Inquiries into the options and costs to reduce GHGs, especially CO₂, emissions indicate that the costs of reductions vary substantially across sectors in any given national economy and, perhaps even more significantly, across countries. This implies that for uniformly mixing pollutants like GHGs the costs of achieving any given level of environmental protection could be reduced if emission reductions were undertaken at locations where the associated costs are lowest. The concept has become known as “where-flexibility” in the climate policy literature. An institutional setting is required to exploit the opportunities of where flexibility, which involves a great variety of private and public decision-makers who originate from different cultures, represent different constituencies (if any), and live in systems with different social norms. Where-flexibility entails linkages both to other international agreements (GATT, Second European Sulphur Protocol, etc.) and to the legal systems of individual nations. As a result of its effects on relative prices, the choice between the international or domestic strategy also affects technological change.

In principle, two different mechanisms achieve where-flexibility: allowances and credit baseline. In the case of allowances, each participant starts with an initial endowment of pollution rights distributed by the government or through an auction. Emission rights must cover each unit of emission. This system has the character of emissions trading. Under a credit-baseline system, each participant has a baseline (i.e., a counterfactual, hypothetical emission trend) at the country, sector, or project level. Some measures are undertaken to reduce emissions. The difference between the baseline and the factual emissions is credited by an institutional body and can be traded. This system has the character of emissions reduction production.

The Kyoto Protocol contains three instruments to make use of where-flexibility: IET embodies the allowance system, while CDM and JI reflect the credit-baseline system. The Kyoto Protocol on Iet allows Annex I parties with commitments listed in Annex B to trade emission allowances during the commitment period. As for JI, Article 6 declares that Annex I parties with commitments listed in Annex B are allowed to transfer or acquire emission reduction units that result from projects during the commitment period (the reduction units are specific to countries; these parties have national baselines). Finally, CDM as defined in Article 12 implies that, starting in 2000, Annex I parties listed in Annex B are allowed to acquire certified emission reductions from projects within the jurisdictions of non-Annex I parties.

Three general principles operate behind these arrangements:

• first, voluntarism indicates the freedom of contracting, i.e., the quantity-price combinations of exchange;
  
• second, supplementarity signifies the responsibility of Annex I parties to fulfil part of their commitments within their own jurisdictions; and
  
• third, additionality means that projects in CDM and JI have to be additional relative to the course of events in their absence (i.e., it must be decided what would happen anyway and what constitutes an additional project).

Ample attention has been paid to formulate principles for the design of where-flexibility instruments at the national and international level. The principles in the literature (Michaelowa, 1995; Watt et al., 1995; Carter et al., 1996; Matsuo, 1998, Matsuo et al., 1998; OECD, 1998; Ott, 1998; EC, 1999) include:

• Environmental effectiveness. All units traded should be backed by sound data and verifiable emissions reductions; the use of the mechanisms is a means to achieve emission commitments agreed under the Protocol and the mechanisms should be designed to improve environmental performance and compliance with these commitments.
  
• Economic efficiency. This includes the cost-effectiveness of the emission reductions required by the Protocol, and over the longer term helping the community of nations to address climate change in a least-cost manner. It also requires the mechanisms to be administratively feasible, such that they do not impose excessive transaction costs on market actors. Economic efficiency will also improve if the market for trading and crediting is accessible to a wide range of potential players.
  
• Equity. While the main issue of equity under the Kyoto Protocol is the determination of assigned amounts or emission targets, the design of the implementation mechanism must also be perceived as equitable. Implementation of the mechanisms should not give an unfair advantage to any party or group of parties to the disadvantage of others (procedural equity). It should also allow new entrants over time.
  
• Credibility. Only a credible market mechanism should be used by the parties and will be accepted by the public. A mechanism of low credibility might be a source of various coalition formations at the negotiations and might undermine the will to comply with the commitments.

In creating a regime for flexible instruments, perhaps the most important lesson about multilateral agreements of the past two decades is that large and apparently “perfect” constructions have rarely been implemented quickly. Quite the contrary, the most successful examples of international regime building are based on a “piecemeal” approach, that is the stepwise evolution of political and legal mechanisms (Ott, 1998). For current DMFs, this might lead to a strategy with several phases that bring together the national and international levels at the speed of progress in international regime building (Holtsmark and Hagem, 1998). This would involve a two-stage game for IET (Ott, 1998), with a “twin cycle system” for JI (Heller, 1995) that focuses on the learning process in creating an international regime for JI.

There are some new and important factors to consider in the design of the instruments (see Ott, 1998). The economic and ecological dimensions of climate change and its mitigation affect different constituencies, sectors, and cultural values of the parties. Stakeholders range from states and international organizations to private companies and NGOs. Incentives motivate both private and governmental participants to report the highest possible baselines of GHG emissions to secure the largest amount of certified reduction credits. However, other processes create the opposite incentives.

The implementation of these instruments can be seen as a further step towards a more flexible and market-oriented policy in international environmental policy, and as an extension of national instruments to the international level. At the national level, some experience has already been accumulated with emissions trading, such as the Emission Trading Program under the US Acid Rain Program, the Los Angeles Regional Clean Air Incentives Markets, and the Norwegian Sulphur Trading programme introduced in 1999. Actual experience is much thinner internationally. Examples of the possibility for emission trading include the Montreal Protocol intended to curb CFC emissions that deplete the ozone layer and the United Nations Economic Commission for Europe (UNECE) Sulphur Protocol.

Many plausible arguments support the use of international mechanisms, as outlined below.

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