Only a quick glance at data from the CDM market reveals that offset prices (per ton of CO2‐e) achieved by project hosts have varied a lot across both projects and host countries, and have often (or even typically) been substantially below the respective (policy bloc‐internal) quota prices. Several reasons exist why we could observe offset prices well below quota prices. First, the buyer often contributes expertise, or even perhaps project finance, in implementing the investments necessary for a successful CDM project, and thus in practice provides capital to the host, and where the return for the buyer can be reaped (in part) through a lower offset price. Secondly, uncertainty related to eventual delivery of CERs from CDM projects (or similarly, Emission Reduction Units – ERUs – from JI projects) at project start‐up can lead to highly variable offset prices, even for actually delivered CERs.

Still, the situation in the CDM market strongly indicates the possibility that bargaining between project hosts and buyers is widespread. Implications could then differ from those under standard, friction‐less market conditions largely dealt with above. A substantial share of the bargaining surplus is then likely to go to offset demanders in the policy bloc. If this is the case, the CDM conveys additional benefits upon the policy bloc when compared to those accounted for above (from the cited papers).

Such situations, with project search and bargaining, leads to a more complicated picture around CDM‐ type mechanisms, as compared to my discussion above. I will in this section discuss some of these complications and changes in market function. It is, in particular, not entirely clear whether such bargaining can lead to a separate justification for “net mitigation”: I will here argue that it does not.

At a general level, such bargaining leads to rent sharing between individual buyers (firms in policy‐bloc countries) and sellers (project hosts in fringe countries). This will generally result in project hosts being paid lower prices for offsets than the quota price in the primary market; but at the same time generally higher offset prices than production costs so that hosts operate with a positive net profit, in total, and often also at the margin.

The literature has only a few examples of work where bargaining in the CDM market is modeled analytically. We will here discuss two key such papers, by Liski and Virrankoski (2004) (LV),<sup>11</sup> and Bréchet, Ménière and Picard (2012) (hereafter BNP); starting with the latter paper.

BNP’s presentation is simplest to present. They consider a framework with alternative relative “bargaining strengths” for the host and buyer, respectively, in the context of a partial‐equilibrium model with no limitation on offset host supply, for a given offset price offered to hosts. This means that the fringe is assumed to be “large” relative to the policy bloc, which is clearly a general feature of the CDM to date (at least in a notional sense: in terms of the potential total supply of CDM projects from the entire fringe). They assume that the sharing of the bargaining surplus, between host and buyer, is governed by a “bargaining parameter” for the sharing of the bargaining surplus. Their main approach is to argue that higher bargaining shares going to offset hosts (offset buyers) leads to a less (more) beneficial offsetting solution for offset buyers. This in turn leads to a lower (higher) optimal mitigation ambition for the policy bloc, and thus to a less tight cap.

The approach of LV is different, and builds on matching models developed for the labor market mainly by Mortensen and Pissarides (see Pissarides (2000), Mortensen and Wright (2002)). LV explicitly assume search frictions in offset markets, with resulting costs, which take two forms: a) search and

> 11 See also Liski (2001) for a similar model.

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