of governance. Such fragmentation in the carbon market is less than optimal. As the future could bring various approaches and mechanisms, a common framework at UN level seems desirable. Within the UN there is considerable experience in developing methodologies and system for verification and reporting and institutions have been established to govern and to accredit. There could be a common accounting system to avoid double counting and to ensure the environmental quality of units created. The basics are already in place within the UNFCCC and the Kyoto Protocol. However, not all new mechanisms need to be governed through the UNFCCC.

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1. INTRODUCTION
For the atm osphere it does not m atter where emission reductions are made (i.e., the impact is the same whether the reductions take place in Stockholm or in Tokyo, or in Johannesburg), but it is vital that they are made. However, the costs of reducing emissions can vary significantly between companies, sectors, regions and countries. Therefore, the use of flexible mechanisms, which provides flexibility where mitigation is taking place, as well as facilitating more cost efficient reductions, is of great interest to anyone interested in mitigating climate change. Climate change is a global problem that can only be solved through international co-operation. The ultimate objective of the UN Framework Convention on Climate Change (UNFCCC) is “stabilization of the concentrations of greenhouse gas in the atmosphere at a level that will prevent dangerous anthropogenic interference with the climate system”. The Kyoto Protocol, adopted under the Convention in 1997, has been acknowledged as an important first step to meet this objective. One of the results from the Kyoto Protocol was the establishment of flexible mechanisms, of which the Clean Development Mechanism (CDM) is the perhaps most well-known. The modalities and procedures of the mechanisms were adopted in Marrakech in 2001.

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The flexible mechanisms were decisive components that assisted in the conclusion of the Protocol as well as in encouraging nations to ratify the Kyoto Protocol. The Kyoto Protocol entered into force in 2005, after Russia had ratified the agreement. It has now been ratified by 191 governments. The USA initially signed the protocol but has not ratified it, whilst Canada withdrew in December 2011.1 The first commitment period of the Kyoto Protocol started in 2008 and ends in 2012, and there is a general understanding that in the near future deeper reductions are necessary. Currently, negotiations on a second commitment period are taking place at UN level. Simultaneously, there are on going negotiations on a more comprehensive global climate change regime that will commence in 2020 and must include further far-reaching mitigation action from a broader set of countries. As negotiations on a future, more comprehensive and farreaching climate change agreement progresses, it is apparent that flexible mechanisms will have a role to play in a new climate regime as well. Hence, discussions on the design on new flexible mechanisms are intensifying. The future landscape of flexible mechanisms to operate in will be radically different from the one in which the current mechanisms were established. The Kyoto Protocol is a topdown approach under which a number of industrialised countries have taken quantified emission reduction obligations, whereas the agreement at the UN climate meeting
For more information on the Kyoto Protocol, visit the UNFCCC website www.unfccc.int
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in Durban in December 2011 opens up the possibility of developing a system of bottom-up pledges taken by industrialised, emerging and developing countries. This report is about international flexible mechanisms and the role they can play in combating climate change. In Durban, countries agreed upon establishing a new market based mechanism. However, the details are still unknown and will have to be decided over the coming years. Some of the current proposals are presented in this report. The intention is not to give a full description of the current situation or complete answers about what the future will bring, but rather to pose relevant questions and to stimulate debate and discussion. Based on the learning from the development and operation of the project-based Clean Development Mechanism, the report identifies and discusses principles that can be incorporated in any, current or new, market-based instruments with a potentially larger scope, such as sector based mechanisms. In this regard, the report also discusses the need to strike a balance between detailed control and the flexibility to incorporate larger parts of the economy or sectors. The report is divided into two parts; the first (chapter 2-3) begins with a short description of what flexible mechanisms are, the rationale behind them and a description of the flexible mechanisms of the Kyoto Protocol. A full chapter (chapter 3) is devoted to the most well-known of the flexible mechanisms, the Clean Development Mechanism, and its achievements so far. The aim of the chapter is to utilise the experience gained from CDM when considering future mechanisms. Fuller,

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comprehensive, insights from the CDM can be found in the literature2. This first part serves as a background and is primarily directed towards those readers who feel they need the basics of flexible mechanisms. Those readers who are familiar with the Kyoto Protocol and its flexible mechanisms can skip this part of the report and instead turn to the second part (begins at page 29). The second part of the report focuses on the future of flexible mechanisms. After a chapter on what the flexible mechanisms, old and new, are expected to deliver in a future climate change regime, it continues with a chapter on the future of the CDM. In chapter 6 different proposals for new mechanisms, in particular the sectoral crediting mechanism (also known as sectoral no-lose target) are described and discussed. It also includes a brief design comparison. The report concludes with a chapter on the future context of market-based mechanisms and some conclusions on ways forward.

2 See for example the World Bank publication “10 Years of Experience in Carbon Finance: Insights from working with the Kyoto Mechanisms,” published May 2010, or the research reports produced for the High-Level Panel on the CDM Policy Dialogue, 2012

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PART 1
- The Background

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2. WHAT ARE FLEXIBLE MECHANISMS?
Flexible m echanism s as tools in combating climate change were first introduced in the early 1990s. The flexible mechanisms of the Kyoto Protocol, in particular the CDM, are the most well-known. They can be seen as policy instruments for international co-operation in the climate change that provide the possibility of undertaking emission reductions at a lower cost as well as providing flexibility across time and place. The availability of mechanisms may increase willingness to take on deeper, more ambitious commitments, even if domestic low cost options have already been exhausted. They can also give other benefits that extend beyond climate change, such as contributing to sustainable development. International mechanisms contrast with domestic mechanisms such as the EU ETS that deal with reducing emissions within a country or region based upon domestic legislation. Furthermore, flexible mechanisms can assist countries in changing their development track towards a society with lower greenhouse gas emissions and give insights into the matter of climate change mitigation and the challenges and possibilities it offers. Flexible mechanisms may also protect the global competitiveness of nations and companies, and stimulate technical innovation. A concrete benefit of using flexible mechanisms is to accelerate the earlier replacement of less

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efficient technologies and to avoid lock-ins. In addition, flexible mechanisms, or levies on them, can be a source of revenue used for climate finance. One crucial point to bear in mind when reading this report is that flexible mechanisms themselves do not lower emissions. An emission reduction commitment has to be the starting point after which flexible mechanisms, within a framework, can utilize the market to facilitate that the reductions are carried out in a cost efficient way. A crediting mechanism only provides an incentive to reduce emissions if there is a reasonable global carbon price and can only be assured if demand is larger than the supply of credits and allowances in the market.

International greenhouse gas markets
The establishment of an international greenhouse gas market, putting a price on greenhouse gas emissions across the globe, is one of the most important achievements of the Kyoto Protocol. Through its flexible mechanisms, it provides a price signal in all countries, including those where greenhouse gas emissions are not capped. However, the continued development of the greenhouse gas market is uncertain due to concerns over the long-term climate framework post 2012. It is important to bear in mind that a greenhouse gas market is a regulations-based market; supply and demand have been created by political decisions setting up a framework, a welldefined emissions cap and subsequent regulations. To achieve

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a long-term stability of the market, participants need to recognise that there is a clear political commitment. Governments bear the responsibility for creating confidence in greenhouse gas markets, by setting rules that are perceived to be of long-term nature and stable, and by providing business with confidence to plan ahead and take actions. There should also be provisions for review, in order to take into account learning whilst ensuring that those that have taken actions are not disadvantaged. Market information has to be transparent for the formation of a well-functioning market and an effective price signal. High liquidity and a sufficiently large number of players in the greenhouse gas market are needed if the market is to perform efficiently and generate cost efficient reductions.

The flexible mechanisms of the Kyoto Protocol
Three flexible mechanisms were introduced in the Kyoto Protocol – International Emissions Trading (IET) in allocated emission allowance units (AAUs) between countries with emission caps, and the two project-based mechanisms, JI (Joint Implementation) and the CDM (Clean Development Mechanism). The common feature of these three mechanisms is that they enable a country with emission limitation commitments to be credited for reduction measures that have been taken in other countries; the flexible mechanisms of the

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Kyoto Protocol can be used for offsetting3 the emissions in countries with emission limitation commitments. CDM - Clean Development Mechanism4 The Clean Development Mechanism (CDM, Article 12 of the Kyoto Protocol) provides the possibility for countries with emission limitation commitments under the Kyoto Protocol to gain credits for emission reductions by investing in project activities in countries without such commitments5. The emission reductions are calculated in relation to a baseline and must be additional, i.e. have to exceed those that would have taken place without the project. Countries can authorize companies to participate in the CDM, and CDM projects can therefore be implemented both by countries and by companies. The CDM has two equally important purposes: to contribute to emissions reductions beyond those that would have otherwise occurred and that can be used by developed countries to meet a part of their commitments, and to contribute to sustainable development in host countries. For the latter, the host country has to approve the project and issue a Letter of Approval that certifies that the project contributes to sustainable development. This is required in order for the project to be registered as a CDM project by the CDM Executive Board. The

3 For a general discussion on offsetting see chapter 4 4 A more thorough discussion on the CDM follows in chapter 3 5 The Kyoto Protocol divides countries into two groups roughly in the same way that the UNFCCC did. Throughout this report the terminology developed and developing countries is used for sake of simplicity.

