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the European Union's Emissions Trading Scheme and the Kyoto Protocol's 
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Report to Congressional Requesters: 

United States Government Accountability Office: 
GAO: 

November 2008: 

International Climate Change Programs: 

Lessons Learned from the European Union's Emissions Trading Scheme and 
the Kyoto Protocol's Clean Development Mechanism: 

GAO-09-151: 

GAO Highlights: 

Highlights of GAO-09-151, a report to congressional requesters. 

Why GAO Did This Study: 

International policies to address climate change have largely relied on 
market-based programs; for example, under the European Union’s 
Emissions Trading Scheme (ETS) phase I (2005 to 2007) carbon dioxide 
emissions reductions were sought by setting a cap on each member 
state’s allowable emissions and distributing tradable allowances to 
covered entities, such as power plants. Beginning operation in 2002, 
the Kyoto Protocol’s Clean Development Mechanism (CDM) has relied on 
offsets, allowing certain industrialized nations to pay for emission 
reduction projects in developing countries—where the cost of abatement 
may be less expensive—in addition to reducing emissions within their 
borders. 

Legislative proposals to limit greenhouse gas emissions are under 
consideration in the United States. In this context, GAO was asked to 
examine the effects of and lessons learned from (1) the ETS phase I and 
(2) the CDM. GAO worked with the National Academy of Sciences to 
identify experts in market-based programs and gathered their opinions 
through a questionnaire, interviewed stakeholders, and reviewed 
available information. 

What GAO Found: 

According to available information and experts, the ETS phase I 
established a functioning market for carbon dioxide allowances, but its 
effects on emissions, the European economy, and technology investment 
are less certain. Nonetheless, experts suggest that it offers lessons 
that may prove useful in informing congressional decision making. By 
limiting the total number of emission allowances provided to covered 
entities under the program and enabling these entities to sell or buy 
allowances, the ETS set a price on carbon emissions. However, in 2006, 
a release of emissions data revealed that the supply of allowances—the 
cap—exceeded the demand, and the allowance price collapsed. Overall, 
the cumulative effect of phase I on emissions is uncertain because of a 
lack of baseline emissions data. The long-term effects on the economy 
also are uncertain. One concern about design and implementation was 
that the economic activities associated with emissions from covered 
entities would shift from the European Union to countries that do not 
have binding emission limits––a concept known as leakage. However, 
leakage does not appear to have occurred, in part because covered 
entities did not purchase allowances but received them for free. The 
effect of the ETS on technology investment also is uncertain but was 
likely minimal, in part because phase I was not long enough to affect 
such investments. Phase I of the ETS offers three key lessons: (1) 
accurate emissions data are essential to setting an effective emissions 
cap; (2) a trading program should provide enough certainty to influence 
technology investment; and (3) the method for allocating allowances may 
have important economic effects, namely, free allocation may distribute 
wealth to covered entities whereas auctioning could generate revenue 
for governments. 

According to available information and experts, the CDM has provided 
flexibility to industrialized countries with emission targets and has 
involved developing countries in efforts to limit greenhouse gas 
emissions, but the program's effects on emissions are uncertain, and 
its effects on sustainable development have been limited. Nonetheless, 
the CDM’s effects reveal key lessons that can help inform congressional 
decision making. Specifically, the CDM has provided a way for 
industrialized countries to meet their targets that may cost less than 
reducing emissions at home; however, available evidence suggests that 
some offset credits were awarded for projects that would have occurred 
even in the absence of the CDM, despite a rigorous screening process. 
Such projects do not represent net emission reductions and can 
compromise the integrity of programs––including the ETS––that allow the 
use of CDM credits for compliance. We also found that the cost-
effectiveness and overall scale of emission reductions are limited by 
the current project approval process, although proposed changes may 
improve its effectiveness. Key lessons from the CDM include: (1) the 
resources necessary to obtain project approval may reduce the cost-
effectiveness and quality of projects; (2) the need to ensure the 
credibility of emission reductions presents a significant regulatory 
challenge; and (3) due to the tradeoffs with offsets, the use of such 
programs may be, at best, a temporary solution. 

What GAO Recommends: 

GAO is not recommending executive action. However, in deliberating 
legislation for emissions trading, Congress may wish to consider the 
lessons learned from the ETS and the CDM. 

To view the full product, including the scope and methodology, click on 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-09-151]. For more 
information, contact John B. Stephenson at (202) 512-3841 or 
stephensonj@gao.gov. 

[End of section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

EU Emissions Trading Scheme Established a Carbon Market and Provides 
Lessons That Could Inform U.S. Decision Making on Climate Change 
Policy: 

The CDM's Environmental and Economic Effects Provide Important Lessons 
That Can Inform Congressional Deliberations on Climate Change Policy: 

Concluding Observations: 

Matters for Congressional Consideration: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: Summary of Joint Implementation: 

Appendix III: Panel of Experts: 

Appendix IV: GAO Contact and Staff Acknowledgments: 

Figures: 

Figure 1: EUA 2007 Prices: 

Figure 2: Net Positions of Covered Entities in EU Member States in 
Phase I: 

Figure 3: Price Differential between CERs and EUAs: 

Figure 4: CDM Pipeline: 

Figure 5: Distribution of CERs by Host Country: 

Figure 6: Summary of Responses from Expert Panel: Effects of CDM on 
Public Awareness: 

Figure 7: Additionality in the CDM: 

Figure 8: CDM Project Cycle: 

Abbreviations: 

CER: Certified Emissions Reduction: 

CDM: Clean Development Mechanism: 

EU: European Union: 

ERU: Emission Reduction Unit: 

ETS: Emissions Trading Scheme: 

EUA: European Union Allowance: 

IPCC: Intergovernmental Panel on Climate Change: 

JI: Joint Implementation: 

NAS: National Academy of Sciences: 

UN: United Nations: 

UNFCCC: United Nations Framework Convention on Climate Change: 

[End of section] 

United States Government Accountability Office:
Washington, DC 20548: 

November 18, 2008: 

The Honorable Joe Barton: 
Ranking Member: 
Committee on Energy and Commerce: 
House of Representatives: 

The Honorable John Shimkus: 
Ranking Member: 
Subcommittee on Oversight and Investigations: 
Committee on Energy and Commerce: 
House of Representatives: 

The Honorable Darrell Issa: 
Ranking Member: 
Subcommittee on Domestic Policy: 
Committee on Oversight and Government Reform: 
House of Representatives: 

In 2005, the European Union's (EU) member states implemented the 
world's largest program to limit emissions of carbon dioxide--the most 
significant greenhouse gas--from the electric power and certain 
industrial sectors of their economies. The program, known as the 
Emissions Trading Scheme (ETS), relies on a cap-and-trade model similar 
to that used in the United States to limit airborne emissions of sulfur 
dioxide that cause acid rain and is the first international carbon 
dioxide trading program. Under the ETS, the EU member states determine 
the total amount of allowable carbon dioxide emissions, distribute 
these allowances to covered entities such as power plants, oil 
refineries, and other manufacturing facilities, and enable these 
covered entities to trade allowances. The first trading period--phase 
I--ran from 2005 to 2007; the second phase, currently underway, runs 
from 2008 to 2012.[Footnote 1] Some observers view the ETS as a 
flexible and cost-effective tool to reduce emissions. Alternatively, 
other observers have said that the first ETS phase did not decrease 
emissions, imposed high costs on industrial entities and consumers, and 
may adversely affect the international competitiveness of European 
industries. As the U.S. Congress considers legislation intended to 
address climate change, the EU's experience implementing the ETS may 
prove useful in informing Congress's decisions. 

The EU's implementation of the ETS stems from commitments its member 
states and the EU made under the Kyoto Protocol (the Protocol), an 
international agreement to minimize the adverse effects of climate 
change, which was developed within the United Nations Framework 
Convention on Climate Change (UNFCCC).[Footnote 2] To date, 182 
countries--including all of the EU member states--have ratified the 
Protocol, which set binding emissions targets for 37 industrialized 
countries and the European community, covering carbon dioxide and five 
other greenhouse gases.[Footnote 3] For context, the EU member states 
collectively ranked as the world's third-largest emitter of carbon 
dioxide in 2004, behind the United States and China.[Footnote 4] The 
U.S. signed the Protocol in 1998 but is not bound by the Protocol's 
terms because it was not submitted to the Senate for ratification and 
therefore has not been ratified. 

The Protocol identifies several mechanisms available to help meet the 
binding targets, including emissions trading and the Clean Development 
Mechanism (CDM).[Footnote 5] Emissions trading allows countries with 
emissions lower than the level specified in the Protocol to sell excess 
allowances to countries with emissions exceeding their Kyoto targets, 
thereby creating a commodity in greenhouse gases (known as a carbon 
market). Emissions trading can help minimize abatement costs by 
enabling covered entities that face relatively high costs in reducing 
their emissions to buy excess allowances from other entities with lower-
cost opportunities. 

The CDM allows countries with binding targets under the Protocol to 
implement projects that reduce or avoid emissions--such as the 
construction of renewable energy infrastructure--in a developing 
country that does not have a binding emissions target under the 
Protocol. The logic of the CDM is that it provides a cost-effective way 
for industrialized nations to reduce emissions of greenhouse gases, 
which may cost less in developing nations, while also promoting 
sustainable development in countries that host projects. CDM projects 
earn credits, each equivalent to 1 metric ton of carbon dioxide, that 
an industrialized country sponsoring the project can sell or use for 
compliance with its Kyoto target. These credits are known as Certified 
Emissions Reductions (CER) or simply as "carbon offsets."[Footnote 6] 

In accordance with the Protocol, CDM projects must meet several key 
requirements. For example, CDM projects must provide real, measurable, 
and long-term benefits related to the mitigation of climate change. In 
addition, projects need to achieve reductions beyond any that would 
occur in absence of the CDM, a concept known as "additionality." Before 
credits are issued, projects must undergo review by national officials 
of the country where the project occurs and have an external party 
validate documentation and verify emission reductions. The Executive 
Board, a UNFCCC regulatory body established by the Protocol, is 
responsible for supervising the CDM. 

The Protocol requires industrialized countries to achieve their binding 
targets between 2008 and 2012. Recognizing this requirement, the EU 
government enacted a law, known as a directive, to establish the ETS, a 
market-based emissions trading program through which member states 
would reduce their carbon dioxide emissions while minimizing any 
adverse effects on economic development and employment.[Footnote 7] The 
ETS began with the first phase to gain experience with emissions 
trading before the Protocol's 2008 to 2012 commitment period and 
operated phase I from 2005 to 2007. Phase I included approximately 
11,000 electric power and industrial installations in 25 member states, 
which accounted for about half of the EU's carbon dioxide emissions. 
[Footnote 8] 

Under the ETS, each member state was required to propose its own carbon 
dioxide emissions cap and allocation scheme in a National Allocation 
Plan. The ETS Directive established some general criteria for the 
National Allocation Plans but gave member states flexibility in how 
they determined their cap and methods for allocating allowances--such 
as free distribution or auctioning--to covered entities. For phase I, 
the EU directive allowed member states to auction up to 5 percent of 
their allowances, but 21 member states chose to distribute all 
allowances free of charge. After documenting the cap and allocation 
plan in its National Allocation Plan, each member state submitted it to 
the European Commission--the EU's executive branch--for approval. The 
aggregated national caps from the 25 approved National Allocation Plans 
represented the total level of emissions allowed from facilities 
covered under the ETS, also referred to as the cap. 

Under the ETS, covered entities trade carbon dioxide allowances (known 
as European Union Allowances, or EUAs) with other covered entities; 
entities that are not covered under the ETS also may trade EUAs if they 
set up a trading account in a member state's registry, an electronic 
system that tracks ownership of allowances. To further minimize costs, 
covered entities are allowed to purchase a limited number of CDM 
credits (CERs) and use them toward compliance with their caps. Covered 
entities can trade EUAs and CERs in several ways. For example, they may 
buy and sell directly with one another or use exchanges and other 
trading platforms operated by third parties. Trading activity in CERs 
and EUAs has increased steadily in the past several years and accounted 
for nearly all of the financial value of the global carbon market in 
2007. According to the World Bank, the financial value of EUAs and CERs 
totaled about $63 billion in 2007, of which approximately $50 billion 
consisted of EUAs and $13 billion consisted of CERs.[Footnote 9] 

An examination of the environmental, economic, and technological 
effects of the first ETS phase and the CDM provides a number of useful 
lessons that could inform decision making in the United States, where 
numerous legislative proposals to limit greenhouse gas emissions are 
under consideration. Within this context, we examined (1) what experts 
and available information indicate about the effects of the EU ETS 
phase I and the lessons learned that can inform congressional 
deliberation on climate change policies, and (2) what experts and 
available information indicate about the effects of the Kyoto 
Protocol's CDM and the lessons learned that can inform congressional 
deliberation on climate change policies. 

To respond to these objectives, we reviewed information on the ETS and 
CDM available from the EU, the UN, the academic literature, and market 
research firms. We also conducted semistructured interviews with 
international government officials; industry representatives; 
environmental advocacy organizations; market traders; researchers; and 
owners, developers, and auditors of CDM projects. Following our data 
collection and interview process, we then collaborated with the 
National Academy of Sciences (NAS) to recruit a panel of experts to 
assist in identifying the key themes and lessons learned from the ETS 
and CDM that could influence decision making in the United States. The 
26 experts were recruited based on their experience and expertise with 
international climate change programs and their knowledge of the U.S. 
policy development process. We engaged the experts using a Web-based 
questionnaire that included both open-and closed-ended questions. 
Finally, we identified important themes through a content analysis of 
responses to the open-ended questions, and summarized responses to the 
closed-ended questions. We conducted our work from October 2007 to 
November 2008. 

Results in Brief: 

According to available information and experts, the primary effect of 
the first ETS phase was to establish a functioning carbon market for 
allowances, but its effects on emissions, the European economy, and 
technology investment are less certain. Nonetheless, experts suggest 
that phase I offers important lessons that can inform congressional 
decision making. Specifically: 

* Effects. The primary effect of the first ETS phase was to establish a 
functioning carbon market for allowances. By limiting the total number 
of allowances under the program and enabling covered entities to sell 
or buy allowances to cover their emissions, the ETS used market forces 
to set a price on carbon emissions that fluctuated based on changes in 
supply and demand. Accordingly, the price collapse after the release of 
emissions data in 2006 showed that phase I was overallocated--the cap 
exceeded actual emissions. That is, the supply of allowances was 
greater than the demand. This resulted primarily from uncertainty 
surrounding the data used to set the emissions cap and distribute 
allowances. Moreover, the ETS's cumulative effect on emissions across 
the EU member states is uncertain. While several researchers and about 
half of the experts concluded that the ETS resulted in a cumulative 
decrease in emissions compared to a business-as-usual scenario, the 
European Commission told us that data limitations preclude definitive 
conclusions about the ETS's effect during phase I. Overallocation of 
allowances posed challenges in assessing the program's long-term 
economic effects--in particular whether economic activities associated 
with emissions of covered entities shifted to countries that have not 
adopted binding emissions limits, a concept known as leakage. According 
to available information, leakage did not likely occur because, for 
example, facilities received allowances for free, based on projected 
emissions, and the cap exceeded emissions. In addition, the effect of 
the first ETS phase on technology development and innovation is 
uncertain but likely minimal in part because the compressed trading 
phase did not provide enough time to affect investments in clean 
technology. The price collapse of carbon allowances also reduced the 
incentive for covered entities to invest in new technologies. 

* Lessons learned. According to available information and experts, the 
ETS revealed lessons about three key aspects of phase I, including data 
requirements for setting an effective emissions cap, how program design 
features may influence the effectiveness of emissions trading, and 
about the economic impacts. First, accurate emissions data are 
essential to setting an effective emissions cap and achieving the 
intended environmental objectives. Second, a trading program should 
cover a long enough time period to influence technology investment 
decisions. Third, the ETS demonstrated that the method of allowance 
allocation can have important effects for government and regulated 
industries. For example, free allocation can create and transfer 
substantial amounts of wealth to program participants whereas an 
auction may generate revenue that governments can use for a variety of 
purposes, such as reducing the tax burden for low-income individuals or 
supporting research and development of less-carbon-intensive 
technologies. 

