new mechanisms

8/8/2019 New Mechanisms

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New Emission Reduction Mechanisms:

Filling in the Details and Bringing in the Private Sector

IETA supports efforts to develop new market-based emission reduction mechanisms in thecontext of a new international climate change agreement. Experience with the CDM and involuntary markets shows us that market-based mechanisms create keen interest in emissionreduction activities in developing countries, which is crucial in situations where the issue ofclimate change competes for attention with many other economic and social challenges. IETAfeels strongly that the invaluable momentum that these mechanisms have created must be

preserved and heightened in the next agreement.

At this stage of the negotiations, however, IETA believes that there is a need for Parties andinterested stakeholders to take a more measured approach to the design of new mechanisms.It is necessary to consider in more detail the ideas already on the table and, critically, toevaluate if and how these proposed mechanisms are likely to attract the private sectorinvestment required for success.

Flexible, market-based mechanisms to incentivize emission reduction in developing countriesare possible because, while the cost of reducing greenhouse gas emissions variesconsiderably from country to country, the net benefit to the atmosphere equates whereveremissions are reduced. Such mechanisms not only achieve the same greenhouse gasreduction at a lower societal cost, the use of the market also frees governments from the

impossible task of obtaining the perfect information needed to identify cost effective emissionreductions in a top-down manner. Given the right market structure, the private sector cansimply be unleashed to seek out the most cost-effective emission reductions.

The provision of a market structure that will best enable the private sector to address climatechange, however, is not an insignificant or simple task, but it is a crucial one. The IPCC,UNFCCC, IEA, and Stern and Garnaut Reports have all emphasized the critical role that privatesector capital must play if the international community is to successfully address climatechange. Indeed, the UNFCCC has stated that the carbon market including flexible, market-based mechanisms must be significantly expanded to meet the need for additionalinvestment and financial flows and to transfer critical, climate-friendly technology alternatives.

Given all of these points, IETA believes that there is an urgent need to get to work filling inthe details of new mechanism that have been proposed by Parties and stakeholders alike. Thisdocument begins modestly, with a list of key foundational questions that IETA hopes will helpnegotiators to consider how (and if) the proposals on the table today will function in practice.

As implied above, however, clarity as to basic design is not the only test proposals for newmechanisms must meet. IETA also believes that there are several key design features that willsignificantly impact the ability of the private sector to engage with new mechanisms. Thisdocument lays out the criteria that new mechanisms should meet if they are to attract privatesector investment and direct it to emission reduction activities in the most efficient manner.


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Filling in the Details: The Fundamental Questions

The following questions should be asked of each proposed new mechanism.

1. How will the new mechanism reduce emissions?For example, will emissions be reduced through the introduction of an intensity-based orabsolute no lose target; through support for a domestic policy measure; or through the

transfer of lower-emitting technologies?

2. What is the mechanisms source of funding?For example, if emissions reduction credits are issued to governments or private entitieswith the intention of being purchased, who is the buyer?1; if emission reductions aresupported by a multilateral fund, who contributes to or invests in the fund?; if emissionreductions stem from the transfer of technology, who funds the transfer and manages IPR?

3. What is the incentive structure for participation within the mechanism?For example, how are the following actors drawn to participate in the mechanism:(1) National and local governments, (2) emitting entities in the host country,2 and(3) other project developers and investors, international or domestic?

4. How does the mechanism harness private sector ingenuity and capitalize on privatesector aptitude for efficiently and effectively discovering low-cost solutions?In other words, do private sector actors have the ability to take the initiative in terms ofidentifying, investing in, and/or implementing emission reductions, or are theyfundamentally dependent upon other actors to provide the return on their investment orto move first?

5. What are the supply/demand dynamics of the mechanism?In other words, when considering the level of activity that the mechanism aims toincentivize, can the necessary investment or demand for credits reasonably be expected tomaterialise? For instance, for credit-issuing mechanisms, what impacts do levels ofambition or supplementarity limits have on demand, and should they be considered inconjunction with possible new supply of emission reductions?

6. What are the major political risks of this mechanism, and can these risks bemitigated?For example, if a government fails to carry out its obligations under the mechanism, ordoes so unsatisfactorily, to what extent, if any, does it impact private sector investment? Isit possible to isolate the private sector from this risk or to mitigate the risk to investors?

7. In what ways can this mechanism create perverse incentives or unintendedconsequences, and how can these risks be mitigated?For example, will this mechanism discourage further government regulation (e.g. higherfuel efficiency standards) because governments wish to preserve the carbon finance drawnto their country? Will the mechanism impact decisions taken on environmental

conservation (e.g. bio-fuel demand driving rainforest clearing for agroforestry operations)?

Note: Beyond these fundamentalquestions lie equally crucial functionalquestions as well.Examples of functional questions include: What governance arrangement is necessary for thismechanism?; Is there a need to measure, report, and verify emission reductions achievedthrough the mechanism, and at what level; Is it necessary to determine additionality and,considering past experience, how can this be done successfully?; What data is required to getthe mechanism up and running, and how will that data be gathered?; In what time frame canthis mechanism be fully functional and, until then, how can the Parties ensure that emissionreduction activities do not lose momentum?

1Will credits be fully fungible with AAUs and domestic compliance units? If not, how will they be utilized?

