Carte CDM and Law PDF

L Lakshmi holds an LL.M and M.A (Pub. Admn.
,) from Osmania University

and a Postgraduate Diploma in Business Administration from AP Productivity
Council. She is currently working as Consulting Editor at Amicus Books, an
imprint of Icfai University Press. She is also the Consulting Editor, Icfai Journal
of Environmental Law, a quarterly journal published by Icfai University Press.
Prior to joining Amicus Books she was a practicing lawyer for five years. Her
areas of interest are environmental law, labour laws, and administrative law.
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Clean Development
Mechanism and Law
Edited by
L Lakshmi
Amicus Books
The Icfai University Press
Clean Development Mechanism and Law

Editor: L Lakshmi
2008-09 The Icfai University Press. All rights reserved.
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Contents
Overview
1. Enlisting Carbondioxide Capture and Storage as a Clean

Development Mechanism Project: Legal and Regulatory
Issues Considered
Olawuyi Damilola Sunday
2. Flexible Mechanisms for Climate Change Compliance:

Emission Offset Purchases under the Clean Development
Mechanism
29
Christopher Carr and Flavia Rosembuj
3. Linking the EU Emissions Trading Scheme to JI, CDM and

Post-2012 International Offsets
49
J. de Spibus
4. Links between European Emissions Trading and CDM

Credits for Renewable Energy and Energy Efficiency
Projects
85
David M. Driesen
5. Linking Community Forestry Projects in India with

International Carbon Markets: Opportunities and
Constraints
105
Rohit Jindal and Shailesh Nagar
6. The Commerce Clause Meets Environmental Protection:

The Compensatory Tax Doctrine as a Defense of Potential
Regional Carbon Dioxide Regulation
Heddy Bolster
126
7. Balancing Cost and Emissions Certainty: An Allowance

Reserve for Cap-and-Trade
168
Brian C. Murray, Richard G. Newell and William A. Pizer
8. Greenhouse Gas Emissions Charges and Credits on

Agricultural Land: What can a Model Tell Us?
198
Joanna Hendy, Suzi Kerr and Troy Baisden
List of Cases
210
Index
211
Overview
Due to massive industrialization the planet Earth had been witnessing a
tremendous development in all spheres of human activities. In consequence,
there is increase in huge quantities of atmospheric concentrations of carbon
dioxide, methane, and nitrous oxide in the atmosphere. This in turn has
been found to be escalating the temperature of Earth resulting in global
warming and climate change. The concern for the health of the individuals
made the States realize the likely adverse effects of global climate change on
human health that led them to propose for mitigating the GHGs by
entering the United Nations Framework Convention on Climate Change
(UNFCCC). The efforts further led to Kyoto Protocol in 1997, which
advocated for framing and implementation of flexible mechanisms enabling
the industrialized countries to pursue their goals of GHG reduction by
purchasing GHG emissions.
The Kyoto Protocol provided for three mechanisms that enabled developed
countries to acquire greenhouse gas reduction credits. These mechanisms
II
include- Joint Implementation (JI) wherein a developed country with

relatively high costs of domestic greenhouse reduction could set up a project
in another developed country. Whereas, under the Clean Development
Mechanism (CDM) a developed country could sponsor a greenhouse gas
reduction project in a developing country where the cost of greenhouse gas
reduction project activities is usually much lower, but the atmospheric effect
is globally equivalent. The developed country would be given credits for
meeting its emission reduction targets, while the developing country would
receive the capital investment and clean technology or beneficial change in
land use. Finally under International Emission Trading (IET) the countries
can trade in the international carbon credit market to cover their shortfall in
allowances. Countries with surplus credits can sell them to countries with
capped emission commitments under the Kyoto Protocol. These carbon
projects can be created by a national government or by an operator within
the country.
The Clean Development Mechanism (CDM) a market based concept
developed under Article 12 of the Kyoto Protocol was intended to allow
industrialized countries -Annex B countries with a greenhouse gas reduction
commitment to invest in projects that would reduce emissions in developing
countries as an alternative to more expensive emission reductions in their
respective countries. The members further intended to assist developing
countries in achieving sustainable development, while contributing to
stabilization of greenhouse gas concentrations in the atmosphere. It is
supervised by the CDM Executive Board (CDM EB) under the guidance of
the Conference of the Parties (COP) of the United Nations Framework
Convention on Climate Change (UNFCCC).
An industrialized country that wishes to get credits from a CDM project
must obtain the consent of the developing country hosting the project that
the project will contribute to sustainable development. Then, using
III
methodologies approved by the CDM Executive Board (EB), the applicant the industrialised country must establish a baseline estimating the future
emissions. Then it is validated by a third party agency, called a Designated
Operational Entity (DOE), to ensure the project results in real, measurable,
and long-term emission reductions. The EB then decides whether or not to
register the project. If a project is registered and implemented, the EB issues
credits, called Certified Emission Reductions (CERs), known as carbon
credits, where each unit is equivalent to the reduction of one metric tonne
of carbon dioxide. Any proposed CDM project has to use an approved
baseline and monitoring methodology to be validated, approved and
registered. Baseline Methodology will set steps to determine the baseline
within certain applicability conditions whilst monitoring methodology will
set specific steps to determine monitoring parameters, quality assurance, and
equipment to be used, in order to obtain datas to calculate the emission
reductions. With costs of emission reduction typically much lower in
developing countries than in industrialised countries, industrialised
countries can comply with their emission reduction targets at much lower
cost by receiving credits for emissions reduced in developing countries as
long as administration costs are low.
However, the concern is with regards to inclusion of forests in CDM
schemes as they have been excluded from CDM. There is so far no
international agreement about whether projects avoiding deforestation or
conserving forests should be initiated through separate policies and measures
or stimulated through the carbon market. One major concern is the
enormous monitoring effort needed in order to make sure projects are
indeed leading to increased carbon storage. In response to concerns of
unsustainable projects or spurious credits, the World Wide Fund for Nature
and other NGOs devised a Gold Standard methodology to certify projects
that use much stricter criteria than required, such as allowing only
renewable energy projects.
IV
India being a party to the United Nations Framework Convention on

Climate Change (UNFCCC) is one of the forerunners of CDM projects.
Indias CDM potential represents a significant component of the global
CDM market. Presently The National CDM Authority (NCDMA) in India
has accorded Host Country Approval to projects in various sectors covering
energy efficiency, fuel switching, industrial process, municipal solid waste
and renewable energy.
This book would cover the various issues related to framing, functioning of
CDM schemes and machinery for effective reduction of carbon dioxide
emissions post Kyoto. It would enumerate the regulatory schemes and
machinery constituted by the developed countries like in mitigating
emissions. The comparative analysis of various successfully implemented
schemes across the globe especially in US, UK, EU, and Australia would
serve as an exemplary model to the developing countries.
In Enlisting Carbondioxide Capture and Storage as a Clean Development
Mechanism Project: Legal and Regulatory Issues Considered the author
Olawuyi Damilola Sunday identifies that the global concern for the adverse
effects of climate change on human health have culminated in United
Nations Framework Convention on Climate Change (UNFCCC) and
Kyoto Protocol. Kyoto Protocol recognized the Clean Development
Mechanism (CDM) Project as an incentive for governments and companies
in industrialized countries to invest in Green House Gases, and an aid in
promoting sustainable development in the countries hosting the projects.
The only drawback with these projects is that they do not have an answer
for the operational and application issues related to Carbon dioxide Capture
and Storage (CCS) technology involved in a CDM project. The author
identifies inadequate regulatory mechanisms that require to be filled at
various stages of CCS and therefore advocates for development of a
comprehensive global legal framework that would address the Carbon
dioxide Capture and Storage (CCS) technology issues concerning project

operation, remediation, assessment of project boundaries, fixing liability or
accounting for leakage and permanence, monitoring, validation and verification.
In Flexible Mechanisms for Climate Change Compliance: Emission
Offset Purchases under the Clean Development Mechanism the
authors Christopher Carr and Flavia Rosembuj states that carbon credits
have witnessed tremendous growth in international market since 2005 due
to their flexible approach. The international carbon markets are especially
flourishing with two market-based tools one cap and trade, second emission
offsets or project based program. In cap and trade program the emissions are
capped at a certain level by the regulatory authorities. The regulated entities
in turn are allocated allowances to emit a certain amount of Greenhouse
Gases (GHGs). The entities subsequently are allowed to trade in with their
allowances to meet their compliance obligations. In emission offset, or
project based programs like CDM, the credits are generated from projects
that reduce GHG emissions below a certain baseline that is beyond the
regulated cap. Subsequently these credits are sold to entities that can use
them to meet regulatory compliance obligations within the scope of a cap.
The regulatory costs of getting a project and its methodology approved by
the CDM Executive Board, and the cost of implementing the project are
perfectly drafted and executed. The authors finally suggest that regulatory
infrastructure constituted for CDM projects can be considered as a model
for other national and international programs related to climate change.
Prof. J. de Spibus in his article Linking the EU Emissions Trading
Scheme to JI, CDM and Post-2012 International Offsets comments on
the Linking-Directive by European Union Emissions Trading Scheme (EU
ETS). He finds that the Linking directive though did not impose any limit
on the import of JI/CDM credits yet it required the Member States to set
maximum quantity of Kyoto units. The directive was found to be one of
the causes for collapse of prices in the Emission markets in EU. Realizing
VI
this EU ETS decided to impose strict limits on the use of JI/CDM credits
during the second trading period beginning from 2006. The author intends
to examine the International and European legal framework to find a better
utilization of JI/CDM credits in post-2012 international offsets. Based on
his examination of commissions proposal on the third trading period of the
EU ETS and the related reports the author suggests for introduction of
quantitative and qualitative restrictions for the use of international offsets
within the EU ETS. The author finds that the European view on the
appropriateness of linking the EU ETS with the international project
mechanisms has changed over the years. The efforts of EU ETS were timely
supported by the proposals made by the Environmental Committee of the
European Parliament on the ETS in the Council.
In Links between European Emissions Trading and CDM Credits for
Renewable Energy and Energy Efficiency Projects the author David M.
Driesen critically examines the relationship between the Kyoto mechanisms
and sustainable development. He finds that the short term cost effectiveness
that emission trading fosters does not correspond with the long-term goals
set by the climate change treaty and the principles of sustainable
development. He suggests that European Union can increase demand for
CDM credits by adopting stringent regulations in the trading sector.
However such approach may create pressure to expand the use of cheap
CDM credits. In order to achieve sustainable development the author
suggests the European Union and other nations currently in compliance
with Kyoto targets must take meaningful steps toward sustainable
development, to acquire increased credibility. The developing countries in
turn would recognize the stand of the developed nations and come forward
and express their willingness to make commitments.
Linking Community Forestry Projects in India with International
Carbon Markets: Opportunities and Constraints the authors Rohit
Jindal and Shailesh Nagar identify that prior to Kyoto; community forestry
VII
projects in India were implemented to strengthen rural livelihoods. In Post

Kyoto however there has been tremendous rise in expectations for selling
carbon sequestered from various Indian projects in international markets.
The authors study the forest projects taken up at Seva Mandir and
Foundation for Ecological Security (FES) and their tie up with Chicago
Climate Exchange (CCX), the single largest market that receives
sequestration credits from forest projects. They find that the Seva Mandir
and FES have the potential to sell carbon sequestration credits on the CCX
and generate incomes for their local communities. The authors suggest
other NGOs planning to take up such projects to establish relationship
with CCX by making simple payment arrangements on small contiguous
sites that are easy to monitor and administer. They hint that these small
performance-based payments will ensure the local communities with longterm stake in conserving the plantations, and provide economic incentives
for conserving forests and other valuable natural resources.
In The Commerce Clause Meets Environmental Protection: The
Compensatory Tax Doctrine as a Defense of Potential Regional
Carbon Dioxide Regulation the author Heddy Bolster discusses the issues
raised during implementation of the Regional Greenhouse Gas Initiative
(RGGI) to reduce greenhouse gas pollution from power plants, and the
report submitted by the Californias Environmental Protection Agency on
the emissions trading program in the state. Both the RGGI agreement and
the California report, identify leakage of emissions as a major hurdle in
implementation process. The author identifies that leakage of emissions
from regulated to unregulated regions is usually taken up by the regulated
entities in order to avoid caps on emissions. The same strategy is being
applied by the Electricity suppliers when they import power from outside
the regulated region. In consequence there is no or minimal decrease in
emissions from power plants. The author finds that the States covered under
RGGI, and California are successful in controlling emissions associated with
VIII
energy imported into their regions. Yet such limitations are found to be
effecting the interstate imports under the Interstate Commerce Clause of
the US Constitution. The author therefore intends to explore the possibility
of applying the principles of compensatory tax doctrine to prevent leakage.
The doctrine states that even if a state regulation imposes a burden on
interstate commerce, it may survive constitutional scrutiny if it is designed
to make interstate commerce bear the burden.
In Balancing Cost and Emissions Certainty: An Allowance Reserve for
Cap-and-Trade the authors Brian C. Murray, Richard G. Newell and
William A. Pizer present the scope, advantages, limitations and the legal
regimes for using carbon tax, cap-and-trade systems to control emissions.
They find cap-and-trade system as a system that fixes the quantity of
emissions allowed, but its market price remains uncertain. Whereas, in a
carbon tax the price of emissions is fixed and the quantity of emissions
remains uncertain. Therefore, an alternative system is suggested by the
authors that is fixing a safety valve. The new system would take up a capand-trade system along with a price ceiling at which additional allowances
can be purchased. Till the allowance price remains below the safety-valve
price, this system acts like cap-and-trade. Whereas, once the safety-valve
price is reached, this system behaves like a tax. Thus the safety valve
represents a mechanism that falls between price or quantity of instrument.
The authors therefore advocate for allowance reserve which stipulates both a
ceiling price at which cost relief is provided and a maximum number of
allowances to be issued in exercising that relief. They finally suggest that an
allowance reserve and suggest for tightening the future cap, by placing an
upper limit on the available number of extra allowances.
Joanna Hendy, Suzi Kerr and Troy Baisden in their article Greenhouse
Gas Emissions Charges and Credits on Agricultural Land: What can a
Model Tell Us? examine the impact of emissions from agriculture sector.
IX
In this regard the authors make a study of the land use and emissions
implications of climate policies that provide landowners credits for
regenerating indigenous forest and scrub. The authors, team of economists
from Motu Economic and Public Policy Research, and scientists from
Landcare Research, Agresearch, Scion/Ensis, and NIWA develop LURNZclimate. LURNZ-climate is a computer model that simulates the effect of
climate change policies on rural land use in New Zealand. The study
intended to predict the land-use change across the whole country and
thereby calculate the greenhouse gas implications of land-use change.
Subsequent to this simulation study, New Zealand has been recognized to
have developed the capacity to empirically investigate the potential impacts
of policies designed to charge farmers in proportion to the amount of
methane and nitrous oxide that which is emitted by their livestock and
reward them for regenerating indigenous forest. The first simulation study
finds that agricultural emissions charge based on land use are not so effective
in reducing emissions. The second simulation showed that the inclusion of a
reward for regenerating forest and scrub without a similar reward for
plantation forestry had a negative impact and increased emissions growth.
The authors conclude by stating that a further careful empirical analysis of
potential policies has to be made by devising more tools in second phase of
LURNZ study.
1
Enlisting Carbondioxide Capture
and Storage as a Clean
Development Mechanism Project:
Legal and Regulatory Issues
Considered
Olawuyi Damilola Sunday*
The Clean Development Mechanism of the Kyoto Protocol
provides an incentive for governments and companies in
industrialized countries to invest in Green House Gases (GHG)
reductions projects in developing countries and be credited for
GHG reduction achieved through these projects, through the
issuance of Certified Emission Reductions (CERs). Carbon
dioxide Capture and Storage technology has been identified as
one of such viable projects that can be carried out by
industrialized nations for CERs as it offers high GHG mitigation
potential. Of concern, however, is the lack of a clear, defined
legal and regulatory framework which addresses some of the
technical concerns associated with the CCS technology like
leakage, permanence, boundary issues, and allocation of
*
Faculty of Law, Murray Faser Hall University of Calgary, Alberta, Canada. E-mail: dsolawuy@ucalgary.ca
2009 Icfai University Press. All Rights Reserved.
CLEAN DEVELOPMENT MECHANISM AND LAW
liabilities among others. This article shows that there is an

urgent need for a legal framework which addresses these
technical concerns, if CCS is to be enlisted as a CDM
compatible project.
Introduction
Realizing the likely adverse effects global climate change may impose on human
health, the world community came together under the United Nations
Framework Convention on Climate Change (UNFCCC) to jumpstart efforts,
aimed at addressing these concerns. These efforts led to the Kyoto Protocol of
1997 which advocates taking concrete steps and binding commitments to reduce
greenhouse gasses that contribute to global warming. At the heart of The Kyoto
Protocol lie its flexible Mechanisms which allow industrialized countries to pursue
their goals of GHG reduction by purchasing GHG emission reductions from
elsewhere, mostly from non annex I and II countries. 1 One of such mechanisms
is the Clean Development Mechanism (CDM). 2 The CDM provides an incentive
for government and companies in industrialized countries to invest in GHG
reduction projects in developing countries. The CDM also aims to promote
sustainable development in the countries hosting the projects. 3
However, the CDM rules as elaborated by The Marrakech Accords 4 do not
define in clear terms, whether the Carbon dioxide Capture and Storage (CCS)
technology will qualify as a CDM project. Though CCS is not one of the project
types originally included when the CDM was first established, previous studies
show that CCS is a promising emission reduction option with potentially
important environmental, economic and energy supply security benefit. 5 CCS is a
process consisting of the separation of carbon dioxide (CO2) from industrial and
energy related sources, transportation to a storage location and long term
isolation from the atmosphere through storage in geological formations. This
technology has the potential of reducing overall mitigation costs and increasing
flexibility in achieving greenhouse gas emission reductions worldwide. 6 CCS
could in fact yield 15% to 55% of the cumulative mitigation efforts required
worldwide up to the year 2100 (roughly 220 to 2200 GtCO2). 7 It will also be an
important element in furthering the transfer of CCS technology and expertise to
developing countries. 8
Enlisting Carbondioxide Capture and Storage as a

3
Clean Development Mechanism Project: Legal and Regulatory Issues Considered
The CCS idea has however attracted a degree of concern from scholars, 9
these concerns bother on the absence of a clearly defined legal and regulatory
framework in which CCS is to operate, the absence of global mandatory
standards or guiding principles for CO2 capture; transport; storage site selection;
injection; project operation; decommissioning; stewardship; or remediation,
assessment of project boundaries; accounting for leakage and permanence;
monitoring, validation and verification. This article is an attempt to address these
concerns and to answer the question -How could CCS projects contribute to the
general objectives of the CDM?. Similarly, most of the existing works on CCS
focus only on the technical aspects, 10 this article in contrast concentrates on legal
issues surrounding CO2 storage, with emphasis on the key legal and regulatory
issues to be addressed before CCS activities can be included in the portfolio of
climate change mitigation activities under the CDM.
This article sets out in part 1 by giving an analysis of CDM, part 2 analyses
the CCS technology, its prospects and challenges. Part 3 discusses the eligibility
of CCS projects as CDM projects under the UNFCCC and the Kyoto Protocol.
Part 4 offers recommendations on the development of a framework to address
technical concerns associated with CCS technology. This article shall argue that
there are significant benefits waiting to be exploited for mitigating global GHG
emissions through deploying CCS technology, but these may remain in the realm
of imaginations if adequate legal and regulatory frameworks are not put in place
to close all existing regulatory gaps.
1. The Clean Development Mechanism: An Overview

1.1 What is CDM?
The Kyoto Protocol, known for its efforts at tackling global climate change by
fixing emission limits to be achieved by industrialized nations by 2012, is even
more famous for providing three flexible mechanisms through which
industrialized countries can achieve their commitments. These mechanisms
enable countries to pay for emission reductions anywhere on the planet, based
on the idea that since climate change is a global problem, 11 reductions are
equally good for the climate no matter where they occur. 12 One of such flexible
mechanisms is the Clean Development Mechanism (CDM). 13
The CDM evolved from the Brazilian proposal for a Clean Development
Fund (CDF) in a meeting of the ad hoc group on the Berlin mandate in 1997 just
prior to COP-3. 14 The CDF idea was to finance adaptation measures through
penalties levied on industrialized countries not reaching their targets; to ensure
much more flexibility in achieving emission reductions and for the possibility of
international emissions trading to achieve the emission reductions where it could
be done at the least cost. At the COP-3 in Kyoto, the idea became a subject of so
much disagreements and skepticism. An apparent contradiction emerged
between the goals of emission reduction in the North and sustainable
development in the South due to the differing priorities of different countries and
regions of the world. The differing sets of priorities between developed countries
and the developing countries as they arose at Kyoto, has been roughly tabulated
as follows: 15
Industrialized Countries
Developing Countries
Emissions reduction
Sustainable development
Emissions trading and credits
Equity
DC participation
Common but differentiated responsibilities
Joint Implementation
Technology Transfer
Sinks
Financial Assistance
Compliance and Verification
Special Circumstances
Clean Environment
Poverty Reduction
After so much opposition most especially from developing countries, CDM

was eventually accepted as part of the Kyoto Protocol to serve as a balance point
to meet the yearnings of both the developed world and the developing nations. 16
The purposes of the CDM as defined under Article 12 of The Kyoto Protocol
include:
To assist non-Annex I countries in achieving sustainable development,
To assist non-Annex I countries in contributing to the ultimate objectives of

the FCCC as described in Article 2 (to stabilize GHG concentrations in the
atmosphere at a level that would prevent dangerous anthropogenic

5
interference with the climate system within a time frame sufficient to allow
ecosystems to adapt naturally to climate change, to ensure that food
production is not threatened, and to enable economic development to
proceed in a sustainable manner.
to assist Annex I countries in achieving compliance with their quantified

emissions limitation and reduction commitments under Article 3 of the
Protocol. 17
The core of the CDM is to transfer and acquire emission reductions between
developing countries and developed countries on a project basis. Developed
countries can get Certified Emission Reductions (CERs) through CDM projects
during this period. Typically, a project proponent will identify an investment that
would lead to reduced greenhouse gases in a developing country and approach
the government of the country where the investment is located in for approval. 18
The government will then decide whether the project meets its sustainable
development needs and approve it as a CDM project.
The Fourth Conference of the Parties (COP-4) to the UNFCCC held in
November 1998 passed the Buenos Aires Plan of Action (BAPA). This plan
requests the COP to set up detailed structures, rules, guidelines, operation
procedure and methodology for CDM, so that CDM can be fully applicable by
2000. After a few years of tough negotiation,. Bonn Agreement. was adopted by
the COP-6 in July 2001, which set a political basis for the future implementation
of CDM. In November 2001, the COP-7 was held in Marrakech where the
negotiation for CDM had a new improvement. Several agreements were made to
specify some important CDM issues, such as its operation pattern, rules, and
procedures. 19 An Executive Board (EB) of CDM was also formed to take
responsibility for making series of decisions on many detailed technical issues for
the implementation of CDM.
It is however surprising to note that the CDM rules do not define what a
CDM project is, it only states the eligibility requirements and the project
requirements. This has created uncertainties as to whether CCS projects qualify
as CDM projects. The only explicit reference made to CCS in the Kyoto Protocol
is that Annex-I countries need to research, promote, develop and increasingly
use CO2 sequestration technologies. 20 The Marrakech Accords also was only able
to further clarify the Protocol regarding technology cooperation stating that

Annex I countries should indicate how they give priority to cooperation in the
development and transfer of technologies relating to fossil fuel that capture and
store greenhouse gases. 21 But in all, there is no text referring explicitly to CCS
project-based activities in The Kyoto Protocol. Thus, we are left to ponder on
what qualifies as CDM projects and whether CCS activities can qualify as CDM
projects. We may perhaps move closer to answering this if we analyze the
eligibility requirements of every CDM project.
1.2 Eligibility Requirements of CDM

1.2.1 Participant Eligibility
The participant eligibility requirement for CDM project implementation stipulates
that both countries (developed countries and developing countries) should have
ratified the Kyoto protocol, that participation in CDM project should be voluntary,
and that the government should designate a national authority for the CDM. 22
Developed countries are also required to transfer and acquire CERs generated by
CDM project. 23
1.2.2 Project Eligibility

The question here is what project qualifies as a CDM project?. The CDM rules do
not define what a CDM project is; instead the rules only require that: 24
CDM projects must promote sustainable development in the countries in

which they are located;
The emissions reductions from CDM projects must be real, measurable,

long-term, and additional to reductions that would have occurred without
the project.
Funding for CDM projects must not divert funding from existing official
development assistance. 25
The requirements also include that the project has to generate CERs
compared to the baseline emission, the methodology applied by the project has
to be approved and if the project has a great environmental impact, a solution
has to be made to minimize that impact. The project baseline should also be

7
established on a project-specific basis; in a transparent and conservative way;
taking into account the relevant national or sectoral policies; and a reasonable
system boundary has to be set and the leakage issue needs to be fully considered.26
An eligible CDM project needs to be verified by the Operational Entity (OE)
and certified by the Executive Board (EB). Project Operational Entity is responsible
for validating proposed CDM project, submitting the project proposal to the EB
for registration, verifying emission reductions generated by EB and sending the
application to EB for issuing CERs. The Executive Board on the other hand is
responsible for supervising the CDM project. The main tasks of the EB include
making detailed rules for modalities and procedures for the CDM according to
the decision and recommendation of COP, suggesting simplified rules for smallscale CDM project, developing and approving new methodologies for CDM, and
making recommendations to the COP for the designation of operational entities.
Having gotten a fair idea of the eligibility rules of the CDM, I shall later in
this work use these criteria to assess CCS to see whether it can satisfy the
sustainability, additionality and other requirements of the CDM rules, but that will
be after we have a fair understanding of the CCS technology.
2. Carbon Dioxide Capture and Storage Technology: An

Overview
CO2 is one of those gases identified as responsible for global climate change. 27
CO2 is emitted principally from the burning of fossil fuels, both in large
combustion units such as those used for electric power generation and in smaller
distributed sources such as automobile engines and furnaces used in residential
and commercial buildings. 28 Flue gases emitted from medium to large point
sources typically contain 3.15% (by volume) of carbon dioxide. 29 It is thus
generally agreed that limits will have to be placed on the atmospheric
concentration of CO2 and other greenhouse gases in the atmosphere and that
emissions of CO2 will need to be reduced significantly below their current levels
in order to stabilize its atmospheric concentration at a reasonable level. 30
Carbon dioxide Capture and Storage (CCS) is an option in the portfolio of
mitigation actions for stabilization of atmospheric greenhouse gas concentrations
which could allow fossil fuels to be used with low emissions of greenhouse
gases. 31 CCS involves the use of technology, first to collect and concentrate the
CO2 produced in industrial and energy related sources, transporting it to a
suitable storage location, and then storing it away from the atmosphere for a
long period of time. 32 Application of CCS to biomass energy sources could result
in the net removal of CO2 from the atmosphere by capturing and storing the
atmospheric CO2 taken up by the biomass. 33 CCS also has the potential to
reduce overall mitigation costs and increase flexibility in achieving greenhouse
gas emission reductions.
The Carbon dioxide Capture and Storage process can be split into four
separate stages:
i.
The Capture process: This involves the actual separation of the

carbon dioxide (or carbon) from fuel or fuel gases. Because of
scale considerations, capture from processes that generate large
amounts of carbon dioxide is most cost-effective. 34 Such large
sources are, for instance, power plants and heavy industry. Some
of these sources could supply decarbonized fuel such as hydrogen
to the transportation, industrial and building sectors, and thus
reduce emissions from those distributed sources. Capture
processes can be carried out through the Post combustion/Gas
scrubbing routes, 35 Pre-combustion/Syngas approach, 36 and Oxy
fuel routes. 37
ii.
Compression: After capture, CO2 is usually compressed to form

a supercritical or dense fluid and is generally transported by high
pressure pipeline to the storage site. Compression is a major
consideration in several sequestration schemes, e.g., ocean or
geologic sequestration.
iii. Transportation: The transportation step is required to carry

captured CO2 to a suitable storage site located at a distance from
the CO2 source. Because of the large quantities involved, captured
carbon dioxide can be transported most economically in liquid
form through pipelines. 38 For transport over sea, it might be
attractive to use tankers in some cases. 39

9
iv. Storage: Potential storage methods include injection into deep

saline aquifers (onand offshore), in depleted oil or gas fields (onand offshore), in active oil or gas fields for enhanced oil or gas
production (on- and offshore), in coal seams (onshore), or by
direct injection into the water (offshore). Some industrial processes
also might utilize and store small amounts of captured CO2 in
manufactured products. CO2 may also be disposed after its
removal as a natural constituent of gas from certain fields. 40
As of mid-2005, there have been three commercial projects linking CO2
capture and geological storage: the offshore Sleipner natural gas processing
project in Norway, the Weyburn Enhanced Oil Recovery project in Canada 41 and
the In Salah natural gas project in Algeria. Each captures and stores 1.2 Mt CO2
per year. 42
The process described above offers the potential to meaningfully reduce
worldwide CO2 emissions in a practical manner and to become an important
climate change mitigation option. Indeed, estimates for CO2 global geological
storage potential range from 1,000 to over 10,000 Gt CO2 in depleted oil and
gas reservoirs, saline aquifers and unminable coal seams. 43 This represents more
than 26 to over 260 times the amount of projected energyrelated CO2 emissions
in 2030. 44 This will undoubtedly be a major step in meeting the challenge of
limiting GHG emissions and meeting the ultimate objective of the UNFCCC.
Placing the CCS idea near the CDM objective, it becomes obvious that CCS
will in no small way assist in meeting the over all objectives of FCCC. The
apposite questions and litmus tests here are:
i.
Will CCS assist non-Annex I countries in contributing to the

ultimate objectives of the FCCC to stabilize GHG concentrations
in the atmosphere at a level that would prevent dangerous
anthropogenic interference with the climate system?. This will
obviously be answered affirmatively as CCS has the tendency to
remove from the atmosphere about 1,000 to over 10,000 Gt
CO2, the gas which accounts for over eighty-two percent of all
greenhouse gas emissions. 45 Since CCS projects are large in
nature and offer the potential to mitigate millions of tonnes of
10
CO2 emissions, this will ultimately help to stabilize GHG

concentrations in the atmosphere at a level that would prevent
dangerous anthropogenic interference with the climate system.
ii.
Will CCS assist Annex I countries in achieving compliance with

their quantified emissions limitation and reduction commitments
under Article 3 of the Protocol? The answer to this is yes. Even
though no single technology option will provide all of the emission
reductions needed to achieve stabilization, 46 CCS as an option in
the portfolio of options could facilitate achieving stabilization
goals because CCS projects are large in nature and offer the
potential to mitigate millions of tonnes of CO2 emissions thus
assisting industrialized countries to reduce from the atmosphere a
great deal of CO2 which alone accounts for about 82 per cent of
total green house emissions. 47 This means that if industrialized
nations can effectively achieve CO2 reduction from the
atmosphere, they would have gone a long way in ensuring a
drastic reduction in their green house gas emission thereby
achieving significant reductions in global GHG emissions.
iii.
Will CCS assist non-Annex I countries in achieving sustainable

development?. Ordinarily, CCS will offer an important opportunity
to help developing countries move from the unsustainable fossil
fuel economy and attract technological advancements to
themselves. But the degree of sustainability that can be achieved
through CCS will be dependent on how far we are able to
respond to the technical concerns associated with the CCS idea.
These concerns range from permanence, leakage, project
boundary issues to monitoring, validation, and verification and
additionality issues. Since sustainability looks at how we can meet
our needs without compromising the needs of future generations, 48
we cannot say we have achieved much GHG reductions if the
CO2 we capture now later leaks or escapes back to the
atmosphere. For CCS to be described as meeting sustainable
development needs of non annex 1 countries, it must thus be
shown to remain perpetually safe and environmentally sound.

11
In September 2005, the Intergovernmental Panel on Climate Change (IPCC)
produced a Special Report on Carbon Dioxide Capture and Storage, which
summarizes the current status of research, technology development, and
deployment of CCS. 49 The special report was presented at a side event at the
meetings of the Parties to the United Nations Framework Convention on Climate
Change (UNFCCC) (COP 11) and the Parties to the Kyoto Protocol (COP/MOP 1)
in Montreal in December 2005. At the side event, the UNFCCC Subsidiary Body
for Scientific and Technological Advice (SBSTA) decided that CCS project
methodologies could be eligible for submission under the Clean Development
Mechanism and as of June 23, 2006, three methodologies have been submitted
to the CDM Executive Board. 50 Because CCS is not one of the project types
originally included when the CDM was first established, the CDM Executive
Board now has the task of reviewing these methodologies and then submit
recommendations to the COP/MOP regarding whether CCS should be included
on the list of eligible project types under the CDM. SBSTA also requested that the
Secretariat organize a working group at the 24th session of SBSTA (SB 24) 51 to
study CCS and present a report for consideration at its 25th session (November
2006). 52 At SB 24, two in-session workshops and six side events related to CCS
were organized. 53 Both workshops focused on information sharing and no
decisions were taken related to CCS. While there was general support for using
CCS as an emissions-reduction mechanism, environmental non-governmental
organizations and some developing countries were concerned about these
technical concerns which have been left unaddressed.
I believe that if CCS must be considered as an option in the portfolio of
CDM mitigation activities, there is an urgent need for legal and regulatory
framework which will address these concerns, establish procedures and
modalities for accounting of CO2-storages reflecting issues related to project
boundaries, leakage and permanence and conform with appropriate site
selection criteria, to minimize risk of leakage from storage sites. This is my next
concern in this work.
3. Legal and Regulatory Issues in Carbon Capture and Storage

Despite the potential benefits of using CCS technology to address climate change
and enhance energy security, several unresolved legal and regulatory issues
have been identified as being critical to the future success of CCS technology
12
development and its deployment as a CDM project. Most of these relate to the
injection and storage of CO2 and the long-term stewardship of the storage site.
These concerns will now be discussed under three heads:
a.
Injection and Storage stage: This include concerns on storage, site

selection criteria, leakage and permanence, assessment of project
boundaries;
b.
Crediting period: This include issues of monitoring, validation and

verification; additionality issues, and
c.
Post crediting period: This include issues of monitoring long term

leakage, need for supervision unit, post injection liabilities
amongst others.
3.1 Injection and Storage Stage

3.1.1 Storage
Four main legal and regulatory issues relating to the storage of CO2 call for
answers if CCS is to be considered as a mitigation option under the CDM and
under other existing international treaties: which methods of storage should be
allowed under the CDM?, what might be addressed in guidelines on site
selection?, what should be taken into account in the development of guidelines?,
Who might prepare these guidelines?.
Consistent standards are needed in carbon storage to ensure the highest
level of prevention of leakage into the ground, water, and air systems over the
long term. This highlights the importance of a well defined regulatory standard
and legislative action which will ensure that a CCS project under the CDM would
demonstrate careful site selection which would include assessing whether
abandoned or active gas wells will compromise the integrity of the
sea, conducting detailed site characterization that encompasses an assessment of
the geological characteristics of the storage reservoir and cap rock;
understanding the hydrogeology, geochemistry and geomechanics at the site;
assessing the volume and permeability of the storage formation; and
understanding the sites geological trapping mechanisms. 54

13
This shows the need for the CDM Executive Board to establish operational
rules and to establish uniform standards for the salient features of operation in
accordance with the reservoir characteristics. A standard regulation of well
design should include operational practices, materials used, number and age of
wells, potential geophysical changes, pathways in the event of leakage, and
duration of storage.
Similarly, the greatest technical risk to long term storage integrity is
considered by many to be the potential failure of a well due to the corrosive
effects of CO2. Thus some CCSCDM specific standards are required for
confirming the potential leakage through site characterization and realistic
models that predict movements of CO2 over time and locations where emissions
might occur need to be done.
3.1.2 Project Boundary

The modalities and procedures for CDM state that the project boundary
encompasses all anthropogenic greenhouse gas emissions under the control of
the project participants that are significant and reasonably attributable to the
CDM project activity. 55 Emissions from a project that go beyond the project.s
boundary are called. leakage. 56 From this provision, there are certain legal and
regulatory questions that need clarification and appropriate legislative action. For
example, what should be included in the project boundary?, what factors need to
be taken into account in addressing project boundary issue? How should the
energy penalty from Carbon Capture and Storage be factored in?. 57
I believe that a minimum Project Boundary definition needs to be formulated
which should be derived from a complete project structure description (the
physical delineation).The project boundary of the CDM project activity need to
accommodate full life cycle analysis of the CCS project i.e., The Project boundary
should be broad enough to encompass GHG emissions during CO2 capture,
transport and injection phases in order to measure the degree of emissions that
are been reduced due to the CDM activity. The analysis of the project boundary
will also need to consider the long-term CO2 storage aspect of CCS and should
be flexible to accommodate disparate storage types (e.g., Enhanced Oil
Recovery, Enhanced Coal bed Methane, Enhanced Gas Recovery), each of which
has specific characteristics.
14
In terms of leakage, it is equally important that CCS project methodologies

under the CDM adequately account for potential significant, attributable sources
of emissions outside the project boundary. For example, the loss in efficiency of a
power facility, which results from CO2 capture, will likely require additional
makeup power from another source. The emissions from the make-up power
source, if beyond the project boundary, should be factored in when calculating
net emission reductions from the project activity. A methodology that
incorporates a full-life cycle analysis of the CDM project within the project
boundary will serve to minimize potential leakage.
So much legislative action is indeed required to address these project
boundary concerns if CCS is to stand firmly as a GHG mitigation option under
the CDM.
3.1.3 Leakage and Permanence

Project leakage is the total change in emissions by human sources which occur
outside the CDM project activity boundary, which is measurable and attributable
to the CDM project activity. 58 The risks due to leakage from storage of CO2 in
geological reservoirs cannot be underestimated. This includes global risks 59 and
local risks. 60 Injection well failures or leakage of abandoned wells could create a
sudden and rapid release of CO2 back to the atmosphere. Hazards associated
with this type of release primarily affect workers in the vicinity of the release at
the time it occurs, or those called in to control the blow-out. A concentration of
CO2 greater than 7.10% in air would equally cause immediate dangers to
human life and health. 61
So much therefore needs to be done to prevent the menace of CO2 leakage.
The selection of storage sites for CCS projects together with methods for early
detection of leakage (preferably long before CO2 reaches the land surface), are
effective ways of reducing hazards associated with diffuse leakage. Adequate
legal and regulatory frameworks are required to ensure that storage sites
proposed for CCS CDM projects have been thoroughly characterized and
analyzed, and that the documentation is a part of the Project Design Document
(PDD).This framework is also needed to provide for appropriate monitoring
technologies, such as 3D seismic surveys, to grasp the storage situation, to verify
the amount of injected CO2 being stored, to detect leakage as soon as it
happens; and to lay down a measure to prevent and address future leakage
after injections of CCS in the long term.

15
3.2 Crediting Period

A key issue in balancing environmental additionality and cost-effectiveness is
establishing how many emission credits are generated by a particular CDM
activity, and over what time frame the credits are being created. Establishing
these characteristics of the flow of CERs requires a counterfactual baseline, as
well as an estimate of the emissions change relative to that baseline. The legal
and regulatory actions needed under this phase are highlighted seriatim.
3.2.1 Monitoring
The modalities and procedures for the CDM requires that the monitoring plan for
a CDM project activity provides for the collection and archiving of all relevant
data necessary for estimating greenhouse gas emissions and determination of
baselines. 62 Monitoring is a basic requirement for CCS project and as an
important part of the whole risk management strategy. A framework to ensure
appropriate monitoring is thus necessary, this framework should include
monitoring of the amount of CO2 injected to the reservoir and the relevant data
from the injection project, and identification of all potential sources of increased
emissions outside the project boundary that are significant and attributable to the
project activity during the crediting period.
In my view, proper and long-term monitoring of the reservoir is required, so
that leakage from the site will be detected and appropriately accounted for. It is
important that the monitoring program covers the CO2 storage and addresses
possible leakage pathways in an appropriate way. These leakage pathways
would have been identified during the analysis of the storage site. It should be
decided who is responsible for the monitoring after the crediting period, the
project participants or the host country, and the length of this period. The
monitoring system must be technically feasible, able to detect physical leakage
(during project operation & long-term leakage) including fugitive emissions
above a certain level (i.e. above the threshold, assuming that a threshold is
introduced and accepted), and should not be prohibitively costly.
A legal framework is necessary to provide for and enforce standard
procedures / best practice, and monitoring guidelines for various types of
formations, including operational rules such as: well injection pressure, injection
rate, temperature, etc.
16
3.2.2 Additionality Assessment

The Kyoto Protocol specifies that a CDM project must provide additional
reductions in emissions than would not have occurred without the project. 63 In
practice, this means that a baseline of. what would have occurred without the
project. must be defined, and any emission reductions additional to this baseline
level of emissions can yield. Proving additionality for the majority of CCS projects
will likely be relatively straight forward, as CCS is only implemented for emission
reduction purposes. However, it may be more difficult to prove additionality for
Enhanced Hydrocarbon Recovery (EHR) projects where CCS projects gain
financial benefits from additional hydrocarbon production through injecting
CO2. There is thus a need for legislative action in this area to create a standard
methodology to establish the emissions baseline from which the performance of
a CCS project can be assessed (and potentially rewarded with credits).It is clear
that this question needs to be carefully addressed, because if the baseline against
which CERs are allocated is miscalculated, there is a significant risk of creating.
certified hot air. which could undermine real abatement opportunities in other
sectors and undermine the environmental integrity of the CDM. 64 The
development of rigorous baselines is the only way to guarantee the integrity of a
reduced tonne of CO2.
Similarly, current accounting methods used by the Parties to the UNFCCC
are based on the assumption that fuel combustion automatically leads to CO2
emissions. This assumption clearly does not take cognizance of the CCS technology.
Thus, there is also the need for legislative action in this regard to ensure the
modification of existing methodologies, or definition of additional methodologies
which will take into account the impact of CCS technologies on CO2.
On the whole, there is a need for a standard legal framework stating clearly
the methodologies for estimating BAU emissions baselines. Ideal baselines
should be: (i) credible from an environment perspective; (ii) transparent; (iii)
simple and practical leading to low transaction costs; as well as (iv) limit the
crediting uncertainty for project developers and investors. Accounting rules
should build on the principles of financial accounting, i.e., relevance,
completeness, consistency, transparency and accuracy while not being too
cumbersome.

17
3.3 Post Crediting Period

Due to the long life span of CCS projects, there is a need for the establishment of
long term CCS enabling infrastructures (such as monitoring and verification
regimes and accounting protocols for very long term emission storage
performance criteria by storage site).Legal issues related to this will be
considered here.
3.3.1 Monitoring Long Term Leakage

Standards for the measurement, monitoring, and verification (MMV) of injected
CO2 are crucial to any regulatory or legal framework for CCS because they
provide for the collection of vital data on containment, reactivity of CO2 with
surrounding well materials, seismic activity, leakage, and long-term storage,
which are necessary for establishing who is liable in the event of leakage or
disruption. For MMV in particular, existing and future CCS projects will provide
the most concrete basis for a regulatory framework, especially when coupled with
modeling in the research and development phases of a project. Because MMV is
site-specific, it would be inappropriate to develop a single MMV framework with
a uniform set of requirements. However, it is imperative that guidelines are
established to try to create consistency and uniformity where possible. One way
to set up flexible but meaningful monitoring guidelines would be to rely on
objectives and performance standards instead of specific measurement
techniques. 65
CCS-CDM specific issues will ultimately need to be addressed in a more
comprehensive CCS regulatory framework. In general, monitoring of stored CO2
should focus on two dimensions: lateral migration of CO2 and vertical leakage
of CO2 outside the storage area. A variety of MMV techniques are currently being
applied and reviewed in active projects such as Weyburn and Sleipner to review
lateral and vertical migration of the injected CO2. 66
Another area that could be included in a framework is the use of monitoring
data to provide feedback into reservoir management practices during the
injection phase of the project. Such a step could potentially be far more
important than monitoring later in the project.
18
There are few established guidelines for the specific kinds of monitoring that
should be done for CCS in the short- and long-term, including who should be
doing the monitoring, for how long a site should be monitored, and how to
determine long-term MMV responsibilities in case of existing CO2 compliance
systems, such as the EU Emissions Trading Scheme (EU ETS), 67 trans-border
projects, or projects in international waters. The Australian government recently
developed principles for regulating CCS projects that also include general
guidelines for when in the CCS process the MMV step should take place, and
how it should be done. 68 There is however a need for a standard regulatory
framework which will regulate MMV in all jurisdictions covered by the Kyoto Protocol.
3.3.2 Allocation of Risks and Treatment of Liabilities

Liability is one of the most essential regulatory issues facing CCS projects. It is
very important to address it because it will impact the costs of CCS projects and
will be crucial in advancing public acceptance of the technologies and processes.
Liability issues can be divided into short 69 and long-term, 70 with the
preponderance of unresolved liability issues relating to long-term storage. 71
i.
Short-term Liability: A common liability issue raised in connection with the

shortterm aspects of CCS projects is operational liability, which refers to the
environmental, health, and safety risks associated with capture, transport,
and injection of CO2. Most short-term liability issues will probably be taken
care of by the CER contract, but certain issues should be considered in a
regulatory framework, including exemptions under special circumstances.
Short-term liabilities will likely have a set timeframe, they are therefore
easier to manage and plan for, and could be addressed in a regulatory
framework relatively quickly. The more urgently needed regulations are for
long-term liability.
ii.
Long-term Liability: There are three types of liability issues that are
relevant for longterm CCS projects: environmental, in situ, and
trans-national liability. 72 Environmental liability is associated with any CO2
leakage from the storage sites that may affect the global climate by
contributing to CO2 concentrations in the atmosphere. In the event of any
CO2 leakage or migration to the atmosphere, responsibility must be
assigned to address any harm caused to the global climate. In situ liability is

19
associated with leakage or migration that could result in public health,
environmental, or ecosystem damage. Failure to properly address these
issues could lead to negative public perceptions and an inability to procure
appropriate sites for injection and storage. Trans-border liability on the
other hand refers to liability issues that may affect more than one country.
This is important in instances of migration of CO2 across national borders
and/or damage to the global climate caused by CO2 leakage in one
individual country. These issues will have to be addressed by the Kyoto
Protocol and other relevant treaties. 73
The first area that should be addressed is how to determine where
local/national liability and international liability differentiates. It is possible that
CO2 could leak far from its injection point and storage area, and if that leakage
point is in another country or in international waters, a framework for
determination of which party is liable for clean up, remediation, or loss of
resources should be established. 74 These issues could be set up in an
international framework, but specifics would probably be worked out on a caseby case basis. In the case of CO2 leaking into the atmosphere and causing.
environmental liability,. this is probably best addressed as part of a broad
climate policy designed to control greenhouse gases like the Kyoto Protocol. 75
Since CCS projects are designed to last for centuries, there should be
parameters and guidelines laid down, and some sort of limitation or reference
should be included to determine how long certain parties are liable and at what
point the stored CO2 becomes a public liability. Also, a basic compliance system
should be established to assure accountability and proper enforcement in the
event of leakage or other damage. Similarly, due to the longevity of CCS
projects, determining responsibility for cost coverage is crucial, and one option
could be the establishment of special funds or insurance schemes to cover
compensation or remediation in the case of any leakage or damage resulting
from the process in the long term.
4. Recommended Framework for Addressing these Concerns

It is pertinent to note from the onset that several efforts have been undertaken or
are currently in process for addressing the regulatory gaps discussed above. For
instance, the Conference of the Parties serving as the meeting of the parties to
20
the Kyoto Protocol (COP/MOP), in response to these concerns invited parties to

provide to the secretariat, by 13 February 2006, submissions on the
consideration of CCS as Clean Development Mechanism project activities, taking
into account issues relating to project boundary, leakage and permanence.
Eleven submissions containing different recommendations were received. 76 Most
of these submissions however focused mainly on the technical concerns with little
or nothing said on the legal and regulatory gaps 77 which has been the main
focus of this article.
The issue of CCS as a CDM project also came up for discussion at the
second meeting of the Parties to Kyoto Protocol (COP/MOP 2) and twelfth
session of the Conference of the Parties (COP 12) concluded on Friday, 17
November 2006 in Nairobi, Kenya. 78 The COP/MOP recognized the rapidly
expanding portfolio of CDM project activities and that CCS in geological
formations could lead to the transfer of environmentally safe and sound
technology and know-how, and the attainment of GHG reductions. 79 The COP
however identified the legal and regulatory gaps still existing and thereby
requested the Executive Board to continue to consider proposals for new
methodologies, including the project design documents for CCS in geological
formations as CDM project activities. The COP in its decisions also encouraged
parties to organize global and regional workshops to enhance capacity-building
on CCS technologies and their applications and to share information on these
workshops broadly. The COP also sent invitations to intergovernmental
organizations and non-governmental organizations to provide to the secretariat,
by 31st May 2007, information addressing these concerns discussed in this
work. 80
With the COP still inviting parties to make submissions to the secretariat, by
31st September 2007 on gaps to be filled if CCS is to be enlisted as CDM project
activities, it is clear that these regulatory concerns are yet to be resolved and still
call for solutions.
I am of the view that the time to act is now. The COP can no longer afford
to delay action on laying down a detailed legal and regulatory framework which
will address all these concerns raised in this work. I believe that these salient
issues ought to be addressed as soon as possible to resolve all these technical

21
concerns hindering the deployment of CCS as a GHG mitigation option under
the CDM. CCS will no doubt assist in the GHG mitigation efforts of most
countries while delivering sustainable development to the doorsteps of
developing countries if these issues are laid to rest.
I consequently wish to recommend the following as immediate actions which
ought to be taken and finalized with utmost priority by the Executive Board of
CDM:
i.
The EB should intensify its call for immediate proposals, organize

workshop and/or conferences as soon as possible to deliberate
extensively on these issues and finalize with utmost priority on a
legal framework to address these concerns based o the out comes
of these deliberations,
ii.
A legal framework should be laid down by The Executive Board

and then submitted as recommendations to the COP/MOP for
prompt adoption and incorporation into the CDM Modalities and
Rules. The legal and regulatory framework which I envisage should:
a.
Describe clearly the criteria for the demonstration and

assessment of additionality most especially for Enhanced Oil
Recovery and Enhanced Coal Bed Methane Recovery project
activities;
b.
Lay down an international best practice and environmental

criteria for site characterization including assessment of the
risk of emission releases from the project and of impacts on
the surrounding environment;
c.
Establish operational rules, and determine whether there will

be uniform standards for the salient features of operation. If
uniform standards are preferred then their appropriate level
needs to be determined;
d.
Formulate and define the idea of minimum Project Boundary.