According to available information and experts, the CDM has helped 
industrialized countries make progress toward achieving their emissions 
targets at less cost, and has involved developing countries in these 
efforts, but the program's effects on emissions are uncertain and its 
impact on sustainable development has been limited. Moreover, the cost- 
effectiveness of emission reductions achieved by the program and the 
overall scale of these reductions are limited by the existing project 
approval process, although proposed improvements may address these 
challenges. Key lessons from the international experience with the CDM 
could help inform congressional decision making. Specifically: 

* Effects. The CDM can lower costs for nations with binding targets 
under the Kyoto Protocol and entities covered by the EU ETS by allowing 
them to earn credits for projects that cut emissions in developing 
nations, where reductions may be cheaper, and use these credits toward 
their emission target or cap. The CDM also has involved developing 
nations, primarily China and India, in the global carbon market by 
providing them with experience in emissions trading. Overall, the net 
effect of the CDM on international emissions is uncertain, in part 
because it is nearly impossible to ensure that projects are additional-
-that is, that the emission reductions would not have occurred in the 
absence of the CDM. The UN has implemented a lengthy, rigorous review 
process, and while this process may provide greater assurance of 
credible projects, available evidence suggests that some credits have 
been issued for emission reduction projects that were not additional. 
Nonadditional projects, in turn, can compromise the integrity of 
programs that allow the use of CDM credits for compliance, such as the 
ETS, because these projects allow covered entities to increase their 
emissions without a corresponding reduction in a developing country. In 
addition, the overall effect of the CDM on sustainable development has 
been limited, although available information indicates a modest impact 
on technology transfer. Finally, many stakeholders and experts 
expressed concern that the CDM's approval process was unclear, 
impractical, and resource intensive, and some said that the extensive 
requirements have deterred otherwise legitimate projects. However, 
recognizing the potential benefits of the CDM, the experts recommended 
possible reforms and alternatives to more effectively achieve the CDM's 
goals, including streamlining the measurement and review processes, 
targeting the CDM toward certain countries and industry sectors, and 
providing incentives for developing countries to set their own emission 
targets. 

* Lessons learned. The international experience with the CDM has 
provided key lessons regarding the cost-effectiveness and environmental 
effects of offset programs, as well as the tradeoffs that can occur as 
a result of their use. First, while the CDM may reduce compliance costs 
for covered entities, it may not be a cost-effective means of achieving 
emission reductions in developing nations, due primarily to high 
transaction costs imposed on project participants. Second, it is 
important to ensure that each project represents real, measurable 
emission reductions, and that nonadditional projects are not used in 
lieu of real reductions mandated by a cap-and-trade program. Due to 
inherent challenges in measuring offsets, however, it may be difficult 
to provide such assurances. Finally, while proposed improvements may 
help to streamline the CDM and improve its effectiveness, offset 
programs present significant tradeoffs for mandatory emission reduction 
programs that use them for compliance, and therefore may be best used 
as a temporary means to help transition developing countries into a 
more comprehensive climate change strategy. 

We are not recommending executive action. However, in deliberating 
legislation intended to limit greenhouse gas emissions through 
emissions trading and the use of carbon offsets, congress may wish to 
consider lessons learned from the ETS and CDM. Regarding emissions 
trading, Congress may wish to consider (1) the importance of ensuring 
the availability and reliability of historic emissions data, (2) the 
need for long-term certainty to encourage investments in less-carbon- 
intensive technologies, and (3) how the means of distributing 
allowances to emit greenhouse gases--such as free allocation versus 
auctioning--create and redistribute substantial wealth. 

Regarding the CDM and use of offsets for compliance, Congress may wish 
to consider: (1) that it may be possible to achieve the CDM's 
sustainable development goals and emissions cuts in developing 
countries more directly and cost-effectively through a means other than 
the existing mechanism; (2) that the use of carbon offsets in a cap- 
and-trade system can undermine the system's integrity, given that it is 
not possible to ensure that every credit represents a real, measurable, 
and long-term reduction in emissions; and (3) that while proposed 
reforms may significantly improve the CDM's effectiveness, carbon 
offsets involve fundamental tradeoffs and may not be a reliable long- 
term approach to climate change mitigation. 

Background: 

Greenhouse gases--including carbon dioxide, methane, nitrous oxide, and 
synthetic chemicals such as fluorinated gases--trap heat in the 
atmosphere and prevent it from returning to space. The heat-trapping 
effect, known as the greenhouse effect, moderates atmospheric and 
surface temperatures, keeping the earth warm enough to support life and 
varies depending on the gas. Each unit of the non-carbon-dioxide gas 
generally has a greater warming effect than each unit of carbon 
dioxide, although carbon dioxide is the most prevalent anthropogenic 
greenhouse gas and has the greatest overall effect on warming.[Footnote 
10] According to the Intergovernmental Panel on Climate Change (IPCC)-
-an organization within the UN that assesses scientific, technical, and 
economic information on the effects of climate change--global 
atmospheric concentrations of these greenhouse gases have increased 
markedly as a result of human activities over the past 200 years, 
contributing to a warming of the earth's climate. 

Climate change is a long-term and global issue because greenhouse gases 
disperse widely in the atmosphere once emitted and can remain there for 
an extended period of time. Among other potential impacts, climate 
change could threaten coastal areas with rising sea levels, alter 
agricultural productivity, and increase the intensity and frequency of 
floods and tropical storms. The effect of increases in atmospheric 
concentrations of greenhouse gases and temperature on ecosystems and 
economic growth is expected to vary across regions, countries, and 
economic sectors. 

One of the greatest challenges underlying policies to address climate 
change is reducing greenhouse gases while meeting rising energy 
demands. Energy demands are met largely through fossil fuel combustion, 
which releases greenhouse gases--primarily carbon dioxide. In fact, 
fossil fuel combustion accounts for the largest share of growth in 
greenhouse gas emissions, according to the IPCC. For example, 
greenhouse gas emissions from electricity and heat production grew 145 
percent between 1970 and 2004; emissions from road transportation 
increased 120 percent. Other sources of greenhouse gas emissions 
include agricultural activities, transportation, forestry, waste 
management, and residential and commercial activities. 

According to the IPCC, in 2004, developed countries, including the 
United States, constituted 20 percent of global population, but were 
responsible for nearly half of global greenhouse gas emissions. The 
total emissions from some developing countries, which have lower per 
capita emissions but larger populations, have begun to approach the 
total emissions from developed countries, which tend to have higher per 
capita emissions and smaller populations. Recent economic development 
in nations such as China and India has reduced poverty but also has 
increased energy use, which has caused rapid growth in emissions. In 
the absence of mitigation policies[Footnote 11]--i.e., policies that 
would reduce greenhouse gas emissions--the IPCC projects that between 
2000 and 2030, two-thirds to three-quarters of the projected increase 
in global carbon dioxide emissions will occur in developing countries, 
although per capita emissions will remain substantially lower than 
those of developed countries.[Footnote 12] The IPCC also projects that 
compared to 2000, global greenhouse gas emissions will increase between 
25 percent and 90 percent by 2030 in the absence of new climate 
mitigation policies. 

According to the IPCC, climate mitigation policies are essential to 
facilitate a transition to a less-carbon-intensive energy 
infrastructure and stabilize the climate. In the short term, policies 
designed to increase energy efficiency or induce a switch to less- 
carbon-intensive fuels, such as from coal to natural gas, can reduce 
emissions. In the long term, however, major technology changes will be 
needed to establish a less-carbon-intensive energy infrastructure. To 
that end, climate mitigation policies may require facilities to achieve 
specified reductions or provide an incentive to reduce emissions by, 
for example, establishing a price on emissions. The policies that set a 
price on emissions, also known as market-based programs, include 
emissions trading and emissions taxes. 

The cost for facilities to reduce emissions depends on numerous factors 
that may vary by facility, such as the age of capital equipment. Under 
an emissions trading program, the cost of an allowance to emit 
greenhouse gases influences each facility's decision about whether and 
how much to reduce emissions. Because reduction costs vary among the 
facilities, some will choose to reduce emissions and sell excess 
allowances while others will opt to purchase allowances to cover 
emissions. According to economic theory, this will result in reductions 
at the facilities with the lowest costs. As the emissions cap becomes 
stricter, the supply of allowances decreases and causes prices to rise. 
As a result, the incentive to reduce emissions increases. In short, the 
allowance price is key to achieving a net reduction in emissions. 

A problem may arise, however, if economic activity similar to that 
covered under one country's market-based program is not likewise 
subject to binding carbon limits in another country. This can lead to 
the movement of economic activities associated with emissions from 
countries that have adopted binding emissions limits to countries that 
have not done so. This geographic displacement of emissions is a 
concept known as leakage. Overall, leakage could impede progress toward 
the environmental objectives of a market-based program by shifting 
emissions to areas without a binding carbon limit. As allowance prices 
rise, production may be shifted abroad to existing competitors or new 
firms; in addition, covered entities may shift some of their production 
to facilities that exist in countries without binding carbon dioxide 
limits. 

Many countries, such as the member states of the EU, have begun to 
mitigate or reduce greenhouse gas emissions by adopting market-based 
policies such as carbon taxes, cap-and-trade programs, and offset 
programs, as well as other policies, including energy efficiency 
standards; voluntary agreements; education campaigns; and research, 
development, and deployment of advanced technologies. Governments also 
may use a portfolio of policies. For example, in the EU, a variety of 
measures are underway to reduce greenhouse gas emissions, including the 
ETS--its cornerstone--as well as measures to promote renewable energy 
sources, implement performance standards intended to improve energy 
efficiency in new buildings, and reduce carbon dioxide emissions from 
new passenger cars. 

The EU--a unique economic and political partnership between 27 
countries--is composed of multiple institutions, including three 
decision-making institutions.[Footnote 13] Two bodies serve as the EU's 
legislative branch--the European Parliament, composed of 
representatives directly elected by EU citizens, and the Council of the 
European Union, composed of a representative from each member state. In 
the environmental field, both bodies must approve legislation for it to 
become law. However, neither branch can initiate legislation; they may 
act only on legislative proposals submitted by the European Commission, 
which is the EU's executive branch. Although each member state is 
represented on the Commission, Commission members serve the common EU 
interest rather than representing their member state.[Footnote 14] In 
addition to proposing legislation, the Commission ensures proper 
implementation of EU directives, including those enacted as part of the 
European Climate Change Programme.[Footnote 15] For example, the 
Commission proposed the ETS Directive to establish the Emission Trading 
Scheme, which was amended and then approved by the Parliament and 
Council, and has implemented it by approving member states' National 
Allocation Plans, helping to develop a system to track allowances, and 
assessing progress of the ETS, among other tasks. The Court of Justice 
of the European Communities has considered law suits brought by member 
states challenging the Commission's rejection of National Allocation 
Plans and by covered entities challenging various aspects of the ETS, 
but has otherwise not played a significant role with respect to the 
ETS. 

EU Emissions Trading Scheme Established a Carbon Market and Provides 
Lessons That Could Inform U.S. Decision Making on Climate Change 
Policy: 

According to available information and experts, the primary effect of 
the first ETS phase was to establish a functioning carbon market for 
emissions allowances, but its effects on emissions, the European 
economy, and technology investment are less certain. In particular, 
data limitations make it impossible to know whether phase I reduced 
emissions below the level that would have occurred in the absence of 
the ETS. Nonetheless, experts suggest that phase I offers important 
lessons about program design and implementation that may prove useful 
in informing congressional decision making. 

Creation of the ETS Established a Market for Carbon Allowances: 

The primary effect of the first ETS phase was to establish a 
functioning carbon market for allowances in which emissions caps were 
set and allowances to emit carbon dioxide were distributed, bought, and 
sold. By limiting the total number of allowances under the program and 
enabling covered entities to sell or buy allowances to cover their 
emissions, the ETS used market forces to set a price on carbon 
emissions that fluctuated based on changes in supply and demand. For 
example, EU emissions allowances known as EUAs traded at €8.57 ($10.40) 
per metric ton of carbon dioxide on January 3, 2005; reached a peak 
price of €31.58 ($37.48) per metric ton on April 19, 2006; and then 
collapsed when the 2005 emissions data, which had been verified by 
third parties, showed that phase I was overallocated.[Footnote 16] That 
is, the overall cap exceeded actual emissions--the supply of allowances 
was greater than the demand. The price collapse also resulted partially 
from the fact that covered entities were largely unable to carry unused 
allowances to the next trading phase, a concept known as banking. 
[Footnote 17] The general prohibition on banking allowances, however, 
helped confine the overallocation to phase I because the member states 
set new caps in 2008 and issued new allowances.[Footnote 18] 
Interperiod banking would have given covered entities an incentive to 
reduce emissions during phase I, despite overallocation, and to save 
unused allowances for a later trading phase, which had more stringent 
emissions caps. 

Although the absolute supply of allowances did not change during phase 
I, the market's perception of the balance of supply and demand 
dramatically changed. Prior to the release of 2005 verified emissions 
data in the spring of 2006, ETS participants and market analysts 
expected a shortage of allowances, and allowance prices steadily 
increased. The release of verified emissions data, however, showed that 
the 2005 emissions cap--i.e., the supply of allowances--exceeded actual 
emissions that year, causing the price collapse. See figure 1 for a 
graph displaying the allowance price trends in phase I. 

Figure 1: EUA 2007 Prices: 

[Refer to PDF for image] 

This figure is a line graph depicting the following data: 

EUA 2007 Prices: 

Date: January 2005; 
U.S. Dollars: 10.4. 

Date: April 2005; 
U.S. Dollars: 19.2. 

Date: July 2005 
U.S. Dollars: 32.6. 

Date: October 2005; 
U.S. Dollars: 27.7. 

Date: January 2006; 
U.S. Dollars: 27.8. 

Date: April 2006; 
U.S. Dollars: 33.6. 

Date: July 2006; 
U.S. Dollars: 19.9. 

Date: October 2006; 
U.S. Dollars: 14.8. 

Date: January 2007; 
U.S. Dollars: 6.5. 

Date: April 2007; 
U.S. Dollars: 1.2. 

Date: July 2007; 
U.S. Dollars: 0.2. 

Date: October 2007; 
U.S. Dollars: 0.1. 

Source: Point Carbon (2007). 

[End of figure] 

The demand for allowances, on the other hand, was influenced by covered 
entities' allowance allocation, the cost of carbon dioxide abatement 
options, and the level of carbon dioxide emissions over the course of 
phase I.[Footnote 19] Specifically, the extent to which the initial 
free allocation covered each covered entity's emissions influenced 
demand throughout the ETS market. For example, some covered entities 
were in a net "short" position--they did not receive enough allowances 
from the free allocation to cover annual emissions--while others were 
in a net "long" position--they received a surplus of allowances. The 
covered entities that were short on allowances had to reduce emissions, 
purchase allowances, or both in order to comply with the ETS, whereas 
the long entities could sell or hold onto the excess allowances. 
Footnote 20] The short and long positions of covered entities varied by 
industrial sector and among the member states. 

With respect to industrial sectors, the demand for allowances came 
largely from the power sector. Most power generation facilities were 
short whereas industrial facilities, including iron and steel; 
manufacturing ceramics; and pulp, paper, and board manufacturing were 
long. Member states allocated the shortage to the power sector because 
they believed this sector could reduce emissions at a lower cost than 
covered entities in other sectors. In addition, there were concerns 
that compliance with the ETS would create costs for covered entities 
that compete with facilities outside the EU that are not subject to 
carbon limits. Therefore, member states generally allocated the surplus 
to the globally competitive industrial sectors and the shortage to the 
power sector, which does not generally compete with entities outside 
the EU. 

With respect to member states, the net position of all covered entities 
was long in 19 of the EU member states and short in the rest of the 
member states.[Footnote 21] Specifically, the net position of covered 
entities in Greece, Ireland, Italy, Spain, Slovenia, and the United 
Kingdom was short because the covered entities' annual emissions, on 
average, exceeded the number of allowances in the initial allocation. 
Accordingly, covered entities in these member states purchased 
allowances on the market to cover emissions beyond their allocation. 
The range of short and long positions of covered entities among the 
member states demonstrates that the stringency of the member states' 
caps may have varied. For instance, member states with covered entities 
in a net short position likely established more stringent caps than 
those with net long positions. Figure 2 shows which member states had 
covered entities with net short and net long positions. 

Figure 2: Net Positions of Covered Entities in EU Member States in 
Phase I: 

[Refer to PDF for image] 

This figure contains a map of the EU, with countries indicated in the 
following categories: 

Net long position (0% to less than 10% long): 
* Austria; 
* Belgium; 
* Cyprus; 
* Denmark; 
* Germany; 
* Netherlands; 
* Portugal. 

Net long position (10% to less than or equal to 20% long): 
* Czech Republic; 
* Finland; 
* France; 
* Hungary; 
* Luxembourg; 
* Poland; 
* Slovakia; 
* Sweden. 

Net long position (greater than 20% long): 
* Estonia; 
* Latvia; 
* Lithuania; 
* Malta. 

Net short position (0% to less than 10% short): 
* Greece
* Italy
* Slovenia 

Net short position (10% to less than or equal to 20% long): 
* Ireland; 
* Spain; 
* United Kingdom. 

Source: GAO analysis; MapArt (illustration). 

