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3. GHG EMISSION REDUCTION MARKET OPPORTUNITIES

3.1. A SSESSMENT OF THE INTERNATIONAL MARKETS FOR GHG REDUCTIONS

3.1.1. Rules for the Kyoto Mechanisms and their Implications for International GHG Market Architecture The Kyoto Protocol is a very complex agreement. Defining quantified binding commitments requires clarity concerning the timescales, the range of gases covered, the basis upon which to compare them, and the rules for monitoring, reporting and compliance. In addition, the desire to make the commitments as economically efficient as possible led to the incorporation of a range of mechanisms that are unprecedented in international law. These mechanisms are intended to enable countries to limit the economic impact of their domestic emission obligations through emission credits trading, or through investments in projects in other countries where it might be cheaper to reduce emissions. The details of the rules governing these mechanisms have considerable implications for the real impact of the Protocol. The Protocol includes three mechanisms (see Box 3.1) that allow the Parties to secure reductions in the mos t cost effective ways. In addition, these mechanisms stimulate international investment and provide essential resources to support cleaner economic transition and development: East-West investment through International Emissions Trading and Joint Implementation, and North-South investment through the Clean Development Mechanism.

BOX 3.1 THE KYOTO MECHANISMS

· Joint Implementation (JI) allows a country to claim credit for emission reductions generated by its investments in another industrialized country. These efforts result in a transfer of equivalent ‘emission reduction units’ (ERUs) between the two countries (Article 6). Although the achievement of credits through JI offsets governmental efforts, this mechanism is generally envisaged for promoting international private sector investment in emission-reducing projects.

· Clean Development Mechanism (CDM) allows similar types of emission reduction projects in developing countries to generate ‘certified emission reductions’ (CERs) for use by the investor. The Protocol requires that such projects must contribute to the sustainable development of the host country and help it contribute to the ultimate aim of the UNFCCC (Article 12).

· International Emissions Trading (IET) stipulates the transfer among countries of part of their allowed emissions, called ‘assigned amount units’ (AAUs) (Article 17). This could be linked to domestic trading schemes, allowing international trading of emission allowances between private entities that could offset domestic regulations.

The mechanisms differ as to whether they are “project-based” (JI and CDM) or they are limited to countries with emission limitation commitments (JI and IET), see Figure 3.1. The

NSS Ukraine 91 emission limitation commitments of Annex B countries establish an overall cap on their GHG emissions. IET allows transfers of portions of that cap from one country to another while keeping the cumulative cap fixed. Each country must keep its actual emissions below its national cap, as adjusted through emission trades (i.e., increased by purchases and reduced by sales of emission allowances). The fixed cumulative cap, together with the requirement that each country hold sufficient allowances to cover its actual emissions, ensures environmental integrity. Within a “cap and trade” system, individual emission reduction actions or “projects” undertaken by companies reduce actual emissions and so help to meet the adjusted national caps.

FIGURE 3.1 KYOTO PROTOCOL FLEXIBILITY MECHANISMS

Source: International Emission Trading: From Concept to Reality, IEA, 2001.

JI involves project-based trading for projects implemented in countries with emission limitations (Annex B countries). Since the reductions achieved by such projects contribute to meeting the national commitments of the receiving country, any allowances awarded to the investing country must also be subtracted from the emissions allowed in the receiving country, to avoid double counting. For this reason, the Protocol requires that ERUs awarded for JI projects must be subtracted from the host country’s AAUs. Consequently, the Kyoto mechanisms create two principal types of greenhouse gas offsets:

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· Purchase of surplus allowances from countries that are below their Kyoto targets · Creation of carbon credits through project-based mechanisms (i.e., CDM and JI) Therefore, we can speak of two types of GHG markets: allowances, or “cap and trade” market, and credits, or “projects” market. At the same time, these mechanisms raise a few challenges related to the rules for their application: · Party’s eligibility to participate in flexibility mechanisms · Participation of private sector in the implementation and operation of the Protocol · Creation of a new type of emis sion unit for sink credits (RMU) · Substitution among the four types of emission units (i.e. AAU, ERU, CER, and RMU) · Limits on trade between Annex B countries · Early start of JI Eligibility to participate in flexibility mechanisms The Marrakech Accords confirmed that a Party’s eligibility to participate in the mechanisms would depend on its compliance with the terms of the Protocol, including methodological and reporting requirements. This will be subject to oversight by the Enforcement Branch of the Compliance Committee. At COP-7, Parties continued to argue as to whether the compliance regime should be “legally binding” or “politically binding”. A decision on the legal nature of the compliance regime was deferred until the first meeting of the Parties after the Protocol comes into force. Participation of the private sector The Kyoto Protocol is a treaty between sovereign states. Consequently, Annex B governments are the entities responsible for meeting their emissions limits. However, while some countries believe that only governments themselves may utilize the Kyoto mechanisms, (i.e. IET), others believe that participation of the private sector (industrial emitters, emission brokers, etc.) is necessary to achieve the potential cost savings made possible by the Kyoto mechanisms without compromising the responsibility of Annex B governments. New provisions reached at COP-7 allow national governments to authorize legal entities, principally private companies, to become involved in many aspects of the implementation and operation of the Protocol. For example, in accordance with the Marrakech Accords, “designated operation entities” will be accredited by the Executive Board to validate, verify and certify emission reductions generated by CDM projects 33. Accreditatio n criteria include tests of legal status, competence, financial capacity and stability, insurance coverage and resources, and will be subject to regular review.

33 www.unfccc.de/cop7/documents/accords_draft.pdf

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New type of emission unit COP -7 confirmed that a range of carbon sequestration activities would be available to generate carbon credits that can be used to meet national commitments. In addition to the existing units for tradable GHG credits a new unit for forestry projects was introduced. Previously, the following three unit types were defined: · Assigned Amount Unit (AAU) –units assigned to Annex 1 countries, corresponding to their emission level allocated in the Kyoto Protocol. · Emission Reduction Unit (ERU) – unit produced by reducing emissions in Joint Implementation (JI) projects. · Certified Emissions Reduction (CER) – unit produced by reducing emissions in projects under the Clean Development Mechanism (CDM). All these units can be used to fulfill either the Annex 1 commitment during the first commitment period of the Kyoto Protocol or they can be banked (meaning saved) for a second commitment period. The new unit is the Removal Unit (RMU). These units are comparable with other units except that they are not bankable for the second commitment period. Under Article 3.3 of the Protocol, “forestation,” “reforestation” and “deforestation” activities will be accounted for while, under Article 3.4 (additional sink activities), each Party may choose to apply all or a selection of additional activities (forest management, cropland management, grazing land management and re-vegetation) during the first commitment period. Emission reductions claimed must be proven to be human-induced and to have occurred since 1990. Sink accounting rules for the first commitment period have been created, including negotiated Party caps on credits from forest management and JI sink projects. Substitution among emission units The purpose of the mechanisms is to allow nations to use the most cost-effective means available to achieve compliance with their international obligations. Each Annex B Party must hold sufficient allowances to “cover” its actual emissions for the first commitment period. Under Article 3 of the Protocol, AAUs, ERUs, and CERs equally contribute to a country’s assigned amount, therefore the article allows full substitution among the mechanisms to achieve compliance. Some Parties believe that economic efficiency would be improved by allowing full substitution among emission units (i.e. AAUs, ERUs, CERs, and RMUs) because it would result in a more liquid market and lower transaction costs. A key provision of the COP-7 states that the four units, generated by the various mechanisms and processes under the Kyoto Protocol, should be fungible (i.e. equivalent and interchangeable) and allowed to be traded in one market.

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Limits to trade between Annex B countries Trade of all four emission units is possible if the trading Parties comply with the Protocol provisions, including those related to effective maintenance and reporting of the national emission inventory. Parties must also have in place a national registry to record transfers and acquisitions of units. To hedge the price of emission units, additional limits on trade between Annex B Parties were set out in the Marrakech Accords. In accordance with these limits, each Party must maintain in its registry a “commitment period reserve” which should not drop below 90% of the Party’s assigned amount or 100% of five times its most recently reviewed inventory, whichever is lower. This means that net transfer of quotas to registries in other countries should at all times, during the period 2008-12, be less than 10% of the Kyoto target of a country. Alternatively, a country can transfer to other countries up to five times (due to the five -year period) the difference between its annual emission according to the newest verified national report and its Kyoto target (provided that the reported and verified emissions are lower than 90% of the Kyoto target). Legal entities, such as companies, cannot trade when the Party does not meet the eligibility requirements. Early start of JI At COP-7, it was decided that Annex I Parties that cannot meet the Protocol’s inventory requirements can still host JI projects through a project design and approval process similar to the CDM. Moreover, emission reduction projects starting in 2000 may be eligible to be qualified as JI projects if they meet environmental additionality, or the “beyond and above” rule. Two tracks have been defined for the verification of ERUs: Track 1 – If a host country complies with national emission accounting and reporting requirements, then it may verify if the emission reductions from JI projects are additional to any that would otherwise occur. Subject to such verification, it may transfer the appropriate ERUs to the investing country. Track 2 – If a host country does not meet the required standard of emission accounting and reporting requirements, then verification of the emission reductions will be undertaken by an accredited independent entity in accordance with procedures managed by the JI supervisory committee. Most of the above restrictive proposals are motivated merely by concerns of some OECD governments about the possible economic implications, competitiveness in particular, of Kyoto’s first period commitments.

3.1.2. Analysis of GHG Emission Reduction Policies of OECD Countries

The first test that Kyoto Protocol must pass is feasibility. Can the commitments be met by all OECD countries? At what cost? Some critics maintain that most countries will not be able to comply with their commitments, or that they could do so only at exorbitant costs. The IPCC

NSS Ukraine 95 results suggest that, in aggregate, Kyoto commitments are unlikely to be very disruptive for any of the OECD countries, provided that they make use of opportunities for domestic ‘no regret’ options and of flexibility mechanisms detailed in the treaty (see Box 3.2.).

BOX 3.2 IPCC C ONCLUSIONS REGARDING THE COSTS OF EMISSIONS LIMITATIONS The cost estimates for Annex B countries to implement the Kyoto Protocol vary between studies and regions. The great majority of global studies reporting and comparing these costs use international energy/economic models. Nine of these studies suggest the following GDP impacts: 1. In the absence of emissions trading between Annex B countries, the majority of global studies show reductions in projected GDP of about 0.2% to 2% in 2010 for different OECD regions. With full emissions trading between Annex B countries, the estimated reductions in 2010 would be between 0.1% and 1.1% of projected GDP. 2. For all regions costs could be increased by the following factors:

· Constraints on the use of Annex B trading

· High transaction costs in implementing the mechanisms

· Inefficiency of domestic implementation 3. For all regions costs could be reduced by the following factors:

· Inclusion of ‘no regret’ opportunities in domestic policies and measures

· Use of the CDM, sinks, and inclusion of non-CO2 greenhouse gases Source: Policy Makers Summary. IPCC – WGIII, 2001.

Current emission trends and future projections say also a lot about the challenges facing OECD countries.

3.1.2.1. European Union34 EU countries vary in terms of emission trends, policies and prospects. Governments are now taking measures that affect energy market investments. Specific regulations to promote renewable energy and co-generation are commonplace; and all countries except Spain have enacted broader economic incentives in the form of energy or eco-taxation, while Denmark, the UK and the Netherlands, among others, are implementing pilot emission cap-and-trade programs. Negotiated agreements with energy-intensive industrial sectors, mostly as part of the negotiated package around tax legislation, are also commonplace. Numerically, the picture is very varied (see Figure 3.2). Overall, the EU has met its UNFCCC commitment to keep CO2 emission below 1990 levels by 2000, mainly due to emission reduction in Germany and the UK that have offset growth elsewhere. In both countries, the reduction was caused by “spin-off” effects: the ‘wall fall’ reduction arising from German reunification, and the ‘dash-for-gas’ reduction arising from UK electricity privatization. However, detailed national studies suggest that in both cases, such ‘free gains’ have

34 Grubb Michael et al., Keeping Kyoto – A Study of Approaches to Maintaining the Kyoto Protocol on Climate Change, 2001.

96 NSS Ukraine accounted for no more than half of the national reduction. These studies conclude that Germany and the UK will achieve their target and the EU is likely to do so too, in spite of the fact that emissions have risen in many other EU countries.

FIGURE 3.2 PERCENTAGE CHANGE IN AGGREGATE GHG EMISSION FROM SELECTED OECD COUNTRIES IN CO2 EQUIVALENT TO 1990 LEVEL

Source: UNFCCC

%30

%15 %13 %15 %10 %11 %8 %6

%0 -%2 -%8 -%15 -%16 Austria Germany EU Netherlands Japan USA Canada Australia -%30 UK

Various studies by the European Commission suggest 35 that the EU may collectively limit its CO2 emissions to about 1990 levels (see Table 3.1) if abatement policies continue, and about 4% down from 1990 levels in terms of the Kyoto basket of gases. According to such scenarios, the remaining gap to the Kyoto target could be filled by carbon sink provisions and the use of the Kyoto mechanisms. Projections of current trends suggest that the countries that are most clearly not yet on track in achieving their targets tend to be the smaller and richer member states, which consequently would have to invest the most through the Kyoto mechanisms if they cannot sufficiently change domestic emission trends. Overall, the EU will be able to comply with the provisions of the Kyoto treaty given sufficient political will and a wider use of the Kyoto mechanisms.

3.1.2.2. Germany 36 Germany, as the largest emitter in the EU, has launched GHG emission reduction policies long ago. It has taken on the responsibility for the largest reduction: 252 MtCO2, which represents a 21% emission reduction between 1990 and the first compliance period. While

35 See, for example, http://europa.eu.int/comm/environment/enveco/climate_change/sectoral_objectives.htm 36 Gummer John and Robert Moreland, The European Union & Global Climate Change: A Review of Five national Programs. Pew Center on Global Climate Change, June 2000.

NSS Ukraine 97 actions have been taken nationwide, the improvement in the German position to date – a reduction of about 17% in GHG emissions from 1990 to 2000 – largely reflects the dramatic decrease in emission from the former GDR. This reduction is unlikely to continue at the same speed, and meeting the Kyoto target will be difficult but possible. The government has a national program that includes a reduction in coal use and production, voluntary agreements with the industry, traffic measures, eco-taxes, and a strong emphasis on co-generation and renewable energy. The German policy is the result of the government’s keen desire to see the Kyoto Protocol implemented by 2002.

TABLE 3.1 EUROPEAN UNION BUBBLE ALLOCATION (MTCO2)

Member State % Change Absolute Change Total (1990) Total (2008/12) (1990-2008/12) Austria -13 -10 74 64 Belgium -7.5 -10 139 129 Denmark -21 -15 72 57 Finland 0 0 73 73 France 0 0 637 637 Germany -21 -252 1,201 949 Greece 25 26 104 130 Ireland 13 7 57 64 Italy -6.5 -36 542 506 Luxembourg -28 -4 14 1 Netherlands -6 -12 208 196 Portugal 27 18 69 87 Spain 15 46 301 347 Sweden 4 3 69 72 United Kingdom -12.5 -97 775 678 Total -8 -336 4,334 3,998 Source: Gummer John and Robert Moreland, The European Union & Global Climate Change: A Review of Five national Programs. Pew Center on Global Climate Change, 2000.

3.1.2.3. The United Kingdom37 The UK has historically had a high per capita level of GHG emission. It has accepted a reduction of 12.5% between 1990 and 2008/12, and has adopted a national target to about double this percentage. The country has already achieved a 14.6% reduction due primary to substantial fuel switching from coal to natural gas. However, further reduction in this area is limited and, like the rest of EU countries, the UK will have to fight with increases in the transportation sector emission. To ensure continued reductions, the government is relying heavily on several measures, including greater use of renewable energy, eco-taxes, and voluntary agreements with the industry. The country is also examining the possibility of a domestic emission trading (ET) scheme. The national target of obtaining 10% of electricity generation by 2010 from renewables is ambitious. However, it does not yet threaten the fulfillment of the UK’s strong commitment to achieve its obligation under the Kyoto Protocol.

37 Ibid.

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3.1.2.4. The Netherlands38 The Netherlands is often considered as an environmental leader and indeed was at the forefront of EU appeals for action on climate change at both Rio and Kyoto. However, the Dutch economy, which has grown faster than the EU average, is energy-intensive, partly due to the country’s large resources of offshore natural gas. Although the Netherlands has accepted a 6% emission reduction between 1990 and 2008/12, it has increased its CO2 emission by about 17% since 1990. This increase brings into question the country’s ability to reach its Kyoto target. The government has already stated that it intends to take advantage of IET to meet half of its target. Like Germany, the Netherlands is introducing a wide range of measures to achieve its goal and is promising more. These measures will affect some of the traditional strengths of the national economy (the transport sector and its energy-intensive industries) and will involve further taxation. Nevertheless, it is difficult to be optimistic about the country’s ability to meet its obligations under the Protocol.

3.1.2.5. Japan39 Since 1997, Japan played a key role in the OECD efforts to tackle climate change. At the same time, its overall greenhouse gas emission rose about 10% from 1990 to 1998 (see Figure 3.2). Japan in 1990 was one of the most energy efficient economies in the world, and had limited perceived room for additional efficiency improvements. The Japanese “master plan”, presented in the aftermath of the Kyoto conference, relies mainly upon “technological innovations” to return its domestic emissions below 1990 levels. It assumes that the 6% target will be secured with a 3.4% contribution from carbon sinks, and 1.8% from use of the Kyoto mechanisms. Japan’s renewable energy industries have not had the same degree of incentive as have those in EU and, notwithstanding some notable exceptions (e.g., Mitsubishi wind turbines), they tend to lag behind European companies, especially in domestic applications. Furthermore, for Japan the addition of non-CO2 gases to the ‘Kyoto basket’ makes its target more difficult to achieve, not less. Legislative progress has been slow. All this has led to considerable pessimism about the prospects for major GHG reductions.

3.1.2.6. US, Canada and Australia40 Greenhouse gas emissions in the US, Canada and Australia are generally much higher than in the EU economies, both per capita and per unit of GDP. In sharp contrast to the FSU countries, they continued rising through the 1990s to levels of 11-15% above 1990 levels, driven by population and economic growth (see Figure 3.2.) The US and Canada, with Kyoto allowances of 7% and 6% below 1990 levels respectively, thus face potentially large cutbacks under Kyoto. A similar situation is found in Australia, though this country received a much more generous allowance in Kyoto due to particular economic and political circumstances.

38 Ibid. 39 Grubb Michael et al. Keeping Kyoto – A Study of Approaches to Maintaining the Kyoto Protocol on Climate Change, 2001. 40 Ibid.

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These fundamentals have determined a consistent policy of these countries, which have previously worked together with Russia, Ukraine and Japan in the “Umbrella Group”, trying to maximize flexibilities in the Kyoto Protocol. The US did much to determine the final structure of the Protocol and its wide range of flexibilities. For all these countries, it is only by using the Kyoto mechanisms that it will be possible to meet their commitments at economically acceptable costs. The US internal debates have been dominated by economic studies that project a 4% loss of GDP arising from reduction of domestic CO2 emission from projected BAU scenario levels in 2005 to its Kyoto target, and 30% cut of domestic emission in 2008 that results in serious economic shock. Given its emission trends to date and high costs of compliance, the US Kyoto commitment does represent a larger absolute task than for other countries. Some economic studies41 emphasize that the US is amongst the world’s highest per capita as well as absolute emitters, uses energy less efficiently than most OECD countries, and has a large potential for apparently cost-effective energy efficiency improvements (as well as large renewable energy resources). However, the dominant economic analyses in the US have tended to neglect opportunities for cost reduction including the various flexibilities (multiple gases, carbon sinks, and the flexibility mechanisms) in the Kyoto Protocol. Instead, the US research community proposed more profound alternatives, specifically caps on the domestic price of emission allowances, and targets framed in terms of emission intensities (i.e., emissions per unit of economic output). Whatever the case, these proposals could have a deep effect on the two GHG market architectures.

3.1.2.7. Capping the price of emission allowances Price cap proposals have mostly been intended to address the concerns of certain OECD countries (mainly the US) whose costs under the Protocol could be unacceptably high. The idea behind the price cap is very simple: given a regime of quantitative GHG emission targets, there is a transparent world market for emission allowances, which leads to a common market price. If the market price rises above a predetermined threshold, additional allowances are issued at the threshold price. The proponents of the price cap argue that the cost of climate policy will thus be limited ex- ante. They also argue that, under uncertainties about emission reduction costs, a price-based policy is preferably to a quantity-based policy. As long as there is no risk of crossing a threshold of GHG concentration beyond which damages increase non-linearly, short -term quantity control on emissions is unnecessary.

In practice, a price cap has already been used in the Danish CO2 trading system for the electricity sector since January 2001. The price cap lies at 40 Danish Crowns (about $5) per ton of CO2. This level has been set to prevent Danish coal-fired power plants from becoming uncompetitive in the fully liberalized Nordpool electricity market.

41 See, for example, Alison Bailie, et al. The American Way to the Kyoto Protocol: An Economic Analysis to Reduce Carbon Pollution. July 2001.

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However, model studies show that price cap can compromise environmental effectiveness by potentially reducing both domestic actions and investment flows via the Kyoto mechanisms.

For example, a price cap level below $20/tCO2 (or $75/tC) could add several percentage points to allowed emission under the Kyoto targets. At the same time, the implied trade-off between increased damages, primarily in developing countries (due to reduced investments via a CDM), and cost reduction for OECD countries would be contrary to some of the key principles adopted under Article 3 of the FCCC.

3.1.2.8. Introducing intensities targets focusing on emissions per unit of GDP Emission intensity is normally defined as the quantity of a pollutant emitted per unit of GDP, or unit of production. Intensity targets are then defined in terms of a percentage reduction relative to some baseline intensity. US emission intensity improvements, over the last decade, have often been quoted in response to criticism about the lack of US action to reduce carbon emission. Indeed, the emission intensity of the US economy improved by 15% between 1990 and 1999. In comparison, the rest of OECD countries improved emission intensity only by 11% 42. Over the same period the US GDP increased by 33%, pushing the carbon emission 12% up. In energy intensity improvement over the 1990s, the US shows an even greater gap with OECD countries as a whole: 13% compared with 6.3%. Thus, the rationale behind proposing intensity targets becomes quite clear: · The US is improving efficiency and intensity at a faster rate than other OECD countries · Intensity targets leave room for economic growth, and the US economy has grown particularly fast. Intensity targets also mitigate one of the key drawbacks of the absolute caps agreed in Kyoto, because they filter out economic growth from emission reductions. Indeed, strong economic growth does not jeopardize meeting intensity targets, whereas it would increase the difficulty of meeting absolute targets. Emission intensity targets, henc e, could give developing countries the opportunity for unrestricted economic growth – as long as their emission intensity improves. Whereas intensity targets are interesting for fast-growing economies, they pose a problem for those in recession or slowdown. For example, while the US emission intensity improved by 15% in 1990 – 2000 and absolute emission grew by 12%, absolute carbon emission in Ukraine, undergoing economic transition after the collapse of the FSU, declined by 51%, but carbon intensity increased by 18% 43 (see Fig. 3.3.) A universal target would thus result in a much stronger target for Ukraine than for the US or the possibility that the US and other OECD countries would sell allowances to Ukraine, which clearly contradicts the spirit of the FCCC.

42 Benito Mueler et.al., Rejecting Kyoto - A Study of Proposed Alternatives to the Kyoto Protocol, July 2001. 43 Brunello, Anthony and Boris Kostukovsky, Ukraine and the International Greenhouse Gas Emissions Trading Market, August 2001.

