climate finance: regulatory and funding strategies for ......products’ carbon content 281 sandra...

Regulatory and Funding Strategies for Climate Change and GlobalDevelopment

CLIMATE FINANCE

Edited by Richard B. Stewart, Benedict Kingsbury and Bryce Rudyk

Climate Finance

A project of the Institute for International Law and Justice (IILJ ) at New York University School of Law

Climate FinanceRegulatory and Funding Strategies

for Climate Change and Global Development

E d i t e d b y

Richard B. Stewart, Benedict Kingsbury, and Bryce Rudyk

A publication of the New York University Abu Dhabi Institute

aNew York University PressN e w Y o r k a n d L o n d o n

N E W Y O R K U N I V E R S I T Y P R E S SNew York and London

www.nyupress.org

© 2009 by Richard B. Stewart, Benedict Kingsbury, and Bryce RudykAll rights reserved

A Cataloging-in-Publication Data record for this book is available from the Library of Congress.

ISBN-13: 978-08147-4138-2 (pbk.) ISBN: 0-8147-4138-X

New York University Press books are printed on acid-free paper, and their binding materials are chosen for strength and durability.

We strive to use environmentally responsible suppliers and materials to the greatest extent possible in publishing our books.

Manufactured in the United States of America

p 10 9 8 7 6 5 4 3 2 1

Climate Finance v

Contents

Acknowledgments xi

Foreword: NYU Abu Dhabi and the Sustainable Environment xiii

Mariët Westermann and Philip Kennedy

Summary of Key Findings and Recommendations xv

About the Contributors xvii

part i Climate Change and Mitigation: Overview and Key Themes

1 Climate Finance for Limiting Emissions and Promoting Green Development: Mechanisms, Regulation, and Governance 3

Richard B. Stewart, Benedict Kingsbury, and Bryce Rudyk

2 Understanding the Causes and Implications of Climate Change 35

Michael Oppenheimer

3 The Climate Financing Problem: Funds Needed for Global Climate Change Mitigation Vastly Exceed Funds Currently Available 42

Bert Metz

4 The Future of Climate Governance: Creating a More Flexible Architecture 48

Daniel Bodansky

vi Contents

part i i Proposals for Climate Finance: Regulatory and Market Mechanisms and Incentives

A. Trading or Taxes?

5 Cap-and-Trade Is Preferable to a Carbon Tax 57Nathaniel O. Keohane

B. Reforming the Clean Development Mechanism (CDM )

6 Expectations and Reality of the Clean Development Mechanism: A Climate Finance Instrument between Accusation and Aspirations 67

Charlotte Streck

C. Sectoral Programs for Emissions Control and Crediting

7 Why a Successful Climate Change Agreement Needs Sectoral Elements 79

Murray Ward

8 Sectoral Crediting: Getting the Incentives Right for Private Investors 85

Rubén Kraiem

9 Forest and Land Use Programs Must Be Given Financial Credit in Any Climate Change Agreement 90

Eric C. Bettelheim

10 Stock-and-Flow Mechanisms to Reduce Land Use, Land Use Change, and Forestry Emissions: A Proposal from Brazil 96

Israel Klabin

D. Leveraging Trading to Maximize Climate Benefits

11 Mitigating Climate Change at Manageable Cost: The Catalyst Proposal 105

Bert Metz

12 Engaging Developing Countries by Incentivizing Early Action 111

Annie Petsonk, with Dan Dudek, Alexander Golub, Nathaniel O. Keohane, James Wang, Gernot Wagner, and Luke Winston

Contents vii

E. Linking Trading Systems

13 Carbon Market Design: Beyond the EU Emissions Trading Scheme 125

Henry Derwent

F. Investor Perspectives

14 Incentivizing Private Investment in Climate Change Mitigation 135

Marcel Brinkman

15 Investment Opportunities and Catalysts: Analysis and Proposals from the Climate Finance Industry on Funding Climate Mitigation 143

Nick Robins and Mark Fulton

part i i i Bringing Developed and Developing Countries Together in Climate Finance Bargains: Trust, Governance, and Mutual Conditionality

A. Meeting Developing Country Climate Finance Priorities

16 Developing Country Concerns about Climate Finance Proposals: Priorities, Trust, and the Credible Donor Problem 157

Arunabha Ghosh and Ngaire Woods

17 Developing Countries and a Proposal for Architecture and Governance of a Reformed UNFCCC Financial Mechanism 165

Luis Gomez-Echeverri

18 Climate Change and Development: A Bottom-Up Approach to Mitigation for Developing Countries? 172

Navroz K. Dubash

19 Operationalizing a Bottom-Up Regime: Registering and Crediting NAMAs 179

Rae Kwon Chung

viii Contents

B. Conditionality and Its Governance

20 From Coercive Conditionality to Agreed Conditions: The Only Future for Future Climate Finance 189

Jacob Werksman

21 Getting Climate-Related Conditionality Right 197Kevin E. Davis and Sarah Dadush

22 Making Climate Financing Work: What Might Climate Change Experts Learn from the Experience of Development Assistance? 206

Ngaire Woods

part iv National Policies: Implications for the Future Global Climate Finance Regime

23 Climate Legislation in the United States: Potential Framework and Prospects for International Carbon Finance 213

Nathaniel O. Keohane

24 The EU ETS: Experience to Date and Lessons for the Future 221

James Chapman

25 Greenhouse Gas Emissions and Mitigation Measures in China 228

Jie Yu

26 Cities and GHG Emissions Reductions: An Opportunity We Cannot Afford to Miss 234

Partha Mukhopadhyay

27 A Prototype for Strategy Change in Oil-Exporting MENA States? The Masdar Initiative in Abu Dhabi 241

Sam Nader

part v Climate Finance and World Trade Organization (WTO) Law and Policy

28 The WTO and Climate Finance: Overview of the Key Issues 247Gabrielle Marceau

Contents ix

29 Carbon Trading and the CDM in WTO Law 254Robert Howse and Antonia Eliason

30 Countervailing Duties and Subsidies for Climate Mitigation: What Is, and What Is Not, WTO-Compatible? 259

Robert Howse and Antonia Eliason

31 Border Climate Adjustment as Climate Policy 266Alexandra Khrebtukova

32 Enforcing Climate Rules with Trade Measures: Five Recommendations for Trade Policy Monitoring 272

Arunabha Ghosh

33 Carbon Footprint Labeling in Climate Finance: Governance and Trade Challenges of Calculating Products’ Carbon Content 281

Sandra G. Mayson

part vi Taxation of Carbon Markets

34 Fiscal Considerations in Curbing Climate Change 291Lily Batchelder

35 Tax and Efficiency under Global Cap-and-Trade 300Mitchell A. Kane

36 Tax Consequences of Carbon Cap-and-Trade Schemes: Free Permits and Auctioned Permits 305

Yoram Margalioth

Afterword: Reflections on a Path to Effective Climate Change Mitigation 311

Thomas Heller Abbreviations 317Index 321

Climate Finance xi

Acknowledgments

This book is a result of the Climate Finance: Financing Green Develop-ment project of the Institute for International Law and Justice (IILJ) at New York University School of Law, undertaken jointly with NYU’s Frank Guarini Center on Environmental and Land Use Law (CELUL). The project has received very generous support and encouragement from the NYU Abu Dhabi Institute, an innovative partnership of NYU and Abu Dhabi. Our colleague and friend NYU President John Sexton was a driv-ing force, together with Abu Dhabi and NYU leaders, in the inception of this partnership and its embrace of this project. Mariët Westermann, the Provost of NYU Abu Dhabi, and Philip Kennedy, the Faculty Director at the NYU Abu Dhabi Institute, made possible the project’s major confer-ence on climate finance in Abu Dhabi in May 2009, in which develop-ing and developed country participants from governments, the climate finance industry, multinational businesses, international organizations, NGOs, and academic and research institutions presented and discussed preliminary versions of the proposals and analyses that appear in the fol-lowing chapters.

We are grateful to all authors and conference participants, to NYU Abu Dhabi for their support and for funding much of the work needed to pro-duce this book, to the Emirates Center for Strategic Studies and Research for the kind hospitality in hosting the conference, and to NYU Law School, Dean Richard Revesz, and the Hauser Global Law School Program. Our faculty colleagues Kevin Davis (Director of the closely linked Financing Development Project), Robert Howse (on trade and investment issues), and Lily Batchelder and Mitchell Kane (on tax issues) contributed much to the planning of this project, as well as their own essays. We acknowledge with thanks the support for faculty research provided by the D’Agostino and Greenberg Fund and a grant to the IILJ from Carnegie Corporation of New York for work on global administrative law and specific issues

xii Acknowledgments

concerning developing countries, to which Simon Chesterman and Ange-lina Fisher contribute greatly. We also thank Tom Heller, Ngaire Woods, and Bernard Heikel for invaluable support and wise advice, and Marcel Brinkman and Henry Derwent for serving as panel chairs.

Toni Moyes, formerly Research Fellow at NYU’s CELUL and now with the New Zealand Ministry for the Environment, played a key role in the formulation of the project. As we sought to construct a unified field of climate finance from a very diffuse body of practice and ideas, her imagi-nation and persistence in synthesizing the vast literature and identifying participants and perspectives were invaluable. She has been succeeded in this role by Bryce Rudyk, Research Fellow at CELUL, to whom the senior editors also express deep appreciation. Bringing together the participants at the conference in Abu Dhabi was a team effort. At NYU Law School, Sarah Dadush, Sun-Young Suh, Alma Fuentes, Basilio Valdehuesa, and Meera de Mel, as leader of the team, worked indefatigably to plan and organize the conference and also the climate finance website (at www .iilj.org) which accompanies this book. Sarah and Sun-Young as rappor-teurs also furnished extensive notes and summaries of the conference, which helped greatly in the drafting of parts of this book. Considerable assistance was provided both in New York and Abu Dhabi by the staff of NYU Abu Dhabi: Maura McGurk, Larry Fabian, Brett Heger, Jennifer Sloan, Nils Lewis, Antoine El Khayat, Diana Chester, Peter Christensen, Catherine Kosseau, Brooke Beyer, Carol Gardner, Dean Williamson, and Hilary Ballon.

This is an unusual volume in condensing into thirty-six short and tren-chant policy essays considerable thought, analysis, and research. Steve Maikowski, the director of NYU Press, has provided exceptional leader-ship and guidance in taking on this project and enabling us to produce and distribute this book in very timely fashion. We also thank the other staff at the Press. At NYU Law School, James Chapman, John Wunderlin, and Rachel Jones did sterling work in editing, checking, polishing, and proofreading the essays under considerable time pressure.

Finally, we are deeply thankful for the support of our much-loved fam-ilies and friends.

Richard Stewart, Benedict Kingsbury, Bryce RudykNew York City, September 2009

Climate Finance xiii

ForewordNYU Abu Dhabi and the Sustainable Environment

Mariët WestermannProvost, NYU Abu Dhabi

Philip KennedyFaculty Director, NYU Abu Dhabi Institute

This book is the first volume of policy papers issuing from the NYU Abu Dhabi Institute. It demonstrates NYU Abu Dhabi’s commitment to schol-arship on matters that have critical significance in the world today. And we consider it fitting, with the selection of Abu Dhabi as home for the International Renewable Energy Agency and the ground-breaking work of Masdar, that this volume tackles one of the most pressing global issues: climate change.

Climate change mitigation and adaptation requires complex thinking across a wide range of fields: science, economics, finance, public policy, and law. Effective action demands the collaboration of institutions on all continents. Resulting from a conference on novel mechanisms and frameworks for financing climate change abatement — organized jointly by NYU’s School of Law and the NYU Abu Dhabi Institute — the papers in this book exemplify this cross-disciplinary and inter-continental ap-proach. Abu Dhabi is an apt location for such a meeting of minds and call to action. As a flat, low-lying, desert country with an extensive Gulf coastline, at a latitude of 24° N, Abu Dhabi has a particularly direct un-derstanding of the risks attached to even a small rise in global temper-atures and sea levels. The Emirate’s long-term strategy to diversify its economy beyond hydrocarbon resources includes a major commitment to

xiv Foreword

renewable energy research and the policy work required to translate such new knowledge into economically viable applications.

Just as Abu Dhabi is taking a leadership role in fostering research and meaningful dialogue toward a sustainable environment, NYU Abu Dhabi is developing its new campus on Saadiyat, a natural island of great beauty, in a manner that will minimize its environmental impact. In the same spirit, NYU Abu Dhabi’s undergraduate curriculum offers a multi-disciplinary concentration on the environment. Students will study and research environmental science to understand the scientific foundations of climate change, responsible use of natural resources, and sustainable development. They will learn about a wide range of strategies that can in-hibit damaging and irreversible environmental change, while making con-nections between abstract scientific concepts, the physical world around us, and local and global policy.

As a full partnership between Abu Dhabi and NYU’s global commu-nity of scholars and students, NYU Abu Dhabi fosters the development of well-founded and practical solutions to the most challenging problems of our century. We hope that this book is but a first step.

Abu Dhabi, September 2009

Climate Finance xv

Summary of Key Findings and Recommendations

Meeting the imperative of achieving major reduction in greenhouse gas emissions in developing as well as developed countries, without sacrificing urgently needed development, requires far greater attention to the emerg-ing subject of climate finance than it has yet received. To achieve the nec-essary mitigation of climate change in developing countries, additional in-vestments of €55 – 80 billion each year during the period 2010 – 2020 may be required, rising to USD 92 – 96 billion per year by 2030. Carbon mar-kets are part, but only part, of the solution. Innovative financing, regula-tion, and governance are essential. The following strategies are proposed:

• Avarietyofnewarrangementstogeneratepublicandprivateclimatefinance and engage developing countries in mitigation are needed; a single uniform design is neither feasible nor desirable. Ideally, they should be designed to support and not retard the future adoption by major developing countries of emissions caps.

• A suite of revised or newmarket-basedmechanismsmust be de-veloped to mobilize very large increases in private investment in developing country mitigation. These include a reformed Clean De-velopment Mechanism (CDM) and credit offset trading systems es-tablished pursuant to domestic cap-and-trade climate regulation by developed countries.

• These mechanisms must leverage private investment in order toachieve net climate benefits and secure long-term low carbon devel-opment.

• Carbonmarkets cannot be autonomous; they must be structured,regulated with developing as well as developed country involvement in their design and governance. Governance arrangements should be transparent and provide for appropriate mechanisms for account-

xvi Summary of Key Findings and Recommendations

ability to non-state actors, including investors and non- governmental organizations.

• Linkages among national and regional regulatory/trading systemsthrough allowance trading and transfers of offset credits will play a key role; achieving them will require coordination among govern-ments.

• Governance arrangements and the determination of conditions onofficial development assistance (ODA) must be changed signifi-cantly to enhance developing countries’ roles, build trust, and assure climate-sustainable development. Greater integration or coordina-tion of international ODA mechanisms is also needed.

• Thenewarrangements forbothprivate investmentandODAmustbe structured to match with the different types and costs of mitiga-tion opportunities available in developing countries.

• New institutional arrangements are needed to recognize, facilitate,and coordinate the diversity of decentralized climate initiatives among both developing and developed countries.

• WorldTradeOrganization(WTO)traderulesneedtobeinterpretedand applied to accommodate domestic climate-related regulatory measures, including border carbon adjustments to deal with com-petitiveness and leakage issues and mitigation technology subsidies, so long as they are non-discriminatory and not protectionist.

• TheWTOanddevelopingcountriesneedtodevelopadditionalca-pacities to monitor and respond to adoption of climate-related do-mestic measures that impact trade in potentially distortionary or protectionist ways.

• Changes in tax laws, including a degree of harmonization amongnational tax systems, are needed in order to avoid creating market distortions and regulatory inefficiencies in trading-based climate regulatory systems.

Climate Finance xvii

About the Contributors

Lily Batchelder is Professor at NYU School of Law. Her research centers on income taxation, wealth transfer taxation, tax incentives, and social insurance. She previously worked at Skadden, Arps, Slate, Meagher & Flom, where she focused on transactional and tax policy matters.

Eric C. Bettelheim is a Founder and Executive Chairman of Sustainable Forestry Management Ltd. His publications include coeditorship of the Royal Society’s volume on free-market approaches to land-use change and forestry, which includes an article of his on carbon sinks.

Daniel Bodansky is the Emily and Ernest Woodruff Chair in International Law at the University of Georgia, and is the US-nominated arbitrator under the Antarctic Environment Protocol. Formerly he served as US State Department Climate Change Coordinator and advised the UN in climate change and tobacco control.

Marcel Brinkman is Associate Principal in McKinsey & Company’s Lon-don Office and a member of McKinsey’s Corporate Finance practice. He co-leads the McKinsey’s Environmental Finance service line and leads the Project Catalyst Carbon Finance work.

James Chapman is Research Fellow at the Center for Environmental and Land Use Law at NYU School of Law. His research focuses on es-tablishing links between distinct emissions trading schemes and on nuclear waste law and policy and its implications for low-carbon de-velopment.

Rae Kwon Chung is Ambassador for Climate Change for the Republic of Korea. He received the 2007 Nobel Peace Prize for his work with the IPCC and was Director for the Environment and Sustainable Devel-opment Division at the UN Economic and Social Commission for Asia and the Pacific.

Sarah Dadush is Fellow at the Institute for International Law and Justice at NYU School of Law. She works primarily on the Institute’s Financing

xviii About the Contributors

Development program. Her research focuses on the regulation of im-migrant remittances and innovations for development financing.

Kevin E. Davis is the Beller Family Professor of Business Law at NYU School of Law. His current research centers on contract law, the gov-ernance of financial transactions involving developing countries, and the general relationship between law and economic development.

Henry Derwent is President and CEO of the International Emissions Trad-ing Association. Previously he was the international climate change director for the UK government and served as the prime minister’s special representative during the UK G8 presidency in 2005.

Navroz K. Dubash is Senior Fellow at the Centre for Policy Research in New Delhi and Associate Professor at the Centre for the Study of Law and Governance, Jawaharlal Nehru University, Delhi. He has held po-sitions at the National Institute of Public Finance and Policy (Delhi), the World Resources Institute, and the Climate Action Network.

Antonia Eliason is an Associate in Allen & Overy’s London office. She clerked at the European Court of Justice and at the Legal Affairs divi-sion of the WTO. She was also a visiting research fellow at the World Trade Institute, where she researched climate change mitigation and issues related to the SPS Agreement.

Mark Fulton is global head of strategic planning at Deutsche Asset Man-agement Climate Change Advisors in New York. He has extensive ex-perience in research and management in private banking.

Arunabha Ghosh is Oxford-Princeton Global Leaders Fellow. He previ-ously worked as Policy Specialist at UNDP’s Human Development Report Office in New York, where he authored the 2006 HDR and coauthored the 2005 and 2004 editions.

Luis Gomez-Echeverri is with the Global Energy Assessment Program at the International Institute for Applied Systems Analysis. He has held positions at UNDP and the Secretariat of the UNFCCC and led the UN secretary-general’s WEHAB (Water, Energy, Health, Agriculture, and Biodiversity) initiative.

Thomas Heller is Professor at Stanford Law School and Senior Fellow at Stanford’s Freeman Spogli Institute for International Studies and at the Woods Institute for the Environment. He is Executive Director of the Climate Policy Initiative, Climate Advisor to George Soros, a member of the core team of Project Catalyst, and advises Working Group III of the IPCC.

About the Contributors xix

Robert Howse is Lloyd C. Nelson Professor of International Law at NYU School of Law. He is a contributor to the American Law Institute project on WTO Law, has been involved in several NAFTA arbitra-tions, and is a core team member of the Renewable Energy and Inter-national Law project.

Mitchell A. Kane is Professor of tax law at NYU School of Law. His cur-rent research focuses on the intersections between tax law and policy and economic development, climate change and corporate gover-nance. He clerked for the Honorable Karen LeCraft Henderson of the US Court of Appeals for the D.C. Circuit and was a tax associate at Covington & Burling.

Nathaniel O. Keohane is Director of Economic Policy and Analysis at the Environmental Defense Fund and Adjunct Professor at NYU School of Law. He has published articles on environmental economics in numerous academic journals and is the coauthor of Markets and the Environment.

Alexandra Khrebtukova is currently clerking at the United States Court of International Trade for the Honorable Donald C. Pogue. She rep-resented the Republic of Palau in UN negotiations on fisheries and oceans and law of the sea, and was an IILJ scholar at NYU School of Law.

Benedict Kingsbury is Murry and Ida Becker Professor of Law and Direc-tor of the Institute for International Law and Justice at NYU School of Law. He has written extensively on trade-environment disputes, the United Nations, and interstate arbitration and the proliferation of international tribunals.

Israel Klabin is President of the Brazilian Foundation for Sustainable De-velopment and Partner of Klabin Irmãos & Co. He worked in the Brazilian government, was elected mayor of Rio de Janeiro, and was an adviser for the Alliance for Progress under President Kennedy. He helped organize UNCED in 1992.

Rubén Kraiem is Partner and Co-chair of the Carbon Markets, Climate Change and Clean Technology practice at Covington & Burling LLP and adviser to the Coalition for Rainforest Nations.

Gabrielle Marceau is Counsellor in the Office of the WTO Director- General Pascal Lamy and Associate Professor at the Law Faculty of the University of Geneva. She has written widely on international trade and dispute settlement in international law.

xx About the Contributors

Yoram Margalioth is Law Professor at Tel Aviv University and was a Global Visiting Professor of Law at NYU School of Law. He is also the Out-side Director of IDB Development Corp. Ltd. He has served as Dep-uty Director of Harvard’s International Tax Program and worked for the World Bank.

Sandra G. Mayson is a public defender in New Orleans. She received her JD from NYU School of Law, where she was an IILJ scholar. She has served as a legal adviser to Palau’s Permanent Mission to the United Nations and as Publications Editor of the international environmental organization Oceana.

Bert Metz is Fellow with the European Climate Foundation and a leading member of the ClimateWorks Foundation Project Catalyst team. He led the Netherlands delegation to the Kyoto Protocol negotiations and was elected co-chairman of the IPCC’s Working Group on Climate Change Mitigation for the Third and Fourth Assessment Reports.

Partha Mukhopadhyay is Senior Research Fellow with the Centre for Pol-icy Research in New Delhi. He formerly worked with the Infrastruc-ture Development Finance Company and was a member of the Prime Minister’s Taskforce on Infrastructure. His has also worked for EX-IM Bank of India and the Trade Policy Group of the World Bank.

Sam Nader is the Head of Carbon Finance Unit at Masdar, the Abu Dhabi future energy company.

Michael Oppenheimer is the Albert G. Milbank Professor of Geosciences and International Affairs in the Woodrow Wilson School and the Department of Geosciences at Princeton University. He was a lead author on the IPCC’s Third and Fourth Assessment Reports and has served on the US National Academy of Science’s panels on the At-mospheric Effects of Radiation, Climate Variability and Change, and Alternative Liquid Transportation Fuels.

Annie Petsonk is International Counsel for Environmental Defense Fund. She has previously worked at UNEP and for the administrations of presidents George H. W. Bush and Bill Clinton in the Office of the US Trade Representative.

Nick Robins is Head of the Climate Change Centre of Excellence at HSBC in London. He is the co-chair of the UNEP Finance Initiative’s Cli-mate Change Working Group and a member of the UK government’s Sustainable Development Panel. He has coauthored a number of re-ports on climate finance.

About the Contributors xxi

Bryce Rudyk is Research Fellow at the Center for Environmental and Land Use Law at NYU School of Law. His research focuses on financing climate change mitigation and adaptation. He has previously worked as a lawyer in transnational litigation.

Richard B. Stewart is University Professor and John Edward Sexton Pro-fessor of Law at New York University School of Law, where he directs the school’s Center on Environmental and Land Use Law and Global Law School Program. He has formerly served as Assistant Attorney General for Environment and Natural Resources, US Department of Justice, and Chairman, Environmental Defense Fund.

Charlotte Streck is Founding Partner and Director of Climate Focus. She is also lead counsel for climate change with the Center for Interna-tional Sustainable Development Law at McGill University and an ad-viser to the Prince of Wales Rainforest Project. She previously worked as Senior Counsel with the World Bank.

Murray Ward is President of Global Climate Change Consultancy. From 1996 to 2002 he led the New Zealand Ministry for the Environment’s climate change team. He is a key architect of the Kyoto framework and is recognized for his international work on LULUCF and market trading mechanisms.

Jacob Werksman is Director of the Institutions and Governance Program at World Resources Institute and Adjunct Professor of law at New York University and Georgetown University. He represented the Alli-ance of Small Island States in the Kyoto Protocol negotiations.

Ngaire Woods is Professor of International Political Economy at Oxford University, where she directs the Global Economic Governance Pro-gramme. She has been an adviser to the UNDP’s Human Develop-ment Report, a member of the Helsinki Process on global governance, of the resource group of the UN secretary-general’s High-Level Com-mission into Threats, Challenges and Change, and of the Common-wealth Secretariat Expert Group on Democracy and Development.

Jie Yu is Director of Policy and Research at the Climate Group China. She previously worked as vice president of policy for low-carbon banking group Climate Change Capital. She is an author of China’s first wind energy report and has worked on various projects to promote sus-tainable energy policy in China.

Part I

Climate Change and MitigationOverview and Key Themes

Climate Finance 3

Chapter 1

Climate Finance for Limiting Emissions and Promoting Green Development

Mechanisms, Regulation, and Governance

Richard B. StewartUniversity Professor and John Edward Sexton Professor of Law,

NYU School of Law

Benedict KingsburyMurry and Ida Becker Professor, NYU School of Law

Bryce RudykResearch Fellow, Center on Environmental and Land Use Law

Climate finance is a critical element of global climate policy that has re-ceived far less attention than emissions limitations and climate regula-tory architectures. This book redresses this deficit. It focuses on what is required to meet the need for vastly increased funding for climate miti-gation and green development in developing countries. It presents new proposals to generate climate financing from both private and public sources and to deliver funds through means that will engage developing countries, build mutual trust, and secure effective long-term emissions re-ductions. The book also examines the vital but often neglected regulatory, trade, tax, and governance elements of global climate finance. Its propos-als and analysis are designed to enrich the political and policy debate, not only for the United Nations Framework Convention on Climate Change (UNFCCC) process but more broadly. The complex issues of global cli-mate finance cannot be resolved in a single agreement or a single forum;

4 stewart, kingsbury, and rudyk

they will continue to demand fresh insights and creative approaches like those presented in this volume.

1. Three Key Determinants of Climate Finance

Climate finance policies for limiting greenhouse gas (GHG) emissions and promoting green growth in developing countries are driven by three key sets of factors: climate science; the economics of mitigation and develop-ment needs and opportunities; and domestic and international political economy.

Climate Science Imperatives

Climate science, as set forth in the 2008 Intergovernmental Panel on Climate Change (IPCC) reports and confirmed by subsequent findings, demonstrates that we face serious risks of far-reaching climate damage unless greenhouse gas emissions growth is immediately sharply reduced. The reductions must steadily continue with the objective of stabilizing at-mospheric GHG concentrations in the 450 ppmv CO2-equivalent (CO2e) range and thereby limiting warming to around 2°C over pre-industrial levels. (Oppenheimer, chap. 2.)

Financing Needs and Mitigation Opportunities

Even if developed country emissions are sharply curtailed, these cli-mate targets cannot be met without very large reductions in developing country GHG emissions relative to business-as-usual (BAU) levels. Focus-ing on the period to 2020, a major study by Project Catalyst found that additional investments in developing country mitigation (over and above expected future increases in funding under existing official development assistance (ODA) programs and the Clean Development Mechanism (CDM)) in the order of €55 – 80 billion each year during the period 2010 – 2020 are required. A United Nations study using a different methodology estimated that the annual requirement by 2030 will be USD 92 – 96 billion. Significant additional amounts (estimated by Project Catalyst at €10 – 20 billion annually) will be needed for investment in developing country ad-aptation — a central issue for many African and Asian countries and small island states. We do not address it systematically in this volume because

Climate Finance for Limiting Emissions and Promoting Green Development 5

extensive further studies and innovation are required for adequate adap-tation-focused financial mechanisms to be put in place. Given the limits to bilateral and multilateral ODA, which is sourced mainly in developed countries, very large amounts of private capital must be mobilized to meet the shortfall. Project Catalyst estimates that between €10 – 20 billion annu-ally of private capital might be available. If this amount were used to fi-nance mitigation actions through international credit offset markets at the market price in a single global market for all credits (with one tonne in credits for one tonne of reduction in emitted carbon-equivalents) in cov-ered economic sectors worldwide, the reductions achieved would fall far short of that required to meet the climate targets. The conclusion is that carbon markets must be structured by governmental actions to leverage the private capital available in order to achieve significantly greater emis-sions reductions than would be produced by an open market, such as the current market for Certified Emissions Reduction (CER) credits issued by the CDM.

Also critical is the character of mitigation opportunities in developing countries. Project Catalyst classifies these opportunities in three broad categories based on the costs of emissions reduction. (Metz, chap. 3; Bet-telheim, chap. 9.) These are

• sectorswherereductionscanbeachievedatnegativecost(i.e.,miti-gation investments will earn a positive economic return), mainly in energy efficiency including buildings and transportation;

• sectorswhere reductions canbe achieved at low tomoderate cost,primarily in forestry and agriculture; and

• sectorswith relatively high cost reduction opportunities, primarilyin energy production.

In addition, there is a need to promote low-carbon development, includ-ing through investment in infrastructure and imaginative urban policy. (Mukhopadhyay, chap. 26.)

The Political Economy of Climate Policy

As the costs of achieving even relatively modest GHG reductions, and allied concerns about international competitiveness, become politically more salient in developed countries, and as developing countries be-gin to confront strong demands for emissions limitations commitments,


domestic political and policy factors increasingly dominate global climate policies. If the economic and political stakes continue to rise in this way, as seems highly likely, it will not be possible to sustain the UNFCCC/Kyoto model of a single universal global climate regulatory and finance regime, although it may remain a long-term goal and regulative ideal. Do-mestic economic and political factors in powerful states and in the Euro-pean Union (EU) are increasingly setting limits to (while also motivating) inter-state agreements on climate issues. The most basic elements of global climate finance architecture must be reasonably aligned with what is po-litically workable within the US and the EU, accommodating also any vi-tal points for their prosperous allies such as Australia, Canada, and Japan. Similarly, domestic policy preferences in major emerging economies such as China, India, and Brazil are part of the foundation for their positions in international climate negotiations, where they can in effect exercise a veto on many issues. The less powerful countries, both developed and developing, also have bargaining power, because unwillingness by them to vigorously follow domestic policies that are needed for various inter-national climate agreements actually to work may blunt the purpose of the agreements and unsettle the adherence to them of the more powerful states. From the standpoint of inter-state pre-agreement bargaining and post-agreement implementation, there is what might be called a “politi-cal cost curve” in national (or regional) politics that deviates substantially from the economic cost curves that dominate in climate policy analysis. Some economically and environmentally attractive global options will not be pursued because the domestic political costs (or internal bargaining problems in the EU) would be too great, while some measures that are neither economically efficient nor environmentally optimal may prevail because they are preferred for domestic political reasons, and therefore adopted in order to achieve agreement. In principle, a global cap-and-trade system covering all countries with significant emissions, with allow-ance allocations to ensure equity for developing countries, would be the best solution for all if fully workable, but establishment of such an ar-rangement is not likely in the near term.

For political and economic reasons, both developed and developing countries are demanding greater flexibility in their international climate commitments and arrangements and greater scope to manage climate mitigation on their own terms. They are demanding latitude to take into account their different national circumstances, views of international commitments, domestic political factors, legal and institutional back-


grounds, and economic costs and competitive exposures. As a result, the global climate regime has begun to move from a top-down command ap-proach, exemplified in the Kyoto Protocol, to a more flexible bottom-up approach and assume a more plural, decentralized, and even fragmented character. (Bodansky, chap. 4.) This tendency, which while controversial has received some endorsement in the Bali roadmap and the Copenhagen process, is likely further to intensify in the coming years.

The politics of ODA in developed countries and the demands of devel-oping countries for much greater roles in its governance will make it ex-traordinarily difficult to achieve a unified multilateral climate ODA mech-anism with funding at adequate levels. Arrangements for global private-sector climate finance will be strongly shaped by legislation in the EU, the US, and other countries defining their markets for offset credits from developing countries. But the major developing countries, which have many lower-cost mitigation opportunities, also enjoy substantial market power. The ultimate terms of trade will likely be set through partly de-centralized negotiated arrangements with many accommodations of spe-cial situations, not unlike what has occurred since 1947 under the General Agreement on Tariffs and Trade (GATT) and related trade regimes. Re-cipient developing countries will demand stronger commitments of both public and private funding from developed countries as the price of their participation in mitigation, and greater voice in the governance of fund-ing mechanisms and in how funds are used. They want latitude to devise, register, and receive credits for their nationally appropriate mitigation ac-tions (NAMAs). The challenge for climate finance will be to accommodate these various and often conflicting demands, which will generate a plural-ity of financing mechanisms and market arrangements, while delivering sufficient mitigation funding through means that achieve effective climate protection and green development.

2. New Market-Based Carbon Finance Mechanisms

The coming years will see the emergence of a variety of new climate fi-nance mechanisms using international emissions trading markets to at-tract private investment in mitigation activities in developing countries. Apart from a reformed CDM, these mechanisms will generally be estab-lished pursuant to cap-and-trade regulatory systems in developed coun-tries that recognize international credit offsets. Ideally, they should be


designed to support and not retard the future adoption by major develop-ing countries of emissions caps.

Emissions Trading Systems, Not GHG Taxes

There has been considerable debate over whether GHG emissions taxes (including carbon taxes) or a cap-and-trade system, supplemented by off-set credit trading, should be used as the basic regulatory tool for limit-ing GHG emissions. Powerful policy and political considerations show that trading systems are superior to taxes. Caps focus political attention on environmental objectives and have the potential to ensure that they will be met. The option of issuing allowances gratis rather than auctioning them may be critical in gaining political support for climate regulation without sacrificing efficiency or effectiveness. In the international context, developing countries would never agree without compensation to impose the same level of taxes as developed countries. This would result either in differences in tax levels, creating serious leakage and loss of competitive-ness in developed countries, or in the need for compensatory financing by massive transfers of ODA from developed countries. Use of international trading with generous allowance allocations to enlist developing countries is politically more feasible and more efficient in achieving mitigation.1 Trading systems have already begun to dominate. The EU is operating a cap-and-trade system with international offset credits, the US is poised to adopt such a system, and many other developed countries will likely fol-low suit. (Keohane, chap. 5; Batchelder, chap. 34.)

A Plurality of Market-Based Climate Finance Mechanisms

The plural character of the emerging global climate regime will require diverse new climate finance mechanisms to accommodate the differing circumstances and objectives of both developed and developing countries. Because of the dominance of emissions trading systems for climate regu-lation, the inclusion of international credit offsets in developed countries’ domestic legislation, as well as the CDM and its successor(s), the mecha-nisms for private investment will generally involve some form of climate/carbon markets. These markets will not, however, arise spontaneously, nor will they operate autonomously; they must be created, structured, regu-lated, and governed in order to meet the objectives of developed coun-


tries, developing countries, and investors and to protect the climate. The suite of potential climate finance mechanisms using private investment includes the following:

A Reformed and Expanded CDM

Even harsh critics of the CDM — who complain of maladministration; lack of environmental integrity in credits; failure to tap energy efficiency, renewable energy, and forestry and land use mitigation opportunities; and failure to promote long-term sustainable development — accept that some successor version of the CDM will still be needed to provide private climate finance for the least developed countries. Others believe that the CDM can be reformed so that it continues to play an important, if no longer predominant, climate financing role. The proposed reforms include changes in its governance, strengthened administrative capacities, mecha-nisms to promote accountability to non-state actors, steps to enhance the environmental integrity of CDM credits, removal of barriers to program-matic CDM projects, and removal of limitations on forestry, agricultural, and land-use projects. (Streck, chap. 6).

Sectoral Approaches

Major developing countries have refused to assume economy-wide caps, of the type envisaged in the Kyoto Protocol model, in part because of the risk of crimping their economic development. This refusal, coupled with the limitations of the project-based CDM, has sparked wide interest in sectoral agreements under which internationally tradable offset cred-its would be awarded for limitations achieved in a given economic sector such as electric power generation or cement manufacture. One promising version of this approach is sectoral no-lose targets (SNLTs), under which the host developing country receives credits if it succeeds in reducing sec-tor emissions below the target (typically set by negotiation and expressed either in terms of absolute emissions or emissions intensity) but assumes no obligations and suffers no consequences if it fails to do so. Other sector-based modalities include technology-based emissions limitations, NAMA crediting, and cooperative ventures between developed and devel-oping country industries including technology sharing. (Ward, chap. 7.) Sector-specific targets reduce risks of unnecessarily limiting growth and better address competitiveness issues, although they of course fail to deal with emissions in sectors not covered by agreements.


Sectoral crediting, however, poses the important and investment-deter-ring problems that arise when one (or more) of several individual mitiga-tion actions within the sector fails, with the result that the overall sectoral target is not fully met. From a private investor standpoint, two solutions are proposed. Host governments could indemnify participants with suc-cessful projects for any credit shortfalls. Alternatively, they could devise sector programs that specify each participant’s share of the reductions needed to meet targets; credits would be awarded to those participants who achieve their share of reductions even if others do not. (Kraiem, chap. 8.)

Credit Trading Systems for Forestry and Agriculture

Project Catalyst analysis reveals abundant relatively low cost mitigation opportunities in forestry and agriculture. Nearly half of the developing country mitigation opportunities during the period to 2020 fall into these categories, but most of them are not eligible for CDM credits due to CDM restrictions on these sectors. Belated recognition of these opportunities has generated proposals for forestry credits. Reducing emissions from de-forestation and forest degradation (REDD), a prominent example, would award internationally tradable credits to countries that reduce historical deforestation rates. The US Waxman-Markey climate legislation envisages large volumes of credits for forest sector mitigation in developing coun-tries. However, more is needed to sustain existing forests than just re-ducing deforestation rates, and the agriculture sector continues to be ne-glected. In order to succeed, forestry and agriculture crediting programs must recognize that a large portion of emissions are driven by the struggle of the rural poor to survive. Programs must alter the economics of rural land use, and must ensure that economic benefits from trading actually reach the rural poor. The failures of extractive industries to respect and confer sufficient benefits on local people, resulting in violence and bit-ter poverty in resource-rich areas, provide warnings and lessons for for-eign climate mitigation initiatives based on basic changes in developing country resource uses. Such projects and policies must also promote in-vestment in sustainable methods of intensified agricultural production as the planet’s land area per person shrinks and demand for food increases. Implementing forest and agriculture offset credit systems will also require ODA and capacity building assistance to strengthen host country admin-istrative and legal capabilities. (Bettelheim, chap. 9; Klabin, chap. 10.)


Steps to Leverage Private Investment Funds and Enhance Climate Benefits

In order to meet climate targets, market-based climate finance mech-anisms must achieve robust net global emissions limitations; the Kyoto Protocol – CDM fails to do so because reductions achieved in developing countries are offset by higher emissions by developed country sources using offset credits to avoid making otherwise required reductions. The climate finance regime must also leverage the capital available; the CDM does not because it issues credits one-to-one for reductions. The require-ments for net reductions and leveraging might be met in a number of different ways, although the proposals all face difficulties. (Metz, chap. 11; Petsonk, chap. 12.)

• Creditscanbediscountedbyawardinglessthanonetonneofcreditfor each tonne of reductions.

• Developing countries may be required (for example, in sectoralcrediting agreements) to achieve reductions on their own before be-ginning to earn credits.

• Different tradingmarkets can be established for different types ofmitigation activities, grouped by their costs per unit of emissions reduction. One market could be established for low cost energy ef-ficiency investment, a second for higher cost forestry and agricul-ture investment, and a third in still higher cost energy production investments. By reducing the rents that lower cost mitigation invest-ments would otherwise earn in a single trading market, market seg-mentation can stretch available capital to achieve greater reductions. A related approach is to award different levels of credits per unit of emissions reduced, with more credits in sectors in which emissions reduction costs tend to be higher.

• An international intermediary institution (or institutions) such asa “Carbon Bank” would buy, through a reverse auction or negoti-ated agreements, offsets from developed country suppliers at prices based on their costs and sell them to developed country credit buy-ers at global credit market prices. The bank would use its purchas-ing power to eliminate or reduce the rents that suppliers would otherwise earn by selling credits through an open global market, and thereby obtain additional reductions that could be devoted to reducing net global emissions.


• EnvironmentalDefenseFund’sCLEAR(CarbonLimits+EarlyAc-tions = Rewards) proposes adoption by developing countries of a multi-year absolute emissions limit covering either the whole econ-omy or the major emitting sectors, establishing a Clean Investment Budget (CIB). (Petsonk, chap. 12.) This limit would initially be set at a level above its current emissions levels in order to accommodate economic growth, but below BAU. The country would earn inter-nationally tradable allowances based on the extent to which its fu-ture emissions are below the CIB limit. Through arrangements with international financial institutions and otherwise, the allowances could be leveraged, for example by using them as collateral for debt financing for NAMAs to promote higher levels of mitigation and green development.

These mechanisms would, by one means or another, achieve leverage by reducing the amount of economic rents that developing countries would otherwise earn under open market systems. For that very reason, they will be strongly opposed by developing countries, but developed countries are increasingly likely to insist on leveraging as a condition of access to their trading markets. If the volume of credited mitigation investments increases substantially as a result of domestic legislation in developed countries, developing countries may still regard this as a gain relative to the status quo.

Linking Climate Finance Markets

The development, through a more or less decentralized process, of dif-ferent climate finance mechanisms, different domestic cap-and-trade sys-tems, and associated international allowance and offset markets will gen-erate a variety of credit trading markets governed by different rules. In order to enhance market efficiencies and thereby achieve greater climate benefits, the different markets should be linked to facilitate cross-market trading — this will in turn require that incompatible design features be minimized. (Derwent, chap. 13.) The most important of these features are the relative stringency of caps (i.e., price paths); offset credit recognition rules (both qualitative and quantitative restrictions); the degree of long-term regulatory certainty (including the extent of potential market inter-vention by government); price controls (floors or ceilings); banking and borrowing rules; and the monitoring, reporting, and verification (MRV)


and enforcement regime. Allowance allocation, coverage, point of regula-tion, and a host of other system features have no or minimal effect on the ability to link different markets. Finally, successful linking cannot oc-cur until a pedigree of maturity and demonstrated effectiveness has been achieved in both. Private trading entities — including brokers, investors, financial services firms, and exchanges — can achieve a measure of har-monization through standard contract terms and private standard-setting mechanisms, but some of the most important features will be fixed by governments in domestic legislation. Multilateral agreements and insti-tutions may define some key parameters, but top-down standardization of many of these features through multilateral agreements is unlikely to be feasible for some time, so harmonization of these aspects will depend in significant part on regulatory coordination among governments, partly facilitated by international institutions.

Regulation and Governance of Climate Finance Markets

Climate finance markets are neither spontaneous nor autonomous. While privately constituted or self-regulated markets are possible with regard to some specific aspects, in practice many aspects of regulation needed for climate finance markets require state action. Key features of such markets must be established and structured pursuant to domestic legislation and agreements among countries. They must be regulated to ensure that the interests of the various participating and affected coun-tries are met, and also that climate protection and green development ob-jectives are achieved, including through capital leveraging. At the same time, regulatory certainty on mid- to long-term targets and the imple-menting framework is necessary in order to attract investment capital on favorable terms. (Brinkman, chap. 14; Robins and Fulton, chap. 15.) These competing demands present vitally important but neglected issues of governance. The CDM governance issues that have only belatedly re-ceived wide recognition will be posed many times over, albeit in different institutional contexts, as new market-based climate finance mechanisms are established. These governance issues require much greater attention when new mechanisms are established, rather than postponing the prob-lems until many years later, as happened with the CDM. The governance arrangements for these institutions include Global Administrative Law procedures for transparency, participation, reason-giving, and review in


order to promote accountability and responsiveness to the various con-stituencies, including investors and environmental and social NGOs, with an interest in their decisions.2

Beyond Markets

Markets alone will not spur realization of all or anywhere near all of the relevant available developing country mitigation opportunities. In some cases, prescriptive regulation or direct government investment will be required. Moreover, even where market-based incentives can operate in ways that facilitate environmental protection and green development, they often need to be complemented and supported by other measures. For example, Project Catalyst analysis points to positive economic returns on investments in energy efficiency, but the fact that many of these theo-retically profitable investments are nonetheless not being made indicates the presence of powerful institutional, informational, principal-agent, and other barriers that markets by themselves cannot overcome. Overcoming these barriers in order to enable markets to function will require host gov-ernments to take regulatory, informational, capacity-building, and other measures that will in turn depend on ODA and other support from devel-oped country governments and multinational bodies. In other cases, the returns provided by market-based climate finance mechanisms will not be sufficient to support needed mitigation investments. These situations may require government guarantees, up-front financial support, or mar-ket support measures such as feed-in tariffs for renewable energy. (Brink-man, chap. 14; Robins and Fulton, chap. 15.) A final example is the need for long-term investment plans and policy structures to achieve low-car-bon development in areas such as transportation infrastructure and urban development. (Mukhopadhyay, chap. 26.) Markets may not be capable of delivering and coordinating the required investments on the scales re-quired. Host governments, backed by ODA and international financial institutions, will have to take a lead role, with private capital (including that leveraged from international trading mechanisms) playing a support-ing role. The need for these various non-market elements underlines that developing and developed country governments and international finan-cial institutions must play a major role in the design and governance of a climate finance mechanism using private capital.


3. Bringing Developing and Developed Countries Together in an Effective and Equitable

Climate Finance System

While there is much variation, overall there is a deep lack of trust be-tween developing and developed countries on climate change issues, and particularly on climate finance. This is due in part to a sorry history with regard to the negotiation and implementation of global commitments on development, climate, and institutional reform. Developing countries also see basic illegitimacy in demands that they sharply limit their GHG emis-sions without compensation for the role of already-rich countries in pro-ducing the historical stock of emissions that is causing warming today and for the future. Distrust by developing countries is intensified by the pau-city of financial transfers made under the UNFCCC system, and by their dissatisfaction with the governance of several of the key climate finance institutions and arrangements. The legacy of distrust has helped make un-likely, at least for now, the possibility of a grand bargain on an encom-passing global cap-and-trade system with equitable allowance allocations for developing countries. Instead, trust will have to be built step-by-step through cooperation on various means to fund initiatives in developing countries that simultaneously achieve mitigation and development goals, consistent with local circumstances and priorities.

With 1.4 billion people living in extreme poverty, poverty reduction must be a priority, all the more so as desperately poor people either are hardly emissions producers at all or have little choice about their actions (e.g., in burning forest wood for cooking and heat). In many cases they are vulnerable to serious adverse consequences both from climate change and from efforts to combat climate change by pressing emissions limitations on developing countries. Such limitations threaten the ability of develop-ing countries to increase their energy supply in order to bring electricity to 1.6 billion people living without it, and more generally to bring modern energy sources to 2.5 billion people lacking access to them. (Ghosh and Woods, chap. 16.)

International Public Funding: Needs and Mechanisms

In order to engage and assist developing countries in limiting their GHG emissions without compromising economic development and pov-erty reduction, very large flows of funds to developing countries are re-


quired. Generating these flows while ensuring that they can and do re-duce greenhouse gas emissions and promote socially and environmentally desirable development under arrangements of trust and confidence is the core of the global climate finance problem. Existing flows are grossly inad-equate to the task. While there is much uncertainty, the scale of what may be demanded is suggested by the above-noted estimates of Project Cata-lyst that €55 – 80 billion annually of extra funding beyond that expected to be provided through expansion of existing programs is needed during the period 2010 – 2020, and of the UNFCCC that USD 92 – 96 billion extra will be needed annually by 2030.

Adaptation — the priority for many developing countries — is also vastly underfunded. Project Catalyst estimates that €10 – 20 billion per year will be required for adaptation, and the UNFCCC puts this estimate at USD 28 – 67 billion by 2030. Both estimates dwarf the current transfers for ad-aptation of perhaps USD 1 billion per year, including transfers under the UNFCCC. The CDM sets aside only 2% of investments to assist with ad-aptation costs through the Adaptation Fund. Significant further adapta-tion funding is envisaged in the Waxman-Markey US Emissions Trading System (ETS) bill, which makes 5% of the revenues received by the US government from auctioning permits potentially available for adaptation and technology transfer in developing countries. This apart, current pro-posals offer little prospect of attracting the massive funding and invest-ment needed for adaptation, as this is difficult to integrate into the cur-rent or incipient global carbon finance systems. (Ghosh and Woods, chap. 16; Gomez-Echeverri, chap. 17.)

Some of the needed additional funds will necessarily be transfers from governments of wealthy countries to developing countries (ODA). Bilat-eral climate-oriented ODA has a strong programmatic and public-political dimension in initiatives such as Japan’s USD 10 billion Cool Earth Part-nership, Norway’s Climate and Forest Initiative, Germany’s International Climate Initiative, the European Union’s Global Climate Change Alliance, and Australia’s International Forest Carbon Initiative. Set-asides from ETS permit auction revenues, including the US ETS under the Waxman-Markey scheme and an expanded EU ETS post-2012, may generate much increased funding. However, past experience in this and other fields of bilateral ODA raise questions of whether the projected rates of disburse-ment will in fact be achieved, and whether such funds provide stable and sustained backing for ongoing projects and policies in developing coun-tries over the longer term.


Potentially more important than direct bilateral ODA is the provision of funding through multilateral institutions, much of which is multilat-erally routed ODA. The only financial resources under the authority of the UNFCCC Conference of the Parties (COP) are those managed by the Global Environmental Facility (GEF), the sole operating entity for the fi-nancial mechanism established by the Convention. Major issues arise as to maintaining the present mechanism, the role of the GEF going for-ward, and whether all compliance-linked funding should in the future be under the auspices of a single operating entity system. It has been strongly argued that an Executive Board should act as the new operating entity under the authority of the UNFCCC COP, and that a reformed financial mechanism should incorporate the principle of subsidiarity, so that de-cisions about where to apply the funding — for example, to underwrite NAMAs — are left (within broad parameters) to each country. (Gomez-Echeverri, chap. 17.) Under this vision, the governance structure would include national entities and implementation hubs that are linked to the UNFCCC system, the MRV system, and the system of compliance. (Gomez-Echeverri, chap. 17.)

The GEF allocates some USD 250 million per year for climate-related energy and transportation projects. Some multilateral funds outside the UNFCCC system are larger, particularly the World Bank’s Climate In-vestment Funds, which exceed USD 6 billion divided between the Clean Technology Fund and the Strategic Climate Fund. The World Bank’s Car-bon Investment Unit is also active, purchasing credits on behalf of other entities. The modest scale of the World Bank’s Forest Carbon Partnership Facility, at some USD 165 million, and the UN REDD funds of USD 35 million, reflect the slowness of the integration of forest issues into carbon finance structures, although the Waxman-Markey scheme and modifica-tions envisaged to the CDM and the EU ETS may accelerate this. In to-tal, these multilateral funds, even taking into account projected bilateral ODA, are nowhere near large enough for what is needed. Their objectives and policies were often formulated with very limited developing coun-try participation. Moreover, each fund typically has separate procedural rules and its own governance structure. Many have insufficient transpar-ency and accountability. Because of the operational complexity of many of the funds, dedicated experts are required at the national level in or-der to access and benefit from them, sapping the already weak national monitoring and reporting capacities of many developing countries, and imposing high transaction costs. In many cases they fund projects rather


than programs or sector plans of action, limiting their ability to respond to developing country priorities in overall development strategy.

Governance of International Public Funding

Housing these funds within the World Bank or conceivably the Inter-national Monetary Fund (IMF) is the general preference of developed countries seeking assurances about strong management and prevention of misappropriation. Developing countries, however, lack effective votes and voice in these institutions (even with reform of the IMF), and resent the dominance of the industrialized countries and the effective veto power of the US. The GEF attracts similar objections, leading many developing countries to prefer it to be simply an operational entity, not a financial mechanism. The Adaptation Fund has more appeal for developing coun-tries as a model for climate finance governance, with a Board compris-ing 16 members and 16 alternates representing the five United Nations regional groups (2 from each), the small island developing states (1), the least developed countries (1), Annex I Parties (2), and non – Annex I Par-ties (2). (Ghosh and Woods, chap 16.)

The credibility of the climate public finance regimes will be enhanced if the principal inter-governmental financing mechanisms are actually able to monitor and evaluate the effectiveness of financial flows, combining self-reporting by member states with institutional reporting of the origin and destination of financial flows. A review capacity — to assess the timeli-ness, adequacy, and impact of financial transfers — would buttress the sys-tem. Developing countries are also pushing for binding multilateral finan-cial commitments from developed countries as an essential part of any global deals that would include some form of limitations commitments by major developing countries. They have proposed international agreement on means of raising additional public funds for mitigation investment in developing countries, including dedication of revenues from auctioning allowances in developed countries’ domestic trading systems, taxes on in-ternational emissions trading, and international levies on bunker and avi-ation fuels. A much less ambitious approach would be to include funding initiatives by developed countries in the framework proposed by Korea for registering national climate undertakings, including NAMAs by devel-oping countries.


Financing Bottom-Up Approaches to Climate Mitigation in Developing Countries

Whereas developing countries tend to favor strong participatory inter-state governance of financial mechanisms, with regard to emissions con-trols for developing countries they generally favor bottom-up approaches, such as NAMAs, over top-down approaches, such as explicitly binding targets or systems with implicit future targets. In addition to political and equity arguments (made also by some developed countries) for greater autonomy, more specific environmental and developmental arguments are advanced for flexibility and bottom-up approaches to promote mitiga-tion actions adapted to the circumstances (including institutional circum-stances) and priorities of individual developing countries. It is argued, first, that strengthening domestic institutions in developing countries remains essential to successful low-carbon development. (Dubash, chap. 18.) Where national institutions are dysfunctional or severely distorted by capture, top-down measures such as emissions trading systems with caps or targets — designed to change relative prices, signal economic opportu-nity, and stimulate actors to capture efficiency — are in practice blunted and even produce distorting effects. Second, trying to generate targets for developing countries currently risks perverse results. Classifying any sec-toral reforms by reference to standard cost-curve metrics and methodolo-gies, such as negative cost, co-benefits actions, and positive cost, involves drawn-out negotiations and may be counterproductive. Such classifica-tions give countries incentives to demonstrate that their possible actions carry high positive costs, which means they need to avoid undertaking these actions unless they receive climate financing. Thus, sectoral ap-proaches can risk discouraging early action while rewarding stonewalling and late action. (Dubash, chap. 18.) Moreover, any approach to calculation of credits that requires construction of a counterfactual baseline (such as a business as usual (BAU) baseline) against which to judge progress, risks gaming and high transaction costs. Thus, in the short run, when early action is at a premium, a bottom-up approach to climate mitigation may well deliver more and earlier mitigation than top-down approaches. (Dubash, chap. 18.)

The bottom-up approach depends on there being both the incentives and the capability for developing countries to take significant national measures on their initiative. The Korean proposal for registration and crediting of NAMAs seeks to provide the incentives. The very concept of


NAMAs, and then the formal possibility of registering them, provides a form of international and local recognition that has helped catalyze some national action. Much greater impetus comes, however, from the possibil-ity that NAMAs that produce emissions limitations as confirmed by MRV might receive financial support from the global climate finance regime. Fi-nancing for NAMAs may be unilateral (provided by the developing coun-try itself, typically where there are also economic or other non-climate reasons to take the action), provided by grants or investment by foreign states or multilateral institutions (supported NAMAs), or through recog-nition with carbon offset credits (credited NAMAs). (Chung, chap. 19.) This proposal does not, however, solve the capability problems: the need for developing countries to have the capability to identify and implement promising NAMAs; define their emissions baselines and trends and the projected effect of a new policy or measure; facilitate the necessary meas-urement, reporting, and verification of the reductions; and manage any financial inflows in a responsible and accountable fashion. Some, such as Mexico, have actively built up capability and generated GHG inventories and baselines to support a substantial catalogue of prospective NAMAs. Brazil has also taken substantial steps, particularly with regard to forests and its Amazon Fund, but also in some industrial and energy sectors. But many developing countries do not have this ability or the financial, institutional, and personnel resources to build it very quickly. Capacity also depends on technology transfer in many instances. In all of these re-spects, effective bottom-up approaches to climate mitigation have much in common with long-standing problems in development and develop-ment assistance. Because capacity building is not itself a NAMA under any ordinary definition, ancillary arrangements for capacity building and technology transfer are essential.

Conditionality in Climate Funding

Aid donors and concessional funders of low-carbon green develop-ment or of mitigation measures unsurprisingly want to set conditions on the use of their funds, and to ensure close supervision. This raises ma-jor problems about fairness of conditions and of their construction and supervision, particularly what might be called the good governance of conditionality.

Applying some conditions to developing country performance is inevi-table, and may indeed be helpful in overcoming opportunistic tendencies


of some leaders and officials to divert funds for private or political ends. However, many unilateral conditions are viewed antagonistically by devel-oping countries. In the GEF, conditionalities are set and enforced in what is perceived as a one-sided fashion through the “contributor prerogative.” It is argued instead that developed countries should work in partnership with developing countries to use their investments to build institutional and policy conditions in recipient countries for more sustainable climate-related polices to take root. (Werksman, chap. 20.) Such a reciprocal deal could encompass direct access to funding with relaxed conditions for de-veloping countries whose national institutions can demonstrate that they meet fiduciary standards through sound national systems for measur-ing, reporting, and verifying (MRV) funded actions. Such quality assur-ance and accountability mechanisms would be an integral part of a new deal on international funding for the bottom-up approach. (Werksman, chap. 20.) Indonesia’s proposal that incoming funds go into its Climate Change Trust Fund for onward distribution may prove a test case for such arrangements.

Conditions are also set by private funders, such as the group of com-mercial financial institutions adhering to the Equator Principles, which itself integrates closely with the inter-governmental but private-sector- oriented International Finance Corporation (IFC), so that Equator banks are expected in their project lending to insist on IFC Performance Stan-dards, even where the IFC is not a funder for the project. These and other conditions set by private financing sources increasingly incorporate climate- related requirements. But the reasons for doing so are complex, and it cannot be presumed that these conditions are cost-effective, reflect the best interests or priorities of developing countries, or are necessarily adhered to. This phenomenon of private or hybrid public-private condi-tionality plays an ever more visible part in climate finance, but its effects and actual significance have not yet been sufficiently evaluated. (Davis and Dadush, chap. 21.)

The politics and psychology of donating money, particularly public money, often generate strong donor-set incentives and conditions in the belief that they will lead the recipient to adopt and achieve the donors’ objectives. In practice, however, such structured incentives or conditional-ity may often reflect other donor predilections, and they may well impede realization of the stated objectives. (Woods, chap. 22.) On the recipients’ side, local ownership (including local willingness to provide resources for the project), local management and implementation, and local control of


redesign and adaptation of the project as these become needed make a huge difference to success. On the funders’ side, rich countries that are potentially willing to accept tough binding emissions commitments are much less willing to accept binding financial commitments. This raises uncertainties that may increase the risk for developing countries in mak-ing long-term commitments, having had much experience in the past with projects undertaken with careful adherence to a bevy of conditions, and which the donor then decides not to continue funding. (Woods, chap. 22.) Assuring financing from private markets raises other difficult complica-tions of stability.

4. National Policies and the Global Climate Finance Regime

As well as being politically inescapable, there are many other reasons to build an international climate regime in ways that accommodate some existing and future national policy choices. Pluralism can have global policy benefits in encouraging experimentation, learning, and improve-ment. Allowing different national approaches may enable agreement on more demanding levels of climate mitigation and assistance. More scope is left for national political processes, including democratic processes where these function well, in making future choices. Significant deference to developing countries is demanded by them, as an acknowledgment of their sovereignty coupled with acknowledgment of their limited role in historical carbon build-up from anthropogenic emissions. These concerns can lead many developing countries strongly to resist simply accepting what appear to be instructions on climate policy from developed coun-tries, even if the proposed policies may be entirely well-intended and ac-companied by full and adequate financial support. Yet, the multiplicity of national policy approaches that the bottom-up ethos celebrates faces the hazard of being a cacophony that neither produces much climate change mitigation or forest and environmental protection nor generates cost-effective and socially beneficial development for people who need it. Some significant overarching regulation, supervision, and coordination are therefore essential. In this light, part 4 of the book focuses on some key national (and EU) policies and the interactions both among these different national measures and with an emerging international climate finance regime.


Developed Country Climate Legislation and Global Carbon Markets

As discussed above, flows of (usually private) funds made possible be-cause investors receive carbon offset credits — which have value due to their tradability in the carbon markets of the developed countries — have considerable importance for mitigation in developing countries. Both the European ETS and the Waxman-Markey legislative scheme in the US limit the percentage of emissions permits derived from foreign offsets, and both seek to promote some offsets in their own territories. They also limit the kinds of foreign projects that can generate offset credits usable in their markets: thus, the EU excluded forest projects from the ETS, the Waxman-Markey scheme envisages excluding many projects not meeting specific US standards, and the New Zealand scheme excludes credits re-lating to nuclear power projects.

The Waxman-Markey scheme in the US is designed to be open to some potential integration with, but also to strongly influence, other national and international emissions abatement and carbon finance schemes. Up to USD 1 billion per year in credits from approved foreign and interna-tional cap-and-trade systems will be accepted in the US, although after a phase-in period this will be at a 20% discount. However, the foreign or international schemes will be required to meet stringent substantive and procedural standards, to be applied by US government agencies (prin-cipally the Environmental Protection Agency), an arrangement likely to require application of Global Administrative Law principles and proce-dures to ensure adequate consideration of the interests of other countries, other investors, and other global constituencies. This legislation also seeks to move toward sectoral crediting for certain countries and sectors over time, and will render individual projects ineligible for crediting where it would be covered sectorally. (Keohane, chap. 23.)

The EU ETS has been the main source of demand for CDM credits. Steps by the EU to toughen up on recognition of these credits is likely to force some reform of the CDM, which may raise some problems of unilateralism even as reforms are much needed. At the same time, efforts to bolster the carbon price and stability in the EU ETS market, through laying out a predictable total cap beyond 2020 and other measures such as making it an EU-wide market with auctions rather than continuing with highly variable national measures, will give support to the CDM and other offset credit systems. The EU is also taking steps to foster an


eventual global ETS market, based on the expected national cap-and-trade schemes in the US, New Zealand, Australia, and elsewhere. (Chap-man, chap. 24.)

Developing Countries’ Initiatives and Policy Innovations

China does not (and likely for a long time will not) accept an econ-omy-wide emissions cap. However, it is taking an increasingly significant raft of voluntary measures (often driven by economic modernization and energy security goals) which may substantially reduce emissions be-low BAU, while also advancing some development objectives including rural electrification using some renewable sources. The government has required increased energy efficiency in building designs and pursued re-ductions in emissions intensity especially in the power sector. This and other policies have driven up the demand for ultra-supercritical power stations, wind power equipment, and other technologies that due to large-scale production have dropped in price, helping to establish their Chi-nese manufacturers as leaders in these global markets. The possibility of registering these actions as NAMAs, and conceivably receiving credits far beyond those generated by the current range of CDM projects in China, may bring China further into the climate finance regime. (Yu, chap. 25.)

Within the complex mix of national, inter-governmental, and global policymaking structures, good climate policy innovation must be actively fostered and receive quick recognition and financing. Much of this inno-vation must occur in sub-national political units, such as cities. While US cities typically use much more energy per capita than European or other cities, the variance among US cities is very large, and comparable vari-ance is beginning to appear amongst Chinese cities. Some of this can be redressed through building standards and other transposable initiatives, but much relates to complex combinations of historical development and current policies concerning the role of public transport, tax and other in-centives to live densely or diffusely and close or far from work, as well as some cultural conditioning. (Mukhopadhyay, chap. 26.) Reform of urban policy might have major emissions-reducing effects: perhaps one-third of emissions mitigation in India by 2050 could be through lower-carbon cit-ies. But it is not readily incentivized or funded through private invest-ments driven by crediting for the major foreign offset markets. Urban


policy is so complex that it must be tailored to innumerable local speci-ficities and political structures — making metrics, replication, and rapid diffusion difficult — and it must necessarily be pursued largely though bottom-up processes.

All of this calls for further reflection on what drives national policy formation on climate issues. The US and EU political processes have re-ceived intense study, so the factors influencing the approaches emerging there are broadly understood even if not robustly predictable in their out-comes; but much less is generally known about Chinese policymaking processes. An interesting experiment potentially related to future policy formation is the Masdar initiative to create a moderate-sized carbon- neutral city with innovative technology in Abu Dhabi, which if it succeeds could conceivably be an incubus for rethinking national and international approaches to climate change in several oil-exporting states with high per capita emissions and incomes. (Nader, chap. 27.)

Understanding the Evolution of National and Global Climate Policies

In none of these cases is the national government (or the EU) forming policy in an entirely autochthonous fashion, even if the national processes can seem quite insular. Each takes some account of policies elsewhere, of positions in international institutions, and of some broad global forces and trends. In this respect, a model of a two-level game, in which na-tional officials and interest groups act in national politics and in intergovernmental politics, is insufficient. Some elements of both national and inter-state policy formation on climate issues extend beyond simply interest- driven bargaining. In some part, the politics is global, at least in the modest sense of being not simply national or inter-governmental, as the work of the IPCC or of major transnational climate lobby groups illus-trates. National policies are also shaped by processes of mimesis or diffu-sion. A few basic models of cap-and-trade credit offset carbon market de-sign and regulation may emerge, as existing national schemes are studied by the next adopters. Best practices may also develop, on matters ranging from treatment by national electricity regulators of renewable supplies to the grid (e.g., through feed-in tariffs) to certification and verification of emissions reductions. Such standardization may potentially facilitate both financial flows and regulatory design.


Autonomy in national or regional climate policies may indeed be an objective of some who wish to maintain the possibility of national control (or patronage and rent-seeking), but it comes at a high cost in unreal-ized efficiency gains. A proliferation of regulatory arrangements invites arbitrage and opportunism that may eventually lead to the ironing out of incongruities, but at considerable fiscal and environmental cost. Regula-tory competition likewise can have benefits, but also major costs. Regu-latory cooperation, mutual recognition arrangements, and real coordina-tion between national regulators and funders with different objectives and constituencies may become effective only very slowly. Some structures of transnational and international regulation will almost inevitably be demanded, but will come into tension with the values of bottom-up ap-proaches. Such tension is already manifest in questions concerning the application of global trade law to climate issues, and may develop in the future on some taxation issues affecting climate finance.

5. Trade Law and Climate Policies

Climate finance and regulation and international trade law will increas-ingly intersect. As international and, more pertinently, national climate change regulations affect and potentially distort trade between states — not only between states that adopt GHG emissions regulation and those that do not, but also between states that adopt differing levels and forms of regulation — international trade law will be implicated. (Marceau, chap. 28.) Potential or actual World Trade Organization (WTO) challenges to domestic climate measures (and similar challenges under regional trade agreements) might chill or retard the implementation of domestic climate regulation. But trade law may also have a positive influence on the de-sign of measures to combat competitive and leakage concerns, as well as prevent protectionism in the guise of environmental measures. Climate measures will also test the limits and analytical precision of the environ-ment-related exceptions under Art. XX of the General Agreement on Tar-iffs and Trade (GATT) and similar exceptions in other WTO agreements. Because the issues likely to arise are complex and novel, the impact of the multitude of trade rules on climate finance and mitigation are difficult to anticipate and address. However, WTO officials, at least, are optimistic that the WTO agreements can accommodate properly designed domestic climate regulatory measures.


Trading Climate Assets

While the trading of Assigned Amount Units (AAUs) between Annex I states is regulated by the UNFCCC and Kyoto Protocol, trading across borders and systems of allowances issued under domestic cap-and-trade systems and other assets created pursuant to climate regulatory law, such as renewable energy certificates (RECs), is not explicitly addressed in WTO agreements or any other current international agreement. It is likely that the WTO would have some jurisdiction over this trading and government measures to regulate or support the market, but it is not clear whether allowances will be treated as financial instruments or other types of services under the General Agreement on Trade in Services (GATS), or potentially as goods under GATT. Similar uncertainties arise in relation to offset credits produced through the CDM and joint implementation under the Kyoto Protocol and under the trading systems created pursuant to do-mestic cap-and-trade systems in the EU, US, and other developed coun-tries. Because of the nature of the transactions involved, which might be seen as investments with government involvement, the provisions of the Agreement on Trade-Related Investment Measures (TRIMS), the Govern-ment Procurement Agreement, or the Technical Barriers to Trade (TBT) Agreement might apply as well as GATS and GATT. (Marceau, chap. 28; Howse and Eliason, chap. 29.)