This should be derived from complete project structure
description
(the
physical
delineation)
which
also
accommodates full life cycle analysis;
22
e.
Define potential leakages as emissions due to the project

which occurs outside the project boundary (CO2 sources can
be in or out of boundary depending on the nature of the
project),
f.
Lay down a common and consistent methodology for

different CCS projects based on a standard principle,
g.
Lay down standard procedures / best practice monitoring

guidelines or protocols for various types of formations,
including operational rules such as: well injection pressure,
injection rate, temperature, etc. This methodology should
highlight applicable techniques and must be flexible to allow
for new techniques, must be technically feasible, able to
detect physical leakage (during project operation & long-term
leakage) including fugitive emissions above a certain level
(i.e. above the threshold, assuming that a threshold is
introduced and accepted), and should not be prohibitively
costly;
h.
Lay down standard methodologies for emission inventories

and develop accounting rules which will be used in
accounting for long-term leakage;
i.
Address specifically issues, such as permanence and

responsibility for remediation in the event of emission
releases, both during the crediting period and subsequently;
j.
Address health, safety and environment risks in further detail

and develop common cost-effective remediation techniques;
k.
Lay down a mechanism to allocate liability for any seepage

among parties;
l.
Ensure the standardization of methodology for monitoring.

This is necessary to determine who will conduct the
monitoring, and who will bear the cost, and
m. Make appropriate provisions for cases where geological

formations used for storage cross national boundaries.

23
I recommend that this framework does not need to be in form of a new
stand alone regulatory framework or treaty rather it should be incorporated into
the current CDM Modalities and rules by the COP/MOP of The Kyoto Protocol as
an improvement on the Marrakesh Accords. I believe this will be faster and less
stressful than having to create a fresh treaty on CCS as a CDM activity.
Conclusion
CCS technology has the potential of reducing overall mitigation costs, increasing
flexibility in achieving greenhouse gas emission reductions and in contributing
positively to the attainment of the overall CDM objectives. Its viability and global
acceptability as a CDM Project will however depend on how soon the COP/MOP
to the Kyoto Protocol can provide a legal/ regulatory framework which will
address the concerns of permanence, leakage, project boundary, liability
amongst others which have consistently been identified as the ills of his viable
technology. This is a task which must be accomplished without further delay. This
work will be a useful guide to the COP/MOP in achieving this necessary task.
Endnotes
1
Non Annex I and II countries under UNFCCC include developing countries like
China, India and Nigeria amongst others.
The other flexible mechanisms are emissions trading and Joint Implementation
(JI).see online: See Online: United Nations Framework Convention on Climate
Change, http://unfccc.int/resource/docs/convkp/kpeng.html
See online, Foundation for International Environmental Law and Development,

<www.field.org.uk/climate_2.php>
Decision 17/CP.7 of the Seventh session of The Conference of Parties to the UNFCC
(COP-7) in Marrakech.
Organization for Economic Co-operation and Development,. Prospects for CO2

Capture and Storage. Online: Organization for Economic Co-operation and
Development, www.oecd.org/publications see also Intergovernmental Panel on
Climate Change Report,. Workshop on Carbon Dioxide Capture and Storage.,
(2002) Regina, Canada at 15-18.
McKee, B, Solutions for the 21st Century, Zero Emissions Technologies for Fossil
Fuel (2002) OECD/IEA, at 2-4.
24
IPCC Report, see note 5 above.
Ibid.
See for e.g., International Energy Agency,. Legal Aspect of Storing CO2. (2005)
International Energy Agency at 3.
10
See for e.g., Anderson, S & R, Prospects for Carbon Capture and Storage Technologies
(2003)2 ENDA, see also Bachu, S. and Celia, M., Geological Sequestration of CO2: Is
Leakage unavoidable and acceptable?, (2002,Sixth International Conference on
Greenhouse Gas Control Technologies, Kyoto, Japan, October).
11
Jonathan Wiener,. Global Environmental Regulation: Instrument Choice in Legal

Context.(1999) 108 Yale L.J. 677 at 691-692.
12
Ibid at 689-690.
13
For the other flexible mechanisms see note 2 above.
14
Karen Holm Olsen,. Clean Development Mechanism.s contribution to Sustainable

Development, A review of the literature, online: United Nations Environmental
Programme, www.uneprisoe.org/karen at 2.
15
Youba Sokona, The Clean Development Mechanism: What Prospects for Africa?
(2005) ENDA at 1.
16
It has thus been variously described as the Kyoto surprise, The Kyoto baby, the
win-win mechanism and as having the handwriting of both the South and the
North. see Aslam, M.A.,. The Clean Development Mechanism: unraveling the.
Mystery, (1998)Islamabad 2 at 21, see also Karen Holm Olsen, Supra note 14 at 2.
17
See also Unep Ris Centre, Clean Development Mechanism Legal Issues Guidebook
to the Clean Development Mechanism, online: Unep Ris Centre www.uneptie.org/
energy/publications/files/cdm_LEGAL_issues.htm - 10k -
18
See Foundation for International Environmental Law and Development, note 2 above.
19
The basic rules for CDM can be found in Decision 15, Decision 17 and the
attachments of COP-7. Supra note 2.
20
Art. 2, Para. iv, Kyoto Protocol. Supra note 2.
21
Paragraph 26, Decision 5/CP.7. Supra note 2.
22
See paragraphs 28 -30 of the annex of Decision of the COP-7 (Clean Development
Mechanism Modalities and Procedures). Supra note 2.
23
Ibid. see Paragraph 31 and 32.
24
Decision 17 of the COP-7.
25
See supra note 3.

25
26
Ibid.
27
Others include Methane (CH4), Chlorofluorocarbons (CFCs), Nitrous oxide (NOx)

and Ozone (O3). See Nigel Bankes,. Course Material for LAW 649.32, University of
Calgary. at 69-70. Online: University of Calgary,www.ucalgary.ca/it/computersupport/
blackboard.html
28
CO2 emissions also result from some industrial and resource extraction processes,
as well as from the burning of forests during land clearance.
29
For example, flue gas from a coal-fired power plant typically contains about 14%
CO2, 5% O2, and 81% N2. online: IPCC, http://www.ipcc.ch
30
Under IPCC scenario B1 in its Climate Change 2001 report, emissions of CO2 will
have to be reduced by approximately 40% by 2100 in order to stabilize the
atmospheric concentration of CO2 at no more than 50% above its current level
online: IPCC, http://www.ipcc.ch.
31
Other mitigation options include energy efficiency improvements, the switch to less
carbon-intensive fuels, nuclear power, renewable energy sources, enhancement of
biological sinks, and reduction of non- CO2 greenhouse gas emissions. See
generally Susanne Haefeli,. CCS issues. Accounting and Baselines under the
UNFCC. (2004) OECD/IEA at 8.
32
IPCC,. Special Report on Carbon Dioxide Capture and Storage,. September 2005,
Chapter 5, online: IPCC, http://www.ipcc.ch/activity/srccs/index.htm
33
See note 22 above, at 17.
34
See note 32 above.
35
In which the CO2 is scrubbed from the gas exiting the combustion or production
process. These are the most commonly used technologies today and, for example,
they can capture up to 99 per cent of the processed/flue gas exiting a boiler or a
gas sweetening unit.
36
In which a synthetic hydrogen and CO2 rich gas is produced from the fuel. This
approach is used in Integrated Gasification Combined Cycle plants (IGCC). It is a
clean coal technology under development with few already existing plants in Europe
and the US, but with promising prospects as a large-scale technology.
37
In which the combustion process is fired with oxygen rather than air to create a flue
gas primarily comprising CO2. This approach is still in a R&D phase. All three
processes consume a significant amount of energy, and thus entail costs. This is
referred to as the. energy penalty. of the capture process. The energy penalty
typically ranges between 15 to 40 per cent of the energy output in the case of CO2
capture at a coal-fired power plant. See generally Thambimuthu, K.,. Zeroing
emissions with CO2 Capture and Storage, Presentation at COP8, online: IEA,
http://www.iea.org/envissu/cop8/ieaside/kelly.pdf.
26
38
CO2 transmission pipelines already exist in countries like the USA. see online: US
Department of Energy, Capture Sequestration R&D Projects Database, http://www.
fossil.energy.gov/fred/feprograms.jsp?prog=Carbon+Sequestration
39
The transportation chosen will very much depend on the storage site, because the
farther this is from land the more expensive it will be to carry the CO2.
40
The Norwegian State oil company has been injecting around a million tones of CO2
a year since 1996. a by-product of the gas they produce from the North Sea
Sleipner west gas field, directly into sub-seabed formations.
41
This stores CO2 captured in the United States. see note 38 above.
42
See note 33 above.
43
International Energy Agency, Carbon dioxide Capture and Storage Issues

Accounting and Baselines under the United Nations Framework Convention on
Climate Change (UNFCCC) (2004) OECD/IEA at 5.
44
Ibid at 8-10.
45
Ibid.
46
IPCCC, Third Assessment Report, online: IPCC, http://www.ipcc.ch/activity/srccs/

index.htm.
47
supra note 43.
48
See Bruntland, G, The World Commission on Environment and Development,. Our

Common Future., ( Oxford University Press, Oxford) at 38.
49
IPCC Special Report, see on line: IPCC, http://www.ipcc.ch/activity/srccs/index.htm.
50
NM_0167 White Tiger Oil Field CCS project in Vietnam; NM_0168 capture of CO2
from LNG complex and its storage in an aquifer in Malaysia; and SSC_038
Anthropogenic Ocean Sequestration by Changing the Alkalinity of Ocean Surface
Water, Online: UNFCC, http://cdm.unfccc.int/methodologies
51
This was held from May 17-26, 2006. Ibid
52
UNFCCC SBSTA. FCCC/SBSTA/2005/L.26, December 5, 2005, online: UNFCC,

http://unfccc.int/resource/docs/2005/sbsta/eng/l26.pdf
53
IISD, Earth Negotiations Bulletin,. Twenty-fourth Sessions of the Subsidiary Bodies of

the UNFCCC and First Session of the Ad Hoc Working Group Under the Kyoto
Protocol: 17-26 May 2006,. online: IISD, http://www.iisd.ca/download/pdf/
enb12306e.pdf
54
See Canadas submissions to the COP/MOP, FCCC/KP/CMP/2006/MISC.2, at 15-18.

supra note 2.

27
55
Decision 17/CP.7 (FCCC/CP/2001/13/Add.2).
56
See note 3 above.
57
Submission by Austria on behalf of European Community. See supra note 55 at 10-11.
58
See note 43 above.
59
Global risks involve the release of CO2 that may contribute significantly to climate
change if some fraction leaks from the storage formation to the atmosphere.
60
Local risks refer to local hazards that may exist for humans, ecosystems and
groundwater if CO2 leaks out of a storage formation.
61
See IPCC Report, note 32 above.
62
Supra note 43.
63
See Article 12 paragraph 5(c) of Kyoto Protocol. Supra note 2.
64
Supra note 32.
65
See Kate Robertson, International Carbon Capture and Storage Projects

Overcoming Legal Barriers (2006) NETL-2006/1236 at 3-8.
66
The most often used techniques are time-lapse 3D seismic imaging (also called 4D
seismic) and vertical seismic profiling (VSP) in wells, along with injection well
pressure and rate monitoring, but a consensus of the most appropriate techniques to
use has not been reached. Ibid at 8-10.
67
Ibid.
68
Ministerial Council on Mineral and Petroleum Resources,. Carbon Dioxide Capture

and Geological Storage: Australian Regulatory Guiding Principles,. November 23,
2005,http://www.industry.gov.au/assets/documents/itrinternet/Regulatory_Guiding_
Principles_for_CCS20 051124145652.pdf
69
Generally considered to cover the timeframe of the project and any contractual time
period covering post-injection.
70
Long-term timeframes are generally defined as 50-100 to thousands of years.
71
See note 57 above.
72
TNO, Environmental Challenges of the E&P Industry: Dealing with CO2 online:
TNO, http://gcceuconference. epu.ntua.gr/Portals/1/documents/02.Elewaut.pdf
73
So much work is currently been done in this regard to effect changes into
International treaties like the London Convention /London Protocol, Convention for
the Protection of the Marine Environment of the North-East Atlantic (OSPAR), to
address these Trans boundary liability issues. See International Energy Agency,.
Legal Aspects of Storing CO2, (2005) OECD/IEA, at 12-18.
28
74
CSLF, Considerations on Legal Issues for Carbon Dioxide Capture and Storage
Projects, Report from the Legal, Regulatory and Financial Issues Task Force, 13
August 2004. http://www.cslforum.org/documents/Legal_Issues_Report_P14C.pdf
75
M.A. de Figueiredo, D.M. Reiner, and H.J. Herzog, Framing the Long-Term In Situ
Liability Issues for Geologic Carbon Storage in the United States, Mitigation and
Adaptation Strategies for Global Change, 10: 647-657, October 2005,
http://sequestration.mit.edu/pdf/Framing_the_Long-Term_Liability_Issue.pdf
76
These submissions were submitted by Australia, Austria on behalf of the European

community and its member states, Bangladesh, Brazil, Canada, Japan, New
Zealand, Norway, Qatar, Saudi Arabia, and Switzerland. See FCCC/KP/CMP/
2006/MISC.2. Supra note 2.
77
An exception is the submissions by Canada which touched on certain regulatory

issues. Supra at 11-12.
78
The Conference was attended by six thousand participants from one hundred eighty
countries. online: UNFCCC, http://unfccc.int/2860.php
79
See UNFCCC, Nairobi Conference. online: UNFCCC, http://unfccc.int/meetings/

cop_12/items/3754.php
80
Ibid.
2
Flexible Mechanisms for Climate
Change Compliance: Emission
Offset Purchases under the Clean
Development Mechanism
Christopher Carr* and Flavia Rosembuj**
The authors provide an overview of recent developments on clean
development mechanism a specific type of offset program for
climate change compliance. Their article gives a background on
how CDM of the Kyoto Protocol works and investigates aspects
of CDM purchase agreements from a legal perspective. They
found out that "the international carbon market has shown how
market-based mechanisms can muster capital to address global
climate change and transfer climate-friendly technology to the
developing world.
*
**
Counsel Vinson & Elking LLP, 1455, Pennsylvania Avenue, NW, Washington, D. C., 2004.
E-mail: Ccarr@velaw.com
Senior Legal Counsel, Co-financing and project finance, legal department, World Bank. 1818 H street
NW, MC 6-401 Washington D.C. 20433. E-mail: frosembuj@worldbank.org
2008 N.Y.U. Environmental Law Journal. This article was originally published in the NYU Environmental
Law Journal, Vol. 16. Reprinted with permission.
Source: wbcarbanfinance.org
30
Introduction
From 2005 through 2006, the international market for carbon credits
experienced tremendous growth and reached an annual market value of over
US $30 billion. 1 As part of this growth, new tools, skills, and capital have been
introduced into the international carbon market to address the global problem of
climate change.
Broadly speaking, the international carbon market has involved two types of
market-based tools to reduce greenhouse gas emissions. The first tool is a cap
and trade program. Under such a program, emissions are capped at a certain
level by regulatory fiat, regulated entities are allocated allowances to emit a
certain amount of Greenhouse Gases (GHGs), and these entities can then trade
allowances to meet their compliance obligations. An entity whose emissions fall
below its allocated amount can sell unneeded allowances for compliance
purposes. An entity whose emissions are higher than its allocated amount can
purchase allowances from others who are willing to sell them.
The second type of program is an emission offset, or project based
program. As opposed to a cap and trade regime, offsets involve a baseline and
trade regime. These offset credits are generated from projects that reduce GHG
emissions below a certain baseline outside of a regulated cap. These credits can
then be sold to entities that can use them to meet regulatory compliance
obligations inside a cap.
This article focuses on a specific type of offset program the Clean
Development Mechanism of the Kyoto Protocol (CDM). 2 This article (i) begins
with an overview of the Kyoto flexible mechanisms (including the CDM), (ii)
explains how CDM offset credits are generated, (iii) examines the growth of the
international carbon market, (iv) explores aspects of CDM offset purchase
agreements, and (v) summarizes several lessons learned. In sum, the
international carbon market has shown how market-based mechanisms can
muster capital to address global climate change and transfer climate-friendly
technology to the developing world. This article provides an overview of recent
developments in the CDM and an understanding of how market based
mechanisms may address global climate change. This is, however, only an
overview, and other sources delve into these topics in greater detail.
Flexible Mechanisms for Climate Change Compliance:

Emission Offset Purchases under the Clean Development Mechanism
31
I. Overview of the Flexible Mechanisms

The United Nations Framework Convention on Climate Change (UNFCCC)
established an international system for addressing the issue of climate change. 3
In doing so, it set a broad objective of stabilizing GHG emissions at a level that
would prevent dangerous anthropogenic interference with the climate system. 4
The UNFCCC sought to achieve such a goal within a time frame sufficient to
allow ecosystems to adapt naturally while still allowing economic development
to proceed in a sustainable manner. 5
Furthermore, the UNFCCC established an aim of reducing GHG
emissions to 1990 levels. 6 In doing so, the UNFCCC acknowledged that there
could be some degree of co-operation between the parties to the UNFCCC,
when it stated that these GHG emissions could be attained individually or
jointly. 7 However, the UNFCCC did not itself set binding emission reduction
commitments. 8
Unlike the UNFCCC, the Kyoto Protocol, negotiated in December 1997, sets
out firm GHG emission reduction targets for developed countries (listed in Annex
I to the UNFCCC) to be met within an agreed commitment period (200812). 9
The Protocol requires the Annex I parties to reduce their emissions by an average
of 5.2% from 1990 levels. 10 The specific targets (or assigned amounts) were set
out in Annex B of the Protocol. 11 The Annex I Parties were then given the
opportunity to reach their targets by the adoption of command-and-control
regulations or by using the flexibility mechanisms in order to comply with their
assigned emission levels. 12
During the negotiation of the Kyoto Protocol, the United States was the main
driving force for the inclusion of the so-called flexibility mechanisms. The Kyoto
Protocol includes three flexibility mechanisms: (i) the Joint Implementation
provisions, set out under Article 6; (ii) the Clean Development Mechanism, in
Article 12; and (iii) International Emissions Trading under Article 17.
The Joint Implementation provisions allow Annex I parties to transfer to, or
acquire from, another Annex I country, Emission Reduction Units (ERUs)
generated by projects that reduce manmade GHGs or enhance the
anthropogenic removal of such gases by sinks. 13
32
The Clean Development Mechanism allows Annex I countries to finance

projects that reduce emissions in developing countries that are Kyoto parties but
have not made commitments to reduce their GHG emissions. In return, Annex I
countries receive Certified Emission Reductions (CERs) from those projects. 14
These CERs then can be used for compliance in Annex I countries. 15 Thus, under
the CDM emission credits generated from climate-friendly projects in the
developing world can be used for compliance purposes in the developed world.
Finally, under the International Emissions Trading provisions, Annex I
countries can trade Assigned Amount Units (AAUs) among themselves. 16 AAUs
are allocated to Annex I parties at the beginning of each commitment period
based on each partys targets set out in Annex B of the Protocol.
By the end of the first commitment period, in 2012, an Annex I country must
be in compliance with its obligations under the Kyoto Protocol such that its
emissions of GHGs are either less than or equal to its AAUs, which can be duly
adjusted with any of the following assets:
i.
ERUs transferred through Joint Implementation (JI) projects,
ii.
CERs resulting from the Clean Development Mechanism, and
iii.
AAUs themselves that may be traded by means of International

Emissions Trading. 17
Each one of the above mentioned assets (ERUs, CERs and AAUs) represents
one metric ton of CO2 equivalent. 18 One ton of a GHG reduction from a CDM
or JI project anywhere in the world can be converted into a ton of carbon dioxide
equivalent by multiplying it by a pre-determined global warming potential. 19 This
conversion allows for a common currency whereby ERUs, CERs, and AAUs can
be freely exchanged for compliance purposes, as each represents a ton of
carbon dioxide equivalent. A party to the Kyoto Protocol can also authorize a
private entity to participate in these flexible mechanisms. 20 In this way,
companies and other non-sovereigns can undertake climatefriendly projects and
generate emission reduction credits. These credits can then be used for
compliance purposes, or sold or traded in emissions markets to others who may
need the emission credits for compliance purposes.

33
The CDM, on which this article focuses, began operation shortly after the
adoption of the Marrakech Accords. The Marrakech Accords resulted from
the 2001 meeting of all of the parties that are signatories to the UNFCCC
(Conference of the Parties or COP). The Marrakech Accords supplemented the
Kyoto Protocol by identifying in detail the modalities and procedures by which the
flexible mechanisms would operate. 21
The CDM directs the design and development of emission reduction offset
projects located in the developing world under the Kyoto Protocol. For instance,
the CDM provides the framework for the development of baselines and
monitoring methodologies for measuring emission reductions from projects. It
also develops procedures by which emission reductions could be verified by
independent third parties. 22
Although the Kyoto Protocol was negotiated in 1997, it did not enter into
force until February 16, 2005, when the required number of countries finally
ratified it. 23 When Kyoto became effective, the CDM was ready for a period of
significant growth in the volume of GHG emission reductions that could be
generated by environmentally-friendly projects.
II. The Creation of Certified Emission Reductions

The main institutions involved in overseeing the CDM are the Conference of the
Parties serving as the Meeting of the Parties (referred to as the COP/MOP) 24
and the Executive Board (EB). The COP/MOP provides overall authority and
guidance to the CDM. 25 The EB is composed of ten members (two from Annex I
and eight from non Annex I countries). 26 The EB manages the day-to-day
supervision of the CDM. 27 The EB is assisted in its activities by panels of experts,
working groups, and the CDM registration and issuance team. 28
Every CDM project has a defined project cycle that derives from the
Marrakech Accords and guidance provided by the COP/MOP and EB. The
formal project cycle starts with the Project Design Document (PDD). The PDD
contains details about the proposed CDM project, including of a description of
the project activity that will reduce GHG. 29
The PDD substantiates each projects additionality by demonstrating that
the project creates emission reductions that are additional to those that would
have occurred under a business as usual scenario. In order for a CDM project
34
to generate CERs, the project proponents must present a counterfactual, that is,
a description of the reductions that would have occurred in the absence of the
investment. 30 Each PDD must describe the baseline scenario 31 from which this
additionality is measured and must include a detailed monitoring plan. 32
A written Letter of Approval (LOA) from the host developing country must
also be obtained for the project. 33 The Kyoto Protocol is an international
agreement between sovereign parties, but through this letter of approval a
sovereign can devolve rights and obligations to private entities, allowing them to
take advantage of the flexible mechanisms.
The PDD, together with the LOA, is submitted by the project sponsor to an
independent entity for validation. 34 This entity is known as the Designated
Operation Entity (DOE). 35 The DOE reviews the PDD and submits it together with
the LOA to the EB. The formal acceptance by the EB of the validated project as a
CDM project activity is known as registration. A request for registration is
considered granted and the registration final within eight weeks of the EBs
receipt of the request, unless prior to the expiry of that period three or more
members of the EB (or a party involved in the CDM project itself) request review
of the proposed CDM activity. 36
In the implementation phase, the project is carried out and the monitoring
plan submitted in the PDD takes effect. Based on the monitoring plan in the PDD,
GHG reductions are calculated and submitted for verification as CERs. 37 A
different DOE needs to be hired by the project sponsors (unless the project is
small scale) to verify the GHG reductions and to generate a verification report
that certifies in writing the amount of additional emission reductions attributable
to the project. 38
If everything goes as planned, the EB ultimately issues the CERs in the
amount of one CER for each ton of carbon dioxide equivalent of emissions
reduced. 39 A percentage of the CERs issued is transferred to a special account
used to finance projects that help developing countries adapt to the adverse
impacts of climate change. The remaining CERs are forwarded to the accounts of
the participants in the CDM project.

35
III. Growth of the International Carbon Market

The international carbon market has grown tremendously over the past several
years. Prior to February 2005, when Kyoto Protocol came into effect, the market
was relatively inactive, particularly within the private sector. Early market activity
was largely prototype buying by sovereigns and international financial institutions
like the World Bank. Prototype buying showed, through learning by doing, how
CDM and JI transactions could be undertaken.
With the entry into force of the Kyoto Protocol, the international carbon market
grew to US$30 billion in two years. 40 The volume of credits generated by projects
that reduce greenhouse gases more than quadrupled from 2004 to 2006. 41
The potential for market growth is much larger. For instance, the UNFCCC
Executive Secretary, Yvo de Boer, has said that carbon finance could generate up
to $100 billion annually in financial flows to developing countries. 42
As mentioned in the introduction, the international carbon market has so far
been dominated by two types of market-based mechanisms. The first is the
trading of allowances that have been allocated to regulated entities under a cap
and trade program.
Indeed, based on the monetary value of trades, the dominant force in
international trading has been the European Union Emission Trading System (EU
ETS). The EU countries entered into a burden sharing agreement whereby they
collectively agreed to reduce their emissions by 8% from 1990 levels in
accordance with the Kyoto Protocol. Each individual EU country then agreed to
cap its emissions at certain levels. 43 EU countries devolved compliance
obligations down to individual regulated entities, allocating each a certain
number of allowances. 44 The EU market topped US$20 billion in 2006. 45
The other dominant type of transaction in the international carbon market
has been emission offset projects, in particular those under the CDM. 46 The
principal buyers of such credits have been EU countries and Japan. 47 The main
reason for this is that, depending on the rules of various regulatory programs,
entities regulated by the EU ETS can use CDM credits for compliance purposes. 48
Japanese private entities have also purchased CDM credits as part of voluntary
targets set to help their country meet its Kyoto commitments.
36
Other regulatory regimes, including those in the United States, could also
link to either the CDM, the EU ETS, or other regulatory regimes, depending on
the specific provisions in each system and applicable law. 49 Through this linking,
it could be possible for credits to be traded between the regulatory regimes of
different countries.
A wide variety of projects have been launched under the CDM, including
renewable energy projects such as wind and hydroelectric; energy efficiency
projects; fuel switching; capping landfill gases; better management of methane
from animal waste; the control of coal mine methane; and controlling emissions
of certain industrial gases including HFCs and N2O. 50 CDM projects have taken
place throughout the developing world, including in Asia, Africa, and Central
and South America. 51
However, certain countries have dominated the market. The World Bank
estimates that from 2002 through 2006, China represented 60% of the
cumulative CDM market in terms of credit volume. 52 Based on the number of
projects (as opposed to credit volume), China still represents 50% of the
market. 53 Other dominant sellers include India and Brazil. 54 These concentrations
aside, CDM projects have been registered in over 45 countries. 55 In total, as of
October 2007, over 80 million CERs have been issued from over 20 countries. 56
Early purchases of carbon credits received a significant boost with the
commencement of the Prototype Carbon Fund (PCF) of the World Bank, which
began carbon purchases in the year 2000. The basic concept of the PCF is quite
simple: the fund collects contributions from participating entities and uses those
funds to facilitate projects that reduce GHG emissions. The emission reductions
so generated are then distributed to the entities that contributed to the fund pro
rata based on the amount of their respective contributions. The Prototype Carbon
Fund helped to pioneer the development of the carbon market and demonstrate
how CDM and JI transactions could work. 57 Notably, since the development of
the PCF there has been a proliferation of carbon funds both in the World Bank
and the private sector. The World Bank currently manages ten carbon funds with
approximately US$2 billion in capital commitments. 58
At the time of this writing, over 700 projects have made it through the
rigorous CDM process and been both validated by a Designated Operational
Entity and registered by the CDM Executive Board. 59 This has also led to the

37
approval of over sixtyfive methodologies for measuring emission reductions from

different types of projects. 60 The projects in the current CDM pipeline are
expected to generate approximately two billion CERs through 2012 (the end of
the first Kyoto commitment period). 61
IV. Purchasing Carbon Credits through Erpas 62

An Emission Reduction Purchase Agreement (ERPA) is a specialized form of a
purchase and sale agreement, involving what can be considered a relatively new
type of commodity an emission reduction. 63
CDM transactions can take many different forms. In simplest terms, there is
a seller and buyer of emission reductions. The seller typically has some
ownership or control of the project which is generating the emission reductions.
At a minimum, the seller needs to have legal rights to the emission reductions
being sold. However, in some transactions the buyer may take other roles as
well, including providing funding to the project activity, preparing the relevant
Kyoto documentation, contributing technology or expertise, taking an equity
position in the project, or any other number of approaches.
Given the wide variety of possible approaches to carbon finance
transactions, ERPAs can also take widely varying forms. Several different template
ERPA contracts are publicly available. For instance, the International Emissions
Trading Association (IETA) has developed a model form of ERPA. 64
In its pioneering role in the carbon finance market, the World Bank
developed a form of ERPA that became a prototype for many transactions. In line
with the World Banks approach, most ERPAs principally make payment on the
future delivery of emission reductions. 65 Contracts may involve varying degrees
of up-front financing. 66 However, most ERPAs both those of the World Bank
and others remain forward contracts, in that the contracts are typically entered
into well before the delivery of the CERs.
A. Contracting for a Regulatory Asset Amidst Regulatory Uncertainty

Two broad categories of risk exist in ERPAs. Project risk arises out of the physical
activity occurring that reduces or sequesters emissions. Kyoto risk arises out of
uncertainty surrounding the regulatory status of emissions reductions generated
by the project. 67
38
The value in a CDM transaction derives from a regulatory regime the

Kyoto Protocol. Accordingly, CDM transactions involve a variety of regulatory
risk. For example, the project may not be approved by the CDM executive board;
the CDM may be discontinued post-2012; or CDM standards may change,
reducing or eliminating the value of the carbon finance revenue stream.
Understanding the allocation of regulatory risk in ERPAs is important. Two
approaches to this regulatory risk can be seen in VER (Verified Emission
Reduction) and CER contracts.
For example, the World Banks Prototype Carbon Fund (PCF) began
purchasing emission reductions roughly five years before the entry into force of
the Kyoto Protocol in 2005. These initial PCF ERPAs were designed to stimulate
the generation of emission reductions that would eventually be convertible into
CERs under Kyoto. 68
Because the Kyoto system was still in flux, the PCF structured its purchases
around VERs. An emission reduction in these early PCF contracts was defined as
all existing and future legal and beneficial rights arising from one GHG
reduction. This included the right to any CERs arising from that GHG reduction. 69
Under a VER contract, the buyer and seller agree to a monitoring protocol,
which was used to verify the emissions reductions generated. If a VER project is
subsequently registered by the CDM Executive Board this monitoring protocol is
adjusted to maximize the delivery of CERs from the project. 70
Currently, the Kyoto Protocol is the primary driver of value in carbon
transactions. However, VER-type contracts allow the parties to create, transfer,
and pay for emission reductions despite regulatory uncertainty. 71
When Kyoto entered into force, many market players focused on CER
contracts, under which the buyer would only pay for a compliance grade asset
CERs issued by the CDM Executive Board. 72 Under these contracts, the seller
bears the risk of a projects failure to generate CERs. This includes the risk that
the project will not receive the approval of the CDM Executive Board. 73
The World Bank has continued to use VER contracts after the entry into force
of the Kyoto Protocol in order to allow maximum flexibility to sellers interested in
contracting with the Bank. The VER mechanism also helps sellers develop difficult
projects and innovative methodologies. 74

39
VER contracts also provide a bridge to the post-2012 carbon market.

Because the first Kyoto commitment period ends in 2012, projects that plan to
generate emission reductions post-2012 involved the risk that no Kyoto
compliance exists, or that the current regime will be replaced by a different one.
Either outcome could reduce the value of credits.
However, the World Bank has realized that post-2012 purchases can
contribute to market stability, during the transition from the first commitment
period to the regime that follows. 75 This can be particularly true where projects
need revenue for more than the approximately five years remaining in the first
commitment period. The approach the World Bank has usually followed is
entering into hybrid contracts that include the purchase of CERs for emission
reductions delivered up to 2012 and purchase of VERs thereafter. 76 To
accomplish the goal of post- 2012 purchases, the approach the Bank has usually
followed is hybrid purchases, including the purchase of CERs for emission
reductions delivered until 2012, and purchases of VERs thereafter. 77 Thus, as VER
contracts facilitated the development of the carbon markets before the Kyoto
rules were fully developed, they also provide a mechanism for contracting
forward into the post-2012 world. 78
Experiences in the VER market also have ramifications for the so-called
voluntary market for GHG emission reductions. In the voluntary market, parties
can buy and sell emission reductions based on contractually agreed-upon
verification protocols, outside of a regulatory regime such as the Kyoto Protocol. 79
B. Standardization, Risk and Price

Standardized conditions for ERPAs have been developed by the World Bank and
other third-party buyers in an effort to build market capacity through increased
uniformity in terms. However, wide variation in contract terms exists due to
variation in project risk and buyer and seller preferences.
In 2005, the World Bank developed standardized sets of General
Conditions that apply to its agreements. These General Conditions are
incorporated by reference into World Bank ERPAs. The use of General Conditions
increases the transparency of transactions, increases fairness by offering
comparable terms to all sellers, and reduces transaction costs and negotiation
time. 80 The ERPA contains negotiated terms covering price, volume, and other
project-specific conditions. 81
40
One constant in both World Bank CER and VER contracts is that the seller
bears the risk that the agreed upon project activity, such as capping a landfill or
improving energy efficiency, will not take place. 82 The assumption underlying this
allocation is that the seller is best-positioned to assess and bear project risk.
However, significant differences in Kyoto risk allocation can be seen
between the World Bank VER and CER contracts. Under the VER General
Conditions, the buyer (the World Bank acting as trustee of a carbon fund) bears
the risk that the project may not be registered and commits to make a payment
based on the agreed-upon monitoring protocol if that registration does not occur
within a specific time period. Furthermore, under the VER General Conditions,
the Bank bears the risk that the agreed-upon methodology will not be not
approved by the CDM Executive Board, and a less favorable methodology will be
applied to the project.83 By comparison, in a CER contract, the seller bears these
risks.84
Another crucial issue in ERPA contracting regards the remedies that are
available if a seller breaches its obligations under an ERPA. Both the World Bank
VER and CER General Conditions provide for three remedies in the event of a
sellers unintentional failure to deliver the contracted-for emission reductions: (i)
allow delivery in subsequent years, (ii) convert the amount of emission reductions
subject to a delivery failure to a call option, or (iii) if, and only, if, the delivery
failure persists for three consecutive years or in any of the last three years of the
contract, terminate the ERPA and recover the World Banks costs. 85 Notably, the
World Bank forgoes the right to terminate for just one or two years delivery
failure, as long as the breach is not an intentional breach. Rather, there must be
a continuing delivery failure in order for the World Bank to have the right to
terminate. The intent behind this approach is to enhance the income flow stability
to the seller, to allow it to obtain financing for the project. Both the CER and VER
General Conditions provide for more stringent remedies in the event of an
intentional breach. 86
By comparison, some CER contracts by other buyers require the seller to
guarantee delivery. Under such contracts, if the seller fails to deliver emission
reductions from a project, it must deliver CERs from a different source to the
buyer. Guarantee provisions have the potential of converting an ERPA from an

41
asset to a liability for the seller. This occurs if a project fails to deliver emission
reductions and the seller incurs higher costs for obtaining those emission
reductions from a different source. However, sellers that offer guaranteed
delivery can obtain higher prices. 87
Other provisions unique to ERPAs as compared with other purchase and
sale agreements can be seen in the World Bank General Conditions. For
instance, ERPAs allocate the responsibility between buyer and seller for paying for
the share of proceeds required to fund certain CDM administrative expenses and
adaptation measures. 88 Under the VER General Conditions the buyer pays the
share of proceeds, while under the CER General Conditions the seller pays the
share of proceeds. 89 This allocation mirrors the allocation of risk in Kyotocompliant projects.
In 2006, CER prices averaged above US$10.00. One study has shown a
significant range in CER prices from around US$6.00 to over US$24.00. 90 Thus,
CER prices exist along a wide band, indicative of the significant variety in risk
between projects, be it project risk, the choice of remedies, the existence of a
delivery guarantee, or some other allocation of risk. This price variation is
indicative of significant differences in risk between projects, and demonstrates the
impact of the allocation of risk and responsibilities in ERPAs on carbon prices.
Average CER prices in 2006 were demonstrably higher than VER prices, further
reflecting the importance of risk in emission reductions pricing. 91
The future is likely to continue to see some convergence in contracting
terms, although varying project activities and approaches to risk make cookiecutter contracts unlikely to emerge soon in the wider market.
V. Lessons Learned
Several lessons can be learned from the growth of the carbon market. First, both
the EU ETS and CDM were successful in bringing substantial amounts of capital
into the carbon market in a short amount of time. In the two years following the
entry into force of the Kyoto Protocol in 2005, the carbon market experienced
tremendous growth from a prototype market to one measured in the tens of
42
billions of dollars. The market expanded to include a wide variety of project types
and market participants.
Second, the CDM was instrumental in developing a regulatory infrastructure
capable of generating significant amounts of offset credits. This regulatory
infrastructure includes a process for validating projects, creating and revising
emission reduction methodologies, and issuing credits subject to third-party
verification.
This CDM regulatory infrastructure can serve as a model for other national
and international programs. Few regulatory programs satisfy every goal of every
stakeholder, and the CDM is no exception. One significant challenge for the
CDM will be to evolve to scale. Increased scale, if properly implemented, can
allow more capital, development and technology benefits to flow to the
developing world, while also scaling up increased greenhouse gas emission
reductions in a cost-effective manner.
Third, the international carbon market is just that a market. Markets
respond to incentives. Early CDM projects involved credits that could be
generated both quickly and relatively inexpensively. This is not surprising since
markets seek the most efficient mechanism for creating economic value. The
question of what incentives are provided by the international carbon market is
driven in significant part by political decisions that shape the regulatory structure.
Risk in the carbon market has had a significant impact on the pace of
projects and the price of carbon credits. Even though the framework of the Kyoto
Protocol was agreed to in 1997, the volume of projects did not increase
significantly until the entry into force of the Kyoto Protocol nearly seven years
later. In the interim period, a number of buyers took innovative approaches to
assessing risks, including the purchase of carbon credits under VER structures
before the entry into force of the Kyoto Protocol. The World Bank played a
significant role in spearheading the learning by doing of how transactions
could take place in the international carbon market. However, the allocation of
Kyoto risk continues to have an impact on projects and carbon pricing. Various
approaches to allocating rights and responsibilities have allowed parties to tailor
risks and benefits to their particular needs. Market continuity is also a significant
issue. CDM projects involve upfront costs, including the regulatory costs of
getting a project and its methodology approved by the CDM Executive Board, as

43
well as capital costs in implementing the project itself. These upfront costs can be
a particularly significant issue for renewable energy projects, which require a
certain length of time to recover costs through carbon payments. If these projects
cannot recover payments for carbon credits beyond 2012, the end of the first
Kyoto commitment period, many worthwhile projects may not be feasible. At the
time of this writing, much remains to be done to ensure a viable and vibrant
post-2012 international carbon market.
In sum, carbon finance has shown that a market-based mechanism can
draw significant amounts of capital, both public and private, to the problem of
climate change, as well as spur economic activity in, and transfer climate-friendly
technology to, developing countries. The international carbon market has
learned significant lessons, and has developed a regulatory infrastructure for
offset credits through the CDM. These lessons learned can provide a roadmap
not only for improving the CDM, but also for expanding the carbon market to
include new market participants and regulatory regimes.
About the Author

Christopher Carr is co-head of the climate change practice group at the law firm
of Vinson & Elkins and a former Senior Counsel at the World Bank. Flavia
Rosembuj is a Senior Counsel at the World Bank. The views expressed in the
article are the views of the authors and do not necessarily represent the views of
the World Bank or Vinson & Elkins.
Endnotes
1
KARAN CAPOOR & PHILIPPE AMBROSI, STATE AND TRENDS OF THE CARBON MARKET 2007 3
(World Bank 2007), available at http://carbonfinance.org/ docs/Carbon_Trends_
2007-_FINAL_-_May_2.pdf.
See Kyoto Protocol to the United Nations Framework Convention on Climate

Change Art. 12, Dec. 10 1997, UN Doc FCCC/CP1997/L.7/Add.1, available at
http://unfccc.int/resource/docs/convkp/kpeng.pdf, 37 I.L.M. 22 [hereinafter Kyoto
Protocol].
See United Nations Framework Convention on Climate Change, May 9, 1982, S.

Treaty Doc. No. 102-38 (1992), 1771 U.N.T.S. 107, 165, UN Doc. A/AC/237/18,
44
available at http://unfccc.int/resource/docs/convkp/conveng.pdf. UNFCCC is used

hereinafter to refer both to the treaty document and to secretariat charged with
overseeing its execution.
4
Id. at Art. 2.
Id.
Id. at Art. 4.2(b).
Id.
Id. at Art. 1-26.
Kyoto Protocol, supra note 2, at Annex B. For background on the negotiation of the
Kyoto Protocol and the design of the CDM, see RAUL ESTRADA-OYUELA, A Commentary
on the Kyoto Protocol, in ENVIRONMENTAL MARKETS: EQUITY AND EFFICIENCY (Graciela
Chichilnisky & Geoffrey Heal eds., Columbia University Press 2000); FARHANA YAMIN
(ED.), CLIMATE CHANGE AND CARBON MARKETS: A HANDBOOK OF EMISSION REDUCTION
MECHANISMS (Earthscan 2005); MICHAEL GRUBB, THE GREENHOUSE EFFECT: NEGOTIATING
TARGETS (Royal Inst. of Intl Affairs 1989); MICHAEL GRUBB ET. AL., THE KYOTO PROTOCOL:
A GUIDE AND ASSESSMENT (Royal Inst. of Intl Affairs 1999).
10
See UNFCCC, Kyoto Protocol http://unfccc.int/kyoto_protocol/items/ 2830.php (last

visited Nov. 12, 2007); see also ENERGY INFORMATION ADMINISTRATION [EIA], ANNUAL
ENERGY OUTLOOK 2002: WITH PROJECTIONS THROUGH 2020 23 (2001), available at
http://www.gcrio.org/ OnLnDoc/pdf/aeo2002.pdf.
11
Kyoto Protocol, supra note 2, at Annex B.
12
See generally GRUBB, supra note 9.
13
Kyoto Protocol, supra note 2, at Art. 6, 1.
14
Id. at Art. 12, 3.
15
Id.
16
Id. at Art. 17.
17
See id. at Art. 3, 1014; see also id. at Art. 4.
18
UNFCCC, Emissions Trading, http://unfccc.int/kyoto_protocol/mechanisms/emissions_

trading/items/2731.php (last visited Nov. 12, 2007).
19
The Kyoto Protocol regulates six greenhouse gases, each of which is indexed, on a
per-ton basis, based on global warming potential relative to carbon. Thus, one ton
of carbon equals one tCO2e. Methane is 23 times more potent than carbon as a
GHG, and thus reducing one ton of methane is equivalent to reducing 23 tons of
carbon. The industrial gas HFC-23 is 12,000 times more potent than carbon as a
GHG. Energy Information Administration [EIA], Comparison of Global Warming

45
Potentials from the Second and Third Assessment Reports of the Intergovernmental
Panel on Climate Change (IPCC), http://www.eia.doe.gov/oiaf/1605/gwp.html (last
visited Nov. 12, 2007); see also Kyoto Protocol, supra note 2, at Art. 5, 3.
20
See, e.g., Conference of the Parties Serving as the Meeting of the Parties to the Kyoto
Protocol, Montreal, Nov. 28, 2005Dec. 10, 2005, Modalities and procedures for a
clean development mechanism, 7, UN Doc. FCCC/KP/CMP/2005/8/Add.1
(Mar. 30, 2006), available at http://cdm.unfccc.int/Reference/COPMOP/08a01.pdf
[hereinafter Modalities and Procedures].
21
See UNFCCC, Kyoto Protocol, http://unfccc.int/kyoto_protocol/ items/2830.php (last visited

Nov. 12, 2007) (describing the effect of the Marrakech Accords on the Kyoto Protocol).
22
See UNFCCC, Verify and Certify ERs of a CDM project activity, http://cdm.unfccc.int/
Projects/pac/howto/CDMProjectActivity/VerifyCertify/ index.html (last visited Nov.
20, 2007).
23
UNFCCC, Status of Ratification, http://unfccc.int/Kyoto_protocol/ background/

status_of_ratification/items/2613.php (last visited Nov. 12, 2007); see also Kyoto
Protocol, supra note 2, at Art. 25, 1.
24
The COP/MOP, a subset of parties to the UNFCCC, consists of those parties that
have also ratified the Kyoto Protocol. Thus, the United States and Australia are not
members of the COP/MOP. See Kyoto Protocol, supra note 2, at Art. 13, 12.
25
For a detailed review of law-making by COPs, see Jutta Brunne, COPing with
Consent: Law-Making Under Multilateral Environmental Agreements, 15 LEIDEN J.
INTL L. 1 (2002).
26
Modalities and Procedures, supra note 20.
27
Id. at 5.
28
Id. at Decision 7/CMP.1, 12.
29
Id. at 3538.
30
Id. at 43.
31
Id. at 4448.
32
Id. at 53.
33
Id. at 40(a).
34
Id. at 35.
35
Id. at 2627.
36
Id. at 41.
37
UNFCCC, CDM Project Activity Cycle, http://cdm.unfccc.int/Projects/ pac/index.html

(last visited Nov. 20, 2007).
46
38
The CDM allows for expedited procedures for small scale projects. See United
Nations Framework Convention on Climate Change, Small scale CDM project
activities, http://cdm.unfccc.int/Projects/pac/pac_ssc.html (last visited Nov. 20, 2007).
39
UNFCCC, Verify and Certify ERs of a CDM project activity, supra note 22.
40
CAPOOR & AMBROSI, supra note 1, at 3.
41
See id. at 21.
42
Interview by unknown with Yvo De Boer, Executive Secretary, UNFCCC, in Bonn, Fr.
(October 30, 2006), available at http://www.ecologie.gouv.fr/ IMG/pdf/interview_
yvo_de_boer.pdf.
43
Council Decision 2002/358, 2002 O.J. (L 130) 1, 13 (EC); see also Council
Directive 2003/87, 2003 O.J. (L 275) 32, 3235 (EC).
44
Council Directive 2003/87, Art. 11, 2003 O.J. (L 275) 32, 36 (EC).
45
46
See id. at Table 1.
47
Id. at 22 (Fig. 3).
48
The use of credits from forestry projects and large hydroelectric projects is restricted.
See Council Directive 2004/101, arts. 11(a)(b), 2004 O.J. (L 338) 18, 2021 (EC).
49
See e.g., Climate Stewardship and Innovation Act, S. 280, 110th Cong.
144145 (2007).
50
51
Id. at 24.
52
Id.
53
Id., citing to Jorgen Fenhann, UNEP Risoe Centre, CDM projects by host region,
http://cdmpipeline.org/cdm-projects-region.htm (last visited Nov. 20, 2007).
54
CAPOOR & AMBROSI, supra note 1, at 24 (Fig. 4).
55
UNFCCC, Registration, http://cdm.unfccc.int/Statistics/Registration/NumOfRegisteredProj

ByHostPartiesPieChart.html (last visited Nov. 20, 2007).
56
UNFCCC, CERs issued by host party, http://cdm.unfccc.int/Statistics/Issuance/

CERsIssuedByHostPartyPieChart.html (last visited Nov. 20, 2007).
57
See DAVID FREESTONE, The World Banks Prototype Carbon Fund: Mobilizing New
Resources for Sustainable Development, in LIBER AMICORUM IBRAHIM F.I. SHIHATA
265, 280 (Sabine Schlemmer-Schulte & Ko-Yung Tung eds., 2001).
58
See WORLD BANK, CARBON FINANCE FOR SUSTAINABLE DEVELOPMENT 19 (2006), available
at http://carbonfinance.org/docs/CFU_AR_2006.pdf.

