90 NSS Ukraine 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: 92 NSS Ukraine · 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 NSS Ukraine 93 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