[End of figure] 

Furthermore, allowance data reveal that while most allowances were 
issued and used within the same member state, transfers of wealth from 
covered entities in short member states to those in long member states 
occurred in some cases where the entities did not have sufficient 
allowances to cover their emissions. One study showed that the United 
Kingdom imported EUAs to cover about 14 percent of its verified 
emissions, making it the largest net importer of EUAs in phase I. 
[Footnote 22] According to this study, 17 member states were net 
exporters of allowances. The extent of exporting varied among these 
member states, ranging from net exports that accounted for about 1 
percent of total allowances to 34 percent. Overall, however, 
researchers have concluded that wealth transfers in phase I have been 
minimal but note this may change with increasingly ambitious targets in 
subsequent trading phases. 

The Effect of ETS Phase I on Emissions Is Uncertain Because of Data 
Limitations: 

Although the first ETS phase was overallocated--the overall emissions 
cap exceeded actual emissions by more than 3 percent in phase I 
[Footnote 23]--the ETS's cumulative effect on emissions across the EU 
member states is uncertain largely because of data limitations. First, 
there is an inherent uncertainty about how actual emissions compare to 
the emissions that would have occurred in the absence of the ETS. This 
is because it is impossible to forecast future emissions levels in a 
business-as-usual scenario with complete certainty. For example, 
emissions depend on numerous factors, such as fuel prices and economic 
conditions that vary and are difficult to predict. Second, the use of 
information about past emission trends can reduce the uncertainty of 
business-as-usual projections but historical, facility-specific data-- 
i.e., baselines--were generally unavailable prior to phase I. The lack 
of baseline data made it more difficult to forecast business-as-usual 
emissions and therefore characterize the effect of the ETS on 
emissions. According to the Commission, the data limits preclude 
definitive conclusions about the impact of phase I on emissions. 

The tight time frame to establish emission caps and the limited 
authority to collect baseline data from covered entities made it 
difficult to overcome these data limitations. Over the course of 6 
months, each member state had to identify which entities to regulate 
under the ETS, obtain baseline emissions data for the covered entities, 
establish an emissions cap that would be consistent with its Kyoto 
target, and determine how many allowances to distribute to each covered 
entity. At the time, most member states had high-level, aggregated data 
on carbon dioxide emissions that accounted for sources within and 
outside the scope of the ETS. However, the member states did not have 
baseline data that broke out emissions on a facility-specific basis, 
which was necessary to determine both the total emissions released by 
all entities covered under the ETS as well as how many allowances each 
particular entity would need to cover its annual emissions. The member 
states took steps to obtain baseline data but, according to the 
Commission, were constrained by the tight time frame and limited 
authority to collect data--some member states did not yet have in place 
a national law or regulation mandating submission of emissions data. 
[Footnote 24] 

The lack of historical baseline data therefore largely prohibited 
member states from basing their caps on average emissions over a 
sustained period of time preceding the program's establishment, an 
approach that the United States used successfully in establishing a cap-
and-trade program for sulfur dioxide from power plants in response to 
the 1990 Clean Air Act amendments. The U.S. program used average 
emissions from 1985 to 1987 as the baseline against which to measure 
reductions required to begin in 1995 and 2000, thereby providing 
greater certainty that the program achieved reductions relative to past 
emissions levels. The use of a historical baseline in the sulfur 
dioxide program also reduced the covered entities' incentive to 
increase emissions prior to the program's establishment to obtain a 
greater allowance allocation--the baseline years occurred too far 
before the announcement of the program. Reliance on historical data 
spanning several years rather than one year also reduced the risk that 
the baseline did not represent typical emissions levels, which can vary 
across years due to economic conditions and price levels.[Footnote 25] 

In contrast, the EU member states generally based their emissions caps 
on business-as-usual projections and allocation decisions on recent 
baseline emissions data voluntarily submitted by covered entities. The 
inherent uncertainty of business-as-usual projections was compounded by 
the assumptions underlying the models used to forecast emissions. 
Specifically, the models incorporated assumptions about factors that 
influence business-as-usual emissions projections, such as economic 
growth and relative fuel prices. Some member states made relatively 
optimistic assumptions about economic growth, which resulted in higher 
projections of emissions. Regarding allocation decisions, member states 
used recent baseline emissions data submitted by covered entities, 
which meant that covered entities that released more carbon dioxide per 
unit of output received higher allotments than those with lower rates. 
[Footnote 26] Some researchers have questioned the reliability of these 
data because of the potential incentive for covered entities to inflate 
emissions. According to one researcher, member states assessed the 
quality of the emissions data provided by covered entities by, for 
example, cross-checking it. 

The uncertainties underlying phase I emissions caps were especially 
problematic because the reduction goals of the first phase were modest. 
It is worth noting, however, that phase I preceded the commitment 
period under the Kyoto Protocol (2008 to 2012) and moreover that the 
first phase was intended to simply gain experience with emissions 
trading before 2008. According to available information, member states 
intentionally established emission caps at levels near business-as- 
usual projections, which effectively left smaller room for error in 
determining emission levels. 

While some ETS observers have concluded that emissions abatement under 
phase I was unlikely because the cap exceeded actual emissions, several 
researchers have concluded that the ETS resulted in a cumulative 
decrease in emissions compared to business as usual scenario.[Footnote 
27] The researchers stated that some covered entities likely reduced 
emissions by, for example, switching to cleaner fuels to generate power 
or improving energy efficiency, in response to the allowance price in 
the early stages of phase I. In addition, approximately half of the 
experts concluded that the first phase resulted in a cumulative 
decrease in emissions compared to a business-as-usual scenario. Several 
experts attributed the reduction to the allowance price, noting that it 
was likely high enough to encourage some abatement, and several others 
identified published research as the basis for their response. Several 
of the experts clarified that the reduction in emissions was modest. 

Phase II of the ETS, which recently began and coincides with the 
commitment period under the Kyoto Protocol, relies on the same 
decentralized process to establish the emissions cap and allocation in 
phase I but differs in several ways. First, member states took verified 
emissions data from phase I into account to set emissions caps in phase 
II. According to our literature review and discussions with ETS 
stakeholders, the Commission took a stricter approach in approving the 
phase II National Allocation Plans and required member states to set 
more ambitious caps. Second, member states will continue to distribute 
most allowances for free in phase II but the amount of auctioning is 
expected to increase--about half of the EU member states plan to 
auction allowances in phase II.[Footnote 28] Third, phase II differs 
from the first phase by allowing all covered entities to carry over, or 
bank, unused allowances to trading periods after phase II. The 
increased banking provisions in phase II may provide covered entities 
greater incentives to reduce carbon emissions. For example, banking 
provides an incentive for facilities to reduce emissions early, when 
costs are low, and save the allowances for a later time, when costs are 
high. 

Looking ahead to phase III (2013 to 2020), the Commission has proposed 
legislation to amend the ETS by, for example, harmonizing the cap- 
setting and allocation process. Under the legislative proposal, the 
Directive would, according to the Commission, set a single, EU-wide 
emissions cap, which would amount to a 21 percent reduction in 2020 
below 2005 verified emissions. The level of auctioning used to 
distribute allowances also would increase under the proposal. The 
Commission anticipates the legislation will be adopted in late 2008 or 
early 2009. 

Phase I Economic Impacts Vary by Sector but Long-Term Effects Are 
Uncertain: 

The economic impacts of the ETS have varied among covered entities in 
the short term and are uncertain in the long term. Impacts of concern 
under the ETS have included leakage--the shifting of covered entities' 
economic activities to countries that have not adopted binding emission 
limits--and the competitiveness of covered entities, compliance costs, 
and price changes for consumer goods and services, such as electricity. 
While some energy-intensive industries covered under the ETS compete 
globally, our research shows that leakage was unlikely in phase I in 
part because covered entities received allowances for free and the cap 
exceeded actual emissions; when allowance prices are lower, leakage is 
less likely. Specifically, the emissions cap did not create a shortage 
of allowances that would have generated an allowance price high enough 
to encourage covered entities to relocate or move production to 
countries without limits on carbon dioxide emissions. One expert noted 
that it is too soon to judge the long-term economic impacts of the 
first phase.[Footnote 29] 

With respect to leakage, some researchers have assessed the likely 
extent of leakage to date and identified factors that contribute to the 
risk of leakage, such as global competitiveness, carbon intensity--the 
amount of carbon dioxide released per unit of output--and other 
factors. Available information shows that under the ETS, leakage is a 
greater risk among covered entities that rely on energy-intensive 
processes and have a limited ability to pass the allowance price to 
consumers due to international competition with entities not subject to 
carbon constraints. For example, a 2007 study based on energy and 
electricity data in the United Kingdom concluded that the potential for 
leakage is a valid concern for several sectors covered under the ETS, 
including cement, iron and steel, and pulp and paper.[Footnote 30] Some 
ETS participants also have stated that auctioning allowances rather 
than freely allocating them would increase costs and therefore may 
increase leakage risk among globally competitive industries covered 
under the ETS.[Footnote 31] According to some of the energy-intensive 
industries, their covered entities would not be able to pass allowance 
prices to consumers while remaining competitive with entities outside 
the ETS that are not subject to carbon constraints. 

Although researchers present consistent conclusions about the sectors 
most vulnerable to leakage, there is disagreement about the extent to 
which leakage would affect vulnerable sectors if allowance prices were 
to rise or if the number of allowances allocated freely were reduced. 
Beyond the uncertainty about future international carbon constraints, 
opinion regarding the extent to which ETS industries will be able to 
pass allowance prices to consumers varies. In addition, decisions about 
where to locate industrial production depend on factors outside of 
allowance prices, such as transportation costs. 

Some ETS power producers, however, have already demonstrated an ability 
to pass allowance prices to consumers and benefited economically from 
free allocation under phase I. Studies have found that in the EU's 
deregulated energy markets, power producers passed on the market value 
of allowances to consumers by adding the value of the allowances to 
energy rates. Available information identifies a variety of factors 
that contributed to energy rate increases, though, making it difficult 
to determine the extent to which higher prices resulted from the ETS. 
According to available information, additional reasons for energy price 
increases include ongoing deregulation of the EU electricity markets, 
weather conditions--which affect supply and demand for energy--and 
fossil fuel prices.[Footnote 32] Nonetheless, to the extent that power 
producers in deregulated markets added the value of allowances--which 
they received for free--to the rates that they charged consumers, the 
first ETS phase resulted in windfall profits for this sector while 
contributing to increased costs for some energy consumers.[Footnote 33] 

Despite the potential economic impacts of a system to limit carbon 
dioxide emissions, the first ETS phase included several features that 
covered entities could use to limit compliance costs. For example, 
phase I included the use of international offsets in the form of CDM 
credits, discussed in the next section of this report, as a cost 
containment feature.[Footnote 34] Offsets can reduce the costs of 
compliance by allowing facilities to pay for abatement in areas where 
it may be cheaper to do so and apply the credits toward their own caps. 
Another feature intended to reduce costs allowed covered entities to 
bank allowances from one year to another within the first phase. In 
theory, banking provides an incentive for facilities to reduce 
emissions early, when costs are low, and save the allowances for a 
later time, when costs are high. According to available information, 
banking provided limited abatement incentives in practice, however, 
because covered entities generally were not allowed to carry allowances 
from phase I to phase II. As a result, very few covered entities could 
minimize costs in phase II by using allowances from phase I. 

The Commission has since proposed legislation to modify allocation 
methods and cost containment features for the third trading phase and 
beyond. First, the Commission's proposal would allow full banking of 
unused allowances from the second phase while restricting the use of 
CDM offset credits starting in 2013 if no future international climate 
change agreement has entered into force. Second, the Commission's 
proposal would end free allowance allocation to the power industry in 
2013. According to the Commission, requiring the power industry to 
purchase allowances through an auction and market trading would 
eliminate windfall profits in this industry and provide an incentive 
for less-carbon-intensive power generation. The Commission also has 
proposed to gradually phase out free allocation and increase auctioning 
to other entities covered under the ETS but will evaluate the potential 
risks of leakage associated with such an approach. 

The Effect of ETS Phase I on Technology Development and Innovation Are 
Uncertain but Likely Minimal: 

It is too soon to know whether the first phase had an impact on long- 
term technology development and innovation, and researchers conclude 
that the impact, if any, is likely minimal. According to the IPCC, 
technology research and development are essential to the development of 
a less-carbon-intensive energy infrastructure required to reduce 
emissions in the long term.[Footnote 35] A senior official at the 
Council on Environmental Quality told us that emissions trading can be 
a cost-effective tool to achieve long-term reduction goals but that in 
some cases it may not provide incentives for technology investment. 
Several EU industry representatives told us that covered entities have 
begun to consider the ETS and associated costs when making business 
decisions but this has not resulted in widespread technology changes. 
Available information suggests that regulatory uncertainty, low carbon 
prices, and program design features likely dampened incentives in the 
first phase to invest in clean technologies. 

First, the uncertainty about future emissions caps--and thus the extent 
of abatement required at covered entities--and restrictions on banking 
limited the incentive to invest in technology in advance of the first 
phase. Specifically, the duration of phase I was not compatible with 
investment decision timelines. According to a European power industry 
official, it may take 5 to 10 years for technology investments to come 
to fruition, a longer time frame than the first phase's 3-year trading 
period. The general inability to bank unused allowances to the second 
trading phase (2008 to 2012) also limited abatement incentives in phase 
I. The allowances expired at the end of phase I and thereby provided an 
incentive to emit rather than reduce carbon dioxide emissions and save 
the allowances for another time. 

Second, the expected reduction goals for phase I were modest and, 
according to some market analysts, allowance prices have not been high 
enough to influence technology investment decisions, such as 
development of carbon capture and storage. Identified by the IPCC as a 
key potential abatement technology, carbon capture and storage involves 
capturing carbon dioxide from a power plant's emissions, transporting 
it to an underground storage location, and then injecting it into a 
geologic formation for long-term storage. While other options exist to 
reduce emissions--such as energy efficiency improvements, a switch to 
less-carbon-intensive fuels, nuclear power, and renewable energy 
sources--carbon capture and storage is considered by many an essential 
technology because it has the potential to greatly reduce emissions 
from power plants while allowing for projected increases in electricity 
demand.[Footnote 36] One consulting firm has estimated that 
demonstration projects to test carbon capture and storage in the EU 
between 2012 and 2015 would cost €60 to €90 per metric ton of carbon 
dioxide abated, well above the phase I allowance price.[Footnote 37] 

Third, available information also suggests that the rules governing 
allowances for new entrants--covered entities that did not begin 
operation until after a member state's submission of a National 
Allocation Plan--limited incentives to invest in low-carbon 
technologies. The ETS Directive required member states to ensure new 
entrants had access to allowances but did not specify how they should 
do so.[Footnote 38] In practice, all of the member states distributed 
allowances to new entrants for free. Researchers believe that free 
allocation to new entrants reduces the investment costs of carbon- 
intensive technologies, such as coal-fired power plants, compared to 
low-carbon technologies or renewable energy, and effectively eliminates 
the incentive for investment in low-carbon technologies. 

The allocation rules for covered entities that closed during the first 
phase also affected investment incentives. Available information 
indicates that most of the member states required closing plants to 
give back the allowances rather than sell them on the market, thereby 
providing an incentive for these facilities to continue operating. 
Covered entities that would have closed in the absence of the ETS may 
have continued operating in order to keep the allowances. 

Finally, the Commission has sought to provide greater certainty about 
emission caps for future trading phases. The EU has committed to 
continue emissions trading and aims to finalize by late 2008 or early 
2009 the Commission's proposed legislation that would modify the 
trading phases after 2012. Among other things, the proposal aims to 
reduce greenhouse gases by at least 20 percent by 2020. 

ETS Phase I Experience Offers Key Lessons about Program Design and 
Implementation: 

Available information and experts revealed lessons about three key 
aspects of phase I, including the importance of baseline data, program 
design and implementation, and related economic effects. In particular, 
experts discussed how these lessons might inform the design of U.S. 
climate change policies. 

Baseline Data: 

First, available information indicated that accurate baseline data are 
essential to setting an effective emissions cap and achieving the 
intended environmental objectives. The accuracy and availability of 
baseline data at the covered entity, sector, and national level also 
influence the effectiveness of the emissions cap. 

Availability of data. About half of the experts said that emissions 
data should be in place before starting an emissions trading program. 
Many experts commented, however, that they would not expect the United 
States to encounter the data challenges experienced in the first phase 
because certain data are already available and several noted that 
existing data about U.S. emissions are sufficient to establish an 
emissions trading program. Specifically, they stated that the United 
States has good data on fossil fuel consumption that can be used to 
estimate economy-wide carbon dioxide emissions as well as facility- 
specific data on carbon dioxide emissions from power plants that have 
participated in the Clean Air Act's sulfur dioxide emissions trading 
program. Moreover, our literature review indicates that the 
availability of historical baseline data would reduce the incentive for 
covered entities to inflate baseline emissions prior to the 
establishment of a program to obtain a greater allocation. Nonetheless, 
a few experts said that emissions data in the United States could be 
improved. For example, one expert noted that emissions of greenhouse 
gases other than carbon dioxide are more uncertain. 