Border Measures to Address Leakage and Competitiveness Issues

There is strong political concern that climate regulation will impair the competitiveness of firms and sectors in regulated economies relative to those in states with less stringent or no regulation. Because investment and business activity will tend to flow to jurisdictions with lower produc-tion costs, difference in domestic climate regulations will, absent coun-tervailing international or domestic rules, result in leakage of production emissions to jurisdictions with weaker or no regulation. The result is not simply a loss in economic competitiveness in regulating jurisdictions (which threatens domestic political support for climate regulation), but a loss of environmental effectiveness, as the emitting activities are shifted around rather than reduced. Moreover, leakage spurs carbon-intensive development in jurisdictions with weak or no regulation, making it more difficult for them to reverse course in the future. International agreement


on common climate regulatory policies is one solution. In its absence, states may well adopt domestic rules requiring imported products be ac-companied by emissions certificates like those required of domestic pro-ducers under domestic cap-and-trade laws, or be subject to some form of economically equivalent border carbon credit adjustment. (Khrebtukova, chap. 31.) The effect is to impose an economic charge reflecting climate externalities on all goods, whether domestic or imported, consumed in the regulating jurisdiction. States, including developing countries, which regard climate externalities as less costly and oppose strong regulations, will of course oppose carbon levies on their exports. Although the issues of trade regulatory law are again complex and novel, border carbon meas-ures may well be consistent with WTO rules if applied in an evenhanded way without discrimination against imported goods. Adoption of such measures by some states will spur their adoption by others, creating a bottom-up pattern of international regulation that may eventually provide a foundation for international agreement on common climate regulatory norms.

Free Allocation of Climate Assets and Direct and Regulatory Climate Subsidies

Another step that regulating states may take to protect their industries’ competitiveness is to issue emissions allowances for free rather than auc-tioning them. In most of the current and proposed developed country cap-and-trade systems, all or most of the allowances are distributed gratis at least for the short- and mid-term. (Keohane, chap. 23; Chapman, chap. 24.) The WTO Subsidies and Countervailing Measures (SCM) Agreement contains specific rules concerning subsidies and limits to them where they may cause adverse effects on trade. Under one interpretation of free allowance allocations to domestic producers — as a transfer of a valu-able asset from the government to private entities without compensation — they and tax breaks with similar effects might represent actionable or countervailable subsidies under WTO law. An analogous logic might con-ceivably conclude that states that do not regulate their carbon emissions when a majority of states do so are granting their industries an unlaw-ful subsidy under the SCM. (Howse and Eliason, chap. 30.) Direct subsi-dies — whether for production or export — for climate-friendly technolo-gies, including tax breaks and other forms of direct government financial


support for wind, solar, and biofuels, as well as regulatory measures such as feed-in tariffs and renewable energy portfolio and credit standards, also pose issues under the SCM Agreement; in the case of biofuels, the Agree-ment on Agriculture is also relevant.

Carbon Footprint and Other Standards Created by Non-state and Hybrid State-Private Actors

The proliferation of initiatives for carbon footprint labeling schemes currently being developed by business and non-profit organizations alone and also in conjunction with states could adversely affect developing country exports and pose international regulatory and governance con-cerns. Mandatory carbon labeling standards adopted by states, as Japan contemplates, would be subject to potential challenge for failure to con-form to the TBT Agreement’s Code of Good Practice for standard set-ting. It remains an open question whether these requirements apply to privately run labeling schemes that have some form of state sponsorship or involvement.. (Mayson, chap. 33.) Alternatively, states may adopt as mandatory private carbon labeling standards and invoke them as “rele-vant international standards” which, under the TBT, create a “safe harbor” presumption of legality when the state rules are challenged. It is unclear whether and under what circumstances private voluntary standards might enjoy such a presumption, including where there are competing private standards. The legal validity of carbon footprint labeling standards can be strengthened if the initiatives are based on widely accepted scientific and standard-setting principles, adopted with adequate transparency and broad-based participation, and accompanied by technical assistance to developing countries and small producers to support compliance.

Developing Country Concerns with Climate-Related Trade Measures

Developing countries are concerned by developed country motiva-tions in climate policy generally, and especially so as regards the move to link trade measures with climate. (Ghosh, chap. 32.) One concern is that climate-related trade measures such as border carbon adjustments will be used for protectionism and eco-imperialism camouflaged as environ-mental protection. Developing countries are also concerned that current


steps to lower barriers against trade in environmental goods and services (under negotiation in the Doha round) could be implemented in a lop-sided way that disadvantages developing countries. A further concern is that stringent intellectual property rights may inhibit needed technology transfer. To prevent unjustified trade distortions and potential inequi-ties, it is argued that better reporting by states of relevant domestic trade measures is needed, along with greater capacity in the WTO and in devel-oping countries to monitor domestic trade measures, and greater trans-parency in climate-related domestic initiatives that impact trade. (Ghosh, chap. 32.)

6. Taxation Issues in Climate Finance

The tax treatment of emissions trading systems (which as discussed above are the dominant instrument for achieving mitigation) and the new types of assets (emissions allowances and offset credits, collectively “permits”) that they create is an important subject just beginning to achieve recog-nition. Tax issues are important because the efficiency and effectiveness of trading systems in achieving climate protection goals can be seriously compromised by inappropriate domestic tax policies and by international differences in tax treatment.

Emissions trading markets produce cost savings and enhance environ-mental benefits relative to traditional prescriptive regulation because they allocate emissions limitations among sources in the most cost-effective pattern, and thereby achieve aggregate limitations at lowest cost. Trad-ing systems achieve this efficient result because sources seeking to mini-mize their overall costs of dealing with emissions will invest in emissions abatement to the point where marginal abatement costs equal the cost of acquiring or continuing to hold permits, which is the same as the market price of permits. Since, in a given trading system, the market price of per-mits is the same for all sources, their marginal abatement costs will also be the same, producing an efficient abatement allocation. (This explains why it is desirable to link different trading systems so that sources cov-ered by different systems all face the same permit price.)

The tax treatment of abatement costs and of permits can impair reg-ulatory efficiency by disrupting the equilibration of marginal abatement costs and permit costs. For example, a country may grant tax subsidies to certain politically favored emission abatement technologies, such as


ethanol or wind power, thereby reducing their after-tax costs. As a result, more investment will flow to such technologies and less to other abate-ment methods that, pre-tax, have lowers costs, undermining the efficiency of the trading system and driving up the overall costs to society of lim-iting emissions. Similar distortions and inefficiencies can occur in the international allocation of abatement investments if different countries adopt different tax rates for abatement or for permits. The resulting inef-ficiencies may not only create very large amounts of economic waste, but also undermine political support for strong climate mitigation regulation by driving up abatement costs. Analysis of these tax issues leads to the following conclusions (Batchelder, chap. 34; Kane, chap. 35; Margalioth, chap. 36):

If an emissions trading system is adopted, tax and other subsidies for particular abatement methods or for energy use should be, to the maxi-mum extent feasible, eliminated unless justified by non-climate externali-ties, because they threaten to create market distortions, regulatory inef-ficiencies, and economic waste.

Distortions and regulatory inefficiencies caused by differences in the tax treatment of abatement and permit costs can arise either within a given jurisdiction or across jurisdictions. The major source of problems will be the persistence (contrary to the immediately above policy recommenda-tion) of tax and other subsidies for particular abatement methods, such as renewable energy. Two different strategies can be used to eliminate or reduce the resulting distortions. First, tax all permit costs the same across all jurisdictions, and also tax all abatement costs the same across jurisdic-tions; if this is achieved, it is not necessary also to equalize the treatment of abatement and permit costs within any jurisdiction. Second, tax all per-mits and abatement costs the same (at the margin) in each jurisdiction; if this is achieved, it is not necessary also to equalize tax rates and other tax rules among jurisdictions. As a practical matter, it is much less difficult to implement the second strategy than the first. This strategy is compatible with tax and other subsidy programs for certain specific abatement meth-ods if they are properly designed. International agreement by major states on adopting this strategy should be pursued through multilateral climate negotiations rather than bilateral tax treaties.

Distortions and inefficiencies can also be independently caused by the various aspects of the tax treatment of permits that create a lock-in effect that leads firms to hold permits longer than they otherwise would in or-der to defer taxes on the increased value of the permits. As a result, permit


values will rise because of tax considerations, distorting the tradeoff be-tween abatement and holding permits. Partial solutions include auction-ing permits or taxing the value of gratis permits when issued. Tax changes should also be adopted to address distortions caused by the interaction between fluctuating permit prices and tax rules.

Differences in the treatment of abatement costs and of permit costs in different jurisdictions will require tax authorities to develop transfer pricing rules to police tax arbitrage practices by multinational businesses operating in more than one jurisdiction that pose risks of trading market distortions.

Finally, trading systems present important macro-level issues of effi-ciency and equity. By imposing a cost on emissions, trading systems in-crease the price of energy and of goods and services produced by it, which has a net regressive effect. Auctioning permits and using the proceeds to make direct transfers to lower-income households or providing them with tax credits can offset or reduce this effect.

7. Conclusion: The Ways Forward on Climate Finance

The issues raised by climate science, economic analysis, and the political economy of climate policy, fleshed out in the chapters of this book, gen-erate rich and powerful implications for future carbon finance arrange-ments. These include the following:

• Avarietyofnewarrangementstogeneratepublicandprivateclimatefinance and engage developing countries in mitigation are needed; a single uniform design is neither feasible nor desirable. Ideally, they should be designed to support and not retard the future adoption by major developing countries of emissions caps.

• A suite of revised or newmarket-basedmechanismsmust be de-veloped to mobilize very large increases in private investment in developing country mitigation. These include a reformed CDM and credit offset trading systems established pursuant to domestic cap-and-trade climate regulation by developed countries.

• These mechanisms must leverage private investment in order toachieve net climate benefits and secure long-term low-carbon devel-opment.


• Carbonmarkets cannot be autonomous; they must be structured,regulated with developing as well as developed country involvement in their design and governance. Governance arrangements should be transparent and provide for appropriate mechanisms for account-ability to non-state actors including investors and NGOs.

• Linkages among national and regional regulatory/trading systemsthrough allowance trading and transfers of offset credits will play a key role; achieving them will require coordination among govern-ments.

• Governance arrangements and the determination of conditions onODA must be changed significantly to enhance developing coun-tries’ roles, build trust, and assure climate-sustainable development. Greater integration or coordination of international ODA mecha-nisms is also needed.

• Thenewarrangements forbothprivate investmentandODAmustbe structured to match with the different types and costs of mitiga-tion opportunities available in developing countries.

• New institutional arrangements are needed to recognize, facilitate,and coordinate the diversity of decentralized climate initiatives among both developing and developed countries.

• WTOtrade rulesneed tobe interpretedandapplied toaccommo-date domestic climate-related regulatory measures, including border carbon adjustments to deal with competitiveness and leakage is-sues and mitigation technology subsidies, so long as they are non- discriminatory and not protectionist.

• TheWTOanddevelopingcountriesneedtodevelopadditionalca-pacities to monitor and respond to adoption of climate-related do-mestic measures that impact trade in potentially distortionary or protectionist ways.

• Changes in tax laws, including a degree of harmonization amongnational tax systems, are needed in order to avoid creating market distortions and regulatory inefficiencies in trading-based climate regulatory systems.

N o t e s

1. Richard B. Stewart and Jonathan B. Wiener, Reconstructing Climate Policy: Beyond Kyoto (2003).


2. The Global Administrative Law Project at New York University School of Law undertakes and promotes academic research and policy debate on the use of these mechanisms to improve global regulatory governance. See www.iilj.org/gal. An overview of global administrative law is provided in Benedict Kingsbury, Nico Krisch and Richard B. Stewart, “The Emergence of Global Administrative Law,” 68:3 – 4 Law and Contemporary Problems (2005), 15.

Climate Finance 35

Chapter 2

Understanding the Causes and Implications of Climate Change

Michael OppenheimerAlbert G. Milbank Professor of Geosciences and International Affairs,

Woodrow Wilson School and the Department of Geosciences, Princeton University

Key Points

• Carbon Dioxide (CO2) — emitted through electricity generation, transport, agriculture, and forestry — is responsible for four-fifths of the warming effect of current emissions of long-lived greenhouse gases and will persist in the atmosphere for many decades, with a significant fraction remaining for more than a millennium. CO2 levels are already higher than any time in at least the past 850,000 years.

• While the effects of climate change cannot be predicted with cer-tainty because future emissions trajectories are not known and our understanding of the climate system (particularly feedbacks) is lim-ited, we are already seeing significant climatic impacts, including: increasing mean ocean temperature and sea level; increasing ex-tremes of heat and drought; changes in ranges of species; melting of ice sheets, Arctic sea ice, and glaciers; and increasing severity of some extreme climatic events.

Causes of Climate Change

The basic scientific framework of the climate change issue is well un-derstood: greenhouse gases (GHG) emitted in the process of electricity

36 Michael Oppenheimer

generation, transport, agriculture, and forestry are accumulating in the atmosphere, gradually altering the heat balance of the Earth and inevita-bly changing its climate. The greatest concern arises from long-lived gases (carbon dioxide, methane, halocarbons, and nitrous oxide) because they persist in the atmosphere for a period ranging from decades to longer than a millennium after release. Of these, carbon dioxide is the most im-portant because it accounts for about four-fifths of the warming effect of current emissions of the long-lived GHGs. Atmospheric carbon dioxide levels are already one-third greater than in preindustrial times, and higher than at any time in at least the past 850,000 years. Other trace constitu-ents emitted from human activity affect the climate in important ways, but are much less persistent. These include ozone (a key component of smog) and soot and other particles, the latter having both warming and cooling effects.

All this we know with certainty. It is also certain that over the past century, the Earth has warmed by about three-fourths of a degree Cel-sius (°C). It is very likely that the combined influence of all these gases and particles has caused most of the observed warming of the past half-century.

Carbon dioxide from the combustion of fossil fuels (coal, oil, and natu-ral gas) for electricity generation, transport, and other purposes produces almost 60% of the warming effect of the current emissions of long-lived gases. Another 20% comes from carbon dioxide and other gases emitted during the cutting and burning of forests for the purposes of conversion of lands for timber production, agriculture, pastoral use, and related set-tlement. Climate change cannot be slowed significantly, and the climate cannot be stabilized, without large reductions in emissions from fossil fu-els and strong measures to curb deforestation.

Consequences of Climate Change

There are two general sources of uncertainty in projecting future climate change. First, estimates of future emissions of the greenhouse gases vary widely, although most projections envision emissions continuing to grow for at least the first half of this century. The second source of uncertainty arises from our limited understanding of the climate system, particularly the responses (called feedbacks) of the individual components of the

37

Diff

eren

ce fr

om 1

961-

1990

(mm

)(a) Global average surface temperature

(b) Global average sea level

(c) Northern Hemisphere snow cover

(˚C)

Tem

pera

ture

(˚C)

(mill

ion

km2 )

(mill

ion

km2 )

Year

Fig. 2.1. Changes in temperature, sea level, and Northern Hemi-sphere snow cover. Observed changes in (a) global average surface temperature, (b) global average sea level from tide gauge and satel-lite data, and (c) Northern Hemisphere snow cover for March–April. All differences are relative to corresponding averages for the period 1961–1990. Smoothed curves represent decadal averaged values, while circles show yearly values. The shaded areas are the uncertainty intervals estimated from a comprehensive analysis of known uncertainties (a and b) and from the time series (c). (Source: Climate Change 2007: Synthesis Report; Contribution of Working Groups I, II, and III to the Fourth Assessment Report of the Intergov-ernmental Panel on Climate Change, Figure SPM.1, IPCC, Geneva, Switzerland)


Earth system — including clouds, ice sheets, and ocean circulation — to the initial greenhouse warming. The range of possibilities is enormous.

If prompt action is taken to stem emissions, it remains possible that a modest additional global warming of not much more than 1°C would occur. Even if limited to this level, such warming would be greater and faster than any global climate change during the history of civilization, and would doubtless cause disruption of ecosystems and risk of extinc-tion of some species, as well as problems for many nations, especially de-veloping countries in coastal or semi-arid regions. On the other hand, un-constrained emissions would lead to a warming that could reach as high as six degrees, which would present us with an unmitigated worldwide disaster.

Either of these scenarios, and any in between, would be expected to result in intensification of all of the current climate trends. Atmospheric warming has already resulted in a mean ocean temperature increase of nearly 0.8°C. Polar ice sheets in Greenland and Antarctica are shrinking at their peripheries. Summer Arctic sea ice is retreating, opening naviga-tion routes around the North Pole. The 2007 Report of the Intergovern-mental Panel on Climate Change (IPCC) estimates that a global warm-ing of about 3 – 4°C by 2100 (in the middle of the projected range) would cause the Arctic to become largely free of summer ice, while more re-cent estimates suggest this outcome could occur before midcentury. The oceans are becoming more acidic as they absorb some of the carbon di-oxide added to the atmosphere. The resulting effects are likely to trans-late into increased difficulty for shell-forming organisms, like coral, and substantial effects on marine ecosystems, food chains, and all those that depend on them, including humans.

With a somewhat lesser degree of certainty, we can say that extremes of heat and drought have increased. When precipitation does occur, there is a tendency for it to fall with greater intensity, increasing the potential for flooding. The IPCC indicates that a 3 – 4°C warming and associated drought probably would significantly reduce agricultural productivity in developing countries in the tropical and subtropical regions, where malnutrition and episodic starvation are already endemic. Of particular concern is the potential reduction of water available on the Asian sub-continent as Himalayan glaciers shrink, with the outcome that some of the major rivers, including the Ganga, may maintain significant flow only seasonally. Extreme heat waves of the sort that struck Western Europe in 2003 — associated with the deaths of at least 35,000 people — would

Understanding the Causes and Implications of Climate Change 39

become the norm rather than a rare occurrence, and even more extreme events are expected to occur. While human ability to adapt to such im-pacts may improve over time, it is likely that many other species will fail to adjust successfully. The IPCC estimates that 30% or more of all species will become at risk of eventual extinction at a persistent warming below 3 – 4°C.

Perhaps the broadest threat from a geographic perspective relates to the projected rise in sea level. IPCC’s projection, a rise of 18 – 59 cm over this century, accounts for two of the three major drivers of sea level rise: expansion of ocean water and melting of glaciers. However, it does not fully account for the potential contribution from ice sheets because, at the time, there was no satisfactory way to do so. But over the past two years, a variety of preliminary estimates of how large the contribution from

F-gases1%

CO2 (fossil fuel use)57%

CO2 (other)3%

CO2 (deforestation, decay of biomass, etc)

17%

CH4

14%

N2O8%

Fig. 2.2. Global anthropogenic GHG emissions (2004). (Source: Climate Change 2007: Mitigation of Climate Change; Working Group III Contribution to the Fourth Assessment Report of the Intergovernmental Panel on Cli-mate Change, Figure TS.1b, Cambridge University Press)


the ice sheets of Greenland and Antarctica may become have appeared in the literature, resulting in a possible total sea level rise of as much as 1 – 2 meters during this century, with a further multi-meter increase dur-ing the remainder of the millennium. Such a sea level rise would devas-tate wetlands; obliterate many low-lying, densely populated deltaic areas, including much of Bangladesh; and wreak havoc along coastlines in the developed world as well, where monumental amounts of permanent in-frastructure would be at risk, forcing a costly (if gradual) retreat. A sea level rise of this sort appears to have occurred in the distant past when Earth warmed to similar levels, but at that time fixed human settlement had not yet evolved and retreat would have been far easier.

A close examination of the full range of potential impacts indicates that the most serious risks begin to increase markedly once warming ex-ceeds 1 – 2°C above recent temperatures. Based on such findings, the EU has adopted a long-term objective of limiting warming to no more than 2°C above recent temperatures (corresponding to about 1.2°C above pre-industrial temperatures). This goal was endorsed by the major emitting countries, both developed and developing, meeting in July 2009 at an un-usual joint conference held at the annual G-8 meeting.

The opportunity to avert such a warming shrinks markedly with every year of further delay in reducing emissions. Of particular concern is the rapid growth in emissions from large developing countries like China, In-dia, and Brazil. Unless developed countries are able to reduce their emis-sions substantially over the coming decade as a first step, and unless de-veloping countries are able to lower their emissions significantly below business as usual expectations during the following decade, there is little chance that such a warming would be averted.

Responses to Climate Change

With these concerns in mind, we should quickly develop and implement policies and institutions (both internationally and domestically) to rapidly change our carbon emissions trajectory and provide the means to cope with the inevitability of some additional warming. These include:

1. Institutions and financing that would facilitate adaptation — already a key issue — even in developed countries.

Understanding the Causes and Implications of Climate Change 41

2. Policies that would effectively impose a continuously increasing price on carbon. Such policies must include a stringent cap in the 2020 timeframe, along with subsequent reductions on emissions from all developed countries. The US, Canada, Australia, Japan, and many European countries have yet to act to reduce their emissions.

3. A collaborative decision on the part of countries with large emis-sions on the respective roles and responsibilities of developed and developing countries in achieving emissions limitations, along with adoption and implementation of a treaty that embodies these con-cepts in specific numerical obligations, accompanied by enforcement provisions and appropriate financing mechanisms. Rapid agreement on reduction of deforestation is an important supplement to limita-tions on fossil fuel emissions.

4. Funding and collaborative arrangements sufficient to provide in-centives for research and development, and commercialization of emerging low-carbon technologies.

These objectives offer a stark challenge requiring immediate and focused attention by governments. An honest reading of the scientific evidence provides no excuse for hesitation. Prompt and effective action to reduce emissions is our only option.

F u r t h e r R e a d i n g

Intergovernmental Panel on Climate Change, Fourth Assessment Report (2007), Full Report available at http://www.ipcc.ch/pdf/assessment-report/ar4/syr/ar4_syr.pdf, Summary for Policymakers available at http://www.ipcc.ch/pdf/assessment-report/ar4/syr/ar4_syr_spm.pdf.

http://www.ipcc.ch/pdf/assessment-report/ar4/syr/ar4_syr.pdf

http://www.ipcc.ch/pdf/assessment-report/ar4/syr/ar4_syr.pdf

http://www.ipcc.ch/pdf/assessment-report/ar4/syr/ar4_syr_spm.pdf

http://www.ipcc.ch/pdf/assessment-report/ar4/syr/ar4_syr_spm.pdf

42 Climate Finance

Chapter 3

The Climate Financing ProblemFunds Needed for Global Climate Change

Mitigation Vastly Exceed Funds Currently Available

Bert MetzSenior Fellow, European Climate Foundation

Key Points

• EvenassumingambitiousGHGreductionsbydevelopedcountries,large additional reductions in developing country emissions will be required in order to limit global warming to 2°C. This pathway re-quires global emissions to peak no later than 2015, and to fall 50% from 1990 levels by 2050, split so that developed nations shoulder the majority of the burden.

• In developing countries, some of these reductions have negativecosts, such as energy efficiency in buildings, transport, and industry. Many areas have moderate positive costs (agriculture and forestry), and technology-intensive sectors (notably renewable energy) require significant funding.

• Onthebasisoftheprincipleofcompensationforincrementalcostsby developed countries, a total of €65 – 100 billion annually over the 2010 – 2020 period is needed to finance these reductions and meet developing countries’ adaptation needs. However, these cost figures do not capture the significant positive externalities throughout so-ciety from low-carbon investment such as increased employment, heightened energy security, improved agricultural productivity, and improved infrastructure.

The Climate Financing Problem 43

Background

The latest assessment of the Intergovernmental Panel on Climate Change (IPCC) clearly shows that climate change risks will be manageable if global mean temperatures do not increase more than 2°C above the pre-industrial period. This requires a global trajectory towards stabilization of greenhouse gas (GHG) concentrations in the atmosphere of 450 ppmv CO2 equivalent (CO2e) to give us even a 40 – 60% chance of meeting the 2°C target. This requires global GHG emissions to start declining no later than 2015 and fall to 50% below 1990 levels by 2050. For the period end-ing in 2020, this translates into a global emissions reduction of 17 Gt CO2e compared to business as usual (BAU) by 2020 (see Figure 3.1).

Existing technologies can achieve over 90% of the global emissions re-ductions needed by 2020. Technology costs are already rapidly declining, and new technologies will further reduce costs and increase effectiveness. The costs of low-carbon transition are manageable. If the savings from negative cost mitigation actions can be effectively captured through intel-ligent regulation and incentives, the costs of more expensive investments

Global GHG emissions, Gt CO2e per year

44

61

52

70

45

40

0

75

20302020201020001990

450 ppm pathway

BAU

35

70

55

60

65

50

-35-17

Fig. 3.1. 17 Gt of reductions below the reference pathway in 2020 are required to stay on a 450ppmv pathway. (Source: McKinsey Global GHG Abatement Cost Curve v2.0 (2009); M. G. J. Den Elzen and M. Meinshausen, Multi-gas emission pathways for meeting the EU 2°C climate target, 2006; IEA World Economic Out-look 2007; Project Catalyst analysis)

44 Bert Metz

can be offset. The main question of this essay is, “what level of financing will make achieving these reductions possible?”

Developed and Developing Country Contributions

Equity demands that developed countries need to realize substantial emis-sion reductions by 2020 of 25 – 40% below 1990 on average (with differen-tiation amongst them). We do not have the luxury of time to enter into a global climate agreement where developed countries move first and de-veloping countries follow on behind. Developing countries need to deliver the rest of the reductions in order to meet the overall global emissions freeze and decline. According to scientific analysis, developing countries’ emissions should be 15 – 30% below the BAU baseline by 2020. The ques-tion is, how this can be realized in a way that is consistent with the nego-tiation mandate that was agreed upon in Bali in December 2007 (the Bali Action Plan), and that is fair to developing countries with their generally low incomes and limited responsibility for current climate change?

Project Catalyst assumes that developing countries implement their contribution in the form of a low-carbon development plan — made up of nationally appropriate mitigation actions (NAMAs) — that steers their economies towards a low-emission, sustainable economy over a longer period of time through specific NAMAs. This ensures that climate change mitigation is a development-oriented transformation of the economy that would enable countries to avoid large negative impacts from further cli-mate change. It would also have many benefits for energy security, health, employment, mobility, and competitiveness.

The Funding Needed by Developing Countries

Based on this notion of low-carbon development, estimates have been made of the incremental costs of capturing the opportunities for energy efficiency improvement in buildings, transportation, and industry; mov-ing to a low-carbon energy supply and reducing deforestation; improv-ing sustainable forest management; and moving to sustainable agriculture. Figure 3.2 shows the McKinsey cost curve for the group of developing countries. Costs of measures are expressed in euro per tonne of CO2e avoided, based on social rates of return (4%). These costs are the costs for the society, not the costs for private investors.


The curve shows many opportunities (approximately one-third of the required reductions) with negative costs, meaning they pay for themselves because of saved energy costs, mostly in buildings, transportation, and in-dustry, with an average rate of return on investment of 17%. For the ag-riculture and forestry sector, most options have moderate positive costs. Power sector costs are generally higher. Some emerging technologies, such as solar PV and concentrated solar power, have even higher costs, given their current state of development.

Investment in all of these sectors — especially the second — also has a strong record of stimulating growth across the economy through similar historical analogies (railroads and electrification, for example) and recent data on green job creation and its positive effects on society, and these benefits are not fully borne out by the cost curve above. These benefits include increased energy security, reduced energy prices and volatility in the long term, reduced vulnerability to energy price shocks, and reduced pollution from particulates.

Based on this cost curve, the total incremental cost (i.e., the total of all positive cost measures) for developing countries can be calculated. The negative costs are not subtracted because in most cases government poli-cies and measures are needed to capture the negative cost potential; these

8

Abatement potentialGt CO2e

0

20

40

60

-20 10 12 142 4 60

-80

-60

-40

Cost of abatement € / tonne

Energy efficiency, in buildings, transportation and industry requires financial support to overcome barriers (loans, best practice info, capacity building)

Demonstrations and investment in emerging technologies requires support to compensate incremental costs (grants) and international cooperation

Power supply, agriculture and forestry requires financial support to compensate incremental costs (grants and carbon market); best practice info

1 32

Fig. 3.2. Different financial support for different areas of the cost curve. Develop-ing country abatement cost curve, 2020 (up to costs of €60/t). (Source: Project Catalyst analysis; McKinsey Global GHG Abatement Cost Curve v2.0 (2009))

46 Bert Metz

will require substantial action from developing countries and even inter-national support in the form of capacity building or loans to overcome up-front capital constraints.

Adding up the incremental costs for the period 2010 – 2020 gives an av-erage total of €35 billion per year. Allowing a higher rate of return in de-veloping countries and covering transaction costs and specific funding for emerging technologies brings the total to €55 – 80 billion annually. To this total, the incremental costs of adaptation measures in developing coun-tries need to be added. Catalyst estimates these adaptation costs at €10 – 20 billion per year on average for the period 2010 – 2020, just for knowledge development, disaster management, and planning, with significantly more after this timeframe. This brings the overall amount of funding needed to support developing countries in making their contribution to an ambi-tious Copenhagen agreement and adapting to climate change to €65 – 100 billion per year (see Figure 3.3).

Cost of 12 Gt of developing countries abatement

Adaptation cost (knowledge, planning and preparation, disaster management in all developing countries, climate resilient development in vulnerable countries)

* Assumes all abatements delivered at average cost; 4% discount rate

** Based on increased financing for global public goods (including research), expected funding required priority investments for vulnerable countries (based on NAPA cost estimates), and provision of improved disaster support instruments (based on MCII work)

Adaptation cost (climate resilient development in other developing countries)

35

Additional cost for higher developing country financing rate (10%)

10

Required flows for abatement at cost to society*

Total financing requirement for abate-menti n developing countries

2-9

5-30

7-11

Estimated transaction costs of €1-5 per tonnecarbon abated

10-20

5

Adaptation cost estimate**

55-80

2-9

Financing need for high cost technology deployment

7-1155-80

65-100

Total financing requirement for developing countries

€ billion on average per year 2010-20

~~

Fig. 3.3. Developing countries would require up to €65–100 billion per year in incremental cost financing. (Source: McKinsey Global GHG Abatement Cost Curve v2.0 (2009); V. Bosetti et al. “International energy R&D spillovers and the economics of greenhouse gas atmospheric stabilization,” Energy Economics 30(6) (2008); UNFCCC; Project Catalyst analysis)



Intergovernmental Panel on Climate Change, Climate Change 2007: Synthesis Report; Contribution of Working Groups I, II, and III to the Fourth Assess-ment Report of the Intergovernmental Panel on Climate Change (2007), avail-able at http://www.ipcc.ch/publications_and_data/publications_ipcc_fourth_assessment_report_synthesis_report.htm.

McKinsey and Company, Pathways to a Low Carbon Economy (2008), available at https://solutions.mckinsey.com/climatedesk/CMS/Default.aspx.

Netherlands Environmental Assessment Agency, “Chair’s Summary Report: Where Development Meets Climate: Development Related Mitigation Op-tions for a Global Climate Change Agreement,” available at http://www.pbl.nl/en/dossiers/Climatechange/Publications/International-Workshop-Where- development-meets-climate.html.

Project Catalyst, Towards a Global Climate Agreement: Synthesis Briefing Paper June 2009, available at http://www.project-catalyst.info.

http://www.ipcc.ch/publications_and_data/publications_ipcc_fourth_ assessment_report_synthesis_report.htm

http://www.ipcc.ch/publications_and_data/publications_ipcc_fourth_ assessment_report_synthesis_report.htm

http://www.pbl.nl/en/dossiers/Climatechange/Publications/International-Workshop-Where-development-meets-climate.html



http://www.project-catalyst.info

http://www.ipcc.ch/publications_and_data/publications_ipcc_fourth_assessment_report_synthesis_report.htm

48 Climate Finance

Chapter 4

The Future of Climate GovernanceCreating a More Flexible Architecture

Daniel BodanskyEmily and Ernst Woodruff Professor of International Law,

University of Georgia School of Law

Key Points

• To ensure greaterparticipation, it is essential to allowgreaterflex-ibilityforstatestomitigateclimatechangeontheirownterms.

• Nationalmitigationactionswillneedtobeintegratedintoaninter-nationalagreementtoensureenvironmentaleffectiveness.

• As the recent proposals from theUnited States andAustralia sug-gest, flexibility in deciding on climate commitments is not just aconcernofdevelopingcountries.

Everyone wants to learn from history, so as not to repeat it. But whatare the lessons of the Kyoto Protocol? Although opinions differ widely,agrowingconsensusaccepts theneed forgreaterflexibility inanewcli-matechangeagreement.TheKyotoProtocoltargetscoveronlyaboutone-quarter of global emissions. Perhaps the central challenge for a new cli-mateagreement is tobroaden thiscoveragebygetting theUnitedStates,China, and other major emerging economies on board. Giving statesgreater flexibility in their choice of commitments will not, by itself, beenough. However, it couldmake a new agreement more attractive to awidergroupof statesbyallowing them, in settingcommitments, to takeintoaccounttheirdifferingnationalcircumstances,viewsofinternationalcommitments, domestic political processes, legal backgrounds, and eco-nomiccosts.

The Future of Climate Governance 49

Flexibility in the Context of Climate Change

International agreements vary widely in the latitude that they give par-ticipating countries. At one end of the spectrum, some agreements take a uniform top-down command approach, requiring states to undertake particular policies and measures. At the other extreme, agreements can adopt a highly flexible bottom-up approach, allowing each of the partici-pating states to define its own commitments. In the environmental realm, the Convention on International Trade in Endangered Species (CITES) illustrates the top-down approach. It prescribes which species to protect and how to do so (through a permitting system for imports and exports). Similarly, the international oil pollution treaty (MARPOL) prescribes very specific rules regarding the construction and design of oil tankers. Con-versely, the US-Canada Air Quality Agreement illustrates a bottom-up ap-proach, codifying in an international agreement the pre-existing domestic air pollution programs of the two participating states.

When it was adopted, the Kyoto Protocol was hailed by many for its flexibility. Rather than requiring states to adopt particular policies and measures such as efficiency standards, the Kyoto emissions targets give states freedom in deciding how to reduce emissions and (to a limited de-gree) when and where to do so. But although Kyoto gives states freedom in deciding how to implement their commitments, it does not give them similar flexibility in defining their commitments. Instead, it prescribes a single type of international commitment (absolute emissions targets rela-tive to a fixed historical baseline), the scope of those targets (economy-wide), the gases covered (a basket of six greenhouse gases), and the in-ternational offsets that can count towards meeting the targets (certified emission reductions created through the collective decisionmaking of the Clean Development Mechanism (CDM)). As a result, states that are wor-ried about the risks to economic growth posed by an absolute, economy-wide emissions cap, or that wish to focus on a particular sector or gas, or that prefer to adopt a price-based rather than a quantity-based instrument (that is, a tax rather than a quantitative cap on emissions) are effectively excluded from the regime.

Flexibility in the choice of commitments is particularly important in the climate change regime because of the huge domestic sensitivities in-volved — much greater than the sensitivities raised by any prior interna-tional environmental issue. Climate change implicates virtually every area of domestic policy, including industrial, agricultural, energy, transpor-

50 Daniel Bodansky

tation, and land-use policy. Building domestic coalitions to address the problem will require many compromises (as the drafting of US climate change legislation currently illustrates). A new international climate agree-ment needs to encourage states to do more, but it also needs to give states the necessary space for their domestic political processes to unfold. The importance of flexibility has long been recognized for developing coun-tries in articulating nationally appropriate mitigation actions. But, as the United States and Australian proposals in the Copenhagen negotiations emphasized, it is also of concern to developed countries.

A Growing Consensus

The need for greater flexibility was a central conclusion of the Climate Dialogue at Pocantico, a group of policymakers and stakeholders from 15 countries convened by the Pew Center on Climate Change. As the Pocan-tico report explained, “the types of policies that can effectively address greenhouse gas emissions in a manner consistent with national interest will by necessity vary from country to country. To achieve broad partici-pation, a framework for multilateral climate action must therefore be flex-ible enough to accommodate different types of national strategies by al-lowing for different types of commitments. It must enable each country to choose a pathway that best aligns the global interest in climate action with its own evolving national interests.”1

A Flexible Approach: The US and Australia Proposals

What might a more flexible approach entail? The United States’ proposal for an implementing agreement suggests one option.2 It envisions devel-oped countries committing to emissions targets, but allows them to imple-ment their commitments “in conformity with domestic law.”3 Although the meaning of this phrase is not altogether clear, it appears to allow de-veloped countries, through their national legislation, to specify their tar-gets in somewhat different ways. Of course, for the international targets to have any determinate meaning, there must be limits to these national variations. But, within reasonable bounds, a new climate regime should recognize the reality that developed countries may decide to define their

The Future of Climate Governance 51

targets differently in their national legislation — for example, with respect to precise sectoral coverage, base years, or allowable offsets.

A potentially broader type of flexibility is illustrated by an Australian proposal to establish schedules of national commitments and actions, which is similar to the nationally appropriate mitigation action (NAMAs) registry proposal of Korea.4 Rather than defining commitments through a top-down negotiating process, as in Kyoto, states would engage in a bottom-up process, in which they would develop national schedules of commitments and actions and then register those commitments and ac-tions internationally. As the Australian proposal explains, the schedule approach would “give Parties substantial flexibility to craft commitments and actions in a manner appropriate to their national circumstances.” Schedules could include both legally binding commitments as well as non-binding actions. The Australian proposal suggests that developed country schedules should include comparable mitigation efforts, includ-ing emission targets, while developing country schedules could include other types of commitments or actions, such as sectoral targets or par-ticular policies and measures.

Balancing Flexibility and Effectiveness

As both the US and Australian proposals recognize, in providing for greater flexibility, it is important to retain elements of integration in the new regime. A system of pledge and review, in which each state merely comes forward with its own national programs, would be extremely flex-ible, but it would not produce a sufficient level of effort. States may be unwilling to put forth their fullest effort unless they are confident that those efforts will be reciprocated by others at a roughly comparable level. Although states should have a certain degree of flexibility in their choice of commitments and actions, these commitments and actions need to be negotiated together and integrated into a single international regime, to promote reciprocity and coordination of national efforts.

To the extent that states undertake different types of commitments and actions, this will make the task of ensuring the comparability of ef-forts among countries even more challenging and urgent than under an exclusively targets-based approach. In the Bali Action Plan negotiations, states have proposed a wide array of criteria to assess the comparability of

52 Daniel Bodansky

developed country commitments. These include: the form and nature of commitments (legal vs. non-legal, quantified vs. unquantified); their com-prehensiveness and duration; a country’s absolute and per capita levels of emissions, emissions reduction potentials, geography, resource endow-ment, economic structure, and historical responsibility; and provisions for third-party review and compliance.5 Although agreement on a common methodology or formula to assess comparability of efforts seems unreal-istic, much more analytical work is needed to enable countries to make their own individual assessments of one another’s efforts in order to reach a politically acceptable outcome.

Conclusion

Is breaking the impasse on climate change merely a matter of elaborat-ing a more flexible architecture? Obviously not. Flexibility is a necessary but not a sufficient condition for agreement. States first must have the po-litical will to act. The point of flexibility is to avoid creating obstacles to agreement, so that, when states do decide to act, they have the freedom to move forward in a manner that makes sense for them.


Daniel Bodansky and Elliot Diringer, Towards an Integrated Multi-Track Climate Framework (Pew Center on Global Climate Change, 2007).

Pew Center on Global Climate Change, Report of the Climate Dialogue at Pocan-tico (2005).

N o t e s

1. Report of the Climate Dialogue at Pocantico (Washington, DC: Pew Center on Global Climate Change, 2005), p. 9.

2. “US Submission on Copenhagen Agreed Outcome,” UN Doc. FCCC/AWGLCA/2009/Misc.4 (Part II), p. 106.

3. Id., art. 2.1(a).4. “Schedules in a Post-2012 Treaty,” Submission of Australia, UN Doc. FCCC/

AWGLCA/2009/Misc.4 (Part I), p. 22.5. See Revised Negotiating Text, FCCC/AWGLCA/2009/INF.1, paras. 55 – 59.

Part II

Proposals for Climate FinanceRegulatory and Market Mechanisms and Incentives

A

Trading or Taxes?

Climate Finance 57

Chapter 5

Cap-and-Trade Is Preferable to a Carbon Tax

Nathaniel O. KeohaneDirector of Economic Policy and Analysis,

Environmental Defense Fund

Key Points

• Contrarytotheviewsofmanyeconomistsandpolicyanalysts,cap-and-tradesystemsaresuperiortotaxesforlimitingGHGemissions.

• Thekeyadvantageofcap-and-tradeoveracarbontax is thatacapputs a direct limit on the quantity of emissions, while letting themarketdeterminetheprice.Thisensuresnotonlythattheenviron-mentalobjectiveismet,butalsothatthepoliticalandsocialdebatearound a cap-and-tradeprogram is appropriately focusedon envi-ronmental goals.

• Cap-and-tradefacilitates internationalharmonizationandcoopera-tiononclimatepolicy, therebyreducing thecostsof limitingemis-sionsonaglobalbasis.Cap-and-tradeeasilyaccommodateslinkagesbetweennationalemissionstradingsystemsthatwill inturnequal-izethemarginalcostofabatementacrossthesecountries.Cap-and-tradecanalsoprovideincentivesfordevelopingcountriestoreduceemissions in order to gain access to carbonmarkets in developedcountries.

• Proponentsof carbon taxesoftencriticizecap-and-tradebecause ittypically involves freeallowanceallocations.But frombothaneco-nomicandenvironmentalperspective,howallowancesareallocatedislessimportantthanthestringencyofthecap.Further,thealloca-tion of allowances fulfills a potential political function in buildingsupportforasystemthatputsapriceoncarbon.

58 Nathaniel O. Keohane

Background

Firstproposedin1968,cap-and-tradecameintoitsownin1990withthepassage of theUSCleanAir Act Amendments, which created an emis-sions trading system for sulfur dioxide emissions from electric powerplants.Thatprogramhascutemissions inhalfat less thana thirdof thepredictedcost,withoverwhelmingbenefits tohumanhealthandecosys-tems.1Sincethen,theEuropeanUnionhasestablisheditsEmissionTrad-ingScheme(ETS) forcarbondioxide(CO2) toachieve itsemissions tar-gets under the Kyoto Protocol. And cap-and-trade is the centerpiece ofclimatelegislationunderconsiderationintheUSCongress.Despitethesesuccesses, calls for a carbon tax still abound.This chapter compares thetwo policy instruments and argues that a cap-and-trade system is supe-riorforcontrollinggreenhousegas(GHG)emissions,onpolitical,policy,andeconomicgrounds.

Underacap-and-tradeprogram, total allowableemissionsare limited(thecap),andanequivalentnumberofallowancesarecreated,whichmaybe bought or sold on amarket (the trade). At the end of each compli-anceperiod,eachregulatedfacilitymustsubmitallowancesinanamountequal to itsemissions. Inmanysystems,firmsmayalsobankallowancesfor use in later years, or borrow them in limited amounts from futureperiods.

Both a cap-and-trade systemand a carbon taxput a price on carbon—giving polluters strong economic incentives to reduce pollution cost-effectively, and creating a powerful reward for technological innovation.Bothpolicy instrumentsalsotakeadvantageof the informationavailabletoindividualagents,ratherthanrelyingonthelimitedknowledgeofreg-ulators to identify andmandate facility-level performance requirementsortheuseofspecifiedtechnologies.

Intheory,ifthemarginalcostsofabatementarestaticandknownwithcertainty,andintheabsenceofanypoliticalconsiderations,acarbontaxand cap-and-trade program can be designed to be perfectly equivalentwith respect to the allocation of abatement across firms, the marginalpriceofemissions,andtherealeconomiccostsofachievingagivenemis-sions target.2Acap-and-tradesystemandacarbontaxarealsosimilarintermsofadministrativecosts(thecostsofoperatingatradingmarketarerelativelyminimal),andrequire thesameamountandaccuracyofemis-sions data to monitor and enforce compliance.

Cap-and-Trade Is Preferable to a Carbon Tax 59

Raising Revenue

Despite their theoretical similarities, cap-and-tradeandacarbon taxex-hibit important differences in practice.One commonly cited distinctionis that a tax raises government revenue, while cap-and-trade programshave typically involved generous allocations of free emission allowancestoregulatedentities.(Notethatwhilefreeallocationisacommonfeatureofcap-and-tradeprograms,itisnotanecessaryone:emissionallowancescouldalternativelybesoldatauction, raising thesameexpectedrevenueasatax.)

From an economic perspective, whether the government raises reve-nue is lesssignificant than itmayappear.Whatmattersmore ishowtheeconomicvaluerepresentedby theallowances isallocated.Economicef-ficiency can be enhanced by auctioning allowances (or imposing taxes)toraiserevenueandusingittoreducepre-existingdistortionarytaxesonlabor and capital3—butonly ifpoliticiansarewilling to reducemarginaltax rates rather than spending the revenueonper capita rebatesorgov-ernment programs.

Ifrevenueisnotrecycledsoastoreducesuchdistortions,howtheeco-nomicvalue inallowances isallocatedhas implicationsfordistributionalincidence—butnot for efficiency. Free allocation, by itself, doesnotun-derminetheenvironmentaloreconomicperformanceofacap-and-tradesystem:thatperformancedependsontheincentivescreatedbytheallow-anceprice,whichisafunctionofthestringencyofthecapratherthanthemethod of allowance allocation.On the other hand, free allocation is apowerfulpoliticaltool,offeringareadymeansofcalibratingthetrade-offamong different interests.This political flexibility is likely tomake cap-and-trademore effective than a carbon tax in accommodating politicalrealities while still accomplishing the ultimate goal of controlling GHGemissions.

Price vs. Quantity

Amuchmore fundamentaldifferencebetween cap-and-trade anda car-bon tax is the distinction between setting a price and controlling quan-tity. Under a cap-and-trade program, the total quantity of cumulativeemissions—andthustheenvironmentalperformanceoftheprogram—is


fixed.Thepriceofemissionsisuncertain,however:it isgeneratedbytheallowance market, determined by factors such as the stringency of thecap, the pace of technology development, the prices of fossil fuels, andenergydemand.

Incontrast,acarbontaxdeterminesthepricedirectly,butleavesactualemissionsuncertain—dependentonfactorssuchastherateofeconomicgrowth,thecostandavailabilityofabatementtechnology,andpoliciesad-opted inother jurisdictions (which set the international termsof trade).As a result, a taxmay not achieve—indeed, is unlikely to achieve—anyparticularlevelofcumulativeemissionsspecifiedinadvance.

This prices vs. quantities distinction is important for several reasons.First,thegoalsofclimatepolicyarecommonlydefinedintermsofquan-tity targets: temperature changes, GHG concentrations, or cumulativeemissions.While some economists have advocated setting a price equalto the marginal damages from emissions, we simply lack the necessaryinformationtodoso.ArecentsurveybytheIntergovernmentalPanelonClimateChange (IPCC) found that estimates ofmarginal damages varyby a factorof 30, fromUSD3 toUSD95permetric tonneofCO2, andthatmanyofthoseestimatesignorenon-marketdamagesandcatastrophicimpacts.4

Second, framing the issue in terms of price or quantity leads to verydifferent debates about policy objectives. A proposal to tax emissionsfocuses the debate on the size of the tax and the potential costs to theeconomy. In contrast, aproposal to capemissions frames thediscussionintermsofemissionstargetsandtheconsequencesofclimatechange.Asa consequence, cap-and-trade is likely to lead tomore ambitious emis-sionsreductiongoals,whileataxistantamounttoproposingalessstrin-gentpolicy.

Third,cap-and-tradeenhancestheprospectsforharmonizinginterna-tionalaction.AvertingdangerousclimatechangewillrequiredeepcutsinGHGemissionsbytheworld’sadvancedeconomiesaswellasmeaningfulreductionsfrommiddle-incomeanddevelopingcountries.Doingsoatthelowest possible cost, however, requires that themarginal costs of abate-mentbeequatedacrosscountries.Inthiscontext,cap-and-tradehasakeyadvantage over a carbon tax:marginal costs can be equalized simply bylinking allowancemarkets indifferent countries. Individual countries orregionsthatestablishdomesticcap-and-tradeprogramscan letregulatedfirmspurchase allowances fromother systems for compliancewith theirown,withminimalcoordination.Incontrast,achievingcost-effectiveness


through a harmonized carbon tax requires explicit international agree-mentuponacommontaxrate,anenormouspoliticalchallengeandmostlikelyunattainable.

Fourth,acap-and-tradesystemcanpromotebroadinternationalpartic-ipation.Carbonmarketsinthedevelopedworldwillbeapowerfulattrac-tor for emergingeconomies.These countries,whichare rich in low-costabatementopportunities,wouldbenet sellers in aglobal carbonmarket—givingthemastrongeconomicincentivetojoin.(Carbonmarketsthusservethegoalofequityaswellasefficiency,providingascalablemeansoffinancinglow-carbondevelopment.)Leadingdevelopingeconomiesreadyto take on domestically enforceable targets could take full advantage ofcarbonmarkets by linking their own cap-and-trade systems with thoseindevelopedcountries.Otherdevelopingcountries, lacking the capacitytoestablishcap-and-tradesystems in thenear term,couldparticipatebysellingoffset credits. In turn, theEUandUSwillhave considerable lev-erage to push for strong action on climate change, in return for carbonmarket access.An emissions tax provides neither such an incentive norsuchleverage.

Price vs. Quantity and Economic Efficiency

Although the arguments just outlined favor cap-and-trade, the distinc-tion between price and quantity instruments also provideswhat is typi-cally cited as the strongest economic argument for a carbon tax.Whenmarginal abatement costs areuncertain, the relative efficiencyof a priceinstrumentversusaquantityinstrumentdependsontherelativeslopesofthemarginal benefit andmarginal cost functions. Because themarginalbenefitsofreducingGHGemissionsaregenerallythoughttobeflatrela-tive to the marginal costs, many economists have concluded that a taxwillbepreferableonefficiencygrounds.

This argument hinges on the presumption that marginal benefits ofabatement are flat—equivalently, that the harm from emitting a ton ofgreenhouse gases stays roughly the same as emissions increase.Thisde-pends in turnon two(oftenhidden)assumptions:first, that therelevantpolicyproblemisoneofmanagingtheflowofemissions(forexampleonan annual basis); second, that policies are path-independent—in otherwords, that the initial choice of policy does not constrain subsequentpolicies.Neitherassumption is valid.Actual cap-and-tradeprograms for


GHG emissions would allow full banking and borrowing, setting a cu-mulative target rather than a series of annual targets.This approach iswell-suitedtoclimatechange,whereimpactsaredrivennotbyshort-termemissionsbutby theaccumulationof long-livedgreenhousegases in theatmosphere.Moreover,thedifficultiesandfixedcostsinvolvedinpassinglegislation,andthegradualadaptationofregulatedentitiestoestablishedpolicies,meanintherealworldthatthosepolicieswillbepoliticallydif-ficult tochange.Oncea framework isput inplace, it is likely toremain.Theseargumentssuggestthattheproblemoughttobedefinedintermsofconcentrations (or cumulative emissions over several decades), and thatpolicies should be assessed in light of their performance over a similartimehorizon.

Once the problem is defined in termsof cumulative emissionsundera long-lived policy framework, the nature of the damages from climatechange takes on new significance. Growing scientific evidence suggeststhatclimaticresponsestotemperatureincreasesarehighlynonlinearandcharacterizedbytippingpoints—levelsofwarmingthatwouldtriggerrel-atively rapid and irreversible changes inmajor componentsof theEarthsystem.ExamplesincludethelossofArcticsummerseaice,themeltingoftheGreenlandandWestAntarcticIceSheets,theweakeningoftheNorthAtlanticThermohalineCirculation,lossofcoralreefs,andthedisappear-anceoftheAmazonrainforest.Thesenonlinearitiesinthedamagesfromclimate change imply that themarginal benefits of abatement, far frombeing flat,may be relatively steep, whenmeasured in terms of cumula-tiveemissions.Theintuitionissimple:Whentheclimatesystemexhibitsthresholdeffects,andpoliciesarehardtochangeonceenacted,puttingalimitoncumulativeemissions ispreferable tosettingaprice, inorder toensurethatwedon’texceeddangeroustippingpoints.

Althoughtheprecisetemperaturesatwhichthesethresholdsoccurareadmittedly uncertain, such uncertainty compounds the concerns ratherthan alleviating them. We cannot rule out the possibility that we areheadedfortrulycatastrophicconsequences:Weitzman,forexample,esti-matesthatthereisa5%chancethatbusiness-as-usualemissionswillleadtoawarmingofmorethan10°Canda1%chanceofexceeding20°C.Theoverwhelmingimportanceofsuchfat tails intheprobabilitydistributionof harms diminishes the significance of the expected (average) welfaremaximization framework that underlies the prices vs. quantities argu-ment,whichfailstogiveadequateweighttorelativelylowprobabilitiesof


veryseriousharm.Instead,whatWeitzmancallshis“generalizedprecau-tionaryprinciple”dovetailswith themoregeneralargument thatclimatepolicy is best viewed in terms of riskmanagement. Even if these argu-mentsdonot(yet)provideatheoreticalargumentforcap-and-tradeovera carbon tax, they lend urgency to the practical arguments made here:namely, that a cap-and-trade program is amore promising approach toachieve the near-term emissions reductions needed to hedge the risk ofcatastrophe.

Conclusion

Thischapterhaspresentedthecaseforusingcap-and-trade,ratherthanacarbontax,tocontrolgreenhousegases.Asystemoftradablepermitsof-fersagreatdealofflexibilityinallocatingthevalueofemissions,enhanc-ingitspoliticalfeasibility.Cap-and-tradealsopromotescost-effectiveness,broad participation, and equity in the international context, withmuchlesscoordinationthanataxwouldrequire.Finally,controllingthecumu-lativequantityofGHGemissions is likely tobe superior to settinga taxeven on narrow economic efficiency grounds, given the importance oflimitingGHG concentrations below potentially dangerous thresholds intheclimatesystem.


Nathaniel O. Keohane, “Cap and trade rehabilitated: Using tradable permits tocontrolU.S.greenhousegases,”Review of Environmental Economics and Policy 3:1–21(2009).

GilbertE.Metcalf,“DesigningacarbontaxtoreduceU.S.greenhousegasemis-sions,”Review of Environmental Economics and Policy3(2009).

WilliamD. Nordhaus, A Question of Balance (NewHaven, CT: Yale UniversityPress,2008).

Robert N. Stavins, Proposal for a U.S. Cap-and-Trade System to Address Global Climate Change: A Sensible and Practical Approach to Reduce Greenhouse Gas Emissions, Hamilton Project Discussion Paper 2007-13. (Washington, DC:BrookingsInstitution,2007).

Gary Yohe, Natasha Andronova, and Michael Schlesinger, “To hedge or notagainstanuncertainclimatefuture?”Science306:416–17(2003).


N o t e s

1. National Acid Precipitation Assessment Program, National acid precipita-tion assessment program report to Congress: An integrated assessment(Washington,DC:NationalAcidPrecipitationAssessmentProgram,2005).

2. W.DavidMontgomery,“Marketsinlicensesandefficientpollutioncontrolprograms,”Journal of Economic Theory5:395–418(1972).

3. LawrenceH.Goulder,IanW. H.Parry,andDallasBurtraw,“Revenue-rais-ingvs.otherapproachestoenvironmentalprotection:Thecriticalsignificanceofpre-existingtaxdistortions,”RAND Journal of Economics28:708–31(1997).

4. G. W.Yoheetal.,“Perspectivesonclimatechangeimpactsandsustainabil-ity,” inM. L. Parry et al., eds., Climate Change 2007: Impacts, Adaptation, and Vulnerability; Contribution of Working Group II to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change (Cambridge,UK: CambridgeUniversityPress,2007),pp.811–41.

B

ReformingtheCleanDevelopment Mechanism(CDM)

Climate Finance 67

Chapter 6

ExpectationsandRealityofthe CleanDevelopmentMechanism

A Climate Finance Instrument between Accusation and Aspirations

CharlotteStreckDirector, Climate Focus

Key Points

• TheCDMhas,bymanyaccounts,met itsobjective in termsof thefundsithas leveragedfromtheprivatesectortoachievemitigationindevelopingcountries,thecapacityithasbuilt,andtheawarenessithasraised,nottomentionthelessonsithasprovided.

• Despitethesesuccesses,theCDMhasbeenroundlycriticizedfrommanyfrontsintermsofitsgovernancepractices,environmentalin-tegrity,andcontributiontosustainabledevelopment.

• TheCDMhas toomuch experience and future potential to justifyabandoningitinthepost-2012climateframework.Muchneededre-form,focusingonimprovingtheenvironmentalandadministrativecredentials of the scheme and an expansionof its scope and scale,will transformtheCDMintoa trulyuseful tool forsustainablede-velopmentandclimatepolicy.

Introduction

BorninthelasthouroftheKyotoProtocolnegotiationswithmodestex-pectations, theCleanDevelopmentMechanism (CDM) offers a story of

68 Charlot te Streck

unprecedented success. By June 2009, the CDM Executive Board (EB)registeredmorethan1,500projects thatareexpectedtocreate1.6billiontons of greenhouse gas (GHG) emission reductions by 2013.The CDMhasattractedtheinterestoftheprivatesectorinindustrializedanddevel-opingcountriesalikeandbuiltaglobalcarbonmarket.

The CDM initiated a paradigm shift in support of developing coun-try actionundermultilateral environmental treaties. In itsdesign,nego-tiatorsreliedheavilyonexperiencefromtheGlobalEnvironmentFacility(GEF)andtheMultilateralFundfortheimplementationoftheMontrealProtocol. They modeled the EB after the Multilateral Fund’s ExecutiveCommittee, and introduced the concept of additionality, closely relatedto the incremental cost principle of theMultilateral Fund and theGEF.AtthebehestoftheUS,negotiatorshoweverintroducedtwoinnovationsintheCDM’sdesign,makingitsoperationalcharacterfundamentallydif-ferent from those of the GEF and theMultilateral Fund: (i) investmentwas linked to tradable emission certificates; and (ii) private entities au-thorizedbyStatePartieswereinvitedtoparticipate.Byinvolvingmarketsand private actors, theKyoto Protocol leveraged significant financial re-sources for low-carbon investment indeveloping countries. In 2007 and2008alone,theCDMmobilizedUSD15billioninprimarytransactionsinCertifiedEmissionsReductions credits (CERs). In comparison, theGEF—the single biggest environmental trust fund and financial mechanismforfourinternationalenvironmentalconventions—receivedUSD3.13bil-lion in August 2006 from 32 donor governments for its operations be-tween2006and2010.

Despite these impressive figures, the CDM has not elicited the hap-piness or pride that onewould expect. Instead, it stands in a witheringcrossfireofcriticism.Somecomplain it fundsbusiness-as-usualprojects,failing to create real emission reductions. Others assail its governancepractices,or claim that itsprojectsare too small to incentivize themoresubstantiveemissionreductionsneededtoshifteconomiestowardalow-carbon development path. It is simultaneously too small and too ambi-tious, and it targets the wrong emission reductions or does not deliverthem at all.

Theextent of its successmay have contributed to these troubles.TheEB and independent verifiers cannot cope with the volume of techni-callydetailedworkgeneratedby thefloodofprojects,and industrializedcountriesfearthatmoreoffsetsareproducedthantheiremissiontradingschemescanabsorb,loweringtheirdomesticGHGabatementefforts.

Expectations and Reality of the Clean Development Mechanism 69

WithlessthansixmonthsbeforeUnitedNationsFrameworkConven-tiononClimateChange(UNFCCC)negotiatorsconveneinCopenhagentodecideon a future climate framework, it is time to evaluatewhichofthe criticisms are valid andwhich are expressions of general discontentwiththeKyotoProtocolortheconceptofoffsetting.Inthisbriefpaper,IassesswhethertheCDMhasmettheobjectivesinArticle12oftheKyotoProtocol and compare its performance with the expectations about therole of themechanism andwhat it can deliver. I conclude with a shortproposalofthemechanism’sroleinapost-2012climateframework,andIpresentareformagendatoachieveit.

Evaluation of Performance

The CDM’s purpose according to Article 12.2 of the Kyoto Protocol istwofold:

• To assist Parties not included in Annex I to achieve sustainabledevelopment and contribute to the ultimate objective of the Con-vention

• ToassistAnnexIPartiescompliancewithquantifiedemissioncutsandreductioncommitmentsunderArticle3oftheKyotoProtocol

ApplyingtheletteroftheKyotoProtocol,bothobjectiveshavebeenmet.First, it is a developing country’s prerogative to define whether a CDMprojectfallswithinitssustainabledevelopmentstrategywhenitapprovesthe project. Sustainable development is not defined by theKyotoProto-col or the decisions of theMeeting of the Parties, so all 1,671 registeredCDMprojects with host country approval are assumed to contribute tothe country’s sustainable development.The Kyoto Protocol simply doesnot leaveanyroomtosecond-guess theapprovalsandunderlyingpolicydecisionsofCDMhostcountries.

Second,theCDMcontributestoAnnexIcountries’abilitytomeettheiremission reduction targets. Since 2000, public and private entities fromindustrializedcountrieshaveusedtheCDMtolowerthecostsofcompli-ancewith the targets setby theKyotoProtocol.MostWesternEuropeangovernmentshaveestablishedCERpurchaseprogramsorauthorizedtheWorldBanktoacquirecarboncreditsontheirbehalf,andtheEUprivatesectorhaspouredmoneyintotheCDMtoreducethecostsofcompliancewiththeEuropeanUnionEmissionsTradingSystem(EUETS).


Thus, if theCDMhasachieved its legallydefinedobjectives,whatarethesourcesofgeneraldiscontentwiththemechanism?

Sources of Unhappiness

AcentralcriticismoftheCDMhascenteredonthenatureofsustainabledevelopment, and the different understandings of how theCDMcan orshouldcontributetoit.Cansustainabledevelopmenttaketheformofin-dustrialenergyefficiencyorlandfillgasdestruction,ormustitbeassoci-atedwithdecentralizedandsmall-scalemitigationandrenewableenergyprojects?Does it createunjustified economic rents, or does efficiency inmarginalabatementnotaffectthevalueofamitigationaction?Themostproblematicfeatureofdefiningsustainabledevelopmentisthat,whilethetermiswidelyused, itembodiessomanyconsiderationsandvalues thatneed to be balanced (social, economic, environmental, and ethical) thatitssubstanceisoftenhardtopindown.

Asamarketmechanism,theCDMsearchesforthecheapestemissionreductions, and it has been more effective in reducing mitigation coststhan in contributingmore broadly to sustainability. Yet, from a climatechange perspective, it is arguably more worrisome that the CDM hasnotmoveddevelopingcountries towardsustainable low-carbondevelop-mentpaths.Criticshavechallengedtheprerogativeofthehostcountrytodefine sustainable development and have expressed concern over CDMfundsgoing toprojectswith little sustainabledevelopmentbenefits (e.g.,destroyingindustrialgases).

A second significant issue is theCDM’sclimate change integrity.Thismechanism’s success is dependent upon real, measurable mitigation ofGHGemissions.Itiscrucialthatreductionsareadditionaltowhatwouldhave occurred otherwise. The EB’s interpretation of additionality hasbeendebated vigorously. Some authors claim thatmany registered proj-ectswouldhaveoccurredintheabsenceofCDMcertificationandawardofCERs,whileotherscomplainthat theEBisexcessivelystringent in itsassessmentofadditionality.TheEB’sadditionality test embodiesa coun-terfactual that can never be conclusively proven. As long as the CDMevaluates additionality through a test that is coupled with amotivationcriterion (why did you engage in the project, and did the CDM influ-ence your investment decision?), it is unlikely that a satisfactory solu-tiontotheseproblemswillbefound.Criticswillcontinuetoquestionthe


assertionsofprojectdevelopers thatCERsareessential,projectdevelop-ers will have trouble accepting a test which contradicts their entrepre-neurialspirit(requiringthemtoexplainwhytheprojectwillfailwithoutCERs), verifiersmistrust project developers and the EBmistrusts verifi-ers,andacademicswillcontinuetofindplentyofreasontochallengethewholesystem.

Toaddtothesecomplaints,theCDMdoesnotworkefficiently.Theap-provalprocess is ineffective, slow, andguidedbypolitical considerationsrather than factual competence.Themechanism has failed to develop aregulatory due process to guarantee fundamental fairness, justice, andrespect for property rights.The credibility of the CERmarket dependslargelyontherobustnessofitsregulatoryframeworkandtheprivatesec-tor’s confidence in the opportunities provided by the mechanism. Thisconfidence is at risk in the face ofmounting complaints about the con-tinuedlackoftransparencyandpredictabilityintheEB’sdecisionmaking.The governance structure should be reviewed and reformed, taking intoaccount the need to provide private-sector participants (not representedin the Conference of the Parties (COP)/Meeting of the Parties (MOP))with due process and to ensure the conditions for fair and predictabledecisions.

Finally,theCDMhasyettoproducetherequisitescaleofemissionre-ductions.Todate, incentiveshavebeen tooweak to foster the economictransformations necessary to prevent developing countries from follow-inghigh-emissiondevelopmentpaths.WhiletheCDMhasworkedwherecarboncanaddnew sourcesoffinance to investments inprivate-sector-driven projects, it has failed to mobilize emission reductions for largerpoliciesandprograms,includingdecentralizedsourcesofemissionssuchastransportorbuildingemissions.

Reasons to Keep the CDM

TheCDMhasleveragedmorefinanceintoGHGemission-reducingproj-ects in developing countries than any other international mechanism,morethanitsdesignerseveranticipated.ThereareotherreasonstokeeptheCDM:

• It enjoysbroad support amongdeveloping countries. Inparticular,poorer and smaller countries have established their nationalCDM


authorities only relatively recently and are just starting to engagewiththemechanism.Thereisariskoflosinggoodwillandcoopera-tionofdevelopingcountriesinabolishingamechanismthatenjoyswidespreadsupportandwhilecapacity-building toparticipate in itis still ongoing.

• It is a linchpin of the international carbon market, supporting acommunity of innovative investors and compliance credit buy-ers, and providing important lessons for scaled-up carbon tradingmechanisms.

• Ithasbeenvaluableincreatingawarenessofclimatechangeandca-pacities toaddress it amongsectorsand stakeholdersnotnormallyinvolvedinclimatepolicy.

• Itremainsausefultooltoprovideaccesstoprojectfinanceforemis-sion reductions inmostdeveloping countries, especially those thatarepoorerorsmaller,andforsomesectorsofemergingeconomies.

The CDM should therefore not be abandoned without considering theassociated political costs. The mechanism certainly needs reform, butshouldwedismissitasfailedexperiment,acorruptandflawedexpressionof dysfunctionalUNbureaucracy?Or shouldwe engage in a reasonablediscussionon a feasible reformagenda and ameaningful future role fortheCDM?

The Reform Agenda

TheCDMisinurgentneedofreform.Itneedsassistanceincreatingmoreambitiousandbroaderincentivesfordevelopingcountryemissionreduc-tions.Asecondgenerationofmarketandnon-marketmechanismsunderthe UNFCCC is needed.

CDMreformandexpansionshouldbebuiltonthreepillars:

1. TheCDM’s environmental credibility needs to be strengthened byreplacingtheEB’sadditionalitytestwithalternativetoolstoevaluateemission reductions, including clear criteria, sectoral benchmarks,approvedmulti-project or sectoral baselines, discount factors, andpositivelistsforcertainprojectclassesorprojectsinleastdevelopedcountries.AdecisionshouldbetakenaftertheEBorUNFCCChas


commissioned a study on the impact of the various proposals onthesupplyofemissionreductionsfromparticularregionsorprojectclasses.

2. IftheCDMistosurvivebeyondKyoto’sfirstcommitmentperiod,itsadministrativeproceduremustmeetinternationaldueprocessstan-dards. Private economic actor firmswill invest time and resourcesingenerating,monitoring,andcertifyingemissionsreductionsonlyif they are assured a reasonabledegreeof regulatory certainty.TheCDMgovernancewillhavetobeputontherighttrackforthesec-ond commitment period, enhancing the predictability of its deci-sionsandprivate-sectorconfidenceinthesystem.Professionalizingthe EB is an essential step. Full-time, salaried individuals, selectedon the basis of their technical and administrative expertise, withsufficienttechnicallyskilledsupportstaff,cangivetheEBtheneces-sary independence and resources to deal properly and impartiallywith a growing volume and complexity ofwork. In addition, a re-viewmechanism of the decisions of the EB should be established.Thiswould give project participants, and other entitieswith rightsand obligations under the CDM, the right to obtain review of EBdecisions.

3. Finally,expansionofboth thescopeandscaleof theCDMisvital.As a project-basedmechanism, it suffers from inherent barriers inpromoting broader policy change, in some instances even creatingperverseincentiveswhichdelayadoptionofmuchneededenviron-mentalregulatorymeasuresthatwouldreduceemissionsstandards.Therefore theCDMmustbesupportedbymoreambitioussectoralandpolicycreditingmechanisms.Inaddition,thereareanumberofstepsthatcanbetakentoallowtheCDMtobenefitruralandpoorcommunitiesmoreeffectively:

• Removalofbarriers toprogrammaticCDMprojectssuchasen-ergyefficiency,decentralizedelectricity,heatingandcookingso-lutions,transport,andagroforestryprograms.

• Removal of limitations on forestry, agricultural, and land-useprojects to allow for projects on landdeforested after 1990, andexpansion of covered activities to include projects that promotesustainable management and restoration of forests, peat, andgrasslands.


