3.1 Establishing a Basis for Understanding JI and Host Countries' Concerns . ...... is with an order-of-magnitude approximation such as a âdiscountâ applied ...
UNDERSTANDING CONCERNS ABOUT JOINT IMPLEMENTATION
Russell Lee James R. Kahn Gregg Marland Milton Russell Kathryn Shallcross Thomas J. Wilbanks
with contributions by: T. Randall Curlee Jonathan Rubin Diccie Way
October 1997
Prepared by The Joint Institute for Energy and Environment 600 Henley Street Suite 314 Knoxville, TN 37996-4138
This document reproduced on recycled paper.
PREFACE AND ACKNOWLEDGMENTS
This Report illuminates the issues surrounding Activities Implemented Jointly (AIJ)/Joint Implementation (JI) under the United Nations Framework Convention on Climate Change, particularly with regard to the major concerns of prospective host countries. By using a game theoretic approach that takes the self-interests of the participants as the basis for analysis, the Report clarifies what AIJ/JI is and is not. Based on these insights, the Report examines host country concerns about industrialized countries “getting the credits,” the loss of “low-hanging fruit” (low-cost opportunities to reduce greenhouse gases), getting shortchanged, the risk of AIJ/JI leading to emissions caps, losing official development assistance (ODA), unintended adverse impacts, mismatch with host countries’economic and environmental priorities, and the loss of sovereignty. The Report also examines the interests and concerns of other parties in the negotiations — in particular, the positions of investors, their host partners, the investors’countries, and the global community at large (as well as host countries). In a departure from many previous studies, this Report assumes that parties negotiate in their self-interest rather than strive to maximize global welfare. In doing so, the Report clarifies the opportunities that arise under AIJ/JI and the constraints on its operation. The analysis concludes that there are indeed opportunities for reducing greenhouse gas (GHG) emissions through negotiation among the parties, with each seeking the maximum advantage for itself. It then outlines steps that are required to achieve gains that are real, significant, and attainable. Consequently, the analysis demonstrates that real gains are possible for all parties if they are willing to forego insistence on the perfect instrument, and to accept that the gains must be shared. The Report thus makes the leap from previous, troubling formulations that seek implausible theoretical optima to solutions that are practical and feasible to achieve. This Report was designed to contribute to discussions leading to international negotiations on measures to control greenhouse gases. Research for this Report was initiated and partly funded by the Joint Institute for Energy and Environment (JIEE), a collaborative partnership of the Oak Ridge National Laboratory, the Tennessee Valley Authority and the University of Tennessee. It was also supported in part by the Office of Economics, Electricity and Natural Gas Analysis, in the Office of Policy and International Affairs of the U.S. Department of Energy. This funding was provided to, and accepted by, JIEE with the explicit agreement that the study and the publication of its findings were to be conducted by JIEE researchers with no direction or control exercised by the sponsors. Consequently, the Report does not necessarily represent the views of the U.S. Department of Energy nor any other U.S. government body. The authors alone bear full responsibility for the material in this Report.
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The lead author of this Report is Russell Lee; other authors are listed in alphabetical order on the cover. Assistance in producing and formatting this document was provided by Diccie Way and Tanya Brown. The authors had the benefit of extensive review from colleagues at JIEE. We also wish to acknowledge the assistance of several outside experts who were formal reviewers of the final draft of this document and to absolve them of responsibility of any positions taken in the Report. The reviewers include: David Lewis Feldman, Senior Research Scientist Energy, Environment and Resources Center, The University of Tennessee Howard Gruenspecht, Director Office of Economics, Electricity and Natural Gas Analysis Office of Policy and International Affairs, U.S. Department of Energy Elmer C. Holt, Senior Economist Office of Policy and International Affairs, U.S. Department of Energy David William Pearce, Professor Associate Director, Centre for Social and Economic Research on the Global Environment (CSERGE) Michael Toman, Senior Fellow Resources for the Future Wytze van der Gaast, Editor JI Quarterly.
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TABLE OF CONTENTS
PREFACE AND ACKNOWLEDGMENTS................................................................................ ii EXECUTIVE SUMMARY........................................................................................................ vi 1. PURPOSE AND BACKGROUND ....................................................................................... vi 2. MAJOR INSIGHTS.............................................................................................................. vi 3. ADDRESSING CONCERNS ABOUT JI............................................................................ viii 4. BASELINES......................................................................................................................... ix 5. CONCLUSIONS ................................................................................................................... x 6. ORGANIZATION OF THE PAPER...................................................................................... x 1. INTRODUCTION .................................................................................................................1 1.1 Purpose................................................................................................................................1 1.2 Background..........................................................................................................................1 1.3 Organization of the Paper .....................................................................................................3 2. FRAMEWORK FOR CONSIDERING CONCERNS ABOUT JOINT IMPLEMENTATION ...........................................................................................................5 2.1 Concerns About Joint Implementation ..................................................................................5 2.2 Game-Theory Framework for Addressing Concerns About JI ................................................6 2.3 Insights from Game Theory ................................................................................................ 12 3. UNDERSTANDING HOST COUNTRIES’CONCERNS ................................................... 15 3.1 Establishing a Basis for Understanding JI and Host Countries’Concerns ............................. 15 3.2 Why Should Industrialized Countries Get the Credit? .......................................................... 16 3.3 Loss of Low-Hanging Fruit ................................................................................................. 19 3.4 Apprehension About Getting Shortchanged ......................................................................... 26 3.5 Risk of JI Collaboration Leading to Caps That Will Inhibit Economic Growth ..................... 30 3.6 Fear of Losing Official Development Assistance .................................................................. 32 3.7 Unintended Adverse Impacts ............................................................................................... 36 3.8 Mismatch with Host Countries’Priorities and Technology Needs ........................................ 38 3.9 Fear of Loss of Sovereignty................................................................................................. 41 4. SUMMARY AND RECOMMENDATIONS ....................................................................... 44 REFERENCES ......................................................................................................................... 48 APPENDIX A- OVERVIEW OF GAME THEORY LITERATURE IN THE CONTEXT OF INTERNATIONAL ENVIRONMENTAL NEGOTIATIONS ...............................................A-1 A1. INTRODUCTION...........................................................................................................A-1 A2. OBSTACLES TO TRADING AND JOINT IMPLEMENTATION ................................. A-2 A2.1 Factors reducing the efficiency of trading........................................................................A-2 v
A2.2 Strategic behavior...........................................................................................................A-3 A2.3 The basics of game theory...............................................................................................A-5 A2.4 Free riding ......................................................................................................................A-8 A2.5 Imperfect information .....................................................................................................A-8 A3. IMPLICATIONS OF GAME THEORY FOR JOINT IMPLEMENTATION ..................A-9 A4. CONCLUSIONS........................................................................................................... A-11 APPENDIX B- SUMMARY OF OTHER PARTIES’CONCERNS........................................ B-1 APPENDIX C- ISSUES ASSOCIATED WITH FOREST MANAGEMENT JI PROJECTS... C-1 C1. THE COMPLEXITY OF FOREST MANAGEMENT AND THE CARBON CYCLE..... C-1 C2. DEFINING A BASELINE, MONITORING, AND VERIFICATION.............................. C-2 C2.1 Baselines......................................................................................................................... C-2 C2.2 Monitoring and Verification ............................................................................................ C-2 C2.3 Carbon Accounting......................................................................................................... C-3 C2.4 Leakages ........................................................................................................................ C-4 C3. TEMPORAL BOUNDARIES AND EMISSIONS CAPS ................................................ C-4 C4. SUMMARY AND IMPLICATIONS............................................................................... C-5
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UNDERSTANDING CONCERNS ABOUT JOINT IMPLEMENTATION
EXECUTIVE SUMMARY
1.
Purpose And Background
The purpose of this paper is to develop a better understanding of some of the more serious concerns about Joint Implementation (JI), especially those of many of the countries that would prospectively host JI projects. JI was introduced in the United Nations’1992 Framework Convention on Climate Change as a means by which countries that are Party to the Convention can meet their commitments to reduce greenhouse gases (GHGs), in part, by obtaining “emissions credits.” Firms and other organizations in these countries obtain these credits by arranging projects that reduce emissions in other (host) countries. These projects might involve new renewable energy power plants, retrofits of existing plant and equipment, forest management projects or any other project that either reduces net emissions, or sequesters carbon. However, thus far, although the Parties have agreed in principle to emissions reductions, there are no binding quantitative commitments by any countries to reduce GHGs and there is no JI program. The international pilot JI program [called Activities Implemented Jointly (AIJ)]), though providing participants with useful experience, does not provide for any emissions credits. Thus, as the Convention’s Third Conference of the Parties in Kyoto, Japan approaches, there is considerable debate about whether JI should in fact be implemented. Many observers view JI as a potentially significant means of lowering the costs of reducing GHG emissions and promoting sustainable development. But many countries have severe reservations about whether JI would be effective and whether it would be in their own best interests. This study addresses these concerns.
2.
Major Insights The major insights of this study are that:
(a) JI negotiations are analogous to a “game.” It is useful to consider JI negotiations using a field of study called game theory in which different players have different goals and strategies. There are many “players” or “parties” in these negotiations, and it is useful to group them into five categories: (1) investors in JI projects, (2) their partners in the host countries, (3) the investors’ countries, (4) host countries, and (5) the “global community.” The latter represents the collective position of the Convention (non-governmental organizations are also part of the global community). As in game theory, these parties will use strategies in their negotiations to try to obtain the best possible terms for themselves.
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(b) JI projects are partnerships. JI projects are joint ventures in which investors and host partners both provide inputs to a production process and share in its outputs — including the emissions credits. Investors provide some combination of capital, know-how and technology. Host partners/countries provide a situation that qualifies as a JI project, and possibly plant and equipment, labor and other resources. Thus, investors are not “donors” because they are not donating anything, nor are hosts "giving away" anything. Each is a party in an arms-length transaction that sets up an ‘enterprise’from which each hopes to gain. (c) All parties will benefit from well conceived projects. Each JI project should have the approval of the investor's country, host country, and a panel representing the Convention, as well as of course the investor and its host partner. Thus, all parties involved will benefit from JI projects because otherwise they would not approve them. Investors benefit because they can reduce their emissions at costs lower than those available in their own countries. Investors’countries benefit because they are able to meet cost-effectively their emissions commitments. Host partners benefit because of the technology and capital that they gain, and the added revenue that they provide. Host countries benefit because JI provides them with additional investment capital at less-than-market rates — technology that can be diffused into the rest of their economies and/or increase their output of goods and services. Finally, the global community benefits because global emissions targets are more likely to be realized when they are made less costly to attain. (d) JI is a type of international trading. The emissions credits produced by a JI project are a commodity, just as, for example, copper is a commodity. There is a market for copper because firms are willing to pay for it in order to produce final goods such as copper wire that they sell. Similarly, there would be a market for emissions credits because (and only because) investor countries’ commitments to limit their GHG emissions lead them to require that their firms limit their emissions. Credits would be used by these firms together with land, labor, capital and materials as factors of production in, for example, generating electricity within the emission limits set by their government. And just as a country with copper resources might seek a foreign investor in a mining project, so too might a host partner join with a foreign investor in a JI project. In each case, the host country has a comparative advantage in producing the commodity (copper or credits) at a low cost, and exports it to another country in exchange for something it values more highly. (e) Parties must be willing to forego theoretical maximum benefits in order to gain. JI and trading of emissions credits provide win-win-win-win-win opportunities in which all (five) parties are better off with JI than without. But each party must be willing to accept gains that are less than what it would get if the other parties only see the situation its way. Neither the investor country and firm nor the host country and host firm can get all the “surplus” that results from the efficiency gains in using JI mechanisms. And in particular, the global community player must recognize that JI cannot be used to implement a global least-cost optimization of emission reduction.
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(f) Baselines should be defined for both countries and individual projects. Ideally, countries without caps (which many observers expect to be the so-called non-Annex countries) should have baselines, as well. JI project baselines should be defined at the “margin” (e.g., not the average of existing power plants).
3.
Addressing Concerns About JI
As one would expect from a game-theory perspective, different concerns about JI have been raised depending on each party’s vantage point. From the perspective of the host countries’interests, which are a major focus of this report, the key concerns are: (1)
Why industrialized countries should get the credits.
(2)
Loss of low-hanging fruit.
(3)
Apprehension about getting shortchanged.
(4)
Risk of JI collaboration leading to caps that will inhibit economic growth.
(5)
Fear of losing Official Development Assistance (ODA).
(6)
Unintended adverse impacts.
(7)
Mismatch with host countries’priorities and technology needs.
(8)
Fear of loss of sovereignty.
The major insights from this study, which we previously summarized, provide a means of addressing these concerns. Concerns (1) to (5) center around the issue of whether the host country will be at economic disadvantage as a result of JI. The best chance of resolving the first three of these concerns (where the credits go, low hanging fruit, and fear of getting shortchanged) appears to be in the parties developing an understanding of JI projects as being joint ventures in which the investor and host partner recognize that there are opportunities for both to benefit, and accept that each will try to negotiate the best possible terms for itself. The best chance of resolving Concerns (4) and (5) appears to be in the parties recognizing and accepting that JI and other policies (such as emissions caps on non-Annex countries and ODA) are separate issues that should be decoupled from those dealing with JI. ODA, for example, is aid provided by foreign governments and multilateral organizations; whereas, JI entails gain-seeking partnerships between firms (as well as governments and organizations) and their host partners.
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Concern (6) is largely about adverse environmental effects from economic growth. The best way of mitigating this impact is also the very thing that developing countries would want to avoid — taking on emissions caps. But countries that aspire to economic growth must make tough decisions and realize that it is difficult to have one’s cake and to eat it too. Concerns (7) and (8) (mismatch with priorities and loss of sovereignty) deal more with host countries’sense of national priorities. The best way of addressing this type of concern is for investors and the host country to appreciate each other’s outlook. Investors should be sensitive to these concerns; and should propose projects that address, to the extent possible, host countries’priorities and that minimize foreign ownership of host-country resources. Host countries should recognize that investors need to try to make a profit and thus might not propose projects in which host countries would place the highest priority.
4.
Baselines
The issue of defining baselines remains as perhaps the most daunting issue confronting JI. Baselines need to be defined to determine the quantity of emissions credits from any project. A baseline is the situation that would have occurred had there been no JI program. The project baseline should be defined on the basis of GHG-emissions of the most likely alternative, which would have been implemented had there been no JI support. For countries with an emissions cap, their cap is effectively their national baseline. For countries without a cap, however, defining a national baseline is problematic. Ideally, baselines should be defined both for an individual project, as well as for its host country. The method for defining these baselines should be agreed upon by the Parties as part of the JI protocol. Carbon-accounting is a problem in forest management projects, especially in countries without a national baseline. In these cases, it seems prudent to use heuristic adjustment factors (to reflect leakages) when calculating the emissions credits in these types of projects. The issue of measuring GHG-emissions reductions compared with a baseline is complicated enough when the project involves fuel switching in an individual industrial or power plant or afforestation of an area previously without biomass cover. It is more serious for efficiency improvements that reduce GHG emissions, and it is far more serious yet for projects focused on institutional processes that could have far bigger long-term impacts, such as integrated resource planning. It is likely in fact, that the most profound contributions to GHG-emissions abatement will be the ones hardest to document, and therefore probably least suitable for JI. The Parties should devote more attention to developing these other initiatives, such as institutional changes. Nevertheless, the probability that JI cannot facilitate all forms of emission reduction should not be allowed to interfere with its implementation where it can work well.
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5.
Conclusions
JI is a form of international trade in which GHG emissions credits are commodities. It follows that JI and the establishment of an international market for trading emissions credits go hand in hand. The latter is a logical extension of JI and expands its benefits. A game-theory perspective is useful for understanding concerns about JI. Many of these issues stem from host countries’concerns about: their being economically disadvantaged as a result of JI, adverse environmental consequences of economic growth, and inconsistencies with their national priorities. These concerns can be addressed by the parties once they understand that: (1) JI can provide gain for all parties, but probably less gain for each party than it would attain if other parties agreed to its perspective; (2) procedures can be implemented to reduce any adverse environmental consequences of JI projects, but that parties must consider accepting these risks in return for other, greater gains; and (3) parties can negotiate conditions in JI contracts to allay their concerns about national priorities, while still making the deals attractive enough for all parties to participate. Leakage effects and other limitations in being able to perfectly monitor and verify the net decrease in GHG emissions in JI projects should not preclude them. Institutional procedures must be implemented to ensure an adequate degree of effectiveness in the JI program, but should not give rise to transactions costs that strangle it and stifle its effectiveness. To reduce transactions costs, guidelines should be established by countries, as well as by the Convention, a priori to allow umbrella approval for projects that conform to certain parameters. A panel can “spot check” (i.e., sample) projects to monitor and verify performance, after the fact (not prior to approval). Once commitments are made to reduce GHG emissions, the Parties bound by these commitments will presumably honor and meet them — with or without JI. Thus, JI has no direct effect — adverse or beneficial — on global climate; it simply makes attaining any given level of GHG emissions reductions cheaper. (Of course, by making control cheaper it makes overall agreement easier and changes the trade-off to the advantage of higher reduction targets.) Efforts to block JI from becoming a viable program under the Convention will not help address the risks of climate change, but will only hurt developed and developing countries alike.
6.
Organization of the Paper
The paper is organized as follows. Section 1 is an introduction to the paper and provides background information. Section 2 develops a conceptual framework to address JI concerns. The framework serves two main purposes. The first is to provide an organizational structure for classifying the different concerns. The second, and more important, is to provide a perspective for analyzing the basis of the concerns and, subsequently, for suggesting ways that the parties can address them. Of all of the concerns, those of the prospective host countries are probably the most serious. Different host countries have different concerns, but they can be organized into eight categories. xi
Section 3 focuses on the most important of these concerns. It describes the basis of these concerns, and discusses ways of understanding them that will hopefully help the parties to address them. Section 4 highlights key points in the paper. Particular attention is given to recommendations on actions that the parties themselves can take to address both their own concerns and the concerns of the other parties. The Appendices provide supplementary information. Appendix A is a summary of the literature on game theory, as it applies to transboundary pollution issues, with specific attention paid to JI. Game theory provides the paradigm that we use to develop the general framework in Section 2. Appendix B tabulates concerns of the other parties, who would be the principal participants in developing any JI protocol or in individual JI projects. The analysis reflected in Appendix B is not as extensive as that in Section 3. Notwithstanding, Section B summarizes these other concerns so as to provide a broader perspective on the different viewpoints of the different players, on the range of their concerns, and on possible ways of addressing them. Appendix C is a discussion of issues that arise in the context of carbon-sequestering biomass projects. A major challenge in these projects is how to measure the net reduction in GHGs over time, for which these projects are responsible. The discussion of baseline issues is especially key.
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1. INTRODUCTION 1.1 Purpose This paper discusses concerns raised about Joint Implementation (JI). JI was introduced in the United Nations’1992 Framework Convention on Climate Change (FCCC or “the Convention”) as a means by which countries that are Party to the Convention can meet their commitments to reduce greenhouse gases (GHGs), in part, by being responsible for net reductions in other countries. The former countries are termed the investors’ countries and the latter are host countries. Section 1.2 gives background information on JI. Many countries, electric utilities, and analysts view JI as a potentially significant means of both lowering the costs of reducing GHG emissions and promoting sustainable development. But many other countries and analysts have severe reservations about whether JI will be effective and whether it will be in the best interests of their own countries. Thus, depending on one’s distinct perspective and goals, JI carries with it different benefits and risks. The purposes of this paper are to identify and to discuss these concerns. Specifically, the purposes of the paper are to: •
develop a conceptual approach for considering these concerns based on game theory, which is a field of study developed by mathematicians, economists, operations researchers, and others;
•
analyze the basis and develop a better understanding of the concerns of prospective host countries, whose concerns are probably the most serious of all of the concerns; and
•
offer recommendations on actions that the parties themselves can take to address both their own concerns, and the concerns of the other parties.
1.2 Background More than 150 countries are now Party to the FCCC. In this Convention, the Parties agree to stabilize the atmospheric concentration of GHGs at a level that would prevent harmful changes in global climate. In the Convention, certain countries are identified as those that will take the lead in reducing GHG emissions. These are the Annex I countries, which are essentially the industrialized countries, including Eastern Europe. The Annex II countries are a subset of these countries, and are essentially the countries in the Organisation for Economic Cooperation and Development (OECD). All other Parties not listed in Annex I or II are the non-Annex countries. The non-Annex countries are basically the developing countries. Article 4(2)(a) of the Convention provides for the Parties to meet their commitments to reduce GHG emissions “jointly with other Parties.” Thus, investors in a country that has a cap on its GHG emissions can finance, or otherwise arrange for, projects in other countries to reduce the net emissions of GHG; and in return these investors would receive credit for the quantity of emissions 1
reduced. These credits would presumably have to be accredited by some organ of the Convention or its Conference of the Parties (CoPs). Investors could then apply these credits to commitments that their respective countries have required of them, as part of their countries’ commitments to the Convention. These emissions credits could ultimately be traded, like the SO2 emissions permits in the United States. From these investors and their countries’ standpoint, JI provides them with an opportunity to meet their commitments by financing foreign projects that reduce GHG emissions at a cost less than that of domestic options. For the partners in the countries in which these projects would be located, JI provides these host partners and their countries with something of value (i.e., emissions credits) that they provide to investors in return for other compensation such as advanced power generation technology, funds, or a share of the credits. Many analysts anticipate that the Annex II countries will be the first to have formal caps on their GHG emissions, followed by the other Annex I countries. Many analysts also assume that the investors in any JI program will be from the Annex II countries, and that the other Annex I and nonAnnex countries will be the prospective host countries of JI projects. Currently, there is an international pilot JI program, referred to as “Activities Implemented Jointly” (AIJ), which is scheduled to end in the year 2000. In AIJ, investors and host partners are proceeding with projects that will reduce the net emissions of GHGs. In this pilot phase, no credits are being accrued to any Party as a result of AIJ projects. Rather, AIJ is viewed as a preliminary phase to encourage private-sector investment and innovation in technologies to reduce or sequester GHG emissions; to promote the implementation of projects to test and evaluate methods for measuring, tracking, and verifying the costs and GHG-reducing benefits of these projects; and to develop experience that will contribute to developing a formal JI protocol after the AIJ phase is completed. Proponents of JI point to its main benefits: that for investors and their countries, it is a means of more cost-effectively meeting any commitment that they make to reduce GHG emissions, and that for host partners and their countries, it provides them with something of value (i.e., opportunities for emissions credits) that they otherwise would not have. Yet, there are significant concerns and opposition to JI that might preclude there ever being an agreement among the Parties for the next phase. After analyzing these concerns, this paper takes the position that they are quite understandable, once viewed from the perspective of the parties that are concerned, and that given this understanding, there are actions that the parties can take to enhance the prospect that JI will be of benefit to them, as well as to all of the other parties.