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FIGURE 3.3 CO2 EMISSIONS PER UNIT OF GDP (2000)

Source: US DOE, International Energy Annual 2000, Washington 2002

3.1.3. Analysis of the Competing Role of JI/CDM and IET at International GHG Markets Both mechanisms raise two big challenges. The first is their indefiniteness. While the CDM states explicitly that CERs can be accumulated from the year 2000 onwards, the provisions of JI simply state that ERUs shall represent a transfer between national allowed e missions in the first commitment period (2008-12). This has been interpreted as JI activities cannot be credited before 2008. The second is that their creation has raised high investment expectation in FSU and developing countries. Two groups of countries have begun looking forward to resource flows under these mechanisms, highlighting their advantages and competing for future investments. On the one hand, the financial attractiveness of JI projects strongly depends on the design of the CDM rules. It is quite clear that the soft rules for CDM (including carbon sinks) will make JI projects less attractive for potential investors than CDM. On the other hand, US withdrawal from the Kyoto Protocol has important economic consequences for all Parties, as it tends not only to lower compliance costs within the rest of OECD countries, but also to reduce the total level of resources through project-based mechanisms. Indeed, smaller amounts of trading at higher price could increase resource flows to the developing countries through the CDM. Larger volumes of trading at lower prices would bring the opposite results. Apparently, low-price estimates are unrealistic, since FSU will never sell its surplus gratis. At the opposite extreme, there is lack of confidence that the FSU (i.e., Russia and Ukraine) will

102 NSS Ukraine be able to build a perfect cartel by regulating the supply of allowances to maximize the total revenue. To do so, they would have to neutralize China as possible free rider. If we use the oil market analogies, then we can speak of a cartel built by Russia, Ukraine, and China (see Table 3.7) It is known that the oil markets similarly maintain prices well above equilibrium levels through mutual interests of the OPEC countries. In case of GHG emission reduction market this would suppose a cooperative behavior of the cartel members built on internal redistribution of profits. Nominally, there are no obstacles to such a cartel. During the recent years there was further increase of trade and growing cooperation in different spheres among the three countries. On the other hand, legal and administrative prerequisites for domestic emission reductions trading still have to be created in these countries.

TABLE 3.2 CARTEL RUSSIA, UKRAINE, AND CHINA (RESTRICTION ON SUPPLY OF SURPLUS AAUS AND CERS)

Source: Gruetter Jurg, The GHG Market after Bonn, 2001

As emission allowances exporters, Russia and Ukraine would profit under all scenarios by restricting their supply to 20 - 30% of the total surplus. In accordance with the Marrakech Accords, this assumption is even more realistic as banking is permitted. In fact, both countries can either reduce their supply of AAUs to get more revenue during the first commitment period, or bank excess allowances for future use during the second commitment period.

3.1.4. Summary of GHG Relevant Policies of Major OECD Countries Key decisions reached in November 2001 in Marrakech provide a complex set of rules for implementing the Kyoto Protocol based on the broad principles of the Bonn Agreement. According to these rules, different groups of OECD countries will rely on diverse policies to move towards their targets as domestic politics allows. The EU will support sufficient domestic action to promote innovation and change in the emission trend for a variety of strategic and internal political considerations. Japan, Canada and Australia will try to secure access to the FSU surplus, while the EU will try to maintain a ‘reasonable’ GHG reductions price, as will developing countries do. Assuming Marrakech Accords as a plausible basis for the Kyoto Protocol ratification, we have to admit that without the US, the theoretical ‘equilibrium’ price will be lower than it is in the interests of any of the key participants, see Table 3.3. Moreover, under unlimited allowances exchange, the ‘equilibrium’ international carbon price will likely be too low to meet core political objectives of most Parties. This means that the ‘international’ carbon price will be a political construct reflecting willingness to pay, market power, and managerial

NSS Ukraine 103 approaches to so-called “hot air” 44. The closest analogy is the oil market, which similarly maintains price well above the equilibrium price by mutual consent of OPEC members.

TABLE 3.3 CLIMATE POLICIES OF MAJOR OECD C OUNTRIES AND THEIR COSTS ABARE – GTEM Models45 (all GHG) Price of traded Domestic Total compliance Reductions in Type of scenario tons ($/tC) reductions cost ($B) compliance cost (MtC) from the Kyoto scenario Kyoto scenario 60.7 358 49.9 n/a Kyoto without the US 3.4 14 1.1 92.5% Kyoto without the US and 32.0 100 9.3 37.5% without “hot air” Source: Gruetter Jurg, The GHG Market after Bonn, 2001.

On the one hand, Marrakech Accords do not hold any formal quantified constraints on international allowances transfers. On the other, the provision that each Party must maintain in its registry a “commitment period reserve”46 implicitly sets quantified constraints upon imports of AAUs. Appare ntly, such constraints would have dual consequences. First, their effect would be highly variable: some countries (perhaps most) would be completely unaffected, while some other might be affected a lot (i.e. Australia, Canada and Japan) and forced into more intense domestic action. Furthermore, because all Parties are linked through the Kyoto mechanisms, the US withdrawal from the Kyoto Protocol will have important economic consequences for all of them: it will tend to lower compliance costs whilst also reducing the level of resources through the mechanisms. Lower US demand will lead to a lower international price. Indeed, according to most projections, without the US the demand from other countries might be met entirely from the FSU surplus (see Table 3.4.)

44 See for example Russian Green Investment Scheme. 45 ABARE stands for Australian Bureau of Agricultural and Resource Economics, GTEM stands for Global Trade and Environmental Model. 46 Which should not drop below 90 per cent of the Party’s assigned amount or 100 per cent of five times its most recently reviewed inventory, whichever is lowest.

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TABLE 3.4 EVALUATION OF CLIMATE POLICIES OF MAJOR OECD COUNTRIES Environmental Effectiveness Economic Efficiency Annex I Emissions compared Permit Annex I Policy Scenario Domestic abatement to 1990 level price costs (in reductions billion (in MtC) Excl. US Incl. US (US$/tC) US$) KP with the US (with IET) 755 -4% -5.1% 46% 36 19 KP without the US (with IET) 235 -4% +8% 22% 16 3.5 Bonn Agreement 130 -0.1% +10.6% 14% 9 1.8 Source: Grubb Michael. The Bonn-Marrakech Agreements on Implementing the Kyoto Protocol: Implications for the Kyoto Mechanisms. Presentation to Kyoto Mechanisms Expert Network, Amsterdam, Dec. 6, 2001.

This poses a difficult dilemma. It is evident now that the US will not enter the Kyoto Protocol for the first commitment period. Therefore, a constraint on imports would help to prevent countries from simply buying up very cheap emission allowances instead of promoting domestic action. Yet its effect in other respects could be more problematic: the reduction of the allowances demand would depress the international price and volume of transfers to Russia and Ukraine through IET and JI, and to developing countries through the CDM. Without the US, import constraints will further reduce demand, causing a decrease in the international price and resource flows under the mechanisms. In fact, without the US, economic costs are now seen much lower as the EU has already taken many steps to reduce its carbon emission. If we include the FSU allowances surplus, then the potential supply of cheap carbon permits will flood the market, and CDM projects will find fewer buyers. Given the lack of modeling precision, the first principal conclusion is that it is not even in the FSU’s own interest to trade the total surplus, as its income may be quite insensitive to traded volumes. Figure 3.5 indicates that the FSU income would be similar across a range of 20% to 30% of surplus trading.

FIGURE 3.4 REVENUES TO EITS WITHOUT THE US PARTICIPATION: DEPENDENCE ON THE % OF TRADED SURPLUS Source: Grubb Michael et al. Keeping Kyoto – A Study of Approaches to Maintaining the Kyoto Protocol on Climate Change, 2001.

Revenues to EITs = f(% of hot air traded) 3500 3000 2500 No sinks1 2000 Sinks (Pronk II)

M95$ 1500 1000 500 0 0% 20% 40% 60% 80% 100%

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Aggregated supply and demand at global carbon market In the absence of an open and liquid market for GHG emission reductions, and given the heterogeneity of the few transactions that have been executed, determining the price to pay for AAUs/ERUs is a big problem (see Box 3.3.)

BOX 3.3 CURRENT MARKET PRICES OF GHG EMISSION REDUCTIONS

· The Prototype Carbon Fund of the World Bank monitors the emerging carbon market to ensure that the price it pays for ERUs/CERs is broadly in line with prices paid by other buyers under comparable transactions. Until now, emission reductions have been valued across a wide price

range—from about $3.7/Ce (or $1/CO2e) for non-verified reductions, to over $29/tCe ($8/tCO2e) for allowances that are recognized by governments under existing domestic schemes.

· The Dutch national emissions reduction purchasing tender ERUPT in its first round in the year

2000 (five JI projects to the amount of 4M tons of CO2 equivalent) had an average price of around $28/tC (or $7.5/ton CO2).

· Natsource made an analysis of around 60 transactions involving 15M tons of carbon. It has revealed prices between $2 and $11/tCe (between $0.6 and $3/tCO2e) for verified emission reductions and between $15 and $44/tCe (between $4 and $12/tCO2e) for allowances that had gained approval by the respective buyer country. Sources: www.prototypecarbonfund.org/html/ar_home.htm; www.senter.nl/erupt/projects.htm; Review and Analysis of the Emerging GHG Market. Natsource, 2001.

As follows from the above analysis, current market prices are very volatile and depend to a considerable extent on the quality of certificates. The future evolution of these prices is even more speculative. In fact, prospective market prices will depend strongly on the evolution of demand and supply. Demand will depend upon factors such as economic growth in OECD countries, voluntary corporate commitments, and future US commitments. Supply will be largely influenced by barriers to project development, abatement costs within OECD countries and “hot air” trading. Figure 3.5 breaks down the elements of demand and supply, indicating that, depending on these factors, the future market for credits from CDM/JI projects may be relatively small. This would imply possible prices ranging from zero to about $25-$29/tCe ($7–$8/tCO2e) in a medium -growth scenario excluding the US. If the US were to take commitments under the Protocol, prices would likely be substantially higher.

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FIGURE 3.5 ESTIMATES OF POTENTIAL DEMAND AND S UPPLY OF EMISSION REDUCTION CREDITS, M TCO2E/Y

Source: http://www.prototypecarbonfund.org/html/ar_home.htm

However, it needs to be noted, that in case all hot air is sold on the market, these excess credits might well be higher than total demand (depending on the growth scenario in OECD countries). For details see for example Grütter (2002a).47 Most recent GHG price estimates produced with the CERT model (which is a meta model based on various underlying models and which was produced for the World Bank’s NSS Program) indicate that prices might be even somewhat lower than those stated above. Grütter (2002b) 48 describes a scenario with the following assumptions: · partial participation of the USA (30% of emission reductions required) · 50% CDM implementation rate · 2 US$ transaction costs for CERs and 1 US$ transaction costs for JI/IET · 2% of CERs will go to a special adaptation fund · 50% supplmentarity of EU · Stackelberg (price leadership) solution for the former Soviet Union (FSU). The Stackelberg solution describes a specific form of a price finding process in a cartel situation. Thus, the authors of the paper do not assume that the countries of the former Soviet

47 Grütter, J. (2002a), The Potential GHG Market in EIT Countries , Paper prepared for the NSS Program of the World Bank. 48 Grütter, J., Kappel, R., Staub, P. (2002), The GHG Market on the Eve of Kyoto Ratification, Report prepared on behalf of the NSS program of the World Bank.

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Union will be able to form a monopoly, but they will be able to restrict their GHG demand and keep the GHG prices at a level higher than they would be with full compeitit ion. Under the assumptions laid out above, CERT yields price estimates of 3-20 US$/tC, with prices in the most realistic scenario (medium business as usual case, meaning: medium growth rates of emissions in case no Kyoto commitment have to be adhered to) in the range of 7-17 US$/tC, which corresponds to 2-5 $/tCO2.

3.2. INSTITUTIONS AND PRODUCTS FOR THE GHG MARKET

3.2.1 Recent Evolution of Commodity/Stock Markets and their Products Historically, financial markets have been dealing with the trade of commoditie s and stocks for more than a century, and over that time increasingly complex instruments have been developed. As financial products gain market acceptance, they are often modified to create new ones, ever innovating to satisfy the demands of increasingly sophisticated market participants. The motivating factor behind the genesis of advanced products in commodity markets is always the need to create new and better ways to manage risk.

The success of the SO2 and NOx trading program in North America supports the argument that its core elements should be applied to GHGs trading. Certainly, we can expect that all standard financial products available in the credit or allowance markets will be available for the international GHG market as well. Although GHG allow ances49 are not yet tradable financial assets, they do share characteristics with currencies, stocks, bonds, and other financial instruments. The SO 2 allowances traded at the Chicago Board of Trade on behalf of the US EPA have similar characteristics to GHG allowances. Domestic environmental markets may offer some ideas regarding the financial dimension of GHG allowances (see Box 3.4.)

49 Where the distinctions between ERUs and AAUs are not important, these tradable units will be referred to as allowances, because they “allow” the holder to emit a special amount of GHG (e.g., one ton of carbon equivalent).

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BOX 3.4 THE SO2 AND NOX ALLOWANCES MARKETS IN THE US AND CANADA The US current ly manages two major emission quota trading schemes for air quality management: the Acid Rain Allowance Trading Scheme (in which power plants are the main parties) and the Californian RECLAIM scheme, a system of tradable permits for NOx and SO 2, introduced with the intention of making ozone abatement programs more efficient.

· In the US, the acid rain trading program created an effective market for SO 2 quotas (allowances). The number of transactions rose from 215 in 1994 (with 9.2M allowances traded) to 1,429 in 1997, when 15.2M allowances were traded. In that year, 7.9M allowances were traded in 810 transactions that took place among economically distinct organizations. Cost savings in 1995 were estimated at US$ 225 -375M, or 25-34%, when compared with abatement without trading.

· The Californian RECLAIM program is also claimed to be successful. Since its introduction in 1994, emissions were kept below a progressively decreasing target. Among different firms, more

than 29,000 NOx tons were traded in 352 transactions with a total value of US$ 23.6M. For SO2, more than 51 trades were established, including 13,500 tons, and a total value of US$ 18M.

· Since 1994, Canada’s Pilot Emission Reduction Trading (PERT) Program has contributed to the reduction of nearly 14,000 metric tons of ground-level ozone precursors (NOx and VOCs). Source: Emissions trading: Environmental policy’s new approach. Richard F. Kosobud (ed.). John Wiley & Sons, 2000.

GHG emission trading will not officially start until the Kyoto Protocol enters into force, and the difficulties arising in the treaty negotiations may suggest that the adoption of formal regulation is still far ahead. However, international negotiations will only concern the country obligations. On the other hand, private companies will be subject to the rules of national and sub-national governments where they operate. These regulations may well take place before the ratification of the Protocol. Many countries are taking steps to ensure that they will be ready for international emission trading when the rules are finalized (see Box 3.5.) Australia has consulted on options for a domestic GHG trading scheme. Similar initiatives are underway in Canada and the US. GHG emission trading systems are also under consideration in France, Germany, the Netherlands, Sweden and Norway.

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BOX 3.5 AN O VERVIEW OF THE CURRENT MARKETS FOR GHG EMISSIONS TRADING

· The Canadian Greenhouse Gas Emission Reduction Trading Pilot (GERT) is designed to test the effectiveness of emission reduction trading for GHGs in the country context. This pilot is a partnership between the federal government, a number of provinces, industry, labor and environmental groups.

· The Chicago Climate Exchange is the first U.S. voluntary regional pilot program for GHGs trading of. The program will design and test an emissions market based in the US mid-west. If the design phase is successful, a second phase would set up the actual market and trading mechanism. In the final phase, scheduled for 2004, the market would be opened to global trading. Under a voluntary agreement, participating companies would be issued tradable emission allowances. Emitting firms would commit to a phased schedule for reducing their emissions 5% by 2005.

· Denmark's energy companies started national CO2 trading within a cap and trade system in 2001. The country will run a free permits scheme until 2003.

· Under the UK voluntary scheme, companies set themselves targets to cut CO2 emissions and are given cash incentives by the government if they meet their pollution goals. The scheme, involving almost 50 industrial sectors, is on target to commence in April 2002. The first auction will take place at the end of February. It has to clarify who will be claiming their share of the £215M incentive and how UK trading will continue from here. Under the scheme, the UK government aims to cut carbon dioxide emissions by 20%, which is well below the 12.5% target under the Kyoto Protocol.

· The EU scheme of emission exchange, worth as est imated 1.3B euros annually to each member state, is set to run from 2005 to 2008 (i.e., for 3 years prior to the Kyoto Protocol's trading

program). The downstream compliance system would cover CO2 emissions from large fixed-point sources such as refineries, metal smelter and power plants and will primarily affect energy, steel & iron, pulp & paper, building materials and a few other sectors. Sources: www.cleanerandgreener.org/environment/transactions ; www.chicagoclimatex.com ; www.eyeforenergy.com/emissions

As follows from the above, a long-term strategy needs to embrace both existing and pending national and international trading schemes. Meanwhile, global market opportunities for trading emissions already exist. Since 1997, transactions representing over 30M tons of CO2 equivalent reductions have been conducted around the world. Participants in the early transactions have included governments and other entities such as electric utilities, oil companies, processing industries, wood product companies, and non-profit organizations. In the first forward deal under the UK's newly developed trading scheme, the chemical group DuPont sold 10,000 year 2002 greenhouse gas emission allowances to MIECO, a unit of the Japanese trading company Marubeni Corp.

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3.2.2. Overview of Current GHG Market Products and Prices Most leading companies have now recognized that they will need to operate within greenhouse gas emissions constraints. Firms with GHG liability can utilize the trading market to implement their hedging strategies. Firms with a high ratio of emissions to profits, or with high barriers to shifting their emission-intensive capital, have incentive to adopt an active trading strategy as a means of achieving compliance. For these firms, many of whom operate in conventional commodity markets, GHG emissions will simply be another instrument within the larger commodity trading strategy to be managed as any other purchased production input (i.e., raw materials). As in all traded markets, the largest single factor influencing action is the perceived future price curve. As in any emerging market, perceptions vary dramatically. Some investors take the view that the market currently offers a portfolio of emission reductions at highly risk- discounted price, offering an opportunity to lower future compliance costs and offering a substantial return on investments. Other investors expect the market to be flooded with available emission allowances as the time remaining before the first commitment period shortens and this increase in supply will put pressure on prices. As emission trading takes off internationally, the information needed to manage it and the available products will multiply rapidly. For example, the purchase of a call option provides the buyer with a hedge against future higher prices, but no obligation to purchase in the event that the firm's price perceptions are inaccurate. At the same time, a sale of a call option permits the seller to enhance the returns (through the receipt of a premium) from a currently non-income producing asset, and may enhance its eventual sale by decreasing future transaction costs. Similar to the US sulfur dioxide market, GHG emission trading makes it possible to "bundle" emission compliance with either raw materials or finished products, enabling firms to differentiate their products in terms of price and/or public perception. Emission compliance can move up or down the supply chain, as firms attempt to divest liability to, or remove liability from, suppliers or consumers of their products. In this manner, firms might sell "greenhouse neutral" products to enhance their competitive position. Below we outline some of the most widely used financial products in the current GHG market.

3.2.2.1. Forward Settlement This type of transaction is much like the immediate over-the -counter (OTC) settlement. The delivery of allowances and the payment, however, happen some time in the future, as the name indicates. These types of transactions allow market participants to lock in future purchases at prices that meet their individual needs. It is also a sound tool for managing cash flow, as the buyer is able to book the definitive price of the future purchase well in advance. The last point can serve as a guarantee to the project owner in Ukraine that he will be able to sell his ERUs at a given price during the first commitment period.

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3.2.2.2. Future Contracts Futures are a variant of the forwards that are traded on financial exchanges. One difference to the forward contract is that the seller is permitted to deliver the product any time during a delivery period. The rule has a wide use in the trade of commodities (i.e., grain or coal), but in case of GHG credits it will have a small effect, since the project owner can store his ERUs without costs. Viewed in the context of GHG market, futures also can be seen as price guarantees that significantly reduce the risk of JI project. Future contracts require the services of financial exchanges, which in turn require some level of liquidity on the GHG market.

3.2.2.3. Swaps For settlement transactions (both immediate and forward), allo wances are usually being exchanged for cash. This is the simplest form of allowance transfer and the most common in emissions trading markets. However, swaps have also become another popular type of transaction. At its most basic, swaps allow one party to exchange allowances of one vintage year for allowances of another vintage year from a second party. Viewed in the context of compliance with domestic carbon reduction programs, swaps have the ability to use the GHGs market to efficiently re-distribute carbon allowances. Take for example a utility, which has plenty of allowances for the year 2008 but is 10,000 vintage 2014 carbon allowances short, and a metallurgical plant that is short on vintage 2008 allowances yet has at least 10,000 carbon allowances in excess for the year 2014. Through a swap transaction, the utility could exchange its surplus vintage 2008 carbon allowances for the metallurgical plant’s surplus 2014 allowances. Viewed in the context of AAUs, the same kind of swap could have place between two countries, say Ukraine and the Netherlands.

3.2.2.4. Options At their most basic, options are a means to hedge the risk of a rise or fall in price, but they can also be used to maximize revenue on a portfolio of allowances. Options provide the option buyer the right but not the obligation to buy a commodity (in our case, AAUs or ERUs) at a specified price by a certain date. They can best be related to insurance policies in which an individual pays out a premium to the seller or “insurer.” The insurer provides a “policy” to cover the buyer’s risk of prices going up or down, depending on where the buyer sees their exposure.

3.2.2.5. Call Put into practice, options can be useful to a party that may need to buy carbon credits in the future and is hoping the price for these products will fall over time. Without options, the buyer faces a risk: if the price falls, he saves money, but if the price actually rises he will have lost money by hesitating to purchase carbon credits earlier. The option use d to manage this risk is known as a call option . To hedge the risk that prices will increase (known as the upside risk ), the party can enter into an option transaction with a counterpart. The option allows the option buyer to buy credits at a specific point in the future (the option exercise date) and at a specific price (the strike price). In return, the option buyer pays the option seller a premium.

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BOX 3.6 CALL OPTIONS: RIGHTS AND O BLIGATIONS OF THE BUYER AND S ELLER Buyer: The buyer is entitled to buy (or call) credits at a predetermined strike price on the date of expiration. This position might be taken by a company that is short on GHG credits during the First Commitment Period and wants to hedge the upside price risk. Risk is limited to the amount paid for the premium. Seller: The seller grants the right to purchase to the buyer and collects a premium. Note that under this arrangement the seller has the obligation to sell the credits at a predetermined price at the discretion of the call buyer. This position might be taken by a company that has an excess of carbon credits, is satisfied by the strike price, and is using a call option premium to maximize the value of its inventory. Source: Emission Trading Handbook, 1999.

As the exercise date approaches, the option buyer needs to decide how to act. If the market price for allowances is higher than the option strike price, the option buyer will exercise the option and buy the allowances for the strike price. If the market price for allowances is equal to or lower than the strike price, the option buyer will simply enter the market and purchase the allowances over-the -counter. In this case, the penalty associated with rising prices is limited to the premium paid by the option buyer.

3.2.2.6. Put The contrast to the above example would be a situation where a party knows it has surplus of GHG credits, but does not want to sell them right away. The party hopes that in the future the price for the credits will increase, allowing it to realize more profit from the sale than if it had sold immediately. The risk is that the market price for credits will actually drop in the future. To hedge this risk, the party can purchase an option to sell its credits at a given point in the future for an agreed upon price. The option buyer pays a premium to the counterpart providing the option. When the exercise date arrives and the market price is lower than the strike price set in the option, the option buyer will take advantage of the transaction and sell credits to the option seller for the agreed upon strike price. If the market price is above the strike price, the option buyer will forgo exercising the option and take her allowances to the over -the-counter market to gar ner a larger sale price. This type of option is known as a put option , and the option buyer’s risk of decreasing prices (known as the downside risk ) is limited to the cost of the option premium.

