A Framework for Achieving Environmental Integrity and the Economic Benefits of Emissions Trading Under the Kyoto Protocol

Robert R. Nordhaus, Kyle W. Danish, Richard H. Rosenzweig, and Britt Speyer Fleming

Robert Nordhaus is a member of the Washington, D.C., law firm of Van Ness Feldman, P.C.; L.L.B., Yale Law School (1963); B.A., Stanford University (1960). Kyle W. Danish is an associate at Van Ness Feldman; J.D., Temple University School of Law (1997); M.P.A., Princeton University Woodrow Wilson School of Public and International Affairs (1996); B.A., Haverford College (1989). Richard H. Rosenzweig is a principal at Van Ness Feldman; M.A., American University (1984); B.A., Northeastern University (1982). Britt Speyer Fleming is an associate at Van Ness Feldman; J.D., American University Washington College of Law (1997); B.A., Dartmouth College (1994). The authors extend their gratitude to the following individuals for their helpful comments: Christian Albrecht, Carlton Bartels, Timothy Denne, A. Denny Ellerman, Joseph Goffman, Erik Haites, Dale Heydlauff, Fanny Missfeldt, Jake Werksman, Jonathan Wiener, and Thomas Wilson. Responsibility for any errors or omissions rests solely with the authors.

[30 ELR 11061]

Introduction

In a previous Article in ELR,¹ the authors examined issues related to international greenhouse gas emissions trading under the as-yet unratified Kyoto Protocol to the United Nations Framework Convention on Climate Change.² This Dialogue builds upon, and assumes the reader's knowledge of, the previous Article.

As explained in that Article, the Kyoto Protocol provides that the countries listed in the Kyoto Protocol's Annex B—and possibly private companies in those countries—may meet emission reduction commitments through the buying and selling of emission allowances called assigned amount units (AAUs).³ Many governments and firms are planning on using emissions trading as a compliance tool for the Kyoto Protocol's first "commitment period," which will run from 2008 to 2012. Because emissions trading can reduce the costs associated with implementing commitments under the Kyoto Protocol, it also can promote long-term participation in international efforts to address climate change.

Emissions trading, however, also introduces a risk of noncompliance in the form of "overselling." Overselling will occur if an Annex B Party to the Kyoto Protocol sells AAUs that it ultimately will need to cover its 2008-2012 emissions and thus will be unable to meet its emission limitation or reduction commitment under Article 3 of the Kyoto Protocol.⁴

Concerns about overselling risks have prompted a number of governments and nongovernmental organizations to propose rules aimed at preventing or deterring overselling. These proposals appear in a single negotiating text that is being used to focus the international negotiations on rules governing the Kyoto Protocol's emissions trading mechanism.⁵ The government delegations have set a goal to make final decisions on the rules for emissions trading and other key elements of the Kyoto Protocol at the sixth Conference of the Parties (COP-6), which will be held in The Hague on November 13-24, 2000.

In the previous Article, the authors analyzed the problem of overselling and evaluated the rules that appear in the Chairmen's Negotiating Text. The Chairmen's Negotiating Text contains seven options: (1) the Originating Party Liability rule; (2) the Shared Liability rule; (3) the Acquiring Party Liability rule; (4) the Trigger rule; (5) the Compliance Reserve rule; (6) the Units in Surplus to Plan rule; and (7) the Surplus Units rule.⁶ The authors assessed these various proposed rules with respect to their effectiveness in minimizing overselling risks, their workability, and their impacts on the ability of emissions trading to reduce costs of compliance.

The previous Article reported the following findings:

Option 1, Originating Party Liability, would hold selling (originating) Parties liable for their overselling. It essentially would rely on end-of-period sanctions to deter originating Parties from overselling. If effective in deterring overselling, this approach would be optimal because it would provide for essentially unfettered trading. However, the authors concluded that this approach could not be effective because of the barriers to the establishment of sanctions that both cannot be avoided and that exceed the potential economic benefits of overselling to originating Parties. Accordingly, the authors recommended that, to the extent that [30 ELR 11062] policymakers are concerned about overselling, they should consider an additional safeguard(s) that would supplement sanctions.⁷

Options 2, 3, and 4 (Shared Liability, Acquiring Party Liability, and Trigger) are all variations of an approach that imposes some or all of the liability for overselling on Parties that acquire AAUs. Under these rules, AAUs sold by a noncompliant Party would be invalidated for compliance purposes in the hands of the buyers. The authors concluded that this approach, referred to generically as "Acquiring Party Liability," could be highly effective in deterring overselling because it would encourage buyers to discriminate among originating Parties on the basis of their likelihood of compliance.⁸ However, the authors also found that a pure Acquiring Party Liability approach would impose on buyers a risk that, for at least the first commitment period, many could not assess or manage cost effectively. Acquiring Party Liability therefore could preclude a substantial number of "good" transactions, i.e., transactions that would not contribute to overselling. The authors therefore recommended that policymakers consider alternative approaches that could be equally effective in preventing overselling but that would have a less adverse impact on the emissions trading market. Acquiring Party Liability could be a useful supplement to such an alternative approach.⁹

Options 5 and 6 (Compliance Reserve and Units in Surplus to Plan) would maintain liability for overselling in originating Parties but would impose quantitative constraints on the amount of AAUs they could sell. Under the Compliance Reserve rule, each time an originating Party transferred some of its AAUs, it would have to set aside a given percentage of its remaining AAUs in a reserve account. AAUs in the reserve account could not be sold for the duration of the commitment period. The Chairmen's Negotiating Text appears to contemplate the establishment of a single reserve percentage that would apply to all Parties although it does not specify any methodology or decisionmaking process that should be used to arrive at a particular number. The authors found that the problem with this approach is that there is no optimal percentage that fits the circumstances of each country. Consequently, if the specified percentage were set too low for too many Parties, the rule would be ineffective in preventing overselling. If the specified percentage were set too high, the rule would preclude a substantial number of "good" transactions.¹⁰

