This is an invited discussion on the Morozova and Stuart’s paper “The Size of the Carbon Market Study”. It suggests a number of issues for consideration in appropriately estimating the size of carbon markets. They include Annex 1 (industrialised) countries’ baseline emissions; qualitative and quantitative assessments of the role of carbon sinks; and the difficulty from an economic and legal perspective of interpreting and inferring impacts in relation to specific provisions attached to each flexibility mechanism for regulating the extent of their use.Emissions trading; Clean development mechanism; Joint implementation; Carbon market; Greenhouse gases; European Union; Supplementarity restrictions

Zhang, ZhongXiang

English

Research Papers in Economics

December 2000 
 
The Size of the Carbon Market Study: Discussion
1 
 
ZhongXiang Zhang 
Faculty of Economics and Faculty of Law 
University of Groningen 
P.O. Box 716 
9700 AS Groningen 
The Netherlands 
Tel: +31 50 3636882 
Fax: +31 50 3637101 
Email: Z.X.Zhang@Rechten.RUG.NL 
 
 
 
The paper of Morozova and Stuart (2000) attempts to gauge the potential size of 
carbon market in the first commitment period under the Kyoto Protocol by means of 
examining recent studies.  A reading of their paper suggests a number of issues for 
consideration in appropriately estimating the size of carbon markets. They include 
Annex 1 (industrialised) countries’ baseline emissions; qualitative and quantitative 
assessments of the role of carbon sinks; and the difficulty from an economic and legal 
perspective of interpreting and inferring impacts in relation to specific provisions 
attached to each flexibility mechanism for regulating the extent of their use. 
 
 
1. Baseline emissions in Annex 1 countries 
Once the Kyoto Protocol enters into force, the greenhouse gas (GHG) emissions 
targets will become legally binding. Because emissions in Annex 1 countries are 
expected to continue to rise under the business-as-usual (BAU) scenario and because 
the emissions targets will not become binding until the first commitment period, the 
real reductions must thus be measured against their projected BAU or baseline 
emissions levels over the commitment period. Accordingly, the mandated reductions 
from projected baseline emissions levels represent the potential demand in the GHG 
offset market. In practice, how the needed reductions will take place will depend on 
the relative differential between the marginal cost of domestic abatement in Annex 1 
countries and the international price of emissions permits. But, in theory, the needed 
emissions reductions reflect the maximum size of carbon market in physical terms. As 
potential demand is a starting point for any estimate of the size of carbon targets, the 
Stuart and Morozova paper should have provided readers a survey of existing 
estimates for baseline emissions in Annex 1 countries. 
                                                           
1 This discussion is invited by the United Nations Conference on Trade and 
Development, Geneva. The views expressed here are those of the author. The author 
bears sole responsibility for any errors and omissions that may remain.   To a large extent, the baseline emissions determine the cost of meeting a given 
emissions target (Zhang, 1997). The larger the size of the gap between the baseline 
emissions and the Kyoto target, the higher the marginal abatement cost of meeting the 
target. When net emissions reductions required of the EU in 2010 rise from 27.9 
million tons of carbon (MtC) in the case of the low official EU baseline projection to 
234 MtC, the median value for the EU baseline emissions estimated by the four 
economic modelling studies, the autarkic marginal abatement cost in the EU sharply 
rises to US$ 249.9 per ton of carbon from US$ 9.1 per ton (Zhang, forthcoming). This 
sharp increase in emissions reductions required of the EU drives up the total Annex 1 
countries’ demand for permits and hence the market price of permits. Thus, there is a 
significant increase in demand for the certified CDM (clean development mechanism) 
credits. As a result, the size of the CDM market increases almost a half in the case of 
the high EU baseline in comparison with the case of the low official EU baseline 
projection. In the mean time, the value of the CDM market, that is, the product of the 
market price of permits and the supply of the certified CDM credits, increases almost 
one and a half as a result of the increase in both the price and the supply (see Table 1). 
 
 
Table 1   
The size and value of the CDM market and the shares of China and India in 2010 
under the two trading scenarios under two alternative EU emissions baselines
a 
 
  No limits  EU ceilings with the 
however clause 
Size of the CDM market (MtC) 
CDM market (million 1998 US$) 
Net CDM market (million 1998 US$) 
420.7 (292.1) 
6685.0 (2795.6) 
3831.5 (1565.0) 
281.7 (195.4) 
2565.9 (1103.4) 
1433.2 (603.0) 
 
a The figures in parentheses are calculated based on the low official EU baseline 
projection. 
Source: Zhang (forthcoming). 
 
