JI and Business Involvement in CEE

Workshop of JI experts, REC
18-19 April 2001

By Maria Khovanskaia

In the eyes of experts in CEE (Central and Eastern Europe) region, the concept and practice of Joint Implementation are inherently controversial. JI was initially designed as a two-goal policy tool targeting both environmental and economic objectives. Yet, the underliying objectives often appear to conflict with each other. As witnessed by the pilot phase of JI - Activities Implemented Jointly - this unavoidably distorts the channeling of environmental-friendly investments from potential donor countries, especially as far as the private capital is concerned. The ongoing discussion inside the JI community about business engagement in the GHG mitigation activities identified the following core problems:

1. Is there a mechanism more efficient in terms of implementation, e.g. Emission Trading (ET)? How those two mechanisms could be combined?
2. What are the main barriers on the way towards successful business engagement?
3. In case if the advantages of JI are recognized as worth the complexity of implementation, what are the ways to overcome the above-mentioned controversy in order to attract investments and to make business-to-business option operational?

This paper summarizes the considerations about the first two questions leaving the discussion of the last one to the participants of the workshop.

1. JI vs ET. Why JI? The current situation with the Climate Change issues is characterized by the high level of the political uncertainty due to the incomplete Kyoto Protocol ratification. Whether USA will finally find a compromise solution and ratify the Protocol, or EU will ratify the Protocol unilaterely, and how the other countries will be affected - all those issues add even more uncertainties to those already associated with JI and, hence, significantly cloud its future.

The mentioned political considerations augment the rivalry between Emission Trading and Joint Implementation. (CDM is not of big relevance in the region since all CEE countries are signatories of the Protocol and, hence, listed in Annex B. Nevertheless, CDM is also a competitor for the donors' resources.) Neither of the mechanisms has consolidated around itself all of the most influential players on the field. While Russia and the US seem to prepare for the Emission Trading option, the last workshop of Europesn Climate Change Programme ("Flexibility Mechanisms" subgroup) in Brussels on 23 March revealed that European Union studies the possibilities how to achieve the Kyoto targets through the combination of JI mechanism and ET. EU has already started development of an ET scheme though the idea of JI is not abandoned.

1.1. Naturally, both mechanisms have their "pros" and "cons". The proponents of ET argue that:

1. It is the less bureaucratic type;
2. It would be sufficient to establish an international legal entity and a scheme of trading in order to make ET functioning.

However, some experts point out that:

1. This mechanisms can play only the finance-accumulating role. Funds might be raised through the ET though there is no guarantee that those funds will serve the needs of the environmental quality improvement in the host country.
2. Under this type the 'hot air " problems appear to be rather significant.
3. Ethic concern: those countries which are mainly responsible for the GHG effect will not participate in the real abatement leaving it to the less developed ones.

1.2. JI as a policy tool has certain advantages over ET. The most important advantages are as follows:

1. In contrast to ET Joint Implementation is a project-based mechanism. Thus, there are less opportunities for inflating emission reductions;
2. If done correctly, JI is an opportunity to modernize the preferential areas of the Economies in Transition (such as energy and transport sectors) through climate-friendly technologies.

Generally speaking, JI was designed "to ensure real emission reductions through investment and, hopefully, technological innovations and sustainable development" .

The current challenge for Economies in Transition (EIT), especially for the AC ( Accession Countries), is to choose an appropriate mechanism (or a mixture thereof) which would be most instrumental in pursuing their economic, environmental and development national goals. In the next section the main loopholes associated with business involvement in JI will be considered.

2. Main problems of business involvement in JI. What prevents businesses from involvement in JI? The answer is that risks appear to be rather high, and the rather low returns do not compensate for them. The conclusion one can derive from the discussions is that the problems of JI projects mainly result from:

a) Multiple-objective nature of Joint Implementation;
b) Economic and social realities of the CEE region: relatively unstable economies under transition regime, traditionally big and inefficient bureaucracy etc.

2.1. Problems due to the multiple objectives. As was already mentioned above, JI has multiple objectives (environmental effectiveness, economic effectiveness, and some authors mention also equity) in every of which different agents hold their vested interests. As a result, JI efficiency criteria differ from participant to participant. The governments in host and donor countries, businesses on both sides, environmental NGOs, international GHG control institutions - each of them has its own expectation about JI and their own interests (see Table 1).

Under this multiple-attribute decision making context, the constant trade-offs between conflicting objectives occur. For example, there is a critical trade-off between procedures, which are more attractive to investors, but offer less environmental security. Vice versa, the procedures sounder in the environmental sense, impose greater investor risks and reduce participation level. Therefore, it is simply not possible to fulfill expectations of all the JI agents.

The lack of clear guidelines on both the national and international levels deepens the unresolved conflict of the opposite interests leaving the room for mutual mistrust, legal disputes, and inefficient bargaining. No doubt, this increases uncertainties and, partly, transaction as well as start-up costs negatively affecting investments in JI. The list of the most "hot" issues is as follows:

2.1.1. Financial additionality. This is the most telling example of conflicting interests. The requirement for both financial and environmental additionality divided the agents. While the environmental organizations call for limiting JI to projects to an internal rate of return no more than 5%, the potential donors state that "most projects have a too low rate of return to make it interesting for banks of other investors (banks are happy with 12 - 15 % and investors with 20-25 %)". Moreover, the leveling of the play field to 5% will stop the CEE countries from competing for JI projects through the provision of better conditions for additionality. This is, of course, of no interest to the donor side.

