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Today we have Professor Tom Heller, who is going to talk to us about energy, Guangdong, China issues, and of course the post-Kyoto regime, what that may look like. Thanks, Christine. I want to thank Civic Exchange and CLP and the others who have made it possible for me to be here, and more importantly than that, have created an on-going dialogue that is tremendously valuable to me and to my research associates at Stanford. I do worry a bit always since a number of you people have been good enough to listen to me in the past and I don't want to simply go over things that I have talked about. The last time that I was here I had a chance to talk a bit about the development of natural gas markets and the importance on gas-on-coal substitution in the power sector in emerging markets like China and India. I am not going to concentrate on that today, although there are a number of new results from studies that we have been doing in collaboration with Chinese and Indian colleagues, some of them just up-river in Guangzhou, and I am happy to say something about that, although I think we will probably be back in September to do a full-scale presentation in Guangzhou of the results that our models have been suggesting may be future energy scenarios of interest to the provincial government and hopefully to the national government. So, I am not going to concentrate on that, although I think those questions remain of great importance. What I am going to talk about makes me uneasy because I feel slightly like a war correspondent coming back from the front, which is moving very rapidly, and trying to report about what's going on, and it is never clear what is going on! The talk will have some of the character of a series of possible directions in both the international negotiations and in the implications of those negotiations, or the engagement of those negotiations, with major questions like China's energy future. But be that as it may, I just make the point that what I am saying always has a contested character, often a hypothetical character, but hopefully it will be a good basis for discussion and of interest to you. Let me start off with the broad question, which is the negotiations over the post- 2012 regime at the international level under the auspices of the United Nations framework convention on climate change, and there are many, many fronts on this particular battle, hard for anybody to keep up with all of them and what is going on in each set of events that are there. I am just going to concentrate on two that I am more familiar with than others. The first is what I would call the conventional negotiation process or fora. As all of you are aware, I am sure, the Kyoto Protocol extends until 2012. That is the end of the first commitment period. There are obligations under the structure of the Kyoto Protocol to renegotiate what will happen in that second commitment period, and those negotiations were supposed to have been completed by the year 2008 under the original terms of the Kyoto Protocol. I would say - and this is really editorial comment by me, perhaps biased - that those negotiations in the conventional sense are extremely stalled. That is to say, there is not a lot of what I would call real negotiation, of people making new proposals, of concessions, of learning for that matter, from the first period. The negotiations have gone forward in the conventional format with the European Union being the principle advocates, as you may have seen in their proposals under this conventional negotiation process of an architecture, a structure of the post-2012 regime that looks remarkably like the first period. That is to say, it would be an extension of most of the major instruments and ideas from the 2008 to 2012 period, hopefully under the European Union proposals some ratcheting up of the targets and timetables that the participants would engage themselves or commit themselves to do. But the mechanisms, for example, the flexibility mechanisms, including the clean development mechanism, are by and large untouched. They go forward into the future. The idea is that the United States and Australia, those who have stood to the side, would basically take on commitments not unlike the European commitments. And I think there is some increasing pragmatism on the part of the European negotiators about the expected behaviour of the leading developing countries. I think the hope was, and still is in more demanding circles in the Union, that countries like China and India would take on some kind of mandatory commitments. That is to say, if not full targets, they would take on sectoral commitments or intensity commitments of some kind, but that there would be a hard legal commitment by the leading developing countries as a first step toward their complete incorporation in the regime. My own sense is that the leading developing countries have made it clear that is not going to happen. There will not be hard commitments. The Chinese issuance of the national action plan was very affirmative in saying China is extremely interested in this problem and will look to those climate-favouring measures that are consistent with its development plans and try and take action there, but will not make hard commitments which they believe are inappropriate given the history of climate change and the priorities imposed by the poverty relief and economic development. I think China and India will remain in that position, and that will simply be