BOX 3.7 PUT OPTIONS : RIGHTS AND OBLIGATIONS OF THE BUYER AND SELLER Buyer: The buyer is entitled to sell (or put) GHG credits at a predetermined price on the date of expiration. This position might be taken by a company that is long on credits and wants to hedge the downside price risk (i.e., to sell them at a guaranteed minimum price). Risk is limited to the amount paid for the premium. Seller: The put seller grants the put buyer the right to sell credits and collects a premium. Note that under this arrangement the seller takes on the obligation to buy the allowances at a predetermined price at the discretion of the put buyer. This position might be taken by a company that is short on credits, satisfied by the strike price and is using a put option premium to minimize its upside price risk for purchasing credits. Source: Emission Trading Handbook, 1999.

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Companies engaged in the initial phases of carbon credits trading have had access to purchases of carbon sequestration projects ranging in price from $0.50 to $1.0 per ton of CO2 equivalent for straight price purchases. Those involved in these trades indicate that serious sellers in the marketplace have strived to keep the price below $2.0 per ton and that prices are holding steady. Presently one of the basic markets for carbon credits trading is the OTC market. Various broker firms such as Cantor Fitzgerald and Natsource match buyers and sellers. As the liquidity of the GHG market increases, more institutionalized trading systems are being set up. Two years ago, the Sydne y Futures Exchange has launched a GHG trading platform (i.e., electronic marketplace). Since April 2001, the International Petroleum Exchange in London is involved in the nation-wide UK carbon Trading System. Voluntary initiatives such as the

Chicago Climate Exchange are harnessing the success of the SO2 program in the design of a carbon dioxide trading program in the US. Just recently, Cantor Fitzgerald in association with PricewaterhouseCoopers established CO2e.com: a web-based, broker -assisted marketplace for bilateral trading of emission reductions. This activity is further supported by recently introduced legislation regarding the domestic carbon trading program in Europe and the US. Some emission allowances brokers indicate that the upper end of the price ranges closer to

$2.0 per ton of CO2 equivalent or as high as $2.50 per ton, although there have been very few trades that occurred at those prices, and the $0.50 per ton range is a more accurate representation of general trading activity. Projects based on clean energy technologies such as solar power, wind power, biomass, small hydropower, fuel switching or methane gas recapture, range in price from $2.0 per ton upward to $50.0 or higher 50.

TABLE 3.5 RECENT GHG EMISSIONS TRANSACTIONS MMT Description of transaction Date of CO2 Niagara Mohawk (USA) to Arizona Public Service (USA). CO2 - SO 2 swap. 1997 2.27 Reductions due to fuel switch (gas). American Electric Power (USA) et al, The Nature Conservancy (USA), Fundaci? n 1998 53.10 Amigos de la Naturaleza (FAN), Bolivia. Noel Kempff Mercado Project. Doubled park’s size to 3.8M acres; community development. Suncor Energy (CDA), The Nature Conservancy (USA), The Program for Belize. Rio 1998 0.40 Bravo Project. Expansion of protected area; community development. Niagara Mohawk (USA) to Suncor Energy (CDA). Sale of 100,000 tons; option on 10 1999 10.10 MMT. Reductions due to fuel switch (gas), demand side management, other measures. Central & Sout h West (USA), The Nature Conservancy (USA), Sociedade de Pesquisa 1999 1.00 em Vida Selvagem e Educazgo Ambiental (SPVS), Brazil. Guaraquezaba Project. Acquisition, restoration, protection and management of 20,000 acres of Atlantic Forest in Parana State; promotion of sustainable development in the surrounding community. Ontario Power Generation (CDA) and Zahren Alternative Power (USA). Spot 1999 2.50 transaction; credits from capturing methane from landfills and using it to generate electricity.

50 Jacobson, Lisa and Allison Schumacher, Emissions Trading: Issues and Options for Domestic and International Markets. BCSE, 2000.

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IGF Insurance Company (USA), Greenhouse Emissions Management Services, Inc. 1999 2.80 (CDA), farmers in State of Iowa (USA). Options on credits from increases in soil carbon through switching to low-till and no-till agriculture. Tokyo Electric Power Company (TEPCO) and the government of New South Wales 2000 0.30 (Australia) agreed to an $82M carbon offset deal. Under the arrangement, TEPCO will invest in tree planting in New South Wales over the next ten years in exchange of carbon credits equal to the amount of CO2 sequestered by the trees. TransAlta Corp announced an agreement to purchase up to 2.8M metric tons of carbon 1999 2.8 emission reduction credits (CERCs) from farms in the U.S. through carbon sequestration practices. Canadian electric utility TransAlta purchased allowances for 24,000 tons of CO2 2000 2.4 equivalent from German utility company HEW. Under this deal, HEW will replace some of its coal-fired generation capacity with wind turbines over the next 7 years. Total 77.6 Source: http://www.cleanerandgreener.org/environment/transaction.htm; Business Council on Sustainable Energy.

3.2.3. Insurance and Other Risk Management Tools Major greenhouse gas emitters recognize that some form of GHG emission regulation is likely to be introduced in the next few years. The introduction of legislation would pose a significant financial risk to polluters, since the cost of internal compliance may be difficult and expensive. So, it might happen that for many companies the cheapest way to emission compliance will be through the purchase of emission reduction units on GHG markets. However, at this phase of emerging GHG emission reduction markets, such transactions are inherently risky. In fact, they suppose the purchase of an asset, which consists of the documented absence of invisible gases generated by projects located in emerging markets over a period of many years, where the host country must consent to transfer the asset to the buyer51. Even in case that the ERUs are delivered, their market value is highly speculative and their liquidity is not assured. Hence, beyond the traditional risks faced by investors in the emerging-markets on future GHG market, companies will face additional risks, which can be grouped into four main categories: 1. Product risks · Signing of the Kyoto Protocol · Compliance with the Protocol · Definition of relevant baseline · Baseline approval procedure The principal risk associated with greenhouse gas market products has a political nature: will the Kyoto Protocol enter into force? Will the host country ratify the Kyoto Protocol and maintain compliance with it? Will the host country sign the Memorandum of Understanding (MoU). This uncertainty may cause companies to delay their participation in the GHG market, and the delay may cause companies to become exposed to higher compliance costs,

51 http://www.prototypecarbonfund.org/html/ar_home.htm

NSS Ukraine 115 or alternatively lose out on capturing valuable new sources of revenue to complement core business activities. Rather than losing the opportunity, an attractive solution is to structure current transactions to elim inate or reduce the risk outlined above. Baseline risks relate to the creditability of the ERUs. Is the project’s baseline adequately set? Will its assumptions remain valid, enabling it to generate the expected level of certifiable ERUs on schedule? Apparently JI projects as such require a special insurance on possible revisions of set baselines, verification and certification procedures, unforeseen carbon leakages, etc., which can reduce the amount of certified ERUs. As the GHG market develops and the rules for JI/CDM projects become clearer for insurers , one can expect that new insurance tools will be offered in a due time to reduce such risks. Other product risks could be insured via the existing insurance tools for investment projects52. 2. Country specific risks · Political risks (i.e. war, macroeconomic crisis, non-transfer of currency, non- compliance/breach of the contract by a political authority) · Uncertainty of a host country law · Currency risk (uncertain foreign exchange rate) These risks have a long exposure period influenced by the uncertainty surrounding the evolving climate policy process: whether the host/investor country will ratify the Protocol; whether the host country will meet the Protocol requirements; when the investor’s country companies will become subject to binding regulations, etc. In general, such risks can be insured against by investment risk guarantee agencies or insurance companies. Currency risks can be insured against by hedging agreements through commercial banks. It should be also mentioned that, in the case of Ukraine, a key problem is its poor credit rating, which will lead in many cases to extremely high insurance premiums. 3. Project risks · Construction risk (time delay, technology failure) · Off-take risk (will it deliver the e xpected quantity of creditable ERUs?) · Fuel supply risk · Financing risk, etc. These risks are generic to the JI/CDM project and are faced to some extent by all of the financiers. It can be foreseen that risks (as well as expected returns on capital) on the GHG market will be higher than on the traditional financial markets. Thus, JI project investors have to be ready to pay relatively high insurance premiums in order to cover at least part of the risks associated with producing carbon credits. They must weight the environmental and technological aspects of a project. While clean energy technology projects usually have higher up-front costs, they provide a higher degree of environmental integrity and greater

52 Insurance against baseline risks should be subsumed under product risk

116 NSS Ukraine potential for accuracy in emissions verification. Some investors view sequestration projects as inherently risky until the domestic and international rules are determined. This is due to the uncertain nature of carbon uptake in sequestration projects. Another issue that plays a role in companies’ decision-making process is the investment risk associated with JI projects that is estimated as rather high. Therefore, banks active in the field of project finance could play a role in applying screening methods for financially viable JI projects per se, since it is their duty to evaluate cash flows of projects under various circumstances. In fact, different instruments should be developed to tackle the various types of risks associated with investments in JI/CDM projects. This include the so-called “carbon insurance”, which might be feasible but costly. In theory, it will be possible to insure the financial losses when a project fails and to generate money to acquire carbon credits elsewhere on the international GHG market. It is expected that insurance companies or banks will early start seeking GHG reductions, green certificates, etc. to be subsequently sold to businesses and/or Protocol Parties to help them comply. Multilateral Development Banks (MDBs) might also set up special carbon funds and invest in diverse projects that generate carbon credits. Such banks as Credit Lyonnais and UBS do undertake said activities. 4. Price risks In case of GHG market, it is impossible to always accurately predict what the price of AAUs or ERUs will be in the future, whether it is years or even months ahead. All GHG market participants would have to agree that, although everyone has its own view of the direction of credit prices, no one really knows for sure. In a sense, this puts even the most experienced emissions marketing participant on an equal footing with a freshman in GHG allowances or credits trading. What really sets the two apart is how they use the tools available in the marketplace to offset what they cannot accurately predict in price. At the core of the advanced structures discussed above is a focus on managing price risk. Price risk can vary depending on one’s perspective, and therefore requires different management strategies. The numerous tools available in emission trading markets can be used in various combinations and at different times in order to execute a comprehensive market strategy to protect both upside and downside risk on GHG market. The creative use of calls and puts is one example (see Box 3.8.) The basic option tools of calls and puts could be combined and utilized in creative ways to manage risk in increasingly sophisticated ways. Calls and puts on their own allow the buyer to hedge price risk in one direction: either the upside risk in buying allowances or the downside risk in selling allowances. However, hybrid structures can mitigate price risk in both directions at the same time.

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BOX 3.8 TRANSACTION S TRUCTURES FOR PRICE RISKS HEDGING Forward Settlement. It may be structured as:

· Pay now (at a discounted rate) and receive title to credits in future years

· Pay upon delivery, where payment is made in future years on an agreed date in return for delivery of title to credits created in those years. The second transaction type is often restricted to those with investment grade credit. Credit problems often may be solved through negotiation. Streams: Both immediate and forward settlement is available for streams of allowances of consecutive vintages. Streams of consecutive vintages allow the buyer to secure the emission reduction credits of the vintages that he/she considers most valuable. It also allows the seller to package and receive revenue for credits generated over a long period of time. Call Options: Options provide a level of flexibility and risk management that cannot be provided through other types of transactions, by giving the purchaser of the option the right but not the obligation to buy at a specified price for a specified premium. Options can give both buyer and seller the opportunity to hedge against price and regulatory risk. In an uncertain market, options allow traders to take early positions at relatively low cost. Options also provide a window of time during which rules for trading will become clearer. Contract liability clauses: Special conditions may be provided where the buyer requires assurances that the emission reduction credits being transferred in the future will actually be valid under future regulations. For example, if a mandated Emissions Trading Program is put into place and the transacted emission reduction credits are not valid under the future program, the party delivering emission reduction credits will return the initial payment plus interest or substitute valid credits. Source: http://www.natsource/greenhouse_gas.htm

3.2.4. Carbon Investment Funds JI has not yet entered into a phase where investor and host Parties can transfer actual ERUs. However, in principle it is possible to undertake forward or option transactions, provided that the host country has developed a registry of all AAUs so that it can allocate them to JI projects and record the possible transfers. Currently there are great expectations for the use of these arrangements in cooperation with Multilateral Carbon Investment Funds. Box 3.9 contains examples of such funds. The PCF is probably one of the most promising sources of financing JI projects in Ukraine. It seems that under this arrangement the host country and participating countries come forward with applicable projects on a more frequent basis than is being seen bilaterally. As the analysis of the first PCF financed JI project in Latvia shows, the contract between the Government of Latvia and the PCF stated a minimum amount of carbon credits to be sold at a fixed price. If the Liepaja project generates surplus amount of ERUs, then the project owner (i.e., host country) delivers a certain percentage of these credits (at future market price), whereas the percentage itself is a function of the market price. The Emission Reductions Purchase Agreement (ERPA) between the Government of Latvia and the PCF is a forward contract, not an option. It means that the project owner has a guaranteed future income (if he can deliver the credits.) Besides that, the ERPA has been specified in such a way that a project owner can get a part of the ERUs price in advance.

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Assuming a similar contract between the PCF and Ukraine (or another project owner in the country), the following issues should be of first importance in evaluating the benefits and risks for the Ukrainian project owner: · PCF can catalyze additional funds for GHG reduction projects · Transfer of more efficient and cleaner technologies and know -how · Environmental benefits at the local and global level · Low capacity and experience of the host country to negotiate with investors can lead to the effect of “low hanging fruits” · Failure to perform project monitoring can have a crucial influence on the host country commitments under the KP

BOX 3.9 EXAMPLES OF INVESTMENT FUNDS FOR JI PROJECTS Dexia-FondElec Energy Efficiency and Emission Reduction Fund is a 70M euro equity fund established by the European Bank for Reconstruction and Development (EBRD) to improve energy efficiency and reduce GHG emissions in Central and Eastern Europe. The fund is capitalized by the EBRD, Dexia Group, and several Japanese firms. It is managed by FondElec – a private equity fund management firm. The fund is focusing on energy service companies (ESCOs), district heating systems, and combined heat and power (CHP) projects. Prototype Carbon Fund (PCF), opened in January 2000, is a $145M fund sponsored and managed by the World Bank to purchase carbon emissions reductions in renewable energy and other carbon offset projects in developing countries [and economies in transition] and distribute the carbon emissions reduction credits to PCF investors, which so far include 6 Northern countries governments and 15 private companies, including British Petroleum, RaboBank, Deutche Bank, and 6 Japanese electric utility companies. All PCF-supported projects must have the approval of the host country’s government. The PCF’s geographic focus is Africa, Latin America, and Central and Eastern Europe. Near-term projects include a waste methane recovery project in Latvia, a rural renewable project in Uganda, and a 36 MW sugarcane bagasse power project in Guyana. Renewable Energy and Energy -Efficiency Fund (REEF) was established by the International Finance Corporation (IFC) to invest in renewable energy and energy -efficiency projects in developing countries and economies in transition. The principal fund manager is Energy Investment Fund (EIF). The REEF, with $100M in equity and $100M in debt, will consider investments in projects with total capitalization requirements of between $1 and $100M. REEF may also make loans to projects or project sponsors on a bridge or permanent basis. Sources: http://www.ebrd.org; http://www.prototypecarbonfund.org

Another promising approach to help private companies investing in JI projects in countries with poor credit rating is to improve the return on their investments in countries like Ukraine. Under this approach, the Netherlands’ government buys the reduction of GHG emissions (i.e., ERUs) that these projects generate, thus creating an additional source of income to boost the financial viability of JI projects and accelerate their implementation. According to such scheme, if a Dutch investor achieves a measurable CO2 reduction in another country (say Ukraine), then the Netherlands’ government buys this reduction53. Such investments might be

53 In case of JI project, an investor has to supply to the government at least 0.5M ton of CO2 equivalent during the term of the contract.

NSS Ukraine 119 of high interest to the host country, since they give it a chance to develop sustainable energy projects that may not have been achieved without selling ERUs (see Box 3.10.)

BOX 3.10 THE NETHERLANDS’ EMISSION REDUCTION UNIT PROCUREMENT TENDER (ERUPT) The Dutch national emissions reduction purchasing tender (ERUPT) is currently in its second round of tendering. Following a successful first round that secured the purchase of several million tons of emission reductions to be used by the Netherlands during the first commitment period, a second round has been opened with two separate tenders for both CDM and JI projects. ERUPT opportunities:

· Encouragement of major foreign investments without national government guarantee

· No contribution from the local budget

· Use of the most advanced technology

· Source of high quality regional employment during construction and operation

· Cost price per offered ERU calculated as the breakeven for pro ject feasibility

· Making feasible small scale projects Source: www.carboncredits.nl

3.2.5. Critical Evaluation of Potential Role of these Institutions and Products in Ukraine In spite of the fact that Ukraine has taken important steps to comply with its commitments under the UN FCCC, little has been done to develop the appropriate institutional capacity to participate in international market-based flexibility mechanisms to maximize revenues associated with JI and IET. This phenomenon can be explained as misperception, lack of encouragement, traditionalism, and underestimation of future gains at the GHG market. In Ukraine, the roots of this phenomenon are much deeper: the GHG market is still viewed by a vast majority of potential stakeholders as just another economic system for the international community to organize. While the country has an educated work force, the GHG market evidently requires additional human attributes. It should be recognized that enormous management problems still exist in the country considering that the majority of plant managers have little or no business experience. In the past, they were given a plan describing whom to hire, what to pay, what to produce, and where to ship what they produced. The managers never bought anything, never sold anything, never set any prices, and never made any decision on what to produce. Basically, plant managers were the same as army officers. Clearly, transforming a command- and-control mentality to a market mentality is not easy if it is possible at all. Viewed in the context of the GHG market, Ukraine currently lacks a pool of financially and technically qualified personnel with the experience to identify, develop and manage various JI projects. Educational qualification for baseline setting, verification, certification and financial appraisal is still not widely available. The consequences of this are felt both by

120 NSS Ukraine foreign companies looking to work together with local governments on JI projects, and by international financial institutions trying to make investment decisions on local projects. One of these consequences is the fact that it is difficult for local developers to access the capital needed for domestic carbon reduction projects. Competing projects are not compared on an equal basis and so the best pr ojects in the energy or municipal sectors are sometimes not selected. Additionally, there is still a lack of awareness about the GHG market prospects among the policymakers in the government. Many of them tend to underestimate the potential gains of IET and JI, mainly due to time lags. Very often, it takes 5 to 10 years or more to realize economic and environmental benefits of flexibility mechanisms, whereas political mandates of policy makers have much quicker expiration dates. Currently, there are several major barriers to Ukraine’s participation in the GHG allowances trading. The first barrier is a general lack of information and experience among the national policymakers. Climate issues still have a relatively low priority among many governmental institutions and an institutional framework for the participation in the GHG market is practically absent. The second barrier is the general macro-economic climate of Ukraine (poor credit rating, high interest rate, policy uncertainty, etc.) IET and JI are good models for removing this barrier, but in practice they haven’t yet led to an appropriate number of investment projects. The third barrier consists of potential donors and project developers unawareness of Ukraine's future climate policy options (i.e., adoption of a CO2/energy tax or allocation of AAUs to individual sectors and firms). In the case of Ukraine, critical evaluation of potential role of the GHG market institutions and products means that careful oversight regulations for monitoring, reporting, and review must be implemented before opening the floodgates of IET. In practice, this sequencing can be secured by allowing countries to participate in the GHG allowances trading only after passing an initial eligibility screening, where they demonstrate to achieve minimum standards for accountability and capacity. Priority areas might include the following: · Systems for the development of national inventories and GHG projections · National registry systems · Domestic institutions and procedures for JI, including project registration procedures, national guidelines on baselines and monitoring, and rules for issuing emissions reductions units (ERUs.) · Domestic institutions and procedures for emissions trading (including emission permit allocation, market rules, and national guidelines for monitoring, as well as verification and enforcement systems)

3.3. UKRAINE’S GHG MARKETING STRATEGY

3.3.1. Barriers to Foreign Direct Investment in Ukraine’s JI Projects There are great expectations for the use of JI in cooperation between OECD countries and Ukraine. The formers expect to acquire additional cost-effective ERUs to meet their emission

NSS Ukraine 121 commitments under the Kyoto protocol. The latter expects that JI projects will foster investment and technology innovation and some environmental benefits. Theoretically, JI relies on rewarding capital investment through a stream of ERUs. Practically, even if large GHGs reductions are possible or expected, for the investor to have confidence that the reductions will be available to recover the upfront investment, he must be confident that the overall finance plan of the project will hold. This requires that future cash flows will be in line with budgeted costs and benefits of the project. For example it may require that energy produced by the project can be sold at the price foreseen or that production costs of the project will be in line with the ex ante budget. This, in turn, requires some decree of economic stability in the host country. Up to now international donor institutions and Ukrainian partner agencies identified more than 100 project proposals that could be qualified as good candidates for JI 54. However, it is worth to note that most project developers consider that financing JI projects will not yield the expected rates of return, making it difficult to draw investors. Very rarely foreign project developers consider Ukraine’s GHG reduction projects financially viable. To some extent the reasons for their skepticism are related to general political and macroeconomic climate in the country. Ukraine is seen as one of the most difficult Eastern European countries to do business in due to red tape, corruption and unsteady legislation. Indeed, since the independence in 1991 Ukraine’s total FDI figure of $5.3 billion compares unfavorably to the more than $61 billion attracted by Poland and $7.3 billion by the Moscow city alone. If we compare Ukraine with other economies in transition, then we will see that the gap between the corresponding economic indicators reaches 10 times or even more, see Table 3.6.

TABLE 3.6 FOREIGN DIRECT INVESTMENT INFLOWS IN EASTERN EUROPEAN COUNTRIES VS . UKRAINE, MILLION $US Country 1998 1999 2000 2001 2002 Czech Republic 3,699 6,313 4,986 4,923 8,200 Poland 6,365 7,270 9,341 5,713 5,200 Romania 2,031 1,041 1,025 1,157 1,250 Slovakia 562 354 2,052 1,475 4,000 Ukraine 743 496 595 792 859 Source: The Economist Intelligence Unit

Clearly, this gap separates economically viable GHG reduction projects and the financing sources available to fund them. As a result, many potential sustainable energy projects are never implemented because they cannot secure funding. Various studies devoted to this investment gap distinguish a number of barriers that may deter FDI in JI projects in Ukraine. First, as it was mentioned above, is the general macroeconomic climate in the country. This barrier applies more strongly to Ukraine than other economies in transition (EITs), because some of the uncertainty in the Ukrainian economy relates to the process of transition to a

54 The USAID, CIDA, WB, UNDP/GEF, and the Ukraine’s State Committee on Energy Saving are just a few institutions gathering information on JI projects.

