the next commitment period with so-called permanent credits (for example AAUs or CERs from nonLULUCF projects). The same restriction does not apply to the use of lCERs; however if the accumulated stocks of stored carbon from a projects for which lCERs have been issued declines during the five-year certifications, Annex-B countries must replace a proportional share of the lCERs that they used. If a project fails to submit a certification report, all lCERs issued to the project must be replaced.

# <u>Consequences for pricing and profitability</u>

Built to redress weaknesses related to business-as-usual counterfactuals, features of the project cycles also influence a set of transaction costs that vary among types of projects. Because of this, the overall cost of operating a project can be high even when abatement costs are themselves low. This is the case for agricultural land-use projects, where the design of the CDM, the complex biochemistry of soil carbon sequestration and the frequent need to coordinate the activities of many land-users combine to inflate transactions costs. Moreover, many transaction costs are fixed and this works against small-scale projects in general, and smallholder and community-based projects in particular (Michaelowa et al., 2003; Skutsch, 2005).

Drawing on Dudek and Wiener (1996) and Cacho, Marshall and Milne (2005), Cahco and Lipper (2007) provide a topology of transaction costs for soil sequestration projects based on five categories: i) search and negotiation; ii) board approval; iii) project management; iv) monitoring and v) enforcement and insurance. Using this framework, the authors draw on published project reports for smallholder reforestation and afforestation projects to calculate project transaction costs by category. They find disparate results with wide differences among projects across all categories. They report search and negotiation costs ranging from US$22,000 to $160,000; and approval costs from $12,000 to $120,000. Differences in monitoring costs were remarkable, ranging from $5,000 to $270,000.<sup>43</sup> As discussed, the formal rules associated with implementing projects also work to limit demand. For example, in the case of CDM projects, limits on how CERs can be used under the EU ETS prevent full arbitrage between the markets and consequently CDM credits trade at a discount to their European counter-parts.<sup>44</sup> The restriction spills into formal markets for price discovery and risk management as well; for example, CERs originating from land-use projects are excluded from the European Climate Exchange. Rules that exclude projects from the CDM also shift some projects to voluntary markets where credits trade at a steep discount to credits traded under the European Union ETS (EU ETS) or the CDM. For example while all carbon prices fell dramatically in 2008 as global economic conditions worsened, spot prices for CDM offsets still remained above US$15 tCO2e for most of 2009. By comparison, the World Bank (2010a) estimates that the price for voluntary credits averaged less than US$5 per ton.

In addition, market sentiment disfavoring land-use projects appears to extend beyond the effects of the formal rules. Outside of the CDM, this is revealed in the voluntary markets where offsets from land-use projects sell at a discount to other types of mitigation projects. In their review, Hamilton et al. (2010) noted that all of the over-the-counter agricultural soil credits they tracked originated on the Chicago Climate Exchange and, in line with that market, traded for an average price of US$1.20 per ton; forest carbon offsets sold for just under US$3 per ton and afforestation and reforestation credits sold for just over US$4 per ton, on average.<sup>45</sup>

> 43 The authors found that enforcement and insurance costs were largely unreported.

> 44 For example, the EUA-CER price spread ranged between 2-3 Euros during the first 9 months of 2010. (CDM Climate Reserach, 2010)

> 45 As global economies slowed along with prospects for a US cap-and-trade, prices collapsed further and the Chicago Climate Exchange closed its doors in 2010.

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