47
59
UNFCCC, CDM Statistics, http://cdm.unfccc.int/Statistics/index.html (last visited

Nov. 20, 2007).
60
UNFCCC, Methodologies for CDM Project Activities, http://cdm.unfccc.int/

methodologies/PAmethodologies/approved.html (last visited Nov. 20, 2007).
61
UNFCCC, CDM Statistics, supra note 59.
62
This section draws heavily on the Authors prior work, available at Christopher Carr
& Flavia Rosembuj, World Bank Experiences in Contracting for Emission Reductions,
15 ENVTL. LIAB. 114, 116 (Mar.Apr. 2007).
63
See id.
64
Intl Emissions Trading Assn [IETA], Buyer Limited and Seller Co., Ltd.: Emissions
Reduction Purchase Agreement (Dec. 3, 2005) (draft for discussion purposes),
available at http://www.ieta.org/ieta/www/pages/download.php?docID=1318; see
also Certified Emission Reductions Sale and Purchase Agreement [CERSPA],
http://www.cerspa.com/downloads/CERSPA_Template_Eng_v1_4-2007.doc (last visited
Nov. 7, 2007) (an open source contract template for buying and selling CERs).
65
See CAPOOR & AMBROSI, supra note 1, at 34.
66
Id.
67
Carr & Rosembuj, supra note 62, at 118. While transactions may involve a variety of
other risks, focusing on these two types of risks helps to understand the
fundamentals of CDM transactions.
68
Id. at 11617.
69
Id. at 117. See Intl Bank for Reconstruction and Dev. [IBRD], General Conditions
Applicable to Verified Emission Reductions Purchase Agreement: Clean Development
Mechanism Projects, at 3, (Feb. 1, 2006), available at http://carbonfinance.
org/docs/VERGeneralConditions.pdf [hereinafter VER General Conditions] (providing
a definition of Emission Reductions).
70
Carr & Rosembuj, supra note 62, at 118; Conference of the Parties Serving as the
Meeting of the Parties to the Kyoto Protocol, Montreal, Nov. 28, 2005Dec. 10,
2005, Report of the Conference of the Parties serving as the meeting of the Parties to
the Kyoto Protocol on its first session, 8, UN Doc. FCCC/KP/CMP/20005/ 8/Add.1
(Mar. 30, 2006), available at http://cdm.unfccc.int/Reference/COPMOP/08a01.
pdf#page=31. The CDM Executive Board supervises the CDM, under the authority
and guidance of the Conference of the Parties serving as the Meeting of the Parties
to the Kyoto Protocol.
71
Carr & Rosembuj, supra note 62, at 117.
48
72
Id. at 117; see, e.g., Intl Emissions Trading Assn [IETA], Code of CDM Terms:
Version 1.0, available at http://www.ieta.org/ieta/www/pages/getfile.php?docID=
1794 (Sept. 11, 2006).
73
Id. at 117.
74
Id. at 117.
75
WORLD BANK CARBON FINANCE UNIT, THE ROLE OF THE WORLD BANK IN CARBON FINANCE: AN
APPROACH FOR FURTHER ENGAGEMENT 13 (2006), available at http://carbonfinance.org/
docs/Role_of_the_WorkBank.pdf.
76
Carr and Rosembuj, supra note 62, at 117.
77
Id.
78
Id. at 117.
79
For instance, in the United States, companies have voluntarily bought and sold
emission reductions in the absence of a federal greenhouse gas regulatory program.
80
Carr and Rosembuj, supra note 62, at 117.
81
See, e.g., PROJECT ENTITY & INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT
(AS TRUSTEE OF FUND), CLEAN DEVELOPMENT MECHANISM CERTIFIED EMISSION REDUCTIONS
PURCHASE AGREEMENT (2006), http://carbonfinance.org/docs/CER_ERPA_07_07_06_
model.doc.
82
Id. at 118. See, e.g., VER General Conditions, supra note 69; see also IBRD, General
Conditions Applicable to Certified Emission Reductions Purchase Agreement (2006),
http://carbonfinance.org/docs/CERGeneralConditions.pdf [hereinafter CER General
Conditions].
83
See, e.g., VER General Conditions, supra note 69.
84
See, e.g., CER General Conditions, supra note 82; Carr & Rosembuj, supra note 62,
at 118.
85
VER General Conditions, supra note 69, at 13.03(a)(i); CER General Conditions,
supra note 82, at 13.03(a)(i); Carr & Rosembuj, supra note 62, at 118.
86
87
Id.; CAPOOR & AMBROSI, supra note 1, at 32.
88
Conference of the Parties Serving as the Meeting of the Parties to the Kyoto Protocol,
Montreal, Can., Nov. 28-Dec. 10, 2005, Annex 66, UN Doc.
FCCC/KP/CMP/2005/8/Add.1 (March 30, 2006). The adaptation fee includes a two
per cent deduction from CERs issued for projects (except those located in Least
Developed Countries). The administrative fee US$0.10 per CER issued for the first
15,000 CERs for which issuance is requested in a given calendar year and US$0.20

49
per CER issued for any amount in excess of 15,000 CERs for which issuance is
requested in that calendar year. Id. at Decision 7/CMP.1, 37.
89
VER General Conditions, supra note 69, at 5.05; CER General Conditions, supra
note 82, at 5.05.
90
91
Id.; see CAPOOR & AMBROSI, supra note 1, at 31.
3
Linking the EU Emissions Trading
Scheme to JI, CDM and Post-2012
International Offsets
J. de Spibus*
The author evaluates the Linking-Directive approved by European
Union Emissions Trading Scheme (EU ETS). The author finds
that though the Linking directive did not impose any limit on the
import of JI/CDM credits yet it required the Member States to
set maximum quantity of Kyoto units. The directive lead to collapse
of prices in the EUs emission markets, in consequence the EU
ETS decided to impose strict limits on the use of JI/CDM credits
during its second trading period. The author intends to examine
the International and European legal framework to find a better
utilization of JI/CDM credits in post-2012 international offsets.
The author finds that the European view on the appropriateness
of linking the EU ETS with the international project
mechanisms has changed over the years. Therefore, the author
suggests for introducing quantitative and qualitative restrictions
for the use of international offsets within the EU ETS.
*
Former professor of International and European lLaw (university of fribaurg); consultant, NCCR trade
regulation. World Trade Institute, Haller Strasse 6, Berne, Switzerland. E-mail: joelle.desepibus.@unifr.ch
2008 J. de Sepibus. Reprinted with permission of author.

Source: www.nccr.trade.org.
50
Introduction
The so-called Linking-Directive adopted in 2004 doesnt impose any limit on
the import of JI/CDM credits under the European Union Emissions Trading
Scheme (EU ETS), but requires from the Member States to set, in accordance with
their supplementarity obligations under the Marrakesh Accords, the maximal
amount of Kyoto units each covered installation is entitled to use for compliance
under the scheme. Fearing a second price collapse of the European Union
Allowance, the Commission decided, however, in 2006 to impose strict limits on
the use of JI/CDM credits during the second trading period. This paper examines
the legal basis of the Commissions decision and explores further the
international and European legal framework within which the current debate on
the use of JI/CDM credits and post-2012 international offsets takes place. It
analyses in particular the recent proposal of the Commission on the third trading
period of the EU ETS and the related report of rapporteur Doyle of the European
Parliament and discusses the necessity to introduce quantitative and qualitative
restrictions for the use of international offsets within the EU ETS against the
backdrop of the international negotiations on a new global deal on climate
change.
While the international discussions about a global and comprehensive post2012 agreement to fight climate change started in Bali in December 2007, the
first trading period of the European Union Emissions Trading Scheme (EU ETS)
has come to an end. Its environmental effectiveness is highly contested, as
Member States, facing a type of Prisoners Dilemma, 1 were unable to resist the
temptation to hand out generous emissions allowances, causing the collapse of
the price of the European Union Allowance (EUA) 2 at the end of 2006 and
reducing to zero the incentives to abate emissions and to develop alternative
fuels and more energy-efficient technologies. The question naturally arises as to
whether the second (20082012) and third trading periods (20132020) of the
EU ETS will witness a more positive environmental outcome.
Although the European Commission 3 has cut the proposed amount of
allowances (the cap) for the second trading period by about 10%, many
analysts 4 expect the shortage of allowances to be covered entirely by the import
Linking the EU Emissions Trading Scheme to JI, CDM and

51
of cheap credits of often dubious environmental effectiveness from the Kyoto

Protocols project mechanisms. 5 There is indeed growing concern that a
significant part of the credits generated by the JI 6 and CDM 7 do no reflect real,
verifiable emission reductions and that the CDM in particular is inadequate to
assist developing countries in bringing about structural changes to reduce their
dependence on fossil fuels. 8
This would mean that the principal legal instrument adopted by the EU to
fight climate change neither encourages investments leading to a progressive
decarbonisation of the industries covered in the EU nor significantly helps
developing countries in their transition towards a low-carbon economy as
required by the Bali Action Plan. 9
While the critique regarding the inability of the Kyoto Protocols project
mechanisms to contribute effectively to long-lasting reductions of greenhouse
gas emissions will not be discussed at length, this study sheds some light on
the rules which govern the use of CDM and JI credits and post-2012
international offsets 10 within the current EU ETS and in the proposals for its
third trading period. 11
After a brief account of the debate preceding the adoption of the Linking
Directive, 12 which amended the ETS-Directive in respect of the Kyoto Protocols
project mechanisms, we examine its content and analyse the criteria established
by the Commission in its guidance on the ETS 13 at the end of 2006 to limit their
use in the second trading period. We then present the international and
European legal framework within which the current debate on the use of JI/CDM
credits and post-2012 international offsets, which are also referred to as
external credits, takes place. We discuss in particular the recent proposal of the
Commission on the ETS 14 and the related report of rapporteur Doyle 15 of the
European Parliament and evaluate their proposals in the light of the scientific
findings presented by the 2007 IPCC 16 and the international commitments made
by the EU at the UNFCC Conference in Bali. 17 Finally, we conclude with an
outlook on the debate regarding the use of offsets by emission trading schemes
in the United States.
52
I. The Use of CDM and JI Credits within the EU ETS

The EU ETS, launched in January 2005, is an EU-wide cap-and-trade
scheme for CO2 emissions from energy-intensive industry, covering about 45% of
greenhouse gas emissions in the EU. Its legal framework is set out by the
Directive, which established a scheme for trading in greenhouse gas emission
allowances
within
the
Community
(ETS-Directive). 18
The
scheme
distinguishes between two distinct trading periods: phase I, a three-year

period from 1 January 2005 until 31 December 2007, and phase II, a
five-year period, coinciding with the Kyoto Protocol commitment period,
starting 1 January 2008 and ending in 2012. 19 Its aim is to help Member
States reduce their greenhouse gas emissions to meet their targets under the
Kyoto Protocol at minimum costs. The scheme itself does not set an upper
limit (the cap) to the number of allowances, but leaves that decision to the
Member States, which have to fix the maximal amount of allowances
allocated to their industry in their National Allocation Plans (NAPs). The NAPs
are submitted to the European Commission (the Commission), which has to
assess them and decide whether to grant approval. 20 It may reject a plan, or
any aspect thereof, if it finds it to be incompatible with the criteria set out in
Annex III of the ETS-Directive. 21
A. The Linking Directive

1. The Commissions Proposal
In its original version, the ETS-Directive did not include the possibility for
operators to use Kyoto units for compliance under the scheme. The importance
of the project-based mechanisms in increasing the cost-effectiveness of the EU
ETS was, however, already stressed in its preamble. 22 On 23 July 2003, the
Commission presented a proposal aiming at linking the CDM and JI
mechanisms with the ETS, 23 which took the form of an amendment to the ETSDirective. 24 The proposal allowed for the conversion of JI and CDM credits into
allowances for use in the EU ETS from 1 January 2008 onwards. 25 No limit on
the amount of credits to be converted was foreseen, but the Commission was
required to undertake an immediate review by the comitology procedure 26 in

53
the case that the amount of credits reached 6% of the total quantity of allowances
and to consider whether a maximum percentage, for example 8%, should be
introduced.
The most frequently invoked reason for the inclusion of the project-based
mechanisms was that they reduce the compliance costs for the sectors covered
under the EU ETS by broadening the range of opportunities to reduce emissions
in another Member State or outside the EU at lower costs. 27 Another advantage is
that they allow sources not covered by the ETS-Directive to engage in
implementing cost-effective reduction options. Finally, the combination of
emission caps and the possibility to use CDM and JI was meant to help kick-start
the international carbon market. Many environmental Non-Governmental
Organisations (NGOs) were, however, opposed to the use of JI and CDM credits
within the EU ETS, because they feared that a massive import of Kyoto units into
the system would significantly lower the market price of the EUA and lead to little
or no domestic abatement. 28 They also expressed doubts about the
environmental quality of the credits generated by the Kyoto Protocols projectbased mechanisms. 29
2. The Legal Framework

The final Directive, the so-called Linking-Directive, was adopted on 27 October
2004 after intensive debates. 30 It differed significantly from the Commissions
proposal. Contrary to this proposal, which imposed a conversion of CDM and JI
credits, operators are allowed to use CDM and JI credits directly to offset their
reduction obligations under the ETS-Directive. 31 Whereas CDM credits may be
taken into account in both trading periods, JI credits can enter the scheme from 1
January 2008 onwards. 32 The clause triggering a review in the case that Kyoto
units reach a certain percentage of overall allowances, was dropped. Member
States are, instead, required to define an installation-specific limit in their
national allocation plans (NAPS) in accordance with criterion 12 of Annex III of
the ETS-Directive. The use of credits resulting from land use, land-use change
and forestry (LULUCF or sinks) projects, as well as from nuclear facilities is
excluded. 33 Special provisions concern the use of JI and CDM credits from
projects that affect emissions from installations under the EU ETS and domestic
projects, so-called unilateral JI. 34
54
According to criterion 12 of Annex III of the ETS-Directive, Member States

have to mention the maximum amount of Kyoto units, which may be used by
operators covered by the scheme as a percentage of the allocation of the
allowances to each installation. The percentage must be consistent with the
Member States supplementarity obligations, which were laid down in the
Marrakesh Accords. 35 These provisions require Annex 1 Parties to ensure that the
use of the flexible mechanisms of the Kyoto Protocol is supplemental to domestic
action and that domestic action constitutes a significant effort made by each of
them to meet their targets under the Kyoto Protocol. 36 No precise information is,
however, provided with respect to the supplemental character of the flexible
mechanisms, either by the ETS-Directive or in the Marrakesh Accords.
B. The Commissions Decision to Restrict the Use of JI and CDM

Credits in the Second Trading Period of The EU ETS
With respect to the second trading period, the Commission indicated at the end
of 2005 37 that Member States had to take into account the aggregate reductions
in greenhouse gas emissions when evaluating the fulfilment of criterion 12 of
Annex III. This meant that Member States had to consider the overall recourse to
the flexible mechanisms when fixing the percentage of CDM and JI credits to be
used within the EU ETS. The Commission did not however provide any
information on how the supplementarity principle should be interpreted.
It was only in its third guidance on the criteria of Annex III from November
2006 that the Commission became more assertive. 38 It departed from its
formerly cautious attitude and announced that it would assess the NAPs in a
manner which would allow the ETS to unfold its full environmental and economic
potential in terms of environmental and economic benefits. It not only
significantly reduced the caps proposed by the first batch of NAPs submitted, but
provided guidance regarding the interpretation of criterion 12 of Annex III in a
three-step process. It first developed a formula allowing the calculation of the
overall amount of JI/CDM credits to which a Member State can have recourse
between 2008 and 2012. Second, it indicated which rules Member States have
to observe when fixing the limit for the use of Kyoto units for the covered
sectors. Third, it set a minimal percentage of Kyoto units any installation subject
to the EU ETS is entitled to use. The criteria set out by the Commission are briefly
discussed below.

55
1. The Maximal Overall Use of JI and CDM Credits by Member States

The Commission stated that the maximum amount of JI/CDM credits Member
States were allowed to have recourse to between 2008 and 2012 would have to
be calculated in relation to the reduction effort they had to make to meet their
targets under the Kyoto Protocol 39 and the so-called Burden-Sharing
Agreement. 40 This reduction effort would have to be calculated with respect to
the three different baselines, the base year of the Kyoto Protocol (in general
1990), 2004 and 2010. 41 Half of the highest difference between the level of
greenhouse gas emissions in one of these years and the reduction target laid
down in the Burden-Sharing Agreement and the Kyoto Protocol represents the
maximal amount of JI/CDM credits a Member States is allowed to import. This
formula fixed an effective ceiling of 50% on the number of JI/CDM credits to be
used by a Member State with respect to their reduction effort. 42
The recourse to three different baselines to calculate the national reduction
effort seems at first sight somewhat confusing, but was probably chosen for
political reasons. By allowing Member States to rely on the highest figure
resulting from these calculations, the Commission was able to take into account
the large diversity of Member States emission paths since 1990 without
penalising one over the other. It thereby arguably reduced the important
potential for conflict arising from its interpretation of the supplementarity
principle. Caution was indeed required, as the Commissions interpretation is
based on rather weak legal foundations. Indeed, neither the Kyoto Protocol 43 nor
the Marrakesh Accords nor any Community instrument contains a numerical
definition of the supplementarity requirement. If it is true that the European
Union during the negotiations of the Marrakesh Accords had insisted that at least
half of the emission reductions to achieve compliance with the Kyoto Protocol
should be realised domestically, this limit remained controversial and did not
become legally binding. 44 Moreover, it concerned the overall recourse to
external credits and thus also included credits Member States intended to
acquire through emission trading according to the rules laid down in Article 17
of the Kyoto Protocol. 45 Accordingly, by interpreting the requirements of Article
12 of Annex III of the ETS-Directive as a compulsory ceiling of 50% with regard to
the aggregate use of JI/CDM credits by Member States the Commission could
rely neither on Community law nor on international public law.
56
2. The Repartition of JI and CDM Credits between the Sectors Covered by

the EU ETS and the Non-covered Sectors
With respect to the repartition of JI and CDM credits between the covered and
non-covered sectors of the EU ETS, the Commission clarified that Member States
were free to choose which sectors should bear the burden of the domestic
reduction effort. 46 Member States which had not purchased any Kyoto units
with government funds, and did not intend to do so, were allowed to distribute
the full amount of CDM/JI credits among the installations of the covered
sectors. 47 If, on the contrary, the government had purchased or intended to
purchase Kyoto units, Member States were required to deduct the amount of
JI/CDM credits from the overall ceiling when fixing their use within the EU ETS. 48
Regarding intended purchases of Kyoto units, the Commission further specified
that Member States had to substantiate sufficiently their intention, which meant
that they had to demonstrate that an operational programme was in place and
that it had taken concrete steps and committed budgetary resources for the
purchase of carbon credits. 49
Finally, the Commission stated that notwithstanding the result of the criteria
set out above, the limit imposed on the use of JI/CDM credits by installations
under the EU ETS might not be lower than 10% of the allowances allocated to
each installation. It justified this decision by arguing that it reflected a
reasonable balance between domestic reductions and incentives for operators to
invest in projects in developing countries. The Commission did not substantiate
this statement. In the light of the overall cap imposed on covered sectors in the
second trading period this assertion is, however, problematic. Indeed, the
aggregate limit to the use of JI/CDM within the EU ETS amounts to 13% of the
overall cap, while the cap in the second trading period is only 6% lower than
comparable 2005 emissions. 50 Accordingly, the amount of JI/CDM credits
exceeds by nearly a factor of two the overall reduction effort required by
operators under the EU ETS with respect to 2005 emissions and theoretically
allows the covered sectors to achieve all emission reductions outside the
European Union. 51

57
The reasons why the Commission fixed a minimum threshold of 10% of

Kyoto units per installation, were probably not so much related to the necessity
to strike a balance between domestic mitigation measures and investments
outside the EU, but to find an acceptable compromise between new and old
Member States. Indeed, as most new Member States have no gap to fill with
regard to their Kyoto target due to the break-down of their economies in the
1990s, their domestic operators would not have been entitled to have recourse to
any JI/CDM credits under the EU ETS according to the first two criteria set out
above. Thus, by fixing a minimal threshold of 10%, the Commission ensured that
the differences with respect to the use of Kyoto units in the various Member States
remained within acceptable boundaries. 52 Indeed, if operators in one Member
State can use a significantly higher amount of credits than those in another
Member State, the former have a competitive advantage. 53
Moreover, the Commission probably also tried to reduce the risk of a legal
challenge 54 of its decision to reduce significantly the proposed caps of most new
Member States. 55 These sometimes significant cuts had been necessary as the
new Member States had decided to increase the amount of allowances
by 12.7% in the second trading period compared to 2005 emissions. 56 Thus, by
allowing the operators of these Member States to have recourse to JI/CDM
credits, even though they were on track to meet their targets under the Kyoto
Protocol, the Commission was probably trying to compensate for the economic
disadvantage resulting from the reduction of their caps. 57 This purpose is evident
in particular in the case of Lithuania. This country, which has no compliance
problems regarding its Kyoto target, had initially proposed to fix a limit of 10%
with respect to the use of JI/CDM credits by its operators. As the Commission had
reduced its proposed cap by 47% 58 it allowed, in a second decision on an
amended Lithuanian NAP, an increase of the CDM/JI limit up to 20% of its cap
in clear contradiction to its own guidelines. 59
This strategy of the Commission to limit the legal challenges was, however,
not entirely successful. Seven out of ten of the new Member States but
interestingly not Lithuania started legal proceedings against the decision of the
Commission with respect to their NAPs in the second trading period. Slovakia,
followed by Poland, the Czech Republic, Hungary, Latvia, Bulgaria and Romania
filed a legal complaint with the Court of First Instance in 2007, requesting the
annulment of the Commissions decisions. 60
58
II. Linking the EU ETS to JI, CDM and post-2012 International

Offsets in the Third Trading Period
A. The European and International Legal Framework
The Kyoto Protocol does not envisage any numerical reduction targets after the
first commitment period ending in 2012. As a result, in the absence of any new
international agreement or national commitments to limit greenhouse gases, the
demand for JI and CDM credits runs the risk of decreasing progressively towards
the end of the first commitment period of the Kyoto Protocol. To prevent such an
outcome the European Union pledged in its Spring Council in 2007 61 to
unilaterally reduce its greenhouse gas emissions by 20% by 2020 compared to
levels of greenhouse gases in 1990 and to endorse a 30% reduction objective in
the case of the conclusion of a comprehensive international agreement on
climate change for the period after 2012.
In December 2007, the Conference of the Parties of the UNFCC 62
(COP 13) 63 and of the Kyoto Protocol (MOP3) 64 adopted the Bali Action Plan 65
paving the way for post-2012 negotiations and aiming at the conclusion of such
an agreement by the end of 2009 in Copenhagen. 66 Regarding the
commitments made, the Bali Action Plan differentiates between those of
developed country Parties and developing country Parties. For developed country
Parties, the decision calls for measurable, reportable and verifiable nationally
appropriate mitigation commitments or actions, including quantified emission
limitation and reduction objectives. Due to the resistance of the delegations of
the US, Canada, Japan and Russia, an indicative range of mitigation
commitments by industrialised countries (2540% reduction compared to 1990
levels) that is considered necessary by the IPCC to stay below a two-degree
increase of global mean temperature, however, was not integrated into the text,
but relegated to a reference in a footnote. 67
With regard to developing country Parties, the decision calls for nationally
appropriate mitigation action supported and enabled by technology,
financing and capacity-building, in a measurable, reportable and verifiable
manner. Developing countries thus have a clearly worded point of reference that
any commitments on their part have to be matched by clearly identifiable support

59
from industrialised countries. 68 This requirement corresponds to a plea constantly

being made by developing countries and was again highlighted at the session in
Bali by the publication of a paper by the Secretariat of the UNFCCC, which
stressed that investment and financial flows of US$ 379.5 billion were necessary
for mitigation as well as several tens of billions for adaptation by 2030. 69
Less than a month after the conference in Bali in January 2008 the
European Commission put forward a so-called climate package, 70 which
included a proposal for a third trading period of the EU ETS (ETS-Proposal) 71 and
a proposal on the distribution of the emission reduction effort among the
Member States (effort-sharing proposal). 72 The ETS-Proposal takes the form of a
draft amendment to the ETS-Directive and the effort-sharing proposal constitutes
a draft decision. Both proposals are based on Article 251 EC Treaty, which is
known as the co-decision procedure.This implies that whereas the Council and
the European Parliament discuss the Commissions proposal independently both
must approve one anothers amendments and agree upon a final text in identical
terms. 73
Whereas the effort-sharing proposal defines the contribution of Member
States to meeting the Communitys greenhouse gas emission reduction
commitment from 2013 to 2020 for greenhouse gas from sources not covered
under the ETS-Directive, the ETS-Proposal fixes the cap for the covered sectors
during this period. The two proposals also determine the share of carbon credits
that may be imported, the effort-sharing proposal with respect to the
non-covered sectors 74 and the ETS-Proposal regarding the covered industries.
Following the decision of the European Spring Council of 2007, both proposals
adopt a two-step approach. They first lay down the rules allowing the EU to
reach a 20% reduction target by 2020 and, in the second step, indicate how
these rules may be adapted if a global international agreement enters into force.
In its spring session in March 2008 the European Council endorsed the
Commissions climate package, considering it as a good starting point and
stated as its objective to secure an ambitious, global and comprehensive post2012 agreement on climate change at Copenhagen in 2009 consistent with the
EUs 2C objective that ensures scaled-up finance and investment flows for both
mitigation and adaptation. 75
60
B. The ETS-Proposal of the European Commission

The Commissions ETS-Proposal 76 replaces the national caps with an EU-wide
cap. With respect to the current ETS-Directive the scope is enlarged to include
aviation, petrochemicals, ammonia and the aluminium sector as well as two new
gases. 77 In the case that no international agreement is adopted, the Commission
proposes to impose a 21% reduction in EU ETS sector emissions compared to
2005 by 2020, which corresponds to a reduction of 14% relative to 1990.
Emission allowances are to be cut by 1.74% annually, starting from 2013.
Compared to the other sectors, which have to reduce their emissions by about
10%, the reduction effort required from the EU ETS sectors is thus twice as
important. Taken together, the reduction commitments result in an overall
reduction of 14% compared to 2005, which is equivalent to a reduction of 20%
compared to 1990. 78
The Commission proposes to increase auctioning to around 60% of the total
number of allowances in 2013. Whereas full auctioning will be the rule from
2013 onwards for the power sector, free allocation will be gradually phased-out
on an annual basis between 2013 and 2020 for other sectors. However, certain
energy-intensive sectors will continue to get all their allowances for free if they
are at significant risk of carbon leakage. 79 Member States are in charge of the
auctions and receive all the proceeds. The linkage of the EU ETS with other capand-trade systems is allowed provided that the environmental objectives of the
EU ETS are not undermined.
1. The Recourse to JI/CDM Credits and Other International Offsets by the

Covered Sectors
a. In the Absence of a Global Climate Agreement
According to the ETS-Proposal JI/CDM credits from all types of project
established before 2013 and accepted in the Community scheme during 2008
and 2012 may be exchanged for allowances of the third trading period up to the
remainder of the level which they were allowed in the second trading period and
may be used without restriction in the third trading period. 80 Furthermore, the
Commission proposes to allow the use of external credits resulting from projects
started in least developed countries from 2013 onwards. 81 The justification for

61
this privileged treatment is that these countries are especially vulnerable to the
effects of climate change and are responsible only for a very low level of
greenhouse gas emissions. 82 Finally, in the event that the conclusion of an
international agreement on climate change is delayed, operators are allowed to
have recourse to credits from project activities in third countries with which the
Community has concluded agreements. 83 However, once an international
agreement on climate change has been reached, only CERs from third countries
which have ratified that agreement shall be accepted in the Community scheme. 84
The reasons given by the Commission for allowing the exchange of CDM
and JI credits is that it gives operators certainty that they may use them after the
end of the second trading period. Clearly, the Commission also wants to avoid a
price collapse similar to the one seen in the first trading period. This risk is all the
more real, as the number of JI/CDM credits considerably exceeds the reduction
required from operators with respect to their 2005 emissions. 85 Moreover, if the
seven Member States which required the annulment of the Commissions
decision regarding their NAPs were to win their legal challenge, another
significant quantity of allowances would flow into the EU ETS and diminish further
the relative scarcity of allowances imposed by the Commission.
b. In the Case of a Global International Climate Agreement
The ETS-Proposal foresees that upon the conclusion of a future international
agreement the ETS-Directive should provide for an automatic adjustment of the
use of credits from JI/CDM credits and potentially additional types of credits
and/or mechanisms envisaged under such an agreement. Operators may use up
to half of the additional reduction taking place due to the international
agreement CERs, ERUs or other types of credits earned in countries which have
concluded the international agreement. 86 Once an international agreement on
climate change has been reached, no CERs from third countries which have not
ratified that agreement may be accepted as complying with the ETS.
C. The Draft Report of the European Parliament on the ETS-Proposal

The European Parliament entrusted the compilation of the first draft report on the
ETS-Proposal to an Irish rapporteur of the Conservative Party, Mrs Avril Doyle,
who published it in June 2008. 87 Simultaneously, Satu Hassi, the Finnish
62
rapporteur of the Green Party, finalised her draft report on the Effort-Sharing
Proposal. 88 The vote on both reports by the Environmental Committee of the
European Parliament is scheduled for 7 October2008. 89
In line with the Commission the Doyle Report endorses the strategy of the
European Council with respect to the overall emission reduction targets, i.e. a
reduction of greenhouse gas emissions of 20% or 30% with respect to 1990
levels in the case of the conclusion of an international agreement on climate
change. 90 In contrast to the ETS-Proposal, the report suggests that an increase of
the reduction commitment would occur only after the ratification of a global
international agreement and not as soon as it is concluded. 91
Regarding the use of international offsets the report stipulates that operators
should be allowed to use external credits up to an average of 5% of their
emissions during the period from 2013 to 2020, provided they use less credits
from CDM and JI projects during the 2008-2012 period than the equivalent of
6,5% of their 2005 emissions and that they do not carry over entitlements from
that period. In other words, operators under the ETS have the choice to either use
external credits at a level of 5% of their annual greenhouse gas emissions 92 or
to bank the credits they had been granted in the second trading period.
According to the Doyle Report, this option enables operators to use external
credits for almost half of their abatement effort between 2013 and 2020 and
would ensure that in the period 20082020, operators effectively reduce
emissions below those for 2005.
Unlike the Commissions proposal, the report also addresses the growing
criticism levelled against the Kyoto Protocol project mechanisms by requiring
additional qualitative guarantees with respect to the environmental integrity of
international offsets. 93 Accordingly, the rapporteur proposes to accept exclusively
JI/CDM credits and/or other external credits provided for by a global climate
accord if they come from so-called Gold Standard-type projects. 94 Where
bilateral agreements with third countries are concluded, the report further
specifies that credits envisaged by these agreements may also come from
sustainable forestry activities in developing countries. 95 Finally, the rapporteur
suggests that operators may use credits up to a non-specified percentage of their
emissions from sustainable actions to reduce deforestation and increase

63
afforestation and reforestation in developing countries, once appropriate

provisions on liability, discounting and permanence have been laid down, which
are also accepted by a US federal emissions trading system. 96
Through the simple reference to Gold Standard-type projects, the report
deliberately leaves open the exact definition of such projects. To shed some light
on its potential meaning it might be useful to recall briefly the aims of the Gold
Standard 97 organisation and the requirements it sets out for CDM projects. The
Gold Standard is a private foundation supported by NGOs, which was created
to ensure that carbon markets work for a long term climate solution and that
they stimulate local sustainable development. Applying the standard CDM
procedure, 98 the organisation does not itself judge or verify emission reductions,
but sets out additional requirements with which a CDM project has to comply if a
proponent wants to obtain the Gold Standard label for its project. Its main
features are the restriction of eligible projects, the requirement for a sustainability
assessment and the stipulation of stricter criteria for the stakeholder consultation
process. They will be briefly explained below.
Unlike the CDM rules, which admit nearly all types of projects, 99 only
renewables and end-use energy efficiency projects are eligible under the Gold
Standard. 100 The reason advanced for this restriction is that these projects
reduce emissions at the source and hence contribute to reducing the
dependence of developing countries on fossil fuels. As under the CDM rules,
projects must lead to real, verifiable reductions in greenhouse gas emission and
contribute to the sustainable development of a country hosting a CDM project.
The definition of sustainability is, contrary to a normal CDM project, not left to
the country hosting a CDM project, but set out in detail by two tools of the
organisation, the Gold Standard Requirements and the Gold Standard Toolkit.
According to the latter project proponents are asked to assess the risk that their
project activities will have severe negative environmental, social and/or economic
impacts, and must demonstrate that their project activities have clear sustainable
development benefits through a detailed impact assessment. Hence a project has
to be scored on environmental, social and technological and economic
indicators. 101 To allow for a detailed score to be given, twelve specific
environmental, social and economic indicators have to be considered, which
together with the scoring form the sustainable development matrix. Furthermore,
a sustainability monitoring plan has to be set up to assist in verifying the impact
64
of the project on the sustainable development of the host country. 102 Finally, the
Stakeholder Consultation Guidelines set out by the Gold Standard must be
respected; these lay down strict criteria for the involvement and information of
local stakeholders, in particular NGOs supporting the Gold Standard.
By requiring that credits come from Gold Standard-type projects, the Doyle
Report ensures that the Gold Standard is not entrusted a monopoly position with
regard to the certification of external credits allowed into the ETS. The question
as to which criteria will have to be fulfilled and who is responsible for formalising
and controlling them must thus still be answered.
D. Evaluation of the ETS-proposal and the Draft Doyle Report

The Commissions ETS-Proposal addresses many of the issues highlighted for
reform during the review process, including the call for an overall EU cap and a
global limit on the use of JI/CDM credits in the third trading period. It thus puts
an end to the legal uncertainty created by the reference to the supplementary
criterion set out by the Marrakesh Accords and the free-riding of certain Member
States. Furthermore, by allowing EUAs and CERs to be banked, the ETS-Proposal
helps to prevent the potential overallocation in the second trading period
leading to a complete price collapse of the EUA and the demand for carbon
credits in the international carbon market dying down as the end of the first
commitment period of the Kyoto Protocol approaches. 103
Notwithstanding these improvements, the Commissions proposal has been
strongly criticised by NGOs 104 and academics 105 alike for its lack of
environmental ambition, the overemphasis on international offsets and the
absence of any qualitative criteria ensuring their environmental quality in the
case of a global climate agreement.
1. The Lack of Environmental Ambition

The emission reductions, both in the case of the 20% and the 30% reduction
scenario, are well below the recommendations of the IPCC regarding the action
to be taken by industrialised countries to stabilise global warming at about 2
degrees Celsius above pre-industrial levels. 106 Hhne, for instance, indicates
that, to reach this target, industrialised countries would have to reduce their
emissions to between 25% and 40% below 1990 levels by 2020 whereas

65
developing countries would have to keep emissions between 15% and 30% below
baseline. 107 He concludes thus that an EU target compatible with limiting climate
change to 2 degrees Celsius would require reductions of emissions within the EU
to
at
least 30% below 1990 levels plus support for developing countries through CDM
or another carbon mechanism of the order of magnitude of an additional 10
percentage points. 108
The necessity for taking stronger action is, in particular, recognised by the
Hassi Report on Effort-Sharing. Recalling that the European Parliament had itself
called in October 2006 for a 30% reduction target, the rapporteur proposes to
turn upside down the Commissions proposal by using the reduction target
of 30%1 as a starting point and keeping the 20% reduction as a fallback option in
the case that no international agreement on climate change is concluded. 109
Hassi finally advocates that the recourse to credits resulting from projects in third
countries should, as a rule, not replace the domestic reduction effort but reflect
an additional commitment taken by industrialised countries to assist developing
countries. She proposes instead that the EU endorses a so-called additional
external commitment, which, in the case of the conclusion of a global climate
accord, would mandate the EU to assist developing countries in their activities to
mitigate climate change. 110
2. The Emphasis Placed on International Offsets

The important recourse to international offsets by covered sectors, which is
contemplated by both the ETS-Proposal and the Doyle Report, is expected to
reduce significantly the potential carbon price within the EU ETS. 111 According to
Hassi this necessarily entails that innovation within the EU, which reduces its own
dependence on fossil fuels, will be slowed down considerably. 112 With regard to
the power industry, which is responsible for 24% of the European Unions
greenhouse gas emissions, 113 this means in particular that the expected EUA
price will be insufficient by itself to trigger a massive switch to renewable energies
or to enable the development and large-scale deployment of CCS for fossil-fuel
power stations in the next decades. 114 Given that most existing large electricity
plants will have to be replaced in the next 1020 years and that fossil-fuelled
power stations have a life-time of approximately 40 years, 115 many analysts
66
hence expect that in the absence of decisive action supporting the deployment of
renewable energies 116 and/or nuclear energy in the recently liberalised power
industry, the European power industry will be locked into a fuel mix with a high
share of fossil fuels 117 for many decades to come.
The significant recourse to international offsets envisaged by the ETSProposal is indeed likely to prevent the expected EUA price from increasing
sufficiently to ensure a rapid decarbonisation of the power industry as called for
by Al Gore 118 to meet the recommendations of the IPCC. 119 It is interesting to
note that the Commission once again has recourse to a 50% ceiling for external
credits, which echoes the limit initially proposed for the Linking Directive and
the ceiling established in its decision in 2006 for the second trading period. 120
Unlike the latter decision the new 50% ceiling does not provide for exceptions in
favour of the new Member States and is exclusively applicable to the covered
sectors of the ETS in the case of the conclusion of a new global climate accord.
3. The Absence of Qualitative Criteria for International Offsets

The criticism regarding the absence of qualitative requirements regarding the use
of international offsets from the ETS-Proposal is rooted in the growing concern
about the environmental effectiveness of the CDM mechanism. 121 Its proponents
upheld that through this choice the EU is missing an important opportunity to
send a clear signal to the stakeholders of the international carbon market that
the EU is no longer willing to back projects which do not lead to real and
measurable emission reductions and support sustainable development. 122
Against this argument it may be objected that the decision of the
Commission to refrain from requiring qualitative criteria with respect to Kyoto
units is inherent to its choice to allow banking of EUAs from the second to the
third trading period. Indeed, any restriction of eligible offsets in the third trading
period could easily be eluded by the covered sectors through the swapping of
CDM/JI credits for EUAs in the second trading period, which can then be
banked. The positive effects of the additional qualitative requirements on the
environmental integrity of the CDM projects would thus remain quite limited.
Regarding the criticism on the absence of qualitative criteria for external
credits in the case of the conclusion of an international climate agreement, the

67
Commission replied that its proposal does not preclude any decision of the EU to
require stricter criteria within the framework of the future climate accord. 123
Moreover, by keeping all options open the EU is ensured more leverage during
the international negotiation process and greater room for maneuvre to craft
new innovative instruments.
While these arguments are at first sight appealing, the lack of a clear
position of the EU on the environmental integrity of external credits has its
drawbacks. Indeed, the EU partly forfeits its reputation as a leader in the climate
change debate and runs the risk of continuing to finance the false emission
reductions of projects that do not foster sustainable development. The proposal
of the Doyle Report, restricting the use of external credits to Gold Standard-type
credits, represents, in this respect, a good compromise. 124 Even if the proposal
remains unsatisfactory in terms of the clarity of its wording, it offers a good
starting point for a stricter policy regarding the use of international offsets in a
situation where lessons from the international carbon market have still to be
learnt.
The reference to the Gold Standard is pertinent, as the requirements of this
label, supported by numerous NGOs, do indeed represent an innovative and yet
pragmatic way to ensure better environmental quality of greenhouse gas
emission offsets. The Gold Standard, however, does not address all criticisms
levelled against the CDM mechanism. For instance, the verification of the Gold
Standard Requirements is done by the same private entities which are criticised
for their insufficient neutrality and sometimes dubious professionalism. 125 Also,
there is a lack of control of the work of the Gold Standard organisation by
democratic institutions. Finally, a restriction of the CDM mechanisms to
renewable energy and end-use energy projects presents, besides the obvious
advantages of this kind of projects in limiting the dependence on fossil fuels, also
has disadvantages. First, it reduces the scope of this mechanism to discover and
address cheap mitigation options and impairs the stability of the international
carbon market. 126 Second, the additionality 127 of renewable energy and enduse efficiency projects is often doubtful and subject to gaming. 128 Third, many
experts suggest that the offset mechanism does not represent an appropriate
instrument to encourage this type of project and that they would be better
68
supported by other instruments such as investment subsidies and/or technical

assistance. 129
Hence, a simple reference to the Gold Standard, as suggested by some
NGOs 130 which would entrust this organisation with the control of the
environmental quality of offsets allowed into the EU ETS, does not seem
advisable at this stage. However, the procedural and material requirements set
up by the Gold Standard could offer a good model for the constitution of a
European label, which would not only set up a positive list of admissible
projects, but ensure its sustainability through the formulation of supplemental
requirements similar to those set out by the Gold Standard. Such a label, which
could be revised from time to time to respond to evolving needs would of course
not address all environmental shortcomings of the actual CDM label, but could,
combined with a revision of the current CDM procedure, represent a concrete
step towards improving the environmental quality of international offsets.
III. Conclusions
The debate on the criteria governing the linkage of the EU ETS with international
offsets takes place against the backdrop of the international negotiations on a
new global deal on climate change which is expected to be concluded in
Copenhagen at the end of 2009. Its general boundaries are set by the unilateral
commitment of the EU in 2007 to reduce its greenhouse gas emissions by 20%
or by 30% and the Bali Action Plan adopted at the end of 2007, which makes
any commitment of developing countries dependent on a clearly identifiable
support of developed countries, including technology transfer, financing and
capacity-building. 131
The European view on the appropriateness of linking the EU ETS with the
international project mechanisms has changed over the years as the discussion
on the numerous interpretations of the supplementarity criteria testifies.
Whereas the Commission was initially sceptical as to an integration of Kyoto
credits into the EU ETS, fearing lax international rules on CDM and JI, 132 the
position has changed due to the pressure from emitters. By the time the Linking
Directive was finally adopted, a general shift of attitudes had taken place as the
absence of a clear limit for CDM und JI by this Directive attests. A major reason
for this change of heart was that companies covered by the EU ETS had made

69
clear that they would remain inflexible regarding the initial amount of EUAs
allocated unless they could get access to the CDM. 133
The collapse of the EUA in 2006, however, somewhat dampened the
enthusiasm generated by the successful kick-off of the international carbon
market. Moreover, the IPCC stressed that industrialised countries had to step up
their domestic reduction effort significantly to stabilise global warming. 134
Further, the analysis of a growing number of academics and observers of the
CDM market shows that many CDM projects are not additional 135 and that the
mechanism in its current form is unable to mobilise funds on the scale they are
needed. 136 Especially in the United States, which is likely to take a firmer grip on
climate change after the presidential elections at the end of 2008 and where
many states are preparing to set up emission trading schemes, the linking with
external credits is intensely debated. Whereas certain critics argue that the
recourse to international offsets leads to large transfers of money in favour of
China and India which are not matched by any significant emission
reductions, 137 others are in favour of their use but call for strict procedural
safeguards to ensure their environmental integrity. 138
In the European Union, the upcoming vote in October 2008 by the
Environmental Committee of the European Parliament on the ETS- and BurdenSharing proposals and later on the vote in the Council is mobilising thousands of
stakeholders behind the scenes. The pressure to maintain the current system is
important, as the considerable financial interests of both the covered industries of
the EU ETS and the stakeholders of the international carbon markets are at
stake. 139 Given the wide spectrum of views among the Member States and the
European Parliament, the stage is no doubt set again for an intense tug-ofwar. 140 It remains to be seen whether the final compromise on the linking issue
will ultimately meet the common climate challenge.
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Endnotes
1
The Prisoners Dilemma results from the fact that all Member States will benefit when
emission reductions goals are met but each Member State has an incentive to overallocate allowances to in-state firms providing them an opportunity to become net
sellers to the emissions credit market. See Kurkowski (2006: 716).
An EUA is equivalent to one tonne of CO2.
Hereafter the Commission.
See The World Bank (2008: 9), Openeurope (2007), WWF (2007).
The Kyoto Protocols project mechanisms are the CDM and the JI. CDM stands for
clean development mechanism and JI for joint implementation. CDM and JI projects
lead to the emission of so-called Certified Emission Reductions (CERs) in the case of
the CDM and Emission Reduction Units (ERUs) in the case of JI. They are commonly
called the Kyoto units and may be used by the Parties included in Annex B for
compliance under the Kyoto Protocol.
Article 6 of the Kyoto Protocol.
Article 12 of the Kyoto Protocol.
Delbeke (2008), Wara (2008), Wara et. al., (2008), Lohmann (2008), International
Rivers (2008), Voigt (2008), Schneider (2007), Muller (2007), Michaelowa (2007),
Pearson (2006), Egenhofer et. al., (2005), De Larragan (2005), Meijer et. al., (2005),
Michaelowa (2005), Bygrave et. al., (2004).
74
See FCCC/CP/2007/6/Add.1, Decision 1/CP.13, Bali Action Plan at http://unfccc.

int/resource/docs/2007/cop13/eng/06a01.pdf#page=3
10
An international offset in this context represents a credit which certifies the reduction,
removal, or avoidance of greenhouse gas emissions by a project taking place
outside of the European Union and that is used to compensate for greenhouse gas
emissions occurring in the European Union. See also for a more general definition of
the meaning of an offset the Offset Quality Initiative (2008: 2).
11
Although crucial for the environmental integrity of the ETS, the linkage of the EU ETS
with other emission trading schemes will not be examined in this publication. See for
a thorough discussion on this subject inter alia Flachsland et. al., (2008), Schle et. al.,
(2006), Anger (2006).
12
See Directive 2004/101/EC of the European Parliament and of the Council of 27

October 2004 amending Directive 2003/87/EC establishing a scheme for trading of
greenhouse gas emission allowances within the Community, in respect of the Kyoto
Protocols project mechanisms.
13
European Commission (2006). Communication from the Commission to the Council

and the European Parliament on the assessment of national plans for the allocation
of greenhouse gas emission allowances in the second period of the EU ETS
accompanying Commission Decisions of 29 November 2006 on the national
allocation plans of Germany etc., COM (2006) 725.
14
European Commission (2008). Proposal for a Directive of the European Parliament

and of the Council amending the Directive 2003/87/EC so as to improve and
extend the greenhouse gas emission allowance trading system of the Community.
COM (2008) 16.
15
European Parliament (2008). Draft report on the proposal for a directive of the
European Parliament and of the Council amending Directive 2003/87/EC so as to
improve and extend greenhouse gas emission allowance trading system of the
Community of 11th June 2008, Committee on the Environment, Public Health and
Food Safety, rapporteur Avril Doyle, (COM (2008)0016C6-0043/20082008/
0013(COD), the Doyle report.
16
The Intergovernmental Panel on Climate Change (IPCC) was established in 1988

under the auspices of the United Nations Environment Programme and the World
Meteorological Organization for the purpose of assessing the scientific, technical
and socioeconomic information relevant for the understanding of the risk of humaninduced climate change. To date, the IPCC has issued four comprehensive
assessments in 1990, 1996, 2001 and 2007. More than 2500 scientists contributed
to these assessments, relying mainly on published and peer-reviewed scientific
technical literature. The IPCC shared the 2007 Nobel Peace Prize with former Vice
President of the United States Al Gore. See http://www.ipcc.ch.

75
17
The United Nations Climate Change Conference in Bali at http://unfccc.int/

meetings/cop_13/items/ 4049.php.
18
See Directive 2003/87/EC of the European Parliament and of the Council of

13 October 2003 establishing a scheme for trading in greenhouse gas emission
allowances within the Community and amending Council Directive 96/61/EC.
19
Article 9 (1) ETS-Directive.
20
Article 9 ETS-Directive.
21
Article 9 (3) ETS-Directive.
22
See paragraph 19 of the Preamble of the ETS-Directive. Moreover, Article 30 of the

Directive stated that the use of credits from project mechanisms was one of the
issues to be considered in the review of the Directive. The inclusion of a direct link
with the Kyoto mechanisms was, indeed, strongly advocated by both industry and a
number of Member States. See for more details on the linking debate preceding
the adoption of the original Directive, Lefevere (2005: 516), Hgstad Flm (2007: 25
ff.), Klepper et. al., (2005).
23
See Lefevere (2005: 517).
24
European Commission (2003). Proposal for a Directive of the European Parliament

and of the Council amending the Directive establishing a scheme for greenhouse
gas emission allowance trading within the Community, in respect of the Kyoto
Protocols project mechanisms, COM (2003) 403.
25
The conversion was to be done by Member States, which were granted the right to
issue one new allowance in exchange for one CER or ERU. Under the proposal
Member States kept the freedom to impose other criteria for the conversion of Kyoto
credits into allowances. See Lefevere (2005: 524).
26
The comitology procedure in the European Union refers to the committee system,
which oversees the acts implemented by the European Commission on behalf of the
Council of Ministers. Amendments submitted to this procedure may be decided more
quickly than those governed by the normal legislative process. See http://europa.eu/
scadplus/glossary/comitology_en.htm.
27
28
29
See for a thorough analysis of the discussion on the influence of the various
stakeholders on the final content of the Linking Directive Hgstad Flm (2007: 25 ff.).
30
See Directive 2004/101/EC of the European Parliament and of the Council of 27

October 2004 amending Directive 2003/87/EC establishing a scheme for
greenhouse gas emission allowance trading within the Community, in respect of the
Kyoto Protocols project mechanisms. The modalities of the inclusion of the CDM
and JI, were, indeed, highly contentious. Whereas industry and certain Member
76
States pleaded for the full fungibility between CERs, ERUs and EUAs, many
environmental NGOs opposed any linking or at least required strict limits for their
use within the EU ETS. See Lefevere (2005: 520), Hgstad Flm (2007: 25ff.)
31
See Article 11a ETS-Directive.
32
See for a discussion on the opportunities and threats of the inclusion of the CDM
and JI in the EU ETS Lefevere (2005: 520ff.).
33
On the insistence of the European Parliament a clause has been added, which
requests CDM and JI projects regarding dams with a capacity over 20 MW to
comply with relevant international guidelines.
34
See Article 11b ETS-Directive.
35
The Marrakesh Accords adopted by the Conference of the Parties (CoP 7) define the
modalities of the use of the project-based mechanisms adopted by the Kyoto
Protocol. The supplementarity requirement was integrated in the Marrakesh
Accords on the insistence of the European Union. See Langrock et. al., (2004:6).
36
The Marrakesh Accords stipulate: the use of the mechanisms shall be supplemental
to domestic action and that domestic action shall thus constitute a significant effort
made by each Party included in Annex I to meet its quantified emission limitation
and reduction commitments under Article 3, paragraph 1. See Article 1 Draft
Decision-/CMP.1 (Mechanisms) contained in Decision 15 /CP.7. See also Langrock
et. al., (2004: 6)
37
European Commission, Communication (2005). Further guidance on allocation

plans for the 2008-2012 trading period of the EU Emission trading Scheme, COM
(2005) 703 final.
38
European Commission (2006). Communication from the Commission to the Council

and the European Parliament on the assessment of national allocation plans for the
allocation of greenhouse gas emission allowances in the second period of the EU
Emissions Trading Scheme accompanying Commission Decisions of 29 November
2006 on the national allocation plans of Germany etc., COM (2006) 725.
39
According to the Kyoto Protocol the 15 old Member States of the EU have to reduce
a basket of six greenhouse gases by 8% over the period 20082012 with respect to
their emissions in 1990. As Article 4 of the Kyoto Protocol allows groups of countries
to agree on a common reduction target, the EU has subsequently redistributed this
target among the different countries in a burden-sharing agreement. The ten new
Member States, which joined the EU in 2005, are only liable under the Kyoto
Protocol. Malta and Cyprus have no reduction commitments at all.
40
At the meeting of the Environment Council held on 16 and 17 June 1998, the
Member States of the European Union agreed to divide the 8% emission reduction
for the European Community between the Member States. Each Member State is
individually responsible for reaching the specific target set under this agreement.