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1.3 Organization of the Paper After this brief introduction to the paper, Section 2 develops a conceptual framework to address JI concerns. The framework serves two main purposes. The first is to provide an organizational structure for classifying the different concerns. The second, and more important, is to provide a perspective for analyzing the basis of the concerns and, subsequently, for suggesting ways that the parties can address them. Five different types of parties are identified:1 •
the global community, which is the collective interests of the Parties to the Convention, and whose welfare is dependent on the global environment; investors in JI projects (both actual and prospective); host partners in JI projects (both actual and prospective); investors’countries, that have likely committed to GHG emissions reductions; and host countries, where the JI projects take place.
• • • •
Of all of the concerns, those of the prospective host countries are probably the most serious. Different host countries have different concerns, but they generally fall into about eight categories. Section 3 focuses on the most important of these concerns. It describes the basis of these concerns, and discusses ways of understanding them that will hopefully help the parties to address them. Section 4 highlights key points in the paper. Particular attention is given to recommendations on actions that the parties themselves can take to address both their own concerns and the concerns of the other parties. The Appendices provide supplementary information. Appendix A is a summary of the literature on game theory, as it applies to transboundary pollution issues, with specific attention paid to JI. Game theory provides a paradigm that we use to develop the general framework in Section 2. Appendix B tabulates concerns of the other parties, who would be the principal participants in developing any JI protocol or in individual JI projects. The analysis reflected in Appendix B is not as extensive as that in Section 3. Notwithstanding, Section B summarizes these other concerns so as to provide a broader perspective on the different viewpoints of the different players, on the range of their concerns, and on possible ways of addressing them. Appendix C supplements some of the discussion in Table 1 of Appendix B. Appendix C is a discussion of issues that arise in the context of carbon-sequestering biomass projects. A major
1
Note that the term “parties” (lower case “p”) is used for these key “players” in JI; whereas “Parties” (upper case “P”) is used to refer to the signatories of the Convention.
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problem with these projects is how to measure the net reduction in GHGs for which these projects are responsible. The discussion of baseline issues is especially key.
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2. FRAMEWORK FOR CONSIDERING CONCERNS ABOUT JOINT IMPLEMENTATION 2.1 Concerns About Joint Implementation JI has many proponents. Its primary appeal is that it is a cost-effective means for Parties to meet their GHG emissions-reduction commitments. Analysis by Jepma and Lee (1995) indicates that global reduction targets are more likely to be achieved efficiently with JI. Jefferson (1995) supports JI as a means of early action to address climate change, providing finance and technology, and satisfying a broad range of environmental goals. Pearce (1995) suggests that JI might encourage the Parties to commit to greater emissions reductions than they otherwise would, and that JI might also permit wider participation in any agreement (which would reduce the leakage problem that is discussed elsewhere in this paper). Wisaksono (1995) states that JI can benefit developing countries by, for example, financing the construction of power-generation plants in these countries. Van der Burg (1994) discusses a number of issues and difficulties with JI (most of which are noted in this paper); but concludes that these might be surmountable, that JI can be a useful tool for GHG reduction, and that it is advisable to pursue JI in order to reap its benefits. Some of these benefits are noted in the U.S. Initiative on Joint Implementation (USIJI) (U.S. 1996) report. It summarizes USIJI’s accomplishments under the international pilot JI program [called Activities Implemented Jointly (AIJ)], pointing to JI as a means of attracting private sector resources and of stimulating the diffusion of innovative technologies to mitigate climate change. Yet, many concerns have been raised about JI. Hare and Stevens (1995) object that JI would allow industrialized countries to “off-load” their responsibilities. Maya (1995) and Schrijver (1995) discuss some of the developing countries’concerns about the loss of their sovereignty. Maya (1995) questions whether JI is a ploy for industrialized countries to unload their outdated technologies. Fritsche (1994), Jackson (1995), Heintz and Tol (1995), and Metz (1995) have expressed reservations about biomass projects, particularly about measuring the baseline conditions against which the reductions in GHG are to be compared. Roland and Haugland (1994) expressed concerns about free-riding (refer to Appendix A). Hare and Stevens (1995) suggest that JI would undermine technological innovation and diffusion. Heintz and Tol (1995) and Maya (1995) suggest that there would be reduced emphasis by industrialized countries on, and that JI funds would simply replace funds from, the Global Environment Facility (GEF) and Official Development Assistance (ODA). Analysts are also concerned that any gains would be lost as a result of transactions costs (Jackson 1995) or emissions “leakages” in which any reductions in GHGs are offset by increases elsewhere (Maya 1995). Graham (1995) and Metz (1995) emphasize that monitoring and verification of GHG reductions are crucial to the integrity of the program. Maya (1995) and others are concerned about the loss of “low-hanging fruit,” i.e., low-cost GHG mitigation options that host countries would be giving up. Aware of these and other concerns, Mintzer (1995), Leslie and Verdugo (1995), Maya (1995), Graham (1995), Wrexler et al. (1995), and Yaker (1995) have suggested various criteria and guidelines for a JI program. Finally, Pearce (1995) has expressed concerns about a “real” JI program (with emissions credits) taking so long to get off the ground.
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However, far fewer studies have tried to scrutinize systematically these concerns, to better understand their basis, and to offer ways of addressing them. These are the objectives of this paper. 2.2 Game-theory Framework for Addressing Concerns About JI Game Theory and JI We use basic concepts from game theory to develop a framework for considering the concerns about JI. Game theory is a branch of mathematical economics that depicts interactions among economic agents as being similar to a game in which there are different players, each with its own desire to do as well as possible and each behaving strategically so as to try to achieve its goals. We use ideas from game theory to understand better, and to address, the concerns about JI by focusing our attention on their source. Thus, the game theory framework not only points to an efficient way of categorizing these concerns, but more importantly, it provides insights into ways of addressing them by prompting us to analyze each concern from the perspective of its source. In addition, findings in the theoretical literature on game theory provide an awareness of what to expect from “games” such as JI. Appendix A is a brief review of this literature. This game theory approach of analyzing JI and other transboundary pollution issues has developed only recently in the literature (refer to Appendix A). Traditionally, JI is considered from the point of view of a single social welfare function that is maximized subject to a constraint on GHG emissions. The conclusion from this conventional analysis is that a system that allows trading of emissions permits (c.f., JI) results in greater social welfare than one that does not. The important economic gain from trading is that it allows the target reduction in emissions to be achieved at the least cost. With such a result, one might be initially surprised that support for JI is far from universal. However, if JI is thought of as a game, with different players, then these concerns about JI are hardly a surprise. There are many types of “games” in JI. The first type is about the protocol for the JI program. The players in this case are the Parties to the Convention, as well as other parties who have a stake in JI. They include investors, partners in host countries, and nongovernment organizations. The Parties to the Convention are the primary negotiators in the Conference of the Parties (CoPs), where JI protocol is to be formulated. Potential investors (e.g. electric utilities) and host partners will also make their positions known. A second type of JI game is the negotiation to reach agreement on individual JI projects. In a JI project, investors and host partners are the primary negotiators — though we envision, and recommend, that the investors’countries and host countries will have authority to approve or reject any JI contract. Such a requirement may dissuade some investors from pursuing JI opportunities, but it will be in their best interest in the long run to have the support of their own country as well as the host country in any JI project.
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Other games include those among: ·
various interest groups (e.g. political parties, non-governmental organizations, industry groups, etc.) within a country in defining the country’s position on JI;
·
the member states of larger regional political units, such as the European Union, in which the member states have their own positions and the larger political unit might have yet another position (e.g. whether to have overall European Union, or individual country, GHG-emissions commitments);
·
other formal, or informal, “coalitions” of countries such as the “North” and the “South”;
·
investors and host partners in operating their projects, after they have begun; and
·
the parties involved in monitoring and verifying the GHG-emissions reductions of a project.
However, the two types of games that we concentrate on are the negotiations in developing a protocol for the JI program, and the negotiations to reach agreement on individual projects. Players in the JI Game Depending on which JI negotiation is considered, some players figure more prominently than others. In “top-level” negotiations about the general nature of, and indeed whether to have, a JI program, the primary players in this game are the Parties to the Convention. Also, “outside” players, such as non-governmental organizations that have “special” interests, figure in these negotiations. In a different type of negotiation, that about a specific JI project, the players are first and foremost the investor and the host partner. The players also include the investor’s country and the host country, as well as interests of the global community at large. Each of these players has a stake in the negotiations. To simplify our analysis, yet retain the crux of our framework, we categorize the players into one of five types. Each of these players or parties has a unique perspective and objective with regard to JI2: •
Global community. The global community is a somewhat abstract concept that represents the collective viewpoint of the Parties to the Convention (and of nongovernmental 2
In the rest of this paper, the term “parties” will usually be used rather than “players.” These parties (lower case) are distinct from the Parties (upper case P) to the Convention, which are the countries who are the signatories to the Convention.
7
organizations), that it is desirable to protect the global environment by significantly reducing GHG emissions. Beneath this simple idea, of course, is the fact that each of the Parties and non-governmental organizations has its own agenda (and some even disagree with the goal of reducing GHG emissions — which is exactly what we would expect in games). Thus, the “global community” consists of very different types of players. The global community might be thought of as representing the Framework Convention’s protocol on JI, after it is agreed upon. But beforehand a single global community perspective is lacking. •
Investors. Investors are generally firms and other entities who have financial resources to fund JI projects. Being responsible to their shareholders, investors are searching for opportunities to obtain an attractive return on their investment, relative to their risk. Investors that are electric utilities, for example, are searching for ways of reducing their GHG emissions at a cost that is less than what it would cost domestically. Other investors may be speculators who anticipate that they can profit from trading in emissions credits. In general, investors are not national governments. Note, too, that we avoid the use of the term “donor.” Investors in JI expect something in return for their investment; they are not donating their funds.
•
Host partners. These parties own or control the resource in the country where the JI project is to take place. The resource could be a coal-fired power plant that would be retrofitted to use natural gas for cogeneration, for example. Or, the resource could be a forest stand that would be preserved under a JI project. We use the term “host partner,” rather than just “host” or “recipient,” to make clear that it is an active participant in a two-way agreement, rather than just a passive beneficiary. The host partner can be from the private sector, a local utility, or even a national government. There is generally a distinction between a host partner and the country in which it is located, which is the host country.
•
Investors’countries. These countries are the countries in which the investors are located. The primary goal in JI of the investors’ countries is to meet their commitments to reduce GHG emissions in the most cost-effective way. They also have a secondary goal of providing opportunities for their manufacturers to export GHG-reducing products to host countries. These countries may themselves be JI investors, but in many cases their role in JI projects will be limited to approving them, and to monitoring and verifying their accomplishments. All of the Parties to the Convention are potential investors’countries, though in practice they are likely to be only from among the Annex II (i.e., industrialized) countries.
•
Host countries. These countries are where the JI projects take place. Presumably, only the Parties to the Convention will be allowed to qualify as possible host countries (though if countries that are not Parties to the Convention can participate, this does not affect the discussion in this paper). There is disagreement among analysts (and among some of the Parties) about whether non-Annex countries should be involved in JI. As discussed further below, for the purpose of this paper, we assume that prospective host countries will include
8
the non-Annex, as well as Annex I and II, countries. In fact, many of the concerns raised about JI are in this very context. Whether non-Annex countries are included in any JI protocol will likely be crucial to the program’s success or failure. It is widely believed that these countries offer the most opportunities for JI projects.3 Some analysts have suggested, however, that JI be carried out among only the Annex I or Annex II countries. Whereas, most Annex I countries take JI to include non-Annex countries, and point to Article 4.2(a) of the Convention, whose wording does not exclude non-Annex countries.4 Notwithstanding this wording, some countries — particularly some of the developing and newly-industrializing countries — have expressed opposition to JI. It is these concerns that are the motivation for this paper, which attempts to describe the basis of their concerns and to offer insights and ways of addressing them. The Players’Goals and Strategies One of the most important aspects of game theory is that it provides for the study of conflict and cooperation in situations in which there are players, each with their own objectives and strategies. In addition, the “payoff” to any player depends on the actions of the other players. Thus, to understand better the concerns that the various parties raise about JI, it is insightful to identify their objectives and strategies. Tables 1 and 2 suggest what might be the parties’ objectives and basic strategies for their JI-protocol and JI-project games (i.e., negotiations), respectively. These suggestions illustrate the nature of different players’objectives and of their strategies when each is attempting to maximize its own gain.
3
According to Jackson (1995), most GHG-reduction opportunities are in the Annex I countries. Regardless of whether this is indeed the case, it is likely that most Annex I countries anticipate that most of the initiatives to reduce their GHG emissions will be domestic programs, and that JI will account for a small percentage of the countries’net reductions. 4
Appendix A reviews Barrett’s (1995) terminology for these variants of JI.
9
Table 1. Parties’ objectives and strategies in a JI-protocol game Parties
Goals
Strategies
Global community
Sustainable economic development. To minimize climate change while enabling countries’economies to grow. Operationally, accomplished through emissions caps.
Develop compromises so that all of the Parties agree. The individual Parties’perspectives, and thus their strategies, are essentially those of either the global community, investor’s country, or host country in a JI-project game (as described in Table 2). The global community will strive to develop a protocol that will facilitate the development of JI projects; and that will give it final authority to approve or reject JI projects, and to decide on the level of emissions credits to be accredited to each project.
Investors
Prospective investors are represented only indirectly through their country’s participation in the CoPs and other meetings, and through any information that they provide.
Lobby their governments to represent their viewpoints in the negotiations.
Host partners
Prospective host partners are represented only indirectly through their country’s participation in the CoPs and other meetings, and through any information that they provide.
Lobby their governments to represent their viewpoints in the negotiations.
Investors’countries
Develop a protocol that will allow them to meet their GHGreduction commitments in the most cost-effective way, without jeopardizing their economic competitiveness.
Emphasize the positive aspects of JI — as a means of technology transfer, a local economic stimulus, and the other environmental benefits such as reduced air pollution in the host countries. Promote the economic interests of firms in the investors’countries by helping them identify JI opportunities.
Host countries
Maximize the future well-being of their own country.
If a JI program is deemed to be in the best interests of the country, then support it. But if a JI program is deemed to be a risk to the country, then avoid discussion of its prospect; emphasize negative aspects of JI to gain concessions in the protocol; or block it outright with objections that cast the country in a good light with respect to the global community.
Table 2. Parties’ objectives and strategies in a JI-project game Parties
Goals
Strategies
Global community
We assume that the global community is represented by a panel or commission whose primary goal is to reduce the concentration of GHGs in the atmosphere in a way that maintains the integrity of the JI program. Concerns such as the cost-effectiveness of a project and its external costs and benefits, other than its GHG-impacts, are left to the other parties.
To assess and verify that a project will perform as planned with regard to its reducing GHGs. Thus, the panel representing the global community will be concerned about issues such as emissions leakages, and other issues summarized in Table B.1 of Appendix B. (The global community’s broader concerns about global GHG concentrations are largely addressed in the JI-protocol game.)
Investors
Meet their GHG-reduction commitments in the most costeffective way — i.e., maximize return on investment, within an acceptable level of project risk. Or, as speculators, to trade emissions credits to maximize profit, subject to an acceptable level of risk. Possibly some public relations benefits to GHGemitters during the early stages of the program.
Develop cost-effective projects and negotiate for the best terms for themselves.
Host partners
Improve its economic well-being as much as possible. If the host partner is the country itself, then national concerns will override the benefits of individual projects.
Negotiate to acquire advanced equipment and industrial processes at the lowest possible cost; receive payments in return for allowing afforestation; and/or receive other favorable terms in the JI contract.
Investor’s country
Improve its economic well-being by meeting its GHG-reduction commitments in a way that minimizes any adverse effects on its economy.
Enable its firms to meet their GHG-reduction commitments in the most cost-effective way. Prevent/discourage projects that might lead to displacement of domestic investment. Encourage technology development and exports that do not harm competitiveness.
Host country
Maintain its national sovereignty, maximize its economic growth, and improve other factors such as air pollution that affects the health and social well-being of its population.
Ensure that the contract between the investor and host partner does not result in undesirable effects to the country as a whole. Assist the host partner in securing the most favorable terms.
2.3 Insights from Game Theory We adopt the game-theory paradigm as a way of understanding these concerns better and of developing ways of addressing them. The approach that we take in addressing a concern is to try to understand it from the perspective of the party that is voicing it, from its vantage point, and given its priorities and goals. Consistent with our game-theory paradigm, we suggest that a JI protocol should stipulate that every JI project must be approved by all five parties.5 The unique aspect of the Framework Convention would appear to establish property rights, not only for investors and host partners, but for investors’countries, host countries and the global community as well. The precise approval process remains to be specified, but it might take the following form: •
an investor or prospective host partner initiates or identifies a project idea, and approaches its counterpart (i.e., prospective host partner or investor, respectively);
•
the investor and host partner reach agreement on the general terms of the project;
•
the investor and host partner present the general terms of the proposed agreement to their respective countries (including the different responsible jurisdictions within the country). To reduce transactions costs that might jeopardize the viability of JI, countries might agree to blanket approval of proposals that fall within pre-defined conditions. Exceptions to these conditions would be addressed on a case by case basis;
•
the investor, host partner, investor’s country, and host country reach agreement on the terms of the proposed project, and submit this proposal to a panel or commission, that is an organ of the Framework Convention (this panel would represent the interests of the global community). To reduce transactions costs that might jeopardize the viability of JI, the Framework’s commission or panel might provide conditional blanket approval of proposals that fall within pre-defined conditions.
5
It is recognized that none of the five types of parties is monolithic or homogeneous in makeup. For example, the global community consists of many different countries and other stakeholders, each with a different perspective. However, the global-community concept represents the common goal of reducing GHG emissions and climate change, first and foremost. Likewise, governments consist of many political parties, branches, agencies, and individuals. But regardless of these differences, the primary goal of an investor’s country in JI is to meet its GHGemissions commitments with the least cost (including any ancillary effects). Similarly, the primary goal of a host country is to improve its welfare as much as possible. Sometimes, some of the parties might agree to collude, or to cooperate, to help realize their interests. For example, the European Union and other regional organizations (e.g. league of small island states) are coordinating national positions and exerting considerable influence. 12
•
the investor, host partner, investor’s country, host country, and panel reach agreement on the terms of the project, and it is approved as an accredited JI project.
Each party potentially has something to gain from a JI project: the global community gets reduced GHG emissions; an investor has an opportunity to reduce its GHG-mitigation cost; the host partner has access to revenue-enhancing foreign technology and might be compensated financially (depending on the negotiated terms of the contract); the investor’s country is better able to attain its emissions commitment; and the host country might get local jobs and higher productivity from the JI project as well as external benefits such as reduced air pollution. Each party also has something to lose, especially if the project does not perform as expected. Therefore, each party is a player in this “game.” Thus, we suggest that a JI protocol be defined such that all five parties must approve a JI project if it is to be implemented. With this protocol, a party would not be required to accept a JI project that it does not want. Every party must expect that a JI project will provide it with a net benefit. It would take only one party to reject a project -- not a majority. That is, to be realized, a JI project must be regarded as a win-win-win-win-win situation. To reduce transaction costs, approval of projects might be granted automatically if they fall within certain pre-specified conditions. In addition, the JI protocol might develop clear and transparent protocols for projects, that investors and host partners can themselves largely enforce, buttressed by spot checks by the other parties after the project is in operation (in effect, handling approval, monitoring and verification processes as a single combined process with cost-effective sampling of projects). The game theory literature tells us, however, that strategic behavior and bargaining among the players is to be expected, and that a fully cooperative agreement is unlikely (refer to Appendix A). Imperfect information about the projects, asymmetric information (i.e., one player knowing more than another), a player’s market power, free-riding behavior, dynamic gaming over time, transactions costs, and other factors all contribute to the likelihood that an agreement will be less than optimal, if an agreement is reached at all. Furthermore, the players in a game have incentive to effect asymmetric information in their favor, possibly by misrepresenting their own situation and interests (though there are risks to misrepresentation as well), so as to garner the best possible payoff for themselves. Bargaining and sequential sharing of information are also part of the process. If there is an agreement, then the end result, although benefitting all of the parties, is one in which each party is likely not as well off as if the other parties had cooperated. In trying to better their individual positions, the parties leave potential gains unrealized. Yet, the game-theory literature says that solutions can be negotiated, even under these conditions. Figure 1 is a sketch of a “house” built of five pieces, a simple metaphor to illustrate the idea that without any one of the five parties, a project will collapse. Of these parties, the concerns of prospective host countries have been among the most serious. They might ultimately affect whether the Parties agree on a JI protocol. In the next section, we focus on the key concerns of many of the prospective host countries. 13
Figure 1. Use of a house as an analogy to illustrate need for agreement among all parties
3. UNDERSTANDING HOST COUNTRIES’ CONCERNS 3.1 Establishing a Basis for Understanding JI and Host Countries’ Concerns The framework that Section 2 outlined provides a conceptual approach for understanding concerns about JI. This approach is based on ideas from game theory. This game-theory approach suggests that, rather than considering climate-change policy with a single objective, each element of any policy should be addressed from the perspective of the different parties. Although game theory has not been developed sufficiently to model all facets of JI, we put into practice some of the more intuitive ideas from game theory to suggest ways of understanding and addressing the different parties’concerns. Of all of the concerns about JI, those of the prospective host countries are probably the most serious. They not only act as barriers to individual JI projects, they reflect pervasive fundamental concerns that call into question whether the Parties can agree on a JI protocol at all. Thus, we focus on what we regard to be their most serious concerns:6 (1) (2) (3) (4) (5) (6) (7) (8)
Why should industrialized countries get the credit; Loss of low-hanging fruit; Apprehension about getting shortchanged; Risk of JI collaboration leading to caps that will inhibit economic growth; Fear of losing Official Development Assistance (ODA); Unintended adverse impacts; Mismatch with host countries’priorities and technology needs; and Fear of loss of sovereignty.
Sections 3.2 to 3.9 discuss each of the concerns in this list, and offer ways for the parties to understand and address these concerns. Every prospective host country does not have all, or even some, of these concerns because each country has its own unique perspective. One host country may disagree with another. Thus, actions taken to placate one set of countries may vex others. Notwithstanding the differences among countries, our desire is to provide a better understanding of their concerns. By so doing, we hope to improve information and to reduce the uncertainty of all parties — and thereby to increase both the chances of solutions (i.e., agreements) to both the JI-protocol and JI-project games, as well as the social welfare to all parties from the resolution of these games.
