It is important to consider ways in which international and national (domestic) policy instruments are likely to complement or conflict with one another in achieving GHG emissions reduction commitments at least cost. A substantial number of economic models suggest that use of the Kyoto mechanisms, established by Articles 6, 12, and 17 of the Kyoto Protocol (see Sections 6.3.1 and 6.3.2), combined with efficient domestic policies could significantly reduce the cost of meeting the emissions limitation commitments in the Protocol.⁸⁰ The results of these models rely on assumptions of perfect foresight or certainty over future levels of emissions and on fully efficient domestic mitigation policies in Annex I Parties. They also assume that developing countries will respond to the market signal given by the international market of CERs and generate CDM projects accordingly.⁸¹ Moreover, these models implicitly assume that national economies are operating within an efficient market framework. However, when an inefficient market framework is assumed the conclusions may differ. This is an area in which further research is necessary.

Articles 6 and 12 of the Kyoto Protocol enable governments and entities of Annex I countries to support JI projects in other Annex I countries and CDM projects in non-Annex I countries, respectively, in return for emissions credits. Several countries have suggested the participation of legal entities in IET, although Article 17 (on IET) does not mention the participation of entities in IET other than Parties (see Australia et al. (1998) and United Kingdom of Great Britain and Northern Ireland (1998)).

The following discussion assumes that any supplementarity provisions are not binding.⁸² In addition, MAC refers here to the marginal social abatement costs. Also, in this discussion it is assumed that the initial market is perfect and then how various factors influence this is assessed.

If IET under Article 17 is limited to Annex I governments, they would need to trade AAUs or introduce a domestic emissions trading scheme to equate their national MACs. Views differ as to whether national governments have the information to equate the national MACs. Experimental evidence indicates that governments have the necessary incentive when trading with other governments.⁸³ If both Annex I governments and legal entities are allowed to engage in IET under Article 17, this difference of views becomes academic as long as the domestic policies allow the legal entities to use the three Kyoto mechanisms as part of their compliance strategy. Government participation in the Kyoto mechanisms changes the AAs available for emissions by domestic sources.

For entities to equalize their MACs there must exist either a fully comprehensive domestic taxation system, which reflects the international price of AAUs, or open access to the international emissions market for sources of emissions and entities covered by domestic policies. In theory, several domestic policy regimes can be envisioned that would allow entities in Annex I countries to equalize their MAC so as to minimize the total cost of reduction. The implications for different types of domestic policy instruments are as follows (Dutschke and Michaelowa, 1998; Hahn and Stavins, 1999):⁸⁴

• Domestic tradable permits. The domestic tradable permit programme must cover virtually all emissions sources, the cap must be set equal to the national AA after trading by the government, and the participants must be allowed to engage in international exchanges using the Kyoto mechanisms.⁸⁵ Participants would be allowed to use CERs and ERUs from CDM and JI projects towards compliance with their domestic obligations. The country could also host JI projects. Participants could also buy or sell AAUs under Article 17 if participation by legal entities was allowed.⁸⁶
  
• Domestic emissions and/or carbon tax. The domestic emissions and/or carbon tax must cover virtually all emissions sources, and the tax must be set equal to or less than the national marginal cost of abatement after trading by the government. Entities receive tax credits for CERs and ERUs, and for AAUs if participation by legal entities is allowed under Article 17. The country could also host JI projects.⁸⁷
  
• Non-tradable permits. Virtually all sources are covered by non-tradable emissions limits, which allow the use of quotas to achieve compliance. The total emissions allowed under the permits must be equal to or less than national AAs after trading by the government. Entities could use purchased CERs and ERUs–and AAUs if participation by legal entities is allowed under Article 17–towards compliance with their emissions limits. The country could also host JI projects to reduce emissions below the emissions limits or to enhance sinks.

If sources are subject to regulations, design or performance standards, VAs, or taxes and at the same time there is no permit allocated to the source, and CERs, ERUs, or AAUs cannot be used for compliance, entities might still be allowed to trade them on the international market, provided that the volume sold does not exceed the volume of quotas acquired. Such domestic policies are unlikely to equate MACs across sources and so will not result in the lowest cost of compliance with the national emissions limitation commitment.

In practice, the combination of domestic policies and Kyoto mechanisms necessary to achieve cost-effectiveness may not be implemented for at least two reasons. First, use of the Kyoto mechanisms may be restricted in some countries, either because supplementarity restrictions are binding or because a national government that imposes an emissions tax may limit the use of the mechanisms towards compliance with tax liabilities to protect its revenue.

Second, it is difficult to cover all sources and relevant sinks with policies that provide an incentive to implement measures that equate MACs. Some sources are small and are excluded for administrative reasons. Other sources, such as methane emissions by livestock, are difficult to include in a trading or tax regime. Thus, the overall cost-effectiveness of the system will fall short of the theoretical ideal.

When part of the GHG emissions reduction needed to realize the Kyoto commitments offers net economic benefits to the national economy, the role of the Kyoto mechanisms changes significantly. Relative to a theoretical scheme of complete and perfect trading, a purely national mitigation strategy would still give rise to inefficiencies for individual countries or sources, as a result of differentials in MACs. However, the advantages that could be obtained from eliminating such inefficiencies through international mechanisms are more limited because of principal-agent problems.

Thus, if access to the international mechanisms is limited to governments, the Kyoto mechanisms are likely to be used only to reduce positive marginal domestic abatement costs. And, since measures with positive costs under a regime with restrictions make up only a fraction of total mitigation under an efficient domestic policy, the quantitative significance of the Kyoto mechanisms is greatly reduced. If access to the Kyoto mechanisms is given to individual sources, there arises the potential for a second principal-agent problem in that individual entities may mitigate in ways that minimize private costs but fail to minimize social costs in the national economy. In this case, both international efficiency and domestic efficiency are jeopardized.

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