77
Member States targets vary significantly, ranging from a reduction of 21% for
Germany and Denmark to an increase of 25% for Greece. The EU burden-sharing
agreement was made legally binding through its inclusion in the ratification decision,
adopted by the Council on 4 March 2002. See Council Decision 2002/358/EC
concerning the approval, on behalf of the European Community, of the Kyoto
Protocol to the United Nations Framework Convention on Climate Change and the
joint fulfillment of commitments thereunder.
41
Art. 2.3 par. 4 of the third guidance on the criteria of Annex III reads: The level of
effort to reduce greenhouse gases a Member State is required to undertake is
determined by assessing the amount of reduction it is required to undertake in
relation to base year emissions, greenhouse gas emissions in 2004, and projected
emissions in 2010.41 In the next step, half of the figure representing the highest
effort is calculated. This figure is considered to be the maximum overall amount of
JI/CDM credits that a Member State can make use of in addition to domestic action,
while respecting its commitments to ensure that the use of the Kyoto mechanisms is
supplemental to domestic action. See European Commission, COM (2006) 725.
42
It has however to be noted that the ceiling does not fix the overall domestic reduction
effort of Member States as the latter remain free to engage in international trading
of emission allowances, as set out under Article 17 of the Kyoto Protocol.
43
See Article 17 of the Kyoto Protocol.
44
The formulation proposed by the European Union during the negotiations of the
Marrakesh Accords was that each party should acquire and surrender no more
emission certificates from abroad than the equivalent of 50% of the difference
between five times the emissions in one of the years between 1994 and 2002, on
the one hand, and its number of assigned units, on the other. See Langrock et. al.,
(2004: 6).
45
Article 17 of the Kyoto Protocol foresees that Parties included in Annex B may
participate in emissions trading for the purposes of fulfilling their commitments
under Article 3 of the Kyoto Protocol.
46
Point 2.3 reads: In respect of Member States which do not intend to purchase any
Kyoto units with government funds, a Member State may allow its operators covered
by the Community scheme to make use of CDM/JI credits to the full amount of this
limit. See European Commission, COM (2006) 725.
47
This limit was to be understood as a percentage figure specified as a share of the

approved cap for the trading sector. See European Commission, COM (2006) 725.
48
Point 2.3 reads: In respect of Member States which intend to purchase Kyoto units
with government funds, these purchases are taken into account. The amount of
JI/CDM credits that can be used by installations in the Community scheme in that
Member State is reduced by the annual average amount of intended or substantiated
government purchases. See European Commission, COM (2006) 725.
78
49
See European Commission, COM (2006) 725.
50
European Commission (2008a: 15), Ellerman et. al., (2008: 33). With respect to
verified emissions in 2007 the reduction represents 7.1%. EU-15 will undertake most
of the overall 20082012 effort, with a cap set at 8.7% lower than verified 2005
emissions while emissions in EU-12 will be allowed to increase by 3.6% above the
2005 benchmark. See The World Bank (2008: 10).
51
EU ETS emissions have actually grown by an average of 1% per year since 2005,
with a more vigorous growth in the Eastern Member States. Thus some analysts
revised their forecasts slightly upward with regard to the likely shortfall in the second
trading period. See for a view of analysts expectations on the shortfall of allowances
in the second and third trading period The World Bank (2008: 9ff.).
52
As a matter of fact, the approach chosen by the Commission resulted in CDM/JI

limits for individual Member States of 10% to 20% of approved caps. See Press
release of 13.7.2007, Emissions trading: Commission adopts decisions on
amendments to five national allocation plans for 2008-2012, IP/07/1094.
53
See Langrock et. al., (2004: 12).
54
See for an analysis of the legal risks taken by the Commission when reducing the
proposed caps for the second trading period de Sepibus (2007a: 18).
55
For instance, the Commission reduced the proposed cap of Lithuania by 47%, of
Latvia by 56%, of Estonia by 4 % and of Poland by 26.7%. Overall, the Commission
cut by 10.4 % the overall caps originally proposed by the Member States, leading to
a maximum of 2.098 million EUAs. See The World Bank (2008: 9 ff.).
56
The NAPs of Bulgaria and Romania are not included in these figures as they have
special circumstances due to their having recently joining the EU (in 2007). See
Schleich et. al., (2007: 22).
57
See for an analysis of the approval process of the NAPs Ellerman et. al., (2007),
Zapfel (2007), de Sepibus (2007a).
58
See European Commission, Decision on the 2nd NAP of Lithuania.http://ec.europa.

eu/environment/climat/pdf/nap2006/20061128_lt_nap_en.pdf
59
See European Commission, Decision on the amended 2nd NAP of Lithuania,

http://ec.europa.eu/environment/climat/pdf/nap2006/lt_nap_amendment_en.pdf
60
Case T- 32/07, Slovakia v. Commission, OJ C 69 of 24.03.2007, p.29, Action

brought on 7 February 2007; Case T-183/07, Poland v. Commission, OJ C 155
of 07.07.2007, p.41, Action brought on 28 May 2007; Case T- 194/07, Czech
Republic v. Commission, OJ C 199 of 25.08.2007, p.38, Action brought on 4 June
2007; Case T-221/07, Hungary v. Commission, OJ C 199 of 25.08.2007, p.41,
Action brought on 26 June 2007; B T-369/07, Bulgaria v. Commission, Case T499/07, Action brought on 27 December 2007, Romania v. Commission, T-483/07,
OJ C 51 of 23.02.2008, p.57, Action brought on 22 December 2007, Latvia v.

79
Commission, T-369/07 , OJ C 269 of 10.11.2007, p.66, Action brought on 26

September 2007. See for an analysis of these cases de Spibus (2007a and b).
61
The reduction objective of 30% is explicitly made subject to the condition that other
developed countries commit themselves to comparable emission reductions and
economically more advanced developing countries make an adequate contribution.
See European Council, 7224/1/07 REV 1. The Conclusions of the European Council
were themselves based on a climate package presented by the Commission in
January 2007. See European Commission, COM (2007) 2.
62
In December 2007, a Conference held in Bali brought together representatives of

over 180 countries and culminated in the adoption of the Bali Roadmap, which
charts the course for a new negotiating process designed to tackle climate change,
with the aim of completing this by 2009 in Copenhagen. See The United Nations
Climate Change Conference in Bali at http://unfccc.int/meetings/cop_13/items/
4049.php
63
The COP 13 is the 13th Conference of the Parties of the UNFCCC and includes, in
particular, also the US.
64
The MOP 3 is the 3rd Conference of the Parties of the Kyoto Protocol and does not
include the US, which has not ratified the Kyoto Protocol.
65
See FCCC/CP/2007/6/Add.1, Decision 1/CP.13, Bali Action Plan at http://unfccc.

int/resource/docs/2007/cop13/eng/06a01.pdf#page=3
66
See for more details on the negotiation process Egenhofer et. al., (2008: 25ff.),
Watanabe et. al., (2008: 4ff.), Ott et. al., (2008: 91ff).
67
It is important to note that the Ad hoc Working Group established in Montreal in

2005 under the Kyoto Protocol (AWG-KP) had recognised in August 2007 that the
emission scenario with the highest probability to remain under a 2 degrees Celsius
level increase of global mean temperature requires Annex I Parties to reduce
emissions to between 25 and 40% below 1990 levels by 2020 and that these ranges
would be significantly higher if emission reductions were to be undertaken exclusively
by Annex I Parties. See FCCC/KP/AWG/2007/L.4, 31 August 2007, par. 7.
68
See Ott et. al., (2008: 93). The claim of developing countries to receive funds and
help from industrialised countries is based on the fact that they have emitted less
greenhouse gases and thus have less responsibility for climate change than
industrialised countries. Moreover, they are less able to finance emissions reductions.
See table of per capita emissions in Neuhoff (2008: 60).
69
Watanabe et. al., (2008: 9). In comparison the project-based emission reduction in
2007 amounted to a value of US$ 6 billion in 2007. See The World Bank (2008: 2).
70
The package proposed by the Commission includes a Strategic Energy Technology

Plan, European Commission (COM (2007) 723), a Support Scheme of Carbon
80
Capture and Storage (CCS) (COM (2008) 13/18) and a revision of the Directive
promoting the use of renewable energy sources (COM (2008)19).
71
European Commission, COM (2008) 16.
72
European Commission (2008). Proposal for a decision of the European Parliament

and the Council on the effort of Member States to reduce their greenhouse gas
emissions to meet the Communitys greenhouse gas emission reduction
commitments up to 2020, COM (2008) 17..See for a step by step explanation of the
co-decision procedure http://ec.europa.eu/codecision/stepbystep/text/index_en.htm.
73
Under the co-decision procedure, a new legislative proposal is drafted by the

European Commission. This proposal is then submitted to the European Parliament
and the Council, which discuss the proposal independently. In order for the proposal
to become law, Council and Parliament must approve each others amendments
and agree upon a final text in identical terms. See for a step by step explanation of
the co-decision procedure http://ec.europa.eu/codecision/stepbystep/text/index_
en.htm
74
The Commission proposes to allow the annual use by Member States of credits from
greenhouse gas emission reduction projects in third countries of up to 3% of each
Member States emissions from sources outside the ETS in 2005.74 This quantity is
equivalent to a third of the reduction effort in 2020. Each Member State is allowed to
transfer the unused part of this limit to another Member State.
75
European Council (2008). Presidency Conclusions of the European Spring Council of

13/14th March 2008, Nr. 7652/1/08, REV 1, par. 17 ff.
76
European Commission, COM (2008) 16.
77
The two new gases are nitrous oxide and perfluorocarbons. Overall, these sectors
represent nowadays about 60% of total greenhouse gas emissions in the EU. See
European Commission, Memo 08/34, 23 January 2008.
78
The Commission estimates that EU ETS sectors must contribute more than other
sectors because it is cheaper to reduce emissions in the electricity sector than in most
other sectors. See European Commission, Memo 08/34, 23 January 2008.
79
This means that there is a threat that companies may relocate to third countries with
less stringent climate protection laws.
80
Whereas ERUs from JI projects may be taken into account for emission reductions
until 2012, CERs may be taken into account with respect to emission reductions until
2012 but also from 2013 onwards. See Article 11a, par. 2 and 3 ETS-Proposal.
81
These credits may be used until those countries have ratified an agreement with the
Community or until 2020, whichever is the earlier. See Article 11, par. 4 ETSProposal.

81
82
This entitlement applies to all least developed countries until 2020 provided that
they have by then either ratified a global agreement on climate change or a bilateral
or multilateral agreement with the Community. See Art. 11a par. 4 ETS-Proposal.
83
See Article 11a par. 5 ETS-Proposal. The agreements concluded by the Community
have to provide for the use of credits in the Community scheme from renewable
energy or energy efficiency technologies which promote technological transfer and
sustainable development. Any such agreement may also provide for the use of
credits from projects where the baseline used is below the level of free allocation
under the measures referred to in Article 10a of the ETS-Proposal or below the levels
required by Community legislation. See Article 11a par. 6 ETS-Proposal.
84
See Art. 11a par. 7 ETS-Proposal.
85
See The World Bank (2008: 9).
86
See Article 28 par. 3 ETS-Proposal.
87
European Parliament (2008). Draft report on the proposal for a directive of the
European Parliament and of the Council amending Directive 2003/87/EC so as to
improve and extend greenhouse gas emission allowance trading system of the
Community, rapporteur Avril Doyle, (COM(2008)0016 C6-0043/2008 2008/
0013(COD)) Doyle Report.
88
See European Parliament (2008). Draft report on the effort of Member States to
reduce their greenhouse gas emissions to meet the Communitys greenhouse gas
emission reduction commitments up to 2020, Rapporteur Satu Hassi, (COM
(2008)0017 C6-0041/2008 2008/0014(COD)) Hassi Report.
89
The opinion of the European Parliament is prepared by a rapporteur, who issues a

draft report and a draft legislative resolution, which is discussed and amended within
the relevant parliamentary committee, then debated in a plenary session, where it is
adopted by a simple majority. The parliamentary committee meets several times to
study the draft report prepared by the rapporteur. The rapporteur and the members
of both the parliamentary committee responsible and any other European
Parliament committee may propose amendments to the Commissions proposal.
These amendments, together with those proposed by the parliamentary committees
asked for an opinion, are put to the vote in the parliamentary committee
responsible. Once the report is adopted in the parliamentary committee, it is placed
on the agenda of the plenary session and put to the plenarys vote. See
http://ec.europa.eu/ codecision/stepbystep/text/index_en.htm
90
For instance, a 20% reduction effort by 2020 compared to 1990, which would be
raised to 30% in the case of an international agreement on climate change.
91
Amendment to Article 11a par. 7 ETS-Proposal. See Doyle report, cited above.
92
This possibility is subject to the above mentioned condition.
82
93
The mechanisms are indeed increasingly criticised by experts and academics for their
focus on unsustainable projects incapable of reducing the dependence of developing
countries on fossil fuels, their inability to guarantee additional emission reductions
and their potential for generating perverse policy incentives. See Wara (2008), Wara
et. al., (2008), Lohmann (2008), Schneider (2007), Michaelowa (2007), Pearson (2006).
94
Amendments to Recitals 22, 25, Art. 11a par. 2, 3, 4, 7 of the ETS-Proposal. See
Doyle Report, cited above.
95
See Amendment to Article 11a par. 6 of the ETS-Proposal. See Doyle Report, cited
above.
96
Amendment to Article 28 paragraph 4 subparagraph 1 a (new) of the ETSProposal. See Doyle Report, cited above. For a discussion on the inclusion of forest
activities by the future climate regime see in particular Helme et. al., (2008: 103 ff.)
97
See cdmgoldstandard.org.
98
See UNFCCC (2005). Decision adopted by the Conference of the Parties serving as
the meeting of the Parties to the Kyoto Protocol 30 March 2006, 3/CMP.1 Modalities
and procedures for a clean development mechanism as defined in Article 12 of the
Kyoto Protocol, FCCC/KP/CMP/2005/8/Add.1.
99
A notable exception is nuclear power. The Bonn Agreements stipulate in particular

that developed parties have to refrain from using nuclear power for CDM projects.
See UNFCCC (2001). Review of the implementation of commitments and of other
provisions of the convention. Preparations for the first session of the conference of
the parties serving as the meeting of the parties to the Kyoto Protocol (Decision
8/CP.4). Decision 5/CP.6, Implementation of the Buenos Aires Plan of Action,
FCCC/CP/2001/L.7, 24 July.
100 Renewable energy projects are defined as the generation and delivery of energy
services (e.g. mechanical work, electricity, heat) from non-fossil and non-depletable
(landfill gas excluded) energy sources. End-use energy efficiency projects are
defined as activities that reduce the amount of energy required for delivering or
producing non-energy physical goods or services. See Paragraph III.d.2 and 3 of the
The Gold Standard Premium Quality Carbon Credits Requirements (The Gold
Standard Requirements) published at: http://www.ecofys.com/com/publications/
documents/GSV2_Requirements_20080731_2.0.pdf
101 See Annex I of the Gold Standard Toolkit.
102 See Paragraph VII.a of the Gold Standard Requirements.
103 Many stakeholders in the international carbon market, such as the World Bank, were
however disappointed by the Commissions Proposal insofar as the use of CERs is so
far limited to the use of credits from projects initiated before 2012 or of projects
from least developed countries. See The World Bank (2008: 34).

83
104 WWF (2008), Greenpeace (2008), CAN (2008).

105 Hhne (2008), Schneider (2008).
106 IPCC (2007), Barker (2008).
107 Hhne (2008).
108 Hhne (2008: 2).
109 Hassi justifies this choice on the basis that the 20% target is far too low if the EU
wants to make an equitable contribution towards keeping the increase in global
warming below 2 degrees Celsius.109 She contends further that it is easier for
Member States to direct the planning and implementation measures from scratch
with regard to a 30% reduction target, which may, in the case of unsuccessful
international negotiations be easily downgraded, whereas it is much more difficult to
tighten the reduction effort once an international climate agreement has been
concluded. See European Parliament (2008), draft Hassi Report, cited above.
110 See European Parliament (2008), draft Hassi Report, cited above.
111 See for an analysis of the expected EUA price in the various scenarios European
Commission (2008), Commission Staff Working Document SEC (2008) 85/3, Impact
Assessment, Document accompanying the Package of Implementation measures for
the EUs objectives on climate change and renewable energy for 2020.
112 See European Parliament (2008), draft Hassi Report, cited above.
113 See IEA (2006: 171).
114 According to Dieter Helm the most likely outcome of the Commissions ETS-Proposal
on the power sector is a large-scale dash-for-gas, the use of more coal and
eventually the renewed construction of nuclear power plants. See Helm (2008: 12).
115 See for more information on the investment conditions in the recently liberalised
European power market de Spibus (2008: 37).
116 See for more details on the necessary investments in the power infrastructure in the
case of a large deployment of renewable energies de Spibus (2008: 32).
117 In 2004, conventional thermal energy fuelled by coal, gas and oil emitted most of
them, with a share of almost 54% for electricity production. Coal and lignite
accounted for 29.5%, gas for 20% and oil for 4.5%. The second-largest source was
nuclear energy, which generated 31%, i.e. almost a third of the EUs electricity.
Together, these sources contributed about 85% of the total production, leaving the
remainder for renewable electricity production. See EEA (2007).
118 In his speech of 17 July 2008, Al Gore called for US power to be fuelled by 100 %
from renewable energy sources in ten years. See http://www.wecansolveit.org/
pages/al_gore_a_generational_challenge_to_repower_america/
84
119 According to the IPCC report the CO2 emissions of industrialised countries must be
reduced between 50% and 85% to ensure the highest probability of stabilising the
global temperature increase between 2 and 2.4 degrees Celsius above pre-industrial
levels. See IPCC (2007: 15).
120 European Commission, COM (2006) 725.
121 Wara (2008), Wara et. al., (2008), Lohmann (2008), Schneider (2007), Michaelowa
(2007), Pearson (2006).
122 Greenpeace (2008), WWF (2008), See European Parliament (2008). draft Hassi
Report, cited above.
123 Oral response of the Commission staff member Jrgen Salay at the hearing of the
European Parliament on the Hassi Report in June 2008. See also Salay (2008).
124 A similar proposal is made by Satu Hassi in her draft report on Effort-Sharing, where
she argues for limiting the use of Kyoto units and other international offsets to
projects on renewable energies and energy efficiency and discounting the credits
generated by 50%. See European Parliament (2008), draft Hassi Report, cited
above.
125 See for instance Wara et. al., (2008), Schneider (2007).
126 Hampton (2007 :10).
127 The term additionality in this context means that CDM project must lead to emission
reductions which would not have occurred in the absence of the project.
128 Michaelowa et. al., (2008), Michaelowa (2007), Purohit et. al., (2007), Michaelowa
et. al., (2007), Willis et. al., (2006).
129 See Driesen (2006), Willis et. al., (2006).
130 See WWF (2008).
131 See Ott et. al., (2008: 93). The claim of developing countries to receive funds and
help from industrialised countries is based on the fact that they have emitted less
greenhouse gases and thus have less responsibility for climate change than
industrialised countries. Moreover, they are less able to finance emissions reductions.
See table of per capita emissions in Neuhoff (2008: 60).
132 See Michaelowa (2004: 3).
133 See Hgstad Flm (2007), Michaelowa (2004: 4).
134 IPCC (2007: 15).
135 The term additional means that the projects do not lead to real emissions
reductions, which would have occurred in the absence of the project. See Schneider
(2007), Wara (2008), Wara et. al., (2008), Michaelowa (2007).
136 Sterk (2007).

85
137 Wara et. al., (2008).

138 Offset Quality Initiative (2008).
139 See for instance the report of The World Bank (2008).
140 See, for instance, the harsh bargaining of negotiation process of the LinkingDirective Hgstad Flm (2007).
4
Links between European Emissions
Trading and CDM Credits for
Renewable Energy and Energy
Efficiency Projects
David M. Driesen*
This article asks whether the European Unions (EU) Emissions
Trading Scheme has encouraged investment in renewable energy
and energy efficiency projects in developing countries. So far, it
has produced very little investment in either in spite of the EU's
decision to allow credits for projects undertaken in developing
countries through the Kyoto Protocols Clean Development
Mechanism. This may reflect the relatively high cost of renewable
energy and the awkwardness of assessing the additionality of
energy efficiency projects. While the literature generally
associates emissions trading with innovation, emissions trading
does not encourage innovation with high short term costs, even
when such innovation has strong positive spillover effects.
University professor, Syracuse University College of law, E. I. white hall Syracuse, NY. 13244-1030.
E-mail: ddriesen@law.syr.edu
2006 David M. Driesen. Reprinted with permission of author.

Source: papers.ssrn.com
86
Emissions Trading Scheme (ETS) stimulate energy efficiency

WillandtheuseEuropean
of renewable energy in developing countries through the Clean
Development Mechanism (CDM)? This article addresses this question as a means
of critically examining the relationship between the Kyoto mechanisms and
sustainable development. The papers first part explains why the goals of
attaining sustainable development and of effectively addressing climate change
make this question important. The second part presents a theoretical analysis
explaining why the short term cost effectiveness that trading fosters may not
coincide with the long-term goals animating the climate change treaty and the
sustainable development ideal. This analysis also provides a means of
organizing empirical information about supply and demand to evaluate the
likelihood that the Kyoto mechanisms will significantly increase developing
countries use of renewables and energy efficiency. The third part examines the
demand side of the equation, discussing the extent to which the legal architecture
of the European trading program provides room for financing CDM projects. The
fourth part examines the question of supply, evaluating the extent to which CDM
fosters projects that increase use of renewable energy or enhance energy
efficiency. A concluding Section summarizes the results and discusses their
broader significance for the evolution of the Kyoto mechanisms.
I. Renewables, Energy Efficiency, Climate Change and

Sustainable Development
The Framework Convention on Climate Change (Framework Convention)
articulates a goal of avoiding dangerous destabilization of the climate. 1
Achieving this goal may require a shift away from dependence upon fossil fuels. 2
Accordingly, the Kyoto Protocol to the Framework Convention explicitly
encourages the enhancement of energy efficiency and the increased use of
new and renewable forms of energy. 3 In the long run, effective climate change
policy must induce a significant shift away from fossil fuels.
The delegates that adopted the Framework Convention approved a broad
agenda for achieving the goal of sustainable development at the same time. This
agenda, called Agenda 21, explicitly emphasized the importance of a shift to
renewable energy and of energy efficiency. 4
Links between European Emissions Trading and CDM Credits

for Renewable Energy and Energy Efficiency Projects
87
Improved energy efficiency decreases the need to burn fossil fuels and
thereby decreases the emissions associated with that burning. Thus, enhanced
energy efficiency comports with a view of sustainable development as linked to
reducing the throughput of materials and pollution needed to adequately support
a good life. 5
Increased reliance upon renewable energy is even more crucial to
sustainable development. Fossil fuels constitute non-renewable resources. If the
present generation exhausts these resources it will leave nothing for future
generation, thereby raising an inter-generational equity issue. 6 Sustainable
development will require increased consumption and energy use in developing
countries in order to meet the basic needs of very large populations of people.
To the extent this growth comes from increased use of fossil fuels, it will create
serious long-term and short term health and environmental hazards that will
undermine the goal of adequately meeting peoples basic need for a healthful
life with adequate environmental quality. 7
The drafters of the Kyoto Protocol created the CDM, in part to meet the
need for sustainable development. 8 And the European Parliament cited the
potential of European demands for credits to aid in achieving sustainable
development as a reason to allow use of credits from CDM projects to satisfy the
obligations of European polluters regulated under the ETS. 9 Therefore, an
evaluation of the CDMs capacity to move developing countries away from fossil
fuels provides one measure of CDMs success as an instrument of sustainable
development.
Furthermore, developing country success in moving away from a fossil fuel
basis for economic development would facilitate evolution of an adequate
climate change regime. The Kyoto Protocol constitutes a first step toward meeting
the Framework Conventions goal of avoiding dangerous interference with the
climate. While the continuation of business as usual in many countries has
already rendered this goal impossible to meet, the Kyoto Protocol will prove a
partial success if it begins an evolution significantly ameliorating climate change
dangers. Developing countries are unlikely to commit to meaningful cuts in
greenhouse gas emissions; unless they come to believe that a sustainable path of
reducing dependence on fossil fuels is a viable approach. The cost of renewable
energy has fallen as its use has increased. 10 Many renewable energy options,
however, remain much more costly than fossil fuel options. More deployment of
88
currently expensive renewable energy will increase learning by doing and drop
the price, thus making a path away from fossil fuels attractive. If developing
countries do not commit to significant cuts in emissions, prospects for meeting
long-term goals for ameliorating climate change are bleak. Hence, the question
of whether the European trading program will interact with CDM to increase
deployment of renewables and realization of energy efficiency matters greatly to
the future of climate change policy and sustainable development more generally.
II. An Analysis of Trading and Innovation

Proponents of sustainable development often like to imagine that it comports with
free market liberalism. 11 There are some areas where both converge. For
example, reduced agricultural subsidies serve both liberalism and sustainable
development goals. 12 But in some areas, free markets tend to maximize present
consumption without adequately protecting the environment or future generations.
Most of the law and economics literature argues that emissions trading
encourages innovation more effectively than traditional regulation. 13 This
argument might suggest that trading encourages renewable energy, implying
congruence between free market liberalism and sustainable development.
Recent scholarship, however, has cast some doubt on the hypothesis that
trading encourages innovation. 14 The acid rain program has delivered cost
effective reductions primarily through the use of extremely conventional
technology, namely scrubbers and low sulfur coal. 15 It certainly has not
encouraged serious movement away from fossil fuels. 16 Indeed a recent study,
the most comprehensive one to date, argues that the acid rain program
encouraged less innovation than the prior command and control programs
aimed at reducing US sulphur dioxide emissions. 17 The Montreal Protocol
produced a major technological change, the phase-out of ozone depleting
substances. 18 While the Protocol authorized limited trading, no trades actually
occurred. Clearly, the relationship between trading and innovation is more subtle
than the conventional view suggests.
Those equating trading with innovation argue that trading produces
innovation by encouraging polluters to go beyond compliance. 19 This is true with
respect to sellers of credits. But buyers of credits achieve fewer reductions than
they would under a comparably designed traditional performance standard. 20

89
Thus, they have less incentive to innovate than they would have under a
comparably designed traditional regulation, which would require reductions from
all regulated sources.
The assumption that trading produces innovation conflicts with the induced
innovation hypothesis that economists frequently employ to analyze
innovation. 21 This hypothesis assumes that necessity is the mother invention i.e.,
that firms will tend to innovate when the cost of employing conventional
approaches is high. 22 But trading lowers the cost of employing conventional
approaches by allowing polluters to shift reduction obligations to the facilities
with the lowest compliance costs. The induced innovation hypothesis would
therefore suggest that trading does not encourage more innovation than
comparable performance standards without trading. 23
The Kyoto mechanisms serve the Framework Conventions goal of
encouraging cost effectiveness. 24 They create incentives for polluting facilities (or
countries) to purchase credits reflecting the cheapest possible approaches to
pollution control. This poses an issue, because the cheapest current emission
reduction options may not coincide with those offering the greatest long-term
environmental benefits or even the lowest longterm economic costs. 25 For
example, even if massive investment in deploying solar technology or fuel cells
would bring prices down to very low levels over time and provide enormous
environmental benefits (less smog, climate change, coal mining, oil drilling, and
oil spills), emissions trading will not make such investments economically rational
unless the current costs of deploying solar power or fuel cells is less than that of
other emission decreasing options.
The emissions trading literature tends to create an image of trading as
magic, rather than as a type of regulatory program. 26 Trading encourages
buyers to avoid making expensive local reductions by purchasing as many credits
as they need to meet regulatory obligations, no more. 27 And it encourages them
to buy the cheapest available credits to meet these targets. This means that the
sellers can only sell as many cheap credits as the buyers need, and cannot sell
credits costing more to generate than the cheapest emission reductions available
in the program.
90
This market preference for a limited amount of cheap available credits

means that analyzing the ETSs capacity to support CDM projects reflecting
efforts at deploying renewables and enhancing energy efficiency requires
analysis of both the demand side (ETS) and the supply side (CDM). Therefore,
this article will assess the likely demand for CDM credits emanating from the ETS
and the likely supply of credits from renewable energy and energy efficiency
projects. Since sellers of credits from these types of projects must compete with
sellers of credits from other types of projects and might have to compete with
sellers of hot air credits, the relative prices of credits will also influence the
capacity of trading between the European Union and developing countries to
encourage renewables and energy efficiency. Credits from renewable energy
and energy efficiency projects compete on the basis of price for the limited
demand for credits from buyers seeking only to meet their limited regulatory
obligations.
III. European Trading as a Source of Demand

The European Union has developed a regional trading program as part of its
effort to meet its Kyoto target. 28 The amount of emission reduction demanded by
the program and the percentage of credits allowed from CDM will ultimately
establish the maximum potential ETS demand for CDM credits.
The European Commissions initial ETS proposal favored enforceability and
simplicity over cost effectiveness and flexibility. This proposal contemplated
trading of carbon dioxide emissions only between well monitored sources within
the European Union that assumed caps on their emissions under the program. 29
This approach resembles that of the US acid rain program, which has succeeded
largely because it confines itself to a single pollutant emitted from a small group
of well-monitored sources, namely large emitting units at electric utilities. 30
The European Parliament, however, ultimately passed a more liberal
proposal that left some potential to imitate the vices of earlier unsuccessful US
programs, which allowed trading with uncapped and poorly monitored sources.
The EUs 2003 Directive, like the initial proposal, only limits the carbon dioxide
emissions of large industrial sources. 31 It does so by requiring two phases of
reductions. Polluters subject to the scheme must meet a phase one target in the
2005-2007 time period. 32 They must meet a phase two target by 2012. 33 The

91
Directive, however, left the choice of targets to national governments within the
European Union, subject to some supervision by the European Commission. 34 A
recent study commissioned by the World Wildlife Fund has found that the caps of
many countries for phase one demand insufficient reductions to change business
as usual or adequately contribute to meeting Kyoto targets. 35 This implies weak
demand for CDM credits.
While the 2003 Directive followed the European Commission Proposal in
targeting a narrow sector and leaving reduction decisions largely to national
governments, it departed from the proposal by enlarging the possible sources of
credits. First, it allows credits for projects that reduce any one of six greenhouse
gases, including some, such as methane, that usually are very difficult to
monitor. 36 Second, it opens up the possibility of negotiating mutual recognition
of credits with non-EU trading programs. 37 Finally, it envisages some use of CDM
and joint implementation credits, but leaves the details to subsequent
elaboration. 38
The European Parliament amended the 2003 Directive in 2004, largely in
order to address the linkages between the ETS and the Kyoto mechanisms. 39 This
Linking Directive sought to increase the diversity of low-cost compliance
options while safeguarding the environmental integrity of the communitys
trading scheme. 40 It opined that this linkage would increase demand for CDM
credits and thereby provide aid to developing countries . . . in achieving their
sustainable development goals. 41 Accordingly, it authorized use of credits from
CDM projects, called Certified Emission Reductions (CERs) beginning in 2005. 42
But the Directive punts on the vital issue of the extent to which operators
may rely upon CERs to fulfill their obligations under the Directive. It allows each
Member State to authorize regulated sources to satisfy a specified percentage
of their emission reduction obligations through the purchase of CERs. 43 The
Linking Directive also suggested that the percentage should be small by requiring
compliance with the Kyoto Protocols supplementarity obligation, the obligation
to use credits only to supplement domestic compliance efforts. 44 But in the same
paragraph, it stated that domestic action will thus constitute a significant
element of the effort made, which suggests wider use of CERs, since domestic
action can remain a significant element even if a small majority of credits
92
comes from CERs. 45 Thus, a crucial paragraph about the extent of reliance on
CERs looks like an effort to paper over policy differences on the role of CERs and
accordingly yields vague guidance. It tracks fairly similar language found in the
Marrakech Accords to the Kyoto Protocol. 46 The European Parliament clearly
decided, however, to prohibit credits for projects involving land use or nuclear
power. 47 The Linking Directive also discourages the use of large hydropower
credits by requiring member states to ensure that relevant international criteria
will be respected when approving use of these CERs. 48 Hence, the total
demand for CERs will be limited by the percentages allocated for CERs in
national trading plans under the ETS Directive and by several discrete limitations
on problematic projects.
The supplementary concept, then, limits the maximum potential demand for
CDM and JI credits. The amount of the limitation depends upon the volume of
demand for credits. The demand for credits, in turn, depends on the amount
reductions required in the trading scheme and the percentage of reductions
allowed for CER. Individual countries, not the EU, make the decisions about
precisely how much reduction to demand in the trading program and what
percentage of that reduction may come from CERs.
The World Bank has estimated that the annual average demand for all Kyoto
credits (including AAUS, CDM, and JI) at 600 to 1150 MtCO2e. 49 The ETS regulates
sectors representing 46% of European CO2 emissions. 50 Accordingly, NATSOURCE
has estimated that the European Emission Trading Scheme will generate demand
for credits of 110 MtCO2ee. 51 This amount might prove less than the demand
generated by governments and private parties outside of the trading scheme. 52 The
NATSOURCE estimate, however, represents total demand for JI and CDM credits,
not CDM alone (the topic of this article). Nevertheless, this number represents a
reasonable estimate of total potential ETS demand for CDM credits.
These numbers, however, are subject to some caveats. As of this writing the
National Allocation Plans do not include firm targets for 2012 or firm numbers
limiting the use of credits from the project-based mechanisms for phase II of the
ETS. Weak targets will lower demand. Conversely stronger targets will increase
demand. Final decisions about what percentages of project based credits to
allow into the system will also influence demand emanating from the ETS.

93
Promoters of renewable energy and energy efficiency projects hoping to sell

credits to facility owners regulated under the European ETS will find that their
offerings will face competition from other types of both JI and CDM projects. If
economic rationality governs the purchase decisions of the regulated industries,
they will choose the cheapest available credits from among these offerings,
perhaps discounting for risk (if there is any). This competition could reduce actual
demand for CDM renewables and energy efficiency credits substantially.
Unfortunately, available data on the prices of CDM credits is quite limited.
Many of those involved in projects have attempted to keep pricing data
confidential. 53 This raises a transparency concern. One of the chief advantages
of trading is that it reveals the actual cost of reductions. Since actual cost usually
are lower than projected costs, this information can help spur subsequent actions
to clean the environment. On the other hand, operators who have funding for
projects not dependent on purchases by CER purchasers would want to hide the
low cost of credits they can offer, since the low cost would suggest a lack of
additionality in some cases. Transparency is vital both to informing the policy
process and to providing a post-hoc check on the accuracy of a priori
additionality determinations. The limited data available does not justify strong
conclusions about how various types of approved projects are competing on the
basis of price.
A wild card variable comes from hot air. 54 To the extent that polluters are
allowed to purchase credits reflecting hot air, which should be cheap because
they cost nothing to produce, demand for renewable or energy efficiency CERs
should diminish or disappear altogether. In phase one, some hot air may come
into the ETS through countries like Poland, which have caps higher than current
emissions under both Kyoto and the ETS. While political rejection of hot air may
restrain use of extensive use of these credits, economic rationality will likely push
facility owners toward favoring hot air over CERs, unless countries choose to
provide tighter restraints on hot air than they apply to CDM, something not
required by the Linking Directive.
IV. CDM Projects as a Source of Supply

Examination of CDM projects suggests that project developers have favored
endof- the-pipe controls to ameliorate business as usual to projects providing
renewable energy and energy efficiency. At first glance, it might appear that the
94
CDM has done a magnificent job of encouraging renewable energy. After all, 19
of the 35 registered projects as of November 1, 2005, were renewable
projects. 55
Figure 1: Registered Projects # of Projects Based on Type (as of Nov. 1, 2005)
But examining the projects from the more meaningful perspective of how
many CERs different types of projects generate yields a very different picture.
Approved renewable energy projects CDM are expected to generate only. 7
MtCO2e over the lifetime of the approved projects.
Registered
Projects: Type
# of Projects
(as of 11/22/05)
Metric Tonnes CO2

Reductions per Year
% of CERs /
Yr
Renewables
19
638,965
8%
Energy Efficiency
6,580
0%
Large Hydro
104,155
1%
Non-Renewables
12
7,072,276
90%
Total
35
7,821,976
100%

95
This constitutes less than 10% of the available CDM credits.

Registered Projects % of CERs Generated Per Year
It also constitutes less than 1% of the European potential demand for project
mechanisms credit. As companies must plan to meet the phase one limits of the
ETS in the 2005-2007 time period, the current supply could seriously limit the
maximum potential European finance of sustainable development supporting
CDMs in phase one.
Renewables projects in the pipeline could expand this supply. If all of these
projects are approved, renewable project would generate 15% of the total credits.
CER Pipeline % of CERs Generated Per Year (Excluding Registered Projects)
96
So far, only one small energy efficiency project has received certification.
The pipeline contains very few energy efficiency projects as well.
Ben Pearson has suggested several reasons why the CDM program has not
generated a large supply of renewable energy credits. 56 The main reason is that
renewable energy often costs more than other approaches to generating credits.
Consequently, CDM developers have favored projects that contribute little or
nothing to meeting sustainable development goals, but efficiently provide large
volumes of cheap credits.
Typically, these projects capture or destroy gases with high global warming
potential, such as methane and HFC-23. 57 Project developers understand that
buyers maximizing cost effectiveness will want the cheapest credits available, not
necessarily those that deliver the broadest and most important long-term
environmental, economic, and social benefits.
Energy efficiency projects often pay for themselves, but that means that
honest oversight will tend to make life difficult for energy efficiency projects.
Energy efficiency has terrific potential for cheap reductions in greenhouse gases.
But energy efficiency measures typically involve many low volume steps, each
generating a small amount of reductions in greenhouse gases indirectly, by
lessening demand for electricity generated by fossil fuels. This makes such
projects unattractive for prospective purchasers of credits. In addition, because
these projects often pay for themselves by generating reduced energy costs over
time, serious questions about whether a project is additional, and therefore
eligible to generate credits, should make it hard to get these projects approved.
Policy interventions, such as information programs to make people aware of the
opportunities for energy efficiency, taxes making carbon expensive, and
efficiency standards for cars, buildings, and appliances can help. But the CDM,
in the past, has generated project credits, not policy interventions. So, it is not
surprising that CDM developers have not done much with energy efficiency.
The Conference of the Parties meeting in Montreal in 2005, however,
attempted to increase the use of energy efficiency credits by authorizing credits
for efficiency projects forming part of a government program to increase
efficiency. 58 Assuring that such credits are truly additional will necessarily involve
a difficult inquiry into the motives of the policy-makers adopting energy efficiency
programs.

97
One would expect that renewable energy projects, while offering enormous
long term benefits, would present difficulties for developers seeking to quantify
reductions. Renewable energy projects do not directly reduce emissions, they add
energy with little or no added emissions. They reduce emissions indirectly, by
displacing more carbon intensive energy supply sources. Hence, estimating the
value of credits requires calculation of the amount of energy produced, the
associated emissions (if any), and the carbon emissions associated with the
energy sources displaced. While this is possible, especially with less innovative
projects that make a priori calculations of energy production reliable, it is more
complicated than calculating the value of credits from a project that simply
reduces the impacts of business as usual directly without starting down the path
of fundamental change. Again, trading, with its emphasis on a priori calculation
and low costs, does little to encourage renewable energy.
V. Lessons from CDMs Lack of Impact on Sustainable

Development
Currently, only a few European countries seem on track to meet Kyoto limits.
Others have significant shortfalls. The European Union and the international
community generally will face pressures to make up the shortfall. They will face
the question of how and whether to shore up commitments to sustainable
development in that context.
Available options include:
Paper Compliance Relax oversight of CDM credits to make project

approval easier and liberalize their use in the ETS.
Ratchet down the caps in the ETS.
Increase the stringency and breadth of non-ETS programs in the EU.
Limit CDM to track Sustainable Development Goals.
Non-compliance.
Tradings relationship to sustainable development offers some lessons about

how to think through these options.
98
Trading creates an economic dynamic that can make paper compliance

attractive. In the United States, at least, use of emissions trading often leads
regulators into the trap of losing sight of long-term goals like sustainable
development or even the realization of real verifiable surplus emission
reductions. Instead of treating emissions trading as a means to achieve
sustainable development, regulators involved in trading tend, over time, to view
stimulation of a trading market as an end in itself. They often view impediments
to trading, such as regulatory oversight and limits on the use of questionable
credits, as barriers to trading or transaction costs. 59 This view tends to lead
almost inexorably to efforts to lower the barriers and transaction costs. This
perspective will support an approach to encouraging renewables and energy
efficiency by making approval and use of those credits easier.
While the lowering of transaction costs might increase the supply of credits,
it often does so at a cost in environmental quality. 60 Transaction costs are not
usually deadweight losses. They usually purchase something of value. In emissions
trading markets, the transaction costs related to governmental oversight of the
validity of credits purchase quality. 61 Absent such oversight, buyers, sellers, and
brokers may have no interest in the quality of credits, since any credit acceptable
to a regulator serves the function motivating the purchase, i.e., satisfying
regulatory demand for credits. 62 Any reduction of transaction costs should avoid
undercutting important elements of the oversight function.
The European Union can increase demand for CDM credits by adopting
stringent regulations in Phase Two for the trading sector. Such an approach may
create pressures to expand the use of cheap CDM credits and hot air. If that pressure
is not resisted, then risks exist of having the cheapest credits, hot air, crowd out
everything else. This will create the appearance, but not the reality, of compliance.
Developing countries and other observes are already skeptical of nations
claims that they are taking meaningful steps to address climate change. If
climate policy-makers in developing countries do not believe that the developed
countries have taken meaningful local action to address climate change, then
they may resist assuming meaningful obligations in the post-Kyoto period.
Conversely, if the European Union and other nations currently undertaking
compliance with Kyoto targets take meaningful steps toward sustainable
development, then the developed country will acquire increased credibility that

99
may enhance developing countries willingness to make commitments. Similarly,

the claims of some US politicians that complying with Kyoto is too costly to be
achieved will lose credibility over time, if the EU does comply without reliance on
hot air and non-additional project credits. This would aid ongoing efforts by
many people in the United States to change the federal governments
irresponsible climate change policy.
One way of increasing the use of renewables would be to restrict competing
types of CDM credits. This would force buyers to choose options favoring
sustainable development, instead of giving primacy to short term cost effectiveness.
Another option involves increasing the reductions from sectors not covered
by the ETS Directive or enhancing other policy measures aimed at the Kyoto
targets. The EU has under consideration a tax reform aimed at transport;
countries have implemented renewable energy portfolio standards; many nations
have imposed energy efficiency standards; and some countries have used carbon
taxes in a limited fashion. Because trading measures have limited capacity to
finance renewables and energy efficiency, increasing the scope and stringency of
these more targeted policy measures may better stimulate moves toward
sustainable development than tweaking the trading mechanism.
Conclusion
The goal of sustainable development is in some tension with the goal of short
term cost effectiveness. The sooner we face up to the tension between free
market liberalism and sustainable development, the better the chances for
effective climate change policy.
Endnotes
1
Report of the Intergovernmental Negotiating Committee for a Framework Convention

on Climate Change on the Work of the Second Part of its Fifth Session, UN
Conference on Environmental and Development: Framework Convention on Climate
Change, 5th Sess., pt. 2, Annex I, UN Doc. A/AC.237/18 (1992) (Part II)/Add.1,
1771 UNTS 108, available at <http://unfccc.int/2860.php> Art. 2 [hereinafter
Framework Convention].
100
See WORKING GROUP III TO THE SECOND ASSESSMENT REPORT OF THE INTERGOVERNMENTAL
PANEL ON CLIMATE CHANGE, CLIMATE CHANGE 1995 ECONOMIC AND SOCIAL DIMENSIONS
OF CLIMATE CHANGE 241 (James P. Bruce et. al., eds., 1996) (noting that renewable
energy sources emit little carbon and that switching to renewables will reduce emissions).
Report of the Conference of the Parties on its Third Session, Kyoto Protocol to the UN
Framework Convention on Climate Change, 3rd Sess., pt. 2, Annex I, UN Doc.
FCCC/CP/1997/7 add.1, December 11, 1997, reprinted without certain technical
corrections in 37 I.L.M. 22 (1998) Art. II, 1(a)(i),(iv) [hereinafter Kyoto Protocol].
See generally UN Conference on Environment and Development, Agenda 21, UN

Doc. A/CONF.151.26 (1992). For a discussion of the Agenda 21 provisions
addressing renewable energy and air pollution generally, see David M. Driesen, Air
Pollution, in STUMBLING TOWARD SUSTAINABILITY 257- 261 (John C. Dernbach ed. 2002)
[hereinafter STUMBLING].
See DAVID M. DRIESEN, THE ECONOMIC DYNAMICS OF ENVIRONMENTAL LAW 89 (2003)

(explaining the link between Dalys idea of reduced throughput and technological
innovation), HERMAN E. DALY, BEYOND GROWTH (1996) (developing a concept of
sustainable development linked to reduction in throughput).
See Douglas A. Kysar, Sustainable Development and Private Global Governance, 83

TEX. L. REV. 2109 , 2118 (2005) (describing the idea of protecting the interests of
future generations as the most widely accepted meaning of sustainable
development.); John C. Dernbach, Synthesis, in STUMBLING, supra note 4, at 5
(explaining that sustainability implies meeting the needs of the present without
compromising the ability of future generations to meet their own needs).
See generally Rio Declaration on Environment and Development, UN Conference on

Environment and Development, UN Doc. A/CONF.151/5 Rev. 1, princ. 1, reprinted
at 31 I.L.M. 874 (1992) (stating that human beings are entitled to a health and
productive life in harmony with nature).
See Kyoto Protocol, supra note 3, Art. 12, Sec. 2 (describing achieving sustainable
development as part of the purpose of the clean development mechanism).
Council Directive 2004/101/, preamble, Amending Directive 2003/87/EC

establishing a scheme for greenhouse gas emission allowance trading with the
Community, in respect to the Kyoto Protocols project mechanisms. 2004 O.J.
(L 338), 18, 18 (EC) [hereinafter, Linking Directive].
10
See, e.g., R. WISER ET. AL., LETTING THE SUN SHINE: AN EMPIRICAL EVALUATION OF
PHOTOVOLTAIC COST TRENDS IN CALIFORNIA (LBNL-59282, NREL/TP-620-39300 ) ii
(2006) (discussing a 25% decline in solar energy costs in California since 1998);
LESTER R. BROWN, PLAN B: RESCUING A PLANET UNDER STRESS AND A CIVILIZATION IN TROUBLE
158-59, 164 (2003) (discussing drastic decreases in wind and solar costs); Anthony
D. Owen, Renewable Energy: Externality Costs as Market Barriers, 34 Energy Policy
632, 634 (2006) (documenting sharp declines in the price of renewables between
1980 and 1995). Cf. MARK BOLLINGER & RYAN WISER, BALANCING COST AND RISK: THE

101
TREATMENT OF RENEWABLE ENERGY IN WESTERN NATURAL RESOURCES PLANS iv-v (LBNL

58450) (2005) (noting a sharp increase in the cost of wind power in 2005, but
suggesting this increase might be anomalous).
11
See generally Kysar, supra note 6, at 2114 (discussing the tendency to adapt
sustainability to fit the market liberalism framework).
12
See id. at 2146 (identifying the elimination of agricultural subsidies as an area

where reform would advance both free market liberalism and sustainability).
13
See, Robert N. Stavins, Policy Instruments for Global Climate Change: How Can
Governments Address a Global Problem, 1997 U. CHI. LEGAL F. 293, 302-03; Robert
W. Hahn & Robert N. Stavins, Incentive- Based Environmental Regulation: A New Ear
for an Old Idea, 18 ECOLOGY L. Q. 1, 13 (1991); Bruce A. Ackerman & Richard B.
Stewart, Reforming Environmental Law: The Democratic Case for Market Incentives,
13 COLUM. J. ENVTL. L. 171, 183 (1988); Daniel J. Dudek & John Palmisano,
Emissions Trading: Why is this Thoroughbred Hobbled?, 13 COLUM. J. ENVTL. L. 217,
234-35 (1988).
14
See, e.g., David M. Driesen, Design, Trading, and Innovation, in MOVING TO MARKETS
IN ENVIRONMENTAL PROTECTION: LESSONS AFTER TWENTY YEARS OF EXPERIENCE (Jody
Freeman & Charles Kolstad eds. 2006) (forthcoming) [hereinafter, Driesen, Design];
Joel F. Bruneau, A Note On Permits, Standards, and Technological Innovation, 48
J. ENVTL. ECON. & MAN. 1192 (2004); Juan-Pablo Montero, Permits Standards, and
Technology Innovation, 44 J. ENVTL. ECON. &MAN. 23 (2002); Juan-Pablo Montero,
Market Structure and Environmental Innovation, 5 J. APPLIED ECON. 293 (2000); David
M. Driesen, Is Emissions Trading an Economic Incentive Program?: Replacing the
Command and Control/Economic Incentive Dichotomy, 55 WASH. & LEE L. REV. 289,
313-22, 325-38 (1998) [hereinafter, Driesen, Dichotomy]. See also David A.
Malueg, Emissions Trading Credit and the Incentive to Adopt New Abatement
Technology, 16 J. ENVTL. ECON. &MAN. 52 (1987); W.A. Magat, Pollution Control And
Technological Advance: A Dynamic Model of the Firm, 5 J. ENVTL. ECON. & MAN. 95 (1978).
15
See David M. Driesen, Does Emissions Trading Encourage Innovation?, 33 ENVTL. L.