a fact of life that has to be dealt with in these negotiations. So, I would say on the whole there is not much progress. There is a fair amount of posturing that goes on, but if you talk to the negotiators in the UNFCC conventional process, things are stalled and people are worried about that. So, there are a number of other fora. I know Christine is working in the G8 Plus 5 legislators' fora. There are many other fora. There are, of course, endless conferences. You can spend your life going from one talk fest to another not learning very much but hearing basically the same litany of complaints and demands. But what is beyond that? There is some movement going on around the edges of the standard negotiation, which is being motivated in part out of the office of the UN secretary-general. Kofi Annan never paid too much attention to these issues; god knows he had enough other things to worry about. But Ban Ki- moon, since he has become secretary-general has, partly under pressure from negotiators who are very worried about a failure of the post-2012 negotiations, For that, let me just refer to an exercise in what I would call translation of diplomatic language that no-one in his right mind, or lay person, could possibly understand, but in the world of diplomacy could be significant. And what I am going to refer to is the message that the secretary-general delivered to the G8 meeting in Heilingendamm in Germany last month. And of course the G8 meeting did have the participation of India and China and Russia, the other major actors in the system. Along with issues of HIV Aids, the secretary-general highlighted climate as a principle priority of his tenure. Since the climate change convention is a UN document, in a sense the secretariat of the framework convention does report to the secretary-general. And god knows the job of secretary-general must be the worst job in the world; everybody demands things of you; you have no power, no money; just a hopeless situation. But, if there is a place where he might have some authority, maybe there is some power with regard to these stalled negotiations. His message was a five-part message to the heads of state assembled at the G8 meeting. He first said he welcomed various statements. I think he was particularly referring to those of China and the United States that had been done recently. The United States, the Bush administration, made the incredible concession that there really was a problem here and that we ought to take it seriously. And he did make a concrete proposal which was they wanted to get the leaders of probably the thirteen leading companies, or at least the European Union, the United States, Japan, China and India together to talk about technology-based solutions, to bring new technologies on line. Bush had made this statement two days before the G8 opened. The secretary-general welcomed both the Chinese national action plan for climate and the US statement of seriousness and intent. He then said very importantly that he would urge that whatever took place under these various initiatives go on through the UN process. What does that mean? It means that the United States should not set up any kind of a separate process outside the framework convention negotiations, as Bush was indicating he was going to do. And at the G8 meeting itself, in the final statement, Bush did agree that that would be the case, that he would do things under the UN process. Exactly what that means remains entirely unclear at the present time because no further steps have been taken, but it was a concession. The next thing the secretary said, which I think is very important, is he urged flexibility on the negotiators. Now, I think what he would want I know what he was saying - but what he was implying was you must begin to think more creatively than simply replicating the structures that are now in the Kyoto Protocol. You must be able to pull back from demands that people join the Kyoto Protocol structure, and think about the negotiations more flexibly - the instruments, the goals, how countries will line up. And I will say something about that in just a minute. The fourth thing he said, he made what I consider to be a very significant statement that I will talk about somewhat in this discussion. He said we must learn lessons from the past period. What does that mean? It means we didn't do things perfectly. There are things that are not going well in terms of the instruments and the mechanisms that we have and, in thinking about the post- 2012 period, we cannot simply replicate them. He is talking about the flexibility mechanisms and about CDM in particular. Fifth, he said we must understand the importance of the development of technology. He is saying there that there probably should be in the negotiations a somewhat separate set of institutions and pillars to work on technology cooperation with respect to technologies that continue to be far across the commercial horizon. I think what he is suggesting is what I am going to call in this talk a multi-pillared approach. That is to say, there are a series of different institutions potentially with different players heavily engaged in dealing with particular problems think of the European Union from which that term comes. So, in the European Union monetary union is different than the full set of people; Schengen and immigration controls have different players and different institutions. The idea is that we need a more diversified structure within the post-2012 period to deal with what