The Clean Development Mechanism:
A Primer

By Michael Toman and Marina Cazorla

SEPTEMBER 29, 1998 -- The Clean Development Mechanism (CDM) is one of several "flexibility mechanisms" authorized in the December 1997 Kyoto Protocol to the 1992 United Nations Framework Convention on Climate Change (signed at the Rio de Janeiro "Earth Summit").

The Kyoto Protocol specified legally binding commitments by most industrialized countries to reduce their collective greenhouse gas (GHG) emissions by at least 5 percent compared to 1990 levels by the period 2008-2012. With the goal of reaching these targets at the lowest possible cost for countries that committed to reductions, the Protocol created two flexibility mechanisms, GHG emissions trading and CDM. The CDM is also intended to be an opportunity for developing countries that did not accept binding emissions reductions at Kyoto to be involved in GHG mitigation.

This essay introduces CDM’s purpose, mandate and institutional structure as authorized in the Kyoto Protocol; focuses on the principal technical and administrative issues that will arise as the CDM is designed and implemented; and discusses some of the main unresolved issues with the CDM that confront the Conference of Parties to the Framework Convention.

The Kyoto Protocol and Article 12:
Organization and Purpose of the CDM

The CDM was created as a successor to "Joint Implementation" (JI). JI consists of a bilateral agreement between two entities to complete a GHG mitigation project. The investor is from an "Annex B" industrialized country that must reduce its emissions under the Framework Convention. JI potentially can provide credit for emissions abatement to the investor at a lower cost than domestic abatement. In other words, JI is a form of "emissions trading." At the same time, a developing country host can benefit from new investment that increases economic productivity and may reduce local environmental problems. Under the Kyoto Protocol, JI projects still can be undertaken between entities in Annex B industrialized countries (as specified in Articles 3 and 4). However, collaborative projects to reduce emissions or sequester carbon in developing countries are now to occur through the CDM.

Article 12 of the Kyoto Protocol identifies three specific goals for the CDM: (1) to assist in the achievement of sustainable development, (2) to contribute to the attainment of the environmental goals of the Framework Convention, and (3) to assist Annex B parties in complying with their emissions reduction commitments. In particular, Article 12 specifies that developing countries are to benefit from CDM projects resulting in "certified emission reductions" (CERs) and that industrialized countries may use CERs to comply with their quantified emissions reduction commitments under the Kyoto Protocol. Essentially, this allows for voluntary projects similar to previous JI projects between Annex B and non-Annex B countries. The difference is that unlike previous JI projects, CERs are specifically authorized to apply to Annex B emissions reduction targets.

Article 12 establishes three bodies to oversee the CDM: the representatives of the Conference of Parties (COP), an executive board established by the COP, and independent auditors to verify project activities. However, the Protocol provides almost no guidance on what exactly the CDM would do or how it would operate. Instead, the structure and authority of supervisory bodies and the CDM are left for future negotiation.

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CDM Design Issues

In order for CERs to be created from CDM projects, a number of overlapping technical, regulatory, project finance and administrative functions must be performed. Before any CDM project can be established, there must be demand for CDM projects and CERs; developing countries’ concerns about uneven bargaining positions during project contract negotiations must be addressed; liability must be assigned, and insurance procured; project financing also must be obtained; and the benefits of projects must be allocated among participants. It is important to bear in mind that the CDM is a form of market, one in which valuable goods and services are to be bought and sold. Many of these functions may be most effectively undertaken by private markets or existing international institutions; the key question is what functions need to be undertaken by new CDM institutions.

Criteria for selection of projects. CDM projects must presumably fulfill certain criteria in order to be certified upon completion, but these criteria have not yet been established. Possible criteria include: method or extent of technology transfer; specific performance or design standards for transferred technology; capacity and willingness of both national and local governments to host the project; existence and nature of agreements for sharing project benefits (CERs and financial returns) and project liability between investor and host; and limits on local environmental or other social impacts. A particularly important question is what criteria might be established for determining "sustainable development" and other benefits for host countries. Another important question is whether references to "emission reductions" in Article 12 are interpreted as allowing or precluding carbon sequestration projects under the CDM.