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additionality – the project resulting in emission reductions that are real and go beyond what would otherwise have occurred – is controlled by detailed procedures and a system set up at UN level. Through the CDM, emission-reduction projects in developing countries can earn certified emission reduction (CER) credits, each equivalent to one tonne of CO2. They are issued ex-post (afterwards) and hence the CDM contributes to the economy of the project primarily once it becomes operational. The CERs can be traded, and used by developed countries to meet a part of their emission limitation commitments under the Kyoto Protocol. The CDM is also the main source of income for the UNFCCC Adaptation Fund, which is financed by a 2% levy on CERs issued by the CDM. The Adaptation Fund finances adaptation projects and programmes in developing countries that are particularly vulnerable to the adverse effects of climate change. JI - Joint Implementation Whereas the CDM is a co-operation between countries with and without mitigation commitments, Joint Implementation (JI, Article 6 of the Kyoto Protocol) is also a project-based mechanism, but one where total emission allocations are being redistributed between two countries with emission limitation commitments. A country with emission limitation commitments under the Kyoto Protocol can be credited emission reduction units by investing in emission-reduction projects in another country with emission limitation commitments. The emission reductions in both JI and the

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CDM are calculated in relation to a baseline and must be additional, i.e. must exceed what would have taken place without the project. IET - International Emissions Trading, trade of AAUs between countries International Emissions Trading (IET, Article 17 of the Kyoto Protocol) enables Parties with quantitative commitments in accordance with the Protocol to purchase and sell emission rights from/to one another. The Kyoto Protocol deals only with trading amongst countries. The possibility of international trading in emission allowances under the Kyoto Protocol began in 2008. There have only been a handful of trades in AAUs and, therefore, no established market price exists. International Emissions Trading under the Kyoto Protocol operates according to the “seller beware” principle, i.e. the traded AAUs remain valid for the buyer independently of whether the seller subsequently defaults on its Kyoto emissions obligation. A Commitment Period Reserve, where countries are required to maintain a reserve of allowances in its national registry, is designed to prevent over-selling of AAUs.

Regional emission trading systems
In addition to the flexible mechanisms of the Kyoto Protocol, the Protocol has assisted in providing the rationale for the development of regional emissions trading systems. These are established domestically, not as part of the UN system and typically form a key element of a country or region’s overall 12

mitigation action. These are systems that enable companies covered by a domestic emissions "cap" to trade surplus allocations with those that are "short" of allocation. The most important one, in number of participants and traded volumes, is the European Union Emission Trading Scheme (EU ETS). It covers more than twelve thousand installations across the European Union and encompasses half of the EU’s carbon dioxide emissions and 40 % of its total greenhouse gas emissions.6 Regional emissions trading systems can link to a global carbon market through the use of offsets from project based mechanisms. Until a new global climate regime comes into force, regional markets, determined by domestic or regional legislation, will be the main source of the demand for offsets. The EU ETS has been the main driver for the international carbon market and source of demand for CDM credits. This is about to change. The common EU policy on climate and energy and the EU Emission Trading Scheme has a direct impact on the market for CDM. The EU ETS Directive restricts which types of emission reduction units companies can use in the EU ETS in Phase 3, from 2013 to 2020. This, together with speculation regarding further restrictions on types of projects, has created some turbulence in the CDM market. The Emissions Trading Directive stipulates that for CDM projects registered after 2012 only CERs from projects in least developed countries (LDCs) can be used for compliance.

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

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A number of countries and regions have adopted or are introducing carbon pricing mechanisms or emissions trading schemes. These include Australia, which has a carbon pricing mechanism that will transform into an emissions trading scheme in 2015. The Australian ETS allows for its participants to cover 12,5 per cent of its emissions through CDM-credits. It has been announced that the Australian scheme will link with the EU ETS.7 In addition, emissions trading schemes are in operation or will be introduced in New Zealand, Korea, the Regional Greenhouse Gas Initiative (RGGI) in the Northeastern parts of the U.S., California and Quebec. Moreover, seven provinces/cities in China are also introducing pilot emissions trading schemes (see also map on page 75). The use of offsets within these schemes varies in both types permitted as well as quantity.

7 Australian and European Commission agree on a pathway towards full linking Emissions Trading Systems, Press release 28 August 2012, http://www.climatechange.gov.au/en/media/whats-new/linking-ets.aspx

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3. THE CDM - OPERATION AND EXPERIENCES SO FAR
The m ost well-known flexible m echanism is the CDM, which actors in developed countries can use to contribute financially to projects in developing countries and use emission reductions to comply with their targets. Since 2005, the CDM has reduced global emission by more than 1 billion tonnes of carbon dioxide equivalents through more than 4600 projects, and has in total generated more than $150 billion of private investments in emission reducing projects. The CDM has built experience, capacity and comfort with the use of market mechanisms and has been instrumental for many developing countries when considering domestic market mechanisms. The first CERs were issued on the 20th of October 2005 and on the 7th of September 2012 the billionth CER was issued. According to estimates8, another billion CERs are expected to have been issued towards the end of 2012. That means that it took almost 7 years to reach the first billion but only months thereafter to reach the second.

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

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The majority of the demand from certified emission reduction units (CERs) from the CDM comes from companies within the EU ETS, but also Japanese companies have been major buyers. Initially, multilateral funds and governmental purchase programmes played an important role in developing the mechanisms at a time when there was considerable uncertainty about whether the Kyoto Protocol would enter into force or not. Not unlike the situation of today, where the post-2012 regime remains undecided. FIGURE 1

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

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BOX 1 - What the CDM has achieved

• • •

• •

• •

Attracted over $150 billion of private investment Reduced to date over 1 billion tonnes of greenhouse gas emissions in 79 countries. Provided price signalling and marginal abatement cost discovery in unexpected sectors such as the landfill and industrial gas sector. Exponentially increased the greenhouse gas accounting, monitoring and reporting expertise. Positively influenced the awareness and understanding of clean technologies, emissions trading and future action for climate change both in the private and public sector. Enabled developing countries to gain first-hand experience and to enhance their local human capacity and institutions for managing and controlling GHG mitigation. Built significant carbon market infrastructures for project development, verifications, and finance services. Attracted financing for clean technology transfer improving livelihoods of millions, reducing local air pollution and biodiversity loss, increasing gender equality and access to electricity.

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

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The CDM – “Operational” learning
Understanding how the CDM has functioned and changed over the years provides some valuable lessons for the establishment of new market based measures. Below is an overview of some of the areas that have been discussed during the first years of the CDM. Project types Since participation in the CDM is voluntary on both sides, the development of projects is driven not only by rules regarding which activities are eligible but also by costs, risk-return ratio and the (changing) eligibility of which credits can be used for compliance. The early CDM market was dominated by industrial gas projects with low abatement cost and high returns. These projects, while being criticised for overly high returns and low sustainable development benefits, rapidly provided the early market with volumes and liquidity. These mitigation opportunities had been virtually ignored before they were mobilized under the CDM. Thus the CDM stimulated cost efficient action to curb extremely potent greenhouse gas emissions. This resulted in large profits for host countries and also provided the Adaptation Fund with early and significant revenues. Regional/national acceptance of credits from specific project types can also have a major impact. Forestry and land-use projects, which could have provided low abatement costs

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albeit higher transaction cost and large volumes, account for merely nineteen of the more than 4600 registered projects. This mainly because such projects have not been eligible for use within the EU ETS. In total, thirty-three project types have received issuance so far. The ten largest project type categories have contributed to ninety-three per cent of the issued volume. In the future, the bulk of the issued CERs will stem from a much larger number of projects and around half of the volume is projected to come from renewable energy projects. Countries and regional distribution The CDM is a market-based mechanism; hence projects will be implemented where the collective conditions for cost efficient mitigation are found, within the limits created by policy decisions. So far this has led to a situation where the CDMprojects have largely been centred in a few countries. More than 50 per cent of the projects have been developed in China. Another 20 per cent have been developed in India. Countries that have been successful in attracting investors to CDMprojects are those who have a low country risk and an enabling investment environment. To a great extent these are also countries with rapidly growing economies and greenhouse gas intensive baselines, i.e. where there are high emissions that can be reduced. Through the CDM, a less carbon intensive development path has been offered. About two per cent of the world's registered CDM projects are

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in the African continent.9 The development of the African CDM market has been hampered by a generally unfavourable investment climate. Attracting investors and lenders to projects is often difficult since investments have been perceived as too risky. Limited industrial activity and infrastructure in several countries have also put obstacles in the way of the development of the more successful categories of CDM-projects. Small projects are particularly affected by high transaction costs, which has also hampered CDM development on the African continent where small-scale projects are dominant. A change, however, seems to be emerging. Least Developed Countries as well as Small Island Developing States, have been subject to efforts at UN level to enhance regional distribution. Least Developed Countries also get a favourable treatment by a change in the EU ETS rules regarding projects registered after 2012. This has led to a considerable shift towards projects in LDCs in recent years, which in turn has also increased the number of projects on the African continent. Eight of the 37 Programme of Activities (PoAs)10 registered are in African countries. This gives hope that PoA will better cater
9 There are however funds and purchase programmes that have a larger percentage of projects in Africa than the global average, for instance, about a fifth of the bilaterally contracted projects of Swedish governmental purchase programme are in Africa. 10 Programme of Activities, PoA, often called Programmatic CDM is a voluntary coordinated action by a private or public entity which coordinates and implements any policy/measure or stated goal (i.e. incentive schemes and voluntary programmes), which leads to anthropogenic GHG emission reductions or net anthropogenic greenhouse gas removals by sinks that are additional to any that would occur in the absence of the PoA. A PoA allows an unlimited number of CDM programme activities (CPAs) over a wide area to be run under a single administrative umbrella.

