International Climate Change Programs: Lessons Learned from the European Union's Emissions Trading Scheme and the Kyoto Protocol's Clean Development Mechanism
Published: 2008-11-18T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: International policies to address climate change have largely relied on market-based programs; for example, under the European Union's Emissions Trading Scheme (ETS) phase I (2005 to 2007) carbon dioxide emissions reductions were sought by setting a cap on each member state's allowable emissions and distributing tradable allowances to covered entities, such as power plants. Beginning operation in 2002, the Kyoto Protocol's Clean Development Mechanism (CDM) has relied on offsets, allowing certain industrialized nations to pay for emission reduction projects in developing countries--where the cost of abatement may be less expensive--in addition to reducing emissions within their borders. Legislative proposals to limit greenhouse gas emissions are under consideration in the United States. In this context, GAO was asked to examine the effects of and lessons learned from (1) the ETS phase I and (2) the CDM. GAO worked with the National Academy of Sciences to identify experts in market-based programs and gathered their opinions through a questionnaire, interviewed stakeholders, and reviewed available information.
section_title: What GAO Found
paragraphs: According to available information and experts, the ETS phase I established a functioning market for carbon dioxide allowances, but its effects on emissions, the European economy, and technology investment are less certain. Nonetheless, experts suggest that it offers lessons that may prove useful in informing congressional decision making. By limiting the total number of emission allowances provided to covered entities under the program and enabling these entities to sell or buy allowances, the ETS set a price on carbon emissions. However, in 2006, a release of emissions data revealed that the supply of allowances--the cap--exceeded the demand, and the allowance price collapsed. Overall, the cumulative effect of phase I on emissions is uncertain because of a lack of baseline emissions data. The long-term effects on the economy also are uncertain. One concern about design and implementation was that the economic activities associated with emissions from covered entities would shift from the European Union to countries that do not have binding emission limits--a concept known as leakage. However, leakage does not appear to have occurred, in part because covered entities did not purchase allowances but received them for free. The effect of the ETS on technology investment also is uncertain but was likely minimal, in part because phase I was not long enough to affect such investments. Phase I of the ETS offers three key lessons: (1) accurate emissions data are essential to setting an effective emissions cap; (2) a trading program should provide enough certainty to influence technology investment; and (3) the method for allocating allowances may have important economic effects, namely, free allocation may distribute wealth to covered entities whereas auctioning could generate revenue for governments. According to available information and experts, the CDM has provided flexibility to industrialized countries with emission targets and has involved developing countries in efforts to limit greenhouse gas emissions, but the program's effects on emissions are uncertain, and its effects on sustainable development have been limited. Nonetheless, the CDM's effects reveal key lessons that can help inform congressional decision making. Specifically, the CDM has provided a way for industrialized countries to meet their targets that may cost less than reducing emissions at home; however, available evidence suggests that some offset credits were awarded for projects that would have occurred even in the absence of the CDM, despite a rigorous screening process. Such projects do not represent net emission reductions and can compromise the integrity of programs--including the ETS--that allow the use of CDM credits for compliance. We also found that the cost-effectiveness and overall scale of emission reductions are limited by the current project approval process, although proposed changes may improve its effectiveness. Key lessons from the CDM include: (1) the resources necessary to obtain project approval may reduce the cost-effectiveness and quality of projects; (2) the need to ensure the credibility of emission reductions presents a significant regulatory challenge; and (3) due to the tradeoffs with offsets, the use of such programs may be, at best, a temporary solution.

section_title: Letter
paragraphs: In 2005, the European Union’s (EU) member states implemented the world’s  largest program to limit emissions of carbon dioxide—the most significant  greenhouse gas—from the electric power and certain industrial sectors of  their economies. The program, known as the Emissions Trading Scheme  (ETS), relies on a cap-and-trade model similar to that used in the United  States to limit airborne emissions of sulfur dioxide that cause acid rain and is  the first international carbon dioxide trading program. Under the ETS, the EU  member states determine the total amount of allowable carbon dioxide  emissions, distribute these allowances to covered entities such as power  plants, oil refineries, and other manufacturing facilities, and enable these  covered entities to trade allowances. The first trading period—phase I—ran  from 2005 to 2007; the second phase, currently underway, runs from 2008 to  2012. Some observers view the ETS as a flexible and cost-effective tool to  reduce emissions. Alternatively, other observers have said that the first ETS  phase did not decrease emissions, imposed high costs on industrial entities  and consumers, and may adversely affect the international competitiveness of  European industries. As the U.S. Congress considers legislation intended to  address climate change, the EU’s experience implementing the ETS may  prove useful in informing Congress’s decisions.
The EU’s implementation of the ETS stems from commitments its member  states and the EU made under the Kyoto Protocol (the Protocol), an  international agreement to minimize the adverse effects of climate change,  which was developed within the United Nations Framework Convention on  Climate Change (UNFCCC). To date, 182 countries—including all of the EU  member states—have ratified the Protocol, which set binding emissions targets  for 37 industrialized countries and the European community, covering carbon  dioxide and five other greenhouse gases. For context, the EU member states  collectively ranked as the world’s third- largest emitter of carbon dioxide in  2004, behind the United States and China. The U.S. signed the Protocol in 1998  but is not bound by the Protocol’s terms because it was not submitted to the  Senate for ratification and therefore has not been ratified.
The Protocol identifies several mechanisms available to help meet the  binding targets, including emissions trading and the Clean Development  Mechanism (CDM). Emissions trading allows countries with emissions  lower than the level specified in the Protocol to sell excess allowances to  countries with emissions exceeding their Kyoto targets, thereby creating a  commodity in greenhouse gases (known as a carbon market). Emissions  trading can help minimize abatement costs by enabling covered entities  that face relatively high costs in reducing their emissions to buy excess  allowances from other entities with lower-cost opportunities.
The CDM allows countries with binding targets under the Protocol to  implement projects that reduce or avoid emissions—such as the construction  of renewable energy infrastructure—in a developing country that does not  have a binding emissions target under the Protocol. The logic of the CDM is  that it provides a cost-effective way for industrialized nations to reduce  emissions of greenhouse gases, which may cost less in developing nations,  while also promoting sustainable development in countries that host projects.  CDM projects earn credits, each equivalent to 1 metric ton of carbon dioxide,  that an industrialized country sponsoring the project can sell or use for  compliance with its Kyoto target. These credits are known as Certified  Emissions Reductions (CER) or simply as “carbon offsets.”
In accordance with the Protocol, CDM projects must meet several key  requirements. For example, CDM projects must provide real, measurable,  and long-term benefits related to the mitigation of climate change. In  addition, projects need to achieve reductions beyond any that would occur  in absence of the CDM, a concept known as “additionality.” Before credits  are issued, projects must undergo review by national officials of the  country where the project occurs and have an external party validate  documentation and verify emission reductions. The Executive Board, a  UNFCCC regulatory body established by the Protocol, is responsible for  supervising the CDM.
The Protocol requires industrialized countries to achieve their binding  targets between 2008 and 2012. Recognizing this requirement, the EU  government enacted a law, known as a directive, to establish the ETS, a  market-based emissions trading program through which member states  would reduce their carbon dioxide emissions while minimizing any  adverse effects on economic development and employment. The ETS  began with the first phase to gain experience with emissions trading  before the Protocol’s 2008 to 2012 commitment period and operated phase  I from 2005 to 2007. Phase I included approximately 11,000 electric power  and industrial installations in 25 member states, which accounted for  about half of the EU’s carbon dioxide emissions.
Under the ETS, each member state was required to propose its own  carbon dioxide emissions cap and allocation scheme in a National  Allocation Plan. The ETS Directive established some general criteria for  the National Allocation Plans but gave member states flexibility in how  they determined their cap and methods for allocating allowances—such as  free distribution or auctioning—to covered entities. For phase I, the EU  directive allowed member states to auction up to 5 percent of their  allowances, but 21 member states chose to distribute all allowances free of  charge. After documenting the cap and allocation plan in its National  Allocation Plan, each member state submitted it to the European  Commission—the EU’s executive branch—for approval. The aggregated  national caps from the 25 approved National Allocation Plans represented  the total level of emissions allowed from facilities covered under the ETS,  also referred to as the cap.
Under the ETS, covered entities trade carbon dioxide allowances (known as  European Union Allowances, or EUAs) with other covered entities; entities  that are not covered under the ETS also may trade EUAs if they set up a  trading account in a member state’s registry, an electronic system that tracks  ownership of allowances. To further minimize costs, covered entities are  allowed to purchase a limited number of CDM credits (CERs) and use them  toward compliance with their caps. Covered entities can trade EUAs and  CERs in several ways. For example, they may buy and sell directly with one  another or use exchanges and other trading platforms operated by third  parties. Trading activity in CERs and EUAs has increased steadily in the past  several years and accounted for nearly all of the financial value of the global  carbon market in 2007.  According to the World Bank, the financial value of  EUAs and CERs totaled about $63 billion in 2007, of which approximately $50  billion consisted of EUAs and $13 billion consisted of CERs.
An examination of the environmental, economic, and technological effects  of the first ETS phase and the CDM provides a number of useful lessons  that could inform decision making in the United States, where numerous  legislative proposals to limit greenhouse gas emissions are under  consideration. Within this context, we examined (1) what experts and  available information indicate about the effects of the EU ETS phase I and  the lessons learned that can inform congressional deliberation on climate  change policies, and (2) what experts and available information indicate  about the effects of the Kyoto Protocol’s CDM and the lessons learned that  can inform congressional deliberation on climate change policies.
To respond to these objectives, we reviewed information on the ETS and  CDM available from the EU, the UN, the academic literature, and market  research firms. We also conducted semistructured interviews with  international government officials; industry representatives;  environmental advocacy organizations; market traders; researchers; and  owners, developers, and auditors of CDM projects. Following our data  collection and interview process, we then collaborated with the National  Academy of Sciences (NAS) to recruit a panel of experts to assist in  identifying the key themes and lessons learned from the ETS and CDM  that could influence decision making in the United States. The 26 experts  were recruited based on their experience and expertise with international  climate change programs and their knowledge of the U.S. policy  development process. We engaged the experts using a Web-based  questionnaire that included both open- and closed-ended questions.  Finally, we identified important themes through a content analysis of  responses to the open-ended questions, and summarized responses to the  closed-ended questions. We conducted our work from October 2007 to  November 2008.
subsections: section_title: Background
paragraphs: Greenhouse gases—including carbon dioxide, methane, nitrous oxide, and  synthetic chemicals such as fluorinated gases—trap heat in the  atmosphere and prevent it from returning to space. The heat-trapping  effect, known as the greenhouse effect, moderates atmospheric and  surface temperatures, keeping the earth warm enough to support life and  varies depending on the gas. Each unit of the non-carbon-dioxide gas  generally has a greater warming effect than each unit of carbon dioxide,  although carbon dioxide is the most prevalent anthropogenic greenhouse  gas and has the greatest overall effect on warming. According to the  Intergovernmental Panel on Climate Change (IPCC)—an organization  within the UN that assesses scientific, technical, and economic  information on the effects of climate change—global atmospheric  concentrations of these greenhouse gases have increased markedly as a  result of human activities over the past 200 years, contributing to a  warming of the earth’s climate.