2If crediting takes place at the sector or national level, not directly to the private entity, what is theincentive mechanism for private participation? For example, will there be a domestic program forcrediting below this level, and how will it be constituted and managed to reduce risk to participatingprivate sector entities?


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Bringing in the Private Sector: Criteria for Private Sector Involvement

The following lists should be used to evaluate the merits of proposals for new mechanisms interms of their ability to attract private sector investment.

Economic Criteria

In order to attract private sector finance, new emission reduction mechanisms must meet thefollowing economiccriteria:

1. Provides incentive for a conventional economic return for the provision of anenvironmental benefit: While many private sector actors have social andenvironmental motives in addition to economic ones, the first and most importantmotivation for emission reduction activity by the private sector will always be thepursuit of profit. Attempts to penalize overly profitable activities through taxes orextra tests and regulations will only stifle the ability of the private sector to provideenvironmental benefits.

2. Creates an incentive for emission reduction activity in areas that have previouslybeen unattractive for investors: The provision of carbon finance is intended to fill thegap between the cost of business-as-usual and low-carbon investment. The moreattractive that new flexible mechanisms make investment in previously unattractivelow-carbon activities, e.g. through the creation of enabling environments and thelowering of transaction costs, the more the private sector will enthusiastically pursuethem.

3. Provides for segmentation in terms of either of the following options:1. Segmented emission reduction activities that lie below sectoral or large-

scale policy level:These activities must be small enough to be an investmentmanaged directly by private sector actors. Activities managed directly by theprivate sector create the maximum amount of investor security and, therefore,will result in greater levels of investment.

2. Segmented emission reduction investment that leads to the creation of amanageably small asset, e.g. a carbon bond: It is likely infeasible for emissionreduction activities that require very long-term or large-scale investments,e.g. nation-wide policy implementation or large-scale infrastructuredevelopment, to be managed directly by carbon investors as under the currentCDM. Investment in those emission reduction activities must still be capable ofbeing held and traded as private sector assets, however.

4. Rewards early action: A mechanism that rewards early action not only ensures thatalready-extant private sector activity is not disincentivized in the transition periodbetween the Kyoto and post-Kyoto commitment periods, but also ensures that delaysin implementation on the part of the public sector or international community do notnegatively impact good faith action by the private sector to lower emissions in themeantime.

5. Gives the greatest possible regulatory certainty over the lifetime of the activity orthroughout its pre-determined crediting period: There is a need to ensure that theregulatory institution is sufficiently stable to allow the project to complete its creditingperiod(s) or to allow the investment made to reach maturity. The present uncertaintyas to whether all CDM projects will remain eligible for crediting post-2012demonstrates the relevance of this criterion.


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Legal and Regulatory Criteria

In order to attract private sector investment, any new emission reduction mechanism mustprovide investment security and minimize transaction costs by fulfilling the following legaland regulatorycriteria:

1. The system must grant rule-making, executive, and review powers to an independent,non-political regulatory body, driven by an overarching regulatory objective andpreferably established at the international level;

2. Accounting for the complexity of the mandate, that bodys functions and designshould incorporate, as appropriate, the principle ofseparation of powers;

3. Procedural rules governing the relationship between regulator and regulatedcommunity must guarantee transparency, predictability, efficiency and legitimacy ofcommunication and decisions taken within the system;

4. Material rules must be unambiguous and clear, allowing a high level of guidance to theregulated community, clear steps to compliance and the ability to enforce such rules;

5. Clear procedures must exist for review and revision of rules previously established;6. The following general principles must be enshrined, inter alia,:

a. Due process: the right to be heard, the right to address an independent judgein public, the right to appeal, and the right to a judgment within a reasonableperiod of time,

b. Legality: persons can only be bound by rules that existed and were publishedat the time of acting, so rules must not have retroactive effect,

c. Ownership: The legal classification of the resulting emission reduction units(e.g. a commodity, good, or a choice in action) must be determined as a matterof Treaty; laws and regulations at a regional/national level must observe thisclassification, thus ensuring clear ownership right protection for emission

reduction units or other forms of investment;3

7. State accountability and investor liability must remain separate;48. An international, independent, judicial body must be empowered for the purpose of

resolving disputes between the regulator and private parties and enforcingjudgments;

9. The mechanism must be enshrined in the domestic law of participating Parties,through the provision of domestic laws that protect investment, ensure ownership ofissued units and allow for transfer of such ownership, and provide recourse indomestic courts when necessary (the treaty shall give guidance to the Parties as to how

such disputes are to be resolved in domestic jurisdictions);

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10.Direct transfer of emission reduction units or investment return to each entity witha monetary stake in the emission reducing activity must be provided;

3 Clear legal classification and ownership rights are key to attracting greater amounts of private sectorcapital through capital market instruments (e.g. bonds) that rely on techniques where certainty isafforded by the legal nature of the underlying instrument.4 The failure of a government to meet its commitment (be it sectoral or national) should not be passedon to investors that have fulfilled their obligation. In other words, emission reduction units should notbe delayed nor should emission reductions units be revoked once issued as a result of Party non-compliance with obligations under the Protocol.5This should lead to the harmonization of domestic rules in order to create investment certainty and

facilitate private investment.


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Please contact Kim Carnahan at [email protected] if you have questions or comments, or

require further information in relation to the positions contained in this document.

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