 
2. The role of sinks 
During climate change negotiations at the COP-6 which ended in November 2000, the 
Americans were keen on the broadest and most generous definitions of sinks 
absorbing greenhouse gases in the atmosphere, while the Europeans wanted sharp 
curbs on the use of sinks. In the end, it had become clear that the two sides no longer 
disagreed on whether additional land use change and forestry activities in the first 
commitment period should be included, rather they disagreed over the extent of usage 
of sinks to meet their emissions targets. This fact alone may have profound 
implications for the size of the carbon market. On the one hand, allowing domestic 
sinks to meet targets could have the effect of reducing Annex 1 countries’ demand for 
permits abroad because sinks provide them with less costly abatement options at 
home. On the other hand, inclusion of sinks under the CDM opens up the possibility 
in comparison with domestic actions of obtaining even less costly abatement options 
from the developing countries. Although it is very difficult to indicate which counter-
effects will prevail because of a lack of cost data at a macro level, the Morozova and 
Stuart paper would have enriched the policy relevance at least if a qualitative 
discussion of implications of the inclusion of sinks had been done.  
  2 
3. Implications of the supplementarity clause 
Under the Kyoto Protocol, each of the Articles defining the three flexibility 
mechanisms carries wording to the effect  that the use of the mechanism must be 
supplemental to domestic actions. Article 6 states that emission reduction units from 
joint implementation projects should be “supplemental to domestic actions” for the 
purpose of meeting quantified emission limitation or reduction commitments. Article 
12 states that Annex I Parties may use the certified emission reductions from CDM 
projects to contribute to compliance with “part of their quantified emission limitation 
and reduction commitments”, while Article 17 states that emissions trading shall be 
“supplemental to domestic actions” for the purpose of meeting quantified emission 
limitation or reduction commitments. The absence of a precise definition of the 
meaning of supplementarity within the text of the Protocol has lead to the existing 
differing interpretations of these provisions. At one extreme, the supplementarity 
clause could be interpreted  simply to mean that domestic actions should provide the 
main means of meeting Annex 1 countries’ commitments, so that any action abroad 
would be additional to domestic actions. At the other extreme, the clause could be 
interpreted to mean that any action abroad will be supplemental to whatever domestic 
actions are taken. This implies that any one Annex 1 country could use the flexibility 
mechanisms as much as it wished in order to meet its Kyoto commitments. Whether 
the supplementarity clauses will be translated into a concrete ceiling, and if so, how 
should a concrete ceiling on the use of the three flexible mechanisms be defined 
remain to be determined. In my view, the supplementarity clause is of significant 
policy relevance to the ongoing negotiations on the overall issue of flexibility 
mechanisms. While Morozova and Stuart paper does cite results from Zhang (1999), 
the paper does not pay sufficient attention to this topic, As the topic is important in 
that different interpretations of clauses may affect the size of the carbon market 
considerably, it will be useful to elaborate on the subject further.  
To date, there have been many proposals calling for a restriction on the use of 
flexibility mechanisms. The most representative is the EU proposal. Documented as 
the Community Strategy on Climate Change (European Union, 1999), the EU 
proposal calls for limits on both buying and selling countries.  
Under the EU proposal, “however, the ceiling on net acquisitions and on net 
transfers can be increased to the extent that an Annex B Party achieves emission 
reductions larger than the relevant ceiling in the commitment period through domestic 
action undertaken after 1993, if demonstrated by the Party in a verifiable manner and 
subject to the expert review process to be developed under Article 8 of the Kyoto 
Protocol.” (European Union, 1999). This so-called “however” clause allows an 
importing (exporting) country to purchase (sell) more than the amount defined by the 
above alternatives if verifiable domestic abatement by that country can be 
demonstrated. Thus, the “however” clause effectively raises the importing ceiling and 
allows an importing country to purchase emission reductions from abroad up to 50% 
of the emission reduction requirement, provided that the country can verify a similar 
volume of domestic abatement undertaken after 1993. 
Using the global model based on the marginal abatement costs of 12 regions, 
Zhang (1999, 2000, 2001) have analyzed the economic effects of the EU proposed 
concrete ceilings both on Annex 1 countries and on non-Annex 1 (developing) 
countries. These analyses have clearly shown that, although the US and Japan are 
firmly opposed to such a restriction, they tend to benefit more from it than the EU, 
which strongly advocates such ceilings (see Table 2). On the other hand, the EU 
  3benefits much more with such a restriction than without it, whereas the US, Japan and 
the former Soviet Union are made worse off in comparison with the no limits case. 
Moreover, Zhang’s results have shown that the EU ceilings with the “however” clause 
have the less stringent effects on the US, Japan and the former Soviet Union than the 
EU ceilings without such a clause. 
 
