Enforcing Compliance: The Allocation of Liability in International GHG Emissions Trading and the Clean Development Mechanism

The possibility of international trade in credits for greenhouse gas (GHG) emission reductions is a key "flexibility mechanism" built into the December 1997 Kyoto Protocol for international GHG reduction. The Protocol allows ntities in Annex I countries (the industrialized countries agreeing to cap their total emissions) to trade emission reductions. Through the "Clean Development Mechanism" (CDM), investors in Annex I countries also can secure GHG reduction credits for emission-reducing activities in non-Annex I developing countries that have not accepted national emission caps.

For these forms of international emissions trading to be seen as credible forms of real emissions reductions, legal responsibility, or liability, must be assigned for the failure of promised emission reductions embodied in the credits to materialize.

While a well-functioning compliance system is crucial for the integrity of trading, however, excessive restrictions on trading to enforce responsibility could stifle emission credit markets and raise international compliance costs to unacceptable levels. The desirable allocation of liability trades off these two concerns. Liability for the "quality" of an emission reduction credit when created could rest with buyer, seller, or both parties; it also could stay with whoever originally is assigned the liability, or the liability could be transferred as credits are resold. A very high level of compliance by sellers could always be ensured by "gold plating" credits or permits. Before credits can be sold we could require they be certified by an independent agent. Buyers and sellers would then have to decide how often to bring in the certifiers, trading off the costs of more frequent quality control against the advantage of a more continuous flow of certified credits or permits. Since this approach is likely to be quite expensive, either because of certification costs or illiquidity, we focus in this paper on systems that allow trading of emission permits or credits prior to certification with post-trade liability rules that aim to enhance the credibility of trading.

Designing good compliance systems would be easy if everybody - traders and governments - had lots of information about the emission-reducing activities of different entities and there were strong legal sanctions within every participating country for nonperformance. In practice, information is scarce and not evenly shared, and both domestic and international enforcement mechanisms are limited in what they can accomplish. Starting with these two points, we first consider some of the general institutional background for international emissions trading. We then consider the assignment of liability in an international GHG trading system for the Annex I developed countries, focusing on the assignment of liability for "bad" emission permits when the seller country is not in compliance with its Kyoto targets known as "assigned amounts." We turn then to address issues of credibility and liability in the context of CDM joint ventures.