Conclusions

Cassandravoicespredicting theCDM’sdoom fail to recognize the criti-cal role that project-based offset mechanisms, including the CDM, willplay ina future climate regime.Theyare crucial to expanding the scopeof emission mitigation, leveraging private-sector investment, encourag-ing innovation,broadeningglobal support, andsecuringapoliticaldeal.TheCDM remains a valuable tool for incentivizing emission reductionsinsmallerandlow-emittingdevelopingcountries,anditshouldcontinueinsectorsthatdonotformpartofmoreambitiousGHGreductioneffortsin emerging economies.Where projects are implemented in the contextofbroaderGHGaccountingprograms,existingprojectscanbeconvertedandfollowJointImplementationaccountingrules.

However, to continue past 2012 theremust be reforms and improve-ments in its environmental and operational performance.These are es-sentialtocounteranalarmingtendencyamongEUandUSpolicymakersto call for the domestic design of international offset mechanisms. Since the demand for carbon credits ismainly generated by emission tradingschemesinindustrialcountries,thesecountrieshavethepowertodictatetherulesofthegame.If theydecidetowieldthispower,notonlywoulddevelopingcountries losemuchof their influence,but theCDMandtheCERmarket could find itself subject to amultitude of conflicting offsetstandardsfromWashingtonandBrussels.

Toomuchhasbeenlearned,andtoomuchremainsviable,forpolicy-makerstoabandonafunctionalprojectoffsetsystem.Outlinedaboveareonly a fewof the reasonswhywe should extend theCDM’s lifeline andwhy we should all be interested in a robust, credible, harmonized, anduniversalinternationaloffsetstandard.

F u r t h e r R e a d i n g s

Christiana Figueres andCharlotte Streck, “Enhanced FinancialMechanisms forPost2012Mitigation,”World Development Report 2010, Technical Background Paper,inpress.

Axel Michaelowa, Purohit Pallav, Additionality determination of Indian CDM projects: Can Indian CDM project developers outwit the CDM Executive Board? (London:ClimateStrategies,2007).

KarenHolmOlsen, “TheCleanDevelopment’sContribution to SustainableDe-velopment:AReviewoftheLiterature,”84Climatic Change1(2007).


Lambert Schneider, Berlin,Oko Institut, Is the CDM fulfilling its environmental and sustainable development objective? An evaluation of the CDM and options for improvement(2007).

CharlotteStreckandJoleneLin,“MakingMarketsWork:AReviewofCDMPer-formance and the Need for Reform,” European Journal of International Law (2008).

Michael Wara, “Measuring the Clean Development Mechanism’s PerformanceandPotential,”55UCLA Law Review1759(2008).

C

SectoralProgramsforEmissions Control and Crediting

Climate Finance 79

Chapter 7

WhyaSuccessfulClimateChangeAgreementNeedsSectoralElements

MurrayWardPrincipal, Global Climate Change Consultancy; Former Senior

Climate Change Negotiator, New Zealand Government

Key Points

• Sectoralelementssuchassectoralno-losetargets(SNLTs)andotherkinds of sectoral agreements are an essential next step to climatechangemitigationindevelopingcountries,andcanbenefitbothde-velopinganddevelopednations.

• SNLTscanbenefitdevelopingcountriesbyenhancingthescaleofin-centivesforprivate-sectorinvestment,motivatingsector-wideemis-sions achievements, and providing linkages to global carbonmar-kets.SNLTsare ineffectatypeofsectoralNAMAcrediting.SNLTsworkbestforemissions-intensivesectorswithafewmajorsources,e.g.,electricitygeneration,cement,ironandsteel,aluminum,oilandgasproduction, and refining.They typically set emissions-intensityrequirements.

• For sectors where SNLTs will not work, other kinds of sectoralagreements can address use of low-carbon technology, technologydiffusion,etc.

Sectoral Approaches — New and Necessary

Sectoral elements are anecessarypart of any international climatemiti-gation agreement that seriously engages developing countries. Althoughthereisgreatvarietyamongsectoralproposals,theyallseektoencourage

80 Murray Ward

mitigationacrossasectoroftheeconomy,ratherthanjustonaproject-by-projectbasis.Therehavebeensomeearlymisstepsalongthewayregard-ingwhatismeantbyasectoralapproach,anditisnotablethatproposalsforsectoralelementsinitiallycamemainlyfromdevelopedcountries.Thishas raised suspicions and clouded inclusion of sectoral elements in theglobalregimeforthepost-2012period.Butthecaseforthemisstrong.

Sectoral — How?

Thequestion ishowsectoral elements formitigatingemissions indevel-opingcountriesmightplayaroleinaglobalclimatechangeagreement.Inpractice,itmaybeseenthatthedeliveryofcurrentmechanismsandpro-gramshappensinsectors.IntheCleanDevelopmentMechanism(CDM),it is clear that there is significant sector-level specialization.This is truefor project developers, technology providers, and those providing bothproject finance and carbon finance.And in the non-UNFCCCworld ofthe Asia Pacific Partnership and theMajor Emitters Forum,most tech-nologycooperationactivitieshavebeendevelopedanddeliveredthroughsector-specifictaskgroups.

Of particular importance is how these existingmechanisms andpro-grams may be enhanced to scale up mitigation activities in developingcountries—and the technology and financing transfers and investmentneeded for this tohappen.Can thisbemoreeffectivelyachievedby tak-ingasectoralapproach?Whataretheinherentconstraintsandchallengesthatneedtobeaddressed?Indeed,theveryterm“sectoralapproach”hasbeenpartoftheproblemingettingtheseissuesdiscussedinanobjective,analytical,andsuspicion-freemanner.Whatdoesitmean—exactly?

What Sectoral Approaches Are Not About

First, one common suspicion has been that developed countries favorsectoral commitments as a means to avoid stringent binding economy-wideemissiontargets for themselves.But thosedevelopedcountries thatstressdomestic sectoral circumstanceshave increasinglymade clear thattheir objective is simply for these circumstances to gain some recogni-tionasnegotiationsdecidethedifferentiatedleveloftheireconomy-widecircumstances.Thus,forexample,Japanwantsotherstounderstandhowefficientitseconomyis—soithasahighabatementcostcurve—andNew

Why a Successful Climate Change Agreement Needs Sectoral Elements 81

Zealandwantsotherstounderstandthatabout50%ofitsemissionscomefromtheagriculturesector,wheremitigationpossibilitiesforsuchthingsasruminantmethaneemissionsfromitslivestockarequitelimited.

Second,sectoralapproachesarenotabouttryingtohaveindustries indevelopingcountries(andtheirgovernments)signuptobindinginterna-tional sectoral agreements. Nor are they about negotiating performancebenchmarks for industrial processes that may be the basis for possibleborder tax adjustments or, in developed countries, the basis for alloca-tionsofgrandparentedallowancesindomesticemissiontradingschemes.Fordevelopedcountries,then,asectoral approachisnotabouttheiremis-sions (in the international agreement anyway); it is aboutmitigation indevelopingcountries.

Theoneexceptiontothisisthespecialcaseofinternationalmarineandaviation bunker fuels.These emissions arguably should be managed bybothdevelopedanddevelopingcountriesonasectoralbasis.There isanongoingdebateastowhethertheseshouldbemanagedbytheirrespectiveexistingmultilateralintergovernmentalprocesses(InternationalMaritimeOrganization and InternationalCivilAviationOrganization), or broughtunder a United Nations Framework Convention on Climate Change(UNFCCC)agreement.Butthisdebateisoutsidethescopeofthispiece.

A Flexible Approach

Soifwenowhaveabetterideaofwhatasectoralapproachisnot,dowenowknowwhatis?Itisdescribedbysomeasaportfolioofpossiblemeas-ures that can be specific to the sector in question—and also to a givencountry.Forexample,inasideeventattheJune2009UNFCCCsessionsin Bonn organized by theWBCSD on its Cement Sustainability Initia-tive,asectoralapproachwasdescribedas“acombinationofpoliciesandmeasures, developed to enhance efficient, sector-by-sector, greenhousegasmitigation,addressingdata,policy, technologyandcapacitybuildingwithineachsector,”withtheelaboration:

• International cooperationwithmajor sector actors to develop andshareappropriatesectortools,systems,data,bestpractices,UNFCCCcreditingpolicies,benchmarking,andtechnologydevelopment.

• Nationallyappropriatemitigationactions(NAMAs)tunedtoasec-tor.Emissiongoalsandpoliciescoulddifferdependingonnational

82 Murray Ward

ambition,commonbutdifferentiatedresponsibilities,and localcir-cumstances.

Presumably, this rather all-encompassing description of a sectoral ap-proach has resulted from a process in the global cement sector that in-volvesmajorindustryplayersinbothdevelopedanddevelopingcountries.Therefore, it may well indicate how the term “sectoral approach” needstobecommunicated inarangeofsectors toallaysuspicionsofdevelop-ingcountries.Butwhilethisratherbroad,all-things-to-all-peopleethosisfine,negotiationsrightlyfocusonmorespecificpolicytoolsthatseemtobe getting traction in the negotiations.

Sectoral No-Lose Targets

One such policy tool is sectoral no-lose targets (SNLTs).A countrywillnotbepenalized if it fails tomeetanSNLT,but thecountrywill receivecarbon credits if it meets or beats the target.These credits can be soldinto the internationalmarket for compliance carbon units.Therewouldthenneed to be somemeans to translate this national-level incentive toindividual investments andchangedpracticeson theground.This couldbe throughdomesticpolicies, or there are also ideas for complementaryinternational policies.

A related policy tool is NAMA crediting: granting credits for non-bindingnationallyappropriatemitigationactionsthatmeetcertaincondi-tions.Ifthisisdoneonasectoralbasisinagivencountry,itissimilartoSNLTs.Putanotherway,SNLTscanbeseenasoneelementoftheconceptof NAMA crediting.

A key argument in favor of sectoral crediting is that it is not con-strained by the additionality-based procedures that have created suchcomplications for both project-based and programmatic CDM. Sectoraltargets are by their nature crediting baselines. If these are agreed by anegotiating process (just as developed country targets are agreed), thenadditionalityneednotbe a concept tobe applied (just as it isnotwhendevelopedcountriesbeattheirtargetsandcanselltheirsurplusunitsintothemarket).Atthesametime,thesectoraltargetsshouldbesetat levelsthatavoidcreditingforactionsthatwouldjusthappenanyway,includingthosesupportedbyotherfinancingandtechnologytransfermechanisms.

Why a Successful Climate Change Agreement Needs Sectoral Elements 83

SNLTs(orsectoralNAMAcrediting)arethereforeseenasanenhancedmarketmechanism that can serve to scale up investment in low-carbontechnologies and practices. It also provides developing countries withgreater flexibility and domestic control over policies andmeasures thatcanleadtocreditsbeingawarded.

However, thereneeds to be aworkablemetric for the crediting base-line and robust monitoring, reporting, and verification (MRV) systemsin place to ensure that it is clear by howmuch a country hasmet andbeaten its target inthatsector.Forthisreason,SNLTscannotnecessarilybe applied to all sectors of all developing countries. SNLTs are likely tobemostbeneficialforemissions-intensivesectorswithasmallnumberoflargesources,e.g.,electricitygeneration(andpotentiallytransmissionanddistribution)andindustrialsectorssuchascement,ironandsteel,alumi-num,upstreamoilandgasproductionandrefining,etc.

SNLTs are generally proposed to be of an intensitynature, e.g.,GHGemissionsperunitofproduction(ofcementorelectricity,etc).

WhilefordevelopingcountriesSNLTscanbeamechanismtoscaleuplocalinvestment,fordevelopedcountriestheycanbeameanstohelpas-suage theconcernsofdomesticconstituencies. Inorder forcarboncred-itstoactasameaningfulincentiveforinvestmentindevelopingnations,developednationswill need to adopt ambitious targets. Such targets areunlikelytobepopularwithsomepowerfuldomesticconstituenciesunderanycircumstances,butwillundoubtedlybemorepoliticallyfeasibleifde-velopingcountriesalsotakeonmoreambitiouspoliciesandmeasures.Inthisway,sectoraltargetscanserveasanimportanttransitionmechanismbetweenthepoliciessetoutintheUNFCCCandtheKyotoProtocolandmoreambitiouspoliciesessentialinthefuture.

Therealpolitikofthisiscrucial.Andintheabsenceofenhancedmar-ketdemandforcredits,increasedsupplywilljustdepressthevalueofcar-bon to the detriment of the entire market—and slow the technologicalinnovation that is critically needed tomove to the next rounds of sub-stantialcutsinemissions.

Using Sectoral Agreements Where SNLTs Are Not Appropriate

AdifferentsectoralapproachmayneedtobeadoptedinsectorsforwhichSNLTs are not appropriate. For example, SNLTsmay not be a practical

84 Murray Ward

policy tool for some sectors thatmay be difficult tomonitor or control(e.g., the transport sector, including auto manufacturing or buildings).Also,SNLTsmaynotyetbeappropriateinmanydevelopingcountriesbe-causetheyfirstneedtodevelopandimplementrobustMRVsystems.

Sectoralagreementsmaystillhaveconsiderablevalueinthesecircum-stances.Sectoralagreementscouldincludesuchmeasuresas

• Commitmentsframednotinemissionsterms,buttosuchthingsaspenetrationratesofcertainlow-andzero-carbontechnologies(e.g.,percentrenewablepower,percentcarboncaptureandstorage(CCS)ready coal-firedpowerplants, vehiclefleet emission intensity stan-dards,newbuildingperformancestandards,etc.)

• Commitmentstotechnologydiffusionthroughcooperationintech-nology research and development, technology transfer, joint ven-tures,intellectualpropertyrightsprotection,etc.

ThegeneralconceptsofNAMAs,andthebroadunderstandingsofsectoralapproachrepresentedbytheBonncementsectordefinition,areevolvinginways that accommodateand facilitate just thesekindsof actions—forbothdevelopinganddevelopedcountries.


R.Baron,I.Barnsley,andJ.Ellis,Options for Integrating Sectoral Approaches into the UNFCCC(OECD/IEA,2008),seeCOM/ENV/EPOC/IEA/SLT(2008)3.

R. Baron, B. Buchner, and J. Ellis, Sectoral Approaches and the Carbon Market (OECD/IEA,2009),seeCOM/ENV/EPOC/IEA/SLT(2009)3.

M.Wardetal.,The Role of Sector No-Lose Targets in Scaling Up Finance for Cli-mate Change Mitigation Activities in Developing Countries (May 2008), avail-able at http://www.GtripleC.co.nz.

http://www.GtripleC.co.nz

Climate Finance 85

Chapter 8

Sectoral CreditingGetting the Incentives Right for Private Investors

RubénKraiemPartner and Co-chair, Carbon Markets, Climate Change and

Clean Technology Practice, Covington & Burling LLP

Key Points

• Sectoral crediting raises obvious concerns for investors in specificprojects or activities within a sector, who will be concerned thattheymaynotqualifyforoffsetcreditsiftheoverallsectoraltargetisnotmetbecauseofforcesoutsidetheircontrol.

• One potential solution to this problem is for the host governmenttoindemnifyinvestorsforanyshortfallintheoffsetcreditsawardedtoagivenprojectbecauseoffailuretoachievesectoralgoalsduetounderperformancebyotherprojects.

• Another potential solution to this problem would be to requirecountriestosubmitcomprehensivesectoralprogramsthatwillspec-ifythecontributionsofindividualprojectsoractivitiestotheoveralltarget. Once those programs are certified as adequate tomeet theoverall objective, individual firms could receive credits based onwhetherornottheyfulfilledtheirportionofthesectoraltarget,notwhethertheoverallsectoraltargetwasmet.

One important and innovative proposal in current climate policy dis-cussions is to abandon the project-based Clean Development Mecha-nism(CDM)infavorofsectoraltargetsandcrediting,atleastforcertaincarbon-intensivesectorsincountriesthatmeetavarietyofothercriteria.Under this approach, no carbon credits would be issued for individual

86 Rubén Kraiem

mitigationprojectsoractivitiesunlesstheentiresectormanagedtomeetthesectoraltarget.Thisapproachhasthepotentialbothtoscaleupmitiga-tioninvestment indevelopingcountriesandtodrasticallystreamlinethemonitoringandverificationprocessforcreditingemissionsreductions.

This approach, however, also raises an important concern for pro-spective investors:why invest in costlymitigationmeasures if there is arisk that thedesiredoffset creditswillnotbe issued, irrespectiveofhowthe individualactivityorprojectperforms,because therestof thesectorfailedtomeetitsoveralltarget?Thischapterfirstexplainstheconceptofsectoralcreditingandthedifficultiesthatitmaypresenttoinvestors,thenoutlinesapossiblesolutiontotheproblemthatstillpreservesthecentralfeaturesofthesectoralapproach.

Sectoral Crediting: A New Flexibility Mechanism?

Of the threeflexibilitymechanismsunder theKyotoProtocol, theCDMhashadbyfarthegreatest impact.BecauseofCDM,low-costabatementtechnologieshavebeendeployedinimportantsectorsthroughoutthede-velopingworld.Localcapacityhasbeencreated,andinfrastructureputinplace formeasurement,monitoring, and verification of emission reduc-tions.AndCDMhasprovidedaninvaluablepricesignalforcarbonabate-ment.Butithashadsomeimportantlimitations.Qualifyingandregister-ingindividualprojectshavebeenundulycumbersome,withhigher-than-expected transaction costs.The scale of deployment has been small bycomparisonwiththeactualabatementchallenge.And,mostimportantly,theoveralltrajectoryofemissionsinkeyindustrialsectorsthroughoutthedevelopingworldhascontinuedtopointrelentlesslyupward.

Sector-basedcreditingisincreasinglyseenasthenext-generationcom-plement or successor to CDM. Instead of crediting reductions in emis-sions achieved by project-level activities, the idea is to credit reductionsbasedontheperformanceofanentire industrialsector inagivencoun-try.Reductionsachievedinanyoneinstallationorprojectwithinasectorwillbecreditedonlyifandtotheextentthatsectoralperformancereflectsan improvementagainstabaselineorachievesa target set for the sectorasawhole.

Sectors eligible for crediting might include power generation or ce-mentandsteelproduction,amongothers.Theperformanceofthesectorwould bemeasured against a sectoral baseline (such as a set emissions

Sectoral Crediting 87

levelbelowbusiness-as-usual(BAU))oragreedtarget.Asectoralbaselineor targetcouldbe setbyreference toabsoluteemissions fromthesector(i.e., absoluteemissions relative toabaseline setbelowBAUfor the sec-tor)or,more likely,onthebasisofacarbonintensity targetora levelofemissionsperformancebasedonaparticulartechnology.Thetargetscanbeno-losetargets:creditsareawardedifthetargetismet,butthereisnoobligationtoachieveitoranysanctionifthereisashortfall.Whatiscriti-cal is that there is an appreciable course correction on a broad sectoralbasis—fromaBAUscenariothatishighlydependentoncarbon-intensiveindustrial processes to a low-carbonpathway for continuedgrowth.Thepurpose of sector-based crediting is to provide the necessary financialsupports for this effort.The question is, will it work? In particular, is itrealistictoexpectthatprivatecapitalwillflowtoactivitiesthatareaimedat generating these sector-based credits?

Risks to Investors Presented by Sectoral Crediting

The challenge, from an investor’s perspective, is simple.Most proposalssuggest that sectoral crediting can only be accomplished in one of twoways:either(i)thehostcountryisawardedtheinternationaloffsetcredits(expost,presumably)andthenallocatesthemtoactivitiesthataredeemedtohavecontributedtoreachingthesectoraltarget,or(ii)theparticipantsinthoseactivitiescandirectlyobtaintheoffsetcredits,butonlyifandtothe extent that the sectoral targets have indeed been reached. In eithercase, the obvious risk is that an individual project participant will per-formpreciselyasintended,butthatthesectoraltargetwillnothavebeenreached because other entities within the sector have under-performed.This risk could very well discourage both foreign and domestic privatecapital.Whywouldanyone invest ingeneratingthesecreditswhenthereis a crucial element that is, virtuallybydefinition,outsideof thecontroloftheinvestor?

An Alternative Approach

There are several possible answers to this problem, but to accept anyone of themwill require some adjustment to the assumptions that havethus far informed the international and domestic discussion on no-lose

88 Rubén Kraiem

targetsandsectoralcrediting.Themostobviouspossibilityisthatthehostcountry government would assume the risk of other participants’ non-performance.Inotherwords,participantswhodidperformwouldbeen-titled tomake an indemnity claim against the government for the valueofthecreditstheywouldotherwisehavereceived.Thegovernmentwouldthen either fine or take other enforcement action against the under-performers(effectivelymakingtheproposedsectoraltargetobligatoryfordomesticpurposes),orfindsomealternativesourceofrevenuetopaytherequiredindemnity.Ineithercase,suchasolutiongoesagainstthegrainof theno-lose concept: i.e., the idea thatwhat is involvedhere is only acarrotandnotastick.Moreimportantly,perhaps,itstillleavestheprivateinvestor at some risk if the host government simply fails to performonits indemnity.Unless anduntil there is a guaranty facilityof somekind,akin to theWorldBank’sMultilateral InvestmentGuarantyAgency, thisriskcouldwellbeamajordisincentive to investment inallbut themostfinanciallysecureandreliablehostcountries.

Analternativesolutionmightbeasfollows:first,nationalpolicymech-anisms for achieving the sectoral targets would need to be established.Dependingon the framework, these targets andpolicies couldbe estab-lishedbyinternationalagreement,thecountryororganizationissuingthecredits,orbythehostcountry.Specificpolicymechanismscouldincludeincentive structures, such as payments for environmental services, taxincentives, feed-in tariffs, etc.Theycouldalso include internallybindingmeasures, such as performance standards for the relevant installationsor a sectoral cap-and-trade system. Individual sector participantswouldthen bid in their proposed contributions to a sectoral goal: a utility, forexample,mightformallyundertaketoachieveacarbonintensitygoalthatisequaltoorbetterthanthesectoraltarget.Bycollectingthesebids,thehostgovernmentwouldassembleaportfolioofqualifiedprojectsthatcol-lectively achieve (or over-achieve) the intended result. The plan wouldthenbepresentedtotheagencyissuingthecorrespondingcredits(inthecase of the United States, that wouldmost likely be the EnvironmentalProtectionAgency), which could satisfy itself that the plan itself is fea-sible,thatitissupportedbyappropriateresources,andthatthetotalcon-tributionsdoindeedadduptothesectoraltarget.

Iftheindividualparticipantthenperformedatalevelequaltoorbetterthanitsacceptedbid, itcouldclaimthoseoffsetcreditsdirectlyfromtheissuingagency. Ifnot, then itwouldowean indemnityobligation to thehostgovernmentand/ortothe issuingagency.If thesectoral targetwere

Sectoral Crediting 89

notreachedattheendofwhateveristherelevantmeasuringperiod(say,3to5yearsfromthetimewhenbidswereinitiallyreceived),thetargetforthe succeedingperiodwouldbe ratchetedup (i.e.,wouldbemademorestringent) by a corresponding amount, thus providing a disincentive forover-promising. If the targetwere exceeded, the additional offset creditswould be awarded to the host government for discretionary allocation,thusprovidinganincentivetothegovernmenttosetrealistictargets,andtoensureproperenforcementandimplementationoftherelevantpoliciesand measures.The essential point is that individual participants wouldneed tomake a specific, binding commitment as to their owncontribu-tion,butcouldtheninvestwithouthavingtoaccountfortheriskofnon-performanceby thegovernment and/orby theother sectorparticipants.Atthesametime,asectoralgoalwouldhavebeensetandappropriatein-centiveswouldbeinplacethatwoulddrivetheachievementofthatgoal.

Indesigninganoffsetcreditingsystem,theperfectmustnotbetheen-emyof thegood.Whatmattersmost is that the system incentivizes andmobilizescapital,andthatthetrendandtheeffectoverallbeinthedirec-tionofalow-carbonpath.Theaboveproposalisaimedataccomplishingthesegoals,whilepreservingthecoreadvantagesofasectoralapproach.


RichardBaron,BarbaraBuchner,andJaneEllis,Sectoral Approaches and the Car-bon Market(OECD/IEA,June2009),COM/ENV/EPOC/IEA/SLT(2009)3,29May2009.

Lambert Schneider and Martin Cames, “A framework for a sectoral creditingmechanism in a post-2012 climate regime,”Report for theGlobalWindEn-ergyCouncil(Öko-Institute.V.,InstituteforAppliedEcology,May2009).

90 Climate Finance

Chapter 9

ForestandLandUsePrograms MustBeGivenFinancialCreditin AnyClimateChangeAgreement

EricC.BettelheimFounder, Former Executive Chairman,

Sustainable Forestry Management

Key Points

• Nearlyhalfofthemitigationactionsavailableintheperiodto2020consist of reducing deforestation and improving agricultural prac-ticesinthetropicsandsub-tropics.

• Developedcountriesfaceseverelimitationsonthecost-effectivenessof mitigation actions they can take by 2020. However, developingcountries have significant potential to take cost-effective land use,agriculture,anddeforestationmitigationactionsquickly.

• A substantial portion of land use, agriculture, and deforestationemissions indevelopingcountriesaredrivenby thestruggleof therural poor to survive. No plan will succeed unless the rural pooraregivensufficientfinancialincentivetoabandonthoseactivitiesinfavorofother,lesscarbon-intensiveoptions.

Inlightoftheincreasingunderstandingofthetiminganddepthofemis-sionsreductionsrequiredtoachievea2°Ctargetandtherelativecostsofdoing so, the next global climate change agreement will need to createincentivesforsubstantialglobalmitigationactionstooccurby2020.Thattimeline isdependentonsignificantchanges in forestry, agriculture, andlandusepracticesinthetropicsandsub-tropics.However,thesechangeswillonlyoccur ifwecreate the right incentives fordevelopingcountriesandtheirruralpoor.

Forest and Land Use Programs 91

Historical Responsibility and the Need for Immediate Reductions in Developing Countries

Thenext10yearsarecrucial tosuccess instabilizingatmosphericgreen-housegases(GHG)atalevelwhichoffersarealchanceofavoidingcata-clysmicclimatechange.Althoughtheindustrializedcountriesareprimar-ily responsible for the urgency of the problem, emissions reductions indevelopingcountries canbe achievedmuchmorequickly, inexpensively,andefficiently thanreductions indevelopedcountries. In fact,over two-thirdsof themost effectiveandaffordable emissions reductions that canbe achieved by 2020 must come from opportunities in the developingworld.The technology required to achieve deep cuts in emissions fromthedevelopedworldwillsimplynotbeavailableanddisseminatedatsuf-ficient scale for another 20-plus years.Current estimates are that only 5billionofthe17billionmetrictonnesinannualglobalreductionsrequiredby2020canbeachievedcost-effectivelythroughtechnologicalchangeintheindustrialworld.

The unavailability of plentiful cost-effective reductions in the devel-oped world challenges the assumptions and dynamics underlying theKyoto Protocol and the European emissions trading system. Both focusoverwhelminglyonforcingdramaticandrapidchangestotheenergyandindustrial infrastructure of the developed world—an approach that wasbased on a sense of historical responsibility and fairness.Unfortunately,what may have seemed equitable and fitting is neither economicallyachievablenorenvironmentallysensible.

While developed countries still must take the lead in reducing theiremissions,theymustberealisticaboutthepracticallimitsofwhattheycancontributedomesticallyby2020.Overthelongerterm,to2050andbeyond,technologicalchangemustprovidemostofthesolution.Inthemeantime,thedevelopedcountriesmusthelp to enableandpay for farbigger thanexpectedreductionsfromtheruralareasofthedevelopingworld.

Benefits of Emissions Reductions in Agriculture, Forestry, and Land Use

A total of 31% of global emissions result from agriculture, forestry, andland use (AFOLU)—17% from deforestation and forest degradation and14%fromagriculture(seeFigure9.1).

92 Eric C . Bet telheim

The emissions fromAFOLU—90% ofwhich occur in the developingworld—offer nearly half, 46%, of the world’s potential emissions reduc-tions(seeFigure9.2).Thisisbecausephotosynthesisisbyfarthemostef-ficientmeansofcapturingandstoringcarbondioxide,andthemostcost-effectivebecause it requiresneithernew infrastructurenor technologicalbreakthroughs.What isrequired isachange in theeconomicsandregu-lationof landuse.However, to realize theseemission reductions,properincentives will be required—primarily by crediting them in the world’scarbontradingsystems.If theseemissionsreductionsoccur, itbuystimefor developed countries to put in place greener economies without fur-therdepressingglobaloutputandcompetition.

The incentives for crediting AFOLU for industry in the developedworldareobvious: low-costcompliancecredits inthenear term.Thein-centives for developing countries (forested, deforested, and unforestedalike)areevenmorecompelling:significantcapital innewinvestmentin

Forestry17%

Waste and Wastewater

3%

Energy Supply26%

Transport13%

Residential and Commercial Buildings

8%

Industry19%

Agriculture14%

Fig.9.1.GlobalGHGemissionsbysector(2004).(Source:Climate Change 2007: Synthesis Report; Contribution of Working Groups I, II, and III to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change,FigureSPM.3,IPCC,Geneva,Switzerland)


their rural areas, higher agricultural productivity and land values, pres-ervation of extant fresh water and biodiversity resources, and povertyalleviation. Further, changes in landusewill generate investment capitalthroughthecreationofoffsetsthatcanfundacountry’scontinueddevel-opmentandtransitiontoalow-carboneconomy.

A Market-Based Solution: Changing the Patterns of Land Use

In order to accomplish these goals, biologically stored carbonmust be-comeworthmorestandingupandinthegroundthancutdownandcon-verted into animals and crops. Fortunately, tropical landwhich capturescarbon,evenatrelativelylowcarbonprices,isworthupto10timesmorethan the same landharvested for timber and then converted to agricul-ture.ThroughcreditingAFOLUinglobalemissionstrading,annualpay-mentsofbetweenUSD40and100billiontodevelopingcountriesforthebiological storageofcarboncouldbemade.Such funding, togetherwithmulti-lateral capacity and institution building programs, is necessary to

Forestry & agriculture

0

Cost of abatement€/t COe

By 2020

• Forestry is 31% (~5.9 Gt) of global abatement potential, and 41% (~5.5 Gt) of developing world potential

• Agriculture is 15% (~2.9 Gt) of global abatement potential, and 16% (~2.2 Gt) of developing world potential

-40

20

0

100

10

-100

80

60

40

-20

20

-80

-60

155

AbatementGt CO2e

Fig.9.2.Forestryandagricultureaccountfor46%ofpotentialglobalabatement.Developingcountryabatementcostcurve,2020(uptocostsof€60/t).(Source:McKinseyGlobalGHGAbatementCostCurvev2.0(2009))

94 Eric C . Bet telheim

counter the current incentives to cut trees and continue unsustainableforestandagriculturalpractices.

SimplyprovidingcapitalthroughAFOLUcreditingwillnotrealizethisenormous opportunity unless the economics of rural landuse is under-stood.All toooften thedebate is about thedriversofdeforestationas iftheywereremotefromhumanneedsorsomehowavoidable—thingsthatcould simply be switched off.Nothing could be further from the truth.Therealdriversarethenecessitiesoflife:food,shelter,energy,andwater.80%oflandusechangeinthedevelopingworldisforfood,48%forsub-sistencefarming,and32%forcommercialagriculture.Globaldemandforfoodwillincreasesubstantiallyasthepopulationgrowsfrom6.5billiontoaprojected9.5billion in thenext40years.Almostallof thepopulationgrowth this centuryand the consequent strainon landwilloccur in thedevelopingworld.Thelandontheplanetavailableperpersonwillshrinkfromover 5hectares in 1950 to less than2hectares in 2050asdemandsfor food and higher standards of living increase. The intensification ofagriculture is therefore essential if any significant tropical forests are toremain intactbymid-century.That intensification isonlypossible if sig-nificantnewcapitalinvestmentisforthcoming,andifwemaintainforestsaswatershedsandsourcesofrainfall.

It is also usually overlooked that over 80% of the world’s wood har-vest comes fromnative forests.Demand forwood forbuildingmaterial,paper,andtimberproductsisunlikelytoabategivenpopulationandeco-nomicgrowth.Newplantationsonamassivescalearerequiredtocreatea sustainable substitute supply, and this also requires significant capitalinvestment. Inaddition, fullyhalfof theworld’s forestharvest isusedasfuel for theruralpoor.InpartsofAfrica, itsupplies90%ofenergy.AnyReducingEmissionsfromDeforestationandForestDegradation(REDD)policymustreducetheharvestofnativeforestsandthereforealsothreat-enstoremovetheonlysourceofenergyavailabletotheruralpoorofthedevelopingworld,aswellasdecreasethe landavailabletothemforfoodproduction.Thesepeoplearewidelydispersedandthereforeneedlocallyreceivedpaymentstoprovidethemwiththefinancialwherewithaltobuyorbuildalternativesourcesofenergyandtochangetheir landuse.Theymustreceivehigherpaymentsthantheyreceivenow.Nopolicyprescrip-tionortop-downsolutionwillworkwithoutprovidingsuchpayments.Inshort, unless there are significant newmarket-based incentives for fun-damental change in rural land use practices as awhole, noREDD-onlypolicywillsucceed.


National and Global Programs

It isoftenassumedthat thegoal isasinglemarketandasingleprice forcarbon.However, that is not what is happening or likely to happen fora very long time.What is happening is the emergence of national andregional trading schemes that will have varying regulations. Any globalclimatechangeagreementmustprovideforthisrealityaswellassetcom-monstandardsforinternationalrecognitionofforestandlandusecredits.Although theEUexcludes forestand landusecredits,programs inAus-tralia,NewZealand,andtheUSwillincludethem.By2012,therewillalsolikelybecarbonmarketsinmostlargeeconomiesincludingChina,India,Japan,Brazil,andSouthAfrica,aswellaselsewhere.Wemustworknowtoensurethatthesecountrieswilladoptstandardsthatwillallowfor in-ternationaltradingofallforestandlandusecredits.Ifwefailinthis,thelogicofmathematicsandeconomicsdemonstratethatwewillfailtodealsuccessfullywithclimatechange.

Conclusion

Climatechange isaglobalprobleminneedofaglobalsolution,andde-velopingcountriesholdthekeytosuccess.Togivehumanitythetimeandthemeanstomoveontoa low-carbongrowthpath,wemustprovidere-wards and support that bring a green revolutionof sustainable develop-mentand investment to theruralareasof thedevelopingworld.Tosumup a complex reality: enabling 50% of emissions reductions via tropicalandsub-tropicalforestsandagricultureinthenearfuturewillmake80%industrialreductionsbymid-centurypossible;awinningformulaforall.


OfficeofClimateChange,UKGovernment, “ClimateChange:FinancingGlobalForests,”The “Eliasch Review”(2008).

Charlotte Streck, Sebastian M. Scholz, “The Role of Forests in Global ClimateChange:WhenceWeComeandWhereWeGo,”International Affairs82:5(2006).

IanR.Swingland,JohnGrace,GhilleanT.Prance,andLindsayS.Saunders,“Cap-turingCarbon&ConservingBiodiversity:TheMarketApproach,”Philosophi-cal Transactions of The Royal Society: Mathematical, Physical & Engineering Sciences (2002).

96 Climate Finance

Chapter 10

Stock-and-FlowMechanismsto ReduceLandUse,LandUseChange,

andForestryEmissionsA Proposal from Brazil

Israel KlabinPresident, Brazilian Foundation for Sustainable Development

Key Points

• The vastmajority of Brazil’s emissions are generated by deforesta-tion and other changes in land use—problems that were not welladdressedbyKyotogenerallyortheCDMmechanismspecifically.

• The global climate governance regime should use a stock-and-flowmechanism to reduce landuse, landuse change, and forestry(LULUCF) emissions, by providing heavily forested countrieswithREDDfunding(throughcreditsorloansandgrants)tiedtospecificemissions reductions based on historical deforestation rates, and adividendbasedonthetotalamountofforeststockremaininginthatcountryasaproportionofglobaltropicalforestcover.

• This mechanism provides value not just for avoiding emissionsthroughREDDbutalsoformaintainingandreinforcingforeststocks.

• Ifthismechanismiscombinedwithtargetsandincentivestoreducedeforestationratesrather than juststabilizingthem,significant lev-elsofefficientabatementcanbeachieved.

Onemajor limitation of the 1997 Kyoto Protocol is that it does not doenoughtoreducegreenhousegas(GHG)emissionsfromdevelopingna-tions.Inparticular,itdoesnotdoenoughtocreateincentivesforcountries

Stock-and-Flow Mechanisms 97

to reduce emissions caused by agriculture, land use, and deforestation.Recognizingthis,thereisstrongsupportforemissionstargetsforthema-joremergingeconomies,significantfinanceandtechnologytransferfromAnnexInations,andastock-and-flowmechanismtocreateincentivestoreducelanduse,agriculture,anddeforestationemissions.

CO2 Emissions from Brazil

Roughly75%ofBrazil’sCO2emissionsarisefromchangesinlanduse,inparticulartheconversionofforeststoagricultureandcattleranching.Theportion of CO2 emissions from theuseof fossil fuels is relatively low inthe countrydue to thehighproportionof renewable energyuse (46.4%in2007).

Thereisanurgentneedforadrasticreductionofthedeforestationratein theAmazon region, requiring the control of several variables such asthe demand for products in forested areas.The wood produced by theforestfluctuatesover time, thusmakingmonitoringfiguresunstableanddifficulttoobtain,buttheBraziliangovernmentintendstoreducedefor-estationintheAmazonregionto5,740km2peryearby2017.Thiswouldbe an important step forward to control the current disorderedoccupa-tion of the forest.

The Failure of Kyoto and the CDM Mechanism to Adequately Address Deforestation

Thefinancemechanisms established by the Kyoto Protocol were unableto reduce or halt the expansion of GHG emissions in Brazil. Financingforlanduse,landusechange,andforestry(LULUCF)projectswaspracti-cally nonexistent.Within this broad category of projects, theCleanDe-velopmentMechanism(CDM)onlyallowsreforestationprojects inareasdeforestedbefore1990andforestationwheretherehadbeennopreviousforest vegetation for at least 50 years. Such restrictions, considered a se-rious mistake, were discussed extensively at the Bali Conference of theParties(COP13),andreconsiderationoftheseissueswillbeamajorcom-ponentofanyfutureclimatechangeregime.

BraziliancarbonprojectsforKyoto,basedonenergyefficiencyandal-ternativesourcesofenergy,wereclearlyatadisadvantage,incomparisontotheonesfromcountrieswithhigheremissions,duetoBrazil’sstarting

98 Israel Kl abin

pointofacleanerenergymixandthustheloweremissionsbaselineofitspower system.Many biofuels, reforestation, and power generation proj-ectscouldnotbeconsideredforaccreditationduetopre-existingdomes-ticregulationmandatingtheirimplementation.

Therefore, there is a need to rethink new options for scaling up thefinancial resources necessary for forest protection. Any new financialmechanism should be effective, sustainable, predictable, performance-based, and supported by diversified sources.Many recognize a need tocombine non-market financial resources andmarket-basedmechanismstoensuresustainabilityofactions.

Creating Incentives to Slow Deforestation

TherecentUnitedNation’sreportonfinancialflowsandinvestmentesti-mates that anadditional annual investmentofUSD200–210billionwillberequiredby2030toreducecarbondioxideequivalent(CO2e)25%be-low1990levels.However, therecenteconomicturmoilwillrequiresomedownward revision of this amount due to the emissions avoided by re-ducedindustrialproduction.

The estimated realisticmitigationpotential in developing countries isapproximately 7,000MtCO2e in 2020.Most of this potential (5,250MtCO2e) is available at a cost of less thanUSD25perMtCO2e.This esti-mate takes into account reductions potentially available through CDM,reducing emissions from deforestation and forest degradation (REDD),andcarboncaptureandstorage(CCS).

Various proposals have been presented to increase the financial re-sources available for low-carbon projects. The most effective proposalcamefromtheGroupof77andChina,arguingthat the levelof fundingfor adaptation andmitigation projects should be based on defined bud-getarycontributionsfromdevelopedcountries.For instance,0.5–1.0%ofthegrossnationalproduct(GNP)ofAnnexIPartieswouldgiveanomi-nalannualleveloffundingamountingtoUSD201–402billion.

Stock-and-Flow Mechanism: A New REDD Proposal

TheWoodsHoleResearchInstituteandIPAM(aBrazilianthink-tankfo-cusedontheAmazon)haveproducedasophisticatedproposal,theStock-


and-FlowMechanism, to implement REDD. It guarantees payments foremission reductions as well as dividends for the total amount of foreststillpreservedbyeachcountry.AlthoughBrazil’sprofilemakesitparticu-larlyrelevanttoprovideadequatefundingstructurestorewardREDDef-forts, thisproposal isappropriate foranydevelopingcountrywith forestcover. It is effective not only for countries like Brazil with a large stockandmoderate deforestation rate but also for countries withmedium orsmallstocksandhighorlowdeforestationrates.

Usinghistoricaldataondeforestation as abaseline, one can calculatethe emissions reductions generated by a lowered deforestation rate, andthese arepaid for either throughmarketmechanisms like sectoral cred-iting or through grants and loans.Afixed proportion of this funding iswithheld and set aside into a fund that is distributed among countriesparticipating in thismechanismbasedon their contribution to the totalglobalstockoftropicalforestcover.

Ifacountryemitsoveritsbaseline,itwillnotreceiveanyREDDcred-itsand,inaddition,itwillbepenalizedwithareductioninitsstockdivi-dend,alsoreduced inproportion to itsdeforestationrate inexcessof itsbaseline.

Thismechanismhasseveraladvantagesovertheclassic,simpleREDDcreditingmechanism.Itprovidespositiveincentivestomaintainandim-proveforeststocks(contributingtobiodiversity,waterresources,andsoilprotection),anditdoesnotpunishcountries thathavealreadytakenac-tiontohaltdeforestationthroughearlyaction,suchasCostaRica.Iten-suresthatreductionsarenotno-lose,asemittingbelowbusiness-as-usual(BAU)levels isrewardedandemittingoverBAUlevelsbrings increasingpenalties. It also provides incentives for developing nations to put pres-sureononeanothertoimproveREDDefforts,aseachindividualcountryreceivesmorefundingifothercountriesimprovecarbonstocks.Crucially,thisshouldhelpcombatinter-countryleakagewhilethenationalbaselinecombatsintra-countryleakage.

According to IPAMand theWoodsHoleResearchCenter, themech-anism can be enhanced by including emission reduction targets insteadof justdefiningabaselineusinghistoricaldeforestationrates.IPAMesti-mates indicate that a stock-and-flowmechanismwith these reducedde-forestation targets is themost effective (in termsofmitigation) and sec-ondmostefficient(intermsofeffectiveCO2reductionsvs.creditsgener-ated)instrumenttoreduceemissionsfromdeforestation:seeTable10.1.

100 Israel Kl abin

Conclusion

Brazil and other developing countries committed themselves under theKyoto Protocol to reduce emissions in the Kyoto commitment period2008–2012,buttheirobligationswerenotquantified.Ifthecurrenttrendremains unaltered, the contribution of developing country emissions tototalGHGstocksintheatmosphereshouldgrowfromaround20%oftheworldtotalin2000to45%by2030.

It isourbelief that thehighest-emittingdevelopingcountries (includ-ingChina,India,andBrazil)shouldbeboundbycommitmentsfortheiremissionreductions,buttheleastdevelopedcountriesshouldnot.Ideally,these initial commitmentswould last from 2020 to 2050.TheEuropeanUnion’s (EU) potentially acceptable proposal to accompany these devel-oping country commitments is to reduce emissions across the EUby atleast20%below1990levelsby2020—andeventoadopta30%targetifasatisfactoryinternationalagreementtakeseffect.

Emissionsmitigation through LULUCF needs to be adequately dealtwith if the global climate regime is to achieve the targets necessary toavoidharmful climatechange ina cost-effectivemanner.Onecontendertoproduceefficientandeffectiveresultsisthestock-and-flowmechanism,whichwill create the right incentives forheavily foresteddevelopingna-tionstoengagewithdeforestationinameaningfulway.


BNDES, Amazon Fund documents and institutional information, available athttp://www.amazonfund.gov.br.

Table10.1Comparison of Effectiveness, Efficiency, and Equity for Different REDD Proposals

(Target Set at 20% and Withholding Level = 0.75) Reductionin Efficiency(EffectiveCO2DifferentREDDProposals Emissions Reductionsvs.Credits)

National historical 61% 71%Higherthanhistoricalforlowdeforestation 66% 69%Weightedaverageofnationalandglobal 63% 83%Uniformfractionofquantifiedstock 64% 57%Standardstock-flow 65% 99%Stock-flowwithtargets(75-20) 74% 89%


Comitê Interministerial sobreMudança doClima (Brazil-FederalGovernment),Plano Nacional sobre Mudança do Clima (Brasília, November 2008). Portu-gueseversion.

The Government of Norway, Reducing Emissions from Deforestation and Forest Degradation (REDD ): An Options Assessment Report(March2009).

UNFCCC,Investment and Financial Flows to Address Climate Change: An Update FCCC/TP/2008/7,26November2008.

WoodsHoleResearchCenter,How to Distribute REDD Funds across Countries? A Stock-Flow Mechanism(December2008).

Woods Hole Research Center, A Revised Stock-Flow Mechanism to Distribute REDD Incentive Payments across Countries(January2009).

D

LeveragingTradingtoMaximize ClimateBenefits

Climate Finance 105

Chapter 11

Mitigating Climate Change at Manageable Cost

The Catalyst Proposal

BertMetzSenior Fellow, European Climate Foundation

Key Points

• EvenassumingambitiousGHGreductionsbydevelopedcountries,largeadditionalreductions indevelopingcountryemissionsarere-quired inorder to limitglobalwarmingto2°C.Atotalof€65–100billion annually over the 2010–2020 period is needed to financethesereductionsandmeetdevelopingcountries’adaptationneeds.

• International carbon markets similar to the existing CDM couldprovide an additional €15–20 billion annually, leaving the maincontributionof€50–80billion topublic funding. It isunlikely thisamount of public funding can be put together under the currenteconomiccircumstances.

• Several options exist for regulating the carbonmarket to getmorefunding from it, achieve additional reductions, and meet a sub-stantial portion of the shortfall.These include discounting creditsawarded, allowing developing countries to sell credits only if theyalso achieve uncredited reductions, and restricting the award ofcredits to high mitigation cost sectors.

• A novel andmore effective option is establishing an intermediarybody(orcarbonbank)thatwoulduserevenuesfromcreditsalestofundincrementalcostsofmitigationactionsindevelopingcountries,therebycapturingtherentthatexistsinanunregulatedmarket.That

106 Bert Metz

rentthencouldbereinvestedinadditionalabatementmeasures.Thecarbonbankcanbecentralizedordecentralized;thelatterapproachmightbepoliticallyattractive.

Background

Realistic estimates for the fundingneeded tofinancemitigationandad-aptation activities in the developing world are in the range of €65–100billion annually on average over the 2010–2020 period.This takes intoaccount the rangeof abatement activitieswithmoderate and largeposi-tive costs and the barriers to finance thatwill have to be dismantled orovercome.

Where to Find the Money?

Thereare,inprinciple,twosourceswherethemoneycanbefound:publicfundsandthecarbonmarket.Thefirstquestionis:whatwouldbeareal-isticnumberfortheamountthatcanbeobtainedfrompublicfunds?In-creasingofofficialdevelopmentassistance (ODA)and transfersof fundsgeneratedbyCO2 taxes; revenues fromauctioningofdomestic emissionallowances in developed countries; international auctioning of emissionallowances to developed countries; and levies on international aviationand shipping are the most prominent proposals under discussion. Allhave serious limitations. For instance, an increase in ODA has alreadybeenpromisedbydevelopedcountries forassistingdevelopingcountriesto meet the Millennium Development Goals (MDG). Climate changefunds should be additional toMDG funds, but government budgets ofmostdevelopedcountriesareunderseriouspressure.Formostotherop-tions,internationalagreementisneeded.

The Carbon Market

At present, the carbon market—as we know it from the experience ofthe Clean Development Mechanism (CDM)—is driven by the demandforoffsetsindevelopedcountries.Therefore,thevolumeofthefinancingthrough themarketdependson thedevelopedcountryemissionsreduc-

Mitigating Climate Change at Manageable Cost 107

tiontargets.Ifweassumea25%onaveragedevelopedcountryreductionbelow1990ratesby2020(thelowerendofthe25–40%below1990rangefor developed countries collectively as their equitable share of the efforttowardskeepingtheglobaltemperatureincreaselimitedto2°Cabovepre-industrial), theCatalystcalculations indicatethat€15–20billionperyearout of the total incremental cost of developing country climate financecanbe covered through the carbonmarket.This conclusion is basedonthe assumption that, as is currently the case under the CDM (ignoringthe small adaptation levy), offset credits are sold and bought at amar-ket clearing price, and the buyer receives one tonne of credit for everytonneofoffsetachieved.Undertheseassumptions,thetotalvalueofmar-kettransactionswouldbemuchhigherthan€15–20billionannually,butmuchof thatvaluewouldaccrue toprojectdevelopersorbrokers in theformofeconomicrents(theexcessofrevenuesreceivedoverprojectcostsincludinganormalprofittocovercapitalcosts).Thiswouldmeanthatanamountof€50–80billionwouldberequiredfrompublicsources,which,forthereasonsabove,maynotbeunlikely.

Can the Carbon Market Be Reformed and Regulated to Deliver Much More, Reducing the

Developing Country Finance Shortfall?

There are in principle several ways to delivermore incremental cost fi-nancingoutofthecarbonmarketthroughregulatorymeasures.Thesim-plest is todepart from 1:1 offset crediting and require a discount: devel-opedcountriesandtheirfirmsthatwant touseoffsetcreditsareobligedtobuy,forinstance,twotonsofoffsetsforeachtoncredited.Anotherap-proach is to have developing countries accept undertaking some reduc-tions themselves and selling credits if theyare able to reducemore thanwhat they promised to do anyway.Thismeans some of the incrementalcostsarepaidforbydevelopingcountriesthemselves(althoughtheymaybeabletoearnrentstocoverthosecosts throughcreditsalesonthead-ditionalreductions).Athirdapproachistorestricttheawardofcreditstooffsetsfromhighcostsectors(i.e.,thepowerandindustrysectors)sothatahighershareofcarbonmarketfinancingisdirectedtothesectorswherethe rents (the excess of revenues received from credit sales over reduc-tioncosts)arelower,andmorereductionscanbeachievedwiththesameamountofmarketfinancing.

108 Bert Metz

Thefourthapproach,onethatstepsoutsidetheframeworkthathasde-velopedtodate,istocreateanintermediarybody(acarbonbank)thatisthesole issuerofcredits(seeFigure11.1).Thisbankwouldsellcredits todevelopedcountriesatpricescommensuratewiththe(high)marketvalueofcredits indevelopedcountries,butwoulduse themoney tocover theincrementalcostsofthemeasuresindevelopingcountries,eliminatingtherentsthatwouldotherwiseaccruetosellersofoffsetcredits.Inprinciple,thediscountingapproachcanproducea similaradditional fundingflow,theothertwoapproachesprobablylessso.Inallcases,it isassumedthatthe least developed countries will continue to have access to a project-basedCDM,likewhatiscurrentlyavailabletoalldevelopingcountries.

Acarbonbankwouldcoverthefinancingthroughthecarbonmarket,but inprinciplecouldalsomanage thepublic funds thathave tosupple-mentcarbonmarketfinancing,creatingabasisforintegratedandefficientfinancing.

Thecarbonbank idea couldbe implemented in the formof a centralinternational body.This would have obvious advantages in terms of ef-ficiency and transparency, but would not necessarily get the requiredpolitical support.Developingcountries ingeneralare reluctant toacceptthiscentralizedmodelbecauseoftheirexperienceswiththeWorldBankandtheGlobalEnvironmentFacilityindisbursingotherclimate-change-

3

“Carbon bank”DevelopedCountries

DevelopingCountries

2 Offsets sold 1 Offsets bought

2 Market value 1 Incremental cost

4

“Carbon bank” leveraging mechanism:

1 “Carbon bank” purchases offsets by financing the incremental cost of emissionsreductions in developing countries.

2 “Carbon bank” sells offsets at market prices to developed countries.

3“Carbon bank” captures the difference between the incremental cost of emissions reductions in developing countries and the market cost of emissions sold to developed countries.

4“Carbon bank” uses the difference to finance either incremental costs of further abatement in developing countries or adaptation measures.

Additional abatementor adaptationmeasuresfinanced

Difference

Fig.11.1.Acarbonbankcouldhelptoraiseadditionalfinancingformitigationoradaptationmeasures.(Source:McKinseyGlobalGHGAbatementCostCurvev2.0(2009);ProjectCatalystanalysis)

Mitigating Climate Change at Manageable Cost 109

related funds; they complain about lengthy bureaucratic procedures anddominance ofWorld Bank policy over their interests. Developed coun-triesmightalsohavehesitationsonacentralizedmodel,particularlyifthecarbonbankwouldalsohandle theirbilateral contributions; they like tohavecontroloverthedestinationoftheircontributions.

However,thebankcouldalsobesetupinadecentralizedform,eitherasaseriesofregionalbanksorevenanetworkofnationalbanks(mayberegional for small countries).Thiswould enhance the feeling of owner-shipofdevelopingcountries.Infactseveraldevelopingcountrieshaveal-readysetupnationaltrustfunds,suchastheBrazilianAmazonFundandthe Indonesian Climate Change Trust Fund. For developed countries, adecentralized structuremight alsobe attractive, since itwould allow forbilateral arrangements and increase choice.

Where Does That Bring Us?

With a regulated carbonmarket, the share of the funding coming fromthemarketcanlikelybeincreasedto€20–40billionperyear.Thatreducesthepressureonpublic funding significantly, reducing its contribution to€45–60billionper year.While itwillprobablynot completely cover theshortfallinfundingthatcanbeexpected,because€45–60billionisstillaveryhighnumberunderthecurrenteconomiccircumstances,itprovidesamuchbetterchanceofmeetingtherequiredfundingneedsforanambi-tiousCopenhagenagreement.

Thereisalsotheissueofeffectivenessandefficiencyofthecurrentcar-bonmarket.Theproject-basedCDMis thedominantmechanism in themarket at themoment.There are doubts about the integrity of the sys-tem, because it is very likely that part of the emission reductions cred-itedthroughtheCDMwouldhavehappenedanyway;inotherwords,thisleads tohigheremissionsoverall than intended.Thecarbonmarket inapost-Kyotoagreementwouldhavetobe5to10timeslargerthanthecur-rent CDM. Doing that by scaling up the project-based CDM is not anoption.More efficient sector-based program approacheswill have to re-placetheCDM.Theseprogramapproachescanmoreeasilybecontrolledtoonlycreditadditionalaction.

Theoptionofthecarbonbank,combinedwithsector-basedprogram-maticapproacheshassomeotheradvantagesoverthealternatives:thereisabetter chanceoffixing the current imbalances inCDMfinancialflows

110 Bert Metz

(mostmoneygoesto10developingcountriesandmanydevelopingcoun-tries do not receive anything) and providing funding to all developingcountries.Acarbonbankwouldalsoeffectivelyeliminatethevolatilityofthe carbon price, something that is quite detrimental to investments inlow-carbonoptionsindevelopingcountries.


McKinseyandCompany,Pathways to a low carbon economy (2009), available athttps://solutions.mckinsey.com/climatedesk/CMS/Default.aspx.

Netherlands Environmental Assessment Agency, “Chair’s Summary Report:Wheredevelopmentmeetsclimate:Developmentrelatedmitigationoptionsforaglobalclimatechangeagreement,”availableathttp://www.pbl.nl/en/dossiers/Climatechange/Publications/International-Workshop-Where-development -meets-climate.html.

Project Catalyst, Financing global action on climate change, available at http://www.project-catalyst.info.

Project Catalyst, Towards a global climate change agreement — Synthesis Report (2009), available at http://www.project-catalyst.info/images/publications/synthesis_paper.pdf.

https://solutions.mckinsey.com/climatedesk/CMS/Default.aspx






http://www.project-catalyst.info/images/publications/synthesis_paper.pdf

http://www.project-catalyst.info/images/publications/synthesis_paper.pdf


Climate Finance 111

Chapter 12

EngagingDevelopingCountriesbyIncentivizingEarlyAction

AnniePetsonkInternational Counsel, Environmental Defense Fund

with DanDudek,AlexanderGolub,NathanielKeohane,JamesWang,GernotWagner,andLukeWinston

Key Points

• To encourage developing countries to move to low-carbon devel-opmentpaths as swiftly aspossible,EnvironmentalDefenseFund’sCLEARproposal(CarbonLimits+EarlyActions=Rewards)offersdeveloping countries Clean Investment emissions budgets (CIBs)that can enable developing countries to access a pool of emissionsallowances initially greater than their business-as-usual expectedemissions, if they place domestically enforceable absolute caps onthe emissions of their major emitting sectors.

• By promoting early, broad-scale access to carbonmarkets,CLEARseekstohelpemergingeconomiesgainaccesstothecapitalneededtofinancethistransition.

• CLEARprovidesameasurable,reportable,andverifiablemechanismthatrewardsanydevelopingcountrymakingafirmcommitmenttoreduceemissionsearly,applyingthebenefitsofcarbontradingonascalefargreaterthanaproject-by-projectbasis.

• CLEARcouldalsohelpbuildcapacityearlyoninanumberofareas(technology;abatementopportunities;infrastructure;financialinsti-tutions,products,andexpertiseinthemitigationsector)indevelop-ing nations.

112 annie petsonk et al.

Introduction

Theworld’scollectiveefforttocurbclimatechangewillrelyheavilyupontheglobalmarketplace—theonly force largeandstrongenoughtodrivethe needed innovation and carry through the necessary reductions ingreenhousegases (GHG).Thisapproach isbeing taken seriouslyaroundtheworld,asevidencedbythesuccessoftheEuropeanUnionEmissionsTradingSystem(EUETS),thepassageoftheAmericanCleanEnergySe-curityAct(ACES)throughtheHouseofRepresentativesinJune2009,andproposalsunderdevelopmentinanumberofindustrializedandemergingeconomies such as Australia, New Zealand, the Republic of Korea, andMexico.ProposalsunderdiscussioninthelatteraimtoengageincarbonmarketsmuchmorebroadlythanavenuescurrentlyavailablethroughtheKyoto Protocol’s Clean DevelopmentMechanism (CDM). Enactment ofstrongUS cap-and-trade climate legislation could,more than any othersingle step,unite industrializednations indemonstrating theopportuni-tiespresentedbylow-carboneconomicgrowth.

Theeffort toprevent theworst effectsofglobalwarmingwill require,however, not just serious emissions cuts by industrialized countries butalsoearlyemissionsreductionsbymanyothers—including,most impor-tantly, the twodozenor so largest, fastest-growing, andmost influentialemergingeconomies.Thisproposal isdirectedat thethisgroup,offeringaframeworkthatcanaddressconcernsabout limitingemissionswithoutconstrainingeconomicgrowth,andcanhelpgeneratefinancingtofacili-tatetheswiftandearlyshifttowardslow-carbonpathways.

The Basic Idea

CLEAR (Carbon Limits + Early Actions = Rewards) invites developingnations that do not yet have emissions reductions obligations to adopta Clean Investment Budget (CIB), amulti-year absolute emissions limitcoveringeitherthewholeeconomyorthemajoremittingsectors.Reflect-ingthenegotiationsunderwayinthecontextoftheUNFrameworkCon-vention on Climate Change and legislative developments in the UnitedStates, nations that undertake nationally appropriate mitigation actions(NAMAs)couldproposetotheinternationalclimatetreatybodyaCleanInvestmentBudget(CIB)initiallysetatlevelsatorbelowtheiranticipatedNAMA emissions pathway (Fig. 12.1). Nations could be given access to

Engaging Developing Countries by Incentivizing Early Action 113

theresultingpoolofCIBemissionsallowancesearly,resultinginCIBal-lowancesinexcessofthecountry’semissionsatthebeginningoftheCIBperiod (Fig. 12.2).These allowances couldhelpprovide funding to assistthenationswiththetransitiontoalow-carboneconomybyallowingde-velopingcountriestodockintothecarbonmarketswiftlyandefficiently.Manydeveloping countries lack thefinancing to implement such trajec-tories. CLEAR taps the power of carbonmarkets to help nationsmoveswiftlyandearlytolow-carbonpathways.

CIBswouldbemadetransparent,feasible,andenforceableviadomes-ticlegislationthatbindscoveredsectorstothedeclaredpath.CIBswouldneedtobedeterminedinadvanceforatleasttwosuccessivecommitmentperiods (with the second limit lower than thefirst), toensure incentivesexist early on to transition to a high-technology, low-carbon economy(Fig. 12.3). Figure 12.3 illustrates a hypothetical CIB over two five-yearcommitment periods starting in 2013. The upper darker areas indicatetheportionofallowancesavailableabovecurrentemissions.Initially,onlythedarkareaabovecurrentemissions is theareaat thebeginningof theCIB period. As the CIB delivers financing to help implement NAMAs,

2013 2018 2023

Gt CO2e

Time

Business as usualpathway

Nationally AppropriateMitigation Actions

(NAMA)

Clean InvestmentBudget (CIB)

Fig.12.1.CleanInvestmentBudgetsetatorbelowanation’sNAMApathway.(Source:EnvironmentalDefenseFund,The CLEAR path: Re-warding early actions by emerging economies to limit carbon(2009))

114

2013 2018 2023

Gt CO2e

Time



(NAMA)

Low-carbon, highefficiency pathway

CIB emissions allowances aboveactual emissions provideup-front financing for low-carbon development


2013 2018 2023

Gt CO2e

Time



(NAMA)

Low-carbon, highefficiency pathway

CIB emissions allowances aboveactual emissions provideup-front financing for low-carbon development


Fig. 12.2 (top).EarlyaccesstoCleanInvestmentBudgetscanhelpfinancelow-carbondevelopment.(Source:EnvironmentalDefenseFund,The CLEAR path: Rewarding early actions by emerging economies to limit carbon(2009))Fig.12.3(bottom).CIBallowancesallocatedonanaverageannualbasis,fortwoperiods.(Source:EnvironmentalDefenseFund,The CLEAR Path: Rewarding early actions by emerging economies to limit carbon(2009))


however,theresultingemissionreductionswouldrendermoreCIBallow-ances surplusandavailable forfinancingmoreeconomicandmore low-carbongrowth,creatingapositivecycleforevenmoreambitiousNAMAs,consistentwiththeBaliActionPlan.

How Much Room Is There for CLEAR?

At the2009G8Summitheld inL’Aquila, Italy, and in theMajorEcono-miesForumassociatedwith theSummit, leadingnations recognized theimportanceofavertingmore than2°Cofwarming,a thresholdalso rec-ognized in the Waxman-Markey climate change legislation that passedtheUSHouseofRepresentativesshortlybeforetheSummit.If,consistentwith thesedevelopments,nationsvoluntarilyadoptNAMAs that includedomesticallyenforceablemulti-yearlimitsontheabsoluteGHGemissionsof their major emitting sectors, set below BAU and at levels consistentwith2°C,theycoulddockintothecarbonmarketandreceiveCIBs.Table12.1andFigure12.4illustratetheconstraintsimpliedbyamaximumglobal2°Cincrease.Figure12.4depictsemissionsasindicatedinTable12.1.

Note thatTable 12.1 considers the case inwhich theEuropeanUnionfollowsits20-20-20approach.If,however,theEUtookatightertargetin2020of30%below1990levels,andsetasideapercentageofitspost2012allowances to contribute to CLEAR, then at €10–20/ton the tighter EUtargetcouldsecureafurther€24–48billioninfinancingfrom2013–2020,withoutany leveraging.Leveraged two toone, it could secureup to€96billion in financing.While these estimates are contingent upon a num-ber of factors, they are significantly larger than existing flows and rankamongthehighestproposednewfundingmechanismsforGHGemissions

Table 12.1Emissions Targets Assumed to Achieve 2 Degrees (% Difference from 1990 Base Year)

Country/Group

Canada, Japan, Other Restof Restof Major-Emitting OECD OECD E.Europe/ Tropcial Developing US Europe Russia Pacific Eurasia Deforestation Countries

2020 –23% –20% –10% 10% –10% BAU BAUuntil2016;2050 –77% –80% –80% –80% –50% –29% peakin2019; then decline


mitigation in emerging economies. Moreover, CIB allowances could beusedtogenerateevengreaterlevelsoffinancing,asdiscussedbelow.

ButasFigure 12.4makesevident, there is little time tospare.BecausetheavailabilityofCIBsisnecessarilycontingentuponthegapbetweenex-istingemissionpathwaysandthepointatwhichthe2°Cthresholdisex-ceeded,everyyearofdelayinsigningontoaCIBmeansfewerCIBsthatoffer sufficient incentives to sign up will be available.Themost crucialtime forembarkingon theCLEARpath is theperiodbetween2010and2020, at the latest. If the CLEAR path is not implemented by then andthereisnoprogresstowardlimitsondevelopingcountries’emissions,theatmospheric headroom to accommodate CIBs will disappear by around2023—evenwithmajoremissioncutsbyindustrializednations.Ifthereisnoprogresstowardemissions limits inemergingeconomies,progressonemissionreductionsinindustrializednationsislikelytoslow,sharplyin-creasingthedangerofirreversible,catastrophicconsequencesfromglobalwarming.

The calculation of atmospheric headroom reflects an environmental

0

10

20

30

40

50

60

1990 2000 2010 2020 2030 2040 2050

GH

G E

mis

sion

s (G

t CO

2E/y

ear)

Year

Developing countries' emissions BAU until 2°C pathway crossed

Deforestation reduced

Industrialized countries capped

2°C target with >80% probability, 4.0 % max. annual reduction after 2050

Fig.12.4.Emissionspathwaysrequiredtolimittemperatureto2°Cwarming.(Source:EnvironmentalDefenseFund,The CLEAR Path: Rewarding early actions by emerging economies to limit carbon(2009))


constraintonthetotalsizeofallCIBsavailablethroughtheCLEARpath.Asecondconsiderationisrelevantaswell:howtomakeCIBsmosteffec-tiveinthecontextofglobalcarbonmarkets.

Achieving Maximum Emissions Reductions through Carbon Markets

A primary goal of the CLEAR path is to provide a readily availablesourceof capital tohelp emerging economiesfinance the transition to alow-carbon economy through nationally appropriate mitigation actions(NAMAs).Realizingthisgoal,however,requiresmorethansimplygrant-ingthesecountriesagenerousallotmentofallowances:aframeworkmustbeerectedtoensurethatCIBfundingiswellspent.Thissectionsketchesouttherangeoffinancingmechanismsthatcouldbeused.

Financing Mechanisms

One could imagine three broad channels for disbursing CIB funds.First,CIBallowances couldbeusedas collateral to secure traditionalfi-nancingthroughprivatebanksorperhapsexportcreditagenciesforemis-sionreductionprojectsthatare“noregrets”orofrelativelylowmarginalcost.Thereturnoninvestmentfortheseprojectswouldenablethenationtorepaythe loanandusetheCIBallowancesasnewcollateral fora fur-ther loan, in effect enabling the CIB allowances to serve as a revolvingfund.Used in thisway,CIBswould facilitatefinancingbyalleviating theneed for alternative loan guarantees and expanding access to credit.Be-cause thefinancierswouldretain their incentive toassess theviabilityofprojectsandmonitorperformance,thisapproachwouldrequirerelativelylittleoversightbytheauthorityholdingtheCIBallowancesotherthantoperformduediligenceon thebanksproviding thefinancing, and to en-surethat thecontract termswerenottoogenerous.SinceCIBsmightbeusedonlyas collateral, a substantial fractionof themwouldbe returnedtothecarboncapitalaccountafterthecompletionoftheunderlyingloan,andthenusedascollateralforfurtherloans.Moreover,allowancescouldbe(partially)retiredafterloanrepaymenttofurtherstrengthentheenvi-ronmentalintegrityoftheprogram.

A second option—perhaps less leveraged but alsomore tightly over-seen—could be a systemof carbon loan payments or carbondividends.


In this case, theCIB allowances serve as a guaranteed streamof carboncashflow.Bankswouldprovide incrementaldebtorequityfinancing foremissionsreductionsprojects(inconjunctionwithotherbasefinancing).Thehostcountryorprojectsponsorwouldrepayitsdebt(orpayoutdivi-dends)withCIBallowances.Inthemeantime,allowanceswouldbeheldin escrowby theCIB trustee,whowoulddisburse the funds andmoni-torcompliance.Theauthoritywouldalsoberesponsibleforapprovingtheprojects and determining their expected yield of emissions reductions.Paymentscouldstillbestructuredtoyieldcarbonleverageofgreaterthanton-for-tonreductions.

Finally,directgrants, fundedbytheproceedsfromthesaleofCIBal-lowances,wouldbethemosttightlyoverseenandprobablyleastleveragedalternative. A grantmechanism could bemodeled after theMultilateralFundestablishedbytheMontrealProtocol toassistdevelopingcountriesinreducingozone-depletingsubstances,whichiscommonlyseenasasuc-cess.Asinthatcase,theresponsibilityofoverseeingnationalactionplanscouldbeassigned toonecentral, internationalbody,whileotherentitiesworked on a local level (the Implementing Agencies in theMultilateralFund)toapprovefundingandmonitorprojects.Grantscouldbedirectedattheincrementalcostofemissionsreductions.

