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The global carbon market is a loose collection of diverse greenhouse gas reduction transactions and is broadly classified as follows:

• Project-based or baseline and credit system: Emission reductions are created and traded through a given project or activity. CDM and JI are examples of

the project-based system where CERs and ERUs are generated respectively (UNFCCC, 2002).

• Allowance market or cap and trade system: Emission allowances are defined by regulations at the international, national, regional or firm level. Examples of allowance market include the EU Emission Trading System or EU ETS (regional), the UK and the Danish trading systems (national), and BP and Shell internal trading (firm level).

• Voluntary market: Individuals and companies account and trade their greenhouse gas emissions on a voluntary basis. The voluntary market

involves either carbon compensation or travel compensation programs. With carbon compensation, a client holds a CO2 account and offsets their

emissions by obtaining credits from sellers of credits. With travel

compensation, individuals and companies offset the greenhouse emissions of their air travels by buying standardized certificates.

The CDM market is one of the fragmented (partial) carbon markets and will be in competition or an alternative to the other options.

Table 4.2: Required Emissions Reduction Estimation for Annex I Countries in 2010 (Figures in Million Tons of Carbon, MtC and million tons of Carbon Dioxide MtCO2) Models/ Studies Emission reductions required in Annex I (MtC)

Emission reductions required in Annex I (MtCO2) EPPA 1312 4811 Haites 1000 3667 G-Cubed 1102 4041 GREEN 1298 4759 SGM 1053 3861 Vrolijk 669 2453 Zhang 621 2277 RIIA 666 2442 GTEM 1023 3751

Sources: Zhang (2000), Ellerman and Decaux (1998), Haites (1998), McKibbin et al. (1999), and Vrolijk (1999).

CDM Market Estimation before COP7

Under the Kyoto Protocol, the developed countries take the lead in limiting and reducing the emissions of greenhouse gases (GHGs). The Protocol sets emissions

targets for the developed countries that they can fulfil individually or jointly, through using the flexible mechanisms provided for, namely Joint Implementation (Article 6), Clean Development Mechanism (Article 12), and Emissions Trading (Article 17), and other forms of flexibility in the design of the Kyoto Protocol. These Kyoto mechanisms are expected to lower substantially the costs of meeting the quantified emission limitation and reduction commitments (QELRC) targets. The inclusion of another five gases in addition to CO2 as well as some forms of removal and

sequestration of gases within developed countries will also greatly reduce costs for the emission reductions.

The CDM has received much attention in the COP’s meeting because it gives developed country parties the chance to achieve some of their reductions at lower cost by investing in projects in developing countries, where the marginal cost of abatement may be lower. Therefore many industrialised countries are eager for the implementation of the mechanism to proceed expeditiously. They are anticipating difficulties in meeting their Kyoto commitments through domestic measures, and as a result are looking at the mechanism for a solution of their problem.

Vrolijk (2000) asserts that the cost reductions from emissions trading exceed 50% for Annex B countries; it is even higher for some specific countries. Due to the fact that many non-Annex B countries are interested in seeing progress made towards implementation of the CDM, those have the potential to channel substantial investment in clean, sustainable projects.

The emission market depends on the growth of emission, as a result of the Annex I Parties’ economic development. On the demand side of the Annex I countries (namely OECD countries) the projected emissions for each Party in excess of its target comprise the total potential demand on the emissions market. The supply side (economies in transition and developing countries) of the emission quota market is more complicated: some quota may be available because some countries’ emission will stay below the target such as former Russia and Ukraine. Parties are expected to take some emission reduction measures independent of price signals and other investments through both JI and the CDM.

A number of studies estimate the size of the CDM in the carbon market i.e. GHG market (Table 4.3). Among them, Austin and Faeth (1999) argue that global modelling exercise tend to overestimate the CDM flows because, in practice, political institutions and transactions costs will probably keep CDM activity at a much lower level than the estimates.