Climate change is a long-term and global issue because greenhouse gases  disperse widely in the atmosphere once emitted and can remain there for  an extended period of time. Among other potential impacts, climate  change could threaten coastal areas with rising sea levels, alter  agricultural productivity, and increase the intensity and frequency of  floods and tropical storms. The effect of increases in atmospheric  concentrations of greenhouse gases and temperature on ecosystems and  economic growth is expected to vary across regions, countries, and  economic sectors.
One of the greatest challenges underlying policies to address climate  change is reducing greenhouse gases while meeting rising energy  demands. Energy demands are met largely through fossil fuel combustion,  which releases greenhouse gases—primarily carbon dioxide. In fact, fossil  fuel combustion accounts for the largest share of growth in greenhouse  gas emissions, according to the IPCC. For example, greenhouse gas  emissions from electricity and heat production grew 145 percent between  1970 and 2004; emissions from road transportation increased 120 percent.  Other sources of greenhouse gas emissions include agricultural activities,  transportation, forestry, waste management, and residential and  commercial activities.
According to the IPCC, in 2004, developed countries, including the United  States, constituted 20 percent of global population, but were responsible  for nearly half of global greenhouse gas emissions. The total emissions  from some developing countries, which have lower per capita emissions  but larger populations, have begun to approach the total emissions from  developed countries, which tend to have higher per capita emissions and  smaller populations. Recent economic development in nations such as  China and India has reduced poverty but also has increased energy use,  which has caused rapid growth in emissions. In the absence of mitigation  policies—i.e., policies that would reduce greenhouse gas emissions—the  IPCC projects that between 2000 and 2030, two-thirds to three-quarters of  the projected increase in global carbon dioxide emissions will occur in  developing countries, although per capita emissions will remain  substantially lower than those of developed countries. The IPCC also  projects that compared to 2000, global greenhouse gas emissions will  increase between 25 percent and 90 percent by 2030 in the absence of new  climate mitigation policies.
According to the IPCC, climate mitigation policies are essential to  facilitate a transition to a less-carbon-intensive energy infrastructure and  stabilize the climate. In the short term, policies designed to increase  energy efficiency or induce a switch to less-carbon-intensive fuels, such as  from coal to natural gas, can reduce emissions. In the long term, however,  major technology changes will be needed to establish a less-carbon- intensive energy infrastructure. To that end, climate mitigation policies  may require facilities to achieve specified reductions or provide an  incentive to reduce emissions by, for example, establishing a price on  emissions. The policies that set a price on emissions, also known as  market-based programs, include emissions trading and emissions taxes.
The cost for facilities to reduce emissions depends on numerous factors  that may vary by facility, such as the age of capital equipment. Under an  emissions trading program, the cost of an allowance to emit greenhouse  gases influences each facility’s decision about whether and how much to  reduce emissions. Because reduction costs vary among the facilities, some  will choose to reduce emissions and sell excess allowances while others  will opt to purchase allowances to cover emissions. According to  economic theory, this will result in reductions at the facilities with the  lowest costs. As the emissions cap becomes stricter, the supply of  allowances decreases and causes prices to rise. As a result, the incentive  to reduce emissions increases. In short, the allowance price is key to  achieving a net reduction in emissions.
A problem may arise, however, if economic activity similar to that covered  under one country’s market-based program is not likewise subject to  binding carbon limits in another country. This can lead to the movement of  economic activities associated with emissions from countries that have  adopted binding emissions limits to countries that have not done so. This  geographic displacement of emissions is a concept known as leakage.  Overall, leakage could impede progress toward the environmental  objectives of a market-based program by shifting emissions to areas  without a binding carbon limit.  As allowance prices rise, production may  be shifted abroad to existing competitors or new firms; in addition,  covered entities may shift some of their production to facilities that exist  in countries without binding carbon dioxide limits.
Many countries, such as the member states of the EU, have begun to  mitigate or reduce greenhouse gas emissions by adopting market-based  policies such as carbon taxes, cap-and-trade programs, and offset  programs, as well as other policies, including energy efficiency standards;  voluntary agreements; education campaigns; and research, development,  and deployment of advanced technologies. Governments also may use a  portfolio of policies. For example, in the EU, a variety of measures are  underway to reduce greenhouse gas emissions, including the ETS—its  cornerstone—as well as measures to promote renewable energy sources,  implement performance standards intended to improve energy efficiency  in new buildings, and reduce carbon dioxide emissions from new  passenger cars.
The EU—a unique economic and political partnership between 27  countries—is composed of multiple institutions, including three decision- making institutions. Two bodies serve as the EU’s legislative branch—the  European Parliament, composed of representatives directly elected by EU  citizens, and the Council of the European Union, composed of a  representative from each member state. In the environmental field, both  bodies must approve legislation for it to become law. However, neither  branch can initiate legislation; they may act only on legislative proposals  submitted by the European Commission, which is the EU’s executive  branch. Although each member state is represented on the Commission,  Commission members serve the common EU interest rather than  representing their member state. In addition to proposing legislation, the  Commission ensures proper implementation of EU directives, including  those enacted as part of the European Climate Change Programme. For  example, the Commission proposed the ETS Directive to establish the  Emission Trading Scheme, which was amended and then approved by the  Parliament and Council, and has implemented it by approving member  states’ National Allocation Plans, helping to develop a system to track  allowances, and assessing progress of the ETS, among other tasks. The  Court of Justice of the European Communities has considered law suits  brought by member states challenging the Commission’s rejection of  National Allocation Plans and by covered entities challenging various  aspects of the ETS, but has otherwise not played a significant role with  respect to the ETS.
section_title: EU Emissions Trading Scheme Established a Carbon Market and Provides Lessons That Could Inform U.S. Decision Making on Climate Change Policy
paragraphs: According to available information and experts, the primary effect of the  first ETS phase was to establish a functioning carbon market for emissions  allowances, but its effects on emissions, the European economy, and  technology investment are less certain. In particular, data limitations make  it impossible to know whether phase I reduced emissions below the level  that would have occurred in the absence of the ETS. Nonetheless, experts  suggest that phase I offers important lessons about program design and  implementation that may prove useful in informing congressional decision  making.
subsections: section_title: Creation of the ETS Established a Market for Carbon Allowances
paragraphs: The primary effect of the first ETS phase was to establish a functioning  carbon market for allowances in which emissions caps were set and  allowances to emit carbon dioxide were distributed, bought, and sold. By  limiting the total number of allowances under the program and enabling  covered entities to sell or buy allowances to cover their emissions, the  ETS used market forces to set a price on carbon emissions that fluctuated  based on changes in supply and demand. For example, EU emissions  allowances known as EUAs traded at €8.57 ($10.40) per metric ton of  carbon dioxide on January 3, 2005; reached a peak price of €31.58 ($37.48)  per metric ton on April 19, 2006; and then collapsed when the 2005  emissions data, which had been verified by third parties, showed that  phase I was overallocated.  That is, the overall cap exceeded actual  emissions—the supply of allowances was greater than the demand. The  price collapse also resulted partially from the fact that covered entities  were largely unable to carry unused allowances to the next trading phase,  a concept known as banking. The general prohibition on banking  allowances, however, helped confine the overallocation to phase I because  the member states set new caps in 2008 and issued new allowances.  Interperiod banking would have given covered entities an incentive to  reduce emissions during phase I, despite overallocation, and to save  unused allowances for a later trading phase, which had more stringent  emissions caps.
Although the absolute supply of allowances did not change during phase I,  the market’s perception of the balance of supply and demand dramatically  changed. Prior to the release of 2005 verified emissions data in the spring  of 2006, ETS participants and market analysts expected a shortage of  allowances, and allowance prices steadily increased. The release of  verified emissions data, however, showed that the 2005 emissions cap— i.e., the supply of allowances—exceeded actual emissions that year,  causing the price collapse. See figure 1 for a graph displaying the  allowance price trends in phase I.
The demand for allowances, on the other hand, was influenced by covered  entities’ allowance allocation, the cost of carbon dioxide abatement  options, and the level of carbon dioxide emissions over the course of  phase I. Specifically, the extent to which the initial free allocation  covered each covered entity’s emissions influenced demand throughout  the ETS market. For example, some covered entities were in a net “short”  position—they did not receive enough allowances from the free allocation  to cover annual emissions—while others were in a net “long” position— they received a surplus of allowances. The covered entities that were short  on allowances had to reduce emissions, purchase allowances, or both in  order to comply with the ETS, whereas the long entities could sell or hold  onto the excess allowances. The short and long positions of covered  entities varied by industrial sector and among the member states.
With respect to industrial sectors, the demand for allowances came largely  from the power sector. Most power generation facilities were short  whereas industrial facilities, including iron and steel; manufacturing  ceramics; and pulp, paper, and board manufacturing were long. Member  states allocated the shortage to the power sector because they believed  this sector could reduce emissions at a lower cost than covered entities in  other sectors. In addition, there were concerns that compliance with the  ETS would create costs for covered entities that compete with facilities  outside the EU that are not subject to carbon limits. Therefore, member  states generally allocated the surplus to the globally competitive industrial  sectors and the shortage to the power sector, which does not generally  compete with entities outside the EU.
With respect to member states, the net position of all covered entities was  long in 19 of the EU member states and short in the rest of the member  states. Specifically, the net position of covered entities in Greece, Ireland,  Italy, Spain, Slovenia, and the United Kingdom was short because the  covered entities’ annual emissions, on average, exceeded the number of  allowances in the initial allocation. Accordingly, covered entities in these  member states purchased allowances on the market to cover emissions  beyond their allocation. The range of short and long positions of covered  entities among the member states demonstrates that the stringency of the  member states’ caps may have varied. For instance, member states with  covered entities in a net short position likely established more stringent  caps than those with net long positions. Figure 2 shows which member  states had covered entities with net short and net long positions.
Furthermore, allowance data reveal that while most allowances were  issued and used within the same member state, transfers of wealth from  covered entities in short member states to those in long member states  occurred in some cases where the entities did not have sufficient  allowances to cover their emissions. One study showed that the United  Kingdom imported EUAs to cover about 14 percent of its verified  emissions, making it the largest net importer of EUAs in phase I.  According to this study, 17 member states were net exporters of  allowances. The extent of exporting varied among these member states,  ranging from net exports that accounted for about 1 percent of total  allowances to 34 percent. Overall, however, researchers have concluded  that wealth transfers in phase I have been minimal but note this may  change with increasingly ambitious targets in subsequent trading phases.
section_title: The Effect of ETS Phase I on Emissions Is Uncertain Because of Data Limitations
paragraphs: Although the first ETS phase was overallocated—the overall emissions  cap exceeded actual emissions by more than 3 percent in phase I—the  ETS’s cumulative effect on emissions across the EU member states is  uncertain largely because of data limitations. First, there is an inherent  uncertainty about how actual emissions compare to the emissions that  would have occurred in the absence of the ETS. This is because it is  impossible to forecast future emissions levels in a business-as-usual  scenario with complete certainty. For example, emissions depend on  numerous factors, such as fuel prices and economic conditions that vary  and are difficult to predict. Second, the use of information about past  emission trends can reduce the uncertainty of business-as-usual  projections but historical, facility-specific data—i.e., baselines—were  generally unavailable prior to phase I.  The lack of baseline data made it  more difficult to forecast business-as-usual emissions and therefore  characterize the effect of the ETS on emissions.  According to the  Commission, the data limits preclude definitive conclusions about the  impact of phase I on emissions.