REP. (Envtl. L. Inst.) 10094, 10105 (2003) (noting the dominance of these traditional
technological options and discussing claims that the acid rain program encouraged
innovation). Cf. Byron Swift, Command Without Control: Why Cap-and-Trade Should
Replace Rate-Based Standards for Regional Pollutants, 31 ENVTL. L. REP. (Envtl. L.
Inst.) 10330 , 10338 (2001) (claiming that trading encouraged some innovation).
16
A. DENNY ELLERMAN ET. AL.,MARKETS FOR CLEAN AIR: THE US ACID RAIN PROGRAM 130
(2000) (noting that the acid rain program did not produce greater reliance on
renewable energy).
17
See Margaret R. Taylor, Edward S. Rubin, and David A. Hounshell, Regulation as the
Mother of Innovation: The Case of SO2 Control, 27 LAW & POLY 348, 370 (2005).
Cf. David Popp, Pollution Control Innovations and the Clean Air Act of 1990, 22
102
J. POLY ANALYSIS &MGMT 641 (2003) (agreeing that command and control caused
more innovation than trading, but arguing that trading did better at encouraging
environmentally superior innovations).
18
See generally EDWARD A. PARSON, PROTECTING

(2003).
19
See Adam B. Jaffe et. al., Environmental Policy and Technological Change, 22 ENVTL.
& RESOURCE ECON. 41, 51 (2002); Malueg, supra note 14, at 8-9 & n. 33.
20
See Malueg, supra note 14; Driesen, Dichotomy, supra note 14, at 334; DAVID
WALLACE, ENVIRONMENTAL POLICY AND INDUSTRIAL INNOVATION: STRATEGIES IN THE USA,
EUROPE, AND JAPAN 20 (1995) (explaining that the Malueg model casts doubt on the
claim that emissions trading necessarily spurs innovation); Chuhlo Jung et. al.,
Incentives for Advanced Pollution Abatement Technology at the Industry Level: An
Evaluation of Policy Alternatives, 30 J. ENVTL. ECON. & MAN. 95, 95 (1996)
(marketable permits may not provide greater incentives than standards, because
the incentive effects of marketable permits depend on whether firms are buyers or
sellers).
21
Driesen, Design, supra note 14.
22
See Richard G. Newell et. al., The Induced Innovation Hypothesis and Energy-Saving
Technological Change, 114 Q. J. ECON. 941 (1999).
23
Driesen, Design, supra note 14, at ___.
24
See Framework Convention, supra note 1, Art. 3, Sec. 3 (stating that measures to
combat climate change should be cost-effective).
25
See David M. Driesen, Free Lunch or Cheap Fix?: The Emissions Trading Idea and the
Climate Change Convention, 26 B.C. ENVTL. AFF. L. REV. 1, 44 (1998) (explaining this
point with a renewable energy example).
26
Cf. David M. Driesen, Markets are Not Magic, 20 ENVTL FORUM 19 (Nov.-Dec. 2003).
27
See Driesen, Dichotomy, supra note 14, at 324-25 (explaining why trading only
provides limited incentives for reductions).
28
See Council Directive 2003/87, 2003 O.J. (L 275) (EC) [hereinafter ETS Directive].
29
See Commission Proposal for a Directive of the European Parliament and Council
Establishing A Scheme for Greenhouse Gas Emission Allowance Trading Within the
Community and Amending Council Directive 96/61/EC, 2002 O.J. (C 075 E) 9.
30
See generally Brennan Van Dyke, Emissions Trading to Reduce Acid Deposition, 100
YALE L. J. 2707 (1991).
31
See ETS Directive, supra note 29, Annex 1.
32
Id., Art. 11, Sec. 1.
THE
OZONE LAYER: SCIENCE
AND
STRATEGY

103
33
Id., Art. 11, Sec. 2.
34
Id., Art. 11.
35
SEE ILEX ENERGY CONSULTING, THE ENVIRONMENTAL EFFECTIVENESS OF THE EU ETS: ANALYSIS OF
CAPS: A FINAL REPORT TO WWF V-VI (2005).
36
See ETS Directive, supra note 28, Art. 3 (a), Art. 24.
37
Id. Art. 25.
38
Id. Art. 30.
39
Linking Directive, supra note 9.
40
Id., L 338/18.
41
Id.
42
Id. Art. 11a.
43
Id., Art. Sec. 8(c), 338/23.
44
Id. 338/19 (par. 6); Kyoto Protocol, supra note 3, Art. 6, Sec. 1(d).
45
See Linking Directive, 338/19 (par. 6).
46
See Decision 15/CP.7, Principles, nature and scope of the Mechanisms Pursuant to
Articles 6, 12, and 17, of the Kyoto Protocol, FCCC/CP/2001/13/Add.2, at 2
(2001).
47
See Linking Directive, supra note 9, 2 (adding Art. 11a to the 2003 Directive).
48
Id., 2(b)(6).
49
See E. Haites & S. Seres, Estimating Market Potential for the Clean Development
Mechanism: Review of Models and Lessons Learned, PCFPLUS REPORT 19 (2004).
50
American Bar Assn, Sustainable Development, Ecosystems, and Climate Change,

ABA ENVT, ENERGY, & RESOURCES L.: YEAR IN REV. 120, 123 (2004).
51
Gernot Klepper & Sonja Peterson, Emissions Trading, CDM, JI, and More- The
Climate Change Strategy of the EU 11 (FEEM Working Paper No. 55.05, April
2005). This estimate might be off by 65 MtCO2e in either direction. Id.
52
See id.
53
FRANCK LECOCQ & KARAN CAPOOR, STATE AND TRENDS OF THE CARBON MARKET 2005, at 26
(2005), available at http://www.ieta.org/ieta/www/pages/getfile.php?docID=899.
54
Frank Lecocq, State and Trends of the Carbon Market 2005 (Executive Summary),
CARBON MARKET UPDATE 10, 11 (September, 2005) (explaining that the amount of
AAU from Russia and the Ukraine are a key uncertainty).
104
55
See http://www.cd.unfcc.int.html (last visited Nov. 4, 2005).
56
See Ben Pearson, CMD is Failing, 56 TIEMPO 12 (2005).
57
Id. at 12. For a critique of a major HFC-23 project see Newest Biggest Deal, DOWN
TO EARTH (November 15, 2005), available at http://www.downtoearth.org.in/cover.asp?
foldername=20051115&filename=anal&sid=1&sec_id=7 (last visited November 11,
2005). This Article estimates that HFC-23 projects account for 24% of all CERs sold.
58
Decision-/CMP.1: Further Guidance Relating to the Clean Development Mechanism,

COP/MOP 1, Montreal UN Climate Change Conference, 5 (2005), at http://unfccc.int/
files/meetings/cop_11/application/pdf/cmp1_24_4_further_guidance_to_the_cdm_
eb_cmp _4.pdf.
59
See David M. Driesen & Shubha Ghosh, The Functions of Transaction Costs:
Rethinking Transaction Cost Minimization in a World of Friction, 47 ARIIZONA L. REV.
61, 92-98 (2005) (discussing the tension between the impetus to reduce transaction
costs to encourage trading and the need to preserve effective government oversight
to protect environmental quality from poor quality trades).
60
See id. at 93-94 (explaining why both buyers and sellers of pollution credits share
incentives to exaggerate the value of traded reductions).
61
Id. at 93 (explaining that government oversight makes it possible to distinguish good

from bad emissions trading transactions).
62
Id. at 92-94.
5
Linking Community Forestry Projects in
India with International Carbon
Markets: Opportunities and Constraints
Rohit Jindal* and Shailesh Nagar**
The authors highlight the fact that India would benefit
tremendously through community forestry projects and the local
communities could accrue benefits by selling carbon sequestered
by these projects in Kyoto-based markets. However they find that
though India is eligible for conducting its business there is no
awareness among the public to take up such initiatives. In order
to prove that India has the potential to take up such projects he
conducted research in two prominent Non-Government
Organizations (NGOs) that have well established forestry
projects Seva Mandir and Foundation for Ecological Security.
They calculate the carbon sequestration potential for these two
NGOs, and identified the likely challenges and areas of
concern. The potential gains that the local communities may
accrue from sale of carbon credits. Despite all these efforts the
authors find that these projects are not taking off as expected,
*
**
Phd candidate Michiagn State University. Research Associate World Agroforestry Centre and Sokoine
University of Agriculture, Morogoro, Tanzania. E-mail: Jindalro@msu.edu
Senior Project Officer at Foundation for Ecological Security. E-mail: shailashnagar@gmail.com
2009 Icfai University Press. All rights reserved.
106
due to delayed approval of land use. This is despite the fact that
there is huge demand in the market as the first commitment
period for mitigating emissions by the parties under Kyoto is
coming to an end by 2012. In such circumstances these projects
may need alternate avenues for selling carbon sequestration
credits, and one such viable market is the Chicago Climate
Exchange. CCX is the only largest carbon credit market that
takes up community forestry projects. Thus, India with all the
potential by joining hands with CCX may gain huge profits in
the carbon markets and also expand its supply base by linking
up with other member nations.
1. Introduction
Community forestry projects have long been implemented in India with an aim to
strengthen rural livelihoods by improving local natural resource base. Until now,
the major benefits from these projects were in the form of timber and NonTimber Forest Products (NTFPs) for the local communities. However, with the
ratification of the Kyoto Protocol 1 in 2005, there has been a growing expectation
that additional benefits could accrue by selling carbon sequestered by these
projects in Kyoto-based markets (Poffenberger et. al., 2001). Similarly, many
new forestry projects were initiated with the express objective of selling carbon
credits in international markets. Examples include TIST, Tamil Nadu 2 and Plan
Vivo based Women for Sustainable Development, Karnataka (FAO, 2004).
However, due to long delays in approval of land use sequestration projects, 3 the
Kyoto-based market for carbon sequestration credits hasnt really taken off (IISD,
2006). With the first commitment period under Kyoto ending in 2012, many of
these projects may need alternate avenues for selling carbon sequestration
credits. One viable market that has grown in recent years is the voluntary
emission reduction programs, particularly the Chicago Climate Exchange. 4
The Chicago Climate Exchange (CCX) was set up in 2003 to provide an
opportunity to business houses and other large entities to voluntarily reduce their
carbon emissions. Members can trade in carbon credits to fulfill their yearly
Linking Community Forestry Projects in India with

International Carbon Markets: Opportunities and Constraints
107
emission reduction targets. CCX has been growing rapidly; in 2005 alone, CCX
traded 1.43 million tons of carbon dioxide (tCO2) worth US$ 2.8 million, making
it the third largest carbon market in the world (Point Carbon, 2006). This
included trade in carbon sequestration credits from land use projects. Since the
two larger carbon markets European Union Emission Trading System and New
South Wales GHG Abatement Scheme are yet to trade in carbon sequestration
credits from forestry projects, CCX probably represents the single largest market
for such credits. This is a welcome opportunity for community forestry projects in
India which can potentially tap into this growing market for carbon credits.
Likewise, CCX may also gain from linking up with these projects and expanding
its supply base.
However, most researchers and policy makers in India appear to be
unaware of CCX or of other voluntary programs that have come up in different
parts of the world. Review of recently published literature suggests there are
several studies in India that look at eligibility conditions for selling carbon credits
in Kyoto markets, but none that explores the same for CCX or for any other
voluntary market. What are the main requirements for selling carbon credits in
these markets? Do community forestry projects sequester enough carbon to sell
in these markets and what price schedules could they expect? Similarly, till date,
these voluntary markets have restricted their supply of carbon credits to certain
geographic regions. For example, CCX mainly meets its demand for carbon
sequestration credits from farmers in the US. With the increase in demand for
carbon credits, these markets will need to know more about potential suppliers
elsewhere. Who are these suppliers? How many carbon credits can they sell and
at what price? Do these suppliers have a long-term commitment to participate in
the carbon market?
This article attempts to answer some of these questions from the perspective
of community forestry projects in India. For preserving clarity in discussions and
with a view towards practical applicability, the article mainly considers the case
for selling carbon credits on the CCX. However, wherever necessary, the article
also considers broader issues and areas of concern. It is based on an extensive
research with two prominent Non-Government Organizations (NGOs) in India
that have well established forestry projects Seva Mandir and Foundation for
Ecological Security.
108
Research data were collected through field visits to selected project sites,
followed by open-ended discussions with community representatives, respective
NGO staff, and senior officials of the state Forest Department. Secondary data
sources consisted of recent reports on carbon markets, particularly CCX, and
details on relevant protocols for international carbon sequestration projects.
Carbon sequestration potential for the two NGOs was calculated on the basis of
their in-house monitoring studies and some recent literature on biomass
accumulation rates in India. Finally, critical challenges and areas of concern
were identified through a stakeholder workshop in Udaipur, India.
The rest of the article is organized as follows: the next Section provides
useful information on forestry interventions of the two NGOs. This is followed
by an estimation of annual carbon sequestration potential of these forestry
projects and a review additionality, leakage, permanence, and monitoring
issues to determine the relative feasibility of selling carbon sequestration credits
on CCX. Section four identifies potential gains for local communities from sale
of carbon credits. The article ends with a discussion on important areas of
concern such as food security and suggests some modifications in the present
set up of rules.
2. Forestry Initiatives of Seva Mandir & Foundation for

Ecological Security
Seva Mandir is a prominent Indian NGO that works towards development of
local communities in more than 580 villages, of Udaipur and Rajsamand districts
in southern Rajasthan. 5 It aims to strengthen local livelihoods, build peoples
capabilities and promote sustainable village institutions in these villages (Seva
Mandir, 2005). The organization works in partnership with village level
institutions, which take responsibility for managing various activities implemented
by the organization. Representatives of these institutions are regularly trained to
improve their skill levels, and to seek their assistance in implementing different
development projects. Since late 1980s, the organization has taken up several
forestry initiatives to increase local incomes by improving the natural resource
base in the area. The central focus of this work is to reverse the ecological
degradation of village common lands, 6 which are often over-exploited and

109
unable to fulfill local needs (Seva Mandir, 2006). Productivity is restored through
tree plantations and soil and water conservation measures. Seva Mandirs
forestry interventions that can earn carbon sequestration credits include:
i.
Pastureland development on panchayat grazing lands. The village

institution obtains permission from the local panchayat 7 to
manage the land for a fixed duration of time (usually five to ten
years), after which the permission needs to be re-sought. A
boundary wall is constructed around the land to thwart open
grazing and to encourage regeneration of rootstock. New
plantations are undertaken to improve tree density. All activities
are executed as per a management plan prepared by Seva
Mandir staff in participation with the local community. Villagers
can partake grass, dried tree branches, and bamboo shoots
through manual harvesting. Since 1990, the organization has
covered 1953 hectares of land 8 under pastureland development,
spread over more than 50 villages.
ii.
Joint Forest Management (JFM) on forestlands under the new

forest policy (1990), which allows local communities to manage
forestlands. Seva Mandir assists village institutions in obtaining
permission from the state forest department before constructing a
boundary wall and taking up tree plantations. Plantation activities
are carried out as per a long-term management plan, prepared in
consultation with the forest department. Villagers can harvest
grass and other Non-Timber Forest Products (NTFPs) from the
forestland, along with a fixed share of final timber harvest.
Usually, the productivity of forestlands is higher than panchayat
lands. The total area covered under JFM activities since 1990
is 715 hectares (ha).
iii.
Plantations on private lands under which individual farmers

receive financial and technical support from Seva Mandir to take
up tree plantations. The organization usually favors small and
marginal farmers over large farmers. Since 1990, 5210 ha of
land have been covered under private plantations on patches of
land that were usually less than 1 ha in size.
110
The Foundation for Ecological Security (FES) works towards restoring

about 73,000 hectares of degraded lands in ecologically fragile areas across
seven states in India. 9 It works in close participation with village communities to
prioritize local needs and to plan various natural resource development
interventions with them. Its target beneficiaries consist of about hundred
thousand rural households, eighty percent of which belong to landless, small and
marginal farmer categories. Through its work, FES has been able to generate
more than 4.4 million days of employment for these poor households
(FES, 2005). A major component of the organizations strategy is to work, as far
as possible, on entire landscapes and promote natural regeneration. However,
the organization does take up tree plantations, often in areas that are contiguous
to naturally regenerating lands. Activities that aid in carbon sequestration include:
i.
Regeneration of panchayat grazing lands and revenue wastelands

through plantation and protection activities. Village communities
obtain permission from respective panchayats or from the revenue
department (in case of revenue wastelands) before initiating the
work. Boundary wall is usually constructed to improve the survival
rate of saplings by controlling open grazing. FES also prepares a
long-term management plan for each project site that encourages
sustainability of the intervention. Villagers have access to all NTFPs
from regenerated sites, such as grass, firewood, and fruits.
Since 1990, FES has worked on 5,808 ha of panchayat grazing
lands and 18,810 ha of revenue wastelands.
ii.
Joint Forest Management activities of FES are similar in setup to

those of Seva Mandir as they both follow standard guidelines of
the forest department, the major difference being that FES works
in different agro-ecological zones in the country while Seva
Mandirs works in one particular region. The total forest area
covered after 1990 is 5,787 ha.
iii.
Watershed development 10 on contiguous patches of land that include

both private and common lands. Watershed development is an
integration of several natural resource interventions such as soil and
moisture conservation, afforestation and reforestation, and construction
of water harvesting structures. Since 1990, FES has implemented
watershed development programs over 3,010 ha of land.

111
3. Feasibility of Linking with Chicago Climate Exchange

CCX a voluntary emission reduction and trading program whose members are
required to reduce their carbon emissions by 1% every year below their average
annual emissions from 1998-2001. Its members include Ford, DuPont, IBM,
Motorola, New Mexico, Chicago, and Universities of Minnesota and Iowa.
Members that cannot reduce their own emissions can buy carbon offsets from
other members that exceed their reduction targets and from farmers engaged in
carbon sequestration. 11 Since its inception in 2003, CCX has traded more than
6.4 million tCO2, including trade in carbon sequestration credits from land use
projects and forestry plantations (called as CCX forest carbon emission offsets).
Farmers and local communities can thus make money from their conservation
efforts by selling carbon offsets to CCX members. The basic specifications for
setting up such forest-offset projects are:
i.
Forestation and forest enrichment projects should have been

initiated on or after January 1, 1990 on unforested or degraded
land.
ii.
Forest conservation projects are eligible if taken in conjunction

with forestation on a contiguous site.
iii.
Demonstration of long-term commitment to maintain carbon

stocks in forestry.
iv.
Independent third-party verification of carbon stocks (where required).
If the above rules are satisfied, the two forestry projects can potentially sell
carbon offsets through CCX on the basis of annual increase in the above-ground
living biomass. But first, an estimation of carbon sequestered by them.
3.1 Annual Carbon Sequestration Potential

Carbon sequestration potential is defined as the amount of carbon dioxide (CO2)
fixed by plants through their photosynthetic activity. Although plants fix CO2 both
as aboveground biomass and below-ground soil carbon, CCX rules currently
allow for trading in only above-ground biomass contained in live plants. Forestry
112
projects are thus designated on the basis of their annual carbon sequestration
potential; projects that sequester less than 2000 tCO2 per annum as small,
between 2000 t CO2 and 12,500 tCO2 per annum as medium, and with more
than 12,500 t CO2 per annum as large forestation projects. Size determines
monitoring requirements for each project, as discussed below.
Detailed carbon analysis of the two projects was difficult due to time and
resource constraints; both NGOs covered large number of project sites that were
seldom contiguous. These sites varied with species mix, soil characteristics, mix of
planted versus natural regenerating trees, and eventual survival rates of the
trees. Although a high proportion of the project sites was believed to be
managed in a sustainable manner, working out the exact percentage required
an extensive survey in the area. Finally, the specific annual off take in the form of
grass harvests, fuelwood and other NTFPs was not known across different sites.
The present study therefore relied on recent estimates of biomass accumulations
in somewhat similar agro-ecological conditions in India, to arrive at mean values
of carbon sequestration for the two selected projects.
Poffenberger et. al., (2002) estimate that the above-ground mean annual
growth in degraded forests from protection and plantation was 3 tons C/ha
(carbon per hectare). 12 Similarly, Murali et. al., (2002) quote Seebauer (1992) to
report a national mean annual increment (MAI) of 3.6 tons C/ha for plantations.
Ashish et. al., (2006) arrive at a higher estimate of 5.24 tons C/ha for Rajasthan,
but their sample plots also include primary forests under protection, which tend
to add an upward skew to their calculations. In comparison, fewer estimates
were available for plantations on revenue or panchayat lands. A relevant study
was found to be conducted by FES itself, which reported an MAI of 1 tons C/ha
to 3 tons C/ha (Mondal et. al., 2005). Annual carbon sequestration is usually
taken as 0.5 times the MAI (Poffenberger et. al., 2002). By taking lower bounds
of the above estimates (to account for various uncertainties described above), the
present study estimates that the current carbon sequestration potential of all
forestry interventions taken together for Seva Mandir and FES is 16,421 tCO2 per
annum and 77,245 tCO2 per annum, respectively (see table 1 below; for details
see annex 1).

113
Table 1: Current Carbon Sequestration from Selected Forestry Projects in India

Seva Mandir
FES
Total
Area under post-1990 plantations ha
7,878
33,415
41,293
Annual above-ground biomass growth t C
8,950
42,096
51,046
Carbon sequestration tCO2/annum
16,424
77,245
93,669
Potential annual market value at CCX 13 @ $4/t CO2.
$65,697
$308,981
$374,678
3.2 Compatibility with CCX rules

This Section evaluates the extent to which FES and Seva Mandirs forestry
interventions are compatible with the CCX rules described above. As the
calculations in table 1 show, both FES and Seva Mandir have significant number
of carbon sequestration credits that can potentially be sold through CCX or other
international markets. Since, all these credits pertain to post-1990 plantations on
unforested (in case of panchayat and revenue lands) or degraded (in case of
forestlands) lands, they satisfy the first rule. The second rule is important for
plantations on forestlands. Typically, forestlands in India have a residual
rootstock that can quickly regenerate through protection (Ravindranath et. al.,
2001, Poffenberger et. al., 2002). Therefore, both Seva Mandir and FES
encourage regeneration of old trees through construction of a boundary wall and
other conservation measures. These organizations also take up new tree
plantations on the same forestlands. This qualifies their projects under rule two of
CCX, which states that forest conservation is eligible in conjunction with new
forestation efforts on contiguous sites. Field visits to some of the project sites
reveal that local communities have a long-term commitment to protect and
conserve these forestry projects. In addition, self-documented case studies and
published reports of the two organizations stress on sustainable management of
the forestry interventions undertaken by them (FES, 2005; Seva Mandir, 2005).
Therefore, the forestry initiatives of the two organizations also qualify under rule
three. Finally, if both organizations decide to market their entire annual carbon
sequestration potential through CCX, they would fall under the category of large
forestation projects. This requires them to instill independent monitoring and
verification procedures. At present, most of the monitoring is done by field staff
in conjunction with community representatives. A third-party verification process
would therefore induce additional costs for the two organizations. Although, it is
114
difficult to estimate the exact escalation in monitoring costs, it is bound to be

substantial due to existence of non-contiguous sites spread over a large area.14 A
useful tool in this regard could be the new decentralized carbon models being
developed by some researchers that make use of satellite imagery. However,
most of these models are still in the pilot stage and it is difficult to compare their
costs with those of conventional monitoring systems.
3.3 Additionality, Leakage and Permanence

The discussion in Section 3.2 indicates that forestry interventions of Seva Mandir
and FES qualify to sell carbon sequestration credits on the CCX. However,
typically, international trading in carbon sequestration credits also requires
fulfilling additionaility, leakage and permanence clauses (UNEP, 2004).
Additionality requires proving that carbon sequestration credits being claimed by
a project are additional to any that would occur in absence of the project (UNEP,
2004). Most forestry interventions implemented by the two organizations include
construction of boundary wall around the protected site. Field-observation of
some of these sites shows that the biomass accumulation rates (and thus the
carbon sequestration rates) are significantly higher inside the boundary wall than
outside. This indicates that increased rates of carbon sequestration on project
sites would not have happened in the absence of the protection measures
induced by the project. 15 Thus additionality can be easily verified through sitespecific biomass studies in the area.
Leakage requires that project beneficiaries should not cut any trees, neither inside
nor outside the project boundary. This is a contentious issue as local communities
often depend on forest resources for their livelihood needs such as obtaining
fodder for livestock, firewood for energy needs and fruits for selling in nearby
markets. To forego these benefits in lieu of the carbon payments would result in
shifting of use to another piece of land, which in an overall context would be
undesirable. On the other hand, if communities are allowed to harvest a certain
percentage of the annual biomass growth in terms of dead and fallen trees,
manual harvesting of grass, and mature bamboo poles, they may have a larger
stake in protecting the growing trees. Therefore, a balance needs to be attained
between short-run carbon sequestration benefits and long-term sustainability of
the site.

115
It is relevant to note here that CCX already incorporates this element by

paying for only 80 percent of the eligible forestry offsets. The balance 20
percent is saved in a CCX forest carbon reserve pool, to account for any net
losses in the carbon stocks. This 20 percent reserve may thus be sufficient to
fulfill the annual biomass needs of the local communities for the selected
forestry interventions in India.
Permanence refers to long-term commitment to protect plantations. Current
discussion on permanence has also focused on the option of producing
temporary carbon credits versus long-term carbon credits (see IISD, 2006; UNEP,
2004). However, in voluntary carbon markets, commitment to protect plantations
for about 20 years is usually sufficient to demonstrate permanence. In case of the
two forestry projects in India, both have several sites where local communities
have been successfully managing their forestry plantations for more than 15
years. In general, however, permanence is inextricably linked to leakage. As
discussed above, if communities are allowed to harvest a proportion of the
growing biomass for their sustenance needs, then tree plantations are much
more likely to be protected for long durations of time.
4. Potential Gains from Trading in Carbon Sequestration

Credits
The previous Section shows that forestry interventions undertaken by both Seva
Mandir and FES are eligible to sell carbon sequestration credits on CCX. What
are potential benefits from this carbon trading from the perspective of local
communities, the two NGOs and international carbon investors?
4.1 Sustainable Development Benefits for Local Communities

Sale of carbon sequestration credits can often generate additional incomes for
local communities. Recent literature documents livelihood and other development
benefits of carbon sequestration projects in several developing countries across
Africa and Latin America (e.g. see Jindal et. al., 2006; Rosa et. al., 2003; Smith
and Scherr, 2003). Similarly, the two forestry interventions covered under this
study in India can contribute towards sustainable development through carbon
payments.
116
As table 1 shows, the total financial value of carbon sequestration credits from
FES and Seva Mandirs forestry projects on CCX is $374,678 per annum.
Admittedly, not all of this financial value is immediately realizable, as the total
availability of carbon sequestration credits from the two projects (93,669
tCO2/annum) is much more than the current demand on CCX. In fact, only a small
percentage of these carbon credits may actually find buyers in international markets.
However, even small sales of carbon credits will generate additional incomes for
local communities, while creating opportunities for bigger sales in the future. These
incomes will be useful in extending local conservation efforts, in reducing livelihood
pressure on forests and can provide for sustenance needs of many poor families.
For example, FES is implementing Joint Forest Management program in
Chitravas and Rawach villages, in district Rajsam and (Rajasthan). Under this
program, the local community obtained an approval from the state forest
department to manage 276 ha of forestland. Since 2002, FES has helped the
community construct a stone fence around this forest and in planting more than
50,000 trees of indigenous species. These plantations are managed by the
village forest protection committee, which has banned all timber felling and
allows for only manual cutting of grass and for collection of dead and decaying
branches as firewood. The current carbon sequestration potential of this forestry
initiative is estimated to be 1,266.2 t CO2 per annum, with a financial value of
$5,064.8 per annum (or Rs.227,907 in the local currency). Discussions with
community representatives revealed that this is a significant amount of money. If
annual carbon payments were available to them, community members will have
an enhanced economic incentive to protect these plantations and in taking up
more conservation efforts. Since most farmers in the area were very poor, carbon
payments will also provide them with additional sources of income.
4.2 Additional Funding Support for NGOs

Carbon payments also represent opportunities for attracting additional funding
support. Many NGOs in India are actively involved in forestry interventions and
are in constant need for financial assistance. Seva Mandir, for example, submits
regular project proposals to international donor organizations to fund its forestry
activities (Seva Mandir, 2006). Similarly, FES receives financial support from
National Dairy Development Board, India and from some international
organizations. However, this funding support is often limited and may not always
meet local requirements.

117
Carbon markets, on the other hand are growing rapidly (Point

Carbon, 2006). The Executive Board of the Kyoto Protocol recently approved the
first carbon sequestration project, which is expected to finally boost the
Kyoto-based markets for carbon sequestration credits. Similarly, the CCX has
shown impressive growth and is now the third largest carbon market in the
world. Since its inception in 2003, the carbon price on CCX has increased by an
impressive 300 percent. There are thus increasing opportunities to raise money
through sale of carbon sequestration credits through CCX and other international
markets. A relationship with CCX can in fact help the two Indian NGOs to learn
the intricacies of international carbon trading, find more carbon buyers and thus
generate additional financial support for their forestry programs. As international
carbon rules are still being formulated, these NGOs also have an opportunity to
share their own experience of how these rules actually play out in the field and
suggest necessary modifications.
4.3 Benefits for CCX and its Members

Chicago Climate Exchange is a voluntary emission reduction program. However,
increasing environmental awareness, growing threat of global warming and
changing market perceptions have convinced more and more firms to commit
for emission reduction programs, leading to increasing demand for carbon
credits at CCX. Till date, CCX has mainly met this demand for carbon credits
from emission reduction and carbon sequestration programs within the US.
However, judging from the recent growth of CCX, demand may outstrip supply in
not too distant future. The CCX has therefore started looking for additional
suppliers of carbon credits and the two NGOs covered in this study are certainly
qualified to fulfill this role.
Striking a relationship with Seva Mandir and FES will thus help CCX to tap
into a relatively large supply of carbon sequestration credits. On its part, CCX
will also get to experience the particulars of a relationship with grassroots NGOs,
which may gain more significance as carbon markets continue to grow. Finally,
CCX members can gain satisfaction (and goodwill) from the fact that their
carbon payments are able to contribute towards sustainable development
initiatives in poor communities.
118
5. Critical Challenges and Concerns Regarding Carbon Trading

The immediate objective of this study was to assess the feasibility of linking
forestry interventions in India with international carbon markets, particularly the
CCX. The above discussion shows that carbon trading is not only feasible, it also
has several potential gains for the three main stakeholder groups. However,
discussions with community representatives, project staff of the local NGOs and
senior forest officials also highlighted some important concerns regarding
carbon trading.
5.1 Transaction Costs and Need for an Aggregator

Transaction costs include the costs of negotiating, contracting, implementing and
monitoring any carbon sequestration project. Although the two NGOs already
pay for most of these costs from their existing sources of funds, establishing a
carbon payment system will impose additional transaction costs on them. Most
important among these will be setting up contracts with CCX and paying for third
party monitoring and verification.
One way to bring down these transaction costs is to aggregate carbon
credits from individual farmers and then sell them in one lot at the CCX. This can
help avoid the cost of setting up individual contracts between CCX and the
individual farmers in India. The intermediary organization, i.e. the aggregator,
can set up a single contract with CCX on behalf of all the local farmers.
However, this aggregator will still need to establish some contracting
arrangement with local farmers to ensure that proper protocols are followed.
Therefore, the most plausible arrangement at this stage will be for Seva Mandir
and FES to form a federation and assume the role of aggregator for their
farmers. On its part, CCX will need to impart necessary training to this federation
in order to ensure successful carbon trading.
As regards monitoring and verification requirements, both NGOs may need
to modify their current system of monitoring through field staff and community
representatives. This is not to suggest that this participatory system does not
work, but international carbon buyers will desire a more impartial system, such
as independent verification. One possible strategy will be to introduce site
specific monitoring through hand held GPS (geographical positioning system).
These GPS devices are relatively inexpensive, easy to use and can help in more
rigorous tracking of carbon plantations. 16

119
5.2 Subsistence Farming and Food Security Concerns

Seva Mandir and FES mainly work with small farmers who are only able to meet
subsistence needs from their farms. Most poor families derive a substantial
proportion of their food requirements from these small farms and by collecting
NTFPs from common lands. Long-term carbon plantations with strict guidelines
on leakage may thus deprive these poor families from meeting their subsistence
needs. Some community representatives even felt that as the population
continues to grow, there will be additional demand for agricultural land.
However, if most of the land is locked in multi-year carbon commitment, then
local communities may be threatened with food insecurity. This is even more
pertinent in case of poor communities which may not have secure rights over
land. As carbon sequestration services become more valuable, powerful
landowners may grab these lands and drive the poor away, further threatening
their livelihoods (Kerr et. al., 2006). There is thus a need to balance carbon
sequestration activities with local needs for immediate livelihood support.
5.3 Carbon Sequestration on Common Lands

A large proportion of the land in rural India is in the form of village common
lands. Some of it is owned by the revenue department and a sizeable proportion
by the state forest department. These common lands have a significant potential
to earn carbon sequestration credits. At present, village communities need
approval from the respective authorities to take up plantations on these common
lands. Existing laws and policies such as the JFM policy, state that most NTFPs
belong to local communities, while timber benefits are shared between the
community and the respective authority. Management rights over such common
lands are only approved for a fixed time period, after which the community
needs to reapply or the management rights get transferred back to the authority.
These norms and procedures thus thwart long-term conservation commitments
by the local communities. In addition, there are no provisions for sharing of
carbon payments.
For example the Nayakheda village (panchayat Ghodach, district
Rajsamand) initiated an integrated watershed program in early 1990s with
financial support from Seva Mandir. Under this program, approval was obtained
from the local panchayat to take up tree plantations on 29 ha of common
120
pastureland. The villagers also planted trees on 100 ha of individually owned

lands. Since then, the village community has actively protected these plantations.
The present study estimates that the total carbon being sequestered by these
plantations is about 236.6 t CO2 per annum, with a financial value of $946.4 on
the CCX. However, the lease for the common lands ends in 2009 and the
panchayat has threatened to take over these common lands. There is thus little
motivation for the community to invest in more conservation efforts, leave aside
maintaining long-term carbon plantations.
There is thus a need to clarify rules on management rights over common
lands for local communities in India. On the other hand, as carbon payments
become more significant, there is a possibility that state forest department and
local panchayats may become much more rigid in transferring management
rights to local communities. This is a potential area for conflict that needs to be
resolved at the earliest. A practical way out may be to share carbon payments
between local communities and respective authorities, similar to arrangements
on sharing of timber benefits.
5.4 Necessary Modifications in Rules

Kyoto rules for carbon sequestration projects are often perceived as too rigid and
difficult to follow (IISD, 2006). There has been a move to simplify these rules,
especially for small-scale community forestry projects (UNEP, 2004). In comparison,
rules for carbon sequestration projects on CCX are relatively simpler and easy to
follow. However, from the perspective of the local communities, some
modifications in these rules will make them even more relevant and effective.
The foremost among these is that trading in carbon credits from forestry
projects on CCX is presently restricted to North America and some countries in
South America. The present study has shown that NGOs in India not only
generate significant carbon sequestration credits, but they also meet most of
CCXs requirements. In addition, carbon payments to local communities in India
will generate substantial developmental benefits, achieving a possible win-win
between environment conservation and economic development. As the CCX
continues to grow, it is high time for it to initiate relationships in other regions of
the world, particularly in India where forestry projects are already well
established.

121
Secondly, the exchange may need to define sustainability more precisely.

The present rules call for long-term commitment to conserve forest plantations,
but do not clarify the issue of leakage. This article has argued that making small
provisions for annual harvesting of biomass should not be termed as leakage
and in fact, such exemptions may ensure the permanence of carbon stocks.
Finally, CCX only allows for trading in aboveground carbon stored in live matter.
However, forest plantations often fix substantial amounts of carbon in the soil,
which accumulates as organic matter (Poffenberger et. al., 2002). If trading is
allowed for belowground carbon, it may provide a still higher economic incentive
for local communities to participate in carbon sequestration activities. 17
6. Conclusion
Seva Mandir and FES can potentially sell carbon sequestration credits on the
CCX and generate additional incomes for their local communities. Establishing a
relationship with CCX may in fact open avenues for carbon trading with other
international players. A viable strategy in this regard will be to start with simple
payment arrangements on small contiguous sites that are easy to monitor and
administer. Experience gained during these pilot projects may be handy in
expanding the scale of operations when international demand for carbon
sequestration credits rises further. Such performance-based payments may also
ensure that local communities have a long-term stake in conserving these
plantations.
On their part, the carbon markets will need to look at integrated role of
forests. Carbon payments can provide economic incentives to local communities
for conserving forests and other valuable natural resources. However, these
communities also depend on the same resources for their immediate sustenance
needs. Achieving a balance between these immediate needs and the long-term
priorities of the global society can truly promote sustainable solutions to global
warming.
122
Annex 1
Calculation of Current Annual Carbon Sequestration from
Forestry Interventions of Seva Mandir and FES, India
1.
All calculations are based on a conservative Mean Annual Increment (green,

above ground) of 1 tC/ha for revenue / pasturelands and 2.5 tC/ha for
forestlands.
2.
Annual carbon sequestration taken as 50% of MAI. Measured in terms of t C/ha.
3.
Result from (2) is multiplied with 3.67 to get annual carbon sequestration in
terms of tCO2/ha.
4.
Present price on CCX is $4.40/ tCO2 (Rs200/tCO2)
Foundation for Ecological Security (FES)

Total area under post-1990 plantations on forestlands = 5787 ha
Annual carbon sequestration from forestlands
= 2.5 x 5787 x 0.5 x 3.67

= 26,547.9 tCO2/annum
Total area under post-1990 plantations on

Panchayat/revenue lands/watershed development
= 27,628 ha
Annual carbon sequestration
= 1 x 27628 x 0.5 3.67

= 50697.4 tCO2/annum
Total current carbon sequestration from

Post-1990 FESs forestry initiatives
= 77,245.3 tCO2/annum
Potential financial value at CCX @ $4/tCO2
= $308,981 per annum
Seva Mandir (SM)

Total area under post-1990 plantations on forestlands = 715 ha
Annual carbon sequestration from forestlands
= 2.5 x 715 x 0.5 x 3.67

= 3280.1 tCO2/annum
Total area under post-1990 plantations on

Panchayat/revenue lands/watershed development
= 7,163 ha

Annual carbon sequestration
123
= 1 x 7154 x 0.5 3.67

= 13,144.1 tCO2/annum
Total current carbon sequestration from

Post-1990 SMs forestry initiatives
= 16,424.2 tCO2/annum
Potential financial value at CCX @ $4/tCO2
= $65,697 per annum
Acknowledgement
Acknowledgements to Michigan Agricultural Experiment Station for funding this study.
Thanks to the respective staff at FES and Seva Mandir for providing field support and
for participating in the brainstorming workshop at Udaipur. Authors also express
gratitude for villagers of Chitrwaas, Rawach, and Nayakheda for sharing their views on
implications of a carbon payment system. The opinions expressed here are those of
authors alone and do not necessarily represent views of respective organizations.
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Seva Mandir. 2006. Seva Mandir: 5th Comprehensive Plan 2006-2009. Udaipur, India.
Smith, J., and S. Scherr. 2003. Capturing the Value of Forest Carbon for Local
Livelihoods. World Development. 31 (12), pp 2143 2160.
UNEP. 2004. CDM Information and Guidebook. Second edition. Edited by Myung- Kyoon
Lee. Contrbutors J. Fenhann, K. Halsnaes, R. Pacudan, and A. Olhoff. UNEP Riso Centre
on Energy, Climate and Sustainable Development, Riso National Laboratory, Denmark.
UNFCCC. 2003. Caring for Climate: A Guide to Climate Change Convention and the yoto
Protocol. United Nations Framework on Climate Change Convention (UNFCCC), Bonn,
Germany. (http://unfccc.int/resource/cfc-guide.pdf)
Endnotes
1
Kyoto Protocol was ratified in 2005 to reduce emission of greenhouse gases into the
atmosphere. Under its Clean Development Mechanism, developing countries can
sell carbon sequestered by their forests to industrialized countries as carbon credits
or carbon offsets. These are units of carbon dioxide that have been absorbed by
forests from the atmosphere (UNFCCC, 2003).
For details, see www.tist.org
Called the LULUCF sector, i.e. land use, land use change and forestry.

125
Other examples include New South Wales Greenhouse gas Abatement Scheme in
Australia.
For more details see www.sevamandir.org
Apart from privately owned lands, there exist several kinds of common lands in
Indian villages. Prominent among these are revenue lands (owned by the
government revenue department), forestlands (owned by the state forest
department), and panchayat grazing lands (revenue department owns these lands,
but the village panchayats are the custodians). For more details on different property
regimes in India, see Kerr et. al., (1997).
Panchayats are democratically elected village councils in India.
CCX allows for trading in carbon sequestration credits from afforestation and
reforestation activities initiated only after 1990 on previously un-forested lands.
These are Gujarat, Rajasthan, Orissa, Madhya Pradesh, Andhra Pradesh, Karnataka
and Uttaranchal. More details on FES are available on www.fes.org.in
10
It is relevant to note that Seva Mandir too has a watershed development program,
much similar to FESs approach. However, the area covered under forestry subcomponent of Seva Mandirs watershed work is reported separately under different
forestry heads and is thus included in the above estimates.
11
For details, please see http://www.chicagoclimatex.com
12
1 ton C = 3.67 t CO2.
13
Price as on October 22, 2006.
14
In case of FES, this would cover different geographic regions that are far apart from
each other.
15
Acknowledgements to Esther Duflo at MIT for suggesting this innovative, yet costeffective means to verify additionality. If accepted, this methodology may help in
reducing transaction costs associated with carbon sequestration projects.
16
Indeed, the small holder tree plantation project (TIST), based in India and Tanzania
already uses hand help GPS to monitor their carbon plantations before selling
carbon credits in international markets. For more details see www.tist.org
17
Important to note that CCX already allows for trading in soil carbon, but it is
restricted to grasslands and conservation easements in US.
6
The Commerce Clause Meets
Environmental Protection: The
Compensatory Tax Doctrine as a
Defense of Potential Regional
Carbon Dioxide Regulation
Heddy Bolster*
On December 20, 2005 seven northeastern states announced an
agreement to implement the Regional Greenhouse Gas Initiative
(RGGI), in an effort to reduce greenhouse gas pollution. In
doing so, those states formally committed to implementing the
first market-based regulatory program for carbon dioxide
emissions trading in the United States. When electricity suppliers
begin to import power from outside the regulated region in order
to avoid the constraints of the emissions cap, resulting in little or
no net decrease in overall emissions associated with the power
consumed inside the region the movement of emissions
associated with power consumed inside the region is called
leakage. The regulatory approaches available to RGGI to fight
the problem of leakage may be subject to attack as violations of
*
Professor of law, Boston College of law, USA. 262 Danforth St. Portland me 04102, USA.
E-mail: mail: hdb8@hayoo.com
2006 Boston College Law review. This article was originally published in Boston College Law Review,
Vol. 47 (737). Reprinted with permission.
Source: www.bc.edu
The Commerce Clause Meets Environmental Protection:

The Compensatory Tax Doctrine as a Defense of
Potential Regional Carbon Dioxide Regulation
127
the interstate commerce clause of the US Constitution. This Note

explores the possibility of using the concepts embodied in the
compensatory tax doctrine to defend a regulatory scheme that
might be used by RGGI to combat leakage. The compensatory
tax doctrine (a three pronged test) embodies the principle that a
state regulation that burdens interstate commerce may still
survive constitutional scrutiny if it is a compensatory tax designed
merely to make interstate commerce bear a burden already borne
by intrastate commerce. This Note analyzes the application of
commerce clause jurisprudence and the compensatory tax
doctrine to the alternatives that RGGI may elect to use to combat
the problem of leakage and evaluates the likely success of those
options. This Note argues that the RGGI states, and any
reviewing court, should draw on compensatory tax doctrine
principles in crafting, and supporting, a regulation that imposes
burdens on imported electricity equivalent to those imposed on
electricity generated inside the region by the regulatory cap.
Introduction
On December 20, 2005, seven northeastern states signed an agreement to
implement the Regional Greenhouse Gas Initiative (RGGI) in an effort to
reduce greenhouse gas pollution from power plants. 1 This agreement marked
the first formal commitment to implementing a market-based trading program
for carbon dioxide (CO2) emissions in the United States. 2 In March 2006,
Californias Environmental Protection Agency released a report summarizing the
emissions trading program options that the state was exploring for regulating
greenhouse gas emissions. 3 Both the RGGI agreement and the California report,
however, identify a particular concern regarding regional cap-and-trade
emissions programs that of leakage. 4
Leakage the movement of emissions from regulated to unregulated
regions to avoid caps on emissions can occur when a cap-and-trade scheme is
implemented on a state or regional, rather than national, level. 5 Electricity
128
suppliers begin to import power from outside the regulated region to avoid the
constraints of the emissions cap, resulting in little or no net decrease in overall
emissions associated with the power consumed inside the region. 6 To combat
this problem, the RGGI states and California could limit emissions associated
with energy imported into the region. 7 Because limiting interstate imports places
burdens on the trade of electricity, however, this approach may be subject to
attack under the Interstate Commerce Clause of the US Constitution. 8
This article explores the possibility of applying the concepts embodied in the
compensatory tax doctrine to defend a regulatory scheme that might be
employed to combat leakage, focusing on RGGI as the model scheme. 9 The
compensatory tax doctrine stands for the principle that even if a state regulation
burdens interstate commerce, it may survive constitutional scrutiny if it is a
compensatory tax designed merely to make interstate commerce bear a burden
already borne by intrastate commerce. 10 Any regulation the RGGI states adopt to
address leakage will necessarily impose burdens on interstate commerce
because they will have to limit, either directly or indirectly, electricity imports from
out of state. 11 This article argues that the RGGI states, and any reviewing court,
should draw on compensatory tax doctrine principles in crafting, and supporting,
a regulation that imposes burdens on imported electricity. 12
Part I of this article provides an introduction to the RGGI program and the
particular problem of leakage. 13 Part II introduces the potential legal challenges
to the program based on the Commerce Clause of the US Constitution, and
explores the compensatory tax doctrine as developed by the US Supreme
Court. 14 Part III analyzes the application of Commerce Clause jurisprudence and
the compensatory tax doctrine to the alternatives that RGGI may use to combat
the problem of leakage and evaluates the likely success of those options. 15 Part
III concludes that although the compensatory tax doctrine may not be directly
applicable to the regulation of emissions leakage, the legal principles it
embodies should be used to uphold the regulation. 16 In addition, if RGGI can
overcome the legal and political obstacles in its path, it may serve as an effective
experiment in the regulation of CO2 emissions and eventually could be a
template for a national regulatory program aimed at slowing global warming. 17

129
I. Climate Change and the Regional Greenhouse Gas Initiative

The states participating in RGGI are taking action because they recognize that
climate change poses serious risks to human health and global ecosystems. 18
Climate change is a result of global warming, which in turn is caused by the
accumulation of greenhouse gases in the earths atmosphere, principally CO2. 19
Various scientific models indicate that the average global temperature could rise
by up to 7.7 degrees Fahrenheit by the middle of this century. 20 This expected
temperature increase could greatly exacerbate shortages of food, water, and
energy supplies, and increase the number of refugees around the world not to
mention raise national security concerns relating to nuclear proliferation,
terrorism and the potential for war. 21 For this reason, many countries, as well as
state and local governments and private economic entities in the United States,
are taking action to limit greenhouse gas emissions. 22
A. The Regional Greenhouse Gas Initiative: Regulatory Structure

The purpose of the RGGI program is to regulate CO2 emissions using a marketbased approach, commonly referred to as cap-and-trade. 23 The cap-and-trade
approach allows facilities subject to the regulation to achieve emission reduction
targets, and thus avoid potential penalties, in an economically efficient
manner. 24 Under the standard cap-and-trade model, the government sets an
aggregate cap on the amount of allowable emissions in the region. 25 The cap is
then distributed either through allocation or sale to each emitting facility in the
form of allowances, where one unit (usually a ton) of pollutant equals one
allowance. 26 Each facility must own the same number of allowances as the
number of tons of pollutant it emits. 27 The current proposal is to implement the
RGGI cap in two phases. 28 Between the years 2009 and 2015, the RGGI states
will cap CO2 emissions at approximately 120 million tons, which is
approximately equivalent to the average emissions of the highest three years
between 2000 and 2004. 29 In the second phase the cap will be reduced by 10%
from 2015 through 2020. 30
The cap-and-trade approach creates a market for the allowances when a
cleaner power facility has more allowances than it needs to cover its emissions. 31
The cleaner facility can then sell its surplus allowances to dirtier facilities that do
not have enough allowances to cover their emissions. 32 If the demand for
130
allowances increases, the market price for allowances also will increase. 33 Dirtier
facilities then face the choice of either reducing emissions or purchasing
allowances because the net emissions from the region cannot exceed the cap. 34
This approach gives facilities flexibility not available to them under traditional
command and control regulations; each facility can design its own compliance
strategy based on economic efficiency and adjust its strategy over time in
response to changes in technology and the market. 35 In fact, the federal
government used a cap-and-trade program to regulate the emissions that cause
acid rain largely because of the flexibility the approach offers. 36
Because the federal government has not implemented a national regulatory
program for CO2 emissions, the northeastern states, through RGGI, may act
without fear of preemption by existing federal law. 37 This does not mean,
however, that RGGI lacks legal obstacles. 38 For example, although each state
has the individual authority to regulate CO2 emissions, each must determine how
to fit that regulation within its state regulatory framework. 39 Some states can
adopt the RGGI regulations through the rulemaking authority vested in their
respective state agencies, while others require enabling legislation to give effect
to the RGGI rules. 40 Once the cap-and-trade regulations have been adopted,
each RGGI state will monitor and enforce those rules. 41 That enforcement may
raise additional challenges in particular, the problem of leakage. 42
B. The Problem of Leakage and Regulations that Burden Interstate

Commerce
Implementing a cap-and-trade program at the regional level presents problems
that do not arise when a similar program is implemented at the national level. 43
The RGGI cap-and-trade program will operate on the supply side that is, CO2
emission allowances will be allocated to, and traded among, fossil fuel-fired
electricity generators within the region that supply electricity to the grid. 44
Because the emissions cap will apply only to in-region generators, the RGGI plan
will not limit emissions from electricity that is imported into the region and used
by consumers within RGGI states. 45 Generators outside the capped region will be
able to export power freely to the entities inside the region that are responsible
for procuring and delivering electric power to consumers without concern for the

131
cap resulting in emissions leakage. 46 Entities that deliver electricity to the

consumer are referred to as Load-Serving Entities (LSEs). 47
The leakage problem presents two related problems for regulators in the
RGGI region. 48 First, generators outside the RGGI region will have a competitive
advantage over generators within the region because they will have little
incentive to invest in the cleaner technologies required to achieve the emission
cap. 49 As a result, electricity outside the region will become less expensive than
electricity produced inside the region. 50 This leads to the second problem. 51 The
resulting increase in cheaper, imported electricity will undermine the goal of the
program because imported emissions will not count towards the regions
emission limits even though they are directly associated with the regions
electricity consumption. 52
As expressed in their Memorandum of Understanding, the RGGI states
already are committed to a supply side cap-and-trade program. 53 During the
initial phase of the program, the RGGI states have decided not to take direct
regulatory action to stem leakage, but have agreed to implement measures to
monitor electricity imports and reevaluate whether action is required at a later
date. 54 In the meantime, the RGGI states will establish a working group to
consider potential options for addressing leakage. 55
Various options are available to address the problem of leakage. 56 One
option is to supplement the initial domestic cap-and-trade program (imposed on
in-state electricity generators as a source of emissions) with a second, load-side
cap-and-trade regulation imposed on LSEs, but only on the electricity they import
into the region. 57 This load-side regulation would treat electricity imports as an
additional source of emissions included in the CO2 emissions cap for the
region. 58 LSEs would initially be allocated CO2 allowances on the same basis as
that of in-region generators LSEs would receive allocations based on historic
imports just as generators receive allocations to cover their historic generation. 59
In-state generators would be legally responsible for their own emissions under
the first regulation. 60 Under the second regulation, LSEs would be legally
responsible for the emissions associated with the electricity they import from
states outside the RGGI region and distribute to in-state consumers. 61 The total
cap on CO2 emissions would therefore cover those emissions produced in the
region by electricity generators, as well as those emissions produced outside the
region that are directly associated with consumer demand for electricity inside the
132
region. 62 The LSEs would engage in the same market for allowances with
electricity generators and make operating choices based on economic efficiency.63
This regulatory scheme would likely face challenges based on the Interstate
Commerce Clause of the US Constitution, however, because the regulation
imposed on LSEs would place restrictions only on imported electricity. 64 Electricity
generators outside the RGGI region wishing to sell into the region at lower prices
likely will challenge the regulation as a violation of the dormant Commerce
Clause, which prohibits any state from enacting regulations that discriminate
against (or place burdens on) interstate commerce. 65 The RGGI states should
thoroughly consider potential Commerce Clause challenges before implementing
a cap-and-trade program on electricity imported by LSEs to stem leakage. 66
II. Commerce Clause Jurisprudence and the Development of

the Compensatory Tax Doctrine
The Commerce Clause of the US Constitution provides that the Congress shall
have Power . . . to regulate commerce . . . among the several States. 67 Although
phrased as an affirmative grant of power to Congress, the Commerce Clause
has long been recognized to have a negative aspect which denies states the
power to discriminate against, or burden, interstate commerce. 68 A variety of
reasons are given for this negative aspect of the Commerce Clause (called the
dormant Commerce Clause); two are of particular interest here. 69 First, it
prohibits economic protectionism by the states that is, regulatory measures
designed to benefit in-state economic interests by burdening out-of-state
competitors. 70 Second, it promotes economic efficiency that would be undone if
states were free to place burdens on the flow of commerce across their
borders. 71 The Supreme Court has stated that in granting Congress authority
over interstate commerce, the Framers sought to avoid tendencies toward the
economic Balkanization that had plagued relations among the colonies and later
among the states under the Articles of Confederation. 72
The first step in evaluating the constitutionality of a state law under dormant
Commerce Clause jurisprudence is to determine whether the challenged statute
regulates evenhandedly with only incidental effects on interstate commerce, or
discriminates against interstate commerce either on its face or in practical
effect. 73 Where the regulation is evenhanded and the effects are incidental,
the statute will be upheld if the regulation passes the Pike v. Bruce Church, Inc.