Specificity of data. The required accuracy of data at the covered 
entity, sector, and national level depends on, and must therefore be 
compatible with, the program's point of regulation. The point of 
regulation may occur (1) "upstream" and cover sources of carbon dioxide 
when they first enter the economy, such as fossil fuel producers; (2) 
"downstream" and cover direct and indirect emitters, such as power 
plants; or (3) at a combination of upstream and downstream sources. A 
downstream program like the ETS requires facility-specific data in 
order to determine how many allowances to distribute to individual 
entities. In contrast, programs that incorporate upstream sources, such 
as the one proposed in the Lieberman-Warner Climate Security Act of 
2008,[Footnote 39] primarily rely on economy-wide data, which may be 
more readily available than facility-specific data. Several experts 
stated that an upstream program would simplify data requirements and 
avoid the phase I challenge to obtain the facility-specific baseline 
data. Available information also identifies the simplified data 
requirements of an upstream program as an advantage but notes that such 
programs demand greater cooperation and political support than 
downstream programs. 

Program Design Features: 

The second group of key lessons relates to how program design features 
may influence the effectiveness of emissions trading and includes the 
following features: the emissions cap, program scope, allocation 
method, measures to limit risk of leakage, program timeline, and 
linking to other programs. As noted by several experts, some 
implementation challenges, such as data limitations or lobbying 
pressure to inflate the cap for a particular industry sector, are 
inevitable but steps can be taken to minimize their consequences. In 
addition, nearly all of the experts discussed ways that design features 
can maximize incentives to cost-effectively reduce emissions. 

Emissions cap. Experts identified design features that would provide 
incentives to reduce emissions even if the cap initially exceeds 
emissions. For example, several experts recommended establishing a long-
term, declining emissions cap, which would ensure gradual emissions 
scarcity in the program. A few experts also pointed out that allowing 
full banking with a long-term declining cap would provide an incentive 
to reduce emissions earlier. 

Program scope. The scope of the program, specifically the extent to 
which it regulates all greenhouse gas emissions in the economy, 
influences the cost-effectiveness of reductions. In theory, 
opportunities for cost-effective reductions will increase as the number 
of sources included in the program increases but in practice there may 
be limits to enhancing cost-effectiveness with expanding scope. Many of 
the experts stated that a U.S. program should include as many sources 
of carbon dioxide emissions as possible; several also stated that it 
should cover all six greenhouse gases. Several experts noted, however, 
that emissions trading may not be the most effective way to control all 
greenhouse gas emissions. One expert clarified that while the scope of 
a trading program should be "as wide as possible," it should only 
include emissions that "can be credibly monitored, reported, and 
verified." Similarly, the European Commission told us that the ETS 
began with a narrow scope, regulating approximately half of the EU's 
carbon dioxide emissions, because of feasibility concerns and plans to 
expand to other gases and sectors in the future. Another expert echoed 
the idea of targeted expansion in noting that forestry and agriculture 
sources should be only gradually involved in a trading program because 
of uncertainties in measuring emissions. Furthermore, one expert 
suggested alternative forms of regulation, such as emission standards, 
to limit the non-carbon-dioxide greenhouse gases that may not be 
effectively monitored or enforced under emissions trading. 

Allocation method. According to available information, the way a 
program distributes allowances also impacts the program's total cost 
and the distribution of cost burden among stakeholders. An auction, for 
instance, may impose costs on particular sectors covered under the 
program but generate revenues that may be used to offset the cost of 
the emissions trading program on consumers or covered sectors through 
reinvestment in other programs, which may or may not relate to climate 
change. Some of the experts who discussed the benefits of auctioning 
provided examples of ways to use auction revenues, such as research and 
development of clean energy technologies, to lower income taxes, to 
lower business taxes, to expand earned income tax credits, or for 
energy efficiency programs. In addition, one expert noted that greater 
use of auctioning also may minimize the perverse incentives favoring 
processes that are more-carbon-intensive under the ETS rules for 
closure and new entrants. Accordingly, many of the experts stated that 
a trading program should maximize the level of auctioning. 

Free allocation to emitters, on the other hand, may reduce costs for 
sectors covered under the trading program but not for consumers. 
Although the ability of covered entities to pass costs to consumers in 
the form of higher product prices varies, available information reveals 
that free allocation does not prevent increases in consumer product 
prices resulting from the emissions program. The first phase shows that 
covered entities may still pass costs through to consumers. 

Risk of leakage. The experts also provided insights about potential for 
leakage to affect covered sectors. Most of the experts said that 
leakage would pose a risk under a U.S. emissions trading program, 
although views on the degree of risk varied. Some of the experts 
clarified that it would pose a significant risk for certain industries, 
in particular energy-intensive industries that compete with facilities 
in countries without binding carbon caps. The option most frequently 
identified to prevent leakage was securing global participation in 
international climate agreements. 

The experts discussed alternative options to reduce the risk of leakage 
in the absence of a global agreement, including some form of targeted 
free allowance allocation, cost containment mechanisms, and trade 
measures. The alternatives involve a set of tradeoffs and as one expert 
noted, require detailed information about "which sectors or subsectors 
would experience leakage." For example, free allocation may reduce 
compliance costs for globally competitive entities but as another 
expert noted, may deter investment in less-carbon-intensive 
technologies. Moreover, one expert pointed out that entities may sell 
the allowances and relocate anyway. Some of the experts stated that 
cost containment mechanisms, such as allowing the use of offsets, could 
reduce the cost impact on covered entities by lowering the allowance 
price. The lower allowance price in turn is expected to reduce the risk 
of leakage. Many of the experts suggested trade measures to level the 
playing field for globally competitive, carbon-intensive entities. 
Trade measures identified included either a border tax or an allowance 
requirement for goods imported from entities not subject to carbon 
constraints. However, a few experts discussed drawbacks, such as 
difficulty in identifying which sectors are vulnerable to global 
competition and the possibility of retaliatory trade measures. In 
addition, opinions vary as to whether these trade measures would be 
permitted under World Trade Organization rules. 

Program timeline. Many of the experts viewed the program timelines as 
an important feature to reduce uncertainty that deters investment in 
less-carbon-intensive technologies, while several also emphasized cost 
certainty as a key feature. The experts commenting on timelines stated 
that a trading program should cover a long enough time period to 
influence technology investment decisions. A few experts noted that the 
risk of subsequent changes to specified targets--because of developing 
scientific opinion or changes in political commitments--makes it 
important also to provide certainty about costs to incentivize 
technology development. For example, specifying a minimum auction price 
for allowances would increase certainty about the long-term value of 
investments to reduce emissions. 

Linking. Finally, the experts presented a wide range of opinions 
regarding the extent to which a program benefits from linking to other 
trading programs. Linking occurs when covered entities in one program 
can use the allowances from another trading program for compliance and, 
sometimes, vice versa.[Footnote 40] For example, linking the EU ETS to 
a U.S. trading program could allow covered entities in the United 
States to purchase EUAs and use them to cover emissions. In theory, 
linking can enhance the cost-effectiveness of the participating 
programs by enabling covered entities to take advantage of differences 
in the costs of abatement options. According to available information 
and experts, the design features of the program also will carry through 
to the linked program. As a result, it may be difficult and less cost- 
effective to link programs in practice. Many of the experts discussed 
the complications resulting from linking programs with different cost 
containment measures, in particular a safety valve. Safety valves are 
mechanisms, such as maximum allowance price, that trigger cost 
containment actions. For example, one kind of safety valve might allow 
the government to sell additional carbon allowances if the market price 
for allowances exceeded a predetermined amount--the increased supply 
may lower the market price but also would increase the emissions cap. 
Linking a program with a safety valve to another program without one 
would carry the safety valve through to the latter program. About one- 
third of experts concluded that linking programs with different cost 
containment measures may compromise the environmental integrity of the 
programs. 

Wealth Transfer: 

The third and final category of lessons relates to wealth transfer, as 
the ETS demonstrated that giving away allowances can create and 
transfer substantial assets of considerable value. The distribution of 
wealth creates a strong incentive for regulated entities to influence 
the design and implementation of a trading program. Five experts 
clarified that while lobbying pressure from stakeholders is inevitable, 
steps should be taken to minimize the effects. Along those lines, some 
of the experts stated that auctioning allowances would minimize the 
adverse impact of lobbying activity--that is, it would reduce pressure 
to increase individual allocations that may compromise the emissions 
cap. Another expert noted that the inevitable lobbying activity 
warrants having decision makers set the cap in federal legislation to 
ensure greater accountability. Finally, available information also 
indicates that while there may be advantages to starting with a small 
program and expanding it, modifying emissions trading programs can 
introduce technical and political challenges. As an official at an 
international research organization observed, it is difficult to change 
who gains and who loses under a trading program after it has been 
established. 

The CDM's Environmental and Economic Effects Provide Important Lessons 
That Can Inform Congressional Deliberations on Climate Change Policy: 

According to available information and experts, the CDM has enabled 
industrialized countries to make progress toward achieving their 
emissions targets at less cost and has involved developing countries in 
these efforts; however, the program's effect on emissions is uncertain, 
and its impact on sustainable development has been limited. Further, we 
found that the CDM's approval process significantly limits the scale 
and cost-effectiveness of emission reductions achieved through the 
program, although several proposed reforms may help to streamline this 
process. Nonetheless, the international experience with the CDM has 
provided key lessons that may help inform congressional decision 
making. 

The CDM Has Enabled Covered Entities to Pursue Lower-Cost Reductions 
and Involved Developing Countries in the Global Carbon Market: 

Beginning operation in 2002, the CDM can allow countries to make 
progress toward their emissions targets under the Kyoto Protocol at 
less cost through the use of carbon offset credits. This includes not 
only countries under the EU ETS, but all countries that have ratified 
the Protocol and meet certain requirements. However, while countries 
outside the scope of the ETS--specifically, Canada, New Zealand, 
Switzerland, and Japan--have invested in CDM projects, demand has been 
driven primarily by covered entities in the EU, which can count CDM 
credits toward their emissions caps under the ETS. For many of these 
entities, investing in CERs can provide a lower-cost alternative to 
reducing emissions on-site or purchasing EUAs. Further, the 
availability of CERs may produce lower allowance prices than would be 
observed under a no-offset scenario. As a result, the CDM can 
potentially reduce firms' compliance costs regardless of whether these 
firms choose to purchase CERs. 

While both EUAs and CERs can be used for the same purposes in the ETS, 
investors in the CDM market face higher risks, depending on the type of 
CER purchased.[Footnote 41] "Primary CERs" involve a higher level of 
uncertainty because most purchases involve forward contracts--the buyer 
purchases the rights to future credits instead of the credits 
themselves. Because primary CERs are not issued until the project is 
completed and emissions are verified, there is some risk that the 
project will not produce the expected number of CERs. For example, the 
CDM's Executive Board may delay or reject a project and even approved 
projects might not be built on schedule or within budget. Further, the 
amount of actual reductions may differ from what was planned--for 
example, wind projects may generate more or less electricity depending 
on weather conditions. One study shows that projects reaching the 
registration phase tended to yield only about 76 percent of their 
forecasted CERs.[Footnote 42] In order to reduce market risks, an 
increasing number of CDM participants purchase "secondary" CERs, which 
are offered with a guarantee of delivery. These secondary CERs, 
represented in figure 3, carry less risk and are more expensive than 
primary CERs, although they still sell at a discount to EUAs.[Footnote 
43] 

Figure 3: Price Differential between CERs and EUAs: 

[Refer to PDF for image] 

This figure is a multiple line graph depicting the following data: 

Price Differential between CERs and EUAs: 

Date: 5/21/2007; 
Price (nonadjusted USD) EAUs: 21.98; 
Price (nonadjusted USD) CERs (secondary market): 16.35. 

Date: 6/1/2007; 
Price (nonadjusted USD) EAUs: 23.9; 
Price (nonadjusted USD) CERs (secondary market): 17.45. 

Date: 6/15/2007; 
Price (nonadjusted USD) EAUs: 22.78; 
Price (nonadjusted USD) CERs (secondary market): 15.6. 

Date: 7/2/2007; 
Price (nonadjusted USD) EAUs: 21.68; 
Price (nonadjusted USD) CERs (secondary market): 15.25. 

Date: 7/16/2007; 
Price (nonadjusted USD) EAUs: 18.7; 
Price (nonadjusted USD) CERs (secondary market): 13.95. 

Date: 8/1/2007; 
Price (nonadjusted USD) EAUs: 20.55; 
Price (nonadjusted USD) CERs (secondary market): 16. 

Date: 8/15/2007; 
Price (nonadjusted USD) EAUs: 19.68; 
Price (nonadjusted USD) CERs (secondary market): 16.3. 

Date: 9/3/2007; 
Price (nonadjusted USD) EAUs: 19.85; 
Price (nonadjusted USD) CERs (secondary market): 16.5. 

Date: 9/17/2007; 
Price (nonadjusted USD) EAUs: 20.53; 
Price (nonadjusted USD) CERs (secondary market): 16.6. 

Date: 10/1/2007; 
Price (nonadjusted USD) EAUs: 21.63; 
Price (nonadjusted USD) CERs (secondary market): 17. 

Date: 10/15/2007; 
Price (nonadjusted USD) EAUs: 22.63; 
Price (nonadjusted USD) CERs (secondary market): 17.65. 

Date: 11/1/2007; 
Price (nonadjusted USD) EAUs: 21.7; 
Price (nonadjusted USD) CERs (secondary market): 17.4. 

Date: 11/15/2007; 
Price (nonadjusted USD) EAUs: 22.65; 
Price (nonadjusted USD) CERs (secondary market): 17.85. 

Date: 12/3/2007; 
Price (nonadjusted USD) EAUs: 22.95; 
Price (nonadjusted USD) CERs (secondary market): 18.15. 

Date: 12/17/2007; 
Price (nonadjusted USD) EAUs: 22.35; 
Price (nonadjusted USD) CERs (secondary market): 17.1. 

Date: 1/2/2008; 
Price (nonadjusted USD) EAUs: 23; 
Price (nonadjusted USD) CERs (secondary market): 17.35. 

Date: 1/15/2008; 
Price (nonadjusted USD) EAUs: 23.23; 
Price (nonadjusted USD) CERs (secondary market): 17.35. 

Date: 2/1/2008; 
Price (nonadjusted USD) EAUs: 19.18; 
Price (nonadjusted USD) CERs (secondary market): 14.35. 

Date: 2/15/2008; 
Price (nonadjusted USD) EAUs: 20.85; 
Price (nonadjusted USD) CERs (secondary market): 15.35. 

Date: 3/3/2008; 
Price (nonadjusted USD) EAUs: 20.85; 
Price (nonadjusted USD) CERs (secondary market): 14.8. 

Date: 3/17/2008; 
Price (nonadjusted USD) EAUs: 21.3; 
Price (nonadjusted USD) CERs (secondary market): 15.1. 

Date: 4/1/2008; 
Price (nonadjusted USD) EAUs: 22.5; 
Price (nonadjusted USD) CERs (secondary market): 15.8. 

Date: 4/15/2008; 
Price (nonadjusted USD) EAUs: 25.05; 
Price (nonadjusted USD) CERs (secondary market): 16.55. 

Date: 5/1/2008; 
Price (nonadjusted USD) EAUs: 23.6; 
Price (nonadjusted USD) CERs (secondary market): 16.3. 

Date: 5/15/2008; 
Price (nonadjusted USD) EAUs: 24.65; 
Price (nonadjusted USD) CERs (secondary market): 17.1. 

Date: 6/2/2008; 
Price (nonadjusted USD) EAUs: 26.45; 
Price (nonadjusted USD) CERs (secondary market): 18.1. 

Date: 6/16/2008; 
Price (nonadjusted USD) EAUs: 27.2; 
Price (nonadjusted USD) CERs (secondary market): 19.9. 

Date: 7/1/2008; 
Price (nonadjusted USD) EAUs: 29.38; 
Price (nonadjusted USD) CERs (secondary market): 23.2. 

Date: 7/15/2008; 
Price (nonadjusted USD) EAUs: 26.45; 
Price (nonadjusted USD) CERs (secondary market): 23.3. 

Date: 8/1/2008; 
Price (nonadjusted USD) EAUs: 21.33; 
Price (nonadjusted USD) CERs (secondary market): 18.1. 

Date: 8/15/2008; 
Price (nonadjusted USD) EAUs: 23.15; 
Price (nonadjusted USD) CERs (secondary market): 21. 

Date: 9/1/2008; 
Price (nonadjusted USD) EAUs: 25.05; 
Price (nonadjusted USD) CERs (secondary market): 22.15. 

Date: 9/15/2008; 
Price (nonadjusted USD) EAUs: 23.2; 
Price (nonadjusted USD) CERs (secondary market): 20.2. 

Date: 10/1/2008; 
Price (nonadjusted USD) EAUs: 23.25; 
Price (nonadjusted USD) CERs (secondary market): 19.62. 

Source: Point Carbon (2008). 

