"Economic Development and the Environment"
on the Sakhalin Offshore Oil and Gas Fields II

Copyright (C) 1999 by Slavic Research Center, Hokkaido University.
All rights reserved

How to Design and Operate the Kyoto Mechanisms

Takamitsu Sawa

Emissions Trading

Administrative body and Emission Right

[14] First of all, let us think about emissions trading among the Annex I countries. It is likely that emissions trading which involves private firms will be more efficient in a number of ways. For better understanding of emissions trading, however, we will first examine emissions trading among countries, in line with the provisions of the Protocol, and then extend the concept to the case when private firms participate in emissions trading.
[15] The Conference of the Parties to the UNFCCC serving as the meeting of the Parties to the Kyoto Protocol (COP/moP) is expected to administer emissions trading. The COP/moP may establish a subsidiary body to which parts of the tasks required to administer emissions trading are delegated. The COP/moP or its subsidiary body (hereinafter we call it as the administrative body) will assign to Annex I countries transferable emissions rights which are valid for the commitment period from 2008 to 2012, based on their reduction commitments given in the Kyoto Protocol. Serial numbers might just as well be given to the assigned transferable emission rights to identify the country of origin. The administrative body receives reports from the countries concerning the serial number traded, the amount traded, the destination traded and the remaining amount of assigned emission rights. Moreover, it tracks the transferred emission rights, and discloses such information as the occasion demands.
[16] The administrative body must confirm that each country complies with her commitment. The total amount of GHGs emissions during the commitment period must be less than or equal to the amount of emission rights remaining at the government's
as well as domestic firms' hands at the end of the commitment period. In order to do so it suffices for the administrative body to receive the above-mentioned report only once at the end of the commitment period. However, since emissions are required to be reported once a year, transfer of emission rights might just as well be simultaneously reported

[17] If such reports were publicized, they would serve as a useful source of information for emissions trading. On the basis of such information the administrative body will be able to recommend a country whose emissions are likely to exceed her holding emission rights at the end of the commitment period to control emissions so that she can comply with her commitment.

How to Trade Emission Rights

[18] The emission rights are traded through bilateral transactions, listing in commodity exchanges or through brokerage. The dominant form of trading may be left entirely to market trends, but it should be noted that the market does not necessarily choose an equitable system of trading. To avoid possible inefficiency, unfairness and non-transparency associated with bilateral transactions, it may be advisable to limit emissions trading to some marketplaces authorized by the administrative body or some other bodies. By limiting trading and transactions to a few places, it is expected that principles of fairness and openness are ensured, and that tracking can be conducted comprehensively and in real time.
[19] Transactions via the Internet may be recommendable; the merits of which include immediate information disclosure to market participants, and low costs for establishment as well as operation of the market. In the United States, it is reported that everything from airline tickets to Barbie dolls are auctioned online, and that bidding on the Internet is becoming more and more popular.
[20] After the commitment period is over, each Annex I country should report to the administrative body on how much emission rights it possesses and how much GHGs it emitted during the commitment period. If the occasion demands, each country must accept the administrative body's review. Based on the report and the review, the administrative body finally concludes whether or not each country has complied with her commitment. What kind of sanctions should be taken against noncompliance is a very controversial problem. One simple solution is that noncompliance should be compensated by purchasing emission rights to make up for excess GHGs emissions. The payment may be regarded as a fine.

Sellers' or Buyers' Liability

[21] The liability of emissions trading is also one of the hottest controversial issues. It concerns whether the liability lies in either sellers or buyers. As a possible compromise it might be more reasonable to share the liability by both parties. Suppose that the country A sells a part of assigned emission rights to the country B and ends up with noncompliance. In case of sellers' liability the country A has to fill the deficit somehow or other, while the emission rights bought by the country B is effective in spite of the country A's noncompliance. In case of buyers' liability the seller country is entitled to buy back the emission rights sold to the buyer countries. That is to say, the emissions trading is invalidated retroactively in backward order from the most recent trading up to the point where the accumulated amount of trading equals the country A's deficit of emission rights. As a result some buyer countries might be compelled to buy emissions rights to make up a possible unintentional deficit.
[22] In accordance with ordinary commercial customs, the sellers' liability principle may be more acceptable, but the buyers' liability principle is favorable due to the following reason. The buyers' liability principle is likely to discourage emissions trading and hence encourage self-help rather than reliance upon others, since emissions trading imposes risk to some extent on buyers. Buyers' liability will cause more or less dispersion of the price of emission rights. The higher the price is, the more confident the seller is, and vice versa. In case of buyers' liability, however, the trading system becomes extremely complicated and buyers' compliance may be likely to be jeopardized due to sellers' noncompliance.

Economics of Emissions Trading

[23] Given the market price of one carbon ton emission right of CO2, each country is supposed to reduce GHGs emissions domestically as far as the marginal reduction cost is less than the market price of emission rights. To put it differently, each country reduces domestically up to the point where the marginal reduction cost equals the market price of emission rights. If the amount of the domestic reduction thus determined is less than the assigned target, then purchasing emission rights may fill the shortage. If the converse is true, then the surplus may be sold at the market price.
[24] It is often said that some countries such as Russia and Ukraine may be able to attain their commitments without any further efforts to reduce GHGs emissions, while some other counties such as Japan and the US are difficult to attain their commitments. To put it differently, the former countries' marginal cost curves are far lower than the latter countries' The former countries will certainly have incentive to participate the market of emissions trading as sellers, while the latter countries will have incentive to participate as buyers.
[25] One severe criticism against emissions trading stems from the fact that Russia's CO2 emissions in 1995 was by 30 % less than that in 1990. Certainly, without any significant efforts Russia will be able to attain her target, i.e., stabilize GHGs emissions at the level less than or equal to the 1990 level. To put it differently Russia's marginal reduction cost to attain the target is zero, and hence Russia will be in a position to sell huge amount of emission rights at a bargain. As a result countries with relatively high marginal reduction cost will enjoy the extremely cheap price of emission rights, and hence will be apt to neglect duties of reducing GHGs emissions domestically.