None of these financing mechanisms is sufficient by itself; they arecomplementsratherthansubstitutes.UsingCIB-AAUsascollateralcouldappeal to countries with well-developed capital markets, and would besuitedtoprojectswhereanincrementalinvestmentiseasilyidentifiedandyieldsreliableandsignificantoperatingcostsavings—forexample,energyefficiencyincommercialbuildings.

Carbon loan payments or dividends would be more appropriate tofinance projects where (i) the incremental cost was fairly well defined,(ii) theresultingemissionsreductionscouldbeaccuratelyestimatedandmonitored, but (iii) those emissions reductions fail to translate into fi-nancialgains.Finally,grantscouldbeusedtofinancepoliciesorbroaderprojects(e.g.,transmissionnetworkstosupportrenewables)thatcontrib-ute to long-term reductions in emissions but are less suited to conven-tionalprivate-sectorprojectfinance.

ComplianceandEnforcement

Compliance and enforcement are central issues in the design of anyinternational regime; climatepolicygenerally, and theCLEARpath spe-


cifically,arenoexception.InthecontextofCIBs,twodistinctcomplianceproblemscanbeidentified.First,isthecountryusingitsCIBallotmenttofinancecleaninvestment?Second, is theCIBcountrymeeting itsobliga-tiontoholdallowancessufficienttocoveritsemissions?

Eachof theseproblems is individually familiar frominternationalen-vironmentalpolicy.Multilateraldevelopmentbanks aswell asprivatefi-nanciers face similar challenges in overseeing how grants and loans arespentinthecontextofeconomicdevelopment.Asinthatcontext,robustoversightoffinancialflowswillbenecessarytoensurethatcountriesusetheirCIBstofundlong-termprojectsthatwillreduceGHGemissionsinthe long run.The stringency of such oversight would presumably varydepending on the financing mechanism used. In particular, when CIBallowances are effectively given to the recipient country as grants, thecaseforstringentoversight(onbothnormativeandpracticalgrounds)isstrongest.WhenCIBallowancesareusedascollateral,with theprospectof eventually retiring them rather than releasing them into themarket,the potential impact on the atmosphere ismuch reduced, and thus theneedforoversightisaswell.

OnepossibilityisforCIBallowancestobeheldinanescrowaccountinordertoallowforoversight.This,inturn,canserveasakeyincentiveforcompliance,whichoughttobeespeciallyeffectiveintheearlyyearsoftheprogram.IfacountryhasembarkedontheCLEARpathandvoluntarilytakenonaCIB,presumablyitwillfinditvaluableinthefirstfewyearstocomplywith the requirements in order to continue to receive thewith-held(escrowed)tons.ThislogicarguesforgivinglargeCIBs,butholdingmostallowances in reserveandreleasing themonly slowlyover time. InthiswaytheCIBcanhelpsolvenotonlytheinitialparticipationproblembutalso theongoingdynamicparticipation(continuation)problem. It isalsocrucialthattheescrowaccountbeheldaslongaspossible.

To aid compliance, CLEAR can draw on several risk managementtools:

• Monitoring. Rulesmust require reporting of absolute emissions—acrucial element of monitoring-reporting-verification (MRV) with-outwhich there is no assurance any climate goal can be achieved.WithMRV,marketactorsaremorelikelytomaintaindiscipline.

• Insurance.CLEARrulescouldrequirenationstoofferaninsurancepool of pre-agreed allowance quality which could be used as re-placementsifanymarketableCLEARreductionswerechallenged.


• Leverage Limits.WhileCLEARallowances couldbeused toobtainloans greater than the current value of allowances, rulesmight es-tablishrisk-based leverage limitsandrequire thatsomeCLEARal-lowancesbeheldinescrow.

• Allowance Devaluation. If MRV indicates that a CLEAR nation isnotachievingfullemissionreductionvalue,carbonmarketadmin-istratorscoulddevalueitsallowancesintheirtradingprograms.

• Plan Robustness. Plans must be transparent, feasible, and enforce-able via domestic legislation that binds the government to the de-clared path.

Ultimately, as in any agreement among sovereign nations, enforcementcannotbeimposedentirelyfromwithout.Thelong-runsolutiontocom-pliance,therefore,hastorestonensuringthatitremainsintheeconomicself-interest of sovereigns and companies and communities in theirma-joremittingsectorstocontinuetofollowlow-carbondevelopmentpaths.CIBsneedtofinanceinvestmentsthatmakeitmoreattractiveexpost tocontinuealong the low-carbonpath than toabandon it.Certainlyestab-lishing the international anddomestic frameworks for such systemswillentailovercomingsignificantdomesticpoliticalresistance.However,onceestablished, such systems can create an endogenous source of politicalsupport,bypromotingthegrowthofcleanenergyindustrieswithnewin-centivesandresourcesanddeliveringcleanenergyandbetterlivingstan-dards toconsumers,who thenbecomeconstituents for remaining in theframeworks.Those domestic constituencies can thenhelp to sustain thepoliticalwilltocontinuetoparticipateinlow-carbondevelopmentframe-worksgoingforward.Ineffect,theactofparticipatingintheregimehelpstoreshapeincentivesinfavorofcompliance.

Conclusion

Aframeworkthatbeginswithindustrializednationsadoptingstrongbind-ingcapsontheirabsoluteemissions,andthatinvitesdevelopingcountriesto take the CLEAR path, rewards and incentivizes emerging economiesto move swiftly to reduce their emissions and increases the chances ofavoiding globallydangerous climate change.The sooner emerging econ-omiesmove to establish CIBs, the greater the rewards they will receiveintermsoffinanceforsustainabledevelopment,andthesoonertheycan


transition to more sustainable low-carbon economic development. Thegreaterthedelay,thelessremainingemissions-absorptivecapacitywillbeavailable, and themore difficult it will be for the world to avert severeclimate change.


A.Petsonk,“‘DockingStations’:DesigningaMoreOpenLegalandPolicyArchi-tectureforaPost-2012FrameworktoCombatClimateChange,”19Duke Jour-nal of International and Comparative Law433(2009),availableathttp://www.law.duke.edu/journals/djcil/.

G.Wagner,N.Keohane,A.Petsonk,andJ.Wang,“DockingintoaGlobalCarbonMarket:Clean InvestmentBudgets toFinanceLow-CarbonEconomicDevel-opment,”inThe Economics and Politics of Climate Change (Helm&Hepburn,eds.),forthcoming,OxfordUniversityPress(2009).

http://www.law.duke.edu/journals/djcil/



E

LinkingTradingSystems

Climate Finance 125

Chapter 13

CarbonMarketDesignBeyond the EU Emissions Trading Scheme

HenryDerwentPresident, International Emissions

Trading Association

Key Points

• TheEUETShasproventhepotentialofacap-and-tradeschemetoreduce carbon emissions on a large scale.Despite criticismsof themannerof its implementation, its failure to stimulatemuch invest-ment in low-carbon technology, and its price volatility, importantlessonshavebeenlearned,andonmanyfrontsithasperformedbet-ter than expected.

• Theconceptofoffsettingcontinuestoraisepoliticalandmoralcon-cerns inmany quarters, despite supplementarity being taken seri-ouslybydevelopedcountries.

• With the future of the CDM currently uncertain, it is importantwhendesigningasuccessortoKyotonotto losethebenefitsof theCDMtodevelopingcountries.Butitisalsoimportanttomakesurethat new or improvedmechanisms are designed in away that ap-pealstoprivate-sectorinvestorsand—atleastinitially—coversrisksthatcouldputinvestorsoff.

• Over time, a global carbonmarket is most likely to emerge fromlinksestablishedbetweennationalandregionalschemes.Therateatwhich this occurs is highly dependent on the balance between theextentofincompatibledesignfeaturesandthebenefitstobereapedfromsuchlinks.

126 Henry Derwent

The EU ETS

Much has been written about the European Union Emissions TradingSystem (EU ETS) and what it has demonstrated about the potential ofcarbon trading. It is generally acknowledged that the allocation processin the first period, pre-Kyoto,was uncoordinated, and as a result issuedtoomanyemissionsallowances,givingrisetoanembarrassingpricecol-lapse.Yetrecenteconometricanalysissuggeststhatwhenallowancepriceswerehigh,significantcarbonreductiondidoccur.Itisalsoacknowledgedthatthesecondphase, thoughdemonstratingtheabilityof theEuropeanCommission toget togripswithexcessivenationalallocations,hasbeenflawedbycontinuationofconditionsmakingfreeallocationofemissionspermits politically unavoidable, and that the recently concluded frame-workforthethirdphasehasnotimprovedmattersallthatmuch.Butoverthe Kyoto commitment period, the EU ETS has been, as was intended,thepremierEuropeanemissions reductionpolicy. Ithasworked to limitemissionsgrowth.

A further criticism is that even if the ETS has worked in the shortterm, it has induced little if any investment in low-carbon technologies.Current allowance prices barely justify fuel switching in power stations,let alone the construction of low- or no-carbon generation alternatives.This criticism,however, begs thequestionofwhatourobjectives shouldbe.Theprimaryeconomicpurposeofemissionstradingistoidentifyandsmoke out the lowest-cost emissions reduction options when it is clearthat carbon needs to be reduced.There is no justification for installinglow-carbon capital equipment quickly if underlying trends in the econ-omyarepullingcarbonemissionsdown,oriftherearecheaperuntappedreservoirsoflow-carbonactivity.

Also, the ETS has been criticized for excessive price volatility. Evi-dence here is usually dominated by the price-collapse in Phase 1. Phase1wasavowedlyexperimentaland insulated fromtheKyotocommitmentperiod. It served to convince theEUmember states collectively that theCommissionneededtotakeatougherroleinthefutureinapprovingal-locations and improving the flow of information.The second period ofprice weakness, in 2009, is fundamentally different. It would in fact beamatterforsomeconcernifthepriceofcarbonontheEUETShadnotreflectedthedecreaseinemissionscausedbydecreasingenergycostsandproduction activity due to the economic downturn. This experience infact shows that the market is working properly. If the Phase 1 story is

Carbon Market Design 127

excluded, thevolatilityof the carbonpricehasbeennogreater thaneq-uities formuchof theperiod,andcertainlynoworse thanoil andsomeother commodities.

However, the argument about the relationship between the EU ETSprice and low-carbon investment persists. Critics acknowledge that to-day’spriceoughttobenorealguidetotheexpectedcostofcarbonoverdecadaltime-scales.Therealissueisexpectedcarbonpricesovertheme-diumtolongerrun.HerethereisdefinitelyaquestionastowhytheEU’scommitment to at least a reduction of 20% by 2020, irrespective of theoutcomeofCopenhagen, hashad so little impact on low-carbon invest-mentplans intheEU.Somepossibleanswersare that fromnowto2020is just not a long enough period; or that the Copenhagen internationalnegotiations will provide the final figure, and there is no point in act-ing in advance of it; or that 20% is in fact a low enough level of am-bition to be achievable by a combination of expected regulatory meas-uresandrevenue-accountactivities suchascontinuing toadjust the fuelmix.Thereisapersistentsuggestionfromsomefirmsandacademicsthatlonger-term price uncertainty is a political risk that governments oughttounderwriteinsomeway.

Offsets

Thedegree towhichdevelopedcountryemissions reductionobligations,and the obligations that those countries delegate down to their compa-nies, can be satisfied by any formof offset has been the subject of con-tinuingdebateeverywhere.On theonehand,achievinga reduction inaglobalpollutantatthelowestcostavailable,whereverintheworldthere-ductiontakesplace, isacentraltenetofarationaleconomicapproachtogreenhousegas(GHG)reduction.Ontheotherhand,manypeoplethinkthat developed countries, and companies within those countries, oughtnot to be given a cheap way out of their obligations and their formerprofligacy, and ought to be concentrating on reducing their own emis-sions rather thanoffsetting thembyreductionselsewhere.Plus therearesomepoliticalobjectionstopayingforeigncountriesforemissionsreduc-tionswhentherecouldbejobsorothereconomicadvantagefromtakingaction at home.

ThissetofargumentswassettledintheMarrakechinternationalnego-tiationsbya“supplementaritylimit”onoffsets,whichhasbeenrespected

128 Henry Derwent

in theEUETSbut has still given enough scope forCleanDevelopmentMechanism (CDM)offset credits to enjoy a strongmarket, and in somecases handsome profits, through EU ETS compliance demand. But thedemandforCDMreductionsnowshowssignsofslowingdownasmanymemberstateshavebegunpursuingcheaperoffsetopportunitiesprovidedbysurplusAssignedAmountUnits(AAUs)fromotherAnnexIcountries,particularly thegenerousAAUsettlements thatRussia, theUkraine,andothereconomiesintransitiontookawayfromKyoto.

Otherwise themarkethas in factdonewhatmarkets are supposed todo: found the lowest-hanging and lowest-risk fruit first, even if someofthesefruitshavenotbeentoeveryone’staste.Thosedevelopingcountriesthathavebenefited,andthosewhothinktheywillhaveachanceofdoingso in the future, have quicklywarmed to theCDMeven if at an earlierstagetheirnegotiatorswerehardtoconvinceofitsmerits.TheCDMhasachieved investment in developing countries that would not have hap-pened otherwise, some of it involving technology transfer and capacitybuilding; it has awakened interest in emissions reductions in countriesthatstillstronglydenythattheyhaveanyobligationtoreduce;andithaspromotedinternationalpartnership—alljustasitwasintendedto.

Beyond the CDM Approach

Yet the futureof theCDM isnow seriouslyuncertain.TheEUhas real-izedthattheemissionsreductionstreamscreatedbythetranchesofCDMprojects accepted for Phase 2 of the EUETSwill continue to provide alarge proportion of the reductions availablewithin the space defined bytheir supplementaritypolicy: there is little room left fornewoffsetproj-ects.Theyhave alsobecomeconcerned that aperpetuationof theCDMwill create incentives for developing countries to refrain from adoptingemissions reduction targets of their own.And theynote that the rise indevelopingcountryemissionscontinues tobe so steep that theprincipleofoffsettingdevelopedcountryemissionswithsomedevelopingcountryonescanonlyhavealimitedlife.

Thisnews,combinedwiththegeneraluncertaintyaboutglobalcarbonprices,has come close toknocking thebottomoutof theCDMmarket.Thereareasmallnumberofmainlypublic-sectorfundsthatarepreparedto takeabetonpost-2012CDM1prices,butoverall thepreference is towaitandsee.Alotofconfidenceandcapacityisleakingoutofthemarket


as a result. It is possible that CDMdemand from theUS andAustraliacouldcome in justat the right time to takeover fromthe shrinkingEUappetite,but it isat leastas likelythat therewillbeagapand/oradelay.WhileAustraliahasmoved in thedirectionofgreaterwillingness touseemissions reductions availableon theworldmarket, there isdeep suspi-cionintheUSabouttheCDM,andmuchoftheavailablespacethereforinternational offsets could be occupied by favored, if still rather vague,forestryoffsetproposals.

The EU has been setting out amore detailed version of its vision ofthe future, which is clearly linked to its Copenhagen negotiating strat-egy.Theyhave specified that theCDMis expected tocontinue forLeastDevelopedCountries,and thataversionof themany-headedconceptofsectoral crediting could act as ameans ofmoving the larger developingcountries away from project-dependence towards a future where thesecountrieshaveemissionstradingschemesliketheEU’sthatcouldlinkintoawiderglobal system.Butapart fromthedifficultyofpersuading thedeveloping countries,whose suspicionof sectoral targets isdeep-rooted,little attention seems tohavebeengiven so far to the fundamentalneedto design a crediting mechanism that will be bankable and will attractprivate-sector investors. Conventional CDM projects look like familiarproject financemodels, with extra revenue. But how can the disciplinesofprojectfinancebeappliedtoawholeeconomicsectorwithoutmassivepoliticalrisk?Whoarethecounter-parties,whobearstherisk,andwhereis the collateral?

Other New Mechanisms

The same concern arises with other ideas for newmechanisms that arebeing repeatedly discussed in the international negotiations and in con-versations between stakeholders, including other approaches to sectoralagreements such as the crediting of developing country actions that gobeyondNationallyAppropriateMitigationActions(NAMAs)andReduc-ingEmissionsfromDeforestationandDegradation(REDD).Itisfarfromclearwhat theoverall impacton thebalanceof supply anddemandwillbe,thoughingeneralitseemslikelythatverysubstantialadditionalsup-plycouldbecreatedthroughtheseroutes.

Yet clearly, somethingmust be done to engage the larger developingcountries more firmly in the enterprise of reducing their business-as-

130 Henry Derwent

usual (BAU) emissionsbeyondwhat they are likely to regard initially asnationallyappropriate;theremustbeabalancebetweenpersuadingthemforgeopoliticalreasonstogofurtherandpayingforemissionsreductionsthat go further still.Those payments are bound to be a combination ofpublicandprivatemoneyfromdevelopedcountries.

Clarificationof the size of thosepayments and theproportion that islikely to come from additional public-sector funds or other sourceswillbeveryimportantinordertoestablishthebasisforapoliticalagreement.But thenatureandeconomic justificationof theprivate-sectorcontribu-tionmust alsobedefined in terms thatwillmake sense to thepotentialcontributors.Carbonfinance started as a supplementary revenue sourceforprojects.Thereseemstobenoreasonaproject-basedapproachcouldnot continue alongside or within sectoral-level obligations, or alongsidethe introduction of cap-and-trade as a domestic means of producing anationally appropriate level of emissions reductions.Departing from theprojectapproachrequiresanewlookatthenatureoftheinvestmentanditsrisks,andthepotentialforrisk-reduction.Atime-limitedorotherwisediminishing availability of these support mechanisms would build oninternational precedents, althoughwhile available they could overlap orrun together rather thanpresent a sudden jumpbetweenwhathasbeenprovedsuccessfulandwhathasnorecordofaccomplishment.Anewpro-gram of policy risk guarantees from international financial institutions(IFI),perhapsincludingguaranteedlevelsofemissionreductionpurchase,couldbridge thegap, eitherdirectlyorpassed through thehost countrygovernment. Special public-private institutions couldperhaps be createdtodefineanddrivethesector-wideemissionsreductionproposals.

The Global Market

Theultimatevision forcarbonfinance, in themindsofmanystakehold-ers, is a global market.The attractions in terms of economic efficiencyareobvious,andthere isnoreasonaglobalmarketcannotbeconsistentwith the principle of common but differentiated responsibilities. But itseemsveryunlikelythatmajornationalandregionalauthoritieswillsub-mittoacentralscheme,particularlyifrunbyaUnitedNationsagency.Itis now generally accepted that a globalmarketwill instead emerge overtimefromthegradualcomingtogetherofnationalandregionalschemes.But there will probably be a battle between the economic pressures to


harmonizeandthepoliticaldesiretopreservedesigndifferencesresultingfrom initial national political requirements. Experiencewith the incom-patibledesignfeatures,suchasdifferentformsofoffsetsorpricecontrols,maymake it easier to compromise at a laterdate, butnotnecessarily.Agreatdealofanalysisanddiscussionregardingthevariousmeansoflink-ingandunification,andwhomightgainorlose,isgoingtobenecessarybeforeasufficientconstituency is likely tobebuiltup forsacrificingdif-ficultpoliticalchoicesalreadytakeninfavorofagreatergood.


R. Baron, B. Buchner, and J. Ellis, Sectoral Approaches and the Carbon Market (IEA/OECD,June2009).

CarbonTrust/Climate Strategies,Global Carbon Mechanisms — Emerging Lessons and Implications(March2009).

EU papers on international climate change policy (January 2009), available athttp://ec.europa.eu/environment/climat/future_action.htm.

http://ec.europa.eu/environment/climat/future_action.htm

F

InvestorPerspectives

Climate Finance 135

Chapter 14

IncentivizingPrivateInvestmentin Climate Change Mitigation

MarcelBrinkmanAssociate Principal, McKinsey & Company

Key Points

• Reducinggreenhousegasemissionswillrequiresignificantlevelsofinvestment,bothprivateandpublic.

• Investmentindevelopedcountriesoffersgreaterinvestmentsecurityduetoefficientcapitalmarketsandinvestmentprocessesnotfoundin developing economies, although the latter presentmore oppor-tunitiesduetogreaterratesofeconomicgrowthandinfrastructuredevelopment.

• Up-front capital investment likelywill not be attractive to the pri-vatesectorunlessgovernmentsprovidesufficientcashflowsupport.Because only aminority of such investments are inherently finan-ciallyviable,government-mandatedincentivessuchascarbonpric-ing,standards,anddirectsubsidies/feed-intariffswouldberequiredtogenerategreaterinvestmentsinmitigation.

• Theprivate sector could respond to incentives that provide a highdegree of regulatory certainty into the future and that effectivelycounterprincipal/agentproblems.

Leaders in many countries are seeking ways to reduce greenhouse gas(GHG)emissions; ever increasingattention isbeing focusedonhow thenecessary reductionswillbeachieved.Thechallenge is significant; if theproposedcutsare tobeachieved, thepower sectormustfindnew,cleanways of generating electricity; automobile fleets must be replaced with

136 Marcel Brinkman

more fuel efficient or electric alternatives; and old and inefficient build-ingsmustbephasedoutandreplacedwithnew,energyefficientones.

Theglobalscientificcommunityassertsthattheworldneedstoreduceitscarbonemissionstolimitglobalwarmingto2°Cabove1990levels.Toachievethislimit,theworld’snationsmuststabilizeatmosphericconcen-trationsofcarbondioxideequivalents(CO2e)at450partspermillionpervolume (ppmv), as compared to approximately 385ppmv today.This re-quires limiting global emissions to 44GtCO2e in 2020 and to 35Gt in2030—alargereductionfrombusiness-as-usualscenariosandlowerthantoday’slevels(approximately46Gtin2005).

The investment needed to achieve this reduction is significant andpresents challenges for investors.National governments donot have themeanstoinvesttheamountsrequired,especiallygivencurrenteconomicconditions. Private capitalmust play amajor role in climate change in-vestments, but will only do so within a stable, favorable regulatory andmarketframework.Thismeansthatakeychallengeforgovernmentswillbetoprovidesufficientcashflowsupporttomakeup-frontcapitalinvest-mentbytheprivatesectorattractive.Theclearimplicationofthis:tocre-ate a lower-risk environment that encourages capital investment, policy-makerswill likelyneedtoprovide incomesupport tomitigationprojectsviadomesticregulation.

Where Is Investment Needed?

TheMcKinseyGreenHouseGasAbatementCostCurve(seeFigure14.1)assessesthetechnicalopportunitiestoabateCO2eemissionsthatcostun-der€60/tonne in theperiod to2020, as shown in thegraph.Abatementopportunitiesexaminedfallintothreecategories:

• Energyefficiency(buildings,transport,industry),representing5Gt• Low-carbonenergysupply,representing4Gt• Terrestrialcarbon(forestryandagriculture),representing10Gt

Investment in these sectorswould start to turn these opportunities intoreal reductions.McKinseyestimates that inorder to reachadesired450ppmv pathway, €350 billion of incremental capital investment is neededbetween2010and2020,and€595billionbetween2020and2030.SectorestimatesareshowninTable14.1.

137

35 38250

10

20

105 15 20 30

30

40

50

60

-10

-100

-20

-30

-40

-50

-60

-70

-80

-90

Abatement cost€ per tCO2e

Note: The curve presents an estimate of the maximum potential of all technical GHG abatement measures below €60 per tCO2e if each lever was pursued aggressively. It is not a forecast of what role different abatement measures and technologies will play.

Lighting – switch incandescent to LED (residential)

Cropland nutrient management

Tillage and residue mgmt

1st generation biofuels

Clinker substitution by fly ash

Electricity from landfill gas

Small hydro

Reduced slash and burn agriculture conversionReduced pastureland conversion

Grassland management

Organic soil restoration

Pastureland afforestationNuclear

Degraded forest reforestationReduced intensive

agriculture conversion

Coal CCS new buildIron and steel CCS new build

Motor systems efficiency

Rice management

Cars full hybrid

Gas plant CCS retrofit

Solar PV

Waste recycling

High penetration wind

Low penetration wind

Residential electronics

Residential appliances

Retrofit residential HVAC

Insulation retrofit (commercial)

Power plant biomass co-firing

Geothermal

Coal CCS retrofit

Degraded land restoration

Abatement potentialGtCO2e per year

Solar CSP

Building efficiency new build

2nd generation biofuels

Efficiency improvements other industry

Insulation retrofit (residential)

Cars plug-in hybrid

Fig.14.1.Opportunitiestoachievea450ppmpathwayexistatunder€60/t.(Source:McKinseyGlobalGHGAbatementCostCurvev2.0(2009))

Table 14.1 DevelopingNation GlobalInvestmentNeed InvestmentNeed

€ bn in € bn in € bn in € bn inSector 2010–2020 2020–2030 2010–2020 2020–2030

Buildings(mainlyenergyefficiency) €125 €155 €25 €45Transportation(mainlyenergyefficiency) €70 €215 €25 €100Industry(mainlyenergyefficiency) €75 €80 €40 €50Power €65 €125 €30 €70Waste €10 €10 €5 €5Forestryandagriculture(terrestrialcarbon)* €5 €5 €5 €5

*Forestryandagriculture(terrestrialcarbon)representaverysignificantabatementopportunity(10Gt),butrequire lessup-front capital investmentasmostof thechangesarebehaviorbased, e.g., changedagriculturalpracticesoravoidingdeforestation through increasedeconomicactivity inandaroundthe forest.Thecapitalexpenditurefiguresshowninthetablerelatetoafforestation,i.e.,theinvestmentrequiredtoplanttrees.

138 Marcel Brinkman

What Are the Differences in Investment Conditions between Developing and Developed Nations?

When considering the investment needed for low-carbon economicgrowth, thedifferences indevelopedanddevelopingnations’ investmentenvironments are important. Developed nations have efficient capitalmarketsand investmentprocesses,andshouldbecapableof implement-ing the right policies to support climate investment. The challenges indevelopingnations are greater, as investorsneed toovercome regulatoryuncertainty and infrastructure and deployment obstacles. However, theinvestment opportunities are often also greater due tomajor infrastruc-tureinvestmentsandfastereconomicgrowth.

• Developed nations require €220 billion of capital investment peryear between 2010 and 2020, and €315 billion between 2020 and2030: this is mainly driven by replacement or upgrade of existingbuildings(47%ofthetotalcapitalneedby2020)andtransportationstock(20%ofthetotalcapitalneedby2020).

• Developing nations require €130 billion of capital investment be-tween 2010 and 2020, and €280 billion between 2020 and 2030:Chinarepresentsalargeshareofthis(€60billionor44%).

How Can Investment in Mitigation Be Attractive for Countries and for the Private Sector?

Investmentrequirestherightfinancialandregulatoryincentives.Anyin-vestmentneedstorecovertheinitialinvestmentandthecostofemployingits capital over time, adjusted for the underlying risk of the investment.Governments couldmake the economics ofmitigation projects positivefor investors; this requires assurances of climate revenues formitigationviapoliciesandmeasures thatwill stay inplace,despitechanges ingov-ernment,forthelifeoftheproject.

Currently, only a limited number of investments that will produceemissions reductions are inherently financially viable (net present valuepositive)—those shownon the left-handsideofFigure 14.1.Anexamplewouldbeenergyefficiencyprojectsthathaveenergysavingshighenoughtomorethanrecouptheinitial investment.However,eventheseprojectsmaystillneedchangesingovernmentpolicies,regulation,orsupportfor

Incentivizing Private Investment in Climate Change Mitigation 139

up-front financing to realize the potential savings and overcome invest-ment barriers.

Otherabatementopportunitiesrequirefinancialincentivestocompen-sateinvestorsforthehighercostofanabatementprojectrelativetoalter-native investmentopportunities.Anexamplemightbeawind farm thatrequiresadditionalfinancial incentives inorder tocompetewithahigh-carboncoal-firedpowerplant.

Climateandotherregulatorypoliciesaretheleversleftinthehandsofgovernment to bridge the gap between returns that an investor requirestomakeaparticularinvestmentandthereturnsthatwouldotherwisebereceived.Themainmethods for incentivizing investors are carbonmar-kets,subsidies,andfeed-intariffs,aswellasotherpolicyinstrumentslikestandards.

Carbon Pricing

Carbon pricing, either through taxing emissions or through a cap-and-tradeoroffsetcredittradingsystem,affectsinvestmentprospectsbycon-ferring amonetary benefit on emissions reductions. Attaching prices tocarbonthroughregulationandmarketsincreasesthecostsofhigh-carbontechnologies and also themarketpricesof goods and servicesproducedthrough such technologies, to the benefit of investments in low-carbontechnologies. Carbon trading markets also generate commercially valu-ablecarboncreditsforlow-carboninvestments.

Not only does carbon pricing help align private incentives to reduceemissions with public goals, it can also create a revenue stream (eitherthrough carbon taxes or auctioning emissions permits) for governmentsto spend on emissions reduction in other sectors, or to use to reduceother taxation requirements. However, not all emissions can be easilycaptured inacap-and-trademarketorwithacarbontax,and long-termuncertainty about the level of the carbon price can blunt the incentivesprovided.

Carbonmarkets will likely develop rapidly in the next few years, in-creasingtheopportunityforinvestors.Currentlytherearetwomaintypesofcarbonmarkets:

• Regional and national domestic Emission Trading Systems (ETS),requiring sources to hold emissions permits that can be freely

140 Marcel Brinkman

traded.ThemainexampleistheEuropeanUnionETS;legislationtoestablishsuchasystemisprogressingintheUS.Emittingfirmsarethemainactorsinthismarket.

• International (offset) credits generated indeveloping countriesun-der theCleanDevelopmentMechanism(CDM)canbe sold tode-velopedcountryfirmssubjecttodomesticETSordirectlytoAnnexIcountriestomeettheirKyotocommitments.Low-carbonprojectscanearnCDMcreditsiftheyprovethattheyresult inemissionre-duction(i.e.,areadditional).

The CDM offset credit market has grown rapidly but is still limited inscale(140Mtofcreditsgeneratedin2008)andneedstoscaleupsignifi-cantlyinordertoplayamajorroleintheinternationalfinancingofabate-ment. It isquestionablewhether thatwill bepossiblewithproject-basedoffsetsonly.Sector-basedschemes,whicharetypicallylargescalebytheirnature,mayberequired.

Many mitigation technologies are capital intensive and have a longinvestment horizon, in particular those in the power sector. Relying oncarbonmarketstoprovidereturnshasproventobeproblematicinsomecases because of uncertainties created by large fluctuations in carbonprices. Many market participants have argued that some form of priceregulation or government steps to establish a price floor might be re-quiredinordertomakecarbonmarketmoreeffective.

Subsidies

Direct subsidies for capital investment or operating expenses, such asthoseprovidedby feed-in tariffs in thepowersectorwhichrewardcleanenergy with a payment for each kWh generated, promote certainty re-gardingreturns(solongastheyareineffect)andhavedirectpositiveef-fectontheinvestmentcashflowprofile.Feed-intariffshaveproventobeoneofthemoreeffectivepoliciesintermsofstimulatinginvestmentandhave been a policy of choice formany countries.However, they can beexpensiveforgovernmentsunlesstheyarepaidforbyendusersdirectly.

Incentivizing Private Investment in Climate Change Mitigation 141

Regulatory Standards

Mandatory standards to promote climate objectives include engine ef-ficiency standards for automotives and other products, and renewablepowerstandardsthatrequirepowercompaniestoproduceacertainpro-portionof their electricity fromclean sources.Although these standardsdonot includeadirectfinancialelement, theydoimposethesamestan-dards on an entire industry, thus maintaining a level playing field andpassingoncoststoconsumersthroughhigherprices,thus,ineffect,pro-vidinganincreasedreturnontheinvestmentinabatement.Policymakerslike standards as they do not incur costs to the government.As a non-marketapproach,however,theycanbeinefficientbyenforcingabatementevenwhereitisveryexpensivetodoso.

Alimitednumberofbestpracticeregulatoryandpolicymeasurescanstimulate investment toachieveasignificantamountofabatement,ofteninconjunctionwithcarbonmarkets:

• Renewable power standards (RPS) can often boost returns fromrenewable power,making projects viable. Feed-in tariffs are an al-ternativetoRPS;theycanactasaguaranteedpriceforpowergen-erated, reducingproject risks.Experience shows that feed-in tariffshavebeenasormoreeffective thanRPS indrivinguptakeofwindgeneration.

• Energy efficiency in industry is often linked toupgrading facilitiestobestpracticelevels.Chinainparticularisintheprocessofshut-ting downmany sub-scale production facilitieswith low efficiency(e.g.,incement)andreplacingthemwithbest-in-classfacilities,cre-atingopportunitiesforinvestors.

• Energyefficiencystandardsforcars,buildingcodesforhouses,andappliancestandardscandrive innovationandinvestment inenergyefficienttechnologiesandtheirapplication.Ifinvestorshavereason-ableassurancethatsuchstandardswillbemaintainedandstrength-ened, they will invest in the likely winners (e.g., car or appliancemakers that are already more efficient than the competition andstandtobenefitfromtighteningstandards).

• Carbon-contentfuelstandardsopenopportunities forbiofuels,andmake them competitive. Without standards, biofuels are not eco-nomic compared to petrol or diesel.

142 Marcel Brinkman

Other Important Elements of Climate Regulatory Policies

Whendecidingondomesticregulation,policymakerscouldconsider:

• Regulatory risk.Asdiscussedabove,manyclimate-relatedtechnolo-gies rely on government policies to be economically viable.Whilesome government policies represent credible commitments overlongerperiodsoftime(e.g.,mostfeed-intariffs),othersaresubjectto significant political uncertainty. New Zealand provides a recentexample where the planned emission-trading scheme was put onhold after a change in government. Some type of policy guaranteemayberequiredtoinducethedesiredlevelofinvestment.

• Agency problems/industry structure. Principal-agent problems are a major challenge for energy efficiency projects. In many instances,the logical investors(e.g.,ownersofapartmentbuildings incaseofbuilding insulation)might not capture the benefits (reduced heat-ing bills) because theywill accrue to a third party (tenants).Gov-ernments could consider creating alternate business structures likeEnergyServicesCompanies,orESCOs,whichinvest in(residentialbuilding)energyefficiencyinreturnforanannualfee.

Attractive Opportunities for Investment in Climate Change Mitigation Can Only Exist If Current Policies Are Strengthened

Tomeetabatementtargetstheworldneeds€350billionperyearofincre-mentalcapitalinvestmentinmitigationbetweennowand2020insixeco-nomicsectorsacrossallnations,developedanddeveloping.Policymakerswill likely need to create the conditions that will trigger private invest-ment in mitigation and spur competition among companies to achievelow-carboneconomicgrowth.Well-designedpolicies, inprinciple,couldspur cost-effective emission reductions, increase energy security, makeeconomies more robust, boost innovation rates, and support economicgrowthanddevelopment.


McKinsey & Company, Pathways to a Low-Carbon Economy: Version 2 of the Global Greenhouse Gas Abatement Cost Curve,2009.

Climate Finance 143

Chapter 15

InvestmentOpportunitiesandCatalystsAnalysis and Proposals from the Climate Finance

Industry on Funding Climate Mitigation

NickRobinsHead of Climate Change Centre of Excellence, HSBC

MarkFultonGlobal Head of Climate Change Investment Research and Strategy,

Deutsche Bank

Key Points

• Investments in low-carbon energy solutions have grown almostfive-fold in thepastfiveyears.However, investmentsneed togrowafurtherten-foldtodriveemissionsontoasafepath,withalmostatwenty-fold expansion in energy efficiency in buildings, transport,andindustry.

• Improving regulatory certainty is the lowest-cost option, and thisapplies at every level from local (e.g., planning permission, fiscalcertainty) to international (e.g., policy on technology transfer orcreditgenerationanddemand).

• Increasing local capacity to absorb low-carbonfinancewill alsobecrucial,requiringthetransferofknowledgefromthosewithexper-tise in thedevelopedworld to theircounterparts in thedevelopingworld.

• Reducing the perceived risk of investing in low-carbon projects isacrucial step in thisprocess regardlessof the successof theprevi-ous two options, and the use of credit guarantees backed by pub-lic fundsandcarbon insurance incaseofprojectnon-executionor

144 nick robins and mark fulton

credit non-delivery will play a key role inmaking low-carbon in-vestmentsattractive.

It is clear significant support from private finance will have to be mo-bilized in order tomeet the world’smitigation and adaptation needs inthecomingyears.Asmatterscurrentlystand,therightincentivesarenotinplace for this tooccur in sufficient volume tohave thedesired effect.A hospitable climate for low-carbon investment rests on two main pil-lars:certaintyonmid-andlong-termtargetsandacomprehensivepolicyframeworkto implementthesetargets.Thispaper focusesonthesecondof these, examininghow toboth reducefinancingbarriers and intensifycapacitybuilding andknowledge transfer from thedeveloped to thede-velopingworld.Anoverviewof barriers to financing is given, before anexaminationofsomekeyareaswherescaled-upinvestmentcouldhaveasignificantimpactsuchastechnology,energyefficiency,andforestry.

Barriers to Financing: An Overview

On the regulatory side, private finance needs long-term regulatory pre-dictability based on transparent rules and procedures at the national,international, andUN levels.Under this regime, climate change institu-tions such asDesignatedNational Authorities would exist and functionefficiently,whilemarketswouldinternalizethecarbonexternality.Onthefinancialside,thecurrentdifficultyofobtainingdebtfinanceupfrontforprojects,theriskofpossiblelate-ornon-executionoftheproject(includ-ing non-delivery of credits), and volatility of carbon prices—assisted byuncertainty on the demand side from cap-and-trade schemes—all con-tributetosignificantprojectriskthatdisincentivizesinvestment.

Oneapproachtoovercomethesebarriers isregulatoryinnature,sub-stitutingclarityandpredictabilityforuncertaintyandopacity in interna-tional and national regulation. Another is infrastructure-based, increas-ing the physical (electricity grid, available resources), institutional, andhuman (technology workers, public agency capacity, local financial re-sources,andknow-how)capacitytoabsorblow-carboninvestmentatthelocal,regional,andnationallevelsindevelopingcountries.

Athirdapproachis theuseofpublicfinance.Debtguaranteesbackedbypublic funds,oneof thecoresuggestionsof thispaper,wouldsignifi-cantly reduce project risk caused by any number of the above barriers.

Investment Opportunities and Catalysts 145

One possibility is the creation of amechanismwhereby the home gov-ernmentofaforeigninvestorissuesguaranteesinordertofacilitate low-carboninvestmentsinhostcountries.Examplesofthesemechanismscur-rently exist:OverseasPrivate InvestmentCorporation (OPIC) andotherexport credit agenciesprovidede-risking services,while theMultilateralInvestmentGuaranteeAgency(MIGA),traditionallyaguarantorfornon-commercial risk, has also been recently experimenting with mitigatingcommercial risk. Credit risk guarantees and other risk-sharing instru-mentscanconsiderably lowertheinvestmentbarriersformanyinvestorsandkeeptherisksassociatedwithdirectinvestmentsatareasonablelevel,evenwhenthereexistsuncertaintyinlong-termpolicyandregulation,lo-calinfrastructure,andcapacityatthelocallevel.

There is also adesperateneed for readily available commercial insur-ance for low-carbon projects to protect developers and investors acrosshost countries andmarket environments from risk. One solution is thecreationof aCarbon InsuranceVehicle, equippedwithpublic fundsbutopen to private participation.This should be used to insure generationanddeliveryrisksassociatedwithcarboncredits,helpingtobothscaleupprojectactivitiesandassistmitigationefforts inregionsandsectorswithlittle activity todatedue toperceived risks.This couldbe centralizedorset up at a national level, managed by export credit agencies—possiblyintegratedwiththecreditguaranteeeffortsmentionedabove.

Theactivistfiscalresponsetotheglobaleconomicdownturnalsosug-gests innovativewaystomobilizecapital.HSBCestimatesthatoverUSD500 billion has been allocated to a range of climate change investmentthemesaspartofeconomicrecoveryplans.Packagesincludedirectspend-ing, tax breaks, and loan guarantees,with over two-thirds coming fromAsia,notablyChina,Japan,andSouthKorea.KoreahasbeenparticularlyassertiveinseeingitsGreenNewDealasaleverforthenextphaseinitsindustrialdevelopment,deployingpublic funds tocrowd incapital fromthenationaldevelopmentbank,aswellaslocalpensionfunds.

Thecredit crunchhas also exposed the inabilityof capitalmarkets ascurrently structured to deliver resilient investment returns. Institutionalinvestors are searching for new asset classes and strategies—that canmatch pension fund liabilities, for example—and the climate economyisemergingasanattractivesourceof long-termreturns.Increasinglycli-mate change isbeingviewedas another exampleof systemic risk failureoncapitalmarkets,withthefailuretoadequatelypricecarbonbeingcom-pounded by incentive-driven short-termism.This continues to result in


misallocationofassetstocarbonintensiveoptions.Long-termreformstogovernance, disclosure, rating, and listing rules are a necessary comple-ment to deliver capital markets that are fit for purpose for the comingclimateeconomy.

Areas Ripe for Greater Levels of Investment

Institutionally thenext climate treatyneeds tobeable tohandlea sharpincreaseinthelevelofproject-andfund-basedactivitywithoutbecominga bottleneck to climate finance.There should be an increased focus onareaswhere,todate,theflexiblemechanismsundertheConventionhavehad little activity: geographical (Africa and Central Asia), sectoral (en-ergyefficiency,reducingemissionsfromdeforestationandforestdegrada-tion(REDD)),orespeciallyintermsofscale(smallprojects,programsofactivities).The last typewill require clear standards, reducedproceduralcomplexity, and intensive capacity building at regional and local levels.Again, the use of credit guarantees backed by governments could be ofgreatuseindirectingfinanceespeciallytowardsprogramsofactivities,aswellasthedirectdeploymentofpublicfunds.

Technology

Currently, a number of hurdles to effective investment in low-carbontechnologyexist.Firstly, therearehigh transactioncostsand timingun-certainties all along the technology innovation process. Secondly, thereis a lack of long-term local currency financing options and foreign ex-changerisksforforeigncurrencyloans,appropriateinstrumentstoman-agecommercialandpoliticalrisks,andappropriate intermediariesor in-cubators to channel appropriate financing and technical support to newentrepreneurs.

Investmentinlow-carbontechnologywillrequireprivatefinance(for-eign direct investment), public finance (credit guarantees), and public-privatepartnerships.Publicfinancecanbeusefullydeployedtoincentiv-izeprivatefinanceboth in the formof venture capital tobridge the gapbetween concept and proven technology and project/corporate financeandprivateequity to fund thedeploymentof the technology.Developedcountrygovernmentscouldprovidesupportthroughcreditenhancement


schemes—using theirowncredit rating to spur low-cost capitalflows toprivate-sector players. Versions of such schemes currently exist in theUnitedStates,suchastheUSDepartmentofEnergyLoanGuaranteePro-gram enacted under the Energy PolicyAct of 2005,which evaluates re-newableenergy,carboncaptureandstorage(CCS),alternativefuel,energyefficiency, andpollution control equipmentprojects.Todate, companiessuch as Solyndra, NordicWindpower, and Beacon Power have receivedUSD 594million in government loan guarantees from this program. InJuly2009,theUSgovernmentannouncedthemostrecentroundofsolici-tationby theProgram,offeringup toUSD30billion in loanguaranteesfor various renewable energyprojects. In addition,within theAmericanClean Energy and Security Act of 2009, as passed by the USHouse ofRepresentatives, there is a proposal to establish aUSD 7.5 billionCleanEnergy Deployment Administration (CEDA). Under CEDA, a CleanEnergy InvestmentFundwouldbe establishedwhichwill providedirectloans, letters of credit, loan guarantees, insurance products, and creditenhancements to support investments in clean energy technologies. Inthedevelopingworld,additional fundingmaybenecessary.Mechanismsestablished in the United Nations Framework Convention on ClimateChange(UNFCCC)andtheKyotoProtocol,or fromtheworldofdevel-opmentassistance,canserveasmodelsforappropriatefundingschemes.Undertheconvention,theGlobalEnvironmentFacilityandoffsetmecha-nisms(i.e.,theCleanDevelopmentMechanism(CDM))arebothusedtoimproveprojecteconomicsforcommerciallydeployabletechnologies.Us-ing the lessons learned under these regimes, an international financingmechanismfortechnologydevelopment,demonstration,anddeploymentcould be constructed. In development assistance, there are a number ofschemes thatcouldserveasattractivemodels.One is theportfoliooffi-nancingoptionsavailablethroughtheInternationalFinanceCorporation.The International Finance Corporation offers a wide range of financingoptions including loans from its own account, syndicated loans, quasi-equityfinancing,equityfinancing,riskmanagementproducts,andcreditguarantees. Another potentialmodel is the USD 6.1 billion Climate In-vestment Fund of theWorldBank.The funds have flexiblemandates toco-finance public and private clean technology projects in tandemwithotherWorld Bank facilities and other multi-lateral development banks.Whilethefundiscurrentlymorefocusedontechnologiesatornearcom-mercialdeployment, a similar fundwith amandate forfinancing earlierstagetechnologiescouldhavesubstantialimpact.


Energy Efficiency in Buildings

Greatmitigationpotentialexistsincommercialandresidentialbuildings,especiallythroughenergyefficiency(EE)andgreateruseofrenewableen-ergy. In their construction and occupation, buildings use nearly 40% oftheworld’senergyandareresponsible forasimilar levelof totalenergy-related CO2 emissions. Standards should incorporate considerations re-lating to climate change and sustainability, such as resistance toweatherimpactsandwaterefficiency.

Severalmarket barriers prevent these solutions frombeing effectivelydeployed:universallimitedknowledgeofEEopportunities,landlordsun-willingtopayforEEmeasuresthatlowertenants’utilitybills,andtenantsunwillingtospendmoneyonpropertythatrevertstolandlordattheendof a lease.There are also broader financial/policy concerns: limited ac-cesstocapitalforEEimprovements,theneedforrapidpaybacks,prohibi-tivepermittingrequirements,thedisparitybetweenprojectsizeandlargetransactioncosts,andenergysubsidiesthatdiscourageconservation.

A number of solutions can be deployed to help overcome these ob-stacles,intermsofcapacity/know-howandfinance.Themosteffectivein-vestmentmaywellbeindisseminatinginformationtotenants,landlords,investors,anddevelopersabout thegains tobehad fromeffectiveuseofEEmeasures,especiallythosethatmorethanpayforthemselveswithinashorttimeframe.Thepublicsectorcouldhaveaninvaluableroleinbring-ing togetherfinancial institutions from thedevelopedworldwith exper-tise inEEtechnologydeploymentandtheircounterparts inthedevelop-ingworld, so that this information can be effectively shared.Additionalfinancial incentives will also be needed, in the form of direct subsidies,tax incentives,andcreditenhancements; theuseofpublic funds tosteerdeveloping country development towards EE deployment in buildings;or using some form of carbon pricing—possibly generation of certifiedemissionsreduction(CERs).

Forestry, REDD

Deforestation of tropical forests has made up 10–35% of global carbonemissionsperyear since 1990.Whenstanding, tropical forestsconstitutegiantreservoirsofcarbonthatmustbepreservedtokeepglobalwarming


undercontrol.Forestsoffertheclimatechangeinvestortheopportunitytosequestercarbonandevenpotentiallyderivevaluableandtradablecarboncredits.Thekey to this is using a sustainable approach tomanaging theforestandensuring that theenduseof the timber reducescarbonemis-sions (e.g., second-generationbiofuels,housing, furniture).Reforestationof degraded lands would be particularly positive for carbon sequestra-tion.Thereisclearlyaneedtoincludereducingemissionsfromdeforesta-tion and forest degradation (REDD) in the new climate treaty, possiblycombining itwithnationaleconomicdevelopmentandcapacitybuildingprograms.Crucially, theprivate sectorshouldgetaccess toREDD-basedcarboncreditstoproperlyfinanceit,bearinginmindtheneedtoaddressnon-permanence in an environmentally credible and financially viablemanner.

TheAmerican Clean Energy and Security Act of 2009, as passed bytheUSHouse of Representatives, would establish a programwithin theUSDepartmentofAgriculture (USDA) tooversee thegenerationofoff-setcreditsfromforestryanddomesticagriculturalsourcesasaresultofacap-and-tradesystem.Asthecurrentproposalstands,thebillwouldalsorequiretheUSDAtoestablishasetofagricultural,livestock,andforestrycarbon sequestration and management practices, policies, and method-ologies for project approval and verification measures. In addition, thebillwoulddirect5%ofallowancesgeneratedfromthecap-and-tradesys-tem to secure agreements from developing nations to prevent tropicaldeforestation.

A wide range of proposals to spur private-sector investment in sus-tainable forestry are being considered through the UNFCCC negotia-tions.Ahead ofCopenhagen, 17 proposals have been put forward by 25parties to incorporate forestry more fully into the post-Kyoto climateagreement:

• A coalition including Guyana, the Central African Republic, andothers advocates for comprehensive land-based and land-use ac-counting.

• Australia has proposed that all anthropogenic emissions related toland use, including deforestation, should be included in emissionsbaselines and in mitigation commitments.

• Indonesia advocates for expanding the sectors covered to includewetlandrestoration.


• Belarusadvocatesforaddingrevegetation,devegetation,forestman-agement,croplandmanagement,grazinglandmanagement,wetlandrestoration, and wetland conservation to activities recognized un-der theConvention, such as afforestation, reforestation, anddefor-estation.

• China has submitted a proposal encouraging a tightening up ofland-useaccounting indevelopedcountries toensure robust emis-sionsreductionsbyAnnexIpartiestotheConvention.

• TheEUhas proposed a series of technical definitions around landuse(e.g.,“‘forest’isaminimumareaoflandof0.05–1.0hectarewithtreecrowncover(orequivalentstocking level)ofmorethan10–30percentwithtreeswiththepotentialtoreachaminimumheightof2–5metersatmaturityin situ.”)inordertotightencompliance.

Crafting a well-thought-through regime that unlocks substantial capitalflows intosustainable forestrywillbecritical toachieving low-costmiti-gation.

Conclusion

Some general policy points can be distilled from the above discussion.Thereisaclearneedforprivatefinancetobeusedinafarmoresignificantmanner than ithasbeen todate inglobalefforts tomitigategreenhousegas emissions, especially in developing nations. Indeed, the UNFCCCfindsthat86%ofinvestmentandfinancialflowstoaddressclimatechangewill come from theprivate sector.Thepublic sectorneeds toplaya roleincreatingtherightincentivesforthistooccur.Theseincentivesfallintothree broad categories: firstly, improving the regulatory uncertainty cur-rentlyfacedbyinvestorsatthelocal,regional,national,andinternationallevels; secondly, creating mechanisms to channel private and public fi-nance todesired locations; and thirdly,usingpublic funds to reduce therisk towhichprivate fundsareexposedandcreating incentives todivertstreamsoffinancetowardslow-carbonalternatives.Butpublicfundscan-not address the challenge alone. Capitalmarkets themselves need to bemodernizedtointegrateclimateriskmanagementintotheroutineevalua-tion,allocation,andgovernanceofassets.Thisisanimportantagendaforfurther enquiry thatneeds to takeplace alongsidenational and interna-tionalclimatepolicy.



DeutscheBankAdvisors,DeutscheBankGroup,Global Climate Change Regula-tion Policy Developments: July 2008 – February 2009 (February2009),availableat http://www.dbcca.com/research.

Deutsche Bank Advisors, Deutsche Bank Group, Investing in Climate Change 2009: Necessity and Opportunity in Turbulent Times (October2008),availableat http://www.dbcca.com/research.

HSBCGlobalResearch,Building a Green Recovery(May2009),availableathttp://www.hsbc.com/1/2/sustainability.

UNEP Finance Initiative Climate Change Working Group, Financing a Global Deal on Climate Change(June2009).

http://www.dbcca.com/research

http://www.dbcca.com/research

http://www.hsbc.com/1/2/sustainability

http://www.hsbc.com/1/2/sustainability

Part III

Bringing Developed and Developing Countries Together in Climate Finance Bargains

Trust, Governance, and Mutual Conditionality

A

Meeting Developing Country Climate Finance Priorities

Climate Finance 157

Chapter 16

Developing Country Concerns about Climate Finance Proposals

Priorities, Trust, and the Credible Donor Problem

Arunabha GhoshOxford-Princeton Global Leaders Fellow,

Woodrow Wilson School, Princeton University

Ngaire WoodsProfessor of International Political Economy;

Director of the Global Economic Governance Programme, University of Oxford

Key Points

• The long history of mutual mistrust between North and South asdonorsandrecipientsofdevelopmentaid isachallengeforclimatefinance negotiations.

• A stable and securepoolof climatefinance is essential.Thedevel-oped countries must recognize that their promises of future cli-matefinancingneedtobecredibleand locked in fromvolatilityorbacksliding.

• Trusted institutions for decision-making and disbursement of fi-nance are essential, and the Bretton Woods institutions may not be theanswer.

• Effectivemonitoring, verification, and compliancemechanisms areneedednotonlyforemissionsreductions,butalsoforcommitmentsonfinancingandtechnologytransfers.

158 arunabha ghosh and ngaire wo ods

The North-South Negotiating Gap on Climate Finance and Institutions

Whilethereismuchvariationamongdifferentdevelopinganddevelopedcountries,overallthereisarealNorth-Southgapinclimatenegotiations.Current proposals on climate financing do not do enough to overcome thelackoftrustandmutualcredibilitybetweendevelopinganddevelopedcountries.This essay analyses the priorities and concerns of developingcountriesandproposesthreeplanksforabridgeacrossthegap.

The lackof trustbetweendevelopedanddevelopingcountriesreflectsnotonlyalackofappreciationofeachother’sdomesticpoliticalcommit-mentsandconstraints,butalsoahistoryofbad faith in themakingandimplementationofglobalcommitmentsondevelopment,climate,andin-stitutionalreform.

Developingcountriesviewcallstostabilizeandreducetheirgreenhousegas(GHG)emissionsasbothillegitimateandathreat.Theyconsiderthedemandsillegitimatebecauserichcountriesareprimarilyresponsibleforthehistoricalstockofemissions,theatmosphericconcentrationofwhichis causing globalwarming.The calls are a threat because curbing emis-sions couldundermine the growthnecessary to liftmillionsout of pov-erty. With 1.4 billion people living in extreme poverty, poverty reduction fordevelopingcountriesisthepriority.Anydesiredactionagainstclimatechange has to be reconciled to that imperative.

Absent sufficient financing, any commitment to curb GHG emissions would limit the ability of developing countries to increase their energysupply, a centralpartof their efforts to reducepoverty.About 1.6billionpeopleindevelopingcountrieslivewithoutelectricity,and2.5billionlackaccess tomodernenergysources.Even in fast-growingChinaandIndia,more thanhalfof thepopulation relieson traditionalbiomass for cook-ing.Theeasiest and fastestway to increase energy supplyunder currentcircumstances often involves the construction of plants with highGHGemissions.However, theprovisionoffinancing to improve the efficiencyof existing and oncomingmodern energy infrastructurewill offer a po-tentialwin-win situation:manydevelopingcountriesmaybeable tousefinancingfromindustrializednationstoreduceemissionswhileincreasingeconomic growth rates. Accomplishing this goal will require substantialtechnologydevelopment,diffusion,andtransfer,inadditiontofinancing.

Many developing countries also believe that industrialized nations have notpaidsufficientattentionto thechallengesofadaptation.Theimpera-

Developing Country Concerns about Climate Finance Proposals 159

tive forpoor countries to adapt (rather thanmitigate) strengthens everyday as efforts tomitigate by rich countries falter.Yet adaptation is oftentreatedasasideissue,andcurrentspendingonadaptation(aboutUSD1billion)isafractionoftheestimatedrequirements.

Fromadevelopingcountryperspective,thedemandsandprioritiesofrichcountriesassumethatonly theirown internalpoliticsmatters—andthatlargedevelopingcountries,insteadofreducingemissions,aresimplystalling. Developed countries seem to insist on setting demanding condi-tions on recipients of climate financing, and anyhow to be reluctant toprovidefinancingwithoutbothsettingeventualcapsfordevelopingcoun-triesandloweringcompetitivecostsfortheirowneconomies.Developingcountriestaketheviewthatsincerichcountrieshaverepeatedlyfailedtomeettheirpastcommitmentsondevelopmentassistance,anynewclimatefinancingproposalswill lackcredibilityunlessthereisadequateaccount-ability of developed countries to keepnot only their emissions commit-ments, but also their financing commitments to developing countries. Donorshave reduced fundingor altered conditions even in caseswhererecipientsmetspecifiedconditions.Whereprovided,fundingwasvolatileand unpredictable, thus undermining their best-laid plans. Making com-mitments for reducing emissions or adopting climate-friendly policieswithoutfinancialguaranteesis,therefore,notpoliticallyacceptabletode-veloping countries. Current or potential large emitters among developing countrieshavesomerealnegotiatingpowertoinsistonthesedemands.

Severaldevelopingcountrieshaveproposedunilateralclimate-friendlymeasures.Chinaaimstosupply40%ofitsenergyfromrenewablesourcesby2050.OtherannouncementsincludeBrazil’sonreducingdeforestation,Mexico’sandSouthAfrica’sonemissionsreductionandstabilization,andIndia’s on energy efficiency and the development of renewable energies.Yet,allarehesitanttosignanagreementthatwouldcaptheirfutureemis-sions without assurances that they will receive substantial technologicalor financial support from developed countries.They have received littlesuchsupportthusfar.

Developing countries have set out a broad agenda for financing andtechnologytransfer.TheG-77andChinahaveproposedafinancialmech-anismaccountabletotheUnitedNationsFrameworkConventiononCli-mateChange(UNFCCC)withbalancedrepresentationanddirectaccesstodemand-driven funding.They alsopropose a technologymechanism,includingamultilateralfundundertheUNFCCC,andtheycallonindus-trializednations todivert asmuchas 1%of their grossnationalproduct


to help finance emissions-reducing technology projects in the developing world.Theywantmultilateralmechanismstocoverboththefullcosts(forpreparingnationalcommunications,patents,andlicensefees,andforad-aptation)andfullincrementalcosts(formitigationactions,transferoflow-carbontechnologies,R&D,andforbuildinginstitutionalframeworks).

In the eyesofdeveloping countries, the approachofdevelopedcoun-tries has been inadequate and perhaps even counterproductive. Devel-opedcountriesseemdeterminedtousetheWorldBanktochannelfund-ing,andeventhennotthefullmultilateralInternationalBankforRecon-structionandDevelopment(IBRD)mechanismsbutclimate-relatedtrustfunds.This isseriousbecauseglobalpublicfinancingcannotbeavoided.For instance, evenwith an intervening carbonbank thatfinances abate-mentprojectsindevelopingcountriesandsellsoffsetstodevelopedcoun-triesataprofit,30–45%ofannualfinancingneedswouldhavetobecov-ered using public sources. Moreover, it is unlikely that the sums generated wouldbesufficientforadaptationactivities.Anotherproposal,whichlev-erages pre-committed emission reduction plans in developing countries to generate loans in the carbon market for mitigation activities, wouldstillraisequestionsaboutthepredictabilityoffundinginfuture.Ina2009submission to theUNFCCC, theUnited States recognized the need forfinancing, technology, and capacity-building support but left the sectionintendedforspellingoutfinancingarrangementscompletelyblank.

Holding both sides to account in the financing relationshipwill be akey element for any financingmechanism to be both politically accept-ableandeffective.Fromtheabovediscussion,threeprinciplesemergeforclimate financing mechanisms and their governance.

1. Ensure the Creation of a Secure Pool of Climate Finance

There must be a credible basis for confidence that a huge gap will notemergebetweenpromisedanddeliveredfinancial assistance.Developingcountries seek guarantees. As the Algerian delegate argued at the Bonn climatemeetinginMarch2009:“Alotterywouldnotgetmuchticketsalesifitdisclosedtheprizeafterthedraw.”

Estimates of the amount of funding required to adequately addressglobal warming vary wildly. A draft report by the UNFCCC’s ExpertGrouponTechnologyTransferestimatesthatadditionalannualspendingonmitigationtechnologiesofUSD262billiontoUSD670billionwould


beneededby2030(currentspendingrangesbetweenUSD77billionandUSD164billionayear).Duetothevarietyofestimates,developingcoun-triesarehesitanttoagreetoasetamountoffinancing,callinginsteadforindustrializedcountriestocoverthefullincrementalcostsoflow-carbontechnologies. In light of these requirements, the institutional responseso far has been inadequate. Since 1991, theGlobal Environment Facility(GEF)hasallocatedonlyUSD2.5billiontoclimateprojectsandclaimstohave leveragedanotherUSD15billion inco-financing. Its“strategicpro-gram,” approved in Poznan inDecember 2008,would devote onlyUSD50milliontoscale-uptransfersoftechnology.

Onewaytoovercomethis is tocreatemechanismsthatassurefinanc-ing without appropriation or interference at the national level in donorcountries, such as a carbon tax, aviation, and/or maritime levies, auctions of emission allowances, or direct development assistance. Regardless ofthe option(s) chosen, the fundingwould have to be available through amultilateral mechanism to reduce unpredictability and unexpected condi-tionalityoffinancing.

2. Use (or Build ) Trusted Institutions for Decisionmaking and Disbursement of Finance

Participation in climatemitigationwill not be secured only by financialincentives.Equallyvitalisthestructureofrepresentationindecisionmak-ing.Many industrialized countries favor theWorld Bank as a financingand disbursement mechanism. Developing countries have long expressed dissatisfactionwith the lack of votes and voice accorded to them in theInternational Monetary Fund (IMF) and the World Bank, which givesindustrialized countries a majority of votes and the United States vetopower. Similarly, the Global Environmental Facility (GEF) lacks legiti-macy among developing countries because its governance structures give undue weight to the influence of developed countries.Most developingcountries have rejected the GEF as a financial mechanism, choosing totreat it only as an operational entity.

Theindustrializedcountries’gripontheIMFandWorldBankhasleddevelopingcountriestoexitwhentheycan,inpracticalterms,fromeachinstitutionbynotborrowingandnot takingadvice fromthe institutions(whenever theycanaffordnot to). Inclimatechangegovernance,exitofthis kind could render shared objectives unattainable.


Amore specific concern iswhether developing countrieswould havecontroloverthechoiceofpoliciesandtechnologiestheyadopt.TheWorldBank’sCleanTechnologyFund(CTF)hasbeenheldhostage toUSpoli-ticians and organizations opposed to financing coal-based technologies, evenifthepotentialefficiencygainsandemissionsreductionpotentialfordeveloping countries are large.TheCTF’s operatingmandate requires itto respond to country-owned strategies. Yet, domestic politics in donorcountries threatens to close the option ofmultilateral support for large-scale energy investments in developing countries.

Many of these problems could be resolved through appropriate gov-ernance structures that would provide greater representation and con-trol to developing countries. For example, the Adaptation Fund model has managed to avoid replicating the World Bank or GEF representa-tion. Its board, comprising 16members and 16 alternates, represents the5UnitedNationsregionalgroups(2fromeach),thesmallislanddevelop-ing states (1), the least developed countries (1),Annex I Parties (2), andnon–AnnexIParties(2).TheCTFalsohasbalancedrepresentationbutishobbledbydomesticpolitics.Anewfinancingand/ortechnologymecha-nismwouldneedasimilarstructure.However,formalseatsatthetableorvotingrightsarenotenoughtosecureeffectivevoiceandinfluence.Alsoimportant are: the role and selectionof seniormanagement; the staffingand location of an organization; the decision-making rules (or form ofconsensusdecision-making);and thecapacityofdevelopingcountries toidentifytheirownprioritiesandtoholdinstitutionsandtheirrepresenta-tives toaccount.Additionally,proposals to itsboard shouldbe reviewedby an independent expert committee.

3. Develop Effective Monitoring, Verification, and Compliance Mechanisms for Financing and

Technology Transfer Commitments

Athirdimportantelementoffinancingmechanismsconcernsmonitoringandverification.Monitoringfinancialand technology transfersmightbetechnicallyeasier thanmeasuringemissions.Todate,however, reportingon financial contributions has been mixed at best thanks to data deficien-cies,multiplesourcesoffunding,andinconsistenciesindefinitions.

Industrializedcountrieshaveemphasizedtheimportanceofeffectivelymonitoringemissions.However,developingcountriesareconcernedabout


thecostsofcomplyingwithverificationsystems,aswellaspotentialasym-metries in the application of such systems. In the past, verification andcompliance programs have either been ineffective or been appliedmoreharshly against developing countries than against industrialized countries. Forexample, in theWorldTradeOrganization (WTO), theTradePolicyReviewMechanism (TPRM) has done little to bridge the gaps in infor-mation about compliance thatwould be of use to developing countries.Similarly, the IMF surveillanceprocess is a robustpolicemanof smaller,poorerdeveloping countries buthas little if any effect onwealthy coun-tries.Anemissionscomplianceregimeshouldavoidsimilarinequities.

Acrediblefinancingmechanismintheclimateregimewouldneednewinstitutional features for monitoring and evaluating the effectiveness offinancial flows. First, self-reporting bymember states should be supple-mented by more frequent institutional reporting to measure the originanddestinationoffinancialflows.Oneoption is touse theOrganisationforEconomicCo-operationandDevelopment’s(OECD)CreditorReport-ing System.But, if theWTO’snewaid-for-trademonitoringmechanismis a precedent, developing countries would demand a dedicated systemundertheUNFCCCtoensuretherewasnodoublecountingofassistanceprovided.Secondly,thedatamustbealsoanalyzedtoevaluatetheimpactof financial flows.Here the experience of theWorld Bank and regionaldevelopment banks in project evaluation could strengthen reviews heldwithin the UNFCCC. Third, knowledge networks could be establishedataregional level to facilitate thesharingof informationandexperienceacrosscountriesandbuildcapacityformonitoringandevaluation.Finally,compliance-orientedpeerreviewprocedureswouldbeneededwithintheUNFCCCtoapplypressureondevelopedcountriestocomplywithcom-mitments.Discussions about the timeliness, adequacy, and impact of fi-nancialtransfersshouldbeincludedinextensivereviewssimilartothoseconductedforemissionsandimplementationofcommitmentsunderAr-ticle8oftheKyotoProtocol.


The ineffectiveness of conditionality is outlined in Tony Killick, “Principals,Agents, and theFailingsofConditionality,” Journal of International Development 9:4,pp.483–495(1998).

Fora fuller elaborationofdevelopingcountries’ experience inother regimes,see Arunabha Ghosh andNgaireWoods, “Governing Climate Change: Lessons


fromOtherGovernanceRegimes,”inDieterHelmandCameronHepburn(eds.),The Economics and Politics of Climate Change (Oxford:OxfordUniversityPress,2009).

The volatility and lack of predictability in aid financing is examined inAlešBulíř and A. Javier Hamann, “Volatility of Development Aid: From the FryingPanintotheFire?”IMF Working PaperWP/06/65(2006).

On the need for reform in international financial institutions, see NgaireWoods, The Globalizers: The IMF, the World Bank, and Their Borrowers (Ithaca,NY:CornellUniversityPress,2006).

On the purpose and politics of monitoring, see Domenico Lombardi andNgaire Woods, “The Politics of Surveillance,” Review of International Political Economy (November 2008); andArunabhaGhosh, “InformationGaps Informa-tionSystems,andtheWTO’sTradePolicyReviewMechanism,”Global Economic Governance Working Paper 2008/40(Oxford,May2008).

Climate Finance 165

Chapter 17

DevelopingCountriesandaProposalforArchitectureandGovernanceofaReformed

UNFCCC Financial Mechanism

LuisGomez-EcheverriInternational Institute for Applied Systems Analysis

Key Points

• There is a pressing need forwholesale reform of the financing ar-rangements under theUNFCCC atCopenhagen, in terms of scaleof funding as well as scope andmethod of governance structures,withtiestocompliance.

• The current situation of financial support for emissions reductionandadaptationsupportischaracterizedbyagreatnumberoffundswith complex administrative processes, minimal transparency oraccountability,andconflictingmandatesthatdonotnecessarilyad-dressor respond todevelopingcountryconcerns.These fundscol-lectivelydonothavethecapacitytochangethecourseofglobalde-velopmenttowardsalower-carbonpath.

• New efforts to address these issues need to deal with the histori-calbaggageofdistrustbetweenrichandpoorcountries; frame thenegotiationswithintheprincipleofthelegalobligationandcompli-ance to replace thepresentde facto voluntary system; significantlyincreasetheabilityoftheUNFCCCtocarryoutitsobjectives;bringsomemeasure of harmony and good governance to themultiplic-ityoffunds;anddrawsignificantinterestfromtheprivateandpub-licsectors,bearinginmindthehistoricalsourcesoffinancefortheConvention’spurposes.

166 Luis Gomez-Echeverri

Introduction

As has been highlighted in a number of chapters in this book, the en-gagement of developing countries is fundamental to the success of anypost-2012climateregime.Developingcountryengagementisinextricablylinkedtoissuesofgovernanceandinstitutions.Thislinkisanissuebothlegal as well as practical. It is a legal issue, because developing countryengagement is based on the principle of common but differentiated re-sponsibilities,aswellasontheobligationsandcommitmentsspelledoutin Article 4 of the United Nations Framework Convention on ClimateChange (UNFCCC). This Article spells out the commitment of devel-opedcountries to supportdevelopingcountryefforts.And it is apracti-calissue,becausewithoutwell-designed,well-functioning,andresponsivegovernanceinstitutions—includingafinancialmechanismthatcanfacili-tate and implementmitigation and adaptation funding—the chances ofsignificant developing country engagement are remote. Without this en-gagement,itwillbepracticallyimpossibletosuccessfullymitigateclimatechange.