6
Concerns of the other parties are summarized in Appendix B.
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3.2 Why Should Industrialized Countries Get the Credit? Concerns About Industrialized Countries Getting the Credit The first concern is fundamental. Some prospective host countries do not understand why actions taken in their own country to reduce the net emissions of GHGs are credited to industrialized countries, which are responsible for most of the GHG problem in the first place. Host countries have raised this concern either because they anticipate that the government itself might be a host partner or because they are concerned about the welfare of the local communities, firms and other organizations within their country who might be doing business with foreign investors. Sometimes, this concern is phrased in a way that questions why investing countries will “take credit” for emissions reductions in host countries (Hanish et al. 1992; Moomaw 1994; Metz 1994; Climate Network Africa 1995; Hare and Stevens 1995).7 Understanding JI To its advocates and many other analysts, JI offers a win-win situation in which the objective of the global community to limit GHG emissions is accomplished in the most cost-effective way by countries that have made commitments to reduce their GHG emissions. Sometimes lost in the discussion about JI, however, is that host countries also gain from JI. Host countries have an asset which is currently of no value to themselves but which has value to others. This asset can be realized to the host countries’ advantage only through JI. This asset consists of opportunities which an investor can help realize by collaborating with a host partner to produce emissions credits at a cost that is less than the cost the investor would have to pay in its own country to achieve the same reduction in emissions. The cost differential between industrialized and developing countries arises largely because of inefficient technology and inefficient use of technology in developing countries. These inefficiencies stem from a lack of information, capital, and institutional capability. JI is a means of equalizing efficiencies across countries. Also, as emissions caps are expected to decrease in future years, the demand for JI deals will increase, which will provide more opportunities for prospective host partners. Opportunities arise from a host country’s existing energy systems (e.g., a power plant that can be retrofitted to reduce its GHG emissions), as well as from its future energy needs (e.g., a new power plant). There are also potential opportunities in forest management and other projects that sequester carbon. One way to think of a JI project is that it is a partnership or joint venture between an investor from a country that has an emissions cap and a host partner in a host country that controls idle GHG7
This phrasing is also sometimes used in expressions of concern about the JI emissions reductions being substituted in place of domestic reductions within industrialized countries, rather than being in addition to them. In the framework of our game-theory paradigm, this latter concern is also categorized as being a concern of the global community, in terms of their desire to reduce climate change by maximizing the reduction of GHG emissions. Table B.1 in Appendix B provides some commentary on the global community’s perspective about this issue.
16
reducing assets. The investor provides (at least part of the) financial capital, new technology, and/or other input to the project. The host partner provides the use of a resource that embodies an idle asset (such as land for a reforestation project or an existing power plant for a retrofit project).8 This “resource” could even be a counterfactual alternative new power plant, over which a low-GHG emitting plant is chosen to be constructed. The investor’s contribution is usually financial in nature, whereas the host partner’s contribution is usually in-kind resources. The products of the joint venture consist of whatever such a project would normally produce, such as electric power, heat, or some other energy service (or, for example, possibly an eco-tourism site in the case of some forest preservation project), plus GHG-emissions credits. Under the likely terms of a JI project agreement, the host partner’s share of the output would likely be the energy services (produced at a lower cost than without the JI investment). The host partner would also likely retain ownership of its resources, as well as the capital supplied by the investor. The investor’s share of the output would likely be the emissions credits. However, virtually everything would be negotiable. The host partner could negotiate for some of the credits and the investor could negotiate for some of the revenues from the project. Thus, according to this understanding of JI, investors clearly are not “donating” their financial capital. And host partners are certainly not “giving away” their emissions credits. Nor are the host partners really selling the emissions credits, nor the investors buying them. Rather, a host partner and an investor are each contributing resources to a project, and are sharing its products. In particular, the emissions credits are not the host partner’s to give away or sell, but are an output of a joint venture between it and an investor. Credits a Co-Product of a JI Project Thus, it is essential to recognize that JI is not about which countries are most responsible for climate change. Rather, JI is about investors providing to host partners something that they would otherwise not have, and in return investors negotiate for some of the output from their joint project - the emissions credits. It might help to make this point clearer by noting that prospective investors are generally not the governments of industrialized countries. It could be a government, but it is more likely to be a private firm or partnership of firms, or perhaps a nongovernment organization (NGO), or perhaps even an emissions-credit trader or broker. Host partners should recognize that they are not “giving away” credits to industrialized countries. Credits are a co-product from joint ventures. It is difficult to argue against the idea that firms, and even NGOs, want something in return for their money. To make JI more attractive and to increase the chances of negotiating a JI protocol, the Parties should continue to communicate and to provide more information about their proposals for the JI program. Then they might see it, not as something that shifts the burden caused by industrialized countries to the developing countries, but as an opportunity for mutual benefit for all 8
The host partner owns this asset, but the host country controls it because the country, not the host partner, is a Party to the Convention and its provision for JI. 17
parties. To this end, it is fundamentally important that prospective host countries recognize their participation as one where a host partner within their country (or possibly the country itself) agrees to allot (perhaps some of) the emissions credits to its investor partner and, in return, is compensated with something else (e.g., improved technology). To make this case more compelling, Annex II countries would do well to try to make other aspects of JI as attractive as possible to the non-Annex countries that still doubt its merits. JI and International Trade JI is a form of international trade because some of the products that a JI project produces, i.e., the emissions credits, are exported from the host country to the investor’s country. To make this clear, we draw an analogy with the trade of a commodity such as copper (also refer to Appendix A for discussion of related literature). In international trade, a country might have a resource such as copper that it can supply at a “competitive” cost. That is, the cost of producing the copper is less than that in most places in the world. The analogy in JI is that a host country has a comparative advantage over many other countries in terms of having situations in which GHG emissions can be reduced at lower cost than elsewhere. Just as copper is a commodity, GHG emissions-reduction credits are a commodity. These commodities, whether they be copper or emissions credits, can be traded in international markets. [We take JI in its broadest sense, to include trading of emissions credits, and not simply the generation of credits from the JI project.] The commodity traded is an output of a production process in the host country, and is an input to production in the investor’s country. That is, as a result of commitments to limit emissions, countries will implement policies and regulations within their respective countries that will require their industries to limit their GHG emissions. Thus, a producer such as an electricity generator will need not only land, labor, capital, and materials as “factors of production” to produce electricity, but GHG emissions credits (i.e., permits) as well. In international trade, a market exists in which countries have demand for a resource such as copper. This demand exists because copper has value as an input to production, where it is used as raw material for finished goods for which there is demand. If there is no demand for these goods, then there would be no market for copper. Likewise, in JI, there is demand for GHG emissionsreduction credits. This demand exists because (and only because) of the need for investor countries’ firms to reduce GHG emissions as a result of countries’commitments, which are to be agreed upon as part of the Framework Convention. If there is no binding commitment to reduce GHG emissions, then there is no market. Host entities need capital to exploit their comparative advantage. Otherwise, the resource would remain unexploited. Frequently, host entities can increase the capital available to develop their 18
projects by attracting “outside” (i.e., foreign) partners. Similarly, in JI, a host partner might be able to finance, or otherwise proceed, with its GHG-reduction project by attracting foreign capital and/or technology. JI provides opportunities for host entities to develop more projects than they otherwise would, because of foreign demand for emissions credits. Host entities can “trade” emission’s credits, which are of relatively low value to them, for assets of greater value (e.g. plant and equipment). Because the host entity agrees to have a partner, it must share in the output of the project. In a copper mining project, the output to be shared would be the copper. Any copper exported to the foreign partner’s country would be international trade, and affect the countries’trade balances. Similarly, in a JI project, the output would include emissions credits. Everything in the project is subject to negotiation, however, and the host partner and foreign investor could share the credits. Any credits going to the investor would be international trade of that commodity. Each party trades, or collaborates on a JI project, in their self-interest; but both parties are better off with the trade, or JI project, than without it. Otherwise, the parties would not freely engage in the trade. Parties have the opportunity, though not any requirement, to collaborate. Of course, in both international trade and JI, there are risks. Subsequent developments in the future might make one of the parties in the trade worse off than if it did not engage in the trade. For example, the price of the commodity might decline thus rendering the project unprofitable. Such is the nature of markets and trade. Thus, just as countries that have materials or goods to sell want access to the markets in which firms and consumers are willing to pay for them, so too should these countries want access to JI. With it, they have opportunities to transform an idle asset (emission reduction possibilities) into one which can be traded for goods and services of immediate use for consumption or investment. Opposition to it, on the other hand, would risk barring themselves from the very thing to which they want free access — international markets in which they can make the best deals possible. 3.3 Loss of Low-Hanging Fruit Concern About Low-Hanging Fruit One of the most common concerns raised about JI is that a host country loses some of its low-cost options for reducing GHG emissions. The risk to the host country is that sometime in the future, it too might be subject to emissions caps. Then, it will have to reduce its GHG emissions, but will have only higher-cost ways of doing it. This concern is frequently referred to in the literature as host countries’ “loss of low-hanging fruit,” or as industrialized countries “skimming the cream of the crop” (Torvanger 1993; Jones 1994; van der Burg 1994; Selrod et al. 1995; Climate Network Africa 1995; Maya 1995; Metz 1995; Vellinga and Heintz 1995).
19
Previous Responses to Low-Hanging Fruit Concerns Some of this same literature offers responses to these concerns. Jones (1994) suggests that these host countries would be no worse off in the future than the countries that are likely to be subject to a cap now: “ ... future position of the developing country would be somewhat the same as that of an Annex I country today that has already implemented more abatement measures than its other Annex I partners ... these countries have seen fit to sign the FCCC, despite their relatively higher marginal cost position.” Heintz et al. (1994) offer that the experience that host countries gain with these more desirable technologies will facilitate their dealing with emissions commitments in the future. Jones (1994), Selrod et al. (1995), and Vellinga and Heintz (1995) indicate that early adoption of renewable energy and other GHG-reducing technologies will provide an infrastructure to manufacture, distribute, maintain, etc. these technologies. Early development of infrastructure reduces barriers to utilizing these technologies in the future. Jones (1994) even suggests that host countries might actually be better off because someone else will have paid for low-cost options instead of the host country paying in the future for both lowcost and high-cost GHG abatement measures. Jones’(1994) statement suggests that he is assuming that if a host country has a cap in the future, then the cap would be set irrespective of the emissions credits the country had previously generated. It would benefit twice from JI, once in generating the credits and again in having a high baseline against which its lower emissions would be compared. Whether such an assumption is valid, however, is debatable and is indeed the basis for some of the host countries’concerns. In the rest of this section, we offer a somewhat different understanding and response to the concern of low-hanging fruit. The basis for our thinking about this concern is the game-theory framework at Section 2, and the perspective on how to understand JI provided in Section 3.2. Establishing Baselines The key motivation for having JI projects is, of course, the emissions credits that they produce. Without credits, investors would not participate, and host partners would not benefit. To determine the quantity of emissions credits, baselines need to be defined. A baseline is the situation that would have occurred had there been no JI program. Baselines, against which JI projects are to be compared, are needed to determine their emissions credits. Ideally, baselines should be defined both for an individual project, as well as for its host country. The method for defining these baselines should be agreed upon by the Parties as part of the JI protocol (Graham 1995). The project baseline is specific to the project itself. It should be defined on the basis of the “most likely” option that is available to the host partner and that meets its set of requirements. “Cost” would be a major factor in determining the most likely option because a host partner would presumably want to meet its needs at least cost. There might be situations, however, in which institutional or other considerations will also affect which option is most likely; and the definition of the project baseline must accommodate these other considerations. Thus, a general definition of the 20
project baseline is that it is the project or condition that most likely would have occurred had there been no JI support.9 To the extent possible, baselines should be defined in advance, with different baselines for different types of projects (e.g. new power projects, retrofit projects, energy efficiency projects, forest management projects, etc.). Defining baselines in advance has the advantage of reducing uncertainty and risk to host partners and investors. It also has the advantage of reducing transactions costs that would arise from detailed assessments of each project (just as a single, generic environmental impact assessment is less expensive to complete than many individual detailed environmental impact statements). The benefits (and thus credits) from a JI project should be considered at the margin, as the incremental benefit in terms of the avoided GHG emissions. For example, if a wind power JI project is developed, then its emissions credits should be based on the difference between its GHG emissions and those expected from the project that would have been built had there been no JI support for the wind project. [(An adjustment would have to be made for the different sizes of the projects (i.e., kWh of electricity generated).] If the wind power project replaces an existing power plant, then its emissions credits should be based on the emissions of the project that it replaces (i.e., a specific plant must be identified). For example, in a retrofit project, the baseline is the existing project and its corresponding GHG emissions. In determining project baselines, it will probably be impossible to account for emissions leakages and other indirect effects. It would be intractable to measure accurately these effects to calculate the net emissions credits from a project. Rather, they must be considered somewhat qualitatively and subjectively by the host country, and by a panel that represents the interests of the Convention (i.e., global community) (Metz 1995). Perhaps the easiest way of accounting for leakages is with an order-of-magnitude approximation such as a “discount” applied uniformly to all (or similar) projects. Parties would probably agree that it is impractical and unreasonable for investors and host partners to bear the risk of uncertainty in not only the future performance of their project (in terms of its GHG emissions and other output such as electric power), but also of a baseline as well. Thus, once a baseline is established for a project, it should probably not be subject to change. Only the actual performance of the project would affect the emissions credits attributed to the project. National baselines must be estimated differently from project baselines. For countries subject to an emissions cap their national baseline is essentially their cap. If a country with a cap were to host a JI project, then the country would still have to meet its GHG-emissions commitments as defined by its cap, and credits from the project would go toward meeting that cap only if that was the
9
In some respects the idea of defining a counter-factual baseline is similar to that of defining the “avoided cost” in U.S. renewable-energy (and other qualifying) power projects, under the Public Utility Regulatory Policy Act. 21
agreement among the parties. The cap is an efficient way of minimizing emissions leakages and other similar effects (see Section 3.7). For countries without a cap, however, national baselines are more difficult to define (Metz 1995; Vellinga and Heintz 1995); and there is, in fact, no widely accepted way to define them. One option is to define a national baseline based on the country’s current energy infrastructure (i.e., its GHG emissions), population, and/or Gross Domestic Product, and on projections of their growth. The specific details of such an approach would have to be resolved however. In spite of the difficulty in defining a national baseline for countries without emissions caps, having a national baseline is important for determining the credits from carbon-sequestering projects (Appendix C), as well as an efficient way of addressing the emissions leakage problem. One of the main problems in establishing baselines is that of finding a balance between accuracy and verification on the one hand, and keeping transaction costs low on the other. Several proposals have been formulated, which can roughly be described as: • •
determining a static baseline at the bilateral level and having random checks by the FCCC, determining a dynamic baseline to be adjusted during the project's lifetime in case unexpected things happen with the project, establishing a baseline matrix by region and by project type, and using partial crediting whereby a baseline is defined at the bilateral level and credit is given on only a part of the emissions reductions (so as to create a buffer for miscalculations).10
• •
Understanding Both the Gains and the Losses From Parting With the Low-Hanging Fruit The idea of having low-hanging fruit means that a host country has something that it can, together with an investing partner, produce at relatively low cost, i.e., emissions credits. This low cost means that there is a “gap” between the value of the fruit (its market price) and its cost. This gap provides incentive for an investor to provide financial resources to produce the fruit. The financial resources of the investor are “put to work” to produce other output, such as electric power, at a cost less than what the host partner could have achieved alone. Thus, in a JI project, an investor and a host partner each provide input to a production process such as generating electric power. The investor and host partner agree to divide the output with, for example, the investor getting the emissions credits and the host partner getting the rest of the output. The investor’s gain is the difference between its investment and the value of the emissions credits. The host partner’s gain is, for example, the plant and equipment purchased using the investor’s resources. This capital produces electric power, that the host partner sells, at less cost than any options that it would otherwise have had without the investor. Without JI, neither the investor nor host partner would have such an opportunity to gain.
10
Personal communication by W.P. van der Gaast. 22
The source of prospective host countries’concerns about their loss of low-hanging fruit is of course the possibility that they will face emissions caps in the future, and that they will have “used up” their low-hanging fruit. If they do not sell these low-cost emissions credits, then they will not have to pay for the high-cost measures at all (or at least would postpone it). Thus, in their selfinterest, these countries assess whether the risk of losing an opportunity to use the low-hanging fruit themselves in the future is more than offset by the value of the capital and other benefits that the host partners/countries gain in the interim, if they participate in a JI project. For example, in an electric power project, the host partners will have the benefit of lower costs and/or increased revenues, the social returns from which augment the potential economic growth of the country by providing investment capital. A further point needs to be stressed. The host countries prototypically will have far higher social returns to capital than will the investors’ countries. (Capital is scarce relative to labor and other resources, and therefore marginal returns are higher.) This has these implications: (a) global output will rise as capital is moved to higher productivity uses in host countries; (b) host countries will grow faster than they otherwise would have, and relative to the investors’countries; and (c) the income of host countries will be augmented (by returns to added capital) at a relatively fast rate over the period between the JI project and when (if) the host countries would otherwise want to harvest the low-hanging fruit. This capital appreciation would make the cost of meeting emissions caps in the future easier to bear. In effect, an idle asset is put to productive use, generating income that can be used to purchase a substitute asset (if it is needed) in the future, at a higher rate of return than that available to those who bought the asset. Also, in making their assessments of the JI options, host countries should account for the possibility that participation in a JI project does not necessarily mean that they will lose their lowhanging fruit. A host country may not be faced with a constraining emissions cap any time soon (as discussed in Section 3.5, it is to all parties’advantage to resolve this question at the outset so as to reduce the uncertainty with which parties must subsequently address their JI options). There is also uncertainty about the future costs of GHG-emissions abatement. New technologies might be developed that will result in costs lower than the current low-hanging fruit. Thus, there is risk on both the “up-side” and “down-side” in that future GHG abatement costs could be greater, or less, than current costs. Therefore, host countries, as one of five parties in our game-theory paradigm, must assess their relative benefits and costs of each proposed JI project. A host country should consider different scenarios (e.g. caps) and estimate the costs associated with each scenario, including: (a) transactions costs associated with negotiating and monitoring the project; (b) the expected present value of the future costs of limiting its GHG emissions to satisfy a cap, taking into account the probability of such a cap; and (c) the expected present value of any external costs of the JI project such as dislocations to local communities (refer to Section 3.7).
23
The benefits that a host country should consider include: (a) (b) (c) (d) (e) (f) (g) (h)
lower-cost energy and increased production from more efficient plants; the expected return on the increased profits from lower-cost, more efficient plants, or from other capital provided by the investor; any emissions credits that the host partner negotiates with the investor (see Section 3.4); initial infrastructure for the manufacture and distribution of low-GHG emitting fuels and/or technologies; experience and know-how gained about low-GHG emitting technologies and/or GHG sinks; stimulation of the local economy (e.g. high-productivity jobs) and national economy; the expected present value of any external benefits such as reduced air pollution; and any terms that it is able to negotiate into the contract [such as options to re-purchase the credits, local assistance, etc. (as discussed in Section 3.4)].
These costs and benefits will not apply to every possible JI project, but they are indicative of the types of costs and benefits that host countries should consider in assessing the value of a project to the country. The basic questions that a host country must address are whether it will be faced with a constraining emissions cap in the future, and whether the near-term benefits from the capital provided by the investor, as well as other external benefits of the project, outweigh the possible added costs in the future. Also, host countries should consider that as global caps are lowered in future years, the demand for JI projects will increase, thereby providing host countries with “new” lowhanging fruit. As a result, host countries might be in the same, relatively advantageous, position in the future as they are now. The loss of low-hanging fruit is a risk, but it is impossible to make a generic assessment of the expected costs and benefits. Host partners/countries’assessments must be done on a case by case basis. After making such assessments, host partners/countries and investors might find themselves differing on the merits of a JI project. This difference would be attributed to differences in their perceptions of the risk and level of emissions caps that host partners will face in the future, as well as their estimates of both the future price and cost of emissions credits, and of any external benefits and costs. To the extent that all of the parties can share information and resolve uncertainty, these differences can be reduced or even resolved. Having a JI program in place would at least provide prospective host countries with the opportunity to identify situations where they surmise that they will benefit. Without a JI program, they would not even have this opportunity. With such opportunities, host countries should, in their own interests, negotiate the best possible terms for themselves. Risk of Lower Caps With JI Participation Part of the apprehension that prospective host countries have about selling their low-hanging fruit is that they fear that GHG-emissions reductions from JI projects will make their emissions cap lower, in the future, than it would otherwise have been. Their reasoning is that the investor gets 24
credited for any reductions, and that these reductions are correspondingly debited from the host countries’GHG-emissions “accounts.” For example, assume that a host country’s carbon-equivalent emissions in 20 years will be 40 million tons if it does not participate in any JI projects. Assume too that with participation in JI, the annual emissions would be 37 million tons. The basis of the country’s concern is that, because the investors get the credit for this reduction (as discussed elsewhere, this is not necessarily the case), the Convention will be inclined to stipulate that the country’s cap should be 3 million tons less than what it otherwise would have stipulated. For instance, assume that the Convention’s JI protocol stipulates that the country will have an emissions cap of 36 million tons 25 years from now, which is 4 million tons less than what the emissions would be without a cap and without any JI projects. But because the JI projects reduce the country’s emissions by 3 million tons, the prospective host country fears that its cap would be adjusted to 33 million tons. From its standpoint, it may think that it has been penalized for participating in JI. However, from the standpoint of the global community, the 33 million ton cap is not unreasonable. If the Convention decides that all (including non-Annex) countries should have a national baseline, even if they do not all have a binding cap at this time, then the Convention implies that there is a global cap (including non-Annex countries) that reflects its judgement of a “safe” level of global GHG emissions. If this is the case, then for every credit to a country, there should be a debit to the partner country (as there would be if all countries had explicit caps). Otherwise, there would be double-counting of credits and the overall global cap on a safe level of emissions would be violated. With a 33 million cap, the host country is no worse off from the standpoint that it must reduce its emissions by 4 million tons, just as it would have with a 36 million cap. Because it sold its low-hanging fruit in the JI projects, the country must resort to other options to effect these reductions. As discussed previously in this section, these options might, but will not necessarily, be more costly. However, the host country has presumably gained something in return for the credits that it shared with investors; e.g., more efficient technology, funds, or whatever other terms were negotiated in the JI contracts. If a prospective host country is faced with the possibility of an emissions cap in the future, then it would understandably prefer to have both the benefit of its past JI projects and the higher cap, i.e., emissions of 37 million tons and a cap of 36 million tons (rather than 33 million tons). In its selfinterest, it should thus try to negotiate the higher cap. The host country would argue that the moratorium on emissions constraints on the non-Annex countries should be a true moratorium and a postponement of commitment, and not a deferment of an immediate commitment. The country would thus advocate a formula for setting caps that is as favorable as possible for itself (e.g. emissions per capita) and that is independent of any previous participation in JI projects. Other parties would have different perspectives: •
From the perspective of investors, a higher cap on host countries would mean that the value of credits that the investors already own would be less than with a lower cap because of the
25
lower worldwide demand for emissions reductions. But on the other hand, investors would have to pay a lower price for purchasing additional credits in the future. •
The investors’countries would benefit from lower prices if the host countries’caps are higher, but the investors’countries would also benefit if other countries have the lower cap, to make them less economically competitive with the investors’countries.