The tight time frame to establish emission caps and the limited authority  to collect baseline data from covered entities made it difficult to overcome  these data limitations. Over the course of 6 months, each member state  had to identify which entities to regulate under the ETS, obtain baseline  emissions data for the covered entities, establish an emissions cap that  would be consistent with its Kyoto target, and determine how many  allowances to distribute to each covered entity. At the time, most member  states had high-level, aggregated data on carbon dioxide emissions that  accounted for sources within and outside the scope of the ETS. However,  the member states did not have baseline data that broke out emissions on  a facility-specific basis, which was necessary to determine both the total  emissions released by all entities covered under the ETS as well as how  many allowances each particular entity would need to cover its annual  emissions. The member states took steps to obtain baseline data but,  according to the Commission, were constrained by the tight time frame  and limited authority to collect data—some member states did not yet  have in place a national law or regulation mandating submission of  emissions data.
The lack of historical baseline data therefore largely prohibited member  states from basing their caps on average emissions over a sustained period  of time preceding the program’s establishment, an approach that the  United States used successfully in establishing a cap-and-trade program  for sulfur dioxide from power plants in response to the 1990 Clean Air Act  amendments. The U.S. program used average emissions from 1985 to 1987  as the baseline against which to measure reductions required to begin in  1995 and 2000, thereby providing greater certainty that the program  achieved reductions relative to past emissions levels. The use of a  historical baseline in the sulfur dioxide program also reduced the covered  entities’ incentive to increase emissions prior to the program’s  establishment to obtain a greater allowance allocation—the baseline years  occurred too far before the announcement of the program. Reliance on  historical data spanning several years rather than one year also reduced  the risk that the baseline did not represent typical emissions levels, which  can vary across years due to economic conditions and price levels.
In contrast, the EU member states generally based their emissions caps on  business-as-usual projections and allocation decisions on recent baseline  emissions data voluntarily submitted by covered entities. The inherent  uncertainty of business-as-usual projections was compounded by the  assumptions underlying the models used to forecast emissions.  Specifically, the models incorporated assumptions about factors that  influence business-as-usual emissions projections, such as economic  growth and relative fuel prices. Some member states made relatively  optimistic assumptions about economic growth, which resulted in higher  projections of emissions. Regarding allocation decisions, member states  used recent baseline emissions data submitted by covered entities, which  meant that covered entities that released more carbon dioxide per unit of  output received higher allotments than those with lower rates. Some  researchers have questioned the reliability of these data because of the  potential incentive for covered entities to inflate emissions. According to  one researcher, member states assessed the quality of the emissions data  provided by covered entities by, for example, cross-checking it.
The uncertainties underlying phase I emissions caps were especially  problematic because the reduction goals of the first phase were modest. It  is worth noting, however, that phase I preceded the commitment period  under the Kyoto Protocol (2008 to 2012) and moreover that the first phase  was intended to simply gain experience with emissions trading before  2008. According to available information, member states intentionally  established emission caps at levels near business-as-usual projections,  which effectively left smaller room for error in determining emission  levels.
While some ETS observers have concluded that emissions abatement  under phase I was unlikely because the cap exceeded actual emissions,  several researchers have concluded that the ETS resulted in a cumulative  decrease in emissions compared to business as usual scenario. The  researchers stated that some covered entities likely reduced emissions by,  for example, switching to cleaner fuels to generate power or improving  energy efficiency, in response to the allowance price in the early stages of  phase I. In addition, approximately half of the experts concluded that the  first phase resulted in a cumulative decrease in emissions compared to a  business-as-usual scenario. Several experts attributed the reduction to the  allowance price, noting that it was likely high enough to encourage some  abatement, and several others identified published research as the basis  for their response. Several of the experts clarified that the reduction in  emissions was modest.
Phase II of the ETS, which recently began and coincides with the  commitment period under the Kyoto Protocol, relies on the same  decentralized process to establish the emissions cap and allocation in  phase I but differs in several ways. First, member states took verified  emissions data from phase I into account to set emissions caps in phase II.  According to our literature review and discussions with ETS stakeholders,  the Commission took a stricter approach in approving the phase II  National Allocation Plans and required member states to set more  ambitious caps. Second, member states will continue to distribute most  allowances for free in phase II but the amount of auctioning is expected to  increase—about half of the EU member states plan to auction allowances  in phase II. Third, phase II differs from the first phase by allowing all  covered entities to carry over, or bank, unused allowances to trading  periods after phase II. The increased banking provisions in phase II may  provide covered entities greater incentives to reduce carbon emissions.  For example, banking provides an incentive for facilities to reduce  emissions early, when costs are low, and save the allowances for a later  time, when costs are high.
Looking ahead to phase III (2013 to 2020), the Commission has proposed  legislation to amend the ETS by, for example, harmonizing the cap-setting  and allocation process. Under the legislative proposal, the Directive  would, according to the Commission, set a single, EU-wide emissions cap,  which would amount to a 21 percent reduction in 2020 below 2005 verified  emissions. The level of auctioning used to distribute allowances also  would increase under the proposal. The Commission anticipates the  legislation will be adopted in late 2008 or early 2009.
section_title: Phase I Economic Impacts Vary by Sector but Long- Term Effects Are Uncertain
paragraphs: The economic impacts of the ETS have varied among covered entities in  the short term and are uncertain in the long term. Impacts of concern  under the ETS have included leakage—the shifting of covered entities’  economic activities to countries that have not adopted binding emission  limits—and the competitiveness of covered entities, compliance costs, and  price changes for consumer goods and services, such as electricity. While  some energy-intensive industries covered under the ETS compete globally,  our research shows that leakage was unlikely in phase I in part because  covered entities received allowances for free and the cap exceeded actual  emissions; when allowance prices are lower, leakage is less likely.  Specifically, the emissions cap did not create a shortage of allowances that  would have generated an allowance price high enough to encourage  covered entities to relocate or move production to countries without limits  on carbon dioxide emissions. One expert noted that it is too soon to judge  the long-term economic impacts of the first phase.
With respect to leakage, some researchers have assessed the likely extent  of leakage to date and identified factors that contribute to the risk of  leakage, such as global competitiveness, carbon intensity—the amount of  carbon dioxide released per unit of output—and other factors. Available  information shows that under the ETS, leakage is a greater risk among  covered entities that rely on energy-intensive processes and have a limited  ability to pass the allowance price to consumers due to international  competition with entities not subject to carbon constraints. For example, a  2007 study based on energy and electricity data in the United Kingdom  concluded that the potential for leakage is a valid concern for several  sectors covered under the ETS, including cement, iron and steel, and pulp  and paper. Some ETS participants also have stated that auctioning  allowances rather than freely allocating them would increase costs and  therefore may increase leakage risk among globally competitive industries  covered under the ETS. According to some of the energy-intensive  industries, their covered entities would not be able to pass allowance  prices to consumers while remaining competitive with entities outside the  ETS that are not subject to carbon constraints.
Although researchers present consistent conclusions about the sectors  most vulnerable to leakage, there is disagreement about the extent to  which leakage would affect vulnerable sectors if allowance prices were to  rise or if the number of allowances allocated freely were reduced. Beyond  the uncertainty about future international carbon constraints, opinion  regarding the extent to which ETS industries will be able to pass  allowance prices to consumers varies. In addition, decisions about where  to locate industrial production depend on factors outside of allowance  prices, such as transportation costs.
Some ETS power producers, however, have already demonstrated an  ability to pass allowance prices to consumers and benefited economically  from free allocation under phase I. Studies have found that in the EU’s  deregulated energy markets, power producers passed on the market value  of allowances to consumers by adding the value of the allowances to  energy rates. Available information identifies a variety of factors that  contributed to energy rate increases, though, making it difficult to  determine the extent to which higher prices resulted from the ETS.  According to available information, additional reasons for energy price  increases include ongoing deregulation of the EU electricity markets,  weather conditions—which affect supply and demand for energy—and  fossil fuel prices. Nonetheless, to the extent that power producers in  deregulated markets added the value of allowances—which they received  for free—to the rates that they charged consumers, the first ETS phase  resulted in windfall profits for this sector while contributing to increased  costs for some energy consumers.
Despite the potential economic impacts of a system to limit carbon  dioxide emissions, the first ETS phase included several features that  covered entities could use to limit compliance costs. For example, phase I  included the use of international offsets in the form of CDM credits,  discussed in the next section of this report, as a cost containment feature.  Offsets can reduce the costs of compliance by allowing facilities to pay for  abatement in areas where it may be cheaper to do so and apply the credits  toward their own caps. Another feature intended to reduce costs allowed  covered entities to bank allowances from one year to another within the  first phase. In theory, banking provides an incentive for facilities to reduce  emissions early, when costs are low, and save the allowances for a later  time, when costs are high. According to available information, banking  provided limited abatement incentives in practice, however, because  covered entities generally were not allowed to carry allowances from  phase I to phase II. As a result, very few covered entities could minimize  costs in phase II by using allowances from phase I.
The Commission has since proposed legislation to modify allocation  methods and cost containment features for the third trading phase and  beyond. First, the Commission’s proposal would allow full banking of  unused allowances from the second phase while restricting the use of  CDM offset credits starting in 2013 if no future international climate  change agreement has entered into force. Second, the Commission’s  proposal would end free allowance allocation to the power industry in  2013. According to the Commission, requiring the power industry to  purchase allowances through an auction and market trading would  eliminate windfall profits in this industry and provide an incentive for less- carbon-intensive power generation. The Commission also has proposed to  gradually phase out free allocation and increase auctioning to other  entities covered under the ETS but will evaluate the potential risks of  leakage associated with such an approach.
section_title: The Effect of ETS Phase I on Technology Development and Innovation Are Uncertain but Likely Minimal
paragraphs: It is too soon to know whether the first phase had an impact on long-term  technology development and innovation, and researchers conclude that  the impact, if any, is likely minimal. According to the IPCC, technology  research and development are essential to the development of a less- carbon-intensive energy infrastructure required to reduce emissions in the  long term. A senior official at the Council on Environmental Quality told  us that emissions trading can be a cost-effective tool to achieve long-term  reduction goals but that in some cases it may not provide incentives for  technology investment. Several EU industry representatives told us that  covered entities have begun to consider the ETS and associated costs  when making business decisions but this has not resulted in widespread  technology changes. Available information suggests that regulatory  uncertainty, low carbon prices, and program design features likely  dampened incentives in the first phase to invest in clean technologies.
