Transaction costs, institutional rigidities and the size of the clean development mechanism

Transaction costs and institutional rigidities will reduce the attractiveness of the Kyoto Protocol flexibility mechanisms compared to domestic greenhouse gas abatement options. The clean development mechanism (CDM) in particular is likely to entail considerable costs of baseline development, project registration, verification and certification. The activities implemented jointly pilot phase and the prototype carbon fund programme give indications about these costs. There is evidence that projects with high implementation costs have high transaction costs as well. Moreover, CDM projects have to be approved by host country institutions, and so far only a small share of host countries has been able to set up these institutions. Several of the larger host countries intend to only approve projects if the market price is above a certain threshold. Some governments will also levy fees to finance costs of approval bodies. We assess these issues using a quantitative model of the Kyoto Protocol permit market. We conclude that while changes in demand from Annex B countries remain the crucial factor, the size of the CDM will depend to a significant degree on transaction costs and institutional barriers in host countries.