The Units in Surplus to Plan rule would require a Party wishing to trade to first allocate its allotment of AAUs roughly evenly among each of the five years of the commitment period. Then, in any year of the period, a Party could sell only those AAUs allocated to that year and unsold AAUs allocated to previous years that were deemed surplus to its cumulative emissions. The authors found that the Units in Surplus to Plan rule would all but eliminate overselling risks. However, the authors also concluded that the rule would have negative implications for the development of a robust emissions trading market. First, the rule would have the effect of delaying the commencement of the trading in the first commitment period until submission and review of the year 2008 emissions inventories, which might not be completed until as late as 2010 or 2011. Second, the rule would lead to year-to-year uncertainty as to the amount of AAUs available in the marketplace.¹¹

Option 7 (Surplus Units) would allow Parties to trade only those AAUs not needed for compliance during the commitment period. In effect, this rule would prohibit registry-based trading during the commitment period. By limiting sales of AAUs to those deemed actually surplus, this approach would eliminate overselling. However, this approach also would eliminate most of the environmental and economic benefits of emissions trading.¹²

We thus concluded in the previous Article that, while some of the proposed rules currently outlined in the Chairmen's Negotiating Text have promising elements, no single rule strikes the optimal balance of environmental integrity, workability, and economic efficiency. In this Dialogue, we build on our findings from the previous Article to outline an alternative approach for addressing overselling risks: the Hybrid Option. The Hybrid Option aims to provide for a prompt start for emissions trading. It ensures buyers of the availability of a substantial amount of AAUs that are not subject to later invalidation or repatriation. At the same time, the Hybrid Option would reduce both the risk of overselling and the amount of overselling that could occur.

This Dialogue provides a description of the Hybrid Option followed by an analysis of the proposal's likely effectiveness in preventing overselling, its workability, and its impact on the ability of the emissions trading market to reduce compliance costs.

Description of the Hybrid Option

Overview

Optimally, a Party participating in emissions trading would estimate its likely emissions during the commitment period, ensure that it holds a corresponding amount of AAUs at the end of the period, and sell its surplus. The Hybrid Option aims to achieve this result by requiring each Party to establish two accounts in its registry, a Reserve Account and a Surplus Account, and requiring that each Party set aside in its Reserve Account a quantity of its AAUs that corresponds to an estimate of its commitment period emissions. The Party then may allocate its remaining AAUs to its Surplus Account and sell those AAUs subject to Originating Party Liability.

The Hybrid Option initially would derive each Party's estimate of commitment period emissions by means of a Straight Line Method. The Straight Line Method would extrapolate an emissions trend from the Party's last four available [30 ELR 11063] pre-commitment period emissions inventories.¹³ Under the Straight Line Method, the Party's estimate of commitment period emissions, and its corresponding allocations to its Surplus and Reserve Accounts, would remain fixed for the length of the commitment period.

The Hybrid Option provides for two additional components that could provide for greater liquidity without adding significant risks or administrative costs. First, a Party may obtain a lower Reserve (higher Surplus) and begin issuing AAUs before or during the commitment period if it can demonstrate to the satisfaction of the Kyoto Protocol compliance institution that it will emit at a lower level than the level derived in accordance with the Straight Line Method. If approved, the Party's estimate is subject to prospective adjustment on the basis of its annual emissions inventories. This component is called the Optional Method. Second, buyers are free to acquire AAUs from a Party's Reserve Account at any time subject to Acquiring Party Liability. This is called the Acquiring Party Liability component.

Figure 1 provides a schematic illustration of how the rule would work for a hypothetical originating Party with a downward trend in emissions. Figure 2 illustrates how the rule would work for an originating Party with an upward trend in emissions.

Figure 1

[SEE ILLUSTRATION IN ORIGINAL]

Figure 2

[SEE ILLUSTRATION IN ORIGINAL]

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We believe that the rules outlined here would reduce both the risks of overselling and the amount of overselling that could occur. At the same time, they would give buyers certainty before the start of the commitment period that a significant supply of AAUs not subject to later invalidation would be available for purchase and provide them the option of buying additional AAUs at any time at their own risk.¹⁴ The Hybrid Option would impose minimal administrative burdens additional to those already contemplated for the Kyoto Protocol's compliance framework.

Eligibility and General Compliance Rules

A Party (and its legal entities) may not sell AAUs unless the Party has met its Article 5 and 7 commitments and otherwise complied with the following eligibility rules:

[] Registry. All AAUs have a unique serial number. No acquired AAU is valid for compliance purposes unless prior to the trade it was registered to the originating Party and the trade is promptly recorded to the account of the acquiring Party. This effectively precludes overdrafts. The registry must be transparent to Parties and legal entities.¹⁵

[] Surplus and Reserve Accounts. Each Party must establish two accounts in the registry: (1) a Surplus Account (from which Originating Party Liability AAUs may be sold) and (2) a Reserve Account (from which Acquiring Party Liability AAUs may be sold).¹⁶

[] Annual Inventory. Issuers must undertake an annual emissions inventory and promptly report results.¹⁷

[] Sanctions Amendments. To be eligible to sell AAUs, a Party must have ratified any amendment or instrument relating to "binding consequences" of noncompliance, and agree to cure any outstanding noncompliance with Article 3 prior to withdrawing from the treaty pursuant to Article 27.

[] True-Up. A Party that is out of compliance with its Article 3 commitment at the end of a budget period has a six-month true-up period to purchase AAUs, emission reduction units (ERUs), or certified emission reductions (CERs) to cure its noncompliance.

[] Repayment With Interest. A Party that does not cure its noncompliance by the end of the true-up period is subject to a deduction from its second budget period assigned amount equal to its overage plus an interest penalty.¹⁸

Allocation of Risk of Noncompliance

[] Sale of AAUs. A Party may sell AAUs from its Surplus Account subject to an Originating Party Liability rule. A Party may sell AAUs from its Reserve Account subject to an Acquiring Party Liability rule.