First, the uncertainty about future emissions caps—and thus the extent of  abatement required at covered entities—and restrictions on banking  limited the incentive to invest in technology in advance of the first phase.  Specifically, the duration of phase I was not compatible with investment  decision timelines. According to a European power industry official, it  may take 5 to 10 years for technology investments to come to fruition, a  longer time frame than the first phase’s 3-year trading period. The general  inability to bank unused allowances to the second trading phase (2008 to  2012) also limited abatement incentives in phase I. The allowances expired  at the end of phase I and thereby provided an incentive to emit rather than  reduce carbon dioxide emissions and save the allowances for another  time.
Second, the expected reduction goals for phase I were modest and,  according to some market analysts, allowance prices have not been high  enough to influence technology investment decisions, such as  development of carbon capture and storage. Identified by the IPCC as a  key potential abatement technology, carbon capture and storage involves  capturing carbon dioxide from a power plant’s emissions, transporting it  to an underground storage location, and then injecting it into a geologic  formation for long-term storage. While other options exist to reduce  emissions—such as energy efficiency improvements, a switch to less-  carbon-intensive fuels, nuclear power, and renewable energy sources—  carbon capture and storage is considered by many an essential technology  because it has the potential to greatly reduce emissions from power plants  while allowing for projected increases in electricity demand. One  consulting firm has estimated that demonstration projects to test carbon  capture and storage in the EU between 2012 and 2015 would cost €60 to  €90 per metric ton of carbon dioxide abated, well above the phase I  allowance price.
Third, available information also suggests that the rules governing  allowances for new entrants—covered entities that did not begin  operation until after a member state’s submission of a National Allocation  Plan—limited incentives to invest in low-carbon technologies. The ETS  Directive required member states to ensure new entrants had access to  allowances but did not specify how they should do so. In practice, all of  the member states distributed allowances to new entrants for free.  Researchers believe that free allocation to new entrants reduces the  investment costs of carbon-intensive technologies, such as coal-fired  power plants, compared to low-carbon technologies or renewable energy,  and effectively eliminates the incentive for investment in low-carbon  technologies.
The allocation rules for covered entities that closed during the first phase  also affected investment incentives. Available information indicates that  most of the member states required closing plants to give back the  allowances rather than sell them on the market, thereby providing an  incentive for these facilities to continue operating. Covered entities that  would have closed in the absence of the ETS may have continued  operating in order to keep the allowances.
Finally, the Commission has sought to provide greater certainty about  emission caps for future trading phases. The EU has committed to  continue emissions trading and aims to finalize by late 2008 or early 2009  the Commission’s proposed legislation that would modify the trading  phases after 2012. Among other things, the proposal aims to reduce  greenhouse gases by at least 20 percent by 2020.
section_title: ETS Phase I Experience Offers Key Lessons about Program Design and Implementation
paragraphs: Available information and experts revealed lessons about three key  aspects of phase I, including the importance of baseline data, program  design and implementation, and related economic effects. In particular,  experts discussed how these lessons might inform the design of U.S.  climate change policies.
subsections: section_title: Baseline Data
paragraphs: First, available information indicated that accurate baseline data are  essential to setting an effective emissions cap and achieving the intended  environmental objectives. The accuracy and availability of baseline data at  the covered entity, sector, and national level also influence the  effectiveness of the emissions cap.
Availability of data. About half of the experts said that emissions data  should be in place before starting an emissions trading program. Many  experts commented, however, that they would not expect the United  States to encounter the data challenges experienced in the first phase  because certain data are already available and several noted that existing  data about U.S. emissions are sufficient to establish an emissions trading  program. Specifically, they stated that the United States has good data on  fossil fuel consumption that can be used to estimate economy-wide carbon  dioxide emissions as well as facility-specific data on carbon dioxide  emissions from power plants that have participated in the Clean Air Act’s  sulfur dioxide emissions trading program. Moreover, our literature review  indicates that the availability of historical baseline data would reduce the  incentive for covered entities to inflate baseline emissions prior to the  establishment of a program to obtain a greater allocation. Nonetheless, a  few experts said that emissions data in the United States could be  improved. For example, one expert noted that emissions of greenhouse  gases other than carbon dioxide are more uncertain.
Specificity of data. The required accuracy of data at the covered entity,  sector, and national level depends on, and must therefore be compatible  with, the program’s point of regulation. The point of regulation may occur  (1) “upstream” and cover sources of carbon dioxide when they first enter  the economy, such as fossil fuel producers; (2) “downstream” and cover  direct and indirect emitters, such as power plants; or (3) at a combination  of upstream and downstream sources. A downstream program like the  ETS requires facility-specific data in order to determine how many  allowances to distribute to individual entities. In contrast, programs that  incorporate upstream sources, such as the one proposed in the Lieberman- Warner Climate Security Act of 2008, primarily rely on economy-wide  data, which may be more readily available than facility-specific data.  Several experts stated that an upstream program would simplify data  requirements and avoid the phase I challenge to obtain the facility-specific  baseline data. Available information also identifies the simplified data  requirements of an upstream program as an advantage but notes that such  programs demand greater cooperation and political support than  downstream programs.
section_title: Program Design Features
paragraphs: The second group of key lessons relates to how program design features  may influence the effectiveness of emissions trading and includes the  following features: the emissions cap, program scope, allocation method,  measures to limit risk of leakage, program timeline, and linking to other  programs. As noted by several experts, some implementation challenges,  such as data limitations or lobbying pressure to inflate the cap for a  particular industry sector, are inevitable but steps can be taken to  minimize their consequences. In addition, nearly all of the experts  discussed ways that design features can maximize incentives to cost- effectively reduce emissions.
Emissions cap. Experts identified design features that would provide  incentives to reduce emissions even if the cap initially exceeds emissions.  For example, several experts recommended establishing a long-term,  declining emissions cap, which would ensure gradual emissions scarcity in  the program. A few experts also pointed out that allowing full banking  with a long-term declining cap would provide an incentive to reduce  emissions earlier.
Program scope. The scope of the program, specifically the extent to which  it regulates all greenhouse gas emissions in the economy, influences the  cost-effectiveness of reductions. In theory, opportunities for cost-effective  reductions will increase as the number of sources included in the program  increases but in practice there may be limits to enhancing cost- effectiveness with expanding scope.  Many of the experts stated that a U.S.  program should include as many sources of carbon dioxide emissions as  possible; several also stated that it should cover all six greenhouse gases.  Several experts noted, however, that emissions trading may not be the  most effective way to control all greenhouse gas emissions. One expert  clarified that while the scope of a trading program should be “as wide as  possible,” it should only include emissions that “can be credibly  monitored, reported, and verified.” Similarly, the European Commission  told us that the ETS began with a narrow scope, regulating approximately  half of the EU’s carbon dioxide emissions, because of feasibility concerns  and plans to expand to other gases and sectors in the future. Another  expert echoed the idea of targeted expansion in noting that forestry and  agriculture sources should be only gradually involved in a trading program  because of uncertainties in measuring emissions. Furthermore, one expert  suggested alternative forms of regulation, such as emission standards, to  limit the non-carbon-dioxide greenhouse gases that may not be effectively  monitored or enforced under emissions trading.
Allocation method. According to available information, the way a program  distributes allowances also impacts the program’s total cost and the  distribution of cost burden among stakeholders. An auction, for instance,  may impose costs on particular sectors covered under the program but  generate revenues that may be used to offset the cost of the emissions  trading program on consumers or covered sectors through reinvestment in  other programs, which may or may not relate to climate change. Some of  the experts who discussed the benefits of auctioning provided examples of  ways to use auction revenues, such as research and development of clean  energy technologies, to lower income taxes, to lower business taxes, to  expand earned income tax credits, or for energy efficiency programs. In  addition, one expert noted that greater use of auctioning also may  minimize the perverse incentives favoring processes that are more-carbon- intensive under the ETS rules for closure and new entrants. Accordingly,  many of the experts stated that a trading program should maximize the  level of auctioning.
Free allocation to emitters, on the other hand, may reduce costs for  sectors covered under the trading program but not for consumers.  Although the ability of covered entities to pass costs to consumers in the  form of higher product prices varies, available information reveals that  free allocation does not prevent increases in consumer product prices  resulting from the emissions program. The first phase shows that covered  entities may still pass costs through to consumers.
Risk of leakage. The experts also provided insights about potential for  leakage to affect covered sectors. Most of the experts said that leakage  would pose a risk under a U.S. emissions trading program, although views  on the degree of risk varied. Some of the experts clarified that it would  pose a significant risk for certain industries, in particular energy-intensive  industries that compete with facilities in countries without binding carbon  caps. The option most frequently identified to prevent leakage was  securing global participation in international climate agreements.
The experts discussed alternative options to reduce the risk of leakage in  the absence of a global agreement, including some form of targeted free  allowance allocation, cost containment mechanisms, and trade measures.  The alternatives involve a set of tradeoffs and as one expert noted, require  detailed information about “which sectors or subsectors would experience  leakage.” For example, free allocation may reduce compliance costs for  globally competitive entities but as another expert noted, may deter  investment in less-carbon-intensive technologies. Moreover, one expert  pointed out that entities may sell the allowances and relocate anyway.  Some of the experts stated that cost containment mechanisms, such as  allowing the use of offsets, could reduce the cost impact on covered  entities by lowering the allowance price. The lower allowance price in turn  is expected to reduce the risk of leakage. Many of the experts suggested  trade measures to level the playing field for globally competitive, carbon- intensive entities. Trade measures identified included either a border tax  or an allowance requirement for goods imported from entities not subject  to carbon constraints. However, a few experts discussed drawbacks, such  as difficulty in identifying which sectors are vulnerable to global  competition and the possibility of retaliatory trade measures. In addition,  opinions vary as to whether these trade measures would be permitted  under World Trade Organization rules.
Program timeline. Many of the experts viewed the program timelines as  an important feature to reduce uncertainty that deters investment in less- carbon-intensive technologies, while several also emphasized cost  certainty as a key feature. The experts commenting on timelines stated  that a trading program should cover a long enough time period to  influence technology investment decisions. A few experts noted that the  risk of subsequent changes to specified targets—because of developing  scientific opinion or changes in political commitments—makes it  important also to provide certainty about costs to incentivize technology  development. For example, specifying a minimum auction price for  allowances would increase certainty about the long-term value of  investments to reduce emissions.
