New Emission Reduction Mechanisms:

Filling in the Details and Bringing in the Private Sector

IETA supports efforts to develop new market-based emission reduction mechanisms in the
context of a new international climate change agreement. Experience with the CDM and in
voluntary markets shows us that market-based mechanisms create keen interest in emission
reduction activities in developing countries, which is crucial in situations where the issue of
climate change competes for attention with many other economic and social challenges. IETA
feels strongly that the invaluable momentum that these mechanisms have created must be
preserved and heightened in the next agreement.

At this stage of the negotiations, however, IETA believes that there is a need for Parties and
interested stakeholders to take a more measured approach to the design of new mechanisms.
It is necessary to consider in more detail the ideas already on the table and, critically, to
evaluate if and how these proposed mechanisms are likely to attract the private sector
investment required for success.

Flexible, market-based mechanisms to incentivize emission reduction in developing countries

are possible because, while the cost of reducing greenhouse gas emissions varies
considerably from country to country, the net benefit to the atmosphere equates wherever
emissions are reduced. Such mechanisms not only achieve the same greenhouse gas
reduction at a lower societal cost, the use of the market also frees governments from the
impossible task of obtaining the perfect information needed to identify cost effective emission
reductions in a top-down manner. Given the right market structure, the private sector can
simply be unleashed to seek out the most cost-effective emission reductions.

The provision of a market structure that will best enable the private sector to address climate
change, however, is not an insignificant or simple task, but it is a crucial one. The IPCC,
UNFCCC, IEA, and Stern and Garnaut Reports have all emphasized the critical role that private
sector capital must play if the international community is to successfully address climate
change. Indeed, the UNFCCC has stated that the carbon market – including flexible, market-
based mechanisms – must be significantly expanded to meet the need for additional
investment and financial flows and to transfer critical, climate-friendly technology alternatives.

Given all of these points, IETA believes that there is an urgent need to get to work filling in
the details of new mechanism that have been proposed by Parties and stakeholders alike. This
document begins modestly, with a list of key foundational questions that IETA hopes will help
negotiators to consider how (and if) the proposals on the table today will function in practice.

As implied above, however, clarity as to basic design is not the only test proposals for new
mechanisms must meet. IETA also believes that there are several key design features that will
significantly impact the ability of the private sector to engage with new mechanisms. This
document lays out the criteria that new mechanisms should meet if they are to attract private
sector investment and direct it to emission reduction activities in the most efficient manner.

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 Filling in the Details: The Fundamental Questions

The following questions should be asked of each proposed new mechanism.

1. How will the new mechanism reduce emissions?

For example, will emissions be reduced through the introduction of an intensity-based or
absolute ‘no lose’ target; through support for a domestic policy measure; or through the
transfer of lower-emitting technologies?

2. What is the mechanism’s source of funding?

For example, if emissions reduction credits are issued to governments or private entities
with the intention of being purchased, who is the buyer?1; if emission reductions are
supported by a multilateral fund, who contributes to or invests in the fund?; if emission
reductions stem from the transfer of technology, who funds the transfer and manages IPR?

3. What is the incentive structure for participation within the mechanism?

For example, how are the following actors drawn to participate in the mechanism:
(1) National and local governments, (2) emitting entities in the host country,2 and
(3) other project developers and investors, international or domestic?

4. How does the mechanism harness private sector ingenuity and capitalize on private
sector aptitude for efficiently and effectively discovering low-cost solutions?
In other words, do private sector actors have the ability to take the initiative in terms of
identifying, investing in, and/or implementing emission reductions, or are they
fundamentally dependent upon other actors to provide the return on their investment or
to ‘move first’?

5. What are the supply/demand dynamics of the mechanism?

In other words, when considering the level of activity that the mechanism aims to
incentivize, can the necessary investment or demand for credits reasonably be expected to
materialise? For instance, for credit-issuing mechanisms, what impacts do levels of
ambition or supplementarity limits have on demand, and should they be considered in
conjunction with possible new supply of emission reductions?

6. What are the major political risks of this mechanism, and can these risks be
mitigated?
For example, if a government fails to carry out its obligations under the mechanism, or
does so unsatisfactorily, to what extent, if any, does it impact private sector investment? Is
it possible to isolate the private sector from this risk or to mitigate the risk to investors?

7. In what ways can this mechanism create perverse incentives or unintended

consequences, and how can these risks be mitigated?
For example, will this mechanism discourage further government regulation (e.g. higher
fuel efficiency standards) because governments wish to preserve the carbon finance drawn
to their country? Will the mechanism impact decisions taken on environmental
conservation (e.g. bio-fuel demand driving rainforest clearing for agroforestry operations)?

Note: Beyond these fundamental questions lie equally crucial functional questions as well.
Examples of functional questions include: What governance arrangement is necessary for this
mechanism?; Is there a need to measure, report, and verify emission reductions achieved
through the mechanism, and at what level; Is it necessary to determine additionality and,
considering past experience, how can this be done successfully?; What data is required to get
the mechanism up and running, and how will that data be gathered?; In what time frame can
this mechanism be fully functional and, until then, how can the Parties ensure that emission
reduction activities do not lose momentum?