are essentially separate problems. What I would like to do in the beginning of this talk is talk about some lessons learnt and what that might mean with respect to thinking about the next period. First is that I think the first part of the UN convention process has been based on a view that the way you approach international relations or a treaty and create cooperative action among countries who are engaged in dealing with a common problem is to create a series of laws and policies and regulations in the treaty that leads to technology. In other words, you figure out what the treaty ought to say; you enact it into law; that will create incentives; and private businesses will respond to those incentives. This is not the way a lot of international regimes have developed. If you look at something like the WTO or the EU itself, it has grown in a very different pattern. A small number of countries, who shared relatively common interests because often their economies and their policies were reasonably close to each other, would work out agreements among themselves. This is certainly true of the WTO, which started very small, and obviously true of the European Union. You had six countries. They worked out a series of agreements among themselves. Others gradually came in but entered the Union on terms that were set up by the Union, the so-called acquis communautaire. The rules and the policies that were there were accepted with some negotiation around the edges, and the Union grew from nine, to fifteen, to 24, to 25, to 29 now at the present time, but in a very different dynamic than trying to anticipate the whole structure. And indeed, if you try to say "could we reach agreement at the beginning between the 29 who are now part of the Union", you certainly would not have the institutional structure that you have today in this alternative process of looking to the development of international regimes. In other words, the regime was mini-lateral rather than multilateral and it grew, and most international regimes turn out to have actually grown in that way. One of the things that this might suggest is that, in the call for flexibility that the secretary-general is making, that we ought to be looking a great deal more at what different nations and small groups of nations are willing to do, driven largely by their domestic politics rather than being driven by an international treaty that dictates terms to which they have to conform. What we will be interested in doing is looking among these different measures that evolve at the national or the regional level, looking for ways to create gateways between them to try and integrate them, to get them talking and perhaps trading with one another, until you gradually evolve the conditions that turn out to be acceptable to larger numbers of people. And the idea that we must create a universal regime at the outset with common conditions probably is not an appropriate way to go forward. Secondly, the driving force behind the UN treaty up to this point has been what I call scientific normative, meaning that you get scientists and economists generally together. They figure out the scientific problem. The economists try and figure out the most efficient way of getting there. In other words it becomes an optimisation problem. You then create an international agency that is going to enforce the treaty and that is the model that we have used thus far. What I want to suggest is something I think more likely to succeed that I would call a gravitation model. What a gravitation model does is, or what the metaphor suggests it is actually not a model it suggests that you look rather closely at where the world is going in its important component pieces. That means looking at the politics in different countries, and where technology is going, for example what is happening in terms of price relationships among fuels. The world has a whole series of forces within it, and that is the idea of gravitation. You try and focus on where things are going and where you see opportunities for improvement through cooperative action, whether in a multilateral or mini- lateral level, in where those forces are already heading. If you start running against those forces you are going to run into a shipwreck. So, if the world is moving sharply in terms of energy security, you had better move with those forces instead of against them. If the United States, as it will, enacts climate change controls after the Bush administration leaves office in 2008, you work with what that system is going to do rather than trying to impose obligations on that system that it is not going to accept. This approach recognizes that the drivers are largely national and largely contained within the vectors and the movements of technology that we see. I want to come back to that, but what it does is it drives you away from a pure economic theory to one that is much more political, economic and organisational - what are people going to do, either because organisations have certain trajectories and certainly political economies, or because nation states have certain trajectories. Where do I think this is going? I think that one of the things that would reflect this possibility is to imagine a post-Kyoto regime that basically accepted the fact that in annex one countries, including the United States, they will enact a series of measures that are mandatory at the national level but probably only reach an effective price level or price signal that is consistent with the national economy and