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to project types such as small renewable energy and energy efficiency, project types that are likely to fit these countries. See also chapter 5 for a more comprehensive description of PoA. Technology transfer and diffusion Technology transfer is an important aspect in both the UNFCCC and the Kyoto Protocol. It is not specifically defined but can relate to the transfer of specific technical equipment. It can also be any systematic knowledge for the manufacture of a product, for the application of a process or for the rendering of a service. It needs not necessarily be an entirely new technology, but can just as well concern the increased use of a technology that is common practice in one geographical area but not in another, or the use of existing technology in a new way. Technology transfer may also entail the transmittal of technical knowledge and experience. Studies11 have shown that roughly a third of the CDM projects have involved technology transfer. Judging by project design documents, the highest rates of technology transfer can be found for industrial gas (over 90 per cent) and methane avoidance (about 85 per cent) projects whereas technology transfer for biomass energy (about 35 per cent) and renewable energy (just over 20 per cent) projects account for less.12

11 Haites, Duan, Seres (2006) Technology transfer by CDM projects. Climate Policy 6, 327344 and Seres, Haites, Murphy (2009) Analysis of technology transfer in CDM projects: An update. Energy Policy 37, 4919-4926 12 Benefits of the Clean Development Mechanisms 2011, UNFCCC

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One example where the CDM has led to transformation on a large scale is wind power in China. Feed-in tariffs in combination with CDM revenues have led to 40 million tonnes of emission reductions in this sector. This has made China the world-leading wind power producer. When the first Chinese wind CDM project started its approval process in 2004, the Chinese capacity was less than 100 MW installed capacity. FIGURE 2

Investment in different CDM technologies
Million $US 80 000 70 000 60 000 Tra n s p o r t 50 000 40 000 30 000 20 000 10 000 EE Su p ply Fos sil fu el s w itch H yd r o G e ot h e rm al EE D e m an d Win d

0
5 6 4 0 7 0 8 0 9 20 10 20 11 20 20 20 20 20 20 20 12 0 0 0 *

S ol a r

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

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Private sector participation Since the Kyoto Protocol entered into force and the launch of the EU Emissions Trading Scheme in 2005, the private sector, principally in Europe and Japan, has been the forerunners in the development of the CDM. The interest of EU industry in the CDM has grown primarily because companies that have installations covered by the EU ETS can use CERs to meet their quota obligations. The diversity of projects and methodologies put before the CDM Executive Board is a clear sign of the ingenuity of the private sector in finding different mitigation possibilities. Furthermore, companies with new climate-efficient technology have often become involved in the CDM as a way of disseminating their products in the market. The CDM has brought business to a whole new line of service providers; project developers, brokers and independent verifiers. Banks and financial institutions have also become interested in the CDM market. In addition to coordinating some of the national funds and purchasing programmes, some of the financial players have launched their own private funds for the acquisition of CDM and JI credits. These funds have succeeded in attracting a relatively large amount of capital from the private sector. Additionality Additionality is a central concept in the CDM and refers to whether the emission reductions would have taken place even without the CDM-project. Additionality is usually proven in

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one of two ways: either through financial (or investment) analysis, i.e. the proceeds from the sale of certified emission reduction units means that the project becomes financially feasible, or that CDM helps the project to overcome barriers, known as “barrier analysis”. Implementing and evaluating additionality under the CDM has proven to be challenging. The CDM experience has shed light on the inherent and practical challenges and uncertainties of determining the scenario representing “what would have occurred otherwise” thus making it difficult to prove additionality with absolute certainty. The diversity of factors considered and approaches taken in individual investment decisions by different entities in a variety of circumstances has made the task of assessing a project’s additionality based on investment analysis very challenging from a global perspective. This has contributed to making additionality the main point of much of the criticism that has been directed towards the CDM. This has contributed to a high CDM regulatory risk13, which in turn has made it difficult to use expected carbon finance revenues to strengthen the financial viability of projects and to help incentivize potential financiers and lenders to leverage the necessary underlying finance.

13 Regulatory risk is the exposure to financial loss arising from the probability that regulatory agencies will make changes in the current rules (or will impose new rules) that will negatively effect the already-taken action.

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BOX 2 Additionality assessment in the CDM
Additionality is a central concept in the CDM and means that emission reductions would not have taken place without a CDM-project. The concept was already introduced in the Kyoto Protocol in 1997, but was then submitted to the CDM Executive Board for definition. The additionality requirements differ for small scale and large scale projects. For small scale methodologies it is common to present the additionality requirements as eligibility critera, i.e. the methodology specifies exactly which conditions must be met for the project to qualify as a CDM project. The CDM Executive Board’s way to review projects and ensure additionality has changed through the years. At first, it was up to each project proponent to find a way to show additionality, but in 2004 the CDM Executive Board published the first additionality tool which set the standard for how additionality is proven. Over time the additionality tool has been enhanced with added flowcharts, questions to be answered and more required steps in order to specify and clarify different requirements. The "Validation and Verification Manual" first released in 2008, has further helped to ensure a transparent and homogeneous treatment of projects and enabled non-additional projects to be discharged early in the process. In 2008, the benchmarks for additionality were introduced. The concept was first applied for energy-efficient refrigerators. In this methodology the identified benchmark represents a certain percentage of the most efficient refrigerators available on the market. If a refrigerator falls into this category it is considered additional and its emission reductions can be credited in a CDM project. This procedure means that as technology advances and more efficient refrigerators come on the market, higher efficiency is required to be considered additional. A possible further development in the field of additionality is to a greater extent use technical criteria that are objective and easier to verify than project-specific conditions. It is also possible to work on designing eligibility criteria, such as for projects in certain regions, and thus to define in advance what is to be regarded as additional.

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Governance and predictability in decisions The CDM is governed by the CDM Executive Board, consisting of ten members and ten alternates serving for a period of two years.14 The CDM Executive Board reports to the Parties to the Kyoto Protocol. The CDM has been criticized for being administratively overly cumbersome and small projects have been particularly affected since they are less able to carry high transaction costs. Another, and more serious, concern is lack of transparency and predictability in the decision making. This is partly due to the fact that the CDM is a bottom-up-process and the detailed rules and the application of these has developed over time. Decisions are also part of the policy making process as some issues are pushed from the Parties to the Kyoto Protocol to the CDM Executive Board to handle. Although several steps have been taken over the years to increase transparency and consistency in the rulings of the Executive Board, those investing in CDM are still exposed to considerable regulatory risk.

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

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PART 2
- Future flexible mechanisms

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4. WHAT ARE FLEXIBLE MECHANISMS EXPECTED TO DELIVER?

It is possible to identify a num ber of benefits that the current and potential future flexible mechanisms could bring to the future international climate change regime and principles to which they should adhere. This chapter presents the expectations that usually are voiced in discussions on flexible mechanisms. When designing a flexible mechanism, one central question to keep in mind is whether some principles or benefits are more important than others. It is unlikely that a mechanism with many purposes delivers equally well on all of them, so it is important to be clear on the objectives. The experiences gained from the CDM, as well as those from the establishment of regional and national trading schemes, provide valuable insight into the development of future market-based systems to support a new climate regime. It must, however, clearly be stated that flexible mechanisms themselves do not solve the climate change problem. They are tools to help meet emission commitments cost-effectively, and need to be underpinned by mitigation commitments. Their effectiveness in contributing to addressing climate change depends upon this target.

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Environmental integrity
Maintaining environmental integrity, that is, making sure actions taken are indeed contributing towards solving the climate change problem, is important for the overall climate regime, as well as for providing confidence and credibility to carbon markets and flexible mechanisms. Furthermore, environmental integrity is essential to secure political and public support for a mechanism. Environmental integrity needs to be maintained on a system level, but on a project level absolute certainty should be weighed against transaction costs. One of the lessons learned from the CDM is the need to strike a balance between seeking to measure every single tonne of greenhouse gas reduced (at each project site) and estimating - with proper accuracy, justification and conservativeness - the total greenhouse gas impact of a creditable activity. Striking such a balance is necessary for keeping transaction costs manageable while safeguarding environmental integrity. Too high transaction costs erode the carbon price signal and thus the impact of market mechanisms. In spite of the detailed control that is exercised over CDM projects, the additionality and environmental integrity of emission reductions have been questioned and formed the key critique of the CDM in the public debate, as well as being a cause for developing new mechanisms. However, new market mechanisms will not put such concerns at ease; if flexible mechanisms are to be scaled up from project level to a sectoral

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

Cost efficiency and flexibility across time and place
Putting a price on greenhouse gas emissions is an efficient driver for mitigation action. Such a price signal can be created either by rewarding emission reduction or by making the polluter pay for the emissions that take place. Flexible mechanisms have been established that operate according to both methods. Flexible mechanisms make use of the fact that the mitigation costs vary across sectors and nations. As a result, actors other than nations can contribute towards meeting national commitments and obligations. But cost difference is not the only rationale; the flexibility across time which emission trading provides is perhaps more important. The global economy may go up or down, but the economic conditions experienced by different types of producers in different regions will vary. Emission reduction obligations are usually set with a time horizon of up to ten years and it is difficult to predict the prevailing conditions at the time when they are to be met. With access to a greenhouse gas market such obligations will be easier to meet and thus to accept. This is equally true for a country considering taking on mitigation commitments as it is for a company adhering to a compliance regime. For example, if an individual company is

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experiencing a period with high economic growth and temporary higher emissions, it can buy allowances on the market (matching the cost of purchase against increased production) and remain in compliance. Such flexibility within an emission trading system allows the company to efficiently carry out (not change) its own emission reduction strategy, for example, the orderly introduction of its own emission reducing investments at its facilities.

The role of offsetting
Offsetting is as an activity that compensates for the emission of carbon dioxide or other greenhouse gases by providing for an emission reduction elsewhere. The main reasons for offsetting are cost efficiency and to gain flexibility across time and place. 15 The “moral aspects” of offsetting The use of offsetting cannot be considered without considering the context in which it is used. For example, it needs to be considered if a country took reduction commitments with the understanding that they would achieve these domestically or whether they took ambitious commitments because they could use offsetting to achieve a part of them in a more cost-effective manner. In the former case, the morality behind outsourcing the emission reduction work may be questioned. In the latter case the possibility to use offsetting may have facilitated a more ambitious commitment.
15 It should be noted that this is a discussion about offsetting, not about the flexible mechanisms of the Kyoto Protocol per se, although they can be used for offsetting.

