Introduction

The agreement on a system for the trading of emissions was one of the main objectives of Non-European industrialized countries in the negotiations on the Kyoto Protocol. It was, however, quite a contentious demand. Whereas the members of the so-called "JUSSCANNZ-Group" (Japan, USA, Switzerland, Canada, Australia, Norway and New Zealand) declared agreement on this instrument to be an indispensable element of any protocol, this demand was met with caution by most Member States of the EU and most developing countries. European and developing countries feared alike, that trading might provide a cheap way for the US, Canada, Australia and New Zealand to "buy" themselves out of their obligations. This concern was raised particularly because of the large emission reductions that had taken place in Russia and other countries with economies in transition due to economic decline. It was feared that these countries would introduce a large amount of tradable emission permits into the system.

The objection of developing countries was - and still is - to a great extent based on ethical grounds. This is first of all the concept of "pollution rights," which has an ethically objectionable connotation for many environmentalists in industrialized countries as well. Second, and this was voiced most articulately by India, developing countries raised some fundamental concerns with regard to equity. Quite clearly, the approach taken by the Kyoto Protocol does not take equitable distributional considerations into account, since emission allocations are based on past emissions - the so-called "grandfathering approach." This structural deficit will have to be remedied once these countries are supposed to enter the trading system.

These fundamental questions shall not be explored in this contribution, which will deal with those elements of an emissions trading system that found their way into the Protocol and some that were missing. The language on Emissions Trading has remained rather rudimentary, after it had disappeared completely from the negotiating text in the final hours of negotiations in Kyoto. Mainly because of the immense pressure of the JUSSCANNZ-countries, a much reduced text was finally incorporated as Article 17.

This text contains the basic principles, but its main feature is the fact that it can be interpreted to anyone's liking. Some countries apparently base their strategy on an early start of the regime with many of the rules being left to the market to develop. Afterwards these rules would have to be accepted by those Parties that enter the market at a later stage.

The agreed rules on Emissions Trading

The regulations on Emissions Trading can be found in Article 17 and in the paragraphs 3.10 and 3.11 of the Kyoto Protocol. Since they are rather short, they shall be reproduced here in full:

Article 17:

"The Conference of the Parties shall define the relevant principles, modalities, rules and guidelines, in particular for verification, reporting and accountability for emissions trading. The Parties included in Annex B may participate in emissions trading for the purposes of fulfilling the commitments under Article 3. Any such trading shall be supplemental to domestic actions for the purpose of meeting quantified emission limitation and reduction commitments under that article."

Article 3.10:

"Any emission reduction units, or any part of an assigned amount, which a Party acquires from another Party in accordance with the provisions of Article 6 or of Article 17 shall be added to the assigned amount for the acquiring Party."

Article 3.11:

"Any emission reduction units, or any part of an assigned amount, which a Party transfers to another Party in accordance with the provisions of Article 6 or of Article 17 shall be subtracted from the assigned amount for the transferring Party."

This is not much text in view of the immensely complex task, but nevertheless there are several rules of the envisaged trading system that appear to be settled:

a) Primary participants in a trading regime will be the Parties to the Kyoto Protocol listed in its Annex B. These are the northern members of the OECD as well as most Central and Eastern European countries and some successor states of the former Soviet Union. Parties without legally binding emission reduction and limitation objectives under the Protocol are thus precluded from participating in trading. This concerns first of all the developing countries, but furthermore those industrialized countries that do not ratify the Protocol or that are not included in Annex B. Article 17 therefore provides an incentive to take on legally binding obligations in order to participate in trading. Restriction of participation to those Parties with legally binding targets should ensure that the overall amount of units circulating in the system are stable. If certified emission reductions generated by the Clean Development Mechanism were tradable, however, this principle would be violated. This "cap" on the overall amount of units circulating in the system is not only required by ecological considerations, but should furthermore provide stability and allow a dependable market to develop.

b) The basic mechanism for a trading regime has been defined in Article 3, paragraphs 10 and 11. Any emission reduction units, or any part of an assigned amount, which a Party acquires from another Party shall be added to the assigned amount for the acquiring Party and shall be subtracted from the assigned amount of the transferring Party.

c) The commodity that may be traded is called "any part of an assigned amount". This term refers to the "budget"(assigned amount) allocated to the Parties by Article 3.7 and Annex B of the Kyoto Protocol. The protocol thus does not follow the principle of per-capita distribution, as would be required according to ideas of equity and demanded for example by India. Instead, Article 3.7 stipulates that the "assigned amount" for the commitment period 2008-2012 for each Party is equal to the percentage inscribed for it in Annex B of its base-year emissions of the "basket" of gases listed in Annex A, multiplied by five.