133
balancing test. 74 This test examines whether: (1) the law effectuates a legitimate
local purpose, (2) the burden imposed on interstate commerce is not clearly
excessive in relation to the putative local benefits, and (3) there are alternative
means for promoting the local purpose as well without discriminating against
interstate commerce. 75 Where, however, the state regulation is discriminatory,
meaning that it provides differential treatment of in-state and out-of-state
interests, it is virtually per se invalid. 76 The regulations proponent will only
overcome the per se rule of invalidity if it can show that the regulation advances
a legitimate local purpose that cannot be adequately served by reasonable
nondiscriminatory alternatives. 77 Facial discrimination by itself may be a fatal
defect, and invokes the strictest scrutiny of any purported legitimate local purpose
and of the absence of nondiscriminatory alternatives. 78
The hybrid regulatory approach described above could be challenged as a
facially discriminatory regulation because the regulation covering LSEs only
regulates emissions associated with imported electricity and therefore expressly
treats in-state and out-of-state interests differently. 79 The LSE regulation imposes
burdens on electricity crossing state lines only. 80 Therefore it burdens out-of-state
generators wishing to sell into the RGGI region, but does not itself impose the
same burdens on in-state generators. 81 Thus, the regulation would most likely be
subject to strict scrutiny under the dormant Commerce Clause. 82
A. An Exception to the Dormant Commerce Clause Rule of Invalidity:

The Compensatory Tax Doctrine
The US Supreme Court has recognized a narrow exception to the per se rule of
invalidity for facially discriminatory regulations, in the form of the compensatory
tax doctrine. 83 Under the compensatory tax doctrine, a facially discriminatory
regulation may survive strict scrutiny if it is a compensatory tax designed merely
to make interstate commerce bear a burden already borne by intrastate
commerce. 84 Although often expressed as an independent doctrine unto itself,
the compensatory tax doctrine is merely a specific way of justifying a facially
discriminatory tax because it achieves a legitimate local purpose that cannot be
achieved through nondiscriminatory means. 85
The Supreme Court laid the groundwork for the compensatory tax doctrine
in the 1869 case of Hinson v. Lott. 86 In Hinson, the state of Alabama imposed a
134
tax on all liquor imported into the state equal to the tax imposed on all liquor
distilled within the state. 87 The Supreme Court stated that the tax on imported
liquor was merely a complementary provision necessary to make the tax equal
on all liquors sold in the state. 88 Therefore, the Court held that this was not an
attempt to regulate commerce, but an appropriate and legitimate exercise of the
states taxing power. 89
Since Hinson, the Court has more clearly defined and significantly limited
the compensatory tax doctrine through a line of cases beginning in 1937 with
Henneford v. Silas Mason and culminating in the decision of Fulton Corp. v.
Faulkner in 1996. 90 Modern application of the compensatory tax doctrine
involves a three-part test set out in 1994 in Oregon Waste Systems v. Department
of Environmental Quality of the State of Oregon and refined in Fulton Corp. 91
The three conditions necessary for a valid compensatory tax are: (1) a state must
identify the intrastate burden for which the state is attempting to compensate; (2)
the tax on interstate commerce must be shown roughly to approximate but not
to exceed the amount of the tax on intrastate commerce; and (3) the events on
which the interstate and intrastate taxes are imposed must be substantially
equivalent that is, they must be substantially similar in substance to serve as
mutually exclusive proxies for each other. 92 Given the relatively short life and
limited application of the formalized three-part test, it is necessary to examine
earlier cases, which address each of the prongs only implicitly, to analyze the
compensatory tax doctrine fully. 93
B. The History of the Compensatory Tax Doctrine

1. Henneford v. Silas Mason: Formal Validation of the Compensatory Tax
Nearly seventy years after its decision in Hinson, the Supreme Court formally
recognized the validity of a compensating tax in 1937 in Henneford v. Silas
Mason. 94 In Silas Mason, the State of Washington imposed two taxes, a 2% tax
on retail sales and a compensating 2% tax on the privilege to use any article of
tangible personal property within the state. 95 The use tax did not apply to articles
for which a tax equal to or greater than 2% had already been applied out-of
state. 96 The plaintiffs in Silas Mason brought machinery, materials and supplies
into Washington that were purchased at retail in other states for use on the

135
construction of a dam on the Columbia River. 97 Washington assessed a use tax

on the items because they had not been subject to a sales tax out of state. 98
The Court first acknowledged that the regulatory scheme was discriminatory
on its face; the tax would never be payable on items purchased within the State
of Washington because those items would be subject to a sales tax. 99 The burden
of paying the use tax, however, was imposed equally on residents and
non-residents who used their property within the state. 100 The Court noted that
when the account was made up, the stranger from afar was subject to no greater
burdens as a consequence of ownership than the dweller within the gates. 101 The
Court reasoned that while one paid upon one activity or incident, and the other
upon another, the sum was the same. 102 This reasoning implied that the sale and
use of articles within the state were substantially similar events because the
burdens fell on similarly described people those taxpayers using articles in the
state and the taxes were therefore functionally equivalent. 103 The Court
concluded that the scheme was not an unlawful burden on interstate commerce
because it did not in fact burden commerce; it did not place a greater burden on
goods purchased outside the state than those purchased inside the state. 104 The
Court also rejected the proposition that the scheme amounted to protectionism of
local retailers. 105 Because the tax was imposed on use, rather than import of the
goods, and there was equality in the laying of the tax, there was no protectionism.106
2. Maryland v. Louisiana: Rejection of the First-use Tax

Since the Supreme Courts validation of the compensatory use tax in Silas
Mason, it has steadfastly refused to apply the compensatory tax doctrine to areas
outside the realm of sales and use taxes. 107 For example, in its 1981 decision in
Maryland v. Louisiana, the Supreme Court struck down a Louisiana first use tax
imposed on any natural gas imported into the state that was not subject to
taxation by another state. 108 In effect this tax meant that only gas from the outer
continental shelf (the OCS) an area of ocean that lies beyond state, but
within federal, boundaries was subject to the tax. 109 The tax imposed was equal
to the severance tax the state imposed on gas producers in the state. 110 Because
of numerous tax exemptions and credits, however, the net effect of the tax
scheme was to tax OCS gas moving through and eventually out of the state but
not to tax Louisiana consumers of OCS gas. 111
136
As an initial matter, the Court addressed the State of Louisianas claim that
the taxable uses within the state broke the flow of commerce and were wholly
local events, subject to state regulation. 112 The Court rejected this reasoning,
stating that gas crossing a state line at any stage of its movement to the ultimate
consumer was in interstate commerce during the entire journey from the
wellhead to the consumer, even though interrupted by certain events within a
particular state. 113
Finding the tax scheme facially discriminatory towards interstate commerce,
the Court set out to determine whether it could be upheld as a compensatory tax
under Silas Mason. 114 The Court held that the compensatory tax doctrine requires
identification of the burden for which the state is attempting to compensate. 115
Louisiana claimed that it was attempting to compensate for the burden of the
severance tax on local production of natural gas. 116 The Court rejected this
argument, stating that although Louisiana has an interest in protecting its natural
resources and therefore could impose a severance tax on domestic producers, it
had no comparable sovereign interest in being compensated for the severance of
resources from land outside its boundaries. 117 Therefore, the first-use tax could
not have been designed to meet the same ends as the severance tax it could
not have been designed to protect Louisianas natural resources. 118 The Court
said that the use of gas and severance of gas could not be considered
substantially equivalent events, reasoning implicitly that because the burden of
the two taxes fell on differently described taxpayers (in-state producers and outof-state consumers) and did not meet the same ends, the taxes were not
functionally equivalent. 119 The Court differentiated these circumstances from the
case of sales and use taxes, where a state attempts to ensure uniform treatment
of goods to be consumed in the state by imposing taxes on substantially similar
events occurring wholly within the state. 120
The Court concluded that the common thread running through the cases
upholding compensatory taxes was equality of treatment between local and
interstate commerce. 121 Because the pattern of credits and exemptions principally
burdened gas moving out of state, the tax was not a valid compensatory tax. 122
3. Armco, Inc. v. Hardesty: An Emphasis on Substantially Equivalent Events

137
The Supreme Court zeroed in on the notion of substantially equivalent events

in 1984 in Armco v. Hardesty. 123 In that case the Court struck down a tax
imposed by West Virginia on gross receipts of tangible property sold at
wholesale. 124 The Court found the regulation to be facially discriminatory
because it exempted local manufacturers from the tax. 125 West Virginia defended
the tax, which was 0.27% of the wholesale price, as a compensatory tax for the
far higher 0.88% manufacturing tax on local manufacturers. 126 The Court
rejected the argument, holding that manufacturing and wholesale were not
substantially similar events. 127 The Court noted that the manufacturing tax was
not reduced when the goods were sold out of state, providing evidence that the
tax was in fact a manufacturing tax and not a proxy for the gross receipts tax
imposed on wholesalers from out of state. 128 In addition, the Court found that it
would be impossible to determine which portion of the manufacturing tax was
attributable to manufacturing and which portion to sales, and therefore it would
be impossible to do an accounting to determine whether the tax on intrastate
commerce roughly approximated the alleged compensating tax on interstate
commerce. 129
The Court also noted that when the two taxes were considered together,
discrimination against interstate commerce persisted because there was no
exception in the wholesale tax regulation for manufacturers who had already
paid a manufacturing tax in their home state. 130 If the scheme were upheld,
manufacturers from out of state would pay both a manufacturing tax and a
wholesale tax, while a West Virginia resident would pay only a manufacturing
tax. 131 The Court indicated that this would clearly violate the anti-protectionist
purposes of the Commerce Clause. 132
C. The Modern Compensatory Tax Doctrine and the Three-part Test

1. Oregon Waste Systems, Inc. v. Department of Environmental Quality
of the State of Oregon: The Three-part Test Established
The Supreme Court set out the three elements of the compensatory tax doctrine
distinctly for the first time in 1994 in Oregon Waste Systems, Inc. v. Department
of Environmental Quality of the State of Oregon. 133 In that case, an Oregonbased solid waste disposal company challenged an Oregon regulation that
imposed a $2.25-per-ton surcharge on out-of-state waste disposed of at landfills
138
within Oregon. 134 The Oregon-based company regularly shipped waste from
neighboring Washington into Oregon for disposal. 135 The Oregon Supreme
Court upheld the surcharge as a compensatory fee with an express nexus to
actual costs incurred by state and local governments associated with disposing of
the waste. 136 The US Supreme Court reversed and invalidated the surcharge. 137
The Court held that because the rule was facially discriminatory, it was per
se invalid unless it advanced a legitimate local purpose that could not be
adequately served by reasonable nondiscriminatory alternatives. 138 The Court
began by recognizing the settled principle that interstate commerce may be
made to pay its way and that [i]t was not the purpose of the commerce clause
to relieve those engaged in interstate commerce from their just share of state . . .
burdens. 139 The Court noted that since Hinson v. Lott in 1869 the compensatory
tax doctrine had been used to express these principles, while also ensuring that
no state exacts more than a just share from interstate commerce, which is a
central purpose of the Commerce Clause. 140
The Court set out the first and second prongs of the compensatory tax
analysis requiring the state to (1) identify the intrastate burden for which the state
is attempting to compensate and (2) show that the burden on interstate
commerce roughly approximated, but did not exceed, the burden on intrastate
commerce. 141 Applying these two requirements, the Court held that Oregons
failure to identify a specific compensating charge on intrastate commerce equal
to or exceeding the surcharge was fatal to its claim. 142 Oregon claimed that the
surcharge compensated for general taxes paid by Oregon residents who
disposed of in-state waste. 143 The Court rejected this claim because it was
impossible to determine which portion of the general taxes were attributable to
the disposal of waste, and therefore the Court could not determine whether the
two burdens were roughly equivalent. 144 Accordingly, the state failed the first two
prongs of the analysis. 145
The Court further stated that even if it were possible to calculate the portion
of the general taxes that contributed to an intrastate burden roughly equivalent to
the interstate burden, the surcharge would still be invalid because the general tax
and the surcharge were not imposed on substantially equivalent events. 146 Thus,
the surcharge also violated the third prong of the analysis. 147 Under the
equivalent events analysis, the Court reasoned that earning income and

139
disposing of waste were even less equivalent than wholesale and manufacturing,
which were found not to be substantially equivalent in Armco. 148 The court
reasoned implicitly that the two taxes were not designed to meet the same ends,
because income taxes cover far more than disposal of waste and the two could
not be functionally equivalent to each other. 149 Moreover, the fact that
Oregon-based shippers of out-of-state waste were charged the surcharge and
income tax refuted the argument that the events were substantially (or
functionally) equivalent. 150 The Court noted that the prototypical example of
substantially equivalent events is the sale and use of articles within the state and
that the only compensatory taxes upheld had been use taxes on products
purchased out of state. 151 The Court refused to weigh comparative burdens
imposed on dissimilar events. 152
2. Fulton Corp. v. Faulkner: The Modern Test Summarized

The modern embodiment of the compensatory tax doctrine was summarized
most recently in Fulton Corp. v. Faulkner in 1996. 153 The case involved an
intangibles tax on the fair market value of corporate stock owned by North
Carolina residents. 154 Residents were entitled to take a deduction equal to the
fraction of the issuing corporations income that was subject to tax in North
Carolina. 155 Therefore, if a resident owned stock in an in-state corporation the
stock was not subject to the tax because the taxable percentage deduction was
100%, but stock in an out-of-state corporation was subject to the tax. 156
Therefore, the Court first determined that the regulatory scheme was facially
discriminatory. 157
The Supreme Court again recognized that there may be cases where a
facially discriminatory tax may be upheld if the combined effect of the multi-tax
scheme is to subject intrastate and interstate commerce to equivalent burdens. 158
The Court then reiterated the three conditions necessary for a valid compensatory
tax: (1) a state must identify the intrastate burden for which the state is attempting
to compensate; (2) the tax on interstate commerce must be shown roughly to
approximate but not to exceed the amount of the tax on intrastate commerce;
and (3) the events on which the interstate and intrastate taxes are imposed must
be so substantially similar in substance as to serve as mutually exclusive proxies
for each other. 159
140
To meet its burden under the first prong, North Carolina argued that the
taxable percentage deduction (i.e. the tax on out-of-state stock interests)
compensated for the burden of the general corporate income tax paid by
corporations doing business in North Carolina. 160 The Court rejected this
argument, holding that in addition to merely identifying the intrastate burden for
which it seeks to compensate, the state must also show that the intrastate tax
serves some purpose for which the state may otherwise impose a burden on
interstate commerce. 161 The Court held that because North Carolina had no
general sovereign interest in taxing income earned out of state, it would fail the
first prong of the analysis unless the state could identify some instate activity or
benefit to justify the compensatory tax. 162 North Carolina attempted to cure this
deficiency by pointing out that the out-of state corporations benefited from the
use of the states capital markets without paying corporate income tax and that
the intangible tax compensated for this loss. 163 The Court declined to create a
precedent that would allow the imposition of a tax on entities involved in
interstate commerce any time they happened to use facilities supported by
general state tax funds. 164
Under the second prong of the analysis, the Court in Fulton addressed the
problem of interstate burdens that are imposed as a compensatory measure for
generally defined intrastate burdens. 165 The second prong requires that the
burden on interstate commerce be shown roughly to approximate, but not
exceed, the amount of the burden on intrastate commerce. 166 North Carolina
justified the intangibles tax and corresponding taxable percentage deduction as a
measure for maintenance of the capital market for the shares of both foreign
and domestic corporations. 167 The Court noted that the tax for which the state
purported to compensate was a general corporate income tax that paid for a
wide range of things, including construction and maintenance of a transportation
network, institutions to educate a workforce, and local fire and police
protection. 168 The state could not say what percentage of that general tax was
allocated to support the capital market and whether that proportion was greater
or smaller than the one imposed on interstate commerce by the intangibles
tax. 169 The Court emphasized the point made in Oregon Waste, namely that it is
generally unwilling to make the complex quantitative assessments required by the
compensatory tax doctrine when general forms of taxation are involved. 170 The
Court confirmed its unwillingness to permit discriminatory taxes on interstate

141
commerce to compensate for charges purportedly included in general forms of

intrastate taxation. 171
In addressing the third prong of the analysis, the Court noted that recent
decisions expressed an extreme reluctance to recognize new compensatory
categories outside the sales/use tax combination recognized in Silas Mason. 172
The third prong requires that the compensating burdens fall on substantially
equivalent events. 173 The Court explained that to meet this requirement the
taxed activities must be sufficiently similar in substance to serve as mutually
exclusive proxies for each other and that the two taxes must be functionally
equivalent. 174 The Court held that actual incidence of the tax upon the same
class of taxpayers is a necessary precondition for a valid compensatory tax,
reasoning that if the burden falls on differently described entities then the taxes
cannot be functionally equivalent. 175 The Court recognized that the ultimate
distribution of burdens may be different from the statutory distribution of
burdens, particularly when the nominal taxpayer can pass the burden to other
parties, such as consumers. 176 The Court held that a state defending a
compensatory tax scheme has the burden of showing that, at a minimum, the
actual incidence of the two burdens is such that the real taxpayers are within the
same class, so that a finding of combined neutrality as to interstate commerce is
at least possible. 177
North Carolina argued that because corporate earnings influence the price
of stock, the intangibles tax and the income tax are essentially taxing the same
event. 178 The Court held that this was insufficient, and that the difference
between the parties on which the taxes fell was of great significance. 179 The
Court noted that in Silas Mason, the use tax was acceptable because the effect of
the regulatory regime was to help in-state retailers to compete on terms of
equality with retailers in other states who are exempt from a sales tax or other
corresponding burden. 180 In Silas Mason, all taxpayers using their property within
the state bore an equal burden whether paying a use tax or a sales tax. 181 This
equality did not exist in Fulton because the allegedly compensating taxes fell on
taxpayers who were differently described. 182 The income tax paid by corporations
doing business in the state would be reflected in the stock price, and the actual
burden of the tax would be borne by other parties such as consumers of the
corporations products. 183 By contrast, the Court stated, it was unlikely that the
142
stock price of corporations doing business outside the state would reflect the
impact of the incidence tax because North Carolina investors make up a small
portion of the national market. 184 Thus, the economic incidence of that tax would
fall on the resident shareholder. 185 The Court noted that the objective of the
equivalent event requirement is to enable in-state and out-of-state businesses
to compete on equal footing. 186 The combination of the two tax schemes violated
this objective because the actual incidence of the intangibles tax fell squarely on
the shareholder and thus encouraged North Carolina investors to favor
investment in corporations doing business within the state. 187 The Court stated
that the compensatory tax doctrine is fundamentally concerned with equalizing
competition between in-staters and out-of-staters. 188 The Court cautioned,
however, that the difficulty in comparing the economic incidence of allegedly
complementary tax schemes on different taxpayers and different transactions
leads to the conclusion that courts will be unable to evaluate equivalency outside
the context of traditional sales/use taxes. 189
III. Applying Commerce Clause Jurisprudence to the Problem

of Leakage
Although addressing climate change at the state and regional levels is certainly
suboptimal, it could eventually have important effects on national policy. 190
Individual state actions create a patchwork of policies around the country that is
both inefficient for businesses and risky for the acting states, which risk driving
business out of state. 191 This patchwork, however, often inspires the regulated
community to lobby the federal government for national action. 192 In addition,
states can serve as laboratories for experimenting with various regulatory options
to determine the best model for national action. 193 RGGI may serve this
experimental function well. 194 For these reasons the RGGI states should use every
avenue available to them, including the compensatory tax doctrine, to protect the
regulatory scheme from invalidation based on the Interstate Commerce Clause. 195
The compensatory tax doctrine may not be accepted by a court as
applicable legal doctrine for emissions regulations because the burden imposed
is not in the form of a tax. 196 As the Supreme Court noted in Oregon Waste, Inc. v.
Department of Environmental Quality of the State of Oregon, however, the
compensatory tax doctrine is merely a specific way of justifying a facially discriminatory
tax that achieves a legitimate local purpose that cannot be achieved through

143
nondiscriminatory means. 197 The RGGI states should therefore argue for the
expansion of compensatory tax doctrine principles to cover important state and
regional environmental regulations such as the RGGI program. 198
A regulatory approach that adequately addresses leakage may require a
second regulation imposing a cap on the emissions associated with electricity
imported into the region by LSEs. 199 This regulation would be passed after the
implementation of the first cap on domestic electricity generators and only if it
was determined that leakage was undermining the goals of the program. 200 If
the RGGI states decide to use this hybrid regulatory approach to address
leakage, they should employ the compensatory tax doctrine to defend the
scheme by arguing that the regulation of imported electricity is necessary to
further a legitimate local purpose and that the combination of the two
regulations is nondiscriminatory in effect. 201 The purpose of the initial emissions
regulation imposed on generators is to reduce CO2 emissions associated with instate electricity consumption in order to protect the states interests in public
health and welfare and preservation of natural resources. 202 The regulation of
imported electricity through LSEs is a compensatory measure designed simply to
make interstate commerce bear a burden already borne by intrastate
commerce. 203 In other words, the combination of the two regulations merely
levels the playing field across all electricity generators serving the region. 204
Because the LSE regulation is necessary to effectuate the purpose of the initial
regulation, the combination of the two does not have a discriminatory effect, and
is therefore a legitimate compensatory tax or burden on interstate
commerce. 205
A. Application of the Compensatory Tax Doctrine to the Hybrid

Approach
Under the first step of the dormant Commerce Clause analysis, a court would
likely determine that the second regulation imposed on LSEs does not regulate
evenhandedly with only incidental effects on interstate commerce. 206 Rather,
because the LSE regulation only regulates emissions associated with electricity
that crosses state lines while exempting domestically generated electricity, a court
would likely determine that the regulation of imported electricity discriminates
against interstate commerce on its face. 207
144
As noted above, courts review facially discriminatory regulations under a

strict scrutiny test based on the assumption that they are per se invalid. 208 To
overcome this assumption, the proponent of the regulation must show that the
regulation advances a legitimate local purpose that cannot adequately be served
by reasonable nondiscriminatory alternatives. 209 This may be shown by applying
the principles embodied in the three prongs of the compensatory tax doctrine. 210
1. Application of the First Prong of the Compensatory Tax Doctrine:

Identifying the Intrastate Burden Requiring Compensation
Under the first prong of the compensatory tax doctrine, the RGGI states must
identify the intrastate burden for which the regulation of emissions associated
with electricity imports seeks to compensate. 211 It is reasonable to assume that a
court would accept the assertion that the states adopted the regulation in good
faith as compensation for the domestic burden of the emission cap placed on
in-state generators, rather than suspecting some ulterior motive. 212 The states will
also be required to show that the intrastate burden serves some purpose for
which the state may otherwise impose a burden on interstate commerce. 213
One purpose of the intrastate burden on electricity generators is to protect
the RGGI states natural resources and public health by reducing CO2 emissions
associated with electricity consumption. 214 The RGGI states do not, however,
have a sovereign interest in protecting other states natural resources or public
health and safety, and no court has yet held that a state has a legitimate interest
in reducing global pollutants outside its borders. 215 Therefore, a court could
invalidate the regulation because the intrastate burden that the generator
regulation imposes serves a purpose for which the state may not otherwise
burden interstate commerce. 216 Similarly, the Court in Maryland v. Louisiana
rejected the argument that because the state imposed a severance tax on gas
extracted from its own soil, it could impose a compensating first-use tax on
imported gas. 217 The Court held that Louisiana had no sovereign interest in the
severance of resources from land outside its borders, that the alleged
compensating tax was invalid, and that the state had to identify an in-state
activity in order to justify the first-use tax. 218
The LSE regulation that the RGGI states may impose, however, is unlike the
Louisiana regulation in Louisiana because it is necessary to promote the states
legitimate interest while the Louisiana regulation was not. 219 In both Louisiana

145
and Fulton Corp. v. Faulkner, the Court held that the state must identify an
in-state activity or benefit to justify the compensatory levy, a task that neither of
the states could do. 220 The RGGI states, on the other hand, may be able to
overcome the sovereign interest argument by showing that the regulation of
emissions associated with imported electricity is necessary to carry out the
purposes of the in-state regulation, and that the two regulations are designed to
meet the same end. 221 The RGGI states should argue that the combination of the
two regulations serves the legitimate local interest of protecting the natural
resources and the health and welfare of their citizens, and that a regulatory
scheme that places some burden on interstate commerce is necessary to
effectuate that purpose. 222 If the states cannot regulate emissions from imported
electricity, then the regulation of domestic emissions will not be effective. 223 This
argument thus directly addresses the requirement set out in Louisiana that the two
regulations be designed to meet the same end, because both regulations are
ultimately designed to protect the states public health and natural resources. 224
Based on this reasoning, the RGGI states could persuade a court that the
regulation satisfies the first prong of the compensatory tax doctrine. 225
2. Application of the Second Prong of the Compensatory Tax Doctrine:

Equivalent Burdens on Interstate and Intrastate Commerce
The second prong of the compensatory tax analysis requires that the burden on
interstate commerce roughly approximate, but not exceed, the burden on
intrastate commerce. 226 The RGGI states will not encounter the problems faced
by states that sought to compensate for burdens imposed on intrastate commerce
by general forms of taxation as Oregon did in Oregon Waste and North
Carolina did in Fulton, because the LSE regulation compensates for a specific
regulation focused on emissions from fossil fuel-fired generators, rather than a
generally applicable resident taxation. 227 The complexity of the accounting in the
case of emissions trading, however, is sure to raise its own challenges. 228
It is well-established that pure economic protectionism is not considered a
legitimate local purpose under Commerce Clause jurisprudence. 229 Therefore, if
a regulation had the effect of putting instate generators at a competitive
advantage over out-of-state generators, that regulation would be struck down. 230
It is therefore critical that the RGGI states consider this issue from the beginning
of the program if they intend to address the problem of leakage in the future. 231
Even under a regulatory scheme that only targets domestic generators, the RGGI
146
states should set the initial cap on emissions for the region at a level that includes
the emissions associated with historic imports on the same basis as historic
in-region generation. 232 Under the second regulation, LSEs should receive
allowance allocations on the same basis that generators are given allowances. 233
Any inequality in the method by which allowances are distributed to LSEs for their
imports as compared to domestic generators could lead a court to detect
economic protectionism. 234 The RGGI states must be able to show that the
allocation of allowances to imported electricity under the second regulatory
measure is nondiscriminatory because it is based on the same historic baseline
as the allocation of allowances to domestic generators. 235
Also critical to the defense of the regulation on imported electricity will be
the method by which actual emissions associated with imported electricity and
domestic generator emissions will be measured. 236 If the methods used are not
the same, then the states will run a greater risk of having the regulation of
imported electricity struck down, because the court will not be able to weigh the
burdens quantitatively. 237 For example, if the states use actual emission rates for
instate generators because they are able to inspect those plants, but use assumed
rates based on megawatt-hour output for imported electricity because they are
unable to inspect out-of-state plants, a court could find that either the burdens
were not equivalent or that it was too cumbersome to attempt to weigh them. 238
For this reason, RGGI should use a common system of assigning CO2 attributes
to electricity for both generators and LSEs. 239
Both the allocation of allowances and measurement of emissions will likely
raise the sort of difficult quantitative questions that the Supreme Court has
continually used to strike down compensatory regulations. 240 For example, in
Armco, Inc. v. Hardesty, the state attempted to impose a wholesale interstate tax
to compensate for a manufacturing intrastate tax. 241 The Court complained that
it could not determine what part of the manufacturing tax was attributable to
manufacturing and what part to sales and therefore it struck down the burden on
interstate commerce, even though the burden on intrastate activities was
arguably the greater of the two. 242 To survive the second prong of the analysis,
the RGGI states must ensure that the accounting of allowances and emissions
reveals the actual burdens imposed and that the burden on interstate commerce
is no greater than the burden on intrastate commerce. 243

147
3. Application of the Third Prong of the Compensatory Tax Doctrine:

Substantially Equivalent Events
Under the third prong of the compensatory tax doctrine, the RGGI states would
be required to show that the events on which the interstate and intrastate burdens
fall are substantially equivalent; that is, they are sufficiently similar in substance
to serve as mutually exclusive proxies for each other. 244 The states should be able
to show that emissions associated with imported electricity and emissions from
domestically generated electricity serve as mutually exclusive proxies for each
other because they are functionally equivalent. 245 In Louisiana, the Court held
that severance of natural gas and import of gas into the state for use were not
comparable and no equality existed because the state was not ensuring uniform
treatment of goods and materials to be consumed in the state. 246 Instead, goods
were burdened differently depending on whether or not they were destined for
interstate commerce. 247 By contrast, in the case of the regulations imposed on
LSEs and in-state generators, the states are attempting to impose a burden on
imported electricity equivalent to the burden on domestic electricity to ensure
uniform treatment of electricity consumed in the state. 248 This treatment is unlike
that in Louisiana, but similar to that in Henneford v. Silas Mason, where the Court
upheld the combination of the sales and use taxes because the regulations
ensured uniform treatment of goods and the burden was imposed equally on
residents and non-residents making use of goods within the state. 249
Moreover, the burden of the two regulations falls on the same class of
actors either all generators selling to the state whether resident or non-resident,
or ultimately on all consumers within the state and thus the regulations are
functionally equivalent. 250 This is similar to the Courts reasoning in Hinson v.
Lott, where it upheld a tax on each gallon of liquor imported into the state on the
ground that it complemented a tax of equal magnitude on each gallon of liquor
distilled in the state and was necessary to equalize competition between in-staters
and out-of-staters. 251 Here, as in Hinson, the two taxes are functionally
equivalent and therefore the two events serve as mutually exclusive proxies for
each other. 252 The hybrid scheme is unlike the scheme in Fulton, where the Court
expressly found that the actual incidence of the burdens due to the corporate
income tax and the intangibles tax fell on differently described taxpayers. 253 The
Court concluded that because one tax fell on domestic corporations while the
other fell on individuals investing in out-of-state corporations, the two could not
be functionally equivalent and the discriminatory regulation was invalid. 254 By
148
contrast, the burdens of the two regulations here fall on similarly described
entities, those serving a states electricity market and ultimately consumers within
the state, and therefore the two burdens are functionally equivalent. 255
As sensible as this argument seems, the fact remains that the Supreme
Court has continuously refused to acknowledge any expansion of the
compensatory tax doctrine beyond the sales and use tax category since its 1937
decision in Silas Mason. 256 For example, in Armco the Court held that
manufacturing and wholesale are not substantially similar events, reasoning that
the taxes imposed on the two were not functionally equivalent to each other. 257
The Court in Fulton stated: Hinson does not alter our conclusion today that
Courts will ordinarily be unable to evaluate the economic equivalence of
allegedly complementary tax schemes that go beyond traditional sales/use
taxes. 258 It appears that the Court is largely unwilling to open the door to
allowing facially discriminatory regulations as alleged compensatory regulations
outside sales and use taxes because the quantitative evaluations required to
determine whether the burdens are equivalent are too cumbersome. 259 The
principles embodied in the doctrine, however, are still of value to the RGGI states
because they may form the foundation of an argument for upholding the
regulation. 260
For one, there is a critical distinction between the hybrid approach to
regulating emissions and each of the allegedly compensatory taxes that the
Court has struck down since Silas Mason. 261 In every other case the Court has
found that the combination of regulations either did in effect, or had the potential
to, favor domestic interests over out-of-staters. 262 By contrast, here it is assumed
that the RGGI states will design a combination of regulations that do not favor
domestically generated electricity over imported electricity. 263 In Louisiana, the
combined effect of the imposed tax and tax credit scheme was to burden only
gas traveling out of state; therefore, the tax was invalidated. 264 In Fulton, the
regulations had the effect of encouraging North Carolinians to invest in domestic
rather than out-of-state companies. 265 By contrast, as was the case in Silas
Mason, the RGGI regulations would have the effect of burdening all electricity
consumed in the state equally and therefore should be upheld. 266
It is also worth considering the words of the Court in Armco when evaluating
the manufacturing and wholesale taxes. 267 The Court noted that because no
exception existed in the regulation for imported goods already subject to

149
manufacturing tax in another state, the combination of the two regulations could
have the effect of favoring domestic goods. 268 If out-of-state generators are
subject to emissions caps in their home states, then the LSE regulation will not
further burden them because they will already be producing clean electricity and
the regulation will not run into the Armco problem. 269 Before implementing a
hybrid approach, however, the RGGI states must consider whether the regulation
on imported electricity requires some exceptions. 270 For example, the regulation
should account for other potential burdens associated with CO2 emissions that
are not imposed in the RGGI region but could be imposed in other states, such
as CO2 emissions taxes. 271 Taking this issue into account as well as the Courts
approach to compensatory taxes, the RGGI states may be able to avoid
invalidation of future attempts to address leakage. 272
Conclusion
The ultimate solution to the problem of leakage is to implement a nationwide
regulatory program for greenhouse gas emissions. Until that time, state
regulators must do their best to combat global warming by implementing
regional programs and to prevent leakage. If RGGI is committed to a supply-side
regulatory scheme, there are several factors that should be considered before
implementing a regulation that covers imported electricity through LSEs. In order
to meet the requirements of the compensatory tax doctrine, the RGGI states must
be able to show with absolute certainty that the combined effect of the
regulations is to impose equal burdens on electricity to be consumed within the
state that the burden on interstate commerce is no greater than the burden on
intrastate commerce.
The initial carbon dioxide emissions cap should be set at levels that include
emissions associated with historic imports as well as historic in-state generation,
to avoid difficult accounting of allowances in the second phase of the program.
The RGGI states must also determine how to allocate allowances associated with
historic imports during the phase of the program that only subjects in-state
generators to regulation. The allocation of allowances must not favor in-state
electricity generators.
The RGGI states must also determine how carbon emission attributes of
imported electricity should be measured. The method used should be the same
150
as the method used for measuring emissions associated with domestically

generated electricity, to avoid any differential treatment of in-state and out-ofstate generators that could invalidate the regulation.
Even if these precautions are taken by the RGGI states, there is still a
substantial likelihood that a court would strike down the regulation of imported
electricity through in-state LSEs as a violation of the dormant Commerce Clause.
Faced with such a challenge, RGGI states should argue that the principles
embodied in the compensatory tax doctrine should be applied to validate the
regulatory scheme, because the scheme achieves a legitimate local purpose that
cannot be achieved through nondiscriminatory means. First, the regulation of
imported electricity compensates for the domestic burden caused by the emission
cap placed on in-state generators. Second, the regulatory scheme places equal
burdens on both in-state and out-of-state actors by placing them on equal
footing with regard to emissions allowances. Third, the emissions associated with
imported electricity and emissions from domestically-generated electricity serve
as mutually exclusive proxies for each other. A court reviewing the hybrid
regulatory scheme should accordingly extend the applicability of this dormant
Commerce Clause exception.
In the event that the RGGI program merely regulates in-region generators
and does not address the problem of leakage, the program will still be a
valuable tool. The action of the RGGI states, in combination with actions taken in
other states such as California, may be the catalyst required to set a national
movement in motion. At the very least, the RGGI program will inform other
regulators around the country of the strengths, weaknesses, and potential pitfalls
of a cap-andtrade program for regulating greenhouse gas emissions.
Endnotes
1
See Regional Greenhouse Gas Initiative Memorandum of Understanding 12

(Dec. 20, 2005) [hereinafter RGGI MoU], available at http://www.rggi.org/docs/
mou_final_12_ 20_05.pdf. Greenhouse gases are those gases in the earths
atmosphere that contribute to the greenhouse effect; that is, they absorb and
reradiate energy from the sun back toward the earth, causing the earths surface

151
and lower atmosphere to warm more than they otherwise would. See C.C. LEE,
Dictionary of Environmental Legal Terms 284 (1st ed. 1996); Environmental
Protection Agency, Terms of Environment: Glossary, Abbreviations, and Acronyms,
http://www.epa.gov/OCEPAterms/gterms.html (last visited Aug. 29, 2006).
Seven states are participating in the RGGI program: Connecticut, Delaware, Maine,
New Hampshire, New Jersey, New York, and Vermont. See RGGI MoU, supra, at 1,
67. The Memorandum of Understanding also contains an explicit provision
allowing Massachusetts and Rhode Island to become signatories at any time prior to
January 1, 2008, under certain conditions. See id. at 8.
2
See RGGI MoU, supra note 1, at 12; Envt Ne., The Regional Greenhouse Gas
Initiative: An Overview of the RGGI Program and its Importance 3 (2005)
[hereinafter Envt Ne. Overview], http://www.env-ne.org/Program%20Fact%20Sheets/
ENE_RGGI_Background.pdf. Market-based regulatory programs are commonly
referred to as cap-and-trade programs. See infra note 23 and accompanying text.
These programs implement an aggregate cap on allowable emissions in a region
through government regulation. See infra note 25 and accompanying text. The cap
is then distributed to polluters in the form of allowances. See infra note 26 and
accompanying text. Each polluter must own enough allowances to cover its own
emissions, but polluters are allowed to buy and sell allowances among each other.
See infra notes 2732 and accompanying text.
See generally Cap and Trade Subgroup, Cal. Climate Action Team, Cap and Trade
Program Design Options (2006) [hereinafter California Report], available at http://
www.climatechange.ca.gov/climate_action_team/reports/2006-03-27_CAP_AND_TRADE.
PDF. The Cap and Trade Subgroups report was appended to the Climate Action
Teams more general report evaluating the impact of climate change on California
and the options available to the state, which was presented to the California
legislature and Governor Arnold Schwarzenegger. See Cal. Climate Action Team,
Cal. Envtl. Prot. Agency, Climate Action Team Report to Governor Schwarzenegger
and the Legislature 5 (2006), available at http://www.climatechange.ca.gov/
climate_action_team/reports/2006-04-03_FINAL_CAT_REPORT.PDF; see also Climate
Action Team Reports to the Governor and Legislature, http://www.climatechange.
ca.gov/climate_action_team/reports/index.html (last visited Sept. 16, 2006) (listing
the Climate Action Teams reports and appendices). On August 30, 2006,
Californias leaders announced an agreement to enact legislation that would place
sharp limits on carbon dioxide emissions within the state. See Felicity Barringer,
Officials Reach California Deal to Cut Emissions, N.Y. Times, Aug. 30, 2006, at A1.
See California Report, supra note 3, at 22; RGGI MoU, supra note 1, at 9.
See California Report, supra note 3, at 22.
See id.
152
See Richard Cowart, Another Option for Power Sector Carbon Cap and Trade
Systems Allocating to Load 34 (Regulatory Assistance Project, 2004),
http://www.rggi.org/docs/allocating_to_load.pdf; see also California Report, supra
note 3, at 2122.
See US Const. Art. I, 8, cl. 3 (granting authority to regulate interstate commerce to

the federal government); Stacey E. Davis, Ctr. for Clean Air Policy, Policy Options for
Reducing Greenhouse Gas Emissions from Power Imports 20 (2005) [hereinafter
Policy Options], available at http://www.energy.ca.gov/2005publications/CEC-6002005- 010/CEC-600-2005-010-D.PDF (identifying differential treatment of in-state
and out-of-state power as a potential Commerce Clause violation).
See infra notes 18272 and accompanying text. The arguments in this Note could
also be applied to the regulatory scheme that California is currently adopting. See
supra note 3.
10
See Fulton Corp., v. Faulkner, 516 US 325, 331 (1996) (quoting Assoc. Indus. of
Mo. v. Lohman, 511 US 641, 647 (1994)); see also Walter Hellerstein,
Complimentary Taxes as a Defense to Unconstitutional State Tax Discrimination, 39
Tax Law. 405, 406 (1986) (examining compensatory tax doctrine jurisprudence).
11
12
13
14
15
16
Id.
17
18
See RGGI MoU, supra note 1, at 1.
19
See Eileen Claussen, An Effective Approach to Climate Change, Science, Oct. 29,
2004, at 816; Joint Science Academies Statement: Global Response to Climate
Change 1 ( June 7, 2005), http://nationalacademies.org/onpi/06072005.pdf.
Carbon dioxide is the most abundant anthropogenic greenhouse gas in the world.
Envt Ne. Overview, supra note 2, at 1. It is released into the atmosphere when
carbon-based fuel is burned. See id. In 1780, the level of CO2 in the earths
atmosphere was approximately 280 parts per million (ppm) and had been for at
least 6000 years. See Elizabeth Kolbert, The Climate of Man III: What Can Be Done?,
The New Yorker, May 9, 2005, at 54. As the industrial age took hold, CO2
concentrations began to rise slowly at first and then more rapidly. See id. By the
1970s, the CO2 concentration in the atmosphere was approximately 330 ppm and
in 2000 it reached 369 ppm. Id.; see also Lester R. Brown, Growing . . . Growing . . .
Gone?, Mother Earth News, Dec.Jan. 2004, at 70, available at http://www.

153
motherearthnews.com/Nature_and_Environment/2003_December_January/Growing___
Growing___Gone_.
20
See Elizabeth Kolbert, The Climate of Man II: The Curse of Akkad, The New Yorker,
May 2, 2005, at 69. This predicted increase in temperature is based on model
predictions that show that if we continue to produce greenhouse gases at the rates
necessary to meet increasing demand, atmospheric CO2 will reach 500 ppm
around the middle of this century. Id. There is evidence that CO2 concentrations in
the earths atmosphere were that high about fifty million years ago when crocodiles
lived in Colorado and ocean levels were three hundred feet higher than they are
today, putting much of todays inhabited land underwater. Kolbert, supra note 19, at 54.
21
See generally Peter Schwartz & Doug Randall, An Abrupt Climate Change Scenario
and Its Implications for United States National Security (2003), available at
http://www.environmentaldefense.org/documents/3566_AbruptClimateChange.pdf.
This report, commissioned by the US Department of Defense, identified these and
other consequences as the possible and even likely results of an abrupt climate
change event that could be caused by the collapse of the Atlantic conveyor as a
result of global warming. See id. at 13; see also RGGI MoU, supra note 1, at 1.
22
See M.J. Bradley & Associates, Momentum Builds in the US Whats Filling the
Federal Vacuum on Climate Change?, Envtl. Energy Insights, Apr.May 2005, at 14.
Through the Kyoto Protocol, most of the countries in the world, including the United
Kingdom, the European Union nations, and Russia, have committed to reducing
greenhouse gas emissions to at least 5% below 1990 levels by 2012. See Kyoto
Protocol to the United Nations Framework Convention on Climate Change, Dec. 10,
1997, 37 I.L.M. 22 (1998); United Nations Framework Convention on Climate
Change, Kyoto Protocol: Status of Ratification, http://unfccc.int/files/essential_
background/kyoto_protocol/application/pdf/kpstats.pdf (last visited Aug. 31, 2006).
On January 1, 2005, the European Union launched a capand-trade program
covering CO2 emissions from large industrial polluters that will eventually cover
twenty-five countries with a target of reducing CO2 emissions to 8% below 1990
levels by 2012. European Commn, EU Action Against Climate Change 3 (2005),
http://ec.europa.eu/environment/climat/pdf/emission_trading2_en.pdf; see also
Joseph A. Kruger & William A. Pizer, Greenhouse Gas Trading in Europe: The New
Grand Policy Experiment, Envt, Oct. 2004, at 823 (analyzing the European Union
emissions trading system). Individual states, including New Hampshire,
Massachusetts, California, Oregon, and Washington, have made commitments to
reducing greenhouse gases. See M.J. Bradley & Associates, supra, at 23. Mayors
from 132 US cities have taken the Kyoto pledge of 7% reductions below 1990 levels
by 2012, and fifty of the worlds largest cities signed onto greenhouse gas emission
reductions of 25% by 2030 at the UN World Environment Day conference held in
June 2005. Id. at 34. Additionally, in 2003, various institutional investors
representing $2.7 trillion worth of assets formed the Investor Network on Climate
Risk to examine the risks of climate change to their portfolios. Id. at 1. The group
154
called on members to invest $1 billion in companies developing clean technologies

and to adopt standards for climate risk disclosure. Id. at 12. In 2005, JPMorgan
Chase announced that it would factor CO2 emissions into its lending practices. Id. at 2.
23
24
See Envt Ne. Overview, supra note 2, at 2. To ensure compliance with the cap, the
RGGI states will develop a method of enforcement that may be imposed on the
regulated facilities. See Model Rule XX-6.5 (Regl Greenhouse Gas Initiative 2006),
http://www.rggi.org/docs/model_rule_8_15_06.pdf (setting out a model compliance
scheme).
25
See Envt Ne. Overview, supra note 2, at 2; Office of Air and Radiation, US Envtl.
Prot. Agency, Tools of the Trade: A Guide to Designing and Operating a Cap and
Trade Program for Pollution Control 1-2 (2003) [hereinafter EPA Guide], available at
http://www.epa.gov/airmarkets/international/tools.pdf.
26
See Envt Ne. Overview, supra note 2, at 2; EPA Guide, supra note 25, at 1-2.
27
Id.
28
Memorandum from the RGGI Staff Working Group to RGGI Agency Heads 2
(Aug. 24, 2005) [hereinafter RGGI Staff Memorandum], http://www.rggi.org/
docs/rggi_pro posal_8_24_05.pdf.
29
See id.; see also RGGI MoU, supra note 1, at 2. If Massachusetts and Rhode Island
join the program, the cap will be increased to approximately 150 million tons. See
RGGI MoU, supra note 1, at 8.
30
RGGI Staff Memorandum, supra note 28, at 2.
31
See EPA Guide, supra note 25, at 1-2 to -3.
32
See id. Cap-and-trade is a workable solution in the case of CO2 because CO2 is a
uniform pollutant; it has the same atmospheric impact regardless of where the
source is located. See Envt Ne. Overview, supra note 2, at 2. By contrast, localized
pollutants such as mercury and particulate matter directly impact the health of the
local communities and ecosystems surrounding the emission source. Id. This
localized impact raises concerns over the creation of hotspots of pollution and
related social and environmental justice issues. See EPA Guide, supra note 25, at 22. Therefore, for localized pollutants it is usually necessary to implement site-specific
command-and-control regulation, which does not allow the flexibility of cap-andtrade programs. See id.
33
See EPA Guide, supra note 25, at 1-2 to -4.
34
See id. at 1-2 to -3. Dirtier facilities that exceed the emissions cap may be subject to
additional penalties. See supra note 24.