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In the negotiations on a future climate change regime, many governments have introduced pledges that are conditional on the use of offsets. Levels of offsetting Most systems have a limit on the amount of offsetting that is allowed; for the industrialised countries that are part to the Kyoto Protocol, the use of flexible mechanisms has to be supplemental to domestic action. This was later specified to mean that a considerable part of the effort to meet obligations was to be made domestically. For businesses in the EU ETS there is a quantified limit per installation on the amount of emission reductions from CDM and JI that can be used. Concerns over competitiveness The use of “offsetting” in form of project-based mechanisms, in particular the CDM, has resulted in infrastructure investments in developing countries, paid by developed countries. There is concern, voiced especially by tradeexposed industry, that by improving infrastructure in developing countries one may, however, be harming the competitiveness of the industry in the industrialised countries. There is little documented evidence to demonstrate this at present. There are many factors affecting competitiveness and the risk of the CDM seriously affecting the level playing field is probably small. Is the low hanging fruit being picked? There is concern that “offset” projects will result in the “cheaper” reduction possibilities (low hanging fruit) being used up in developing countries. From a mitigation point of

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view it is most important that the fruit are being picked, not who does it. From time to time you will hear concerns that the low abatement opportunities, the low hanging fruit, will all be picked through the CDM16 and that this might force host countries to invest in more expensive measures to meet their future reduction targets. This argument has been examined, with Castro17 finding that the CDM is not yet capturing a large portion of the identified abatement potential in most countries. The study concludes that although the costs of most emissions reduction opportunities grasped are below the average credit price, there are still plenty of available low-cost opportunities to be tackled by future processes.

Finance
Substantial mitigation is needed to limit global warming. The estimated incremental cost for mitigation in developing countries ranges from US$140 billion to US$175 billion per year in 2030.18 As part of the Copenhagen Accords from COP 15 in 2009, the international community has agreed to mobilize US$ 100 billion per year by 2020. The UN Secretary General’s High Level Advisory Group on Climate Change Financing reported in 2010 that US $30 billion

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

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to US $50 billion annually could be generated in increased carbon market flows to developing countries, “if and when carbon markets are further developed and deepened”. The report emphasizes that instruments based on carbon pricing are particularly attractive because they can provide both incentives for mitigation as well as raise revenues. Achieving carbon market flows of this magnitude would rely on ambitious mitigation commitments from developed countries and the introduction of new mechanisms. According to OECD, public finance for climate change mitigation reached more than US$ 13 billion in 2010. This can be compared to investment in CDM projects that, in the same year, was US$ 47 billion.19 The capacity for investment and finance through carbon markets is potentially much larger than what can be collected through public funds. This would especially appeal to governments as the source of funding would not come directly from governments’ budgets.

Sustainable development and other benefits
Flexible mechanisms can bring benefits that extend beyond climate change mitigation, such as contributions to sustainable development.20 Mechanisms can assist countries

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

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in changing their development track towards a society with lower greenhouse gas emissions. This is particularly important at a point in time when many developing countries build longlasting infrastructure like electricity generation systems. A concrete benefit of using flexible mechanisms is the acceleration of the replacement of less efficient technology. Contribution to sustainable development, or rather how to enhance contribution to sustainable development, is an important factor in the development of new market mechanisms. Since contribution to sustainable development can take different forms it is not easy to define or quantify in a uniform way. The example of CDM shows the difficulties of evaluating the extent to which an individual project has contributed to sustainable development. It is even harder to say that one project has contributed more than another. In contrast, at least with present day mechanisms, the emission reductions are clearly monetized and therefore easier to evaluate. In the case of CDM, sustainable development benefits are to some extent taken into account in the market price of emission reductions; in some cases, projects with clear sustainable development benefits can gain a premium. In discussing the development and evolution of the Kyoto Protocol project-based mechanisms, as well as the development of future flexible mechanisms, the issue on how to promote benefits besides mitigation needs to be better addressed. It is evident that it is hard to ensure those benefits if they are not quantified or indexed, and in order for a marketbased mechanism to deliver well on parameters they should be monetized.

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It seems highly unlikely that countries could agree on common sustainable development priorities or to adopt someone else’s standards but inspiration could, for example, be sought in the Millennium Development Goals. It may be possible, based on the host country prerogative to decide, to ask host countries to specify their own sustainable development priorities and suggest indicators for how the contribution to those priorities could be evaluated.

Increase acceptability of a climate change regime
As flexible mechanism have the potential to lower the cost of climate change mitigation and provide flexibility in how this can be achieved, which may increase the likelihood that countries will commit to reducing greenhouse gases. The flexible mechanisms were a decisive component in the conclusion of an agreement in Kyoto and also encouraged nations to ratify the Kyoto Protocol; similar can be expected in a future climate change regime. In the case of the Kyoto Protocol, developed countries were attracted to the flexible mechanisms as they provided cost efficiency in complying mitigation commitments. In a new climate regime, mitigation is not the only important aspect. Adaptation and finance is likely to play a larger role and flexible mechanisms can act as a vehicle for financing mitigation or as a source of revenue for adaptation. Another aspect of the tools is that they enable countries that

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are themselves no major emitter or have a demand for offsets to make a greater contribution to the global goal through using mechanisms and by contributing to their overall development. This is for instance one of the aims of the Swedish governmental CDM and JI purchase programme. This can also be linked to "results-based" financing and moving the CDM away from offsetting.
The benefits and expectations identified above are clearly applicable in varying degrees both to the post-2012 CDM as well as any new market-based mechanisms that are developed. The next chapter concentrates on the future of the CDM and the following chapter on new market mechanisms.

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5. THE FUTURE OF THE CDM

As seen in chapter 3, the CDM and the project types have changed over time. It is likely that the CDM will continue to evolve and that the mechanism will play a different role in a future climate change regime. The CDM is already moving in the direction of less developed countries and from large projects to smaller projects and programmes. Its use for offsetting is also likely to change and other features may gain greater dominance, such as the contribution to sustainable development or as a channel for climate finance. Governments have, in many UN meetings, stressed the need for the CDM to continue as a mechanism. After a number of years of operation and learning, there is clearly a need to continue its development to enable the mechanism to fit within a post-2012 climate regime. If new mechanisms, targeted at the more advanced members of the developing country group, are developed in a way that allows for more flexibility in implementation and less bureaucracy, it is also important, from a fairness perspective, to streamline the mechanisms that are targeted mainly at less developed countries. Some of the possible developments of the CDM could include:

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Programme of Activities
Lately, there has been a transition from the traditional projectby-project-based CDM to more comprehensive approaches. Programme of Activities, PoA, often called Programmatic CDM allows for an unlimited number of CDM programme activities (CPAs) over a wide area to be run under a single administrative umbrella. PoA is a voluntary coordinated action by a private or public entity which coordinates and implements any policy/measure or stated goal (i.e. incentive schemes and voluntary programmes) that leads to greenhouse gas emission reductions or net greenhouse gas removals by sinks, which are additional to those that would occur in the absence of the PoA. PoA increases the attractiveness of a range of smaller and dispersed CDM projects, such as those installing efficient cook stoves, solar water heaters, biogas digesters and other smallsize renewable energy generating systems. These are project types that may be particularly suitable for Least Developed Countries, countries where the CDM will continue to play an important role post 2012. One of the rationales behind PoA was a desire to capture smaller, more dispersed emission sources, as well as the possibility to start small and then scale up. The rules of PoA were based on the modalities and procedures for CDM although PoA differs in two significant ways; its modular feature and the possibility to extend with time. In particular, the monitoring requirements can be challenging when

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covering a number of small and dispersed units. There might have been unforeseen changes over time which were impossible to predict at the registration of the first units.

Increased standardisation
The project-based mechanisms of the Kyoto Protocol are developed in a bottom-up process. As a result, a wide variety of project-types have evolved, including disparate approaches, which in turn has emphasized a need for standardisation. Through greater standardisation there is a potential to calculate emission reductions and assess additionality in a more homogenous and consistent way. In addition, transaction costs for the individual project proponent can be lowered. Standardised baselines can be established for a country or a sector within a country. Projects within that country or sector can use the standardised baseline and thus save the expense of developing a project specific baseline. A standardised baseline, being developed centrally without the potential bias of the project proponent, could also better guarantee environmental integrity. The standardised baseline may be either qualitative, e.g. “the baseline for new electricity generation is a gas turbine”, or quantitative; e.g. “the baseline emission factor for grid connected electricity generation in country X is Z kg CO2/kWh”. Standardised baselines have been possible within JI since its onset. Recently, this is also possible within the CDM, and the

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CDM Executive Board has launched work in this area. The development of standardised baselines could be a stepping stone from project-based mechanisms towards more comprehensive approaches, including new market mechanisms.

A role for the CDM beyond offsetting – a “receipt” for finance
The Kyoto Protocol set up a system focusing on mitigation; in a future climate change regime finance is likely to take a more dominant part. At the COP 15 in Copenhagen in December 2009, a Green Climate Fund (GCF) was established. Developed countries then pledged to provide US$100 billion of private and public sources annually by 2020 to support developing countries’ climate policy efforts. These decisions mean that a new role for the CDM can be envisaged. With additional demand for finance to support mitigation comes an increased need to make sure that the finance also delivers real emission reductions. Certified emission reductions, CERs, from a CDM project are not per se offsets. It is the use of these CERs that determines whether or not a CDM project is offsetting, not the mechanism itself. If the CER is retired or not used, it is effectively mitigation in developing countries. A CER can then be seen as “receipt” or proof that an emissions reduction has taken place and the financial contribution through the CDM as payment for performance. Furthermore, there are possibilities to ensure net mitigation through the CDM, even in the case where the resulting CERs

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are used for offsetting other emissions, for example; in the conservativeness of the methodologies and in the setting of length of the crediting periods, further emission reductions can be achieved than those credited for in the terms of CERs. The rigorous control systems that have been built up for the CDM could be used to ensure that finance is targeted towards delivering mitigation action. An objective of the Green Climate Fund is to promote the paradigm shift towards low-emission and climate-resilient development pathways by providing support to developing countries to limit or reduce their greenhouse gas emissions and to adapt to the impacts of climate change. One possible way for the Green Climate Fund to do this would be to support current and future projects in the CDM by buying, and retiring CERs21. Such an approach would ascertain that the financial support would result in real reductions.