 
Table 2   
The gains in 2010 under the three trading scenarios (%)
a 
 
Scenarios United 
States 
Japan Europea
n Union 
Other 
OECD 
OECD 
 
Former 
Soviet Union 
No limits 
EU ceilings 
However clause 
85.2 
63.7 
79.8 
93.1 
71.9 
76.5 
0.2 
39.2 
16.3 
45.3 
70.8 
63.9 
86.5 
66.0 
78.4 
100.0 
23.5 
41.3 
 
a The gains are measured relative to the total abatement costs in the absence of trading 
for the OECD countries or the total benefits under the no limits scenario for the 
former Soviet Union. 
Sources: Zhang (1999, 2000, 2001). 
 
Furthermore, given that the EU proposal restricts the total demand for permits 
and thus reduces the market price of permits, it should thus come as no surprise that 
such restrictions on the use of flexibility mechanisms are not beneficial to developing 
countries too because they restrict the total financial flows to developing countries 
under the CDM as a result of fewer permits sold and lower prices received (see Table 
3). For the OECD as a whole the “however” clause is less restrictive than the EU 
ceilings, and thus allows a significant increase in demand for the certified CDM 
credits. As a result, the CDM flows under the “however” clause scenario are 1.4 times 
higher than under the EU ceilings scenario, although they are still less than half of that 
under the no limits scenario. With respect to the geographical distribution of the CDM 
flows, because of a great deal of low-cost abatement opportunities available in the 
energy sectors of China and India, as well as their sheer sizes of population, the two 
countries are expected to emerge as the dominant host countries of CDM projects. 
This is confirmed in Table 3, which shows that approximately 60% and 16% of the 
total CDM flows go to China and India, respectively.  
However, it should be pointed out that the importance of the clause depends 
crucially on how well a verification procedure might work in real practice. The above 
cited work of Zhang simply assumes ideal conditions that the amount of domestic 
abatement to be verified could be demonstrated without costs. Consequently, the 
“however” clause relaxes the otherwise very restrictive limits on the use of flexibility 
mechanisms. However, in real practice, since the counterfactual baseline emissions 
are never actually observed, verifying any domestic abatement that reduces emissions 
below the counterfactual baseline emissions will be subject to technical and political 
disputes. This would thus increases transaction costs.  It seems likely that the 
verification procedure in practice will fall short of the ideal and could limit the extent 
to which the “however” clause can bring down the cost of meeting the Kyoto 
commitments. In the worst case, it could even make the “however” clause’s promise 
of relief just illusive.  
 
  4  5
Table 3   
The value of the CDM market and the shares of China and India in 2010 under the 
three trading scenarios 
 
  No limits  EU ceilings 
without the 
however clause 
EU ceilings 
with the however 
clause 
CDM market (million 1998 
US$) 
of which: 
     China 
     India  
Net CDM market (million 1998 
US$) 
of which: 
     China 
     India  
 
2795.6 
 
60.3% 
15.1% 
 
1565.0 
 
59.9% 
15.5% 
 
456.9 
 
59.6% 
15.9% 
 
244.6 
 
59.2% 
16.3% 
 
1103.4 
 
60.0% 
15.5% 
 
603.0 
 
59.6% 
16.0% 
 
Sources: Zhang (1999, 2000, 2001). 
 
 
References 
European Union (1999), “Community Strategy on Climate Change: Council 
Conclusions, No. 8346/99,” 18 May, Brussels. 
Morozova, S. and M. Stuart (2000), “The Size of the Carbon Market Study”, Prepared 
for the United Nations Conference on Trade and Development, Geneva. 
Zhang, Z.X. (1997), “The Economics of Energy Policy in China: Implications for 
Global Climate Change”, New Horizons in Environmental Economics Series, 
Edward Elgar Publishing Limited, Cheltenham, England. 
Zhang, Z.X. (1999), “Estimating the Size of the Potential Market for All Three 
Flexibility Mechanisms under the Kyoto Protocol”, Report Prepared for the 
Asian Development Bank under Contract TA-5592-REG. 
Zhang, Z.X. (2000), “Estimating the Size of the Potential Market for the Kyoto 
Flexibility Mechanisms”, Weltwirtschaftliches Archiv - Review of World 
Economics, Vol. 136, No. 3, pp. 491-521. 
Zhang, Z.X. (forthcoming), “The Economic Effects of An Alternative EU Emissions 
Baseline”, Journal of Policy Modeling. 
Zhang, Z.X. (2001), “An Assessment of the EU Proposal for Ceilings on the Use of 
Kyoto Flexibility Mechanisms”, Ecological Economics, Vol. 37, No. 1, pp. 53-
69. 
 
 

An Assessment of the EU Proposal for Ceilings on the Use of Kyoto Flexibility Mechanisms”,

Estimating the Size of the Potential Market for All Three Flexibility Mechanisms under the Kyoto Protocol”, Report Prepared for the Asian Development Bank under Contract TA-5592-REG.

The size of the carbon market study: discussion

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