[] Allocation of AAUs to Reserve Account. Each Party must allocate its AAUs to its Reserve Account on the basis of the Straight Line Method or the Optional Method described below. AAUs not allocated to the Reserve Account may be allocated to a Party's Surplus Account.

(a) Straight Line Method

* The Party's level of emissions for each of the five years of commitment period is estimated by extrapolating (on a straight line basis)¹⁹ the trend of its emissions levels from four most recently available emissions inventories.²⁰ The sum of the estimates for each year in the first commitment period is the Party's estimated total emissions for the commitment period.

* The Party must allocate an amount of AAUs equivalent to its estimated total emissions for the commitment period to its Reserve Account. The balance is allocated to the Surplus Account.

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* The allocations to each account are fixed for the length of the commitment period, unless the compliance institution determines that base period emissions inventories were substantially incorrect. Any adjustment to Surplus Account is prospective only—rights of Parties or legal entities that purchased AAUs before the adjustment are unaffected.²¹

(b) Optional Method

* Any time on or after January 1, 2005, a Party may elect the Optional Method for purposes of allocating AAUs to its Reserve Account.

* If the Party demonstrates to the Kyoto Protocol compliance institution that its total emissions for the first commitment period will be less than the amount determined under the Straight Line Method, the compliance institution will approve the lower estimate for purposes of allocation to the Surplus Account.²²

* No Party trading under the Optional Method may issue Surplus AAUs in excess of those that it is entitled to under the Straight Line Method until the compliance institution has completed its review of the Party's 2008 emissions inventory.

* If a Party's emissions inventory for any year of the compliance period shows that its actual emissions exceeded its projected emissions for that year, then the Party must reallocate AAUs from its Surplus Account to its Reserve Account in an amount equal to such excess (but not more than the balance in the Surplus Account).²³ Any adjustment of estimated surplus AAUs has only prospective effect—rights of Parties or legal entities that purchased AAUs before the adjustment are unaffected.

* A Party that elects the Optional Method must pay the administrative expenses associated with review of its pre-commitment period estimate and annual emission inventories.

Acquiring Party Liability

An originating Party that complies with the eligibility rules may issue any of the AAUs in its registry, including those AAUs in its Reserve Account, subject to an Acquiring Party Liability rule. This provision applies regardless of the procedure under which the Party's accounts were established. AAUs traded subject to an Acquiring Party Liability rule must be clearly identified as such. In the event that an originating Party fails to meet its Article 3 commitment, the AAUs it sold under an Acquiring Party Liability rule will be repatriated to the originating Party according to a Last-In, First-Out (LIFO) rule until the earlier of the following two events: (1) the originating Party has been restored to compliance or (2) all transferred AAUs have been repatriated.²⁴

Discussion and Analysis

In our previous Article, we asserted that all proposed rules to address overselling should be assessed on the basis of their effectiveness in minimizing overselling risks, workability, and impact on the ability of emissions trading to reduce compliance costs. In this section, we apply this evaluation framework to the Hybrid Option.

Effectiveness of the Hybrid Option in Minimizing Overselling Risks

Emissions (and Surplus) Estimate

The primary means by which the outlined set of rules would reduce the risk of overselling is by requiring that, before the start of the commitment period, Parties set aside in a Reserve Account an amount of AAUs equal to a reasonable projection of its 2008-2012 emissions. The Hybrid Option thus would determine the amount that each Party would have to set aside on the basis of that Party's actual historical emissions. In this respect, the Hybrid Option is superior to the proposed Compliance Reserve rule, which would rely on a one-size-fits-all reserve percentage. In addition, the Hybrid Option would impose a strict and immediately effective upper boundary on the amount of overselling that would be possible.²⁵

[] Straight Line Method. The rules provide for two procedures for establishing an estimate of a Party's commitment period emissions (and therefore the quantity of the Party's AAUs that must be held in the Reserve Account). The Straight Line Method uses a trend line approach, extrapolating the emissions for the first commitment period from the last four available emissions inventories. This trend line methodology for establishing an estimate is superior to an [30 ELR 11066] approach that uses the emissions inventory from a single year as a proxy for commitment period emissions. First, the single-year approach would not address a pattern of increasing emissions. In particular, the single-year approach is vulnerable to distortion on the basis of annual fluctuations; the base year could be a year in which emissions were unusually low. The Straight Line Method's trend line approach, by contrast, would account for annual fluctuations more accurately.²⁶

The trend line estimate could be conservative for some Parties in that it might not reflect fully the effects of policies and measures a Party was planning to implement during the commitment period to reduce its emissions from business-as-usual levels. That is not to say that none of the emissions impacts of such policies would be revealed through the trend line approach. Some governments will start implementing their policies and measures prior to the commitment period in order to effect a gradual reduction in emissions. Indeed, the use of the trend line approach could establish an incentive for early reductions. In any event, originating Parties that believed that the trend line estimate would not adequately account for planned policies and measures could take advantage of the Optional Method, which is analyzed in greater detail below.

Under the Straight Line Method, the Party's estimate is fixed for the entire commitment period. Accordingly, the approach outlined here does not obligate the Kyoto Protocol compliance institution to make annual determinations of tradable AAUs for each issuing Party; only those Parties relying on the Optional Method would be affected. The approach thus would impose a smaller burden of administration on the institution than other proposed rules, such as the proposed Swiss Units in Surplus to Plan rule, which require annual determinations for each Party. For the reasons discussed above, it is our view that the minimal burden on the compliance institution is a positive feature of this approach. In addition, as discussed below, this fixed estimate approach also has benefits for the operation of the emissions trading market.

