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lead.jpg (22302 bytes)    Volume 3 
   Number 4
   26 October 1998 

EQUITY IN THE CDM
ENDA Tiers Monde, Dakar, Senegal
Stephen Humphreys, Youba Sokona and Jean-Philippe Thomas


Introduction
The operational details of the Clean Development Mechanism (CDM) will probably be settled at the Buenos Aires Conference of the Parties (COP4). There has already been much work done outlining possible modes of operation for this mechanism in conferences, papers, and behind-the-scenes negotiations. The result is that there is now general agreement on the available options and principles of functioning of the CDM. Many important issues remain to be resolved however and large questions still hang over squaring the demands of the different stakeholders involved. This paper outlines the basic issues remaining and offers a model of functioning that will suit all actors, with an emphasis on the integration of the principle of equity and the position of African stakeholders. We discuss the links between the mechanisms and two basic equity issues in the CDM – equity between Annex I and non-Annex I countries and equity amongst non-Annex I countries.

Structured Flexibility: Three Mechanisms and their Linkages
The Kyoto Protocol has introduced an innovation into international relations by creating a new property and a new market (assuming it is ratified). It introduces a market-based system in order to give countries with targets flexibility to achieve compliance. Property rights have been allocated over the production of greenhouse gas emissions. Only countries with emission targets (Annex B of the Kyoto Protocol) have rights – known as "tradable permits" – and these permits have been allocated on the basis of "grandfathering": that is, according to use patterns in the past. Countries’ permits are equivalent to their "assigned amount" of targeted emissions of six greenhouse gases. Annex B countries will be able to buy or sell permits on an international market in order to meet their targets. They may also gain "credits" for emission reductions achieved elsewhere through projects either in other Annex I countries or in non-Annex I countries. Countries may also "bank" surplus reductions and credits to use against future targets (after the first compliance period of 2012).

The Protocol outlines three main mechanisms (a fourth mechanism "bubbles" will not be discussed in this paper) to underpin this international regime: International Emissions Trading (IET), Joint Implementation (JI) and the Clean Development Mechanism (CDM). They are all linked by the idea of emission reduction credits that they will generate and exchange. Credits is a blanket term for the Emission Reduction Units (ERUs) that will be traded within the IET market and the Certified Emissions Reductions (CERs) that Annex I countries are expected to achieve through carrying out CDM projects in Developing Countries and JI projects in Economies in Transition. ERUs and CERs are expected to be "fungible" – i.e. inter-changeable on the IET market.

Annex B countries produce the majority of global greenhouse gases and insofar as IET and JI only apply to these countries there is a certain amount of closure over the new market. The CDM however will apply in countries which do not have targets or emission permits and cannot trade in credits for reduced emissions. The question that arises is: where is the flexibility for these countries?

The Clean Development Mechanism
The CDM can be considered the central mechanism for three reasons. Firstly it is the original flexibility mechanism: the CDM is the acceptable version of the original idea of Joint Implementation which was not accepted by developing countries. It is based on the principle that the most cost-effective measures globally must be taken to mitigate climate change, since greenhouse gases have a purely global impact. Secondly its starting date in 2000 gives it an eight year lead on the IET market, meaning it will have a determining effect on the market.

Thirdly, CDM prepares non-Annex I countries for full participation in global action to mitigate climate change. It is the only mechanism with an authentic global reach – and it is important that it extend to as many non-Annex regions and countries as possible. The CDM will orient the future development of non-Annex I Parties along a more sustainable path, it will accelerate their integration into the global economy, and it will lay down the capacity and structures for the eventual elaboration of reliable national baselines. All these factors prepare them for eventual emission targets in the future.

The CDM is destined for countries that by definition ("developing") are expected to increase their emissions in the immediate future. For this reason, unlike JI, the CDM can only operate with net emission limitations, or future avoided emissions. Also by definition these countries do not have emission targets and cannot trade in the IET. For these reasons the idea of cost-effective reductions in itself does not provide an incentive for the involvement of host parties. The CDM therefore has a second purpose: "to assist Parties not included in Annex I in achieving sustainable development". For developing countries CDM projects are seen as an "additional financial mechanism" (as outlined in the UNFCCC) for achieving development. The incentives for investors and hosts in CDM projects are quite different therefore, and this brings a particular problematic to the CDM in addition to those surrounding JI and IET: that of equity.

