Undertaking Emission Reduction Projects

Prototype Carbon Fund and Clean

Development Mechanism
The ratification of the Kyoto Protocol will pave the way for developed countries to
embark on emissions trading by setting up emission reduction projects in developing nations,
which do not have emission reduction commitments. This article studies the potential
costs, risks and returns involved in such projects and looks at the advantages of setting up
large projects.
HARIPRIYA GUNDIMEDA, YAN GUO

each project will need more than one investor. The entrepreneur
I is also transferred some technology for this indivisible invest-
Introduction ment project (or the emission reduction projects) with stochastic

I
f the Kyoto Protocol (KP) is ratified, then the Annex I
countries1 will face emission reduction targets. However,
these emission reductions can be partly offset by the three
flexible mechanisms of the Kyoto Protocol – the joint imple-
mentation (JI) in Article 6, clean development mechanism (CDM)
in Article 12 and emissions trading (ET) in Article 17 respec-
tively. Emissions trading allows the Annex I countries to trade
emission reduction units that are above or below their emission
quotas agreed in the protocol in supplement to the domestic
actions. The application of ET requires a full international
agreement and a well-established trading market. JI allows trans-
fer of emission reduction units (ERUs) resulting from emission
reduction or removal projects (carbon offset projects) among the
Annex I countries. The CDM allows transfer of ERUs resulting
from carbon offset projects (like afforestation and forest
preservation) between Annex I and non-Annex I (developing)
countries (which do not have emission reduction commitments).
If the Annex I countries decide to benefit through JI or CDM,
there will be a large group of firms (henceforth called investors)
interested in investing in projects abroad and several firms in
developing countries (henceforth called entrepreneurs or
implementers or agents), who are interested in taking up these
emission reduction projects through initial capital financing.
There can be small projects as well as large projects but the
investors’ investment is limited to projects that would not have
occurred without co-financing or the additionality component of
the baseline project and would be limited to the cost of carbon
offsets generated. This would increase the internal rate of return
(IRR) of the project and make it profitable.2 For example,
consider the case of the Latvia-Liepaja gas recovery project.
The baseline project objective is to implement modern waste
management system, the funds for which are raised in the
entrepreneurs’ own country. The additional feature of this project
is installing energy cell technology for enhanced degradation of
biodegradable waste, collecting landfill gas containing 50 per
cent methane and generating electricity using this captured
methane gas.3 The investor would invest only in this additional
feature of the project. Also in some large projects like hydro
projects the scale of inputs for the project exceeds the personal
wealth of any single investor. This implies that in such cases
returns.
The product of the project at the end of the period is emission
reduction credits (carbon credit), which is of interest to the
investor. Here the carbon credits are the difference between the
hypothetical baseline emissions and effective emissions. The
entrepreneur is interested in other direct benefits provided by the
project as well as indirect benefits like employment, increased
power production or improved environmental quality. For ex-
ample, in the case of the Latvia project the benefits to the host
country are low public health risk, waste disposal and landfill
gas-fired power. However, the entrepreneurs have no direct
rights over the carbon reductions (carbon credits) and so
cannot market them. The project would be undertaken only if
the entrepreneur has enough capital inputs and if the return from
the project at least equals the opportunity cost of capital. Investors
agree to finance this project only if it fetches at least the carbon
credits which they would have obtained if they had invested on
their own.
II
Risks in JI/CDM Projects
JI and CDM seem quite flexible, but in reality they can be risky
and very costly for various reasons making the mechanisms
shaky. There are mainly three kinds of risks associated with the
projects, which may lead to project failure: non-performance,
non-cooperation and exogenous risk [Mitchell and Parson 2001].
The non-performance risk arises because of the project parti-
cipants’ intentional non-performance of their obligations. For
example, implementers of a reforestation project might plant
less land than promised or plant it badly; investors might fail
to provide promised funding, training or other resources. Second,
projects may fail due to lack of expected cooperation from
non-participants. To succeed, many projects require coop-
eration from actors not involved in project negotiations and not
bound by explicit obligations to the project, particularly host-
country government agencies (if they are not involved in project
negotiation). These risks may result in emission reductions below
expectations despite the participants’ efforts. Such situations are
particularly likely in the resource-poor contexts of non-Annex I