1
Will credits be fully fungible with AAUs and domestic compliance units? If not, how will they be utilized?
2
If crediting takes place at the sector or national level, not directly to the private entity, what is the
incentive mechanism for private participation? For example, will there be a domestic program for
crediting below this level, and how will it be constituted and managed to reduce risk to participating
private sector entities?
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 Bringing in the Private Sector: Criteria for Private Sector Involvement

The following lists should be used to evaluate the merits of proposals for new mechanisms in
terms of their ability to attract private sector investment.

Economic Criteria

In order to attract private sector finance, new emission reduction mechanisms must meet the
following economic criteria:

1. Provides incentive for a conventional economic return for the provision of an

environmental benefit: While many private sector actors have social and
environmental motives in addition to economic ones, the first and most important
motivation for emission reduction activity by the private sector will always be the
pursuit of profit. Attempts to penalize “overly profitable activities” through taxes or
extra tests and regulations will only stifle the ability of the private sector to provide
environmental benefits.

2. Creates an incentive for emission reduction activity in areas that have previously
been unattractive for investors: The provision of carbon finance is intended to fill the
gap between the cost of business-as-usual and low-carbon investment. The more
attractive that new flexible mechanisms make investment in previously unattractive
low-carbon activities, e.g. through the creation of enabling environments and the
lowering of transaction costs, the more the private sector will enthusiastically pursue
them.

3. Provides for segmentation in terms of either of the following options:

1. Segmented emission reduction activities that lie below sectoral or large-

scale policy level: These activities must be small enough to be an investment
managed directly by private sector actors. Activities managed directly by the
private sector create the maximum amount of investor security and, therefore,
will result in greater levels of investment.

2. Segmented emission reduction investment that leads to the creation of a

manageably small asset, e.g. a carbon bond: It is likely infeasible for emission
reduction activities that require very long-term or large-scale investments,
e.g. nation-wide policy implementation or large-scale infrastructure
development, to be managed directly by carbon investors as under the current
CDM. Investment in those emission reduction activities must still be capable of
being held and traded as private sector assets, however.

4. Rewards early action: A mechanism that rewards early action not only ensures that
already-extant private sector activity is not disincentivized in the transition period
between the Kyoto and post-Kyoto commitment periods, but also ensures that delays
in implementation on the part of the public sector or international community do not
negatively impact good faith action by the private sector to lower emissions in the
meantime.

5. Gives the greatest possible regulatory certainty over the lifetime of the activity or
throughout its pre-determined crediting period: There is a need to ensure that the
regulatory institution is sufficiently stable to allow the project to complete its crediting
period(s) or to allow the investment made to reach maturity. The present uncertainty
as to whether all CDM projects will remain eligible for crediting post-2012
demonstrates the relevance of this criterion.

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 Legal and Regulatory Criteria

In order to attract private sector investment, any new emission reduction mechanism must
provide investment security and minimize transaction costs by fulfilling the following legal
and regulatory criteria:

1. The system must grant rule-making, executive, and review powers to an independent,
non-political regulatory body, driven by an overarching regulatory objective and
preferably established at the international level;

2. Accounting for the complexity of the mandate, that body’s functions and design
should incorporate, as appropriate, the principle of separation of powers;

3. Procedural rules governing the relationship between regulator and regulated

community must guarantee transparency, predictability, efficiency and legitimacy of
communication and decisions taken within the system;

4. Material rules must be unambiguous and clear, allowing a high level of guidance to the
regulated community, clear steps to compliance and the ability to enforce such rules;

5. Clear procedures must exist for review and revision of rules previously established;

6. The following general principles must be enshrined, inter alia,:

a. Due process: the right to be heard, the right to address an independent judge
in public, the right to appeal, and the right to a judgment within a reasonable
period of time,
b. Legality: persons can only be bound by rules that existed and were published
at the time of acting, so rules must not have retroactive effect,
c. Ownership: The legal classification of the resulting emission reduction units
(e.g. a commodity, good, or a choice in action) must be determined as a matter
of Treaty; laws and regulations at a regional/national level must observe this
classification, thus ensuring clear ownership right protection for emission
reduction units or other forms of investment;3

7. State accountability and investor liability must remain separate;4

8. An international, independent, judicial body must be empowered for the purpose of

resolving disputes between the regulator and private parties and enforcing
judgments;

9. The mechanism must be enshrined in the domestic law of participating Parties,

through the provision of domestic laws that protect investment, ensure ownership of
issued units and allow for transfer of such ownership, and provide recourse in
domestic courts when necessary (the treaty shall give guidance to the Parties as to how
such disputes are to be resolved in domestic jurisdictions);5

10. Direct transfer of emission reduction units or investment return to each entity with
a monetary stake in the emission reducing activity must be provided;

3
Clear legal classification and ownership rights are key to attracting greater amounts of private sector
capital through capital market instruments (e.g. bonds) that rely on techniques where certainty is
afforded by the legal nature of the underlying instrument.
4
The failure of a government to meet its commitment (be it sectoral or national) should not be passed
on to investors that have fulfilled their obligation. In other words, emission reduction units should not
be delayed nor should emission reductions units be revoked once issued as a result of Party non-
compliance with obligations under the Protocol.
5
This should lead to the harmonization of domestic rules in order to create investment certainty and
facilitate private investment.
4
Please contact Kim Carnahan at carnahan@ieta.org if you have questions or comments, or
require further information in relation to the positions contained in this document.