Linking. Finally, the experts presented a wide range of opinions regarding  the extent to which a program benefits from linking to other trading  programs. Linking occurs when covered entities in one program can use  the allowances from another trading program for compliance and,  sometimes, vice versa. For example, linking the EU ETS to a U.S. trading  program could allow covered entities in the United States to purchase  EUAs and use them to cover emissions. In theory, linking can enhance the  cost-effectiveness of the participating programs by enabling covered  entities to take advantage of differences in the costs of abatement options.  According to available information and experts, the design features of the  program also will carry through to the linked program. As a result, it may  be difficult and less cost-effective to link programs in practice. Many of the  experts discussed the complications resulting from linking programs with  different cost containment measures, in particular a safety valve. Safety  valves are mechanisms, such as maximum allowance price, that trigger  cost containment actions. For example, one kind of safety valve might  allow the government to sell additional carbon allowances if the market  price for allowances exceeded a predetermined amount—the increased  supply may lower the market price but also would increase the emissions  cap. Linking a program with a safety valve to another program without one  would carry the safety valve through to the latter program. About one- third of experts concluded that linking programs with different cost  containment measures may compromise the environmental integrity of the  programs.
section_title: Wealth Transfer
paragraphs: The third and final category of lessons relates to wealth transfer, as the  ETS demonstrated that giving away allowances can create and transfer  substantial assets of considerable value. The distribution of wealth creates  a strong incentive for regulated entities to influence the design and  implementation of a trading program. Five experts clarified that while  lobbying pressure from stakeholders is inevitable, steps should be taken to  minimize the effects. Along those lines, some of the experts stated that  auctioning allowances would minimize the adverse impact of lobbying  activity—that is, it would reduce pressure to increase individual  allocations that may compromise the emissions cap. Another expert noted  that the inevitable lobbying activity warrants having decision makers set  the cap in federal legislation to ensure greater accountability. Finally,  available information also indicates that while there may be advantages to  starting with a small program and expanding it, modifying emissions  trading programs can introduce technical and political challenges. As an  official at an international research organization observed, it is difficult to  change who gains and who loses under a trading program after it has been  established.
section_title: The CDM’s Environmental and Economic Effects Provide Important Lessons That Can Inform Congressional Deliberations on Climate Change Policy
paragraphs: According to available information and experts, the CDM has enabled  industrialized countries to make progress toward achieving their  emissions targets at less cost and has involved developing countries in  these efforts; however, the program’s effect on emissions is uncertain, and  its impact on sustainable development has been limited. Further, we found  that the CDM’s approval process significantly limits the scale and cost- effectiveness of emission reductions achieved through the program,  although several proposed reforms may help to streamline this process.  Nonetheless, the international experience with the CDM has provided key  lessons that may help inform congressional decision making.
subsections: section_title: The CDM Has Enabled Covered Entities to Pursue Lower-Cost Reductions and Involved Developing Countries in the Global Carbon Market
paragraphs: Beginning operation in 2002, the CDM can allow countries to make  progress toward their emissions targets under the Kyoto Protocol at less  cost through the use of carbon offset credits. This includes not only  countries under the EU ETS, but all countries that have ratified the  Protocol and meet certain requirements. However, while countries outside  the scope of the ETS—specifically, Canada, New Zealand, Switzerland,  and Japan—have invested in CDM projects, demand has been driven  primarily by covered entities in the EU, which can count CDM credits  toward their emissions caps under the ETS. For many of these entities,  investing in CERs can provide a lower-cost alternative to reducing  emissions on-site or purchasing EUAs. Further, the availability of CERs  may produce lower allowance prices than would be observed under a no- offset scenario. As a result, the CDM can potentially reduce firms’  compliance costs regardless of whether these firms choose to purchase  CERs.
While both EUAs and CERs can be used for the same purposes in the ETS,  investors in the CDM market face higher risks, depending on the type of  CER purchased. “Primary CERs” involve a higher level of uncertainty  because most purchases involve forward contracts—the buyer purchases  the rights to future credits instead of the credits themselves. Because  primary CERs are not issued until the project is completed and emissions  are verified, there is some risk that the project will not produce the  expected number of CERs. For example, the CDM’s Executive Board may  delay or reject a project and even approved projects might not be built on  schedule or within budget. Further, the amount of actual reductions may  differ from what was planned—for example, wind projects may generate  more or less electricity depending on weather conditions. One study  shows that projects reaching the registration phase tended to yield only  about 76 percent of their forecasted CERs. In order to reduce market  risks, an increasing number of CDM participants purchase “secondary”  CERs, which are offered with a guarantee of delivery. These secondary  CERs, represented in figure 3, carry less risk and are more expensive than  primary CERs, although they still sell at a discount to EUAs.
Despite uncertainties about the delivery of CERs, the CDM market has  grown at a considerable rate over the past few years, mobilizing private  and public sectors in both industrialized and developing countries to  invest billions of dollars in projects designed to decrease greenhouse gas  emissions. CDM transactions amounted to nearly $13 billion in 2007, an  increase of over 200 percent from 2006. On a global scale, the  introduction of CDM credits as a commodity has encouraged businesses  and entrepreneurs to seek out emission reduction opportunities in  developing countries and has spurred the creation of consulting firms that  help steer participants through the approval process.
For developing countries that do not have emissions targets under the  Kyoto Protocol, the demand for CERs has provided an economic incentive  to pursue emission reduction activities. As of October 2008, over 3,800  different projects were seeking credits through the CDM. Of these, over  1,100 have already officially registered through the CDM’s Executive  Board, and nearly 400 have received CERs. The first chart in figure 4  shows the most common types of projects and their growth over time while the second chart shows the volume of credits expected to be  produced through 2012. Because some CDM projects destroy gases  more  potent than carbon dioxide—in particular, industrial gases—these project are an abundant source of credits and, as the second chart in figure 4  shows, represent a larger share of overall expected reductions than the number of projects might suggest.
section_title: Despite Rigorous Review Process, the Net Effect of the CDM on Emissions Is Unclear
paragraphs: The overall effect of the CDM on international emissions is uncertain,  largely because it is nearly impossible to determine the level of emissions  that would have occurred in the absence of each project. This concept of  additionality is fundamental to the credibility of the CDM because only  projects that are additional will lower emissions beyond what would have  occurred without the program. Accordingly, the parties to the protocol  have implemented a rigorous project approval process with an extensive  set of requirements to ensure that credits received through the CDM  represent real and additional emission reductions. However, because  additionality is based on projections of what would have occurred in the  absence of the CDM, which are necessarily hypothetical, it is impossible to  know with certainty whether any given project is additional.
As part of this process, project applicants must demonstrate the  additionality of the proposed project and estimate the emission reductions  that will occur as a result of the project’s implementation. In practice, this  means that applicants must show that the project would not have occurred  without the CDM, due to technological, economic, or other barriers. They  must then estimate the reductions achieved by the project using a  projected business-as-usual baseline. Documentation for the project must  be evaluated by an independent auditing firm, approved by the host  country, and then formally accepted by the CDM Executive Board on a  case-by-case basis. Once approved, emissions from each project are  monitored periodically in accordance with procedures outlined in the  initial project proposal. Credits are issued only for emission reductions  that have been verified by a separate, independent auditing firm.
This process may increase the likelihood that projects are additional, and  evidence indicates that the CDM’s screening process has become more  stringent over time. Many stakeholders we interviewed said that the  majority of projects under CDM are additional and would not have been  undertaken without the opportunity to earn carbon credits. Further, a  majority of experts we consulted agreed that the CDM’s approval process  ensures a higher degree of project quality, on average, than in voluntary  offsets markets, though some suggested that voluntary market standards  represented a fairly low benchmark for quality. Figure 7 summarizes our  experts’ responses.
However, significant challenges to ensuring credit quality exist. Many  experts and stakeholders have suggested that a substantial number of  nonadditional projects have received credits through the CDM, a  conclusion supported by several studies. Further, while CDM participants  we interviewed in India and China did not explicitly criticize the CDM’s  screening process, their comments often ran counter to the concept of  additionality. For example, several representatives from the cement and  auto industries said they would pursue clean energy projects regardless of  the CDM, describing the CDM credits as more of a “bonus” than a driver of  investment. In response to concerns about the quality of projects under  the program, the CDM’s Executive Board has taken steps to improve the  process, such as adding staff, creating a manual for verifiers, and  increasing project reviews and rejections. However, the Executive Board  may find it increasingly difficult to evaluate additionality, according to two  of our experts, as host countries begin to factor the CDM into their  planning efforts and it becomes more difficult to identify what would have  happened without the program.
The presence of nonadditional projects can diminish or negate the  environmental benefits of the CDM. Because the CDM is primarily used by  countries to comply with the Kyoto Protocol’s binding targets and the  ETS’s emissions caps, credits that do not represent real and additional  emission reductions do not represent progress toward these targets or  caps. This is particularly important in the context of cap-and-trade  programs that use the CDM for compliance, such as the ETS, because  nonadditional projects can compromise the environmental integrity of the  emissions cap. If a significant number of nonadditional credits are allowed  into the program, for instance, these credits may allow covered entities to  increase their emissions without a corresponding reduction in a  developing country. This can cause emissions levels to rise above the  targets set by the program, introducing uncertainty as to the actual level of  reductions, if any, achieved by the program. The extent of this effect is  difficult to estimate; it depends on the number of nonadditional credits  and the extent to which offset credits can be used in the compliance  program, among other things. Because of the challenges of ensuring  additionality under the CDM, several experts said the CDM has had a  negligible or negative environmental effect. According to one expert,  maintaining anything less than “a great extent” of additionality is  unacceptable, because the result is a higher level of worldwide emissions  than would have occurred in the absence of the CDM.
In the current phase II of the ETS, the number of CDM credits that can be  used to meet emissions caps is limited. As we have previously reported,  limits on the use of offset credits in mandatory emission reduction  programs involve tradeoffs. On the one hand, such limits may increase  compliance costs. On the other hand, they can help provide incentives for  technology research and promote fundamental changes within industries  bound by the program. Limits on offsets can also help confine the negative  impact of nonadditional offset credits in the event that additionality  controls fail.
In order to fully realize these benefits, however, limits on offsets must be  sufficiently stringent. For phase II of the ETS, the European Commission  established fairly generous limits—member states are able to use CDM  credits for about 12 percent of their emissions cap, on average.  Researchers have since concluded that these limits could allow member  states to achieve the majority of emission reductions through offsets and  reduce little in the EU. This is partly because the limits were based upon  the total emissions cap rather than the “distance to target”—that is, the  gap between the current emissions level and the cap. According to one  European Commission official, the ETS legislative proposal will address  this concern, as it prevents new CDM credits—with some exceptions—  from entering the ETS during the third phase of the scheme. A committee  of the European Parliament also has proposed stricter limits on both the  quantity and quality of credits in the third phase. However, at least one  study disputes whether these changes will be sufficient to ensure that the  EU’s long-term reduction targets are met.