2.1.2. Baseline methodology. Baseline of any JI project is counterfactual by its nature. It is possible to create a credible or defensible hypothesis about it but not a verifiable one. Thus, the investors tend to overestimate the baseline in order to get more ERUs, while international bodies are interested in more objective baseline assessment.

2.1.3. Credit sharing. Since every party participating in JI projects has their own GHG reduction targets, their notion of fair credit sharing might significantly vary. Main issues for bargaining: whether to divide ERUs according to the contribution, how to differentiate between grants and loans, how to consider maintenance and monitoring costs.

2.1.4. Early crediting. JI projects will receive ERUs (Emission Reduction Units) only during the commitment period, while CERs (Certified Emission Reductions) obtained through CDM are allowed to be banked and added to those obtained through the 2008-2012 period. On the one hand, the absence of early crediting makes JI less competitive than CDM. On the other hand, early crediting tightens emission reduction targets for Annex B host countries. Thus, the obvious trade-off for the host governments is either to miss JI investments now or to face a threat to end up with huge penalties for non-compliance in several years.

2.1.5. Project identification. What are the identification criteria for projects and could "sink" projects be identified as Joint Implementation?

2.2. Problems due to the regional economic realities. Despite the economic heterogeneity of CEE countries (some of them prepare to the EU accession, the others are less advanced), there could be defined common features that create problems for successful environmental policy:

1. Economic situation in those countries is more or less subject to the force-major. For instance, sudden changes may occur in such important parameters as fuel prices, tariffs and fees, exchange rates, environmental legislation, etc.
2. Climate Change is a low priority in the region as compared to the national macroeconomic targets, such as GDP growth, unemployment, etc.
3. Large and often inefficient bureaucracy apparatus inherited from the Soviet period.
4. Low public awareness of Climate Change issues and, hence, low public participation in any climate-related activity. One can also mention the insufficient spread of information among local business communities about the opportunities provided by JI.

2.2.1. All this leads to the insufficient government activity in the sphere of JI. One should admit that at the moment there is a lack of institutional infrastructure for JI and clearly defined property rights for emission reductions at the national level. Government support is crucial because project preparation takes a long time and the opinion of the ministry must be clear.

Though JI is a market mechanism, government intervention is required at several levels. In order to improve JI financing prospects governments can undertake the following activities :

a) Standardizing of approval procedures. Government in a host country must provide all potential investors with clear and updated information about procedures, criteria, decision-making authority, monitoring requirements and enforcement provisions. Once this is set up, there is no more room for fear that in case of staff rotation in a host MOE the bargaining procedure should be started again from the beginning.

b) Ensuring national JI eligibility. It is clearly stated in the Protocol that the emission reductions will be recognized only from those countries that comply with broader Kyoto obligations. The latter include developing a national system for measuring and reporting emissions; implementing a national registry; timely reporting of the national inventories and communications. Thus, the countries with poor inventory management and national reporting will be regarded as with JI investment unfriendly climate.

c) Packaging and promoting viable projects, providing information and data for investors. Firstly, the investment volume of the majority of projects is rather small compared to the size of the projects that banks and funds are used to work with. At the same time, they are cost-effective. Possibilities for bundling should be investigated in order to be able to spread the risks and minimize the transaction cost as is already done in Czech Republic by the World Bank. Secondly, projects are very difficult to identify and costly to prepare. Recipient countries might take its part in project identification using their insiders information to reduce some transaction costs.

d) Mobilizing domestic investors. The procedures towards decreasing risks and creating incentives for the domestic investors can be the same as for the foreigners in terms of the institutional framework. At the same time, a law-maker should keep in mind that the CEE domestic enterprises, especially from accession countries, might soon play not only a recipient but also a donor role.

e) Improving domestic legislation. Established property rights over emission reduction units as well as the system of the contract enforcement can significantly increase the willingness to invest in and insure the JI projects.

f) Ensuring public participation and transparency.

2.2.2. While the above requirements are in the major cases not satisfied, the JI projects are not bankable. However, if the governments fulfill their task of setting up the institutional framework, the uncertainties will be lower which will allow JI projects to attract investments not only from international organizations (WB, EBRD, GEF) but also from the private companies, e.g. Merrill Lynch. Additionally, the improved framework will give the room for the insurance companies.

Conclusions. If properly managed Joint Implementation mechanisms can be a powerful mechanism of channeling environmental-friendly investments in the CEE region. In terms of risks and returns JI is often compared with its alternatives - joint venture projects, Emission Trading, CDM. Because of the inherent conflict of JI underlying objectives there is a room for bargaining and, hence, ex-post inefficiency and additional risks in comparison with alternative projects. Those risks are unavoidable. However, the obstacles on the way of the foreign investments due to the imperfections in the institutional framework can be removed by domestic actions. The advantage JI has over its competitors is that JI seems to be the most sustainable solution to the Climate Change Problem.