Global emissions effects of CDM projects with relative baselines

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Abstract

CDM is an offset mechanism designed to reduce the overall cost of implementing a given global target for greenhouse gas (GHG) emissions in Annex B countries of the Kyoto Protocol. A problem with CDM is that it provides incentives to increase, if possible, the baseline emissions for CDM projects, to optimize the value of CDM credits. Under a “relative baselines” crediting rule, the CDM may also unduly increase energy consumption even during the CDM implementation phase. Less than full offset of emissions is then likely, and the CDM will lead to increased global GHG emissions. We show that this is a potentially serious problem, due to asymmetric information between project hosts and the regulator, the CDM Executive Board, and to the basic rules for crediting CDM quotas. In certain cases, the use of “relative baselines” to credit CDM quotas could fully eliminate any emissions reductions achieved by CDM projects. Remedies to overcome the problems are discussed. They may involve setting the baseline independently of initial energy intensity and final output for the project; or involve information revelation mechanisms that minimize policy losses and net rent capture by project sponsors.

Highlights

► The baseline for CDM projects, against which emissions offsets are computed, can be manipulated by project hosts. ► Moreover, under “relative baselines”, CDM credits are given in proportion to output, thus serving as an output subsidy. ► In consequence, the CDM will often leads to global increases in GHG emissions, and this is more likely when baselines can be manipulated. ► Remedies exist, among them to set baselines independently of CDM projects, or to design optimal regulation mechanisms taking asymmetric information directly into consideration.

Introduction

The clean development mechanism (CDM) is an “offset mechanism” under the UNFCCC's Kyoto Protocol. Its main objective is to reduce the overall global costs of implementing a given target for greenhouse gas (GHG) emissions in countries with an established cap on their GHG emissions (the so-called Annex B countries of the Protocol).1 This is done in the way that parties in Annex B countries pay parties in countries with no binding caps (non-Annex B countries) to reduce their emissions. Such reductions are in turn credited against the established emissions quota for the respective Annex B country, thus allowing emissions to increase (be higher than otherwise) in the latter country.

The main purpose of the CDM is not to reduce global GHG emissions, but to keep emissions neutral while costs of implementing a given emissions level are reduced.2 Cost reductions are achieved by shifting implementation costs from (high-cost) high-income countries, to (lower-cost) low-income countries. We here however argue that the CDM often does not keep emissions neutral: global emissions can instead increase. This can occur via several different mechanisms. Only one of these mechanisms, endogenous baselines, will be discussed here.3

Endogenous project baselines is a long-recognized problem with the CDM. It was anticipated in early analytical papers by Bohm (1994), Hagem (1996), Walker and Wirl (1994), and Wirl et al. (1998).4 Wirl et al. (1998) considered efficient design of CDM contracts as a mechanism problem under asymmetric information, and suggested a constrained optimal mechanism to be applied by the “principal” (the CDM Executive Board; hereafter EB). See also Dutschke and Michaelowa (1998), Michaelowa (1998), and Lazarus et al. (2000), and OECD (2001); and later Probase (2003), Greiner and Michaelowa (2003), Michaelowa and Purohit (2007), and Schneider (2007). Recent analytical studies are Fischer (2005), Akita et al., 2007, Akita et al., 2008, and Hagem (2009). Fischer (2005) is probably most closely related to ours, illustrating various ways in which baseline “inflation” can occur. For further discussion of regulators’ setting of baseline methodologies see Flues et al. (2010).

Problems with “baseline inflation” were early recognized by policy makers. Many took the pessimistic view that the CDM would fail by not producing meaningful emissions reductions in low- and middle-income countries.5 To the surprise of many, the CDM has survived, and is in many ways thriving. Overall, the CDM has served as a vital mechanism for access to climate-related finance for lower- and middle-income countries, and given incentives for mitigation action in these countries. The CDM has also likely led to emissions reductions through spillover effects from international technology transfer. But potentially negative effects should not be ignored. Our purpose in this paper is to analyse one of these.

The focus of our paper is on implications of the rules for crediting under the CDM. One basic problem is that, under today's rules, the baselines of individual CDM projects can in many cases be manipulated, and firms have incentives to do so. The ideal “project baseline”, against which CDM credits should be awarded, corresponds to emissions in the hypothetical, and counterfactual, case without a CDM.6 Moreover, the baseline for an individual production unit should be independent of the actual emissions from this unit, during the “baseline” period. Such a theoretically correct baseline is usually impossible to establish, since the “counterfactual” against which current emissions are compared, does not exist. The regulator will then often in reality accept a “startout” emission rate as the baseline. This may give incentives for a firm preparing for a CDM project, to establish a high “startout” rate, as this will facilitate a larger than otherwise reduction in emissions later, when the CDM project is implemented. As seen below, this “baseline” effect could in principle eliminate part, or even all, of the emissions reductions resulting from the CDM project. CDM regulators are likely to be aware of this problem, but may not have the informational basis to address it, and may often lack the incentives to do so (see below).7