It is important to note that while nonadditional projects do not represent a  net decrease in emissions, this does not preclude them from conferring  environmental benefits. For example, a wind power project may be  profitable without the CDM but can be valuable from an environmental  and public health perspective. Further, a few experts pointed out that  permitting offset programs like the CDM in emissions trading programs  may allow the negotiation of more stringent emissions caps, since offsets  can reduce the overall cost of compliance programs. This effect may help  balance out the effects of nonadditional projects.
section_title: The CDM’s Contributions to Sustainable Development Have Been Limited
paragraphs: Although the Protocol does not define sustainable development, in other  contexts the UN has described it as a strategy that “meets the needs of the  present without compromising the ability of future generations to meet  their own needs,” and can encompass environmental, economic, and  political sustainability. The CDM’s rules require that each emissions  reduction project assist a host country in achieving sustainable  development, but does not provide overarching standards with which to  assess these projects. Instead, it delegates responsibility to host countries,  each of which defines its own sustainable development criteria that it can  use to approve or reject CDM projects. Projects could presumably fulfill  this requirement in a variety of ways; for example, by promoting  sustainable agriculture or by introducing renewable technologies to fulfill  energy demand.
Overall, most evidence indicates that the CDM has had a limited effect on  sustainable development. For example, multiple stakeholders we spoke  with said the CDM has not had a significant impact in this area, although  one researcher acknowledged that such outcomes may be difficult to  assess in the short term. Stakeholders in India, many of whom stood to  benefit financially from the CDM, spoke more positively of the CDM’s  contributions to sustainable development, mentioning wide-ranging  benefits such as job creation, improved air quality, and enhanced energy  supply in rural areas.
The CDM’s limited effect could be due, in part, to its market-based  structure. Developing countries may have few incentives to enact stringent  criteria for sustainable development since they are effectively competing  for CDM projects, and stringent standards may raise the cost of developing  a project and deter potential investors. In India, for example, projects are  approved by the national CDM authority based on whether they align with  the country’s pre-existing sustainability guidelines. However, CDM  participants we spoke with in India said it was relatively easy to get a  project approved; on the day we visited, for example, 25 projects had been  reviewed and approved. In addition, because the CDM encourages  investors to seek out the lowest-cost reductions, projects that make  considerable contributions to sustainable development may be at a  disadvantage. Some of the most attractive projects to investors, in terms of  CERs produced, have a relatively small impact on sustainable  development, and the CDM does not provide financial rewards for projects  that exceed minimum sustainable development standards.
Although the CDM does not claim technology transfer as an explicit  objective, most consider the introduction and diffusion of new  technologies in project host countries to be an important outcome. Given  available information, however, the effect of the CDM in this area has thus  far been modest. According to CDM participants we spoke with in India,  most projects have used technologies that were already commercially  available within the country, although some said the CDM has helped  mitigate the risk of investing in new technologies. The experts had a  similar view—of those who provided an opinion, about two-thirds said the  CDM was “not effective” or “slightly effective” as a tool for technology  transfer. On the other hand, slightly over a third believed the CDM was  “moderately” or “very” effective.
Some studies have attempted to quantify the extent of technology transfer  under the CDM. According to a review of available research, between one- third and one-half of CDM projects involve some type of technology  transfer. Such transfer is much more common in certain types of projects,  such as industrial gas projects that utilize “end-of-pipe” technologies  developed in Europe and Japan. Apart from industrial gas destruction, the  project types most likely to involve technology transfer appear to be wind  power, landfill gas capture, and agriculture (biogas). However, one expert  pointed out that most of the wind power capacity represented in the CDM  project pipeline is sited in India and China, countries that have supported  domestic wind industries prior to the CDM. This suggests that while the  CDM may provide a boost to these industries, it is not creating a new wind  industry in either country.
Industrial gas projects have been a controversial source of credits,  particularly those involving the waste gas HFC-23. HFC-23 is produced  during the manufacture of another gas, HCFC-22, which is used in some  air conditioners and in the production of certain plastics. Industrial gases  are several thousand times more potent than carbon dioxide, in terms of  warming potential, and thus yield large quantities of credits. For example,  while these projects account for only 1 percent of projects in the pipeline,  they represent 18 percent of all expected credits through 2012. However,  given that industrial gas projects involve simple, end-of-pipe technologies,  they do little to promote efficient energy use or contribute to long-term  sustainable development objectives.
In addition, some researchers have argued that the CDM is an inefficient  way to reduce industrial gas emissions. For example, one study estimates  that HFC-23 reductions cost project developers less than $1 per ton of  carbon dioxide equivalent, whereas CERs have historically been sold for  $15 to $20 per ton. According to another researcher, payments to  refrigerant manufacturers, investors, and the government of China, where  most projects are sited, will total approximately $5.3 billion, whereas the  costs of these projects are likely to be less than $115 million. While  recently constructed plants cannot earn credits, some observers have  raised concerns that the CDM will be extended to include new incineration  sites. They argued that this could provide perverse incentives for plants to  emit more, not less, as HFC-23 emitters could in theory earn much more  by destroying these gases as they could from actually selling HCFC-22.
Some researchers have downplayed these concerns and identified several  reasons why they do not expect problems to continue. It is unlikely, for  example, that industrial gas projects would have been undertaken without  the CDM. Further, these projects constitute a small and diminishing share  of projects, primarily because the pool of cheap reduction opportunities  has been largely exhausted. In addition, tax revenue from HFC-23 projects  may boost sustainable development programs. In light of the CDM’s  experience with industrial gas projects, however, some researchers have  suggested that certain greenhouse gases could be better addressed by  other mechanisms.
Going forward, many believe the quality of projects will increase as the  number of cheap, “low-hanging fruit” projects decreases. Indeed, current  project trends have shown an increase in renewable energy and energy- efficiency projects, which have the potential to confer long-term  sustainability benefits, and a decrease in industrial gas projects. However,  given that CDM’s market-based design encourages its participants to  pursue low-cost projects, it may ultimately be difficult for the CDM, as  currently structured, to make significant contributions toward sustainable  development goals.
section_title: The Scale and Cost- Effectiveness of the CDM Is Limited by the Current Project-by-Project Approval Process, but Proposed Reforms Could Improve Its Effectiveness
paragraphs: The CDM’s project-by-project approval process may not be a cost-effective  model for achieving emission reductions. Most experts expressed  dissatisfaction with this approach, which requires individual review and  additionality assessments for each project. Observers also have described  the project-by-project approach as inefficient, noting that the long,  uncertain approval process can create risks and costs for investors (fig. 8  shows the resources and time associated with each step in the process).  Host country stakeholders we spoke with generally agreed with this  assessment, saying that the process was bureaucratic and overly  burdensome. Indeed, the length and administrative complexity of the  process, as well as the shortage of available emission verifiers, has  resulted in bottlenecks and delays as the CDM’s administrative structure  has struggled to keep up with the number of projects. Moreover, the  transaction costs and investment risks associated with CDM projects can  reduce their effectiveness as a cost-containment mechanism when linked  to compliance schemes.
While the CDM’s intensive review process may help ensure some degree of  environmental integrity, it also can limit the number of potential projects  in the system. For example, the cost to initiate a CDM project and usher it  through the approval process may be too high for certain projects,  rendering them unviable. Some experts expressed concern that the CDM  discouraged investment in the kinds of projects that would have the most  benefits, because such projects are too costly, while others said that the  extensive process does not necessarily result in a higher quality of credits.  On the other hand, an Executive Board member we spoke with cited an  unexpected but positive result of the delays.  According to him, many  projects waiting for approval have already been implemented but will not  receive credits for emission reductions prior to registration; as a result, the  number of credits issued to these projects may underestimate their  environmental value.
According to some stakeholders, generating the additionality analysis  required under CDM is especially time-consuming, and, in some cases,  impractical. For instance, several host country stakeholders expressed  frustration over the investment analysis component of additionality, which  requires project proponents to demonstrate that the proposed project  would not be financially viable without the revenue provided through the  CDM. They considered this requirement to be unrealistic, since the level of  incremental CDM revenue is often too small to be the sole driver of  investments, particularly in the case of multimillion dollar projects that  have their own revenue stream, such as wind energy plants. Because some  projects do not produce the number of credits that were initially  projected, it is difficult for investors to know whether the projects will be  profitable without the CDM. In addition, CERs are not issued until the  project is registered and emissions have been verified, a process that can  take several years, whereas the upfront financing for the project may be  needed much earlier. Given these difficulties, one stakeholder involved in  CDM finance said that their firm often prepares two sets of financial  documents—one set for internal planning purposes, and another set that  presents the data in a way that complies with CDM requirements. This  stakeholder and others suggested that the ability to get projects approved  depends largely on the ability to meet paperwork requirements, and said  that paperwork is, in some cases, manipulated to artificially comply with  rules that the project proponents think are unreasonable or restrictive.  Several experts also claimed that the investment analysis requires auditors  and Executive Board members who review this paperwork to make  subjective decisions about the intent of investors.
A few stakeholders further commented that the current definition of  additionality was too restrictive and overlooked other benefits of the  CDM. Several felt it was unrealistic to account for every unit of emissions,  recommending instead that the CDM simplify the requirements to let more  projects into the system. A number of experts concurred with this  position, saying that the effort to assess the exact emissions from each  project was impossible and that an imperfect system was not a valid  reason for inaction on climate change.
Indeed, under the current approach, it is unlikely that the CDM will  significantly impact global emissions in the future. According to the  International Energy Agency, global energy-related emissions are expected  to increase approximately 57 percent from 2005 to 2030, with most of the  additional emissions coming from China and India. This represents a  major shift from the time period 1900 to 2005, when China’s and India’s  historical share in cumulative emissions amounted to only 8 percent and 2  percent, respectively. In light of these trends, several experts highlighted  the importance of involving developing countries in efforts to curb climate  change. However, the scale of the CDM is limited not only by the extensive  set of requirements; it also is constrained by the fundamental time and  resource limitations of the 10-member Executive Board and its subsidiary  panels, and the shortage of accredited auditing firms to validate projects  and verify emissions. Even assuming all projects are real and additional, it  is likely that reductions from these projects will only represent about 2  percent to 3 percent of annual energy-related carbon dioxide emissions in  China and India, and less than 1 percent in Africa.
The CDM is not intended to be the sole solution to climate change, but it is  yet unclear whether it can play a significant role. As a number of experts  mentioned, reductions from both the developed and developing world are  needed in order to effectively address climate change. According to some  of these experts, however, it is unlikely that offset programs, on their own,  will be enough to help curb developing country emissions. However,  others claimed that the CDM, if reformed or supplemented, could make a  broader impact worldwide.
Experts provided a number of potential improvements to CDM, many of  which would represent fundamental changes to the current mechanism’s  structure and procedures. Key themes underlying many of the experts’  recommendations were a need to streamline and simplify the approval  process and increase the CDM’s effectiveness by targeting certain project  types, industry sectors, or countries. However, the options presented  below, are not necessarily exclusive of one another; in fact, many experts  suggested a combination of approaches.
subsections: section_title: Sectoral CDM
paragraphs: Many experts recommended that the CDM move toward a so-called  “sectoral approach,” which involves crediting emission reductions in  relation to baselines set for different economic sectors, such as the power  sector or cement industry. For example, the aluminum and cement sectors  could have benchmarks based on the best available technologies in the  industry, and facilities that performed above the benchmark would receive  credits. The advantage of such an approach is that it eliminates the need  for project-specific determination of additionality, because credits are  awarded based on performance in relation to a predetermined baseline.  However, this approach requires reliable historic emissions data to set  baselines and the technical capacity to monitor emissions, requirements  which may prove problematic for some developing countries.