Flaws in Governance = Flaws in Implementation

Many years ago, developed countries agreed to support the climate change mitigation efforts of developing countries. However, they argued thatthere was no need for a new financialmechanism, as they believed theGlobal Environment Facility (GEF), established in 1991, would be ad-equate.However,itisnowobvioustodevelopedanddevelopingcountriesalike that the scaleof fundingand thecurrentoperationalarrangementsfor implementation are inadequate. The Financial Mechanism—whichismeant to play a central role in supporting the implementation of theConvention—isinneedofmajorreform.Thereformisrequiredbecause(a) the severity of the climate change challenge requires amuch greaterscale of action and response than at present, (b) the need and urgencytoactnowratherthanlatertoavoidevenhighercostsandhardship,and(c)themandatesoftheConvention.

The inadequacy of the current arrangements of the financialmecha-nismoftheUNFCCChasgivenrisetoafragmented,complex,andinef-ficient system of finance for climate change and implementation of theConventionthatischaracterizedasfollows:

Developing Countries and a Reformed UNFCCC Financial Mechanism 167

• Alargenumberof fundsandfinancinginstrumentshavebeencre-atedtoaddressspecificclimate-relatedobjectives.Mostoftheseareoutside of the Convention, andmany of them fund pilot projectsrather than large-scale operations.

• Generally, each fund has its own rules of procedure and its owngovernancestructure.Manyofthemlacktransparencyandaccount-ability.

• Becauseof theoperational complexityofmanyof the funds, dedi-cated experts are required at the national level in order to accessandbenefitfromthem.Thishasmajorconsequencesandaddspres-sure to alreadyweak nationalmonitoring and reporting capacitiesofdevelopingcountries.

• Thesefundsandfinancinginstrumentshaveimmensedirectandin-direct transaction costs.

• Theobjectivesofmanyofthesefinancinginstrumentsandfundsareoftenformulatedneithertorespondtothedemandorneedsofde-velopingcountriesnorwiththeirparticipation.

• Amajorityofthesefundsandfinancinginstrumentsprefertofundprojectsratherthanprogramsorsectorplansofaction.Thisaddstothecomplexityandtransactioncostswhileatthesametimedimin-ishing the relevanceand impactvis-à-vis theneedsofmanydevel-oping countries.

• While carbon finance (particularly the offsetmarket) initially hadgreat promise to engage developing countries, it ended up benefiting asmallhandful.Fewprojectssupportedsustainabledevelopmentortransferredtechnologiesaswasinitiallyintended.

• Adaptation—the priority for most developing countries—is vastlyunderfunded and difficult to attract funding and investment as itcannot be easily integrated into the global carbon finance system.

• Ascurrentlydesigned, thefinancialarchitectureneithercreates theproperincentivesforthetransformationtowardlower-carbonecon-omies and societies nor facilitates implementation of strategies,plans,programs,andprojectsforthosethatdowanttotakeaction.

The Challenges

Climatefinancenegotiationshavebeenseriouslyaffectedby thestrugglebetween those who want the public sector to be the major—and even


perhaps the sole and centralized—source of funds and those whowantthe private sector to be the principal vehicle, leaving the public sector to financeonlythoseareasthattheprivatesectorcannotadequatelyfund.

Because of the scale of the effort needed, the solution can only liesomewhere inbetween. It is impossible to conceiveof onepublic-sectorfundthatwouldsupportallrequiredactiononclimatechangethroughoutthedevelopingworld.Equallyimportant,itisalsonaiveandill-informedtoexpect that thecurrent fragmentedworldwithamultiplicityof fundscan do the job of supporting the developing countries adequately and,perhaps evenmore important, that without significant public-sector in-volvement and support, many of the needed private-sector investmentswilleverhappen,orhappenintheareaswheretheyaremostneeded.

Sowhatshouldanidealnegotiationseektoachieve?Beforeevencon-sideringthequestion,theUNFCCCnegotiatorsneedtobeawareofafewrealitiesthataredifficulttoignoreandthatcreateabaselineforthenego-tiations.Thisbaselineandthefactsthatcontributetoitcanbecharacter-izedasfollows:

• Oneoftheprincipalfactors,ifnottheprincipalone,contributingtothelevelofdistrustbetweenrichanddevelopingcountrieshasbeenthe issue of finance (the lack of it) and the unhappiness with thepresentarrangementwithintheConvention.

• Funding within the Convention has had little relation to issues ofcompliance toArticle4of theConvention,a situation that ismostlikely to changedrastically in thepost-2012financial regimeof theConvention.

• Theleveloffundingprovidedhasbeeninsignificantwhenmeasuredagainsttheneedsandmagnitudeofeffortneeded.

• Thecurrentuncoordinatedandfragmentedworldofclimatechangefunding, while often more counterproductive than helpful, is inmany ways also a welcome sign of the interest and willingness ofmany to invest heavily in climate-change-related activities.

AsuccessfulnegotiationonthefinanceandimplementationaspectsoftheConventionwouldthereforeneedto(a)realisticallytakeintoaccountthehistorical baggage of distrust between rich andpoor countries that nowexistsandtrytoaddressit;(b)framethenegotiationswithintheprincipleofthelegalobligationandcompliancetoreplacethepresentdefactovol-untarysystem;(c)createafinancialarchitecturethatplacestoppriorityto


giving the Convention the authority to predictably raise significant rev-enues to levels thatarecommensuratewith thechallengeandtoallocaterevenues fairly in away that places the power in the hands of develop-ingcountries;(d)createafinancialarchitecturethatisgiventhemeanstoforceconsistencyandharmonyamongstthemultiplicityofexistingfundssoastobepartoftheoverallcomplianceregime;and(e)createafinancialarchitecturethatprovidesincentives,influence,andguidanceforprivate-sectorfinancetoflowtowardsclimate-friendlyinvestments.

Conclusion: A Framework for Negotiations

As longas thedebateonfinanceand implementationof theConventionremainsfocusedonwhetheritshouldbemostlypublic-orprivate-sectorsupported and funded, or centralized versus decentralized, there is littlechance that the negotiations will advance in benefit of the Convention.An alternative framework is onewhere thenegotiationswould focusonthe principal objectives that the financial and implementation architec-turewouldneedtoachieve,establishingsomebasicprinciplesthatwouldneedtobefulfilled,andmatchingthemtothepresentrealitiesastheba-sisforthatdesign.

Fundingforclimatechangetodayderivesfromthreeprincipalsourcesandlevels.ThenewfinancialarchitectureshouldbuildonthisrealityandadjustitinordertoenhancetheobjectivesoftheConvention:

• Level I:The resources that flow through the UNFCCC and that are under the direct authority of the Conference of the Parties (COP ).Theonly financial resources under the authority of theCOP are thosemanaged by the GEF, the sole operating-entity of the Conventionup to thatdate.At issuearewhether tomaintain thepresentoper-ating-entitysystem;whattheroleof theGEFshouldbe inthenewregime; andwhether all compliance-linked fundingwouldneed toflowthroughorbecoordinatedbythenewoperating-entitysystem.Whatever the decision, the resources under this category—Level I—would be applied directly to the compliancemechanism and tothemonitoring,reporting,andverification(MRV)system.Itwouldconsist of new funding windows to support areas such as mitiga-tion,adaptation, technologytransfer,andcapacitybuilding.Level IwouldbesupportedbyagovernancestructureundertheUNFCCC,


with an Executive Board acting as the new operating-entity undertheauthorityoftheCOPandbasedontheprincipleofsubsidiarity.As such, it leaves the decision ofwhere to apply the funding (i.e.,howtodisburse)tocountries.Thegovernancestructurewouldneedto include national Climate Change Funds and implementation hubsthatarelinkedtotheUNFCCCsystem,theMRVsystem,andthe system of compliance.The institutional structures would varyaccording to the needs and capacities of countries. But as amini-mum,thesenationalentitieswouldneedtohavethecapacitytoas-sess needs and priorities and be in a position to make decisions on disbursement toprogramsandprojectswith themostpotential foraddressing the various thematic areaneeds.Thesenational entitieswouldalsohavetheresponsibilitytocoordinateandharmonizethedisbursementof funding, topromotestakeholderconsultation,andtoensurethattheclimatechangeprogramsandprojectsfundedarewell-embedded in national development strategies and plans andpreferablyinnationallypreparedclimatechangestrategiesorplans.

Some initial targetorbaseline for this levelcouldbeestablishedfor2010withanagreedrateofincreaseovera5-yearperiod.Theseinitial resourceswould be directed to attend urgent priority needsin adaptation, particularly for countries that are most vulnerable;to fund allNationalAdaptationPlansofAction (NAPAs); tokick-start an urgent program on reduced emissions from deforestationanddegradation(REDD);tosupporttheimplementationofNation-ally Appropriate Mitigation Actions (NAMAs) as they enter into the mainstream; and lastly, activities in support of technology transferand capacity buildingwhich in turn should become the dedicatedandsoleareasofresponsibilityofanewandreformedGlobalEnvi-ronment Facility.

• Level II: The many dedicated public-sector international funds that have been created but that are now outside of the authority or influ-ence of the COP. It isdifficult to imagine that thepresent chaosofmultiplicityof fundswouldremainunregulated.It isnotonlyinef-fectivefromthepointofviewoftheConventionobjectivesbutalsoextremely inefficient.Shouldnegotiators, therefore, insist thatallofthese funds go through theUNFCCCandbeunder thedirect au-thorityoftheCOP?Thiswouldbehardlyrealistic,particularlysincemostofthesefundsarededicatedtocreatingandstrengtheningtheenablingenvironments foractiononclimatechange.What ismore


important is that these fundsbeplacedunder theoveralloversightof the UNFCCC, which would have the responsibility to provideguidance andassesswhether these funds are adhering to theprin-ciples established under the agreements reached in Copenhagen. Ideally, a system to link these funds to compliance and theMRVsystemshouldbe createdwith the caveat that theprincipal avenuefor compliance-related funding is Level I. Level II should be seenascomplementarytothesystemofcompliance,andonethatwouldbeseveral timesas largeasLevel I in the initial stagesascountriesbuildtheircapacities,strategies,andplansofaction.Withtime,thislevel should decrease with Level I increasing in order to supportimplementation.

• Level III:The private-sector and carbon finance that now flows un-regulated and often operates with little transparency, oversight, or guidance.This is by far the largest source of resources for imple-mentationoftheConvention.ButthefullpotentialofthisresourcewillnevermaterializeunlessLevels IandIIareorganized tobreakdown market barriers; create the enabling environment, policies,andregulations;and increase thecapacityofcountries to influenceand direct these resources to climate-friendly investments and cli-mate change priorities. Levels I and IIwould concentrate their ef-forts in leveraging these resources to a scale several times higherthanLevelsIandII.

Atrulyeffectivefinancialarchitecturewouldbeonethatwouldmobilizeand influence theflowof resourcesona scale several times thatofwhatexists today,andthatwouldprovidea frameworkthatcanenhancecon-sistency, harmonization, and investment promotion in climate-friendlyinvestment at the national level.


For more detailed information on the Reformed Financial Mechanism pro-posal, seeBenitoMullerandLuisGomez-Echeverri,Reform of the UNFCCC Fi-nancial Mechanism: Part I: Architecture and Governance(Oxford:OxfordInstituteforEnergyStudies,April2009).

172 Climate Finance

Chapter 18

Climate Change and DevelopmentA Bottom-Up Approach to Mitigation for

Developing Countries?

NavrozK.DubashSenior Fellow, Centre for Policy Research, New Delhi

Key Points

• In the immediate future, bottom-up approaches, such as NAMAs,for developing countries may have substantial environmental ad-vantagesovertop-downapproaches.

• Top-downapproachesbasedonemissioncapsriskcreatingcounter-productive incentives, such as incentives to set overly high emissions targets or to avoid early action in order to receive greater financing and higher caps later.

• Top-downapproachesmayinpracticereduce,ratherthanincrease,the predictability of emissions levels and of emissions reductionsagainstBAUbaselinesormeaningfultargets.

• Strengthening domestic institutions in developing countries isneeded for successful low-carbon development; strategies to do soare an essential part of a low-carbon development and financingprogram,butareunderemphasizedintop-downapproaches.

A top-down approach—specifically internationally specified and bind-ingnationaltargetsandtimetables—haslongbeenthepreferredpositionof environmental advocates. But bottom-up approaches, such as policymeasures to be devised on a country-by-country basis, have also been part of the policy grammar of the climate negotiations. In the process

Climate Change and Development 173

offleshingout theBaliActionPlan,onearticulationofabottom-upap-proach,nationallyappropriatemitigationactionsfordevelopingcountries,is attracting renewedsupport.What shouldwe thinkof suchbottom-upproposals?

Background: The Push toward a Top-Down Approach

For those who put climate changemitigation first (as opposed to thosewho seek to preserve sovereignty or emphasize untrammeled economicgrowth), a focus on targets and timetables is an article of faith. Indeedthis is the bestway of ensuringmeaningful action fromAnnex I coun-tries.Manyoftheseadvocatesalsobelievethatsomeformofhardtargetsisthebestwayofinducingseriousmitigationfromthedevelopingworld.Theyreactwithconsiderableuneasetothepoliticalsupportforaformulaoftop-downcapsfortheNorthandbottom-upmitigationactionsfortheSouth.TheythuswelcomeproposalstohastentheadoptionofsomesortofcapsfortheSouth,suchasincentivesforearlyadoptionofcaps,offersof no-lose targets, and the like. For example, early adoption of a com-mitmenttoreduceemissionsbelowprojectedemissionscouldtriggerre-wardssuchaseligibilitytoselltheresultantemissionsreductionsinacar-bonmarket. Alternatively, some call for embedding developing countrymitigationactionsinabindingplanningframeworktoenablepredictabil-ity of action. Under this approach, countries would develop bottom-upmeasures, but then be asked to aggregate these into a larger national plan, towhichtheywouldbeheldaccountable.

While there isnodoubt thatcaps forallwould, in theory,be thebestenvironmental outcome, in the current negotiating context, focusing inthe short runon explicit caps (or the implicit caps of climate plans) fordeveloping countries is amisguided policy. It will not produce predict-abilityoffutureemissionsfromcurrentbaselines,andintheshorttome-dium termmay bemisguided for environmental reasons, quite separatefromalltheconventionalargumentsaboutdifferentiation,equity,histori-calresponsibility,atmosphericspaceforeconomicgrowth,andthelike.

Tobeginwith,whatarethearguments for inducingdevelopingcoun-tries to take on some form of caps or agree to develop binding plans?Theprimaryargumentemergesoutofclimatescienceassummarizedbythe Intergovernmental Panel on Climate Change (IPCC). If, as a globalcommunity, we are to restrict temperature rise to between 2 and 2.4°C,

174 Navroz K. Dubash

wemustreduceemissionsbyatleast50%fromtheir2000levelsby2050.Even if theNorthdoes takeonambitiousabsolutecaps,additional limi-tationsmust be accomplished in the South to achieve a 50% reduction.Taking the next step of converting the de facto cap for the South as awhole to national-level caps, however articulated, is arguably necessarytoensure that theglobal community ison track toward thisglobalgoal.A national-level cap, even if not articulated in terms of absolute emis-sions, will also send economy-wide signals, and enable integrationwithglobalcarbonmarkets.Thus, it isargued,capsorbindingplansmustbeadopted inorder to ensure themeasurability andpredictability requiredtomaximizeincentivesformitigationactionandtoachieveambitiouscli-mate goals.

Both parts of this conclusion are questionable. Under the prevailingconditions of institutions and governance in developing countries, top-downapproachesmaywellnotbethebestwaytoincentivizelow-carbondevelopment.Moreover,efforts toquantifydevelopingcountrycontribu-tions toward global emission reduction goalsmay, ironically, discouragethe desired early climate mitigation actions and undermine predictability. Irefertothiseffectasaclimatepolicyuncertaintyprinciple.Below,Iex-pand both these arguments.

Low-Carbon Development Needs Effective Institutions in Developing Countries

Tounderstandtheprospectsforlow-carbondevelopment,wefirstneedaperspectiveontheprocessofcurrentandfuturedevelopmentindevelop-ingcountries.Development, Isuggest, isnot justeconomicgrowthfroma lowerbase, but a qualitativelydifferentprocess than economic growthinindustrializedcountries.Anowsubstantialliteraturesuggeststhatsuc-cessfuldevelopmentiscloselytiedtothenatureofeconomic,social,andpolitical institutions. By institutions Imean the rules of the game, bothexplicit and implicit, that guide and shape incentives for decisionmak-ers.Jump-startingdevelopmentrequiresappropriateinstitutionalchange,andunder-developmentistoasignificantextentaresultofpersistentandpoor institutions.

Undertheseconditions,top-downmeasuressuchasemissioncapsde-signed to change relative prices, signal economic opportunity, and stimu-late actors to capture efficiency are blunted and can even produce distort-


ing effects. Where existing institutions limit choices or create perverseincentives, inducing institutional change through the political process should be the primary task. Absent this change in the underlying incen-tives,shiftsinrelativepricesarelikelytoaccomplishlittle.

The Indian electricity sector provides a good example. For at least adecade, there have been considerable economic gains to be had by re-formingtheIndianelectricitysector,but littlehaschanged.Thesector istrappedinaviciouscycleofhighlosslevelsandtheft,agrowingsubsidyburden,anddecliningservicequality.Reversing thiscyclewould lead toconsiderable financial, social, and environmental gains through more effi-cientandequitableelectricityproductionanddistribution.ButreformofIndianelectricityhaslargelyfailedduetotheinterlockingofpoliticalin-terests and governing institutions in the sector. Climate-driven economic incentiveswouldincreasethepotentialeconomicgainsfromreformoftheelectricitysector.Theywould,however,dolittletoaddresstheentrenchedpoliticsandinstitutionsthatblocktheirachievement.Instead,bottom-upinstitutionalreform,backedbycleverpoliticaldealmaking,isrequiredtochange the dynamics in the sector.

Thegeneralpointisthatthemoreimperfecttheinstitutions,themoremarkets will bemissing or incomplete, and the less useful price signalswillbeasadriverofchange.Bottom-upmitigationactions,forgedinthecrucible of domestic political debate, are more likely to ensure institu-tional commitment to carbon reductions goals and perhaps even promote institutionalchangethanaretop-downmitigationcommitments.

Perverse Incentives Created by a Top-Down Approach: The Climate Policy Uncertainty Principle

Theargumentsofarhassuggestedthattop-downmeasures,andthepricesignals they send, are an incomplete and partial solution to climate miti-gation. But whenwe consider their effect in giving countries incentivesto game the climate regime—a climate policy uncertainty principle—top-downcapsmaybedownrightpernicious.Theonlyformofcapsthatguaranteetheenvironmentalintegrityoftheclimateregimeisanabsolutelimit on emissions.However, absolute caps for developing countries arenot on the negotiating table, at least in the short to medium term. All the other forms of caps under discussion introduce serious incentive prob-lemsofvarioussorts.


For example, proposed reductions from a business-as-usual (BAU)trajectoryencouragestrategicnegotiationaboutwhatsuchatrajectoryislikely to look like.Given large variations in economic growth rates overthelastfewdecades,thereislittlebasisforanobjectivedefinitionofBAU.Giventhisuncertainty, there isarisk that thatBAUwillbedefinedgen-erously in the interestsofapolitical solution, leavingconsiderable scopefor developing countries to generate and industrialized countries to buyoffsets,benefitingbothgroupseconomicallybutcompromisingtheenvi-ronmentalintegrityoftheregime.

Indeed, any approach that requires construction of a counterfactualbaselineagainstwhichtojudgeprogressrisksrepeating,ata largerscale,theproblemsofgamingandhightransactioncostthathavecharacterizedtheCleanDevelopmentMechanism(CDM).Recenteffortstodevelopsec-toralapproachescarrythepromiseoflowertransactioncostsbecauseanysuch costs are distributed over potentially much larger gains at the sec-torratherthantheprojectlevel.However,evenhere,discussionhasbeenbogged down over whether a sector baseline should exclude measuresthatareinacountry’snationalinterestanyway,eitherbecausetheybringotherco-benefitsorcanbeachievedatnegativecostandthereforeshouldnot be eligible for any climate-related incentives or support. In practice,puttinganysectoralreformsintovariousbuckets—suchasnegativecost,co-benefitsactions,andpositivecost—isanegotiation-intensiveandpo-tentially counterproductive task. Framed thus, countries have an incen-tive to demonstrate that as many actions as possible carry positive costs, and to do so by simply not undertaking actions unless they are linked to climatefinancing.Thus,manydiscussionsoversectoralapproachescarryexactly the wrong incentives—they discourage early action and rewardstonewallingandlateaction.

Theseareonlytwoamongmanyexamplesofcounterproductiveincen-tivescreatedbyaspectsofa top-downapproach. It isaltogetherpossiblethattheharmcausedbysuchincentiveswouldoutweighthebenefitsofatop-downapproach,oratleastreduceitseffectivenesstoalevelbelowtheeffectivenessthatcouldbeprovidedbyabottom-upapproach.

Answering the Objections to a Bottom-Up Approach

Isabottom-upapproachbasedonnationallydevisedactionsreallyavia-blealternativetothevarioustop-downapproachesunderdiscussion?The


attractivenessof thisapproachlies inthepotentialalignmentof interestsbetweendevelopmentactionsandclimatemitigation.Whywouldadevel-opingcountrynotaggressivelypursuedevelopmentallyusefulmitigationactionsthatyieldclimateco-benefits,especiallyifsupportedbyfinancingfromindustrializednations?Withoutthethreatofimminentcaps,devel-oping countries are more likely to aggressively pursue such policies. Inthe medium to long run, a co-benefits approach may not be sufficient, and developing countries, too,maywell have to take onmore stringentmeasurestomeettheclimatechallenge.However,intheshortrun,whenearly action is at a premium, a bottom-up approach to climate mitigation maywelldelivermoreandearliermitigationthantop-downapproaches.

Therearethreepossibleobjectionstothisconclusionthatshouldbead-dressed head on. First, a bottom-up approach leaves little scope to assess whetherthesumtotalofmeasuresiscollectivelyconsistentwithmeetingtheclimatechallenge.However,ifmeasurabilityandpredictabilityresultsinlesseffectiveaction,thereissurelyacaseforrethinkingtheapproach.

Second,ratherthansacrificingpredictability,perhapsdevelopingcoun-triesshouldbeurgedtotakeonabsolutereductioncaps.However,anef-fective climate deal cannot come at the expense of a globally legitimateagreement. Moreover, there is little doubt that a climate regime that locks indramaticallyunequalpercapitaemissionsacrosscountries,whichasetofabsolutecapsbasedoncurrentemissionlevelswoulddo,wouldbere-jectedasunfairbymuchofthedevelopingworld.

Third, a bottom-up approach by itselfmay fail to satisfy political de-mands by the North that the South make meaningful commitments tolimit emissions. However, this argument conflates effectiveness and theuseoftargets.If, indeed,abottom-upapproachpromises largerandear-lier actions, then the onus must be on advocates in the North to reshape the nature of political demands in the North, rather than bend the re-gimeinadirectionoflowereffectivenesstosuitpoliticalconditionsintheNorth.

In sum, environmental credibility and predictability in developingcountryactionsareundoubtedly tobedesired.However, if thequest forpredictabilitycomesatthecostofmisalignedincentivesandaregimethatcannotbemadeconsistentwithdevelopmentrealities,theremaybegoodreason to open thedoor to other approaches. Since it avoids both theseproblems,abottom-upapproachoffers,atleastintheshortrun,analter-nativeandpotentiallymoreeffectiveavenuetoearlymitigationactionbythedevelopingworld.



J.Gupta,K.vanderLeeuw,andH.deMoel,“ClimateChange:A‘Glocal’ProblemRequiring‘Glocal’Action,”Environmental Sciences4,139–148(January2007).

K. Neuhoff, International Support for Domestic Climate Policies in Developing Countries(UniversityofCambridge,2008).

H.Winkler,R.Spalding-Fletcher,S.Mwakasonda,andO.Davidson,“SustainableDevelopment Policies and Measures: Starting from Development to TackleClimateChange,” inR.BradleyandK.Baumert(eds.),Growing in the Green-house: Protecting the Climate by Putting Development First (World Resources Institute,2002).

Climate Finance 179

Chapter 19

OperationalizingaBottom-UpRegimeRegistering and Crediting NAMAs

RaeKwonChungAmbassador for Climate Change, Republic of Korea

Key Points

• Nationallyappropriatemitigationactions(NAMAs)areonetypeofmechanism to accelerate developing country participation in GHG emissionsreductionefforts.

• NAMAscouldbepurelyvoluntary(forinherentlyfinanciallyviableprojects),internationallysupported(forriskyorexpensiveprojects),or capable of producing tradable credits (for projects in betweenthese two categories), the latter categories requiring internationalconsensus.

• NAMAs would run their MRV through a central global registry,withgreaterlevelsofregulationforprojectsthatarenotpurelyvol-untary,especiallyforthoseprojectsthatrequiresignificantlevelsoffinanceupfront.

• Tradable credits would draw the lowest cost emissions reductionsandbring in largefinancialflows,assuming that sufficientdemandcanberealizedfrommarketparticipantsandgovernmentsindevel-oped countries.

AlthoughthehistoricalburdenofclimatechangerestswithAnnexIcoun-tries,non–AnnexIcountriesareassisting—intheirownways—withmit-igatingclimatechange.However,thecurrentstructureoftheUnitedNa-tionsFrameworkConventiononClimateChange(UNFCCC)andKyoto

180 Rae Kwon Chung

Protocolallows thesecontributions tobeneither recognizednorcoordi-nated.SouthKoreahasproposed thatNationallyAppropriateMitigationActions (NAMAs)undertakenbygovernmentsbe registeredwithan in-ternational NAMA registry, and for appropriate countries andNAMAs,carbon credit or development assistance might be given.

Thispaper outlines the SouthKoreanNAMAproposal, and in doingso, it aims to address three major concerns related to such bottom-up approaches, as they are likely to be a component of any future climateagreement.Thefirstconcernisthatabottom-upapproachwillbeunableto guarantee sufficient reductions to prevent catastrophic warming.Thesecond concern is that a bottom-up approachwill notprovide sufficientaccountability to ensure that carbon finance funds are used effectively.Thethirdconcernisthatabottom-upapproachwillnotbeabletoguar-antee that mitigation measures are undertaken as efficiently as possible. The NAMA proposal contains means of effectively addressing all threeconcerns.

Nationally Appropriate Mitigation Actions

ANAMAcouldbeanyactionrangingfromeconomy-widemitigationtar-getstoaspecificprojectinaspecificsector.Examplesincludesustainabledevelopmentpoliciesandmeasures(SD-PAMs),reducingemissionsfromdeforestation and forest degradation (REDD), cap-and-trade schemes,sector-widetechnologystandards,sectoraltargets,acarbontax,buildinginsulation codes, or congestion targets.Nationswouldbe free to choosetoundertakeasmanyorasfewNAMAsastheywouldlike.

However, NAMAswould only be eligible for carbon credits or otherfinancial support if they fulfilled certain conditions.Consequently, therewouldbethreetypesofNAMA.ThefirstwouldbevoluntaryNAMAs,orthose that requirenosupportanddonotqualify forcredits.Thesecondwould be NAMAs that qualify for international support.The standardsfordeterminingwhetherornotaNAMAwouldreceivefinancialsupportcould be determined by either bilateral or multilateral agreement. Thethirdwould beNAMAswhich are eligible for carbon credits.The stan-dardsfordeterminingwhetherornotaNAMAwouldbeeligibleforcar-bon credits would need to be consistent with the standards adopted byother carbonmarkets to allow for linkage to thosemarkets. In theory, a

Operationalizing a Bottom-Up Regime 181

projectmayfallintoboththesecondandthirdcategories,i.e.,itmaybothqualify for support at the outset andbe eligible for carbon credits uponcompletion.

The boundaries between these three types of categories will need tobedeterminedby some formof international consensusor cooperation.In the absence of such cooperation, all NAMAs are voluntary. As a re-sult, this approach provides substantial flexibility to alter the creditingandsupportstandardstoachievepolicygoals.Themostefficientandef-fectiveoutcomewouldbe achievedby (a)makingNAMAs thatwill payforthemselvesvoluntary,(b)providingcreditsbutnoadditionalsupportfor thoseNAMAs that are not cost-effective on their ownbutwould becost-effective if credited, and (c) providing additional financial supportforvaluablemitigationactions thatare too riskyorexpensive topay forthemselves through crediting alone. Under this approach, NAMAs that qualify forcarboncreditswould likelybe theprimarymechanismforfi-nancing mitigation measures in developing countries.

ThecreditingofNAMAs couldbe structured similarly to the currentstructuringoftheCleanDevelopmentMechanism(CDM).Creditswouldbeawardedforreductionsbelowefficiencystandardsorintensitytargets.ThisaddsadditionalflexibilitytotheNAMAapproach,byallowingpartiestosetdifferentemissionsstandardsfordifferentprojectsorsectors.Cred-itswouldbepurchasedbyAnnexIgovernmentsandmarketparticipantstomeettheirtargets.Theresultwouldbeatransferoffinancialresourcesfromthosecountriestomitigationactionsindevelopingcountries.

Forexample,theefficiencystandardcouldbesethigherorlowerbasedon different priorities. Alternatively, credits could be issued on the pro-gram,policy,orsectorallevel.Forexample,itmightmakesensetoawardcreditsontheprojectlevelforLDCswithlimitednetemissions,butonlyon the sectoral level formajor emerging economies where non-sectoralmeasuresarelesslikelytobeeffective.

Althoughtheflexibilityprovidedbythisapproachwillyieldmanyben-efits, it will also present some challenges. Itmay take some time to es-tablishpoliticallyacceptableintensitytargetsormethodologiesforallthevarious NAMAs that are likely to be undertaken. Fortunately, many tar-getsandmethodologiescouldbebasedoffofpreexistingCDMpractices.Also,notallofthedetailsneedtobespelledoutimmediately.PartiesmayagreeontheprincipleofcreditingNAMAsatCopenhagen,whileleavingdeterminationsofappropriatestandardsforlater.

182 Rae Kwon Chung

MRV and a Global Registry

ForNAMAstoqualifyforsupportorcredits,theywouldhavetobedoneinameasurable, reportable,andverifiable (MRV)manner,asdefinedbyBali Action Plan paragraph 1(b)(ii).MRV standards will act as the linkbetween mitigation efforts in developing countries and financing fromdeveloped countries. As a result, NAMAs should be registered in a central registry chargedwith keeping track of both the totalmitigation actionstaken by developing countries and the total financing provided by An-nex Inations.Theregistrywould function toensure thatanymitigationmeasures that receivefinancingor credits do, in fact, result in verifiableemissions reductions, and that all eligible and reported mitigation meas-uresdo,infact,receivefinancingorcredits.

Registrationrequirementswouldbedifferentforeachofthethreedif-ferent types of NAMAs. Voluntary NAMAs would not need to be reg-istered, but developing countries should have the option of registeringtheminanMRVmannerinordertokeeptrackoftheiroverallmitigationactions.Thisinformationwouldbevaluableinprovidinganaccurateac-countofdevelopingcountries’fullcontributiontoglobalemissionsmiti-gation,aswellashelpingdeterminetowhatextentdevelopingnationsarevoluntarilytakingcost-effectivemitigationactionsthatdonotqualifyforcredits or support.

NAMAs that require support would need to be registered based onanMRVmethodologyagreeduponbythepartyorpartiesprovidingthesupport.This could vary substantially on a project-by-project basis, de-pendingontheprioritiesofthepartiesinvolved.

NAMAs that qualify for creditswould be subject to amore stringentMRVmethodology.Thismethodology would need to ensure that cred-its are effectively equivalent toother carbon credits.This isnecessary toallow linkage to global carbon markets and to maintain environmentalintegrity.

Countrieswouldnotreceivecarboncreditsuntiltheprojectwasactu-allycompleted,butotherformsofsupportcouldpotentiallybeissuedbe-foreaprojectisinitiatedorcompleted.However,firmsshouldstillbeabletoreceivefinancingfortheprojectpriortocrediting.Theparticipantfirmwouldsubmitaprojectideatoabanktoget loanstoinitiatetheproject.The firmwould later pay back the loanswith the revenue generated bythesaleofthecarboncreditsgeneratedbytheproject.Thisapproachhas


already been adopted by many firms initiating unilateral CDM projects, whichaccountforhalfofallCDMprojects.

Although monitoring, reporting, and verification requirements willvarydependingon theproject, several common featureswillneed toberegistered forallprojects.Quantityofemissions, supportneededand is-sued, and credits issued should all be registered.Timeframes forprojectcompletion could also be registered. Many countries may not have capac-ity tomeasure and register theirmitigation efforts.Consequently,devel-oping nations should have the option of requesting and receiving assis-tancetoestablishtherequisitecapacity.

The Advantages of Tradable Credits

One of themost important features of this program is the provision oftradablecredits.Credits issuedforNAMAswouldbetradablewithfirmsandnationsabroad,similartoCDM,orEmissionsTradingSystem(ETS)on a global scale. This system provides several major advantages overother approaches.

Thefirstisthatitallowsmarketstoworktoachievethemostefficientreductions. As it is less expensive to reduce CO2 emissions in develop-ing nations than in developed nations, it is more economically efficient toallowreductionstohappenintheleastexpensivelocale.Aglobaltrad-ing system is the best mechanism to ensure that capital is most efficiently deployed in these circumstances. According to one model, a global trad-ing system including developing countries could reduce global mitigation costs by 70%.

Thesecondis thatatradablecreditschemewillallowforsignificantlygreater overall volumeof financial flows and technological transfer thanan approach that relies on Official Development Assistance (ODA) orinstitutional financing.The vastmajority of the technology and financenecessarytoreduceemissionsbelongstotheprivatesector.Consequently,theprivate sector, not the government, shouldbe theprimary sourceoffinancial and technological transfer. Furthermore, itwill bemore politi-cally feasible inAnnex Inations to arrange forfinancial and technologytransfersthroughatradingschemethanthroughODA.

Foracredittradingschemetobesuccessful,AnnexIwillneedtoen-sure that there is sufficientdemandfor thecredits. If thepriceofcredits

184 Rae Kwon Chung

istooloworunpredictable,thenprivateinvestorswillnothavesufficientincentive to invest sufficient money to ensure a net reduction in emis-sions.There are two primaryways thatAnnex I nations canmake surethat there is sufficient demand for carbon credits.The first is to adoptmore ambitious national emissions targets. By adopting more ambitious targets,AnnexIcountrieswillforcetheirmarketparticipantstopurchasemorecarboncreditsinordertomeettheirtargets,whichwillinturnin-crease thedemand for credits fromdeveloping countries.An alternativeapproachwouldbe forAnnex Igovernments topurchase thecreditsdi-rectlyforretirement.

Althoughbothoftheseapproacheswouldentailsubstantialcosts,theyare preferable to the alternative, whichwould be to finance projects di-rectly throughODA.Thesetechniqueswouldbebothmoreefficientandmore effective than increasing ODA, for the reasons described above.Theywouldalsobemorepoliticallyinsulatedthandecisionsaboutdirectassistance. Finally, the MRV registry would enable efficient tracking oftotalfinancialtransfersfromAnnexItodevelopingnations.

Conclusion

Any climate change proposal will fail unless it both receives substantialparticipationfromdevelopingcountriesandcreatesstrongincentives forprivatecompanies to invest inmitigationactions.Thisproposalwillcre-ate strong incentives for both groups to vigorously participate in globalGHGmitigationefforts.

Thisproposalalsocontainsthetoolsnecessarytoachievethescale,ef-ficiency,andaccountabilitynecessarytoaddressglobalwarming.Solongas the price of carbon credits is sufficiently high, developing countriesshould undertake cost-effectivemitigation efforts to receive those cred-its. Ifefficiencystandardsaresetwisely, then investmentsshouldflowtowheretheywillbemosteffective.Andifacentralregistry isestablished,then every significant mitigation action and dollar spent on carbon fi-nancewillbeaccountedfor.


CenterforCleanAirPolicy,Sectoral Approaches: A Pathway to Nationally Appro-priate Mitigation Actions(December2008).


Hyo-eunJennyKim,“NAMARegistry—Korea’sProposalforPost-2012Negotia-tion,” Presentation at Key Issues of the Post-2012 Climate Change Framework OECD Global Forum on Sustainable Development(March2009).

Republic of Korea, Market-Based Post-2012 Climate Regime: Carbon Credit for NAMAs (August 2008), available at http://unfccc.int/files/meetings/ad_hoc_working_groups/lca/application/pdf/market_based_climate_regime-korea.pdf.

http://unfccc.int/files/meetings/ad_hoc_working_groups/lca/application/pdf/market_based_climate_regime-korea.pdf

http://unfccc.int/files/meetings/ad_hoc_working_groups/lca/application/pdf/market_based_climate_regime-korea.pdf

B

ConditionalityandItsGovernance

Climate Finance 189

Chapter 20

From Coercive Conditionality to Agreed Conditions

The Only Future for Future Climate Finance

Jacob WerksmanDirector, Institutions and Governance Program,

World Resources Institute

Key Points

• A prerequisite to a successful global deal on climate change is theclosingof thegapbetweenexpectationsheldbydevelopedandde-veloping nations with regard to the quantity and type of climatefinance.

• Thesignificant increase ineconomicandpoliticalpower inthede-velopingworldisleadingtothegrowinginfluenceofrecipientcoun-triesonthetermsofclimatefinance.

• The traditionalmodel of conditionalities, whether set at the inter-national or national (investor/developed or recipient/developing) level,needstoyieldtoanewmodelinwhichdonorsandrecipientsagreeontheconditionsunderwhichinvestmentsaremostlikelytosucceed.

• Under this newmodel, a growing recognition of the power of de-veloping countries to set policies and priorities for developmentfinancewill be accompanied by greater levels of responsibility andaccountabilityforthewayinwhichinvestmentsaremade.

A global deal on climate change will depend upon closing the gap inexpectations between developed and developing countries on climate

190 Jacob Werksman

finance.Mostmultilateralenvironmentalagreements(MEAs)provideforthe transferoffinancialand technical resources fromrichercountries topoorercountries.Thesetransfersservethepracticalpurposeoffinancingdeveloping country capacity to implement projects and policy, and the political purpose of providing incentives for developing country partici-pation in responses to global environmental challenges.

However,financial transfers rarely comewithout stringsattached, i.e.,conditionalities imposed by contributor or lending institutions on recipi-ent countries. Conditionalities are thought to be particularly important in the context of global environmental agreements, where scarce finan-cialresourcesmustpromoteglobalpublicgoods—suchasprotectingbio-diversity,theozonelayer,andtheclimatesystem—thatmaynotbepolicyprioritiesfortherecipientcountry.Whileconditioningaccesstofundsisdesigned to ensure that the money buys results, it can lead to resentment andalackofownershipbyrecipientcountries.

In the context of climate change, conditionalities operate in a partic-ularly complex political environment. Climate finance represents, in the eyesofmanydevelopingcountriesandobservers,aformofcompensationforthedamagedonetotheclimatebymorethanacenturyofdevelopedcountryhistoricalemissions,andseveraldecadesofcontinuedemissionsgrowthinthecontextofagrowingscientificcertaintyabouttheextentofthisdamage.At the same time,however, the science tellsus that even ifdevelopedcountry emissionsdrop to zero, thegrowingemissions in thedevelopingworld,particularlyfromemergingeconomies,willstillleadtodangerous climate change.

The climate change negotiations thus raise unique challenges for de-velopmentassistance.WhiletheSouthcanwithsomelegitimacydemandfinancialsupportforreducingemissions,theNorthandtheinternationalcommunity as awhole can legitimately demand a returnon this invest-ment.Inthiscontext,whogetstosettheconditionalitiesthatwill,inturn,drive the investments in countries dependent on climate finance?

Broadly, there are threemain sources of conditionalities thatwill de-terminehowclimatefinanceisinvestedindevelopingcountries:

• Policies agreed multilaterally by the Conference of the Parties tothe United Nations Framework Convention on Climate Change(UNFCCC) and any international financial institutions that may be mandated to implement the climate deal

From Coercive Conditionality to Agreed Conditions 191

• Policies set unilaterally by national legislation and policies in con-tributor countries, includingmandates on how bilateral assistancewillbespentandwhatkindsofactivitieswillbesupportedbycar-bon markets, and/or

• Policiesestablishedbythedevelopingcountrygovernmentitself, inthecontextofnationallow-emissiondevelopmentstrategiesandna-tional adaptation plans

Eachof these setsofpolicies emerges fromandwill shapeadynamicofpower, responsibility, and accountability in the relationship between in-vestor contributor governments, investor institutions, and host govern-ments.Ideally,thesepolicieswouldalign,resultinginconditionalitiesthatdrive investments that are consistent with nationally determined priori-ties. In reality, this seems unlikely.Multilaterally agreed policies tend todrift towardsa lowestcommondenominator,asnegotiatorsare requiredtoaccommodatethecompetingconcernsofmultiplecontributorsanddi-verse recipients.Bilateralpolicies tend to reflect thepriorities and inter-ests of the contributor governments, through an exercise of power thatfavorsparticularcountries,technologies,andpolicies.

National policies to mitigate emissions and adapt to the impacts ofclimate change,where theyexist, are in theearly stagesof formation. Indeveloping countries,many of these plans are vague and targeted at aninternational audience, rather thanwell grounded in a national consen-sus. If the latest round of negotiations on climate finance is to succeedin leveraging significant transformations in developing countries,multi-lateralandbilateralpolicieswillneed tosupportandalignwithnationalplanningprocesses.Thiswillrequireashiftinpowerfromcontributortorecipientcountries,andagreatersenseofresponsibilityandaccountabil-ity by recipient countries.

A Brief History of Climate Finance

Iwillquicklyreviewhowthetwopreviouseffortstodoadealonclimatefinancehavedistributedpower,responsibility,andaccountabilitybetweencontributors and recipients, and then speculate how a new—and better—kindofbargainmaybe emerging from theCopenhagenprocess.Thissummarizes amuch longer andmoredetailedpieceof research that the

192 Jacob Werksman

World Resources Institute is undertaking to both study and inform thenegotiations.

The post-2012 climate regime will depend on building upon andagreeing todifferent terms forclimatefinance thanhavebeensetby thetwo previous (and largely unfulfilled) climate bargains struck.The firstis set out in theUNFCCC, opened for signature at theUNConferenceon Environment and Development (UNCED) in Rio in 1992. The RioBargain provides, in essence, that the agreed full incremental costs ofdeveloping country actions will be financed on a grant basis by devel-oped countries. The bulk of these grants will be transferred through asinglefinancialmechanism,operatedbytheGlobalEnvironmentFacility(GEF) under the guidance of theConference of theParties to theCon-vention(COP).

The COP sets the most general of guidance, while operational poli-ciesandprogramsareagreedinternationallybytheGEFCouncil.SpecificprojectsareimplementedinaccordancewiththepoliciesofoneormoreoftheGEF’simplementingagencies(i.e.,theWorldBank,theUnitedNa-tionsDevelopment Programme (UNDP), and theUnitedNations Envi-ronmentProgramme(UNEP)).

AccesstoGEFfundingrequiresademonstrationthatGEFinvestmentsrepresentnomorethanthe“incrementalcosts”ofimplementingtheCon-vention and, indoing so, generating a “global environmental benefit” inthe form of emissions reductions. In other words, what is funded is bydefinitionthatwhichisnotinthenationalinterest.WorldBankandUNprogram officers manage the project cycles and recover their costs through administrative fees.Their environmental and social safeguard standardsguideprojectdesignandimplementation;theirfinancialsystemsprovidefor fiduciary accountability. Developing country access to GEF funds isthus mediated conceptually through incremental cost financing, and in-stitutionally through theoperationsof the intermediary institutions thatcontributors entrust with designing and overseeing project implemen-tation. This represents a classic contributor-recipient relationship, withconditionalities set and enforced through the exerciseof the contributorprerogative. It is not surprising, under these conditions, that GEF proj-ectsareoftencriticizedashavinglittleofthecatalyticeffectnecessarytotransformnationalpoliciesandpriorities.

Thenextstageinthedevelopmentoftheclimateregimeemergedfromthenegotiationsof the 1997KyotoProtocol to theUNFCCC,whichwas


designed to put in place the first internationally agreed upon, legally binding capongreenhouse gas emissions.Developed countrieswere re-quired to limit their emissions on average to 5% below 1990 levels be-tween2008and2012.With regard toclimatefinance, theKyotoBargainimported the incremental cost concept, aswell as theGEF and its sup-porting institutions.

But in partial response to the observed shortcomings of the financialflows generated by the GEF, the Kyoto Protocol (KP) parties turned tomarket mechanisms as an additional source of money, incentives, andconditions. The KP’s Clean Development Mechanism (CDM) providesameans for incentivizing investments in emissions reducing projects indevelopingcountriesbyrewarding investorswithcarbonoffsets foreachtonofcarbonequivalentofemissionsreduced(theCDMalsoprovidesasourceofgrantrevenue foradaptationactivities indevelopingcountries,by providing that a 2% share of the proceeds from each CDM invest-mentbe set aside for thispurpose).TheCDM’sExecutiveBoard sets, atthemultilateral level, the conditionsunderwhichprojects are eligible asCDM investments.The host governmentmust agree to the project, butthe investormakes the choiceof project and investment.Thus, develop-ing countries could exercise the sovereign power to block a project, butinessence,anewspecializedglobaladministrativebody,and theprivatesector,determinewhethertheprojectisviable.

Fundamentally, the CDM seeks to commoditize the emissions reduced asmeasured against a business-as-usual baseline—what theGEFwouldcharacterizeasthe“globalenvironmentalbenefit”—intoatradablereturnontheinvestment.Powershiftedfromtheexerciseofthecontributorpre-rogative to the operations of a global administrative body overseeing aprivate-sectormarket.Developing countries have been frustrated by theslownesswithwhichtheCDM’sExecutiveBoardhasperformeditsover-sight function, and some of the smaller developing countries have beenfrustratedbytheprivatesector’spursuitofinvestmentinlargerindustrial-izedcountrieswhere low-costoffsetopportunitiesareeasier tocomeby.Responsibility and accountability for the performance of CDM projectsis largely outsourced to the project sponsors and to private-sector com-paniesundercontracttomonitorandcertifytheemissionsreductionsastheyoccur.ItishardtofindevidencethattheCDMispromotinginvest-ments or incentivizing policy changes at the mainstream in the countries whereitoperates.

194 Jacob Werksman

Towards a Successful Climate Change Deal

Asuccessfulclimatechangeagreementwilldependheavilyonanewkindofbargainonclimatefinance thatcatalyzes thekindof transformationalchange indevelopingcountries thatpreviousdealshave failed todeliver.Therehavebeenpromisingsignsthatthedynamicofpower,responsibil-ity,andaccountabilityisshifting.

Developing countries, particularly emerging economies, are more eco-nomicallyandpoliticallypowerful thanduringearlierperiodsofclimatenegotiations.The sizeof their economies and the sizeof their emissionsdemandgreaterrecognition.While thismaynotyieldsignificantnewfi-nancialflows,particularlyinthecontextofaglobaleconomicdownturn,it does mean that developing countries are likely to demand and receive moreformalpowerintheoperationofanynewfinancialmechanisms.

The CDM’s adaptation levy, which is collected without reference tocontributorpurse strings,has led to the creationof anAdaptationFundBoard (AFB) governed by amajority of developing country representa-tives. It is possible that negotiatorswill agree to tap new sources of cli-matefinancede-linkedfromdevelopedcountrycoffers,forexample,lev-ieson internationalairandmaritimebunker fuels,andthe internationalauctioning of emissions allowances.Thismay lead to amutually agreedrelaxationofthecontributorprerogativetosetconditionalities.

InthecontextoftheAdaptationFund,andindiscussionsaroundanynew financial mechanisms established post-2012, developing countriesarealsodemandinggreaterresponsibilityforthemselvesintheprogram-ming of climate finance. Submissions call for “direct access” that wouldallow recipient countries to bypass the traditional “implementing agen-cies”bynominatingnationalinstitutionstoreceive,program,andaccountforprojectsfundedunderanewclimateregime.Anumberofdevelopingcountries have expressed their willingness to demonstrate that nationalfinance ministries or planning ministries can meet international fiduciary standardsinordertojustifythismoredirectlyresponsiblerole.

Are-openingoftheincrementalcostconceptmayalsobeonthetable.Inspiredby efforts thathavebeenmade to calculate themarginal abate-ment costs of reducing emissions in developing countries, some devel-oped countries have suggested that those projects and policies that can be shown to produce near-termpositive rates of return should be imputedtoadevelopingcountry’sbusiness-as-usualbaseline. Inotherwords, thenext generation of climate finance would assume developing countries


willdiscover and invest theirown resources in those activities thathaveboth domestic and global environmental benefits. Grants and conces-sional loanswould only be available for investment further up themar-ginal abatement cost curve.Thus far, developing countries have rejectedthis approach.

TheCopenhagenroundofnegotiationshasalsoproducedsomemove-ment in the directionofmoredirect accountability of developing coun-triesfortheinvestmentstheyhost,inexchangeforgreateraccountabilityof contributors for following through on their financial commitments.The negotiators sketched out the essence of this reciprocal relation in2007. The Bali Action Plan provided—within the same circuitous sen-tence—thatboth“nationallyappropriatemitigationactionsbydevelopingcountryParties”andthe“technology,financingandcapacity-building”tosupport and enable these actions must be included in a Copenhagen deal in“ameasurable,reportableandverifiablemanner.”

From Coercive Conditionality to Agreed Conditions

Asthisbookhighlights,thecostsofaseriousresponsetoclimatechangewilllikelydwarfthelevelofdevelopmentfinanceavailable.Moreover,sta-bilizingthegreenhousegasconcentrations intheatmosphereatsafe lev-elswillnothappenifdevelopingcountryemissionscontinuetorise.Thedynamicsofthenegotiationsaroundclimatefinancehaveslowlycometorecognize this, by searching fornew sourcesof funds, andbybeginningtoexplorewaysinwhichpower,responsibility,andaccountabilityforthedeliveryofclimatefinancearesharedbetweendevelopedanddevelopingcountries.

Coercive conditionalities are profoundly disempowering for develop-ing countries, as they are placed in the positionof recipient required toperformagainstan imposedsetofstandards.Anewandbetterrelation-shipturnsonarecognitionthatsuccesswilldependnotoncoercivecon-ditionalities,but ratheronwise investments that create the right institu-tional and policy conditions in recipient countries formore sustainableclimate-related polices to take root. Direct access to funding for devel-oping countries whose national institutions can demonstrate they meetfiduciary standards, and national systems formeasuring, reporting, andverifyingfundedactionsaretwonewdimensionsofamorereciprocalre-lationship between contributors and recipients that reflect an agreement

196 Jacob Werksman

on the conditions necessary to empower developing countries to shapetheirownclimatepolicies.

Inotherwords, thenext generationof climatefinanceneeds to focuson the incentives necessary to promote good governance within recipi-entcountries—bystrengtheningtheinstitutionsnecessarytoperformthefunctionsofresponsibilityandaccountabilitypreviouslyperformedbyin-termediary institutions.There are good signs from early efforts to fundactivitiestoreduceemissionsfromdeforestationanddegradation(REDD)that both contributors and recipients are recognizing this essential link betweengovernanceandeffectiveclimatefinance.

BoththeWorldBankandaconsortiumofUNagencies(UNDP,UNEP,andtheFoodandAgricultureOrganization)areinvestingincreatingtheconditions necessary for forest-rich developing countries to combat thedriversofdeforestation.TheWorldBank’sForestCarbonPartnershipFa-cilityandtheUN-REDDinitiativearebothprovidinggrantstohelpthesecountriesdemonstratetheirreadinesstohostlarge-scaleforestoffsetproj-ects by funding assessments of their institutional capacity.These studiesare beginning to reveal gaps in countries’ capacity and commitment tomake and enforce basic land tenure and land use policies, to recognizeandupholdtherightsandinterestsoflocalforest-dependentpeople,andtopoliceanddiscourageinternationaltraffickinginillegalforestproducts.Civil society groups in these countries and internationally are taking note, and they are beginning to seeREDD, and this new approach to climatefinance,asameansofgettingcitizensinvolveddirectly inassessingtheirgovernments’readinesstoparticipateinthesenewdeals.

Theinvolvementofnationalcivilsocietyinthedesignofclimatepolicyis the only means of ensuring that the relatively weak incentives madeavailable by international climate finance can take hold in a way thattransformseconomies.Thisrequiresashiftinpowerfromcontributortorecipient government, and then to ultimate beneficiaries of these flows:thecommunitiesandthecitizensthatwillhosttheseinvestments.


GEFEvaluationOffice,Fourth Overall Performance Study of the GEF (OPS4) In-terim Report,GEF/ME/C.35/Inf.1/Rev.1(2009),availableatwww.gefweb.org.

D. Reed, The Institutional Architecture for Financing a Global Climate Deal: An Options Paper,TechnicalWorkingGroup,WWF-International(2009).

http://www.gefweb.org

Climate Finance 197

Chapter 21

Getting Climate-Related Conditionality Right

KevinE.DavisBeller Family Professor of Business Law, NYU School of Law

SarahDadushResearch Fellow, Institute for International Law and Justice,

NYU School of Law

Key Points

• Climate-related conditionality is an inevitable feature of many fu-ture public and private investments in developing countries.

• Climateconditionalityraisestwobasicsetsofsubstantiveconcerns,onerelatingto itseffectivenessandefficiency, theothertoconflictsbetweenclimateconditionalityandbroaderdevelopmentgoalsandequitableconcerns.

• In order to ensure effectiveness and consistency with other objec-tives, publicly funded investment funds using climate conditionsshouldprovidedueprocesstothecitizensofrecipientcountries.

Conditionality has gotten a bad name in development finance. But it may be rehabilitated by the emerging climate change regime. Mitigating cli-mate change by reducing emissions of greenhouse gases (GHGs) fromdevelopingcountrieswillrequiresubstantialamountsofcapital.Someofthat capital will come from individuals or organizations who insist thattheir funds be used in ways that tend to promote mitigation. In otherwords, theywill insist on conditionality.This raises a number of policy

198 kevin e . davis and sarah dadush

concerns, including several that are reminiscent of debates about condi-tionality in other contexts.

Thefirst part of this paper provides anoverviewof existing formsofclimate-relatedconditionality.Thesecondpartsetsoutthemainsubstan-tiveissuesinvolved.Thethirdpartconsidersimplicationsforinstitutionaldesignandtheprocessbywhichconditionsareformulated.

The Landscape of Climate-Related Conditionality

Climate-relatedconditionalitycantakeanumberofdifferentforms,rang-ing fromobligations for the recipientof funds to reduceemissions fromitsownactivities,toobligationstoencourageotheractorstoreduceemis-sions,toobligationsforrecipientstoreportontheirownorothers’effortsto mitigate climate change. Many different kinds of organizations havedemonstrated interest in imposing conditionality of one sort or anotheronfinancialtransferstodevelopingcountriesortoenterprisesorprojectslocated in those countries.

Public Funds Dedicated to Mitigation

Anumberoflargefundssponsoredbypublicactorshavebeencreatedtochannel mitigation-related capital to actors in less-developed countries on concessional terms.These fundsarededicatedexclusively to investmentsin mitigation. Funds created under the auspices of the United NationsFramework Convention on Climate Change (UNFCCC) and the KyotoProtocolandthroughothermultilateralinitiativesinclude:

GlobalEnvironmentalFacility(USD3.1billionfor2006–2010)United Nations Collaborative Programme on Reducing Emissions

from Deforestation and Forest Degradation in Developing Coun-tries(UN-REDD)(USD35million)

WorldBank—ForestCarbonPartnershipFacility(USD165million)WorldBank—ClimateInvestmentFunds(USD6.1billion),madeupof

theCleanTechnologyFundandtheStrategicClimateFund

Additionally, insteadoffinancing specificprojects, theWorldBankCar-bon Finance Unit (CFU) uses money contributed by governments and

Getting Climate-Related Conditionality Right 199

companiesinOrganisationforEconomicCo-operationandDevelopment(OECD)countriestopurchaseproject-basedGHGemissionreductionsindevelopingcountriesandcountrieswitheconomiesintransition.There-ductionsarepurchasedthroughoneoftheCFU’scarbonfundsonbehalfofthecontributorandwithintheframeworkoftheKyotoProtocol’sCleanDevelopmentMechanism(CDM)orJointImplementation(JI)program.

Bilateralinitiativesbydevelopedcountrygovernmentsinclude:

Japan—CoolEarthPartnership(USD10billion)UK—EnvironmentalTransformationFund(GBP800million)Norway—ClimateandForestInitiative(€<600million)UnitedNationsDevelopmentProgramme—SpainMDGAchievement

Fund(€90million)EC—GlobalClimateChangeAlliance(€100million)Germany—InternationalClimateInitiative(€400million)Australia—InternationalForestCarbonInitiative(AUD200million)

Other Bodies That Have Adopted Climate-Friendly Standards and Investment Policies

While many organizations that invest in developing countries do not have funds dedicated exclusively to investments in mitigation, they have ad-optedpoliciesthatcallforgivingprioritytoclimate-friendlyinvestmentsoratleastforavoidinginvestmentsthathavetheoppositeeffect.Someofthese policies are legally binding, others are voluntary.

Publicly sponsored organizations that have taken steps to incorporate climatechangeconcernsintotheirinvestmentdecisionsincludetheInter-nationalFinanceCorporation(IFC),theMultilateralInvestmentGuaran-teeAgency(MIGA),andtheWorldBank,allofwhichincludethereduc-tionofGHGemissionsamongtheprioritiestheyseektoadvanceintheirfinancingofprojects.1Asaresult,theseorganizationsoftenmakefinanc-ingofprojectsconditionalontheclimate-friendlinessofthoseprojects.

Several associations of financial intermediaries have adopted volun-tarycodesofconductthatincludecommitmentstosupportonlyclimate-friendlyprojects.OnesuchinitiativeistheEquatorPrinciples,whichhavebeenadoptedvoluntarilybyover60projectfinanceinstitutions.ThePrin-ciples require participating institutions to observe the IFC Performance


Standards in their lending activities and to provide annual reports ontheirprogress.TheIFC’sPerformanceStandardscurrentlyrequire,amongother things, clients to report certain GHG emissions and encourage them toemploycost-effectivemeasurestoreduceoroffsetemissions.2

Another example is the InvestorNetwork onClimateRisk (INCR), anetworkofmorethan80leadinginstitutionalinvestorswithcollectiveas-sets ofmore thanUSD 7 trillion. In 2008, INCR announced its ActionPlancallingforinvestorstotakeninespecificstepstoaddressthegrowingrisks andopportunities fromclimate change,with a significant focusonreducingGHGemissions.Thestepsincludethefollowingcommitments:

• Support clean technology,with a goal of deployingUSD 10billioncollectivelyoverthenexttwoyears

• Requireandvalidate that investmentmanagers, investmentconsul-tants,andadvisorsreportonhowtheyareassessingclimaterisksintheir portfolios, including risks fromnew carbon-reducing regula-tions, physical impacts, and competitive risks

• Encourage Wall Street analysts, rating agencies, and investmentbankstoanalyzeandreportonthepotentialimpactsofforeseeablelong-termcarboncostsintherangeofUSD20toUSD40permet-rictonofCO2, particularly on carbon-intensive investments such as newcoal-firedpowerplants,oil shale, tar sands,andcoal-to-liquidprojects

• PushtheSECtoissueguidanceleadingtofullcorporatedisclosureofclimaterisksandopportunities

Substantive Considerations

The consequences of adopting any given form of conditionality can beevaluatedalonganumberofdimensions.First,will theconditionsbeef-fective?Inotherwords,aretheexpectationsthatclimate-relatedcondition-alitywill have a significant effect on the behavior of potential recipientsof funding—orother actors—justified?Second,will the resulting reduc-tionsofGHGemissionsbecost-effective?Third,whatimpactwillclimate- related conditionality have on economic development in developing coun-tries?Fourth,will this formofconditionalitypromoteorundermine theequitabledistributionofwealth andeconomicopportunity, either acrossorwithincountries?Weconsidereachofthesequestionsinturn.


Effectiveness

Theideathatclimate-relatedconditionalitywillexertameaningfulin-fluence on behavior cannot be presumed. No particular form of condi-tionalitywillbeeffectiveunlessitisadoptedbyenoughinvestorstocauseameaningfulreductionintheamountofcapitalavailablewithouttherel-evantconditions.Asinglebank’srefusaltofinancecoal-firedpowerplantswillhavelittleornoeffectonoverallinvestmentinthattypeofproject.

Accordingly, themost successful conditions, in termsof effectiveness,arelikelytobeonesattachedtofundingprovidedbythemultilateralandregional development banks.Those entities remain an important sourceof funding for many developing countries, especially when it comes toconcessional funding targeted atmitigation and adaptation-related proj-ects.Moreover,throughtheEquatorPrinciplesandsimilarinitiatives,theconditions imposed by the development banks also tend to be adopted by largenumbersofprivateactors—aformofcross-conditionality.

Of course, the effectiveness of any given set of conditions dependsonwhether theyareactuallyenforced. It isnotalways in the interestsoffundingorganizationstoinsistuponcompliancewithclimate-relatedcon-ditions.For instance,managersofprofit-oriented funds thathave signedon to the Equator Principles may still be tempted to invest in carbon-intensiveprojects thatofferhigh economic returns.Meanwhile, employ-eesofdevelopmentbanksmayexperiencepressuretofunddirtyprojects,either frommember statesor fromconstituencieswithin theirorganiza-tionwhohaveaninterestinmaximizingthevolumeoflending.

Effectiveness isaquestionthatwouldbenefitfromempiricalresearch.Itwouldbeusefultoknow,forexample,whetherorganizationsthathavethe right to insist on compliance with climate-related conditions eitherignoreinstancesofnon-complianceorwaivetherighttoinsistoncompli-ance.Iforganizationsdorelaxtheircomplianceorenforcementstandards,itwouldbehelpfultoknowwhenandwhytheydoso.

Cost-EffectiveEmissionReduction

Totheextentthatclimate-relatedconditionalityisaneffectivemethodof altering the behavior of the recipients of funding or other actors, thenext question iswhether the result is a cost-effective reduction ofGHGemissions. There are several reasons why this outcome cannot be pre-sumed. First, some fundsmay employ social or economic conditions—


including sectoral or geographic limitations—that go beyond requiringemission reductionsandpreclude investment inprojects associatedwithrelatively cost-effective reductions in GHG emissions. Second, when anumber of projects satisfy the conditions of a given fund, itmay, eitheradvertentlyor inadvertently, fail togivepriority totheprojects thatofferthegreatestreductioninGHGemissionsperunitofcapitalinvested.

Onewaytoaddresstheseconcerns is for fundingorganizationstore-view their conditions regularly to ensure that they are promoting cost-effectiveemissionreductions.Amorefundamentalresponsewouldbetoabandon funding conditionality altogether and rely on economic actorsto identify cost-effectivemitigationopportunities using theprice signalsgenerated by, say, a cap-and-trade or credit trading system.

An additional consideration is that conditionality entails certain trans-actioncosts—thecosts thatbothprovidersandrecipientsofcapitalbearin monitoring, reporting, and verifying compliance with any given setof conditions.Those costs can be particularly significant for developingcountries with limited institutional capacity. Transaction costsmay alsobeparticularlyhighwhenrecipientshavetocomplywithseveraldistinctsets of climate-related conditions. If the benefits of conditionality wereoutweighedbytherelatedtransactioncosts,thiswouldweighinfavorofabandoningconditionality(althoughthetransactioncostsassociatedwithalternativesmaynotbetrivial).Onestrategyforlimitingthecostsofcon-ditionality is to enhance consistency across the climate-related conditions imposed by various financial institutions, both public and private.Thiscould be accomplished through explicit harmonization, incorporation by reference to international standards developed through theCopenhagenprocess, or forms of cross-conditionalitywhere one organization adoptsanother’sstandards.

Host-Country Development

Allocatingcapital ina fashion thatefficiently reducesGHGemissionsis not necessarily consistent with maximizing benefits to society alongotherdimensions.Intheabsenceofregulation,themostclimate-friendlyprojects are usually not the ones that generate the largest pecuniary re-turnsforinvestors.Likewise,climate-friendlyprojectswillnotnecessarilygenerate thegreatestamountsofemployment, themosthelpful formsoftechnology transfer, or themost effective formsof adaptation to climate


change.Thisraisesthepotential forconflictsbetweentheinterestsofac-torsconcernedprimarilywithclimatechangemitigationandtheinterestsofinhabitantsofdevelopingcountries.

This issue is coming to a head in thedebate overwhether themulti-lateral development banks and other financial institutions should finance coal-firedpowerplants.TheWorldBankhasagoalofhaving50%of itsenergy portfolio dedicated to low-carbon investment (which includesclean coalwith several conditions attached). If enforced, this policywillreduce the supplyofcapital fornewcoal-firedpowerplants to someex-tent. Is this in thebest interestsofcountries thatdesperatelyneedcheapenergy to sustain their economic development?These concerns are par-ticularly pressing for the Least Developed Countries, which desperatelyneed growth and are only minimally responsible for past and presentGHG emissions, and yet are also most vulnerable to the negative conse-quencesofglobalwarming.

Equity

ThebenefitsofGHGemissionsreductionswillbedistributedglobally,thoughnotnecessarilyuniformly.Meanwhile,totheextentthatindividualprojectscreatejobs,transfertechnology,orsupportadaptationtoclimatechange,thecostsandbenefitsarelikelytobeconcentratedintheprojects’hostcountries,andevenamongparticularsegmentsofsociety.Conditionsthatprecludefinancingforcoal-firedpowerplantsareoneexample:theymayprovideglobalbenefitsattheexpenseoftheinhabitantsofdevelop-ing countries. As another example, conditions that promote investments inREDDmay produce globally diffused benefits in the form of climatechangemitigation and locally concentrated benefits for governments orprivatelandownerswhoreceivecashtransferstoencourageforestconser-vation. But these conditions may simultaneously impose substantial costs onindigenousgroupspreventedfromusingforestsintraditionalways.

Another important issue is whether it is appropriate to impose con-ditions that are inconsistent with the distribution of mitigation-relatedcosts agreed to by states in international negotiations. In other words,is Copenhagen-plus conditionality acceptable?This question is likely tobe a particularly pressing one for the multilateral development banks,whose conditionality arguably should not deviate significantly from in-ternationallaw.


Implications for the Process of Implementing Conditionality

Theprocessesbywhichconditionsareformulatedandenforcedalsoraisesome extremely important concerns. Due process in conditionality—inthecolloquialratherthanthelegalsense—isintrinsicallyworthwhile,andmay also, to the extent that it enhances legitimacy, tend to induce both providersandrecipientsof capital toadoptandcomplywithconditions.Aswehave already argued,widespread adoption and compliance is im-portantifconditionalityistobeeffectiveandimplementedwithminimaltransaction costs.

In thecontextofclimate-relatedconditionality, thecentralproceduralquestionsrevolvearoundtherolesthatdifferentparties,especiallythein-habitantsof recipientcountries,ought toplay in formulatingconditions.Thesequestionsareparticularly important forconditionality imposedbypublicly sponsored actors. It seems intuitive that local constituencies af-fectedbythedecisionofapublicactoroughttobeentitledtobenefitfromwell-designedaccountability,transparency,andparticipationmechanisms.Inotherwords,totheextentthatafund’sinvestmentdecisionsaffectthelevelordistributionofwealth in a society, it ought tobe accountable tomembers of that society who in turn ought to be able to participate inthosedecisions,observetheprocessesbywhichtheyaremade,andholdthe decision-makers accountable.

Thedifficulty,however,withgrantingproceduralentitlementstoactorsfromrecipientcountries is that theymay favordifferentsubstantiveout-comes than providers of capital. For instance, they may prefer projectsthat generate local employment to projects that efficiently reduce emis-sions.Ortheymaypreferprojectsthatsupportadaptationoverthosethatsupportmitigation.Consequently,grantinglocalactorsrobustproceduralentitlementsrisksalienatingfinancierswithopposingpreferences.Gener-ating thiskindof localownershipof theprocessof formulatinganden-forcing conditions, without undermining other objectives, is one of thecentralchallengesassociatedwithallformsofconditionality.

Conclusion

Climate-related conditionality in development finance is probably ines-capable.The challenge going forward will be to fashion conditions thatbalance potentially competing interests in effectiveness, cost-effective


emissions reductions, development, and equity. Formulating institutionsand processes capable of resolving these issues in a legitimate fashionought to be a central concern in designing a global regime to address cli-mate change.


Sarah L. Babb and Bruce G. Carruthers, “Conditionality: Forms, Function andHistory,”Annual Review of Law and Social Science, Vol. 4: 13–29 (December2008).