Project review and CER calculation (before implementation). Prior to the initiation of projects, the "baseline" or previous amount of carbon emissions from the project facility or area in question must be established. The baseline is used to show that purported GHG reductions are "additional" to what otherwise would have occurred. One practical question that arises in assessing additionality is the issue of "project leakage" – when a particular project lowers emissions, but emissions rise in other parts of the host country economy (or elsewhere). This could happen, for example, if a reforestation project in one location was accompanied by greater deforestation elsewhere. There are a variety of options for defining project-level baselines to assess additionality. These include detailed project-level review of projected emissions with and without the project, and streamlined formula-based approaches that estimate emission reductions based on easily observed project characteristics (for example, conversion of a coal power plant to natural gas). Another approach would involve the host country establishing and enforcing "top-down" national or sectoral baselines in an effort to limit leakage, and then assigning shares of the baseline to different emission sources much as emission allowances are allocated in the US program for sulfur dioxide trading among power plants. In this case the validity of the CERs generated from a specific project would depend in part on overall sectoral emissions.

Project monitoring and CER assessment (after implementation). Related to the issue of additionality are technical questions regarding how to measure, monitor and verify the outcomes of individual projects. Both emission reduction and carbon sequestration projects pose their own measurement and monitoring challenges. In either case, some independent entity must intermittently monitor the emissions or sequestration of the project in order to ensure that the benefits of the project accrue over time as represented by project participants. In turn, standards for the accreditation of the certifiers are needed in order to ensure certifier objectivity and credibility.

Rules for CER validity and project liability. For CERs to be credible, there must be rules defining when CERs can be used and assigning legal responsibility in the event that a CDM project is found not to generate the amount of emission reduction promised (either because of misrepresentation before the fact or less than expected performance after the fact). Liability is of less concern if CERs can be used only after an independent (and honest) auditor has certified their existence. If this were the case, prospective credits would be held in abeyance between certifications; the project participants would have to trade off the value of more rapid certification against the cost. If, however, credits can be used in advance of certification, as is the case in some US emission credit trading programs, then questions of after-the-fact liability do arise. Under the Kyoto Protocol, Annex B countries have ultimate responsibility for noncompliance if credits are disallowed. In practice, the assignment of liability to Annex B investors/CER buyers is likely to be efficient since buyers have a financial and reputational stake in CDM projects, possess the resources for effective project oversight, and face enforceable emission ceilings in their own countries. CERs could be transferred to subsequent purchasers without reassignment of liability in order to protect incentives for trading.

Recording of CER exchanges and resulting changes in Annex B parties’ accounts. Some institution must be responsible for accounting for newly created CERs, CER exchanges or transactions, and the application of CER credits to Annex B parties’ GHG emissions obligations.

Marketing, information, financing, and insurance services. If the CER market is designed reasonably well, most prospective investors are likely have access to market financing for well-designed CDM projects. In some cases, however, institutions like the World Bank might need to provide assistance in identifying and providing financing. Insurance against project failure is another important financial or brokerage service, which again could be provided by the private sector or in some cases by multilateral institutions. Finally, market institutions need to be developed for facilitating transactions in CERs as well as "derivative" transactions, such as options to buy or sell CERs in the future. These institutions would serve as a clearinghouse for secondary trades by matching buyers and sellers, and could also be a repository for "banked" or unused CERs. Such institutions would also facilitate exchanges between CERs and emission permits emerging from Annex B trading.

Providing negotiating support for non-Annex B countries. Some developing countries might avoid participation in CDM projects out of fear of possible exploitation by investors due to lack of capacity to negotiate fair contracts. These countries are concerned about the relationship between the CDM and international development assistance, the under-development of the private sector in some developing countries, the lack of developing country capacity to monitor and verify projects independently, and the possibility that investors will take advantage of their lack of technical expertise in project evaluation. The CDM or other institutions could assist by providing access to experienced negotiators and offering training or capacity-building services. However, undertaking these tasks requires a resolution of potential conflicts of interest among the roles of project promoter, host country advocate, and neutral market supporter.