The regulated gases in the so-called "basket" are first of all the three main contributors to climate change: carbon dioxide (CO2), methane (CH4) and nitrous oxide (N2O). The basket furthermore comprises sulphur hexafluoride (SF6) and two groups of industrial gases, hydrofluorocarbons (HFCs) and perfluorocarbons (PFCs). The reduction targets must be achieved for the basket as a whole. Since the respective radiating force for each of those gases is different, the "Global Warming Potential" of each gas, as determined by the Intergovernmental Panel on Climate Change (IPCC), is used to calculate the overall obligation. The overall emissions of these gases has been restricted by the Kyoto Protocol for a first "commitment period" from 2008 to 2012.

A second commodity that might be traded according to Article 3 paragraphs 10 and 11 is called an "emission reduction unit". This term refers to Article 6, where "emission reduction units" may result from Joint Implementation projects and thus clarifies that the "credits" generated may not only be used by the acquiring Party to meet its own obligations, but that these credits are transferable to other Parties.

However, neither the first nor the latter term is sufficiently precise to create a tradable commodity. Therefore a common unit, such as a "tonne of CO2 equivalent," could be defined for Joint Implementation as well as for Emissions Trading. It is not yet clear whether a third category of emission rights - the "certified emission reductions" generated by the CDM - are tradable as well. The Parties thus will have to decide at future conferences on the "fungibility" of those credits.

Open questions

Notwithstanding these basic principles of a trading regime established by the Kyoto Protocol, most issues remain unresolved. These questions are, inter alia, the time when trading might start, the definition of participants and gases that might be traded, the establishment of the rules and procedures for trading, the institutional set-up and the regulations regarding monitoring, verification and ultimately enforcement of the rules. Due to constraints of time and space, only some of these open questions will be addressed in this contribution.

a) When should trading start?

A first - but by no means the only - disagreement among the Parties to the Kyoto Protocol concerns the starting date of such trading. Whereas the US, Canada and other non-European industrialized countries believe that trading could (and should) start immediately, the EU and others claim that the relevant rules etc. of the mechanism will have to be established first by the Conference of the Parties. The latter interpretation appears to be more convincing. This is first of all commanded by the inherent logic of a trading system and, secondly, it is indicated by a careful interpretation of Article 17.

The first argument against permission to start trading immediately after the Protocol enters into force arises from the inherent nature of trading itself. This is because the establishment of an effective trading system requires certainty and credibility. These two elements simply cannot be achieved without basic rules agreed upon beforehand, especially as regards the issues of transparency, verifiability, reporting and accountability. A system without adequate rules does not make sense, neither economically nor politically.

Furthermore, a careful interpretation of Article 17 and an analysis of the negotiation history indicate that the text was changed at a very late stage in order to accommodate the concerns of the EU and some G-77 countries. The Chairman finally settled the argument with a semantic trick - by changing the order of sentences. These editorial changes point to a compromise reached between the major opponents. After long discussions, the US representative, in a carefully worded intervention prior to the adoption of the article, assured that "any country has the opportunity to be involved in shaping the rules before the first trading rights can be applied". Chairman Estrada, when finally gavelling down any further opposition and declaring the provision for adopted, expressly referred to Article 17 as having "the characteristics of an interim arrangement". Trading therefore will not start before the adoption of rules by the COP.

b) Who is going to trade?

After having said above that the Parties to the Kyoto Protocol are the primary participants in a trading regime, it is not yet clear whether private bodies may participate in trading. Article 6.3 on Joint Implementation ("legal entities") and Article 12.9 on the CDM ("private and/or public entities") both provide for the involvement of participants other than Parties. Contrary to the final language in Article 17, the draft text until the last day still contained a provision which gave Parties the possibility to authorize "legal entities" to participate. This question will therefore have to be addressed by future Conferences of the Parties.