•
From the perspective of local (host country) GHG-emitters, they would unequivocally prefer the higher cap. Host partners who have low GHG emissions, however, would prefer the lower (still non-binding) cap, so that the value of the potential credits and thus the demand for JI projects with these partners will be greater.
•
Finally, from the standpoint of the global community, it would prefer that the countries have the lower caps, because they would reduce climate change. On the other hand, in its other desires not to inhibit the economic growth of developing countries, the global community might allow them to have the higher caps.
To the extent that each party recognizes the self-interests of the other parties, and is willing to compromise for mutual gain, they will be able to agree on a system of caps for all of the parties. Host country participation in JI might lead it to have lower caps than it otherwise would have. But only because it has been compensated by the benefits of its JI projects. 3.4 Apprehension About Getting Shortchanged Concerns About Getting Shortchanged A concern of some of the prospective host countries is that, with JI, the industrialized countries will fare better than developing countries. This concern can arise regardless of whether the host countries have an emissions cap themselves. It centers on these countries’concern that they will unknowingly part with the emissions credits for much less than what they are really worth. Errors in calculating the present value of alternative projects, the misallocation of domestic resources, etc. all can contribute to host countries shortchanging themselves. Of course, no host country can be perfectly rational because of imperfect information, and in any event it is difficult to define what “perfectly rational” really means because of the varied political, economic, and social interests within any country. Yet, host countries, as imperfect as they might be, still want be “assured” of adequate compensation from foreign investors. How Can Host Countries Be Assured of Adequate Compensation? The host partner/country situation is complex and this can give rise to the host country’s fear that it will be shortchanged. Its well being depends on the well-being of its firms and citizens. Thus,
26
host countries want to support their own firms and entrepreneurs, and want them to receive adequate compensation for their projects. Keep in mind, though, that it is the host country’s asset (opportunities to restrict GHG emissions) which is involved in the bargain, and that it is benefits to the host country that it seeks to maximize. The prospective host partner owns the resources (the embodiment of the opportunity to reduce GHG emissions) which is the object of the bargain. But, it has no interest in the GHGemissions reduction opportunity except to get the highest private return from its resources that it can achieve. For example, it places limited value on its (host) country’s future ability to reduce GHG emissions, if that were required. Similarly, all ancillary benefits from the agreement (technology development, higher social productivity, developmental/economic advantages of lower energy costs, pollution abatement, etc.) are largely if not totally external to the host partner. Therefore, its objective function in negotiations with investors is (might be) very different from that of the host country. Consequently its valuation of the terms of the bargain over which negotiations take place will also be different. It might trade away terms of great value to the country in exchange for terms of even small value to itself, to the extent that externalities are involved. The possible disquiet between host country and host partner interests means that protection of the host country requires it to involve itself in any JI agreements reached. It needs to establish with the host partner the value of different terms that it might offer, and bargain with the host partner about how the gains will be shared between private and social return. The package that leads to a maximum return for the country as a whole may be sub-optimal to the host partners and vice versa. However, in practice, host country involvement need not be project-specific, which could lead to high transactions costs. It can be accomplished in a satisfactory way by means of “umbrella” terms under which all negotiations for a class of projects proceed. Considering the above, there are many ways in which host partners/countries can obtain adequate compensation for the emissions credits that they are providing to their investors: (a)
Getting an Acceptable Price.11 The most obvious way in which a host partner/country can obtain adequate compensation for the emissions credits is for it not to participate in the JI project unless it gets the price it wants. It does not have to enter into any JI agreement that it does not want to. If it enters into an agreement, then it must be satisfied with its terms. However, history is replete with cases where a host country or tribe shortchanged itself by underestimating its bargaining power, which led it to agree to sell something significantly below its value. A primary reason for this situation occurring was the host country or tribe’s lack of information about the true value of its resource. As discussed in Appendix A, situations with asymmetric information are more likely to lead to lower overall benefits to the parties. To reduce the chance of this occurring, prospective host partners/countries should try to negotiate with many possible investors to get more information on the market and
11
“Price” means the bundle of benefits that the host partner/country takes away from the joint venture which produces, among other things, emissions credits. 27
specifically on what they are willing or unwilling to pay for credits. As a market develops for emissions credits, host partners/countries can study other agreements to gauge the market for credits. Also, host partners/countries might try to negotiate price-indexed compensation (e.g., annual cash payments tied to the prevailing price of the emissions credits). (b)
Negotiating a Share of the Credits. It appears that most discussions of JI assume that all of the emissions credits will go to the investor. This is not necessarily the case. Host partners can try to negotiate a share of the credits (de Buen and Masera 1995; Intarapravich 1995). For example, an investor and host partner might agree on the host partner receiving an increasing percentage of the credits each year. The credits, as well as other output from a project, are products of a joint venture between investor and host partner (see Section 3.1). The allocation of credits between them should be negotiable. If the host partners/countries would rather have credits and give up other benefits in exchange, then that would be open to negotiation. It is a way of sharing in the possible increase in the value of the credits in exchange for reducing the cost (and therefore the risk) to the investor. Sharing of credits does not suggest that the host partner would be buying into a cap. Rather, the host partner would simply own credits just as any trader would, once emissions credits are traded (as SO2 emissions permits are traded now in the U.S.). There are an unlimited number of possibilities to negotiate. The only major requirement for an agreement is that both sides think that they benefit from it.
(c)
Call Options. If a host partner/country fears that the value of the credits will escalate substantially in the future, then it can negotiate to have options to “call” (i.e., to purchase) a certain quantity of emissions credits at a certain price, up to some date in the future. A call option is a contractual agreement that provides the holder of the option the right, but not the requirement, to purchase a quantity specified in the options(s), at a specified price (the socalled strike price), at any time up to a specified expiration date. For example, if the host partner/country does not want to be shortchanged by the possibility that the credits might escalate in value from, say, $10/ton at present, to $50/ton in the future, then it can try to negotiate for the investor to provide it with options to purchase credits at, say, a strike price of $40/ton, up to an expiration date of 30 years into the future. In general, the strike price would be well “out of the money” (i.e., well above the current price). Of course, whether the investor agrees to provide a call option, the quantity, the strike price, and the expiration date are all negotiable. The host can expect to pay for this option with less favorable terms elsewhere in the agreement. If options are provided, but the price of the emissions credits do not increase above the strike price, then the options would expire worthless. In this case, the host partner/country would not profit from the price increase of the options, but it would have the “satisfaction” of knowing that the credits would give it a share of any “windfall” profit that might have occurred. On the other hand, if the price of the credits increases to exceed the strike price, then the host partner/country can exercise the options. Its profit is the difference between the market price at the time the option is exercised and the strike price, multiplied by the number of credits exercised. When the host partner/country exercises its options, the investor loses its credits (or pays the cost of purchasing the credits to give to the
28
host partner/country). As in the previous discussions, whether options are in fact negotiated between an investor and host partner/country would be determined on a case by case basis. (d)
Limit on Duration of Project. To alleviate some of the concern about low-hanging fruit, host countries should try to negotiate limits to the duration of their projects. They should also strive to have contractual terms that stipulate that, after the contractual period has ended, project resources and benefits will all belong to the host partner. Again, the host partner should also expect that the investor will want to be compensated for these terms.
(e)
Side-Benefits. A host country can require that any JI project in the country must serve other commitments mentioned in the Convention, in addition to the primary terms of the contract between the investor and the host partner (Parikh 1994). Examples of such side-benefits are funding a technical training center to enhance a host country’s human capital and its ability to eradicate poverty, financing expanded distribution of electricity to a rural area, building or improving access roads to a power plant, a local education program, or other projects subject to the approval of the government. This is an opportunity for the national government to help its local constituents. Of course, whether the investor agrees to such terms is a matter of negotiation between the investor and host partner/country. The terms will vary on a case by case basis, and should be left to the specific parties involved, rather than universally applied.
Many of these contractual provisions are rather complicated. Consultants and third-party financial advice would provide welcomed assistance to negotiators. There are many possibilities for trying to assure that all parties are “satisfactorily” compensated. Some of these possibilities, such as those in the previous list, are market mechanisms. Others are institutional constraints that affect the terms of the bargain. Because of their intrinsic economic nature, however, prices for credits are best determined through market mechanisms, rather than institutional constraints. Thus, for example, suggestions that the Convention set a floor price or lower bound for credits, with any excess between this price and the GHG abatement cost to be diverted from the JI project into other needs of the local community (Parikh 1993), are examples of institutional constraints that will likely reduce the number of opportunities available to prospective host partners/countries to offer credits, as well as the overall cost-effectiveness of JI. There are many different ways in which host partners/countries can to try to negotiate a JI agreement so that they are satisfied that the investor is not getting the best of the deal and that they are not shortchanged. Such negotiations would be JI-project games, as described in Section 2, and would be characterized by strategic behavior by both investors and host partners, as well as host countries. Requests by one party on some of the terms of the contract (such providing the host partner with call options) will be countered by proposals by the other party on other terms of the contract. The best opportunities for agreement are those where both the benefits and risks (due to uncertainty about future markets) of the project are shared between investor and host. Of course, the host partner/country does not have to agree to any exchange; and it should not, if it considers the terms of the exchange inadequate. As Sect. 3.2 discusses, JI is a form of 29
international trade. Like copper or any other commodity, emissions credits are a commodity that can be produced at lower cost in some countries than in others. Also, like some copper mining projects, it is advantageous, or perhaps even necessary (because of the lack of capital) to partner with foreign investors. In such partnerships, the host partner would expect to share the output produced with its investor partner. Similarly, a host partner in a JI project should expect to share its output — output that might include electricity generation or other revenue, in addition to emissions credits. The investor could use the emissions credits as a factor of production in its country, just as copper exported to an investor’s country would be used as a factor of production. Or, the commodities, whether they be emissions credits or copper, could be sold elsewhere. Thus, JI provides host partners/countries with greater access to international markets (this one being for emissions credits) from which they can profit. However, although it is in the prospective host countries’ self-interest to support the existence of a JI program (because it provides opportunities for projects of benefit), every proposed JI project will not be beneficial. Prospective host partners and countries should reject those that are not of benefit to them, just as investors will do the same. 3.5 Risk of JI Collaboration Leading to Caps That Will Inhibit Economic Growth Risks from JI Collaboration Some developing and newly industrializing countries submit that climate change is not their responsibility to solve, that agreeing to collaborate to address it would appear to make it in part of their problem, and that such collaboration would be to their detriment. JI is one such collaboration, and these countries fear that with JI may come certain risks. A specific risk is that implementation of JI will eventually lead the global community to consider limits on non-Annex countries’ GHG emissions. This concern has not been extensively discussed in the literature, but from the standpoint of certain countries, this risk is quite possibly the underlying basis of their opposition to JI. Understanding the Concerns This concern is understandable and stems from the following considerations. The type of countries for which this concern is most relevant are rapidly industrializing countries that consume a lot of fossil fuel. More importantly, these countries are projected to continue to consume increasing amounts of fossil fuel. In fact, these countries could be the largest fossil fuel users in the future. These countries are developing, or newly industrializing, countries; and they offer many opportunities for JI projects. But their position is that the climate change issue is a developed-country problem and that the latter countries must address the problem themselves. The underlying reason for this position might be that these developing countries do not want to raise the subject of JI at all, because they feel (probably justifiably) that the mere mention of JI will bring with it discussion of limits on emissions. These discussions will affect not only the Annex I countries, but eventually non-Annex countries as well. Thus, these countries feel that there is little for them to gain, compared to the risk that they perceive. The risk is that limits in the future to their GHG emissions, and thus on their use of fossil fuels, will stymie their economic growth. As discussed elsewhere in this paper, many economists 30
insist that an agreement on GHG emissions and JI makes no sense without a cap on all countries.12 Recognizing these criticisms, these countries would prefer that JI not even be raised as an option. To do so would be also to raise ultimately the issue about these countries having a cap as well. Although the idea of caps on these countries in the near future has little international support, the risk that some of these developing countries perceive is that, with JI, a cap on them would be instituted much sooner than it would without a JI program because of the pressure that it will bring to have global caps for all of the Parties. Some of this pressure would come not only from the developed countries that would have caps, but from the global community at large, which wants to limit GHG emissions. Countries that would resist calls by the international community for action, such as global caps, would “lose face” in this community. Thus, understandably, they do not want to take the risk of this happening. What could change the position of these countries toward JI is that the international community recognizes their concern about JI potentially hindering their prospects for economic growth. JI, if it is to receive the support of such countries, must have a GHG-reduction agreement that does not threaten their desire to increase their use of fossil fuel. And consistent with our gametheory paradigm, any arrangement would need the agreement of all five parties. In the case of these countries under discussion, their primary desire in this context is that their economic growth not be reduced as a result of limits on their use of fossil fuels, as they “catch up” with the industrialized countries [in terms of both per capita income and GHG emissions (their position being that the latter is also measured on a per capita basis)]. On the other hand, the primary concern of the investors’countries — who are likely to be the industrialized Annex I countries — is that they meet their emissions-reduction obligations in the most cost-effective way and that other countries do not get a free ride such that the industrialized countries’own economies suffer.13 Thus, 12
Nordhaus claims that without caps on all countries, those without caps (especially the biggest fossil fuel users), will get a “free ride” by benefitting from the global reduction in GHG emissions while not having to reduce their own emissions (Zachary 1997). Hahn says that the great danger in an agreement with two sets of rules on using fossil fuels is that the carbon-intensive industries will move to countries without a cap, which some critics observe already have less onerous environmental, health, safety and labor regulations than most developed countries (Zachary 1997). Other analysts, however, do not give much credence to views that carbon-intensive industries will migrate, arguing that the carbon regime would have to be very strict for this to happen. Some economists also suggest that with one set of countries without a cap, then trading of emissions credits or permits would not work well. The countries without a cap could theoretically issue, and sell, a limitless number of credits. But in practice, the number of credits would be limited by the number of opportunities that host partners have in which the respective benefits to investor and host partner exceed their respective costs. 13
Among the other three parties, investors, of course, want cost-effective JI opportunities; host partners want projects of benefit to them; and the global community wants cost-effective and fair reduction of GHG emissions. 31
from the industrialized countries’ standpoint, whether a country participates in JI projects is immaterial to assessing whether it should have an emissions cap. Hosting JI projects means that a country is able and willing to offer low-cost options for GHG reduction, which is a different matter from whether its GHG emissions are potentially excessive. Pressure to have a cap for a country will come from the latter, not from the former. With or without joint implementation, developing countries will not be subject to caps, but the sheer force of the rate at which emissions are rising in these countries will put pressure on them to accept a cap in the “not too distant” future. Decoupling JI from Caps This notion could be made more apparent if the discussion and negotiation of future caps on non-Annex Parties is decoupled from the discussion and negotiation of JI. Ideally, caps should be set first because an agreement on future caps (if any) for the current non-Annex countries should allay much of their uncertainty about this issue (c.f., the loss of low-hanging fruit). On the other hand, the issue of caps is so contentious that the CoPs should consider discussing a JI-protocol independent of any negotiation on caps, because the latter are likely to be unresolved for some time. In reality, of course, the negotiating positions of the U.S. and some other industrialized countries are making clear that decoupling of JI from caps is difficult to accept in practice. These countries are advocating JI, while being reluctant to make explicit emissions-reduction commitments. Other countries, on the other hand, are holding out on their support of JI until these industrialized countries make acceptable emissions-reduction commitments. Such strategy and positioning is, of course, to be expected in such games, with different players having their own self-interests. One way of decoupling the link between JI and the fear of future caps is to emphasize JI as a vehicle to access "environmentally friendly" technologies, rather than as part of the Convention. Even though JI is part of the Convention, discussing JI in the context of technology transfer could at least maintain a dialogue with prospective host countries, when it might otherwise be virtually impossible. If the issue of future caps for the non-Annex countries is unresolved and/or tabled to a future meeting, and if binding caps are agreed upon for the industrialized Annex I countries, then a JI program can still be discussed, albeit with uncertainty about national baselines and thus about measuring the credits from any project. These issues are also discussed elsewhere in this paper. But in terms of the issue that is central to the current discussion — that JI brings with it a risk of future caps that will inhibit economic growth — it is best to decouple the two issues. With or without JI, there will still be a “risk” to developing countries that they will have caps. It is in the best interest of all of the Parties to resolve the issue of caps expeditiously, so as to eliminate the considerable uncertainty which has the effect of spilling over into other issues as well. 3.6 Fear of Losing Official Development Assistance Many of the countries that would be prospective host countries in a JI program are developing countries. These countries regard Official Development Assistance (ODA) from foreign governments and multilateral agencies (e.g. the World Bank) as being crucial to their future economic 32
development and social well-being. These countries are understandably concerned about any proposed program that might reduce the ODA that they receive. Some analysts refer to this concern as “additionality” in terms of wanting assurance that JI will not substitute for, but rather be in addition to, ODA.14 Sometimes, confusion about JI and ODA being substitutes further arises from the fact that donor agencies are increasingly requiring an environmental management or protection component to ODA projects before they approve them. But in these cases, JI and ODA should be viewed as providing synergy rather than redundancy. The environmental protection objectives of the programs are not identical: JI is focused on mitigating global climate change, whereas the goals of many ODA projects include local environmental concerns such as particulate-matter air pollution. To alleviate concern about the perceived loss of ODA, the Convention and the Parties should agree that prospective host countries will not lose any ODA because of JI. To understand why this assurance is reasonable from the standpoint of all of the parties, one must first recognize the distinction between JI and ODA (Torvanger 1993, Jones 1994, Metz 1994). JI entails a market in which an investor and a host partner combine their resources to produce emissions credits and other benefits, whereas ODA involves a foreign government or multilateral organization such as the World Bank providing resources (such as low-interest loans) to a developing country. The key differences between JI and ODA are summarized in Table 3. Perhaps the most important difference is that a JI project is an economic partnership between an investor and a host partner, whereas ODA is outright assistance provided from a government or multilateral organization to a country. The question sometimes raised of whether industrialized countries should owe developing countries competitive parity is a matter quite different from the point of JI. In fact, there is no pretense of JI being a means for industrialized countries to transfer or to consign their economic wealth to developing countries. Indeed, in many industrialized countries, the national government’s role could be limited to program oversight and to facilitating the development of projects, but not to funding the projects themselves. Instead, in most cases, private investors such as electric utilities will provide the funding. Their motives will obviously be quite different from those of any national government. In particular, they regard any JI project as an investment and they will expect an attractive financial return from it (such as reduced GHG-abatement costs). For them to expect otherwise would be irresponsible to their shareholders. Thus, because of the intrinsic differences between JI and ODA, discussion about the two types programs should be decoupled. In particular, prospective host countries should not fear reductions in ODA from foreign governments and multilateral organizations, Likewise, the investors’ 14
As noted in Table B.1, the term “additionality” is also sometimes used in a different context to refer to the desire that JI projects be in addition to commitments to reduce GHG emissions domestically, rather than being a means of meeting these commitments in a cost-effective way. 33
governments and multilateral organizations should not regard JI as a form of, and thus as a substitute for, foreign aid. They should continue to carry out their ODA policies and missions apart from any JI program. In particular, they should not favor ODA assistance for countries that cooperate with JI, nor penalize those that do not. The fact that they are separate programs is also reason why it would seem inadvisable to require that any participation by an Annex country in JI be contingent on its maintaining a certain level of ODA [as suggested by Metz (1995)]. Such contingencies would blur the distinction between the two programs. Likewise, suggestions that Annex I or II countries provide a minimum fraction of GDP as a minimum level of ODA, in exchange for developing countries’participation in JI, blur this distinction between the two programs. The level of ODA that a country provides depends on many factors and to link it to JI would be overly restrictive given the multifaceted nature of foreign policy. Thus, industrialized countries would probably agree that JI is separate from ODA, but not “in addition to” it, because the latter implies that one can be traded off against the other. Maya (1995) fears that in the limit, large donor countries could freeze all ODA and force developing countries into JI. Of course, there is no guarantee that by rejecting JI prospective host countries would increase, or even maintain, the level of ODA that they receive. However, because industrialized countries would likely agree that JI is not a substitute for, but separate from, ODA then developing countries should press to have this concept be included as part of the JI protocol, including a process for appeal and decision. Ensuring that the Parties comply with this requirement would be difficult as in any international issue, but at least developing countries would have agreement from the industrialized countries on the concept of decoupling JI and ODA, and on a means of appealing any transgressions that they perceive. Language adopted by the First Conference of the Parties in March 1995 is consistent with the idea of decoupling ODA from JI. This language stipulates that the portion of any project funded through ODA is not eligible for JI. This stipulation reflects the fact that the Parties specifically wanted to avoid the potential for JI projects to “crowd out” ODA funds.
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Table 3. Summary of key differences between Joint Implementation and Official Development Assistance Basis of Difference
Joint Implementation
Official Development Assistance
Context
JI projects would all be implemented in the context of the FCCC, as means of controlling GHG emissions in cost-effective ways.
ODA can arise as part of the foreign policy of a country, or of the mission of a multilateral organization such as the World Bank.
Purpose
To provide opportunities for countries, that have committed to reductions in GHG emissions, to do it in a way that is costeffective and that provides benefits to host partners.
To provide funds, low-interest loans and other resources to developing countries to assist their economic development and social well-being.
Participants
Investors, frequently in the private sector; host partners, which may also be in the private sector; investors’countries, which are Parties to the Convention; host countries, which are also Parties to the Convention; and the global community, including nongovernment organizations.
Donor country or multilateral organization, and recipient country. NGOs are often involved, but indirectly.
Nature of the projects
GHG reduction or sequestering.
Depending on the donor agency, various projects such as agriculture, flood control, public health, energy, transportation, environmental management, etc. Projects related to climate change are frequently intended to mitigate adverse impacts or to adapt to them.
Resources provided
Investors provide technology and/or financing. Host partners provide a JI “opportunity.” Other terms negotiable.