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

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6. POSSIBLE FUTURE FLEXIBLE MECHANISMS
The challenge of m itigating clim ate change is tremendous and the international community is currently seeking ways to address this challenge. One outcome of the UN climate change meeting in Durban 2011 was to extend the Kyoto Protocol with a second commitment period. Another one was to launch a process to develop a protocol, another legal instrument or an agreed outcome with legal force under the Climate Change Convention applicable to all countries from 2020. This process is taking place under the Durban Platform and work should conclude as soon as possible but no later than 2015. The aim is to raise the level of ambition and to ensure the highest possible mitigation effort by all countries. The post-2020 climate change regime will most likely consist of a spectrum of commitments and means of implementation. Flexible mechanisms such as emissions trading, the CDM and JI will have a role to play in a future climate change regime as well. Emissions trading is the simplest form of levelling out cost over time and space, and project-based mechanisms are ways of channelling mitigation action to specific areas. Moreover, emissions trading and Joint Implementation are alternative ways to redistribute emission reductions under a cap. The CDM differs from the two in that it brings about emission reductions from within an uncapped environment. The CDM also has the unique feature of being able to introduce a carbon price signal to the private sector in a country even

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though it does not have a limitation on emissions. In that way the CDM can build awareness about the economic importance of reducing emissions to companies well before the host country has imposed restrictions on emissions of greenhouse gases. In UN climate change negotiations, parties have agreed to establish a “new market-based mechanism” under the authority of the Conference of the Parties (COP) and to consider a “framework for various approaches” including markets22. A key difference between the two appears to be the degree of international (UN) oversight foreseen. This difference can be illustrated by the EU proposal for new market based mechanism with strong UN oversight and the Japanese proposal for a bilateral offsetting crediting mechanism that could fit under a framework for various approaches. It is too early to say if there will be just one new market mechanism or perhaps several under a common framework. One over-arching aim for many governments is to ensure that the new market based mechanisms give a net mitigation contribution. As such, there is an underlying assumption that not all emission reductions achieved through the mechanism will be credited, subsequently traded and used for offsetting. The scientific rationale behind this thinking is that in order to meet the challenge of limiting global temperature rise to 2°C, in addition to ambitious emission reduction commitments by
22 Outcome of the work of the Ad Hoc Working Group on Long-term Cooperative Action under the Convention, Decision 2/CP.17, http://unfccc.int/resource/docs/2011/cop17/eng/09a01.pdf

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developed countries in the order of 25-40% by 2020, there is a need for substantial deviations of 15-30% by 2020 from currently projected emissions in developing countries, especially more advanced developing countries. FIGURE 3

Source: Greenhouse gas production pathways in the UNFCCC process up to 2025, CNRSLEPII-EPE, RIVM, MNP,KCS-NTUA, CES-KUL(2003)

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There have been several proposals outlining a wide range of new mechanisms. These include emissions trading systems, sectoral trading, sectoral crediting, crediting for nationally appropriate mitigation actions (NAMAs), market-based mechanisms for reducing emissions from reducing deforestation and forest degradation in developing countries (REDD+) and a Bilateral Offset Credit Mechanism (BOCM). These are diverse proposals and discussed under different agenda items in the negotiations. But they do resemble one another to the extent that they are attempts to take a broader grasp on mitigation, possibly through the use of markets. Table 1 at the end of this chapter makes a comparison of some of the current proposals.

NAMA - Nationally Appropriate Mitigation Action
NAMA refers to a set of policies and actions that countries undertake as part of a commitment to reduce greenhouse gas emissions. The term recognizes that different countries may take varying nationally appropriate action on the basis of equity and in accordance with common but differentiated responsibilities and respective capabilities. The Bali Action plan from 2007 first speaks of “Nationally appropriate mitigation actions by developing country Parties, supported and enabled by technology, financing and capacity-building, in a measurable, reportable and verifiable manner.”

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The Copenhagen Accords from 2009 invites parties to notify their NAMAs and states that NAMAs seeking international support will be recorded in a registry along with relevant technology, finance and capacity building support. Those actions will be added to the list in an appendix to the Copenhagen Accords and these nationally appropriate mitigation actions will be subject to international measurement, reporting and verification in accordance with guidelines adopted by the Conference of the Parties. So far, forty-four developing countries have submitted NAMAs that have been incorporated in Annex II of the Copenhagen Accords. A number of developing countries have pledged economywide, sectoral emission reductions or limitation targets as Nationally Appropriate Mitigation Actions under the Convention. Some of these countries have indicated that they require financial support in order to achieve their commitments, which could be facilitated through crediting. Other developing countries may wish to benefit financially from participation in an international emissions trading scheme, if this participation could be undertaken voluntarily, and on a sectoral, rather than an economy-wide, basis. A NAMA is not a mechanism in itself. Depending on the source of financing a NAMA can be unilateral (domestically funded by the host country), supported (internationally funded through for instance climate finance or Official Development Assistance) or it can be financed through the generation of carbon credits (credited). A credited NAMA is linked to the national government’s climate change mitigation plan. The

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distinction between credited NAMAs and other market based mechanisms is not always clear cut, for instance, the CDM PoA23 model could be one way of implementing a NAMA.

REDD + (Reducing emissions from deforestation and forest degradation)
REDD is the abbreviation for “Reducing emissions from deforestation and forest degradation in developing countries”. The “+” sign after REDD signifies that some conservation activities are also included. At COP16 in Cancun 2010, the parties decided on a framework for REDD+. The implementation will take place in stages, with the first phase mainly encompassing financed capacity building, phase two includes pilot schemes and the establishment of national policy instruments, while phase three is performance-based support for verified emission reductions. A regulatory framework for measurement and reporting, and the establishment of national reference levels is under development and how the performance-based REDD+ activities are to be funded in the long term (phase three) is being discussed. Views differ on whether REDD+ shall be primarily funded through multilateral (assistance) funds or through international emissions markets. Linking REDD+ to the
23 CDM PoA is described in chapter 3. As with regular CDM, PoAs use a preapproved methodology, are verified by an independent third party and registered by the CDM Executive Board.

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international emissions market increases the ability to allocate resources effectively between different mitigation measures and can help to mobilize resources from the private sector. Linking REDD+ to developed countries' commitments in order to reduce emissions through a market solution should in theory pave the way for more ambitious commitments. But the potential for emission reductions in REDD+ is uncertain and immediate access to international carbon markets can create problems with excess supply or excess demand. Bilateral and multilateral funding for REDD+ without a direct connection to the emissions market avoids the risk of affecting the stability of the global emissions market but will not have the potential to use the more cost-effective resource allocation that comes with emissions markets. It is probably difficult to create a long-term financing of sufficient size without marketbased approaches that can tap in to resources outside governmental budgets. A middle way between aid-based and market-based funding would be formalized bilateral agreements with some crediting.

BOCM - a new Bilateral Offsetting Crediting Mechanism
The Japanese government has proposed a new market mechanism tentatively called the Bilateral Offset Credit Mechanism (BOCM).24 It is to be designed, established, and implemented reflecting the domestic circumstances of

24 Government of Japan, various presentations, 2012

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individual countries. The aim is to transfer and disseminate low carbon technologies. The contribution that this transfer brings to emission reductions will be evaluated in a quantitative manner. The mechanism is intended for the period until a new international framework under the UNFCCC takes effect. Various feasibility studies have been conducted in prospective partner countries with the aim of demonstrating the effectiveness of Japan's low carbon technologies and products. They further strive to support the exploration and organization of projects leading to substantial greenhouse gas emission reduction around the globe. The feasibility studies have established methodologies for assessing business prospects for dissemination and transfer of low carbon technologies as well as evaluation techniques of emission reduction effects. The mechanisms will be set up between two partner countries governments forming a Joint Committee to develop the rules and guidelines for the mechanisms, and to approve or reject draft methodologies. Eligibility is established in terms of emissions reduced by accelerating deployment of low carbon technologies, products and services as well as facilitating NAMAs. It is determined through positive lists or benchmarking. Projects are implemented by companies and in order to reduce monitoring costs they make extensive use of conservative default values provided beforehand, as well as estimations

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based on sampling and simulation.25 Emission reductions are calculated as the difference between project emissions and reference emissions. The reference emissions are not project specific but commonly applied to all projects/activities which meet certain eligibility criteria. For instance, the reference can be a default grid emission factor. The respective governments issue credits after third party verification. The BOCM will start as non-tradable credit mechanisms, but will eventually produce credits that can be used for offsetting. The BOCM is presented as a concept in itself, as a new mechanism. There are, however, many similarities with the CDM and it is tempting to describe the BOCM as “streamlined and simplified CDM”. The BOCM moves away from the difficult concept of additionality, reduces monitoring costs by taking advantage of conservative default values as well as sampling, and credits are calculated as the difference compared to a pre-determined reference. Since credits are issue by the respective government and the rules are determined in a Joint Committee, the mechanism is not foreseen to be governed or overseen by the UN.

New market based mechanisms
The 17th session of the Conference of the Parties to the Climate Convention (COP 17), held in Durban in December
25 Conservative Default Values could be used in a number of different areas where the cost of obtaining an actual, project specific, value is difficult or costly. It could be on emissions from a particular type of equipment but also hours of operation etc

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2011, defined26 a new market based mechanism. Furthermore, it was decided that there should be a work programme to elaborate modalities and procedures for the new market-based mechanism aiming to recommend a decision to the Conference of the Parties at its eighteenth session (in Doha, 2012). The decision at Durban does not, however, describe the new market-based mechanism itself, it just states that it exists and that modalities and procedures should be decided by COP 17, in Doha. Countries have during 2012 submitted proposals on the form of the new market based mechanism and how it would operate, and discussions are still in progress. It is too early to say if there will be just one new market mechanism or perhaps several under a common framework, and as seen from the examples, the New Market Mechanisms might very well contain elements recognizable from existing mechanisms. Lastly, although the name suggests that New Market Mechanisms operate using market forces, there are some that may rely on policies/regulation to provide the incentives for those achieving the emission reductions (i.e. companies), rather than a direct price signal. So, in reality, the new market mechanism may be neither one, new nor very market. Any new mechanism is likely, however, to be more integrated into host countries’ domestic climate change policy
26 Report of the Conference of the Parties on its seventeenth session, held in Durban from 28 November to 11 December 2011 (FCCC/CP/2011/9/Add.1) paragraph 83 “Defines a new market-based mechanism, operating under the guidance and authority of the Conference of the Parties, to enhance the costeffectiveness of, and to promote, mitigation actions, bearing in mind different circumstances of developed and developing countries, which is guided by decision 1/CP.16, paragraph 80, and which, subject to conditions to be elaborated, may assist developed countries to meet part of their mitigation”

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framework than present mechanisms. Other outstanding issues are the interaction between new mechanisms and the already existing ones, as well as the extent to which new market mechanisms can be used for offsetting. What can be said with certainty is that new market based mechanisms are intended to draw financial support from carbon markets and encompass mitigation action that will take place in some of the 150 or so countries that makes up the nonAnnex-1 (developing) country group of the UNFCCC. A decision from COP16 (Cancun 2011) contains some guiding principles regarding the design of new market mechanisms; • they should ensure voluntary participation, • complement other means of support for nationally appropriate mitigation action, • stimulate mitigation across broad segments of the economy, • safeguard environmental integrity, • ensure net decrease/avoidance of greenhouse gas emissions, • assisting developed country parties to meet part of their mitigation targets, • ensure good governance and robust market functioning.