Of course, the fixed character of an estimate derived under the Straight Line Method would mean that this rule would be vulnerable to the risk that a Party would oversell because its actual emissions exceeded its estimate. In our view, this risk is not a reason to provide for adjustment on the basis of annual inventories in all cases. The amount of overselling that could occur under such a scenario is limited; the Party only could oversell AAUs corresponding to the difference between its actual and its estimated AAUs.²⁷ In any event, the outlined set of elements still provide for compliance facilitation and a severe end-of-period sanction for noncompliance.

[] Optional Method. The approach provides an Optional Method under which a Party that believes its emissions during the commitment period will be lower than the Straight Line estimate can obtain a lower estimate (and more Surplus AAUs) from the compliance institution. This procedure provides an incentive for originating Parties to take steps to reduce their emissions below business-as-usual levels. At the same time, the Optional Method provides for a variety of safeguards against flawed estimates.

The first safeguard provided by the rules is that the Straight Line Method estimate serves as the presumptive estimate for a Party. Accordingly, Parties that seek to proceed under the Optional Method bear the burden of proving to the Kyoto Protocol compliance institution that their emissions during the commitment period will be lower than the trend line. The second safeguard is that an estimate obtained under the Optional Method is subject to annual adjustment on the basis of review of emissions inventories. The final safeguard is that, until the compliance institution has completed its review of the Party's 2008 emissions inventory, a Party trading under the Optional Method may issue no more than the quantity of Surplus AAUs to which it would be entitled under the Straight Line Method. Parties electing the Optional Method must pay the additional administrative expenses associated with the initial and annual reviews.

Ability to Engage in Acquiring Party Liability Transactions

Under either the Straight Line or the Optional Method, a Party may sell AAUs from its Reserve Account at any time subject to an Acquiring Party Liability rule. This provision would increase the AAUs available to the market without increasing risks of overselling. An originating Party would have to persuade buyers that its emissions would be below the estimate derived for it under the rules. As explained above, buyers bear the risk that they will have to restore Reserve AAUs to the Originating Party. Under the outlined Acquiring Party Liability rule, AAUs would be repatriated on a LIFO basis in the event of an originating Party's failure to meet its Article 3 commitment.

[30 ELR 11067]

Other Safeguards

In addition to these procedures, the elements we propose incorporate a number of other elements that would prevent or deter overselling. The elements include eligibility rules such as those incorporated in the Chairmen's Negotiating Text which require Parties to comply with their Article 5 and 7 commitments and establish domestic registries for reporting and tracking transactions.

The elements also provide for a true-up period and a Repayment With Interest sanction for noncompliance. In our previous Article, we observed that the text of the Kyoto Protocol establishes two potential obstacles to ensuring that any and all Parties that oversell are subject to sanctions.²⁸ The first is that Article 18 of the Kyoto Protocol appears to require that sanctions be established only through an amendment to the Kyoto Protocol and an amendment to the Kyoto Protocol binds only those Parties that assent to it. The second obstacle is Article 27, which authorizes Parties to withdraw from the Kyoto Protocol after one-year's notice. Accordingly, the Kyoto Protocol seems to provide a means for a violating Party to avoid sanctions, either by not assenting to them or by withdrawing before they take effect. The Hybrid Option addresses these concerns in two ways. First, it would condition a Party's eligibility to participate in trading on its accession to any amendment necessary for a sanction to enter into force. Secondly, it stipulates that a Party that opts to exit at the end of the commitment period must compensate the regime for any overselling. This latter provision may be difficult to enforce; nevertheless, it makes clear the Party's obligation if it withdraws.

The outlined set of elements will not eliminate all risks of overselling. However, it is our view that the residual risks of overselling and the amount of overselling that could occur under the rules are not greater than under the Units in Surplus to Plan rule, which would impose both substantially higher administrative costs and large burdens on the emissions trading market.

Market Impact and Workability

The Hybrid Option described above is designed to facilitate a prompt start to trading and to assure buyers of the availability of a substantial volume of AAUs that will be valid for compliance purposes regardless of the compliance status of the originating Party. According to one economic modeling analysis, adoption of the Straight Line Method alone would make available in the emissions trading market approximately 1,715 million metric tons of carbon worth of Surplus AAUs. This number is indistinguishable from the model's reference case in which there is full trading consistent with full compliance.²⁹ The elements of this approach also promote additional liquidity by giving buyers with an appetite for risk the opportunity to acquire any AAUs, even those projected to be nonsurplus, if the buyer accepts the burden of liability in the event of the originating Party's failure to meet its Article 3 commitment.

Early Availability of Originating Party Liability AAUs

A key objective in designing trading rules is to allow AAU buyers (particularly legal entities with domestic compliance obligations) an opportunity to use purchased AAUs as a compliance tool. To do this, they must be able to purchase AAUs no later than the beginning of the first commitment period and they must have reasonable confidence that the AAUs can be used for compliance purposes. Under the elements of the Hybrid Option, registry-based trades could commence well before the first year of the commitment period. A Party that petitioned to sell AAUs under the Optional Method could start trading as of the earlier of the date that it obtained the approval of the compliance institution or the date that the time allotted to the compliance institution for its review expired. The elements in this approach thus avoid the late start imposed by the Units in Surplus to Plan rule while providing comparable levels of protection against overselling.

Buyers would have assurances that the market would have a substantial supply of AAUs not subject to later invalidation. Indeed, even before 2008, buyers would be able to predict with reasonable accuracy the global supply of estimated surplus AAUs that would be available for purchase during the commitment period.³⁰ Accordingly, prospective buyers would have adequate lead time to determine the optimal mix of domestic mitigation activities and purchases of AAUs, ERUs, and CERs on which they would rely for compliance. Because buyers could plan on the availability of a supply of Originating Party Liability AAUs, they would not incur the higher transaction costs associated with the proposed Acquiring Party Liability and Shared Liability rules, e.g., search, negotiation, monitoring, enforcement, and insurance costs.