Economic and Political Weekly October 11, 2003 4331

 Figure 1: Threats to Successful CDM Project Performance
Project Risk
High
Medium risks with High risks that are
limited emission acceptable only if
reductions but participants
significant learning assume risk
Participant Risk
Low High
Low risk with Identifiable risks
reliable emission that require
reductions management
Low
Source: Mitchell and Parson (2001)
countries. For example, projects may fail because a government
agency does not provide water, energy or transport infrastructure
that implementers had assumed would be available. Third, projects
may fail due to risks that have nothing to do with such causes.
The desire for innovation in project technology, organisation or
application makes CDM projects particularly vulnerable to in-
herent project-related risks [Mintzer 1994:44]. Required project
inputs may be higher than expected and higher than the concerned
actor is able or willing to provide. Parties to a project might accept
technical assumptions about the relationship between inputs and
emission effects that turn out to be mistaken. Both uncertain
knowledge and random events may make the actual context for
project implementation quite different from that assumed during
negotiations. A reforestation project may fail because difficult
site conditions demand more time or resources than participants
predicted; because a planted species takes up carbon more slowly
than predicted; or because of fire, drought, etc [Metz 1995:170].
Based on these sources of project failure, Mitchell and Parson
(2001) identify two distinct types of threats to project perfor-
mance: project-related risk and participant-related risk (Figure 1).
Project-related risk consists of uncertainty in performance even
if project participants implement it perfectly, because of tech-
nological risk, external events, or reliance on non-participants.
For low-risk projects, the relationship of effort to outcome is
sufficiently well known that shortfalls in outcome can be readily
attributed to failures of the project participants. For example,
projects involving established technologies come under this
category. For high-risk projects, the relationship of effort to
outcome may be either intrinsically stochastic or poorly under-
stood, so that identifying causes of failure requires considerable
investigation. For example, consider the case of a project in
India which harnesses solar power to generate energy. There
are at least four areas of project risks. First, there is the financial
and operational risk that the project may fail to attract people
financially and technically capable of completing it and to manage
the plant efficiently so as maintain sound financial operations.
Second, there is a technical risk that the technology may not work
properly in the Indian context. For instance, climatological
4332
conditions such as haze and sandstorms may affect the perfor-
mance of critical components of the power plant. Also, the
maintenance and operation of critical solar equipment and control
may prove to be too complex. Third, there is the economic risk
that the application of the technology in India may be more costly
than anticipated, making it completely unaffordable. Fourth,
there is the replicability risk where, even if the demonstration
project works as planned, the project may not lead to its rep-
lication in India. This may be due to lack of proper policy
instruments or economic resources, or simply because the
conditions do not bring about a sufficiently large decrease in
the production costs.4
Apart from the costs arising due to project and participant risk,
transaction costs can also arise due to a cumbersome regulatory
approval process in the host and investor countries for foreign
investment. Further, complex, non-transparent processes govern-
ing the approval and implementation of investment by both sides
can invite opportunistic rent-seeking by host-country officials,
or even raise the troublesome issue of corruption [Powell et al
1997]. Thus transaction costs may take different forms but in
this paper by transaction costs we mean the costs associated with
the process of obtaining JI or CDM recognition for a project and
obtaining the resulting emission credits as defined in OECD
(2001). Hence the transaction costs can be split into the pre-
implementation and implementation phases. The pre-implemen-
tation costs include search costs, negotiation costs, validation
costs and approval costs. Project-based implementation costs
include monitoring costs, certification costs and enforcement
costs [Stronzik 2001].5 Thus in the context of CDM, transaction
costs are important because they may influence the scope and
extent of the use of flexibility mechanisms.
III
Prototype Carbon Fund
Keeping in view the risks and complications involved in
successful implementation of CDM projects, the World Bank
has launched a prototype carbon fund (PCF) to understand and
test the processes and procedures for creating a market in project-
based emission reduction under the joint implementation (JI) and
the clean development mechanism (CDM). Contributors to the
PCF include both companies and governments (‘PCF parti-
cipants’). The fund resources are used to support projects de-
signed to produce emission reductions fully consistent with the
Kyoto Protocol and the emerging framework for JI and the CDM.
The contributors, or ‘participants’ in the PCF receive a pro rata
share of the emission reductions, verified and certified in accor-
dance with carbon purchase agreements reached with the respec-
tive countries ‘hosting’ the projects. The mechanism of this PCF