In principle, baseline methodologies and their implementations are subject to severe scrutiny by the EB, which regulates CDM projects and certifies emissions credits (CERs) on the basis of completed projects. Strict procedures should be in place to make sure that issued CERs actually represent additional GHG emissions reductions within the non-Annex B country bloc. Three main principles for computing the baseline (or “baseline methodologies”) for particular proposed CDM projects can be used: (1) historical emissions; (2) emissions from an alternative, “economically attractive” technology; and (3) average emissions for “similar” projects over the last 5 years.8 Methodologies 2 and 3 should in theory serve to avoid the most serious problems exposed in our analytical discussion below (see also our discussion of how to avoid such problems in Section 4). Similar safeguards, including the so-called “E+/E− policy” are in place for country-wide policies.9 The criteria for the application of methodologies are however often unclear in practice; and the counterfactual cannot be observed and is as noted subject to serious asymmetric information. Strong forces are thus at work to relax these strict formal criteria, since agents’ incentives are to maximize crediting via the mechanism.10

A standard methodology, e.g., for power plants, major renewable energy facilities, and major firm retrofits and new technology implementations, is that CDM crediting is done according to a principle of so-called “relative baselines”. This has two main, potentially distortive, aspects in our context. First, “relative crediting” (per unit of output) is given in terms of the difference between the (fossil) energy intensity of the unit or firm in question, in a “baseline period”, and in the CDM implementation period. Secondly, total credits are awarded by multiplying this difference by the firm's output during the CDM implementation period.11 In the following we will consider CDM projects using this now widely applied crediting principle. Relevant and widespread examples are a coal-fired power plant replaced by a renewable-based power plant; and a firm installing more energy-efficient equipment.

A further standard requirement on CDM projects is “additionality”. This implies a requirement that, in the absence of CDM financing, the project would not have been found profitable and thus not carried out. We will in the following simply take additionality in this sense as given; we however realize that this puts constraints on the profit functions of firms, related to the particular types of projects we have in mind for our analysis.

A CDM project is, typically, defined by an initial investment; as e.g., exposed by Hagem (2009). In our main case below, this is made concrete by assuming that a particular “CDM project technology” leads to the required reductions in the firm's GHG emissions intensity, and this typically requires a fixed capital investment. We below however also indicate some possible cases where a (substantial) fixed capital investment may not be strictly necessary to implement the emissions intensity reduction.

Section 2 sets out a basic case where the firm is a standard profit maximizer, facing no CDM, and determines both its energy input and its energy technology, defined by a productive factor that is a substitute to energy use. Sections 3 Endogenous CDM project baselines and exogenous energy technology, 4 Uncertain and costly project implementation with manipulation of CDM project baselines consider CDM projects where the firm's baseline, on the basis of which CDM credits per produced units are calculated, can be manipulated in response to incentives created by CDM. In Section 5 we consider, briefly, the case where the baseline energy intensity for CDM crediting is exogenous. In both cases, we assume that actual CDM credits are awarded in proportion to output during the CDM implementation period. Section 6 concludes.

Section snippets

Optimal energy and energy technology inputs: basics

Consider a firm producing an energy-intensive output over a unit period. Our first issue is to determine the optimal allocation of this firm, given that the firm faces a competitive market for its output and inputs, and takes all prices as given.12 Assume that the firm's output can

Endogenous CDM project baselines and exogenous energy technology

Using simple analytical examples, we now discuss how and to what degree individual CDM-executing firms may have incentives and be in the position to manipulate their emissions against which CDM credits are issued, and the effects of such manipulation on overall GHG emissions. In this section and the next, we assume that the CDM regulator simply takes observed emissions intensities (emissions relative to output) by CDM-seeking firms to represent relevant baseline intensities. Baseline emissions

Uncertain and costly project implementation with manipulation of CDM project baselines

We now introduce uncertain CDM financing into the model of Section 3.1. We consider two possibilities. First, we assume that the firm's output, energy consumption E, and energy technology choice Q, are all flexible and can be changed within the project period. In the second case, we instead assume that the technology factor, Q, must be determined at the start of the entire period of production. This is realistic when there are significant sunk costs involved in establishing this factor (e.g.,

Exogenous baselines

For some types of CDM projects, the problem that arises from baselines being endogenous are smaller than those pictured in Sections 3 Endogenous CDM project baselines and exogenous energy technology, 4 Uncertain and costly project implementation with manipulation of CDM project baselines. Serious attempts are being made by the EB, in particular for power plants, to decouple baselines from individual-unit emissions.20

Conclusions and discussion

This paper has studied simple examples of manipulation of baselines and outputs of firms seeking CDM credits, in a stylized analytical model. A “CDM project” consists of a firm changing its technology to make it more “energy efficient” (reduce the amount of energy per produced unit). In the model studied in Sections 3 Endogenous CDM project baselines and exogenous energy technology, 4 Uncertain and costly project implementation with manipulation of CDM project baselines, the number of CDM

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