155
35
See EPA Guide, supra note 25, at 1-2. In addition to investing in non-emitting forms
of energy generation such as wind and solar energy, regulated facilities will have an
incentive to improve end-use efficiency, transition to cleaner fossil fuels, invest in
more efficient generation and transmission technology, and even utilize carbon
capture and sequestration techniques to offset their emissions if it is economically
efficient to do so. See id. at 1-3; see also California Report, supra note 3, at 24.
36
See 42 U.S.C. 7651(b) (2000) (aiming to reduce emissions of sulfur dioxide and
nitrogen oxide through an emissions allocation and transfer system); see also
California Report, supra note 3, at 1112 (noting the success of the federal
governments acid rain reduction program). The largest-scale use of the cap-andtrade model in the United States to date is the federal governments acid rain
program under Title IV of the Clean Air Act, but the model has also been used in
regional programs. See 42 U.S.C. 7651 (2000); California Report, supra note 3,
at 1115. Two regional programs, the Northeast NOx Budget Program and the
Regional Clean Air Incentives Program (RECLAIM), used a cap-and-trade
emissions program to regulate ozone and smog, respectively, with varying degrees
of scope and success. See California Report, supra note 3, at 1314.
37
See Envt Ne. Overview, supra note 2, at 3. This statement assumes that RGGI does
not attempt to regulate electricity transmission or wholesale transactions per se that
are regulated by the Federal Energy Regulatory Commission under the Federal
Power Act. See 16 U.S.C. 824 (2000); see also Note, Foreign Affairs Preemption
and State Regulation of Greenhouse Gas Emissions, 119 Harv. L. Rev. 1877, 1878
(2006) (arguing that state regulation of greenhouse gases should not be preempted
by the federal foreign affairs power).
38
See Peter Glaser, Troutman Sanders LLP, Regional Greenhouse Gas Initiative: A
Contrarian Perspective, Presentation to the American Bar Associations Environment,
Energy and Resources Section 23 (Jan. 26, 2006), http://www.abanet.org/environ/
committees/renewableenergy/teleconarchives/012606/1-26-06GlaserPPT.PPT (contending
that the RGGI states face Compact Clause and Commerce Clause hurdles and
questioning whether the states have the political will to regulate CO2 if legislation is
required).
39
40
See id.
41
See id.
42
See id. at 9.
43
See Policy Options, supra note 8, at 45, 8 (discussing problems of regulatory

programs that do not cap emissions outside the regulating state, including the
problem of leakage); Robert R. Nordhaus & Stephen C. Fotis, Pew Ctr. for Global
Climate Change, Analysis of Early Action Crediting Proposals 31 (1998),
http://www.pewclimate.org/document.cfm?documentID=237 (identifying displacement
156
of emissions from sources within the program to sources outside the program as a
potential problem facing non-national programs).
44
See RGGI MoU, supra note 1, at 2; Regional Greenhouse Gas Initiative, About
RGGI, http://www.rggi.org/about.htm (last visited Aug. 23, 2006); supra notes 23
27 and accompanying text.
45
See California Report, supra note 3, at 2223; Cowart, supra note 7, at 5.
46
See California Report, supra note 3, at 2223; Cowart, supra note 7, at 5. The
program cap will cover all in-region fossil fuel-fired electricity-generating units
having a rated capacity equal to or greater than twenty-five megawatts. See RGGI
MoU, supra note 1, at 2. The program may be expanded in the future to include
other sources of greenhouse gas emissions and greenhouse gases other than CO2.
See Regional Greenhouse Gas Initiative, About RGGI, http://www.rggi.org/
about.htm (last visited Aug. 23, 2006).
47
48
49
Id.
50
Id.
51
Id.
52
Id.
53
54
See id. at 9.
55
Id.
56
See California Report, supra note 3, at 2224; Cowart, supra note 7, at 5. For
example, California is exploring a variation of the cap-and-trade approach referred
to as allocation-to-load. California Report, supra note 3, at 21. Under this approach
emission allowances are allocated to electricity providers, or LSEs, rather than to
electricity generators. Id. Each LSE must hold allowances equal to the emissions
created by the electricity it distributes to consumers. Id. Under a complete allocationto-load program, the regulated LSE must hold allowances for all emissions
associated with the electricity it sells to consumers, regardless of where the producing
generator is located, and the cap applies to total emissions associated with all
electricity consumed in the state. Id. In this way, imported energy, as well as
domestic energy, is accounted for in the cap. See California Report, supra note 3,
at 2123; Cowart, supra note 7, at 5.
57
Cf. California Report, supra note 3, at 2123 (discussing the possibility of regulating
CO2 emissions through LSEs, rather than generators). This Note does not address

157
the question of whether individual states have the authority to regulate the emissions
associated with imported power purchased by regulated LSEs. See id. (discussing
existing regulatory authority and additional authority that would require legislative
action to regulate all LSEs in California). This question depends heavily on statespecific legal issues. See id.; see also RGGI MoU, supra note 1, at 7.
58
59
See California Report, supra note 3, at 2123; Cowart, supra note 7, at 5. The
current proposed cap for the total RGGI region approximately 120 million short
tons is based on the average emissions of the highest three years between 2000
and 2004 for each state. See RGGI MoU, supra note 1, at 2; RGGI Staff
Memorandum, supra note 28, at 2. Generators and LSEs alike would receive
allowances on this same historic basis. See California Report, supra note 3, at 2123;
Cowart, supra note 7, at 5.
60
61
See California Report, supra note 3, at 21. The assignment of CO2 attributes to
imported electricity for the purposes of measuring emissions associated with
consumption in the state is a complicated issue that is not addressed in this Note.
See id. at 23. Several methods are available. See id. Before choosing a method, the
regulating community must consider the impact that each method could have on the
legal analysis presented herein. See id.
62
See id. at 2123.
63
See id.
64
See US Const. Art. I, 8, cl. 3; Or. Waste Sys., Inc., v. Dept of Envtl. Quality, 511
US 93, 99 (1994) (holding that state laws placing burdens on interstate commerce
are subject to challenge based on the Commerce Clause of the US Constitution);
Robert B. McKinstry, Jr., Laboratories for Local Solutions for Global Problems: State,
Local and Private Leadership in Developing Strategies to Mitigate the Causes and
Effects of Climate Change, 12 Penn St. Envtl. L. Rev. 15, 67 (2004) (noting potential
Commerce Clause challenges to state and regional regulatory programs).
65
See US Const. Art. I, 8, cl. 3; Or. Waste, 511 US at 99; McKinstry, supra note 64,
at 67.
66
See infra notes 190272 and accompanying text; see also Kirsten H. Engel, The
Dormant Commerce Clause Threat to Market-Based Environmental Regulation: The
Case of Electricity Deregulation, 26 Ecology L.Q. 243, 25052 (1999) (noting the
Commerce Clause objections to market-based environmental regulation and
arguing that such regulation should be upheld based on the logic of the market
participant exception and because it promotes economic efficiency and interstate
harmony, and is not motivated by economic protectionism).
158
67
US Const. Art. I, 8, cl. 3.
68
See Fulton Corp., v. Faulkner, 516 US 325, 330 (1996); Or. Waste Sys., Inc., v.
Dept of Envtl. Quality, 511 US 93, 9899 (1994).
69
See Fulton, 516 US at 330; Or. Waste, 511 US at 9899.
70
Fulton, 516 US at 330 (quoting Assoc. Indus. of Mo. v. Lohman, 511 US 641, 647
(1994)).
71
See Or. Waste, 511 US at 9899.
72
Hughes v. Oklahoma, 441 US 322, 32526 (1979).
73
See Fulton, 516 US at 331; Or. Waste, 511 US at 99; Hughes, 441 US at 336.
74
See 397 US 137, 142 (1970).
75
See id.
76
77
See Or. Waste, 511 US at 10001 (quoting New Energy Co., of Ind. v. Limbach,
486 US 269, 278 (1988)); Hughes, 441 US at 336; see also Maine v. Taylor, 477
US 131, 151 52 (1986) (upholding a facially discriminatory law banning the
importation of out-of-state bait fish into Maine because the fish were subject to
parasites completely foreign to Maine baitfish and could jeopardize the health of the
Maine fish population, and no nondiscriminatory alternatives existed).
78
See Or. Waste, 511 US at 99; Hughes, 441 US at 337; see also Justin M. Nesbit,
Note, Commerce Clause Implications of Massachusetts Attempt to Limit the
Importation of Dirty Power in the Looming Competitive Retail Market for Electricity
Generation, 38 B.C. L. Rev. 811, 842 (1997) (concluding that an outright ban on
imported power would likely be invalidated under the Commerce Clause but that a
surcharge on sales of dirty electricity could pass the Pike balancing test).
79
80
See supra notes 5666 and accompanying text; see also Armco, Inc., v. Hardesty,
467 US 638, 644 (1984) (finding that wholesale tax imposed only on imported
goods burdened interstate commerce).
81
See supra notes 5666 and accompanying text.
82
83
84
See Fulton, 516 US at 331 (quoting Lohman, 511 US at 647).
85
See Or. Waste, 511 US at 102.

159
86
See 75 US 148, 153 (1869).
87
Id. at 150.
88
Id. at 153.
89
Id.
90
See Fulton, 516 US at 332. See generally Henneford v. Silas Mason Co., 300 US
577 (1937).
91
92
See Fulton, 516 US at 33233.
93
94
See Silas Mason, 300 US at 58384; Hinson, 75 US at 15253.
95
Silas Mason, 300 US at 579.
96
Id. at 58081.
97
Id. at 579.
98
Id.
99
See id. at 581.
100 See Silas Mason, 300 US at 58384.

101 Id. at 584.
102 Id.
103 See id. at 58485. This reasoning also implied that the State of Washington had a
legitimate sovereign interest in taxing the use of property within the state once
commerce was at an end. See id. at 582.
104 See id. at 58485.
105 Silas Mason, 300 US at 58687.
106 See id.
107 See Fulton, 516 US at 342 (noting that the court has consistently declined to extend
the compensatory exception beyond sales and use taxes); see also Or. Waste, 511
US at 105; Armco, 467 US at 644; Maryland v. Louisiana, 451 US 725, 760 (1981).
108 451 US at 731, 760.
109 Id.
110 Id.
160
111 Id. at 733.

112 Louisiana, 451 US at 75455.
113 Id. at 75556.
114 See id. at 756, 758.
115 Id. at 758.
116 Id.
117 Louisiana, 451 US at 759.
118 Id.
119 See id.
120 Id.
121 Id.
122 See Louisiana, 451 US at 75960.
123 See 467 US at 643.
124 Id. at 640, 646.
125 See id. at 642.
126 See id.
127 Id. at 643.
128 Armco, 467 US at 643.
129 Id.
130 Id. at 644.
131 Id.
132 See id.
133 See Or. Waste, 511 US at 103.
134 Id. at 9697.
135 Id. at 97.
136 Id.
137 Id. at 98.
138 Or. Waste, 511 US at 99.

139 Id. at 102 (citations omitted); see also Louisiana, 451 US at 753.
141 See id. at 103.
142 Id. at 104.
143 Id.
144 See id.
146 See id.
147 See id. at 103.
148 See id. at 105; Armco, 467 US at 643.
150 See id. at 105.
151 Id.
152 See id.
153 See 516 US at 33233.
154 Id. at 327.
155 Id. at 32728.
156 Id. at 328.
157 Id. at 333.
158 Fulton, 516 US at 331.
159 Id. at 33233.
160 See id. at 334.
161 See id.
162 Id.
163 Fulton, 516 US at 33435.
164 See id. at 335.
165 See id. at 33738.
166 Id. at 336.
161
162
167 See id. at 338.

168 See Fulton, 516 US at 337.
169 Id. at 338.
170 See id. (citing Or. Waste, 511 US at 105 n.8).
171 Fulton, 516 US at 338 (quoting Or. Waste, 511 US at 105 n.8).
172 Fulton, 516 US at 338.
173 Id.
174 See id. at 339 (quoting Or. Waste, 511 US at 103).
176 Id. at 341.
177 Id. at 340. The Court noted that a finding that the burden falls on the same class of
taxpayers is a condition precedent for a finding that the two taxes are
complementary, and declined to decide whether mere incidence is sufficient to
compel the conclusion that the two burdens fall on substantially equivalent events.
Id. at 340 n.6 (citing Armco, 467 US at 643).
179 Id. at 340.
180 See id. at 340 (citing Silas Mason, 300 US at 581).
182 See id.
183 See id. at 343.
184 Id.
185 Id.
186 Fulton, 516 US at 340.
187 See id. at 343.
188 See id. at 342 n.8.
189 See id.
190 M.J. Bradley & Associates, supra note 22, at 2.
191 Id.
192 See id. at 4.

163
193 See New State Ice Co., v. Liebmann, 285 US 262, 311 (1932) (Brandeis, J.,
dissenting) (There must be power in the states and the nation to remould, through
experimentation, our economic practices and institutions to meet changing social
and economic needs.); see also McKinstry, supra note 64, at 1516 (noting that
although states serve as laboratories for environmental policy change and often
serve as a template for federal action, they face unique challenges).
194 See M.J. Bradley & Associates, supra note 22, at 2; supra notes 18, 1822 and
accompanying text. In addition, if California adopts a different program for
reduction of CO2 emissions from that adopted by RGGI, the impact of the two
programs on the national regulated community could be significant and force
federal action. See M.J. Bradley & Associates, supra note 22, at 2; supra notes 18,
195 See supra notes 190194 and accompanying text.
196 See supra note 107 and accompanying text.
197 See 511 US 93, 102 (1994).
198 See id; supra notes 190194 and accompanying text.
200 Id.
201 See Fulton Corp., v. Faulkner, 516 US 325, 342 (1996). There is an obvious
distinction between a tax and a regulation limiting CO2 emissions. See supra note
107 and accompanying text. The emissions cap does, however, ultimately impose
burdens on generators of electricity that wish to participate in interstate commerce
with the RGGI states. See supra notes 5766 and accompanying text. This burden on
electricity crossing regional borders is analogous to the burden imposed by the
traditional taxes considered under the compensatory tax doctrine. See supra notes
202 See RGGI MoU, supra note 1, at 1; Regional Greenhouse Gas Initiative, About
RGGI, http://www.rggi.org/about.htm (last visited Aug. 23, 2006).
203 See Assoc. Indus. of Mo. v. Lohman, 511 US 641, 647 (1994).
204 See supra notes 4363, 99102 and accompanying text.
205 See Fulton, 516 US at 33031; Or. Waste, 511 US at 99. One weakness of this
argument is the availability of the total allocation-to-load regulatory option, which a
court could deem to be a reasonable, less discriminatory alternative. See supra note
56. Although this regulation could still be subject to a Commerce Clause challenge
because it places burdens on interstate commerce of electricity, it likely would not
face the strict scrutiny test imposed on facially discriminatory regulations like the
regulation that RGGI is now considering. See supra notes 7377 and accompanying
164
text. Rather, a court would likely find that it regulates evenhandedly with only
incidental effects on interstate commerce because it does not differentiate between
in-state and out-of-state interests. See California Report, supra note 3, at 23 (noting
that the total allocation-to-load approach generally treats in-state and out-of-state
interests equally); supra notes 7377 and accompanying text. A strong case could be
made that a single load-based emissions cap that included both domestic and
imported energy would pass the Pike balancing test because: (1) it would effectuate
a legitimate local purpose that of reducing greenhouse gases; (2) the burden
imposed on interstate commerce would not be clearly excessive in relation to the
putative local benefits; and (3) there are no alternative means for promoting the
local purpose as well without discriminating against interstate commerce. See Pike v.
Bruce Church, Inc., 397 US 137, 142 (1970).
206 See Fulton, 516 US at 331; Or. Waste, 511 US at 99; Hughes v. Oklahoma, 441 US
322, 336 (1979).
207 See Fulton, 516 US at 333 (finding a statute that burdens interstate commerce but
not intrastate commerce to be facially discriminatory); Or. Waste, 511 US at 100
(stating that a law that taxes interstate activities more heavily is facially
discriminatory); supra notes 5663 and accompanying text; see also Kirsten H.
Engel, Mitigating Global Climate Change in the United States: A Regional Approach,
14 N.Y.U. Envtl. L.J. 54, 7778 (2005) (concluding that an outright ban on
importation of electricity would be a facially discriminatory Commerce Clause
violation unless it was expressly authorized by Congress).
209 Id.
211 See Fulton, 516 US at 332; Or. Waste, 511 US at 103.
212 See Fulton, 516 US at 337 (expressing suspicion that the reason given for imposing
an allegedly compensatory tax was illusory).
213 See Maryland v. Louisiana, 451 US 725, 759 (1981); see also Fulton, 516 US at
334 (holding that North Carolina could not impose a tax on foreign corporations
compensating for the burden of income tax on domestic corporations because North
Carolina had no sovereign interest in taxing the income of a foreign corporation).
214 See RGGI MoU, supra note 1, at 1.
215 See Louisiana, 451 US at 759; cf. Massachusetts v. EPA, 415 F.3d 50, 5456 (D.C.
Cir. 2005), cert. granted, 126 S. Ct. 2960 (2006). In Massachusetts v. EPA, Judge
Randolph, writing for a three-judge panel of the US Court of Appeals for the District
of Columbia Circuit, assumed without deciding that a state has standing to bring an
action based on the generalized grievance of harms associated with global

165
warming. 415 F.3d at 5456. Judge Sentelle, dissenting in part but concurring in the
judgment, stated that the state did not have standing because it did not assert a
specific harm associated with CO2 emissions. Id. at 59 60 (Sentelle, J., dissenting
in part but concurring in the judgment). Judge Tatel, dissenting, stated that the state
did have standing, in part because it had successfully shown injury caused by global
warming. Id. at 64 (Tatel, J., dissenting).
217 See id.
218 See id.
219 See id. at 759; supra notes 4363 and accompanying text.
220 See Fulton, 516 US at 334; Louisiana, 451 US at 759.
221 See Or. Waste, 511 US at 99; Louisiana, 451 US at 759.
222 See Maine v. Taylor, 477 US 131, 15152 (1986) (upholding a facially
discriminatory law banning the importation of out-of-state bait fish into Maine
because the fish were subject to parasites completely foreign to Maine baitfish and
could jeopardize the health of the Maine fish population, and no nondiscriminatory
alternatives existed).
226 See supra notes 141145, 165171 and accompanying text.
227 See Fulton, 516 US at 338; Or. Waste, 511 US at 10405; supra notes 141145,
165 171 and accompanying text.
228 See Armco, Inc., v. Hardesty, 467 US 638, 643 (1984) (striking down an allegedly
compensatory tax, in part because the court could not determine which part of the
tax was meant to be compensatory); California Report, supra note 3, at 21, 23
(discussing the current lack of a robust emissions-tracking system for LSEs); see also
Fulton, 516 US at 338; Or. Waste, 511 US at 10405.
229 See Or. Waste, 511 US at 106 (citing Wyoming v. Oklahoma, 502 US 437, 454
(1992) and New Energy Co., of Ind. v. Limbach, 486 US 269, 275 (1988));
Henneford v. Silas Mason, 300 US 577, 586 (1937).
230 See Or. Waste, 511 US at 106; Silas Mason, 300 US at 586.
231 See California Report, supra note 3, at 2123. Because the initial phase of the
program will only regulate in-region generators, the RGGI states must determine
how to allocate the allowances associated with historic imports so as to avoid
166
allocation problems later in the event that the regulation of imported electricity is
required. See id. If the RGGI states allocate the entire cap of allowances including
those associated with historic imports to generators during the initial phase of the
program and leakage becomes a problem, then there will be the serious issue of
reallocating those allowances associated with historic imports to the newly regulated
LSEs. See id.; cf. Armco, 467 US at 645 (rejecting an allegedly compensatory tax in
part because it was unclear which part of the tax was intended to be compensatory).
232 See California Report, supra note 3, at 2223; Cowart, supra note 7, at 5.
233 Id.
234 See Fulton, 516 US at 338; Or. Waste, 511 US at 10405.
235 Id.
236 Id..
237 See Fulton, 516 US at 342; Or. Waste, 511 US at 105; Armco, 467 US at 643.
238 See Armco, 467 US at 643 (striking down an allegedly compensatory tax in part
because the court could not determine what portion of the tax compensated for the
in-state burden); California Report, supra note 3, at 23 (noting the various difficulties
associated with tracking emissions).
There is currently not a robust tracking system for LSEs to monitor emissions
associated with electricity they deliver to customers. See California Report, supra note 3,
at 23. Options for developing a tracking system include relying on average
emissions and requiring power contracts to include emissions data for electricity
delivered. Id.
240 See supra notes 129, 142144, 168171 and accompanying text.
241 See 467 US at 643.
242 See Armco, 467 US at 643; see also Or. Waste, 511 US at 10405 (refusing to
engage in the type of quantitative assessments that the compensatory tax doctrine
requires). 243 See Silas Mason, 300 US at 584; see also Fulton, 516 US at 342; Or.
Waste, 511 US at 105; Armco, 467 US at 643.
243
245 See id.
247 Id.

167

249 See Silas Mason, 300 US at 584; cf. Louisiana, 451 US at 725.
252 See supra notes 8689 and accompanying text; see also Fulton, 516 US at 339; Or.
Waste, 511 US at 103.
254 Id.
255 See supra notes 173189 and accompanying text; see also Silas Mason, 300 US at 584.
256 See Fulton, 516 US at 338 (emphasizing the Courts reluctance to extend the
compensatory tax doctrine beyond the context of sales and use taxes).
258 Fulton, 516 US at 342 n.8.
261 See infra notes 262266 and accompanying text.
262 See Fulton, 516 US at 343; Or. Waste, 511 US at 106; Armco, 467 US at 644;
Louisiana, 451 US at 759.
266 See Silas Mason, 75 US at 15455; supra notes 5663 and accompanying text.
267 See Armco, 467 US at 644.
268 See id.
269 See id.
270 See id.
271 See id.; supra notes 5663 and accompanying text.
7
Balancing Cost and Emissions
Certainty: An Allowance Reserve for
Cap-and-Trade
Brian C. Murray,* Richard G. Newell** and William A. Pizer***
On efficiency grounds, the economics community has to date
tended to emphasize price-based policies to address climate
change such as taxes or a "safety-valve" price ceiling for
cap-and-trade while environmental advocates have sought a
more clear quantitative limit on emissions. This paper presents a
simple modification to the idea of a safety valve: a quantitative
limit that we call the allowance reserve. Importantly, this idea
may bridge the gap between competing interests and potentially
improve efficiency relative to tax or other price-based policies.
The last point highlights the deficiencies in several previous
studies of price and quantity controls for climate change that do
not adequately capture the dynamic opportunities within a
cap-and-trade system for allowance banking, borrowing, and
intertemporal arbitrage in response to unfolding information.
*
Director for Economic Analysis, Nicholas Institute, and Research Professor, Nicholas School of the
Environment, Duke University. 1616 p st. NW Washington, D.C. 20036. E-mail: forester@rff.org.
** The Gendell Associate Professor of Energy and Environmental Economics, Nicholas School of the
Environment, Duke University- Research Associate at the National Bureau of Economic Research.
E-mail: bcmurray@duke.edu
*** Senior Fellow at Resources for the Future. E-mail: billy.pizer@gmail.com
2008 Resources for the Future. This article was originally published in Resources for Future Discussion
Paper No. 08-24. Reprinted with permission.
Source: www.nber.org.
Balancing Cost and Emissions Certainty:

An Allowance Reserve for Cap-and-Trade
169
Introduction
The economic debate over using taxes versus cap-and-trade to control pollution
emissions revolves around the relative merits of using prices versus quantities as
the policy instrument. A cap-and-trade system fixes the quantity of emissions
allowed but leaves the market price of emissions rights uncertain. In contrast, a
tax fixes the price of emissions at the tax rate but leaves the quantity of emissions
uncertain. This trade-off raises essential questions for policy design: which form
of uncertainty is a greater burden to society? What can be done to minimize that
burden or maximize net benefits? A sizable economics literature has addressed
these questions, dating back to Weitzman (1974) and others.
Taxes and cap-and-trade are, in some sense, extreme examples of the
alternative market based approaches that are available to correct an emissions
externality. The government stipulates that emitters must obtain the right to
emit. These rights (typically called allowances or permits) are either supplied
with infinite elasticity at a fixed price (the tax) or with zero elasticity at a fixed
supply (the cap). A key alternative initially suggested by Roberts and Spence
(1976) and later developed in the context of climate policy by Pizer (2002) is
the idea of a safety valve, in which a cap-and-trade system is coupled with a
price ceiling at which additional allowances can be purchased (in excess of the
cap). So long as the allowance price is below the safety-valve price, this hybrid
system acts like cap-and-trade, with emissions fixed but the price left to adjust.
When the safety-valve price is reached, however, this system behaves like a tax,
fixing the price but leaving emissions to adjust. Given the importance attached by
many stakeholders and policymakers to containing the costs of any US climate
policy, this approach has received considerable attention in the US debate over
climate change regulation (e.g., Samuelsohn 2008), and has come to be known
as the cost-containment issue (Pizer and Tatsutani 2008).
Cap-and-trade with a safety valve represents one of many possible
mechanisms that lie between the two extremes of a pure price or a pure quantity
instrument. It offers a more malleable supply curve for emissions allowances,
containing both vertical and flat segments. This paper discusses a second
mechanism that includes features of both price and quantity instruments. We
believe this approach, which we call an allowance reserve, is particularly
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promising. The basic idea goes one step beyond the safety valve: while the safety
valve stipulates that an unlimited number of allowances be made available at the
specified safety-valve price, the allowance reserve stipulates both a ceiling price
at which cost relief is provided and a maximum number of allowances to be
issued in exercising that relief. Much like a safety-valve mechanism can mimic
either a pure price or pure quantity control, depending on how the cap and
safety valve price are set, an allowance reserve can mimic a pure price, pure
quantity, or safety-valve approach, depending on how the ceiling price and
volume are set.
Three motivations underlie our interest in this mechanism. The first two are
largely practical in nature, while the third hints at a new twist on the conditions
underlying optimality, in contrast to the traditional prices versus quantities
perspective. The first motivation is simple: as we describe below, the safety valve
represents a special case of the allowance reserve where the volume of available
allowances is very large or unlimited. Thus, an allowance reserve has the
capacity to do as well if not better than the safety valve in terms of matching
public interest described below as a blend of economic efficiency and political
feasibility. That is, political economy conditions suggest that public interest may
be better served with an allowance reserve because it is more likely to sustain a
coalition that will enable welfare-enhancing policy to be enacted.
Second, the reserve mechanism addresses one problem with a safety valve.
Although most cap-and-trade programs permit allowance banking, which can
help equilibrate present value prices across different time periods and increase
dynamic efficiency, allowance banking coupled with a safety valve creates a
dynamic problem. Suppose the cap needs to be tightened and as a result the
safety-valve price is expected to increase dramatically at some point in the future.
With an ordinary safety valve, an expectation of much higher prices in the future
would lead rational firms to buy as many allowances as possible at the current,
low safety-valve price in order to save them for use later when prices are high.
Absent a mechanism to limit such purchases, they could effectively overwhelm
efforts to tighten the future cap, thereby undermining long-term environmental
policy goals. An allowance reserve would address this potential problem by
placing an upper limit on the available number of extra allowances.

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Finally, and most importantly at a fundamental level, most economic

analysis of price and quantity controls under uncertainty does not adequately
capture the dynamic nature of the regulatory process suggested by the preceding
paragraph. In particular, as new information arises about the benefits, costs, or
global commitment to solving the problem of climate change expectations
about the likely long-term emissions level and emissions price will evolve.
Therefore, in order to achieve dynamic efficiency, prices need to adjust regularly
so that current prices continue to reflect discounted expected future prices. A capand-trade program with banking, borrowing, and eventual adjustment of the cap
can achieve that result if economic agents have sufficient foresight and capacity
to form rational expectations about the longer term (Newell et. al., 2005). This
factor alone identifies an important advantage of dynamic cap-and-trade with
banking and borrowing over other approaches. Nonetheless, these conditions
may not hold or at least are not assured particularly in the early years of a
program when cost uncertainty would be high, a significant bank would not yet
have developed, and market actors would still be struggling to understand the
new market. An allowance reserve could be used to help the market toward such
an equilibrium by anchoring initial prices near or below the ceiling price.
We focus here on the importance for climate policy design of uncertainty in
the costs and benefits of greenhouse gas mitigation. There are of course other
important design factors to consider, including the degree to which the policy
raises revenue (e.g., through taxes or allowance auctions), how those revenues
are used (e.g., reducing other taxes, additional spending), and the stringency of
the policy (i.e., the cap or tax level). Nonetheless, most of these other elements
can be designed largely independently of the instrument choice of cap-and-trade
versus a tax.
The remainder of this paper is organized into several sections. The next
section provides background on market-based emissions regulation, including
the current policy debate about price versus quantity instruments, and discusses
the allowance reserve idea in more detail. This is followed by a discussion of the
advantages of a reserve-based approach and how it addresses some key
practical problems with the current suite of alternatives. We then discuss the issue
of optimality in a dynamic context where policies evolve over time, making the
case that (1) cap-and-trade with banking and borrowing could approach
optimality with sufficient intertemporal flexibility, and (2) absent the institutions or
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foresight necessary for such optimality, the allowance reserve may be a useful
way to help move market outcomes in the correct direction. We end with a
discussion of the remaining issues that surround practical implementation of the
allowance reserve, including establishing the ceiling price, reserve size, and
release mechanisms. We present conclusions in the final section.
Market-based Emissions Regulation and the Reserve-based

Approach
Market-based emissions regulation works by requiring emitters to hold emissions
allowances and then establishing a mechanism for supplying those allowances.
The two simplest supply mechanisms are (1) a tax that fixes the price associated
with purchasing allowances and (2) cap-and-trade, which establishes a fixed
supply of allowances, either auctions or gives them away for free, and then
allows trading until the allowances are used to cover emissions. The tax is
typically referred to as a price-based approach and cap-and-trade as a quantitybased approach to emissions control. 1
A key point, highlighted by Weitzman (1974), is that price and quantity
controls lead to distinctly different outcomes when there is uncertainty about
costs. While emissions are constant under cap-and-trade, price varies; in
contrast, under a tax, price is constant but emissions vary. Weitzman (1974)
derived conditions under which one or the other policy is preferred in expected
efficiency terms based on the relative slopes of the curves for the marginal cost
and marginal benefits of emissions control. Since then, many papers have found
that for climate change policies, the marginal benefits of mitigation (or marginal
damages from emissions) are relatively flat over the relevant range of annual
emissions, and, using a somewhat modified Weitzman argument, that price-based
policies are therefore preferred in terms of economic efficiency (Kolstad 1996;
Pizer 2002; Hoel and Karp 2002; Newell and Pizer 2003). Note that the quantity
policy (i.e., cap-and-trade) modeled in these papers corresponds to annual
emissions targets without banking or borrowing, a matter we return to below.
Of course, the perfectly inelastic (cap-and-trade) and perfectly elastic (tax)
emissions allowance supply curves are the two simplest extremes of a wide range
of policies the government could use to provide emissions allowances to the
market. Roberts and Spence (1976) examined one alternative: coupling

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cap-and-trade with a price floor and ceiling. This approach generates three types
of outcomes depending on the realized demand: (1) when demand is low, the
price is set by the floor, and the quantity of allowances is below the cap; (2)
when demand is moderate, the quantity of allowances is determined by the cap,
and the price is somewhere between the floor and ceiling; and (3) when demand
is high, the price is set by the ceiling, and emissions are above the cap. 2
Depending on the choice of design parameters (i.e., cap, floor, ceiling), the
policy also has the ability to mimic either a tax (if the price ceiling or cap level is
sufficiently low) or pure cap-and-trade (if the floor is low and the ceiling high).
Owing partly to the previously mentioned authors emphasis on price-based
policies and partly to the politics of wanting to have both certainty about prices
and stringent emissions limits, there has been a significant emphasis on policy
with a relatively low, stringent cap level and low price ceiling. This approach,
where the price ceiling is referred to as a safety valve, has garnered
considerable attention and political support over the past five years as climate
policy proposals have made their way to Congress (Samuelsohn 2008). The price
floor, though it has received less attention in the federal policy debate, is being
implemented in the Regional Greenhouse Gas Initiative cap-and-trade program
in the Northeastern US states.
Representing the allowance reserve idea requires only a slight adjustment to
the Roberts and Spence (1976) supply schedule (see the right panel of Appendix
Figure 2). The price ceiling that previously allowed an unlimited volume of
allowances to be purchased now also has a quantitative limit, which is the
allowance reserve. Basically, we have simply added another kink in the
allowance supply schedule and made it more flexible in its ability to balance
price and quantity goals. Indeed, the first-best policy would be to specify an
allowance supply schedule that mimicked the marginal damages from higher
emissions. In this sense, the allowance reserve offers a well-defined improvement
over the alternative policies developed so far, each of which remains a special
case. In essence, the reserve can be deployed in a way that reflects something
closer to the increasing marginal social cost of emissions.
When implemented, all market-based policies require us to identify a group
of regulated entities whose direct emissions or embodied emissions (for upstream
regulation of fuels) are measured and reported on a regular basis, typically
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annually. Under a tax policy, those entities are then required to pay a specified
tax ($/ton) applied to the measured amount of emissions. Under cap-and-trade,
they are required to acquire and surrender allowances.
A key feature in virtually all proposed greenhouse gas cap-and-trade
programs is banking, under which unused allowances in one year can be used in
subsequent years. With banking, there can be an incentive to reduce emissions
early particularly during a gradual phasedown of emissions targets and it is
not necessary for the market to meet the target exactly each year. If that were the
case, there would be a danger that requiring emissions to match the number of
allowances exactly would result in either too few allowances causing the price
to skyrocket or too many allowances causing the price to plummet. The former
occurred in the California NOx RECLAIM market; the latter occurred in Phase I of
the EU Emissions Trading Scheme (ETS) for greenhouse gases. Both systems
significantly restricted banking and borrowing across compliance periods. In the
EU ETS, the main culprit was that banking was not allowed between Phase I (preKyoto) and Phase II (Kyoto). That, combined with a generous allocation,
eventually led to an excess supply of allowances and drove the price to zero at
the end of Phase I. In contrast, systems that have allowed banking (and possibly
borrowing) have tended to have much smoother price behavior as the price at
the end of one period tends to match the price at the beginning of the next due
to allowance fungibility across periods and market arbitrage.
What about more complex policies? The price floor in the Roberts and
Spence (1976) hybrid policy could be implemented in two ways. If the allowances
associated with the cap are all distributed for free, the only alternative is for the
government to agree to buy any allowances that regulated entities are willing to
sell at the specified floor price. If, however, some of the allowances are
auctioned, the price floor could be implemented by specifying a minimum price
in the auction. In this way, allowances only enter the market if the price meets or
exceeds the floor; otherwise, less than the full volume of allowances are sold.
The price ceiling, or safety valve, could be implemented by having the
government agree to sell additional allowances at the specified ceiling price.
However, there has been a wrinkle in such legislative proposals (e.g., S. 1766 in
the 110th Congress, the BingamanSpecter bill); that is, unlike ordinary

175
allowances, these additional allowances are not bankable and must be used in
the year they are released. This places an implicit limit on the volume of safetyvalve allowances that might be sold in any year, namely the total volume of
emissions for that year. Thus, under such proposals, one could in principle use
safety-valve allowances to meet all of ones current-year emissions obligations
and bank ordinary allowances for the future. Another wrinkle in the safety-valve
provision of S. 1766 is that the safety valve is only available during one month
each year, while firms are doing final balancing of their emissions and allowance
holdings. This avoids a potential run on the safety valve while Congress might be
debating whether to raise the level or remove the safety valve altogether in the
future a debate that would hopefully be completed during the eleven-month
period when the safety valve is unavailable. We return to this issue below, as it is
not obvious that such a sequence of events is likely.
The allowance reserve takes the price ceiling idea a step further. As just
described, an unlimited nonbankable safety-valve could allow the release of up
to one years worth of emissions at any one time. The allowance reserve,
however, could limit the use of this safety valve to a significantly smaller amount.
The appropriate size of the reserve will ultimately depend on the stringency of the
cap, the ceiling price, and the degree of remaining price volatility that is
acceptable. A reserve of perhaps ten to twenty percent of the annual cap would
reflect the range of emissions reductions sought by many current proposals over
the first decade, coupled with varying assumptions about the price ceiling. The
issue of how to choose the reserve size is further addressed later in this article.
This raises an important question: how does the government allocate the
extra allowances from a reserve if demand exceeds reserve supply at the ceiling
price? There are several ways to do this. These are outlined in detail below, but
perhaps the most compelling is analogous to the price-floor approach, but
instead auctions the reserve allowances with a minimum price that is equal to the
ceiling price (versus the floor price). The result would be: (1) no sales, (2) sales
less than the limit, at the ceiling price, or (3) sales equal to the limit, at or above
the ceiling price. Thus, the allowance reserve does not guarantee the ceiling price
in the same way as an explicit price ceiling or safety valve. On the other hand, as
discussed in the next section, it has several practical and theoretical advantages.
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Advantages of an Allowance Reserve

Representing Marginal Damages Across Cumulative Emissions
Based on analyses of marginal damages from emissions, the research cited
above finds that the allowance supply schedule for emissions should be roughly
flat over the relevant range of annual greenhouse gas emissions. This would
seem to suggest that the allowance reserve idea offers no efficiency improvement
over either a tax-based or safety-valve approach. Yet that research does not
consider the marginal benefit function over cumulative greenhouse gas limits (or
in turn the shape of the associated allowance supply schedule) over longer time
horizons. Indeed, it seems almost certain that when viewed over many decades
of cumulative emissions, the marginal damage of the first ton abated would be
higher than the marginal damage of the last.
In this case, the additional kink in allowance supply represented by the
reserve approach, cumulated over many years, should be able to better
represent an upward sloping marginal damage function and deliver an outcome
that is more efficient than the tax-based and safetyvalve approaches.
Of course, given the tremendous uncertainty and time scale concerning
climate change (Weitzman 2008), we must be cautious about economic analyses
of the level and shape of the climate mitigation benefit function. Moreover, we
believe there are yet other reasons to expect that traditional price and quantity
comparisons are problematic in a dynamic setting an issue we return to in the
next section.
Expanding Political-economic Flexibility

Another important concern is that most environmental advocates have opposed
any pricebased approach, including the safety-valve variant. In an October 8,
1997, letter to the President in advance of negotiations on the Kyoto Protocol,
seventeen environmental advocacy groups indicated their opposition to a safety
valve mechanism. 3 More recently, however, these groups have expressed
openness to the idea of a quantity-limited safety valve captured in the allowance
reserve approach. Leading environmental advocacy groups, including some of
those who signed the 1997 letter opposing a safety valve, supported an

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amended version of the Americas Climate Security Act (S. 3036) in 2008, which
included the allowance reserve idea (Eilperin and Mufson 2008). In this way, a
simple interpretation of the allowance reserve that its additional flexibility can
better represent public interest may be the most relevant argument when
public interest includes not just economic views of optimality but also the
perspective of key stakeholders. In other words, one very practical advantage of
the allowance reserve idea is that it may be able to bridge differences between
environmental advocates seeking a cap on emissions and industrial interests
concerned about costs, in much the same way that some viewed the safety valve
more than a decade ago (Kopp et. al., 1997). Operating under the presumption
that failure to enact a climate policy at all would lower social welfare, all else
equal, a design element such as an allowance reserve that can break an
impasse, can enhance overall efficiency relative to the status quo.
Addressing Concerns over Ability to Achieve Long-term Targets

There is a second practical reason for considering the allowance reserve over the
pure safety-valve idea: How would one otherwise deal with evolving expectations
of stricter targets and higher prices? That is, despite the attempt to structure
current proposals with targets through 2050, it seems almost inevitable that
revisions will occur after a decade or so. In anticipation of tightening future caps,
current prices would rise assuming that current allowances could be banked for
future compliance obligations, which are now anticipated to be more expensive.
For example, the US sulfur dioxide trading program was revised in 2005 fifteen
years after passage of the 1990 amendments establishing the program in a
way that lowered allowed emissions by fifty percent in 2010 and seventy percent
in 2015 (US EPA 2005). In response, as shown in Figure 1, the price of
allowances began a significant run-up in 2004 as debate began in earnest over
tightening the emissions cap under the program through the Clean Air Interstate
Rule. By 2005, the rules were finalized, with a halving of the emissions limit set to
begin in 2010. Allowance prices peaked soon after. By 2008, the prices had
settled down to roughly double their predebate level, with a May decline in part
reflecting legal challenges to the rulemaking (Argus Media 2008) or possibly
expectations that climate change regulation will depress future SO2 allowance
prices. All of this has happened years in advance of the actual change in
emissions limits. So clearly market participants do act in anticipation of future
target stringency.
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All of this points to a potential problem with the ordinary safety valve when it
is coupled with banking and evolving expectations of stricter targets. Under these
circumstances, as firms and individuals become convinced that future prices will
be well above the current safety valve, they will want to make use of the safety
valve as much as possible, acquiring emissions allowances cheaply now that will
quickly become more valuable in the future. Or, if safety valve allowances cannot
be banked, will allow regulated entities to preserve more valuable ordinary
allowances for the future. That is, even without the ability to bank safety-valve
allowances, there is a real possibility of accumulating multiple years worth of
allowances if people become convinced of the impending change many years in
advance. The SO2 trading program, for example, saw more than a years worth
of allowances accumulated early in the program without a safety valve, owing to
the relatively easy targets from 1995 through 1999 and anticipation of stricter
targets legislated for 2000.
The accumulation of a large bank of allowances perhaps more than an
entire years worth of allowances poses two related problems. The first is
superficial: from an appearance standpoint, people may see a run on the safety
valve, and a large accumulation of allowances from it, as a systemic failure. The
second is related, but more substantive: a particularly large bank could begin to
thwart efforts to cut emissions in the future. This is not an issue in the SO2
program because emissions reductions are relatively large compared with
historic emissions fifty percent in the 1990 amendments, starting in 2000, and
fifty percent again in 2010 under the Clean Air Interstate Rule. One years worth
of banked allowances would be used up in two years following a fifty percent cut
(were facilities to try avoiding their fifty percent cut in emissions). In contrast, CO2
emissions reductions are anticipated to occur more slowly as entirely new
technologies cutting across many sectors must be brought into use. A relatively
tough target might mean a ten to twenty percent reduction from baseline within
the first decade, in which case a bank on the order of one year of allowances
could delay such a change for five to ten years without reducing emissions. We
emphasize only that this could (but not necessarily would) be a problem because,
even in the worst case, the tougher target could be designed with the bank in
mind, in much the same way that programs with offset credits from uncapped
sources often seek a tougher target than would be practical if those offset
opportunities did not exist. Further, there is little evidence concerning how large

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of an allowance bank firms might accumulate (it could, in fact, be much larger
than one years worth of allowances), how fast they might spend it down, and in
turn how much this might affect any future tightening of the cap.
The allowance reserve tackles both potential problems head on by simply
limiting the volume of extra allowances entering the market and therefore
limiting the potential for these extra allowances to contribute to an excessively
large bank. As noted above, existing legislative proposals for a safety valve limit
the released volume to the annual emissions level. With emissions reductions of
perhaps ten to twenty percent per decade, this seems far more than is necessary
to deal with anything except the desire to bank. In this case, an annual allowance
reserve limit of about ten to twenty percent of the cap should be sufficient to
address short-term uncertainty while leaving longer-term expectations free to
drive near-term prices.
Optimal Policy in a Dynamic Setting

Most of the literature comparing price and quantity policies has ignored the
aforementioned dynamic feature: that policies will inevitably be revised as new
information arises and policymakers revisit the issue what we might call
dynamic price and quantity policies (i.e., policies that are updated over time).
Newell et. al., (2005) emphasize that such revisions can be used to make a
dynamic quantity policy mimic an unadjusted price policy. Here we suggest that
a dynamic quantity policy might do better, even when the price policy is dynamic
as well, particularly in a world where future damages depend only on cumulative
emissions and not on their time path, as is roughly true for greenhouse gases.
The key is intertemporal flexibility coupled with foresight about these revisions. As
we elaborate below, the allowance reserve may in turn help foresight to drive
near-term prices in this case a desirable, even optimal, feature.
To illustrate this point that dynamic quantity policies may do better than
dynamic prices, lets imagine a simple world with three time periods: when
current policy is set (period 0), when that policy takes effect and firms respond
(period 1), and some period in the future when policy can be revised (period 2).
Importantly, improved information on costs, benefits, and participation is arriving
each period, so that there is a better notion of the optimal policy in period 1
(when no policy adjustment is possible) and an even better notion in period 2.
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For simplicity, we could assume that period 2 involves complete knowledge of

costs and benefits and is also the last period of relevant activities. In any case,
with better information in period 2, one can revise either a price or quantity
policy to deliver improved outcomes in period 2 because there will be a better
sense of how to balance costs and benefits compared to period 0.
Assuming revised price and quantity controls are equally efficient in period 2,
the question of comparing various policies hinges on what happens in period 1
when firms respond to policies set in period 0, but with improved knowledge
about costs and benefits as well as foresight about period 2. Consider the firstbest outcome. Based on the working assumption that damages depend only on
cumulative emissions, efficiency would lead us to minimize the expected present
value of the total emissions abatement costs associated with achieving the
cumulative emissions limit decided in period 2. This leads to a simple efficiency
condition that the marginal cost (i.e., emissions price) each period should equal
the present value of expected long-run marginal costs (see the Technical
Appendix for a mathematical formulation of this first order condition and the
arguments that follow.) That is, it would be optimal to choose period 1 emissions
such that marginal costs in period 1 are equal to the (discounted) expected
marginal costs of meeting the cumulative target through the revised period 2
cap. Given the limited information available when period 1 emissions must be
chosen, the cumulative cap will not be known exactly, but with additional
information relative to period 0, expectations of the period 2 cap should be
revised from the expectations in period 0 when the policy is set. Now that we
understand the first-best outcome conditional on available information, we can
examine how dynamic price and quantity policies compare in period 1.
Specifically, consider two policies set in period 0 and revised in period 2: a
tax and a cap-and-trade program, where the cap-and-trade program allows
banking (and borrowing, if necessary).
Performance of a Tax Program

An optimizing government that is setting the period 1 tax in period 0 would
choose a tax level that equates the present value of expected marginal costs
across the periods given the information it has at the time, thereby minimizing
expected total costs as seen in period 0. The important point is that in period 1,
firms would then choose to emit an amount such that their marginal costs given

181
the resolution of cost uncertainty in period 1 are equal to the tax which was set
in period 0. Firms will not match their marginal costs to the expected period 2
marginal costs (updated with new information on both costs and mitigation
benefits in period 1) because there is no incentive to do so. Specifically, there is
no ability to shift compliance obligations from the period with high (expected,
discounted) costs to the one with low (expected, discounted) costs in a tax-based
system. The emissions outcome in the first period would therefore not generally
satisfy the previously mentioned efficiency condition because expectations about
period 2 marginal costs will have changed between periods 0 and 1, but no
responsive action will be taken by the affected parties.
This type of result is inherent in the classic Weitzman framework where
policies are fixed prior to uncertainty being revealed. Neither a price nor (a
nonbankable) quantity policy is optimal ex post because neither exactly matches
realized (or updated expectations about) marginal costs and marginal benefits.
Both instruments are generally inefficient in such a setting, so the issue becomes
one of choosing the instrument with the lowest deadweight loss. Even when
period 1 brings about expected changes in period 2 tax rates, there is virtually no
incentive to deviate from the otherwise standard behavior setting period 1
marginal costs equal to the fixedin- period-0 tax. The only possible incentive to
deviate arises if changed expectations about future tax rates affects investment in
long-lived emissions abatement capital that would be subject to the future tax.
Performance of a Cap-and-trade System

The question is can cap-and-trade in a dynamic setting with banking and
borrowing do any better? To find out, lets imagine that instead of a tax the
government sets a period 1 cap in period 0, firms decide how much to emit
during period 1 and bank or borrow until period 2, and everyone expects that in
period 2 the government will set a period 2 cap to deliver the ultimate,
optimized-with-complete-information-in-period-2, cumulative emissions target
(or, more generally, a cap based on better information in period 2). Note that in
period 2 the government can enforce any emissions level by accommodating or
absorbing the bank or allowance debt acquired by firms in period 1. With this
information in period 1, a cost-minimizing firm would form its best expectation of
period 2 marginal costs and choose period 1 emissions such that marginal costs
in period 1 would equal the discounted value of the expected period 2 marginal
cost, regardless of the first period cap.
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Thus, a cap-and-trade system with banking, borrowing, and an expectation

of eventual adjustment of the emissions target can achieve the best possible
outcome given the information that is known in period 1 even though policy is set
in period 0. What drives this result?
Why Dynamic Cap-and-trade can Deliver a Better Outcome

The key is intertemporal flexibility and foresight. Through dynamic market
arbitrage, whereby firms equate (present value) prices in periods 1 and 2 for the
perfectly fungible allowances, the cap-and-trade system allows the information
revealed about benefits, costs, and future expected targets to be transmitted to
markets today. That is, knowing that new information on costs and benefits
gained during the first period of the policy will lead to adjustment of future caps,
firms have an incentive to adjust emissions during period 1 so that they can bank
(or borrow) more (or less) now in order to equate marginal costs over the two
periods. The existence of an intertemporal market for emissions allowances
something that is absent with a tax provides the vehicle for doing this. Note that
in terms of the efficiency condition, benefit information is transmitted through
expectations about the cumulative target, while cost information is transmitted
through both the cost function itself and expectations about the cumulative target.
The tax instrument, in contrast, only provides market incentives for adjusting
emissions in response to information revealed about period 1 costs in a simple
way that keeps marginal costs equal to the fixed-in-period-0 tax (and does not
respond at all to changes in expectations about benefits or future targets). With a
tax instrument, even if firms correctly anticipate a higher marginal cost or tax in
the future, they cannot arbitrage against this outcome by over complying now
and banking residual allowances for use in the future. This undermines their
ability to efficiently manage costs. Taxes (like the cap) can of course be adjusted
over time, but during the period between adjustments there will be inefficiently
high or low levels of abatement and costs.
Interestingly, this incentive structure differs in a fundamental way from the
classic Weitzman setting. In that static setting, only the tax (or price) policy
provides incentives for firms to change behavior, only in response to new cost
information, and only in a simple way that keeps marginal costs constant. The
quantity policy in that case does not transmit any new information firms must
simply meet the target and have no flexibility to adjust by banking or borrowing.