GHGs Other Than Carbon Dioxide and Sinks

[26] The emission unit is one ton of carbon dioxide (CO2) equivalent. Other GHGs are converted into CO2 equivalent values, based on the global warming potentials (GWP) calculated by IPCC. With regards to the emissions of GHGs other than CO2, it is often pointed out that the amount of emissions of these gases is difficult to estimate accurately in most cases. For example, how precisely can nitrous oxide (NO2) or methane (CH4) emitted from agricultural or forest soils be calculated? This question cannot easily be answered. It is often said that GHGs with inaccuracy in their emissions estimation should be excluded from trading, i.e., emissions trading should be limited only to CO2.
[27] The sources of emissions, however, do not matter in emissions trading between countries, since trading is conducted on CO2 equivalent tons. Therefore, if trading is limited to among countries, the present provisions of the Protocol cannot justify excluding greenhouse gases with low estimation accuracy from emissions trading. However, if private firms participate in the emissions trading, sources of emission rights to be traded may include GHGs other than CO2. In this case, the aforementioned points pertaining to the accuracy of estimation is quite likely to cause disputes.
[28] The Protocol provides that net changes of CO2 removal, due to afforestation, reforestation and deforestation within the country since 1990, shall be used for calculating domestic emissions. Deforestation means CO2 emissions. Afforestation and reforestation means reduction of CO2 emissions. This will contribute to forest conservation in addition to prevention of global warming. Attention should be paid, however, to the fact that CO2 removal by forest is nothing more than borrowing emission rights from the future in the sense that eventually in the future due to deforestation or forest fires CO2 absorbed by forest will be emitted into the air.
[29] In Japan, as well as on the global scale, forests are certainly on a decreasing trend. The Kyoto Protocol, which regards CO2 removal by afforestation as negative emissions, could bring about the potential benefit of preventing further deforestation. The present inventory methodology, however, contains numerous problems that should be reexamined, including whether or not emissions should be identified at the point of deforestation.
[30] If the total amount of GHGs emissions by a certain country within the commitment period being certified by the COP/moP turned out to be less than the amount of emission rights remaining at hands, the country could transfer the excess emission rights to the next period. That is to say, what we call banking is permitted by the Protocol.
[31] Banking means excess reduction within the commitment period. As incentive to utilize every existing opportunity for emission reduction, banking may be desirable. The banked amount, however, may be carried over to the next commitment period. Since this implies that the sum of emissions in the first and the second commitment periods are invariant, banking does necessarily increase emissions in the second period. Taking it into account that global warming is caused by the accumulation of emissions over a long period, banking in the first commitment period will scarcely contribute to prevention of global warming.
[32] Total emissions within the first commitment period should not exceed the emission rights at hands. To put it differently, borrowing from the next period is not permitted. If the administrative body confirms that a country has not fulfilled its commitment, but judges that this has been caused by unavoidable reasons such as extraordinary climate, natural disasters or accidents, the government of the country involved should be permitted to apply for special carrying-over to the administrative body.
[33] The administrative body permits special carrying-over only when it confirms that the noncompliance has been caused by some unavoidable reasons. The shortage in the balance of emission rights for the current commitment period and the penalty premium should be deducted from the initially assigned emission rights for the next period. If noncompliance has been caused by some avoidable reasons, the country is obliged to purchase additional emission rights from countries with surplus emission rights, or from the administrative body in case when no country has surplus emission rights. Some maintain the view that the administrative body should set a penalty price higher than the market price in such cases. The administrative body, if it sells additional emission rights to countries that have failed to meet their commitments, should be required to purchase the same amount in the market within the next commitment period.
[34] As a matter of fact, it should be noted that the above measure in case of noncompliance is nothing more than borrowing deputized by the administrative body. More punitive measures against noncompliance may be conceived, but most of them would be internationally unacceptable. Naturally, there should be some possibility left to introduce more powerful measures in the future against repeated noncompliance.

Participation by the Private Sector

[35] Emissions trading among countries are likely to be conducted as bilateral transactions at least at the beginning. In order to encourage the formation of the marketplace, the participation in emissions trading by private firms would be indispensable. It is entirely left to the government of each country whether or not private sectors such as firms, brokers, and NGO are permitted to participate in emissions trading. In either case, it goes without saying that responsibility of compliance lies with the government.
[36] There exist two different ways for private sectors to participate in emissions trading. First, the government distributes a part of emission rights assigned by the administrative body to private firms according to a certain rule. As the occasion demands, firms can sell or buy assigned emission rights in the market or through bilateral transactions. Second, even in case when private firms are not assigned emission rights, firms may keenly want to have an opportunity to sell emission rights generated by JI or CDM. In order to motivate JI and CDM by private firms the early creation of the open marketplace is really necessary.
[37] In view of cost-effectiveness, it is more desirable for private sectors to participate in emissions trading somehow or other due to the following reasons. First, the government is not necessarily in a position to make correct judgements on the marginal reduction cost of GHGs emissions, i.e., the cost required to reduce one additional unit of GHGs emissions. To put it differently, private firms are in better position to estimate how much marginal cost is needed to reduce their own GHGs emissions. Second, the government does not necessarily have the know-how for commodity trading. It should be recollected that in 1992 when a poor harvest attacked Japan the emergency import of rice was entrusted to trading firms. Third, if emissions trading were limited only to the government, cost-effectiveness would be more or less damaged since bilateral transactions are likely to be dominant.