From an economical point of view, participation by the private sector would greatly enhance the potential for cost-effectiveness and efficiency under a trading regime. It does, however, complicate the system to a considerable extent and would thus require much more thoroughly elaborated rules than governmental emissions trading. Participation of non-governmental actors is conceivable in a variety of forms: first, national governments could allocate parts of their assigned amounts to individual firms which could then be enabled to either sell their unused parts if they over-comply with their obligations, or to buy the required amounts on the emissions market if they fail to reach their target. Governments could, second, allow certain companies to act as brokers and to buy and sell emission rights like any other commodity. This would considerably increase the number of actors in the market and might provide for a "real" market where prices truly reflect the costs of abatement. Private companies - or non-governmental organizations - might furthermore become involved in the monitoring and supervision of trades.

There are, however, some problems connected with the involvement of private actors. First, the number of participants in the trading system might become too large and pose problems for the monitoring and enforcement of the rules. Second, the permission for private actors to participate fully in emissions trading might ultimately undermine the "voluntary" national targets that governments have pledged for themselves. In the case of Germany, the national target of minus 25 percent in 2005 for CO2 is considerably higher than the international obligation. If private companies would be allowed to trade freely, the German government would have difficulties achieving its national target since it could not control the internationally traded flow of emission rights.

And third, for those proponents of Emissions Trading who want to start trading soon in order to gain experience, involving private organizations might delay the start of such trading, because the rules of the game would have to be much more elaborate. Finally, whatever rules on participation in Emissions Trading will be adopted, the national governments that are Party to the Kyoto Protocol remain ultimately responsible not only for achieving their targets, but also for the correct behavior of those private entities they have permitted to participate in Emissions Trading.

c) What can be traded?

The next open question concerns the commodity that will be traded. As indicated above, a common unit will have to be established in order to provide a common denominator for the "parts of an assigned amount" of Emissions Trading and the "emission reduction units" generated by Joint Implementation. The "certified emission reductions" accruing under the Clean Development Mechanism are not tradable under the present rules since they cannot be sold to third parties. Nevertheless, keeping them completely out of the system will require an express decision by the Conference of the Parties, since those credits will be added to the assigned amount of a Party according to Article 3.12 of the Kyoto Protocol and will thus increase the national "budget". Therefore, the "part of an amount" that can be traded should be defined as the "assigned amount plus the units generated by Joint Implementation minus those accruing under the CDM."

A more complicated issue is posed by the diversity of gases regulated under the Kyoto Protocol. The question here is whether all of the six gases should be equally tradable. First, while their widely different global warming potentials can well be estimated on the basis of the IPCC's assessment, their adjustment according to new findings would be much more difficult. Any adjustment, even if it would only take effect after the end of a commitment period, would undermine confidence in the commodity and could mean severe financial losses for investors. Even more difficulties are created by the uncertainty surrounding the inventories of many of those gases in various sectors. Uncertainties in the range of 20 to 90 percent would prevent confidence in the market and keep investors away - not to mention the adverse ecological consequences.

It therefore appears wise to restrict the tradable "parts of an assigned amount" of a country to those gases whose emissions are well monitored. This is first of all carbon dioxide resulting from fossil fuel combustion and possibly some of the industrial gases. All other gases from other sectors should only be allowed to enter the system at a later stage, once these uncertainties have been removed. This delay would also provide for greater certainty as regards their global warming potentials. Furthermore, the tradable certificates should be issued for each of the gases separately in order to avoid a mixing of "credible" commodities with others where substantial uncertainty remains. Also for reasons of uncertainty, the absorption of greenhouse gases by sinks should not be allowed to result in a tradable commodity that could enter the system.

d) How much can be traded?

The Kyoto Protocol determines that any trading shall be "supplemental" to domestic actions for the purpose of meeting the obligations. The insertion of this clause was an attempt by the European Union to limit the possibility for countries to "buy themselves out" of their obligations. Putting limits on trade, although leading to greater inefficiency of the market, could be a legitimate concern under any trading system because of an overriding political emphasis on domestic action. The main reason for a limit is, however, posed by the significant emission reductions in Russia and the Ukraine due to the economic decline after transformation to market economies, the so-called "hot air".

This "hot air" could have the potential to transform Article 17 into a "loophole" and thus considerably weaken the Kyoto targets. It could furthermore distort the market, lead to declining prices and make mitigation efforts by Western industrialized countries unprofitable compared to the possibility to cheaply buy the required emission permits. It would thereby take away an incentive for early action and lead to a continuation of business-as-usual policies in these countries. Moreover, using these emission reductions would increase the overall emission of greenhouse gases until long after the year 2000. Limiting the amount of "hot air," on the other hand, would increase the overall reduction target of 5.2 percent (Article 3.1), since this is calculated by taking the large reductions in Eastern Europe and Russia into account.