Joint Implementation
JI projects are available as an option between Annex I countries, whereby a country can gain tradable credits for financing a project to reduce emissions in another country. Effectively, but not necessarily, this applies to projects carried out by Annex II countries (of the Convention) in Economy in Transition (ET) countries in Eastern Europe. Superficially this regime is similar to the CDM but in fact the two are fundamentally different. Conceptually, JI environmental focus, whereas the CDM focuses on development. ET host countries have their own emission targets and will to choose projects with immediate emission reduction potential. Furthermore for historical reasons, ET countries have many options for energy efficiency and other emission reduction projects. JI is fundamentally about measurable emission reductions – the debate about "low-hanging fruit" is crucial to these countries. Secondly, the CDM will be a multi-lateral mechanism whereas JI is bilateral. In practice JI will operate on a more purely market basis – projects negotiated and implemented between investing partners. Thirdly, ET countries have better developed infrastructures than developing countries. The private sector is strong relative to developing countries and a climate already exists for implementing projects: all these things reduce transaction costs for projects in these countries.

International Emissions Trading
IET will allow countries with emission targets (Annex B of the Protocol) to trade "reduction credits". Each Annex B country will have permits representing its "assigned amount" – the total amount of emissions they are allowed – which they can buy or sell in order to ensure that their targets are reached. So if Country A is in danger of defaulting on its target it can buy ERUs from Country B, which (supposedly) has surplus reductions over its target. There are a large number of difficulties associated with the projected IET regime most of which are beyond the scope of the present paper. What is important here is that, due to the fungibilty of credits, any changes in the value of ERUs on the IET market will have an impact on the value of – and therefore demand for – CERs, and also on the demand for the CDM and JI projects which generate them.

Linkages
Assuming all parties wish to maximise benefits, the difference in stature of the commodity within the different mechanisms will ultimately determine what parties decide to do with their emission reduction potential. There is an incentive for developing country parties to voluntarily enter the IET because this increases the value of their emission reduction potential. Until non-Annex I Parties take on targets the market will not be closed – property rights will not be fully allocated. The pressure will be on henceforth to introduce targets everywhere, thereby closing the market, eliminating "leakage", establishing a global baseline and ensuring additionality. Many developing countries – in Africa in particular – cannot take on targets in the near future. Furthermore targets will limit development in countries which have in no way contributed to the problem.

Comparative Cost of ERUs: From the Annex I point of view the attraction of CDM will depend on the quality and price of CERs gained on the CDM as against those available domestically or through the other mechanisms. The quality depends on the credibility of credits gained through the CDM – which in turn depends on the reliability of baseline and verification methodology. The price will be largely determined by the nature of the projects accepted, the costs imposed by the mechanism itself and the transaction costs of negotiating and developing the project. These factors compared to the relative price of ERUs on the market will determine CDM involvement.

Supplementarity: In addition, much will depend on the ability and willingness of Annex B countries to achieve their emission targets domestically. The principle of "supplementarity" demands that targets cannot be achieved purely through the flexible mechanisms. There is little certainty, however, on how this principle is to be incorporated. Supplementarity will put a ceiling on the extent to which the CDM can be used.

Price volatility: If prices on the IET market are unstable there will be a high risk investing in CDM projects after 2008; if prices are cheap, there will be low demand for CDM. The integrity of the system (as well as its environmental impact) will therefore depend to a large extent on the closure of the IET regime. The less the system is open to unpredictable increases in supply (and the less hot and tropical air available), the higher the incentive for Annex I countries and investors to invest in CDM and JI projects. The time lag between the initiation of CDM (starting from 2000) and IET (2008) should give the former a chance to stabilise before they are exposed to the market.

Credit-Sharing: Credit-sharing refers to the partition of CERs from a CDM project between the investor and the host. The interest of such an arrangement depends on the ability of non-Annex I countries to "bank" credits – i.e. save them for future use against possible emission targets, or trade on the IET as a source of income. It seems desirable that some such system should prevail no matter what final arrangement accrues. The questions are what value CERs will have for a non-Annex I country without targets, and whether a standard should be introduced or whether sharing should be negotiated on a project by project basis.