122 NSS Ukraine market economy. Often there is a lack of affordable capital, because capital markets in the country are not yet well developed. The weakness of the local banking sector hinders access to capital by all but the most financially secure Western and local counterparts, who are able to access funding from the multilateral development banks (MDBs) or foreign commercial banks. Besides that, there is strong competition for scarce capital. The extremely high cost of capital, due to high government borrowing requirements 55, makes otherwise profitable investments look unprofitable. In Ukraine, uncertainty about future climate policies and carbon reductions prices increases both perceived and actual high risks involved with JI projects. Because of these concerns, foreign investors may require higher returns, shorter payback periods, and take a more conservative view of the creditworthiness of their Ukrainian counterparts. As a result, new ventures with more uncertain benefit streams, such as JI projects, are disproportionately affected. Second , in Ukraine there is still a lack of managerial experience. Both local and foreign JI projects developers looking for local partners are still constrained by this factor. Educational qualification for baseline setting, emissions monitoring, verification, general JI project management, and financial appraisal are not quite widely available. The consequences are that the GHGs reduction projects may not get developed due to the lack of expertise, and the costs of JI projects may rise. In addition, without a national JI project office, there is no impetus to continue even with proven success. The consequence of this is felt both by foreign companies looking to work together with local partners through JI, and also by international financial institutions (like PCF) trying to make financing decisions on local JI projects. In the state owned industrial sector, managing directors may ignore carbon or methane emission because it is not their core business. Industrial managers may also lack the experience needed to turn the technical results of carbon emission measurement into a financial proposal suitable for a financial institution. Besides that, the very uncertain economic future of the country makes it difficult to plan for 2008-201256. Third, natural monopolies and state-owned enterprises usually have no experience or incentives to invest in GHGs emission reduction. In Ukraine this often includes utilities, who are accustomed to being judged on how much energy they sell, not how much they save. They often have a direct profit incentive to sell as much energy as possible, even though Demand Side Management (DSM) options might allow the closure of expensive and carbon- intensive peaking blocks or even less efficient and polluting base load plants, and reduce overall system costs. Forthcoming privatization of power generation in Ukraine will clearly force major changes within these organizations, and the rate of such developments will have an impact on future carbon reduction investment levels. Fourth , many local private sector companies have little credit records and hence are often viewed as risky ventures. Combined with the general lack of availability of credit, this means that newer firms find it impossible, or very expensive, to access credits for JI projects. Small

55 Today average interest rate of Ukrainian commercial banks equals to 18-20%. 56 In December 2001 President Kuchma signed a decree “On Preparation for Project of Strategic Economic and Social Development of Ukraine in 2002-2011”.

NSS Ukraine 123 project owners are unlikely to have sufficient collateral to access local financing. Many firms are not creditworthy due to a lack of cash flows and lack of collateral. Privately run GHGs reduction pr ojects often have weak sponsors who lack loan guarantees. Even municipalities are rarely creditworthy in the eyes of local and foreign banks. Fifth , most JI projects are too small to attract the interest of major financial institutions acting in the country. Many financing institutions have minimum lending levels of $5-10M, which results in the fact that projects smaller than $12-25M are much less likely to be supported. Other minimum limits are $50-70M for commercial banks, $6M for the EBRD, and $10M for the IFC. In Ukraine many JI projects will fall below this threshold. MDBs and financing institutions like PCF or Dexia -FondElec do not favor smaller -scale GHGs reduction projects, because they incur in higher transaction costs in proportion to the revenues generated. As the first phase of ERUPT Program revealed, even for relatively small projects transaction costs were equal to $40,000-$50,000 and amounted to 50% of the total project costs. Under these circumstances, most carbon credits buyers will look for purchase contracts, not for investment projects like JI. Sixth, low and unstable energy prices in Ukraine undermine the cost-effectiveness of most energy efficiency projects, but carbon reduction projects tend to suffer additionally due to uncertain ERU stream. Since the independence, energy prices in Ukraine have rapidly converged with market levels, but there are many cases of scheduled energy price increases being delayed or vetoed by Rada (the parliament). A carbon reduction project may find its cost-effectiveness reduced if price increases fail to keep pace with inflation, as it was in Ukraine over the past few years. This may in many instances be more critical for the viability of JI project than low energy prices per se.

3.3.2. Specific measures for the national marketing strategy (institutions, cadres, budget, etc.) Ukraine may be one of the largest suppliers of emission credits and allowances at the international GHG reduction market. First, it is the eighth largest source of GHG emission in the world and was the sixth largest source in 1990. Second, Ukraine’s transitional economy offers many cost-effective ways to mitigate emissions, particularly in industrial sectors. These sectors have a large potential for modernization and efficiency improvements. However, Ukraine will be able to realize this potential only if it develops the capacity and institutions needed to deliver marketable ERUs and AAUs. Until now Ukraine has made a few important steps to comply with its commitments under the UNFCC: it deve loped a national greenhouse gas inventory, formulated a National Action Plan on Climate Change, and submitted a First National Communication to the FCCC Secretariat. As a further crucial step forward, the Cabinet of Ministers established an Inter- ministerial Commission on Climate Change (IMCCC) to organize and coordinate implementation of the national strategy and national action plan to achieve Ukraine’s compliance under the FCCC and, subsequently, the Kyoto Protocol. Hopefully, the next long- awaited step will be the development of a national marketing strategy to participate in international GHG markets.

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This study (Chapters 3,4,5 and Chapter 7 - Plan of Action) provides numerous ideas on suggestions on such a national marketing strategy. Here the most important elements of such a strategy are summarized only. The marketing strategy needs to contain: · Institutional framework (stakeholders, division of responsibilities, linkages with other key players, access to information and data management) · Human, financial, and technical resources · Climate change policies (domestic laws and regulations, emission reduction measures, etc.) Institutional framework. Since 1999 formal inter -institutional linkages exist through the Inter- ministerial Commission on Climate Change. Participating ministries, state committees and experts meet three or four times per year to discuss general aspects of the national climate change policy. Despite the existence of formal institutional linkages, the present level of information exchange and dissemination among the governmental agencies and other stakeholders is not sufficient for adequate decision–making and must be improved within the national marketing strategy. Chapter 4 contains detailed discussion of institutional issues. Speaking of human, financial, and technical resources needed for the development of a national marketing strategy, we have to mention that the lack of human resources is the most crucial obstacle. While technical training and expertise is often extremely high in the country, business skills are still deficient. Ukraine currently lacks a pool of and experienced personnel with professional training in engineering and finance who can identify, develop and manage JI projects. The inadequate availability of suitably qualified counterparts, with experience in managing JI projects involving foreign banks and suppliers, can be identified as the number one barrier to development of a national marketing strategy. At the MENR, the lead ministry, only three employees focus exclusively on climate issues. Among them there are high-level professionals with a good knowledge of climate change issues. Unfortunately, none of them has the necessary backgrounds for developing a national GHG marketing strategy. In other ministries (including the ministries of finance and economy) the situation is even worse, since technical resources such as data collection and management systems, databases, information networks and especially human capital, needed to make electronic transactions in a global GHG market, do not meet the current requirements. Besides, there is further need for considerable investment in building national institutional and policy framework to support a project-based approach. Without such infrastructure in place, JI projects are unlikely to become cost -effective mechanisms for emission reduction, technological innovation, and sustainable economic growth. This framework would need to have clear and operational selection and approval criteria integrated into local and national development objectives, institutional procedures, transparency and public oversight and participation, stable and favorable investment climate for both domestic and foreign investors, and finally, local capacity for baseline and additionality assessment and project validation.

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Climate change policy and politics. The strategy must include policy responses to address emission reduction in Ukraine, technical and legal issues of domestic emission trading (allocation of emission rights, points of regulation, compliance and enforcement), cost assessments of GHG mitigation measures, cost and benefits of Ukraine’s participation in the Kyoto Protocol, and so on. As for international trading, national policy makers believe that in the initial stages of a trading system only the government will be allowed to trade on the international GHG emission reduction markets (while the authors of this report would suggest that private sector participation in GHG trading will be possible). The National Climate Program, adopted in 1997 by a Resolution of the Cabinet of Ministers, is focusing solely on climate issues. The program includes climate change research, monitoring, and adaptation measures. The former State Committee for Hydrometeorology was responsible for its implementation. Currently, the government under the lead of the MENR is developing the concept of national strategy for the implementation of the UNFCCC. Hopefully, this will form the basis for a national marketing strategy as well. In addition, several other programs promote climate change research and encourage climate change mitigation measures. These include the Comprehensive State Energy Conservation Program, which promotes energy efficiency. To implement this program, the parliament adopted in 1994 the Law on Energy Conservation, which authorizes subsidies, tax credits, and other privileges to promote energy efficiency measures. However, strong economic incentives for climate change mitigation projects and behavior do not presently exist, as financial resources allocated for these and related issues are generally extremely scarce in Ukraine. For example, presently the country is unable to finance investment even in widely available energy efficiency technologies57.

3.1. CONCLUSION

A GHG market is now developing. Price estimates are in the range of 1-5.5 $/tCO2, whereas currently prices between 2-7 $/tCO2 are paid on the market. A number of finance instruments such as forwards and options are being used on this market; these instruments need to be well understood to make adequate use of them. Ukraine need however develop the necessary market framework. For doing so, current general investment barriers need to be addressed and institutions necessary to participate in the GHG market set up.

57 In 2001 investments from state budget came to 7M UAH, or 17% of the total sum foreseen in state budget for 2001.

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4. DOMESTIC INSTITUTIONAL, REGULATORY AND LEGAL PREREQUISITES

Article 2 of the Kyoto Protocol describes a variety of domestic policies and measures that Annex 1 parties should implement and further elaborate. Ukraine, as a Party listed in Annex I of the UNFCCC, has a large potential to participate in international carbon trading. To realize this potential, Ukraine, as well as other host countries, has to establish specific national institutions. An efficient implementation of the Kyoto mechanisms is a complex task: numerous stakeholders on all le vels (international, national, local) need to cooperate, including various government institutions, municipalities, industry, international organizations and NGOs. Such cooperation requires efficient coordination, clear and simple rules, transparency in decision-making, and well-functioning information exchange and networking systems.

4.1. CURRENT STATUS OF CLIMATE NEGOTIATIONS

The decisions reached in November 2001 in Marrakech provide a complex set of rules for implementing the Kyoto Protocol based on the broad principles of the Bonn Agreement. According to these rules, each Annex B Party is eligible to transfer or acquire ERUs and/or AAUs58 if it satisfies completely to the following conditions: 1. It is a Party to the Protocol 2. It has established its assigned amount in accordance with accounting modalities under Article 7.4 3. It has established a national system for the estimation of GHGs in accordance with Article 5 4. It has established a national registry for GHGs in accordance with Article 7 5. It has submitted the re quired inventory (for the first commitment period, quality assessment of reporting is limited to emissions from sectors under Annex A of the Kyoto Protocol, and to the annual inventory on sinks) Besides these requirements, for JI projects there is another specific set of rules (see Annex 4.1).

58 (a) An “emission reduction unit” or “ERU” is a unit [issued][transferred] pursuant to Article 6 and requirements there under and is equal to one metric ton of carbon dioxide equivalent, calculated using global warming potentials defined by decision 2/CP.3 or as subsequently revised in accordance with Article 5 of KP;

(b) A “certified emission reduction” or “CER” is a unit issued pursuant to Article12 and requirements there under, and is equal to one metric ton of carbon dioxide equivalent, calculated using global warming potentials defined by decision 2/CP.3 or as subsequently revised in accordance with Article 5 of KP;

(c) An “assigned amount unit” or “AAU” is a unit issued pursuant to the relevant provisions on registries in decision -/CMP.1 (Modalities for the accounting of assigned amounts), and is equal to one metric ton of carbon dioxide equivalent, calculated using global warming potentials defined by decision 2/CP.3 or as subsequently revised in accordance with Article 5 of KP;

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Assuming the Marrakech Accords are a plausible basis for the Kyoto Protocol ratification, Ukraine has to establish special institutions to deal with the flexible mechanisms, a national inventory system, etc., in order to guarantee the value of national AAUs, ERUs, and RMUs.

4.2. JI AND IET ELIGIBILITY

Under the current circumstances, Ukraine may face problems in meeting the requirements of eligibility. At COP-7, it was decided that Annex I Parties that cannot meet the Protocol’s inventory requirements can still host JI projects through a project design and approval process similar to the CDM. Two tracks have been defined for the verification of ERUs: Track 1 (or Fast Track) and Track 2 (or Slow Track). The first track is used to verify emission reduction units when the required domestic specific institution (i.e. National Inventory System) are in place. The second track can be used when a host country cannot meet the eligibility requirements for Track 1; in this case the pr oject must be validated by an independent entity accredited by the JI Supervisory Committee or by the JI Supervisory Committee itself (for a more detailed explanation on the two tracks see Chapter 5). The recommendation of Task 5 below is that Ukraine should as soon as possible allow projects to be accepted under Track 2 and at the same time prepare to become eligible for Track 1. (see Chapter 5 for details). There are several nations (among which Austria and Netherlands) willing to make JI investments in Ukraine. Countries as well as International Financial Institutions (IFI) committed to invest into GHG emission reduction make their investment decisions based on their own set of criteria. It is very important for Ukraine to develop clear and transparent cr iteria for JI project approval, because they will significantly facilitate and accelerate the development, financing and implementation of JI projects.

4.3. BARRIERS TO IMPLEMENT AIJ/JI PROJECTS

Most of the barriers to the implementation of AIJ/JI projects are similar to those that impede FDI in Ukraine (see 3.3.1). They can be classified as follows: · Institutional: Local regulatory capacity and interest of the host country to create and manage JI projects · Financial: Availability of financial resources to support the project management; availability of co-financing for projects from traditional investors · Technical: Specific knowledge of the nuances of JI regulation, monitoring and enforcement · Analytical: Knowledge of methodological issues and quantification methods locally not available

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· Information: Availability of clear, unbiased information on JI Among the barriers that impede the implementation of JI projects in the industrial sector are the following: 1. Most enterprises are in a difficult financial situation, associated with the general structural and economic crisis. They suffer from exorbitant tax burdens, payment debts, raw materials and energy debts, etc. For this reason, enterprises hardly possess the resources needed for carrying out energy efficiency pr ograms among other activities, and do not even have the possibility to attract resources from external sources (bank loans, equity). 2. There is high uncertainty about the future of the Ukrainian market, which makes it very difficult to estimate future input and output prices of any project (and it should be born in mind that any JI project will produce also outputs other than ERUs). 3. The majority of enterprises still lack proper energy management. Generally, in each manufacturing company there is a Chief Engineer responsible for energy efficiency, however, this is a purely technical service that does not tackle the issues of energy conservation. The availability of outside experts trained in this field is also limited. 4. The transfer of state ownership to the private hands is creating instability and conflicts at different levels: · State and private interests · Management vs. shareholders · Shareholders vs. management employees 5. The state has not yet created effective mechanisms for energy saving. The latest regulations on electricity and heat tariffs did not introduce progressive tariff systems to incentive energy saving projects. The same refers to the tax system. 6. The country is lacking a proper infrastructure for energy saving. Currently in Ukraine there are only few energy saving companies, almost no demand-side pr ograms, performance contracts, and energy efficient and environmentally friendly consumer goods. In addition to the existing barriers to the implementation of JI projects in Ukraine, another group of potential obstacles is likely to emerge during the realization of any JI project. These obstacles can be divided into six major groups: technological, organizational and el gal, financial, market, training, and environmental. It is crucial that the Ukraine government addresses those investment barriers so that the investment climate in Ukraine both for traditional investment and for JI investment will become better. However, it also needs to be mentioned that firms have measures to its disposal which allow to manage risks associated with the barriers lined out above and which allow to run successful businesses even within a difficult environment. These measures are more or less

NSS Ukraine 129 known and they are applied at a given stage of project implementation. For example, technological barriers like the risk of a discontinued equipment service and other general project implementation risks can be overcome by insuring the project. This practice can also help to overcome organizational, legal, financial, and market barriers like for example delays in the project start date, difficulties in obtaining direct foreign investments, lack of long-term capital, currency exchange rate risks, and unclear energy tariffs. Other barriers, such as insufficient technological training and increased pollution of a project site, can emerge further into a project, and they can be overcome by training and technical improvements.

4.4. UKRAINE’S EXISTING LEGISLATION RELATED TO CLIMATE CHANGE

During the last decade in Ukraine there has been an extensive law making process in the field of natural resources and the environment protection. Since independence, Verkhovna Rada (the Parliament) of Ukraine has adopted up to 80 laws and over 30 decrees of the Cabinet of Ministers regarding the preservation of the environment. The Ukrainian legislation on environmental protection and rational use of natural resources contains over 200 legal acts with nation-wide implications. The Ukrainian law "On Environmental Protection" (1991), is supported by a number of regulations, such as the "Land Code" (1992), the "Water Code" (1995), the "Forest Code" (1994), the "Mineral Resources Code" (1994), and it is enhanced by other relevant laws such as: "On the Nature Reserve Stock" (1992), "On Wildlife" (1993), "On Atmospheric Air Protection" (1992), "On Environmental Expert Review" (1995), "On Nuclear Energy Use and Radiation Safety" (1995), "On Waste" (1998), etc. The environmental legislation of Ukraine is being developed according to the principles incorporated in the Constitution of Ukraine (Articles 13, 16, 49, 50, 66), and it is formulated in accordance with the “Principal Directions of Ukraine State Policy on Environmental Protection, Use of Natural Resources, and Ensuring Environmental Safety” (1998), which identify prioritie s and long-term strategy for solving national environmental problems, and with the Presidential Decree No 145 (1999) “On Actions to Be Taken to Improve the Law- Making Activities of Executive Power Bodies”. As mentioned before, the Ukrainian law "On Environmental Protection", which could become the basis for JI/IET regulation, covers all environmental issues in each sector of the economy. However, since this law was adopted back in 1991 (long before the ratification of the UNFCCC and the signing of the Kyoto Protocol), it does not have any direct provision concerning climate change mitigation. Under Article 24 of this law, state and private entities have to submit information on releases of harmful substances to the national authorities without any fee being charged. A national system for monitoring GHG emissions is yet to be developed in Ukraine. Currently the state does not require reporting of GHG emissions or activity data for their calculation by either public or private enterprises.

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The other legislative act related to climate change is the Law “On the Atmospheric Air Protection” (1992). The Law determines the legal and organizational foundations as well as environmental standards regarding the protection and use of atmospheric air. The purpose of the law is to enforce measures in order to preserve, improve and recycle atmospheric air, prevent harmful chem ical, physical, biological and other influences on atmospheric air, and ensure a rational use of atmospheric air for industrial needs. Article 16 of the Law concerns the "regulation of activities that influence weather and climate". It states that "in accordance with the international agreements, enterprises, establishments, and organizations are obliged to reduce emissions of carbon dio xide and other substances whose accumulation in the atmosphere may result in negative climatic changes". The law provides for political measures, but does not regulate the formal mechanism of their enforcement, and this discrepancy in GHG emission regulation should be overcome. Some issues related to climate change are included in the Climate Program of Ukraine that was approved by the Decree of the Cabinet of Ministers No 650 of June 28, 1997. This Program stated that the main source of information about the climate, its natural variability, and its anthropogenic changes, was represented by data of hydro-meteorological observations and data of environmental monitoring obtained by a specially authorized central body that had executive power over hydro-meteorological activities. The Decree stipulated that it was nece ssary to gather more effective information about climate, in relation to some sectors of the national economy, and in particular the power sector. It also recognized the absence of a GHG monitoring system in Ukraine and declared that technical-organizational measures and scientific researches would be deployed in order to assist in setting an efficient system to monitor and forecast the climate in Ukraine. This system is envisaged to meet the requirements of the World Meteorological Organization (WMO) World Climate Program and to create preconditions for the UNFCCC implementation. However, this Program is not supported by fina ncial resources.

4.4.1. Conformity of Current Legislation of Ukraine with UNFCCC Requirements The ultimate goal of the UNFCCC is the stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system. The Convention also calls the Parties to join their efforts to the following objectives: · Develop, update periodically, publish and make available to the Conference of the Parties their national inventories of anthropogenic emissions by sources and removals by sinks of all greenhouse gases not controlled by Montreal Protocol, using comparable methodologies approved by COP; · Formulate, implement, publish and regularly update national and, where appropriate, regional programs containing measures to mitigate climate change by addressing anthropogenic emissions by sources and removals by sinks of all greenhouse gases not controlled by the Montreal Protocol, and measures to facilitate adequate adaptation to climate change.

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There are two basic legislative acts in Ukraine related to the UNFCCC: 1. The Law on ratification of the Conve ntion on climate change (1996) 2. Decree of C? on establishment of the Inter-ministerial Commission on Climate Change (1999). So far, the Commission has been able to organize and coordinate activities in pursuance of Ukraine’s commitments under the UNFCCC but , in order to ensure their thorough implementation, it would be necessary to include them in a program that can effectively take advantage of the already existing institutional structure. Despite the indications contained in Article 5 of the ?P, Ukraine still has not developed a national system for the estimation of anthropogenic emissions by sources and removals by sinks of all greenhouse gases not controlled by the Montreal Protocol, its statistical reporting system has not been adjusted for the purposes of collecting relevant activity data. The efforts to develop local methodologies and emission factors so far have been limited. The “Comprehensive State Program on Energy Conservation in Ukraine” addresses a number of issues contained in Article 10 of the KP, and recently the CM of Ukraine promulgated the "Charter of an Inter -ministerial working group for the coordination and realization of especially important energy-saving projects " (March, 14, 2001). Conclusion: In conclusion, we have to emphasize that regulations about formal procedures concerning IET, JI, and its pilot phase are not yet in place. The absence of a coordinated institutional infrastructure able to address the UNFCCC and Kyoto Protocol requirements testifies to the fact that the Ukrainian legislation needs further develo pment.

4.5. EXISTING INSTITUTIONAL FRAMEWORK

The adoption of the Kyoto Protocol is leading all Parties (directly or through specific international or inter-governmental bodies) to the development of new structures aimed at the implementation of the commitments of Annex B Parties, most of which are also UNFCCC Annex I Parties. Ukraine’s government main incumbent tasks are the initiation, coordination, and implementation of the information services aimed at supporting the development of JI and IET activities. In the following the current role of Ukraine’s Ministries with respect to climate change are lined out.

4.5.1. Ministry of the Environment and Natural Resources of Ukraine (MENR) MENR is the primary institution responsible for all climate related issues, including those concerning the Framework Convention on Climate Change. It is the main coordinator of all Climate Change programs in Ukraine and it will possibly coordinate also JI and IET

132 NSS Ukraine activities. MENR formulates the emission contr ol policy, which is implemented by its regional departments. These departments work together with oblast administrations and report to them. Main responsibilities of MENR are: · Environmental protection (policymaking, air pollution abatement). · Environmental impact assessment of industrial activities and investments. · Environmental monitoring and reporting. · Initiation and sponsoring of environmental protection activities. · Nation wide promotion of R&D, education, and training. · International cooperation (negotia ting and signing agreements, exchanging data and expert opinions, participating in conferences and meetings). · Ensuring that the Focal Point (i.e. Minister of the Environment and Natural Recourses) fulfills the requirements of the UNFCCC. State Hydrometerology Service: To be eligible to participate in the flexible mechanisms under the Kyoto Protocol, Ukraine has to establish a national inventory system of sufficient quality. The State Hydrometerology Service under the MENR, is entrusted with the national emission inventory coordination. Its present functions are: · To carry out National Air Pollution Inventory, which focuses primary on harmful pollutants. · To be responsible for the national GHG inventory according to the IPCC methodology using data from energy statistics. · To collect data for the inventory of GHGs. · To develop a new emission inventory system. This system will unify the data collection process needed for the national emission inventory as well as for emission taxation at the local level. The GHG in ventory will be compiled using bottom-up data from individual pollutant sources as well as top-down data from energy statistics.

4.5.2. Inter-Ministerial Commission on Climate Change (IMCCC) To fulfill national commitments under the UNFCCC, IMCCC has the following functions: · Arrange the development of the national strategy and the national action plan to fulfill Ukraine's commitments under the UN Framework Convention and the Kyoto Protocol. · Coordinate activities of the ministries, central and local executive bodies, enterprises, institutions and organizations, for the implementation of the national

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action plan to fulfill Ukraine's commitments under the UN Framework Convention and the Kyoto Protocol. · Produce proposals on the implementation of the KP mechanisms. · Arrange the preparation of national communications of execution of the commitments as per the UN Framework Convention. · Arrange the preparation of a national inventory of anthropogenic emissions by sources and absorption by sinks of all greenhouse gases not controlled by the Montreal Protocol. · Review the UN Framework Convention and Kyoto Protocol, including inputs from other gover nments, Global Environmental Facility, World Bank and other international organizations, and use them as a basis for the preparation of relevant proposals.