There are several ways to deal with this "hot air" problem and the future negotiations on "principles, rules and guidelines" for a trading system will have to deal with it. One possibility, favored by the European Union, is presented by the introduction of a cap on that part of the commitment that can be achieved through trading. The question in this case remains how to define the "part" - as a percentage of the obligation incorporated in Annex B of the Protocol or, an interpretation the US seems to favor, as a percentage of the obligation compared to the business-as-usual scenario. Whereas some countries like Germany favored a 50 percent cap on the use of all flexibility instruments, the Union at the moment appears to be moving towards a fixed percentage of 1990 emissions in the range of 2 to 5 percent.

Other means to deal with the problem might consist of a limit to the seller's capacity, like a prohibition to sell those parts of emission reductions that have been achieved prior to the start of trading, to allow only a partial trading with these assigned amounts or to limit the amount to the percentage of reductions that have been achieved by domestic measures. This might, however, take away incentives for early action on the reduction of GHGs and would also severely affect the EU, since its burden sharing agreement is dependent on the early reductions achieved by countries such as Germany or the UK.

Another proposal that has been put on the table would raise a fee for all transactions under the trading regime, with different levels for intra-OECD and other trades. The easiest way to get rid of the "hot air" problem by simply raising the obligations for Russia and the Ukraine unfortunately does not seem to be a politically feasible option.

Emissions Trading and Non-compliance

The enforcement of the rules is one of the most crucial elements of a trading system. This is evidenced for example by the first analyses of the system established in the US for the trading of sulfur dioxide emission rights. Under the supervision of the Environmental Protection Agency, a very complex system for verification, tracking of allowances and enforcement has been put in place. Unfortunately, under the conditions of today's international politics and law, such a foolproof regime is not a realistic option. This does not, however, dispense with the necessity to establish a rigorous regime for the international trading of carbon dioxide. Procedures and institutions to monitor, verify, assess compliance and enforce the rules in cases of non-compliance must have top priority in the establishment of the trading regime.

The reasons for this are twofold. First, as with other provisions dealt with above, the objective of the climate regime demands that the rather modest obligations of industrialized countries to reduce or limit emissions be fulfilled. Any failure to do so would undermine the climate regime, lead to a much-prolonged reduction in the emissions of greenhouse gases and cast serious doubt on the willingness of industrialized countries to tackle the threat of climate change. This in turn would not bode well for the much-needed involvement of developing countries at a later stage. Second, the credibility of the trading regime itself is at stake. Since trust in the market and the correct behavior of participants is one of the main pillars of this regime, the failure to detect instances of misdemeanor and ultimately to sanction such behavior would prevent the establishment of a stable and thriving market.

Such a compliance system demands several components: first, monitoring and reporting procedures must be in place. The Kyoto Protocol, in Articles 5 and 7, contains the basis for such procedures that need to be adapted to the needs of a trading regime. Those amended procedures need to provide the information required for the close tracking of trades. Compliance with these requirements must furthermore be a precondition for participation in Emissions Trading. Second, the correctness of the data submitted must be assessed. One of the cornerstones of such a procedure, the verification function, has already been incorporated in the Protocol (Article 8). The expert review teams established in this article might also be enabled to check the data submitted on trades, nationally as well as internationally. Additionally, certified auditors linked to the Secretariat could perform some of those functions.

As a third component, the appropriate reaction to a presumed infraction must be determined. This function will ultimately have to lie with the Conference of the Parties to the Kyoto Protocol. Based on a recommendation of a smaller body - like the Implementation Committee of the Montreal Protocol - the supreme body of the Kyoto Protocol will have to decide not only whether to react, but furthermore on the consequences of non-compliance. The Protocol in Article 8.5 already contains a rudimentary procedure to that effect - the Conference of the Parties shall "consider the information received and take decisions on any matter required for the implementation" of the Kyoto Protocol.

Unfortunately, Article 18 on non-compliance does not lend itself well to the establishment of a sanctions regime for Emissions Trading. Although it requires the Parties to "approve procedures and mechanisms to determine and address cases of non-compliance" with the Protocol, it contains a clause that makes "binding consequences" dependent on a formal amendment. Since an amendment to the Protocol requires ratification by at least three-fourths of the parties, its entry into force appears to be very unlikely or would at least take an unacceptably long time. Even if such "consequences" would be adopted and applied provisionally in the interim period until the amendment becomes effective, its legal status would probably be diminished due to the above mentioned clause.