the national political demands of those countries. What you want to do is to bind those countries together under some sort of a principle of comparable effort. It is not to say that Japan and the United States and Europe have to do exactly the same thing and certainly not in the same way. If there is an effective price, in the sense that the volume of reductions to which they are committing in their own national fashions are reasonably comparable in terms of the cost to the economy, good enough. Do not try and make the United States do a particular thing in a particular way. It is not going to do it. It will walk. It has done it once before. Create a framework in which people are taking comparable measures, and then keep them talking and working and looking for gateways between them. At the level of non-annex one countries, the developing countries, I think it is extremely unlikely to damn near impossible to separate China and India legally from the mass of developing countries. The principle of solidarity among countries of the developing world is of extremely high value to the ministry of foreign affairs and the governments in those countries. They will not differentiate legally. It doesn't matter whether you give them incentives or head room. What will they do? I think that they will accept what I would call behavioural differentiation. That is to say, while they don't have legal obligations, they do recognise the importance of climate and the various contributions that are being made to it. Some sort of a standard, in which developing countries pledge that they will do what is consistent with their development priorities to change their trajectories of emissions would be a principal or a standard that they would accept. Under such a principle, they would alter away from the base line on which they currently are in the direction of climate-favouring action. Again, you must have a process thereafter that brings them together in a kind of pledge- and-review-based process, which has proven very effective in other areas of international regulation, like toxics and the like, where you keep people talking and learning, and there are compensating mechanisms that are set up in order to keep them pushing ahead on finding ways to reduce the trajectory of emissions that they are pursuing. So, differentiated standards are a first pillar of the regime I envision. Secondly, I want to spend some time talking about the way we have tried to connect the developing countries, or the emerging markets, to the developed countries through a series of general trading rules within inclusive global markets, largely through CDM. We have tried to create a market that simply operates with a single regulator, called the executive board, which creates general rules about additionality that are seen as ways of creating a smoothly functioning financial market. It is not working for a variety of reasons I think are endemic to financial markets that usually have to do with the quality of regulation. But what has happened is we have had a tremendous growth in CDM projects in recent years. I will come back and look at exactly how that has functioned. That growth has created a whole series of institutions who make good money around the CDM market. It is going to be difficult to displace three different interests: the traders, that is, people who actually make money coming up with these projects and then trading them; the interests in developing countries, who are making money by creating, by working with the traders to create these opportunities; and finally, extremely importantly, the countries seeking compliance because, if you look at both the situation in Europe and Japan, neither is on track to comply with the 2012 agreements. They must purchase CDM instruments in order to comply with their obligations. Japan is right now about twelve percent over its intended trajectory. It is supposed to be six percent under. They must purchase CDM. They really don't have any other way of getting there. Europe is also far off at the present time from their 7% cut obligations. The supply of CDM will be essential to their meeting these obligations at a reasonable cost. So what you have now is a situation in which you have a whole series of interests among both the demand and supply side, as well as on the trading side, that is now locked into place. My own sense is, and this is a sad and speculative comment, is that the supply of CDM is endogenous to the demand. What do I mean by that? The board, the regulator, will expand the supply of CDM to hold the price of compliance down in the countries that need these obligations to comply. The actual behaviour of the regulator, who I think are in good faith and are smart people in most cases but certainly acting under political pressure, is that they are interpreting the base lines. That is, they are interpreting the general rules of CDM to essentially expand and contract the available supply. In other words, in some sense the CDM has become what the Americans used to call a safety valve. If the price gets too high then there is a cap on that price. Now, the Americans wanted to do this in the original negotiations formally. If the price of compliance goes over $20, you could issue more permits. What I am suggesting is CDM has become a surrogate price cap. If the price goes too high, they will issue more CDM projects and the price will remain within an acceptable level. I think that's a very bad way to do things. If you are going to have a price cap, you should