is illustrated in Figure 2.
Some of the potential projects include wind, small hydro, solar
direct, solar photovoltaic, landfill gas, refuse-derived fuel,
geothermal power and heat, and biomass fuels, including
crop-residue fuels such as bagasse, rice-husks, coffee husks
and wood fuels. Energy-efficiency projects include demand-side
management such as manufacturing processes, building and
appliance efficiency measures, and supply-side efficiency such
as transmission, distribution efficiency and gas flaring reduction.
PCF funds are limited to projects that would not have occurred
without PCF co-financing and would be limited to the cost of
carbon offsets generated. The PCF will attempt to negotiate
Economic and Political Weekly October 11, 2003
 Figure 2: Mechanism of Prototype Carbon Fund
$ $
Industries, Economies
Economies
Industries,
Governments PP Transition
transition andand
governments
and Companies and C Developing
companies
CF developing
Countries
countries
F
CO2 2
CO CO2 2
CO
ΩΩ
ΩΩ
$ -–Money
Money – Technology CO2 ––Carbon
Carboncredits
- Technology
Source: www.prototypecarbonfund.org
financing where the price for offsets is paid on delivery of the
offset after the periodic verification of the offsets achieved. In
case the projects require initial capital financing, the PCF will
attempt to limit the initial financing to the cost of generating
the emission reduction. The launch of the PCF has raised hope
for these project-based reductions under CDM and JI.
If the KP or similar protocols are in place in future, the scope
for such carbon trading or carbon projects can be substantial.
It is estimated that the gross annual demand for ERUs between
2008 and 2012 is 1400-2400 Mt CO2 (without the US) of which
the demand for Annex B sinks is around 330 Mt CO2 [Lecocq
2000]. As the carbon credits are the difference between the
hypothetical baseline and effective emissions, they depend on
the effort put in by the agent and also some external factors. Here
the main difficulty arises from the investor’s inability to perfectly
observe the actions of the agent due to high monitoring costs
and technical non-feasibility. The investors therefore face two
types of asymmetric information. The entrepreneurs have private
information about their baseline emissions and the impact on the
production function of this investment; and private information
about their own actions (from now on referred to as effort) during
the project period. To simplify it further, if the projects fetch
a high return to the agent (and carbon reductions are directly
related to the output) then it can be win-win for both investor
as well as entrepreneur. However, if the projects are not that
profitable from the entrepreneur’s point of view (that is, if carbon
credit is the main outcome and no by-products, which yield
monetary benefits to the agent), the investor has to induce the
entrepreneur to put in full effort and avoid shirking (as a lower
target is not of interest to the investor; it delays compliance).
Here the investor is interested in effort rather than output because
carbon reduction is dependent on hypothetical baseline emis-
sions. If the agent claims that the baseline emissions are low and
show higher offset potential, it is not of interest as lower targets
are reached and the investor has over-invested. To ensure that
the agent is acting responsibly with full commitment, the investor
has to use a compensation scheme to optimise the agent’s com-
pliance effort, so that his behaviour is in line with the investors’
targeted output (that is, the emission reductions are really achieved).
Only with a properly designed scheme can the agent put in
appropriate levels of effort and meet the target. If the number
of projects and investors is large then it may be more efficient
Economic and Political Weekly October 11, 2003
to delegate the monitoring to an intermediary (in this case invest
in a fund like a prototype carbon fund) and pay a delegation fee
to the intermediary. Hence, a critical issue is whether it is
worthwhile to introduce an intermediary not only in the context
of PCF but also such intermediaries in the future to make the
in in
JI and CDM more efficient. What are the incentives to be provided
in various projects and under what conditions is it necessary to
go in for an intermediary? In the next section, we analyse these
issues in a non-technical way.
IV
Contracting, Monitoring or Delegation?
As both participant as well as project risk underlie CDM, the
credits
final outcome depends on the type of contracting, that is, con-
tracting with no monitoring, just monitoring, or both or using
an intermediary. In the context of multiple investors and
multiple implementers, using an intermediary might be an
efficient way to diversify the project portfolio risk, given that
the return in individual project is independent across different
projects. In the real world scenario, entrepreneurs take up all
project risks, including risks that cannot be controlled such as
technical uncertainty or non-cooperation of non-participants.
However, in the context of CDM such an approach will deter
participation and innovation in the programme, as new and riskier
technology will never be encouraged. Further, in instances when
project failure is unambiguously due to project risk, such sanc-
tions (that entrepreneur takes all the risk) are likely be difficult
to impose, and may not have the desired effect. Hence, the only
way out is to design proper incentives in order to avoid the failure
of projects. In this section, we will see how to implement the
projects efficiently using the basic principal-agent model. The