[End of figure] 

Despite uncertainties about the delivery of CERs, the CDM market has 
grown at a considerable rate over the past few years, mobilizing 
private and public sectors in both industrialized and developing 
countries to invest billions of dollars in projects designed to 
decrease greenhouse gas emissions. CDM transactions amounted to nearly 
$13 billion in 2007, an increase of over 200 percent from 2006. 
[Footnote 44] On a global scale, the introduction of CDM credits as a 
commodity has encouraged businesses and entrepreneurs to seek out 
emission reduction opportunities in developing countries and has 
spurred the creation of consulting firms that help steer participants 
through the approval process. 

For developing countries that do not have emissions targets under the 
Kyoto Protocol, the demand for CERs has provided an economic incentive 
to pursue emission reduction activities. As of October 2008, over 3,800 
different projects were seeking credits through the CDM. Of these, over 
1,100 have already officially registered through the CDM's Executive 
Board, and nearly 400 have received CERs. The first chart in figure 4 
shows the most common types of projects and their growth over time, 
while the second chart shows the volume of credits expected to be 
produced through 2012. Because some CDM projects destroy gases more 
potent than carbon dioxide--in particular, industrial gases--these 
projects are an abundant source of credits and, as the second chart in 
figure 4 shows, represent a larger share of overall expected reductions 
than the number of projects might suggest.[Footnote 45] 

Figure 4: CDM Pipeline: 

[Refer to PDF for image] 

This figure contains two multiple stacked line graphs depicting the 
following data: 

Number of projects added to the pipeline: 

Year: 2003; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
1; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 2; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 0; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 0; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 2; 
Cumulative number of projects[A]: 5. 

Year: 2004; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
38; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 18; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 2; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 1; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 2; 
Cumulative number of projects[A]: 61. 

Year: 2005; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
313; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 126; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 62; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 22; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 11; 
Cumulative number of projects[A]: 534. 

Year: 2006; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
801; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 328; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 160; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 52; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 33; 
Cumulative number of projects[A]: 1,374. 

Year: 2007; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
1,705; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 515; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 419; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 98; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 73; 
Cumulative number of projects[A]: 2,810. 

Year: 2008; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
2,465; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 641; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 607; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 132; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 95; 
Cumulative number of projects[A]: 3,940. 

Volume of expected CERs (in millions[A]): 

Year: 2003; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
0.1; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 6.8; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 0; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 0; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 38.6; 
Cumulative CERs[A]: 45.5. 

Year: 2004; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
14.5; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 33.5; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 0.5; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 0.1; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 38.6; 
Cumulative CERs[A]: 87.2. 

Year: 2005; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
124.4; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 164.4; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 29.8; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 9.6; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 392.4; 
Cumulative CERs[A]: 720.6. 

Year: 2006; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
310.7; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 328.5; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 87.1; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 91; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 682.8; 
Cumulative CERs[A]: 1,500.1. 

Year: 2007; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
678.1; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 462.3; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 253.7; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 177.5; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 746.7; 
Cumulative CERs[A]: 2,318.3. 

Year: 2008; 
Renewable energy (i.e., using wind, solar, or hydropower technologies): 
928.3; 
Agriculture, cement, and fugitive gas capture (i.e., avoiding landfill 
waste through composting or collecting methane from coal mines): 538.7; 
Energy efficiency (i.e., increasing building efficiency or providing 
energy-efficient appliances): 336.7; 
Fuel switching (i.e., switching fuels from more carbon-intensive 
options, such as coal, to less carbon-intensive options, such as 
natural gas): 207.2; 
Industrial gas destruction (i.e., destroying waste gases used in the 
production of refrigerants, such as HFC-23): 768.6; 
Cumulative CERs[A]: 2,779.5. 

Source: GAO analysis of UNEP Risoe Center data (2008). 

Note: Forestry projects make up less than 1 percent and are excluded. 

[A] Expected number of CERs to be issued through 2012. 

[End of figure] 

While CDM projects have been established in over 70 developing 
countries, most benefits have thus far accrued to fast-growing nations 
such as China and India. In fact, these two countries host over half of 
all registered projects. Conversely, countries in Africa and the Middle 
East have seen little CDM-related investment. For example, only 10 CDM 
projects have been registered in what the UN defines as "least 
developed countries." Figure 5 illustrates the distribution of emission 
reductions by geographic region. 

Figure 5: Distribution of CERs by Host Country: 

[Refer to PDF for image] 

This figure is a pie-chart depicting the following data: 

Distribution of CERs by Host Country: 
China: 53%; 
India: 15%; 
Latin America: 15%; 
Asia-other: 11%; 
Middle East and Africa: 5%; 
Europe and Central Asia: 1%. 

Source: GAO analysis of UNEP Risoe Center data (2008). 

[End of figure] 

Several factors explain the relative concentration of projects. First, 
the relatively large economies in China and India provide a higher 
number of emission reduction opportunities. In addition, these 
countries have developed an institutional capacity that can accommodate 
a large and fast-moving flow of projects. Host country governments, 
banks, and private sector firms have become familiar with emissions 
trading and the CDM, in part because of the financial transfers it 
facilitates. 

While some observers have criticized the unequal distribution of 
projects, it also is true that China and India are expected to 
represent a significant source of future emissions, and the CDM could 
enhance these countries' interest in future international dialogue over 
climate change policy. Many experts said that the CDM has helped to 
engage developing nations and create political buy-in for further 
actions to reduce the global concentration of greenhouse gases; in 
fact, two experts stated that this was the CDM's primary benefit. 
Another noted simply that the CDM represents one of the only incentives 
for developing countries to undertake emission reduction activities. 

On the other hand, less-developed countries may lack the capacity to 
implement CDM activities and navigate the complexities of the process. 
Potential investors in CDM projects also may be deterred from projects 
in certain countries due to an unfavorable investment environment, lack 
of a legal framework, insufficient access to finance, or political 
instability. However, evidence suggests that certain developing nations 
are gaining experience with the CDM, and several programs have been 
created to help expand participation in the future. For example, the UN 
created the Nairobi Framework in 2006, an initiative aimed at building 
CDM capacity in lesser developed nations. 

The CDM also may boost public awareness of climate change in host 
countries. For example, CDM participants in India told us that the 
program has increased overall public knowledge of climate change 
issues, although it appears that specific interest in CDM has largely 
been concentrated within industry and market circles. Some experts we 
consulted agreed with this perspective--a fourth of those who rated the 
CDM's effectiveness characterized it as an "extremely" or "very" 
effective tool to raise awareness about greenhouse gases, as shown in 
figure 6. 

Figure 6: Summary of Responses from Expert Panel: Effects of CDM on 
Public Awareness: 

[Refer to PDF for image] 

This figure is a vertical bar graph depicting the following data: 

Summary of Responses from Expert Panel: Effects of CDM on Public 
Awareness: 

How effective is the CDM in raising public awareness in host countries 
of the sources and effects of greenhouse gases? 

Response: Not at all effective;	
Number of experts: 3. 

Response: Slightly effective; 
Number of experts: 4. 

Response: Moderately effective; 
Number of experts: 8. 

Response: Very effective; 
Number of experts: 1. 

Response: Extremely effective; 
Number of experts: 4. 

Response: Don't know/not sure; 
Number of experts: 6. 

Response total: 26. 

Source: Consolidated responses from experts. 

[End of figure] 

On the other hand, using the CDM to involve developing nations in 
efforts to address climate change may not always have positive effects. 
For example, some experts said the mechanism encourages host countries 
to rely on external funding from industrialized nations. Others went 
further, saying the CDM can dampen or delay efforts by host countries 
to reduce emissions on their own. The CDM does not credit emission 
reductions that result from newly imposed policies or standards, in 
part because it would be difficult to demonstrate that emission 
reductions were a direct result of the law. This may pose a dilemma for 
host countries that want to implement low-carbon policies but also want 
to attract investment through the CDM. Given these considerations, many 
experts and researchers have said the CDM would best be used as a 
temporary tool to help transition countries toward broader commitments. 

Despite Rigorous Review Process, the Net Effect of the CDM on Emissions 
Is Unclear: 

The overall effect of the CDM on international emissions is uncertain, 
largely because it is nearly impossible to determine the level of 
emissions that would have occurred in the absence of each project. This 
concept of additionality is fundamental to the credibility of the CDM 
because only projects that are additional will lower emissions beyond 
what would have occurred without the program.[Footnote 46] Accordingly, 
the parties to the protocol have implemented a rigorous project 
approval process with an extensive set of requirements to ensure that 
credits received through the CDM represent real and additional emission 
reductions.[Footnote 47] However, because additionality is based on 
projections of what would have occurred in the absence of the CDM, 
which are necessarily hypothetical, it is impossible to know with 
certainty whether any given project is additional. 

As part of this process, project applicants must demonstrate the 
additionality of the proposed project and estimate the emission 
reductions that will occur as a result of the project's implementation. 
In practice, this means that applicants must show that the project 
would not have occurred without the CDM, due to technological, 
economic, or other barriers. They must then estimate the reductions 
achieved by the project using a projected business-as-usual baseline. 
Documentation for the project must be evaluated by an independent 
auditing firm, approved by the host country, and then formally accepted 
by the CDM Executive Board on a case-by-case basis. Once approved, 
emissions from each project are monitored periodically in accordance 
with procedures outlined in the initial project proposal. Credits are 
issued only for emission reductions that have been verified by a 
separate, independent auditing firm.[Footnote 48] 

This process may increase the likelihood that projects are additional, 
and evidence indicates that the CDM's screening process has become more 
stringent over time. Many stakeholders we interviewed said that the 
majority of projects under CDM are additional and would not have been 
undertaken without the opportunity to earn carbon credits. Further, a 
majority of experts we consulted agreed that the CDM's approval process 
ensures a higher degree of project quality, on average, than in 
voluntary offsets markets, though some suggested that voluntary market 
standards represented a fairly low benchmark for quality.[Footnote 49] 
Figure 7 summarizes our experts' responses. 

Figure 7: Additionality in the CDM: 

[Refer to PDF for image] 

This figure is a vertical bar graph depicting the following data: 

To what extent has the CDM ensured the additionality of its credits? 

Response: To little or no extent; 
Number of experts: 3. 

Response: To some extent; 
Number of experts: 12. 

Response: To a moderate extent; 
Number of experts: 3. 

Response: To a great extent; 
Number of experts: 6. 

Response: Do not have expertise in this area; 
Number of experts: 2. 

Response total = 26. 

Source: Consolidated responses from experts. 

[End of figure] 

However, significant challenges to ensuring credit quality exist. Many 
experts and stakeholders have suggested that a substantial number of 
nonadditional projects have received credits through the CDM, a 
conclusion supported by several studies. Further, while CDM 
participants we interviewed in India and China did not explicitly 
criticize the CDM's screening process, their comments often ran counter 
to the concept of additionality. For example, several representatives 
from the cement and auto industries said they would pursue clean energy 
projects regardless of the CDM, describing the CDM credits as more of a 
"bonus" than a driver of investment. In response to concerns about the 
quality of projects under the program, the CDM's Executive Board has 
taken steps to improve the process, such as adding staff, creating a 
manual for verifiers, and increasing project reviews and rejections. 
However, the Executive Board may find it increasingly difficult to 
evaluate additionality, according to two of our experts, as host 
countries begin to factor the CDM into their planning efforts and it 
becomes more difficult to identify what would have happened without the 
program. 

The presence of nonadditional projects can diminish or negate the 
environmental benefits of the CDM. Because the CDM is primarily used by 
countries to comply with the Kyoto Protocol's binding targets and the 
ETS's emissions caps, credits that do not represent real and additional 
emission reductions do not represent progress toward these targets or 
caps. This is particularly important in the context of cap-and-trade 
programs that use the CDM for compliance, such as the ETS, because 
nonadditional projects can compromise the environmental integrity of 
the emissions cap. If a significant number of nonadditional credits are 
allowed into the program, for instance, these credits may allow covered 
entities to increase their emissions without a corresponding reduction 
in a developing country. This can cause emissions levels to rise above 
the targets set by the program, introducing uncertainty as to the 
actual level of reductions, if any, achieved by the program. The extent 
of this effect is difficult to estimate; it depends on the number of 
nonadditional credits and the extent to which offset credits can be 
used in the compliance program, among other things.[Footnote 50] 
Because of the challenges of ensuring additionality under the CDM, 
several experts said the CDM has had a negligible or negative 
environmental effect. According to one expert, maintaining anything 
less than "a great extent" of additionality is unacceptable, because 
the result is a higher level of worldwide emissions than would have 
occurred in the absence of the CDM. 

In the current phase II of the ETS, the number of CDM credits that can 
be used to meet emissions caps is limited. As we have previously 
reported, limits on the use of offset credits in mandatory emission 
reduction programs involve tradeoffs.[Footnote 51] On the one hand, 
such limits may increase compliance costs. On the other hand, they can 
help provide incentives for technology research and promote fundamental 
changes within industries bound by the program. Limits on offsets can 
also help confine the negative impact of nonadditional offset credits 
in the event that additionality controls fail. 

In order to fully realize these benefits, however, limits on offsets 
must be sufficiently stringent. For phase II of the ETS, the European 
Commission established fairly generous limits--member states are able 
to use CDM credits for about 12 percent of their emissions cap, on 
average.[Footnote 52] Researchers have since concluded that these 
limits could allow member states to achieve the majority of emission 
reductions through offsets and reduce little in the EU. This is partly 
because the limits were based upon the total emissions cap rather than 
the "distance to target"--that is, the gap between the current 
emissions level and the cap. According to one European Commission 
official, the ETS legislative proposal will address this concern, as it 
prevents new CDM credits--with some exceptions--from entering the ETS 
during the third phase of the scheme.[Footnote 53] A committee of the 
European Parliament also has proposed stricter limits on both the 
quantity and quality of credits in the third phase. However, at least 
one study disputes whether these changes will be sufficient to ensure 
that the EU's long-term reduction targets are met.[Footnote 54] 

It is important to note that while nonadditional projects do not 
represent a net decrease in emissions, this does not preclude them from 
conferring environmental benefits. For example, a wind power project 
may be profitable without the CDM but can be valuable from an 
environmental and public health perspective. Further, a few experts 
pointed out that permitting offset programs like the CDM in emissions 
trading programs may allow the negotiation of more stringent emissions 
caps, since offsets can reduce the overall cost of compliance programs. 
This effect may help balance out the effects of nonadditional projects. 

The CDM's Contributions to Sustainable Development Have Been Limited: 

Although the Protocol does not define sustainable development, in other 
contexts the UN has described it as a strategy that "meets the needs of 
the present without compromising the ability of future generations to 
meet their own needs," and can encompass environmental, economic, and 
political sustainability. The CDM's rules require that each emissions 
reduction project assist a host country in achieving sustainable 
development, but does not provide overarching standards with which to 
assess these projects. Instead, it delegates responsibility to host 
countries, each of which defines its own sustainable development 
criteria that it can use to approve or reject CDM projects. Projects 
could presumably fulfill this requirement in a variety of ways; for 
example, by promoting sustainable agriculture or by introducing 
renewable technologies to fulfill energy demand. 

Overall, most evidence indicates that the CDM has had a limited effect 
on sustainable development. For example, multiple stakeholders we spoke 
with said the CDM has not had a significant impact in this area, 
although one researcher acknowledged that such outcomes may be 
difficult to assess in the short term. Stakeholders in India, many of 
whom stood to benefit financially from the CDM, spoke more positively 
of the CDM's contributions to sustainable development, mentioning wide- 
ranging benefits such as job creation, improved air quality, and 
enhanced energy supply in rural areas. 

The CDM's limited effect could be due, in part, to its market-based 
structure. Developing countries may have few incentives to enact 
stringent criteria for sustainable development since they are 
effectively competing for CDM projects, and stringent standards may 
raise the cost of developing a project and deter potential investors. 
In India, for example, projects are approved by the national CDM 
authority based on whether they align with the country's pre-existing 
sustainability guidelines.[Footnote 55] However, CDM participants we 
spoke with in India said it was relatively easy to get a project 
approved; on the day we visited, for example, 25 projects had been 
reviewed and approved. In addition, because the CDM encourages 
investors to seek out the lowest-cost reductions, projects that make 
considerable contributions to sustainable development may be at a 
disadvantage. Some of the most attractive projects to investors, in 
terms of CERs produced, have a relatively small impact on sustainable 
development, and the CDM does not provide financial rewards for 
projects that exceed minimum sustainable development standards. 

Although the CDM does not claim technology transfer as an explicit 
objective, most consider the introduction and diffusion of new 
technologies in project host countries to be an important outcome. 
Given available information, however, the effect of the CDM in this 
area has thus far been modest. According to CDM participants we spoke 
with in India, most projects have used technologies that were already 
commercially available within the country, although some said the CDM 
has helped mitigate the risk of investing in new technologies. The 
experts had a similar view--of those who provided an opinion, about two-
thirds said the CDM was "not effective" or "slightly effective" as a 
tool for technology transfer. On the other hand, slightly over a third 
believed the CDM was "moderately" or "very" effective. 