have a price cap, and secondly I think the subsidies we are paying are highly inefficient. We need a new instrument for linking much more efficiently and in a much more targeted way the developed and the developing markets I would institute mechanisms that essentially create a fund or a investment fund, or a fund of funds targeting on particularly salient development goals in countries like China and India, but run through a series of mechanisms that are likely to do away with the inefficient subsidies and this capacity to inflate the supply of CDM in response to the demand that is prevalent in the market. In California, Governor Schwarzenegger made a kind of a handshake agreement with Tony Blair that they would link the California market to the British market. That means linking it to the European market, and by extension to the CDM market, so that Californian institutions facing a cap would be able to use CDM to satisfy them in this process. I don't think that's going to happen because the governor has come to realise there are fundamental problems in the CDM market. The Californian system is as close as you can get to a sense of what the US will do in terms of its general shape after the 2008 period, evidenced by the Sanders Boxer Bill currently before the Senate. I'd like to give special attention to a series of issues that arise under the gravitational model that I have been describing. First, there are a lot of possibilities for reducing emissions that are within political economic margins. In many developed countries, you have about a $20 price cap in effect, through a cap and trade system or otherwise. In developing countries, you have got an effective zero price. That's the system that we are going to be facing over the next period of time. So there are opportunities for emissions reductions within those margins at less than $20 in the developing and developed countries. Also, there are the so-called negative cost options, usually associated with energy efficiency, whereby you have both economic gains and environmental gains that persist throughout the developing world. How do you get at those? Secondly, there are a bunch of possibilities close to the political margin, that is to say, a $20 price or a zero price. In China there might be things that are available at $5. In the United States they might be available at $25, just to pick arbitrary examples. They are just outside the political margin. Here, we usually demand that actors and politicians exercise their political will and raise the targets. It is not going to happen. The implication for me is that we should quit thinking about this set of possibilities of opportunities to reduce carbon through a state-centred model that says push up the regulation. Think about it in terms of new business development to capture those opportunities, which is a different model of how you approach potential gains that are available. In summary, my sense is that the regulatory model has limitations, and we must be thinking in these various extra pillars - the pillar about cooperation mechanism between developing countries and developed countries, the pillar about technology cooperation - more creatively than we have been thinking about it so far because prices alone are not going to bring this system into play. What are the probabilities that you will get a successful agreement like that? I don't know. I wouldn't even guess, but I think these are the conditions that you need to get an inclusive agreement based on these changes in perspective that I Let me add a couple of words about CDM because I do want to stress the importance of the linkage mechanism between developed and developing countries. This is what the so-called pipeline of CDM projects looks like in terms of who are the sellers, and where are CDM projects being developed that are in the pipeline so that they could actually provide offsets; that is, people could purchase the emissions reductions in these projects by 2012, if they eventuate. If you actually look at the projects that are now registered, what you tend to see is that the vast bulk of what is being sold in CDM are industrial gases. There is relatively little CO2. What is going on is that buyers, largely in Europe and in Japan, are substituting these offsets for CO2 emissions, so we have a shift in the way that compliance is going on. Maybe there is nothing wrong with that except that I don't think the system is working for a variety of reasons. In addition, of course, as we drive down the price at which compliance occurs, you reduce the incentive for people to invest in technology or other forms of activity that might be much more beneficial in the long run. This is a particular problem if you don't know how long the international system is going to go forward. Secondly, as I will show in a second, there is over-subsidisation. You are paying too much for the reductions that you are supposedly getting. In a number of cases we have inadequate implementation going on. For example, people have committed that they will put into biomass production of electricity only areas where you already had deforestation of waste use, and when you actually examine what is going on, they are cutting existing forest to put it into use. You have serious problems of leakage and project boundaries. One way to see this is, you have a situation where you plant sugar in Brazil and you get CDM credit because the fuels you are producing are displacing, let's say, natural gas- fired power in some way, or you are