CharlesDiLeva, “GlobalWarmingLitigationImpelsU.S.FinancingAgencies toAcknowledgeClimateChange,”inThe Nature of Law: The Newsletter of LEGEN (March2009).

TheEquatorPrinciples,availableathttp://www.equator-principles.com/documents/Equator_Principles.pdf.

IFC, “Performance Standards on Social and Environmental Sustainability,”available at http://www.ifc.org/ifcext/sustainability.nsf/AttachmentsByTitle/pol_PerformanceStandards2006_full/$FILE/IFC+Performance+Standards.pdf.

MultilateralInvestmentGuaranteeAgency,“PerformanceStandardsonSocialandEnvironmental Sustainability,” available at http://www.miga.org/documents/performance_standards_social_and_env_sustainability.pdf.

GarethPorter,NeilBird,NankiKaur, andLeoPeskett,New Finance for Climate Change and the Environment (WorldWildlife Federation and Heinrich BollStiftung,July2008).

N o t e s

1. SeeIFC,“PerformanceStandardsonSocialandEnvironmentalSustainabil-ity,” Standard 3, http://www.ifc.org/ifcext/sustainability.nsf/AttachmentsByTitle/pol_PerformanceStandards2006_full/$FILE/IFC+Performance+Standards.pdf;andWorldBankGroup,“Environmental,Health,andSafetyGuidelines”(knownasthe“EHSGuidelines”),section1.1,“AirEmissionsandAmbientAirQuality,”http://www.ifc.org/ifcext/sustainability.nsf/AttachmentsByTitle/gui_EHSGuidelines2007 _GeneralEHS/$FILE/Final+-+General+EHS+Guidelines.pdf.

2. IFC, “PerformanceStandardsonSocial andEnvironmental Sustainability,”Standard3(11).

http://www.equator-principles.com/documents/Equator_Principles.pdf


http://www.ifc.org/ifcext/sustainability.nsf/AttachmentsByTitle/pol_PerformanceStandards2006_full/$FILE/IFC+Performance+Standards.pdf


http://www.miga.org/documents/performance_standards_social_and_env_sustainability.pdf

http://www.miga.org/documents/performance_standards_social_and_env_sustainability.pdf



206 Climate Finance

Chapter 22

Making Climate Financing WorkWhat Might Climate Change Experts Learn from the

Experience of Development Assistance?

Ngaire WoodsProfessor of International Political Economy;

Director of the Global Economic Governance Programme, University of Oxford

Key Points

• Financing for climate change mitigation will likely involve someformofconditionality,althoughconditionalityaloneisapoorguar-antorofprojectorpolicysuccess.

• Themostimportantfactorsindeterminingprojectorpolicysuccessis the alignment of a projectwith the priorities of the communityand local ownership, local implementation, and the timing, cer-tainty,andreoccurrenceoffunding.

Attheheartofanyglobaldealonclimatechangeliesacompactbetweenwealthy and less wealthy countries. The vast majority of industrializedcountries have already accepted binding commitments to reduce their greenhousegas(GHG)emissions(althoughfewhavemadeanyprogressto reducing emissions in practice). Future progress in limiting emissions relies uponwealthy countriesmeeting their commitments and—equallyimportantly—upon major emerging economies agreeing to accept lim-its on their future emissions. No such deal has yet been forged. At thesame time industrialized countries and emerging economies have agreed that supportmustbeoffered topoorerdevelopingcountries thatwillbe

Making Climate Financing Work 207

severelyaffectedbythefailure(todate) tomitigateemissions.Mostpro-posalsenvisagethatwealthycountrieswillpersuadedevelopingcountriesbyputtingfinancingonthetable.Buthow,andwithwhatstringsorper-formancecriteriaattached?

Climate change experts have framed the problem as one of how tobest use finance to incentivize developing countries to undertake signifi-cant near-term mitigation measures and eventually transition to emis-sionscaps.Theassumptionisthatbysettingupincentivesfordevelopingcountriestodeliver,theindustrializedcountrieswillbeabletotransformpoliciesandpractices indevelopingcountries.Wealthycountrieswill setgoals and disburse financing only upon proven performance of actionstakentowardsthegoals.

A long history of donor efforts to incentivize policymakers in devel-oping countries couldusefully informclimate changeproposals.Donorsoftenbelieve that theuseof structured incentives and conditionality aresufficient to ensure that countries will adopt particular policies ormeetcertainobjectives.Althoughthisisintuitivelyappealing,thehistoryofat-tempts todo this suggests that this isa fundamentallymistakenview. Infact,themainimpactofsuchstructuredincentivesorconditionalitymaywelllieintheeffectonthebehaviorofthoseprovidingthefinancing.

Reliance on incentives and performance-based conditions offers atemptingshortcut,whichoften leadsdonorsawayfromexaminingotherelementsthataresignificantlymorelikelytoshapewhetherornotagov-ernment or local authority will achieve particular goals. Letme outlinesomeoftheseelements.

1. Alignment and Ownership (and How to Test for It)

A core lesson from development assistance is the importance of align-inganyforeign-supportedproposedpolicyorprojectwithacountryoracommunity’sownprioritiesandobjectives.Thislessonhasbeenacceptedbymajor industrializedcountrydonors in the2005ParisDeclarationonAidEffectivenessandthesubsequent2008AccraAgendaforAction.Thelessonisalsooftenexpressedintermsofownership:themoreapolicyorprojectisownedbythosewhoimplementit,andthemorecloselyaproj-ectorpolicyreflects localpriorities,themorelikelyit istosucceed.Thisgoal is easy to state but difficult to translate into operational guidelines. Howdoesonetestwhetherornotaprojectorpolicyislocallyownedor

208 Ngaire Wo ods

sufficientlyalignedandwhatdoesthatmean?Importantindicatorsoflo-calownershipcouldinclude

• theoriginationoftheprojectorpolicy(whohadtheidea?);• thedesignoftheprojectorpolicy;and• the financing and resourcing of the project or policy (have locals

contributed resources?).

The latter isperhaps the clearest indicatorofhowmuchpriority a com-munity gives to the idea proposed.

All that said, any tests of ownership require an initial answer to thequestion “ownedbywhom?” Is it ownershipby a government thatmat-ters,orbyan individualMinisterwithin thegovernment,orbyadisen-franchisedminority?Here providers of external financing have tomakeexplicitly political choices about whose visions and aspirations they aresupportingwithin a society.Nopolicywill succeedwithout local cham-pions—nomatter howmuch this factmight be obscured by the designof performance-based or incentivizing systems.The political choices in-volved are difficult and complex.

It is evenmoredifficult inpractice fordonors to support rather thanoverwhelm local champions. This takes me to a second condition forsuccess.

2. Local Implementation (and Resisting the Temptation to Micro-Manage)

Implementationmustalways relyupon local actorsand institutions.Theexperience of aid demonstrates how tempting it is for external funders—who have identified local champions—immediately to use them as aleveragepoint to try to shapeeverwideranddeeperareasofpolicy.Forexample, somedonorswho established an initial relationshipwith com-munities by helping governments to phase out user-fees for education,have then tried touse theseopenings topush forotherkindsof reform(suchaspublic-private structures) in the education sector.Toquoteoneaid official participating in anOxfordworkshop on aid negotiation andmanagement: “it’s just really hard for us not to get in there and try toshapeeverything.”

What begins as external support for a local initiative can quickly be-

Making Climate Financing Work 209

comeacircumventionoflocalexpertiseandinstitutions.Thismayresultin an erosion of local governance, accountability, and the likelihood ofsuccess. To prevent such consequences, donors should seek to ensureclarity among themselves and holding one another to account in defining (andlimiting)theirgoalsandsubsequentinfluenceoverimplementation.

3. The Timing of Financing

Oftenthetimelineofdevelopmentdisbursal isdeterminedbythedonor,whichresultsinaidbeingdeliveredeithertoofastortooslowly.Disburse-ment pressures to deliver too fast exist where an agency has an annualcycleoflendinganditsofficialsneedtoensurethattheylendoutallthatisavailable.Bycontrast,manyagenciesdeliveraidtooslowlywhererisk-aversion in the bureaucracy and overall risk-minimizing decisionmaking structuresresultinbureaucraticdelaysindisbursement.Ineithercase,thetimingoffinancingwillgreatlylimitthelikelihoodofprojectorpolicyorpolicy-reformsuccess.

4. The Certainty and Recurrence of Funding

Manyofthepoliciesandprojectsaimedataddressingclimatechangere-quirelong-termplanningandinvestments.Ifgovernmentsaretoconsiderexternal financing in planning for the future and in investing in infra-structure or personnel, the financing must be both certain and recur-rent.Yetoftenaid isbothvolatileandunpredictable.Performance-basedconditionsand targets (someofwhichmaynotbe reacheddue toexog-enousshocksbeyondthecontrolofagovernment—suchasadrought,oraglobalfinancialcrisis)are likely tomakeprojectionsofaidreceiptsyetmoreuncertain.Aid-dependentgovernmentsworkwithinverytightcon-straints.Their spending plans are typically developedwithin parameterssetbytheIMFandWorldBank.Themultilateralsanalyzethesourcesofthe government’s revenue and its capacity to service debt in the future.These debt sustainability analyses were created to ensure that efforts bygovernments to meet the Millennium Development Goals do not build upunsustainablelevelsoffuturedebt.Suchadebtbuild-upwouldbetheresult of governments spendingmoneywhich donors had promised butdid not disburse.

210 Ngaire Wo ods

5. Reporting Structures and Local Accountability

Providers of external finance usually require direct reporting back totheminformsthatfittheirownexigencies.Forexample,eachdonorgov-ernmentoftenhasitsownaccountingformatthatitmustusetoreporttoitsownauditor-generalorparliament.Asaresultof this,donorsrequiredeveloping country governments to use numerous different formats forreporting.Thedevastatingresultshavebeendocumentedinastudycom-missionedbydonorsconcernedwiththisproblem.Reportinginthiswaymaximizes theburdenondevelopingcountriesanddoesnotsupportef-fortswithindevelopingcountrygovernmentstosimplify,streamline,andmakemoretransparenttheirownfinances.Forthesereasons,thereport-ingstructureofexternalfinancingislikelytoaffectthelong-termsustain-abilityandaccountabilityofpoliciesorprojects.

6. The Adaption and Renewal of Externally Funded Projects or Policies

Finally, projects and policies need constant ongoing adaptation and re-design, aswell as formal evaluationand renewal.Partofownershipof aprojectorpolicyisownershipoftheprocessesofreview,adaptation,andrenewal.Alltoooftenindevelopmentassistance,theseprocessesarecon-ducted by the external funding agency rather than by (or with) the lo-calchampionsandimplementers.Theresult isasystemofreportingandevaluationthatisunlikelytobringtolightproblemswhichneedresolvingor redesigning around.Donor-designed adaptation and renewal are alsounlikely to strengthen local governance and policymaking capacity.


ElinorOstrometal.,“Aid,Incentives,andSustainability,”Sida Studies in Evalua-tion 02/01: Aid, Incentives, and Sustainability: An Institutional Analysis of De-velopment Cooperation(2002).

WorldBank/IMF,How to Do a Debt Sustainability Analysis in Low Income Coun-tries (2005), available at http://siteresources.worldbank.org/INTDEBTDEPT/Resources/DSAGUIDEv7.pdf.

http://siteresources.worldbank.org/INTDEBTDEPT/Resources/DSAGUIDEv7.pdf



Part IV

National PoliciesImplications for the Future Global

Climate Finance Regime

Climate Finance 213

Chapter 23

Climate Legislation in the United StatesPotential Framework and Prospects for

International Carbon Finance

Nathaniel O. Keohane1

Director of Economic Policy and Analysis, Environmental Defense Fund

Key Points

• There is an increasing prospect of a comprehensive US cap-and-trade program to control GHG emissions. A US carbon marketwould have crucial implications for carbon finance, particularly indevelopingcountries.

• US climate legislation passed by the House of Representatives inJune 2009 would impose a cap-and-trade system to ratchet downGHG emissions from a broad range of sources.Once fully under-wayin2016,thecapwouldcovernearly85%ofUSGHGemissions.Thecapwouldreduceemissionsfromcoveredsectorsby17%below2005 levels by the year 2020, and by 83% below 2005 levels (80%below1990levels)bytheyear2050.Thesetargets,appliedtoapro-gramof suchbroad scope,would represent themostambitiousef-forttodatetakenbyanycountrytoreduceGHGemissions.

• Theproposed legislation provides several points of entry for othercountries togainaccess to theUScarbonmarket.Thiswouldhelpanchoranewbilateral approach toexpandingcarbonmarkets thatcan be a useful complement to the international agreement beingnegotiated under the auspices of the United Nations FrameworkConventiononClimateChange.

214 nathaniel o. keohane

• In particular, US GHG allowances would be fully fungible withcredits fromother emission trading systemswith absolute caps onemissions, and similarly stringentmonitoringandverificationpro-tocols.Moreover,1to1.5billiontonsofemissionsfromcoveredUSsourcescouldbeoffsetbyverifiedemissionsreductionselsewhereintheworld,intheformofcreditsforreducedemissionsfromtropicaldeforestation,creditsforsector-wideemissionsreductionsindevel-oping countries, and project-based offset credits such as CertifiedEmissionsReductionsundertheCleanDevelopmentMechanism.

• Initially, two-thirds of allowances would be allocated for free, an-otherone-sixthgiventostategovernmentstofundenergyefficiency,clean tech research, and adaptation. Over the life of the program,4%of the value of the allowances (an estimatedUSD 50billion inpresentvalue)wouldbeputasidetofundreductionsintropicalde-forestation,withanother 5% (USD70billion) for international ad-aptationandinternationalcleantechnologytransfer.

On June 26, 2009, the US House of Representatives passed a sweepingbillthatwouldreduceUSgreenhousegas(GHG)emissionsby17%below2005 levels by 2020, and 83%below 2005 levels by 2050. If themomen-tumfromtheHousebillcanbecarriedonthroughtheSenate,theUnitedStatesmay at last be taking onmeaningful domestic action, on the eveoftheinternationalnegotiationsinCopenhageninDecember2009.ThischaptersketchesthekeyfeaturesoftheHousebill,focusingontheprovi-sionsthatwouldallowlinkagesbetweentheUScarbonmarketandemis-sionsreductioneffortsinothercountries.

Overview of the House Bill

The American Clean Energy and Security Act (ACES), sponsored byHenryWaxman (Democrat ofCalifornia) andEdMarkey (Democrat ofMassachusetts), is a comprehensive energy and climate bill. At its heartis a cap-and-trade program that would put a declining limit on allow-able GHG emissions frommost of the US economy, including all CO2 emissionsfromfossilenergyuseaswellasprocessemissions(ofCO2 and otherGHGs) fromlarge industrial facilities. (Aseparatecapwould limitthe import and consumption of hydrofluorocarbons.) Sources covered

Climate Legislation in the United States 215

by the cap would be required to submit one allowance for each ton ofGHGemissionsineachyear; theallowanceswouldbefullytradableandbankable.Covered sources could alsomeet their compliance obligationsbypurchasingcredits forverifiedemissions reductions from theUS for-estry and agricultural sectors, as well as from international sources (asdiscussedlaterinthechapter).

The capwould take effect in 2012, covering the electric power sectorand transportation fuel producers, together accounting for roughly two-thirdsofUSemissionsin2005.Fuelsproducerswouldberesponsibleforthecarboncontentoftheirfuels—that is, theeventualtailpipeemissionsfrom combustion.The capwould be extended to covermajor industrialsources in 2014, increasing coverage to just over 75% of 2005 baselineemissions;itwouldbefullyphasedinby2016,whentheinclusionofnat-uralgaswouldincreasecoveragetonearly85%ofbaselineemissions.Thecapwoulddeclineovertime;in2012,itwouldlimitemissionsbycoveredsourcesto97%oftheir2005levels,decliningto83%in2020,58%in2030,and17%in2050.

In the initial years, roughly two-thirds of allowances would be allo-cated gratis to regulated emitters or energy consumers; one-sixthwouldbe allocated to State governments and other non-emitters to fund en-ergy efficiency, clean energy research, adaptation, reductions in tropicaldeforestation,andotherpublicpurposes; theremainingone-sixthwouldbeauctionedbythefederalgovernment,withmostoftheproceedsgoingto fund tax credits for low-incomehouseholds. By 2035, the free alloca-tionwouldbealmostentirelyphasedout.Overthespanoftheprogram,thebillwouldsetaside4%ofcumulativeallowances(worthanestimatedUSD 50 billion in present value) to fund reductions in tropical defores-tation, alongwith another 5%of allowances (USD70billion) to financeinternationaladaptationandinternationalcleantechnologytransfer.

Inadditiontothecap-and-tradeprovisions,ACEScontainsarangeofcomplementarymeasuresdesigned to spur energy efficiency and renew-able energy, including a combined renewable energy/energy efficiencystandard for the electric power sector; strengthened energy efficiencystandards for buildings and appliances; performance standards on newcoal-firedpowerplants;andperformancestandardsforindustrialsourcesof emissionsbelow theminimumthresholdneeded toqualifyunder thecap-and-trade program. Taken together, the entire bill—including thecap-and-tradeprovisions,thecomplementarymeasures,andsupplemental


reductions from tropical deforestation achieved through allowances setasideforthatpurpose—isdesignedtoreducenetUSGHGemissionsby20%below2005 levelsbytheyear2020, fallingto83%below2005 levelsby2050.

WhiletheUShaslaggedbehindotherdevelopedcountriesinitscom-mitmenttoreduceGHGemissions—mostnoticeablybychoosingnottosigntheKyotoProtocol—theproposedlegislationrepresentsaseachange.If enacted, it would become themost ambitiousGHG emissions reduc-tionprogramanywhereintheworld.

Although the required reductions appear less stringent than those al-readyadoptedbytheEU,whencomparedtothe1990baselinecommonlyusedininternationalnegotiations,thatbaselineobscuresthefundamentalchanges in the structureofEurope’s economies thathaveoccurred since1990.TheseincludetheeconomiccollapseincountriesoftheformerSo-viet Union and the ensuing decrease in emissions throughout EasternEurope, the reunificationofGermany (and the subsequent shutteringofhighlypolluting, inefficientEastGermanfactories),andthederegulationof the electric power sector in the United Kingdom (with its attendantdramatic fall in Britain’s reliance on coal-fired electricity generation).Whencomparedto thepropercounterfactual—emissions in theabsenceof climate policy—the targets embodied in the proposedUS legislationturnouttobeatleastasstringentasthecurrentEUtarget.

Inaddition,theUSlegislationcapsGHGemissionsthroughthemiddleofthecentury,specifyingacapforeveryyearthrough2050.(Incontrast,the current commitment protocol under the Kyoto Protocol lasts onlythrough2012.)Suchalongtimehorizoniscruciallyimportanttoprovidetheclearsignalsneededtoshapeinvestmentdecisions.

International Linkages under the Proposed Legislation

Of particular relevance, from the perspective of international carbon fi-nance,aretheprovisionsinACESthatwouldestablishlinksbetweentheUS carbon market and emissions reduction or abatement activities inother countries.These various links canbe thoughtof asdistinctpointsofentryintotheUScarbonmarket.First, thebillprovidesforunlimitedlinkage (full fungibility of allowances)with emission trading systems inother countries, as long as those countries impose mandatory absolute


tonnage limits on totalGHG emissions at the national or sectoral level,and establish provisions formonitoring, enforcement, and offset qualitythat are at least as stringent as those under the US program. (Thus al-lowances issuedunder theEuropeanUnion’sEmissionsTrading Schemecould almost certainlybe tendered for compliancewith theUS system.)The determination ofwhich countrieswould be eligible for this linkageprovision is assigned to theEnvironmentalProtectionAgency (EPA), inconsultationwiththeSecretaryofState.

Second, ACES would allow covered entities to offset up to 1 billiontonsofemissionsannually,usingcreditsforverifiedemissionsreductionsin developing countries (with the limit applied on a pro-rated basis forindividualemitters);asmanyas1.5billiontonscouldbeoffsetwithinter-national credits if the supplyofdomesticoffset creditswere limited.Be-ginningin2017,internationalcreditsaresubjecttoa20%discount,mean-ingthatemittersmustsubmit5creditstooffset4tonsofemissions.Theseinternationalcreditsfallintothreecategories:

1. International forest credits.Thebillauthorizes theEPAAdministra-tor, inconsultationwiththeSecretaryofStateandtheAdministra-tor of the US Agency for International Development (USAID), toenter into agreementsor arrangementswith countrieson reducingemissionsfromdeforestation.Tobeeligibleforcrediting,forestna-tionswillhave todemonstrate, beginning 5 years from the startoftheprogram(extendable8moreyearsinthecaseofsmall-emittingand least developed countries), reductions in total emissions fromdeforestation nationwide, or in their large-emitting states or prov-inces, from a baseline that results in zero net deforestationwithin20 years. Programs in forest nationsmust be undertaken in com-pliancewithrigorousmonitoringandaccountingstandards,andinconsultationwithlocalcommunities,indigenouspeoples,andotherstakeholders.Inaddition,thebillsetsaside5%ofthetotalUSallow-ancepooltoassisttropicalforestnationsinpreparingtoparticipatein this program, to preserve existing forest stocks, and to achievesupplementalreductionsof720millionmetrictonsin2020,andcu-mulativereductionsof6billionmetrictonsby2025.

2. Sectoral credits.The bill directs the EPA, in consultation with theSecretaryofState,toidentifysectorsandcountriesthataresuitableforcreditingonasectoralbasis—meaningthatcreditsareawarded


only if the sector as a whole reduces emissions below a specifiedbaseline. Sectoral crediting would apply to developing countrieswithhighGHGemissionsandcomparativelyhighlevelsofincome,for sectors thatwouldbe capped if theywere in theUnitedStates.TogainaccesstotheUSmarketthroughthissectoralcreditingpro-gram,listednationswouldhavetoestablishadomesticallyenforce-ablesectoralbaselineofabsoluteemissions,setatlevelsbelowbusi-nessasusualandconsistentwithagoaloflimitingglobalwarmingto 2°C relative to preindustrial levels (equivalently, limiting atmo-sphericGHGconcentrationsto450ppmCO2e).

The clear and explicit insistence on meaningful absolute base-lines measured in tons—as opposed to no-lose sectoral intensitytargetsmeasured in tonsperunitofoutput—isacrucial featureofthe legislation. Compared with intensity-based measures, absolutebaselines provide more certainty over the resulting emissions, arelesssusceptibletosubsequentmanipulation(underintensitytargets,allowable emissions depend on measures such as sectoral output,whichisitselfoftenimpreciselymeasured),andpreparedevelopingcountrieseventuallytoestablishadomesticcap-and-tradesystemoftheirownandbecomefullparticipantsinglobalcarbonmarkets.

3. Credits issued by an international body.ThebillauthorizestheEPA,inconsultationwith theSecretaryofState, to issueoffsetcredits inexchangeforinternationaloffsetcreditsissuedbyabodyestablishedpursuant to the UN Framework Convention on Climate Change(UNFCCC)—aslongastheEPAAdministratordeterminedthattheinternationalbody’sproceduresprovidedequalorgreaterassuranceoftheintegrityofoffsetsrelativetotheUSdomesticoffsetprogram.Forexample,CertifiedEmissionsReductionsissuedundertheCleanDevelopmentMechanism(CDM)couldbesoldintotheUSmarketand used for compliance (subject to the 5:4 ratio on internationaloffset credits), at least for project types forwhich theCDMmeth-odologies foradditionalityandverificationof emissions reductionswerefoundadequate.

Starting in 2016, EPAmay not issue project credits for projectsincountriesandsectorsonthesectoralcreditinglist.Thisprovisionis important to create the right incentives fordeveloping countriesto move away from project-based offsets—where concerns aboutadditionalityandmeasurementareendemic—and towards sectoralcaps.


A Two-Track Approach to Expanding Carbon Markets

One of themost significant aspects of theUS legislation is its role as aharbingerofanewmodelforexpandingcarbonmarkets.ThebillpassedbytheHouseofRepresentatives,withitsmultiplepointsofentryintotheUS carbon market, represents a parallel track to building internationalparticipation in reducing GHG emissions—one that can operate along-side (and as a complement to) the international negotiations under theauspicesoftheUNFCCC.TheUNFCCCprovidesthemultilateralforumfor overarching tasks such as setting global targets for emissions reduc-tions and constructing international financing arrangements for cleantechnology and adaptation.ACES, on the other hand,would establish abilateralprocessbywhichtheUScouldgrantaccesstoitscarbonmarkettospecificcountries—intheformofcreditsfortropicaldeforestation,orforsector-wideemissionsreductions,orforproject-basedoffsets.

Somecriticswillsurelyarguethatallowingindividualcountriestosettherulesforaccesstotheircarbonmarketswillundermineeffortstobuilda single globalmarket.AparallelUS system for approvingoffset creditswould likely require a separate set of criteria for additionality aswell asformonitoring, reporting, and verification protocols, potentially addinga further hurdle to the development of emissions reductions projects indevelopingcountries.Thebenefitsofaparalleltrack,however,wouldout-weigh anydrawbacks. First, the ability of developed countries to set thetermsof access to theirmarketswillbe crucial fromapoliticalperspec-tive.IntheUSCongress,forexample,oneofthemostimportantissuesinthedebateaboutclimate legislationiswhetherandwhenmajordevelop-ing economies like China and India will accept binding limits on theiremissions.Bysettingahighbarforemissionreductioncreditsfromothercountries,Congresscancreatetheincentivestructurethatwillencourageothercountries toact—and thereforehelp toassuagedomesticconcernsabouttakingactionintheabsenceofcommitmentsfromothercountries.

Second, a parallel approach offers an additional mechanism to en-courage(andreward)emissionsreductionsinmajoremittingdevelopingcountries, in the event that international negotiations are deadlocked ordelayed.

Finally,aparallelapproachhasthepotential tocreateavirtuouscyclein carbon markets. A country that imposes relatively stringent criteriawill limit the supplyof credits available in itsmarket, effectivelydrivingup theirprice—creatinga stronger incentive fordevelopingcountries to


meet themore stringent criteria. In effect, this is a carbon-market ver-sionoftheso-called“Californiaeffect”—thepositivedynamicthatoccurswhen one (sufficiently large) jurisdiction imposes a higher standard onproductsandtherebyraisesthebarforanentireindustry.

TheUSstandsonthecuspofalandmarkachievement.Climatelegisla-tionalongthelinesofwhathasalreadypassedtheHouseofRepresenta-tiveswould vault theUS to a positionof leadership in the internationalarena,afteroveradozenyearsof laggingbehind.Asimportantly,USac-tiononclimatehasthepotentialtoinduceleadingdevelopingeconomiestoreducetheiremissionsinordertosellcreditsintoaUScap-and-tradesystem—keepingcostslowforAmericanconsumersandbusinesseswhilesecuringmeaningfulemissionsreductionsaroundtheworldandprepar-ingthegroundworkforatrulyglobalcarbonmarket.


Judson L. Jaffe andRobertN. Stavins,Linking a U.S. Cap-and-Trade System for Greenhouse Gas Emissions: Opportunities, Implications and Challenges (Reg-MarketsCenter,2008).

NathanielO.Keohane,Oral Testimony before the Subcommittee on Energy and En-vironment, Committee on Energy and Commerce, United States House of Rep-resentatives, June 9, 2009, available at http://www.edf.org/documents/9924_Keohane%20Testimony%20EC-EE%206-9-09.pdf.

N o t e s

1. The author gratefully acknowledges helpful comments from Peter Gold-mark,JenniferHaverkamp,AnniePetsonk,DickStewart,andGernotWagneronpreviousdraftsof this chapter,whileholding themblameless for any remainingerrors.

http://www.edf.org/documents/9924_Keohane%20Testimony%20EC-EE%206-9-09.pdf

Climate Finance 221

Chapter 24

TheEUETSExperience to Date and Lessons for the Future

JamesChapmanResearch Fellow, Center on Environmental and Land Use Law,

NYU School of Law

Key Points

• The EU has learned valuable lessons about the effective structureand governance of carbon markets through its experience withPhases I and IIof theEUETS.Theschemehasmoved theEU to-wardsexpectedfullcompliancewith itsKyotocommitments.Plansfor post-2012 provide for higher levels of auctioning, wider cover-ageof gases and industry, andamore centralizedandharmonizedschemeoverall.

• There has been some difficulty—especially recently—in creating asufficiently high price on carbon to incentivize a significant shifttowards a low-carbon economy, but a combination of a lower capfor Phase III that decreases annually after 2020 (promising long-term certainty) and other policy measures (such as subsidies andrenewableenergystandards)shouldpromotesuchashift.

• In its 20:20:20package forCopenhagen, theEUhas committed to20% cuts below 1990 levels regardless of the outcome of interna-tionalnegotiations.Ifasatisfactoryagreementonmultilateral limi-tationscommitmentscanbereached,thefigurerisesto30%,pavingthewaytowardsanOECD-widecarbonmarketby2015andawiderglobalcarbonmarketafterthat,withtheCDMcontinuingtoplayarolebutinareformed,refocused,andmorelimitedway.

222 James Chapman

• Even though theEUETSprovides themain sourceofdemand forCERs, the CDM has fallen short in stimulating sufficient broad-base mitigation activity in developing countries. A stepping stonebetweenthecurrentstateofaffairsandassumptionbymajordevel-opingcountriesof a full cap-and-trade system is required.TheEUhasproposed adoptionof sectoral creditingmechanisms todeliverboththenecessarychangesinactionsandtherequisitefunding.TheEU’s de facto control over significant private-sector financial flowsto thedevelopingworld throughtheoffsetcrediting featuresof theEUETSwilllikelyenableittosecureadoptionofthisapproach.

Experience to Date

Operatingfrom2005to2007,PhaseIhadacapof2.4billionallowancesper year. This first period was highly effective in making boardroomsaware of carbon risks and opportunities and stimulating the search forabatementopportunities.Further,theinfrastructureofafunctional,liquidmarket was successfully created. Phase I did, however, encounter prob-lems.Allocationswerenotbasedonverifiedemissions.Also, companieswere able to achieve steep initial reductions by exploiting cheap abate-mentopportunitiespreviouslyoverlooked.Theresultwasadeepdropinallowanceprices.TheEuropeanUnion(EU)respondedbyplacingafire-wallbetweenPhasesIandIIbynotallowingbanking,therebyprotectingPhaseIIfromafloodofcheapallowances.

Currently the EUEmissionsTrading System (EUETS) is in Phase II(2008–12).Thecap,significantlyreducedfromPhaseI, is2.08billional-lowances per year, 6.5% below verified emissions for 2005.The data re-ceivedbytheCommissionindicatethattherehasbeenasufficientdropintotalEUemissionstomakefullcompliancewithKyotocommitmentsap-pearlikely.Theuseofcertifiedemissionsreductions(CER)andemissionreductionunits(ERU)offsetcreditsfromtheCleanDevelopmentMecha-nism(CDM)andJointImplementation(JI)projects,authorizedthroughthe Linking Directive, has helped to lower compliance costs within theEU and generated significant levels of private investment in mitigationprojectsina limitednumberofdevelopingcountries.TheEUhasplacedavarietyofbothqualitativeandquantitativelimitsonrecognitionofoff-setcreditsinordertoprotecttheenvironmentalintegrityoftheETSfromunsound credits or hot air credits, demonstrating the feasibility of both

The EU ETS 223

kinds of regulation. Because the EU provides most of the demand forCERs,theEUregulationsdemonstratethepotentialforrecipientcap-and-tradesystemstoprofoundlyaffectthenormsandpracticesforgeneratingoffsetcredits.ThefunctionalextensionoftheEUETStothecountriesoftheEuropeanEconomicArea,thelinkageoftheEUETStotheKyotooff-setcreditmechanisms,andtherelatedswitchingofcentralregistriesfromtheEU-basedCommunityIndependentTransactionLogtotheUN-basedInternationalTransactionLogarepromising indicationsof theprospectsforfuturelinkingofcarbonmarkets.

Onemajorlessonfrombothphasesisthattheinitialallowancedistri-bution process, based on grandfathered free allocation, is cumbersome,andaNationalAllocationPlan(NAP)system,underwhichallowanceal-locationwasdelegatedtomemberstates,failstoensuretheenvironmentalintegrityoftheresultingcap.Therewereverydifferentallocationmethodsindifferentmemberstates’NAPs,leadingtodifferenttreatmentofsimilartypes of industry. Auctioning of allowances bymember states has beenextremely limited (around 4%).These problems have spurred correctivemeasuresinthedesignofthepost-2012ETS.

Reform

TheEUETS has been established as the core of EU climate policy andwill continue in that role, although it currently covers only 41% of EUgreenhouse gas (GHG) emissions; significant emitting sectors—includ-ing transport, aviation, and agriculture—arenot subject to theETS, be-ing regulated by other policies andmeasures, but are being consideredfor inclusionata laterdate.Legislationhasalreadybeenput inplaceforthe2020objectives,which includeagoal toreduceeconomy-wideGHGemissionsby20%below1990levelsregardlessofwhatotherjurisdictionsdo.Thetargetwillberaisedtoa30%reductionifanewglobalframeworkcanbeagreedupon,althoughthedifficultissueofhowtheburdenofad-ditionalreductionswillbeallocatedamongthememberstateshasyet tobeagreedupon.

At thecoreofPhase III isa singleEU-widecaprather than indepen-dent caps formember states, thus abandoning theNAP system in favorof a centrally administered approach. Phase III requires emissions fromsectorscoveredbytheETStobereduced21%below2005emissions.Do-mesticoffsetsarealsobeingconsidered,alongwithcoverageofadditional

224 James Chapman

gasesandmoreindustrialsectors,tobringnearly50%ofEUGHGemis-sions within the ETS. Also important is that the new legislation sets apolicy of continuous reductions of 1.74% per annum beyond the end ofPhase III in an effort to provide a degree of long-term regulatory cer-taintythathasbeenlacking.PhaseIIIrequiresafullyharmonizedalloca-tionprocessinwhichauctioningisthedefaultallocationmethod:by2013morethan50%auctioningisanticipated,risingto70%by2020and100%by2027.Memberstatesmustalsouse50%ofauctionrevenuefor“climatepurposes.”Anovel featurewill be the ability to auctionallowances earlyor auctionmore new entrant allowances to existing entities if the pricespikessignificantlyinashortspaceoftime.

AnothersignificantfeatureofPhaseIIIisthatitprovidesaguaranteedlevelofdemandforCDMandJIcreditspost-2012,althoughgreaterscru-tinyofoffsetqualityistobeexpected,andquantitativelimitswillensurethattheKyotorequirementofsupplementaritywillbepreserved.

Thedifficultyincreatingasufficientlyhighpricetoincentivizedomes-tic industry to develop and adoptmore expensive forms of technology-intensive abatement such as carbon capture and storage (CCS)hasbeennoted.Notallof this isnecessarilydue to the cap-settingandallocationdecisions:itmayalsobeduetothecurrenteconomicclimateandtolackofpredictabilityon long-termpolicy, although it isdifficult todistill thedriving factors. It is hoped that consensus on international mitigationcommitmentscanbereachedinCopenhagensoastotriggerthe30%cutinEUemissions,whichwilldrivethepricepathfurtherupandpromotelong-termregulatorycertainty.Otherpolicy instruments, suchas there-newable energymandates anddirect subsidies from the economic stim-ulus package, have also been adopted to stimulate a shift to low-carboninvestment, and steps are underway to double R&D funding for low-emissionstechnologyby2012andquadrupleitby2020.

International Offset Use

TheEUETShas,todate,beenthemainsourceofdemandforCDMandJI credits.The EU has welcomed the CDM’s contributions in engagingdeveloping countries in carbon markets and stimulating investors andentrepreneurstoactivelyexploreopportunities forreductions.TheCDMhas alsoproven an important cost-containmentmechanism forAnnex I

The EU ETS 225

Partiesandregulatedfirms.Thereare,however,importantweaknessesinthe CDM.As a project-basedmechanism, it involves cumbersome pro-ceduresandlargetransactioncosts,anditsignificantlylimitsthescaleofmitigatingactivities.Therehavealsobeendifficulties inensuringtheen-vironmental integrityofCERsbecauseofproblems indefiningbaselinesand applying additionality criteria and questions about the reliability ofmonitoring,recording,andverification(MRV)arrangements.BecausetheCDMprovidesandtheEUETSusesoffsetcreditsforreductionsona1:1basis, even environmentally sound projects do not reduce overall globalemissionsbut simply relocate themfromdeveloping todevelopedcoun-tries, while unsound projects may actually lead to emissions increases.Theparticipationofonlyalimitednumberofdevelopingcountriesisalsoproblematic.ThereisthusamajorneedforchangeiftheCDMistoplayakeyroleatthenecessaryscaleinaglobalcarbonmarket.

The EU has continually stressed the need for reform of the CDM toensure that only projects that deliver real and additional reductions arecredited and to extend the mechanism’s reach beyond the low-hangingfruitsoftheverycheapestabatementopportunities.TheEUdoesnotad-vocateatotalhaltoftheCDMby2013,believingthatareformedCDMcanand shouldplay an important rolenotonly in leastdevelopedcountries(LDCs) but also in some sectors in key developing countries not suitedforapplicationofsectoralcreditingmechanisms.Itdoes,however,envis-agethatitwillimposeadditionalregulatoryrestrictionsonrecognitionofCERsfortheEUETS,althoughdetailswilldependonCopenhagen.

The EU’s Vision for the Future

ProgresshasbeenmadeondevelopingtheEU’s long-termclimategoals:the 20:20:20 by 2020unilateral pledge, the 2020 objective of 30%below1990levelsforthedevelopedcountriesasagroup,astatedundertakingtoworkwithdeveloping countries to reduce theirbusiness-as-usual (BAU)emissionsby 15–30%, the 2050global anddeveloped countryobjectives,and,crucially,theoverallobjectiveoflimitingwarmingto2°C,whichin-formsalloftheothers.

TheEUCopenhagenCommunicationalsoincludesavisionforthefu-ture of climate markets. It calls for linking the domestic cap-and-tradesystemsthatwillbeadoptedinthecomingyearstocreateaglobalcarbon

226 James Chapman

market, with a linked EU andUS cap-and-trade system as the nucleus.The EUwants to see a robustOrganisation for EconomicCo-operationandDevelopment(OECD)–widecarbonmarketby2015,whileexploringoptionsforextendingthisnetworktoothereconomicallyadvancedcoun-tries by 2020.The European Commission’s membership in the Interna-tionalCarbonActionPartnership (ICAP), a forum to share experiencesandknowledgewiththegoalof linkingclimatemarkets, isafirststep inthisdirection.

Tohelpachieve theEU’sgoalof adoptionbyalldevelopingcountriesof low-carbon development strategies by 2011, an international registryhasbeenproposedinwhichallmitigationandadaptationmeasurestakenby developing countries are recorded and can be transparently assessed.Developing countryplans shouldhave technical expertise toback them,whichdevelopednationsshouldhelpprovide.

In addition to an improvedCDM, there is a pressingneed for anewmechanismtoactasasteppingstonebetweenproject-basedcreditingandcap-and-tradeindevelopingcountries.TheEUadvocatestheuseofasec-toral offset creditingmechanismwithbaselines set belowBAU,with theultimateobjectiveofphasingitoutovertimeasparticipatingdevelopingcountries adopt cap-and-trade systems that are linked to theglobal cap-and-trade allowance market. The sectoral mechanism envisaged wouldinitiallyfocusontheelectricpowersectorandonsectors,suchasalumi-num and cement, that are subject to intense international competition.TheEUhasstatedapreferenceformultilateralratherthanunilateralcri-teria for such creditingmechanisms, which, it is hoped, will generate asubstantialportionof thedevelopingcountrymitigation investments re-quired toachieve the2°Cgoal.OtherEUsuggestions toraise theneces-sary funds from the developedworld for developing countrymitigationincludepayments intoa central fundbasedona formula that takes intoaccountresponsibilityandabilitytopay,andglobalallowanceauctions.


A.DennyEllerman,“TheEUEmissionTradingScheme:APrototypeGlobalSys-tem?”Harvard Project on International Climate Agreements(August2008).

European Commission, Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, “Towards a comprehensive climate change agreement in Copenhagen”(January2009).

The EU ETS 227

EuropeanCommission,Commission Staff Working Document, Accompanying Doc-ument to the Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC so as to improve and extend the EU greenhouse gas emission allowance trading system, Impact Assessment (2008),see(COM(2008)16final,SEC(2008)53).

228 Climate Finance

Chapter 25

GreenhouseGasEmissionsand MitigationMeasuresinChina

Jie YuDirector, Policy and Research, The Climate Group (China)

Key Points

• Although China’s GHG emissions account for 20% of the world’stotal,itspercapitalevelsarestillrelativelylow.

• Chinahasalreadybeguntakingsignificantactionstomitigatefutureemissionsgrowth, includingadoptingagoalof reducingemissionsby20%perunitofGDPby2010.

• Chinaviewsthetransitiontoalow-carboneconomyasanopportu-nitytodevelopvaluableintellectualpropertyrightsandbrandswithglobalreach.

While China is currently responsible for 20% of global greenhouse gas(GHG) emissions, its per capita emissions levels are relatively low.As aresult of its share of global emissions, industrialized nations have beenpressuringChinatoadoptbindingemissionscaps.However,Chinahassofar refused.Manymay interpretChina’s reluctance tocommit toabind-ingcapasareluctancetoconfrontthechallengesofglobalwarming.Thisisnot thecase. Infact,China isalreadyheavily investing inmajoremis-sionsreductionsacrossawidevarietyofsectors,inspiteofthechallengesthesemeasures present toChina’s efforts to raise living standards for itspopulation.

Greenhouse Gas Emissions and Mitigation Measures in China 229

Furthermore,manyinChinahavecometoseethegrowingmarketforsustainabletechnologyasanopportunitytodiversify,furtheritseconomicgrowth,andreduceitsforeigntradedependence(71%in2007).Recently,Chinese companieshave seenmany successes inwind and solar energy,electric vehicles, and ultra-supercritical thermal power manufacturing.In lightof thesesuccesses,many intheChinesegovernmentbelievethataglobal transition tomoresustainable technologieswillpresentan idealopportunityforChinatoimproveitsresearchanddevelopmentcapacity,gainintellectualpropertyrightsforgloballycompetitivetechnologies,anddevelopstrongChinesebrandswithglobalreach.

Basic Facts about China’s GHGs Emission

TherapideconomicgrowthandurbanizationofChinapresentbothhugechallengesandopportunities.In2007,China’stotalemissionsreached760million tons CO2e,accountingfor20%oftheworld’stotalemissions.Forthefirst time,ChinasurpassedtheUnitedStatesasthe largestemitterofgreenhousegases.However, itsper capita emissions rate is only4.3 tonsCO2, lower than the rateof all industrializednationsand far lower thantheUS’srateof19.9tonsCO2.

Foranumberof reasons,China’semissionsare likely to increase,andwillonlybemitigatedwiththerapiddeploymentofcarbon-neutraltech-nology.First,China isundergoingaparticularlyenergy-intensiveperiodto meet the requirements of infrastructure constructions and improve-mentsinitscitizens’livingconditions.Consequently,industrialemissionsaccount for70%of its total, asopposed to 18% in theUS.However, thispercentageislikelytodecreaseinthefuture.

Second,Chinaessentiallyfunctionsastheworld’sfactory.Fully20%ofChina’s emissionsoriginate inmanufacturingand transportofgoods forexport.SuchexportemissionsarelikelytoconstituteasubstantialportionofChina’soverallemissionsfortheforeseeablefuture.

Third, ifChinamaintains 7.8%annual grossdomesticproduct (GDP)growth, its business-as-usual (BAU) emissions will grow 3.1% annually.Under these assumptions, China’s emissions growth will increase 113%from2005levelsby2030.

In light of these facts, transitioning to low-carbon technologies willbenefitbothChina’senergysecurityandglobalclimatechangemitigationefforts.

230 J ie Yu

China’s Domestic Mitigation Actions

In2006,China launched itsfirstnational energy efficiency target: to re-duce energy consumption across the economy by 20% per unit ofGDPby2010.ThisispartofChina’seleventhfive-yearplan,andthetargethasbeenallocatedtovarioussub-nationalgovernments.

In addition to the economy-wide target, China has designed androlled outmanymore specific implementation programs over the years,including:

• Industrial sector:TheMediumandLongTermEnergyConservationPlan containsmedium- and long-term energy efficiency objectivesfor a dozenmajor industrial products, including steel, copper, andcement.Italsoincludestargetsformajorenergy-consumingequip-ment,suchascoal-firedindustrialboilers,medium-andsmall-sizedmotors, and specific industrial processes.Thisprojectwill cost thepublic and private sectors more than USD 55 billion. It will saveabout300milliontonscoalequivalentandaccountforroughly40%of the total reductions necessary to reach the national energy effi-ciencygoal.TheTop-1,000Energy-ConsumingEnterprisesprogramisacentralpartofthiseffort.Underthisprogram,energyefficiencytargets were assigned for 1,000 major Chinese enterprises whichcollectively account for 47% of China’s total industrial emissions.Key featuresof thisplan include energyauditingandmanagementinstitutions developed with the assistance of the government.Thetotalanticipatedsavingsare100milliontonscoalequivalent.

• Power sector:Thepowersectorisresponsiblefor50%oftheChina’stotal emissions. Emissions will be limited by both increasing thecapacity of renewable energy and improving the energy efficiencyoftheconventionalpowersector.Measuresintendedtoincreaseef-ficiency of the traditional power sector include the replacement ofsmallunitswith largeones to increasesingle-unitcapacity; thede-velopmentofcogenerationandrelatedtechnologies;thepromotionoflargegridinterconnectionandefficientgridoperationtechnology;and the replacement of small oil-fired generating units with unitspowered by natural gas. Additionally, 5% of the total power gen-eration capacity was prematurely retired in 2006—mostly carbon-intensive plants.The nationalUltraHighVoltageGrid and StrongSmartGridplanshavealsobeenrolledoutrecentlyto improvethe


electricitytransmissionefficiency.From2006to2007,thecoalcom-bustionefficiencyincreased7%inthermalpowersectorduetothesemeasures. China’s Medium and Long Term Development Plan ofRenewable Energy contains several specific targets intended to in-crease the importanceof renewableenergy:by2010, theconsump-tionofrenewableenergywillaccountfor10%oftotalconsumption;by2020,thisproportionwillincreaseto15%.

• Building sector: Major policy goals include national design stan-dardsmandating50%energyconservationforallnewlyconstructedbuildings, as well asmore stringent standardsmandating 65% en-ergy conservation for new buildings in 4municipalities and someothermajor cities, such as Beijing, Tianjin, Chengdu, andChong-qing.Thesemeasuresshouldresult ina240milliontoncarbondi-oxide equivalent (CO2e) reduction, which will account for 21% ofChina’sentireenergyconservationplan.

• Transportation sector:Chinaalsointendstoincreasetheavailabilityofpublictransportationanduseofenergyefficientvehicletechnol-ogy. In thenext threeyears,Chinaplans to investUSD500billionon new railway construction. The Adjustment and RevitalizationPlanofAutomobileIndustry,releasedbytheStateCouncilinMarch2009,proposesthatChinaincreasetheshareofnewenergyvehiclesand compact vehicles to about 5%of new auto sales from 2009 to2011.

AccordingtoChineseDevelopmentandReformCommittee’sstatistics,asuccessful reduction of national emissions by 20%per unit ofGDPwillresultina750milliontonCO2ereductionandconserve300milliontonsofcoalequivalent.ThesereductionswouldbelargerthanthecumulativereductionsmadebyAnnex I countriesunder theKyotoProtocolduringthefirstcommitmentperiod.

The Perspective

Chinahopes thatbyrapidlyscalingup the implementationofnewtech-nologies, itwill rapidlyreducecosts througheconomiesof scaleandde-velopmentofnewtechnology.Technologyistheengine,policythewheel,andfinancethefuel.Thehopeisthatbyprovidingtherightpolicyincen-tives,financewillflow to technology innovationanddeployment.China

232 J ie Yu

has actively encouraged this process, even during the economic down-turn. Although global demand for low-carbon technology declined, theChinesegovernmentdecidedtogrowthedomesticmarketforlow-carbonmanufacturingtocompensatefortheshortfallinglobaldemand.

One example of this strategy has been the implementation of ultra-supercritical power plants to replace older, less efficient power plants.From 2004 on, new plants that exceed 600 MW being brought onlinemustusesupercriticalandultra-supercriticalthermalpowertechnology.

Duetothescaleofnewpowerplantconstruction,thecostofthosenewtechnologieshasdroppedsignificantly.Asaresult,ultra-supercriticalde-vicesareabletocompetewitholder,lessefficientsubcriticaltechnology.

Chinahasattemptedtoadoptasimilarapproachtotherenewableen-ergy market, including wind energy, solar energy, and electric vehicles.According to the industry association, the per unit cost ofwind energyinstallationinChinaisnow30%lowerthanitwas3yearsago.

Conclusion

Chinaunderstandsthesignificantchallengesthatglobalwarmingpresentsandhas initiated seriousmeasuresacrosswide sectorsof its economy toaddress the problem. Although it has not committed to a binding cap,itsGHGreductions couldpotentially,within amatterofonlyfiveyears,matchthereductionsmadebyAnnexInationsundertheKyotoProtocol.Chinafurtherseesthespreadof low-carbontechnologiesasanopportu-nitytodiversifyandstrengthenitseconomythroughthedevelopmentofvaluableintellectualpropertyrightsandbrands.


On Chinese domestic mitigation actions and its monitoring, reporting, andverification(MRV)potentials,see Mitigation Actions in China: Measurement, Re-porting and Verification,Working Paper ofWorld Resource Institute, on behalfofThirdGeneration Environmentalism, available at http://pdf.wri.org/working_papers/china_mrv.pdf.

FormoreonChinesedomesticactionwithfigures, see JulianWongandAn-drewLight,China Begins Its Transition to a Clean-Energy Economy — China’s Cli-mate Progress by the Numbers (Center forAmericanProgress,2009),availableathttp://www.americanprogress.org/issues/2009/06/china_energy_numbers.html.

http://pdf.wri.org/working_papers/china_mrv.pdf


For another summary of recent nationalmitigation policies, see PewCenteron Global Climate Change, Climate Change Mitigation Measures in the People’s Republic of China (2007), available at http://www.pewclimate.org/docUploads/International%20Brief%20-%20China.pdf.

http://www.pewclimate.org/docUploads/International%20Brief%20-%20China.pdf

234 Climate Finance

Chapter 26

CitiesandGHGEmissionsReductionsAn Opportunity We Cannot Afford to Miss

ParthaMukhopadhyaySenior Research Fellow, Centre for Policy Research, New Delhi

Key Points

• Lower-carboncitiescansubstantiallycontributetowardsmitigationefforts.Existingvariations in energyuse across citieshave roots inlocal andnational policies aswell as patterns of behavior and cul-turalnorms,allofwhichcanbealteredtoreducecarbonintensity.

• Reducing carbon intensity of cities may not only require manyconventional urbanpolicies onfinancing andbuilding codes tobere-examined, but also othermacro policies such as tax breaks forhomeownership andfiscal transfers to local governmentmayneeda fresh look. In particular,without changes in individual behavior,low-carboncitiesareunlikely.

• Duetotherapidpaceofurbanizationandtheimmenselock-inef-fectsonceurbancapitalstockisbuilt,policymakersmayneedtoacteveniftheoutcomesareuncertain.Thewaitformoreclaritymaybeinterminableandtheconsequencesirredeemable.

Urban areas consumed about two-thirds of the world’s energy in 2006.This is expected to increase to three-fourths by 2030.However, even incities at similar levels of development, per capita urban energy use, andthusGHGemissionspercapita,variesconsiderably.Inlightofthisvaria-tion,would it be possible for governments to enact policies to promote

Cities and GHG Emissions Reductions 235

lesscarbon-intensivecities? If so,what rolecouldsuchpoliciesplay inanewclimatechangeagreement?

An Underappreciated Opportunity

TheaverageurbanAmericanconsumesmorethantwiceasmuchenergyastheaverageurbanEuropean.CitieslikeHongKong,Tokyo,Singapore,and Amsterdam require less than a seventh of the energy of Houston,Phoenix, Detroit, and Denver to meet their transportation needs. Evenwithin theUnitedStates,percapitaenergyconsumptionvariesbya fac-torofthreeacrosscities.Manydevelopingcountries,especiallyIndiaandChina, are rapidly urbanizing, and similar discrepancies are beginningto emerge in these countries. For instance in China, energy use variesby a factorof seven fromChongqing toHohhot, dependingon income,climate, and energy intensity of industries. Given this variation, energypathschosenbycitiesinemergingeconomieswillhaveahugeimpactonglobalGHGemissionlevels.Infact, lower-carboncitiescouldcontributeoverathirdofthecarbonmitigationincountrieslikeIndiaby2050.Thisisanopportunitytoobigtomiss.

Unfortunately, changes in city forms, behavior, and building typesdo not appear to be part of themainstream climate change discussion.McKinsey’sGHGcostcurve,discussedextensively in thisbook,assumesvery limitedsavings frombehaviorchanges.TheUNFCCC, in their“In-vestmentandFinancialFlowstoAddressClimateChange”in2007,aversthat “nearly all additional transport investment needed under themiti-gation scenario is for the purchase ofmotor vehicles and production oftransportfuels,[and]therewillbenosignificantchangetolargetransportinfrastructure investments between the reference andmitigation scenar-ios.”Italsoassumesthat“mostemissionreductionsinthebuildingssec-torresultfromincreasedefficiencyofappliances,spaceandwaterheatingandcoolingsystems,andlighting.”

What Opportunities Exist to Influence Energy Consumption in Cities?

Canpolicyactuallymakecitiesmorecompact,increaseuseofpublictrans-port,andaffectbuildingform?Inordertoencouragethedevelopmentof

236 Partha Mukhopadhyay

moreenergyefficientcities,wefirstneedtoidentifyfactorsthatmayhelpexplain variations in energyuse across cities.While there is still debate,thereseemtobesomebroadcommonalitiesamongcitieswithlowenergyuse. Compactness of course helps, as residents travel less and usemorepublictransportation.Butbuildingtypes,andtheinteractionofbuildingtypewithbehavior,seemtomatteraswell.InasurveyinTaiwan,Hwanget al. (2009) found that 57% of respondents used the air-conditioner atworkwhentheyfeltwarm,butonly16%didsoathome,while58%usedthefanoropenedawindow.Whilewhopaidthebillmusthavebeenrel-evant,itwasalsotruethat“onlyaquarterofworkplaces. . .visited[were]equippedwithfanor[had]. . .operablewindows.”

Nivola (1999) asked why European cities were more compact thanAmericanonesandofferedthefollowinganswers:(a)lessinner-citycrimeand(b)moreinvestmentinmasstransitinsteadofhighways,butalso(c)agriculturalsupportthatraisedlandprices,(d)taxbreaksforhomeown-ership, (e)higher fuel andcar taxes, (f)highergas andelectricitypricesthatmakelargehomesandappliancesexpensive,and(g)highershareoftransfers to local government.Thus, in addition to local policies,macropolicies too appear to affect urban form, albeit in a complex and oftenpoorlyunderstoodmanner.

Evenifthesepolicieschange,citiesarelimitedintheirresponsebythelock-ineffect.Thisreferstotheoften-substantialimpactofexistingurbancapital and systems on the cost of change. For example, Atlanta, whereonly4.5%of the tripsarebypublic transport,wouldneedto increase its74kmof trackby46 times andadd2,800 stations to get the same levelofmetroaccessibilityassimilarlysizedBarcelona,where30%oftripsusepublictransport,eventhoughithasonly99kmoftrackand136stations.The lock-ineffecthas twomajor implications.First,proposals tochangeexistingurbanenvironmentswillbeexpensive.Second,thelateroneacts,themorenewurbandevelopmentwillbe locked into forms thatarenotcompactandenergyefficient.

Specific Policy Options

These complexities and lock-in effects make changing urban form andbehavior a wicked problem, one that is almost incapable of resolution.Are-examinationofsomecommonurbanpoliciesbelowfromaclimatechangeperspectiveillustratesthisdifficultyofcraftingsolutions.


PropertyTaxes

Does the use of property taxes as themainstay of local financing in-duce sprawlbydiscouragingdensification since that leads to increase intaxable value or even by giving small groups the ability to choose theirtaxationlevelsbyincorporatinganewtown?Ifso,aninter-governmentalfiscalsystemthat limits localtaxesandreliesmoreonstatutorytransfersto local governments and user feesmay encouragemore large, compactcitiesandfewersmalltowns.

TaxBenefitsforHomeownership

Similarly,taxbenefitsforhomeownershippromotedevelopmentoflo-cationswithlowlandvaluesandhencehomeprices,usuallyatthefringesof the existing city. Disjunctions between home and work locations in-creasetraveldemandashomeownershipdetersrelocationclosertowork.Transport demand could fall ifmore people rent rather than own theirhomes.Increasingthesupplyofrentalhousingandmakinghomeowner-shiplessaspirationalcouldbecriticaltoalow-carboncity.

LEED-CertifiedModernBuildings

Movingfromsprawltoaesthetics,isamodernbuildingjustglass,steel,and central air-conditioning? LEED-certifiedmodern buildings are nowvisible in India andChina, but do they reduce actual energy consump-tion?Newshametal.(2009)findthat,while,asagroup,LEEDbuildingsconsumedlessenergyperunitarea,uptoathirdofthemusedmoreen-ergy than their conventional counterparts and higher levels of certifica-tiondidnotimplybetterenergyefficiency.

Climate-Responsive Architecture and Behavioral Change

There are other approaches tomodern building that challenge the con-ventional aesthetic imagination. JiangYi (2009) posits two philosophiesofbuildingdesignanduse,viz.:人定胜天 (Réndìngshengtian), i.e., thetriumphofmanovernature,vis-à-vis天人合一 (Tianrénhéyi), i.e., theonenessofmanandnature.Climate-responsivearchitecture,whichlever-ages climatic resources to reduceuseof energy forheating, cooling, and


lightingof buildings, andpart-time, part-space air-conditioning (even ifbyrelativelyinefficientequipment)fostersusertoleranceforawiderangeofindoortemperaturesandmayusemuchlessenergythancentrallyair-conditionedspaceswithmoreenergyefficientequipment.

Cultureandpatternsofbehaviorareclearly important.Thecharacter-izationofEuropeansaspeoplewhowearsweaters indoors inwinterandAmericansasthosewhodothesameinsummermaybeapocryphal,butitdoespointtobehaviorandcultureasbeingcriticalelements.Thesedif-ferencesmayhaverootsindeeperculturalorientations.IsitpossiblethatChina and India, with distinct cultural sensibilities, will think and thusbuilddifferentlythanWesternnations?Cantheirconstructionworkforce,at thebottomof their labor totempole, acquire the ability to erect suchbuildings?

Implementing Change: Governance and Ethical Concerns

Finally, who willmake decisions about what policies to implement andhow tofinance them?Different layers of governance—international, na-tional, and local—will all need to be involved in different capacities toinfluence urban energy consumption. For example, global agreementsare needed tomake international financial flows possible; action by na-tionalgovernmentsisrequiredtochangethetaxstructure,andonlylocalgovernmentsarelikelytobeabletoensurebuildingcodesappropriatetotheirlocalenvironment.

Theseissuesofmulti-levelgovernancearefurthercomplicatedbymat-tersofdetail.IfAnnexIcountriesdodecidetofinancemoreefficientcitybuilding in developing countries, how should these transfers be struc-tured?Approachescenteredoncrediting,whichtendtorelyonaformofBAUbaselineorefficiencytarget,areunsuitedforthesekindsofsystemicchanges.ConditioningonGHGreductionwoulddenytheuncertainandcomplexlinkagesbetweenactionandoutcome.Instead,aspecializedfundcansupportasetofmeasurable,reportable,andverifiable(MRV)climate-friendlyactions incities through theprovisionof long-term low-interestloansorinterest-free,non-repayablefinancialtransfers.

But even if thiswere acceptable, can parties agree on the kind of in-vestmentstosupport?Shouldpublic transportberailorroadbased?Dogas pipelines qualify—because they encourage fuel switching in trans-portand facilitate load-centergasplants?Whataboutwater recycling to


reduce energyuse in transportingwater?Doespublic rental housing, asin Hong Kong, and the additional cost for low-carbon cement qualify?Finally, should one country’s taxpayer pay for cutting property taxes inanother?

Thispaperalsoraisesabroaderconcern:shouldinternationalactorstrytoinfluencesocietalbehaviorinindividualcountries?Culturalrelativismadvocatescautionineffortstoinducebehavioralchanges.However,with-outchangesinbehavior,low-carboncitiesareunlikely.Asecondquestioniswhetherefforts tochangebehaviorarepreposterous.Agoodresponseto this is theanti-smokingcampaign.This is,however,notafirst-choicestrategyfortheOECDcountries,asillustratedbytheirfocusonenergyef-ficiencyandtechnologicalfixestodecarbonizetheircities.Still,thisdoesnotchangethefactthat,regardlessofhowefficientAtlanta’scarsbecome,itsresidentsarelikelytoemitmorecarbonthanBarcelona’s.

Any attempt to reduce urban emissions is fraught with uncertainty.Thechoicebeforeus is either to try to remakeour cities, in spiteof theuncertainty,orwaitandhopethattheuncertaintylessens.Theriskisthatthewaitmaybeinterminableand,worse,theconsequencesirredeemable.


MarilynA.Brown,FrankSouthworth,andAndreaSarzynski,Shrinking the Car-bon Footprint of Metropolitan America Washington(BrookingsInstitution,May2008).

ShobhakarDhakal,“UrbanenergyuseandcarbonemissionsfromcitiesinChinaandpolicyimplications,”Energy Policy(inpress,2009).

Ruey-LungHwang,Ming-JenCheng, Tzu-Ping Lin, andMing-ChinHo, “Ther-mal perceptions, general adaptation methods and occupant’s idea about thetrade-offbetween thermal comfort andenergy saving inhot-humid regions,”Building and Environment, Vol. 44, Issue 6(June2009).

Guy R. Newsham, Sandra Mancini, and Benjamin J. Birt, “Do LEED-certifiedbuildingssaveenergy?Yes,but . . .”Energy and Buildings, Vol. 41, Issue 8(Au-gust2009).

Pietro Nivola, Laws of the Landscape: How Policies Shape Cities in Europe and America(BrookingsInstitutionPress,1999).

Horst Rittel and Melvin Webber, “Dilemmas in a general theory of planning,”Policy Sciences, Vol. 4(1973).

TheWorldBank,World Development Report 2009: Reshaping Economic Geography (2009).


XiuYang, “Overallbuildingenergydata in sevenChinesecities,”Presentation to CCICED Task Force on Energy Efficiency and Urban Development (February2009).

JiangYi,“Harmoniouswithnature:TheChineseapproachtobuildingenergyre-duction,” inMarkKelly (ed.),Public #5: A Human Thing (2009), available athttp://www.woodsbagot.com/en/Documents/Public_5_papers/Harmonious_with_nature.pdf.

http://www.woodsbagot.com/en/Documents/Public_5_papers/Harmonious_with_nature.pdf

Climate Finance 241

Chapter 27

APrototypeforStrategyChangein Oil-ExportingMENAStates?

The Masdar Initiative in Abu Dhabi

SamNaderHead, Carbon Finance Unit, Masdar

Key Points

• Masdar,supportedbytheGovernmentofAbuDhabi,isattemptingto create viable renewable and clean energy solutions, to commer-cialize these solutions, and at the same time to create a culture ofsustainabledevelopmentintheMENAregion.

• MasdarCity,theworld’sfirstzero-carboncity,isoneoftheflagshipprojects, alongwith a 100WMsolarplant, an industrial hydrogenpowerplant, andanationwideCarbonCaptureandStorage (CCS)system.

The debate around climate change and energy security is by now wellknown.A key issue facing ourworld today is how to tackle these chal-lenges inaway thatcansustainhumanprogressandeconomicdevelop-ment,while at the same time safeguardingour environment and the fu-tureofourplanet.Itisclearthereisnosingleanswertothesechallenges.Rather, the solution lies in the diversification of technologies, includingcleanfossilfuelenergy,aswetransitiontowardsalow-carbonfuture.ItiswiththisinmindthatAbuDhabilaunchedtheMasdarinitiativein2006,taking the lead indevelopinganewmodel forgovernmentandbusinesstoworktogetherinturningtheworld’sclimateandenergychallengesintoopportunitiesforsustainablegrowthandeconomicdevelopment.

242 Sam Nader

Awide-ranging,multifaceted initiative,Masdar integrates the full re-newable and clean technology life-cycle—from research to commercialdeployment—withtheaimofcreatingviablealternativeenergysolutionsinanascentandoftenfragmentedindustry.Benefitingfromthefullsup-port of theGovernment of AbuDhabi,Masdar provides a platform forthe development of renewable energy and low-carbon technologies at aglobal levelwhile creating a new clean energy growth-generating sectorintheEmirate.Theinitiativeisdrivenbyfivekeycomponents:educationand research, project development, technology funding, value chain in-dustry,andsustainableliving.

Withmuchof theworld’scarbonemissions increasinglycomingfrompower generation,Masdar’s investment and project deployment strategyinAbuDhabiisfocusedonderivingaconsiderableshareoffuturepowersupplyfromcleanenergysources.ThiswillbeachievedbyleveragingtwooftheEmirate’sgreatnaturaladvantages:year-roundsunshinetoproducesolarpower,andthedevelopmentoffossil-fuel-basedcleanpowergenera-tionprojectsonthebackofalong-establishedhydrocarbonsector.

Masdar has already launched a 100 MW concentrated solar powerplant inAbuDhabiwhichwillbeoperationalbyearly2012.Thiswillbefollowed by a series of similar projects combined with next-generationphotovoltaic power plants in order to reach a target of 1.5 GW of solarelectricityby2020,outofaprojectedinstalledcapacityof20GW.

However,withAbuDhabi’s rapid increase of electricity demand overthenextdecade, therelianceonfossil fuelswill likelyremainhigh.Mas-dar isworking onmaking our dependence on fossil fuelsmore sustain-able,byadvancingandrollingoutmultiplecleanpower technologies in-cludingpre-combustionandpost-combustioncarboncapturesolutions.

ThedevelopmentofanationalCCSnetworkby2020formstheback-boneofthiseffort.ThisprogramconsistsofaseriesofCCSprojectsaimedattakingasignificantcutfromAbuDhabi’scarbonfootprintby2020.ThePhase I project started in summer 2008 andwill be completed in 2014.Once fullyoperational, theprojectwill capture around 5million tonsofCO2peryear—equivalenttoremovingoveramillioncarsfromtheroadsof theUnitedArabEmirates—fromconventional gas-firedpowerplantsandheavy industry,usingchemicalabsorption technology.TheCO2 will betransportedinapipelinenetworkforinjectioninAbuDhabionshoreoilreservoirs.

Masdar has also launched the world’s first industrial-scale hydrogen-basedpowerplant.The400MWplantwill separatenaturalgas intohy-

A Prototype for Strategy Change in Oil-Exporting MENA States 243

drogenandCO2 throughauto-thermal reforming.Thehydrogen is thenburnttoproduceemissions-freeelectricity,whiletheCO2iscapturedandsentintotheCCSpipelinenetwork.

Anotherflagshipproject,andaverytangiblemanifestationofMasdar’svision,isMasdarCity,theworld’sfirstzero-carbon,zero-waste,andzero-carcommunityunderconstructionattheoutskirtsofAbuDhabi.Thecity—whichupon completionwill behome to90,000people—will be fullypoweredbyrenewableenergyandwillshowcaseadvancedtechnologyinenergyefficiencyandgreenbuilding.Itwillconsumearound200MWofpower,comparedwith800MWnormallyrequiredbyaconventionalcityofthesamesize.

Masdar City is a prototype demonstration of how clean technologiesand energy efficiency solutions can be integrated to provide a healthyemission-free environmentwith ahighqualityof life.Many elementsofMasdarCitywillserveasbest-practiceexamplesfortheblueprintsofnewand existing cities.MasdarCitywill provideuswith great opportunitiesand anewwayof life: sustainable industries, green jobs, andnew, cleansourcesof energy. Itwill alsoprovide theworldwitha successfulmodelofsustainableliving.

Webelievethatalloftheseinitiativesandprojectswillhaveasubstan-tialandgrowingimpactonAbuDhabioverthecomingdecadeinreduc-ing emissions and developing human capital. Although Masdar is stillyoung, it is already serving as a catalyst for change in the region and israpidlydeveloping intoaglobal leader in the renewableand low-carbonspace.At thesametime,Masdar is layingthegroundworkforagrowingawarenessofsustainabledevelopmentintheMiddleEast.

Part V

Climate Finance and World Trade Organization (WTO)

Law and Policy

Climate Finance 247

Chapter 28

The WTO and Climate FinanceOverview of the Key Issues

Gabrielle MarceauCounsellor, Office of the Director-General, WTO;

Professor, University of Geneva Law School

Key Points

• WhiletheprimarygoaloftheWTOistopreventunjustifiedrestric-tionsontrade,theWTOhasshownsufficientinstitutionalandnor-mativeflexibility to allowmember states to address environmentalconcernseffectively;thisshouldremaintruewithactionsrelatingtoclimatechangemitigationandadaptation.