Some studies have attempted to quantify the extent of technology 
transfer under the CDM. According to a review of available research, 
between one-third and one-half of CDM projects involve some type of 
technology transfer. Such transfer is much more common in certain types 
of projects, such as industrial gas projects that utilize "end-of-pipe" 
technologies developed in Europe and Japan. Apart from industrial gas 
destruction, the project types most likely to involve technology 
transfer appear to be wind power, landfill gas capture, and agriculture 
(biogas). However, one expert pointed out that most of the wind power 
capacity represented in the CDM project pipeline is sited in India and 
China, countries that have supported domestic wind industries prior to 
the CDM. This suggests that while the CDM may provide a boost to these 
industries, it is not creating a new wind industry in either country. 

Industrial gas projects have been a controversial source of credits, 
particularly those involving the waste gas HFC-23. HFC-23 is produced 
during the manufacture of another gas, HCFC-22, which is used in some 
air conditioners and in the production of certain plastics. Industrial 
gases are several thousand times more potent than carbon dioxide, in 
terms of warming potential, and thus yield large quantities of credits. 
For example, while these projects account for only 1 percent of 
projects in the pipeline, they represent 18 percent of all expected 
credits through 2012. However, given that industrial gas projects 
involve simple, end-of-pipe technologies, they do little to promote 
efficient energy use or contribute to long-term sustainable development 
objectives. 

In addition, some researchers have argued that the CDM is an 
inefficient way to reduce industrial gas emissions. For example, one 
study estimates that HFC-23 reductions cost project developers less 
than $1 per ton of carbon dioxide equivalent, whereas CERs have 
historically been sold for $15 to $20 per ton. According to another 
researcher, payments to refrigerant manufacturers, investors, and the 
government of China, where most projects are sited, will total 
approximately $5.3 billion, whereas the costs of these projects are 
likely to be less than $115 million.[Footnote 56] While recently 
constructed plants cannot earn credits, some observers have raised 
concerns that the CDM will be extended to include new incineration 
sites. They argued that this could provide perverse incentives for 
plants to emit more, not less, as HFC-23 emitters could in theory earn 
much more by destroying these gases as they could from actually selling 
HCFC-22. 

Some researchers have downplayed these concerns and identified several 
reasons why they do not expect problems to continue. It is unlikely, 
for example, that industrial gas projects would have been undertaken 
without the CDM. Further, these projects constitute a small and 
diminishing share of projects, primarily because the pool of cheap 
reduction opportunities has been largely exhausted. In addition, tax 
revenue from HFC-23 projects may boost sustainable development 
programs. In light of the CDM's experience with industrial gas 
projects, however, some researchers have suggested that certain 
greenhouse gases could be better addressed by other mechanisms. 

Going forward, many believe the quality of projects will increase as 
the number of cheap, "low-hanging fruit" projects decreases. Indeed, 
current project trends have shown an increase in renewable energy and 
energy-efficiency projects, which have the potential to confer long- 
term sustainability benefits, and a decrease in industrial gas 
projects. However, given that CDM's market-based design encourages its 
participants to pursue low-cost projects, it may ultimately be 
difficult for the CDM, as currently structured, to make significant 
contributions toward sustainable development goals. 

The Scale and Cost-Effectiveness of the CDM Is Limited by the Current 
Project-by-Project Approval Process, but Proposed Reforms Could Improve 
Its Effectiveness: 

The CDM's project-by-project approval process may not be a cost- 
effective model for achieving emission reductions. Most experts 
expressed dissatisfaction with this approach, which requires individual 
review and additionality assessments for each project. Observers also 
have described the project-by-project approach as inefficient, noting 
that the long, uncertain approval process can create risks and costs 
for investors (figure 8 shows the resources and time associated with 
each step in the process). Host country stakeholders we spoke with 
generally agreed with this assessment, saying that the process was 
bureaucratic and overly burdensome. Indeed, the length and 
administrative complexity of the process, as well as the shortage of 
available emission verifiers, has resulted in bottlenecks and delays as 
the CDM's administrative structure has struggled to keep up with the 
number of projects. Moreover, the transaction costs and investment 
risks associated with CDM projects can reduce their effectiveness as a 
cost-containment mechanism when linked to compliance schemes. 

Figure 8: CDM Project Cycle: 

[Refer to PDF for image] 

This figure illustrates the CDM Project Cycle as follows: 

Project Initiation: Estimated Cost - $80,000-$230,000: 
Estimated time - 1 year: 
Project Preparation: Development of project design documents; performed 
by Project developer; 

Host Country Approval: 

Validation: Evaluation of documents to ensure they meet CDM criteria; 
performed by Accredited third-party auditor (Designated Operational 
Entity); 

Registration: Formal acceptance of validated project into the CDM; 
performed by CDM oversight board (Executive Board). 

Project Operations: Annual Estimated Cost - First year: $20,000-
$35,000; Subsequent years; $15,000-$25,000: 
Estimated time - 1 year (from registration to first credit issuance): 

Monitoring: Ongoing evaluation of project performance; performed by 
Project developer; 

Verification and Certification: Ongoing review and official recognition 
of emission reductions; performed by Accredited third-party auditor 
(Designated Operational Entity); 

CER Issuance: Distribution of credits for achieved reductions; 
performed by CDM oversight board (Executive Board). 

Source: GAO analysis of UNFCCC documents and UNDP data. 

[End of figure] 

While the CDM's intensive review process may help ensure some degree of 
environmental integrity, it also can limit the number of potential 
projects in the system. For example, the cost to initiate a CDM project 
and usher it through the approval process may be too high for certain 
projects, rendering them unviable. Some experts expressed concern that 
the CDM discouraged investment in the kinds of projects that would have 
the most benefits, because such projects are too costly, while others 
said that the extensive process does not necessarily result in a higher 
quality of credits. On the other hand, an Executive Board member we 
spoke with cited an unexpected but positive result of the delays. 
According to him, many projects waiting for approval have already been 
implemented but will not receive credits for emission reductions prior 
to registration; as a result, the number of credits issued to these 
projects may underestimate their environmental value. 

According to some stakeholders, generating the additionality analysis 
required under CDM is especially time-consuming, and, in some cases, 
impractical. For instance, several host country stakeholders expressed 
frustration over the investment analysis component of additionality, 
which requires project proponents to demonstrate that the proposed 
project would not be financially viable without the revenue provided 
through the CDM. They considered this requirement to be unrealistic, 
since the level of incremental CDM revenue is often too small to be the 
sole driver of investments, particularly in the case of multimillion 
dollar projects that have their own revenue stream, such as wind energy 
plants. Because some projects do not produce the number of credits that 
were initially projected, it is difficult for investors to know whether 
the projects will be profitable without the CDM. In addition, CERs are 
not issued until the project is registered and emissions have been 
verified, a process that can take several years, whereas the upfront 
financing for the project may be needed much earlier. Given these 
difficulties, one stakeholder involved in CDM finance said that their 
firm often prepares two sets of financial documents--one set for 
internal planning purposes, and another set that presents the data in a 
way that complies with CDM requirements. This stakeholder and others 
suggested that the ability to get projects approved depends largely on 
the ability to meet paperwork requirements, and said that paperwork is, 
in some cases, manipulated to artificially comply with rules that the 
project proponents think are unreasonable or restrictive. Several 
experts also claimed that the investment analysis requires auditors and 
Executive Board members who review this paperwork to make subjective 
decisions about the intent of investors. 

A few stakeholders further commented that the current definition of 
additionality was too restrictive and overlooked other benefits of the 
CDM. Several felt it was unrealistic to account for every unit of 
emissions, recommending instead that the CDM simplify the requirements 
to let more projects into the system. A number of experts concurred 
with this position, saying that the effort to assess the exact 
emissions from each project was impossible and that an imperfect system 
was not a valid reason for inaction on climate change. 

Indeed, under the current approach, it is unlikely that the CDM will 
significantly impact global emissions in the future. According to the 
International Energy Agency, global energy-related emissions are 
expected to increase approximately 57 percent from 2005 to 2030, with 
most of the additional emissions coming from China and India. This 
represents a major shift from the time period 1900 to 2005, when 
China's and India's historical share in cumulative emissions amounted 
to only 8 percent and 2 percent, respectively. In light of these 
trends, several experts highlighted the importance of involving 
developing countries in efforts to curb climate change. However, the 
scale of the CDM is limited not only by the extensive set of 
requirements; it also is constrained by the fundamental time and 
resource limitations of the 10-member Executive Board and its 
subsidiary panels, and the shortage of accredited auditing firms to 
validate projects and verify emissions. Even assuming all projects are 
real and additional, it is likely that reductions from these projects 
will only represent about 2 percent to 3 percent of annual energy- 
related carbon dioxide emissions in China and India, and less than 1 
percent in Africa.[Footnote 57] 

The CDM is not intended to be the sole solution to climate change, but 
it is yet unclear whether it can play a significant role. As a number 
of experts mentioned, reductions from both the developed and developing 
world are needed in order to effectively address climate change. 
According to some of these experts, however, it is unlikely that offset 
programs, on their own, will be enough to help curb developing country 
emissions. However, others claimed that the CDM, if reformed or 
supplemented, could make a broader impact worldwide. 

Experts provided a number of potential improvements to CDM, many of 
which would represent fundamental changes to the current mechanism's 
structure and procedures. Key themes underlying many of the experts' 
recommendations were a need to streamline and simplify the approval 
process and increase the CDM's effectiveness by targeting certain 
project types, industry sectors, or countries. However, the options 
presented below, are not necessarily exclusive of one another; in fact, 
many experts suggested a combination of approaches. 

Sectoral CDM: 

Many experts recommended that the CDM move toward a so-called "sectoral 
approach," which involves crediting emission reductions in relation to 
baselines set for different economic sectors, such as the power sector 
or cement industry. For example, the aluminum and cement sectors could 
have benchmarks based on the best available technologies in the 
industry, and facilities that performed above the benchmark would 
receive credits. The advantage of such an approach is that it 
eliminates the need for project-specific determination of 
additionality, because credits are awarded based on performance in 
relation to a predetermined baseline. However, this approach requires 
reliable historic emissions data to set baselines and the technical 
capacity to monitor emissions, requirements which may prove problematic 
for some developing countries. 

There are many different ways the sectoral approach could be 
implemented. For example, credits could either be awarded to private 
entities that reduce emissions below the baseline for their sector or 
to countries that implement policies that encourage or compel 
reductions in particular sectors. Sectoral baselines could be defined 
by intensity (emissions per unit of output) or set as an absolute cap. 

Sectoral No-Lose Targets: 

A few experts also advocated the use of sectoral no-lose targets, in 
which tradeable credits are issued to governments that reduce sectoral 
emissions below a preset baseline. There would be no penalties if 
emissions exceed the baseline--the purpose of these targets is to 
mobilize investment in low-carbon technologies in developing nations. 
This approach is similar to the government-administered sectoral 
approach discussed above, except that the national sector-wide 
baselines would be negotiated at the international level instead of 
using the CDM's current institutions and processes. This would have the 
practical effect of eliminating additionality assessment from the 
process altogether, since the targets for industrialized countries in a 
post-2012 agreement would factor in the credits awarded through no-lose 
targets. However, some researchers have concluded that this approach 
would make emissions leakage more likely, since targets are not 
binding. 

Programmatic CDM: 

Some experts that proposed reforms discussed the benefits of the 
programmatic approach, in which a group of small-scale activities is 
credited as one CDM project. In theory, this option helps promote 
projects that may result in significant emission reductions but may not 
be viable on an individual basis; for example, a program that provides 
energy-efficient light bulbs to a significant number of households. The 
aim is to reduce the transaction costs involved in the CDM by 
distributing these costs over a group of activities, an approach that 
may be particularly beneficial for energy-efficiency projects. While 
programmatic CDM has already been approved for use, it has been applied 
in few projects to date. According to stakeholders we spoke with, this 
is partially because it is challenging to design a methodology to 
verify emission reductions on a programmatic scale--for example, it may 
be difficult and costly to take a sample of households in order to 
demonstrate that issued light bulbs are being used and emission 
reductions are achieved. In addition, independent auditing firms are 
responsible for verifying these reductions, and may be reluctant to 
take on the added liability. 

Positive Lists: 

Many experts recommended the use of positive lists, which involves 
creating a list of activities that have been approved as additional and 
are therefore eligible for CDM credits. Such a list could include 
projects that use specific technologies or are located in a particular 
geographic area. Projects that fall outside this list would then be 
subject to added scrutiny or excluded altogether. As with sectoral 
approaches, positive lists remove the need for in-depth, project- 
specific determination of additionality, reducing the risk and 
administrative burden of project approval. However, in the past it has 
proven difficult to negotiate the exact types of projects or 
methodologies that would constitute such a list. 

Mandatory Caps: 

Several experts suggested a transition from CDM to mandatory emissions 
caps, particularly for countries with significant and growing 
contributions to global emissions. This approach would help distribute 
costs and control environmental outcomes, although many consider it to 
be an unrealistic expectation, especially in the short term. Emissions 
from industrialized nations have represented the vast majority of 
emissions to date, and developing nations may be unlikely to 
participate in agreements that significantly hinder their economic 
growth. One expert suggested that allotting generous caps to developing 
nations may help encourage their participation. 

Discounting Credits: 

Due to the inherent problems in determining additionality, a few 
experts recommended discounting credits received through CDM projects. 
For example, with a discount rate of 30 percent, a project that is 
expected to reduce carbon dioxide by 100 metric tons would only receive 
70 credits. While discounting may not help screen out nonadditional 
projects, it can help mitigate the environmental consequences of 
nonadditional credits. Some researchers have suggested using per capita 
emissions or income in host countries as a way to determine the level 
of discounts; others recommend discounting projects where environmental 
benefits are less certain. However, discounting may reduce the chance 
that additional projects, which rely on CER revenue to succeed, will be 
viable through the CDM. 

Phasing Out Offsets: 

A few experts recommended avoiding the use of offsets altogether. 
According to them, offsets are a flawed method of achieving 
environmental and economic goals. A number of experts preferred the 
economic and environmental certainty of a firm emissions cap. 

CDM Experience Offers Key Lessons Learned about Program Design and 
Implementation: 

The design of offset programs such as the CDM, and their use in 
compliance programs, can have important economic and environmental 
implications. In theory, an effective offset program reduces compliance 
costs but maintains overall environmental integrity; in practice, 
however, the CDM experience shows that this is a difficult goal to 
achieve. Using available information, stakeholder interviews, and our 
experts' responses to the questionnaire, we have identified lessons 
learned to help inform congressional deliberations on climate change 
legislation and the use of offset programs. The lessons outlined below 
focus on three essential areas--the cost-effectiveness of CDM projects, 
their environmental effects, and the tradeoffs involved in 
incorporating either the existing CDM program or an improved version 
into future U.S. climate change mitigation programs. 

Cost-Effectiveness: 

The experience of the CDM has provided a number of lessons about the 
costs and economic efficiency of offset programs. One of the most 
obvious benefits of such programs is that they can help decrease the 
cost of complying with emissions targets. However, this also may be a 
disadvantage, if the price of carbon does not reach levels high enough 
to promote fundamental technological changes needed to mitigate climate 
change. In addition, emission reductions achieved through the CDM may 
not always be cost-effective, especially in the case of industrial 
gases such as HFC-23. Because the cost to implement these projects is a 
fraction of the projects' overall credit value, several researchers 
have concluded that it would be more efficient to fund these types of 
projects through more direct means. 

Moreover, the current project-by-project approval process imposes 
extensive time and resource requirements on CDM participants, and the 
associated transaction costs may further diminish the overall cost- 
effectiveness of the program, according to many of our experts. There 
is a fundamental tension between minimizing costs and maximizing the 
quality of offset projects, and our analysis suggests that the CDM is 
not reliably effective in either area. Some stakeholders and experts 
said that high transaction costs weed out the very projects that would 
benefit most from CDM revenue--high-cost projects that involve 
fundamental technology changes. In addition, one expert told us that 
the cost and risk associated with navigating the CDM process diverts 
much of the proceeds from selling CDM credits to project financers and 
verifiers in the developed world. These concerns highlight the 
importance of considering the cost-effectiveness of achieved emission 
reductions in addition to the ability of offsets to lower compliance 
costs. 