displacing the use of oil in the transportation sector. What has happened? What we get is, you see land being converted to sugar. The land that is being converted to sugar has often been soya pasturage. The soya pasturage is migrating towards the Amazon, and the effect is that you are getting deforestation in the Amazon. This is going on in extreme form with the United States right now, where we have provided incredible subsidies to bio fuels from corn. Farmers are ploughing under soy operations. Those soy operations used to be exporting to China. The Brazilians and the Argentineans are now planting more soy in extremely sensitive environmental areas to make up this demand. So, we have got problems of leakage. We have problems of commercial replication. Everybody knows this wonderful project in Delhi where the buses are now running on CNG. Great change in the air. Anybody who goes to Delhi is incredibly thankful that this is happening. Is it sustainable? No, it is not sustainable and it is not replicable because the gas that is being used in those buses is Gale gas, that is, it is gas at subsidised prices. India is moving away from a two-market gas system in which part of it is regulated at low prices supplied by the government, and the rest is at market prices. As India moves towards those market prices, there won't be subsidies that will allow this to go forward in other cities, as is projected. Subjective conditionality in determination: lots of problems. Anyone who is in business knows what this means. You don't just go into a new market in terms of prices. You go in looking at a whole variety of risks that you have relative to your opportunity costs - your hurdle rates, the other things that you would do with your money. What the board is being asked to determine is whether the return that companies are getting in projects that are associated with CDM is a return that they could have had in the market, or is it a function of some set of barriers that no-one can really quantify that would prevent them from going into that market in the first place? In other words, does it have to be a fifteen percent return, a twenty percent return, an eight percent return to qualify for CDM? It becomes a pure political analysis. Same thing with energy efficiency stuff that is supposedly negative cost. Is this actually available, should this be a CDM project or would it have happened anyway? These are difficult issues that are not amenable to scientific judgment, but are political. Here is the bulk of what is going on in CDM. Actually looking at the economics of these industrial gases and shows that, at the very least, these things in the first place are activities that are probably overstating the amount of reductions that you would have if you were simply optimising your industrial production. The problem in HCFC-23 is the following: every time you produce any HCFC-22, which is basically the feedstock in Freon and various types of coolants that are available, you produce as a by-product this bad greenhouse gas, HFC-23. These are the relationships: a kilogram of this gives you that much kilogram of that. This amount of HFC-23 you produce is 11,700 times more powerful a greenhouse gas than CO2. So you multiply this by the global warming potential and you find out how much CO2 equivalent is produced every time you produce that by-product of HFC-23. The currency and market price when we did this was about 9 Euros a ton. What does it cost to actually abate this by-product that is produced? It is about ten cents a ton of CO2, ten Euro cents. What are we doing? We are paying them 2.90, that is 32 percent of nine Euros, which is 2.90 Euros. The cost of abatement is 0.03. You are paying them 2.97 over their cost of abatement. What is happening is, if the money you can earn from the Freon, the commercial product, is 1.60, you earn much more by expanding; you are basically supplying CDM credit. You are much more interested in the CDM product, the by-product, because it is worth a lot more than the product you are trying to sell. So because it is worth a lot more than the product you are trying to sell. So happened in many cases. The Chinese government has been very clever. They have seen there is a huge overpayment here. They have taxed it away. 65 percent goes to the government. They say they put it into sustainable development projects. I would defy anybody to go into the Chinese budget and figure out where exactly it goes. So, two points: we are paying them. If they actually did the proper organisation, if the only thing they were interested in was getting the maximum amount of HCFC-22, the saleable product, they would probably end up with a number that is about 1.4. That is what companies in the first world do when they optimise to produce the saleable product. What we are doing is allowing them to run an industrial project that is inefficient, to produce more of the by- product, which can then be sold in CDM, and then overpaying for the amount that they are actually producing in this system. We all know landfill is an important thing. You are capturing the methane that comes off the fill. Very valuable thing to do and a lot of products are associated with that. I can show you that in Mexico fourteen states had already adopted landfill controls on CH-4, which they repealed. Why did they repeal it? To create a product to sell. In other words, the dynamic trend in policy was local regulation. They have stopped doing it. Adiptic acid, another bad product: all production was in