• The WTO will play a central role in resolving tensions betweenWTOMembers’domesticpoliciestolimitemissionsandtheirobli-gationsunderWTOrules.

• AsthemechanismscurrentlyopentotheWTOtoconfrontclimatechange are limited, the primary effort tomobilizemitigationmustcomefrominternationalagreements.

Climate change, being such a broad issue, intersects with a number ofareas of World Trade Organization (WTO) work, although the WTO’sprimaryfocusistofightdistortingtraderestrictions.ItisoftensuggestedthatWTOruleswillbeinconflictwithdomesticactionstakenundertheUnitedNations FrameworkConvention onClimateChange (UNFCCC)orother similarmultilateralenvironmentalagreements (MEAs),but thisneednotbethecase.TheWTO,liketheUNFCCC,strivestoensuresus-tainabledevelopment.ThisbriefessayfirstoutlinesclimatechangeissueswithinWTOlaw, including theDohaDevelopmentAgenda(DDA),and

248 Gabrielle Marceau

thenaddressessomeoftheareasofpotentialtensionbetweenspecificcli-matemitigationactionsandobligationsundertheWTO.

TheWTO’scoreactivitiesaretonegotiatereductionsoftariffsandsub-sidies; topreventdomestic regulatory andothermeasures thatunjustifi-ablyrestricttrade;tomonitordomesticactionsthatmayaffecttrade;andtosettledisputesamongitsmembers.Basicrules include,amongothers,(1) theprohibitionofunjustifiablediscriminationbetween importedanddomesticlikeproductsand(2)theprohibitionofunjustifiableborderim-portandexportquotas.

Though created followingWorldWar II to stimulate the global econ-omy,theWTOhasdemonstratedaninstitutionalandnormativecapacityto adapt to the changingneedsof itsmembers.AlthoughWTOhasnotyetdiscussedoractedonclimatechangeperse,itisinevitablethatitwilldosointhefuture.AndwhileWTOjurisprudencehasnotyetrespondedtotheneedsofclimatechange,ithasbeenresponsivetoothernewenvi-ronmental needsofmembers.Therefore,when theWTOdealswith cli-mate change, it will benefit from the clarifications ofWTO law on thescope of the environmental exceptions inGeneralAgreement onTariffsandTrade(GATT)ArticleXX;WTOAppellateBody(AB)decisionshavebeenusedtoclarifyrelevantterms,conditions,andissues;andMembers,responding to societal changes, have adopted waivers and even amend-mentstobasicWTOprovisions.Finally,someMembersaretalkingabouta temporary dispute peace-clause for climate-related issues. This couldallowMembers to rapidly adapt their domestic regulatory systems in aWTO-consistentmannertotheneedsofclimatechangemitigation.

Inthispaper,theissueofclimatechangeisaddressedfromtheperspec-tiveoftheexistingprovisionsoftheGATTandtheenvironmentalexcep-tion inGATTArticleXX inparticular, aswell ashow tradenegotiationcanalsofacilitateclimatechangemitigationandadaptationmeasures.

GATT Article XX

Article XX enumerates a list of general exceptions that allowMemberstogiveprioritytopoliciesotherthantrade,suchastheprotectionoftheenvironment.Generally, inWTOlawagovernment isentitled to set thelevelofenvironmentalprotectionitconsidersappropriate.ArticleXXau-thorizessuchenvironmentalmeasuresthatmayincidentallyviolateotherWTO obligations if they are “apt to contribute materially to the policy

The WTO and Climate Finance 249

goalatissue.”Importantly,thecontributionoftheenvironmentalmeasuretothepolicygoaldoesnotneedtobeimmediatelyobservable.AstheABnoted, “itmayprovedifficult to isolate the contribution topublichealthorenvironmentalobjectivesofonespecificmeasure fromthoseattribut-able to theothermeasures thatarepartof thesamecomprehensivepro-gramme.”Thisisveryrelevantasclimatechangeisaglobalphenomenon,and the contribution of any single domestic climate change mitigationmeasuretoglobalmitigationwillbeverydifficulttoestablish.

AnimportantunresolvedissueistheextenttowhichtheenvironmentexceptionofArticleXXcanbeinvokedagainstviolationsofWTOprovi-sions other than those of the GATT (for instance, to the provisions ofthe Subsidies andCountervailingMeasuresAgreement that can becomerelevant if governments issue free emissions allowance as part of a cap-and-traderegulatoryprogram)andwithwhateffects.

Doha Development Agenda (DDA)

IntheongoingDDA,Membersarenegotiatingenhancedtariffreductionson“environmentalgoodsandservices”thatshouldfavorthetradeofthemost needed clean technologies. Currently, theUS imposes tariffs (top-pingoutat 5.2%)on32of the43climate-friendly technologies identifiedby theWorldBank.China imposesdutiesonall but twoof theproductcategories,withamaximumrateof35%.Thesetariffsareanimpedimenttotradeandhinderthespreadanddevelopmentofcleantechnologies.

IntheDDA,Membersarealsonegotiatinghowtooperatetherelation-ship between theWTO rules and the commercial obligations inMEAs,whichcouldbecomerelevantifatreatyrelatedtoclimatechange(CC)isadopted.

Further, concluding theDDAwould furtheropenmarkets in favorofdevelopingcountries’exportsandreducetrade-distortingagriculturepro-tections,thusenhancingtheeconomicpowerofdevelopingcountriesandprovidingthemwithmoremeanstotakeCC-relatedactionsofallkinds.

However, it isworthrememberingthatboththeDDAandGATTAr-ticleXXwerenotdesignedtodealwithclimatechangeissues.Recogniz-ing this,WTODirector-General Lamy insists that once a newmultilat-eralagreementonclimatechangeisadopted,theWTOwillbeabletoacteffectively to allowmembers to implementation their CC commitmentsharmoniouslywiththeirtradeobligations.


Potential Tensions between Climate Policy and International Trade Law

Withtheincreaseindomesticclimatechangeregulation,thepotentialfortensionbetweenitandMembers’WTOobligationincreases.Thissectionlistssomeofthesepotentialareasoftension.

NationalTreatmentandMost-Favored-NationsObligations

All domestic regulations and taxation systems that potentially affecttrade are subject to thenational treatment andmost-favored-nation ob-ligationsoftheWTO—averybroadandpowerfulsetofobligations.Thismeans that importedanddomestic“like”products—definedasproductsthatcompetewitheachother—mustbetreatedsimilarly.Thus,aproductcomingfromacountrywherethereisaclimatechangeprogramandan-otherproduct fromacountrywhere there isnosuchprogramare“like”to the extent that they compete with each other and thereforemust betreatedthesameway,unlesstheArticleXXexceptionisinvokedtojustifysuchviolation.

But if the environment exception is invoked, the importing country’senvironmentalmeasuresmust be “apt to contributingmaterially” to thepolicygoal invoked—that isalleviatingclimatechange—andsuchmeas-uresmustbeimplementedingoodfaith.Thismeansthatcountriesinthesameconditionsmustbetreatedsimilarly,andthelevelofdevelopmentoftheexportingcountriesmustbe taken intoaccount; inaddition,accord-ingtoWTOcaselaw,specificclimatechangeactionsundertakenbyspe-cific exporters (distinct from their government actions)would alsohaveto be taken into account. For example, following the Shrimp-Turtle ABdecision,even thoughdomestic regulationmayallow importsonly froma country that has a climate changemitigation program, it could be ar-guedthatitmustallowimportsfromanon-complyingcountryifspecificexporterswithinthatcountrytakecomparableclimatechangemitigationactions.

So-calledbordertaxadjustmentsraisesignificantissuesunderthena-tional treatment obligations; when can a WTO member impose at theborderataxoratariffagainstgoodscomingfromacountrythatmaynothaveaclimatechangeprogram?Whencanamemberofferitsproducersataxrebateontheirexports?WhatistheuseofArticleXXwhenenviron-mentalleakageisinvokedtojustifyaviolationofWTOrules?


AgreementonTechnicalBarrierstoTrade(TBT)

AsaresultoftheTBT,theWTOhasrulesapplicabletodomesticstan-dardsregulatingproducts, thepreparationandapplicationof thosestan-dards,andtheirmutualrecognition.For instance,governmentstandardson logging certification andother forest product regulations adoptedbyMembers as part of their responses to climate changemust respect theprescriptions of theWTOTBTAgreement.The same is true for all en-ergy efficiency standards, electricity standards, eco labels, certificationschemes,etc.

AnotherimportantruleoftheWTO(mentionedintheTBTandSani-taryandPhytosanitary(SPS)Agreements)isthatifadomesticregulationcomplieswithanexistinginternationalstandard,suchdomesticregulationis presumed to beWTOconsistent even if it restricts trade.At themo-ment,nosuchinternationalstandardsrelatingtoclimateregulationexists.However,ifspecificclimateregulatorystandardswerenegotiatedinterna-tionally,itcouldbearguedthatadomesticregulationimplementingsuchstandardscouldbenefitfromtheWTOpresumptionofcompatibility.

Also relevant ishow todealwithprivate standards, such as those es-tablished by industry groups,NGOs, or the International StandardsOr-ganization.Suchstandardsaregenerallynotsubject toWTOdisciplines,butmaybecomesoiftheyaresponsoredorpromotedbyMembers.WTOlawisnotclearonthisquestion.

FreeEmissionsAllowances

TheWTO has rules concerning the level of specific production sub-sidies thatwillbeallowed; suchsubsidiesare restrictedwhen theycauseadverseeffectsontradeandinternationalcompetition.Additionally,thereare prohibitions on export subsidies. These provisions are relevant todomestic GHG emissions trading schemes that issue free allowances tolocal producers.Aswell, theWTOSubsidyAgreement and thenationaltreatmentallowforsomeformsofexport tax-productrebates, subject tocertain conditions.However, an economy- or sector-wide tax (aswouldbelikelyunderaclimatechangeprogram)isnotproduct-specific,andsounable to be rebated upon export. Finally, the border administration oflicenseswill also be subject to the requirement of the Import LicensingAgreement,withregardtonotification,transparency,andotheradminis-trativeissues.


Agriculture

WTO rules to reduce distorting subsidies in agriculture can also be-comerelevantfortheprotectionoftheenvironment.Reducingdistortingsubsidies will tend to favor themore naturally efficient agriculture pro-ducersand thusreduce theoveruseandenvironmentalabuseofagricul-tural land,whichcanresult inhighGHGemissions.Ontheotherhand,the Agreement on Agriculture provides for unlimited “green subsidies,”the full potential ofwhichneeds tobe explored for climate changepro-grams.Agriculture,whichisoneofthesectorsmostvulnerabletoclimatechange, is also a key sector for international trade through subsidies tobad fertilizers, bad feedstock for animals, subsides to dedicated energycropstoreplacefossilfueluse,improvedenergyefficiency,etc.

RegionalTradeAgreements(RTAs)

Asitisnotclearwheninternationalagreementmightbereached,itisquite possible thatmembers of regional trade agreementswill negotiateCO2standards,orevenclimatechangeconditionedrulesoforigin.AstheWTOhasrulesonRTAs,thequestionarisesastohowitshouldreconcileclimate changeactions takenbyMemberson thenational, regional, andmultilaterallevels.

GeneralAgreementonTradeinServices(GATS)

Therulesontradeinservicescouldalsobecomerelevantastheypro-hibit discrimination between foreign and domestic service providers.TradeofemissionsallowancesandotherclimateassetsmightbecoveredunderGATS,andconsideredasofthesamenatureas“financialservices.”TheGATSrulesoninvestment(mode3)mayalsobecomerelevantasin-vestmentandcompetition-relatedactionswillcrucialtostimulateclimatechangemitigationprograms.

TechnologyTransferandtheAgreementonTrade-Related AspectsofIntellectualPropertyRights(TRIPS)

Finally, TRIPS rules are also very relevant.Mitigating climate changewill be a major technological challenge. Of crucial importance will betechnology transfer between countries; commercialization of low-cost


technologies (many of which exist, but will need to be scaled up); andrelationsbetweeninnovation,patents,andcompulsorylicenses.

Conclusion

There is a significant overlap between climate issues and areas ofWTOcompetence.Assuch,WTOrulesshouldbekeptinmindwhenconstruct-ingapost-2012regimeforclimatechangemitigation.AnynewagreementneednotbeinconflictwiththeWTO.


A.CosbeyandR.Tarasosfky,Climate Change, Competitiveness and Trade (Chat-hamHouseReport,2007).

T. Houser, R. Bradley, B. Childs, J. Werksman, and R. Heilmayr, Levelling the Carbon Playing Field: International Competition and US Climate Policy Design (PetersonInstituteforInternationalEconomicsandWorldResourcesInstitute,2008).

G. C.Hufbauer,S.Charnovitz,andJ.Kim,Global Warming and the World Trade Organization(PetersonInstituteforInternationalEconomics,2009).

G.Marceau andM.Cossy, “InstitutionalChallenges to Enhance PolicyCoordi-nation—How WTO Rules Could Be Utilized to Meet Climate Objectives?”Proceedings of the World Trade Forum 2007, International Trade on a Warming Globe: The Role of the WTO in the Climate Change Debate(2009).

J.Pauwelyn,A Carbon Levy on Imports to Fight Climate Change (Telos,Septem-ber 2007), available at http://www.teloseu.com/en/article/a_carbon_levy_on_imports_to_fight_climate_change.

L.TamiottiandV.Kulaçoğlu,“NationalClimateChangeMitigationMeasuresandTheir Implications for theMultilateral Trading System: Key Findings of theWTO/UNEPReport onTrade andClimateChange,” Journal of World Trade 43(5)(2009).

http://www.teloseu.com/en/article/a_carbon_levy_on_imports_to_fight_climate_change

http://www.teloseu.com/en/article/a_carbon_levy_on_imports_to_fight_climate_change

254 Climate Finance

Chapter 29

CarbonTradingandtheCDMinWTOLaw

RobertHowseLloyd C. Nelson Professor of International Law, NYU School of Law

AntoniaEliasonAssociate, Allen & Overy LLP

Key Points

• WTOrulesare likelytoplayacentralroleintheregulationofcar-bontradingandotherformsofcarbonfinance,bothintheinterimas climate finance regulatory bodies begin to address domesticmeasuresaffectingtradingandinthelongtermasthecarbonmar-ketbecomestrulyglobal.

• This paper examines some key issues in the evolving legal frame-work for international carbon trading and associated services, in-cludingthelikelytreatmentunderexistingWTOagreementsofthethree Kyoto flexibility mechanisms and other trading systems forcarbonassets.

• Althoughnopolicyexhortationsaremadehere,itisclearthatdeci-sionsaboutwhich legalprovisionswillregulatecarbonfinancewillinvolvemany complexities and have significant consequences, andthereforemustbethoughtthroughcarefully.

Capped Emissions Trading

TheKyotoProtocolauthorizesthreeflexibilitymechanismstoreducethecost of compliancewith its emissions targets.The first to be considered

Carbon Trading and the CDM in WTO Law 255

of these is a system of emissions trading among Annex I nations pro-videdunderArticle17,wherecountrieswithcaps(calculatedinassignedamountunits,orAAUs)canreallocatetheburdenofabatementbetweenthem. Although the Protocol contains some general language regardingthissystem,includingarequirementthatAnnexIParties“strivetoimple-ment policies andmeasures . . . in such a way as to minimize adverseeffects . . . on international trade . . . [and] on other Parties, especiallydevelopingcountryParties,”itprovidesverylittlespecificguidanceonthedetails of regulating international emissions trading, nor has significantprogressbeenmadeinclarifyingthesearrangements.Giventhisabsence,World TradeOrganization (WTO) rules are likely to form a significantpartoftherelevantmultilaterallegalregulation.

OnepointtomakeclearisthattradingofAAUsbetweenstatesisgov-erned by the Convention and Kyoto, whereas transnational transfers ofpermits recognized under domestic law as valid within domestic emis-sions trading schemes (such as the EuropeanUnion Emissions TradingScheme(EUETS))arenotaddressedbyanyinternationalagreement.Asyet,theWTOhasnotmadeadeterminationofwhetherandhowanytypeofcarbonmarketandtheassetsbeingtradedfallsunderitsauspices.As-suming theWTOwouldhave regulatory jurisdiction,would these itemsbe treated as financial services under theGeneral Agreement on TariffsandTrade (GATS) or as falling under someotherGATS sectoral classi-fication (perhapsenvironmentalorenergy services)?Alternatively, couldthey be considered goods under GATT, considering the carbonmarketprimarily in termsofhow itaffects the termsandconditionsofproduc-tionofthegoodsforwhichcarbon-basedenergyisaninput?

While Article 17 authorizes emissions trading of AAUs only amongstates, itenvisagesthatcorrelativecarbonpermitsissuedbystatescanbebought and sold directly between private parties or indirectly throughbrokersandexchanges.Inpractice,carbontradingseemsverymuchlikeafinancial service: theexchangeof funds foran intangibleright (topol-lute).Moreover,thereisnophysicalobjectthateverchangeshands.Thatsaid, in their treatment bymarket participants, carbon permits also ap-pear to be very similar to other basic commodities such as oil or corn,and these commodities are unquestionably goods.The answermay notbeof an either/or character: as theAppellateBodyheld inEC-Bananas,thesameregulatoryschememayaffecttradeinbothgoodsandservices,andthereforeboth thedisciplinesof thecoveredagreementson trade ingoodsandthoseofGATSmaybeapplicable.Moreover,itishighlylikely

256 robert howse and antonia eliason

thatregardlessofthetreatmentoftheunderlyingasset(i.e.,allowancesorcredits)anyfinancialproductsusedwithinthecontextofcarbonmarkets(e.g., derivatives such as swaps, futures, and options) will be treated asfinancialproductsandnotgoods.

Ifcarbontradingisconsideredtobeafinancialservice,thenitwouldfallundertheAnnexonFinancialServicestoGATS.Findingcarbonmar-ketstobefinancialservicesunderGATSwouldallowgovernmentssomelatitude in taking prudential regulatory and other measures to protecttheir nationalmarkets and the international carbonmarket.Article 2 oftheFinancialServicesAnnexstatesthat“aMembershallnotbepreventedfromtakingmeasuresforprudentialreasons,includingfortheprotectionof investors, depositors, policy holders or persons to whom a fiduciarydutyisowedbyafinancialservicesupplier,ortoensuretheintegrityandstabilityofthefinancialsystem.”Ifthe“integrityandstability”ofthecar-bonmarketischallenged,asmayhappenifallowancesfromothercoun-trieswithemissionsinexcessoftheircapsaretraded,thebroadlanguageof the Financial ServicesAnnexwill enable governments to support themarket by excluding such permits if they do not conform to acceptablecriteria.

CarbontradingalsoimplicatestheSubsidiesandCountervailingMeas-ures (SCM) Agreement. The definition of subsidy contained in Article1.1(a)(1)(ii)oftheSCMAgreementincludesfinancialcontributions“wheregovernmentrevenueotherwisedueisforegoneornotcollected(e.g.,fiscalincentives suchas tax credits).”Article 1.1(b) laysout theother criterionforasubsidy—thatabenefitbeconferredbythefinancialcontributioninquestion.Thus,ifunderanycarbontradingsystemgovernmentsprovidefree carbon allowances that are then resold on the carbonmarket for awindfallprofit,thismaybeviewedasasubsidy.

CDM and JI

The Clean Development Mechanism (CDM) and Joint Implementation(JI) are theother twoKyotoflexibilitymechanisms,provided inArticles12and6oftheProtocol,respectively.Theyachievecostreductionsbyal-lowing developed countries to fund, directly or indirectly, emission re-duction projects in developing countries (for CDM) or Annex I devel-opedcountries(forJI)andusetheresultingcertifiedemissionreductions(CERsfromCDMprojectsandERUsfromJI)towardsmeetingtheirown

Carbon Trading and the CDM in WTO Law 257

targets.Sincetheseprojectsinvolvefinancingtransferstoothercountriesaswellas thepossibilityof technologytransfer,avarietyofWTOprovi-sionsareimplicated.Alloftherelevantforegoinganalysisfromemissionstradingcouldtheoreticallybeappliedtothesemechanisms.

Oneway to consider these arrangements is as a transfer of emissionsreductions between countries. Conceptualized this way, these projectscouldbeseenasfallingunderGATS,asthetradeinemissionsreductionscouldbeseenastradeinservices:forinstance,ifasteelmillinGermanybuysCERsfromawindfarminMorocco,thiscouldbeseenasthesteelmillpayingthewindfarmtoreducethetotalGHGemissionsofthetwocountriesbyacertainamount,withtheCERasamerecertificationofthisservice.Thisimplicatesmost-favored-nation(MFN)provisionsaswellasNational Treatment andMarketAccess provisionswhere aMember hasboundtherelevantsector(s)initsschedule.

Additionally, theWTOAgreementspertaining to trade ingoodsmayapply (as suggested for international AAU/permit trading above) wherethe scenario above is rephrased in terms of theCERs being goods pro-duced inMorocco and sold to a buyer in Germany or where inputs inenergy production are concerned, for instance.The investment-orientednature of these projects may also implicate the Agreement on Trade-Related InvestmentMeasures (TRIMS). In the event that aproject is in-consistentwitheithernationaltreatment(GATTArticleIII)orquantita-tive restrictions (GATT Article XI), it would be in violation of TRIMSArticle2.1.

Two other potentially relevant WTO agreements are the Agreementon Government Procurement, since these projects involve cross-borderinvestments under the supervision of governmental authorities, and theTechnicalBarrierstoTrade(TBT)Agreement,whichmayapplywhereanAnnexBcountryinvestinginaCDMprojectfaceslocaltechnicalregula-tionsorconformityassessmentprocedures relating toproductsoriginat-ingintheAnnexBcountry.

It isquite likelythatadditionalemissionscreditoffsettradingsystemsbetween developed and developing countrieswill be established in con-nectionwithdomesticETS,suchastheEUETSandtheUSETSprovidedbytheWaxman-Markeylegislation.Inaddition,arrangementstolinkdo-mestic cap-and-trade systemswill generate international emissions trad-inginallowances.Thesesystems,arisinginitiallyunderdomesticlawandagreements among specific states, will generate similar regulatory issuesunderinternationaltradelaw.


RECs

Carbon trading is not the only form of instrument addressing green-housegasemissions.Whereasemission tradingschemes involve the saleandpurchaseofentitlementstoproducegreenhousegases,renewableen-ergy certificates (RECs) serve tomeet the requirement that aminimumshareofelectricitygeneratedmustcomefromrenewableenergysources.Transactions inRECsareakintoemissiontradingschemes,but trade inRECs falls evenmore squarely into the realm of financial services,withthecertificatesusuallybeingdecoupledfromtheunderlyingenergybeinggenerated.

TheanalysisapplicabletoemissionstradingabovewouldalsoapplytotradingofRECs,butduetoRECsbeingdecoupledfromtheactualenergybeingproduced,provisionsofGATSrelatingtotransparencyanddisclo-sure, such asArticleVI if licensing is required or paragraph 2(a) of theFinancialServicesAnnex,willbeparticularlyrelevanttotradeinRECsinordertoavoidproblemsofaccountability.

Conclusion

BecausetheUnitedNationsFrameworkConventiononClimateChange/Kyoto regime has not resolved the regulatory uncertainties surroundingtrading ofAAUs/permits and project-based credit offsets, there is roomfor theWTO to play a role in providing additional regulatory support.WTOruleswillalsobehighlyrelevantfornewinternationaloffsetcreditand permit trading systems established pursuant to domestic law andagreements between individual states, and to international trading ofRECs.ThebasisofWTOregulationcouldbefoundinexisting,yetrarelyused,agreementssuchasTRIMSandtheAnnexonFinancialServices,aswell asmore frequently appliedagreements suchasGATSand theSCMAgreement.Thatsaid, theregulatoryvoidsurrounding internationalcar-bontradinghighlights theneed foran immediatesolutionwithenforce-ment or adjudicatory capabilities, particularly in the current financialclimate.TheWTOcancertainlyhelptofillthegap,butinternationalcli-materegulatorylawsandauthoritiesmustalsoaddresstheissues.ThisisapriorityforCopenhagenandbeyond.

Climate Finance 259

Chapter 30

CountervailingDutiesandSubsidiesforClimate Mitigation

What Is, and What Is Not, WTO-Compatible?

RobertHowseLloyd C. Nelson Professor of International Law, NYU School of Law

AntoniaEliasonAssociate, Allen & Overy LLP

Key Points

• Subsidies are regulated by the WTO through the Subsidies andCountervailing Measures Agreement, which lays down rules forwhichsubsidiesarenotpermittedandrecourseiftheyareused.

• One possible argument is that a state’s omission to internalize thenegative externalityof climate change throughdomestic regulationcancountasasubsidy,althoughtheviabilityofthis lineofreason-inghasbeencalledintoquestion.

• Theallocationoffreeallowancestoprotectdomesticindustryfromthe competitiveness concerns of leakage raises subsidy issues, pos-siblyevencontraveningWTOrules,andthesameappliestocertaineffortstopromoterenewableenergyuse.

Background on Subsidies in the Climate Change Field

The United Nations Framework Convention and Climate Change(UNFCCC) and theKyoto Protocol adopt an approach tomitigation of


climatechangebasedonstatesbinding themselves toreducegreenhousegas (GHG) emissions to agreed levels, basedon thenotionof “commonbut differentiated responsibilities” for developed and developing coun-tries. The Kyoto Protocol, however, does not specify the policies thatstatesmustusetoachievetheboundemissionsreductions,ortherelevantdesirabilityofdifferentpolicy instruments.TheProtocolmerelyprovidesalistofpoliciesthatstatesmayusetoachieveemissionsreductions.

Many of these policies can be pursued either by regulatorymeasures—emissions caps, renewable energy mandates, etc.—and/or throughsubsidies that provide incentives to market actors to engage in behav-ior that leads, either in the short termor long term, to lower emissions.The Intergovernmental Panel on Climate Change (IPCC), in its FourthAssessment Report, notes, “direct and indirect subsidies can be impor-tant policy instruments, but they have strong market implications andmayincreaseordecreaseemissions,dependingontheirnature.Subsidiesaimed at reducing emissions can take on different forms, ranging fromsupportforresearchanddevelopment(R&D),investmenttaxcredit,andprice supports (such as feed-in tariffs for renewable electricity).”1 The International Energy Agency (IEA) in its database “Addressing ClimateChange: Policies and Measures” distinguishes a range of policies thatwouldbeconsideredtohavesubsidyelements,atleastfromtheperspec-tive of international trade rules, including incentives/subsidies (directpayments tomarket actors); public investment; and research and devel-opment.TheIEAdatabasedividesClimateChangePoliciesandMeasuresinto those that support renewable energy and those that support energyefficiency. As is evident from an examination of the measures invento-riedinthedatabase,awiderangeofIEAmembersandotherstateshaveimplementedavarietyofpolicieswithelementsof subsidies.Theperva-siveness and diversity of such policies asmeans of implementingKyotoobligations lead to important consequences both for global governanceofclimatechangeand fortheinternationaltradingsystem,especiallytheWorldTradeOrganization(WTO).

Subsidy Regulation under the WTO

TheUruguayRound Subsidies andCountervailingMeasuresAgreement(SCM) placed in the category of “prohibited” in the SCM Agreement

Countervailing Duties and Subsidies for Climate Mitigation 261

exportsubsidies(subsidiesgivenonlyforproductsthatareexported)anddomesticcontentrequirements(requirements thatgoodssold inacoun-trycontainacertainminimumofdomesticvalueadded).TheAgreementintroduced a category of domestic subsidies called “actionable,” whichcanbe challenged inWTOdispute settlementproceedings, thusprovid-ing amultilateral legal remedyagainst subsidization. Inorder for a sub-sidy tobechallenged inWTOdispute settlementas “prohibited”or “ac-tionable,” ithas to fallwithinthedefinitionofsubsidy inArticle1of theSCMAgreement,whichmeansitmustentaila“financialcontribution”ofgovernmentalfinancialassistancetofirms(fromcashpaymentstoequityinfusions to provision of goods and services belowmarket prices), andalso confer a “benefit” on an enterprise; the subsidymust also be “spe-cific,”eitherdejure(legallytargetedataparticularindustryorenterpriseor group of industries or enterprises) or de facto (in fact used only ordisproportionately by aparticular industryor enterprise or groupof in-dustriesorenterprises).2.1(b)oftheSCMAgreementrefinestheconceptofspecificity:

Where the granting authority, or the legislation pursuant to which thegranting authority operates, establishes objective criteria or conditionsgoverningtheeligibilityfor,andtheamountof,asubsidy,specificityshallnotexist,provided that theeligibility isautomaticand that suchcriteriaandconditionsarestrictlyadheredto.Thecriteriaorconditionsmustbeclearlyspelledoutinlaw,regulation,orotherofficialdocument,soastobecapableofverification.

In the case of prohibited subsidies (i.e., export subsidies), specificity ispresumedanddoesnothavetobeprovenbytheclaimant.

Ifasubsidymeetstheabovecriteriaforactionability,aWTOMembermayeitherchallengethesubsidyinWTOdisputesettlement,seekingtheremedy of removal of the offendingmeasure, or itmay countervail thesubsidy.IfaMemberpursuesthefirstoption, itmustshowtheexistenceofcertain“adverseeffects”onWTOMembersotherthanthesubsidizingMember, including itself.These adverse effects are listed in Article 5 oftheSCMAgreement, and include injury todomesticproducersof a likeproduct in competitionwith the imported subsidizedproduct (injury inthissensemustexistifcountervailingdutiesaretobeimposed);nullifica-tionorimpairmentofbenefitsaccruing“directlyorindirectly”underthe


GATT,inparticulartariffconcessions;orseriousprejudicetotheinterestsof anotherMember. “Seriousprejudice” is furtherdefined inArticle6.3.To show “serious prejudice” the complainingWTOMembermust showthattheeffectofthesubsidyistodisplaceimportsofa“like”productintothemarketofthesubsidizingMember;ortodisplaceexportsofthecom-plainingMembertoathirdcountrymarket;orsignificantpricesuppres-sionorpriceundercutting inthesamemarketwithrespect to likeprod-ucts;orfinally“theeffectofthesubsidyisanincreaseintheworldmarketshareofthesubsidizingMemberinaparticularsubsidizedprimaryprod-uctorcommodityascomparedtotheaverageshareithadduringthepre-viousperiodofthreeyearsandthisincreasefollowsasaconsistenttrendoveraperiodwhensubsidieshavebeengranted.”

Where theMember chooses the option of imposing a countervailingduty(CVD),itmustcomplywiththevariousproceduralandsubstantivecriteriaintheSCMAgreementthatapplyinthecaseofCVDactions,in-cludingtherequirementofshowing“materialinjury.”ThesecriteriaapplyalsowhereaMember is countervailinga “prohibited” subsidy.TheSCMAgreement(Article8)originallyentailedadefined listof subsidies tobedeemed “non-actionable,” i.e., subsidies immunized from challenge inWTOdisputesettlementaswellascountervailingdutyaction,eveniftheywere tobe found tomeet thecriteriadiscussedabove.This list includedcertain subsidies for research and development, environmental protec-tion, and to disadvantaged regions.However, this provision for deemednon-actionabilityappliedprovisionally,foronlythefirstfiveyearsthattheSCMAgreementwas in force.Since itseffectiveexpiration,WTOMem-bershavebeenunable toagree toeithercontinuewith the list as itnowstands or to create a different list.Therefore, today there are no subsidyprogramsthatareexplicitlyprotectedasnon-actionable.

Omission to Regulate — a Subsidy?

JosephStiglitzhassuggestedthatthefailureespeciallyoftheWTOMem-bers not participating in the Kyoto Protocol to internalize the climatechangecostscausedbycarbonemissionsfromtheproductionofproductsisa“subsidy”totheproducersofsuchproducts,resultinginadistortionof internationalmarkets in the trade in goods.MostWTO legal expertswho have commented on Stiglitz’s proposal have dismissed it as clearly


not justifiedunder theWTOrules in theSCMAgreement, sinceoneoranotherofthesecriteriaisobviouslynotmet.AccordingtoBhagwatiandMavroidis, “a subsidy exists only if a government has made a financialcontribution or has incurred a cost. . . .The argument that the UnitedStatespolicy[ofnotparticipating inKyoto] isa ‘hiddensubsidy’ is irrel-evantandcannotjustifyanEUactionundertheSCMAgreement.”2

Nevertheless, among the meanings of “financial contribution” in theSCMAgreement is thegovernmentprovisionofgoodsor servicesotherthangeneral infrastructure.Therearenopre-assignedproperty rights totheatmosphere; instead, statesaregenerally thought tohaveprescriptivejurisdiction over this commons, subject to international obligations bytreaty(e.g.,theKyotoProtocol)orcustom.Thus,whereafirmisallowedto emit carbon into the atmosphereup to a certain ceiling, this is not aconsequenceofsomepreexistingpropertyrightintheatmospherethatisbeingexercisedbythefirm,butrather,of theassignmentofsucharightorentitlementbythestatetothefirminquestion.Sucharightorentitle-ment is a valuable asset, indeedanasset that canbebought and sold inthemarketplace.Thequestionarisesastowhetherthefailuretochargeamarketprice for the asset inquestion constitutes theprovisionof goodsorservices,and thereforeafinancialcontributionwithin themeaningofArticle1oftheSCMAgreement.

Leakage

Various policymeasures have been proposed to address the problem of“carbonleakage”—thenotionthatwhereajurisdictionimposesemissionscapsonitsindustries,theseindustriesmaybecomeuncompetitiverelativetothoseoperatinginjurisdictionswherenosuchcapsexist,orlesserbur-denstolimitorreduceemissions.Bothanincreaseinemissionscapsandtheprovisionof free allowances to selected industrieswould raise issuesundertheSCMdisciplines.Sincerightstopolluteconstituteprovisionofa valuable goodby the government (access to an exhaustiblenatural re-source),andthusa“financialcontribution,”whethertheseareprovidedintheformofbasicentitlementsuptoacertainlevel,orasfreeallowances,theymaywellbeactionablesubsidieswheretheyarespecific(i.e.,targetedatparticularindustriesfacingcompetitivenesspressures)ordefacto(i.e.,disproportionatelyorpredominantlyusedbycertainsectors).


Promoting Low-Carbon Investment

A wide range of subsidy programs purports to address climate changethrough reducing the cost of producing and/or consuming energy fromnon-carbon-emitting sources, relative to conventional, carbon-emittingenergysources.AccordingtotheIPCCinitsFourthAssessmentReport,“OneofthemosteffectiveincentivesforfosteringGHGreductionsarethepricesupportsassociatedwiththeproductionofrenewableenergy,whichtendtobesetatattractivelevels.Thesepricesupportshaveresultedinthesignificantexpansionof the renewableenergy sector inOECDcountriesduetotherequirementthatelectricpowerproducerspurchasesuchelec-tricityatfavorableprices.”

In thePreussenElektra case, theEuropeanCourtheld thatminimum-pricepurchaserequirementsunderGermanlawcouldnotbeconsidered“stateaid” inEuropean lawbecauseof theabsenceofanydirector indi-rect transfer of state resources.3 In theWTO SCMAgreement, by con-trast,a“financialcontribution”includesasituationwhere“agovernmentmakes payments to a funding mechanism, or entrusts or directs a pri-vatebodytocarryoutoneormoreofthetypeoffunctionsillustratedin[SCMAgreementArticle1.1(a)(1)](i)to(iii). . .whichwouldnormallybevested in thegovernmentand thepractice, innoreal sense,differs frompractices normally followedby government.” Since SCMAgreementAr-ticle1.1(a)(1)(iii)includes“purchasinggoods,”theargumentisthatasitu-ationwhere thegovernmentdirects aprivateactor topurchasegoodsata higher thanmarket price is includedwithin themeaning of “financialcontribution”evenifthegovernmentdoesnotincuranycostitself.IntheCanada-Aircraft case (Paragraph 160), theAppellateBody observed that“financial contribution” could include those situations where a privatebodyhasbeendirectedbythegovernmenttoengageinoneoftheactionsdefined in the SCMAgreementArticle 1.1(a)(1)(i)–(iii), even if the gov-ernmentdoesnotbearthecostofsuchdelegatedaction.

However, theGermanminimum-price purchase requirements do notnecessarilyconstitutea“financialcontribution”withinthemeaningoftheSCMAgreement,becausewherethegovernmententrustsordirectsapri-vatebody, theSCMAgreementalso requires that the functionentrustedordelegatedtotheprivatebodybeonethatisnormally performedbythegovernment.

InordertoviolateWTOrules,asubsidyhastohaveconferreda“ben-efit” on the recipient, i.e., a competitive advantage over and above gen-


eral “market” conditions. Someprograms for renewable energymaynotconfer a “benefit” in this sense.Measures thatmerely defray the cost ofbusinessesacquiringrenewableenergysystemsorwhichcompensateen-terprisesforprovidingrenewableenergyinremotelocationsdonotnec-essarily, for instance, confer a “benefit”on the recipient enterprise.Theysimply reimburse or compensate the enterprise for taking some actionthatitwouldotherwisenottake,andtheenterprisehasnotacquiredanycompetitiveadvantageoverotherenterprises,whichneithertakethesub-sidynorhavetoperformtheseactions.

With respect to the requirement of specificity, subsidies that are pro-vided to users of renewable energymay well not be specific if they areavailablegenerallytoenterprisesintheeconomy.


International Energy Agency (IEA), Addressing Climate Change: Policies and Measures Database,availableathttp://www.iea.org/textbase/pm/?mode=cc.

N o t e s

1. S.Guptaetal., “Policies, InstrumentsandCo-operativeArrangements,” inClimate Change 2007: Mitigation; Contribution of Working Group III to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change,B.Metz etal.,eds.(Cambridge:CambridgeUniversityPress,2007),pp.761–762.

2. J.Bhagwati andP.Mavroidis, “IsActionagainstUSExports forFailure toSignKyotoProtocolWTO-Legal?”World Trade Review(2007),6:2,299–310.

3. CaseC-379/98,PreussenElektra AG v. Schleswag AG(2001),I-2099.

http://www.iea.org/textbase/pm/?mode=cc

266 Climate Finance

Chapter 31

BorderClimateAdjustmentas Climate Policy

AlexandraKhrebtukovaScholar, NYU School of Law Institute of International Law and Justice;

Judicial Law Clerk, US Court of International Trade

Key Points

• Border Climate Adjustments (BCAs) are national measures basedon the principle that climate costs should be imposed on GHG-intensive production at the point of market entry rather than thepointofproduction.

• These measures impose a non-discriminatory price on importedGHG-intensivegoodsasaconditionformarketentry,complement-ing the imposition of climate costs on like domestic products vianationalregulation.

• Comporting with the destination principle, BCA measures mayalsobeusedtoremitthecostsimposedbydomesticGHG-intensivegoodsregulationforgoodsdestinedforconsumptionanddrivenbydemandfromothermarkets,encouragingdestinationgovernmentsto similarly employ the market-access-conditioning approach toregulatingGHG-intensiveconsumption.

• BCAmeasurescan improvethepoliticalviabilityandenvironmen-taleffectivenessofnationalregulation,andifthetwoarestructuredcorrectly,theycanbepermissibleundertheinternationaltradelawregime.

Distributing theglobalgreenhousegas(GHG)abatementeffort (andthecostsofthateffort)necessaryinlightofIntergovernmentalPanelonCli-

Border Climate Adjustment as Climate Policy 267

mateChange(IPCC)findings isadauntingproblem.Itappearsessentialto regulateGHG emissions by putting a price, through a carbon tax ora cap-and-trade scheme, on tons of GHG emitted. Doing this throughnational regulation has the potential to cause “carbon leakage,” shiftingGHG-intensive production (such as iron, steel, aluminum,pulp andpa-per, and cement) towards jurisdictionswith less stringent or no regula-tion.Globalizedmarkets for these productsmake such shiftsmore pos-sible,undercuttingemissionscontrolregimes.

Accordingly, measures to correct for the competitiveness-distorting/emissions-leakage effects of domesticGHG regulationmayprove anec-essarycomponentof suchnational schemes,bothasamatterofdomes-tic political viability (to guard industry against unfair competition withforeign goods not subject to similarly stringent climate costs) and envi-ronmental effectiveness (to ensure that total GHG emissions are actu-allyreduced).Iwillcallsuchmeasuresborderclimateadjustment(BCA)schemes,bywhichIwillmeanageneralcategoryofnationalregulationsdirectedatcertaincategoriesofimportedproducts,whichseektoimposea total price on the production of these goods approximating the totalpriceimposedontheproductionoflikedomesticgoods.

The ultimate purpose of a BCA scheme is to substantially preemptemissions leakage. A BCA scheme (used in conjunction with a similarcost internalization scheme imposed on domestic producers supplyingthenationalmarket) ensures that thedomestic emissions reductions arenotoffsetby thepresenceofnon-regulatedproducts in themarketplace.IfGHGsemitted in the courseof industrialproductionare regulatedbyanational cap-and-trade schemecoupledwith aBCA for imports—thatis,ifthepointofclimatecostpaymentoccursatpointofmarketentryinthedestinationmarket—theproblemofemissionsleakagedoesnotariseto the same extent. Because foreignproduction costs are equalizedwiththoseofdomesticproduction throughBCAschemes,producers face thesame costs of selling goods in thedestinationmarket irrespectiveof thelevelofGHGregulationinthecountryoforigin.

The use of a BCA-enabledmarket-access-conditioning approachmayfacilitate the gradual build-up of an eventually comprehensive globalGHG management regime by leaving it up to each state to effectivelyregulateitsowncontributiontoongoingGHGemissionsfromindustrialproductionworldwide.Toprevent against emissions leakage—that is, toeffectivelyregulatesomediscreteportionofcontinuedglobalGHGemis-sionswhichmaybedirectlytracedbacktoconsumptiondemandswithin

268 Alexandra Khrebtukova

agivennationalmarket—StateAregulatesGHGsemittedinthecourseofproducingonlyandall thoseunitsof (covered)production thatenter itsmarket,whetherhome-madeor foreign.Asproducts fromStateB incurcostswhenexportedtoStateA(andsoproducersbasedinStateBcom-plaintotheirgovernment),StateBwillseekinreturntogeneraterevenuefromimposingitsownclimatecostsupongoodsimportedfromStateA.BecauseWorldTradeOrganization (WTO)Membersareonlypermittedto impose costs upon imports from otherMembers evenhandedly withlike costs imposed on like domestic products, the political feasibility ofinstitutingdomesticregulationinStateBisthusincreased.

AnticipatingthelikelihoodthatcountriesoforiginsignificantlyaffectedbyBCAcostsmayseektosubjectStateA’sexportstoBCAasaconditionformarket entry, StateAwithdraws products destined for consumptioninothermarketsfromitsregulatoryscope,possiblythroughremittingal-lowances back to exporting producers. As States B, C, D, etc., begin tosimilarly regulate GHGs emitted because of consumption demands forcertainGHG-intensiveindustrialproduction—that is,asotherStatesbe-gin to similarly conditionaccess to theirmarket (forbothdomestic andforeigncoveredgoods)onthepaymentofapricefor(approximately)eachtonofGHGemittedperunitofproductionseekingmarketentry—anin-creasingquantityofGHGemissionsattributabletoglobalproductionef-fortwillbeplacedwithinthescopeofaneffective(becausenotsubjecttoemissionsleakage)climatecost-internalizationregime.

Becausetheregulatorypurposeofawell-designedBCA,coupledwitha national cap-and-trade scheme which initially allocates GHG permitsbygovernmentauction,isessentiallythesameasthatbehindadirecttaxleviedatpointofmarketentryforGHGsemittedinthecourseofcertainproducts’ production, such BCAmay, in principle, be structurally con-ceivedintheWTOasalegitimatebordertaxadjustment(BTA)scheme.

AWorkingPartyestablishedby theprecursor to theWTOtoanalyzeandclarifyinternationaltradelawonBTAsadoptedthefollowingdefini-tionof taxes: “compulsory, unrequitedpayments to general government.Theyareunrequitedinthesensethatbenefitsprovidedbygovernmenttotaxpayersarenotnormallyinproportiontotheirpayments.”1Theforcedinternalizationofclimatecosts intocostsofproduction throughmanda-toryrequirementstopurchaseandretireanumberofGHGemissional-lowancesorcreditsequal to the tonsofGHGemitted in thecourseofagiven compliance period easily fitswithin this broaddefinition. Leavingasidethespecialproblemsofallowancesdistributedtodomesticindustry


atnocostby thegovernment, themarketpriceofGHGallowancespaidtothegovernmentatauction, inadditiontoanypenaltiespaidforeveryton ofGHG emitted in excess of surrendered allowances or credits, arepaymentstothegovernment.

One could argue that a governmental program imposing a price oneverytonofGHGemitteddoesnotrequireunrequitedpaymentbecauseinreturnforpayment, theregulatedentityreceives theright topolluteaquantityofGHGtonsprecisely inproportiontothatpaidfor.Neverthe-less, as amatter of public policy, GHG emission allowances should notbeconceivedasbenefitsinproportiontothepaymentsmadetothegov-ernment in termsof theirmarketprice, as itwouldbe inconsistentwiththegeneralspiritofnationalGHG-cappinglegislationtoconstruesuchanActascreatingbeneficialrightstopollutewhenitslong-termgoalsareinfacttodrasticallyreduceoreliminateGHGemissions.Moreover,aspricesincrease over time (due to lower caps, higher taxes, or more stringentstandards)therelationshipbetweentaxsurrenderedand“benefit”grantedbreaksdownevenfurther.

Importantly,theAgreementonSubsidiesandCountervailingMeasures(SCM) explicitly allows the remission of prior-stage cumulative indirecttaxeson“energy,fuels,andoilusedintheproductionprocess.”2AWTOMember’sdomesticGHGmanagement regimewhichmandates thepay-mentofsomepriceforeverytonofGHGemittedinthecourseofGHG-intensive regulated entities’ production effort over a given timeframe isessentially a scheme which imposes a tax upon GHG-intensive energyusedinthecourseofcertainindustrialproduction:themajorityofGHGtonsemittedinthecourseofGHG-intensiveproductionisduetotheen-ergy consumed inproducing, rather than someother aspect of thepro-ductionprocess.Accordingly,wereaWTOMembertochoosetoregulatesuchGHG emissions on the destination principle—that is, to impose aprice upon only thoseGHG tons attributable to products consumed onthehomemarket—then,undertheSCMAgreement,thatMembercouldlawfully remit payment for such quantity of GHG that is proportionateto theportionof total regulatedproductioneffort that is exported tobeconsumed(andpresumablyregulated)inothermarkets.

Thesamelegalprinciplesthatgoverntheadjustabilityofconsumptiontaxeswithrespecttoproductsdestinedforexportalsogoverntheadjust-ability for those same payments with respect to foreign products enter-ing thehomemarket forconsumption.Because, as reportedby theBTAWorkingParty,“GATTprovisionsontaxadjustmentappl[y]theprinciple

270 Alexandra Khrebtukova

of destination identically to imports and exports,”3 eligibility for adjust-mentwithrespect totheremissionof taxesonexportsdestinedforcon-sumptioninothermarketsipsofactotranslatesintoeligibilityforadjust-mentintheformoftaxesleviedonimportsseekingaccesstotheUSmar-ket.Accordingly,prior-stagecumulativeindirecttaxesonGHG-intensiveenergy used in the course of production are equally adjustable with re-spect to importedproducts seekingaccess toaMember’smarketas theyarewithrespecttoproductsdestinedforconsumptionelsewhere.

GiventhatallBCAsystemsfacethetoughchallengeofcalculatingthelevel of GHG embodied in imported products, I argue for the use of aBCA scheme based on the destination principle rather than the kind ofmeasures included in many existing BCA proposals, which commonlyuse a “comparability-in-effect” test to establish whether imports comefromacountrywith sufficient levelsofGHGregulation.Calculating thecomparabilityofother regulatory systems isnotoriouslydifficult: apriceon carbon can be used as comparator if a carbon tax or cap-and-tradeschemeisused,but(i)pricevolatility,(ii)differentsystemcharacteristics(e.g., coverage, offset use, intertemporal flexibility), and (iii) other regu-lation (e.g., renewable energy standards)make this comparison far fromeasy.Moreover,once a significantnumberofnations regulateGHG in ameaningfulway, theadministrativechallenges facedbyanagencytaskedwithperformingthesecalculationswillmultiplyexponentially.Regulationusing the destination principle entirely avoids these issues and is morelikelytobeWTO-compliant.

Insum,roomcanandshouldbefoundintheglobalclimateregimeformore stringentunilateral action involving theuseofnon-discriminatoryBCAs,whichdoesnotpreclude theuseofothermeasures to correct forhistorical responsibility or developmental inequities, such as side pay-mentsortechnologytransferagreements.BCAmeasures, inconjunctionwith national cap-and-trade schemeswhich allocate capped tradable al-lowancesbygovernmentauction,maynotonlybejustifiedasamatterofworld trade law, butmay alsoofferuniquebenefits for thedevelopmentofeconomicallyefficientandenvironmentallyeffectiveglobalGHGman-agement.Conditioningmarketaccess forcertaindomesticand importedGHG-intensive goods on the purchase of GHG allowances for everyGHG-ton emitted in the course of productionmay thus provide an im-portantclimatepolicymechanism,encouragingthegradualestablishmentof a transborder administrative regime for coordinating the appropriate


levels of cost distributionnecessary to eventually steer the globe towardbothawell-functioningclimateandawell-functioningeconomy.


JavierdeCendra,“CanEmissionsTradingSchemesBeCoupledwithBorderTaxAdjustments?AnAnalysisvis-à-visWTOLaw,”15 Review of European Com-munity & International Environmental Law 131(2006).

Paul Demaret and Raoul Stewardson, “Border Tax Adjustments under GATTandECLawandGeneralImplicationsforEnvironmentalTaxes,”28 Journal of World Trade 5(1994).

RolandIsmerandKarstenNeuhoff,“BorderTaxAdjustment:AFeasibleWay toSupportStringentEmissionTrading,”24 European Journal of Law & Econom-ics 137(2007).

N o t e s

1. SeeWTO,CommitteeonTradeandEnvironment,NotebytheSecretariat,Taxes andCharges for Environmental Purposes—BorderTaxAdjustment,WT/CTE/W/47,2May1997,at6(citingBISD18S/97).

2. World Trade Organization, Agreement on Subsidies and CountervailingMeasures,AnnexI,(h)andaccompanyingNotes.See also id.,AnnexIIn.61(al-lowingremissionofprior-stagecumulativeindirecttaxesoninputs“thatarecon-sumedintheproductionoftheexportedproduct(makingnormalallowancesforwaste)”).

3. GATT,BorderTaxAdjustmentWorkingParty,at¶10(quoted inPaulDe-maret&RaoulStewardson,Border Tax Adjustments under GATT and EC Law and General Implications for Environmental Taxes,28J.World Trade5,30(1994)).

272 Climate Finance

Chapter 32

EnforcingClimateRuleswith TradeMeasures

Five Recommendations for Trade Policy Monitoring

ArunabhaGhoshOxford-Princeton Global Leaders Fellow,

Woodrow Wilson School, Princeton University

Key Points

• Developingcountriesarerightlywaryofpro-climatetrademeasuresbeingusedasprotectionismbydevelopedcountries,andalsoaboutformulationofnewtraderulesandclassificationsforenvironmentalservicesandembeddedcarbon inways that favordevelopedcoun-tryinterests.

• Developingcountriesneedtobuildgreatercapacity tomonitor thetradepoliciesofothercountries,todetectintimeandchallengedis-guisedprotectionism.

• TheWTOTradePolicyReviewMechanismshouldbestrengthenedtocombatenvironmentalmeasuresthatmightbeprotectionist.

• Developingcountriesneedtoincreasetheirexpertiseandinfluenceon climate-related services, standards, and labels, or the rules willbecomeskewedagainsttheirinterests.

• Emissions measurement and self-reporting capacity in developingcountriesmustbegreatlystrengthened.

Lawsbeingdraftedorproposed indevelopedcountries envisage theuseof trade sanctions to induceparticipationby other countries in a global

Enforcing Climate Rules with Trade Measures 273

climate regime, or to level the playingfield for businesses and avoid re-locationandcarbon leakage,or topunishnon-compliant countries. It ispossible that an international climate agreement may eventually autho-rizecertaintradesanctions,aswasdoneintheMontrealProtocolonthestratosphericozonelayerandforotherenvironmentalaims.Newrulesanddefinitionsarebeingdevelopedonissuessuchasliberalizationoftradeinenvironmentalgoodsandservices,andonspecificationsformeasurementofembeddedcarbonandemissions,whichmaydisadvantagedevelopingcountries.SeveralessaysinthisvolumehighlightdifferentareasinwhichclimatelawandpolicyarealreadyhavingtotakeaccountofWorldTradeOrganization(WTO)agreementsontradeandmarketregulation,includ-ing on trade restrictions, subsidies, taxes, and carbon labeling. Linkagebetweenclimatemitigationand trade law is inescapable, andoffersbothattractions and threats from the viewpoint of developing countries.Thisessay focuses first on major concerns developing countries have aboutsuch linkages, and then proposes five specific ways to ameliorate theseconcerns.

What Are Developing Countries’ Concerns with Trade and Climate Linkages?

Theprimarymotivationforusingtrademeasuresisthefearofindustrialcompetition from non-participating countries. A secondary preoccupa-tion is that emissions will increase elsewhere due to carbon leakage iffirmsrelocatetocountrieswithlowerenvironmentalstandards.Whiletheevidenceforleakageandcompetitivenessthreatsismixed—andrestrictedtoafewsectors—proposalsforlinkingthetradeandclimateregimeshavegainedmomentum.

Fromtheperspectiveofdevelopingcountries,anyseriousattemptsorthreatstoaffecttradethroughclimatemeasurespromptavarietyofcon-cerns. Four sets of concerns about the legality and governance of suchmeasurescanbenotedhere.

First,protectionismmaybedisguisedasclimate-friendlypolicies.Theincentivetoexaggeratetheextentofcarbonleakageisstrong,andspecialinterestscouldhijacktrademeasuresforprotectionistpurposes.

Second,althoughtheWTO’sTechnicalBarrierstoTrade(TBT)Agree-ment governs standards and labeling, it does not apply to private busi-nesses.Therefore,firm-leddecisionstoregulateemissionsbyintroducing

274 Arunabha Ghosh

labeling requirementsandstandardscouldadverselyaffectexportswith-outtheprotectionofWTOrules.

Third,therelaxationoftradebarriersagainstenvironmentalgoodsandservices (EGS) may be applied unevenly and disproportionately benefitdeveloped countries.The liberalization of trade in EGS, which includesproducts and services that yield environmental benefits, such as cata-lytic converters and consultancy services onwastewatermanagement, ispartoftheDohaRoundofnegotiations.TheglobalmarketinEGSises-timated to be aboutUSD 550 billion.Developing countries, on average,have lowapplied tariffs againstEGS andviewdemands to reducebarri-ersasastrategyofrichcountriestopromotenewindustrialsectors.1Yet,whenitcomestotheirexportinterestsinenergy-relatedgoods,develop-ingcountriesfacetradebarriersabroad.Brazil’sdisputeagainstabanonethanolexportstotheUnitedStatesorChinafacinganti-dumpingdutiesagainstenergy-savinglightbulbsintheEuropeanUnion(EU)forseveralyearsarecasesinpoint.

Fourth, since developing countries demand technology transfer as acondition for reducing emissions, they have concerns about how strin-gentlyintellectualpropertyrights(IPRs)areenforcedbythetraderegime.StringentIPRscouldincreasethecostsoftechnology,disadvantagefirmsindevelopingcountries,andunderminedomesticabsorptivecapacityfornew technologies. Compulsory licensing, exemptions from patentability,forgoing patents on publicly funded research, andmultilateral funds tobuyoutpatentsaremeansoffacilitatingtechnologytransferthatdevelop-ingcountriesmightadvocateinthetradeandclimateregimes.

Suggestions for Trade Policy Monitoring

Concernsaboutemissionsleakage,industrialcompetitiveness,andmarketaccesscannotberesolvedwithoutconfidenceinthemeasurement,mon-itoring, and enforcementmechanisms in the trade and climate regimesandwithinallstatesinvolved.Compliancewithnegotiatedrulesiscontin-gentoncrediblemonitoring:statesarelikelytorenegeoncommitmentsiftheybelievethattheiractionswillnotbeeasilydetectedormonitored.Inlightoftheprecedingdiscussion,herearefivesuggestionsforstrengthen-ingtrademonitoringandenvironmentalmeasurements.


1.RecognizeCapacityChallengesfor MonitoringTradeMeasures

A first line of defense against illegitimate trade measures is regularmonitoring.Export-orientedfirmscouldkeepalookoutforpolicychangesabroad, but effective monitoring requires institutional capacity. Manycountries collect commercial intelligence through trade attachés in em-bassiesorvia industrybodies.Amoreformalizedprocesswouldincludeadedicatedstateagencywiththemandateformonitoringtradebarriers.Themost institutionalizedapproachat thecountry level involves regularpublication of foreign trade barriers reports, which when disseminatedwidelygivevaluableinformationonexistingandanticipatedmeasures.

Fewcountries,however,havethekindofinstitutionalcapacityneededtomonitor climate-related trademeasures. A recent analysis of seventydeveloped,developing,andleastdevelopedcountries(justunderhalftheWTO’s membership) found that only half of them collected commer-cial intelligence on a regular basis, and less than a fifth published regu-lar reports on foreign trade barriers (Figure 32.1).2A few large develop-ingcountrieshavebuiltcapacityformonitoringspecificareas(say,Brazil

0

10

20

30

40

50

60

0

5

10

15

20

25

30

35

40

Provisions for collecting commercial intelligence

Specialised agency for trade monitoring Formal report on foreign trade barriers

Perc

enta

ge o

f Cas

es

Num

ber o

f Cou

ntrie

s

Number of countries Percentage of all cases

Fig.32.1.FewWTOmembershavethecapacitytomonitorforeigntradebarri-ers(2008).(Source:Ghosh,“SeeNoEvil,SpeakNoEvil?TheWTO,theTradePolicyReviewMechanism,andDevelopingCountries,”D.Phil.Thesis,OxfordUniversity,2008)

276 Arunabha Ghosh

inagricultureandIndia foranti-dumpingmeasures).Wideruseof trademeasures would require a requisite increase in capacity for developingcountriesingeneral.

2.StrengthenWTOMonitoringof ProtectionistMeasures

A more efficient alternative to country-based monitoring is institu-tional monitoring by the WTO. The WTO’s own Trade Policy ReviewMechanism(TPRM)periodicallyreviewsmemberstates,basedonWTOreports,government reports,andreviewmeetings inwhichallmemberscanparticipate.Althoughreviewsaremorefrequentforthelargesttradingpowers, even those only occur in two-year intervals.More significantly,thankstoresourcelimitationsandagrowingmembership,theWTOhasnevermanaged to conduct the requisite number of reviews as requiredeachyear (Figure 32.2).Further, inonlyhalf the caseswheredeveloping

0 5 10 15 20 25 30

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

Number of Reviews

Ye

ar

Number of actual reviews conducted per year Number of reviews required by review cycle (assuming 6-year cycle for LDCs, as well)

Fig.32.2.TheWTO’scapacitytomonitortradepoliciesisconstrained.(Source:Ghosh,“SeeNoEvil,SpeakNoEvil?TheWTO,theTradePolicyReviewMecha-nism,andDevelopingCountries,”D.Phil.Thesis,OxfordUniversity,2008)


countriesformallychallengedtrademeasuresdidthereportswarnaboutthecontentiousmeasures inadvanceof thedisputes.Withthisrecord, itis obvious that themonitoring of climate-related trademeasures cannotbeaccomplishedwithexistingresourcesorwith theexistingmandate intheWTO.

TheWTO also has a system of notifications, whereby countries sub-mitinformationeverytimenewtrademeasuresareintroduced.Butevenrichcountriesoftenfailtosubmitnotificationsontime.Developingcoun-tries fear that gaps in notifications are deliberate strategies to withholdinformation.

More credible monitoring of climate-related measures would need,firstandforemost,anincreaseintheresourcesallocatedtotheWTO.In-creasedresourceswouldallowformorefrequentmonitoringbytheTBTCommittee and the Committee on Trade and Environment and morecomprehensive reports under the TPRM. A second necessary reformwouldbetostrengthenthenotificationsprocessbyrequiringcountriestonotifytheWTOofclimate-relatedmeasurespriortoimplementingthem.ThisprocedurehasbeenadoptedinnewmonitoringmechanismswithintheWTO dealing with sanitary and phytosanitary standards (SPS) andregionaltradeagreements.Athirdrequirementwouldbetoaskcountriestoexplaintherationalebehindplannedmeasures(againadoptedforSPSmonitoring).Thiswouldincreasetransparency,limitthecosttodevelop-ingnationsofchallengingpotentiallyunfairtrademeasures,andfacilitatetheabilityofthewiderWTOmembershiptoapplypressureagainstcon-tentiousmeasures.

3.DefineCategoriesforEnvironmental GoodsandServicesClearly

To liberalize trade in EGS, environmental goods and services wouldneedtobeclearlydefined.TheWTOusesasix-digitlevelofproductclas-sification,whichmakes itdifficult todistinguishbetweenenvironmentalgoodsandotherproducts.Itisalsodifficulttodeterminewhichproductsto liberalize when the product has multiple uses. Developing countriesare unwilling to open up entire product categories to import competi-tion. Similarly, trademeasures to counter leakagewould have to be tar-getedprecisely at thoseproductswhoseproductionmethods areproventoadoptlowerenvironmentalstandards.Poorlytargetedmeasureswouldotherwisefacechargesoftradediscrimination.

278 Arunabha Ghosh

4.OvercomeMeasurementChallengesofEmbodied CarbonacrosstheSupplyChain

Anothertypeofmeasurementdifficultyarisesfromnotionsofembodiedcarbon, i.e., theamountofCO2 emittedduringeachstageofaproduct’smanufacturinganddistributiontoconsumers.Nostandardmethodologyfor this measurement has been adopted. Top-down analysis is difficultbecause sectoral averages could differ from the specific carbon-intensityof individualproducts.Ontheotherhand,the levelofdetailrequiredinbottom-upprocess examinationswould impose capacity burdensonde-veloping countries.Thus, even if methodologies were agreed upon, thecapacityquestionwouldstillneedattention.

5.BuildDevelopingCountries’Capacityto MonitorEmissions

Thefinalissuerelatesmoredirectlytothecapacityofdevelopingcoun-tries tomeasureemissions.Non–Annex I (NAI)parties submit invento-riesaspartoftheirnationalcommunications,whichdonotincludetimeseriesdataandcoveronlyCO2,methane,andnitrousoxide.Todate,al-though 134NAIpartieshave submitted theirfirst communications, evensomeof the largestdeveloping country emittershavenot submitted fur-ther reports (Figure32.3).This ispartlya strategicmove towithhold in-formation until a climate deal is agreed. But formany other developingcountries,theself-reportingstructureisunderstrain.

Building capacity to monitor emissions is not going to be easy.TheUnitedNationsFrameworkConventiononClimateChange’s(UNFCCC)ConsultativeGroupofExperts,whichprovided technical support tode-veloping countries, allocated onlyUSD 100,000 per country tomonitoremissions. Its mandate expired in 2007 and was renewed only in June2009. Although new centralized satellite technologies could measureemissionsanywhereintheworld,thereisstillacaseforcapacitybuildingwithin individual countries.The climate regime is complex, and parties’willingnesstoparticipatewould,inpart,dependontheirabilitytomoni-torandverifydataontheirownwithouthavingtodependsolelyondatageneratedbyrichcountriesorinternationalorganizations.


Conclusion

WTO rules and institutions are likely to become involved with climate rules in numerous ways. Developing countries have many concerns which, if not properly addressed, may limit the effectiveness or fairness of any global climate change agreement and of the WTO. It will be impos-sible to address many of these concerns unless transparent, effective, and fair monitoring systems are put into place. Otherwise, so-called efficient outcomes in climate negotiations might stumble during the implementa-tion, monitoring, and enforcement stages.


For an overarching paper on links between environmental and trade policy, see Jeffrey Frankel, Global Environmental Policy and Global Trade Policy (Harvard Project on International Climate Agreements, October 2008).

0

5

10

15

20

25

30

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Num

ber o

f Com

mun

icat

ions

Year

NC-1

NC-2

NC-3

Fig. 32.3. Few Non–Annex I parties have submitted more than one national com-munication. (Source: Author analysis)

280 Arunabha Ghosh

Arecentproposalsuggestingpositivelinkagesbetweenstandardsandaccesstotrademarkets:ChristianBarryandSanjayReddy, International Trade and Labor Standards: A Proposal for Linkage(NewYork:ColumbiaUniversityPress,2008).

Foranin-depthanalysisoftheworkingsoftheTPRM,seeArunabhaGhosh,“Information gaps, information systems, and the WTO’s Trade Policy ReviewMechanism,”Global Economic Governance Working Paper 2008/40,(Oxford,May2008).

Forareviewofthemeasurement,reporting,andverificationarrangementsintheclimateregime,seeClareBreidenichandDanielM.Bodansky,Measurement, Reporting and Verification under the Bali Action Plan: Issues and Options (Pew CenteronGlobalClimateChange,April2009).

N o t e s

1. Veena Jha, “Environmental Priorities and Trade Policy for EnvironmentalGoods:ARealityCheck,”ICTSDIssuePaper 7,September2008.

2.ArunabhaGhosh,“SeeNoEvil,SpeakNoEvil?TheWTO,theTradePolicyReviewMechanism,andDevelopingCountries,”OxfordUniversity,D.Phil.The-sis,2008,pp.257–262.

Climate Finance 281

Chapter 33

CarbonFootprintLabelingin Climate Finance

Governance and Trade Challenges of Calculating Products’

Carbon Content

SandraG.MaysonScholar, Institute for International Law and Justice,

NYU School of Law

Key Points

• Carbonfootprintlabeling(CFL)attemptstoquantifytheGHGemis-sions attributable to a product throughout its life cycle, from theharvestingofrawmaterialsthroughproductdisposal.

• CFLcouldimposeanincreasedregulatoryburdenonsmallproduc-ers and a relatively greater abatementburdenondeveloping coun-tries.

• AnumberofCFLstandardshavealreadyemerged,backedbygov-ernments,NGOs, industry groups, and the ISO.Divergent choicesin calculation methodologies (what emissions a CFL covers andhowtheyaremeasured)havecontributedtothismultiplicity.

• Governments seeking to ensure thatmandatorynationalCFLpro-gramsareWTO-compliantshouldadoptasoundinternationalCFLstandard, createdwithwide national and stakeholder participationand sufficiently flexible to accommodate individualized producerdata.

282 SandraG. Mayson

Yesterday, itwas trans-fat; today,carbonfootprint labelsareproliferatingongrocerystoreshelves.Carbonfootprint labelspurport toquantify theembodied carbon of a given product: the total quantity of carbon diox-ideand(insomecases)othergreenhousegases(GHG)forwhichasingleproduct—apear,acellphone,at-shirt—isresponsibleoverthecourseofits life cycle, from creation through use and disposal. Carbon footprintlabeling (CFL) is a new phenomenon but has already staked a place inthe climate regulatory landscape. Viewed most optimistically, CFL har-nesses consumer demand for low-carbon products to encourage emis-sionsreductionsdownsupplychains.Critics,however,seeCFLasaformof disguised protectionism, devised by industry or well-meaning non-governmental organizations (NGOs) and promoted by governments inthedevelopedNorth tocounter thecomparativeadvantageofproducersintheglobalSouthsubjecttolessstringentemissionscontrols.

CFLmayserveasavaluable informational tool topromoteawarenessaboutproducts’emissionscosts.Earlyevidencesuggeststhatproductfoot-printlabelinghelpsfirmstoidentifyCO2emissionshotspotsalongsupplychains.CFLisalsointended,however,toattachacosttogreenhousegasemissions.Ifconsumersrespondtocarbonlabelsinpurchasingdecisions,CFLshouldresultinalossofmarketshareforhigh-emissionsgoodsandservices, andcreatemarket access (or advantage) for goods and serviceswith lowcarboncontent.Byoneview, this is a formofprotectionism—at least ifCFLismandatedbygovernments.Thedifficultyofquantifyingcarbon content compounds the risk that CFLmight distortmarkets, orstrainotherclimatelawregimesbycreatingseparateincentivesforemis-sions reductions. Critics also fear that carbon labels will distract fromotherexternalitiesofproductionandconsumption.

Giventheirregulatoryanddistributionalimplications,thedevelopmentofCFLstandardsdeservescloseattention.Whodecideshowtocalculateembodiedcarbon?NGOsandindustryhavetakentheleadtodate.Theirlabeling standards could, through market impact down supply chains,havesignificanteffectsonclimatefinance—yettheyoperatelargelyinde-pendentlyofinternationalclimateagreementsandofficialstatemeasures.This situation raises important questions about the governance and ac-countabilityofCFL standardizationprocesses. It alsomakes the analysisofCFL’slegalityundertheWorldTradeOrganization’s(WTO)traderegu-latorydisciplinescomplex,since itdepends, inpart,onwhether labelingprogramsaremandatedorpromotedbygovernmentsorestablishedsolelybynon-stateactors.