Donors provide financing, including low-interest loans, and human resources (e.g., technical expertise). Host countries carry out the project responsibly, but do not provide services or commodities to the donor. Goodwill is exchanged.
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3.7 Unintended Adverse Impacts Recent commentary has suggested that participation in the JI program could cause ancillary adverse impacts (Climate Network Africa 1995). These can be classified as leakage effects, longerterm macroeconomic impacts, and the replacement of other desirable activities. Leakages The most immediate concern is that there could be “emission leakages.” That is, some of the reduction in GHG emissions that the JI project provides is offset by increases elsewhere. For example, a forest stand might be preserved by a JI project, but the developer might go elsewhere and cut another stand to develop that land instead. Thus, the net gain in carbon sequestering could be negligible. The issue of emission leakages is particularly troublesome with forest management projects because of the difficulty in establishing a baseline and of measuring the net decrease in GHGs. This issue is primarily one of concern to the global community, which regards leakages as subverting any progress in reducing the global stock of GHGs. Emissions caps on host countries, as well as investors’ countries, provide a means of minimizing this problem because any leakages to another part of the country or economy would have to be offset by reductions or sequestering elsewhere. Appendices B and D provide additional discussion. The conclusion reached there is that emissions reduction and emissions sequestering projects should be treated differently. It is easier to define baselines for emissions reduction projects because they can be directly compared to either the project that they replace or enhance, or to another specific project over which it is selected. Fossilfuel projects can still start up elsewhere in a country, but these would presumably have started up anyway, and would not be considered as leakages. Macroeconomic effects can occur (see the following discussion), but these effects would generally be negligible at the margin, for any given project. Thus, JI projects involving emissions reductions are JI options whose GHG benefits can be verified relative to a baseline, even in the absence of emissions caps for the host country. On the other hand, emissions sequestering projects present more significant baselinedefinition, monitoring, and verification problems. For example, if a tree is harvested by firm A and sold to firm B, should we account for the flow of carbon (from A to B with no emissions until the wood oxidizes, at which time it will show in the account of firm B)? Because of these complications, it seems that the best carbon accounting system, and the one that provides the most incentive for minimizing net GHG emissions, is one that accounts for changes in stocks of renewable carbonbearing materials. Thus, on this basis, from the standpoint of the global community’s desire to reduce net GHG emissions, the preferred approach in theory is to limit host countries’ participation in projects that increase sinks unless these countries come under some sort of emissions cap. But in practice, a 36
reasonable way for the global community to deal with the leakage issue is to impose discounts on credits from these JI projects. The magnitude of the discounts would vary depending on the type of project. These discount factors would obviously be imprecise estimates but would allow a “secondbest” solution to the issue. Macroeconomic Impacts If JI projects are efficient and collectively lead to lower energy prices, then there could be a conservation rebound or take-back effect (Roland and Haugland, 1994 cited by Heintz and Tol, 1995). This effect is similar to the emission leakages concept. The net reduction in GHG emissions is actually less than what would be credited to the JI project. Similarly, if the use of fossil fuel deceases as a result of JI projects, then this would lead to decreases in its price. The price decrease would increase somewhat the quantity of fossil fuel demanded. But this increase would be less than the amount reduced by the JI project. Thus, the JI project would still provide a net reduction in GHG emissions. If a country has emissions caps, then these would effectively limit the leakage effect. But as long as some countries do not have emissions caps, some emissions leakages will take place. Also, the deployment of more efficient technologies could lead to increased economic growth, and subsequent increases in the demand for energy. Some analysts are concerned that, in this way, initiatives intended to improve environmental quality could eventually lead to excessive consumption patterns and increases in emissions and other problems, similar to those experienced in industrialized countries. In essence, this concern is an argument for holding developing countries out of the industrialized world. At one extreme it is an argument for maintaining their poverty. At another it is to direct their development towards a non-CO2 path — which is not now available. The wisdom of this proposition is for developing countries to judge. Hare and Stevens (1995) express concern about hydro and nuclear projects, and more generally about the fuel cycle impacts of any project. These impacts include those associated with construction of a facility, its operation, and its decommissioning, as well as any fuel extraction, processing, and transport. Hare and Stevens (1995) suggest that environmental impact statements be required of all JI projects. But such environmental policies should be a matter for individual countries to decide, not JI. Replacement of Desirable Activities In addition to the long-run environmental impacts of JI projects, Metz (1995) cites Parikh (1993) as noting a possible conflict with food production land use if farmers are attracted by subsidies to grow trees as GHG offsets, instead of food.15 These types of concerns extend beyond those 15
Note, however, that the first agricultural land to be used for tree crops is “marginal,” rather than “good” land. Also, tree crops might have positive externalities such as reducing erosion 37
discussed in Section 3.4 to include situations in which a JI project replaces existing activity. In this example, if a farmer thinks that the present value of the revenues minus costs of growing trees is greater than that of crops, then the farmer would do better to grow trees, a priori. However, even though it might be in a host partner’s interest to participate in a JI project, the host country must keep the country’s broader interests in mind. If the farmer’s income from growing trees is greater than the cost of importing the food shortfall due to the farmer’s decision to grow trees (or the decreased revenue as a result of exporting less food), then on balance the country is still better off. However, it the government anticipates that the food shortfall will cause significant distributional imbalances within the country (e.g. the farmer is better off, but the rest of the population must pay more for food), then it might consider rejecting the project. Alternatively, the government might resort to agricultural policies that will more directly impact its agricultural problems. Undoubtedly, there will be distributional effects. JI could promote competition among investors and prospective host partners for the best projects, leaving others “out in the cold” (Metz 1995). This provides the maximum gains for all parties taken together, but the distribution of these gains might be taken to be unfair. Countries that have a comparative advantage in terms of their opportunities to reduce GHG emissions will generally fare better under JI than other countries. However, the global community’s goal of having a degree of equity is still protected because we assume that it has authority to approve all JI projects. (Though in practice, cost-effective protocols might eliminate the need for third-parties to approve every single project in advance). 3.8 Mismatch With Host Countries’ Priorities And Technology Needs Projects Inconsistent With a Country’s Priorities A related concern that some countries have about JI is that the projects emanating from the program will not be foremost among their own list of priorities (Selrod and Torvanger 1994; Metz 1994; Maya 1995; Yaker 1995). This concern is indeed understandable, especially in countries with low per capita income; explosive population growth; high rates of mortality, especially among the younger age cohorts; internal conflict and civil war; and frequent natural disasters such as droughts and floods. These problems are certainly more immediately important than reducing GHG emissions and they deserve the urgent attention of governments and multilateral organizations. Indeed, it is these types of concerns that are the reasons for having ODA, humanitarian assistance, and other related programs. These programs are, and should be, distinctly separate from JI programs. Recognition of this fact would reduce potential conflicts of interest between the two types of programs. To ensure this distinction between ODA and JI, governments might consider operating these programs from the budgets of different departments or ministries (e.g. “State” or “Foreign Affairs” for ODA and
compared to the current land use. 38
“Energy” or “Commerce and Technology” for JI). Funding for JI would generally be only for government administration and oversight, because private investors provide the project funding in JI. Although a host country would much prefer to be provided with capital in ways that it prefers, JI funds will most often be from private, not public, sources. These sources do not donate these funds but rather would offer them in return for a commodity that they, together with a host partner, can produce at less cost (i.e., emissions credits). Although these projects would likely not address the highest priorities of the host country, it might nevertheless find them attractive. As discussed in Sections 3.1 to 3.3, unlike ODA which entails a donor agency providing funds to a developing country, JI entails a joint venture between an investor and host partner. From the capital or other resources provided by the investor, the host partner stands to gain, for example, higher revenues from more efficient plant and equipment, lower costs from advanced technologies, possibly direct financial considerations, or any other terms that the parties agree on. For their part, host countries should be encouraged to initiate their own proposals. Such proposals would presumably better reflect these countries’priorities. In developing their proposals, host countries should account for the full costs to their country, including government staff and other transactions costs, and negotiate the best terms possible. Then, even though these JI projects might not be the host countries’highest priorities in the larger scheme of things, nevertheless these projects will provide added benefit to these countries. Institutional resources that the Convention can provide can help prospective host countries to identify a good match with its priorities. For example, the Convention can establish an electronic bulletin board for prospective investors and host partners to find the right match, or a clearinghouse to assist investors and host partners to process their agreement expeditiously. These are good ideas so long as they facilitate, rather than restrict, the process of developing agreements [e.g., requiring that all JI projects originate through a clearinghouse would be unnecessarily restrictive] Increasing the exchange of information facilitates the process; it enables host partners/countries to propose projects that they favor. Of course, under the framework that this paper recommends, both the investors’ country and the host country should have authority to approve any JI project. If this situation were to be true, then a host country can approve those projects that it deems to be consistent with its national priorities, and reject those that are not. Dumping Outdated Technologies A specific concern about JI not providing projects of priority to prospective host countries is the anxiety that some of them have that industrialized countries will take advantage of JI and use it to export questionable technologies. There appears to be concern about both old outdated, and new unproven, technologies. For example, Maya (1995) expresses concern that industrialized countries might transfer only current technologies that will become obsolete, at the same time that he questions whether JI might be a “gimmick” for industrialized countries to expand the market for unproven products. Generally, however, concern is centered on the perception that JI might be a “neo-colonial” ploy that will allow industrialized countries to “dump” their outdated technologies and 39
thereby to retain their comparative economic advantage (Parikh 1993; Maya 1995; Kuik and Gupta 1995). As Kuik and Gupta (1995) question: industrialized countries have said they do not want to jeopardize their economic competitiveness, so why would they supply the latest technologies to developing countries? These questions reflect some developing countries’general distrust of industrialized countries (refer to Section 3.9). But the intentions of firms are not to embark on a mission to dump their outdated technologies, nor to support their own countries’goals but simply to make a profit. There are two types of firms in investors’ countries that can profit from JI projects: (a) investors (e.g., emitters of GHG) that can reduce GHG emissions at a cost less than that available elsewhere, and (b) manufacturers of the equipment that are used in these projects: (a)
Investors. Firms do not, and certainly should not, hide the fact that they are trying to reduce their costs. They want to increase their economic competitiveness, and because of that, they have an incentive to supply technologies whose GHG-emissions reduction efficiencies justify their cost. These technologies are not necessarily the latest technology — just as it is not necessarily the case that the latest technology is always employed in industrialized countries. Rather, they are technologies whose performance justifies their cost. In some cases, this would be the latest technology; in other cases, it would not. The fact that the latest technology is not employed in a certain project does not preclude it being used elsewhere where conditions are more opportune.
(b)
Manufacturers. Similarly, the manufacturers of technologies are seeking export markets for their goods. Equipment manufacturers certainly want to increase their foreign market, but their products will be used only if they are cost-effective. If the market for established technologies is saturated in industrialized countries, then these manufacturers might reduce prices to obtain a sale to a JI project. In this way, some projects in developing countries would be one step behind the latest technology, even though they would still have costeffective equipment. Alternatively, in order to get production of a new technology up to efficient levels sooner, manufacturers may aggressively market them to JI projects in developing countries, taking a lower price to justify the added risk to buyers. These are normal economic incentives, and the bargains struck will reflect a balance of benefits to both sides.
Host countries should not think that investors and manufacturers, which are responsible to their shareholders, “ought” to have the host countries’ interests as their primary concern. Nevertheless, host countries can regard JI as providing opportunities for incremental improvement in their infrastructure and well-being, though not as a catalyst that will enable them to achieve quantum leaps in economic prosperity and well-being. As emphasized in this paper, host partners/countries should not be passive nor surrender to an attitude of vulnerability, but should aggressively initiate their own proposals and negotiate the best terms possible for themselves. The level of “advancement” in the technologies will depend on the individual JI project agreements that
40
host partners make (and that host countries approve). If the host country wishes to influence the level of technology used it can do so — though for a price. 3.9 Fear of Loss of Sovereignty An issue that evokes strong sentiment among some of the potential host countries is their feeling that JI will cause a loss of, or at least undermine, their national sovereignty (Metz 1994; Parikh 1994; Selrod et al. 1995; Climate Network Africa 1995). Specifically, these countries fear that, with JI, they will lose authority and control over their land and other domestic resources.16 This type of concern would seem to be more relevant to biomass projects (e.g., forest preservation, afforestation, and reforestation), in which investors might retain ownership over land in a host country for a long time period (Metz 1995). Other types of potential JI projects, such as fuel-switching, would appear to be more agreeable to these countries because they involve engineering plant and equipment, which are not as “intrinsically” part of a nation’s resources as its people, land, and mineral resources. But any type of ownership might be regarded as threatening. To address this concern, parties should focus on the following areas — (a) (b) (c) (d)
sensitivity by investors and investors’countries to host countries' concerns; cooperation among all parties, e.g. in providing information to each other; negotiation and decisions by the host country; and negotiated limits to the duration of JI projects.
Each of these is discussed below. Sensitivity to Host Countries’Concerns About Foreign Ownership Investors and the investors’ countries should be sensitive to the concern that some prospective host countries have about the loss of their sovereignty. This concern is most prevalent in countries that have historically suffered from the throes of colonialism, and it is naturally understandable that they regard with suspicion any foreign venture in their country. Kuik and Gupta (1995) have described these concerns by comparing JI to a “Trojan horse,” another ploy by industrialized countries to extend their exploitation of resources and inexpensive labor in developing countries. Investors should sympathize with this concern. Before encouraging in discussions with prospective host countries, investors should be aware of whether these countries have had a history of colonialism, and of the specific circumstances. In the minds of many developing countries, foreign ownership of productive facilities is as big an issue as foreign ownership of land and natural resources. Inventors must recognize these concerns. They might do well to limit their participation in any JI-related joint ventures and subsidiaries to a 16
Section 3.4 provides discussion on the related issue of countries' concerns that their resources will be exploited, with their being inadequately compensated for the use of their resources. 41
non-controlling interest, with termination clauses agreeable to all parties. As discussed further in this section, host countries should negotiate so that they are satisfied with the terms of any agreement (also refer to Section 3.2). It might help investors to be sensitive to these concerns if they note that concerns about loss of sovereignty are not limited to developing countries. Extensive foreign ownership of land within industrialized countries frequently stirs public sentiment against it, even when it is entirely consistent with what is ordinarily encouraged. For example, some jurisdictions within both Canada and the United States have limits penalizing foreign ownership of land. Thus, investors might wish to avoid proposing projects where they have a controlling, or possibly even part, interest in the land or other resources of a host country; and even where they control the operation of the project. This strategy would offer some protection for host countries concerned about loss of sovereignty under JI, and yet leave sufficient latitude for potential investors to identify and develop projects attractive to them. Also, "ownership" is a fungible concept, often effected through joint ventures, locally incorporated subsidiaries, and leases. These are ways that host countries can retain ownership of their resources. Host countries should also realize, however, that inflexibility toward foreign ownership will limit their opportunities. For example, they might lose projects from independent power producers wishing to invest in their countries. Increased Cooperation and Information-Sharing Bilateral and multilateral cooperation is more likely to lead to greater benefits for all of the parties. This notion is consistent with the findings in theoretical economics (refer to the Appendix A). An important aspect of this cooperation is sharing of information, including each party’s aspirations for a given JI project. Again, this idea is consistent with the theoretical economics literature, which has found that imperfect and asymmetric information among the parties increases the likelihood of more sub-optimal agreements. In the specific context of loss of sovereignty, sharing of information should reduce distrust. Investors in the current pilot phase unequivocally state that they do not want to be involved in a project in a country that does not want it. The gains for investors from JI would not seem to be so great that they would risk host countries’raising sovereignty concerns. Negotiation and Decisions Host countries can, and should, try to negotiate a JI protocol, as well as individual JI projects, that are as favorable as possible for themselves (as will investing countries do the same in their own interests). For example, host countries could insist that no land be sold to foreign investors. Parikh (1995) suggests other institutional JI provisions that would reduce the risk of host countries’ susceptibility to adverse consequences in JI projects. Many of these suggestions would likely be 42
unacceptable to other Parties, but these suggestions serve to make the point that prospective host countries can, and should, negotiate in their own-interest. One of the terms that prospective host countries should require within the JI program is that each JI project require the approval of the host country’s government (as suggested, for example, by Torvanger 1993; Metz 1994; Arts et al. 1994; Climate Network Africa 1995; Hare and Stevens 1995). (In the current pilot phase, that is not the case.) The countries, not the individual investors or host partners, are Parties to the Convention. Any JI project will affect the status of the emissions budgets to which the Parties have agreed. Thus, any JI project under the Convention should at least have the approval of the Parties directly involved (i.e., both the investor’s country and the host country). (See Section 3.4 above.) Certainly, capital-starved countries might be tempted to surrender to the temptation of agreeing to JI contracts that put them at great disadvantage. But if they recognize they too have the right and power to negotiate, then what initially was thought of as environmental colonialism could be recognized as a fruitful technology transfer opportunity (Maya 1995). Negotiated Limits on Duration of Agreement Consistent with the previous point, host partners/countries should consider negotiating specific limits on the duration of each JI project [as suggested, for example, by Metz (1995)]. That way, any domestic capital or other resource would be committed for a limited period of time. One could think of this type of arrangement as a lease, which perhaps is a term that would be more acceptable than “sale” of domestic resources. The length of these agreements could be relatively short, for example ten years, with the option for renewal if agreed upon by the parties, and with a settlement if the agreement ends prematurely.17
17
For example, assume a fuel-switch retrofit project with a projected operating life of 30 years. The agreement with this project could be that the investor finances the cost of the retrofit; the host partner owns the equipment; the investor gets all of the emission credits each year up to year 30; after year 10, the agreement can be terminated at any time by the host partner; if the agreement is terminated between years 10 and 20, say, then the host partner would have to provide annual payments to the investor up to year 20 (because of its financing of the retrofitted plant, whose ownership the host partner retains); between years 20 and 30, the investor would provide payments to the host partner linked to the price of emissions credits at that time (to provide the host partner some “insurance” against under-estimating the value of the emissions credits); and after year 30, the agreement is terminated and any emission credits that the plant provides would belong to the host partner, which is responsible for decommissioning the equipment. Of course, this is only a hypothetical example, but it serves to illustrate the wide variety of terms that can be negotiated into any agreement, that can serve to protect the sovereignty as well as financial interests of the host. 43
4. SUMMARY AND RECOMMENDATIONS This paper presents an approach for understanding concerns about JI which is rather different from past approaches. In the past, proponents of JI have stressed its benefits: a cost-effective and flexible means of meeting GHG emissions commitments, technology transfer and expanded markets for exporters and access to advanced technology for host countries, local environmental benefits, and promoting sustainable development. Proponents of JI would frequently cite well-known results in environmental economic theory, which hold that a system of emissions caps with JI and trading of emissions credits is more efficient that one without them. At the same time, opponents of JI have complained about the leakage and feedback effects which call into question whether JI will be an efficient means of reducing GHG emissions, the risks to investors that the projects will not perform as expected, host partners not receiving the true value of the credits that they provide to investors, possible loss of sovereignty in host countries, a mismatch between JI and these countries’other priorities, and their fear that JI will lead to a loss of ODA or GEF funding, or worse yet that collaboration on actions to address climate change problems will lead to host countries’running the risk of being confronted with emissions caps of their own. The position that this paper takes is that virtually all of these perspectives are reasonable, if they are considered from the point of view of the particular party voicing them. Thus, rather than take a conventional approach of a global welfare maximizing entity, or the position of one party that sees just a part of the picture, we view JI from the point of view of game theory. In game theory, the players each have their own distinct perspective and objectives, and they behave strategically in a way that takes into account the priorities and strategic behavior of the other players. This literature shows that solutions can exist (i.e., there can be agreements), even when the players do not fully cooperate. Applied to the JI context, this literature implies is that even though many parties are involved in different levels of negotiations, and even though these parties have different goals and negotiating strategies, agreements can still be realized in which all of the parties benefit. We do not develop any game-theoretic results in this paper, but rather use the paradigm as a general framework to focus on the importance of accepting different perspectives, on the possibility of achieving agreements among parties that have very different objectives, and on characteristics of a JI protocol and JI projects that help to move toward a successful resolution of the game(s). Although we do not derive any “formal” (i.e., mathematical) results, we have found it useful to draw on game theory concepts to suggest that it is “natural” to expect that different parties will have different positions, and that what is “right” frequently depends on whose perspective is used; that collusion, deception, and other strategies are all to be expected in such games, but that in spite of these barriers, agreements can still be reached if the parties are willing to accept gains that are less than what they would have realized if the other parties agreed to their terms; and that reducing asymmetry in information increases the chances of mutually beneficial agreements. Also, the discussion in this paper will hopefully stimulate more formal treatment of some of the ideas that this paper discusses, which might lead to either analytical or simulation results that indicate that under certain sets of conditions (e.g., on the asymmetry of information, goals of the players, etc.), certain 44
outcomes (e.g. “equilibrium solutions” or agreements) can be attained; while under other conditions, they can not. This game-theory approach has led us to the following considerations: (1)
The game-theory paradigm is aptly suited to JI negotiations. Parties should expect and accept that the other parties will have objectives and strategies different from their own. By taking note of the underlying basis of the other parties’ positions, parties can better understand, negotiate, and reach agreement.
(2)
The parties should view a JI project as a joint venture in which an investor provides financial resources and a host partner provides in-kind resources (such as an existing power plant that can be retrofitted). A JI project takes these as inputs and produces several outputs. Of these outputs, the investor typically receives the emissions credits; and the host partner typically receives all of the other output (e.g. revenues from its enhanced power plant, or other considerations that it negotiates with the investor). What the investor and host partner actually receive is entirely negotiable. The investor can use or sell its credits in the future, and likewise the host partner can invest its share of the output (e.g. invest its increased revenues from the sale of electricity).
(3)
The exchange of emissions credits is a form of international trade. The emissions credits produced by a JI project are a commodity, just as, for example, copper is a commodity. There is a market for copper because firms are willing to pay for it, and it is used to produce final goods such as copper wire. Similarly, there would be a market for emissions credits because (and only because) of countries’ commitments to limit their GHG emissions; and these credits would be used by firms together with land, labor, capital and materials as factors of production in, for example, generating electricity. And just as a firm in a country with copper resources might seek a foreign investor in a mining project, so too might a host partner join with a foreign investor in a JI project. In each case, the host country has a comparative advantage in producing the commodity at a low cost, and exports it to another country.
(4)
Baselines need to be defined to determine the quantity of emissions credits from any project. A baseline is the situation that would have occurred had there been no JI program. Ideally, there should be both project and national baselines. The project baseline should be defined on the basis of GHG-emissions of the most likely alternative, which would be implemented were there no JI support. For countries with an emissions cap, their cap is effectively their national baseline. For countries without a cap, defining a national baseline is problematic but nevertheless highly desirable.