the first world. There was complete voluntary industry abatement of the greenhouse gas aspex, of the production of adiptic acid. What has happened? This has all moved to the third world. Why? Because you can sell the adiptic acid mitigation. Renewable portfolio standards: countries in the third world that were adopting renewable portfolio standards, like South Africa, have stopped. Why should you adopt this regulatory measure when you can sell it? What we are doing is we are creating a series of incentives not to regulate and to over-produce. What we are not grasping is that developing countries had a policy dynamic that was moving toward increasing controls. We have frozen or cut off that dynamic rather than treating these countries in terms of their national trajectories. What any defender of the CDM system is going to say is, yes, we got it wrong at first, but now we are learning how to regulate better. In the 22nd executive board session last year, they changed two rules. One, you can't reverse your policy any more the way Mexico did on landfill regulation. If you have policy in place, that becomes your base line. So, that still creates an incentive not to enact policy to hold the low base line. So, what they then said was, what we will give you as a base line for CDM is what your policy was in 2001. If you want to go ahead and increase your local policy, you will still be allowed to sell to the CDM the credits that you would have had even if you had not enacted improvements in your base line. They have frozen what is a dynamic political process in energy markets at a particular date. This is not adequate. What is the next chapter that is coming to us? In India and China they are planning to submit to the CDM, and there will be political pressure both from those countries and from buyers in Europe, every energy project that they are doing where the emissions are less than a pulverised coal base line. So India is planning to submit what they say is going to be 34 gigawatts of hydro. They can't produce 34 gigawatts of hydro. They don't have the capital, but if they could, they are going to submit it on the difference between hydro CO2 emissions and what pulverised coal, sub-critical coal - 34/33 percent efficiencies - would do. China has already submitted all of their IGCC (integrated gasification combined cycle) gas plants for credit. The difference: how much more efficient are those plants in mitigating than a coal plant would be. China is planning to submit its ultra super-critical coal plants as well as its super-critical coal plants, each of which reduces emissions. Is there anything wrong with that? No, not in a sense, except for one thing: it is going to happen anyway. China is building a certain amount of coal. China is building ultra-super-critical. China has more than 38 plants being built at the super-critical level at the present time. It is happening without any incentive from the outside because it is consistent with China's energy policy and direction. We are going to qualify a lot of this in CDM that will expand the market and not recognise the dynamic transformation of the Chinese and Indian markets for their internal reasons. Should we be supporting gas plant development? Maybe, but not in this way. In other words, what you want to be supporting is incremental changes over where the system is going. You want to understand the internal policy dynamics and focus on getting beyond that. So, what we are looking at through CDM is a process of proliferation of credits without real market transformation relative to what was happening anyway. I would like to propose that we think about a system that corrects this in a variety of ways whilst still dealing with a series of alternative mechanisms. What I would propose that we think about much more seriously is some sort of a targeted development priority. So, if China tells us that they are extremely interested in something like the development of natural gas plants at a greater level than they are already committing themselves to doing, and someone can come up with a series of projects to do that, I think what you want are a series of multiple funds. That is to say, funds in the sense of investment funds that would make money available aimed at transforming markets, not at individual projects. And you may want to do that through a master fund that invests within a series of specific funds energy efficiency, LNG development, whatever it might be but I think you want to run those funds through competition. You want to auction a series of business proposals, the same as any other investment fund does. Who would put the money in? Anybody governments, firms. The return is offsets. What is critically important about this is two things. You want people bidding in the marginal cost of what they are going to be doing. You don't want them bidding in ten cent projects for 2.87. You want them competing with one another to bid in projects in which the selection in the auction has to do with the emissions reduction potential per dollar or per Euro that the fund is putting in. I would stop having political authorities do this regulation. I would set up something like technology and economic assessment panels that some of you may be familiar with from the Montreal Protocol process, whereby you have people who look at the pre-qualification rules of the auction, what you have to do to participate in the auction, and evaluation of the quality of the bids that are put forward, because auctions with prices alone