investor can either contract with entrepreneurs to provide incen-
tives or monitor to prevent the entrepreneur shirking or do both
to get carbon credits given the entrepreneur’s participation
constraint and the investor’s budget constraint. The expected
carbon credit depends on the entrepreneur’s performance and also
on some stochastic variables which cannot be controlled by the
entrepreneur. When there are multiple principals and agents to
implement JI and CDM, an intermediary can be introduced to
diversify independent risk, save transaction and monitoring cost,
and strengthen bargaining power in contract renegotiation. We
discuss below the incentives under vaious heads.
Contracting with entrepreneurs: The type of contract depends
on whether the projects are of high return or low return from
the entrepreneurs’ point of view. High-return projects are defined
as those that can fetch direct benefits for hosting countries’
entrepreneur or manager without much risk. This kind of project
not only produces carbon reduction, but also produces other
products, which are economically attractive to the entrepreneur
(that is, they enjoy a good rate of return even without funding
from the investor). For example, consider the case of a power
plant operated by a firm using waste rice husk or waste peanut
shells as fuel, to produce electricity using the conventional
Rankine steam cycle technology. As this technology has been
in use for more than 100 years and is commercially competitive
with existing sources of electricity, this fetches direct returns to
the entrepreneur (if not, it at least saves the cost of electricity).
This is an ideal project in which both parties are better off.
However, the principal may incur higher transaction costs to
verify the baseline carbon emissions. For instance, renewable
4333
energy projects, such as wind and photovoltaic projects, though
risky require less effort in absolute terms than for large-scale
fossil projects. This is due to the fact that projects with zero
emissions require minimal verification effort in the implemen-
tation phase. Because of the comparative cost advantage in the
host country and the positive externality from the investment
project, social welfare is increased. But optimal effort of entre-
preneur doesn’t mean that the project can perfectly achieve the
targeted carbon reduction as we mentioned earlier. Each project’s
outcome can also depend on some stochastic variables, for
example, states of nature, which cannot be controlled by investor
or entrepreneur. In this case the project is low in participants
risk, but may not be low in project related risk. As neither investor
nor entrepreneur can control the uncertainty of states of nature,
there always exists some risk that a low outcome may occur,
implying that the targeted carbon reduction is not achieved, which
is not of much interest to the investor.
The above scenario is more interesting in the case of a multiple-
investor and single-project setting. The scenario won’t change
except that there may be some cooperation problem and dupli-
cated contract-writing costs. If the investors can make a coalition
or delegate an intermediary to write the contract and pay the
service fee, then both parties can reduce the contracting cost. So
is the situation with multiple profitable projects. Here delegation
to an intermediary can be profitable because the intermediary
not only saves the transaction cost in writing a contract with
multiple principals and agents, but can also diversify the risk
among different independent projects. If the states of nature faced
by each project are independent, then, as the number of projects
goes to infinity the whole risk of the project portfolio can be
largely diversified.
Now consider the case when the project does not fetch a high
return from the entrepreneur’s point of view (can yield good IRR
only with funding from the investor). For example, consider the
case of a reforestation project. The benefits of forests as a source
of timber, fuelwood, fodder and other non-timber forest products
along with environmental services provided by them are well
known. Though the project provides valuable environmental
services now, as the forest can no longer generate direct economic
benefits in the form of timber and fuelwood (due to using trees
for storing carbon) this is economically unattractive for the
entrepreneur. Another example is the case of the Liepaja solid
waste management project in Latvia. Without funding from the
investor, the project IRR is only around 1 per cent and with
funding the IRR is around 5 per cent. So the project becomes
economically unattractive and has too much of risk. There are
three major areas of potential risk namely: technical risk arising
due to the design, construction, operation and reuse of the energy
cells; difficulties in realising the expected gas generation rates
and yields (which is a critical component in supporting, through
energy sales, the financial viability of the project); and a shortfall
in revenue through sales of electrical power.6 As the entrepre-
neurs cannot make direct profits, it is always feasible for them
to put in less than optimal amount of effort than the case of high
return projects. In order to ensure that the entrepreneur chooses
a high level of effort, he must be provided with incentives as
well as be monitored. In the former case, the only option for
the investor is to pay enough compensation to induce agent’s
high effort. Here the optimal compensation scheme pays more
for outcomes that are statistically relatively more likely to occur
under high effort than under low effort (referred to as likelihood
4334