4.5.3. Other Ministries Ministry of Fuel and Energy (MFE) · All important strategic issues regarding national energy production and consumption are competence of the MFE. These include large-scale heat and power production, which causes the most relevant problems regarding GHG emission. The same institution also coordinates local energy. · MFE supplies long-term forecasts for the power sector, information on industry's energy use, and formulates the technological policy for the power sector. · There is no special institutional unit in the MFE that deals directly with climate issues related to energy59. State Committee for Energy Conservation · This is a key institution in implementing governmental policy on energy eff iciency, energy conservation and related climate issues. · It supports the information and engineering activity in the field of energy conservation, energy efficiency and climate change. Ukrainian Ministry of Economy andEuropean Integration (MEEI) · Analysis and formation of State policy of economic and social development. · Forecasts of economic and social development. · Establishment of national priorities of economic development. · Elaboration of coherent foreign trade policy.

59 Apparently, AIJ projects launched so far could be coordinated by the MFE but, at present, their implementation and coordination is organized within the MENR.

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· Economic and social cooperation with the European Union. State Committee on Statistics of Ukraine · Collects updated statistical data on social and economic development. · Works on the convergence of the Ukraine system of national accounts with the UN standard. · Ensures the reliability of the statistical information. Ukrainian Ministry of Finance (MF) · Secure unified finance, budget and taxation policy directed to the implementation of State policy of economic and social development. · Oversees the administration of the national budget of Ukraine. · Coordinate finance and taxation policy of other ministries. · Secure concentration of financial resources on key directions of economic and social development. · Elaborate strategy of internal and external borrowing. · May play an active role in introduction of GHG emission trading as a potential distributor of revenues from emission allowance sales. Ministry of the Foreign Affairs of Ukraine (MFA) The MFA Department of International Organizations. · Coordinates multilateral and bilateral negotiations. · Could provide information for internationa l contracts with possible governmental guarantees. State Committee on Forestry · Formulates governmental policies in the forestry sector, · Protects and restores forestry resources. · Maintains the forestry inventory · Could supply long-term forecast of sink capacity, sequestration and re-emission of carbon from forest fires. Ministry of Transport · Formulates governmental policies for the sector. · Provides theCabinet with forectasts of sector development · Formulates policies of technological change in the sector. · Formulates the emission control policy in the transportation sector, and could supply a long-term forecast of GHG emission from mobile sources.

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4.5.4. Private sector institutions for JI and IET Cooperation with independent private entities on a contract basis can lower administration and transaction costs and, besides that, these entities can: · Provide training in project preparation and in GHGs emission calculations · Educate the public about environmental issues and the value of public participation · Lobby for new laws (or amendments to existing laws) · Offer assistance to government and to the Climate Change State Enterprise (CCSE) · Establish advisory committees in order to help verifying projects or emission reductions and advise on the projects approved or under consideration · Act as watchdogs The following private sector representatives would likely show interest in participating in various stages of GHG mitigation projects: Insurance companies · Have an especially important role in countries with economy in transition to help mitigate macroeconomic, political, technical and ownership risks (see barrier issue above). Energy and environmental audit companies · Can provide technical services in monitoring and verification of project activities · Can help improve methodological guidance for project development and conduct validation of project baselines · Can be used on a contract basis for the deve lopment of the National Communications on Climate Change and other relevant analytical documents · Can help improve methodology for project development and conduct baseline validation Conclusion and Comments The key problem for Ukraine appears to be the lack of sufficient funds and expertise to build the necessary institutional infrastructure for JI projects and IET although, like other EIT countries, Ukraine anticipates to receive assistance in this task from donor countries. Institutions’ efficiency is limited by excessive bureaucracy, and Ukraine needs to address this problem in order to be able to participate in JI projects and IET. The institutional framework should be transparent and clear, proper monitoring, verification and reporting system in place, and project expertise enhanced. The infrastructure should be able to respond to project proposals, and the current institutional bodies should become the supportive and regulatory foundation for establishing main elements of the system to meet the Kyoto Protocol requirements.

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4.6. PROPOSED INSTITUTIONAL FRAMEWORK

4.6.1. General Consideration Ukraine particularly needs to enhance the institutional structure for information dissemination and training, strengthen local institutions, and create public awareness on the Kyoto flexible mechanisms. The regulatory framework establishes the rules of the game and, if well constructed, promotes fairness, transparency, and accountability. It also provides information to the marketplace and orients incentive systems in a way that minimizes stakeholders’ risks.

4.6.2. National Institutional Structure of JI Project and IET Implementation COP -7 established the infrastructure strengthening mechanism that should be adopted by countries with economies in transition. It states that “capacity building for EIT Parties must be country-driven, be consistent with their national sustainable development strategies, reflect their national initiatives and priorities, respond to needs determined and prioritized by EIT Parties, and be primarily undertaken by and in EIT Parties in partnership with other Parties and relevant organizations, as appropriate, in accordance with the provisions of the Convention. Capacity building is a continuous process aimed at strengthening or establishing, as appropriate, relevant institutions, organizational structures, and human resources in order to strengthen expertise relevant to paragraph 3 of this framework.” 60 The experience of many countries that are Parties to the UNFCCC shows that in order to form a reliable institutional and professional base for future JI and IET, Ukraine should establish a proper national infrastructure, including a national inventory system and national registries for ERUs, AAUs and other types of allowances. Additionally, infrastructure for review, monitoring and verification of JI projects is needed at the state, sector and regional level (to be able to participate in Track 1 JI). A basic element of such infrastructure is the JI/IET office. This office might (so a suggestion developed within the context of this study) be a state office for JI projects and tradable allowances management - Climate Change State Enterprise (CCSE). The CCSE must provide for carrying out all the procedures that are envisaged by the UNFCCC and Kyoto Protocol requirements, by COPs decisions, and by the national legislation. The CCSE has to perform routine management of activities of other functional elements of the infrastructure, provide necessary coordination and reporting, develop and implement new units according to urgent needs. Given the economic priority of problems concerning climate change, in order to take advantage of foreign investment and to avoid the creation of additional bureaucratic barriers to investment procedures, CCSE must:

60 FCCC/CP/2001/13/Add.1

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· Be a legal entity · Deal with the National Focal Point (Minister of the MENR) without any intermediaries, which would be inevitable if CCSE was an element of the hierarchical structure of a ministry · Be self-sustained Ukraine has a good experience in establishing and operating state enterprises subordinated to a ministry or to the Cabinet of Ministry, and considering all the issues mentioned above, CCSE should be a state enterprise subordinate to the MENR. The proposed scheme of positioning and interaction of CCSE with the executive bodies is given in the Annex 4.2. Under Track 1 the host Party is solely responsible for all aspects of JI project cycle i.e. establishment of procedures for project selection, evaluation, approval, registration, monitoring, certification, verification, and for the validation of project baseline emissions. Under Track 2, the project cycle follows internationally mandated procedures and involves external validation and verification by an internationally accredited Independent Entity. In order for a project proposal to receive the status of JI project under Track 2, it must be approved by the Government of Ukraine (i.e. Cabinet of Ministers of Ukraine) or its Designated National Authority (DNA), such as MENR and verified for eligibility by an internationally accredited Independent Entity. Ukraine as a host county can develop its own additional guidelines and criteria for project approval beyond what is required at the international level. Depending on whether Ukraine will be able to qualify for Track 1 or Track 2 JI, the role that the CCSE can play in JI investment cycle will differ. In Track 2 JI, which is regulated by internationally mandated procedures and involves external validation and verification by an internationally accredited Independent Entity, the main CCSE functions will be in · Establishing the national legislative and regulatory framework for Joint Implementation, including arranging potential tax and import duty exemptions. · Developing project approval criteria and procedures. · Verifying the conformity of economic, technical, social and environmental indicators of proposed JI projects with selection criteria and submitting them to the MENR for approval · Preparing bilateral Memoranda of Understanding or Letters of Intent between Ukrainian government and investor as well as final Carbon Purchase Agreements. · Issuing ERUs certificates upon appropriate international verification process · Administe r National Registry

In addition, the following activities may be carried out. Although the activities mentioned below are not prerequisite to take part in JI, they would enhance Ukraine’s position on the international JI market.

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· Providing information on the legal and procedural issues regarding project implementation, including terms and conditions of the transactions, environmental assessment requirements, and local consultation procedures, and any fees required. · Providing other services to minimize admin istrative and transaction costs of the investor, for example in organizing local consultation process. · Developing and marketing national project pipeline. · Establishing a web-site and providing public access to JI projects and activity data bases · Building domestic public awareness on JI through mass-media, workshops and other sources of information

Particular assistance of the JI/IET office may be required after the project is validated as an eligible JI project, at which point investor and host enterprises, with the intermediary service of CCSE, sign a Carbon Purchasing Agreement that defines the details of the implementation of the project. This includes project budget, schedule, estimation of actual emissions and volume of expected emission reductions (ERUs). Because of the current lack Ukrainian legislation on the distribution of rights to accrued ERUs, this issue should be addressed in the contract. Clauses regarding the payment for verification and certification services should also be part of the cont ract. According to international practice such contract should include but not be limited to the determination of the following issues61: · compliance with international and domestic legal requirements · allocation of rights to ERUs · allocation of risks and guarantees · definition of what exactly is being sold/bought (i.e. whether emission reductions that may or may not become ERUs) · sale and purchase conditions · delivery obligations and conditions (dates, trigger events, pentalties for non- delivery) · validity of emission reductions (evidence required) · price and terms of payment · liabilities and indemnities · default, termination and remedies · confidentiality · arbitration and dispute resolution

61 Baltic Sea Region Energy Cooperation: Handbook on Joint Implementation (2003)

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· taxes, levies and charges

However, in the long-term (after eligibility for ET and Track 1 JI is obtained), the CCSE administrative structure will require a more complex and more effective structure consisting, at least, of three parts dealing with JI projects, Tradable Allowances, and Information and Registration . Building on the capacities developed by the CCSE in administering Track 2 JI, it will likely have to assume additional functions, such as: · Developing guidance on the national requirements for project information, such as additionality assessment, project baseline analysis, and monitoring plan · Developing national procedures for project validation, monitoring and verification, including possible establishment of an independent monitoring and verification system · Conduct market research on international emissions trading; providing market and macroeconomic analysis for correct estimation of ET potential and appropriate price indicators · To carry out further JI and ET supervisory activities in line with the international requirements, particularly as regards certification, verification and reporting to UNFCCC Secretariat It is envisaged that the CCSE set-up and operation will be financed on the basis of: · State budget sources · Payments for consultative and intermediary services · Assistance from interested foreign, international and national organizations

The central executive bodies and other government institutions that may deal with JI projects, besides of having to be competent and interested, must be authorized to do so by the Cabinet of Ministers. They must have the ability to select the optimal project to be presented to the investor from the point of view of its feasibility, energy efficiency, perspectives of implementation, and attractiveness for potential foreign investors or donors. These abilities will help the Ukrainian Government to play an equal role in the negotiations with potential investor countries and to select among them the best for the national interest.

4.6.3. Developing a National GHG Inventory System Article 5 of the Kyoto Protocol requires that by the year 2007 Annex I countries develop a national system for the estimation of anthropogenic emissions by sources and removals by sinks of all greenhouse gases not controlled by the Montreal Protocol, through which countries must demonstrate that their actual emissions, in the 2008-2012 period, do not exceed their assigned amount. The national inventory system includes all institutional, legal

140 NSS Ukraine and procedural arrangements made within a Party for estimating anthropogenic GHG emissions and removals, and for reporting and archiving inventory information. National GHG inventories were developed in Ukraine for the 1990 base year and for the period of 1991-1998, and were submitted to the UNFCCC Secretariat in 2000. Although these inventories were fairly comprehensive, they were pr epared on an ad hoc basis and suffered from a number of major drawbacks such as incomplete data on certain emission categories, insufficient documentation on methodologies, lack of uncertainty estimation, etc. The inventories used IPCC default emission factors rather then local ones and were not reported in the Common Reporting Format (CRF). In order for Ukraine to be able to participate in of JI and IET successfully, it must develop a sustainable national system that would support annual GHG inventory preparation and management on a permanent basis. The quality of Ukrainian inventories needs to be improved in order to comply with the UNFCCC standards. According to IPCC guidelines, estimations of GHG emissions by sources and removals by sinks are drawn based on specific activity data rather then on the information about GHG emissions provided by companies and institutions. Therefore the inventory preparation in any Annex I country is based on the national statistical information as well as on the additional information provided by companies specifically for the inventory purposes. The Ukrainian statistical data collection system, run by the State Committee on Statistics, is rather complex and provides fairly comprehensive information on fuel consumption and output levels in various sectors of the economy. Comprehensive information on fuel consumption allows to account for about 90% of Ukrainian CO2 emissions. At the same time, the current Ukrainian reporting system does not provide a mechanism for accurately distributing fuel consumption according to IPCC sectoral categories (information is sufficient but it is not processed appropriately). Apart from complicating the process of filling out standard inventory forms, this also presents an additional problem when estimating combustion-related methane and nitrous oxide emissions, which are dependent on the correct information about applied technologies. Further, the aggregation of submitted fuel consumption data does not present a complete national energy balance. Other problems resulting from the fact that Ukrainian data collection has not been adjusted for the inventorying needs include · •Lack of information on hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulphur hexafluoride (SF6) · •Non-accounting for in ternational bunker fuels; · •Lack of information about volumes of solid wastes and categories of waste disposal sites; · •Lack of information of manure management systems in domestic livestock; · •Potential lack of information for Land Use, Land Use Change and Forestry category – the data are poorly recorded as no land registries are currently in place.

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In order to be able to meet UNFCCC and Kyoto Protocol requirements, Ukraine needs to establish and maintain a sustainable national inventory system that can ensure appropriate planning, preparation and management of inventory activities on a regular basis. Developing such system would involve establishing necessary institutional, legal and procedural arrangements to collect information, as well as providing sufficient technical and human capacity. Inventory activities encompassed by the system should include collecting activity data, selecting methods and emission factors appropriately, estimating anthropogenic GHG emissions by sources and removals by sinks, impleme nting uncertainty assessment and quality assurance/quality control (QA/QC) activities, and carrying out procedures for the verification of the inventory data at the national level.62 The responsibilities in the inventory development process need to be designated specifying the roles of various government agencies and other relevant institutions, and a clear process needs to be established for national review, revision, and approval of the inventory. To ensure completeness and accuracy of inventories, the national statistical system should be harmonized with international standards, improving the compatibility of the collected statistical data and inventory data format. New regulations mandating collection of the information on missing activity data need to be introduced, supported where needed with the development of local methods for processing specific statistical data 63. Systematic documentation of inventory methods and sources should be provided to ensure the transparency, consistency and comparability of t he inventories.

4.6.4. National Registries The Kyoto Protocol envisages publicly accessible “national registries” to track who owns emission reduction units or other types of allowances. Such a system will form the basis for determining whether a country is complying with its emission obligations. Countries have already achieved substantial agreement64 on the structure of the registries, including that it will be in the form of standardized electronic databases. Every participating country will have its own identifying code and national account. Private sector entities, when authorized by their governments, will have to hold accounts within the national registry as well. All allowances will be tagged with unique serial numbers, and anyone of them will be located in only one national registry at any given time. The work of creating Ukraine’s national registry cannot be delayed any more. The Government must commission the IMCCC to elaborate the scientific and methodological

62 Invanenko N. (2002): Developing National System of Inventories of GHG Emissions by Sources and Removals by Sinks in Ukraine in accordance with international standards. Canada-Ukraine Environmental Cooperation Program, Kiev. 63 For example when assessing GHG emissions from cement production, it is preferred that the estimates be based on the lime content and production of clinker because CO2 is emitted during clinker production rather than cement production itself. However, clinker is an interim product, on which the enterprises do not have to report. Therefore GHG emissions from have to be calculated based on the available data, i.e. the annual cement output in the country.

64 See the negotiating text on registries at UNFCCC/CP/2000/CRP.4; November 24, 2000.

142 NSS Ukraine aspects of the national registry in accordance with COP’s recommendations and decisions and must identify an organization in charge of maintaining the national registry of Ukraine.

4.7. CONCLUSION

Ukraine needs to put into place the institutions required to participate in the GHG market. It is suggeste d to establish as soon as possible a JI/IET office which would deal with the relevant issues. Furthermore, a national inventory system for GHG and a national registry for allowances need to be build up. The Plan of Action (Chapter 7) elaborates on these steps to be taken by the Ukraine government if the benefits from JI/IET are to be gained by the country.

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5. OPTIONS FOR UKRAINE

5.1. INTRODUCTION: UKRAINE’S POSITION IN THE INTERNATIONAL GHG MARKET

The objective of this chapter is to identify and evaluate the strategic options which Ukraine faces in utilizing its potential for GHG emissions reductions. Chapter 2 has shown that with a view to its Assigned Amount under the Kyoto Protocol, Ukraine is likely to have substantial surplus emission allowances in the period 2008-12 even under a high economic growth scenario without any additional policy measures to reduce GHG emissions. Moreover, Chapter 2 has shown that Ukraine has substantial potential for additional emissions reductions which can be achieved at relatively low costs. On the other hand, Chapter 3 has shown that demand for GHG emission reductions is emerging internationally, and is likely to increase in the near future. The following table summarizes once more some key indicators regarding Ukraine’s projected GHG emissions and reduction potential. A comparison with the demand data in Chapter 3 shows that Ukraine could, potentially, become a major seller of GHG emission reductions up to 2012. Assuming a market price of between 5 and 10 $/t CO2, sale of Ukraine’s surplus emission allowances in 2008-12, which we estimate at 1.1 billion tonnes of

CO2 for energy-related CO2 alone , could – in theory– generate net revenues of between 5 and 10 billion $. In addition, we estimate that there is a potential to reduce at least 750 million tonnes of CO2e in the period 2008-12, at abatement costs below 8 $/t. The realisation and sale of these additional emissions reductions could yield further gross revenues (before deduction of emissions abatement costs) of between 3.5 and 7.5 billion $. A comparison with current foreign direct investment (FDI) levels in Ukraine shows that the magnitude of these carbon-related revenues is, potentially, substantial. Since 1991, Ukraine has received just a little over $4B in foreign direct investments (see Table 3.2.) This corresponds to one of the lowest per capita levels among economies in transition. Declining levels of domestic and foreign investment have created a need to seek alternative investment opportunities. One such alternative may exist through Ukraine’s participation in the Kyoto mechanisms and future international GHG allowances and credits markets. From the perspective of the buyer countries in the OECD, conversely, allowances trading with Ukraine could reduce the likelihood of “carbon-leakage”, i.e. the problem of carbon- intensive industries relocating from OECD to Eastern Europe, FSU and developing countries to avoid GHG emissions regulations. Only a few economic modeling studies have explored the issue of emissions leakage tha t could arise from a uniform carbon tax in EU countries.65 These studies conclude that meeting the Kyoto Protocool’s first period commitments without any offsetting measures could result in leakage of 5% to 20% of emission savings to countries that have sig nificant carbon allowances surplus and therefore do not introduce

65 See Chapter 8 of IPCC WGIII, 2001.

144 NSS Ukraine carbon taxes or equivalent measures. Access of EU and other buyer countries to low-cost GHG emission allowances from Ukraine and other sellers will help these countries keep GHG-related costs at a level that will prevent or at least reduce such relocation of industries. The U.S. non-participation in the Kyoto agreement and the resulting distortion in competition has further increased the need for low-cost solutions to the GHG problem for the remaining buyers under the Kyoto Protocol. At the same time, the absence of the U.S. will also contribute to such a low -cost solution by reducing international demand for GHG allowances, and associated market prices. With this background, we will analyze the following main questions below: · What are Ukraine’s options for utilizing its surplus emissions rights under the Kyoto Protocol (formerly known as “Hot Air”)? · What are Ukraine’s options for generating and selling additional GHG emission reductions? · What could be the respective roles of the Kyoto Protocol’s two mechanisms International Emissions Trading (IET) and Joint Implementation (JI) in selling such additional emission reductions? · Based on an evaluation of these options, what strategy should Ukraine apply?

TABLE 5.1 SUMMARY OF UKRAINE ’S PROJECTED GHG EMISSIONS AND REDUCTION POTENTIAL 1990 1999 2008-12 2008-12 average cumulative (Mt CO2e) (Mt CO2e) (Mt CO2e /yr) (Mt CO2e)

CO2 energy-related 1) 672 289 453 2'265 Other GHG emissions 2) 242 96 151 755 CO2 removals 3) -52 -52 -52 -261 Total GHG emissions and removals 862 333 552 2'760

Kyoto Assigned Amount (rounded) 5) 860 4'300

Surplus AAU - all gases (rounded) 6) 300 1'500 Surplus AAU - only energy-related CO2 (rounded) 7) 220 1'100

Additional Reduction Potential (<8 $/t CO2e) 4) 150 750

Data Sources 1) 1990: 2nd National Communication (1999) p.31; 1999 and 2008-12: Own calculations, according to Scenario A, Chapter 2 2) 1990: Second Nat. Comm., 1999 and 2008-12: Assumed proportional to energy-related CO2, at about 25% of total GHG emissions 3) 1990: First National Communication (1998) p.6; 1999 and 2008-12: assumed to remain constant at 1990 level 4) According to Chapter 2, marginal abatement cost curve 5) Corresponding to 100% of 1990 GHG emissions 6) Calculated as Assigned Amount minus total GHG emissions. This value represents an approximation, because it is based on simplifying assumptions regarding GHG emissions other than CO2, and regarding CO2 removals by sinks 7) Calculated as energy-related CO2 emissions in 1990 minus project emissions in 2008-12

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66 TABLE 5.2 NET INFLOW OF FDI TO UKRAINE IN 1992-2000 1992/93 1994 1995 1996 1997 1998 1999 2000 Net inflow, M $US 219.4 264.1 413.4 541.3 625.4 747.1 471.1 546.0 Rate of growth, % 120.4 156.5 130.9 115.5 119.5 63.1 115.9 Source: State Committee for Statistics of Ukraine

5.2. STRATEGY FOR USING SURPLUS EMISSION ALLOWANCES

5.2.1. Sell or Bank? Under a high economic growth scenario, we estimate that Ukraine has surplus emission allowances of about 1’500 million tonnes of CO2e relative to its Assigned Amount under the Kyoto Protocol for the period 2008-12, corresponding to about 32% of the country’s Assigned Amount. This estimate is however relatively uncertain, because it is based on very rough assumptions regarding CO2 removals by forests and emissions of non-CO2 greenhouse gases, which were not analyzed in detail in this study.

The main focus of our projections was on energy-related CO2 emissions. If we consider these emissions only, the surplus AAUs are about 1’100 million tonnes of CO2. Under a low growth scenario, the amount of these surplus emission allowances will be even higher, reaching up to 38% of emissions in the base year. Ukraine faces two main options for utilizing this asset: · It can sell the surplus allowances to international buyers under the Kyoto Protocol’s International Emissions Trading (IET) mechanism; or · It can bank the surplus allowances to ensure com pliance with its own emissions targets in future commitment periods (i.e. in the period 2013-17 or later). A final and rational choice between these two options is at present difficult due to the fact that the Parties to the Kyoto Protocol have not yet agr eed to any emissions targets for the second commitment period 2013-2017. This results in two major uncertainties: · Ukraine’s post -2012 position in the international GHG market is uncertain, i.e. whether it will be a seller or a buyer in the longer term. · The long-term (post-2012) price level for emission reductions is highly uncertain. Regarding carbon prices, even the mid-term development (up to 2012) is rather difficult to predict, given the uncertainty regarding the entry into force of the Kyoto Protocol as well as persisting uncertainties regarding the demand for and implementation of the flexible Kyoto mechanisms. With this background, and taking into account Ukraine’s need for financing to renew its infrastructure, we propose that Ukraine should in a first step try to sell about 1/3 of its energy

66 In 2001 there was a further 10% decrease of net inflow of FDI in Ukraine’s economy.

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CO2-related surplus allowances, corresponding to about 350 Mt CO 2 for the total period 2008-12. The remaining 2/3 should be banked until more clarity exists regarding post-2012 emission reduction commitments and long-term carbon prices.