Carbon Footprint Labeling in Climate Finance 283

The Rise of Carbon Footprint Labeling

Developinga carbon label isno simple task.Labels takedifferent forms.Comparativelabelssimplypresentinformationaboutaproduct’sembod-iedemissions,likeafoodnutritionlabel.Endorsementlabelssignifythata product’s embodied emissions fall below a given threshold.Organiza-tions that issue labels may require emissions reductions or third-partyverificationasaconditionofthelabel’suse.

Calculatingtheemissionsforwhichasingleproductisresponsiblere-quireschoicesaboutwhat tomeasure(the“systemboundary”)andhow.Will the calculation include emissions frommachinery used to harvestrawmaterials?Fromfactoriesthatproducethemachinery?Fromlandusechange?Workertransport?Whatlevelofdataspecificitywillberequired?ALifeCycleAnalysisapproachrequiresindividualsourcedata,whileen-vironmental input-output (EIO) analysis uses sector-level national aver-ages.Labeldesignersmustalsodecidehowtoaccountforthefactthattheemissionsmight vary according to the user’s choices (e.g., to recycle ornot)andcontext(e.g.,localenergygrid).

Critics contend that these and other conundrumsmake it impossibletoaccuratelyquantifyaproduct’scarboncontent.Thevariablesaresimplytoo uncertain, and the methodological choices too arbitrary. A myopicfixationoncarbonfootprints,moreover,maydistractfromotherenviron-mentalandsocialcostsofproduction.Othersarguethatcomplex,costlylabelingstandards imposeadisproportionateburdenonsmallproducersand circumvent theprincipleof common-but-differentiated responsibili-ties, since—international treaty agreements notwithstanding—producersin developing economies must either monitor and reduce emissions orlosemarketshare.

Despitesuchconcerns,carbonlabelsaremultiplying.Whileotheren-vironmental and social labeling programs took decades to evolve, CFLhasbecomeaninternationalphenomenoninthespaceofafewyears.Thepioneerinitiativeshavebeenhybridprivate-publicprojects,thoughsomeNGOandindustryeffortsareprogressingwithnostateinvolvementatall.

Themost advancedCFL regime is PubliclyAvailable Standard (PAS)2050, designed by the British Standards Institute in collaboration withtheBritish government’sDepartment for Environment, Food, andRuralAffairs (DEFRA) and the Carbon Trust, a government-funded NGO.Twoother hybridCFL initiatives are vying for international status:Onelaunched by the Greenhouse Gas Protocol (a partnership between the

284 SandraG. Mayson

NGOWorldResources Institute and the industry collectiveWorldBusi-nessCouncilforSustainableDevelopment),whichdevelopedasuccessfulset of corporate accounting standards for GHG emissions; the other bythe International Organization for Standardization (ISO) (which essen-tially adopted theGHGProtocol’s corporate emissions accounting stan-dardin2006).

Atthenationallevel,tenGermancorporationshavejoinedforceswiththeWorldWideFundforNature(WWF)andtwoacademicinstitutestodevelop a labeling standard.TheUS-basedNGOCarbon Fund andCa-nadianNGOCarbonCountedare certifying low-carbonproducts. Swed-ish organic standards association Krav has a label underway. Industry-sponsored labels include thosedevelopedbyFrench supermarket chainsCasinoandE.LeclercandSwitzerland’sMigros.

GovernmentsareincreasinglypromotingCFL.JapanandSouthKoreahave both announced plans for government-run labeling regimes. TheBritish government has been integrally involved in the development ofPAS 2050; the Greenhouse Gas Protocol’s Steering Committee includesgovernment agencies from a handful of countries; and the ISO is com-posedofnationaldelegations.TheEuropeanParliamenthascalledforthedevelopmentofdatatoenableGHGfootprintlabeling(includingonim-ports)andisdevelopingaCarbonFootprintMeasurementToolkit.IftheUSCongresspasseslegislationrequiringbordertaxadjustmentsbasedonproducts’embodiedcarbon,itwillhavetoaddresscarbonfootprintingaswell.TheCalifornia legislature, finally, is considering the proposedCar-bonLabelingAct,whichwouldrequirethestatetocreateandimplementa(voluntary)carbonlabelingprogram.

Harmonization of CFL Standards?

The short history of CFL illustrates conflicting trends: diversificationamong labels and a drive towards uniformity. Almost every institutionthathas launched itsown footprinting initiativehas simultaneouslypledfor harmonization.There is no strong evidence of convergence thus far,butmanyCFLstandardsoverlap,andmarketandpoliticalpressuresmaypropelafew—orevenasinglestandard—topreeminence.TheemergenceofadominantCFLstandardcouldlowerimplementationcostsandmiti-gate CFL’s potentially disproportionate burden on small producers anddevelopingeconomies.Theprecise termsofanysuchstandard,however,


would have varying competitiveness implications for different countriesandfirms.

WhilePAS2050mayprovideabasisforauniversalstandard,theGHGProtocol and ISO appearmost likely to achieve it.TheGHG Protocol’sexplicitobjectiveistocreateaharmonizedinternationalstandard,whichithopes the ISOwilladopt.Given thesuccessof theGHGProtocolandISO accounting standards, the ISO’s international profile, and theGHGProtocol’s carefulmulti-stakeholder process, aGHGProtocol/ISO prod-uctfootprintingstandardcouldwelldominatethefield.

CFL and the WTO

TheWTOTBTAgreementrequiresthattechnicalstandards,whichwouldincludecarbonfootprintlabelingstandards,thatareadoptedormandatedbygovernmentsmustconformtotheproceduralandsubstantiverequire-mentsnormsforstandardsettingprovidedintheTBTAnnex3CodeofGoodPractice.Technical regulationsare required tobenon-discrimina-toryand“notmore trade-restrictive thannecessary to fulfill a legitimateobjective.” In the case of domestic or regional voluntary standards ad-opted by non-governmental bodies,WTOmembers are obliged to take“suchreasonablemeasuresasareavailabletothem”toensurecompliancewithAnnex3norms;thisobligationdoesnotextendtointernationalstan-dards. It is unclearwhatdegreeof government involvementor endorse-mentmightbe sufficient tomake theTBTdisciplinesdirectlyapplicabletostandardsettingbyaprivatebody.Wouldaprivateprogrambesubjecttochallenge ifagovernmentsetsmandatorycriteria for,or regulatesac-cessto,acarbonlabel?WouldtheUK’ssponsorshipofPAS2050(viatheCarbonTrust) suffice?WTO lawand jurisprudenceoffer scantguidanceonthesequestions.

CFLstandardsmayalsoengageTBTprovisionsestablishingthatwhenaWTOmembercountrybasesa technical regulationon“relevant inter-national standards” set by a “recognized body,” it enjoys a presumptionof legality.TheTBTdoesnotdefine “relevant international standard”or“recognized” standard-setting body. Nor does it address a situation ofcompetingstandards.AWTOmember thatadoptedaprivateCFLstan-dardcouldwellseektoinvokethepresumption,requiringaWTOdisputesettlementpanelandtheAppellateBodytoclarifytheseissues.GiventheeconomicandenvironmentalstakesofCFLstandard-setting,itwouldbe

286 SandraG. Mayson

appropriate for aWTO tribunal taskedwithdecidingwhetherornot toextend a presumption to a private CFL standard to determine whetherthestandard-settingprocessthatproduceditistransparent,whetherital-lows formeaningful participation by affected interests, andwhether thestandard-settingbody justifiesdecisionsbypublic reasons and evidence.Other TBT provisions that might be relevant to the legitimacy of CFLregimes include the Agreement’s code on conformity assessment proce-dures; its exhortation to allowmarket access to goods that complywithexportingcountries’regulatorystandards;andtheobligationofdevelopedcountriestoassistdevelopingcountryproducerstocomplywith labelingrequirements.

Alternatively, a governmentmight use CFL standards ormethodolo-gies to exclude certain productswith high carbon footprints, or imposea tax on products with heavier footprints. Such a regulation would notonly be subject to theTBTdisciplines but also potentially be subject tochallengeasdiscriminatoryundertheGATT.Thecentral issuewouldbewhetherproductswithheavierfootprintsare“like”similarproductswithlighterfootprints.Ifso,theymustbetreatedthesameunlessthegovern-mentimposingthelabelcanjustifythedisparatetreatment.Thequestioniswhetherthemethodsbywhichaproduct isproduced,consumed,anddisposedof—asopposedtothephysicalcharacteristicsoftheproductit-self—arerelevantindetermininglikeness.Giventhatconsumersmaydif-ferentiate between products with varying levels of embodied emissions,thereisareasonableargumentthatheavy-footprintproductsarenot“like”light-footprint products under the GATT. Even if the products at issueweredeemed like, governmentmeasures treating themdifferentlymightstillpassmusteronashowingthatthemeasuresarenecessarytoprotecthuman, animal, or plant life or relate to the conservation of exhaustiblenatural resources. Such a justification would require, among other cri-teria, that a labeling regime be procedurally fair and flexible enough toaccommodate divergent practices among producers. An EnvironmentalInput-Output (EIO) methodology based on national sectoral emissionsaveragesmightfail.

Conclusion

Whether carbon labels come to function as de facto conditionalities oninvestmentorjusthelptoshapealow-carbonculture,itseemsclearthat


theywill remainoneelementof theemergingmatrixof climatefinance.The development of carbon labels by hybrid public-private bodies pre-sentsachallengeforaccountabilityininternationalgovernance.Giventhespecial trade stature of international standards, inclusiveness in interna-tionalCFL initiatives is paramount. Broadparticipationmight help alsomitigate CFL’s distributional impact.These dictates of good governancealso alignwith the objective of developingWTO-compliant national la-belingregimes.Thecloseralabelingrequirementistoawidelyendorsedinternational standard, and the more adaptable to individual producerdata, themore likely the labeling programwill be to passmuster underWTO law.Thatgeneralprinciple inmind, carbon footprint labeling is anew phenomenon. Climate professionals will have to continue to assesstheeffectofcarbonlabelsonotheremissionsreductionsregimes,aswellastheirtradelawstatus,aslabelingregimesevolve.


A. Appleton, “Private Climate Change Standards and Labelling Schemes underthe WTO Agreement on Technical Barriers to Trade,” World Trade Forum (2007).

PaulBrentonetal., “CarbonLabelingandLow-IncomeCountryExports:ARe-viewoftheDevelopmentIssues,”27Development Policy Review243(2009).

JiangKejunetal.,Embedded Carbon in Traded Goods,ICTSDBackgroundPaper(2008).

Part VI

Taxation of Carbon Markets

Climate Finance 291

Chapter 34

Fiscal Considerations in Curbing Climate Change

Lily BatchelderProfessor, NYU School of Law

Key Points

• Thechoicebetweencap-and-tradeandacarbon tax shouldmostlybe made on political grounds, focusing on whether the targetedpricechangeoremissionslevelisclearer,thelikelihoodofaccuratedistributional offsets, budgetary conventions, agency competence,andthesalienceofthecostimposed.

• Climateregimesarehighlyregressive,disproportionatelyburdeningtheleastwell-off.Offsettingthesedistributionalimpactsisdesirablepurelyfromanefficiencyperspective,andalsobecausesuchregres-sivity undercuts one of the fundamental goals of curbing climatechange.

• Carbon taxes are likely to raise more revenue than cap-and-tradeschemes to mitigate distributional effects because of the politicaltendency to allocate many permits for free. Free permits run therisk of benefiting the owners of politically savvy emitters, ratherthan those who are actually burdened. Funds from both schemes,however,mayfailtoreachthosemostaffected,includingtheelderly,disabled,workingpoor,andunemployed.

• Domestically,distributionaloffsetsaremorelikelytobesufficientlylarge and well-targeted if structured as a universal contributoryscheme, with all carbon revenues transparently used to fund di-rect rebates for all. Internationally, reasonable approaches include

292 Lily Batchelder

gradual extension of permitting or tax regimes to less developedcountries coupledwith international carbon offsets, or excess per-mitallocationsbasedonanobjectivemeasureoffiscalcapacity.

Introduction

Climate change aboundswith fiscal issues. At amacro level, the debatebetween a carbon tax, cap-and-trade system, and command-and-controlregulation isabout theextent towhich the taxsystemis thebestvehicleto address climate policy objectives.At amicro level, energy-relatedfis-calincentivesandthetaxtreatmentofcarbontaxes,carbonpermits,andclimatemarketscanhave important implications fora regime’seffective-ness.Thequestionofhowtoaddressthedistributionalimpactsofcarbonmitigation,bothdomesticallyandinternationally,isalsoafiscalissue.

Thischapterprovidesabriefsummaryofthefiscal,administrative,andpoliticalconsiderationsrelevantindesigningaclimatemitigationregime.It then focuseson the importanceofdistributionaloffsets, and thechal-lenges in implementing them.Otherfiscal issues, including thenutsandboltsoftakingcarbonpermitsandcarbonmarkets,areaddressedbyKane(chap.35)andMargalioth(chap.36).

Fiscal Issues in Climate Regulatory Choices

Whileclimatechangepolicycanbe,andis,implementedthroughavari-etyofmechanisms, includingfiscal subsidies and command-and-controlregulation,thecurrentdebaterightfullyfocusesoncarbontaxesandcap-and-tradesystems.Because the twocan theoreticallybestructured tobeeconomically equivalent, thedecisive issues are political—how eachwillrealisticallybeenactedandimplemented.

Keohane (chap. 5) outlines two critical considerations. Because thedamagesfromclimatechangeappeartorisesharplyabovesomeemissionslevel,cap-and-traderegimescanminimizeexternalitieswithfeweradjust-ment costs.Allowingpermit banking can address permit price volatilityunder a cap-and-trade scheme. In addition, the fact that a carbon tax isdenominatedasa“tax”maygeneratemorepoliticaloppositionandthuslimititsscale.Nevertheless,threeadditionalfiscalissues,describedbelow,

Fiscal Considerations in Curbing Climate Change 293

areusuallyoverlookedandhighlight that theremaybenoone rightan-swer.Thebest choice between carbon taxes and cap-and-tradewill varybycountry,andmaybeahybridofthetwo.

DomesticBudgetaryConventions

Howaclimatemitigationregimewillbetreatedunderacountry’sbud-getary conventions and procedures may be important when selecting aregime.TheEU, for example, requires a unanimous vote for tax legisla-tion,butonlyamajorityvoteforotherbills.Asaresult, ithasadoptedacap-and-traderegime,whichpolicymakerswerecarefultoensurewasnotcategorizedasa tax. Inothercountries,however,enactingtax legislationis typically easier.Forexample, theUSperiodically requires fullypayingfor the cost of any legislation with revenue raisers. Costs and revenueraisersarecalculatedoverafive-orten-yearbudgetwindow.Theserulestend tomake it easier topass tax legislationbecause the taxcommitteescontrolwhichrevenueraisersarepassed.Theyalsoartificiallyreducethebudgetary cost of legislation that raises revenue in the short termwhiledeferringcoststothelongterm.Cap-and-traderegimesaremorelikelytograndfatherexistingemitters in the short term,whichartificially inflatestheirbudgetarycost,andarenottreatedastaxes.Thus,theymaybemoredifficulttoenactinaUS-stylebudgetaryenvironment.

DomesticAdministeringAgency

Statesmustalsoconsiderwhatagencycanadministertheregimemostefficiently.Revenueagenciesusually take the leadoncarbontaxes,whileenvironmental agencies take the lead on permitting regimes. Revenueagencieshave theadvantageofextensiveexperience inauditingandcol-lection, and typically administer energy-related taxes and subsidies al-ready.Buttheirprimaryfocusisonmeasuringincome,notemissions.Anenvironmentalagency,bycontrast,may focusmorenarrowlyon thisdi-mensionandobtainhigher compliance rates.However, thesedifferencesare probably overstated. Countries are increasingly giving substantialresponsibility to other agencieswhen administering tax programs. Like-wise, permitting agencies can verify carbon usemore effectively if theypartiallyrelyoninformationfromrevenueagenciesonfirms’incomeanddeductions.

294 Lily Batchelder

OffsetstoMitigateDistributionalInequity

Because the impact of any climate regulatory regime is likely to bestrongly regressive, a final important issue is what distributional offsetsare likely to accompany each approach.As explainedbelow, suchoffsetsaredesirablepurelyon efficiencygrounds.They are alsonecessary froman equity perspective, even if one disregards historical contributions toclimate change and claims that the current global economic distribution is unjust. In addition, they are important practically.While low-incomeindividualsandcountriestypicallyhave lesspolitical influence, theymayneverthelessblockenactmentofaclimateregimethatdisproportionatelyburdensthem.

Carbon taxes are likely to raise more revenue that can be used forsuchoffsets.Allocatingfreepermitsunderacap-and-tradesystemisan-otherway to limit the distributional impacts. But it is lesswell targetedbecausemuchof thevalueaccrues to investors in recipientfirms, ratherthan the consumersburdened. Freepermits can also result in inequitiesandinefficiencies ifsomeindustriesandcountriesobtainthemforemis-sion reduction efforts that they would have undertaken absent the re-gime.Despite thegreater revenuegeneratedbyacarbon tax,however, itmaybedifficultpolitically todirect suchrevenue to thosemostaffected,asdiscussednext.

Addressing the Regressivity of Climate Mitigation

Offsetting thedistributionaleffectsofaclimateregime iscritical for tworeasons. First, these effects undercut one of the fundamental rationalesfor curbing climate change—avoiding the increased rate of poverty andpreventable deaths that scientists project if we continue on our cur-rent emissions path. In 2000, the World Health Organization (WHO)estimated that climate change already cost about 5.5 million disability-adjusted years of life annually. Stern and others project that further cli-mate change will result in a roughly 11% reduction in global GDP, andlarge increases in infectious diseases andmalnutrition.The total diseaseburden will be borne largely by children in developing countries. Thiscreates a strong imperative to act now.As JohnRoemer argues, there islittlereasontoweighttheutilityofcurrentgenerationsmoreheavilythanfuturegenerations.


If the distributional effects of climatemitigation are not offset, how-ever, the regime may increase poverty and preventable deaths on net.Most economists agree that the burden of any climate regime will bebornelargelybylow-incomeindividualsand,ifitismultilateral,individ-ualsindevelopingcountries.Abouthalfoftheworld’spopulationlivesonless than $2 per day. Largely as a result, an immense number of peoplealreadydieofpreventabledeathseachyear.Forexample, theWHOesti-matedthatmalnutritioncostroughly138milliondisability-adjustedyearsof life in 2000, and unsafe water, sanitation, and hygiene cost about 54million.Thevastmajorityofthesedeathsanddisabilitieswerechildrenindevelopingcountries.

Becauseclimateregimestendtoberegressiveonanationalandgloballevel, theywill increase short-termglobalpovertyabsent largeandwell-targetedoffsets.Attheextreme,thispossibilityimpliesthatweshoulddoless to mitigate climate change if distributional offsets are not enacted at the same time. Put differently, if there are no distributional offsets, wewould be addressing the catastrophic costs that climate change imposesonfuturegenerationsbyimposinggreatercatastrophiccostsonthemostvulnerableindividualsinthepresent.

Second, even if these considerations are disregarded, the distribu-tionaleffectsofclimateregimesshouldbefullyoffsetpurelyonefficiencygrounds. Analyzing the efficiency of a policy change requires holdingdistributionalpreferencesconstant.All societieshavedistributionalpref-erences,andredistributionentailsefficiencycosts.Ifdistributionalprefer-enceswere not held constant, one could argue that all regressive policychanges(say,asubsidyforprivateyachts)wereefficient,even if theonlyefficiency benefits stem from an assumption that society’s distributionalpreferenceshavechanged.

In the climate change context, there are two options for holding thelevel of redistribution constant.One is to use all of the revenues poten-tially generated by the regime to fund transfers offsetting its regressiveeffects. Another is to use these rents in other ways (say, to buy off in-terest groups), and raise existing taxes to fund the even larger transfersnecessarytoholdthelevelofredistributionconstant.Thelatterapproachentailsefficiencycostsbecause it increases thedistortions the taxsystemalready imposeson thechoicebetween laborand leisure.Thus, theonlyway to avoid efficiency costs is touse climate revenuesdirectly to offsetthescheme’sdistributionaleffects.Thisistrueevenundertheassumptionthatthecurrentglobaldistributionisfair.

296 Lily Batchelder

AsillustratedbyFigure34.1,climateregimesareindeedhighlyregres-sive,even inapurelydomesticsetting.Lower-incomehouseholdsbearalargerburdenasapercentageoftheirincomebecausetheytendtospenda larger shareof their incomeoncarbon-intensiveproducts.This is alsotrueinothernationsandacrosscountries.

a.ChallengesinEnactingDistributionalOffsets

A number of political dynamics may limit the ability to offset thesedistributional effects of climate regimes. First, experience suggests that,at least initially, cap-and-trade systems tend to allocatemost permits toexisting emitters for free. Theoretically, this could result in permittingregimes addressing distributional effects more reliably. After all, directtransfersandforeignaidareoftenstigmatizedaswelfare.But if freeper-mitsareallocateddisproportionatelytosomefirms,suchasthosethatareold, large,orpolitically savvy, theywillgenerate sharpdifferences in thecostsoftheregimeforcompetingcompanies.Firmsreceivingfreepermitsmaybeabletoraisetheirpricesintheshorttermbythesameamountas

0

1

2

3

4

5

6

7

1st 2nd 3rd 4th 5th 6th 7th 8th 9th 10th

Carb

on T

ax a

s a

Perc

enta

ge o

f Inc

ome

Income Decile

2008 Metcalf GHG Tax $15/ton CO2

2007 Metcalf Carbon Tax $15/ton CO2

2007 Hassett 2003 Data $14.13/ton CO2

2007 Hassett 1997 Data $12.33/ton CO2

1994 Bull Carbon Tax $5/ton CO2

2004 Parry Auctioned Permits

2002 Dinan & Rogers Auctioned Permits

2000 CBO Auctioned Permits

Fig.34.1.EstimatesofburdenofU.S.carbontaxaspercentageofincomebyde-cile.(Source:TraceyM.Roberts,Mitigating the Distributional Impacts of Climate Change Policy (mimeo,May1,2009))


their competitors.Thenmuchof thebenefitof these freepermitswouldaccruetotheownersofsuchfirmsintheshortterm.Thoseburdenedbytheregime—ordinaryconsumers—wouldobtainrelativelyfewbenefits.

In addition, any funds that are raised by carbon taxes or auctioningpermitsmayfailtoreachthegroupsmostaffectedbyclimatechangepoli-cies.These include theelderly,disabled,workingpoor,andunemployed.While somedevelopedcountriesmaybewilling toprovidedirect trans-fers to such households, others, like theUS,may resist doing so.Thereis traditionallystrongoppositionintheUStotransfersthatarenotcon-ditionalonwork.Offsetsdelivered throughthe taxsystemmay farebet-ter,but theyalsopresentpolitical challenges.For example,most incometaxsubsidiesintheUStaketheformofdeductions,exclusions,andnon-refundable credits. These subsidies provide few benefits to householdsin lower tax brackets, and none to thosewith no income tax liability—roughly40%ofUShouseholds.Theonlytaxbenefitsthatcanreachsuchhouseholdsarerefundabletaxcredits,butthesearealsodifficulttoenactpolitically.

Offsettingthedistributionalimpactofaclimateregimeinternationallywillbeevenharder.Thereisstrongoppositiontoincreasingforeignaidinmanydeveloped countries. For example, according to theCongressionalResearch Service andOMB, theUS spends about 1.2% of its discretion-arybudgetonforeignaidaimedatpovertyreduction,muchlessthantheroughly 28percent spentondomestic income securityprograms.Votersmaybeevenmoreresistanttointernationaloffsetsiftheyinvolvecuttingbackondomesticdistributionaloffsetsthattheyhavecometoviewasanentitlement.

b.StepstoEnhancetheEfficacyofDistributionalOffsets

Despitethesechallenges,pastexperiencedoesimplyat leasttwowaystoimprovethesufficiencyandaccuracyofdistributionaloffsetsthatpoli-cymakersshouldconsider.

First, experience with domestic programs like government pensions(e.g., Social Security in theUS) suggests that earmarking adiscrete rev-enue source for transfers structured as a universal contributory schemecanprotectaprogramovertime.Underauniversalcontributoryscheme,allreceivetransferslinkedtocontributions.Becauseallbenefit,andben-efitsarelinkedtoburdens,theytendtogarnermorewidespreadpoliticalsupport.

298 Lily Batchelder

Thisexperiencesuggeststhattherevenueraisedbyanyclimateregimeshouldbededicatedexclusivelytodistributionaloffsets.Thefundsraisedshould be rebated to all households, not just those bearing the largestburdens,perhapsasaflatdollaramountperperson.Pricesonconsumergoods shouldalso separately state theembeddedcostof carbon taxesorpermitssothatitisclearthatallarecontributing.

Second, opaque redistributive transfers appear to garnermore politi-cal support than transparentones.Thiswould imply allocating freeper-mitsinthedomesticcontext,but,asexplainedabove,theyarelikelytobepoorlytargeted.Instead,issuingdomesticrebatesthroughthetaxsystemasrefundabletaxcreditsisprobablythebetterapproach.

Internationally, excesspermit allocationsmaybe theonlyoption thatispoliticallyviable,giventheaversionindevelopedcountriestospendingonforeignaid.However,doingsoraises targeting issuessimilar to thoseinthedomesticcontext.Ifexcesspermitsareallocateddisproportionatelytosomedevelopingcountries,orsomefirmsoperatingthere,theprincipalbeneficiariesintheshorttermmaybetheinvestorsinsuchcountriesandfirms.Theconsumerswhoareburdenedwouldbenefitrelativelylittle.Asaresult,policymakersshouldconsiderusinganobjectivemeasureoffis-calcapacity,suchaspercapitaincome,toallocateexcesspermits.Allow-ing low-incomecountriesnot toparticipate intaxorpermittingregimesmayalsobeeffectivefromadistributionalperspective.Non-participationcould undercut environmental goals given the large share of emissionsfromthedevelopingworld.But iffirmscouldpurchasecarbonoffsets insuchcountriesinlieuofpurchasingpermitsorpayingtaxesdomestically,there would still be incentives to reduce emissions in non-participatingcountries.Asdiscussedelsewhere in thisvolume,such internationalcar-bonoffsetsarepronetogaming,butnewformsmaybemoreeffective.


JosephE.Aldy,Alan J.Krupnick,RichardG.Newell, IanW. H.Parry, andWil-liamA.Pizer,Designing Climate Mitigation Policy(RFFDiscussionPaper8-16,May2009).

TerryM.Dinan,andDianeLimRogers,“DistributionalEffectsofCarbonAllow-anceTrading:HowGovernmentDecisionsDetermineWinnersandLosers,”55National Tax Journal199(2002).

RobertGreenstein,SharonParrott,andArlocSherman,Designing Climate-Change


Legislation That Shields Low-Income Households from Increasing Poverty and Hardship(CenteronBudgetandPolicyPriorities,May9,2008).

A. Haines, R. S. Kovats, D. Campbell-Lendrum, and C. Corvalan, “ClimateChangeandHumanHealth:Impacts,VulnerabilityandMitigation,”367Lancet 2101(2006).

Joint Committee on Taxation, Climate Change Legislation: Tax Considerations (JCX29-09,June12,2009).

JohnE.Roemer,The Ethics of Distribution in a Warming Planet(CowlesFounda-tionDiscussionPaperNo.1693,April2009).

300 Climate Finance

Chapter 35

TaxandEfficiencyunder GlobalCap-and-Trade

MitchellA.KaneProfessor, NYU School of Law

Key Points

• Two approaches to the taxation of carbonmarkets and abatementopportunities can be taken to avoid distorting the market and itsparticipants’ behavior and thereby to preserve the efficiency oftrading-based climate regulatory systems: inter-firm tax neutralityandintra-firmtaxneutrality.

• Inter-firmtaxneutralityrequiresthatallabatementcostsreceivethesame tax treatmentand thatallpermits receive the same tax treat-ment, regardless of the firm which undertakes the abatement oracquirespermits. In thecontextof international emissions trading,thisapproachrequiresharmonizationoftherespectivedomestictaxratesforpermitsandabatement.

• Intra-firm tax neutrality requires that each firm face the same taxtreatment of actual abatement and permits on the margin. In thecontext of international emissions trading, this approach requireseachcountrytoachievethismatching,butdoesnotrequireharmo-nizationoftaxrates.Itdoesnotrequireinternationalharmonizationoftaxsystems.

• In the real world, intra-firm tax neutrality is the preferred policyapproachdue to the lesser degree of required coordination amongnational taxsystems.Thekeychallenge in implementing intra-firmtaxneutralitywillbe tomatch tax treatmentofpermitsandabate-ment.Becausepermits are likely to receive the same tax treatment

Tax and Efficiency under Global Cap-and-Trade 301

for all holders, this means the efficient tax policy will require re-moving national-level tax differences among different methods ofabatement(exceptwheretheyarejustifiedbynon-climateexternali-ties)ormakingthemineffectiveatthemargin.Coordinationofthisparticulartaxpolicygoalwouldbebestachievedundertheaegisofinternationalclimateagreementsratherthanthroughtaxtreaties.

A cap-and-trade regime relies on the price of permits to signal whichabatementopportunitiesarecost-effective,inlightoftheoverallcap.Justlikeanymarketwhereweusepricesignalstoachieveallocativeefficiency,taxationisaloomingproblem.Totheextentthattaxesdistortprices,themarketwillnotfunctionoptimally,impairingtheefficiencyoftheregula-torysystem.Thevery fact thatonerequiresamarket toachieveefficientabatementinthefirstplaceonlyarisesbecausetherearefirm-specificlow-cost abatement opportunities. Such firm-specific opportunities can takeoneoftwoforms.First,somefirmsmayhavelow-costabatementoppor-tunitiesduetotheownershipofsometypeofproprietarytechnologythatallowsproductionwith fewer emissions than competitors. Second, somefirmsmayhavelow-costabatementopportunitiesbecausetheyhappentooperateinjurisdictionswheretherearerelativelylow-costabatementop-portunities.Taxationpresentsthesametypeofpotentialproblemineachof thesecases: abatementopportunities that shouldbe favoredonapre-taxbasis become relatively expensiveon an after-taxbasisdue todiffer-ential tax treatmentoffirmsoperating in themarket, eitherdue to theirmodeofproduction/abatementortheirterritorial locationofoperations.(Some tax preferences might be independently justified by non-climateexternalities,suchasnationalsecurity,andwouldaccordinglynotdistortthemarket;thesepreferencesarenotthesubjectoftheanalysiswhichfol-lows.)Inafirstbestworldtherearetwowaystostructuretaxsystemsinordertopreserveefficientallocationofabatement.Eachapproachinvolvesconceptsoftaxneutrality,buttheyoperateatdifferentlevels.Thus,wecandistinguishbetweeninter-firmtaxneutralityandintra-firmtaxneutrality.

Inter-firm Tax Neutrality

Inter-firmtaxneutralityisthemoreintuitiveofthetwotypesoftaxneu-trality, albeit the form that ismuchmoredifficult to achieve in amulti-jurisdictionalcap-and-tradesystem.Thegoalistoremovetaxdistortions

302 MitchellA. Kane

that operate to shift abatement away from firms which have low-costabatementopportunitiesandtowardfirmswithhigh-costabatement.Forexample, suppose that FirmA can abate a ton of carbon emissions at acostofUSD20andFirmBcanabateatonofcarbonemissionsatacostofUSD15. Ifwe imagine thatFirmA facesa50%marginal tax rateandFirmBfacesa10%marginaltaxrate,thentheafter-taxcostofabatement(which should give rise to a deductible expense under standard incometaxprinciples),willbeUSD10andUSD13.50,respectively.Allelseequal,FirmAwill inefficiently abate on themargin instead of Firm B. To re-movethedistortionitwouldbenecessarytoensurethatFirmAandFirmBface thesametaxrateontheirabatementexpenses.By itself,however,this conditionwouldnotbe sufficientbecause there is anotheraspectofthemarket thatmay give rise to taxdifferentials. Specifically, firmsmayfacedifferentialtaxtreatmentofpermits(e.g.,theacquisitioncostofper-mitsmightbedeductiblebyeachoftwofirmsbutatdifferentrates).Ifweconceiveofacquiringandholdingpermitsasthefunctionalequivalentofnot abating, thenwhatwe requireunder inter-firm taxneutrality is thatall firms face the same tax treatment with respect to (i) actual costs ofabatement and (ii) actual costs of not abating (i.e., acquiring or retain-ingpermitsandusing themtocoveremissions).Note,however, that in-ter-firmtaxneutralitydoesnot requirethatwetaxactualabatementandpermits the sameaseachother. If theyare taxeddifferentially, then inaliquid market we should observe equilibrium price effects on the priceof permits (whichwill capitalize the tax benefit or detriment relative tothetaxtreatmentofactualabatement),buttherewouldbenoreasonforabatement toshift inefficientlyacrossfirms,asnofirmhasanadvantagerelative to any other firmwith respect to either abating or not abating.The chief problem in achieving inter-firm tax neutrality is that itwouldrequireanunprecedenteddegreeofharmonizationoftaxratesandbasesacrosstheworld.

Intra-firm Tax Neutrality

Adifferent typeof taxneutralitywhichcouldbe substantiallymore fea-sible to implementmight be termed intra-firm tax neutrality.The intu-itionhereisthatifeveryfirminthemarketismadetaxindifferentonthemarginbetweenabatingandnotabating(i.e.,acquiringandholdingper-mits),thenthemarkettakenasawholeshouldbeefficient.Thecondition

Tax and Efficiency under Global Cap-and-Trade 303

required to implement this formofneutrality is thatanygivenfirmfacethesametaxtreatmentofactualabatementcostsandthepermitsthatop-erate as substitutes for that abatement.This condition does not requirethatagivenfirmfacethesametaxrateonallpossiblemethodsofabate-ment andpermits that itmight acquire.Thepoint rather is thatwhenasource faces the choicebetweenparticularmethodsof abatement versusholding an additional permit on the margin, then the tax treatment ofsuch abatement and of such permit should be the same.This is crucialbecausetheconditioncanbesatisfiedwithoutharmonizationoftaxratesacrosscountries.ThusifFirmAoperatesinJurisdiction1andJurisdiction2, intra-firmtaxneutralitydoesnotrequirethat it facethesametaxrateonabatementandonpermitsinJurisdiction1andJurisdiction2.Rather,all that is required is the same treatment of abatement and of permitswithineachjurisdiction, i.e., thatFirmAfacethesametaxtreatmenton(i)permitsheld forsurrender to Jurisdiction1andactualcostsofabate-mentwhich reduce emissions in Jurisdiction 1 and (ii) permits held forsurrender to Jurisdiction 2 and actual costs of abatement which reduceemissionsinJurisdiction2,andsoon.

The Pragmatic Policy Solution

Intra-firmtaxneutralityisthesuperiortaxpolicysolutionforminimizingmarket distortions and regulatory inefficiency because it can be imple-mentedwithouttaxrateandbaseharmonizationacrosscountries,whichwouldbeimpossibletoachieve.Thekeyprobleminachievingintra-firmtaxneutralityisthatgovernments,respondingtopowerfulpoliticalpres-sures, will inevitably give tax credits or other preferences for particularabatement technologies or activities. Permits are very likely to receiveuniform tax treatment (e.g., a straight deduction at the taxpayer’s mar-ginaltaxrateintheperiodthatthepermitissurrendered).Butvariationsin the treatment of abatement costsmean that national tax systemswillnever successfully achieve complete matching of abatement and permitcosts.Nonetheless, intra-firm taxneutrality requiresonly thatfirms facethe same tax treatment for permits and actual abatement on the mar-gin. Infra-marginal taxdifferentialsdonotmatter.Thus, it ispossible toachieveintra-firmtaxneutralityinthepresenceoftaxsubsidiesforpartic-ularabatementmethods,solongasthesubsidiesarefullyexhaustedshortofthemarginatwhichfirmschoosebetweenabatementandpermits.For

304 MitchellA. Kane

example,ifacountrygavetaxcreditsforsolarenergy,intra-firmneutral-itywouldbeachieved so longas theprogram isdesigned inaway suchthat any firm that takes advantage of it exhausts its allotment of creditspriortothepointatwhichitmustdecidebetweenfurtherabatementandholdingpermits.

Inthecontextofdomesticclimatetradingsystems,acountrycansuc-cessfully achieve intra-firmneutralitywithout harmonization of tax sys-tems across countries. In the case of trading systems operating amongstates, coordination among countries is needed.The goal is not to har-monizeratesorbasesbuttoagreethatnationaltaxpreferencesregardingabatementshouldbedesignedtooperateonlyinfra-marginally.Moreover,universalcoordinationisnotnecessarytoattainbenefits,whichwillariseas each additional country adopts thepreferredpolicy.Because theulti-mateobjective isadoptionbyall countriesof the samepolicy, coordina-tionismorelikelytobeachievedundertheaegisofamultilateralclimateagreement,rather thanthroughthe fragmentedprocessesofbilateral taxtreaties.The climate framework agreement is also the preferable forumbecausethetaxpolicygoalinquestionhasimportantsubstantiveimplica-tionsfortheefficientandequitablefunctioningofinternationalemissionstrading. If one ormore countries fail to follow the intra-firmneutralitynorm,forexample,bymaintainingtaxpreferencesthatareeffectiveatthemargin, thenwewill observe toomuch abatement in those countries ascomparedtotheefficientoutcome.Moreover,theeffectwillbetodeflateworldwide permit prices because equilibriummarginal abatement costswill bedepresseddue to the taxpreferences.Countries that arenetper-mit exporterswould thus bear a cost in terms of lower permit revenue.Thus, the coordinationof taxpolicywith respect to trading systemshasefficiency anddistributional consequences that go to the coreof climatepolicyandclimatepolitics.


Thomas Eichner andRuediger Pethig,Efficient CO2 Emissions Control with Na-tional Emissions Taxes and International Emissions Trading, CESIfoWorkingPaperNo.1967(2007).

Carolyn Fischer, “Multinational Taxation and International Emissions Trading,”28 Resources and Energy Economics 139(2006).

EthanYale,“TaxingCapandTradeEnvironmentalRegulation,”37 Journal of Le-gal Studies 535(2008).

Climate Finance 305

Chapter 36

TaxConsequencesofCarbon Cap-and-TradeSchemes

Free Permits and Auctioned Permits

YoramMargaliothVisiting Professor, NYU School of Law;

Professor, Tel Aviv University School of Law

Key Points

• Thetaxtreatmentofcap-and-tradepermitscandistortpermitmar-kets and therebyundermine regulatory efficiency; tax rules shouldbedesignedandifnecessarymodifiedtoavoidtheseproblems.

• In terms of basic tax treatment, abatement and permit (upon sur-render to the government) costs should be deductible from grossincome.Nodepreciationdeduction forpermits shouldbe allowed.Anygainsmadeby sellingpermits shouldbe taxable capital gains,unless the seller carries this out as a business, inwhich case thesegainsareordinaryincome.

• The lock-in effect of imposing taxes only when an asset is sold isexacerbated when permits are allocated gratis, distorting permitprices.This effect can be reduced by auctioning permits (with theadditionalpotentialofusingtheproceedstomoderateregressivity)orbytaxingthepermitsuponreceipt.

• First-in-first-outandinventoryaccounting(usingamark-to-marketbasis)canhelpreduceadditionallock-indistortionsassociatedwithfluctuatingpermitprices.

• Makingthetaxsystemsymmetricwithrespecttopermitgainsandlosses will reduce price volatility and resulting lock-in and otherinefficiencies.

306 Yoram Margalioth

• Cap-and-tradeincreasestheimportanceoftransferpricingrulestoprevent market distortions arising through tax arbitrage strategiesbymultinationalfirmsseekingtoexploitdifferencesacrossjurisdic-tionsinthetaxationofpermits.

Thecap-and-tradesystemcreatesanewasset—thepermit.Thetaxtreat-ment of permits can potentially distort the tradeoffs that sources makebetweenabatingorholdingpermitstocovertheiremissions,andtherebyimpair the efficiencyof the regulatory system.This chapterfirstoutlinestheappropriategeneralincometaxtreatmentofpermits.Itthenaddresseswaysofdealingwiththe intensified lock-ineffectsandinefficienciescre-atedbythecurrenttaxsystem’streatmentofgratispermitallocations—byinventorymanagement practices in the face of permit price fluctuationsand by asymmetric tax treatment of permit gains and losses. It also ad-dressestransferpricingproblemsarisingoutofmultinationalfirms’arbi-trage amongdifferences in the taxationofpermits in thedifferent juris-dictionsinwhichtheyoperate.

The Appropriate Basic Income Tax Treatment of Permits

Businessexpenses,thecostsincurredbythetaxpayerintheproductionofincome,mustbedeductibleiftheincometaxistobeimposedonincomeandnotonsales, therebybecominganexcise taxon transactions. In theUS, forexample, section 162(a)of the InternalRevenueCodeauthorizesthe deduction of “all ordinary and necessary expenses incurred duringthe taxable year in carrying on any trade or business.” Abatement costsincurredinordertoproducebusinessincomeincompliancewiththelawclearlyfallintothiscategoryandshouldbedeductedfromgrossincome.Insteadof incurringabatement costs, the taxpayer canobtain,hold, andinduecoursesurrendertothegovernmentapermittocoveritsemissionsat the endof theyear inwhich theyoccurred.Permits therefore replaceabatementcostsandshouldbesimilarlytreatedfortaxpurposesinorderto avoid distorting the abatement/permit tradeoff; although permits arecapital assets, their cost should accordingly be deducted from gross in-comeuponsurrender.

Priortoactualuseof thepermit, thetaxpayercannot invokeadepre-ciationdeductionbecausethereisnoascertainableusefullifeoverwhich

Tax Consequences of Carbon Cap-and-Trade Schemes 307

itcouldbedepreciated.Moreover,thepermitdoesnotexperiencegradualexhaustion,wearandtear,orobsolescence.

If the firm sells or exchanges an emission permit, the difference be-tween the consideration paid to the firm (the amount realized) and itscost basis in the permit will be the taxable capital gain. The firm willrecognizegainor loss in theyearof the saleor exchange,unless anon-recognitionprovisionapplies.

If thefirm is adealer in suchpermits,namely, itholds emissionper-mits primarily for sale to customers in the ordinary course of trade orbusinessofdealing inpermits,anygainor loss realized fromthesaleorexchangewillbeordinaryincome.

Penalties imposed for emittingwithout a permit, or beyond the levelallowedby thepermit, shouldnotbededucted for incometaxpurposes.In theUS, forexample, section 162(f)of theCodeprovides that “node-ductionshallbeallowedundersubsection(a)foranyfineorsimilarpen-altypaidtothegovernmentfortheviolationofanylaw.”

New Tax Challenges Created by Cap-and-Trade

ExacerbatedLock-inEffectIfPermitsAreAllocatedGratis

Incometaxmeasuresthetaxpayer’spotentialtoconsume.Ataxpayer’sabilitytoconsumeisasmuchaffectedbyachangeinthevalueofheras-sets asbya change in theamountof cash shehas.Nonetheless, changesinthevalueofanassetownedbythetaxpayerarenottaxedbeforeare-alization event takes place. Realization is a sale or other disposition ofthe property.The primary reason for the realization requirement is thedifficulty in assessing the valueof assetsbefore they are actually sold.Asecondaryreasonisliquidityproblemsthattaxpayersmayfaceiftheyarerequiredtopaytaxonanasset’sappreciationprior tosaleordispositionoftheasset.

Whenafirmpurchasesapermit,eitherfromthegovernmentinapri-mary auction or on the secondarymarket, it obtains a cost basis in thepermit. Itmayuse thepermit in thecurrentyear tocover its emissions,deductingthecostuponsurrendertothegovernment,oritmaybankthepermitforuseorsaleinthefuture.Ifafirmdecidestobankthepermit,itmustbeexpectingabatementcosts(itsownandothers’)toincreaseinthe


futureataratethat ishigherthantheyield itcanearnoninvestment inotherassets.Theincometax’srealizationrulewill,however,havea lock-ineffectonthepermitmarket.Firmswill tendtodeferpermitsalesthatmightotherwisebeefficientinordertodeferthetaxontheaccruedcapi-talgain.Thisinturnwilldistortthepermit/abatementtradeoff.

Thelock-ineffectwillbeespeciallysignificantwhenpermitsallocatedgratisarenottaxeduponreceipt,asisthecaseundercurrentUSlaw(ac-cording toRev.Rul. 92-16) and as is generally the case under theEuro-peanUnionEmissionsTradingSystem(EUETS).Thefirmshavea zerotax-basisintheirpermits;hencetheincentivetodeferuseorsaleandthelock-ineffectwillbeevengreater.Thisincreasesdemandforpermitsanddistorts theirmarketpriceupward, tending toresult in inefficientlyhighlevelsofabatement.

Similarly, firmswill be tax-induced to defer the use of their permits,that is, tocontinuebanking them.Compared toother investmentassets,investmentinpermitswithzero-basisprovidesatax-preferredreturnforthe following reason. When a purchased asset is realized, the investorcandeductonlythenominal(thatis,historical)cost.Thismeansthattheamountinvestedinpurchasingtheassetisnotevenadjustedforinflation;hence inflationary gains are taxed, and the real value of the investmentisdecreased.Nosuchout-of-pocket investmentexists incase thepermitwasallocatedgratis.Thismakesbankingapermitthatwasreceivedgratisatax-preferredinvestment,distortingitspriceinequilibrium.

Toreducethedistortioncreatedbythe lock-ineffect, thegovernmentcanauctionthepermitsinsteadofallocatingthemgratis.Auctionmaybepreferableonotherefficiencygroundsandonequitygroundsaswell.Thecapcreatesscarcityand,byallocatingthepermitsgratis, thegovernmentgives the scarcity rent to thefirms,which is likely tohave regressive ef-fect to the extent that the rents are retained by firms rather than being passed on to consumers or labor. Moreover, the cap-and-trade system(evenunderagratisallocation)raisesthepriceoftheunderlyingproductsbyimposingacostonproductsbasedontheemissionsgeneratedintheirproduction,therebyloweringtherealwageanddistortinglaborsupply(asleisurecannotbetaxed).Thismaycreatethesameexcessburdenasataxonlaborincome.Ifpermitsareauctioned,therevenuecanpotentiallybeusedtoreducetaxesonincomeandcapitaltocorrectfortheinefficiencymentioned above, and/or to offset any regressive effects created if low-incomepeoplebearalargershareofthepriceincrease.Ofcourse,whetherrevenuesareactuallyspentinthesewaysispoliticallycontingent.

Tax Consequences of Carbon Cap-and-Trade Schemes 309

If,due topoliticalconstraints, thepermitshave tobeallocatedgratis,then they should be taxed on receipt.Thiswill provide the governmentwith revenueandwill give thefirmsa taxbasis equal to the fairmarketvalueofthepermitonthedateofreceipt, therebydecreasingthelock-ineffecttothesamelevelasotherassets.

InventoryManagementIssues

Arelated issue is the inventory ruleused inassessing taxeson stocksof assets. Firmswhichhave purchasedpermits at different prices at dif-ferent times have an incentive to surrender and deduct the costs of themore expensive permitswhile retaining those permits thatwere boughtfor lowpricestosell inthe longterminordertobenefitfromtaxdefer-ral, thereby exacerbating the lock-in effect.This additional effect can bepreventedby requiringfirms tomanage theirpermits’useand saleonafirst-in-first-outbasis.

Alternatively,afirm’sstockofpermitscouldbevaluedandtaxedannu-allyonamark-to-marketbasis.Thevaluesofallpermitsheldbythefirmare aggregated, based on their market values at the beginning and endof each year.The difference between the opening year balance and theendyearbalanceistaxed.Salesandsurrendersofpermitsthroughouttheyeararededucted fromtheclosingbalance,and theproceeds fromsalesare included in taxable income. Eliminating the realization requirementinthiswaywouldeliminatethetaxincentivefordeferringuseorsaleofapermitandassociatedregulatorydistortions.

The advantages of taxing capital assets on an accrual basis are wellknown,andthequestionofwhether it isefficienttodistinguishbetweentraded assets, such as traded securities, and non-traded assets, whosevalueisdifficulttoascertain,hasbeenmuchdebated.Onecouldmakeacasefortaxingtradablepermitsseparatelyonanaccrualbasis.

LossLimitationRules

Allcountrieswithanincometaxlimitthedeductibilityoflosses.Theycanonlybeusedtooffsetgains(sometimesthisrequirement iseasedbyallowing some loss carry-forward to future tax years). Limited-loss de-ductibility introduces an asymmetry because gains are fully taxed but the taxpayermay not be able to deduct all losses.This asymmetrymayexacerbate the lock-in effect as a result of permit price volatility. Firms


may continue to hold permits in years in which they would otherwisesell thembecause if theydid so theywould incur losses thatwouldnotbe fully tax deductible.This problem and the problems ofmarket pricevolatilitymoregenerally(increasinguncertaintytherebyresultinginsub-optimal production levels and in under-investment in innovation) canbeaddressedinthedesignofacap-and-tradesystembyincludingsafetyvalves to limiteitherexcessivelyhighorexcessively lowpermitpricesorboth.Also,making the tax system symmetricwith respect to gains andlosseswillreducethecosttofirmsofpermitpricevolatilityandincreasetheefficiencyofacap-and-tradesystem.Symmetricaltreatmentcouldbelimitedtopermitsorappliedtoassetsmoregenerally. It is impossible toestimate,withoutempiricalsupport,whethertheinefficienciesaregreaterforpermits than for anyother assets,but there seems tobea consensusthat amove to amore symmetric tax systemwould improve efficiency,andthetreatmentofpermitscouldleadtheway.Encouragingthedevel-opmentofmarketsforpermitforwards,options,andswapscouldassistinhedgingtheriskofpricevolatility,therebyincreasingefficiency.

TransferPricingProblems

Countriestendtohavequitedifferenttaxrates,andcap-and-tradecre-atesanewpossibilityfortaxarbitragebymultinationalfirms—purchasinganddeductingpermitsinonecountrywherethetaxrateishigh,thoughtheactualproductiontakesplace inasecondcountrywherethetaxrateis low. In order to dealwith this problem,whichwill impair regulatoryefficiency, countries must require multinational corporations to matchthe deductions of permits with the actual production whose emissionsarebeingaccountedfor,andapplythesametaxratetobothincomeandexpense.Thisisalreadydonebymanycountriesinothercontextsinvolv-ingmatchingofincomeandexpenseitemsthroughtransferpricingrules.Cap-and-tradewilladdsignificantly tothe importanceofsuchrulesandpractices.


On the application of the problem of lock-in to the cap-and-trade system:EthanYale,“TaxingCapandTradeEnvironmentalRegulation,”37 Journal of Le-gal Studies 535(2008).

Climate Finance 311

AfterwordReflections on a Path to Effective

Climate Change Mitigation

ThomasHellerProfessor, Stanford University

Key Points

• There is a danger that in the international community’s quest fora new climate agreement, we will lock things in too early aroundaweakarrangement, although thedoor isopen forus todomuchmore.

• Twoofthemajorchallengestoreachinganinternationalagreementare: uncertainly about the costs and effectiveness ofmitigation ef-forts; and the conflict between developed countries that want tohaveglobalcap-and-tradeanddevelopingcountriesthatdonot.

There aremany challenges along the path to ameaningful climate pol-icy framework,but twostandoutasparticularly threatening.Thefirst isuncertainty.Morespecifically, there isaseriousriskthatnationswillnotundertake meaningful action because of the persistence of uncertaintysurroundingtherelativecostandeffectivenessofpoliciesdesignedtomit-igateclimatechange.

The second major challenge is the tension between the belief that aglobalcap-and-tradeprogramisthebestpolicyinstrumenttolimitglobalgreenhouse gas (GHG) emissions and the demand for fairness in allo-cating carbon caps among states, especially among developing nations.

312 Thomas Heller

Unfortunately,thedebatehasoftenseemedstuckonthistension,butre-cent actions by developing nations have pointed toward a different wayforward.A growing chorus of voices is arguing thatwe need to quicklycreateaframeworkthatwillhelpencourageandfinancebottom-upmiti-gation actions in developing countries even in the absence of caps.De-spitethepromiseofthisapproach,itremainsonthemarginsofthemain-streamclimatechangedebate.

In light of these developments, I am perhaps more afraid of a weakclimatechangeagreementthannoagreementatall.Myfearisthataweakclimate changeagreementwill result in complacency, and shutdownef-forts focused on building a framework to promote the changes that arealreadyemergingoutof thenationalpoliciesofdevelopingnations.Thismaybeourgreatestopportunity tomitigate global emissions reductionsearly,andwecannotaffordtoletitpassusby.

Uncertainty about Mitigation Benefits and Costs

Uncertaintycanoftenhaveaparalyzingeffectonbothpolicymakingandinvestment. Societies and investors alike are averse to accepting policieswith steep price tags when they are uncertain as to whether or not thebenefits outweigh the costs. However, the risks of inaction are so greatastojustifysubstantialinvestmentinmitigationnow.Recentreports(in-cluding theSternReport) showthat thecostsof inactionoutweigh,byasignificantmargin,thecostsofaction;thatthecurrentfailureofmarketstopricecarbonresultsinmassiveinefficiencies;andthatthecostsofpost-poningfixingtheproblemwillonlyincreaseastimepasses.However,thewidespreadresistancetoclimatechangepoliciessuggeststhatmanypoli-ticiansandvotersdonotbelieveintheseconclusionsorareafraidoftheriskthatcostswillbemuchgreaterthanpredicted.

Obstacles to Global Application of Cap-and-Trade

A second fundamental challenge to our ability to limit global emissionsin a timely fashion is the conflict between industrialized nations’ drivetowardsaglobalcap-and-tradesystemanddevelopingnations’resistancetonationalcaps.

Afterword 313

Industrializednationshaveadoptedorareadoptingdomesticcap-and-trade systems andhave reached a consensus that a global cap-and-tradeprogramwouldbe themost efficient and effectivemeans to address cli-matechange.Thisconsensushasemergedoutofbothscholarlyliteratureand experience with actual policies, including failed attempts at impos-ingBTUtaxes in theUSandcarbontaxes inEurope,aswellas thesuc-cess of SO2 trading programs in both the US and Europe.This under-standing has already been embodied in the cap-and-trade structure oftheKyoto Protocol’s obligations forAnnex I countries, aswell as in theEuropeanUnion Emissions Trading System (EU ETS). Amajor part ofsubsequentdiscussionshasfocusedonincreasingtheparticipationinin-ternational cap-and-tradeuntil it encompasses all nations, or at least allmajoremitters.

However, as is often the case in international negotiations, there is acountervailing principle—common but differentiated responsibility.Thisprinciple centerson the recognition that althoughall nationsbear someresponsibility to address global environmental problems, the scope oftheirobligationsvaryaccording toawidevarietyof legitimateconcerns,allofwhichpushagainstaneasyorstraightforwardapplicationofglobalcap-and-trade. Developing countries strongly resist caps.They point tothe developed countries’ historical responsibility for the greater part oftheemissionsthatarecausingwarmingtoday.Moreover, theyaredeeplyconcernedthattheadoptionofnationalcapswillhemintheirfutureeco-nomicgrowthinawaythatisextremelyconstrictiveandunfair.

Because of the resulting impasse, negotiations have been stuck in abind for some time. On the one hand, we acknowledge that cap-and-trade is themostefficient solution.On theotherhand,weareunable toresolvethedistributionalproblemsnecessarytoimplementitonaglobalscale.

Intheshadowof thisdebate,separatediscussionshavegrownaroundalternativemeansoffinancingmitigationactionsindevelopingcountries,as seen inmany chapters in this book.However, these alternatives havenot been fully embraced by either industrialized or developing nations.Industrializednations tend to viewclimatefinance alternatives to globalcap-and-trade as partial solutions at best, a distraction from the largerpushtowardcap-and-trade.Developingnations,ontheotherhand,tendtoviewmanyoftheseproposedmechanismssuspiciously,inpartbecausetheyfearthattheyareahooktodrawthemintobindingcaps.

314 Thomas Heller

Consequences of the Conflict

The consequence of this conflict and the resulting turn toward smaller,narrowerdiscussionshasbeenabalkanizationofclimatechangenegotia-tions.Atpresenttherearemanyspecialnegotiationsandworkinggroupsfocusedonspecificissues,suchastechnologytransfers,flexibilitymecha-nisms,comparability,carbonfinance,anddeforestation.Thisprocesshasbothadvantagesanddisadvantages.Theadvantagesarethatithelpspoli-cymakers refine specific policies, begin to implement them, and gain agreater understanding of the difficulties they and other similar policieswillpresent.Forexample,discussionsaboutforestryhaveresultedinthedevelopmentofawideportfolioofproposedprogramsforreducingemis-sions fromdeforestationand forestdegradation(REDD),amorerefinedunderstanding of how to create an international framework for REDDcrediting, as well as an understanding of the broader challenges in im-plementing REDD and complex problems presented by sectoral caps orcreditingbaselinesgenerally.

However, the disadvantages to this micro-policy approach are thatparties begin to excessively focuson small victories, reduce their expec-tations, and lose sight of themain goal—creating a framework thatwillfacilitate and encourage global mitigation actions on the scale necessary toavertcatastrophicwarming.Inotherwords,wemayendupwithalotofsmallprojectsthatyieldonlysmallbenefitsandoverallarenotparticu-larlyefficientoreffective,atleastwhenviewedfromaglobalperspective.

An Alternative Path Forward

Accordinglytheviewfromthetopisbleak.However,anentirelydifferentpictureemergeswhenonebeginstolookatnational-levelactionsthatareoccurring across awide variety of nations. Increasingly, both developedand developing countries are beginning to view high-carbon economicgrowthasanoxymoron,becauseof fears that thenegativeconsequencesof high-carbon growth will ultimately undercut the gains reaped fromsuch growth. As a result, we are beginning to see changes in develop-ing countries’ national policies that are consistentwith the idea of low-carbongrowth.Evenmorepromising,theseeffortsbecomepartofinter-nationalnegotiations.ThispositionhasperhapsbeenstatedmostclearlybySouthAfrica,whichsaid:wewilldowhatisinourself-interest;wewill

Afterword 315

dosomethingmore than thatbecausewearepartof theglobalcommu-nity,andtherearethingswewilldostillfurtherwithsupportfromthosewho are better positioned tohelpus.To realize this, policymakersmustanswer the followingquestions:howdowe increasemitigationefforts indevelopingnationsintheabsenceofbindingtargets,andhowdowebeststructure and scaleupfinancial and technical assistance fromdevelopedto developingnations in the absence of national caps? It is to be hopedthatthisbookprovidesusefulanswerstothesequestions.

Climate Finance 317

Abbreviations

AAU Assigned Amount Unit under the Kyoto ProtocolACES American Clean Energy and Security ActAFB Adaptation Fund BoardAFOLU agriculture, forestry, and land useBAU business as usualBCA border climate adjustmentBTA border tax adjustmentCC climate changeCCS carbon capture and storageCDM Clean Development MechanismCER Certified Emissions Reduction under the CDMCFL carbon footprint labelingCFU World Bank Carbon Finance UnitCITES Convention on International Trade in Endangered SpeciesCLEAR Carbon Limits + Early Actions = RewardsCO2e carbon dioxide equivalentCOP Conference of the Parties to the UNFCCCCOP 13 Bali Conference of the PartiesCTF World Bank Clean Technology FundDDA Doha Development AgendaDEFRA UK Department for Environment, Food, and Rural AffairsEDF Environmental Defense FundEGS environmental goods and servicesEIO environmental input-outputEPA US Environmental Protection AgencyETS emissions trading systemEU European UnionEU ETS European Union Emissions Trading SystemGATS WTO General Agreement on Trade in Services

318 Abbreviations

GATT WTO General Agreement on Tariffs and TradeGDP gross domestic productGEF Global Environment FacilityGHG greenhouse gasGNP gross national productIBRD International Bank for Reconstruction and DevelopmentIEA International Energy AgencyIFC International Finance CorporationIMF International Monetary FundINCR Investor Network on Climate RiskIPAM Instituto de Pesquisa Ambiental da Amazônia, or Amazon

Institute for Environmental ResearchIPCC Intergovernmental Panel on Climate ChangeIPRs intellectual property rightsISO International Organization for StandardizationJI Joint ImplementationKP Kyoto ProtocolLDCs least developed countriesLEED Leadership in Energy and Environmental DesignLULUCF land use, land use change, and forestryMARPOL International Convention for the Prevention of Pollution

from ShipsMEA multilateral environmental agreementMFN most favored nationMIGA Multilateral Investment Guarantee AgencyMOP Meeting of the Parties to the Kyoto ProtocolMRV monitoring, verification, and reportingNAI Non – Annex INAMA nationally appropriate mitigation actionNC National CommunicationNGO non-governmental organizationODA official development assistanceOECD Organisation for Economic Co-operation and DevelopmentOPIC Overseas Private Investment CorporationPAS Publicly Available Standardppmv parts per million by volumeR&D research and developmentREC renewable energy certificate or renewable energy creditsREDD reducing emissions from deforestation and forest degradation

Abbreviations 319

RFM Reformed Financial MechanismRPS renewable power standardsRTA regional trade agreementSCM WTO Subsidies and Countervailing Measures AgreementSD-PAMs sustainable development policies and measuresSEC US Securities and Exchange CommissionSNLT sectoral no-lose targetSPS WTO Agreement on the Application of Sanitary and

Phytosanitary MeasuresTBT WTO Agreement on Technical Barriers to TradeTPRM WTO Trade Policy Review MechanismTRIPS WTO Agreement on Trade-Related Aspects of Intellectual

Property RightsTRIMS WTO Agreement on Trade-Related Investment MeasuresUNCED UN Conference on Environment and DevelopmentUNDP United Nations Development ProgrammeUNFCCC United Nations Framework Convention on Climate ChangeUSAID US Agency for International DevelopmentWBCSD World Business Council for Sustainable DevelopmentWTO World Trade OrganizationWWF World Wide Fund for Nature

Climate Finance 321

Index

adaptation, 158 – 160, 167, 194additionality, 68, 70, 72American Clean Energy and Security Act

(ACESA or ACES), 112, 213 – 220

baselines border climate adjustment (BCA),

266 – 271 border tax adjustment (BTA), 250,

268 – 269 business-as-usual baselines, 99, 130, 173,

176 sectoral/efficiency targets, 82, 87bottom-up approach and environmental effectiveness, 172 –

178, 179 – 185, 312Brazil, 96 – 101, 159

capacity-building, 86, 144cap-and-trade compared to carbon taxes, 57 – 66,

291 – 299carbon credits. See offsetscarbon footprint labeling (CFL), 281 – 287carbon leakage, 263, 267, 274carbon markets linkage between, 60, 130 – 131, 216 – 220,

222 – 227, 313 participation of developing countries in,

183 – 184, 311 – 314carbon tax compared to cap-and-trade. See cap-

and-tradeCertified Emissions Reduction (CER).

See Clean Development Mechanism (CDM)

China, 158, 228 – 233, 235

Clean Development Mechanism (CDM), 49, 67 – 78, 81, 105 – 110, 112, 127 – 129, 140, 147, 176, 181, 183, 193 – 196, 218, 222, 224, 226, 256 – 257

achievements, 68, 86, 222, 224 criticism, 68, 70, 82, 97, 193, 225 reform, 72, 85, 128 – 129, 225 – 226CLEAR, 111 – 121 mechanisms for disbursing funds, 117climate change causes and consequences of, 35 – 41 costs of limiting, 46, 105 – 110, 137, 160 estimated emissions levels necessary to

limit, 43, 98, 116, 136, 174climate finance, 3 – 33 comparative advantage of mitigation in

developing countries, 138, 183 and concerns about equity, 44, 91, 107,

190 and economic development, 158 and need for a global bargain, 168 – 171 required levels, 98, 105 – 110, 130, 137,

168conditions on financing, 189 – 196, 197 – 205 in context of CLEAR, 113 cost-effectiveness, 201 – 202 criticisms of, 195, 207 effectiveness, 201, 207 equity, 203 and gap in North-South relations, 159,

190, 204, 207 and local implementation, 191, 208 – 209 and local ownership, 202 – 203, 207 – 208

deforestation. See reducing emissions from deforestation and forest degradation (REDD)

322 Index

distributional concerns carbon tax vs. cap-and-trade, 294 – 299

embedded/embodied carbon. See border climate adjustment (BCA); border tax adjustment (BTA); carbon footprint labeling (CFL)

energy efficiency, 44, 141, 146, 148, 215, 243European Union Emissions Trading System

(EU ETS), 58, 112, 126, 140, 217, 221 – 227, 255, 257, 313

financing of capacity-building, 163, 175, 190 certainty and recurrence of, 209 full and incremental costs, 160 – 161 timing of, 209flexibility in climate change agreements and Kyoto Protocol, 49

global warming. See climate changegreenhouse gases historical responsibility for current stock

and gap in North-South relations, 91, 158, 179, 313

relationship to global warming, 35 – 41

historical responsibility. See greenhouse gases

India, 158 – 159, 175, 235institutional framework and domestic politics, 159 fragmentation of, 167 governance structures of, 161 – 162, 165 –

171, 172 – 178 representation of developing nations in,

162, 193 – 194 and transparency, 163, 194insurance, 145international trade and climate linkages, 272 – 280 and developing country concerns,

273 – 274 of environmental goods and services,

274, 277 and intellectual property rights, 274 monitoring of trade measures and

potential barriers to trade, etc., 274 – 277

IPCC Fourth Assessment Report, 37, 260,

264

Kyoto Protocol lessons from, 48 – 56

labeling requirements and the TBT Agreement, 274land use, land use change, and forestry

(LULUCF), 80, 90 – 95, 96 – 101, 148 – 150, 217

See also reducing emissions from deforestation and forest degradation (REDD)

McKinsey cost curve, 43, 45, 93, 136, 235Mexico, 159monitoring capabilities of WTO, 276 – 277 of embodied carbon across the supply

chain, 278 and gap in North-South relations,

162 – 163 of mitigation actions, 119 of trade measures, 275 – 276monitoring, verification, and reporting capacity-building, 275 – 276, 278 of NAMAs, 182 – 183 and use of appropriate policy instru-

ments, 84, 169 – 170multilateral finance difficulties of crafting equitable national

targets, 98, 311 and gap in North-South relations,

160 – 161 Global Environment Facility (GEF), 68,

147, 161 – 162, 166, 169, 192 – 193, 198 Montreal Protocol Multilateral Fund, 68 a stumbling block in larger debate, 314 World Bank Clean Technology Fund

(WBCTF), 162, 198

nationally appropriate mitigation actions (NAMAs), 44, 81, 82, 112, 129, 170, 172 – 178, 179 – 185

institutions for registering, 182 – 183, 226 NAMA crediting, 180 – 184 See also sectoral crediting, sectoral no-

lose targets

Index 323

official development assistance (ODA), 106, 159, 183 – 184, 207

offsets, 49, 67 – 78, 95, 105 – 110, 111 – 121, 127 – 129, 140, 160, 183, 217, 219, 226

See also Clean Development Mechanism (CDM)

poverty a central factor in crafting effective

REDD policies, 93 as a constraint on developing nations’

mitigation efforts, 158 – 159 and regressive effects of climate regimes,

294 – 299private climate investment, 68, 136, 168 –

171 See also multilateral finance; official

development assistance (ODA) private investment needs, 135 – 142, 143 – 151project implementation adaptation and renewal of active

projects, 210public climate investment security of, 160 use in combination with effective institu-

tions, 144 – 145, 160, 167 – 171

reducing emissions from deforestation and forest degradation (REDD), 90 – 95, 129, 146, 148 – 150, 159, 170, 180, 196, 217, 314

and carbon trading 95 importance of creating the right

incentives for rural poor, 94 importance of REDD in global

mitigation efforts, 91 stock-and-flow mechanism for crediting

REDD emissions, 96 – 101 See also land use, land use change, and

forestry (LULUCF)renewable energy, 45, 242renewable energy certificates, 141 and trade law, 258reporting structures and likelihood of project success, 210

sectoral crediting, 79 – 84, 85 – 89, 109, 129, 140, 146, 176, 181, 217 – 218, 226

and incentives for private investors, 87 misconceptions about, 80 sectoral no-lose targets, 82

taxation of carbon permits, 300 – 304, 305 – 310 income tax, 306 inter-firm tax neutrality, 301 – 302 intra-firm tax neutrality, 302 – 303 lock-in effect, 307 – 309 offsetting regressivity of climate regimes,

294 – 299 See also cap-and-trade, compared to

carbon taxestop-down approaches criticisms of, 173 – 176 examples of, 173 and measurability, 174 and predictability, 174trade law. See WTO

urban planning and policy, 234 – 240, 243

WTO, 247 – 253 Agreement on the Application of

Sanitary and Phytosanitary Measures (SPS), 251

Agreement on Technical Barriers to Trade (TBT), 251, 257, 277, 285 – 286

Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), 252 – 253

General Agreement on Tariffs and Trade (GATT), 248 – 250, 255 – 257, 262, 269, 286

General Agreement on Trade in Services (GATS), 252, 255 – 257

Shrimp-Turtle dispute, 250 Subsidies and Countervailing Measures

Agreement (SCM), 251, 256, 260 – 265, 269

WTO Trade Policy Review Mechanism (TPRM), 163