ratio). Similarly, he offers less compensation for outcomes that
are relatively more likely when low effort is chosen. In this case
the investor pays the agent a fixed amount plus an additional
motivational amount that is incentive-compatible. Therefore the
motivational amount renders the agent’s compensation dependent
on the emission reduction credits and effort via this likelihood
ratio. This is significant because compensation, the traditional
and most significant behavioural control mechanism employed
by management, becomes in part a function of the ability to
measure output and effort. If this relationship were to break down,
managerial control is weakened and improper risk sharing would
result [Goldsmith and Basak 2001]. However, output being
highly stochastic, if it does not depend on effort but depends
on the state of nature, the optimal payment scheme reverts to
fixed wage compensation.
Monitoring: Earlier we said that the final output of the project
also depends on the state of nature, any deviation from the first
best solution representing the social welfare loss. How can the
investor know that the deviation from the first best is because
of state of nature and other exogenous factors and not because
of intentional non-commitment? So an important issue to be
considered is if there is any way to reduce the deviation by
minimising information asymmetry in order to mitigate social
welfare loss. Monitoring is often adopted in principal-agent
problems to improve the agent’s effort by punishing shirking.
Any imperfect information about the agent’s action or states of
nature can be used to improve the contract, as long as the marginal
benefit of getting information is greater than its marginal cost
[Holmstrom 1979]. Given that effort is unobservable, choosing
an appropriate signal or choosing a good performance measure
which includes information about the agent’s effort becomes the
key issue in monitoring. Apparently the more information in-
cluded in the signal about the agent’s effort, the better off the
parties are by monitoring. However, monitoring is costly. Hence,
the investor will balance the gains and costs from monitoring
to get maximum profit. Milgrom and Roberts (1992) endogenise
monitoring into incentive contract, showing how much should
be spent on monitoring for principal. Earlier, under the observable
effort case, the risk-averse agent gets constant wage without
sharing any risk, and under unobservable case, the incentive
contract imposes some risk on the agent to induce high effort.
In this case too, the incentive wage package can be decomposed
into a certain constant amount of wage and the marginal gain
from more effort for agent (incentive intensity). As the effort
cannot be observed, the agent has to take some risk along with
the cost of effort.
V
Delegated Monitoring
Diamond (1984) provides a financial intermediary theory from
the point of delegated monitoring. He proves that as long as the
monitoring costs are less than the contracting costs the delegated
monitoring pays. For the financial intermediary to be viable,
Diamond argued that three conditions must be fulfilled. The
investors must receive an expected return R per unit deposited.
The intermediary must receive an expected return net of monitoring
costs and any dead weight penalties incurred which is at least
zero. Finally, each entrepreneur must retain an expected return
at least as high as he would be by contracting directly with
investors. Given that the CDM system is highly risky, it requires
Economic and Political Weekly October 11, 2003
attracting a diverse collection of projects and participants and
tuning implementation approaches to respond to these differ-
ences: for example, rewarding low-risk projects that generate
near-term reductions while also encouraging high-risk projects
that may involve innovations resulting in large future reductions.
The diversification can reduce the project risk. However, as it
is too difficult for an individual investor to monitor different
projects with different levels of project risk, it is useful to have
an intermediary to reduce the transaction costs. The importance
of the intermediary is not simply a way for investors to hold well-
diversified portfolios, but also a way to strengthen the bargaining
power of investors when renegotiation happens. The asymmetric
information may warrant a renegotiation of the contract. When
renegotiation happens, delegated renegotiation is more efficient
in a situation with dispersed multiple investors and multiple
projects [Bolton and Freixas 1994]. In CDM and JI programmes
where each project involves some non-participant risk also, like
sovereign risk, PCF, as an intermediary to renegotiate with
sovereign countries is more efficient than the investors to guar-
antee the carbon reduction target.
VI
Discussion and Conclusions
Based on the analysis in earlier sections, we would try to
summarise the incentives to be provided in the four cases: (1) low
participant-low project risk; (2) low participant-high project risk;
(3) high participant-low project risk and (4) high participant-high
project risk. The incentive mechanism is summarised in Figure
3. When project risk is low (expected profit is low and the
profitability from incremental effort is low as well), the incentive
intensity is low as well. In such cases it is also reasonable to
say that agent’s performance can be identified very easily, as there
are few variables which are outside control to affect the outcome,
implying higher incentive. Low-risk agents are usually more risk
averse and hence less responsive to incentives, and as seen from