(5)
The issue of measuring GHG-emissions reductions compared with a baseline is complicated enough when the project involves fuel switching in an individual industrial or power plant or afforestation of an area previously without biomass cover. It is more difficult for efficiency 45
improvements that reduce GHG emissions, and it is far more problematic yet for projects focused on institutional processes that could have far bigger long-term impacts, such as integrated resource planning or institutional capacity strengthening, compared with more straightforward physical interventions. There is a chance, in fact, that the most profound contributions to GHG-emissions abatement will be the ones hardest to document, and that as a result JI will deal exclusively with individual production activities rather than with more farreaching institutional changes. The Parties should devote more attention to these latter opportunities. (6)
The low-hanging fruit issue arises when host countries fear that they will be subject to an emissions cap in the future, and that by parting with their low-cost options for mitigating GHG-emissions, they are worse off than if they had not. The resolution of this issue must be made by the host countries themselves for each proposed project on a case by case basis. Specifically, for each case, the host country must calculate the value of the benefits that it negotiates in the JI contract, including the value of any appreciation of capital or revenues from the project, and compare it against the probabilities of different alternative emissions caps and of the costs of emissions reduction in the future. Differences among the parties in their assessments of their benefits will arise as a result of different perceptions of these probabilities. These differences are barriers to JI agreements, but can be reduced by the sharing of information and the resolution of uncertainties.
(7)
Host countries can be assured of adequate compensation, at least to their satisfaction, by negotiating the best terms possible for themselves. Some possible terms to consider are negotiating a share of the credits, call options that provide the host partner/country with the right to buy credits back from the investor at a pre-determined price in the future, limits on the duration of projects, and side-benefits such as local education and social programs. The parties should recognize, of course, that requests by one party on the terms of a contract will be met by counter-proposals by the other party. The most promising opportunities for agreement are those where both the benefits and risks of a project are shared between investor and host.
(8)
Some developing countries are concerned that collaboration in any GHG-reduction effort will implicitly signal their agreement to accept responsibility for implementing such reductions and specifically their concession to having emissions caps. To allay these concerns, the issue of emissions caps should be decoupled from considerations of JI. Caps should be considered without regard to negotiations on JI, and vice versa.
(9)
Confusion sometimes arises about JI and ODA being substitutes. They are in fact distinctly different. JI entails a joint venture; ODA entails funds from a donor agency. Policies and funding for these two types of programs arise from different sources, and should be negotiated independently. Language adopted by the First Conference of the Parties in March 1995 is consistent with the idea of decoupling ODA from JI. This language stipulates that
46
the portion of any project funded through ODA is not eligible for JI because the Parties specifically wanted to avoid the potential for JI projects to “crowd out” ODA funds. (10)
Emissions leakages, where GHG reductions are offset by increases elsewhere, should be expected. It is impractical for any formula that calculates emissions credits to account completely for these leakages. The best way of addressing them in theory is with emissions caps on all countries, including the current non-Annex countries. However, in practice, the use of discount factors to calculate the credits of forest management and other projects provides a “second best” solution. Although some projects will gain, and others lose, from using these adjustments factors, it is likely that all parties (including the global community) will be better off with the JI projects than without.
(11)
Investors should be sensitive to host countries’ priorities about economic and social development in projects that investors propose. Likewise, host countries should be sensitive to investors’priorities to make a profit in projects that host partners/countries propose. Each party will profit by being more aware of the other’s objectives.
(12)
Investors should be sensitive to prospective host countries’concerns about the loss of their sovereignty as a result of JI projects.
Hopefully, these points offer additional information that the parties might use in their quest for initiatives of benefit to themselves, and by so doing, agree on a protocol that is acceptable to all.
47
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Parikh, J. K. (1994) “Role of Markets, Governments, and International Bodies in Joint Implementation with the South,” in K. Ramakrishna (ed) Criteria for Joint Implementation Under the FCCC: Report of a Workshop held 9-11 January 1994, Southampton, Bermuda, Woods Hole, MA: Woods Hole Research Center. Pearce, D. (1995) “Joint Implementation: a General Overview,” in C.J. Jepma (ed) The Feasibility of Joint Implementation, Dordrecht, The Netherlands: Kluwer Academic Publishing. Roland, K. and T. Haugland (1995) “Joint Implementation: Difficult to Implement?” in C.J. Jepma (ed) The Feasibility of Joint Implementation, Dordrecht, The Netherlands: Kluwer Academic Publishing. Schlamadinger, B., and G. Marland (1996) “The Role of Forest and Bioenergy Strategies in the Global Carbon Cycle,” Biomass and Bioenergy, 10: 275-300. Selrod, R., and A. Torvanger (1994) What Might be Minimum Requirements for Making the Mechanism of Joint Implementation Under the Climate Convention Credible and Operational, Report no. 1994:4, Olso, Norway: Center for International Climate and Environmental Research. Selrod, R., Ringius, L. and A. Torvanger (1995a) Joint Implementation- a Promising Mechanism for All Countries?, Policy Note no. 1995:1, Olso, Norway: Center for International Climate and Environmental Research. Selrod, R., Torvanger, A., Karani, P. and J.B. Ojwang (1995b) Joint Implementation Under the Convention on Climate Change: Opportunities for Development in Africa, Report no.1995:5, Oslo, Norway: Center for International Climate and Environmental Research and African Centre for Technology Studies. Stavins, R. N. (1995) “Transactions Cost and Tradeable Permits,” Journal of Environmental Economics and Management 29:133-148. Torvanger, A. (1993) Prerequisites for Joint Implementation Projects Under the UN Framework Convention on Climate Change, Policy Note no. 1993:3, Olso, Norway: Center for International Climate and Environmental Research. U.S. Government (1996) Activities Implemented Jointly: First Report to the Secretariat of the United Nations Framework Convention on Climate Change, DOE/PO-0048 Washington, DC: USIJI Secretariat.
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APPENDIX A - OVERVIEW OF GAME THEORY LITERATURE IN THE CONTEXT OF INTERNATIONAL ENVIRONMENTAL NEGOTIATIONS
A1. INTRODUCTION In this report, we regard joint implementation (JI) as one means of helping countries to meet their commitments to reduce greenhouse gas emissions, and of providing opportunities to investors, host partners, investors’countries and host countries to benefit from JI projects. A key idea that we emphasize is that JI negotiations can be thought of as strategic games. In this appendix, we summarize the game theory literature as it relates to international environmental negotiations and emission (i.e., pollution) permits trading. Over the past several years, a literature in the field of environmental economics has developed which has examined the efficiency of alternative policy instruments in reducing the emissions of pollutants. This literature demonstrated that policies which equate the marginal (incremental) cost of abatement across polluters minimizes the total social cost of reducing pollution. The intuition behind this result is quite simple. If polluter A has a greater cost for his last unit of pollution reduction than does polluter B, total social costs can be reduced if polluter A increases pollution by one unit and polluter B decreases pollution by one unit. The environmental economics literature has shown that the equating of marginal abatement costs across polluters can be generated by either pollution taxes or marketable pollution permits. Many economists favor marketable pollution permits over taxes because of a greater certainty of achieving the target level of pollution [see Weitzmann (1974)] and because of greater potential acceptability of marketable pollution permits by the polluters. The literature about marketable pollution permits has further developed along two lines. The first of these research directions has been to identify further opportunities for cost savings by expanding the trading opportunities. These potential cost savings are primarily related to extended trading of pollution rights to trades over time. Additional cost savings could accrue by expanding permit systems to include multiple pollutants and by expanding the geographical base of the permit systems. The second research direction has to do with identifying real world obstacles to pollution trading, the implications of these obstacles to economic efficiency, and ways to overcome these obstacles. The emissions credits generated by JI projects can be sold and traded just like other pollution permits. The purpose of this appendix is to discuss issues and barriers to pollution permit trading, as well as issues which are unique to JI, and to examine their implications for JI. In order to better understand the implications of these barriers to JI, it is viewed as an economic game, which allows insights to be drawn from the game theory literature.
A-1
In a true marketable pollution permit system, polluters are assigned initial pollution rights, and then can buy and sell the right to pollute. Given the initial allocation, trading will make all trading parties better off. The concept of JI is thought of by some analysts as a system that specifies maximum emission levels for each country, to approximate a marketable pollution permit system. JI allows investors/country to gain credits towards meeting their emissions reductions by arranging (i.e., financing) projects that reduce total emissions below the allowable level in a different country. These JI projects would be arranged by individual polluters operating within a country, or other investors, including the national government of a country. The important economic gain from trading is that it allows the target reduction in emissions to be achieved by those who can reduce emissions at the least cost. The potential magnitude of these cost savings can be quite large. For example, Barrett (1992a) used engineering data to evaluate the costs of stabilizing European Union-wide GHG emissions at 1990 levels by the year 2000. He found that the costs would be 50 times less expensive if trading was allowed across countries in comparison with each member country stabilizing its own emissions. Other studies [e.g., Jackson (1995)] question this potential, but in any event, the magnitude of the actual savings will be reflected in the market created by JI. JI is a term that has been used in connection with three variations of trading systems. In the most sweeping version, all countries have emissions caps and all countries have the right to make trades with other countries. In this system, a given country can exceed its emissions caps if it arranges for another country to be below its emissions cap by the same amount. Barrett (1995) terms this system TCEE (tradeable carbon emission entitlements) joint implementation. In the second version of JI, only certain countries (mostly developed countries) have emissions caps, but developed countries can exceed their caps if they arrange for another country to be below its cap by the same amount, or if they arrange for a corresponding reduction in emissions in a non-capped country. Barrett (1995) terms this system IC (incremental cost) joint implementation, since the trades are achieved by having the investor (capped) countries pay the incremental costs associated with achieving the emissions reductions in the host (uncapped) country. In the third version of JI, only certain countries (developed countries) have caps, and they may exceed their caps only if they arrange for another capped country to be below their cap. Reductions in emissions in uncapped countries do not count towards meeting the requirements of the emissions caps. A variation of this system is to have the participating countries contribute to a fund to reduce emissions in non-participating countries.
A2. OBSTACLES TO TRADING AND JOINT IMPLEMENTATION A2.1 Factors reducing the efficiency of trading As mentioned above, the cost minimizing properties of tradeable permit systems are an established result in environmental economics. However, the literature in environmental economics has pointed out several complications that could serve to reduce the number of trades that take place and the corresponding cost reductions.
A-2
The first complication has to do with the importance of geographical variation in the impact of emissions on damages (Krupnick et al.1983). If this geographical variation occurs, then efficiency requires that this be accounted for in the trading system. However, this complication is not a factor for greenhouse gases, for which the damage is independent of the location of emissions. The second complication has to do with potentially imperfect competition in the market for emissions. If the market for emissions is dominated by a few large firms or countries, then costminimizing properties of the system are not independent of the initial allocation of permits (Hahn 1984). Since energy use and carbon emissions are ubiquitous in the global economy, this is unlikely to be a potential concern, particularly because trades will be made by individual firms (who are very small relative to the market) rather than countries (which are relatively larger compared to the market). A third potential complication which is discussed in the literature on permit systems is the problem of thinness of markets (Hahn and Noll 1982; Atkinson and Tietenberg 1991). If there are insufficiently few potential traders, market prices for permits will not be well established and transactions costs may become quite high. Again, since energy use and carbon dioxide emissions are such a prominent feature of the global economy, there is unlikely to be a problem of thinness of markets. A fourth potential complication is the presence of transactions costs (Stavins 1995). Transactions costs reduce trading and thereby erode the cost-reducing properties of the permit system. In addition, the level of cost reduction may be dependent on the initial allocation of permits. The final complication is the notion that social cost minimization requires trading across polluters over time, as well as trading across polluters at a given point in time. Permit banking and borrowing systems have been devised in the literature as ways to allow trading over time. Kling and Rubin (1997) provide a discussion of this issue for pollution in general, and Leiby and Rubin (1997) provide a specific discussion in the context of GHGs. A2.2 Strategic behavior The initial environmental economics literature on trading of marketable pollution permits assumed that there existed a pollution control authority that could establish a quota for total pollution and initially allocate that quota across individual polluters. Research showed that the initial allocation had no impact on (overall) cost-minimization, in the absence of the complications noted above. Trading would ensure cost-minimization across all possible initial distributions of permits. However, the literature was primarily looking at controlling pollution within a country’s national borders, where the assumption about the existence of a pollution control authority with powers of enforcement is realistic in most cases. However, when one begins to consider global and transboundary pollutants, this assumption is not likely to be valid. Without a pollution control authority to set emission reduction levels and to establish an initial allocation of pollution rights, A-3
countries must negotiate these points. This negotiation process leaves open the possibility that countries will behave strategically, which has the potential to eliminate both the optimality and the cost-minimizing properties of both emissions trading and JI. The following discussion of strategic behavior draws heavily upon Missfeldt (1996). It should be noted that the discussion which focuses on country level behavior is also applicable to firm and NGO behavior. In terms of strategic behavior, countries can choose strategies involving their unilateral choice of emission levels, or choose strategies with regard to negotiating a cooperative choice of emission levels. Negotiations would involve both the total level of emissions and the allocation of emissions across countries. The analysis of the strategic behavior is complicated by the many different types of countries. With regard to total levels of emissions, countries will have different positions with respect to the impact of global climate change on their country, and the cost of their country achieving reductions. For example, low-lying countries are likely to advocate lower world-wide emissions, and fossil fuel producing countries might advocate higher world-wide emission levels. With regard to JI, there are likely to be at least five different positions with regard to the structure of systems. First, there are the developed countries which generally have a high cost of reducing emissions. These can be termed investor countries, since they are likely to invest in activities that reduce emissions in the second type of countries, which are often termed host countries. The third type of position is that of the investors (firms, other organizations, and possibly the countries themselves) who will actually be doing the investing to reduce emissions in the host country. The fourth position is that of the host partners (firms, other organizations, and possibly the countries themselves) who will receive or be economic partners in the investment in the host country. The fifth position is that of all the parties (i.e., the global community) who will potentially suffer from the negative impacts of global climate change. It is important to keep these different positions in mind, because their existence implies that there be different positions across countries. There may even be different position within countries, and the same country may have conflicting objectives. An additional problem with transboundary pollution is that one country may benefit from increasing pollution levels, while other countries are harmed. Even though the harm may be greater than the benefit, the polluting country has no incentive to reduce emissions. As Missfeldt points out although most countries accept the PPP [Polluter Pays Principle], it may become necessary to ‘bribe’ countries in order to bring about a real incentive for pollution abatement, this has been named the victim pays principle (VPP). ( p. 6)
The VPP is common in Europe: some other countries pay to reduce transboundary pollution. Clearly the VPP is a problem for achieving a global solution when some countries are made better-off by increasing emissions. However, an additional problem is that even countries that would be made better off by emissions reductions may behave strategically and become free riders. They benefit from the reduction of others’emissions, but avoid the costs associated with reducing emissions themselves. Is free riding doomed to cause trading or JI schemes to fail? What can be done to reduce free riding? The methodological tools to answer these types of questions are found in the field of game theory, which examines strategic behavior. Instead of economic agents (such as a country) assuming that all variables are exogenously determined, they act with the knowledge that both their behavior A-4
and the behavior of other agents will affect the equilibrium values of these variables. The field of game theory is useful not only in examining how countries might react towards a marketable permit or JI system, but can also shed insight on their strategic behavior in negotiating the initial reductions in emissions. A2.3 The basics of game theory In many studies that use game theory, people assume that individual economic agents are fully cooperative. This assumption will yield the same solution as if there were a central planner who could enforce allocations across the agents. The literature has shown that cooperative games lead to outcomes that are social welfare maximizing across the whole system. In other words, the collective social welfare of all countries is better off under full cooperation than under any other possible solution to the game. It should be pointed out that economists analyze full cooperation, not because they think that is an accurate depiction of reality, but rather because full cooperation represents a benchmark against which other outcomes could be judged. However, full cooperation is not an equilibrium outcome for two reasons. First, some countries will be worse off under full cooperation than they would be without cooperation, unless the gains from the group are redistributed to compensate them from their losses. Second, all countries have a free-rider incentive (Missfeldt 1996). Other potential outcomes of an economic game include Pareto dominance and Nash equilibrium. In the Pareto dominant outcome, the social welfare objective function is maximized with the constraint that no one be made worse off. As Missfeldt (1996) points out, the Pareto dominant outcome does not constitute an equilibrium outcome for some of the same reasons that full cooperation does not. Nash equilibrium can (and frequently will) occur as an equilibrium in the real world. This outcome occurs when agents choose their strategies based on the range of strategies that the other participants might employ. However, the Nash equilibrium will always result in smaller benefits to the system compared to full cooperation or Pareto dominance. The famous “prisoner’s dilemma” is an example of a Nash equilibrium. In the prisoner’s dilemma, two prisoners would go free if they fully cooperate and do not implicate each other, but because they are afraid that each might testify against the other, they both end up testifying against each other and both go to jail. In the context of reductions of GHGs [assuming that there are no agreements such as the Framework Convention on Climate Change (FCCC)], the Nash equilibrium means that a particular country such as the United States would choose a level of GHG emissions depending on the reduction options which each other country might choose. Each level of reduction that the U.S. might choose will have different costs and benefits depending on the emissions levels of all of the other countries. An important result arising from the game theory literature is that countries can negotiate a solution that is better than a Nash equilibrium, but that is not necessarily as good as full cooperation. Each of these solutions involves sharing gains, such as those that could be available through JI. Many redistribution rules are based on some notion of equity, such as uniform percentage reduction in A-5
emissions, uniform per capita reallocation and uniform per Gross National Product (GNP) reallocation (Barrett 1992b). However, as Missfeldt (1996) points out, equity-based rules are seldom efficient and generally reduce the amount of gains to be redistributed. Nonetheless, they are frequently required in order to achieve international agreements. For example, equity-based rules are an integral part of the Montreal Protocol and of the FCCC. Table A.1 compares alternative economic games concerning reduction of GHGs or some other transboundary pollutant. The Business as Usual (BAU) outcome refers to a reference (but unlikely) scenario that there are no emissions reductions at all, because countries do not perceive emissions as in any way harmful, or are unable to reach agreement on their reductions. These results are for static games, or games that have no intertemporal dimensions. Generally, they show that ...full cooperation outperforms non-cooperation and leads to lower levels of pollution. One of the problems with full cooperation is, however, that individual countries may lose out. Cost sharing rules are able to remedy this problem. In the future , it may be desirable to focus on rules which are more readily evaluated, and thus easier to implement in a political negotiation framework, even if this is at the expense of reaching a Pareto efficient solution. In this static framework it appears nevertheless particularly difficult to deter players from free-riding, even if equitable cost-sharing rules are applied. (Missfeldt 1996, p. 33)
However, GHG emissions are a dynamic problem, and the game about emissions reductions must be repeatedly played. Dynamic games are inherently different than static games because of the opportunity for learning about other participants’ reactions, and the possibility for introducing feedback mechanisms. Different types of information structures lead to different types of outcomes which consist of the open loop Nash, the feedback Nash equilibrium and the Pareto optimal solution (full cooperation solution). In the open-loop Nash outcome, participants only know the initial value of the variable changing over time (e.g. the initial value of atmospheric concentration of GHGs). Along the time path of reactions, participants can not make responses to new information, because they can not observe the current levels of concentrations. In essence, it is a strategy of precommitment. Under the feedback Nash equilibrium, participants know the current levels of the concentration at each point in time, but cannot be pre-committed to any actions. The general conclusion from examining these dynamic game theory models is that the stock of pollutant (the atmospheric concentration of GHGs) is lowest under full cooperation, and the open loop Nash equilibrium has lower levels of pollution than the feedback Nash equilibrium (Missfeldt 1996). The previous discussion has presented information about the implications of game theory models to transboundary and global pollution reduction. The general result is that full cooperation is a better outcome than any naturally occurring outcome, but that full cooperation is unlikely to occur because of the free rider problem and lack of full information. Imperfect information is more easily remedied than the free rider problem. The next section will concentrate on the free rider problem and the following section on imperfect information.
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Table A.1 Static game theory concepts of transboundary pollution Type of Analysis Costbenefit analysis
Costefficiency
Business as usual
Nash equilibrium
Full cooperation
max ( D
max
N ∑ i=1 ( Di - ACi )
Pareto Dominance N ∑ i=1 ( Di - AC i )
Payoff function
min ( AC
Solution
MACi = 0
MDi = MACi
N ∑ i=1 MDi = MACi
N ∑ i=1 MDi = MACi U P ≥ Un
Payoff function
min ( AC i )
min ( AC i )
min ∑ i=1 AC i
min ∑ i=1 AC i
subject to a pollution constraint
subject to a pollution constraint
subject to a pollution constraint U P ≥ Un
MACi = 0
N ∑ i=1 MACi = 0
N ∑ i=1 MACi = 0
which fulfills a pollution constraint
which fulfills a pollution constraint
which fulfills a pollution constraint U P ≥ Un
Solution
i
)
i
i
- AC i )
i
i
max i
U P ≥ Un
i
MACi = 0
i
N
i
N
i
Notes: The subscript i stands for country i, and N stands for the total number of countries. The superscripts p and n stand for the type of solution concept: p denoting Pareto dominance, and n the Nash outcome. MAC denotes marginal abatement costs and MD marginal damage. U is the payoff or utility function across all players. D denotes damage, and AC abatement costs. Source: Missfeldt (1996)
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A2.4 Free riding The free rider problem exists because of the public good nature of reductions in GHG emissions. Since many (but not all) countries will benefit from a reduction in emissions, a particular country or group of countries may refuse to participate in GHG reductions, still enjoy the benefits of other countries’reductions, but not pay the costs of reductions. Even with cooperation, countries still have an incentive to free ride if there is no credible international pollution control authority, with powers of enforcement. Under these conditions, cooperative models may degenerate into coercive models, with either positive or negative forms of coercion. Positive coercion methods include inducements or side payments to generate reductions in emissions from those tempted to free ride. Positive coercion strategies include financial aid, linked negotiations and matching mechanisms. However, Missfeldt (1996) points out that Gil and Folmer (1997) find that side payments may turn out to have unintended side-effects, as anticipation of side payments may cause countries to increase their emissions even above their non-cooperative emission levels. Also, the offer of side payments may lead to a loss of international credibility and weaken negotiating positions. Negative coercion consists of denying relations (such as participation in international trade agreements) unless countries participate in their “fair share” of emissions reductions. Linked negotiations relate GHG emissions to other international issues such as access to free trade, other environmental issues which may be more important to the free riding country, or even defense treaties; and they may be positively or negatively constructed. Related to linked negotiations is the concept of trigger strategies (Barrett 1994), which guarantee action by one nation (or coalition of nations) if another nation behaves in a certain fashion. One trigger strategy is the threat to be noncooperative if a particular country tries to free ride in the initial period. A related strategy is tit-for-tat, which requires punishment of the free rider until cooperation resumes. With matching mechanisms, a country or group of countries agrees to reduce emissions only if it is matched by the abatement of other parties. A2.5 Imperfect information Imperfect information has two important implications for JI. First, if countries have imperfect information about either the impact of global warming on each country, or about each country’s cost of reducing emissions, it will be difficult to arrive at a negotiated solution that approximates full cooperation. Second, if investor countries have imperfect information about the opportunities for investing in GHG reduction in host countries, then less than optimal trading will take place. This second type of imperfect information is more complicated than typically seen in economic problems, because it involves not only lack of information, but an asymmetric distribution of information. For example, the host country may know the incremental cost of a JI activity, but the investor country will not. Similarly, the host country will not know the value to the investor country of participating in that JI activity. The presence of this asymmetric information problem will lead to A-8
additional strategic behavior, and will reduce the number of trades that take place. The asymmetric information problem also increases transactions costs, which serve to reduce the number of trades that take place.