Sectoral Crediting and Sectoral Trading
The EU has elaborated on proposals for new market based mechanisms with sectoral coverage and this section is mainly based on the ideas put forward by the EU. One can distinguish 57

at least two types of market-based approaches covering broad segments of the economy: trading and crediting:27 Trading: In accordance with an ex-ante (beforehand) defined absolute target for a broad segment of an economy, emissions allowances are issued. If emissions are lower than the number of issued allowances, excess allowances can be sold to recover, at least partly, the cost of mitigation activities. If emissions are higher than the number of issued allowances, additional allowances need to be purchased on the global carbon market to comply with the target agreed for the broad segment. An underlying assumption is that there is a stringent cap set. The EU ETS can be said to be a domestic example of the trading model (it is not subject to international oversight). The system covers large point sources and is linked to the global carbon market through the use of offsets from JI and the CDM. Companies in the EU ETS may, however, not use the AAUs that have been assigned to the parties of the Kyoto Protocol. In general, trading systems put mandatory obligations on participants and allowances are allocated ex-ante. Setting of the overall cap is crucial Crediting: Existing emissions of a broad segment of an economy are checked against an ex-ante agreed baseline for this segment. If emissions are below this baseline, emission credits are issued, which can be sold to at least partly recover the cost of mitigation activities. If emissions are not below the
27 The idea of a “sectoral approach” covering one specific sector (for instance steel or cement) in all countries across the globe, is not discussed in this report.

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baseline, no penalty is applied (no-lose target). The no-losefeature is technically not necessary but is intended to make participation more attractive. The sectoral crediting model can be illustrated as follows: FIGURE 4

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The establishment of a (sectoral) crediting mechanism, or a sectoral no-lose target, is assumed to be proposed by a developing country and agreed as part of an international climate change agreement. In this sense it is a bottom-up approach where the host country takes the initiative. However, it is assumed there would be a framework, developed topdown, with principles and rules governing the mechanism. Geographical coverage is generally assumed to be one whole country whilst coverage under the sector should be broad enough to limit carbon leakage. For sectors with homogenous technologies or a few large point sources – such as cement – it might be easier to draw the borders of a sector but it may be more complex if the technologies and processes vary greatly, such as for the chemical industry. Participation in the crediting mechanism is assumed to be voluntary for the host country, but mandatory for the emitters that are included in the sector. Those included need to be clearly defined. In addition, good monitoring procedures need to be established. This may speak in favour of an upstream approach with fewer entities and larger emission sources, thereby limiting transaction costs for monitoring and reporting of the system as a whole. On the other hand, a more downstream approach may be better able to provide direct incentives to those who will take the actual mitigation action.

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Baselines
The greatest challenge when establishing a (sectoral) crediting mechanism is to decide on a crediting threshold. Future developments of a sector are difficult to predict and future production, and emissions, may depend on a number of factors (economic growth, fuel prices, technological innovation etc.) that may in the future develop quite differently. Predictions of the “business-as-usual” development are associated with uncertainty and also imposes a risk that the crediting threshold is set too high or too low. With a very ambitious threshold, the financial incentive for the host country to engage in reductions decreases. If the threshold is set with a low ambition, credits can be awarded for very little action and an oversupply of credits could result in low prices and low financial revenue for the host country. A potential solution to the problem of how to set the crediting threshold at an ambitious level – to ensure the achievement of “net” mitigation – and still maintain incentive, could be to give certain financial/technical support at a level below where crediting starts. Baseline setting Baselines can either be established at an absolute level or indexed to one or several parameters (physical metrics of sector like per kWh or economical metrics like GDP). A further option is to use a technology penetration baseline. Each method has its advantages and disadvantages, for example:

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Absolute emissions baselines mean that all measures to reduce emissions can be credited, including demand side management. Absolute emissions baselines may be perceived as a constraint for economic and social development if they are too stringent. The determination of an absolute baseline is also quite demanding as many assumptions about future developments have to be made. For indexed baselines, the emission rate is established and fixed ex-ante (beforehand) and the index monitored. However, in many sectors emissions stem from several sources and it is crucial to use the correct indexes to calculate the baseline. In the case of an indexed baseline, the absolute emission levels will only be determined ex-post (afterwards). Technology penetration baselines have a rather narrow focus but could be used if it is desired to promote a particular technology. However, the BAU (Business As Usual) diffusion rate of a technology may be hard to assess. As the assumptions on emission drivers cannot be verified in an objective manner, it will be difficult to assess a proposal for a crediting threshold on purely technical grounds. Setting a baseline will always involve an element of subjectivity and most likely also an element of negotiation. It would be desirable if the principles for the ambition could be agreed at international level, although it would be hard to reach such an agreement.

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Taking into account existing policies and measures
A key factor to address when determining a baseline for a country’s emissions is how to take into account existing as well as new policies and measures. An inclusion of policies and measures that favour the reduction of emissions into the baseline provide an incentive for the host country to hold off on measures so as not to lose out on crediting. In the CDM this is known as e+/e- where basically an historic cut-off-date has been introduced for which polices and measures to include in the baseline calculation.28 While this approach may have been feasible in the past, climate policies are evolving in most countries and it becomes much harder to distinguish what would have been the BAU scenarios without them. For a sectoral crediting mechanism trying to sort out which policies and measures to take into account based upon the motivation for them, may be even more complex than for the CDM, and is probably not fruitful. The challenges of distinguishing the results of mitigation action from other factors that affect greenhouse gas emissions has been apparent within the CDM and will also occur with a sectoral crediting mechanism, on a possibly even greater scale. Investments in low emission activities may need a mixture of different financial sources and clearly distinguishing the emissions reductions according to source of finance may be challenging.

28 For instance, feed in tariffs for electricity production from renewables

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A pragmatic approach will therefore be needed. Credits from sectoral crediting mechanisms are issued ex-post. This implies that the country needs to provide upfront resources to mitigate emissions. In addition, proposing a sectoral crediting mechanism requires considerable technical knowledge as well as efforts to collect data needed to demonstrate a baseline claim.

Governance
Compared with the flexible mechanisms of the Kyoto Protocol, the new market based mechanisms will require much stronger governance arrangements on host country level. The incentive for the actual emission reduction needs to be created at host country level. In the case of a sectoral crediting mechanism the host country could adopt it through policies and measures, for instance through regulation. (Or, the host country could introduce an emissions trading scheme, set a tight cap and sell the resulting surplus once emissions have been reduced.) After emissions have been reduced below the crediting threshold, the host country would receive credits. It would then be possible for the host country government to distribute these credits to the entities within the sector, and the entities could then sell them on the market. However, this does not seem a likely choice. The incentive structure on host country level needs to be tailored carefully. In a sectoral agreement the mitigation

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action has to be taken at individual installation level, but the issuance of credits depends on the entire sector’s performance. As the credits are issued ex-post the revenue can only be collected after mitigation action has been taken. There is no incentive for an entity to take action if the reward depends on the performance of others, which include competitors. Uncertain future credits do not provide enough incentive for companies to incur costs for cutting emission today so the government will have to provide some sort of incentives. One way of directly involving sector entities in the carbon market would be to combine a national emissions trading scheme with a sectoral agreement. Who would be the potential buyers of credits from sectoral crediting mechanisms? The role of governments becomes increasingly more important as we strive towards more comprehensive (or sectoral) mechanisms. This is not only true for the supply side but also for the demand side. It will likely be difficult for companies under an emission cap to negotiate with the government of another country to buy credits from a sectoral crediting scheme. There will have to be intermediate levels.

“Target” sectors
Experiences with existing market-based instruments have shown that agreeing on workable definitions of sectors and boundaries is challenging. So far, there is no agreement on what is meant by “broad segments of the economy”.

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A sectoral crediting mechanism gives the opportunity to cover different target areas, some important considerations for the selection of target areas could be: • Mitigation potential and costs; • Sectors with a high share of emissions and capital intensive near term investments (technology lock-in); • Synergy with domestic sustainable development policy objectives (e.g., low emission development strategy/mitigation pledge/domestic target); • Overall suitability for a market instrument, including, for example, data availability, relative ease of monitoring, reporting and verification, responsiveness to price signals; • Opportunity to create a financial incentive to stimulate net reductions and/or avoidance of greenhouse gas emissions in the target area; • Feasibility and financing; • Sector/local circumstances (e.g., sector structure, relation to other sectors); • Availability of data; the degree of uncertainty in emission estimates. • Local champions who take action.

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Design comparison
Having briefly described some of the current proposals, it is beneficial to illustrate some of their differences and similarities (see next page). However, it needs to be kept in mind that the list is neither exhaustive nor the proposals definitive.