The proposed volume of 350 Mt CO2 is close to the so-called Commitment Period Reserve level.67 The Commitment Period Reserve provision of the Marrakesh Accords stipulates that a country can sell at maximum 10% of its Assigned Amount , unless it produces reliable inventories demonstrating that its actual GHG emissions justify the sale of emission allowances beyond this reserve level. 10% of Ukraine’s Assigned Amount correspond to approximately 430 Mt CO2e for the total period 2008-12.

Hence, 430 Mt CO2e is the maximum amount of surplus AAU Ukraine could sell until it complies with the inventory requirements. Sale of AAUs up to this limit will, however, mean that transfers of ERUs under Track-1 JI will no longer be possible, because suc h transfers are also subject to the commitment period reserve (see details in Section 5.3.3 below). By limiting AAU sales to the proposed 350 Mt in a first phase, Ukraine can leave room for Track-1 JI at least until it the actua l demand for such Track-1 JI projects will become clearer.

5.2.2. How to Sell? – The Need to Add Environmental Credibility Ukraine will only be successful in selling part of its surplus emissions allowances if the following criteria are satisfied: · It must comply with the Kyoto Protocol’s eligibility criteria for international emissions trading (IET) under Article 17. Specifically, this means that Ukraine must have a recognised national GHG emissions inventory and a national register of emissions rights in place, and comply with its reporting requirements under the Protocol. · It must add environmental credibility to the sale of surplus emission allowances. This relates to the fact that Ukraine’s surplus emission allowances did not result from any real measures to reduce GHG emission. Rather, they can be considered a windfall profit from Ukraine’s successful negotiations in Kyoto. Consequently, most Annex 1 Governments are only likely to buy such emission surplus allowances if appropriate measures are taken to ensure a corresponding, real reduction in GHG emissions. The most promising way to ensure such environmental credibility will be to recycle any revenues from the sale of surplus emissions rights into emissions-reducing projects in Ukraine. To this end, we propose to set up a Ukrainian GHG reduction facility which would support GHG-reducing projects in Ukraine. Such projects could cover a wide range of sectors, such as e.g. district heating, electricity generation, demand-side measures to reduce

67 Each Party included in Annex I shall maintain, in its national registry, a commitment period reserve which should not drop below 90 per cent of the Party’s assigned amount calculated pursuant to Article 3, paragraphs 7 and 8, of the Kyoto Protocol, or 100 per cent of five times its most recently reviewed inventory, whichever is lowest. Source: Decision 18/CP.7 in: FCCC/CP/2001/13/Add.2, p.54.

NSS Ukraine 147 energy consumption in industry and the residential sector, waste management, as well as capacity building activities. The creation of such a facility will, most likely, be an indispensable prerequisite for making the purchase of surplus emission allowances acceptable for buyer governments, particularly in the European Union, Canada and Japan. From the perspective of Ukraine, the facility would be beneficial in channeling funding to the country’s energy infrastructure and other priority sectors. The facility could build on the experience made with the State Energy Efficiency Program. Its effectiveness could be further strengthened if set up as a revolving fund providing loans rather than grants to environmental investment projects on favorable terms. Regarding timing, actual transfers of emission allowances (AAUs and ERUs) to buyers will most likely only become possible around 2008. This is because such transfers require design and installation of registries for Ukraine, the buyer countries as well as at the UNFCCC. In addition, Ukraine’s Assigned Amount for 2008-12 will have to be finally determined and issued into the registry before any Assigned Amount Units can be transferred. Due to their complexity, these tasks are unlikely to be completed before 2008. As a result, Ukraine cannot expect any major cash revenues from the sale of emission allowances before 2008. It may, however, be possible to close forward contracts with buyers. Such contracts would stipulate the delivery, at a later date, of specified amounts of emissions rights at a specified price. Ideally, some buyers may even be willing to pay a part of the purchase price up-front, before the actual delivery of the emission allowances.

5.2.3. The Role of Joint Implementation in Selling Surplus Emission allowances A smaller portion of Ukraine’s surplus emission allowances may also be transferred under the Kyoto Protocol’s Article 6 Joint Implementation (JI) mechanism. This is due to the fact that under normal JI projects, only emissions reductions achieved in 2008-12 can be credited and transferred to a buyer as ERUs. Any ERU’s transferred will be deducted from Ukraine’s emissions budget (the “Assigned Amount”) for that period. This is illustrated in Figure 5.1 below.

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FIGURE 5.1 ILLUSTRATION OF ERU TRANSFER UNDER JI

Investor Host

+ ERUs

– – Emission reduction via JI

Actual emissions Assigned Actual emissions Assigned in 2008-12 amount in 2008-12 amount

JI projects starting in the coming years will, however, already reduce emissions in the years before 2008. Ukraine may sell emission allowances from its 2008-12 budget to JI buyers in exchange for these early reductions. From the perspective of the buyers, such a scheme can make the transfer of surplus AAU emission allowances more environmentally credible. At the same time, the approach creates a level playing field between JI and the Clean Development Mechanism (CDM), since the latter allows developing countries to credit and sell emission reductions achieved from 2000 already. In other words, sale of AAUs in exchange for pre-2008 reductions will strengthen the competitiveness of JI relative to the CDM. Examples of deals involving the transfer of early reductions include the World Bank’s Prototype Carbon Fund and the Dutch Government’s ERUPT tender buying from Romania. Some institutional details however remain to be clarified. In particular, while early reductions could certainly be credited and transferred as ERUs under Track-1 JI, it is at present unclear whether this would also be possible under Track-2 JI. This questions will have to be clarified by the JI Supervisory Committe. The specific advantages and disadvantages of Track-1 and Track-2 JI are addressed in more detail in the next section.

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5.3. SELLING EMISSION REDUCTIONS UNDER JOINT IMPLEMENTATION

5.3.1. Background In Chapter 2 of this study, we have shown that significant potential exists to reduce GHG emissions in Ukraine at relatively low costs. The Kyoto Protocol allows Ukraine to sell such emission reductions to international buyers under its Article 6 Joint Implementation (JI) mechanism. Benefits for Ukraine would include: · Additional foreign investment to up-grade the energy efficiency of its industries and energy sector. · Achieving co-benefits of GHG emissions reductions, such as: enhanced quality and reliability of energy supply, reduced dependence on imported fossil fuels, and reduced health costs related to air pollutants. Below, we describe in more detail the role of the Ukrainian Government in JI transactions. We analyze the importance of the additionality concept, as well as potential problems associated with selling “the low hanging fruit”. Finally, we discuss the differences between the two tracks of the JI mechanism. International Emissions Trading under Article 17 of the Kyoto Protocol, which represents an alternative route for selling Ukraine’s emission reduction potential, will be analyzed in Section 5.4. Annex 5.3 provides an overview of JI- type projects implemented to date.

5.3.2. Some Institutional Characteristics of JI Joint Implementation is a project-based mechanism for emissions trading. As a result, the enterprise which deve lops and implements the emissions-reducing project is responsible for most JI-related steps, such as: quantifying the GHG emission reduction (baseline study, monitoring), ensuring independent verification of emissions reductions, and closing contracts with the buyers of the emissions reductions. The various steps involved in a JI project are described in Chapter 4 of this report. Emission reductions achieved by a JI project are transferred to an international buyer as ERUs. These ERUs are created by converting an AAU into ERUs. The bottom-line is then that ERU transfers will be deducted from the emissions budget (the Assigned Amount) of Ukraine, as illustrated already in Section 5.2.3 above. The Ukrainian Government has primarily the function of enabler in JI projects. It must ensure an efficient approval process as well clear guidelines for project developers. Currently, another important task is the closing of Memoranda of Understanding with interested buyer countries, as a basis for actual JI transactions. Various other functions for Government are not obligatory, but can be assumed if deemed appropriate. These include, e.g., the active promotion of JI through information programs, support in international marketing, and the deve lopment of JI projects in state-owned enterprises. This is described in detail in Chapter 4 of this report.

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An important feature which distinguishes the JI mechanism from Article 17 emissions trading is its ability to channel international funding directly to the emissions-reducing project. Typically, an enterprise hosting a JI project will receive payment for every ERU delivered to the international buyer. To this end, the Ukrainian Government will have to assign the legal title to these ERUs to the hostin g enterprise, along with the right to transfer the ERUs abroad. In order to provide legal certainty, the conditions under which project developers in Ukraine have title to ERUs will have to be regulated by law. See again Chapter 4 for details.

5.3.3. Distinguishing Track-1 and Track-2 JI The Marrakesh Accords distinguish two separate approaches for Article 6 JI which have become known as Track-1 and Track-2 JI: · Under Track-1 JI, the seller country is responsible for verifying the emission reductions achieved by its JI projects. A country is eligible for Track-1 if it complies with Articles 5, 7 and 8 of the Protocol, i.e. if it has an accepted national emissions inventory and allowance registry in place and reports correctly to the UNFCCC. · Under Track-2 JI, emissions reductions achieved by a JI project are verified according to the rules of the JI Supervisory Committee. This track is quite analoguous to the CDM. From the perspective of Ukrainian project hosts and international ERU buyers, both tracks each have their specific advantages and disadvantages: · Delivery risk: ERUs transferred under Track-1 are subject to the commitment period (CP) reserve provision of the Marrakesh Accords (see Section 5.2 for details). This provision is intended to prevent seller countries from failing to meet their own Kyoto targets due to overselling. As result, a project host in Ukraine may find himself unable to transfer ERUs to a buyer if Ukraine sells a large amount of AAUs, or if it fails to comply with its obligations related to inventoris, registries and reporting.68 This represents a significant risk from the perspective of both project developers in Ukraine (who could fail to earn their revenues from ERU sales) and international ERU buyers (who would need the ERUs to ensure compliance with their emissions targets). In contrast, Track-2 transactions are explicitely exempted from the CP reserve · Transaction costs: Track-2 procedures are generally expected to become more bureaucratic than Track-1 procedures (although the latter will differ from country to country). As a result, Track-2 is expected to involve higher transaction costs for e.g. project registration, validation and verification. · Delay risk: The JI Supervisory Committee will only be established after entry into force of the Kyoto Protocol, i.e. at COP/MOP-1 at the earliest. Definition of

68 For example if the Ukraine Government transfers a sizeable part of its surplus emission allowances under IET and at the same time fails to prepare its most recent inventories.

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Track-2 rules will take further time, creating a risk for delay with regard to project registration and ERU issuance. With this background, it is at present difficult to predict whether JI buyers will favor Track-1 or Track-2. Consequently, we recommend that the Ukrainian Government should leave it up to the individual project partners to choose between the two tracks. To this end, the Ukrainian Government should ensure eligibility for both tracks by: · Track-1: Fulfilling in time its obligations under the Protocol with regard to inventories, registries and reporting; · Track-2: Offering an efficient approval process for Track-2 JI projects. The eligibility requirements for Track 1 are identical with those for Article 17 IET and will therefore not involve any additional costs for the Government. In contrast, some (but limited) costs will result from the fact that the Ukrainian Government will need rules and guidelines for Track-1 projects to ensure that the claimed emissions reductions are real and additional. In preparing these rules and guidelines, the Ukrainian Government will be able to draw on emerging work for the CDM as well as Track-1 JI in other countries. In the next section, we analyze the relevance of the additionality issue in more detail.

5.3.4. Additionality The Kyoto Protocol requires that emission reductions transferred under Article 6 JI must be additional to any which would otherwise occur. An analoguous requirement also exists for the CDM. The intention behind these provisions is to ensure the environmental integrity of the JI and CDM mechanisms, i.e. to avoid a situation where utilisation of the mechanisms leads to an increase in global GHG emissions. The additionality criterion of the Kyoto Protocol has become known as environmental additionality. Other additionality concepts, such as e.g. financial additionality or ODA additionality, are explained in the shaded box.

BOX 5.1 ADDITIONALITY Additionality has been one of the key issues within the discussion on JI and CDM projects. One has to differentiate primarily between (a) financial additionality in the sense that project funds are additional to existing Official Development Assistance (ODA) funds, (b) environmental additionality in the sense of JI and CDM projects resulting in emission reduction or GHG mitigation which is additional to what would otherwise occur, and (c) investment additionality in the sense of JI and CDM projects being not financially viable without the revenues from carbon credit sales. The bulk of the literature and discussion on additionality has centered on the second issue, that of environmental additionality (with frequently changing nomenclature). The question whether project -based emission reductions are truly additional to what would otherwise have happened is of critical importance when using JI and CDM as a means to combat climate change. In order to judge whether a project is additional, various methods have been proposed and different additionality concepts have emerged: JI/CDM projects could be compared with other (standard) activities, emission benchmarks could be established, a comparison to historical emission levels could be made, counter-fact fut ure emission levels could be modeled using various parameters. Furthermore, it can be asked whether there are significant barriers that stop JI/CDM projects from being implemented without JI/CDM funds and finally it can be asked whether a JI/CDM project would be commercially viable without JI/CDM funds. Investment additionality is often considered an indicator for environmental additionality. This view is based on the argument that if carbon credits are required to make a JI/CDM project financially viable, this project is unlikely to happen in a “business-as-usual” world without

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JI/CDM project financially viable, this project is unlikely to happen in a “business-as-usual” world without JI/CDM. In other words, insufficient financial viability without JI/CDM credits is then considered a key barrier impeding project implementation in the reference case.

How relevant is environmental additionality from the perspective of the Ukrainian Government? To answer this question, it is first of all important to understand what additional and non-additional emission reductions are, and how they will affect Ukraine’s balance of GHG emissions and emission allowances: 1. The additionality criterion is satisfied if the each ERU69 issued to a JI project is backed

by a corresponding reduction of physical GHG emissions by one tonne of CO2- equivalent. 2. The additionality criterion is not satisfied if one of the two following situations occur: 2.a) If ERUs are issued to a project which does not reduce emissions compared to the pre -project situation. This is sometimes also referred to as a JI project delivering no real emission reductions. 2.b) If ERUs are issued for emission reductions that would occur “anyway”, that is: for emission reductions that would also occur in the absence the financial incentives created by the JI mechanism. Essentially, this case means that emission reductions from “business as usual” energy efficiency improvements are sold to a buyer abroad. What are now the consequences if a JI project (or the emission reductions that it claims) are not additional? With regard to the environment, two cases need to be distinguished: · If Ukraine meets its own Kyoto target, non-additional JI projects will not lead to an increase in global GHG emissions. This is because of the zero-sum-game- nature of JI: Any ERUs transferred to a buyer will be deducted from the Ukraine’s national Assigned Amount. Consequently, non-additional JI projects will simply reduce Ukraine’s amount of surplus emission allowances that can be sold under IET or banked for future commitment periods. · If Ukraine failed to meet its own Kyoto target, non-additional JI project could aggravate the situation by increasing the country’s shortfall in emission allowances, and hence increase global GHG emissions. This situation seems however unlikely, given the country’s large reserve of surplus emission allowances. In conclusion, additionality of JI projects is not an environmental concern if we assume that all Annex 1 countries will collectively meet their Kyoto targets, and will collectively consume all emission allowances issued under the Kyoto Protocol for 2008-12. At maximum, non-additional JI projects in Ukraine could result in a slight acceleration of global emissions, namely if the resulting ERUs were used for compliance in a buyer country in 2008-12, rather than being banked by Ukraine for use in a later commitment period.

69 ERUs are created by converting an AAU into an ERU.

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Besides environmental concerns, however, also the economic importance of the additionality criterion should be recognized. This can be summarized as follows: · Non-additional JI projects will negatively influence Ukraine’s net GHG position, which we de fine as the amount of emission allowances (AAUs) held minus the country’s total GHG emissions in 2008-12. In contrast, the sale of “additional” emission reductions will not affect the country’s net GHG position because both Ukraine GHG emissions and the country’s Assigned Amount will be reduced by the same number of Tonnes of CO2. · A negative change in the net GHG position means that a country will have to make a stronger effort to meet is own Kyoto target. For Ukraine, this will not be relevant in 2008-12 due to its large surplus of emission allowances. It could, however, become important after 2012 where Ukraine would likely have to accept more demanding emissions targets. From an economic perspective, additionality is therefore important for Ukraine espec ially in the longer term. On the other hand, experience gained with JI and CDM projects shows that additionality can be difficult to ensure in practice. In particular, it is often impossible to determine with certainty whether a project (and the associated emission reductions) would be achieved “anyway” without the JI incentive. With this background, we make the following recommendations regarding additionality: · In the short - to mid-term, Ukraine should not restrict JI activities as long as they yield real emissions reductions. Non-additionality in the sense of “emissions reductions being achieved in the absence of the incentives created by JI” (see Case 2.b above) should not be a concern to the Ukrainian Government in the period up to 2012. · The first crediting period for JI projects not extend beyond 2012. No ERUs should be granted for post -2012 emissions reductions until the country’s emissions target for 2013-17 has been defined. · A mandatory re -validation should be required for any JI projects claiming emission reductions after 2012. Such re -validations would have to carried out in the period 2010-12. By that time, Ukraine will know its national emissions target for 2013-17, and will have had time to work out rules to ensure additionality, if required to meet these targets. These recommendations apply only for Track-1 JI, where Ukraine can define its own rules. Rules for Track-2 JI will be defined by the JI Supervisory Committee, as mentioned above. However, we recommend that also for Track-2 JI projects, Ukraine should not approve crediting of post-2012 emissions reductions until it can be ensured that such ERU transfers will not compromise its own compliance.

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5.3.5. Saving The Low Hanging Fruit? Under JI, Ukraine could sell part of its low-cost GHG emission reduction potential to buyers abroad. Some authors and negotiators have expressed concerns that this selling of such “low hanging fruit” could increase the seller countries’ cost of meeting their own emissions targets. In the section on additionality above, we have shown that JI projects will not affect the net GHG position of the seller country if the transferred emission reductions are truly additional to what would happen otherwise. However, even with additional JI projects, the “Low -hang-fruit”-concern remains valid in principle: The sale of low-cost emissions reductions will in fact increase the marginal cost of achieving further reductions. As long as such further reductions are not required to ensure compliance, however, this will have no practical importance. This is precisely the case for Ukraine, since the country will not have to take additional measures to meet its own Kyoto target. As mentioned earlier, this situation may change after 2012, where Ukraine may have to accept more stringent emissions targets of its own. If this situation materializes, Ukraine will have to ensure through appropriate policies that the country can meet its target at the least overall cost. Such policies could include, for example, the introduction of a domestic GHG emissions trading scheme, which would oblige large industrial emitters to reduce their own emissions before they can sell excess emission allowances. A scheme of this type is planned to start 2005 in the European Union (see next section). Under a domestic emissio ns trading scheme, each company will decide on its own whether the sale of low-hanging fruit is beneficial or not. With regard to smaller sources such as residential heating or transport, typical policies to reduce GHG emissions include energy efficiency standards and energy / carbon taxes. As explained in the previous section, the presence of such policies will have to be taken into account when assessing the additionality of JI projects in Ukraine after 2012. If this is done properly, only emission reductions exceeding the level required by these policies will be transferred abroad. As a result, the low -hanging fruit in these sectors will automatically stay in the country and contribute to Ukraine’s compliance with its own emissions target. In conclusion, the low hanging fruits issue need not be a concern to the Ukrainian Government until 2012 because the country will meet its Kyoto target without additional efforts. After 2012, in contrast, new domestic GHG policies may be required to meet Ukraine’s own emission target. Such policies should then of course focus on the least-cost potentials for emission reduction. With the help of appropriate national additionality rules for JI, it would even then be possible to ensure that JI projects could not result in a transfer of these low-hanging fruits abroad. As a practical conclusion, we recommend again that Ukraine should not grant any ERUs for post-2012 emissions reductions until the requirements for the period 2013-17 become clearer.

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5.4. SELLING EMISSION REDUCTIONS UNDER INTERNATIONAL EMISSIONS TRADING

5.4.1. Background In Section 5.3, we have discussed the possibility of generating and selling additional GHG emission reductions under Article 6 JI. We have emphasized that JI is project-based instrument, with demand and supply being primarily driven by private-sector enterprises. The Ukrainian Government should primarily play the role of an enabler for JI by offering clear rules and efficient approval procedures. International Emissions Trading (IET) under Article 17 offers, potentially, an alternative to JI for generating and selling emissions reductions. Specifically, such trading under Article 17 could take two forms: · Ukraine could introduce policies which promote further GHG emission reductions, for example a financial subsidy for energy efficiency measures, or increased energy / carbon taxes. As a result of these policies, the amount of surplus emission allowances (AAUs) which the Government could sell in 2008-12 would increase.

· Ukraine could ntroducei a domestic emissions trading scheme for large CO2 emitters, similar to the scheme that is planned to start in Europe in 2005. The Government would allocate a part of Ukraine’s emissions rights (i.e., part of the National Assigned Amount) to the participating enterprises. These enterprises would have to surrender each year sufficient emission allowances to cover their actual emissions. Companies would be free to sell any excess emissions rights on the international GHG market. Below, we analyse these two options in more detail.

5.4.2. Policy Scenarios for GHG Reduction in Ukraine With the help of appropriate domestic policies, Ukraine could further reduce its GHG emissions. This would allow the Government to generate additional revenues by selling more emission allowances (AAUs) under Article 17 IET. Below, we analyse three such policies for reducing GHG emissions: Strategy 1: A Governmental energy efficiency program, which would support GHG reducing measures with financial subsidies; Strategy 2: Introduction of new energy / carbon taxes, with a corresponding reduction in other taxes so that the Government’s net tax revenues would remain unchanged. Strategy 3: Accelerated switch from coal to natural gas in the power generation sector.

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Figure 5. 2 below demonstrates the emission reductions which could be achieved with these three strategies. The analyses is restricted to energy-related CO2 emissions. The scenarios presented in the figure build on those introduced in Chapter 2 and inclu de the above- mentioned three strategies: Scenario A: Sustainable economic growth with structural changes of the economy and with minimal energy savings. This is considered the most plausible scenario in the absence of further policies directed at GHG emission reduction. Scenario A serves as the reference for the following analyses. Scenario C: Sustainable economic growth without structural changes of the economy and with minimal energy savings. Scenario D: Sustainable economic growth with structural changes of the economy and with 50% implementation of the total energy savings potential through a “moderate” governmental energy efficiency program. Scenario D1: As Scenario D, but with 100% implementation of the total energy savings potential through a “comprehensive” governmental energy efficiency program (Strategy 1). Scenario D1+2: Scenario D1 plus increased energy / carbon tax (Strategy 2) Scenario D1+2+3: Scenario D1+2 plus switch from coal to gas in power generation (Strategy 3). A more detailed descriptio n of these strategies can be found in Annex 5.2. In addition, Annex 5.1 provides an overview of recent policies for reducing GHG emissions in OECD countries.

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FIGURE 5.2 SCENARIOS OF ??2 ENERGY RELATED EMISSION

For 2010, Figure 5.2 indicates a reduction potential of about 230 mln tonnes of CO2 that could be exploited with the help of Strategies 1-3, using Scenario A as the reference. In addition, the figure identifies about 50 mln tonnes of CO2 emission reduction that are expected to result, without the help of specific energy policy measures, from structural changes if the economy grows rapidly. The 230 mln tonnes per year are composed of:

· 95 mln t CO2/a “Moderate” energy efficiency program (“first 50%”)

· 95 mln t CO2/a “Comprehensive” energy efficiency program (“second 50%”)

· 40 mln t CO2/a Energy / carbon tax

· <<10 mln t CO2/a Fuel switch The benefit of these policies for the global climate is obvious. However, would these policies also be economically beneficial for Ukraine? – Annex 5.2 estimates the costs of each policy from the perspective of the Ukrainian Government, taking into account the following main components: · the cost of financing emissions -reducing measures · changes in fuel costs · savings in state health expenditures associated with reduced air pollution

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· revenues from the sale of resulting emission reductions on the international GHG

market, at 8 $/t CO2 The calculations in Annex 5.2 imply that two out of the four considered policy strategies could in fact yield economic benefits for Ukraine. These are: · A moderate Governmental energy efficiency program, and

· A tax reform, with increased taxation of energy consumption (or CO2 emissions) and corresponding reductions in other taxes.70

Together, these two policies could yield emission reductions of about 130 mln tonnes of CO2 per year in the period 2008-12. This result is roughly in line with the MAC curve presented in Chapter 2, where GHG reduction potentials were estimated in a bottom-up approach. In contrast, a forced governmental energy efficiency program as well as forced fuel switch from coal to natural gas in power generation would likely not be profitable for Ukraine.