There are many different ways the sectoral approach could be  implemented. For example, credits could either be awarded to private  entities that reduce emissions below the baseline for their sector or to  countries that implement policies that encourage or compel reductions in  particular sectors. Sectoral baselines could be defined by intensity  (emissions per unit of output) or set as an absolute cap.
section_title: Sectoral No-Lose Targets
paragraphs: A few experts also advocated the use of sectoral no-lose targets, in which  tradeable credits are issued to governments that reduce sectoral emissions  below a preset baseline. There would be no penalties if emissions exceed  the baseline—the purpose of these targets is to mobilize investment in  low-carbon technologies in developing nations. This approach is similar to  the government-administered sectoral approach discussed above, except  that the national sector-wide baselines would be negotiated at the  international level instead of using the CDM’s current institutions and  processes. This would have the practical effect of eliminating additionality  assessment from the process altogether, since the targets for industrialized  countries in a post-2012 agreement would factor in the credits awarded  through no-lose targets. However, some researchers have concluded that  this approach would make emissions leakage more likely, since targets are  not binding.
section_title: Programmatic CDM
paragraphs: Some experts that proposed reforms discussed the benefits of the  programmatic approach, in which a group of small-scale activities is  credited as one CDM project. In theory, this option helps promote projects  that may result in significant emission reductions but may not be viable on  an individual basis; for example, a program that provides energy-efficient  lightbulbs to a significant number of households. The aim is to reduce the  transaction costs involved in the CDM by distributing these costs over a  group of activities, an approach that may be particularly beneficial for  energy-efficiency projects. While programmatic CDM has already been  approved for use, it has been applied in few projects to date. According to  stakeholders we spoke with, this is partially because it is challenging to  design a methodology to verify emission reductions on a programmatic  scale—for example, it may be difficult and costly to take a sample of  households in order to demonstrate that issued lightbulbs are being used  and emission reductions are achieved. In addition, independent auditing  firms are responsible for verifying these reductions, and may be reluctant  to take on the added liability.
section_title: Positive Lists
paragraphs: Many experts recommended the use of positive lists, which involves  creating a list of activities that have been approved as additional and are  therefore eligible for CDM credits. Such a list could include projects that  use specific technologies or are located in a particular geographic area.  Projects that fall outside this list would then be subject to added scrutiny  or excluded altogether. As with sectoral approaches, positive lists remove  the need for in-depth, project-specific determination of additionality,  reducing the risk and administrative burden of project approval. However,  in the past it has proven difficult to negotiate the exact types of projects or  methodologies that would constitute such a list.
section_title: Mandatory Caps
paragraphs: Several experts suggested a transition from CDM to mandatory emissions  caps, particularly for countries with significant and growing contributions  to global emissions. This approach would help distribute costs and control  environmental outcomes, although many consider it to be an unrealistic  expectation, especially in the short term. Emissions from industrialized  nations have represented the vast majority of emissions to date, and  developing nations may be unlikely to participate in agreements that  significantly hinder their economic growth. One expert suggested that  allotting generous caps to developing nations may help encourage their  participation.
section_title: Discounting Credits
paragraphs: Due to the inherent problems in determining additionality, a few experts  recommended discounting credits received through CDM projects. For  example, with a discount rate of 30 percent, a project that is expected to  reduce carbon dioxide by 100 metric tons would only receive 70 credits.  While discounting may not help screen out nonadditional projects, it can  help mitigate the environmental consequences of nonadditional credits.  Some researchers have suggested using per capita emissions or income in  host countries as a way to determine the level of discounts; others  recommend discounting projects where environmental benefits are less  certain. However, discounting may reduce the chance that additional  projects, which rely on CER revenue to succeed, will be viable through the  CDM.
section_title: Phasing Out Offsets
paragraphs: A few experts recommended avoiding the use of offsets altogether.  According to them, offsets are a flawed method of achieving  environmental and economic goals. A number of experts preferred the  economic and environmental certainty of a firm emissions cap.
section_title: CDM Experience Offers Key Lessons Learned about Program Design and Implementation
paragraphs: The design of offset programs such as the CDM, and their use in  compliance programs, can have important economic and environmental  implications. In theory, an effective offset program reduces compliance  costs but maintains overall environmental integrity; in practice, however,  the CDM experience shows that this is a difficult goal to achieve. Using  available information, stakeholder interviews, and our experts’ responses  to the questionnaire, we have identified lessons learned to help inform  congressional deliberations on climate change legislation and the use of  offset programs. The lessons outlined below focus on three essential  areas—the cost-effectiveness of CDM projects, their environmental  effects, and the tradeoffs involved in incorporating either the existing  CDM program or an improved version into future U.S. climate change  mitigation programs.
subsections: section_title: Cost-Effectiveness
paragraphs: The experience of the CDM has provided a number of lessons about the  costs and economic efficiency of offset programs. One of the most obvious  benefits of such programs is that they can help decrease the cost of  complying with emissions targets. However, this also may be a  disadvantage, if the price of carbon does not reach levels high enough to  promote fundamental technological changes needed to mitigate climate  change. In addition, emission reductions achieved through the CDM may  not always be cost-effective, especially in the case of industrial gases such  as HFC-23. Because the cost to implement these projects is a fraction of  the projects’ overall credit value, several researchers have concluded that  it would be more efficient to fund these types of projects through more  direct means.
Moreover, the current project-by-project approval process imposes  extensive time and resource requirements on CDM participants, and the  associated transaction costs may further diminish the overall cost- effectiveness of the program, according to many of our experts. There is a  fundamental tension between minimizing costs and maximizing the quality  of offset projects, and our analysis suggests that the CDM is not reliably  effective in either area. Some stakeholders and experts said that high  transaction costs weed out the very projects that would benefit most from  CDM revenue—high-cost projects that involve fundamental technology  changes. In addition, one expert told us that the cost and risk associated  with navigating the CDM process diverts much of the proceeds from  selling CDM credits to project financers and verifiers in the developed  world. These concerns highlight the importance of considering the cost- effectiveness of achieved emission reductions in addition to the ability of  offsets to lower compliance costs.
section_title: Environmental Effects
paragraphs: A key requirement of offset programs is that issued credits represent real  and additional emission reductions. If this condition is not fulfilled, the use  of offset credits in mandatory emission reduction programs can  undermine the environmental integrity of efforts to meet emissions  targets. In theory, if all offsets were real and additional, the use of these  offsets in a mandatory emissions scheme simply shifts the location of the  emission reductions and would not negatively affect the scheme’s  integrity. However, as many experts mentioned, it is nearly impossible to  demonstrate project additionality with certainty. Researchers have  reported that some portion of projects registered under the CDM have not  been additional, and although there is little empirical evidence to support  a precise figure, some studies have concluded that a substantial number of  nonadditional projects have received credits. As previously indicated, a  significant number of nonadditional projects can introduce uncertainty  about the level of reductions or even compromise the environmental  integrity of a program—such as a cap-and-trade scheme—that enables the  use of offset credits. For example, if CDM credits can be used in on a 1:1  ratio, and not all CDM credits are additional, then emission reductions  may be less than the scheme intends.
The CDM’s oversight board has taken a number of actions to help improve  the process over time, but many experts maintained that the program does  not yet provide a sufficient level of quality assurance. Moreover, the  intensive project-by-project review process used by the CDM significantly  limits the number of projects and the overall scale of the program, making  it unlikely that the CDM, as currently structured, will achieve large-scale  reductions. While the design features of an offset program such as the  CDM can be fine-tuned to help maximize their effectiveness, the  underlying challenges of determining additionality, for example, may not  be eliminated completely.
Some research has advocated limiting the use of offsets in compliance  schemes as a way to reduce the environmental risk of nonadditional  projects; however, our research shows that even restricted offset use can  have broad environmental implications. In particular, the experience of  the ETS illustrates the importance of considering offset limits in the  context of a country’s overall reduction effort, in addition to its overall  emissions target. As noted previously, limiting offsets based on the overall  emissions cap—for example, allowing countries to meet 12 percent of  their emissions cap with offsets—may mean in practice that most or all  reductions occur outside of that country’s borders. If most reductions  occur elsewhere, there may be little incentive for entities under the  compliance program to make infrastructure changes or other  technological investments. Furthermore, the negative environmental  effects of nonadditional offsets increase as the number of imported credits  rises. On the other hand, stringent limits can ensure that a certain portion  of abatement activity occurs at home and help secure a carbon price that  is high enough to spur investment in low-carbon technologies; limits also  can lessen the impact of nonadditional credits. If limits are imposed,  therefore, it is important that such limits are sufficiently stringent and are  based on actual expected emission reductions, not the overall emissions  cap.
section_title: Tradeoffs and Potential Improvements
paragraphs: There is general consensus among climate change experts that both  industrialized and developing countries must be engaged in emission  reduction efforts to meet goals established by the UNFCCC. In light of  these circumstances, several experts we consulted noted that international  offset programs such as the CDM can help to engage developing nations  and encourage emission reductions in areas that may not otherwise have  incentives to do so. In fact, because the CDM provides one of few such  incentives, some experts expressed concerns about eliminating the  program without a practical alternative to take its place. Further, several  experts said that the CDM helps stimulate interest in international climate  change dialogue and may help facilitate progress toward future emission  reduction commitments.
However, using the CDM to engage developing countries and promote  emission reductions also can present tradeoffs. While the CDM may  encourage these countries to participate in emission reduction activities, it  also may increase their reliance on external funding for such activities.  According to several experts, in fact, the CDM effectively deters efforts  that fall outside the scope of creditable activities. Moreover, as many of  our experts pointed out, the concept of additionality presents a difficult  regulatory problem. Rigorous project reviews may help ensure some  degree of credit quality, but also can increase the overall cost of the  program. Overall, many experts suggested that the CDM has not yet  achieved an effective balance of these priorities.
Given these tradeoffs, many experts provided recommendations to help  improve the program. These recommendations, discussed previously,  ranged from small adjustments in the CDM’s approach to more  fundamental shifts in the approval and crediting process. Important  themes underlying these recommendations included a need to improve the  environmental integrity of projects, to simplify the project approval  process by moving away from the project-by-project approach, and to  promote certain types of projects, such as those in which emission  reductions are easily measured or that confer substantial sustainable  development benefits. Most experts recommended a combination of  approaches between and within countries, because the ideal mix of tools  for transition economy countries is unlikely to be suitable for small and  less-developed countries. Such reforms have the potential to increase the  CDM’s value as a cost-containment mechanism and its ability to make  meaningful contributions to environmental goals.