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CDM

Sectoral crediting

Sectoral trading

Bilateral Offsetting Crediting M echanism
Joint Committee

High level guidance

Parties to Kyoto Protocol CDM EB Voluntary

COP

COP

Detailed rules Voluntary/ mandatory

Host country Voluntary for country, mandatory for covered emitters Sector

Host country

Joint Committee

Voluntary for Voluntary country, mandatory for covered emitters Sector Low emitting technologies

Coverage of emission sources Eligibility of activities

All eligible

Additionality

Any within sector

Any within sector

Positive lists, benchmarking, other

Setting baseline/credi t thresholds

CDM Executive Board

International International Joint Committee negotiations, negotiations, UNFCCC UNFCCC

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Developing methodology

Project Institution participant/C established DM EB by UN/Host country? Project participant Host country

-

Joint Committee

Methodology submission Verification

-

Joint committee

By third party By third party Covered emitters/ third party Ex post Ex post Ex ante/ex post? Host country?

By third party

Ex ante/ex post crediting Issuance of credits

Ex post

Institution established by UN

Institution established by UN/Host country?

Host country

Implements and sells

Project participant

Host Host Project country/Entit country/Entit participant ies ies Countries under obligations Covered emitters or others under obligations Countries and companies under obligations

Buyers

Countries and companies under obligations

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7.THE FUTURE LANDSCAPE
The post-2020 clim ate change regim e will consist of a spectrum of commitments and means of implementation. Some countries with emission caps under the Kyoto Protocol will also have caps after 2020. However, to curb global emissions, it will be necessary to encompass all countries and all sources (and sinks) in some way or another. The NAMA pledges have already demonstrated that commitments can take different forms and that a country not able to cap its entire economy may be able to cap some of its sectors. The future landscape for the mechanisms will also change, both the landscape within which they operate as described above but also the manner in which they operate. Sometimes, the idea is expressed that there is a linear evolution beginning by project-based mechanisms, moving on to sector-based mechanisms, finally leading up to economy-wide cap and trade. Such a direct development is, however, difficult to envisage. Perhaps it will be more efficient not to go through all these stages but rather go straight from project-based mechanisms to cap and trade. There are examples of regional trading systems linking, either through direct linking or through the use of the same type of offsets, and this is likely to continue. An evolution towards lower emissions can be expected, but different mechanisms will suit different circumstances and there will be fragmentation.

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FIGURE 5

From project to sector to global carbon market
Cove ra ge Eco n o my- w id e c ap Evolutio n? New Ma rke t Me ch a nis m S e c to r/Polic y/ Natio n ally Ap p r o p riate Mitigatio n Ac tio n St a n d a r dis e d b a s elin e s Pr ogram m atic CDM

CDM

D evelo p m e nt ove r tim e

The flexible mechanisms can help facilitate, and ease, the route to economy-wide caps. The mechanisms in project-based forms provide for price discovery. The experiences from setting baselines, sectoral no-lose targets and sectoral crediting will most likely prove useful in future discussions on economy-wide caps. It will also be important to launch pilot activities whilst awaiting far-reaching commitments necessary to create a significant demand for credits. In the illustration above, standardised baselines can be seen as bridge between single projects and more comprehensive, sectoral approaches, eventually leading on to economy-wide caps. One mechanism

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not to be forgotten, although not part of the picture, is JI. The possibility to do targeted projects even in a capped environment holds appeal, not least because it can be a tool to target mitigation action as well as channelling finance or new technology to specific projects or areas. There need not be a conflict between project-based mechanisms and sectoral crediting as long as there is proper accounting to avoid double counting When trying to single out which type of flexible mechanism is suitable for a given situation, a number of questions should be asked, including: What can be implemented as a project and what is better fitted for a policy programme? What degree of monitoring and reporting is needed and feasible? Who is most suitable to implement the mitigation action, the private sector or the government? In addition to these questions regarding suitability, issues like access to data, ease of monitoring etc. are important. It is not possible to give a straight answer to the question what suits the best, where. After all that is a question policy makers have been struggling with for years in a national context. In the table below, some indicative examples are however given.

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TABLE 2 – SECTOR AND MEASURES
Examples of areas/sectors Instrument/mechanism that could be suitable Rationale

Power generation

Trading/Crediting/CDM

Population of large point sources, ease of monitoring

Electricity consumption

Policy/Sectoral Crediting

Project based approach not efficient

Methane utilization from waste

CDM/Policy

Point source, carbon price signal important

Power generation

Trading

Population of large point sources, ease of monitoring

Buildings

Programmes/Policies

Not quickly responding to carbon market price signal, project based approach not efficient

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Fragmented carbon markets
As seen in figure 6, there are a number of current and emerging domestic, regional and international emissions markets around the globe. Dealing with such a “fragmented” carbon market, emissions trading systems and crediting mechanisms are being implemented and planned both at international and national level. Some, but not all, are part of the UNFCCC framework. This diversity of mechanisms will lead to a variety of unit types using different standards and under different forms of governance. Such fragmentation in the carbon market is less than optimal, but also opens up for different ways of linking the emissions trading schemes. FIGURE 6

Source: IETA (replica made by FORES)

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Complete linking of different systems requires mutual confidence in the design and operations of the systems to be linked and acceptability of ambition of both schemes. Complete linking may pose some risks that need to be considered, especially for smaller schemes, as linking may have an impact on domestic price and overall cost of compliance. Another option is indirect linking, implemented e.g. by schemes choosing to recognise same type of offsets. An interesting example is as previously mentioned the recently announced linking of EU ETS and the Australian ETS, with a one way link to be established in 2015 and negotiations aiming at a full two way link in 2018.29 In order for units from one mechanism to be recognised as valid under another scheme there must be confidence about the quality and environmental integrity of the units. It is also possible to have a one-way link that would only require a unilateral decision by the receiving party. The diverse features of the emerging initiatives and the uncertainty about a future climate change regime makes participation challenging. The current debate, at least at UN level, focusing on governance systems, has so far not adequately addressed the equally important question of how to create incentives for participation from the ones who are to implement the mitigation action. Private sector entities under reduction obligations will very likely be facing a number of different systems under different rules.
29 Australian and European Commission agree on a pathway towards full linking Emissions Trading Systems, Press relaeas 28 August 2012, http://www.climatechange.gov.au/en/media/whats-new/linking-ets.aspx

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The Role of UNFCCC
As the future could bring various approaches and mechanisms, a common framework at UN level seems desirable. Within the UN there is considerable experience in developing methodologies and system for verification and reporting. Institutions have been established to govern and to accredit. This is not to say that all new mechanisms need to be governed through the UNFCCC. This is not the case today. But a system to track the greenhouse gas units and avoid double counting is necessary for the credibility of a climate regime and the basics are already in place within the UNFCCC and the Kyoto Protocol. Hence, it seems rational to build on the existing framework. There are a number of issues where parties need to agree. Common, transparent, accounting rules to be applied to the identification of tradable units and reporting of emission reductions is one. That finance spent on traded units from new mechanisms should not be counted towards the financial commitment by the developed countries and at the same time allows for the generation of credits, is another. Similarly, emissions reductions made in host countries having generated credits should not be counted towards meeting commitments under pledges. The governance structure of a market mechanism needs to strike a balance between the sovereignty of the participating government and the outside oversight needed to build trust. Multilaterally-agreed baselines and methodologies, independent technical review, centralised supervisory

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institutions and compliance procedures are all being advocated. However, it seems unlikely that an agreement can be reached on these issues in the near future. So what are the bare essentials? In order for trade to work, a country with a commitment will need to vouch for the integrity of the units from that country. In contrast, with a no-lose-target, the mechanisms itself will have to be subject to control to ensure integrity of units. High level guidance and commonly agreed principles at UN level will give the possibility to countries, even small ones, to influence the framework as well as giving greater legitimacy than bilateral arrangements could. That is not to say that everything has to be developed through the UNFCCC. As experience shows, that could take a very long time. It might not be optimal from a design perspective either. As far as possible, technical parameters rather than negotiating power should form the basis for establishment of baselines and crediting thresholds as well as caps. There the experience gained though the CDM and the work on standardised baselines will be useful.

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8. CONCLUSIONS
The future landscape for flexible m echanism s to operate in will be very different from that established through the 1997 Kyoto Protocol and the subsequent Marrakech Accords. Whereas the Kyoto Protocol is a top-down approach under which a number of developed countries have quantified emission reduction obligations, the agreement at COP17 in Durban opens up the possibility of the development of a system of bottom-up pledges taken by developed, emerging and developing countries. The agreement in Durban envisages the finalisation of a new agreement in 2015 whereas its implementation is due by 2020. The post-2020 climate change regime will consist of a spectrum of commitments and means of implementation and while being more comprehensive, it will also be more complex. Clearly the depth and breadth of new emission reduction commitments will exert a major influence on how the current Kyoto mechanisms fit in. As will the development of new market mechanisms, in particular their use for offsetting as well as for financial support. The CDM has contributed to the bulk of our collective understanding of what flexible mechanisms are and can be. It has built experience, capacity and comfort with the use of market mechanisms and has been instrumental for many developing countries to considering domestic market mechanisms. The CDM will probably play a different role in the future compared to today and is already moving in the 81

direction of more projects in less developed countries and from large projects to smaller projects and programmes. The evolution of Programme of Activities is in effect a step towards a sectoral approach. The pledges to channel finance for mitigation action from developed to developing countries and the need to find secure ways of doing so, opens up for a new role of the CDM – to serve as a channel for mitigation finance and provide a receipt in the form of Certified Emission Reductions. There is a need for greater efforts in combating climate change and also for more comprehensive tools. A number of developing countries have pledged economy-wide or sectoral emission reductions or limitation targets as Nationally Appropriate Mitigation Actions. Some of these countries have indicated that they require financial support to achieve these commitments, which could be facilitated through direct participation in international emissions trading. Other developing countries may wish to benefit financially from participation in an international emissions trading scheme. The participation is then likely to be undertaken voluntarily, and on a sectoral, rather than an economy-wide, basis. Flexible mechanisms can provide cost efficiency and flexibility across time and place and help facilitate, and ease, the route to economy wide-caps with standardised baselines being the bridge between present and future mechanisms. Flexible mechanisms themselves do not lower emissions. First there needs to be a commitment either to reduce emissions or to provide finance for reducing emissions. When these are in place, flexible mechanisms utilizing the market can facilitate

