FAO 2005 Seminar, O. Cacho 1 Transaction Costs of Carbon Sink Projects Oscar Cacho School of Economics University of New England AUSTRALIA

FAO 2005 Seminar, O. Cacho 2 Outline Background Overview of abatement and transaction costs Reducing transaction costs A model to analyze the effect of project design The measurement problem Conclusions

FAO 2005 Seminar, O. Cacho 3 Background Clean Development Mechanism (CDM) allows Kyoto signatories to reduce greenhouse gas emissions in developing countries (Article 12). CDM projects can operate in the energy sector (reduced emissions) or in the land-use change and forestry (LUCF) sector (sinks). Afforestation and reforestation projects are eligible within the LUCF sector.

FAO 2005 Seminar, O. Cacho 4 Project design Validation project developer National approval host government Stakeholder comments Submit Project Design Document Registration project developer CDM executive board Verification and certification CER issuance operational entity CDM executive board Submitting and approving CDM proposals

FAO 2005 Seminar, O. Cacho 5 Abatement Costs opportunity cost of land-use change ( S P ). Transaction Costs cost of participating in the CER market ( C T ). SASA CTCT QAQA PAPA Q (CERs) P ($) SPSP D QPQP P

FAO 2005 Seminar, O. Cacho 6 Buyer Seller a b c Buyer cost ($/Mg) Emission offsets (Mg/ha) Carbon price ($/Mg CO 2 ) TC C1C1 Seller pays TC a b c TC C1C1 C2C2 Carbon price ($/Mg CO 2 ) Buyer pays TC

FAO 2005 Seminar, O. Cacho 7 years carbon stock (Mg/ha) initial soil carbon lowmediumhigh Managing C stocks Gliricidia in Jambi, Indonesia firewood harvest high medium low

FAO 2005 Seminar, O. Cacho 8 Biomass C in Indonesian systems

FAO 2005 Seminar, O. Cacho 9 Abatement Costs Modeling results for Sumatra, Indonesia (degraded land)

FAO 2005 Seminar, O. Cacho 10 search negotiation approval administration monitoring enforcement insurance Transaction costs find site and group of landholders; survey alternative land uses; gather biophysical, social and economic information about the site; establish relationships with the locals. generating and disseminating information; allowing simplified baselines for smallholder projects. Reduce by:

FAO 2005 Seminar, O. Cacho 11 search negotiation approval administration monitoring enforcement insurance Transaction costs agree on required land uses; assign responsibilities to parties; agree on monitoring and payment schedule. working through farmer groups and local NGOs. Reduce by:

FAO 2005 Seminar, O. Cacho 12 search negotiation approval administration monitoring enforcement insurance Transaction costs cost of delays after submission of Project Design Document; cost of project validation. CDM Executive Board simplifying validation process. Reduce by:

FAO 2005 Seminar, O. Cacho 13 search negotiation approval administration monitoring enforcement insurance Transaction costs keeping records of project participants; administering payments and dealing with problems and disagreements; may require establishment of a local project office. will decrease as countries and market participants gain experience; appropriate IT infrastructure is important.

FAO 2005 Seminar, O. Cacho 14 search negotiation approval administration monitoring enforcement insurance Transaction costs measuring C sequestration actually achieved; certification and verification by Designated operational Entity (DOE). sampling C stocks at longer intervals; using remote-sensing technology; involving landholders in sampling C stocks. Reduce by:

FAO 2005 Seminar, O. Cacho 15 search negotiation approval administration monitoring enforcement insurance Transaction costs ensuring compliance with the terms of the project; may include litigation. providing smallholders with credible prospects and sufficient incentives to prevent abandonment of the project; involving farmer groups and promoting monitoring within the community. Reduce by:

FAO 2005 Seminar, O. Cacho 16 search negotiation approval administration monitoring enforcement insurance Transaction costs no formal insurance for sink projects is available yet. deducting a risk premium from the price paid for C sequestration; diversification of project portfolio (spatial arrangement and project types); keeping a buffer of C stocks that is not converted to CERs. Reduce by:

FAO 2005 Seminar, O. Cacho 17 Reducing transaction costs Generate and disseminate information (LUCF systems, baselines). Bundle projects. Teach smallholders to measure carbon. Encourage community self-regulation. Bundle payments for other environmental services. Promote secure land tenure.