A3. IMPLICATIONS OF GAME THEORY FOR JOINT IMPLEMENTATION Both TCEE and IC joint implementation systems have the potential to minimize the cost of obtaining a target level of pollution. If the target level is set correctly and cooperatively, trading can actually lead to an optimal outcome. What is the difference between TCEE and IC? In a fully cooperative world, they would be the same. However a good way of viewing IC joint implementation is that the cooperative countries agree on a trading system, and then play an additional game with the non-cap countries through IC joint implementation. IC joint implementation can be viewed as a form of positive coercion or side payment to induce non-cap countries to be cooperative. Since a TCEE system is based on full cooperation, an IC joint implementation program, which is consistent with strategies to deal with free riding and other forms of non-cooperation, is more likely to occur. It should be noted that some non-Annex countries may really be operating in a Business as Usual framework, not behaving as a free rider, but less about the climate-change impacts of energy use, especially when compared to more pressing domestic concerns. There are three potential problems with achieving a better solution through IC joint implementation. First, energy may be substantially underpriced (because of subsidies or lack of consideration of the in-country pollution externalities) in non-Annex countries. Kuoppamäki (1997) argues that if this is the case, then it may be better for both Annex and non-Annex countries to concentrate on reducing energy market distortions in the non-Annex countries, than to pursue IC joint implementation. Second, the wealth transfer associated with IC joint implementation is less than the wealth transfer associated with a TCEE system. Finally, there will likely be much higher transactions costs associated with IC joint implementation than TCEE, as discussed below. The wealth transfer issue is discussed by Barrett (1995) and emphasized by Missfeldt (private communication with author). Their arguments are illustrated in Figure A.1 below, where the horizontal axis represents incremental pollution abatement, and the vertical axis dollar measures of cost. MAC refers to the non-Annex countries’ marginal abatement cost function, while the area underneath it measures total abatement cost. Therefore, in Figure A.1, area A represents the total abatement cost of Q1 units of greenhouse gases. However, since the price of marketable pollution permits is equal to the marginal abatement cost, the price of permits when the system generates Q1 units of redution would P1. This means that the value of the permits would be equal to the area of rectangle P1 Q1, implying a value of the reduction that is greater than the cost of reducing the pollution that is equal to area B. An important issue for JI is who gets this surplus of area B, which represents a profit above the cost of the actual reduction. Is it the host partner or the investing firm? The answer to this A-9
question depends on the type of system which would be established, and the negotiations between these parties. Under a TCEE system, where developing countries are granted pollution rights which they may sell, they pay area A to the investing firm and sell the pollution rights for P1 Q1 (area A plus B). In addition, they receive whatever development benefits (employment, less local pollution, reduced dependence on fossil fuels, etc.) which might be associated with the system. Under an IC joint implementation, the investing firm pays the cost of reducing the pollution (area A ) in order for a developed country to receive credit towards meeting its emissions cap. In this case, the host partner receives no profit from the sale of emission credits, but gains the benefits of the project and the host country gains any development benefits. The TCEE system would generate more benefits for the developing countries, since they would receive the pure profit of area B. Transactions costs are likely to be higher under IC joint implementation than under TCEE, because there are likely to be more restrictions on IC joint implementation activities than simple market trades. Two countries that are part of a TCEE system can trade without restriction. However according to the draft Framework Convention (Article 7.2), joint implementation projects must satisfy the following provisions: (A) Projects must be compatible with and supportive of national environmental and development priorities and strategies, as well as contribute to cost-effectiveness in achieving global benefits; (B) Projects must provide a reduction in emissions that is additional to any that would occur otherwise
The draft of Article 7 contains further language that additional provisions based on calculation, measurement, monitoring, verification, review and reporting will be added to the final version of the article. These provisions create transactions costs potentially far above that associated with TCEE. How does an investing country and/or recipient country determine if a project meets the requirements in article 7.2a and 7.2b (as shown above)? These costs are likely to be quite substantial. Barrett cites two JI projects involving Norway that had a total value of $4.5 million and transactions costs of $400,000, or roughly nine percent. In contrast, a trade under the U.S. pollution offset system had a value of $16 million, and transactions costs totally $120,000 (roughly 0.8%). Yet in that US trade, transactions costs were “perceived as being a major impediment to trading” (Barrett 1995) and they are an order of magnitude smaller than what has been observed in some pilot joint implementation projects.
A4. CONCLUSIONS Both TCEE joint implementation and IC joint implementation have the potential to reduce the costs of obtaining the Framework’s target level of emissions of GHGs. Which system is actually more A-10
likely depends on the extent of cooperation on setting emissions caps between developed and developing countries, and the magnitude of the transactions costs. The greater the cooperation, the more likely is the TCEE joint implementation system, and the greater the social welfare. The less the cooperation, the more likely is the IC joint implementation system. Also, the greater the transactions costs, the greater the need for a TCEE system. Table A.2, which is taken from Barrett (1995), makes additional comparisons between IC and TCEE joint implementation.
Table A.2 Comparisons of incremental costs and TCEE systems for joint implementation Criteria
Incremental-cost compensation
A system of TCEEs
Cost-effectiveness
In theory, joint implementation based on incremental costs for compensation is cost effective. However in practice, this approach is likely to have substantial transactions costs.
In theory, a system of TCEEs is costeffective. However, depending on how the system is implemented, transactions costs could be substantial.
Global abatement
Encourages increased global abatement compared to non-cooperative outcome because this approach lowers abatement costs.
Encourages increased global abatement compared to the non-cooperative outcome, but not as much as under incremental-cost compensation unless TCEEs involve lower transactions costs
Leakage reduction
Compared to the non-cooperative outcome, leakage would be reduced. The extent of leakage reduction will depend on the extent to which joint implementation is adopted.
Leakage would be reduced compared to the non-cooperative outcome. The extent of the reduction will depend on how widespread trading becomes.
Resource transfers
Under a strict definition of incremental costs, no resources would be transferred to developing countries
Resources will be transferred to developing countries. The extent of transfers will depend on total reductions in emissions and the distribution of such reductions.
Source: taken directly from Barrett (1995, p. 21)
Source: Barrett (1995)
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Figure A.1 Illustration of wealth transfer issues
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APPENDIX B - SUMMARY OF OTHER PARTIES’ CONCERNS In Section 2, five different types of parties were identified: • • • • •
the global community; investors in JI projects; host partners in JI projects; investors’countries, that have likely committed to GHG emissions reductions; and host countries, where the JI projects take place.
Section 3 focused on the concerns of prospective host countries. In this appendix, we summarize concerns that the other parties have about both a general JI protocol, as well as individual JI projects. The discussion in this section is not as extensive as that in Section 3; but consistent with the approach there, we take the game-theory paradigm as the underlying basis of our consideration of these concerns. The basic idea is that by taking into account the objectives and strategic behavior of each of the other parties, the parties are more likely to arrive at agreements in which all of the parties are “winners.” The discussion that we present in this section is in tabular format. Tables B.1–B.5 summarize, respectively, important concerns of the parties listed above. Appendix C is a discussion of issues that arise in the context of carbon-sequestering forest management projects. Table B.5 summarizes much of Section 3, which provides more extensive discussion of the concerns of many of the host countries. In each table, the concerns are briefly stated in the left column, and discussions of ways of addressing these concerns are in the right column. In some cases, the points are not extensively developed and deserve further thought and analysis.
B-1
Table B.1 Global Community’s Concerns Concern
Addressing Concern
1. Industrialized Countries’Energy Production and Consumption Patterns Remain Unchanged. JI will not be a long term solution to the accumulation of GHG in the atmosphere. JI releases industrialized countries from their “responsibility” of fundamentally changing their production and consumption patterns (Hanish et al. 1992, Metz 1995, Hare and Stevens 1995).
JI Only One Element of GHG Abatement Portfolio. GHG-emitters in countries with emissions caps will likely not rely on JI to be their dominant strategy to reduce their emissions. From an economic standpoint, Jackson (1995) provides data that suggests that firms in industrialized countries have many domestic opportunities to decrease their emissions. From a risk standpoint, with the possibility of the non-Annex countries having caps in the future, as well as the Annex countries, the quantity demanded and thus the price of GHG credits will increase — thus providing incentive for firms to develop better technologies to reduceGHGs. Vellinga and Heintz (1995) suggest that new international markets may actually increase the incentive for technological development to serve these markets. Also,Curlee et al. (1997) point out that the public sector in industrialized countries has reason to fund R&D on technologies to reduce GHGs. These reasons stem, in large part, from the great uncertainty about the effects of GHGs. Some analysts suggest that the international community require investors in the JI program to demonstrate concurrent efforts to reduce GHG emissions domestically (Hanish et al. 1992); but any binding requirement such as this would reduce the number of opportunities available to both investors and host partners, and increase the overall cost of countries’ meeting their GHG-emissions commitments. Incentive for Technology Development. Some analysts even suggest that JI could indirectly lead to lower emissions. For example, Torvanger (1993) and Selrod et al. (1995b) suggest that since JI gives investors an opportunity to employ the lowest cost options, they may be willing to commit to lower emission caps than without JI. This might be the case, but as discussed in Section 3.7, caps and JI are separable concepts. Negotiating one contingent on the other would blur this distinction and could make the negotiations on each more complicated and difficult to reach agreement.
2. There Might Be Few JI Opportunities. The reported information on abatement opportunities may be inaccurate. Low-cost options may in fact be in developed countries (Jones 1994; Jackson 1995). If this is the case, then JI would have little effect on reducing the costs of countries’ meeting their GHG-emissions commitments.
Allow Market to Decide. JI is based on the economic reality that companies — within countries obligated to reduce their GHG emissions — strive to choose the least costly option to achieve their goal (Bohm 1994, Jackson 1995). Therefore, the global community can let the market decide where low cost options exist and how much industrialized countries will invest in JI projects (Jones 1994). Experience from the pilot phase thus far suggests that JI can be an attractive option for some industrialized countries to meet their commitments and for host partners/countries to benefit as well.
3. Bad Fit. A "bad fit" between countries on a JI project can undermine the JI mechanism.
Non-binding Clearinghouse Could Facilitate Appropriate Matches. Thus far the pilot phase has indicated there are “enough” good fits to allow JI to proceed. One possibility for the future would be to use an international clearinghouse as a non-binding facilitator to identify matches between host partner/countries’specific needs and investors’capabilities (Hanish 1991, Wrexler et al. 1995). Host partners/countries as well as investors (and their countries, which are Parties to the Convention) should have authority to agree on projects — thereby ensuring a match to which all of the parties agree.
Concern
Addressing Concern
4. Many Projects Would Happen Anyway. Some JI projects sponsored by investors to reduce GHG emissions are projects that host countries would implement in the near future without international support. The global environmental community is at risk of accrediting a project that would have occurred without JI. Thus, investors and host partners would be getting benefits that they do not deserve. Some refer to this concern as non-additionality (van der Burg 1994).
Global Community Must Provide Oversight. This issue again points out the importance of setting a baseline. An international panel or board should be appointed to review and, if appropriate, approve all proposed JI projects. This panel would be responsible to the Framework Convention, i.e., global community, and should protect its interests. The panel should consist of board members who serve over a time period, thereby having some consistency in the basis of the panel’s decisions and reducing the costs of the board members becoming familiar with the technical details. On every project, this panel has the option of requesting that the investor and its host partner submit their proposed project and document that their proposed JI project would not occur in the absence of JI provisions. That is,if no other feasible option is less costly than the proposed project, then this project would have occurred anyway in the absence of JI; and the board should reject this project as being eligible for JI. A clearinghouse mechanism could facilitate the development and matching of appropriate projects. To reduce transaction costs, the panel would not have to approve every project in advance, but would have authority to spot-check them.
5. Countries Without Caps Free to Emit GHGs. Implementing JI projects in non-Annex countries does not ensure a global reduction in emissions (Torvanger 1993; Hare and Stevens 1995; Pearce 1995). Developing countries without commitments are still free to develop as they see fit, even if that means increasing their GHG emissions beyond the mitigating effects of the JI projects in their countries.
Factors Moderate This Effect. Developing countries will have greatly increased GHG emissions in the future, with or without JI. As these countries’ economies grow, one would expect that fossil fuels will be a significant input to their industrial production (refer to Appendix C). With JI, however, the emissions from these countries could be no greater than without JI, even if they do not have emissions caps. The reason is that JI projects, whose financial costs would be defrayed by foreign investors in return for emissions credits, would substitute for other, marginal projects that emit more GHGs. Without JI, the low-GHG projects would not have the incremental value of the emissions credits to offset partially their financial costs. Working against this effect, however, is that energy-intensive firms in industrialized countries would have incentive to re-locate to a country without an emissions cap, thereby increasing the emissions from that country. This re-location would be a loss of jobs and production for the industrialized country (see Table 2), but there would be no net change in global GHG emissions. Caps on non-Annex countries. If non-Annex countries eventually have a cap as well, then of course they could not increase their GHG emissions unabated. If these countries were to commit to caps, then JI would offer opportunities (i.e., foreign capital or other equivalent benefits) that they would otherwise not have. Even though these countries should, in their selfinterest, resist the imposition of caps on their emissions, its risk provides incentive for them to deploy low-GHG emitting technologies. The installation of high GHG-emitting technologies would make a transition to low-GHG emissions more difficult. Baseline. Some analysts have suggested that the Parties require that any country that participates in JI also commit to domestic GHG reductions (Torvanger 1993; Moomaw 1994). However, any arbitrarily set level will likely result in less cost-effective reduction of GHGs. Rather than set arbitrary levels of domestic GHG reductions, a JI protocol could establish an international panel that is responsible to the Convention and that has authority to approve and
Concern
Addressing Concern reject proposals for JI projects. Part of its decision could be based on examination of data on a prospective host country’s emissions relative to a baseline for the country. This national baseline could be defined in the same way as the caps for the Annex countries, except that it would be non-binding. Non-annex countries could exceed the baseline emissions but would then not be eligible for JI projects. Agreement on such a baseline would, of course, be problematic because it is in the non-Annex countries’self-interest to avoid any cap or baseline whatsoever. But without a cap or baseline on non-Annex countries, climate change will continue unabated.
6._ Measuring the Baseline. Baseline definition is as yet non-standard. (Selrod and Torvanger 1994; Bohm 1994; Climate Network Africa 1995; Jackson 1995). Currently there is no institutional mechanism to objectively determine baselines on a project by project basis nor on the country level (for non-Annex countries). There are incentives to mislead on the baseline issue (Metz 1995). Issuing 'unlimited' credits on the part of host countries could seriously undermine the effort to reduce GHG emissions globally.
Baselines Should Be Defined at Both the National and Project Levels. The baseline is the situation that would have occurred had there been no JI program. Baselines, against which JI projects are to be compared, are needed to determine their emissions credits. Furthermore, baselines need to be defined both for an individual project, as well as for its host country. The method for defining these baselines should be agreed upon by the Parties as part of the JI protocol (Graham 1995). The project baseline is specific to the project itself. It should be defined on the basis of the most likely option, that would be available without JI. The benefits (and thus credits) from a JI project should be considered at the margin, as the incremental benefit in terms of the avoided GHG emissions. For example, if a wind power JI project is developed, then its emissions credits should be based on the difference between its GHG emissions and those expected from the project that would have been built had there been no JI support for the wind project. [(An adjustment would have to be made for the different sizes of the projects (i.e., kWh of electricity generated).] If the wind power projectreplaces an existing power plant, then its emissions credits should be based on the emissions of the project(s) that it replaces (i.e., a specific plant(s) must be identified). For example, in a retrofit project, the baseline is the existing project and its corresponding GHG emissions. In determining project baselines, it will not be possible to account for emissions leakages and other indirect effects. It would be intractable to measure accurately these effects to calculate exactly the net emissions credits from a project. Rather, they must be considered somewhat qualitatively and subjectively by the host country, and by a panel that represents the interests of the Convention (i.e., global community), in their assessment of whether to approve a project (Metz 1995). Parties would probably agree that it is impractical and unreasonable for investors and host partners to bear the risk of uncertainty in not only the future performance of their project (in terms of its GHG emissions and other output such as electric power), but also that of a baseline as well. Thus, once a baseline is established for a project, it should probably not be subject to change. Only the annual performance of the project would affect the annual emissions credits that would be attributed to the project. National baselines are more difficult to define (Metz 1995; Velling and Heintz 1995). Nevertheless, they are crucial for determining the credits from carbon-sequestering projects
Concern
Addressing Concern (Appendix D), as well as an efficient way of addressing the emissions leakage problem.
7. Monitoring and Verification Difficulties. Monitoring and verification limitations (and costs) could make it difficult to determine the reduction in GHG emissions through JI (Moomaw 1994; Selrod et al. 1995). There is incentive for double-counting on the part of investors. An investor claims credits for losing plants at home under its own national plan and takes a JI credit for setting up a similar plant in another country that is better than what would otherwise have existed in that country (Metz 1994).
Credits After the Fact. A preliminary schedule of credits could be established in advance of a project, but actual crediting could be limited to “after the fact,” realized emissions reductions, relative to a pre-determined baseline (Selrod and Torvanger 1994). The CoPs should set a cost-effective system of oversight to monitor and verify (Wrexler et al. 1995; Hare and Stevens 1995). The Convention may decide to limit possible JI projects to those which produce obvious GHG reductions that are easily calculated (Metz 1995). On the issue of double-counting, the investor reduces its emissions in the old country and does not have to purchase emissions permits and can sell any that it holds. But the investor would not get double credits because it isadding to the emissions in the new country. But if another new project was being contemplated in this new country, and the investor replaces it with its own project, that emits less GHGs than the other proposed project, then the investor would stand to gain credits based on the difference in the GHG emissions between the proposed projects.
8. Forest-Management Issues. JI projects designed to act as carbon sinks (e.g. afforestation and forest preservation) will be difficult to monitor and to assign carbon credits (Torvanger 1993). Their inclusion as an option in the JI program is uncertain.
Forest Management Options Need Country Baseline. Carbon sinks are specifically mentioned in the FCCC and in some cases this may be the best choice for a JI project (Torvanger 1993). In some host countries, reforestation and forest preservation are national priorities, but the lack of funds keeps progress on forest issues slow and limited (Intarapravich 1995, Foundation JIN 1996). However, forest management projects must have verifiable net reductions of carbon. When carbon sinks are enhanced or carbon removed from the atmosphere, there has been essentially a change in custody of the carbon and eventual release is not precluded. Thus, in theory, a system of awarding carbon-reduction credits must also have a complementary system of debits. Thus, ideally, both investor and host countries should have emissions caps. However, if host countries do not have emissions caps, then a practical second-best solution would apply discount factors to forest management projects to adjust for the likelihood of emission leakages. A different possibility is to leave forest preservation to the Biodiversity Convention (Parikh 1994).
9. Emissions Leakages. GHG emissions reduction will be less than anticipated due to carbon “leakages.” In these situations, GHG-emission reductions are offset by increases elsewhere in a country. Leakages may occur through activity shifting, market shifting, faulty project calculations, and many other mechanisms (Selrod and Torvanger 1994; Metz 1994; Hare and Stevens 1995; de Buen and Marsera 1995).
National Baselines and/or Authority of Convention to Reject Project. The most effective way of controlling leakages to have emissions caps on all countries including host countries. A body of the CoPs could make emission abatement calculations at the national level (Selrod and Torvanger 1994). However, emissions caps on host countries are unlikely in the near term. Thus, a body of the CoPs could limit projects to those least likely to have leakage problems (Metz 1994), or could set leakage-adjustment factors for different types of projects.
10. Institutional Barriers and Transactions Costs .
Balance Between Integrity and Cost. Transactions costs might be a significant problem.
Concern Institutional barriers and transaction costs for international oversight and administration could make the JI program infeasible.
Addressing Concern Thus, the Convention, as well as investor and host countries must be sensitive to the fact that very taxing requirements for investors and/or host partners will reduce the benefits of JI projects and the number that will take place.
11. Distortion in International Competition. An uncoordinated wave of measures may distort international competition.
Impact Likely Small. Significant trading could affect the market for other goods and services, and that is something needing consideration. But there is no evidence yet that JI will have such a major impact. An ideal situation would be to have general equilibrium analysis but that would be a daunting task.
Table B.2 Investor’s Concerns Concerns
Addressing Concerns
1. Costs. Transactions costs for a JI project may exceed savings from implementing that project (Jones 1994).
Portfolio. JI is only one element of a portfolio of GHG abatement options a company may employ. There is no pressure for a company to engage in JI if they determine that it is not their most cost-effective option. Investors should calculate carefully the costs of any JI project before they invest to determine if this is their best option. A JI clearing-house might reduce transactions costs (Barrett 1992; Wrexler et al. 1995). Transferring some of the transaction-cost burden to the investor’s government may be a viable option in some developed countries (van der Burg 1994).
2. JI Projects Not Meeting Expectations. Actual net reductions (and thus credits) will fall short of expectations (Bohm 1994; Selrod and Torvanger 1994). Parties may change the rules in midstream, after the investment decision is made.
Understanding and Preparing for Risk. Investors should understand that there is risk in any venture they undertake and JI is no different. They should negotiate terms or contracts to protect their interests and hedge against adverse consequences. Also, there exists the possibility of a JI insurance pool in which participants may invest (Foundation JIN 1995). An international JI clearinghouse could be organized to collect and screen all JI offers from non-Annex countries and sell the resulting reduction units to investors. With this arrangement the investor is not tied to any particular JI project and consequently risk greatly decreases (Bohm 1994; Wrexler et al. 1995).