The Hybrid Option would allow Parties that believe that their policies and measures will result in a level of commitment period emissions below that predicted by the Straight Line Method to make their case to the Kyoto Protocol compliance institution for a lower estimate of emissions—and a correspondingly greater amount of Surplus AAUs. Though the Hybrid Option rules provide that a Party trading under this Optional Method could have its estimate adjusted, the adjustment applies only prospectively. This means that buyers could acquire Surplus AAUs from an originating Party trading under the Optional Method without being concerned that their acquisitions would be invalidated on the basis of a later adjustment. In general, the availability of the Optional Method would allow for the introduction of additional Originating Party Liability AAUs into the market while, as discussed above, maintaining adequate safeguards against overselling.

[30 ELR 11068]

Availability of Acquiring Party Liability AAUs

The Hybrid Option also provides that, regardless of the size of an originating Party's Surplus and Reserve Accounts, the Party always is free to sell, and buyers are always free to acquire, Reserved AAUs subject to Acquiring Party Liability.³¹ Therefore, in situations where emissions inventories or other information in the possession of a buyer persuade the buyer that a Party's total emissions will be below the estimate supplied by the Straight Line or Optional Methods, the buyer could acquire AAUs from the Party's Reserve Account at its own risk. Providing buyers the ability to purchase Reserve Account AAUs would minimize the number of "good" trades prevented by the rule. At the same time, buyers would accept the risk of bad guesses. The risk of overselling thus would remain internalized in the emissions trading market.

The elements of the Hybrid Option establish that if buyers acquire Reserved AAUs from a Party that subsequently fails to meet its Article 3 commitment, then those AAUs are repatriated according to a LIFO approach until the originating Party's compliance is restored. This approach is different from the Acquiring Party Liability rule outlined in the Chairmen's Negotiating Text. Under the proposed Acquiring Party Liability rule, an originating Party's failure to meet its Article 3 commitment would result in the invalidation of all of the AAUs it transferred during the commitment period. By contrast, the approach outlined in the Hybrid Option would target only the transactions that were actually nonsurplus, thereby deterring overselling at a lower cost to the trading market. In addition, by providing that transactions will be invalidated in reverse chronological order, it properly imposes the risk of invalidation on the buyers who presumably will have the most information about an originating Party's probability of noncompliance.³² All things being equal, buyers who acquire AAUs from a Party later in the commitment period should be in a better position to assess the likelihood of the Party's compliance than an earlier buyer. For these reasons, it is our view that the approach in the Hybrid Option would allocate risks of overselling more appropriately; it would send the correct signal to the emissions trading market.

Some commenters have suggested that the Acquiring Party Liability and Optional Method provisions of the Hybrid Option add administrative complexity without adding significantly greater market liquidity when compared to an approach that simply provided for the Straight Line Method and that did not allow Reserve AAUs to be sold in registry-based transactions. In particular, they assert that the commercial trading market will make possible the additional transactions that might take place as a result of those provisions. They reason that if a buyer believed that a Party's actual 2008-2012 emissions would be lower than the estimate provided by the Straight Line Method and that the Party therefore would not need some of its Reserve AAUs at the end of the commitment period, then that buyer would be indifferent between the alternatives of purchasing those Reserve AAUs now subject to Acquiring Party Liability and purchasing the right to acquire them after the tune-up period through a forward or options contract. These commenters apply the same reasoning to conclude that the Optional Method provision would be unnecessary. In their view, it would be reasonable to make originating Parties that are dissatisfied with the estimate derived for them under the Straight Line Method to make their case to the commercial market.

We differ on this point. In our view, many buyers will prefer (1) the opportunity to purchase Reserve AAUs from originating Parties during the commitment period and accept the risk that they may have to give the AAUs back later to (2) the opportunity to purchase a right to acquire a Reserve AAU after the commitment period if it turns out to be surplus. A buyer that purchases an AAU in a registry-based transaction (route #1) will hold an internationally recognized right to the use of that AAU for compliance if the AAU turns out to be surplus. By contrast, a buyer who purchases a commercial right to acquire the AAU if it turns out to be surplus (route #2) will hold only a contractual entitlement enforceable under commercial law. The latter transaction is encumbered not only with the risk that the AAU will be needed by the originating Party for compliance but also the additional risk that, even if it is not needed for compliance, the seller will breach its promise to deliver it. In that case, the buyer will be left with only commercial remedies.³³ Because of this additional risk, an entitlement acquired through a registry-based transaction likely will have a higher value than the entitlement acquired in a forward or option transaction.

For these reasons, it is our view that the Acquiring Party Liability and Optional Method provisions would allow for significantly greater liquidity in the emissions trading market. We further believe that this additional market liquidity shouldoffset whatever additional administrative complexity might result from incorporating these provisions in the Hybrid Option. On the other hand, if administrative simplicity is a greater priority, policymakers might prefer a set of rules that provide for trading subject to the Straight Line Method only or that provide for the Straight Line Method and only one of the other two provisions.

Another potential concern about the Hybrid Option is that some countries whose pre-2008 emissions are high relative to their assigned amounts might have no Surplus AAUs under these rules. A means of addressing this concern without significantly increasing overselling risks would be to provide that all Parties that agree to be subject to the Kyoto Protocol's compliance regime may have at least some minimal percentage, e.g., 5%, of their AAUs designated as Surplus AAUs.