The Equity Deficit in the CDM
There are two basic issues of equity in the operation of the CDM. The first is the issue of equity between the two a priori partners – Annex I and non-Annex I Parties. This issue can be considered central to the CDM – without equity at this level the mechanism will be unable to function. The second is equity between non-Annex I countries. The CDM is one of the "additional financial mechanisms" for developing countries referred to in the Convention, and it must therefore be equally accessible to all Parties who have ratified the Convention. This is a question of the structure of the CDM and its potential impact on other financial mechanisms.

"North-South" Equity
The allocation of property rights concerning the production of greenhouse gas emissions brings the issue of equity to the fore of the international regimes to be implemented under the Kyoto Protocol. Clearly a per capita allocation on the global level is the most equitable (see Anil Agarwal). Although this is not possible at present it must be retained as a long term objective of the Convention. The "grandfathering" technique of allocating rights is a first practical step: it should not be considered final as it represents an equity deficit in international rights.

Given the existence of a market in emission reduction credits, CDM projects will produce commodities for this market. The idea is that an energy efficiency (for example) project in a non-Annex I country will produce emission reductions more cheaply than an equivalent project in an Annex I country. The Annex I investor can then sell the reductions, in the form of CERs, at a higher price to countries in need of credits.

However host countries are in an unusual position in that they themselves cannot sell this commodity if they produce it. Therefore the profitable aspect of a CDM project is unavailable to non-Annex I countries. Once more we see a large equity gap at the heart of the international regime. JI projects are crucially different in this way as the host country is also an active participant in the market – in a JI project the interests of the investor and host parties are roughly equivalent. In CDM however the host country has no obvious interest in the emission-reduction component of a project.

Certain developing countries have taken the bull by the horns on this issue – a number of Latin American countries are considering taking on voluntary targets which will bestow value on their own offset commodities. They could then act like Annex I countries and produce, buy and sell as they like. Costa Rica has gone a step further and – in the absence of a regime to support it – produced their own Certified Tradable Offsets (CTOs) and put them up for sale. Costa Rican CTOs are verified by a third party (not yet recognised by the Convention) and guaranteed by the Costa Rican government. The status of CTOs in the Convention is uncertain. If they are accepted they will certainly upset the CDM regime. In the meantime, taking on emission targets is not an available option for many non-Annex I countries – particularly in Africa.

CDM projects must therefore have something equivalent to offer non-Annex I countries. This is the importance of the "sustainable development" clause in Article 12, and the reason why its integration must be at an equivalent level to that of the emission limitation aspect. Much of the debate over the CDM to date has centred on (environmental) additionality – the accurate measurement of the Carbon offsets generated by projects. Accurate baselines and reliable verification methodologies will determine and guarantee the value of the credits – i.e. gains – earned by investing parties. The parallel issue – "financial" additionality – the integration of sustainable development objectives – has not received as much attention. We submit that this issue must be addressed in order to redress the balance of interests in CDM projects: otherwise the regime will not function.

The cost-effectiveness of a regime (or project) can only be considered once the objectives are clear. When it is recognised that the integration of sustainable development objectives is integral to the CDM the question will no longer be whether it is cost effective to do so, but what is the most cost-effective way of doing so. That is to say elements of the CDM that "raise the hurdle" for investors cannot be eliminated on that basis, as long as they remain fundamental objectives of the mechanism. This applies to the "share of the proceeds" – for administration costs, adaptation and credit-sharing – as well as to other project formulation elements that may raise transaction costs. Cost-efficiency must be adhered to in the application of these criteria. As long as the cost per tonne of Carbon avoided remains lower than the domestic cost for investors, demand for the CDM will remain.

We suggest two possible methods of integrating these objectives. A spectrum of sustainable development indicators, drawing on international as well as national sources can be drawn up. The project articulation will choose which of these are applicable to a particular project and how they are to be verified. Project certification will include verification of these indicators. Alternatively the project document will demonstrate how the project fits into the national development plan of the host Party. Once again standards for measurement and verification will be required for certification.

Equity Among Non-Annex I Countries

Climate change is a global problem requiring a global response. In order to ensure the participation of developing countries the UNFCCC offered "new and additional financial mechanisms" to these countries to aid them participate in addressing a problem they did not create and do not have the resources to tackle. The GEF is one such mechanism. CDM is another.