CDM fund administration. Article 12 stipulates that "a share of proceeds from certified project activities [should be] used to cover administrative expenses as well as to assist developing country Parties that are particularly vulnerable to the adverse effects of climate change to meet the costs of adaptation." The COP must still determine how funds will be drawn from CDM projects or CER trading, how large the fund should be, and how proceeds would be disbursed. The question of how funds are raised is of particular interest. If the funding mechanism is based on the proceeds of the project (either direct financial payment or diversion of a share of CERs to a central fund), then in negotiation investors will reduce their willingness to provide benefits to the host country accordingly in order to ensure that the net return on the project remains commensurate with other rates of return throughout the global capital market. In this case the CDM fund would simply be redistributing proceeds among non-Annex B countries. An alternative would be to levy a fixed annual registration fee on any investor interested in being eligible for participation in the CDM.

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Key Decisions on CDM Structure
and Function

There are several ways the CDM could be structured to address project selection, finance and implementation. The CDM could be more centralized and active in CER market operation, playing a role similar to that of the World Bank or the Global Environment Facility (GEF) in screening, selecting, financing, and assisting in implementation of projects. The CDM also could be a market maker, seeking out host countries from whom to acquire credits and reselling them. However, a key question with a more centralized alternative is the extent to which the CDM would have a comparative advantage in carrying out all these functions, especially if by international agreement it became the only entity eligible to carry out these various functions. Experience suggests that many of the functions enumerated above can be carried out more efficiently by the private sector, and that exclusive control over the functioning of a market does not promote market efficiency or adaptability.

Another alternative would be very similar to Joint Implementation, in which an industrialized country and a developing country agree to collaborate on a CDM project which is later certified by an independent auditor. This arrangement would imply a much smaller role for the CDM, one mostly involving definition of basic criteria for project selection and implementation, general oversight of audits and recording of CER exchanges. This system likely is the most dynamic and flexible, with individual actors in the market (investors, financiers, and others) defining the functioning of the CER market through "learning by doing." How successful this approach would be in terms of accountability would depend on the criteria used for project selection and implementation and the quality of oversight applied.

There is a broad debate over the issue of "supplementarity." The Kyoto Protocol refers to the use of international emissions trading (and by extension the CDM) as being "supplemental" to domestic actions. Supplementarity constraints reflect a concern by some Annex B countries that participation in international flexibility mechanisms will limit the scope and stringency of domestic policies, thus retarding the long-term development of technology and improved energy efficiency needed to achieve and go beyond the Kyoto goals. The other side of that argument is that limits on trading and CDM are blunt instruments to improve the credibility of a nation’s commitment to the Kyoto Protocol, and that by increasing the overall cost of compliance with the Protocol the restrictions also contribute to lack of willingness to achieve the target reductions.

Finally, there are inherent tensions among the goals for the CDM articulated in Article 12 of the Kyoto Protocol. For example, a more formulaic approach to project review would lower "transactions costs," but it might also decrease the accuracy of the assessment of additionality. Greater efforts to extract benefits for non-Annex B countries or to reduce uncertainty in the measurement of CERs will increase participation costs for Annex B countries and thereby reduce their interest in participation. To illustrate, requiring selection of the best available abatement technologies might facilitate technological "leapfrogging" by LDCs but would also raise the cost of the project. These tradeoffs and their consequences are the reason why the design of CDM institutions and projects must be considered carefully before implementation. Since early (pre-2008) reductions through the CDM are possible under the Protocol starting in 2000, there is little time to spare in settling some of these basic issues.

Michael Toman directs RFF’s Energy and Natural Resources Division.  Marina Cazorla provides research assistance in the Energy and Natural Resources Division. 

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