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Participation by Legal Entities

Participation of legal entities in a program governed by the Hybrid Option would be straightforward. Consider a hypothetical Party with 100 AAUs, serially marked 1 through 100. Under the Straight Line Method, the Party would distribute its AAUs between its Surplus and Reserve Accounts at the beginning of the commitment period on the basis of its estimated emissions, e.g., AAUs numbered 1 through 25 to the Surplus Account and AAUs 26 through 100 to the Reserve Account. If the Party decided to allow its legal entities to sell AAUs, it could distribute AAUs from one or both accounts to these entities using any of a variety of approaches. Because the Party's domestic registry would be transparent to buyers, buyers would know whether the AAUs they were acquiring originated in the Surplus Account or the Reserve Account.³⁴

Workability

Our approach to evaluating the overall workability of the Hybrid Option is to assess the extent to which it would add administrative burdens that are not already contemplated by the Kyoto Protocol. As we discussed in our previous Article, the Kyoto Protocol establishes a compliance framework that includes several elements.³⁵ First, each Party is obligated to submit an annual inventory of its greenhouse gas emissions. Indeed, Parties already are submitting such inventories pursuant to Article 12 of the Framework Convention on Climate Change. Each Party also will be required to establish a transparent registry that tracks its holdings of AAUs. In addition to these self-monitoring and reporting requirements, the Kyoto Protocol provides for a system of implementation review. "Expert review teams" will appraise each Party's submissions of information. Flawed emissions inventories will be subject to an "adjustment" procedure pursuant to Article 5.2. Finally, the Kyoto Protocol contemplates the establishment of a compliance institution that would impose "binding consequences" on Parties that violate the treaty.

The Hybrid Option would add minimal new administrative burdens to this already contemplated compliance framework. Because Parties already are obligated under the Kyoto Protocol to submit inventories and establish registries, the only new administrative burden they would bear under the Straight Line Method would be the requirement to set up two accounts in their registries instead of one. Under existing provisions in the Kyoto Protocol, the Kyoto Protocol's compliance institution already will be reviewing, and potentially adjusting, inventories submitted by Parties. With the Straight Line Method, the compliance institution would have the extra responsibility of ratifying each Party's estimate of emissions. This responsibility would be modest in scope because, under the Straight Line Method, each Party's estimate would be derived automatically from inventories that the Party already submitted and that the compliance institution already reviewed. The compliance institution then would merely need to ensure that each Party allocated its AAUs on the basis of its estimate. So long as registries are transparent, this oversight role should not present any particular difficulty.

The administrative burdens introduced by the Optional Method are only somewhat greater than those introduced by the Straight Line Method. First, under the Optional Method, the compliance institution would have the additional role of reviewing petitions for lower estimates. While this process would require the compliance institution to exercise a degree of discretion, this discretion would not be unbounded; as discussed above, the Hybrid Option dictates that a Party's presumptive estimate is that which is derived under the Straight Line Method. In addition, the petitioning Party would be required to pay the administrative costs associated with this more in-depth review.

The second administrative burden unique to the Optional Method would relate to the management of the Surplus and Reserve accounts. As discussed above, under the Optional Method, a Party's accounts would be subject to annual prospective adjustment. Parties trading under the Optional Method therefore would have to provide for the possibility of such annual adjustments in the design of their domestic compliance programs.

In our view, these are modest additional burdens. Moreover, if the Hybrid Option would prevent overselling that would otherwise occur under the contemplated compliance framework then the additional burdens associated with the Hybrid Option's administration are properly offset against the avoided administrative and political difficulties of imposing sanctions.

Conclusion

In light of the deficiencies associated with the options that appear in the Chairmen's Negotiating Text, the authors offer an alternative: the Hybrid Option. The Hybrid Option would address overselling risks by limiting from the beginning of the commitment period the amount of AAUs a Party could trade subject to Originating Party Liability to a reasonable projection of the amount of AAUs the Party could trade without overselling. The projection would be based on the trend of the Party's pre-2008 emissions. This approach would limit both the risk of overselling and the amount of overselling that could occur.

At the same time, the Hybrid Option incorporates elements that would promote liquidity. Buyers would have assurances of the availability of a substantial volume of AAUs not subject to later invalidation or repatriation. In addition, [30 ELR 11070] originating Parties that believe that the Straight Line Method for determining their projection is too conservative could petition for a lower estimate under the Optional Method. Finally, the Hybrid Option provides that buyers may acquire Reserve AAUs at any time subject to an Acquiring Party Liability rule. The Hybrid Option thus would allow all AAUs to be traded in the market while establishing an incentive structure that would minimize overselling risks.

The Hybrid Option rules would be formulaic and automatic in their application. The Hybrid Option would require the compliance institution to do little in addition to what is already contemplated under the Kyoto Protocol.

For these reasons, the Hybrid Option is, in our view, a reasonable safeguard against overselling that can contribute to the development of an international greenhouse gas emissions trading market characterized by both economic efficiency and environmental integrity.

1. Robert R. Nordhaus et al., International Emissions Trading Rules as a Compliance Tool: What Is Necessary, Effective, and Workable?, 30 ELR 10837 (Oct. 2000).

2. Kyoto Protocol to the United Nations Framework Convention on Climate Change, U.N. Doc. FCCC/CP/1997/7/Add.2, reprinted in 37 I.L.M. 22 (1998) [hereinafter Kyoto Protocol].

3. Id. art. 17. "AAU" is a widely used shorthand for the units that would be transferable through the Article 17 emissions trading mechanism. "Part of Assigned Amount" is another term used to refer to the same units. Neither term appears in the Kyoto Protocol. For purposes of simplification, this Dialogue will refer to "AAUs." In addition, the Kyoto Protocol does not explicitly provide that private companies or other legal entities may participate in trading, although most Annex B countries support their inclusion. For purposes of simplification, this Dialogue will assume that legal entities may participate in Article 17 trading.

4. Hereinafter, references to a country that would be an Annex B Party to the Kyoto Protocol if and when the Kyoto Protocol enters into force under international law shall appear as "Party."

5. Subsidiary Body for Scientific and Technical Advice and Subsidiary Body for Implementation, Note by the Chairmen: Mechanisms Pursuant to Articles 6, 12, and 17—Text for Further Negotiation on Principles, Modalities, Rules, and Guidelines, U.N. Doc. FCCC/SB/2000/3 (Apr. 12, 2000) available at http://www.unfece.de/resource/docs/2000/sb/03.htm [hereinafter Chairmen's Negotiating Text].