Environmental Effects: 

A key requirement of offset programs is that issued credits represent 
real and additional emission reductions. If this condition is not 
fulfilled, the use of offset credits in mandatory emission reduction 
programs can undermine the environmental integrity of efforts to meet 
emissions targets. In theory, if all offsets were real and additional, 
the use of these offsets in a mandatory emissions scheme simply shifts 
the location of the emission reductions and would not negatively affect 
the scheme's integrity. However, as many experts mentioned, it is 
nearly impossible to demonstrate project additionality with certainty. 
Researchers have reported that some portion of projects registered 
under the CDM have not been additional, and although there is little 
empirical evidence to support a precise figure, some studies have 
concluded that a substantial number of nonadditional projects have 
received credits.[Footnote 58] As previously indicated, a significant 
number of nonadditional projects can introduce uncertainty about the 
level of reductions or even compromise the environmental integrity of a 
program--such as a cap-and-trade scheme--that enables the use of offset 
credits. For example, if CDM credits can be used in on a 1:1 ratio, and 
not all CDM credits are additional, then emission reductions may be 
less than the scheme intends. 

The CDM's oversight board has taken a number of actions to help improve 
the process over time, but many experts maintained that the program 
does not yet provide a sufficient level of quality assurance. Moreover, 
the intensive project-by-project review process used by the CDM 
significantly limits the number of projects and the overall scale of 
the program, making it unlikely that the CDM, as currently structured, 
will achieve large-scale reductions. While the design features of an 
offset program such as the CDM can be fine-tuned to help maximize their 
effectiveness, the underlying challenges of determining additionality, 
for example, may not be eliminated completely. 

Some research has advocated limiting the use of offsets in compliance 
schemes as a way to reduce the environmental risk of nonadditional 
projects; however, our research shows that even restricted offset use 
can have broad environmental implications. In particular, the 
experience of the ETS illustrates the importance of considering offset 
limits in the context of a country's overall reduction effort, in 
addition to its overall emissions target. As noted previously, limiting 
offsets based on the overall emissions cap--for example, allowing 
countries to meet 12 percent of their emissions cap with offsets--may 
mean in practice that most or all reductions occur outside of that 
country's borders. If most reductions occur elsewhere, there may be 
little incentive for entities under the compliance program to make 
infrastructure changes or other technological investments. Furthermore, 
the negative environmental effects of nonadditional offsets increase as 
the number of imported credits rises. On the other hand, stringent 
limits can ensure that a certain portion of abatement activity occurs 
at home and help secure a carbon price that is high enough to spur 
investment in low-carbon technologies; limits also can lessen the 
impact of nonadditional credits. If limits are imposed, therefore, it 
is important that such limits are sufficiently stringent and are based 
on actual expected emission reductions, not the overall emissions cap. 

Tradeoffs and Potential Improvements: 

There is general consensus among climate change experts that both 
industrialized and developing countries must be engaged in emission 
reduction efforts to meet goals established by the UNFCCC. In light of 
these circumstances, several experts we consulted noted that 
international offset programs such as the CDM can help to engage 
developing nations and encourage emission reductions in areas that may 
not otherwise have incentives to do so. In fact, because the CDM 
provides one of few such incentives, some experts expressed concerns 
about eliminating the program without a practical alternative to take 
its place. Further, several experts said that the CDM helps stimulate 
interest in international climate change dialogue and may help 
facilitate progress toward future emission reduction commitments. 

However, using the CDM to engage developing countries and promote 
emission reductions also can present tradeoffs. While the CDM may 
encourage these countries to participate in emission reduction 
activities, it also may increase their reliance on external funding for 
such activities. According to several experts, in fact, the CDM 
effectively deters efforts that fall outside the scope of creditable 
activities. Moreover, as many of our experts pointed out, the concept 
of additionality presents a difficult regulatory problem. Rigorous 
project reviews may help ensure some degree of credit quality, but also 
can increase the overall cost of the program. Overall, many experts 
suggested that the CDM has not yet achieved an effective balance of 
these priorities. 

Given these tradeoffs, many experts provided recommendations to help 
improve the program. These recommendations, discussed previously, 
ranged from small adjustments in the CDM's approach to more fundamental 
shifts in the approval and crediting process. Important themes 
underlying these recommendations included a need to improve the 
environmental integrity of projects, to simplify the project approval 
process by moving away from the project-by-project approach, and to 
promote certain types of projects, such as those in which emission 
reductions are easily measured or that confer substantial sustainable 
development benefits. Most experts recommended a combination of 
approaches between and within countries, because the ideal mix of tools 
for transition economy countries is unlikely to be suitable for small 
and less-developed countries. Such reforms have the potential to 
increase the CDM's value as a cost-containment mechanism and its 
ability to make meaningful contributions to environmental goals. 

However, while improvements to the CDM may help to streamline the 
program and address quality concerns, offsets may be a temporary 
solution at best, according to several of our experts. According to 
some observers, the best approach may be to gradually incorporate 
developing nations under a global emission reduction plan or move 
toward full-fledged, worldwide emission trading, given that emissions 
caps provide greater environmental certainty than offset credits. 
However, political and institutional capacity may make this an unlikely 
possibility. As a result, the CDM may be best used as a transition tool 
to help developing nations move toward a more comprehensive climate 
change strategy. 

Concluding Observations: 

Understanding the lessons learned from the international experience 
with the ETS and the CDM provides the U.S. Congress with an opportunity 
to draw on this experience as it considers legislation intended to 
limit emissions of greenhouse gases. While the ETS and the CDM are the 
largest existing international programs to address climate change, they 
are very different programs with unique strengths and limitations. 
Nonetheless, both programs provide insights into important program 
design and implementation issues that are central to the climate change 
policy proposals currently under consideration in the United States. 
Specifically, the lessons learned from the ETS--the importance of 
reliable data on emissions, the need for long-term certainty, and the 
impact of allowance allocation on wealth transfers--relate directly to 
the development of a domestic cap-and-trade system, which has already 
been considered on the floor of the U.S. Senate. Similarly, considering 
the lessons learned from the CDM--that it may be possible to achieve 
the CDM's goals more cost-effectively through other means, that carbon 
offsets are inherently uncertain and can potentially undermine the 
integrity of a cap-and-trade scheme, and that potential reforms, while 
promising, may not address fundamental tradeoffs--may prove useful in 
informing congressional deliberations over the use of CDM credits or 
other types of carbon offsets in domestic climate change programs. 

Matters for Congressional Consideration: 

In deliberating legislation intended to limit greenhouse gas emissions 
that would employ a cap-and-trade system or allow the use of carbon 
offset programs such as the Clean Development Mechanism, Congress may 
wish to consider the lessons identified above to help ensure that it 
develops policies that achieve the intended results in a cost-effective 
manner. 

Specific lessons from the ETS that the Congress may wish to consider 
include: (1) the importance of ensuring the availability and 
reliability of historic emissions data, with an accuracy compatible 
with the program's point of regulation, from entities that will be 
affected by the regulatory scheme prior to its establishment; (2) the 
importance of long-term certainty in encouraging investments in low- 
carbon technologies; and (3) the importance of understanding how the 
means of distributing allowances to emit greenhouse gases--such as free 
allocation versus auctioning--may create and redistribute substantial 
wealth. 

Specific lessons from the CDM that the Congress may wish to consider 
include: (1) that it may be possible to achieve the CDM's sustainable 
development goals and emissions cuts in developing countries more 
directly and cost-effectively through a means other than the existing 
mechanism; (2) that the use of carbon offsets in a cap-and-trade system 
can undermine the system's integrity, given that it is not possible to 
ensure that every credit represents a real, measurable, and long-term 
reduction in emissions; and (3) that while proposed reforms may 
significantly improve the CDM's effectiveness, carbon offsets involve 
fundamental tradeoffs and may not be a reliable long-term approach to 
climate change mitigation. 

As agreed with your offices, unless you publicly announce the contents 
of this report earlier, we plan no further distribution until 30 days 
from the report date. At that time, we will send copies to other 
interested parties. In addition, the report will be available at no 
charge on the GAO Web site at [hyperlink, http://www.gao.gov]. 

If you or your staffs have any questions about this report, please 
contact me at (202) 512-3841 or stephensonj@gao.gov. Contact points for 
our Offices of Congressional Relations and Public Affairs may be found 
on the last page of this report. GAO staff who made major contributions 
to this report are listed in appendix IV. 

Signed by: 

John B. Stephenson: 
Director, Natural Resources and Environment: 

[End of section] 

Appendix I: Objectives, Scope, and Methodology: 

To address the two objectives, we employed a two-step methodology. In 
the first step, we identified program effects through a review of 
available data and literature and conducted a series of semi-structured 
interviews with Emissions Trading Scheme (ETS) and Clean Development 
Mechanism (CDM) stakeholders to better understand program 
implementation. Specifically, we (1) reviewed relevant emissions 
trading literature, including academic reports, legal documents, and 
economic assessments; (2) obtained empirical evidence from the economic 
literature and available data sources, determined the data were 
sufficiently reliable for this report, and analyzed the data to 
identify impacts on emission reductions, technology innovation, 
competitiveness, and sustainable development; (3) met with U.S. and 
international stakeholders including government officials from the 
European Commission, the Designated National Authority of India, 
China's CDM Fund, the Kyoto Protocol's CDM Executive Board, and the 
U.S. Department of State, as well as representatives from industry 
groups, environmental groups, market traders, researchers, and other 
participants in the CDM (project owners, developers, and auditors); (4) 
considered the U.S. administration's perspective on the ETS and the CDM 
by meeting with the Council on Environmental Quality; and (5) conducted 
a site visit to a CDM offset project in China. We selected stakeholders 
that had significant levels of expertise in the ETS and CDM programs, 
including some stakeholders with direct involvement in the 
implementation of these programs. The CDM project we visited was 
selected based on interviews with project developers, who also 
coordinated our visit to the project. The project, which utilized waste 
gas from an iron and steel plant to generate electricity, was fairly 
representative of a typical CDM venture in terms of its location, size, 
and emission reduction methodology. 

For the second step, we obtained expert opinion on the implications and 
lessons learned for U.S. policymaking using a virtual panel on the 
Internet. To gather expert opinions from the experts, we employed a Web-
based questionnaire that was developed based on the results of the data 
collection efforts in the first phase. By using a Web-based process, we 
were able to overcome some of the potential biases associated with 
group discussions. These biasing effects include the potential 
dominance of individuals and group pressure for conformity. Moreover, 
by creating a virtual panel, we were able to include more experts than 
would have been possible with a live panel. While the method has these 
strengths, there are some potential limitations. For example, there is 
considerable reliance on the experts completing the questionnaire, as 
some may complete only limited sections, or not respond at all. In 
addition, the results of the questionnaire are limited to the issues 
and topics generated by our initial data collection efforts. To 
mitigate the latter limitation, we added generalized open-ended 
questions that provided an opportunity for experts to comment on topics 
not directly addressed by the questions. Lastly, because this was not a 
sample questionnaire, it has no sampling errors. However, the practical 
difficulties of conducting any questionnaire may introduce errors, 
commonly referred to as nonsampling errors. For example, difficulties 
in interpreting a particular question, sources of information available 
to respondents, or entering data into a database or analyzing them can 
introduce unwanted variability into the results. We took steps in 
developing the questionnaire, collecting the data, and analyzing them 
to minimize such nonsampling errors. 

We contracted with the National Academy of Sciences (NAS) to select and 
recruit a panel of experts with a range of experience in both market- 
based climate change programs and U.S. policymaking. Participants were 
to have (1) expertise in market-based tools used to address 
environmental problems, both in the United States and abroad; (2) 
familiarity with potential distributional effects of an emissions 
trading policy, for example, distribution of costs across different 
industries; (3) expertise in evaluating the performance of policies as 
well as knowledge of climate change agreements, politics, and policies, 
both at the international level and in the United States; and (4) an 
understanding of the implementation of U.S. environmental policies. To 
select the experts, we provided NAS with a list of potential experts 
that we identified in our review of the literature. In collaboration 
with NAS, 31 experts who met our criteria were identified. NAS sent 
these individuals an electronic letter via e-mail inviting them to 
participate in the study along with a description of the project. Of 
the 31 experts NAS recruited to participate, 29 agreed and were sent 
the questionnaire. Twenty-six ultimately completed the questionnaire. 
All of the experts who participated completed a form stating that they 
had no conflicts of interest that would compromise their ability to 
participate in the questionnaire. 

Prior to the posting of the questionnaires, we conducted pretests with 
two panel participants. The goals of the pretests were to check that 
(1) the questions were clear and unambiguous and (2) terminology was 
used correctly. We made changes to the content and format of both 
questionnaires as necessary during the pretesting processes. We also 
conducted usability tests of both questionnaires for the Internet to 
ensure operability. The final version of the questionnaire was posted 
on the Internet, and experts were notified of the availability of the 
questionnaire with an e-mail message. The e-mail message contained a 
unique user name and password that allowed each respondent to log on 
and fill out a questionnaire but did not allow respondents access to 
the questionnaires of others. 

In the questionnaire, we asked experts to provide responses to 17 
closed-and open-ended questions on the effects of the European Union 
ETS and CDM, and implications for U.S. policymaking. In particular, we 
asked experts to comment on: effects of the ETS, such as abatement and 
competitiveness; extent to which particular design elements, such as 
methods to distribute allowances, influenced ETS results; effects of 
the CDM, such as on emissions, sustainable development, and technology 
transfer; and implications of lessons learned for design and 
implementation of U.S. program to reduce greenhouse gas emissions. 

Experts had approximately 4 weeks between August 2008 and September 
2008 to complete their questionnaires. We followed up by email and 
phone to those who had not responded by our initial deadline of August 
27, 2008. In some cases, we also asked several follow-up questions 
requesting that experts clarify their responses or elaborate on 
critical policy issues. In order to analyze the open-ended questions, 
we performed a content analysis of each expert's response and grouped 
these responses into overall themes. GAO provided a summary of the 
findings of this report and briefed representatives from the European 
Commission and the CDM Executive Board prior to issuing this report. 
The views expressed by the panel members do not necessarily represent 
the views of GAO. 

We conducted our work from October 2007 to November 2008. 

[End of section] 

Appendix II: Summary of Joint Implementation: 

Joint Implementation (JI) is the third market-based mechanism 
established by the Kyoto Protocol to assist industrialized countries in 
meeting their emissions targets under the Protocol. JI allows countries 
with binding targets under the Protocol to generate credits, called 
Emission Reduction Units (ERU), by implementing projects that reduce 
emissions in other countries that have binding Kyoto targets. For 
example, a company in Finland could earn credits by developing a low- 
emission power plant in Russia and use these credits to comply with its 
ETS cap. JI projects are most likely to take place in eastern European 
economies in transition, where there are opportunities for emission 
reductions at lower cost than in other countries with binding Kyoto 
targets.[Footnote 59] JI projects, like CDM projects, must be verified 
for additionality before they are approved and ERUs can be issued. 
Project verification can take two possible courses: review by the host 
country if the country satisfies certain eligibility requirements, 
known as Track I, or review by the JI Supervisory Council, known as 
Track II. While the processes of each host country's Track I procedure 
can differ from the process of Track II, the issuance of ERUs in both 
cases is the responsibility of the country hosting the project. 

The JI market is significantly smaller and less mature than the CDM 
market and to date, no ERUs have been issued. As of October 2008, the 
volume of credits being verified under JI--i.e. in the pipeline--is 
approximately 11 percent of the volume of credits in the CDM pipeline. 
Under JI, a total of 158 Track II projects and seventeen Track I 
projects have been submitted in thirteen different host countries. 

The JI market is smaller than the CDM market in part because it was 
implemented at a slower rate and covers a shorter time span. For 
example, the JI Supervisory Council was established in 2006, 5 years 
after the establishment of the CDM Executive Board. Moreover, CDM 
projects may receive credit for certain emission reductions occurring 
since January 1, 2000, whereas JI projects may only receive credits for 
emission reductions occurring since beginning of the Kyoto commitment 
period, January 1, 2008. The time and resources required to develop 
host country procedures for JI as well as uncertainty over the role of 
ERUs in a potential future climate agreement, have limited its impact 
to date. Although market analysts anticipate the verification of 
additional JI projects and ultimately the future issuance of ERUs, the 
outlook for the JI market is thus unclear. 

[End of section] 

Appendix III: Panel of Experts: 

Joseph Aldy, Resources for the Future: 

Robert Bailis, Yale University: 

Bruce Braine, American Electric Power: 

Barbara Buchner, International Energy Agency: 

Dallas Burtraw, Resources for the Future: 

Frank Convery, University College Dublin: 

David Doniger, Natural Resources Defense Council: 

David Harrison, National Economic Research Associates: 

Barbara Haya, University of California-Berkeley: 

David Hunter, International Emissions Trading Association: 

Nathaniel Keohane, Yale University: 

Joe Kruger, National Commission on Energy Policy: 

Franz Litz, World Resources Institute: 

Jennifer Macedonia, JLM Consulting: 

Brian Murray, Nicholas Institute for Environmental Policy Solutions, 
Duke University: 

Ken Newcombe, formerly of Goldman Sachs Center for Environmental 
Markets: 

Lydia Olander, Nicholas Institute for Environmental Policy Solutions, 
Duke University: 

Ronald Oppenheimer, Global Commodities, Merrill Lynch Commodities: 

Misato Sato, Electricity Policy Research Group, University of 
Cambridge: 

Anne Smith, CRA International: 

Margo Thorning, American Council for Capital Formation: 

Thomas Tietenberg, Colby College: 

Richard Tol, Economic and Social Research Institute: 

Mark Trexler, EcoSecurities: 

Michael Walsh, Chicago Climate Exchange: 

Michael Wara, Stanford University: 

[End of section] 

Appendix IV: GAO Contact and Staff Acknowledgments: 

GAO Contact: 

John B. Stephenson, (202) 512-3841 or stephensonj@gao.gov: 

Staff Acknowledgments: 

In addition to the contact named above, Michael Hix, Assistant 
Director; Kate Cardamone; Cindy Gilbert; Jessica Lemke; Alison O'Neill; 
Jeanette Soares; and Ardith A. Spence made major contributions to this 
report. JoAnna Berry, Jason Burwen, Richard Johnson, Susan Offutt, and 
Katherine Raheb also made important contributions. 