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that the reductions are carried out in a cost efficient way. A crediting mechanism only provides an incentive to reduce emissions if there is a reasonable global carbon price. This can only be assured if demand is larger than the supply of credits and allowances in the market. In practice this could mean that the success of a crediting mechanism in a developing country could depend on the functioning of the market, and the market price, in a developed county, if that is where the demand comes from. Another way to create demand is through result-based payments. Flexible mechanisms can bring benefits that extend beyond climate change, as for example contribution to sustainable development and technology transfer. However, it is hard to ensure those benefits if they are not quantified or indexed. It should be noted that market mechanisms are likely to deliver optimally on parameters that are monetized. A mechanism with many purposes to fulfil is not likely to deliver equally well on all. Therefore, it will be wise to focus the objective of mechanisms on one aspect rather than to try to create a multipurpose tool. There have been several proposals for new mechanisms and many aspects are still under negotiation. The proposals put forward indicate that there will not only be one new mechanism but possibly several, that they encompass many parameters that are known from already existing mechanisms (thus not all that new). With the new mechanisms there is a much stronger role for governments compared to present day mechanisms. Governments need to provide incentives for private sector participation but how such incentive structures

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can be achieved is largely unexplored. The governance structure of new market mechanisms will need to strike a balance between the sovereignty of the participating government and the outside control needed to build trust. The detailed control possible in the CDM will not be possible in scaled up mechanisms such as sectoral crediting; the challenge in setting stringent and ambitious baselines for a whole sector makes this apparent. Multilaterally-agreed baselines and methodologies, independent technical review, centralised supervisory institutions and compliance procedures can all help build such trust. However, agreement is unlikely on such aspects in the near future. Progress could be accelerated by rapidly determining the areas in which agreement can be anticipated and building up modalities and procedures based around these areas. Such agreement should be sought within the UNFCCC to gain legitimacy through the involvement of a broad spectrum of countries. Mechanisms in project-based forms have provided for price discovery in a wide range of sectors and increased the monitoring and reporting expertise. The challenge of setting baselines at the right level for sectoral no-lose targets and sectoral crediting, although hard, is probably a very useful exercise for later discussions on caps. The development of pilot activities will be both useful and necessary. These will allow both an increased understanding of the parameters for new market mechanisms, a test of their viability as an area for investment, as well as a way of gaining involvement and acceptance by governments and private sector alike. The acceptance of the private sector and the need to provide proper

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incentives is very important since the capacity for investment and finance through carbon markets is potentially much larger than with public funds and would have an extra appeal to governments as the source of funding would not come directly from governments’ budgets. However, time is short and involvement of the private sector and other stakeholders during the development of new market mechanisms is essential, both when improving their operation and their acceptability as tools to stimulate investment towards tackling climate change.

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COMMENT
OLLE BJÖRK - former negotiator and former member of the JI Supervisory Committee Ulrika Raab and Fores have provided us with a timely and important report that puts into perspective the present state of climate change mitigation and negotiations. A state characterised by a surplus of scope and lack of commitment, in which the mobilisation of, or possibly the lack of, finance have come to the fore rather than mitigation itself. The point of departure herein the report as well as in the UNFCCC or to a lesser extent in the Kyoto protocol is that , from a pure climate point of view, it does not matter where reductions are made but rather that they are made. Nor does it matter from the climate perspective who pays as long as somebody does. Given that climate change mitigation is a global common good, distribution of financing the mitigation becomes a crucial challenge. This is dealt with in the convention and the protocol in a politically pragmatic way, by trying to take into account the principle of cost effectiveness laid down in the protocol. Quite a number of analyses point to large cost savings and resource transfers that are linked to globally cost efficient market based approaches compared to approaches sharing out the common effort on the basis of territorial boundaries. In fact, under the current political conditions, it is probably beyond our reach to meet the 2 degree target without applying the principles of cost

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effectiveness and common but differentiated responsibility when allocating actual mitigation action. From these principles and insights the mechanisms have been derived, developed and applied at a concrete level and have become vital tools for climate mitigation. These insights also explain the EU safeguarding the mechanisms and pushing to develop the new market mechanisms in the current negotiations. The CDM is the most successful mechanism so far but is not perfect. Due to the transparency and exactitude of the CDM-process, the mechanism undergoes continuous improvement also helped by constant but not always well founded criticisms from the NGOs. The matter of additionality assessment, even if it is performed by independent entities that have passed a careful accreditation process and subject to intricate and thoughtful procedures will always be there. What would otherwise occur i.e. in the absence of the project, could always be put in doubt. The CDM has gone through a dramatic development entailing three phases, a prompt start, a rapid expansion connected to the hopes at Copenhagen for further commitments, and the present demand squeeze in the wake of a withdrawal to domestic action and protectionist tendencies, partly as a consequence of the economic downturn. A lack of sufficient demand has left the world awash with a surplus of EUAs, AAUs and CERs. Current tendencies to restrict demand for CERs to force more expensive domestic action has put the mechanisms under

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severe pressure. Parallel to this, it is still maintained in the negotiations that CER supply will not be enough to cover necessary reductions and that there needs to be the development of large scale alternatives and new market based mechanisms. From a suppliers point of view this position might seem odd but the idea that the CDM should be reserved for parties that take commitments is maintained and, as a result, there is a reinforcement of the supply surplus. On top of this comes the presently most important agenda item in the negotiations: the implementation of the Copenhagen pledge by industrialised countries to mobilise finance support up to a level of 100 billion USD by 2020. Many intricate formulas and approaches are currently being discussed to find satisfactory solutions to provide and account for these necessary financial flows to developing countries. Most of the analysis is based on ODA experience. The link to measurable reductions is often very weak and sometimes not even existing and very far from the extremely precise and transparent emissions reduction measurement of the CDM. The CDM is already a multipurpose tool and, as suggested in this report, could have yet another role to play – to become a vehicle for contribute to fulfilling the Copenhagen pledge of resource mobilisation. Whether this should be with or without using the offsetting option is important in actual policy but far less important from the above overall climate perspective, namely, that mitigation is needed and that it is of less interest who pays as long as it is paid. From that perspective it is only a book-keeping matter on which account the CERs should be put. Compared to current ODA or even emerging pilot NAMAs the competitive advantage of CDM would be the certified

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emissions reductions that comes with the deal. This way, use of CERs could serve as an attractive means to fulfil the promised mobilisation of capital while some of the present CER surplus could be soaked up while waiting for a deeper and wider demand that should arrive when a new global carbon deal has been agreed in 2015. The institutional set up could be maintained and the weak market situation overbridged by private as well as government purchases. The CDM is in need and undergoes continuous improvement. This report and the recent high level CDM Dialogue group has made a number of suggestions that would merit further discussion. When it comes to new market based mechanisms, the report underlines the inherent weakness in some approaches that propose upscaled crediting mechanisms which would multiply additionality concerns. One way out of this would be to reduce the current strict quantitative additionality. This has been the route taken by the emerging Japanese bilateral BOCM. Another possibly more attractive development is the current wave of emerging plans for ETS schemes around the world i.e in China, India, Turkey, Chile et al. Such an archipelago of trading systems could one day be linked to each other by binding agreements that regulate trade and mutually recognise the commodity traded. Until then, i.e for the foreseeable future, the CDM will be needed and valuable. Care should be taken to avoid a collapse of the system, while constructing "superior alternative" which might be beset by similar weaknesses but at a much larger scale. Given the major inherent difficulties with the crediting approach, the short cut directly to straight cap and trade might be the way to go.

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The bottom line is that mechanisms or similar approaches will become increasingly important if we are to really come to the grips with climate change; a task which necessitates an international cooperative approach. These reflections have been inspired by Ulrika Raab's thoughtful report. The views taken in this afterword do not necessarily reflect those of any negotiation party and do not constitute an official position.

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REFERENCES
Australian Governm ent (2012) “Australian and European Commission agree on a pathway towards full linking Emissions Trading Systems”, Press release http://www.climatechange.gov.au/en/media/whatsnew/linking-ets.aspx Castro Paula (2012) “Does the CDM discourage emission reduction targets in advanced developing countries?” Climate Policy 12, 198-218 CDM Policy Dialogue (2012) “Recommendations from the High-Level Panel in Climate Change, Carbon Markets and the CDM: A call to action”. http://www.cdmpolicydialogue.org/report/rpt110912.pdf European Comm ission (2012) “Emissions Trading System (EU ETS)” http://ec.europa.eu/clima/policies/ets/index_en.htm (retrieved October 2012) Haites Erik, Duan M aosheng and Seres Stephen (2006) “Technology transfer by CDM projects”, Climate Policy 6, 327- 344 Olbrisch Susanne, Haites Erik, Savage M atthew, Dadhich Pradeep and Shrivastava M anish Kum ar (2011) “Estimates of Incremental Investment for and Costs of

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Mitigation Measures in Developing Countries”, Climate Policy 11 (3), 970-986 Seres Stephen, Haites Erik and M urphy Kevin (2009) “Analysis of technology transfer in CDM projects: An update”. Energy Policy 37, 4919-4926 UNFCCC (2011) “Report of the Conference of the Parties on its seventeenth session, held in Durban from 28 November to 11 December 2011” (UNFCCC/CP/2011/9/Add.1) UNFCCC (2011) “Outcome of the work of the Ad Hoc Working Group on Long-term Cooperative Action under the Convention, Decision 2/CP.17” http://unfccc.int/resource/docs/2011/cop17/eng/09a01.pdf UNFCCC (2011) “Benefits of the Clean Development Mechanisms” http://cdm.unfccc.int/about/dev_ben/pg1.pdf UNFCCC (2012) “CDM in numbers”, http://cdm.unfccc.int/Statistics/index.html retrieved 23 Sept 2012.

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