6. See id. at 127-29, PP357-362.

7. See Nordhaus et al., supra note 1, at 10841-44.

8. While the prior Article generally found that the Acquiring Party Liability would be effective in preventing overselling, this finding was qualified with respect to the "Trigger" option. See Nordhaus et al., supra note 1, at 10851. Under the Trigger proposal, each Party would begin trading subject to Originating Party Liability. A Party's trading status would shift to Acquiring Party Liability in the event a "question was raised" about the Party's probability of compliance with its Article 3 commitment. In the previous Article, the authors found that the effectiveness of the Trigger option in preventing overselling would depend on the circumstances and process under which a "question was raised" and Acquiring Party Liability thereby triggered. Under some formulations, a Party effectively could oversell before Acquiring Party Liability was triggered.

9. See Nordhaus et al., supra note 1, at 10851-53.

10. See id. at 10853.

11. Id. at 10853-55.

12. Id. at 10845.

13. Even if the Kyoto Protocol does not enter into force until shortly before the commitment period, governments are obligated to submit annual emissions inventories under Article 12 of the United Nations Framework Convention on Climate Change, opened for signature June 4, 1992, S. TREATY DOC. NO. 102-38(1992), reprinted in 31 I.L.M. 849 (1992) (entered into force Mar. 21, 1994). If and when the Kyoto Protocol enters into force, Article 8 provides that these inventories are subject to review by expert review teams. Kyoto Protocol, supra note 2.

14. It is important to note that the description of this Hybrid Option does not address or account for the possible introduction of a trading rule aimed at addressing the "hot air" issue. Such a rule would tend to reduce the amount of tradable AAUs and increase the complexity of the international emissions trading mechanism.

15. This option does not specify registry requirements in detail. While there are a number of important technical issues related to the establishment of registries, we have chosen not to make those issues a focus of this Dialogue.

16. Parties trading subject to an Article 4 "bubble" may maintain a single set of accounts, but are otherwise subject to the liability rule of Article 4.5 ("In the event of failure by the Parties to [a "bubble"] agreement to achieve their total combined level of emission reductions, each Party to that agreement shall be responsible for its own level of emissions set out in the agreement.") Kyoto Protocol, supra note 2, art. 4.5.

17. The Hybrid Option does not rely on eligibility rules to prevent overselling in the way that some of the proposals characterized in the Chairmen's Negotiating Text do. See Chairmen's Negotiating Text, supra note 5, at 123-25, PP343-349. The Hybrid Option relies primarily on its estimation methods to predetermine the amount of AAUs that may be sold by a Party without overselling. And in the case of the Optional Method, the Kyoto Protocol compliance institution is empowered to adjust the estimates based on its review of annual emission inventories. The necessary requirements under the Hybrid Option are that: (1) the historical emission inventories used to derive the estimates are substantially valid and (2) that Parties trading under the Optional Method submit annual emission inventories so that the compliance institution may adjust their estimates if necessary. With these requirements, an additional rule or rules under which a Party could be excluded from the trading mechanism altogether because of its failure to meet various commitments under Articles 5 and 7 would be unnecessary. Policymakers may conclude, however, that there is value in having the additional safeguard of rendering a Party ineligible to trade if its annual emissions inventory is egregiously inaccurate, if it fails to comply with guidelines for the establishment of an Article 5 national system, or if it violates other such requirements under Articles 5 and 7.

18. The Hybrid Option does not specify a particular percentage for the repayment penalty. It is our view that the penalty should be sufficiently large as to eliminate the economic benefits of overselling in the first commitment period.

19. The aim of the Straight Line Method is to extrapolate from a historical period the trend of a Party's emissions through the commitment period. There a number of means of generating such an extrapolation. Because the authors are not statisticians, the outlined rules do not specify a particular methodology. One possible approach would be to use a simple arithmetic calculation that multiplied the level of emissions in the last year of the historical period by the rate of emissions growth or decline over the historical period and then project that level across the commitment period. Another approach would be to calculate a linear regression line from the historical period and use this line to estimate emissions for the commitment period. Other methodologies are no doubt possible.

20. The choice of four years as the relevant historical period is for illustrative purposes. All things being equal, the greater the number of inventories the greater the confidence level for the estimate. Similarly, the greater the number of inventories the less vulnerable the rule is to gaming whether by inflation of emissions early in the historical period or fraudulent reporting.

21. Because the compliance institution will need time to review the inventories used to derive a Party's Surplus and Reserve Accounts, we recommend that Parties be required to wait to start trading for at least six months after submitting the last of the relevant inventories.

22. We purposefully do not prescribe here what should constitute a sufficiently credible demonstration by a Party under the Optional Method other than that the Party should have to overcome a presumption that the Party's estimate should be that provided by the Straight Line Method.

23. If its actual emissions in a year are less than its estimated emissions for a year, then the Party may reallocate AAUs in an amount equal to the difference from its Reserve Account to its Surplus Account.

24. Joint implementation under Article 6 presents additional issues. We would suggest a rule that requires any Party that transfers ERUs to another Party in connection with an Article 6 project to draw those ERUs from its Surplus Account in the form of a corresponding quantity of AAUs. This rule presumes that AAUs and ERUs are "fungible," which as discussed above, is a notion subject to debate in the international negotiations. The broader issue of whether ERUs should be drawn from a Party's Surplus or Reserve Accounts under the Hybrid Option depends on how the "additionality" of Article 6 projects is calculated. Governments and nongovernmental organizations have proposed a variety of methodologies for measuring a project's additionality. Some formulations would look at whether the project generated reductions or removals that were additional against a particular technology or regional benchmark; others would calculate whether the reductions or removals were additional to the business-as-usual emissions path for the entire country. It can be argued that, under the Hybrid Option, ERUs must be drawn from a Party's Surplus Account unless the Party or an international reviewing body demonstrates that the project would generate reductions or removals additional to the emissions estimate used to calculate the size of the Party's Surplus and Reserve Accounts. In that case, the ERUs could be drawn from the Reserve Account and made subject to Acquiring Party Liability. We have chosen to use a simpler formulation under which all ERUs must come out of Surplus Accounts.