3. Project Failure. Loss of investment (and credits) due to unforeseen events (e.g. forest fire in afforestation project) (Metz 1995; Foundation JIN 1995).
Insurance. In this type of project failure JI insurance would be critical (Metz 1995; Foundation JIN 1995). In the absence of any insurance options, investors should carefully consider in what type of JI project they feel comfortable investing.
4. Imperfect and Asymmetric Information Provided by the Host Country May Mislead Investors (Bohm 1994).
Oversight. This risk exists in any type of transaction and companies should negotiate terms or contracts to protect their interests and hedge against adverse consequences. This concern could be ameliorated depending upon the level of international involvement before JI projects begin. An international body might be able to better assess the information provided by both parties for accuracy.
5. Future Prices. Uncertain future prices make calculation of the actual cost of JI projects difficult (Selrod et al. 1995a).
Planning. Planning is the best way for investors to address uncertainty. They may want to choose projects where the highest percentage of investment cost is in operations and maintenance rather than initial outlay so that if conditions change they can negotiate out of the project without losing the
Concerns
Addressing Concerns major percentage of their investment. Investors should not rely solely on JI projects to meet GHG targets. Finally an international credits bank could reduce total risk (Selrod et al. 1995).
Table B.3 Host Partner’s Concerns Concerns
Addressing Concerns
1. Costs. Transactions costs of a JI project could exceed the benefits (Selrod et al. 1995).
Negotiate. These added costs should enter into the negotiations with investors. JI projects are always voluntary for hosts and they are free to refuse projects that do not appear to have significant benefits.
2. Ownership. Ownership arrangements for JI projects can be unclear and there is the question of project duration and termination (Arts et al. 1994; Selrod and Torvanger 1994; Maya 1995).
Develop an Acceptable Protocol. JI projects should be for a limited time period (Arts et al. 1994). Duration of the JI program, and disposition of projects at their completion need to be made explicit by the CoP. The CoP also could develop some standard recommended (but non-binding) guidelines for duration (depending on project type). Duration and disposition of project should be explicit in each project contract.
3. Project Failure. Imperfect and asymmetric information provided by Contract Safeguards. Hosts also will have the opportunity to invest in a JI the investor country may mislead hosts causing the JI project to not function as insurance pool if one is organized. Additionally, hosts may write provisions anticipated (Climate Network Africa 1995; Maya 1995). A JI project may not into JI contracts which clearly identify expectations which the projects must have the anticipated abatement effect (Selrod and Torvanger 1994). meet before any credits are realized.
Table B.4 Investor Country’s Concerns Concern
Addressing Concern
1. Project Does Not Perform As Expected. Credits will fall short of Raise Approval Standards. This concern is a reality with or without JI. If expectations so the investing country does not meet its Convention obligation. JI is the part of the abatement portfolio causing a country to fall short of expectations then the investor’s country should raise its standard for approving new JI projects. Unfortunately, this may also reduce the number of costeffective opportunities. 2. Adverse Impacts. Companies in the investing country will shift activity and growth to foreign countries (Selrod et al. 1995b). Investor’s country could lose carbon-intensive industry to developing countries that do not have emissions caps. This could have negative consequences for the economy of the investor’s country.
Countries Need to Assess Possible Adverse Impacts. The incentive for firms in countries with emissions caps increases as the price of GHG emissions permits increase. Study is needed on the importance of environmental regulations (e.g. on particulate matter air pollution) on firms leaving a country, compared to other factors such as lower-cost labor and closer access to markets. Investor countries may need to press more to have non-Annex countries accept caps. Investor’s country could require companies to have a certain amount of R&D research or other options in place before they qualify to invest in international projects; but stringent regulations would also have the effect of reducing the number of JI projects.
3. Transactions Costs The costs to the country (for monitoring, administration, etc.) for the JI program could outweigh the benefits (Pearce 1994; Selrod et al. 1995a).
Reduce Costs. If the host country government reduces administrative and other requirements of investors, as well as its own costs, then it will have a greater number of opportunities to attract firms to participate in JI projects.
Table B.5 Host Country Concerns About JI Concerns
Addressing Concerns
1. Industrialized Countries Getting Undue Credit. Investing countries will take credit for reductions in host countries instead of implementing changes in their own countries (Moomaw 1994; Metz 1994; Hanish et al. 1992).
A Joint Venture. The parties should view a JI project as a joint venture in which an investor provides financial (and other) resources and a host partner provides in-kind (and other) resources such as an existing power plant that can be retrofitted. A JI project takes these as inputs and produces several outputs. Of these outputs, the investor typically receives (at least some of) the emissions credits; and the host partner typically receives all (or most) of the other output (e.g. revenues from its enhanced power plant, or other considerations that it negotiates with the investor). The investor can use or sell its credits in the future, and likewise the host partner can invest its share of the output (e.g. invest its increased revenues from the sale of electricity).
2. Loss of Low-hanging Fruit. Hosts countries could be at a disadvantage in the future when making their own GHG emissions commitments if much of the low-cost abatement options in their countries were “lost” to investors through JI projects (Torvanger 1993, Jones 1994; van der Burg 1994; Selrod et al. 1995; Climate Network Africa 1995; Metz 1995; Vellinga and Heintz 1995).
Assess Trade-off Between Benefits of Project and Future Cost of GHG Abatement. JI is a joint venture in which investors and host partners/countries benefit. Host countries should assess the trade-off between their benefits from a JI project (e.g., lower cost energy), including appreciation of its capital, to its costs. The host country should weigh the present non-GHG benefits (e.g. cheaper electricity, cleaner air, jobs, revenue increases, etc.) (Selrod, et al. 1995; Vellinga and Heintz 1995) from JI projects against the future cost of GHG emissions abatement. With this in mind, the host country can negotiate present benefits which they deem sufficient to forego their low-cost abatement options (Torvanger 1993). If the present benefits are not substantial enough, then the host country can choose not to participate in the JI program. In other related literature, Jones (1994) asserts “...future position of the developing country would be somewhat the same as that of an Annex I country today that has already implemented more abatement measures than its other Annex I partners...these countries have seen fit to sign the FCCC, despite their relatively higher marginal cost position.” JI activities in developing countries should facilitate their taking up commitments at a later date under the Convention and should avoid creating unnecessary barriers and disincentives (Heintz et al. 1994). Also, having renewable energy and other forms of technology will provide infrastructure that reduces risk of future caps being a serious problem (Jones 1994, Selrod et al. 1995, Vellinga and Heintz 1995). The host country, if it is a partner, may decide to share credits as part of their contract and bank them for the future (Heintz et al. 1994; Selrod et al. 1995; Vellinga and Heintz 1995; de Buen and Masera 1995). Or the host could try to stipulate that any future emissions target would be no lower than the level of emissions in their country when the JI Program began (Jones 1994) - though this would almost certainly be the case for developed countries.
Concerns
Addressing Concerns
3. Getting Shortchanged. Host countries are concerned that their compensation for the emissions credits, that they provide to industrialized countries, will not reflect the true value of these credits (Hanish et al. 1992, Moomaw 1994; Metz 1994; Climate Network Africa 1995; Hare and Stevens 1995). The host country might not get a fair price for their carbon credits. Transactions costs could be prohibitive (Selrod et al. 1995a). Program length, termination consequences, and their impact on host countries are still uncertain (de Buen and Masera 1995). Uncertain future prices could undermine the host country’s ability to get the most out of its emission credits opportunities (Parikh 1993).
Negotiate Terms. Host countries can be assured of adequate compensation, at least to their satisfaction, by negotiating the best terms possible for themselves. Some possible terms to consider are negotiating: a share of the credits, call options that provide the host partner/country with the right to buy credits back from the investor at a pre-determined price in the future, limits on the duration of projects, and side-benefits such as local education and social programs. The parties should recognize, of course, that requests by one party on the terms of a contract will be met by counterproposals by the other party. The most promising opportunities for agreement are those where both the benefits and risks of a project are shared between investor and host. This international arrangement gives host countries increased access to foreign capital, technology, and international markets (Selrod et al. 1995). Previous literature has noted similar points, but from a slightly different perspective. The Parties could agree to limit the percent of abatement commitment achieved by developed countries through JI (Arts et al. 1994; van der Burg 1994); but this could be overly restrictive. It is not an absolute that all credits from JI projects have to go to the investor. Host countries that see a need to own carbon credits may negotiate sharing with the investor (de Buen and Masera 1995; Intarapravich 1995). JI projects also could serve other commitments mentioned in the Convention, such as sustainable development or eradication of poverty (Parikh 1994).
4. Risk of JI Collaboration Leading to Caps. Climate change is not developing countries’responsibility to solve; but agreeing to collaborate, for example on JI, would appear to make it part of their problem. The risk is that this collaboration could lead the global community to consider emissions caps on developing countries as well. Emissions caps would limit these countries’ use of fossil fuels and their economic growth.
Decouple the Debates About JI and Emissions Caps. Recognize these countries’concerns about JI potentially hindering their prospects for economic growth. Negotiate terms on the emissions caps separate from discussing JI. Defining emissions caps is a major issue. Given a pre-specified global cap, three ways of defining the allocation of these caps are commonly debated: (a) relative proportions of countries’ emissions in 1990, (b) proportions based on GHG emissions per capita, and (c) proportions based on GDP per capita.
5. Loss of Official Development Assistance. JI projects replace other opportunities (e.g. Official Development Aid) and hurt efforts consistent with national priorities (Selrod and Torvanger 1994; Metz 1994; Maya 1995). Some refer to this concern as an additionality issue (Jones 1994).
JI is Distinctly Different from ODA. There must be a clear distinction on the part of all countries that JI investment is not aid (Torvanger 1993; Jones 1994; Metz 1994). Aid comes from governments while JI investments will be made by individual companies (at least in the US and likely other Annex II Parties). Metz (1995) suggests that Party participation in the JI program could depend on Annex I countries maintaining a certain level of ODA, perhaps calculated as a percent of GNP. But such a requirement would blur the
Concerns
Addressing Concerns distinction between ODA and JI.
6. Unintended Adverse Impacts. Participation in the JI program could cause ancillary adverse impacts such as increased emissions (i.e., emissions leakages) elsewhere in the country, increased growth and demand for energy, environmental problems, and excessive consumption patterns similar to developed countries (Climate Network Africa 1995).
Assess the Full Impacts. Host countries will need to assess the external benefits and costs of proposed JI projects. Complicated models that estimate these costs will likely not be available, and in any event will not be very comprehensive. Nevertheless, countries should try to make a first-order assessment of the relative magnitude of these costs. Emissions reductions in one project may be offset with increases elsewhere. An emissions cap is a way of ensuring that the overall emissions of a country remain within agreed-upon limits. But from the host country’s perspective, these are not of concern (but rather a concern of the global community). Host countries can note that projects would be environmentally 'better' because they are more cost-effective ways of reducing GHG emissions than what is available in the investor's country. Arts et al. (1994) suggest that The host country should consider environmental, social and macro effects on the economy before accepting a JI project. Host countries should remember that isolated JI projects are unlikely to have widespread effects within the host country.
7. Inconsistency With Priorities. JI projects may be inconsistent with national priorities (Selrod and Torvanger 1994; Metz 1994; Maya 1995).
Clarify and Adhere to National Priorities. The host country could accept only projects that match its national priorities (Parikh 1993). Host countries should be encouraged to develop JI projects themselves. Alternatively, they may present their needs (based on national priorities) to a clearing-house or other third party mechanism which would match them with investors.
8. Loss of Sovereignty. The JI Program will cause a loss of national sovereignty. Host countries will lose ownership or control over their resources (Metz 1994, 1995; Parikh 1994; Selrod et al. 1995; Climate Network Africa 1995). These resources include not only land and natural resources, but plant and equipment.
Awareness. Potential investors and Annex II (or I) countries need to be aware of host countries’national priorities and sovereignty. Investing countries could analyze circumstances in past instances of colonialism and identify specific ways of avoiding those actions in the JI Program. The CoP or other international body could create institutional JI provisions that would reduce risk of host countries' susceptibility to exploitation (Parikh 1993; Selrod et al. 1995). A basic strategy that would help all parties and that would result in more cost-effective solutions is to reduce asymmetry of information on all sides. Develop a Fair Protocol. The Parties can define the JI protocol so that the host country must approve any JI project within its country (Torvanger 1993; Metz 1994; Arts et al. 1994; Climate Network Africa 1995; Hare and Stevens 1995; de Buen and Masera 1995). Even if this condition is not part of the JI protocol, a host country can stipulate this requirement for projects within its
Concerns
Addressing Concerns country. Investors are likely to be from the private sector, rather than large governments, so that the market power of large industrialized countries would be limited to setting up the rules of the JI program. Host countries should negotiate effectually. For example, they could demand that no land be sold to investors. They could also require that each project have a finite lifetime, say no more than 40 years (or shorter, depending on the type of project) so that foreign influence is limited (Metz 1994; Arts et al. 1994).
APPENDIX C - ISSUES ASSOCIATED WITH FOREST MANAGEMENT JI PROJECTS
C1. THE COMPLEXITY OF FOREST MANAGEMENT AND THE CARBON CYCLE JI projects can have net greenhouse gas (GHG) reduction impact only if they lead to a quantifiable reduction in net emissions to the atmosphere when compared to a baseline emissions scenario. The challenge of monitoring and verification is thus to establish a credible baseline and a measurement scheme that can evaluate the extent to which a JI project leads to a net difference in greenhouse gas emissions. One can envision that there are two basic approaches to reducing net transfer of CO2 to the atmosphere and either of these could serve as the centerpiece of a JI project. One could either reduce sources or increase sinks for greenhouse gases, and some projects will do both. The problems of monitoring and verification are different for the two approaches and Fritsche (1994) suggests that "the uncertainties of monitoring and verifying sink-type JI projects are significantly greater. In addition, the problem of feedbacks is more severe for sink-type JI". This brief discussion is to raise some of the issues associated with sink-type JI projects, particularly those involved with forest management. Afforestation, forest protection, and other forms of forest management comprise a very popular set of JI possibilities. The paper of Matthews et al. (1996) provides a useful starting point for this discussion Many writers have suggested that forest ecosystems and forest products can be managed in such a way as to decrease the net flux of CO2 to the atmosphere. It is difficult, however, to synthesize from the literature a consensus on the role that forests and the forestry sector can play in sequestering carbon (C) (Matthews et al. 1996). The apparent lack of agreement in the literature can be attributed in part to progressive improvement in our understanding of forests in the C cycle and of what is technically, economically, and socially possible in terms of forest management and wood processing. We also need to distinguish between an inventory of the current status of forests and an assessment of the larger impacts that can occur when a decision is made to influence that inventory. Carbon budgeting is a relatively new and untried technique and we are only beginning to appreciate the possibilities and the pitfalls (Matthews et al. 1996). At this early stage of development, it is especially important that analyses make absolutely clear what is and what is not being included. We need to appreciate that forest management can affect the carbon budget in at least four ways: a) carbon is stored on site in living and dead biomass and in forest litter and soils; b) carbon is stored in forest products; c) fossil fuel consumption can be displaced by the substitution of renewable biomass fuels; and d) fossil fuel consumption can be displaced because biomass products often require less fossil-fuel based energy for their production and use than do products manufactured from other materials like steel, glass, and concrete (Schlamadinger and Marland 1996).
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C2. DEFINING A BASELINE, MONITORING, AND VERIFICATION C2.1 Baselines One of the major challenges in evaluating a JI project is in establishing an appropriate baseline against which to measure project achievements. Fritsche (1994) suggests that baselines will need to be at the national level in order to minimize leakage within the economy: "national baselines for JI might be possible to establish - but on the sub-national level, implicit uncertainty will increase as the scope of the JI project decreases." Even with national level baselines, GHG emissions are embodied in commodities involved in international trade, and wood products physically contain C (as do all agricultural products) that will eventually be released. Jones (1994), on the other hand, writes "It is difficult to imagine being able to credibly model the future emission behavior of even one country ... but one practical approach might be to begin by assessing individual investments on a project-byproject basis". The essential issue is that a JI project needs to have clear system boundaries (in space, in economic sectors, and in time) in order to evaluate the impact on greenhouse gas emissions. As a final comment on baselines, it is often perceived that a baseline is a static scenario against which the performance of a mitigation scenario is to be measured. The baseline might be amenable to updating on some regular basis or if it is discovered that there is some error or misconception in the input to the baseline. On the other hand, the baseline should not be subject to continual revision; it has to have sufficient definition that the project is not continually measured against a weakly-defined, moving target. Investors would be loath to make long-term commitments against an ill-defined target. Thus, it is preferable to define baselines in advance. An alternative would be to define (in advance) a baseline scenario in the way that a scientific experiment would define an experimental reference treatment. In this way, measurement and verification would have to evaluate both the treatment and the reference and would credit the JI project with the difference between the two. This approach might be especially appropriate for a biologically based project where many variables beyond the control of the participants - such as weather and insects - might influence the performance of the project. If the JI project involves forest management it would be straightforward to set aside a reference plot to provide a baseline for at least the on-site C storage portion of the project. The question is sometimes raised, "What happens if a forest planted for C sequestration is destroyed by a natural forest fire or otherwise does not accumulate as much carbon as anticipated?" and the reference plot could provide a means of answering this type of question. This way of defining a baseline would reduce the risk (i.e., uncertainty) to investors and host partners. C2.2 Monitoring and Verification The first challenge of monitoring and verification is the definition of system boundaries. Matthews et al. (1996) suggest that accounting for GHG impacts of forestry-related projects should, as a minimum, include: a) above and below ground biomass, b) "necromass", including coarse woody debris, litter, soil organic matter, C-2
c) wood products, and d) fossil fuels (including savings through direct and indirect substitution). Omissions from this list should be stated clearly and the implications discussed. It should not be acceptable to omit components that are likely to see a decrease in C storage. Emphasis should be on the larger contributions and those that run counter to the intended objective, and small positive contributions might be neglected in monitoring once it is clearly established that they would indeed comprise a credit if counted. Basic monitoring might best be a responsibility of the project managers but there is a need for periodic verification by a third party using internationally approved standards and techniques. It is important that monitoring and verification be possible at modest cost so as not to infringe on project objectives. It is generally believed that there are standard forestry techniques that can measure aboveground forest biomass, but measurement of below-ground biomass and soil carbon is more problematic. Satellite imagery might be called upon to monitor changes in land use. Procedures have to be simple enough to permit consistent application by different parties with different access to information. Either direct measurements or a bookkeeping model should suffice. An accounting of carbon should include the basic data on which calculations rely. One might envision a system where project managers maintain a system of stratified sampling with more detailed inventories on a 5-10 year basis subject to international verification. C2.3 Carbon Accounting A fundamental question has been raised concerning accounting for C stored in renewable biomass. When a tree is harvested by Party A and then sold to Party B, should we account for the flow of carbon (from A to B with no emissions until the wood oxidizes, at which time it will show in the account of B), or should we account for the changes in stocks (negative for A, positive for B, zero in total; to show as emissions for B at such time that his stock decreases)? This is a source of continuing international debate and will be the subject of an IPCC/OECD expert workshop early in 1998. We suggest that the most practical accounting, and the one that supplies the most appropriate incentives for minimizing net C emissions, is to account for changes in stocks of renewable C-bearing materials. In many cases CO2 emissions saved by direct and indirect substitution could be the most important elements in the C budget of a forestry scheme (Marland and Marland 1992). However, the actual quantity of fossil fuel displaced by wood fuel and energy-efficient wood products often is not under the control of the mitigation project in practice, but would be determined largely by market forces and the general equilibrium of the larger economy. We need to ask whether system boundaries can be drawn so that these benefits of JI projects are credited to the projects.
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C2.4 Leakages There is a fundamental difference between reducing greenhouse gas sources and increasing greenhouse gas sinks. When sources are reduced the challenge is to account for the amount of reduction, but once reasonable accounting is completed the emission reduction is undeniable and permanent and the global climate system is indifferent about where the reduction has occurred. If a Party to the Framework Convention assists in reduction of emissions within a country that has not agreed to emissions controls, the net reduction is nonetheless real. When sinks are increased, the challenge is to account for the amount of C accumulated, but once the accounting is completed we have to be concerned with the fate of this stored C over time — will the offset be maintained or will the C be released back to the atmosphere. Both source and sink type projects will be confronted with issues of leakage, whether or not these are forest management projects. In a world market place, the way that forests are managed in one area will have an impact on forest management in other areas. The same is true for projects involving energy conservation or fuel switching and it will certainly be true in projects that involve substitution of biomass-based materials for materials made of other raw materials like glass, concrete, and steel. It is this problem of leakage that leads some analysts to call for national-level definitions of baselines and monitoring while other analysts conclude that monitoring beyond the carefully bounded JI project system is futile.
C3. TEMPORAL BOUNDARIES AND EMISSIONS CAPS When sinks are enhanced or carbon removed from the atmosphere, there has been, essentially, a change in custody of the C — C released to the atmosphere at one point has been captured at another. Eventual re-release is not precluded. We suggest that projects of this type, especially, should have temporal as well geographic boundaries; and that when one participant in a JI project transfers C to another there must be a time limit on the contract and specification of which party accepts custody for the C stored in its forests or other reservoirs. A serious question concerns responsibility for stored C after the end of a JI contract period. The idea of a time limit on JI projects helps address some of the concerns about loss of "low-hanging fruit" by making it clear that the investing partner obtains credits only for the duration of the project, but it also suggests that the JI contract should specify responsibility for any stored C at project closure.18 There is particularly a need to examine this responsibility when C emissions in a country with emissions caps are offset by C sinks in a country without an emissions cap.
18
If this policy is implemented as part of a JI-protocol, then it might also have to resolve an issue raised by Marland et al. (In press), Leiby and Rubin (1997), and others about the lending and borrowing of emissions. C-4
C4. SUMMARY AND IMPLICATIONS This appendix points out that like any other prospective JI project, forest management projects are faced with complicated questions about the definition of baselines, efficient monitoring and verification of projects, accounting for the stock and flow of carbon, and leakages that reduce the GHG-reducing benefits of these projects. As in other types of projects, there might be positive spillovers too, such as when durable wood products substitute for other materials. Forest management projects also have the added issue of temporal boundaries. The issue arises because eventual re-release of C is not precluded. The preferred approach for addressing the latter issue is to have: (1) fixed terms on the lengths of forest management projects, (2) formal agreements on the disposition of stored C at the end of these project, and/or (3) adjustment factors for calculating net emissions, which reflect the possibility of leakages, particularly in countries without caps.
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