International carbon prices would need to be substantially higher than the assumed 8$/ t CO2 to justify these latter policies. In conclusion, we recommend that the Ukrainian Government should more closely consider the introduction of two policy instruments: A moderate energy efficiency program to (co -)finance re newal of the energy infrastructure, and a revenue-neutral shift from traditional taxes to energy / carbon taxes. These policies may be economically beneficial for Ukraine even without considering the resulting reductions in GHG emissions. In addition, the sale of the resulting GHG emission reductions under International Emissions Trading (Article 17 IET) could further increase their profitability. The revenues from the sale of surplus emission allowances, as described in Chapter 5.2, could help financing the governmental energy efficiency program.

5.4.3. The Role of Domestic GHG Trading Systems Annex 1 countries can authorize legal entities (companies) in their jurisdiction to participate in Article 17 emissions trading. This is potentia lly an alternative to IET at Government level. The planned European GHG Trading scheme illustrates how this could work (see shaded box). In a domestic trading scheme, a Government essentially, allocates a part of its national Assigned Amount to a limited number of large emitters, usually industry companies. At the end of each year, each company must surrender AAUs equivalent to its actual GHG emissions back to the Government for cancellation. Companies can trade AAUs amongst each other, and market forces ensure that emission reductions are undertaken where the costs of doing so are the lowest. For Ukraine, a domestic GHG trading scheme could potentially yield two important benefits: · It could provide an efficient policy framework for achieving further emissions reductions; and

70 Note: The analysis of the tax reform was based on a number of simplifying assumptions. In particular, the tax reform was assumed to be fully revenue-neutral for the Government. Indirect effects on e.g. economic growth and associated changes in revenues for the Government were not considered.

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· It could provide an efficient way for industry companies to sell their low-cost GHG reduction potential to international buyers – provided that the Ukraine scheme would be linked with, for example, the European Union’s trading scheme. On the other hand, the introduction and enforcement of a domestic GHG trading scheme is a demanding task. For example, the initial allocation of emissions allowances is by experience very controversial, because the emissions allowances distributed through the allocation represent considerable financial values. In addition, a trading schemes needs reliable emissions monitoring in each company, and a credible system of penalties in the case of non- compliance. With this background, we believe that attempts to introduce a domestic GHG trading scheme in Ukraine in the coming years would likely be premature. Instead, we recommend that Ukraine should closely follow the developments in the European trading scheme and, in particular, the corresponding experience of the EU Accession States in Central and Eastern Europe. A domestic trading scheme could however become an option for Ukraine in the longer term, for example after 2012. Such a scheme could largely replace project-based GHG trading under JI, and reduce the associated transaction costs.

BOX 5.2 SUMMARY OF THE PROPOSED EUROPEAN GHG TRADING SCHEME FOR INDUSTRIAL EMITTERS The European Commission has proposed a Draft Directive for a European GHG trading scheme.71 The scheme is intended to ensure reduction of GHG emissions from large industrial sources at the least cost, and thereby to contribute to reaching the European Union’s emission reduction target under the Kyoto Protocol. The Directive proposed as so-called cap-and-trade approach, where the total number of available emissions allowances (= emission allowances) for a specified target period is strictly limited or „capped“. A regulatory authority establishes the overall cap and allocates the available allowances to the capped sources. At the end of the target period, for example annually, each source must surrender allowances equivalent to its emissions. Trading occurs when a source has excess allowances and sells them to an entity requiring allowances. In December 2002, the Council of European Environmental Ministers reached a political consensus on the Directive. This agreement implies that the GHG trading scheme is now virtually certain to enter into force in the coming months, after the remaining differences remain between the positions of the Council of Ministers and the European Parliament have been resolved. As proposed by the Commission, the Directive will cover about 4'000 – 5'000 installations in the following industries (see Directive for mimimum size thresholds): · Combustion installations with a rated thermal capacity exceeding 20 MW, except waste incineration; · Mineral oil refineries; · Coke ovens; · Metal ore roasting, iron and steel production; · Cement clinker production; · Glass manufacturing; · Ceramic products, including bricks, t iles, and porcelain; · Pulp, paper and board.

71 COM(2001) 581, October 2001

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The scheme is to start in 2005, with a pre-commitment period 2005–07 and a first commitment period 2008-12. Participation in the scheme is mandatory. Limited exemptions may be possible in the “warm-up period” 2005- 07.

The scheme will only cover CO2 emissions in the period 2005–07. From 2008 onwards, the scheme may be extended to other gases, provided that they can be accurately monitored. Similarly, Member States may enter additional activities, such as e.g. chemicals or aluminium, into the scheme from 2008 (opt-in mechanism). From 2005 already, Member States may reduce the mimimum size thresholds to include small installations from the sectors mentioned above.

Member States are responsible for the initial allocation of CO2 emissions allowances to the capped sources. To this end, they have to develop national allocation plans which are subject to approval by the Commission. In the pre-commitment period 2005–07, all allowances muist be allocated for free. In the peri od 2008-12, Member States may auction up to 10% of the allowances. Allowances can be banked, i.e. saved for use in later years, subject to certain restrictions. The covered installations (= industry sources) have to surrender allowances equivalent to their emissions by 31 March each year. The penalty for a shortfall in allowances in any one year of the period 2005–07 is 40 €/t CO2. In the p eriod 2008–12, the penalty increases to 100 €/t CO2. Those paying the penalty still have to make up the shortfall by surrendering the corresponding extra allowances in the next year. Member States are responsible for enforcing the penalties. The EU accession countries will, in principle, have to adopt the Directive as part of the Acquis Communautaire, which means that their respective industry sectors should be part of the GHG trading scheme from 2005.72 According to inofficial information, some of these countries are already preparing for the Directive, for example Poland, Czech Republic and Slowenia. Nevertheless, some countries may be granted a certain transition period. For these countries, the GHG trading scheme will likely provide a very efficient way to sell their low -cost emission reduction potential. The traded unit in the EU scheme will be “EU allowances”, not AAUs. Nevertheless, the scheme will have to be linked in some way with Article 17 emissions trading, as well as with JI and CDM. Prospectively, “Kyoto units” (AAU, ERU, CERs, RMUs) will be accepted in the scheme, although certain restrictions may be introduced to ensure that the scheme delivers a real benefit for the global climate.

72 The following 10 countries will accede the EU in 2004: Poland, Czech Republic, Slowakia, Hungary, Slowenia, Estonia, Latvia, Lithuania, Malta, Cyprus. Bulgaria and Romania will accede in 2007.

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5.5. CONCLUSIONS AND STRATEGY RECOMMENDATIONS

5.5.1. Ukraine’s Position and Strategy in the International GHG Market Ukraine has the potential to become a major seller of GHG emission allowances under the Kyoto Protocol. According to our estimates, the country will have surplus emission allowances of at least 1 billion tonnes of CO2-equivalent in the first commitment period 2008-12. If non-CO2 GHG and forestry sinks are included, the surplus allowances may even increase to 1.5 billion tonnes. In addition, the country offers potential for further emission reductions of at least 650 mln tonnes in the period 2008-12 which can be exploited profitably at the projected market price of 8 $/ t CO2. The sale of these emission allowances on the international GHG market could generate substantial revenues for Ukraine, which could help to upgrade the country’s obsolete industries and energy infrastructure. In addition, a further reduction of GHG emissions w ould create substantial co-benefits for the country in the form of reduced dependence on imported fuels, and reduced health costs associated with air pollution.

TABLE 5.3 SUMMARY OF UKRAINE ’S PROJECTED GHG EMISSIONS AND REDUCTION POTENTIAL 1 MT CO2E = 1 MILLION METRIC TONNE S OF CO2-EQUIVALENT 1990 2008-12 2008-12 average cumulative

(Mt CO2e) (Mt CO2e/yr) (Mt CO2e)

Surplus AAU - all gases (rounded) 300 1'500 Surplus AAU - only energy -related CO2 (rounded) 200 1'500

Additional Reduction Potential (<8 $/t CO2e) 0 150 750

The practical value of these potentials will critically depend on the international demand for GHG allowances, that is: On the number of AAU /ERU that can be sold, and on the price at which they ca n be sold. This demand at present still uncertain to some extent. Examples of factors influencing the international demand are: CDM rules, supply of surplus AAUs from Russia, and possible national restrictions regarding the use of Kyoto mechanisms in the buyer countries, particularly the European Union and Japan. Nevertheless, we recommend that Ukraine should make all preparations required to generate these revenues. To this end, we recommend that Ukraine should take the following strategy: 1. For the sale of surplus emission allowances (AAU) for the period 2008-12: · Start negotiations with potential buyers regarding sale of surplus AAU immediately.

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· Sell about 1/3 of the surplus AAU (only those related to energy CO2, corresponding to 350 mln tonnes of ??2) at the average market price of $8.0 /t CO2e. This would generate revenues of about $2.8 billion during the first commitment period 2008-12. Ideally, a part of these revenues can already be received before 2008, through up-front payments · The revenues from these AAU sales should be spent on further emissions- reducing measures, i.e. on further de-carbonization of the national economy. Besides delivering large benefits for Ukraine in the form of renewed energy infrastructure and local environmental benefits, this recycling will be a prerequisite for attracting buyers, because it adds environmental credibility to the sale of surplus AAU. · Reserve the remaining surplus AAUs for sale at a later stage, or for Ukraine’s own use in the second commitment period, 2013-17. These reserve AAUs should not be sold until Ukraine’s emission target for the period 2013-17 has been defined, and until long-term development of carbon prices becomes more certain. 2. For the generation and sale of further emission reductions : · Take all measures required to enable efficient sale of emission reductions under the Kyoto Protocols Article 6 JI mechanism. The demand for and supply of such emission reductions will be primarily driven by the companies involved in these projects. U krainian Government should play an enabling role for JI, by creating clear national rules and an efficient approval process. This is further described in Chapter 4 of this report. · Consider introduction of further domestic policies for stimulating GHG emiss ion reductions in Ukraine. These include, in particular: Introduction of a Governmental program to (co-)finance the renewal of the energy infrastructure, and shift from existing taxes on income / labor to taxes on energy and carbon emissions. With the help of these policies, Ukraine could generate further emissions reductions which the Government could sell on the international GHG market under Article 17 emissions trading. · In the longer term, Ukraine may also consider introduction of a domestic GHG trading scheme involving large emitters such as e.g. power generators, metals, mining and cement companies. Such a scheme will very likely be introduced in the European Union from 2005. Participation in this European Trading Scheme would allow Ukrainian companies to sell emission allowances at substantially reduced transaction costs, compared to Article 6 JI. The proposed generation and sale of emission allowances could bring to the country an impressive financial inflow from abroad, which is comparable with the total FDI since 1991. This is illustrated in Figure 5. 3. Thus, we assume that surplus emission allowances equivalent to 70 Mt CO2 would be sold as AAUs under Article 17 emissions trading, and further emission reductions of about 150 Mt CO2 would be generated and sold as ERUs under

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Article 6 JI. Using a best-estimate market price of 8 $/ t CO2e, we estimate the possible revenues for Ukraine at 1.8 billion $ per year, or 9 billion $ for the total period 2008-12. It may be possible to obtain a part of these revenues already before 2008, through forward purchase contracts with partial up-front payment by the buyers.

FIGURE 5.3 FINANCIAL REVENUES FROM THE USE OF FLEXIBLE MECHANISMS

5.5.2. The Roles of Joint Implementation and International Emissions Trading Ukraine can to some extent choose whether it wants to rely on Article 6 JI or on Article 17 IET for monetizing its emission reduction potential. In addition, there are two variants of JI (Track-1 and Track-2), and IET can in principle be done on the level of the Government or on the level of the large emitters (= industry companies) in the country. What should be the respective roles of these mechanisms in Ukraine’s strategy? The table on the next page summarizes some important elements relevant for this question. The key advantages and disadvantages of the four instruments are as follows: · Track-2 JI, where emission reductions are verified by the JI Supervisory Board, offers low risks for ERU buyers and sellers, because the transfers of ERUs are not subject to the commitment period reserve. In addition, it will prospectively be most widely recognized as an environmentally credible mechanism. · Track-1 JI, where emission reductions are verified by the Ukrainian Government, involves potentially, lower transaction costs to buyers and sellers. However, the

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commitment period reserve provision may create an important risk of non- delivery of ERU. · IET at Government level is, prospectively, the only mechanism through whic h Ukraine can sell its surplus emission allowancesfor the period 2008-12 (surplus AAU, formerly known as “Hot Air”). The key disadvantage is that such trading will not result in any GHG emission reduction unless the revenues from the AAU sales are used to finance further emissions -reducing projects, as explained above. In other words, we expect that recycling of revenues for further environmental investment will be a mandatory prerequisite for Ukraine to find buyers for its surplus AAUs. · IET at company leve l assumes that Ukraine would introduce a domestic GHG trading scheme similar to the one which will start in the European Union in 2005. This is potentially a very efficient instrument to allow the generation and sale of further low -cost emission reductions. However, such a scheme would require extensive preparations and involve high transaction costs for the Government. Based on these considerations, we make the following recommendations: · Ukraine should ratify the Kyoto Protocol. This is the first and foremost pre- condition for participating in the international GHG market. · JI: Ukraine should allow JI investors to choose between Track-1 and Track-2 JI. For this reason, Ukraine should strive to become eligible for both Tracks by taking the institutional measures described in Chapter 4. This will require little time and resources in the case of Track-2, but more substantial resources for Track-1. Consequently, Ukraine should try to make Track-2 JI available for international buyers as soon as possible, ideally from 2004. In parallel, work on the national GHG emissions inventory and a national AAU registry should be intensified to become eligible for Track-1 JI. We estimate that, ideally, Ukraine could reach Track-1 eligibility by approximately 2006. · IET, Government level: With regard to the sale of surplus AAU, Ukraine should start preparations and negotiations immediately, in order to start actually selling AAUs approximately in 2006. The institutional requirements for IET are the same as for Track-1 JI (adequate inventory, registry, reporting). · IET, Company level: A domestic GHG trading scheme for large emitters is likely to become an attractive option for Ukraine in the longer term, if the corresponding European scheme materializes as expected. Ukraine should keep an eye on this option. Preparations could start as early as 2006, with a view to actually starting the scheme after 2012. A domestic GHG trading would essentially replace project- based trading under JI.

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TABLE 5.4 COMPARISON OF JOINT IMPLEMENTATION (JI) AND INTERNATIONAL EMISSIONS TRADING (IET) FROM THE PERSPECTIVE OF UKRAINE Government = Ukrainian Government; ERU = Emission Reduction Unit; AAU = Assigned Amount Unit; CP = Commitment Period

Article 6 JI Article 17 IET Variants: Track-1 Track-2 Government level Entity (company) level (Ukraine supervises ER) JI supervisory board verifies ER Description: Government issues ERUs for achieved emission reductions Government sells AAU Government allocates AAU to Host company sells ERUs to finance emission reductions companies Companies sell AAU What is traded? Emission reductions achieved through projects (traded as ERU) - Surplus AAU - Further emission reductions achieved through policies and measures (traded as AAU) Institutional requirements: Government complies with Art. - Party to the Kyoto Protocol Government complies with Art. 5, 7, 8 Kyoto Protocol 5, 7, 8 Kyoto Protocol - Assigned Amount calculated - National registry in place - Approval process for JI projects in place Advantages: - Low transaction costs for Yes No not applicable Yes companies (buyer / seller) - Low transaction costs for No Yes Yes No Government - Low risk related to CP No Yes No No reserve - High environmental Yes Yes Only if recyling of revenues into Yes credibility emission reduction - Efficient financing of Yes Yes Only if efficient recyling of Yes emission reductions revenues into emission reduction - Allows to sell surplus AAU No (only limited) No Yes No (only limited) Recommendations: Prepare use of mechanism 2003-06 2004 2003-06 2006-12 Use the mechanism 2006-12 2004-12 2006-12 after 2012

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6. PIPELINE OF POTENTIAL JI PROJECTS

6.1. BACKGROUND

In order to help Ukraine to seize potential benefits from GHG emission reduction projects to be implemented in the near future, the chapter reviews existing potential JI projects and identifies new ones. This includes a brief description of each project, a preliminary analysis of GHG emissions reduced by each project, and the related costs for each project in compliance with JI methodology. The selected pilot project pipeline represents a wide variety of possible ventures in different sectors of the Ukrainian economy. The pipeline has been prepared in such a way that it can be used for AIJ pilot phase and for future JI projects under the Kyoto Protocol.

6.2. OBJECTIVES

The study has three main objectives: · Identification and review of existing projects that meet JI requirements · Identification and assessment of new possible pilot projects for JI · Selection of pilot pipeline projects covering the various sectors of the Ukrainian economy

6.3. PRELIMINARY CRITERIA FOR PROJECT SELECTION

The following criteria are used for project selection: · Quality of information · Willingness of project owners to cooperate · Compatibility with and supportiveness of national environment and development priorities and strategies · Real, measurable, and long-term environmental benefits related to the mitigation of climate change that would not have occurred in the absence of such activities · Good prospective economic state of the company · Total amount of investment not less than USD 500,000 · Replicability potential · Proven, conventional technology

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6.4. SCOPE OF SERVICES

National consultants, in close cooperation with foreign consultants and a project coordinator, completed the following subtasks: 1. Information on the project “NSS for Ukraine”, including offers of cooperation, has been sent to potential users of information regarding CO2 emission reduction projects. Primarily, the information has been communicated to key authorities in Ukraine, including the State Committee for Energy Conservation, the Ministry of Fuel and Energy, the Ministry of Industrial Policy, the Ministry of Economy, the Ministry of Ecology and Natural Resources, the Ministry of Transport, the State Committee for Forestry, and several other relevant organizations. 2. A national model for financial analysis and calculation of GHG emission reduction has been developed in close cooperation with the Swiss expert team. The model enables to obtain calculation results in compliance with the UNFCCC Uniform Reporting Format. 3. 30 projects with significant GHG emission reduction potential in different sectors of the Ukrainian economy have been pre-selected (see Appendix). 4. Financial analysis and GHG emission reduction estimation have been carried out for all 30 pre-selected projects. The financial analysis was performed using the specially developed national model, and the results were verified by using the "PROFORM" model, developed by the Lawrence Berkley National Laboratory (USA). Both models gave almost identical project IRR indices.

6.5. GENERAL ASSUMPTIONS FOR FINANCIAL ANALYSIS AND GHG EMISSION REDUCTION CALCULATIONS

Potential JI projects are described using a simplified version of the UNFCCC Uniform Reporting Format for Activities Implemented Jointly (URF). Estimates of GHG emissions were developed following the IPCC methodology [1]. IPCC emission factors for fuel combustion for Ukraine are shown in Appendix B. For JI projects involving substitution or reduced consumption of grid electricity, two separate baseline73 emission factors were applied:

· The first emission factor is 819.7g CO2 per kWh. This is the average emission factor for thermal power plants in Ukraine in 1990, which operate on coal, natural gas and fuel oil.

· The second emission factor is 350 g CO2 per kWh. This represents best available new technology using natural gas.74

73 The baseline denotes the reference case without the project, against which GHG emission reductions are calculated. 74 Assumption: Natural-gas fired combined cycle p lant with efficiency of 57% and 56.1 g CO2/MJ natural gas.

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The two values serve to demonstrate the sensitivity of the projects’ GHG impacts with regard to the baseline emission factor for grid electricity. The values are conservative in comparison with those recommended by the Dutch ERUPT Programme - 1010 g/kWh for electricity- producing projects and 1224 g/kWh for electricity-saving projects, respectively (for year 2000). 75 Financial efficiency analysis of potential JI projects was performed for the following three scenarios: · The enterprise does not receive any compensation for the achieved emission reduction (Scenario A) · The enterprise, together with the investor in the JI project, receives a compensation of $18.3 per ton of carbon emission reduced ($5.0 per ton of CO2) (Scenario B) · As above, with $36.7 per ton of carbon ($10.0 per ton of CO2) (Scenario C). Each of these scenarios was analyzed for three different values of the cost of capital (discount rate): 10%, 20%, and 30%. The cost of capital for an enterprise corresponds to the rate of return that would be achieved investing this capital in the best possible alternative, and the procedure of discounting project costs and benefits accounts for the loss of this return if the project, rather than the best alternative is implemented. In general terms, the cost of capital reflects the annual interest paid by banks on deposited funds. In Ukraine, the hypothesis of a stable 10% discount rate in the cost/be nefit analysis in dollars over a 20-year period is reasonably conservative. Calculations of financial efficiency with higher values of discount rate were performed to account for increased risk of investment in Ukrainian enterprises from the viewpoint of potential external investors. Financial efficiency was analyzed based on the following two main criteria, which are the most commonly used in the international practice of investment evaluation: · Net Present Value (NPV) · Internal Rate of Return (IRR) NPV reflects the present (discounted) net financial benefits of the project over the whole period of its life cycle. A positive value of NPV serves as criterion of project's financial acceptability. IRR reflects the maximum discount rate at which a project repays its cost. An IRR that exceeds the cost of capital suggests project's financial viability. Due to the limited information available concerning possible equity financing it is assumed that all necessary funds for project implementation will be sourced from foreign JI investors. The actual structure of financing will be a subject of negotiations between project owners and potential JI investors.

75 ERUPT Guidelines, Volume 2a: “Baseline Studies, Monitoring and Reporting”, Version 2.0, October 2001, p.32.

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6.6. LIST OF PROPOSED POTENTIAL JI PROJECT IN UKRAINE

National experts have considered a list of the potential JI projects in the context of their eligibility for the JI mechanism and with account to the completeness and reliability of initial data. The consideration has allowed to offer the following projects for the final selection (Table 1).