don't usually work. We have a lot of experience in doing these auctions in oil and gas leasing, for example, and I think we need a different way of getting efficient subsidies. You want to favour activities that are commercially replicable. In other words, you don't want to start engaging in additionality activities project-by-project, which I think is impossible for reasons that I gave you earlier. I think you want to focus on shifting the base line and developing new markets. So, what people bid in are basically business plans, but I suspect these are going to have to be public/private business plans, because the business plans are probably going to be dependent on local complementary policy. So, if someone wanted to bid in a plan to increase natural gas supplies in a particular area, you would be worried about having people as part of that plan who could manage the infrastructure issues, who could manage the risk issues, and you would want to have local governments who would say "we are going to move to time-of-day pricing", because that is going to have an impact on the relevant pure use that prevails in a sustained market. Nothing here has to do with subsidy. It has to do with alternative structures of markets and new business development, and of course, as I suggested, you want these downstream incentives involved. You want to focus, I think, on business centre change with complementary policy that has some ring of conditionality to it, in the sense that there are policy shifts that are necessary in order to produce these investments out of the fund. I think that what you want to do is use a business centre model, because this stuff is beyond regulation, and I would not have any problem in having the technology and assessment panels actually have the capacity to go back to a bidder and say, "Look, we don't think the plan is perfect. You don't have the right complementary policies" or the like. That is in effect negotiating the policy base line as a process of putting these things into play. How many credits do you give to the investors? I think it is a mistake to do what we are currently doing, where we are allowing the market to essentially determine the number of credits, because in a CDM project the additional reductions go to the investors in the project. How would I do this differently? I think what I would do is look at a situation where an investor, a company in an annex one country, or a government would essentially get the number of credits where you took something like the safety valve price, the maximum price the shadow price, if you will. Let's say $20 a ton to start is the expected cost of compliance; the top cost of compliance in the United States. Accepting the fact that there was some sort of risk that this project would not actually eventuate, I would charge them $18 per ton less a risk premium or $20 per ton less a risk, the price that they would have to accept in order to bear this risk. So, you might get the number of credits, that would be "how many dollars have you committed? For every $18 you commit, you get a credit." What does that do? It is going to be less than the total emissions reduction, certainly. It means that the incentives in the system think back to the HCFC argument the incentives in the system go to the environment, because what you are going to get is the fund, every time you have a reduction in the number of credits that are available, the fund has more money available to put into the system, and you can actually maximise the number of credits that are out there. To put it as simply as possible, the number of reductions that is being projected by this system does not have to be, and should not be, the same number of credits accorded. Partially, it is going to be very difficult to figure out what those credits are. Say I have a system that truly changes the market and gives serious incentives for energy efficiency that will now dominate in Guangdong. How many credits does that produce over time? I don't know. You have changed the market; you can't calculate that in any precise sense. But you don't need to pay the investors that amount. What you need to pay them is the opportunity cost of what they would otherwise be paid in order to generate emissions reductions in their home markets, and you shouldn't pay them any more than that because otherwise you undercut the incentive for the technology and domestic investment through this system. I think this will work reasonably well. There are other things that you can do to try and create credible or reputationally sound behaviour by those who are bidding into this system. You could use techniques that have been developed in other investment structures, like tranche payments that are related to performance standards, to try and make sure that, when people bid in, they actually perform in accordance with their contract commitments. I think what we need is a different mechanism than we have at the present time. And maybe one way to do this is to talk about how we could imagine changing the performance of energy efficiency in Guangdong or Shanghai, or how we could increase the gas flow into the system through a series of bids into funds that would link developing markets to developed markets, but in a way that is targeted, that is not gate-able in the same sense because of bad regulation, that is not over-subsidising because of excessive payments into what is essentially a poorly regulated market. I think I will stop at that point and we can just open it up for discussion.