Figure 3 the incentive intensity is low. Due to the high precision
of performance measurement, though it appears that incentive
should be high, in reality this is offset by the low profitability,
strong risk aversion and low responsiveness to incentive. There-
fore, principal can save monitoring cost because of low incen-
tives. For these low-risk projects the contract can be written based
on a set of minimum standard criteria for all the projects (the
criteria can be adjusted after project initiation to meet the par-
ticular exigencies of the project). If feasible the projects can also
be evaluated on completion based on performance criteria (for
instance using emission reductions or effectiveness of standards
as criteria), thereby granting entrepreneurs maximum flexibility.
In this case, the initially agreed contract should provide adequate
incentives and compensation. Here there may be expectations
on the part of entrepreneur that they will be rewarded if they
perform as per expectations. Such entrepreneurs may be encour-
aged through subsidies of monitoring costs to undertake inno-
vative projects and linked with some incentives. However, if the
entrepreneur fails to perform in low-risk projects, there can be
additional sanctions on them like publicising poor performance,
and restricting future CDM participation, etc, [Mitchell and
Parson 2001].
In case of low project risk and high participant risk, profitability
from incremental effort will be discounted by the low expected
profit and so is the responsiveness of the agent to the incentive.
Economic and Political Weekly October 11, 2003
In low-risk projects it is easier to measure the agent’s perfor-
mance, but as the agent’s risk is high he has to be given strong
incentives. But the discounted profitability and responsiveness
to incentive will offset the outcome from the incentives. Thus,
in this case contracting with incentive would work. He should
be given some incentive not to shirk work and to put in optimal
effort. High-risk participants would be allowed to undertake low-
risk projects, but would have to bear the costs of extensive
monitoring to ensure their full performance. Here contracting
would dominate monitoring.
When the project risk is high and agent risk is low, the project
might have high expected profit, but the profitability from in-
cremental effort may be limited due to the low-risk of the agent.
In this case it is very difficult to identify the agent’s performance
because of the high variance of measurement. Minimal incentive
intensity and minimal monitoring can be optimal. This kind of
compensation scheme holds good even in projects which yield
good return to the entrepreneur. In such cases the performance
can be awarded based on behavioural standards. Behavioural
standards would award credits for performing specified actions
and defending against eventualities specified at the time of project
approval [Kerr 1997:2]. Here the participant can be given con-
stant wage but some bonus may be promised if the participants
meet expectations despite unfavourable circumstances, to en-
courage and reward project success. However, if the projects fail,
still they get constant wage and the investor takes the risk.
However, in order to judge that the effort is genuine, the par-
ticipant needs to be monitored (though minimally). In this case
the cost of monitoring can be borne by the investor. The extent
of monitoring chosen depends on the type of project. Projects
like reforestation require only intermittent monitoring. Power
plant projects require more continuous and consistent monitoring
to ensure that the power plant is operated and maintained in ways
that minimise emissions.
When the participant’s risk is high and project risk is high as
well, high profitability can be expected from incremental effort
though it is ambiguous. High-risk agents are less-risk averse than
low-risk agents. If more discretion is given to the agent in high-
risk projects, less-risk averse agents may have more incentive
to find innovative ways to improve performance in order to get
more payoff, which means stronger responsiveness to incentives.
However in case of high-risk projects, it is very difficult to
measure the agent’s performance precisely thereby, lessening the
incentive intensity. Hence, in such cases, higher incentives need
to be provided to the agent, which implies that the investor has
to put in more effort to monitor to improve efficiency. Such
projects are quite risky and are generally not favoured but they
can be quite promising sometimes due to high returns. Rewarding
these risky projects through careful design and implementation
promotes innovations that may improve system efficiency over
the longer term. In such cases, monitoring crucial behaviour,
interim progress evaluations, and identification and responses
to precursors of failure is essential. Otherwise it is difficult to
know the reasons why a project failed (whether it is because of
the risky project or because of the low effort). Here, such high-
risk performers may be asked to submit performance reports
regularly. In such cases, the monitoring costs have to be borne
by the entrepreneur. This would impose some additional cost and
inconvenience on responsible entrepreneurs, but this is the only
way to screen fraudulent entrepreneurs who plan to shirk their
responsibilities, as they are likely to reject such provisions at the
4335
 Figure 3: Monitoring and Incentive Strategy
Project Risk
High
Profitability from incremental effort is Profitability from incremental
low ⇒ incentive intensity (ΙΙ)↓ effort is high ⇒ incentive
Absolute risk aversion high ⇒ ΙΙ↓ intensity (ΙΙ) ↑