The CDM is understood as a market-based mechanism. This means that projects will go where investors see the best opportunities for investment. Since profits are measured in terms of reduced emissions countries with high reduction potential will be the first option. Since investment requires a certain climate of trust and contacts, countries with pre-existing FDI relations with Annex I countries will be chosen at first. Africa scores badly on both counts – only 3% of global FDI in 1997 went to Africa – and will therefore be largely excluded from a market-driven CDM. In addition Africa’s weak infrastructure in terms of transport, telecommunications, energy and institutions make the transaction costs of project-negotiation and development particularly high on this continent.

However Africa’s private sector is currently consolidating, inefficient state-controlled utilities are being privatised throughout the continent and economic barriers are being lifted. Africa’s small status has also meant that it has largely escaped the economic crises of the rest of the globe, something which may work to its favour in the future. The CDM is an opportunity to stimulate this crucial nascent sector. But this will require flexibility with the mechanism for developing countries to ensure that it takes off. Some possibilities follow:

A multilateral fund: Ideally the CDM requires a new institution: preferably stream-lined and unbureaucratic. At the least, it can be housed within a major UN institution such as UNDP, UNEP or UNIDO, or a combination of these, in order that investment can be channelled into emission limiting projects which may not yet be commercially viable. Investors can then receive their credits while funding clean development projects in developing countries.

Regional differentiation and project tracking: The differing conditions that prevail in different developing countries must be taken into account if the CDM is to contribute to climate change action globally. Project development should be monitored (a good first date would be 2005, coincident with the evaluation of Annex I domestic actions) and in the case where fewer projects are implemented in a certain region or group of countries, steps taken to ensure that project proposals from those countries are prioritised. The particular conditions that accrue in the Least Developed Countries – many of which are in Africa – should militate for "seed funds" to be set aside to get the CDM moving in these countries.

Regional action: Africa will have need of the involvement of regional and subregional organisations (particularly the African Development Bank), and of subregional CDM agencies who can build a portfolio of national and subregional projects and liase between Annex I and non-Annex I parties.

Adaptation fund: A certain share of the proceeds of CDM projects is to be set aside for adaptation. Since information on climate change effects and vulnerability is still uncertain, the basic vulnerability of countries that do not have the economic resources to deal with climate change should be prioritised. However even with a 5% cut of the proceeds, the amount available to an adaptation fund will be practically negligible. Furthermore the CDM is the only mechanism with this "tax"– which represents a competitive distortion with regard to the other mechanisms. A similar cut should therefore be levied on JI projects and the Emissions trading market in order to level the playing field and render the adaptation fund credible.

The CDM and other Financial Mechanisms
A major concern for African countries is how the CDM will impact the other financial mechanisms, Development Aid (ODA), GEF, etc. It is disturbing, for example, to read in the conclusions of the Environmental Council 6/10/98 that the EU Commission "indicate how EC ODA might better serve the objective of the UNFCCC." For many African countries today ODA is a basic requirement for their development priorities: a diversion of ODA towards climate change activities would have a contrary effect, particularly given the UNFCCC specification of new and additional funds for this purpose. However CDM projects could be "added" to existing development projects, introducing an emission limitation component and increasing the scope of the project at the same time. The CDM may lead to a re-channelling of ODA towards social development projects where it is greatly needed.

The role of the GEF too will certainly alter due to the CDM. Again it is important that CDM does not replace GEF – the two have fundamentally different roles. GEF can provide invaluable assistance in capacity building for CDM – ensuring that capacity exists in developing countries for creating viable CDM projects, calculating baselines, monitoring and verification, etc. GEF’s role in technology introduction need not be abandoned. The CDM will tend towards projects with a lower risk and a higher economies of scale, but GEF can operate with high-risk technology-penetration projects – to lower the long term costs of low-emission energy technologies. After a certain point these technologies will become commercially viable and enter the field of CDM operation.

African countries are also concerned about the stimulation of foreign investment on the continent. As noted, investment in Africa is growing at the moment, but remains weak. The CDM is a chance to give fresh impetus to investment on the continent. In one way or another the CDM will have an impact on other financial mechanisms in the global context. This is a subject requiring analysis.

For more information on ENDA Tiers Monde - Senegal, see
http://www.enda.sn/energie/indexpea.htm. ENDA can be reached via e-mail at energy2@enda.sn