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TABLE 6.1. LIST OF PROPOSED POTENTIAL JI PROJECT IN UKRAINE

CO2 reduction over Cost of emission Incremen - Investment, project life time, avoided 76, tal costs of IRR78, % # Sector Category Title of the project thousand t USD per t CO eq. project77, Comments, risks , sensitivity 2 USD 819g 350g 819g 350g thousand 79 80 CO2/kWh CO2/kWh CO2/kWh CO2/kWh USD Key element: a ready market to accept the gas that is produced and willingness-ability of consumers to pay competitive for the gas with 26.0/ cash. The project has strong compliance with Energy Skochinsky mine methane capture 1 Gas capture 51,895 2,196,621 -6.92 -5,476 29.7/ national economic development, socio- sector (coal) and utilization 33.4 economic as well as with environment priorities and strategies. (e.g., safety in coal mining). Methane emissions in the baseline and project case are relatively uncertain. Energy Installation of new steam turbines 22.5/ Good risk rating, well-tested technology, 2 Power sector 5,610 990,659 360,323 -2.23 -6.13 -538 efficiency in existing boiler station at Tyre 24.2/ absent of necessity to sell electricity to a grid plant “Dniproshina” (12 MW) 27.1 Energy Kachanov associated gas capture 13.8/ Anticipated amount of associated gas for a 3 Power sector efficiency and utilization (Poltava region) 3,000 589,680 252,000 4.7 11.1 681 16.2/ long-term period may be a critical issue. 19.3 Insufficient data basis The project meets the requirement of Installation of Additional Wind additionality due to the positive Power at Novoazovsk (Donetsk 7.0/ value of incremental costs of the project. Renewable oblast) and Tarkhankut 7.8/ 4 Power sector energy 14,000 621,523 265,608 38.6 90.3 4,158 There is a minor risk that preferential (Autonomous Republic of the 8.8 electricity tariff regimes will not exist for a Crimea) Wind Plants long time, and governmental support for wind power will be lower Energy Co-generation system on coke gas 30.7/ The most sensitive element: the project will be 5 Power sector 13,000 1,583,500 676,710 -9.4 -22.0 -4,894 32.7/ a pilot for the usage of coke gas by gas turbine efficiency at Avdeevka coke plant (16 MW) 35.3 in the Ukraine

76 Cost per t CO2 reduction = (NPV of baseline - NPV of project) / discounted GHG effect project case net of GHG effect baseline 77 NPV of baseline minus NPV of project at 20% of discount rate 78 IRR present without ERU credits / with ERU credits $5 per t CO2 for 350 g CO2 emissions per kWh / with ERU credits $5 per t CO2 for 819 g CO2 emissions per kWh 79 Specific average national emission of 819.7 g CO2 per kWh for thermal power plant in Ukraine for 1990 base year 80 Specific emission of 350 g CO2 per kWh for the best available electricity production technology using natural gas

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CO2 reduction over Cost of emission Incremen - Investment, project life time, avoided 76, tal costs of IRR78, % # Sector Category Title of the project thousand t USD per t CO eq. project77, Comments, risks , sensitivity 2 USD 819g 350g 819g 350g thousand 79 80 CO2/kWh CO2/kWh CO2/kWh CO2/kWh USD The project meets the requirement of Heat recovery for ventilation of 15.7/ Energy additionality due to the positive 6 Industry main production building (Rosava 3 401 344 441 341 848 5.9 5.9 491 18.8/ efficiency value of incremental costs of the project. Good tyre plant) 18.8 risk rating, well -tested technology The project meets the requirement of additionality due to the positive Implementation of 1.5 MW power 3.3/ Fugitive gas e value of incremental costs of the project. 7 Households 2 250 1 337 280 1 224 720 3.8 4.2 1 243 capture plant operating on landfill gas at 20.0/ Major risk: the volume of captured and Lugansk landfill 21.3 utilized landfill gas will be lower than anticipated The project meets the requirement of additionality due to the positive Implementation of 280 kW +560 9.2/ Renewable e value of the incremental costs of the project. kW CHP biogas plant in pig 16.2/ 8 Agriculture energy th 1 039 267 651 246 640 6.1 6.6 398 Conservative estimate of CH4 emission breeding farm 16.7 reduction. Sharp drop of livestock due to the extension of sickness or bad harvest may impact the amount of manure Modernization of smelt er to improve The project proposed by the firm with very Industrial operating efficiency at the 17.8/ good reputation. This project has a variety of 9 Industry processes "Zaporizhzhiya Aluminium 200 000 9 984 817 6 980 229 6.7 9.5 16 162 18.8/ non-greenhouse benefits. Minor risk: Enterprise” 19.2 deterioration of the world market of aluminium conjuncture Installation of new energy 30.2/ efficiency pumps on Dniprovska 3 647 1 117 558 477 589 -5.3 -12.4 -1 447 33.5/ Energy Waterworks 37.9 Good risk rating, well-tested technology. A 10 Households efficiency 25.9/ big social importance of the project Installation of new energy efficient 9 777 2 564 959 1 096 136 -3.6 -8.4 -2 234 28.8/ pumps on Desnianska Waterworks 32.6

12.6/ The project meets the requirement of Energy Installation Gas Turbine Combined additionality due to the positive 11 Households 36 872 4 540 086 474 924 8.6 82.6 9 555 12.9/ efficiency Cycle at Ivano-Frankivsk CHP 15.7 value of incremental costs of the project. Good risk rating, well -tested technology.

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CO2 reduction over Cost of emission Incremen - Investment, project life time, avoided 76, tal costs of IRR78, % # Sector Category Title of the project thousand t USD per t CO eq. project77, Comments, risks , sensitivity 2 USD 819g 350g 819g 350g thousand 79 80 CO2/kWh CO2/kWh CO2/kWh CO2/kWh USD The project meets the requirement of 9.2/ Energy District heating system additionality due to the positive 12 Households 49 700 5 200 610 31.1 17 068 11.2/ value of incremental costs of the project. efficiency rehabilitation in Vinnitsa city 11.2 Good risk rating, well-tested technology. Insufficient data basis The project proposed by the firm with very good reputation on environmental issues. The <0/ project has been approved by the Ukrainian 13 Forestry Afforestation Afforestation in Kharkiv region 470 282 300 18.3 431 6.7/ State Committee of Forestry. ERU sales 9.2 substantially increase financial viability (IRR) of project. High additionality due to insufficient project profitability without ERU revenues. About 20% of the indicated GHG savings Utilizing wood waste as an 7.2/ correspond to methane emission reductions Renewable 14 Households alternative fuel for heating in 3 179 41 1 305 427 017 14.10 13.6 1 411 11.5/ resulting from reduced coal mining. Energy Ivano-Frankivsk region, replacing 11.3 Estimate of GHG emission reduction is coal conservative because methane emissions from decaying wood are not accounted for. Risk: Reliability of wood waste supply to be studied in more detail

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6.7. BRIEF DESCRIPTION OF PROJECTS

The project descriptions are to be found in the separate volume “project pipeline”.

6.8. CONCLUSION

Ukraine has a vast GHG emission reduction potential at very competitive costs per ton CO2 emission reduction. Project options are available in all major sectors of the economy. A number of projects are described in great detail in this study and potential investors can readily build upon the data drawn together and presented in this study.

6.9. BIBLIOGRAPHY

1. Revised 1996 IPCC Guidelines for National Greenhouse Gas Inventories vol. 1-3, IPCC/OECD/IEA. (published in the web site: http://www.ipcc-nggip.iges.or.jp/). 2. Greenhouse Gas Emissions Inventory for Ukraine's power sector: 1990 and 1999, N. Parasyuk, I. Volchin Prepared for: The United States Agency for International Development under Contract LAG-I-00 -98-00005-00 3. Law of Ukraine “On Energy Saving”, 1994 4. Comprehensive National Program of Ukraine for Energy Conservation, approved by Decree of Cabinet of Ministers of Ukraine from February 1997 #148 5. Program on state support for the development of non-traditional and renewable sources of energy and small hydro- and thermo- power engineering, approved by Decree of Cabinet of Ministers of Ukraine from December 31, 1997 6. Action Plan of Cabinet of Ministry of Ukraine (http://www.kmu.gov.ua/titulw7.htm) 7. Evaluation Guidelines for Potential World Bank Activities Implemented Jointly (AIJ) Pilot Projects (http://www-esd.worldbank.org/aij/psc.htm) 8. Inventory GHG emission and sinks in Ukraine: 1990 – 1998 years. 9. First National Communication on Climate Change.- Ukraine, 1998.- 86 ?. - (English, Ukrainian, Russian) 10. Prototype Carbon Fund Project Selection and Portfolio Development Criteria (http://www.prototypecarbonfund.org/)

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7. PLAN OF ACTION

7.1. STEPS TO BE TAKEN BY THE GOVERNMENT

As discussed in the previous chapters, Ukraine stands to gain substantial benefits in foreign investment, technology transfer and capacity building from participation in the Kyoto Protocol mechanisms. Therefore the timely ratification of the Kyoto Protocol and the creation of the necessary national capacity to participate in its mechanisms is our most urgent recommendation to the Government of Ukraine. For participation in the Kyoto Protocol mechanisms, the priority actions to be taken by the government are set out by the eligibility requirements described in the Marrakech Accords. The minimum requirements that would allow Ukraine to participate in Joint Implementation (under Track 2) are · to be a Party to the Kyoto Protocol, · to calculate and record its assigned amount, · and to establish a registry. As explained in Chapter 5, the major function of the Ukrainian Government in Track 2 JI is that of enabler, since it must undertake the task of · closing the Memoranda of Understanding with interested buyer countrie s and · ensure an efficient approval process as well clear guidelines for project developers. Various other functions for Government are not obligatory, but can be assumed if deemed appropriate. These include, e.g., the active promotion of JI through information programs, support in international marketing, and the development of JI projects in state -owned enterprises. In order to be able to participate in international emissions trading and Track 1 JI, Ukraine needs · to have a national inventory system, · to have submitted the most recent inventory, and · to have submitted “supplementary information”. Because of considerable time lags in determination of eligibility, it is advisable that Ukraine starts with building the required capacities as soon as possible. The requirements set out in the Marrakech Accords translate into specific needs with regards to establishment of national institutions and upgrading national legislation. Thus the priority actions for the government to focus are:

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7.1.1. Fulfilling institutio nal requirements. The key institutions that need to be established are: · JI/ IET focal point or JI/IET office, which would be authorized to coordinate and approve the development and registration of projects and emissions trading transactions. Unless a specific authority to coordinate climate change policy development and implementation has been assigned to the focal point itself, other national institutions that deal with climate policy issues also need to be strengthened in order to be able to guide the focal point in its activities. For a more detailed suggestion on the institutional setting see Chapter 4. · Institution responsible for the national inventory, which would be able to conduct appropriate planning, preparation and management of inventory activities on a regular basis. The establishment of such an institution would involve strengthening and adjusting for the needs of the inventory activities, the national systems for data collection and verification, as well as designating overall responsibilities and clarifying the roles of other institutions and government agencies in preparing the inventory. · National registry. A national registry system must be established in order to track all activities related to purchases and sales of emission reduction units, removal units, and units of assigned amount. Such a system should be able to provide supplementary information on the ownership of allowances, activities that lead to their generation, and details of their transfer. The national registry should function as an accounting system, performing not only registration and monitoring of the units. Additionally, it may also be tasked with determining whether Ukraine is in compliance with its emission reduction obligation. When establishing these institutions, a clear division of responsibilities among all agencies involved in climate policy development needs to be established and maintained. More detail on the possible set-up of the national institutions is offered in Chapter 4. The development of strategies and action plans laying out the foundations of the national climate change policy, such as strategy and criteria for JI, emissions trading strategy, domestic GHG mitigation strategy, and other need to be consolidated within such institutions. Even if the Protocol is not ratified, certain obligations under the UNFCCC remain to be fulfilled in Ukraine, such as · adopting national policies and measures to limit its anthropogenic emissions of greenhouse gases in all relevant sectors, including the energy, transport, industry, agriculture, forestry and waste management; and to protect and enhance greenhouse gas sinks and reservoirs. · formulating policies and measures to facilitate adequate adaptation to climate change, including integrated plans for coastal zone ma nagement, water resources and agriculture.

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· strengthening systematic observation and national scientific and technical research capacities and capabilities, systematic observation and development of data archives related to the climate system. · developing, periodically updating and publishing national inventories of anthropogenic emissions by sources and removals by sinks of all greenhouse gases not controlled by the Montreal Protocol. · promoting education, training and public awareness related to climate change. · providing periodic communication of the information related to the implementation of the above to the Conference of the Parties .

7.1.2. Creating the necessary legislative framework Since no national climate change institution would be able to operate without proper legal underpinnings, the government of Ukraine should act promptly to start a legislative and policy-making process that would promulgate the establishment and functioning of the national climate change institutions. Such legislative process should also strive to reflect more general UNFCCC objectives in the overall framework of Ukrainian law. It is important that the establishment of the national Kyoto Protocol institutions is carried out in parallel with the establishment of the overall framework for climate change policy in Ukraine. In particular the legal foundations of such policy need to be introduced into the Laws of Ukraine On Environmental Protection, On Atmospheric Air Protection, On Environmental Expert Review. To reflect the development of the national policies and measures to mitigate climate change, necessary rules and standards need to be reflected in the Laws of Ukraine On Energy Saving and On Electric Energy (particularly the articles on environmental protection, as well as design, construction and refurbishment of electric energy entities), Law of Ukraine On Alternative Liquid and Gas Fuels, Law of Ukraine On Waste, the Law of Ukraine On entrepreneurship in Ukraine (particularly clauses on environmental protection obligations and liabilities), as well as in relevant policies, regulations, and standards governing transportation, construction and commercial sectors.81 Below the (legal) requirements for the most important JI/IET related institutions are set out.

7.1.2.1. JI and Emissions Trading. A designated focal point (e.g. JI/IET Office or “Climate Change State Enterprise”) needs to be accredited to approve JI and emissions trading transactions by the Cabinet of Ministers of Ukraine through an appropriate resolution; its mandate and responsibilities, as well as requirements for coordination with other government agencies, needs to be spelled out. Should the focal point be an independent legal entity, its statute, functions and position within the administrative structure of the central executive power needs to be developed and approved by the relevant executive bodies.

81 Please see C hapter 4 for more detail. Extensive analysis of the legal prerequisities for an effective climate policy in Ukraine is offered in Implementation of the UNFCCC and the Kyoto Protocol in Ukraine, Report of the Canadian-Ukrainian Climate Change Program, Kiev, 2002.

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For the focal point to be able to function effectively, the national strategy on JI and IET needs to be adopted by the government and incorporated into the national development plans. The process of elaborating such a strategy should take into account environmental, economic, and financial issues of implementing Kyoto Protocol mechanisms in Ukraine, reflecting Ukraine’s long- and short -term development goals. The strategy should determine priorities and establish criteria for approval of JI projects, and should lead to the set-up of the administrative procedures and technical requirements for their implementation. In particular, the government needs to make decisions on · Volume of AAUs and ERUs to be sold, suggested price thresholds. · Priority sectors of the economy and/or regions. · Guidelines of best-available technology determination, conditions of technology transfer. · Environmental and financial additionality criteria. · Administrative procedures, including fee schedules. · Guidelines for distribution of the ownership rights, including any provisions for retaining of the allowances by the state. · Regulations for domestic monitoring, reporting, and review. · Stakeholder and public consultation procedures. Such criteria ideally should be independent of political interests in order to demonstrate consistency in project approval and to ensure the political stability needed for JI investment. Additional criteria, such tests of legal status, competence, financial capacity and stability of project hosts, insurance coverage and resources offered by the investing parties can be subject to regular review. To take into account the new trading mechanisms, appropriate laws will need to be up-dated with rules governing assignment and transfer of legal titles to emission allowances (e.g. On Entrepreneurship, On Property). Taking into account that favorable investment climate is a key prerequisite for a positive JI investment decision, on par with the cosiderations of marginal costs and project quality, the Government of Ukraine may want to provide extra encouragement to project developers and investors by offering tax and import duty incentives. As soon as the national JI procedures are established, regiona l and municipal governments may use their self-governance mandates to provide additional incentives for JI investors in their jurisdictions, among other by removing local energy subsidies.

7.1.2.2. National Inventory System. The main objective of setting up a national inventory system is to establish the necessary framework for appropriate planning, preparation and management of inventory activities on a regular basis. The legal foundation for the functioning of such system would involve official designation of an appropriate institution and facilitation of its activities in collecting and processing relevant information. The responsibilities in the inventory development process need to be allocated, specifying the roles of various government agencies and other relevant

178 NSS Ukraine institutions, and a clear process established for national review, revision, and approval of the inventory. More importantly, appropriate legal instruments and government decisions need to be adopted to improve the compatibility of the national statistical system with the international standards. New regulations mandating collection of the information on missing activity data need to be introduced, removing the barriers to systematic inventory preparation such as confidentiality of fuel consumption and other activity data. National guidelines for documenting and archiving inventory data need to be developed to ensure the transparency, consistency and comparability of the inventories even if there are changes in the government or in the inventory team itself.

7.1.2.3. National Registry. As the main purpose of the national registry is to record international transfers and acquisitions between Ukraine and other Parties to the Kyoto Protocol, its functioning also has to be covered by relevant bylaws or government decisions. Particularly, amendments need to be made to recognize the trades within the framework of the Kyoto Protocol and legitimize the use of units as an international commodity under the Ukrainian law. Procedures and trigger events for issuing emission reduction units, removal units, and units of assigned amount should be spelled out and made available. Guidelines for the handling of transaction information need to be developed, including requirements for public availability of the information on the st atus of Ukraine’s Assigned Amount and clauses preventing unauthorized access to registry information that has been marked proprietary or confidential. Such guidelines also need to establish procedures for submitting information on transactions to the Interministerial Commission on Climate Change and other relevant government bodies. It would be recommendable that penalties are introduced for violating the integrity of the registry and communicated to the national and international stakeholders.

7.1.3. Budgetary implications. Budgetary implications will involve the budgetary expenditures required for the establishment of the Kyoto Protocol institutions in the country, as well as the resources required for establishing relevant policies and ensuring appropriate compliance with the international rules. Obviously up-dating the legal system will consume a significant amount of resources. Although not necessarily a financial burden, legislative activities require extensive human resources, time and attention of the government and the parliament, to obtain which a strong government commitment is needed. Although substantial, the strains of creating the legislative foundation for climate policy are time-bound and will not be incurred repeatedly. · JI/ IET focal point. The creation of the Kyoto Protocol institutions will require concrete material investments from the government. Any budgetary expenditures for their administration and staffing, if additional to the approved ministerial budget, will have to be coordinated by the Ministry of Finance, or supported from the regular budget of the Ministry of Environment. Establishing and maintaining a

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JI/IET institution would involve setting up an appropriate office including staffing, office space, necessary office equipment and hardware. Depending on functional responsibilities and tasks, such an office should be staffed with 3-10 people. Given the current level of financing provided to the Ministry of Environment, this appears as a quite significant strain on its resources. · National Inventory System. Yet the most difficult task for Ukraine is to ensure sustainable financing of the inventory activities. The establishment of high quality inventories is resource and time consuming in all countries, however the difference in relative costs of the resources required make inventory preparation in Ukraine more problematic compared to other Annex B parties. In particular, resources are lacking for the initial investment needed to set up an appropriate inventory system, including developing a data storage and archiving system and standard procedures to manage the inventory. Although developing data storage and archiving systems and using quality assurance and quality control methods may not appear as costly to Annex B countries, the hardware, software and human resources required would translate into rather high costs in Ukrainian circumstances. However, not all inventory activities involve high costs. While setting up new data collection procedures may involve high costs (in particular if these are not needed for other purposes), allocating clear institutional responsibilities and developing clear administrative procedures is not so costly. More specifically, the legislative arrangements to allow the preparation of the inventory on a yearly basis and to require submission of the necessary statistical information to the designated inventory authority would significantly facilitate the preparation of the inventories without putting additional strains on the limited budgetary resources. It is also possible for the inventory work to be financed through the Kyoto protocol Mechanisms, since inventories are needed to participate in the Mechanisms. Current international thinking indicates that both buyer governments and international NGOs may be open to the idea of using AAU revenues for financing inventorying activities and/or supporting other national capacity building needs. · National Registry. The registry is in essence a standardized electronic database that can communicate with other similar databases (i.e. registries) through specific data exchange protocols and can store sets of common data elements pertaining to each Kyoto Protocol unit. To establish the registry, Ukraine can either use registry software that have been developed by other countries (if such is available, as seems likely), or commission their own registry, which would enable country specific features to be added. It is unlikely that registry software will be provided by the UNFCCC secretariat. The capital equipment required is a secure, powerful, stand-alone computer. The operational requirement is for staff to enter data on ERU, RMU, and AAU transfers – possibly daily, depending on the volume of transfers. Slovakia’s registry cost 5’000 US$ for software and hardware, 4’000 US$ in the first year for operational costs, and 2’000 US$ for each subsequent

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year. 82 The initial set-up of the registry can be supported either by a one-time donor assistance or through a request to the budget, while its maintenance may be financed through a system of fees on the transactions.

It is important to note however that budgetary constraints substantially differ depending on whether Track 1 or Track 2 eligibility is in question. It appears that Ukraine should not experience any difficulties in fulfilling Track 2 eligibility requirements, provided it has ratified the Kyoto Protocol. The minimum requirements that would allow Ukraine to participate in Joint Implementation under Track 2 are to designate a JI focal point and adopt national project selection criteria and procedures, to calculate and record its Assigned Amount, and to establish a registry. Of them, establishing the registry appears to entail the biggest budgetary expenditures. Under the Marrakech Accords, the freely tradable Assigned Amount is determined as 10 percent of the base year or latest inventory, whichever is higher.83 Clearly the first will be the case for Ukraine. Since the 1990 (base year) inventory has been compiled, establishment and international registration of the Ukrainian Assigned Amount should not present much difficulty. Moreover, 1990 data for Ukraine, especially as concerns fossil fuel combustion, are rather reliable as a full-scale national energy balance was available for that year, and the 1990 inventory already underwent an international review.

7.2. RELEVANT CAPACITY BUI LDING NEEDS

In this section we would like to highlight the major needs Ukraine will face in developing professional and human capacity for participating in the Kyoto Protocol mechanisms. Substantial efforts will nee d to be undertaken to close the existing knowledge gaps in understanding the framework of the mechanisms and to provide opportunities for hand-on training in project development and implementation. The primary need is raising awareness of the climate change issues and Kyoto Protocol mechanisms among government officials and parliamentarians, and ensuring general public awareness support. For the mechanisms to be implementated effectively, it is necessary to educate local governments and industry and suppor t the dialogue among various stakeholders. The capacity building needs of the government include developing understanding of the international GHG market and its dynamics, including macroeconomic implications of a particular market behavior. For example currently there is limited ability to evaluate the impact of potential JI/IET strategy on the country’s market potential in JI and emissions trading, perspective government and industry revenues, and the ripple effect on various sectors of the economy. Rather then developing such capacity within the government itself, it might be useful to provide such expertise to local consultancies, at the same time enhancing the capacity of the

82 OECD (2002): National Systems for Flexible Mechanisms: Implementation issues in countries with economies in transition. Workshop Report, Paris 83 Assigned amount minus Commitment Period Reserve of 90% of its allowable emissions or five times of its most recently reviewed emissions inventory, whichever is lower.

NSS Ukraine 181 policy-makers to request and evaluate economic advise. Whereas the local experts can be trained through intensive training programs or other educational opportunities, it appears more realistic to engage policy makers through bi-lateral exchanges and study tours with the potential buyer governments. Additionally, the capacity of the government to negotiate with investors various aspects of JI project activities and emissions trading transactions need to be enhanced to ensure meaningful cooperation of the Ukrainian authorities. At the same time it is important to build the local consultancy base in order to avoid the siphoning parts of JI investment to foreign consulting companies and agencies. The Ukrainian private sector needs to be made broadly aware of the fact that they could develop JI projects, or gain accreditation as independent operational entities for JI internationally and domestically. More importantly, establishing Track 1 JI in Ukraine will bring the additional benefit of spawning a new set of service industries in the country, just as the global market for JI gave rise to international carbon consultancies. To maximize economic gains from the JI, it is important to develop local expertise in these new areas of economic activities, as at present the number of internationally qualified local JI experts is very low. Engaging and educating local industry representatives on JI and international emissions trading issues may also lead to further mobilization of in-country financial resources. Particular needs for training local experts include

· Transfer of methodologies and know-how on monitoring and data collection, data quality assurance and control. · Building skills in identifying project opportunities and assessing their potential in compliance with international project eligibility requirements (additionally and baseline rules). · Determining financial viability and attractiveness of the project from the point of view of investors. · Performing financial appraisal and due diligence for the project hosts. · Developing project feasibility assessment and preparing project marketing information for JI investors and for regular credit agencies. · Closing knowledge gaps on futures contracts, ability to negotiate ERU sharing with joint venture partners. · Building skills in preparing project design documentation.

Special efforts might be needed to create a pool of financially and technically qualified personnel with the experience to identify, develop and manage various aspects of JI projects. Professional qualifications of domestic operational entities that could provide consulting services in carrying out independent baseline setting and validation, monitoring, verification and certification of projects can be improved through various training courses and hands-on activities in project development and operation.