Precision of performance Absolute risk aversion low ⇒ ΙΙ ↑

measurement high ⇒ ΙΙ↓ Precision of performance
Agent’s risk tolerance high ⇒ ΙΙ↓ measurement high ⇒ ΙΙ↓

Investor takes risk Agent’s risk tolerance

ambiguous ⇒ ΙΙ↓or ↑
Constant wage
High incentive with careful
Minimal monitoring monitoring

Low High Participant

Risk

Profitability from incremental effort Profitability from incremental effort

is low ⇒ incentive intensity (ΙΙ)↓ is high ⇒ ΙΙ↑
Absolute risk aversion high ⇒ ΙΙ↓ Absolute risk aversion low ⇒ ΙΙ↑
Precision of performance Precision of performance
measurement low ⇒ ΙΙ↑ measurement low ⇒ ΙΙ↓
Agent’s risk tolerance high ⇒ β↓ Agent’s risk tolerance low ⇒ ΙΙ↑
Low incentive contracting Very high incentive/careful
With low cost monitoring monitoring

Not much space to give Let the agent take the risk. There is
much space to give incentive to the
Incentives to agent because of agent but limited by project risk
participating constraint

Low

beginning of the project. To verify that self-reporting is reliable
the investor has to incur second-party and third-party monitoring
if necessary. If the project failed due to unforeseen factors despite
good performance, the agents are required to demonstrate full
performance before credits are disbursed [Goldsmith and Basak
2001].
In the above cases, the design of incentives is under the standard
CDM project model involving an exchange in which a single
investor receives credits and a single entrepreneur is paid for
generating them. However, as the CDM develops, some projects
may involve multiple participants on the investor side, with
credits being allocated among them as part of the project design.
Such large emission reduction projects are ideal as they have
low transaction costs.7 However, larger projects would also require
managing a mixed portfolio of projects, including innovative and
high-risk ones, of which some – or many – fall short of expec-
tations. This is similar to diversification of risk of individual
stocks in a stock portfolio. As discussed earlier, this would be
extremely costly for the investors and in such cases using an
intermediary would be highly beneficial to both the parties.
There are several other reasons in support of the use of in-
termediary apart from diversifying the portfolio. As discussed
earlier though it is ideal to have large projects because of low
transaction costs, many countries have small-scale renewable
energy and energy efficiency opportunities that can enhance their
rural economies and provide clean technology in manufacturing
and infrastructure. Financing tiny projects of hundreds of watts
to a few KW of installed power, or to mass distribution of single
energy-efficient appliances, such as air conditioners/solar water
heaters, is very difficult (involving high transaction costs)8 and
also challenging. The costs rise with the number of operational
entities involved and significantly for smaller projects. However,
as the benefits of CDM should reach smaller countries, such
projects need to be encouraged. This implies that cost reduction
measures should be explored so that the ERUs from small deals
can compete with high-volume low-cost projections
(www.prototypecarbonfund.org). Given this heterogeneity of
transactions, determining a price for the ERUs is also a challenge
due to the absence of a public liquid market. The prices also
vary from contract to contract, depending on the level of risk
inherent in the transaction and the underlying project. Prospective
market prices will depend largely on evolution of demand and
supply. This makes the whole mechanism quite risky and com-
plex. As the intermediary is risk-neutral he can bear all the risks
and give a pro rata share of emissions to all the investors according
to their investments in the fund.
As discussed in the introduction there is some non-participant
risk (from governments) associated with the CDM mechanism.
Projects in different sovereign states may face different risk
premia owing to the perceived level of risk of default or project
failure due to the general nature of the economy or the nature
of the government. So using an intermediary with reputation and
bargaining power would minimise risks. The intermediary in this
case can be powerful in influencing governments in undertaking
projects and subsequently contribute to the overall system suc-
cess. Further a large intermediary like the World Bank can ensure
successful screening of the participants due to its experience by
linking current or future participation to past performance. EPW
Address for correspondence:
haripriya@mse.ac.in
Notes
1 Most of the developed and industrialised countries.
2 Assuming a revenue stream based on emission reduction (at US $3 /t
Co2e) the change in IRR for some of the projects are given below:
Energy efficiency – district heating (2–4), wind (0.9–1.3), hydro (1.2–
2.6), bagasse (0.5–3.5), biomass projects (upto 5.0), municipal solid waste
(75.0) (www.prototypecarbonfund.org).