[End of section] 

Footnotes: 

[1] Although the law, or directive, establishing the ETS uses the term 
"period" to refer to 2005 to 2007 and subsequent 5-year periods, in 
practice the EU refers to the 2005 to 2007 period as a learning phase, 
or phase I, and the 2008 to 2012 period as phase II. We use the EU's 
terminology in this report. 

[2] The UNFCCC's ultimate objective is to achieve stabilization of 
greenhouse gas concentrations in the atmosphere at a level that would 
prevent dangerous anthropogenic (man-made) interference with the 
climate system within a time frame sufficient to allow ecosystems to 
adapt naturally to climate change, to ensure that food production is 
not threatened, and to enable economic development to proceed in a 
sustainable manner. It was ratified by the United States, 190 other 
nations, and the European Economic Community. 

[3] The six primary greenhouse gases are carbon dioxide, methane, and 
nitrous oxide, as well as three synthetic gases including 
hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride. The 
remaining signatories to the Protocol were not required to decrease 
their emissions but were required, among other things, to monitor and 
report their emissions in accordance with the UNFCCC. 

[4] GHG Emissions, Yearly Emissions Inventory, in the World Resource 
Institute's Climate Analysis Indicators Tool, Version 5.0. (Washington, 
D.C., World Resources Institute, 2008). The 2004 estimate excludes 
emissions from land use changes as well as from Bulgaria and Romania, 
which joined the EU in 2007. 

[5] Under the Protocol, the use of these mechanisms must supplement 
domestic action for the purpose of meeting the country's emission 
limitation or reduction commitment (i.e., a binding emissions target). 
The third mechanism, Joint Implementation, operates under similar 
principles as the CDM, although it involves emission reduction projects 
in industrialized, rather than developing, countries. To date, activity 
under the Joint Implementation provisions of the Protocol has been 
limited. 

[6] A key distinction in the carbon offsets markets involves whether 
the offsets are purchased for compliance with mandatory emissions 
limits, such as those in the EU or on a voluntary basis in countries 
that do not have binding limits on emissions. The two markets often are 
referred to as "compliance" and "voluntary" markets. See GAO, Carbon 
Offsets: The U.S. Voluntary Market Is Growing but Quality Assurance 
Poses Challenges for Market Participants, [hyperlink, 
http://www.gao.gov/products/GAO-08-1048] (Washington, D.C.: Aug. 28, 
2008) for an overview of the U.S. voluntary offset market. 

[7] Directive 2003/87/EC, 2003 O.J. (L 275) 23. 

[8] In addition to electric power production, the industries covered 
included oil refining, iron and steel, cement, glass, and pulp and 
paper manufacturing. Bulgaria and Romania began participating in the 
ETS when they each joined the EU in 2007. Phase II also includes 
Norway, Iceland, and Liechtenstein, which are members of the European 
Economic Area. 

[9] World Bank, State and Trends of the Carbon Market 2008 (Washington, 
D.C., 2008). 

[10] Water vapor is also a greenhouse gas. According to the IPCC, water 
vapor is the most abundant and important greenhouse gas in the 
atmosphere, but human activities have a small direct influence on the 
amount of water vapor present in the atmosphere. 

[11] The IPCC defines mitigation as technological change and 
substitution that reduce resource inputs, such as energy use, and 
emissions per unit of output. Although several social, economic, and 
technological policies would produce an emissions reduction, with 
respect to climate change, mitigation means implementing policies to 
reduce greenhouse gas emissions and enhance greenhouse gas sinks. 

[12] IPCC, 2007: Introduction. In: Climate Change 2007: Mitigation, 
Contribution of Working Group III to the Fourth Assessment Report of 
the Intergovernmental Panel on Climate Change (B. Metz, O.R. Davidson, 
P.R. Bosch, R. Dave, L.A. Meyer [eds.]), Cambridge University Press, 
Cambridge, United Kingdom. [hyperlink, 
http://www.mnp.nl/ipcc/pages_media/AR4-chapters.html] (accessed Oct. 
31, 2008). 

[13] Other relevant institutions are the European Council and the 
European Court of Auditors. The European Council comprises the member 
states' heads of states (Presidents and Prime Ministers) and the 
President of the European Commission. The European Council is the 
initiator of the EU's major policies. The European Court of Auditors 
audits EU finances. 

[14] Member states choose the President of the Commission by common 
accord and the European Parliament must then assent to the selection. 
Once in power, the Commission President chooses the other Commission 
members, one from each member state, with the assistance of member 
states' governments. Both the Council of the European Union and the 
European Parliament must approve of the President's choices. 

[15] The European Climate Change Programme is a multistakeholder 
consultative process in which experts from the European Commission, 
member states, academics, industry and nongovernmental organizations 
address issues to improve the functioning and cost-effectiveness of the 
ETS, carbon capture and storage, and other climate policies. 

[16] EUA 2007 prices are in 2007 dollars. Prices, which were obtained 
from Point Carbon and adjusted for exchange rates (Purchasing Power 
Parity) and inflation, are based on spot and forward transactions. Most 
EUAs are traded on a forward basis, meaning that a purchaser may agree 
to buy an EUA at a certain price but would not pay and receive the 
allowance until, for example, 2007. 

[17] The ETS Directive allowed member states to decide whether to 
permit banking from phase I to phase II. The Commission permitted 
banking phase I allowances to phase II if (1) they were unused because 
of abatement rather than overallocation and (2) banked allowances were 
subtracted from the member state's phase II cap. Poland was the only 
member state to allow banking to phase II. 

[18] The ETS Directive automatically permitted banking from one year to 
another within the first phase because all allowances issued during 
phase I were valid for the duration of that trading period. 

[19] Convery, Frank and Luke Redmond, "Market and Price Developments in 
the European Union Emissions Trading Scheme," Review of Environmental 
Economics and Policy, vol. 1, no. 1 (2007). 

[20] Although interperiod banking was generally not an option, 
intraperiod banking could give covered entities a reason to hold onto 
excess allowances if, for example, they expected prices to rise during 
the first phase. 

[21] Net position based on the average in phase I of the annual net 
position in each member state, which reflected the difference between 
total allowances issued to covered entities and total allowances 
surrendered by covered entities. Analysis based on emissions data from 
the European Environment Agency's Community Independent Transaction Log 
Viewer. [hyperlink, 
http://www.eea.europa.eu/themes/climate/citl-viewer] (accessed Oct. 10, 
2008). Excludes Bulgaria and Romania, which joined the EU in 2007. 

[22] Ellerman, A. Denny, The EU Emission Trading Scheme: Prototype of a 
Global System? Discussion paper 08-02 (Cambridge, Mass.: Harvard 
Project on International Climate Agreements, August 2008). 

[23] European Environment Agency, Greenhouse gas emission trends and 
projections in Europe (Copenhagen, Denmark, 2008). 

[24] The ETS directive required member states to "bring into force the 
laws, regulations and administrative provisions necessary to comply" 
with the directive by December 31, 2003. This requirement would have 
included the national laws, regulations and policies the member states 
needed to ensure that the covered installations' emissions reports were 
submitted and verified. 

[25] See GAO, Air Pollution: Allowance Trading Offers an Opportunity to 
Reduce Emissions at Less Cost, [hyperlink, 
http://www.gao.gov/products/GAO/RCED-95-30] (Washington, D.C.: Dec. 16, 
1994). 

[26] Several member states made limited use of benchmarking to develop 
part of their allocation plans. Benchmarking distributes allowances 
based on both a standard emissions rate, such as best available 
technology, and an economic indicator, such as the historical 
production levels for the covered entity. 

[27] For example, see Ellerman, A. Denny and Barbara Buchner, "Over- 
Allocation or Abatement? A Preliminary Analysis of the EU ETS Based on 
the 2005-06 Emissions Data;" and Delarue, Erik D., A. Denny Ellerman, 
and William D. D'haeseleer, "Short-term CO2 Abatement in the European 
Power Sector," Working Papers (Cambridge, Mass.: MIT Center for Energy 
and Environmental Policy Research, June 2008). [hyperlink, 
http://web.mit.edu/ceepr/www/publications/workingpapers.html] (accessed 
Oct. 26, 2008) 

[28] During phase I, Hungary, Ireland, and Lithuania auctioned 4.18 
percent, 1.81 percent, and 1.5 percent, respectively, of their total 
allowances. In addition, Denmark planned to auction 5 percent of its 
allowances but sold them on an exchange instead. See Fazekas, Dora, 
Auction Design, Implementation and Results of the European Union 
Emissions Trading Scheme, Columbia University, New York (2008). 

[29] We asked experts to comment on the effects of phase I (2005 to 
2007) because phase II has been underway for less than a year. 

[30] Climate Strategies, Differentiation and Dynamics of EU ETS 
Industrial Competitiveness Impacts (Cambridge, United Kingdom, 2007). 

[31] The basis for free allocation affects the risk of leakage. 
Consistent with economic theory, basing free allocation on historic 
levels of emissions would not reduce the risk of leakage whereas free 
allocation based on firm level changes--known as updating--may reduce 
the risk. Updating links free allocations to the firm's changing 
domestic level of emissions, energy use, or production. If historic 
levels of emissions are the basis for free allocation, a firm's free 
allocation is independent of level changes. In response to high 
domestic carbon prices, a firm could relocate its production to an area 
where carbon is not regulated without affecting its free allocation. 
However, if updating is the basis for free allocation, the firm is more 
likely to consider how its domestic emissions, energy use, or 
production will affect its free allocation. Updating increases the 
opportunity cost of leakage to the firm, as the basis for free 
allocation decreases when production is shifted abroad. Updating 
affects other emissions trading issues that are beyond the scope of 
this discussion. 

[32] The EU's transition from a regulated electricity market to a 
"liberalized" or deregulated electricity market in which electricity 
generators compete to meet the demands of residential, commercial, and 
industrial consumers, coincided with the first phase. The ability for 
generators to pass the cost of allowances to consumers depended in part 
on the progress their member state had made toward deregulation. Some 
member states had deregulated the electricity markets by the time the 
first ETS phase was under way, such as the United Kingdom and the 
Netherlands, whereas others, including Poland and Spain, had not. 

[33] Some industrial consumers had long-term electricity contracts, 
which would have fixed their electricity rates during the first phase. 

[34] A limited number of carbon offset credits generated from certain 
CDM projects could be used to meet caps under the ETS. 

[35] The IPCC refers to investment in technology research, development, 
demonstration, deployment and diffusion, and induced technology change 
to stabilize greenhouse gas concentrations at a level that would 
prevent dangerous anthropogenic interference with the climate system. 

[36] For more on carbon capture and storage, see GAO, Climate Change: 
Federal Actions Will Greatly Affect the Viability of Carbon Capture and 
Storage as a Key Mitigation Option (Washington, D.C.: Sept. 30, 2008). 

[37] Estimates are adjusted for predicted inflation and based on 
installations at new facilities; costs to retrofit existing plants 
expected to be higher. See McKinsey & Company, Carbon Capture & 
Storage: Assessing the Economics (2008). 

[38] ETS Directive, 2003/87/EC, art. 11(3), Oct. 13, 2003. 

[39] S. 3036, 110th Congress (2008). 

[40] Linking also may be one-way--participants in program A could use 
allowances from program B, but not vice versa. Linking also may be 
indirect--participants in programs A and B could use allowances from a 
third program, C, but not from each other. 

[41] Most CERs can be used for compliance in Europe, with one CER being 
equal to one EUA. However, certain types of CERs are not eligible for 
ETS compliance, including nuclear and forestry projects and, under 
certain conditions, large-scale hydropower projects. 

[42] Castro, Paula and Michaelowa, Axel. Empirical Analysis of 
Performance of CDM Projects. Climate Strategies, Zurich, Switzerland 
(2008). 

[43] According to one expert, the current price difference between EUA 
allowances and secondary CERs is primarily due to the limit on imported 
CERs in the ETS. 

[44] The World Bank, State and Trends of the Carbon Market, Washington, 
D.C., 2008. 

[45] Under the Kyoto Protocol, carbon offsets are quantified and 
described in terms of carbon dioxide equivalent. Carbon dioxide 
equivalents provide a common standard for measuring the warming 
efficiency of different greenhouse gases and are calculated by 
multiplying the emissions of the non-carbon-dioxide gas by its global 
warming potential, a factor that measures its heat-trapping ability 
relative to that of carbon dioxide. 

[46] As we reported in August 2008, additionality is fundamental to the 
credibility of offsets because only offsets that are additional to 
business-as-usual activities result in new environmental benefits. See 
GAO, Carbon Offsets: The U.S. Voluntary Market Is Growing, but Quality 
Assurance Poses Challenges for Market Participants, [hyperlink, 
http://www.gao.gov/products/GAO-08-1048] (Washington, D.C.: Aug. 29, 
2008). 

[47] The approval process for large-scale CDM projects is composed of 
validation, registration, verification, and certification. Please see 
figure 8 for an explanation of the process. A separate and simplified 
process exists for small-scale CDM projects. 

[48] The Marrakech Accords state that these auditors, called Designated 
Operational Entities, should perform either (1) validation or (2) 
verification and certification for any given CDM project activity; 
however, upon request to the Executive Board, it is possible that a 
single Designated Operational Entity could perform all the functions. 

[49] For further information on the voluntary carbon offset market, see 
[hyperlink, http://www.gao.gov/products/GAO-08-1048]. 

[50] For further analysis on the potential effects of linking offset 
programs to mandatory emission reduction schemes, see: Stavins, Robert 
N. and Judson Jaffe. Linking Tradable Permit Systems for Greenhouse Gas 
Emissions: Opportunities, Implications, and Challenges. IETA Report on 
Linking GHG Emissions Trading Systems. Geneva, Switzerland, November 
2007. 

[51] [hyperlink, http://www.gao.gov/products/GAO-08-1048]. 

[52] Limits for the use of offsets vary by country, with a range from 0 
percent to 20 percent of a country's total cap, and an average limit of 
11.6 percent. These limits, which apply to the current phase II of the 
EU ETS, were approved by the European Commission based on the Kyoto 
Protocol's principle of supplementarity, which directs industrialized 
countries to use the CDM program only as a supplement to their own 
domestic emission reduction efforts. 

[53] The Commission's legislative proposal restricts use of CDM credits 
in phase III of the ETS in the absence of a post-Kyoto international 
agreement on emission reductions. If there is no such agreement, the 
use of CERs would be restricted to the amount of the unused CERs that 
member states' phase II National Allocation Plans permit. If there is 
an agreement, CERs from its signatories can be used to satisfy up to 
half of the ETS cap. 

[54] Höhne,Niklas and Ellerman, Christian. The EU's emission reduction 
target, intended use of CDM and its +2°C. Ecofys, Köln, Germany (2008). 

[55] National CDM authorities in host countries must approve proposed 
CDM projects before they can be submitted to the CDM Executive Board 
for formal acceptance. 

[56] Wara, Michael W. and Victor, David G., A Realistic Policy on 
International Carbon Offsets (Stanford, Calif., 2008). 

[57] Analysis uses country-specific emissions data from IEA, Key World 
Energy Statistics (2008) as well as data on expected CERs from the UNEP 
Risoe CDM/JI Pipeline Analysis and Database, Oct. 1, 2008. IEA data for 
each region are based on 2006 indicators and include emissions from 
fuel combustion only. 

[58] For example, one study analyzed documentation from 93 projects 
that were registered from 2004 to 2007, and concluded that 
additionality was questionable in approximately 40 percent of these 
projects. However, the author notes that this figure is based on past 
performance and does not reflect recent improvements to the approval 
process. See Schneider, Lambert, Is the CDM fulfilling it environmental 
and sustainable development objectives? An evaluation of the CDM and 
options for improvement (Berlin, Germany, 2007). 

[59] Annex B of the Kyoto Protocol identifies 13 economies undergoing 
the process of transition to a market economy: Bulgaria, Croatia, the 
Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, 
the Russian Federation, Slovakia, Slovenia, and Ukraine. 

[End of section] 

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