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Neither policy transmits any new information about benefits or future targets. In
contrast, in the dynamic cap-and-trade setting that is relevant here, firms do
have an incentive to adjust under the quantity policy in response to both new cost
and new benefit information because of adjusted expectations about future
targets and marginal costs. While both policies can eventually be adjusted to
achieve the desired target, the dynamic cap-and-trade policy provides a
mechanism for firms to respond during the first period, when policy is fixed,
while the tax does not.
All of this suggests that for a cumulative emissions problem like greenhouse
gases, a capand- trade program with sufficient banking and borrowing can in
principle deliver a better outcome than taxing emissions. This conclusion has
been recognized to some degree for some time (Jacoby and Ellerman 2003).
Extending prior research on optimal banking and borrowing (Rubin 1996, Kling
and Rubin 1997) to a stochastic instrument choice context, Newell et. al., (2005)
rigorously showed how intertemporal banking and borrowing would allow firms
to smooth abatement costs across time, thereby offsetting the traditional
disadvantage of cap-andtrade relative to taxes. They also suggested several
practical mechanisms for implementing such an approach, including an
allowance reserve. What is new here, we believe, is that this is the first time
conventional economics has suggested cap-and-trade can be better than taxbased approaches based on Weitzman-like efficiency grounds, with appropriate
dynamic modifications. The key, as discussed above, is that most previous
analyses have either ignored or underappreciated both the evolution of
information and the dynamic nature of policymaking that are core features of a
long-term problem like climate change as well as the common feature of
banking in most trading programs.
How can an Allowance Reserve Enhance Efficiency?

The discussion and results above raise the question: why do we need an
allowance reserve at all if cap-and-trade with sufficient banking and borrowing
can be optimal (given available information)? There are at least three reasons.
First, the allowance reserve does nothing to upset this result. Indeed, the main
point is that the period 1 cap does not really matter so long as there are rational
expectations about future caps. Second (and somewhat countering the first
point), it may be important for the government to send signals concerning its
current expectations about the long-term cap and expected price. This means
184
that not only is the period 1 cap important; so are expectations (in period 0) of
future marginal costs and allowance prices in period 2, which also depend on
future targets and benefits. The ceiling price in the allowance reserve mechanism
is one way the government can signal an initial expectation about the correct
current and future prices.
A third and important reason for considering an allowance reserve is the
concern that borrowing a key mechanism for dealing with unexpectedly high
costs in the short-term may not work as we have assumed. Borrowing may not
be implemented or it may be constrained in ways that limit its usefulness. To
date, market-based policies have included only limited borrowing mechanisms.
For example, the corporate average fuel economy (CAFE) program for light-duty
vehicles allows a firm to undercomply in a given model year if it repays the
borrowed credits within the subsequent three model years. Meanwhile, there are
examples of exceptionally high prices early in a borrowing-constrained cap-andtrade program as market participants anticipated or experienced a shortage of
allowances. These include both the NOx State Implementation Plan (SIP) Call in
the United States and the EU ETS. In the context of an emissions phasedown of
the type discussed for greenhouse gas policy, a well-designed allowance reserve
would change the market dynamics so that high prices tap the reserve and alter
the market from tending to borrow allowances in the short term to either meeting
demand or potentially banking allowances.
Implementation Issues
We turn next to a number of important practical issues surrounding the
implementation of an allowance reserve. Most immediate are determining the
appropriate ceiling price at which the reserve can be drawn down and the size of
the reserve. Additional issues include whether the reserve expands or attempts to
maintain the cumulative cap, how reserve allowances are introduced to the
market, and whether the reserve design parameters would be managed by an
executive board or decided through legislation.
Ceiling Price and Reserve Size

The most challenging implementation questions are the ceiling price at which the
reserve can be tapped and the size of the reserve. In principle, the ceiling price
should be related to the marginal benefit of emissions reduction to ensure that

185
allowance prices an indicator of marginal abatement costs stay in line with

marginal benefits. As noted early on, however, the marginal benefits of
greenhouse gas reduction are not likely to be well-defined and are affected by
some factors beyond policymakers control, including the extent to which other
countries undertake emissions reductions. Thus policymakers may be more likely
to focus on choosing a target ceiling price that is simply not too high, meaning
that it does not create seemingly excessive hardship for the overall economy. Or,
if there is a range of likely allowance prices and economic impacts associated
with a chosen emissions limit, the ceiling price might be set at the upper end of
the predicted range, assuming policymakers and stakeholders are comfortable
with both the cap and the price range.
If the allowance reserve is intended to credibly meet near-term demand at
the ceiling price, then the ceiling price and the size of the reserve are interrelated. A low ceiling price will require a larger reserve to credibly deliver that
price. A greater number of near-term events (e.g., weather, economic fluctuations)
would be likely to come up against a low ceiling price and therefore require a
larger reserve to meet that near-term demand. Alternatively, if the ceiling price is
set high, the reserve plays a lesser role and can be smaller, as the circumstances
under which it is likely to be used become more rare. The size of the reserve
essentially determines its power to keep the allowance price at or below a given
ceiling price; a larger reserve is necessary to ensure lower prices. A distinct issue
not directly addressed here is whether the allowance reserve might be capped
not only annually, but also cumulatively over time and/or phased out.
One might argue that if the reserve is going to work as advertised by
providing strong and reliable relief against a run-up in prices driven by nearterm events it should be large enough to meet demand at the specified ceiling
price under most foreseeable circumstances. The reserve could be set up to
accommodate, for example, all conceivable demand shifts and still maintain the
ceiling price by providing enough additional allowances to meet demand at that
price. This could be informed by a convincingly large number of modeling
scenarios that exogenously set the allowance price equal to the candidate ceiling
price. The possible shortfall of allowances at that price (the difference between
the emissions projected at that price and the proposed cap) would provide an
estimate of the reserve size necessary to maintain that price and cover potential
shortfalls.
186
Another possibility if the program is expected to lean heavily on offsets

(i.e., emissions reductions from outside capped sources) to achieve the cap is to
size the reserve to match the expected offset supply in the event that such offsets
fail to materialize. The Regional Greenhouse Gas Initiative, for example, allows
additional use of offsets at certain allowance price thresholds. However, the
availability of cost-effective offset opportunities is only one source of cost
uncertainty, so its importance would have to be evaluated alongside other
sources of uncertainty.
Finally, in determining an upper bound for the size of the allowance reserve,
it would not make sense to have the allowance reserve be larger than the
difference between the target and the highest business-as-usual emissions
forecast. An indefinite reserve of that size would be capable of lowering
allowance prices to zero under the most pessimistic conditions, and therefore in
practice it would go underused since reserve allowances would only be released
at a price at or above the ceiling price.
Maintaining the Cumulative Cap vs. Establishing a Range

Because uncertainty about costs and allowance demand is likely to be highest at
the beginning of a cap-and-trade program, we presume the reserve would be in
place from the programs inception. Before trading can begin, the government
must allocate allowances to regulated entities either through free allocation or an
auction. The existence of a reserve means that a separate allocation must also be
made to a reserve account. There are two options for creating this reserve
account: (1) create it from future allocations that, if never used, go back to the
future allocation, which would maintain the cumulative cap over time; or
(2) create it from allowances that, if never used, would vanish, which would
establish a range of possible cumulative emissions outcomes that depend on the
degree to which the reserve is tapped. It is also possible to construct a
combination of these two options, with some reserve allowances drawn from the
future and others not. If the cap-and-trade policy includes a price floor, as
suggested above, reserve allowances could also come from any allowances that
remained unused in prior periods. And, revenue from the sales of reserve
allowances could finance offset purchases. Both of these options are variants that
lie somewhere between maintaining the cumulative cap and creating a range of
possible cumulative emissions outcomes.

187
Based on recent policy proposals, a US cap-and-trade program would likely

establish an allowance cap that starts in the near term with allowance quantities
that are perhaps five to ten percent below current emissions levels. The cap
would then be scheduled to decline over several decades until a substantial
reduction in annual emissions is achieved. Recent proposals have called for
reductions on the order of fifty to eighty percent below current levels by 2050, or
about ten to twenty percent per decade. It is unlikely that all of the allowances
over an almost forty year period would be allocated up front. Therefore, the
unallocated future allowances could serve as a source of reserve allowances.
Again, if the objective is to maintain the long-term cap, and if these reserve
allowances are in fact drawn down, this implies that future caps (unless modified
in the future) will be that much tighter.
A policy that seeks to maintain the same cumulative cap, even as the
allowance reserve is tapped, would likely create expectations of higher future
prices if the reserve allowances are used now to lower current prices (rather than
banked to comply with the now tighter future cap). Such behavior would make
sense if current prices are high compared to long-term expectations because
borrowing which would be desired to arbitrage long-term low prices against
shortterm high prices is either constrained or unpalatable. However, most
recent economic modeling of cap-and-trade proposals shows a strong tendency
toward allowance banking in the early years of a program (EIA 2008, EPA 2008,
Murray and Ross 2007, Paltsev et. al., 2007). In this case, allowances from the
reserve should not be necessary to offset near-term shocks (which the banked
allowances can address) and, if the reserve is tapped, it should not depress
current prices. With allowances already being banked to reflect future scarcity,
any allowances moved from the future to the present via the reserve would tend
to be added to the current bank and returned to the future. It is only in the
situation when firms are constrained in some way that is not well-captured by the
referenced modeling results particularly by a near-term shock before a bank
can be built coupled with an explicit or implicit limit on individual borrowing
that system-wide borrowing from future allocations would represent a relaxation
of that constraint, thereby lowering prices and containing costs.
An alternative approach would be to establish the reserve with allowances
that, if unused, would vanish. Here, the cumulative cap is a range and tapping
the reserve more clearly loosens the emissions constraint. The lower bound of the
188
cumulative cap defines the aspirational target of the policy if the reserve is never
tapped and the price remains below the ceiling price. The upper end of the
range, defined by the cumulative effect of tapping the reserve, reflects the
maximum allowable cumulative emissions. Based on the earlier discussion of
how one would set the size of the reserve, this should be sufficient to maintain the
ceiling price unless future expectations drive prices higher.
Just as the approach of system-wide borrowing from future allocations may
make more sense if there is strong societal commitment to a specific cumulative
cap (and a willingness to accept the cost consequences), the cap-range approach
may make more sense if there is strong societal commitment to maintaining
incremental costs below the ceiling price (and a willingness to accept the
emissions consequences). Of course, in either case the long-term cap will
undoubtedly be adjusted in the future; the main issue here is how the
specification of a default cumulative cap (be it larger or smaller) may affect
future expectations and indeed future action. Both approaches address shortterm constraints with an appropriately chosen ceiling price and reserve size.
However, the future borrowing approach, which maintains a predetermined
cumulative cap, may create higher future price expectations and induce more
mitigation than the range approach with the same aspirational cap. On the other
hand, the caps are not exogenous to the choice of design; a range approach
where the aspirational cap is significantly more aggressive than the cap under
the future borrowing approach could create even higher price expectations.
Introducing Reserve Allowances to the Market

Given the structure of the allowance reserve approach, use of the reserve must
involve, at a minimum, payment to the government of the ceiling price for any
tapped reserve allowances. Otherwise there can be no assurance that the cap
only expands when the ceiling price is reached as there is no other way to ensure
that the market is really willing to pay that much. More generally, there are a
variety of ways to increase the cap in response to high prices. Newell et. al.,
(2005) mention several approaches, including the announcement of an
allowance split that makes each outstanding allowance worth more than one ton.
However, this and other approaches that do not require payment to the
government of the ceiling price have trouble maintaining the ceiling price without
issuing too many or too few allowances. We therefore focus on two other
options, which are somewhat equivalent.

189
The first approach, described briefly above, introduces reserve allowances

into the market via a supplemental reserve auction prior to the end of the period
when firms must balance their emissions and allowances (i.e., the true-up
period). Here the government offers a fixed number of allowances (i.e., the
reserve size) to the market via an auction with a minimum price equal to the
ceiling price. If, at the time of the supplemental auction, the market expects the
ordinary allowances to meet demand at a market price below the ceiling price,
then presumably the allowances would remain in the reserve unsold. If, on the
other hand, allowance demand is sufficient to push prices up to or above the
ceiling price, then there should be some willingness to purchase reserve
allowances at the ceiling price. If the reserve size is sufficient to meet demand at
the ceiling price, then there should be enough allowances for both the allowance
market price and the reserve auction price to equilibrate at the ceiling price.
However, if the demand for additional allowances at the ceiling price
exceeds the reserve auction quantity, the auction process would lead to prices
being bid up until the market clears at some price above the ceiling price. In this
case, the allowance reserve does not guarantee a ceiling price in the same way
as an explicit price ceiling or an unlimited safety valve. It puts only so much
weight on addressing cost concerns, leaving some guaranteed maximum level of
emissions intact. As noted earlier, the case when the ceiling price is exceeded
should correspond to a situation when (discounted) long-term price expectations
exceed the ceiling price, not when there is only a near-term disruption or
shortage (unless the reserve size is too small).
Another approach, based on well-known financial instruments, is to have
the government provide financial contracts (call options) that would give the
holder the right, but not the obligation, to buy a certain quantity of allowances at
the ceiling price (i.e., the strike price) during the true-up period each year. 4 In
fact, as pointed out by Unold and Requate (2001), a series of such options of
different size and with different strike prices could be used to replicate any
known marginal damage function or desired allowance supply function. Such
options could be auctioned (like ordinary allowances) or they could come
attached to ordinary allowances on a pro rata basis. 5 The options value,
whether auctioned or given away, would be determined by the ceiling (strike)
price and expectations of whether, when, and with what eventual market price it
190
would be exercised. In the event that allowance prices exceeded the ceiling
(strike) price level, options holders would begin to exercise their option rights, but
would stop once prices fell back below the ceiling price level. One substantive
difference with the reserve auction discussed above is the timing of the allocation
of reserve allowances or options for reserve allowances, with the allocation of
options most likely occurring sooner. Whether this would be an advantage or
disadvantage requires further analysis. Another difference is that under the
option approach, the difference between the market and ceiling price if there is
one goes to the option holder, and options could be either auctioned or
allocated for free. This feature suggests that options could be allocated in a way
to help ensure that legislation passes, but can also create wasteful rent-seeking
behavior.
An Allowance Reserve Board or Legislative Specification?

While some envision a reserve or other cost-containment program with key
design parameters specified in legislation, an alternative is to delegate that
responsibility to an independent executive board. Specific reserve design
elements might be better managed by an independent executive board because,
over time, there would be a clear need to update policy in response to new
information and Congress may not respond in a timely manner. Indeed, part of
the motivation for the reserve in the first place is a recognition that the drivers of
long-term prices will evolve over time, that policymakers will be slow to adjust
parameters, and that borrowing may not be a fully effective or implemented
element, which is required for dynamic efficiency. While a suitably designed
mechanism would, in principle, allow the market to operate for long periods of
time without revision (driven by the expectation of an eventual revision), it is
certainly possible that Congressional inaction might challenge that capacity.
Therefore, governance by an independent board may be useful.
As discussed in Newell et. al., (2005), an important remaining issue would
be the precise governing mandate for such a board, the tools available to it, and
the degree to which it operated subject to legislated rules versus having complete
discretion. There has been a tendency to draw an analogy with the US Board of
Governors of the Federal Reserve, along with parallels between its dual mandate
of managing growth versus inflation and the dual objectives of climate protection

191
versus containing costs. However, there are a variety of differences (Pizer and
Tatsutani 2008), and this remains an active area of discussion.
Conclusions
While much of the debate in the literature on the economics of climate change
regulation has focused on comparing pure price and pure quantity mechanisms
i.e., taxes versus cap-andtrade these policies are increasingly being viewed as
too extreme to meet both practical and political needs. This article has presented
recent and perhaps provocative new arguments suggesting that a sufficiently
flexible cap-and-trade system can in theory do at least as well as and potentially
better than a tax (despite previous literature pointing the other direction).
However, it is unlikely that the required flexibility to borrow allowances from the
future and the associated requirement for rational expectations in dynamic
allowance markets would be ensured in practice. All of this recommends a hybrid
mechanism. Roberts and Spence (1976) first suggested the idea of a cap-andtrade system with both a floor and ceiling price. We have taken their idea one
step further and suggest that the ceiling price could come with a quantitative
limit: what we call the allowance reserve.
We have argued that the allowance reserve addresses certain shortcomings
of the Roberts and Spence idea, including the need for more flexibility in the
elements of policy design to balance competing political interests. It also solves a
possibly thorny technical problem that arises when the Roberts and Spence idea
is applied in a dynamic world that includes banking and a need to update
policies which has the potential to lead to a run on the price ceiling. But
perhaps most fundamentally, it supports the idea of a flexible cap-and-trade
system that seeks to achieve an intertemporal optimum.
A number of additional details remain to be resolved, most notably setting
the ceiling price and reserve size and how an allowance reserve would be
institutionalized. Other issues tend to be primarily cosmetic or of a more general
nature applicable to any market-based policy. In summary, the allowance
reserve may help solve several previously insurmountable challenges in the
current debate over climate policy design. This paper demonstrates that the
notion of capand- trade with an allowance reserve is more than simply a political
solution. Rather given the considerable uncertainties we face now over the costs
192
and benefits of greenhouse gas mitigation, the institutional difficulties faced by

firm-level borrowing mechanisms, and the need for marketbased institutions that
will react to the unfolding of new information over time, a cap-and-trade system
with an allowance reserve is well supported by an economic view of efficient
long-term climate policy.
Figure 1: Historic Prices in the Sulfur Dioxide Allowance Market
Note: CAIR: Clean Air Interstate Rule; FIP: Federal Implementation Plan.

193
Technical Appendix
Consider an effort to seek: min C1 (q1)+C2 (Q q1) where qt is the emissions each
period t, Q is the ultimate cumulative emissions goal (unknown until period 2),
C1 is the cost of emissions level q1(which, unknown until period t, is positive if qt is
below some baseline level and zero otherwise), and the cost functions include
adjustment for discounting to the present.
Given the ultimate resolution of uncertainty in period 2, we know costs in
period 2 are C2 (Qq1) and it would therefore be optimal to choose q1 such that
C1 (q1) = C2 (Q q1) With the information available when q1 has to be chosen,
the best practical outcome would be C1 (q1) = E1 [C2 (Q q1)], where E1 reflects
the expectation formed in period 1 about the costs and target set in period 2.
An optimizing government setting a period 1 tax, t1, in period 0 would
choose t1 = E0 [C1(q1)] where q1 satisfies E0 [C1(q1)] = E0 [C2 (Q q1)], thereby
minimizing expected costs as seen in period 0. Firms would then choose to emit
q1 such that t1 = C1(q1), given the resolution of cost uncertainty in period 1. This
outcome for q1 would not generally satisfy the efficiency condition, C1 (q1) = E1
[C2 (Q q1)] because E1 [C2 (Q q1)] will not generally equal E0 [C2 (Q q1)] =
t1 = C1 (q1) under the tax.
Now imagine the government instead sets a cap q1 in period 0 and a
second period cap q 2 to deliver the ultimate objective Q = q 1 + q 2. Note that
with second period cap q 2, if firms have banked q 1 q1 at the end of period 1,
in period 2 emissions would be Q q1 and marginal costs would be C2 (Q q1).
In this setting, a cost-minimizing firm would choose q1 such that C1 (q1) = E1 [C2
(Q q1)] regardless of the first period cap.
194
Appendix
Figure 1: Emissions and Price Outcomes under Cap-and-Trade versus Emissions Fee/Tax
Figure 2: Emissions and Price Outcomes under Hybrid PriceQuantity Policies
About the Author

Brian C. Murray is the Director for Economic Analysis, Nicholas Institute,
and Research Professor, Nicholas School of the Environment, Duke University.
Richard G. Newell is the Gendell Associate Professor of Energy and
Environmental Economics, Nicholas School of the Environment, Duke University,
a University Fellow at Resources for the Future, and a Research Associate at the
National Bureau of Economic Research. William A. Pizer is a Senior Fellow at
Resources for the Future. Senior authorship is not assigned. The research was
supported in part by a grant from the Swedish Foundation for Strategic
Environmental Research (MISTRA). The authors acknowledge Joseph Aldy, Jon

195
Anda, Jason Grumet, Suzanne Leonard, Tim Profeta, Nicole St. Clair, Robert
Stavins, Tracy Terry, an anonymous referee, and participants at the Resources for
the Future workshop, Managing Costs in a US GHG Trading Program, (Pizer
and Tatsutani 2008) for their insights and suggestions on this issue.
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Pizer, William A. 2002. Combining Price and Quantity Controls to Mitigate Global
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Rubin, J.D. 1996. A Model of Intertemporal Emission Trading, Banking, and Borrowing.
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Samuelsohn, Darren. 2008. Behind Safety Valve Debate Resides 30+ Years of History.
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Endnotes
1
These two allowance supply approaches are shown in Appendix Figure 1 along with
two alternative outcomes for emissions demand.
These outcomes are shown, respectively, as e, f, and g in Appendix Figure 2.
See Samuelsohn (2008) and link to letter at http://www.eenews.net/features/

documents/2008/02/21/document_cw_01.pdf. Specifically, they stated this
proposal would weaken, if not eliminate any incentive for private sector innovation
and investment in clean technologies. Although one can understand the reluctance
of environmental groups to embrace policies allowing greater emissions, the
argument against the safety valve based on innovation incentives is flawed.
Curtailing the possibility of very high allowances prices would not eliminate the
incentive for clean technology innovation and adoption, although it would curtail the
incentive to do so for very expensive technologies that would only be competitive

197
above the safety valve price. Assuming the safety valve price is set appropriately,
however, this is desirable because environmental policies should not, from an
economic perspective, seek to promote technology at any cost. Rather policies
should induce an efficient amount of innovation and adoption, consistent with
societal willingness to pay (Kerr and Newell 2003).
4
If the execution date is not constrained in this way, it would create a very important
difference: the effective annual reserve could accumulate over time if options
accumulate, unexercised, year- after- year. If options can be executed well before the
true-up period, reserve allowances could enter the system based on early
expectations of high prices which, by the time the true up period arrives, have been
revised.
See presentation by Jon A. Anda at the Carbon Market Insights Americas

Conference. October 2931, 2007, New York, NY. Available at: www.pointcarbon.
com/events/recentevents/cmiamericas07.
8
Greenhouse Gas Emissions Charges
and Credits on Agricultural Land:
What can a Model Tell Us?
Joanna Hendy,* Suzi Kerr** and Troy Baisden***
Using the simulation model Land Use in Rural New Zealand
version 1 climate (LURNZv1-climate), we simulate the effects
of an agricultural land-use emissions charge and a reward for
native forest and scrub regeneration. Our results are preliminary
and at this stage should be considered illustrative. We find that,
on its own, an agricultural emissions charge based on solely on
land use would be disruptive and may not be very effective in
reducing emissions. In addition, we find that including an
additional policy that rewards regenerating forest and scrub
without a similar reward for plantation forestry might negatively
impact on plantation forestry, increasing emissions growth in the
short-run. We are currently developing a second version of
LURNZ-climate, which will be more robust and thus lend more
weight to our future results.
*
**
Motu Economic and Public Policy Research. E-mail: jo.hendy@motu.org.nz

Director and senior fellow, Motu economic and public policy research, level 1. 97 Cubu Street, Post.Box.
24390, Wellington, New Zealand. E-mail: Suzi.kerr@motu.org.nz
*** Landcare Research baisden. E-mail: T@landcareresearch.co.nz
2006 Motu Economic and Public Policy research trust. Reprinted with permission from motu and authors.
Source: www.ideas.repec.org
Greenhouse Gas Emissions Charges and

Credits on Agricultural Land: What can a Model Tell Us?
199
1. Introduction
Policies designed to mitigate greenhouse gas emissions through the Kyoto
Protocol have the potential to create political firestorms. In 2003, the government
proposed the ill-fated fart tax this small research levy ignited a damaging
political firestorm despite representing a charge of only 25 cents per tonne
carbon dioxide equivalent. This levy pales in comparison to the price of
European Union Allowances, which have exceeded NZ$50 per tonne in March
and April 2006 before falling back dramatically. Was the outrage all hot air? We
use the simulation model Land Use in Rural New Zealand climate (LURNZ
climate) to explore the impacts of high emissions charges (NZ$50 per tonne) on
productive land uses including dairying, sheep and beef agriculture, and forestry.
The results demonstrate the potential connections between greenhouse gas
mitigation policies across sectors. We examine the large economic and
potentially quite small emissions impacts that could result from exposing
agriculture to the international emissions price. We also examine the land use
and emissions implications of proposed policies that would give landowners
emissions credits for regenerating indigenous forest and scrub. In the absence of
a parallel policy for production forestry, the results are surprising and potentially
disappointing for proponents of biodiversity.
2. About LURNZ-climate
To examine the impacts of devolving Kyoto credits and liabilities for emissions
and sinks to land owners, economists at Motu Economic and Public Policy
Research, and scientists at institutes including Landcare Research, AgResearch,
Scion/Ensis (Forest Research), and NIWA have combined their efforts to develop
LURNZ-climate. Based on economics and natural science, LURNZ-climate is a
computer model that simulates the effect of climate change related government
policies on rural land use in New Zealand. LURNZ-climate predicts land-use
change at a fine spatial scale over the whole country, producing dynamic paths
of rural land-use change and maps of rural land use across New Zealand. In
addition, LURNZ-climate calculates the greenhouse gas implications of land-use
change. With the development of LURNZ-climate, New Zealand now has the
capacity to empirically investigate the potential impacts of policies designed to
alter land-use decisions, including policies such as a charge to farmers in
proportion to the amount of methane and nitrous oxide their livestock emit and a
reward for regenerating indigenous forest and scrub.
200
The first version of LURNZ-climate, LURNZv1-climate, is now operational.

LURNZv1-climate models land-use change on 25ha grid-cells in a grid covering
New Zealand for four major rural land uses: dairy farming, sheep/beef farming,
plantation forestry, and regenerating indigenous forest and scrub. In addition,
LURNZv1-climate calculates the emissions impacts of these land uses for the
three most important land use related greenhouse gases: methane, nitrous
oxide, and carbon dioxide.
We built the LURNZv1-climate database by collecting and enhancing
existing datasets describing land characteristics, including land cover, land use,
economics, governance, geophysical variables and greenhouse gas data. The
database also includes data on greenhouse gas emissions and removals related
to each land use. The land use and cover variables come from the Ministry for
the Environments Land Cover Data Base (LCDB), which is based on satellite
measurements of land cover, and agricultural surveys and censuses. The
economic variables include commodity prices, yields, revenues and expenditures,
costs of land use transitions, amenities, and land values. The governance
variables include maps of conservation and Maori owned land. The geophysical
variables include existing maps such as land-use capability, soil, climate, slope,
and land-usespecific productivity indices developed specifically for this project.
The greenhouse gas data include methane and nitrous oxide emissions for dairy,
sheep, and beef livestock, and fertiliser, and measures of removal of carbon
dioxide from the atmosphere by plantation forestry and regenerating indigenous
forest and scrub. They come from the data collected for the 2002 National
Inventory report (Brown and Plume, 2004) with additional information from
Landcare Research (Hendy and Kerr, 2005).
The land use component of the model is based upon a micro-economic
theoretical model that assumes landowners choose the land use that will give
them the highest economic return, depending on potential returns, conversion
costs, and relative uncertainties associated with the different land uses. To
develop LURNZv1, we derived hypotheses from this theory and then statistically
tested them against actual data. In doing this, we estimated the relationship
between national level land use and prices, interest rates, area of non-rural land,
and the average trend in all unobserved factors such as costs and relative
uncertainties, using 29 years of historical data; this process is explained in more

201
detail in Kerr and Hendy (2006). LURNZv1 uses these estimated relationships to
predict short run land-use adjustment to economic shocks and long run
equilibrium land use at the national level. LURNZv1 then uses spatial algorithms
to map predicted changes across New Zealand, based on the assumption that,
in response to an economic shock, it is marginal land that will change land use
first. LURNZv1 is explained in more detail in Hendy, Kerr, and Baisden (2006).
The greenhouse gas module in LURNZv1-climate includes functions that
project land-use related greenhouse gas emissions per unit of economic activity.
The functions are simple; are based on readily available data and strong
science; are consistent with the national inventory in 2002; evolve so that implied
net emissions approximately match past inventory totals (1990-2002); and can
be linked easily to a variety of models so they can be used in simulations.
Combined with simple projections of the intensity of land-use for each land-use
type, the greenhouse gas module calculates emissions associated with one
hectare of each land use. This is explained in more detail in Hendy and Kerr
(2005) and Hendy and Kerr (2006). Finally, combining the predictions of landuse change with the projections of land-use emissions per hectare, LURNZv1climate calculates the emissions implications of land-use change.
For the remainder of this Article we discuss results produced from LURNZv1climate. Given that the relationships driving the land-use responses in LURNZv1climate are still under development, the underlying mechanisms of the model will
be examined further before results can be considered robust in terms of timing or
magnitude. Thus, the results presented should be taken as qualitative illustrations
of issues arising from the modelled policies.
3. Charging Farmers for their Land-use Emissions

As a signatory to the Kyoto Protocol, the government is obliged to reduce New
Zealands annual emissions to the 1990 level during the 2008-2012 period or
buy assigned amount units on the international market to make up the
difference. Although agricultural emissions have been rising at a much slower
rate than New Zealands overall emissions, in which growth is driven largely
driven by the transport sector, agricultural land use emissions, caused mostly by
methane produced by grazing animals and nitrous oxide derived from animal
excrement, constitute approximately half of New Zealands overall greenhouse
202
gas emissions (Brown and Plume, 2004). Therefore, reducing land-use emissions
could significantly help New Zealand to meet its target and contribute efficiently
to controlling greenhouse gases. A potential policy to help encourage emission
reductions would be to charge farmers in proportion to the amount of emissions
that their animal production produces. This would lead farmers to reduce area in
livestock and particularly in dairy, reduce stocking rates and, if possible, change
farm management to reduce emissions per animal. Current methane and nitrous
oxide monitoring technology makes accurate animal or farm-scale monitoring of
emissions impossible. The proposed policy related payments only to livestock
numbers, which can be monitored. Because of current limitations in LURNZ, we
model an even simpler policy where the government simply charges farmers in
proportion to their land area in each land use, and assumes that each farm
emits an average amount per hectare. This is a less flexible policy because
farmers cannot change their stocking rates in response to the charge. We
therefore underestimate the size of the likely response to a charge based on
livestock numbers.
If dairy farmers were charged $50 for every tonne of carbon dioxide
equivalent emitted in 2002, based on average values, their income would
decrease 60 cents for each kilogram of milk solids that they produced. On
average in 2002, farmers received $5.31 per kilogram of milk solids, so this
charge would have equated to an 11% reduction in revenue. If sheep/beef
farmers were charged the same amount per tonne of carbon dioxide equivalent,
they would pay 85 cents for every kilogram of combined meat and wool,
equivalent to a 22% reduction in revenue. The impact of these revenue
reductions can be measured against net profits, which were $126,469 for dairy
farms and $113,303 for sheep/beef farms when averaged over the last five
years (New Zealand. Ministry of Agriculture and Forestry, 2001-2005a and
2001-2005b). This charge would have reduced net profits by $48,693 for the
average dairy farm and $38,116 for the average sheep/beef farm. These
impacts would directly lower land values and hence farmer wealth.
The charge would also affect people other than farmers, as the indirect
effects would spread out through the economy. Farmers, who would have to pay
the huge cost, would likely reduce their spending. This would negatively affect
their communities, in particular including laying off farm workers or lowering

203
their wages. Farm workers in return would reduce their own expenditure. Thus,
the effects of the charge would flow on through the economy. Sin et. al., (2004)
found that the areas likely to be hardest hit by an emissions charge would be
Gore and MacKenzie in the South Island, and Taihape, Waipukurau, Te Kuiti and
Dannevirke in the North Island. The effect on the economy as a whole may not
be large after an initial period of adjustment if the revenue from the charge were
recycled into other tax cuts, but the transfers of income between people and the
dislocation in some communities would be significant.
In response to such a policy, some marginal land is likely to change to a
lower emitting land use. If, for example, sheep/beef farming on a parcel of
marginal land is no longer profitable, the land is likely to enter plantation
forestry or a state, which we refer to as regenerating forest and scrub, in which
no economic activity is discernable. It is also likely that some land will move from
dairy to sheep/beef (or not convert to dairy as soon if dairy prices and
conversions continue to be high). For example, facing such a charge, farms
considering converting to dairy would find that the difference between their
current returns in sheep/beef farming and the returns they could potentially earn
in dairy would be reduced. This is because dairy farming has higher emissions
per hectare than sheep/beef farming so they face a higher charge. For some
farms on the margin for conversion to dairy, this effect might be large enough to
make sheep/beef more profitable than dairy, and so these farms might choose
not to convert and thereby reduce New Zealands total emissions. In all cases,
the resulting land-use changes will result in lower emitting land use, achieving
the goal of the policy. However, the costs to enterprises and rural economies
may be sufficiently large that the policy is not currently justified, relative to other
policies that would induce emissions reductions in other sectors.
To examine the impact of a NZ$50 per tonne of carbon dioxide equivalent
charge on New Zealand agriculture, we ask, how big would the corresponding
emissions reductions be? To answer this, we first need to know what would have
happened if no policy was introduced. To tell us this, we simulate a reference
case scenario. The reference case gives us a line against which we can measure
the effectiveness of the policy, allowing us to observe the magnitude of the policy
effect and discern whether the policy is achieving its intended result.
204
Figure 1: Emissions under Different Policy Scenarios
For our reference case, we project changes in land use and emissions from
2003 to 2012, using Ministry of Agriculture and Forestry forecasts of commodity
prices and assuming that both the interest rate and the area of non-rural land
are constant. Based on this scenario, LURNZv1 projects that by 2012 dairy area
will expand by 1.2% (18,000ha), sheep/beef area will contract by 2.8%
(199,000ha), plantation forestry will expand by 17.4% (273,000ha), and
regenerating forest and scrub will contract by 5.5% (92,000ha) compared to
2002. The solid line in the figure shows the corresponding agricultural emissions
for the reference case over the period. The emissions are calculated as total
methane and nitrous oxide emissions from dairy, sheep, and beef livestock, and
fertiliser use, net of carbon dioxide removed by plantation forests and
regenerating indigenous forest and scrub.
To find out how much the charge would reduce emissions, we model the
charge as a reduction in the commodity price that farmers receive, assuming that
farmers will respond to the charge in the same way as a commodity price shock.
From 2003 onwards, we reduce the commodity prices relative to those we used
in the reference case by the equivalent of 60 cents for milk solids and 85 cents

205
for meat and wool; these reductions correspond to a charge of $50 per tonne of
carbon dioxide equivalent. We expect that, when compared to the reference
case, dairy would expand less, sheep/beef would contract more, plantation
forests would expand more, and regenerating forest and scrub would contract
less. As a result, we expect that the rise in emissions would be reduced and
indeed this is the case. The dashed line in the figure shows net emissions
associated with this scenario.
We find that dairy area contracts by 1% with the policy, whereas in the
reference case it expanded by 1.2%. Sheep/beef area contracts by 0.3
percentage points more than in the reference case, plantation forestry stays
about the same, and regenerating forest and scrub contracts by 3.8 percentage
points less than in the reference case. The land-use change caused by the policy
reduces the annual growth rate in emissions during 2003 2012 from about 0.5
million tonnes of carbon dioxide equivalent per year in the reference case to
about 0.4 million tonnes of carbon dioxide equivalent per year.
The lower emissions rate from a charge based on land use equates to a 6%
relative reduction in emissions over the first commitment period. This is a small
reduction for a large emissions price. The result therefore suggests that an
emissions tax levied on agriculture will result in relatively small reductions in
emissions, relative to reductions in the profitability of farming that are likely to
flow through the economy. Thus, a policy levying an emissions charge on
agriculture based on emissions per hectare remains a relatively poor policy
option, presuming that significant impacts on land values rural workers and rural
communities cannot be addressed. It is possible however, that the current model
underestimates the magnitude of change that could be achieved through slightly
more targeted policies. A more sophisticated policy, such as a policy where the
government monitored livestock numbers and fertiliser use within each land use,
could give more dimensions along which farmers could reduce their emissions.
4. Rewarding Farmers for Regeneration of Marginal Land

The Government might be able to induce a greater reduction in emissions and at
the same time reduce the impact on farmers, if the government rewarded the
regeneration of indigenous forest and scrub on marginal land. The Government
has developed a policy called the Permanent Forest Sinks Initiative (PFSI) that
206
would provide such an alternative. In addition to lowering agricultural emissions

by reducing the land area in agriculture, the PFSI would encourage landowners
to sequester carbon in forest biomass (Trotter et. al., 2005). Reversion of native
forest also has other benefits, including on biodiversity (Hall, 2001) and water
quality. These are not considered further here.
We simulate the effect of awarding farmers $50 for every tonne of carbon
dioxide equivalent that is removed from the atmosphere by native forest
regeneration from 2003 to 2012 as well as charging them for their livestock
emissions as in the previous simulation. For this policy, farmers would be
rewarded in proportion to the national average rate of carbon dioxide removals
for every hectare that they set aside.
Under this scenario, if farmers set aside land in 2003, the annualized net
present value over the next ten years would be $53 per hectare per year,
assuming a 6% discount rate. This value can be compared with annual costs due
to emissions charges of $149 and $433 per hectare annually in sheep/beef and
dairy farming, respectively. These different charges and rewards alter relative
returns, and we expect that some marginal dairy land would convert to
sheep/beef land, and some marginal sheep/beef land would be allowed to
regenerate native vegetation. Thus, in this scenario, there is potential to reduce
emissions even more, with more land changing toward lower emitting land uses.
Surprisingly, this does not happen. When we compare net emissions in this
scenario to net emissions from the previous scenario, which only includes the
emissions charge, we find that introducing the reward actually increases
emissions growth. In fact, not only does the policy result in greater emissions
than the case of the emissions charge on its own, it results in greater emissions
than the reference case. We find that this policy results in annual emissions
growth during 2003 2012 greater than the reference case by about 0.1Mt of
carbon dioxide equivalent; this is illustrated by the dotted line in the figure.
The reason for this unexpected result is that regenerating forest and scrub
compete with plantation forestry for land. Regenerating forest and scrub
expansion has occurred at the expense of plantation forestry expansion and
consequently, plantation forestry area expands at a slower rate in this scenario
than in the previous scenarios. Net emissions increase because young

207
regenerating forest and scrub remove much less carbon dioxide from the
atmosphere than young plantation forests. This is a short-term problem; in the
long run, removals by naturally regenerating vegetation surpass those by
plantation forestry. However, this effect would actually make meeting our
obligations for the first Kyoto commitment period more difficult.
This result suggests that the PFSI has the potential to achieve a perverse
result during 20082012, by actually making New Zealands net position under
the Kyoto Protocol worse. Rather than suggesting that the PFSI is poor policy, this
result emphasizes that even policies with the potential to produce multiple
environmental benefits such as the PFSI must be considered as part of an overall
picture. In this case, the PFSI would be enhanced if plantation forestry were
rewarded for carbon sequestration as well. Our preliminary results suggest that
the government should consider also rewarding plantation forestry particularly if
they want short-term emission gains.
Similarly, the impacts of levying a charge on land use related emissions
from agriculture would ideally be examined in the context of carbon charges or
emissions trading in the fossil fuel sector. This is not possible with any current
model.
5. Summary
These illustrative simulations demonstrate that LURNZv1-climate is a useful tool
for analysing potential greenhouse gas mitigation policies intended to reward or
tax emissions resulting from land use activities. Our first simulation indicates that
an agricultural emissions charge based simply on land use would be highly
disruptive and may not be very effective in reducing emissions. Our second
simulation shows that the inclusion of a reward for regenerating forest and scrub
without a similar reward for plantation forestry might negatively impact on
plantation forestry, increasing emissions growth in the short-run. This
demonstrates the potential for policies to have unintended, and potentially
perverse impacts when policies are not aligned across sectors.
The model results illustrate the importance of careful empirical analysis of
potential policies, and emphasize the need for tools such as LURNZ that are
applicable to New Zealands unique situation. The results presented here are
208
preliminary in that they illustrate the probable scale and direction of policy
impacts but the exact size of those impacts may not be robust. We are currently
developing a second version of LURNZ-climate, which will be much more robust,
and thus lend more weight to our future results.
Finally, when developing LURNZv1-climate we used publicly available data
whenever it was available. We did this to support our aim of making both
LURNZ-climate and the LURNZ-climate database freely available for research
purposes whenever possible. We hope others will use our data and model to
explore these issues further. For more information, please visit www.motu.org.nz/
land_use_nz.htm.
Acknowledgements
This research is part of Motus Land Use, Climate Change and Kyoto research
programme, which is carried out in collaboration with Landcare Research and
others. This research programme is funded by a grant from the Foundation for
Research, Science and Technology. We would like to thank participants of Motus
Land Use, Climate Change and Kyoto: Human dimensions research to guide
New Zealand policy research workshops between 2002 and 2005, for their
input into the development of the fundamental project, which this report relies
on. Any remaining errors or omissions are the responsibility of the authors.
References
Brown, Len and Helen Plume. 2004. New Zealands Greenhouse Gas Inventory 1990
2002: The National Inventory Report and Common Reporting Format Tables, National
Inventory Report, New Zealand Climate Change Office, Wellington.
Hall, Graeme M. J. 2001. Mitigating an Organizations Future Net Carbon Emissions by
Native Forest Restoration, Ecological Applications, 11:6, pp. 1622-33.
Hendy, Joanna and Suzi Kerr. 2005. Greenhouse Gas Emissions Factor Module: Land
Use in Rural New Zealand-Climate Version 1, Motu Working Paper 05-10, Motu
Economic and Public Policy Research, Wellington, NZ.
Hendy, Joanna and Suzi Kerr. 2006. Land Use Intensity Module: Land Use in Rural New
Zealand-Climate Version 1, Draft Motu Working Paper, Motu Economic and Public Policy
Research, Wellington, NZ.
Hendy, Joanna; Suzi Kerr and Troy Baisden. 2006. The Land Use in Rural New Zealand
(LURNZ) Model: Version 1 Model Description, Draft Motu Working Paper, Motu Economic
and Public Policy Research, Wellington, NZ.

209
Kerr, Suzi and Joanna Hendy. 2006. Drivers of Rural Land Use in New Zealand:
Estimates from National Data, Draft Motu Working Paper, Motu Economic and Public
Policy Research, Wellington, NZ.
New Zealand. Ministry of Agriculture and Forestry. 2001-2005a. Dairy Monitoring
Report, MAF Policy, Ministry of Agriculture and Forestry, Wellington.
New Zealand. Ministry of Agriculture and Forestry. 2001-2005b. Sheep and Beef
Monitoring Report, MAF Policy, Ministry of Agriculture and Forestry, Wellington.
Sin, Isabelle; Emma Brunton, Joanna Hendy and Suzi Kerr. 2005. The Likely Regional
Impacts of an Agricultural Emissions Policy in New Zealand: Preliminary Analysis, Motu
Working Paper 05-08, Motu Economic and Public Policy Research, Wellington, NZ.
Trotter, Craig M.; Kevin R. Tate, Neal A. Scott, Jacqueline A. Townsend, R. Hugh Wilde,
Suzanne M. Lambie, Mike Marden and Ted Pinkney. 2005. Afforestation/Reforestation of
New Zealand Marginal Pasture Lands by Indigenous Shrublands: the Potential for Kyoto
Forest Sinks, Annals of Forest Science, 62:8, pp. 865-71.
List of Cases
Armco, Inc., v. Hardesty, 467 US 638, 644 (1984).
Assoc. Indus. of Mo. v. Lohman, 511 US 641, 647 (1994).
Fulton Corp., v. Faulkner, 516 US 325, 331 (1996).
Henneford v. Silas Mason Co., 300 US 577 (1937).
Hughes v. Oklahoma, 441 US 322, 32526 (1979).
Maine v. Taylor, 477 US 131, 15152 (1986).
Maryland v. Louisiana, 451 US 725, 760 (1981).
New Energy Co., of Ind. v. Limbach, 486 US 269, 278 (1988).
New State Ice Co., v. Liebmann, 285 US 262, 311 (1932).
Or. Waste Sys., Inc., v. Dept of Envtl. Quality, 511 US 93, 9899 (1994).
Index
A
Animating, 87
Malleable, 170
Articulates, 87
Maneuvre, 67
Marginal Land, 202, 204, 206
Combustion, 8, 9, 17
Mimic, 171, 174, 180
Congruence, 89
Counterfactual, 15, 35
Mitigation, 3, 13, 23, 58, 68, 173, 182,

192, 200, 208
Deployment, 12, 21, 66, 88
Pastureland, 109, 120
Discernable, 204
Plummet, 175
Disruptive, 199, 208
Proliferation, 37, 129
Dubious, 51, 67
Prongs, 134, 138, 144
Proxies, 134, 140, 141, 147, 150
Exogenously, 186
Putative, 133
Firestorms, 200
Ramifications, 40
G
Grazing Lands, 109, 110
H
Hazards, 15, 88
I
Intertemporal Arbitrage, 169
L
Landfill, 37, 41
S
Sequestration, 9, 107, 111, 116, 121, 208
Seriatim., 15
Simulation, 198, 200, 208
Skepticism, 4
Spearheading, 43
T
Throughput, 88
212
Unpalatable, 188
Wastelands, 110
Vulnerable, 61
Yearnings, 5
Snap Shot
Clean Development Mechanism and Law

Due to massive industrialization there is increase in huge quantities of atmospheric concentrations of carbon
dioxide, methane, and nitrous oxide in the atmosphere which are escalating the temperature of Earth causing
global warming and climate change. In this regard various regulatory measures are initiated by the States
through legislations and policies encouraging, Carbon dioxide Capture and Storage (CCS) technology, cap
and trade, carbon tax, CDM sequestrisation. Most of the States desire flexibility in achieving cost-effective
emission reductions, and find CDM as the best option. In consequence there is huge demand for these
projects in carbon markets across the globe. Though the projects and schemes are considered feasible for
the developed countries, the developing countries and environmental NGOs fear environmental degradation.
There is enormous pressure for framing a comprehensive international regulatory framework to deal with
key issues like leakage, permanence, boundary issues and allocation of liabilities in CCS technology.
This book provides contemporary attempts of various developed Nations in successfully implementing CDM
sequestrisation schemes and Joint Implementation projects It would be of great use to the students, research
scholars, faculty in Environmental Law, Environmental science, entrepreneurs, corporate entities, regulatory
authorities, policy makers, CDM and joint implementation project developers.

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L Lakshmi holds an LL.M and M.A (Pub. Admn.

,) from Osmania University

The Icfai University Press

Clean Development Mechanism and Law

The Icfai University Press

1. Enlisting Carbondioxide Capture and Storage as a Clean

Olawuyi Damilola Sunday

2. Flexible Mechanisms for Climate Change Compliance:

Christopher Carr and Flavia Rosembuj

3. Linking the EU Emissions Trading Scheme to JI, CDM and

4. Links between European Emissions Trading and CDM

5. Linking Community Forestry Projects in India with

Rohit Jindal and Shailesh Nagar

6. The Commerce Clause Meets Environmental Protection:

7. Balancing Cost and Emissions Certainty: An Allowance

Brian C. Murray, Richard G. Newell and William A. Pizer

8. Greenhouse Gas Emissions Charges and Credits on

Joanna Hendy, Suzi Kerr and Troy Baisden

include- Joint Implementation (JI) wherein a developed country with

India being a party to the United Nations Framework Convention on

dioxide Capture and Storage (CCS) technology issues concerning project

projects in India were implemented to strengthen rural livelihoods. In Post

2009 Icfai University Press. All Rights Reserved.

CLEAN DEVELOPMENT MECHANISM AND LAW

liabilities among others. This article shows that there is an

Enlisting Carbondioxide Capture and Storage as a

1. The Clean Development Mechanism: An Overview

CLEAN DEVELOPMENT MECHANISM AND LAW

Emissions trading and credits

Common but differentiated responsibilities

Compliance and Verification

After so much opposition most especially from developing countries, CDM

To assist non-Annex I countries in achieving sustainable development,

To assist non-Annex I countries in contributing to the ultimate objectives of

Enlisting Carbondioxide Capture and Storage as a

to assist Annex I countries in achieving compliance with their quantified

CLEAN DEVELOPMENT MECHANISM AND LAW

to further clarify the Protocol regarding technology cooperation stating that

1.2 Eligibility Requirements of CDM

1.2.2 Project Eligibility

CDM projects must promote sustainable development in the countries in

The emissions reductions from CDM projects must be real, measurable,

Enlisting Carbondioxide Capture and Storage as a

2. Carbon Dioxide Capture and Storage Technology: An

CLEAN DEVELOPMENT MECHANISM AND LAW

The Capture process: This involves the actual separation of the

Compression: After capture, CO2 is usually compressed to form

iii. Transportation: The transportation step is required to carry

Enlisting Carbondioxide Capture and Storage as a

iv. Storage: Potential storage methods include injection into deep

Will CCS assist non-Annex I countries in contributing to the

CLEAN DEVELOPMENT MECHANISM AND LAW

CO2 emissions, this will ultimately help to stabilize GHG

Will CCS assist Annex I countries in achieving compliance with

Will CCS assist non-Annex I countries in achieving sustainable

Enlisting Carbondioxide Capture and Storage as a

3. Legal and Regulatory Issues in Carbon Capture and Storage

CLEAN DEVELOPMENT MECHANISM AND LAW

Injection and Storage stage: This include concerns on storage, site