Estimating the CDM Market Under the Bonn Agreement

We analyse the impact of the agreement on implementation of the Kyoto Protocol achieved at COP6bis in Bonn in July 2001 on investment in greenhouse gas emission reduction projects in developing countries through the Clean Development Mechanism (CDM). The required actual emission reductions for participating Annex B countries overall will be relatively small, as the United States do not intend to ratify the Protocol and significant amounts of carbon sequestered in domestic sinks will be credited to Annex B countries under Article 3.4 of the Protocol. In addition, there is a large potential supply of surplus emissions quota (hot air) from Russia and other economies in transition. This means that demand for certified emission reductions (CERs) from CDM projects will be relatively small. The magnitude of the CDM as a means for meeting Kyoto Protocol commitments, and individual countries' shares, will be influenced by a host of factors both on the demand and the supply side of the global carbon market. The analysis is based on a quantitative model of the global carbon market, based on marginal abatement cost curves and designed specifically for this type of analysis. We estimate required emission reductions in Annex B countries, the share of the Kyoto mechanisms in meeting this demand, the price for CERs, and the geographical distribution of CDM projects, and discuss distribution of sequestration projects. A ? low demand, low price? carbon market scenario appears likely, with intense competition between developing countries to attract CDM investors. Sensitivity analysis illustrates the likely direction and magnitude of impacts when key supply and demand parameters are changed. We examine the impact of higher or lower implementation and transaction costs, as well as expanding or contracting the supply of CERs through baseline and additionality rules. While the CDM could suffer a loss in competitiveness if transaction costs are too high, changes in CDM supply parameters do not fundamentally change estimates of CDM size and revenue. On the demand side by contrast there are there are a number of factors which could greatly reduce the size of the CDM, or even preclude commercially driven CDM projects altogether. Key factors that could harm the CDM are lower business-as-usual emissions growth in Annex B countries, higher supply of surplus emissions quota (hot air) from EIT countries, and possibly crediting under Article 3.4 of sequestration in agricultural soils. If however the United States participated in implementing the Kyoto Protocol, none of these factors would be a threat to a viable and sizeable CDM. We conclude that although the potential role for the CDM is seriously diminished under the Bonn agreement and without the United States on board, a significant amount of CDM projects in developing countries could still be achieved. Much will depend on international market factors, as well as the design of rules for CDM project implementation. The best strategy is to prepare to be competitive in a low-demand, lowprice market, and at the same time to strive for the United States to still come on board the Kyoto Protocol.