25. Because the constraint would have immediate effectiveness, the Hybrid Option would avoid the Trigger rule's vulnerability to early sell-off. See Nordhaus et al., supra note 1.

26. One concern expressed about using inventories to calculate the permanent reserve is that it creates an incentive to "fraud" those inventories. In our view, the risk of fraud is not substantial. All inventories are subject to Article 8 expert review. In addition, the fact that the Straight Line formula use inventories from multiple years makes it less vulnerable to manipulation than if it relied on the inventory from a single year. However, another concern cited is that some countries may not be able to perfect their inventories until shortly before 2008, meaning that earlier inventories might not form a reliable basis for an estimate. We believe that the use of multiple inventories will dampen the impact of earlier inaccuracies. In addition, to the extent that a Party's annual inventories capture more of its emissions each year leading up to the commitment period, this will be reflected as a rising trend of emissions. The resulting estimate therefore might be sufficiently conservative to counteract the impact of earlier underreporting. If, however, the concern about the reliability of early pre-2008 emissions inventories is particularly strong, policymakers might opt instead for the single-year approach, using the last pre-2008 inventory as the basis for the estimate.

27. Moreover, it is not necessarily the case that this excess would be detected through review of the Party's annual emissions inventories. It is important to remember that emissions inventories will be available subject to a two- to three-year lag. This means that adjustments during the commitment period likely would be possible only on the basis of the 2008, 2009, and 2010 emission inventories. As a result, if a Party's cumulative emissions exceeded its estimate on the basis of its emissions in 2011 and 2012, this excess would not be reflected in the emissions inventories. Indeed, providing for annual adjustments introduces the risk that a Party, whose emissions in 2008-2010 were lower than expected, would be authorized to trade additional Surplus AAUs even if its 2011 and 2012 emissions were high enough that it ended up exceeding its trend line estimate. For these reasons, we conclude that annual review of emission inventories under the Straight Line Method would raise costs of administration without significantly reducing risks of overselling. Over time, however, the Kyoto Protocol compliance institution will be able to review emission inventories more quickly. In that case, the Parties might opt to apply an annual adjustments approach for both the Straight Line Method and the Optional Method in the second commitment period.

28. See Nordhaus et al., supra note 1, at 10842-43.

29. See ERIK HATTES & FANNY MISSFELDT, LIABILITY RULES FOR INTERNATIONAL GREENHOUSE GAS TRADING (EPRI Working Paper, 2000) (on file with the authors).

30. Buyers could reasonably presume that the minimum total supply of Surplus AAUs would be equal to the supply of Surplus AAUs that would be available if each Party traded under the Straight Line Method. In other words, even though each Party trading under the Optional Method would be subject to annual adjustments of its estimated Surplus AAUs, those adjustments would not reduce the amount of the Party's Surplus AAUs to a level lower than that provided by the Straight Line Method. This assumes, however, that Parties issue their Surplus AAUs rather than withhold them in an effort to exert market power or bank them for future periods.

31. Buyers are free to acquire Reserve AAUs even if the calculated size of the Reserve is larger than the country's assigned amount. Presumably, buyers would be wary of acquiring AAUs from a Party whose emissions during the commitment period were estimated to be greater than its initial holding of AAUs.

32. See Erik Haites, International Emissions Trading and Compliance With Greenhouse Gas Commitments (International Academy of the Environment, Climate Change in the Global Economy Programme, unpublished Working Paper No. 77, 1998).

33. The seller might breach its promise under any of a number of scenarios. For example, a buyer and an originating Party government might enter into a contract in 2008 under which the government agreed to sell the buyer a Reserve AAU if it is not needed for compliance purposes at the end of the commitment period. The contract could further establish a price for the sale. By 2012, the AAU might not only be surplus to the originating Party's compliance needs but also could be worth substantially more than the contractual price. In such a case, the originating Party government might opt to breach the contract and sell the AAU to another buyer at the higher market price. This would leave the original buyer in the difficult position of having to enforce its contract against a sovereign government. Buyers acquiring Acquiring Party Liability AAUs through a registry-based transaction would not need to provide for the risk of such a scenario.

34. If the same hypothetical Party decided to trade subject to the Optional Method it would make a similar initial distribution of its AAUs on the basis of its approved estimate, e.g., AAUs 1 through 30 to its Surplus Account and AAUs 31 through 100 to its Reserve Account. Until the compliance institution's review of its 2008 emissions inventory, the Party could issue only the amount of Surplus AAUs it would have if it traded subject to the Straight Line Method, e.g., in this case, Surplus AAUs 1 through 25. In the event that the Party's inventory revealed that its 2008 emissions exceeded the Party's estimate, then a quantity of AAUs equivalent to the excess would be moved from the Party's Surplus Account to the Reserve Account. Thus, in our example, AAUs numbered 29 through 30 might be moved from the Party's Surplus to Reserve Account. Assuming the Party already had issued AAUs numbered 1 through 25, then only AAUs numbered 26 through 28 would remain in the Surplus Account. As explained above, this adjustment only would apply prospectively so buyers of AAUs 1 through 25 would not be affected. Prospective buyers would be able to see the adjustment in the Party's registry and therefore would be able to identify clearly which AAUs had gone from being Surplus AAUs to Reserve AAUs. The vulnerability of an originating Party's higher numbered Surplus AAUs to adjustment would make them less preferable to that Party's legal entities; the Party could use this distinction as an incentive in its domestic regulatory program.

35. See Nordhaus et al., supra note 1, at 10839-41.