The appropriate sanctions - including those with "binding consequences" - should therefore be incorporated into the trading regime. This is possible because Article 18 only talks about binding consequences "under this article". Including sanctions into the Emissions Trading regime would thus have the beneficial side effect of providing the Parties to the Kyoto Protocol with a much needed enforcement regime for the reduction and limitation commitments. The political resistance to hard sanctions notably by the US, which was responsible for the mutilation of Article 18, will still be strong. However, the necessity for such instruments will clearly be evident to US negotiators (and many in the US Congress) and thus meet with less objections.

Non-compliance with the rules of the trading system is conceivable in a variety of ways. Participants may fail to fulfil the reporting or monitoring obligations, they may violate the trading rules or cheat and, ultimately, they may fall into non-compliance because at the end of the commitment period they have exceeded their assigned amount of emissions. In order to provide clarity, a non-exhaustive list of possible cases of non-compliance would be helpful.

A great number of possible consequences for infractions of the rules of trading have been outlined in the literature on emissions trading, but some of them - like personal fines and imprisonment for the management of companies involved - are reserved for domestic enforcement. Should a Party decide to involve private actors, the provision of adequate sanctions at the national level should be compulsory. On the international level, financial sanctions are extremely rare. However, in order to facilitate such fines with regard to non-compliant states, a certain financial deposit should be required for the permission to trade. In case of non-compliance, such deposit might be (partly) lost and go into a fund to finance mitigation and adaptation measures in developing countries.

Emissions trading itself provides the best means for sanctions. First of all, the parts of assigned amounts can be devalued, either partly or completely. There are basically two approaches, depending on whether liability lies with the seller or with both, buyer and seller (shared liability). Under the traditional rules of international law, the seller only would be responsible for the correctness of his behavior. Sanctions would thus be directed towards the country that has sold parts of its assigned amount although it has breached the rules. In the framework of domestic legal systems, this approach is usually sufficient, since penalties for non-compliance can be severe and will be enforced by the judicial and executive branches of government.

Under the conditions of international law, however, this principle of "seller beware" might not work well due to the relative absence of enforcement powers against states. In this case, the "buyer beware" principle creates an environment where any buyer has an interest in observance of the rules by the seller. For example, if a selling country is in danger of exceeding its assigned amount at the end of a commitment period and its parts of an assigned amount may be devalued afterwards, buying them will entail a great risk. The buyer would thus abstain from acquiring emission rights from this country or would do so to a much lower price. Observing the rules and staying within the limits of assigned amounts allocated to it thus becomes a prime interest of any country participating in Emissions Trading. Of course, this approach demands the institutional and procedural devices for detecting non-compliant behavior as outlined above.

Such a "buyer beware" approach demands an early warning system where a supervisory institution raises "yellow" or "red" flags once it becomes apparent that a country might exceed its assigned amounts. Based on yearly reports, this body (this might be the climate Secretariat) would be in a position to assess the performance of all participants and issue a "rating". Any country that stays within the "safe zone" might freely sell parts of its assigned amount. Should a country enter the "danger zone", the supervisory institutions will issue a warning and raise the "yellow flag". This will indicate to potential buyers that its emission rights are in danger of being devalued after the commitment period. Any country that enters the "forbidden zone" might furthermore be barred from trading.

Another possible sanction was introduced by the US under the term "borrowing", but was not accepted by other Parties because it might actually provide a disincentive to comply. According to this concept, the amount of emissions exceeded by a country in a given commitment period will be subtracted from the assigned amount of the next period. Under a strengthened concept of "penalty borrowing", however, a substantial percentage would be added to the amount to be subtracted as a "penalty" in the range of 50 percent. Whereas this might certainly induce for many countries some motivation not to exceed the "budget", it does entail some risks as well. First, the mere possibility of such borrowing could lead a government to the conclusion that a "wait and see"-strategy might be worth following, maybe waiting for some ominous "technological breakthrough" in the abatement of emissions. Second, this kind of sanction does not provide for solutions in case of successive non-compliance. After the second instance of non-compliance, some more traditional sanctions would have to be applied.

For more information contact:

Dr. Hermann E. Ott, Senior Fellow, Climate Policy, Wuppertal Institute for Climate, Environment and Energy, Wuppertal, Germany
Tel.: + 49-202-2492 246 (-129 = Secretariat); Fax: + 49-202-2492 250; e-mail: hermann.ott@wupperinst.org; Internet: http://www.wupperinst.org