FAO 2005 Seminar, O. Cacho 18 Sampling Intensity and CERs

FAO 2005 Seminar, O. Cacho 19 Synergies Data from Murdiyarso et al. for Indonesia * relative to natural forest

FAO 2005 Seminar, O. Cacho 20 Model of contractual arrangements Transaction margin Governance costs Based on Dorward (2001) = Revenue – Governance Costs C T transaction costs C A associated transformation costs (= 0) C L cost of loss due to transaction failure For buyer: if seller defaults, the cost of buying C offsets elsewhere (market price of CERs) + transaction costs already incurred. For seller: if buyer defaults, the cost of converting back to preferred land use + establishment and learning costs already incurred.

FAO 2005 Seminar, O. Cacho 21 The seller’s problem Contractual form Governance costs and returns free marketvertical acceptable to seller RG(s)RG(s) CG(s)CG(s)

FAO 2005 Seminar, O. Cacho 22 The buyer’s problem Contractual form Governance costs and returns free marketvertical acceptable to buyer CG(b)CG(b) RG(b)RG(b)

FAO 2005 Seminar, O. Cacho 23 Feasible solutions Contractual form Governance costs and returns free marketvertical acceptable to both CG(b)CG(b) RG(b)RG(b) RG(s)RG(s) CG(s)CG(s) based on Dorward (2001)

FAO 2005 Seminar, O. Cacho 24 Contractual forms (A) Free Market (B) Individual Farmer Contract (C) Community Contract (D) Vertical Integration private entity establishes individual contracts with farmers to undertake certain land-use practices. NGO establishes a program through farmer groups (farmer- group leaders play a critical role). farmers and C brokers trade in free (local) market, brokers then sell C offsets in international market. firm purchases land, establishes commercial plantations and sells C offsets in the international market (provides employment).

FAO 2005 Seminar, O. Cacho 25 Seller (farmers): Buyer (NGO / government / private entity): Agents Sell C offsets at farm price P F Buys C offsets from sellers at P F and sells them in the CER market at net price P B = P CER – C B P F price obtained by seller per Mg C P B net price obtained by buyer per Mg C P CER price of C in the CER market ($/Mg) C B brokerage costs per Mg C sold in CER market

FAO 2005 Seminar, O. Cacho 26 The buyer’s problem k = contractual arrangements (1,…,K) i = market conditions (1,…,I) m = environmental conditions (1,…,M) j = agent behaviour (comply, default) buyer’s expected utility proportion of C offsets under contractual arrangement k profit to buyer probability (to buyer) of seller behaviour j

FAO 2005 Seminar, O. Cacho 27 The buyer’s problem k = contractual arrangements (1,…,K) i = market conditions (1,…,I) m = environmental conditions (1,…,M) j = agent behaviour (comply, default) cost of failure transaction costs farm price net C market price

FAO 2005 Seminar, O. Cacho 28 The seller’s problem k = contractual arrangements (1,…,K) i = market conditions (1,…,I) m = environmental conditions (1,…,M) j = agent behaviour (comply, default) seller’s expected utility proportion of C offsets under contractual arrangement k profit to seller probability (to seller) of buyer behaviour j

FAO 2005 Seminar, O. Cacho 29 The seller’s problem k = contractual arrangements (1,…,K) i = market conditions (1,…,I) m = environmental conditions (1,…,M) j = agent behaviour (comply, default) cost of failure transaction costs opportunity cost farm price

FAO 2005 Seminar, O. Cacho 30 The measurement problem  B,  S probability of agent behaviour (C T ) B,S transaction costs (for buyer and seller) (C L ) B,S losses due to transaction failure (for buyer and seller) O S opportunity cost of land-use change to seller P B price of C to buyer Max: for each contractual arrangement ( k ), agent behaviour ( j ), market condition ( i ) and environmental condition ( m ), estimate: Optimizing contract design

FAO 2005 Seminar, O. Cacho 31 Conclusions Transaction costs are largely related to obtaining and processing information. Designing efficient projects requires a good understanding of the abatement costs and transaction costs involved. Next step: flesh out model to allow consistent measurement and to help reduce transaction costs.