4336 Economic and Political Weekly October 11, 2003

3 See www.prototypecarbonfund.org/document library/project idea Notes/
Latvia PIN
4 http://wbln0018.worldbank.org/essd/kb.nsf. India Solar power.
5 For example, the typical average costs of the PCF projects for negotiation,
approval, validation and contingency are 2,50,000, 40,000, 20,000 and
31,000 euro respectively [Stronzik 2001].
6 Technical Review and Assessment of the proposed Liepaja Solid Waste
Management Project, May 2000
(www.prototypecarbonfund.org/documents)
7 For instance, the transaction costs for small projects (i e, carbon reduction
of < 50 t/annum) is 1,000 USD/tC while for large projects (with carbon
reduction of 5,000 – 50,000 t/annum), the transaction costs are only 1$/
t C [Stronzik 2001].
8 According to [Pricewaterhousecoopers 2000], the transaction costs for
a new combined cycle gas turbine (CCGT) plant varies from 0.09 to 0.20$/
t C for different levels, for retrofit project from 0.08 to 0.17 $/tC, for
wind project the transaction costs vary from 0.77 to 1.27$/tC, for 1 MW
PV project the costs vary from 67.4-111.0 $/tC, for 1,000 KW PV project,
the costs vary from 674 – 1119$/TC for different levels.
References
Bolton, P and Freixas, S (1994): ‘Direct Bond Financing, Financial
Intermediation and Investment’, Universitat Pompeu Fabra, Bacxelona,
Mimeograph as quoted in: Diamond, D W (1984), ‘Financial Inter-
mediation and Delegated Monitoring’, The Review of Economic Studies,
51(3): 393-414.
Diamond, D W (1984): ‘Financial Intermediation and Delegated Monitoring’,
The Review of Economic Studies, 51(3): 393-414.
Goldsmith, P D, and R Basak (2001): ‘Incentive Contracts and Environmental
Performance Indicators’, Environmental and Resource Economics, 20:
259-79.
Franck, Lecocq (2000): States and Trends of the Carbon Market – DECRG/
PCF Plus Research, http://econ.worldbank.org
Holmstrom, B (1979): ‘Moral Hazard and observability’, Bell Journal of
Economics, 10: 74-91.
Kerr, S (1997): ‘Towards a Theory of Compliance Institutions for International
Traceable Permit Markets: Joint Implementation of the Framework
Convention on Climate Change’, (Report WP 96-25). College Park:
University of Maryland.
Metz, B (1995): ‘Joint Implementation as a Financing Instrument for Global
Reductions in Greenhouse Gas Emissions’ in K Ramakrishna (ed),
Criteria for Joint Implementation under the Framework Convention on
Climate Change, Woods Hole Research Centre, Woods Hole MA, pp 25-34.
Milgrom, P and J Roberts (1992): Economics, Organisation and Management,
Prentice-Hall, Inc.
Mintzer, I (1994): ‘Institutional Options and Operational Challenges in the
Management of a Joint Implementation Regime’ in K Ramakrishna (ed),
Criteria for Joint Implementation Under the Framework Convention
on Climate Change, Woods Hole Research Centre, MA, pp 25-34.
Mitchell, R B and E A Parson (2001): ‘Implementing the Climate Change
Regime’s Clean Development Mechanism’, Journal of Environment and
Development, 20 (2): 125-46.
OECD (2001): ‘Kyoto Mechanisms, Monitoring and Compliance from Kyoto
to The Hague’, http://www.oecd.org/env/cc/
Powell, M, Lile, R and M Toman (1997): ‘Assessing the Constraints
and Opportunities for Private-Sector Participation in Activities
Implemented Jointly: Two Case studies from the US Initiative for Joint
Implementation’, discussion paper 97-38-REV, Resources for Future,
Washington, DC.
Price Water House Coopers (2000): ‘A Business View on Key Issues Relating
to Kyoto Mechanisms’, Funded by UK DETR. London.
Stronzik, M (2001): ‘Transaction Costs of the Project-Based Kyoto
Mechanisms’, EC Energie Project Number ENG2-CT1999-00004,
Manheim.

Ashoka Trust for Research in

Ecology and the Environment Ashoka Trust for Research in Ecology and the Environment
www.atree.org

Positions for ecologically oriented social scientist and an outreach coordinator

ATREE invites applications from motivated and qualified persons for the following two positions:
1. Social Scientist: The applicant should have a Ph. D and/or have a credible publication and research record in sociology,
anthropology, political science or related discipline, with demonstrable research experience in applying an interdisciplinary
approach to ecological and environmental issues. Familiarity with public policy, legal, and governance issues associated with
conservation of biological resources and management of natural resources. Candidate should have the ability to initiate and
manage projects independently and to work as a member of an interdisciplinary team.
This position is at the level of Fellow, and will be based in Bangalore. A Fellow position at ATREE is equivalent to that of Assistant
Professor at an academic institution. This position is endowed, with a modest budget for annual operating costs. The candidate
will be appointed for a renewable 5-year term. Our emoluments are competitive with other academic institutions in India.
2. Outreach Coordinator: The position is based out of Bangalore, but requires extensive travel to project sites in South India,
working closely with our Field coordinator to implement community based developmental activities and participatory research in
the area of Natural resource conservation and management. Master’s degree required in any relevant discipline with 3 years experience
in coordinating and implementing relevant community based activities. Must have demonstrated abilities to work with communities
and plan interventions that have a sustained impact. Will be responsible for all written inputs and outputs for this program. Excellent
oral and written skills in English a must. Oral communications in South Indian languages with knowledge of Kannada preferred.
Salary will be commensurate with qualifications and experience. The appointment will be renewed annually.
Applicants should write to the address below, enclosing their CVs, names of three references, and a letter describing how their
profile fits ATREE’s mission and how they plan to contribute to ATREE’s programs. Applicants must be Indian citizens. For more
information on ATREE please look at www.atree.org
Deadline for application: November 15, 2003 or until suitable candidates are found.

The Director, ATREE, 659, 5th A Main Rd, Hebbal, Bangalore 560024
Phone: 80-3533942, 3530069 Fax: 80-3530070, Email: director@atree.org or info@atree.org

Economic and Political Weekly October 11, 2003 4337