However, while improvements to the CDM may help to streamline the  program and address quality concerns, offsets may be a temporary  solution at best, according to several of our experts. According to some  observers, the best approach may be to gradually incorporate developing  nations under a global emission reduction plan or move toward full- fledged, worldwide emission trading, given that emissions caps provide  greater environmental certainty than offset credits. However, political and  institutional capacity may make this an unlikely possibility. As a result, the  CDM may be best used as a transition tool to help developing nations  move toward a more comprehensive climate change strategy.
section_title: Concluding Observations
paragraphs: Understanding the lessons learned from the international experience with  the ETS and the CDM provides the U.S. Congress with an opportunity to  draw on this experience as it considers legislation intended to limit  emissions of greenhouse gases. While the ETS and the CDM are the largest  existing international programs to address climate change, they are very  different programs with unique strengths and limitations. Nonetheless,  both programs provide insights into important program design and  implementation issues that are central to the climate change policy  proposals currently under consideration in the United States. Specifically,  the lessons learned from the ETS—the importance of reliable data on  emissions, the need for long-term certainty, and the impact of allowance  allocation on wealth transfers—relate directly to the development of a  domestic cap-and-trade system, which has already been considered on the  floor of the U.S. Senate. Similarly, considering the lessons learned from  the CDM—that it may be possible to achieve the CDM’s goals more cost- effectively through other means, that carbon offsets are inherently  uncertain and can potentially undermine the integrity of a cap-and-trade  scheme, and that potential reforms, while promising, may not address  fundamental tradeoffs—may prove useful in informing congressional  deliberations over the use of CDM credits or other types of carbon offsets  in domestic climate change programs.
section_title: Matters for Congressional Consideration
paragraphs: In deliberating legislation intended to limit greenhouse gas emissions that  would employ a cap-and-trade system or allow the use of carbon offset  programs such as the Clean Development Mechanism, Congress may wish  to consider the lessons identified above to help ensure that it develops  policies that achieve the intended results in a cost-effective manner.
Specific lessons from the ETS that the Congress may wish to consider  include: (1) the importance of ensuring the availability and reliability of  historic emissions data, with an accuracy compatible with the program’s  point of regulation, from entities that will be affected by the regulatory  scheme prior to its establishment; (2) the importance of long-term  certainty in encouraging investments in low-carbon technologies; and (3)  the importance of understanding how the means of distributing  allowances to emit greenhouse gases—such as free allocation versus  auctioning—may create and redistribute substantial wealth.
Specific lessons from the CDM that the Congress may wish to consider  include: (1) that it may be possible to achieve the CDM’s sustainable  development goals and emissions cuts in developing countries more  directly and cost-effectively through a means other than the existing  mechanism; (2) that the use of carbon offsets in a cap-and-trade system  can undermine the system’s integrity, given that it is not possible to ensure  that every credit represents a real, measurable, and long-term reduction in  emissions; and (3) that while proposed reforms may significantly improve  the CDM’s effectiveness, carbon offsets involve fundamental tradeoffs and  may not be a reliable long-term approach to climate change mitigation.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to other interested parties. In  addition, the report will be available at no charge on the GAO Web site at  http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  me at (202) 512-3841 or stephensonj@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on the  last page of this report. GAO staff who made major contributions to this  report are listed in appendix IV.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: To address the two objectives, we employed a two-step methodology. In  the first step, we identified program effects through a review of available  data and literature and conducted a series of semi-structured interviews  with Emissions Trading Scheme (ETS) and Clean Development  Mechanism (CDM) stakeholders to better understand program  implementation. Specifically, we (1) reviewed relevant emissions trading  literature, including academic reports, legal documents, and economic  assessments; (2) obtained empirical evidence from the economic literature  and available data sources, determined the data were sufficiently reliable  for this report, and analyzed the data to identify impacts on emission  reductions, technology innovation, competitiveness, and sustainable  development; (3) met with U.S. and international stakeholders including  government officials from the European Commission, the Designated  National Authority of India, China’s CDM Fund, the Kyoto Protocol’s CDM  Executive Board, and the U.S. Department of State, as well as  representatives from industry groups, environmental groups, market  traders, researchers, and other participants in the CDM (project owners,  developers, and auditors); (4) considered the U.S. administration’s  perspective on the ETS and the CDM by meeting with the Council on  Environmental Quality; and (5) conducted a site visit to a CDM offset  project in China. We selected stakeholders that had significant levels of  expertise in the ETS and CDM programs, including some stakeholders  with direct involvement in the implementation of these programs. The  CDM project we visited was selected based on interviews with project  developers, who also coordinated our visit to the project. The project,  which utilized waste gas from an iron and steel plant to generate  electricity, was fairly representative of a typical CDM venture in terms of  its location, size, and emission reduction methodology.
For the second step, we obtained expert opinion on the implications and  lessons learned for U.S. policymaking using a virtual panel on the Internet.  To gather expert opinions from the experts, we employed a Web-based  questionnaire that was developed based on the results of the data  collection efforts in the first phase. By using a Web-based process, we  were able to overcome some of the potential biases associated with group  discussions. These biasing effects include the potential dominance of  individuals and group pressure for conformity. Moreover, by creating a  virtual panel, we were able to include more experts than would have been  possible with a live panel. While the method has these strengths, there are  some potential limitations. For example, there is considerable reliance on  the experts completing the questionnaire, as some may complete only  limited sections, or not respond at all. In addition, the results of the  questionnaire are limited to the issues and topics generated by our initial  data collection efforts. To mitigate the latter limitation, we added  generalized open-ended questions that provided an opportunity for experts  to comment on topics not directly addressed by the questions. Lastly,  because this was not a sample questionnaire, it has no sampling errors.  However, the practical difficulties of conducting any questionnaire may  introduce errors, commonly referred to as nonsampling errors. For  example, difficulties in interpreting a particular question, sources of  information available to respondents, or entering data into a database or  analyzing them can introduce unwanted variability into the results. We  took steps in developing the questionnaire, collecting the data, and  analyzing them to minimize such nonsampling errors.
We contracted with the National Academy of Sciences (NAS) to select and  recruit a panel of experts with a range of experience in both market-based  climate change programs and U.S. policymaking. Participants were to have  (1) expertise in market-based tools used to address environmental  problems, both in the United States and abroad; (2) familiarity with  potential distributional effects of an emissions trading policy, for example,  distribution of costs across different industries; (3) expertise in evaluating  the performance of policies as well as knowledge of climate change  agreements, politics, and policies, both at the international level and in the  United States; and (4) an understanding of the implementation of U.S.  environmental policies. To select the experts, we provided NAS with a list  of potential experts that we identified in our review of the literature. In  collaboration with NAS, 31 experts who met our criteria were identified.  NAS sent these individuals an electronic letter via e-mail inviting them to  participate in the study along with a description of the project. Of the 31  experts NAS recruited to participate, 29 agreed and were sent the  questionnaire. Twenty-six ultimately completed the questionnaire. All of  the experts who participated completed a form stating that they had no  conflicts of interest that would compromise their ability to participate in  the questionnaire.
Prior to the posting of the questionnaires, we conducted pretests with two  panel participants. The goals of the pretests were to check that (1) the  questions were clear and unambiguous and (2) terminology was used  correctly. We made changes to the content and format of both  questionnaires as necessary during the pretesting processes. We also  conducted usability tests of both questionnaires for the Internet to ensure  operability. The final version of the questionnaire was posted on the  Internet, and experts were notified of the availability of the questionnaire  with an e-mail message. The e-mail message contained a unique user name  and password that allowed each respondent to log on and fill out a  questionnaire but did not allow respondents access to the questionnaires  of others.
In the questionnaire, we asked experts to provide responses to 17 closed-  and open-ended questions on the effects of the European Union ETS and  CDM, and implications for U.S. policymaking. In particular, we asked  experts to comment on: effects of the ETS, such as abatement and  competitiveness; extent to which particular design elements, such as  methods to distribute allowances, influenced ETS results; effects of the  CDM, such as on emissions, sustainable development, and technology  transfer; and implications of lessons learned for design and  implementation of U.S. program to reduce greenhouse gas emissions.
Experts had approximately 4 weeks between August 2008 and September  2008 to complete their questionnaires. We followed up by email and phone  to those who had not responded by our initial deadline of August 27, 2008.  In some cases, we also asked several follow-up questions requesting that  experts clarify their responses or elaborate on critical policy issues. In  order to analyze the open-ended questions, we performed a content  analysis of each expert’s response and grouped these responses into  overall themes. GAO provided a summary of the findings of this report and  briefed representatives from the European Commission and the CDM  Executive Board prior to issuing this report. The views expressed by the  panel members do not necessarily represent the views of GAO.
We conducted our work from October 2007 to November 2008.
section_title: Appendix II: Summary of Joint Implementation
paragraphs: Joint Implementation (JI) is the third market-based mechanism  established by the Kyoto Protocol to assist industrialized countries in  meeting their emissions targets under the Protocol. JI allows countries  with binding targets under the Protocol to generate credits, called  Emission Reduction Units (ERU), by implementing projects that reduce  emissions in other countries that have binding Kyoto targets. For example,  a company in Finland could earn credits by developing a low-emission  power plant in Russia and use these credits to comply with its ETS cap. JI  projects are most likely to take place in eastern European economies in  transition, where there are opportunities for emission reductions at lower  cost than in other countries with binding Kyoto targets. JI projects, like  CDM projects, must be verified for additionality before they are approved  and ERUs can be issued. Project verification can take two possible  courses: review by the host country if the country satisfies certain  eligibility requirements, known as Track I, or review by the JI Supervisory  Council, known as Track II. While the processes of each host country’s  Track I procedure can differ from the process of Track II, the issuance of  ERUs in both cases is the responsibility of the country hosting the project.
The JI market is significantly smaller and less mature than the CDM  market and to date, no ERUs have been issued. As of October 2008, the  volume of credits being verified under JI—i.e. in the pipeline—is  approximately 11 percent of the volume of credits in the CDM pipeline.  Under JI, a total of 158 Track II projects and seventeen Track I projects  have been submitted in thirteen different host countries.
The JI market is smaller than the CDM market in part because it was  implemented at a slower rate and covers a shorter time span. For example,  the JI Supervisory Council was established in 2006, 5 years after the  establishment of the CDM Executive Board. Moreover, CDM projects may  receive credit for certain emission reductions occurring since January 1,  2000, whereas JI projects may only receive credits for emission reductions  occurring since beginning of the Kyoto commitment period, January 1,  2008. The time and resources required to develop host country procedures  for JI as well as uncertainty over the role of ERUs in a potential future  climate agreement, have limited its impact to date. Although market  analysts anticipate the verification of additional JI projects and ultimately  the future issuance of ERUs, the outlook for the JI market is thus unclear.
section_title: Appendix III: Panel of Experts
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Michael Hix, Assistant Director;  Kate Cardamone; Cindy Gilbert; Jessica Lemke; Alison O’Neill; Jeanette  Soares; and Ardith A. Spence made major contributions to this report.  JoAnna Berry, Jason Burwen, Richard Johnson, Susan Offutt, and  Katherine Raheb also made important contributions.