Kyoto Protocol and Clean Development Mechanism

The Kyoto Protocol to the United Nations Framework Convention on Climate Change (UNFCCC) was adopted by more than 150 countries at the third session of the Conference of the Parties to the UNFCCC in Kyoto, Japan, on 11 December 1997. It is an international treaty containing binding constraints on greenhouse gas emissions and, mechanisms aimed at cutting the cost of reducing emissions and establishes global markets for greenhouse gas (GHG) emission permits. Under the Kyoto Protocol, industrialized countries and countries with economies in transition will reduce their combined GHG emissions by at least five per cent below their 1990 levels by the first commitment 2008 to 2012. The most important GHG is carbon dioxide (CO2) whose emissions are mainly related to combustion of fossil fuels.

The Protocol shall enter into force on the ninetieth day after the date on which not less than 55 Parties to the Convention, incorporating Annex I Parties which accounted in total for at least 55 % of the total carbon dioxide emissions for 1990 from that group, have deposited their instruments of ratification, acceptance, approval or accession.

• The Kyoto Mechanisms encompass the following three instruments:
  Joint Implementation (JI, Article 6 Kyoto Protocol) projects in other Annex B countries that lead to Emission Reduction Units (ERUs),
• Projects in countries without emission targets (Clean Development Mechanism (CDM), Article 12 Kyoto Protocol) that lead to Certified Emission reductions (CERs), and
• International Emission Trading (IET, Article 17 Kyoto Protocol) of Assigned Amount Units (AAUs) among Annex B countries.

The concepts of JI and CDM refer to project based co-operations between two countries, where GHG emission reductions take place in the country with lower marginal abatement costs. In other words, a country that has adopted a quantified GHG emission reduction or limitation commitment under the Kyoto Protocol can fulfil parts of this commitment on the territory of another country where the costs are lower. The CDM envisages a project co-operation between industrialised countries with commitments (Annex I countries) and developing countries (non-Annex I countries), which have exempted from quantified commitments under the Protocol (JI refers to a project-based co-operation between two industrialised countries).

The main benefits that can be expected from the project-based Kyoto mechanisms are, on the one hand, that they potentially reduce industrialised countries’ costs of meeting the Kyoto Protocol targets, whereas, on the other hand, they are to support the host countries objectives regarding sustainable development.

With the help of CDM, countries which have set themselves an emission reduction target under the Kyoto Protocol (Annex I countries) can contribute to the financing of projects in developing countries (non-Annex I countries) which do not have a reduction target. Contributing to the sustainable development of the host country, the project should reduce the emission of greenhouse gases. The achieved emission reductions can be used by the Annex I country in order to meet its reduction target.

The Kyoto Protocol (Article 12.10) envisages that CDM projects could start from 2000 onwards, but the required regulatory and institutional framework is not yet in place.

2 Financing impact

2.1 Revenue side

The return of CDM investments depends on how emission permits are used by the investor. There are two basic options for the investor:

• sell the emission permits to other companies or governments on international markets
• use the emission credits for offsetting emissions of own operations outside the CDM host country that are regulated by climate policies.

A third option might be banking or saving of emission permits for future use.
Depending on the specific circumstances, renewable energy projects may generate emission permits, thus increasing the expected return. Market prices for emission permits are estimated to be between 5 to 20 EUR per ton CO2 [Janssen (2001)]. Overall financial risk of renewable energy projects may be reduced by engaging in emissions trading and the Kyoto Mechanisms.

2.2 Cost side

Along the CDM project cycle may arise a variety of different transaction costs. This includes the following:

• Project identification and selection: Search costs incurred by project developers and potential investors in identifying prospective projects. The costs for developing project selection criteria, costs of ranking projects according to the preferences of investors are also encompassed
• Project development and baseline determination: Information costs related to the preparation of a project concept note providing relevant information on project baseline, expected additional emission reductions and corresponding costs.
• Project validation: Validation is the process of independent evaluation of a project activity on the basis of the project design document.
• Project approval: Projects need to be approved by the host government.
• Project registration: Registration is the formal acceptance by the relevant international bodies of a validated project as a CDM project activity.
• Project implementation: Monitoring and enforcement costs of contracts during construction, start-up and operation phase.
• Project monitoring and reporting: Monitoring refers to the measurement of data for the determination of actual GHG emissions. Reporting relates to reporting the measured relevant data and the subsequently calculated actual GHG emissions of a project.
• Project certification: Certification is the written assurance by a designated operational entity that, during a specific time period, a project activity achieved the emission reductions as verified.
• Transfer and use of emission permits: Transactions costs at that stage include reporting of transfers of emission permits to dedicated registries.