Table 4.3: Estimation of CDM Market in 2010 before COP7 Study Market share (%) Market size (MtC) Market price (US$/tC) Market value (US$ bn)a US Administration 19-46 144-344 24-42 6.0-8.3 Haitesb 27-57 266-572 37 9.8-21 Vrolijkc 10-12 67-141 2.77-2.99

Austin and Faeth 33-55 397-723 13-26 5.2-17.4

Zhangd 47 292-421 9.6 2.8-6.7 Greene 31 397 EPPAe 55 723 24 17.4 G-Cubede 38 400 13 5.2 ABARE 117-351 181-203.5 2.6-7.1 OECD 33 397 19 7.5 PETf 39 323 6.71 10.6

Source: Edmond et al. (1999), Ellerman and Decaux (1998), Haites (1998), Kolshus et al. (2001), McKibbin et al. (1999), Morozova and Stuart (2001), Vrolijk (1999), World Bank (2003), Zhang (1999), Zhang (2000).

a: Values are expressed in 1995US$. The CDM estimates are based on the specific analysis of energy efficiency improvements in the thermal electricity sector. Two rates of energy efficiency improvement in thermal electricity power generation are examined, 2.5% and 7.5%. The lowest rate is associated with the highest price and lowest carbon market size. Under this illustrative CDM example of energy efficiency, the majority of CERs are generated in China and India.

b: The estimated size of the CDM market in 2010 ranges from 266 MtC in a supplementarity scenario (trade should not exceed 50% of reductions from BAU) to 575 MtC under no limit scenario; it assumes a fixed quota price.

c: Vrolijk and Grubb developed an emission trading model (ITEA) that creates marginal abatement cost curves for each Annex B country. ITEA quantifies the impact of the Kyoto mechanism, but only referring to relative costs (results presented are calculated referenced to the domestic only action scenario; compliance cost of domestic action=100). Ranges vary for scenarios where CDM potential is equal to half the total non-Annex B CO2 emissions in 2010 and scenario where CDM potential

equals the projected 2010 emissions and marginal abatement cost are halved for the CDM. If there is no trade in hot air, CDM market size would range between 101-210 MtC and US$6.16-6.62 billions for market value.

d: This result is obtained from a no-supplementarity scenario. The lowest range estimates are based on the low EU official baseline projection and the highest value is based on the high EU official baseline projection. The price of US$9.6 presented in the fourth column, corresponds to the low EU official

baseline projection. If countries subtract their own abatement cost, the net market size would yield US$1.6-3.8bn., where China would account for 59.9% of the market followed by India (15.5%). Market size and value range is determined by the low (27.9 MtC) and high (234 MtC) official EU baseline projections.

e: Austin and Faeth (2000) analysed the results of these economic models. These models ignore the high transaction costs that may arise from the CDM, and the administrative and adaptation fees. f. PET-Pelangi’s emissions trading model. It is a quantitative model of the implementation of the Kyoto Protocol. It uses information on emission reduction activities in Annex B countries, emission offsets achieved in developing countries through the CDM, and the global market for carbon credits. PET allows for comparative analysis of the impacts of different policy scenarios and implementation rules on the CDM.

The estimates given in Table 4.3 range from US$2.6 to 21bn annually in monetary terms, and 67– 723MtC in emission reductions. Haites’ (1998)estimates range includes a supplementarity scenario (trade should not exceed 55% of reductions from Business As Usual), and carbon price will be in the range of US$9.6-203.5/tC. In its study of the impact of the Protocol on the US economy, the US Administration’s (1998) estimate is extended to include the whole of Annex B. The range includes, apart from standard CDM, an estimate for full trading with key developing countries (larger market size, and substantially lower prices).

Most of the above mentioned models simply assume that CDM projects take the price of carbon credits as given, and from that assumption they derive the size of the market. Hence, they do not take into account the actual dynamics of the market. Some models use only one economic impact study to calculate the CDM market. For example, Vrolijk (1999) based on the US Administration’s impact study calculates CDM investments to range between US$ 6.86 and 4.14 billion (it is worth noting here that the size of the CDM is given only for one country; namely the investment in CDM of only the USA).

The macroeconomic estimates such as those by Haites, Austin and Faeth, US administration are mostly based on computer models and range from 67–723MtC and US$2.6–21bn. The money, although it may seem only a small amount, does matter. The estimated value of the CDM could be substantial compared to ODA, which totals around US$50bn annually. There is also a possibility to attract a large

share of foreign direct investment (FDI), which in the developing countries is around US$240bn per year.

Given that all three Kyoto flexible mechanisms can be used indistinctly to meet emissions reduction requirements, market forces will mostly determine the share of each one. The main advantage of CERs in this respect is that they can be accrued from 2000 onwards; meanwhile the other mechanisms can only account for credits as from 2008. On the other hand, the fees charged under CDM projects for

administrative costs and the adaptation fund will make the CDM less attractive. Still unclear, and quite important for estimating the size of the CDM market, is the extent to which the sustainable development criteria will be applied.