On fair, effective and efficient REDD mechanism design

The REDD process and the need for observations and decision support

Post-2012 emission mitigation strategies must lead to drastic emission reductions of greenhouse gases (GHGs) to prevent dangerous climate change. Accounting for some 18 percent of global anthropogenic GHG emissions in 2004 the reduction of emissions from deforestation and forest degradation (REDD) has become a prominent potential mitigation wedge. In effect, demonstration activities have flourished since the mandate given in the Bali Road Map of 2007 (UNFCCC Decision 2/CMP.13). Initiatives include the World Bank-hosted Forest Carbon Partnership Facility and Forest investment program, the UN-REDD program, Norway's International Climate and Forest Initiative, Australia's International Forest Carbon Initiative, and many other bilateral and private programs and projects. About 40 developing countries have already engaged in the process of designing REDD strategies. At times these various initiatives struggle to identify their synergies and avoid confusion regarding methodological and technical challenges. In particular, any system generating REDD credits is likely to operate within the scope of the principles stated in the Poznan Ministerial statement. These include, inter alia, the development of transparent, collaborative, balanced and inclusive international arrangements to support national REDD efforts. Decision makers also stressed that a reliable framework for measuring, reporting and verification (MRV) is crucial to the integrity and credibility of REDD. Key to the supply of MRV REDD credits is robust and consistent greenhouse gas (GHG) observation and monitoring systems combined with sound accounting methodologies and appropriate reference emission scenarios of deforestation and forest degradation (DD).

With respect to GHG accounting much progress has been achieved so far. It is generally believed that cost effective systems for estimating and monitoring deforestation and changes in carbon stocks can be designed and implemented using a combination of remote sensing assessments and ground based measurements [1]. However, guidance is needed to ensure comparable estimates when remote sensing is used, along with access to data, know-how and capacity building. Addressing forest degradation is especially difficult in this regard, but knowing the causes of degradation can help in designing meaningful stratified sampling approaches to measure it.

In short, the observation and monitoring challenges should not be viewed as a stumbling block for REDD policies to go ahead. However, efforts must be coordinated and streamlined through a robust international institutional arrangement, otherwise the environmental integrity and economic effectiveness of REDD is at risk.

Challenges in the design of reference levels and financial compensation

One of the most challenging aspects in designing a REDD mechanism is the estimation of reference levels (RL). They describe the amount of net/gross emissions and removals from a geographical area under a business-as-usual (BAU) development path. By describing the future emission pathway without any climate protection measures, reference scenarios are crucial to determine the success of emission reduction performances. Reference level can be solely based on historical emission trajectories or additionally take into account circumstances such as global deforestation rate, national forest area or deforestation drivers [2, 3].

When it comes to setting RL there is less clarity on an agreeable methodology. This is related to different country circumstances and interests. On the one hand, countries with low past deforestation rates and potential high future deforestation will not agree to purely historically derived RL. To benefit from REDD and to prevent future deforestation those parties will rather propose to consider 'national circumstances' for RL setting, e.g. through a so-called 'Development Adjustment Factor'. On the other hand, many developing countries still lack sufficient technical and expert capacity to develop proper RL methodologies. Furthermore, if the process of developing and reporting such RL is not carefully designed, there is a risk of creating a so-called "lemons market" [4]. This occurs when the seller knows considerably more about the real quality of a product than the buyer, resulting in a reduced quality of supply of the respective product. In a REDD context, the "lemons" would materialize in the form of globally inconsistent and inflated RL adjustments, leading to non-additional emission reductions. Under a carbon market scheme this potentially results in an oversupply of cheap REDD credits. Because negative emission deviation from the RL would be matched by financial compensation, a credible method for the measurement of additional REDD units is absolutely essential for financial efficiency in the light of scarce resources dedicated to REDD [5] and avoiding the risk of artificial RL inflation [6].

Besides RL design the choice of the financial mechanism for a future REDD regime is intensely debated. Again, this is partly related to different developing country circumstances, but here the discussion is dominated by concerns about managing the potential oversupply for REDD credits under a market or lacking demand under a fund mechanism. Another major concern is the negative socio-economic and environmental effect of a sole carbon focus for REDD [7]. To overcome these risks the REDD mechanism might distribute compensation benefits (e.g. credits) not only based on the amount of emissions reduced, but also on the ecological and social value of the forests in question. Ideally, such form of REDD mechanism would aim to distribute credits to those REDD activities that provide the maximum total benefit from emission reduction, ecological and social values. However, since the financial consideration of co-benefits is currently only favoured by some parties its compulsory inclusion is likely to overburden the REDD policy negotiations. Additionally, financing and monitoring challenges previously mentioned also apply to co-benefit valuation.

This paper describes two linked proposals for the essential building blocks of REDD policy implementation. First, we propose an institutional REDD design aimed at generating globally consistent reference scenarios at the country level from which to derive MRV REDD credits. The second part of the paper describes a possible financial mechanism design for generating such REDD credits in an economically efficient manner, while incentivizing the valuation of forest co-benefits.

Institutional support for transparent, fair and efficient reference level setting

Globally consistent DD emission reference scenarios at the national level are important for a large number of reasons. These include avoiding international leakage as well as ensuring transparency, fairness and efficiency. Fairness relates to the issue of relative distributional gain of financial resources made available. Compensation of future REDD actions against a historical RL will favour countries with a high historical emissions on a relative scale. This will increase the risk that future drivers of deforestation geographically shift to historical low deforestation countries and, thus, create asymmetric winner/looser profiles between REDD countries. In this sense low deforestation countries loose out two times under a purely historical baseline setting. First their supply potential for REDD is decreased and secondly their true baseline will be pushed up due to international leakage of REDD actions implemented in high deforestation countries. On a total market level "over-compensation" by countries with historically high deforestation due to a grandfathering rule will compromise both environmental integrity and cost effectiveness of REDD. Finally, such 'over-compensation' could lead to the supply of non-additional emission reductions and thus to an inflation of REDD credits [8].

Irrespective of the fact that reliable historical DD data do not exist for the Pan-tropical belt, the currently proposed methods to quantify RL on historical information will be insufficient without the consideration of national circumstances (drivers) and global data streamlining. Thus, we propose a system of establishing reliable and acceptable RLs based on a global forest information coordination body and RL algorithm implementation centre.

Data and quality requirements for reference level determination

The determination of the 'true' RL will not only shape global efficiency, but also be an important component for countries' planning REDD actions - regardless of how emissions reduction will be credited for. It is important to note that the 'true' BAU scenario does not have to be the same as the crediting RL [9]. The latter can be influenced by the 'Development Adjustment Factor' or eventually be the outcome of a negotiated "formula". Pure reliance on negotiation, however, potentially leads to political bargaining by strong actors. This could disadvantage less powerful developing countries in gaining financial access to REDD resources and threaten the environmental effectiveness of the REDD mechanism.

In the interest of fairness and efficiency, the final aim for RL determination will be that the 'true' BAU scenario and the crediting RL converge or in cases where the tropical countries are willing to take on responsibilities the crediting RL should be below the 'true" BAU baseline. To achieve this aim, it is essential to set up and implement harmonized and/or standardized rules and procedures for the collection, interpretation and consistent processing of various sources of forest data. These include earth observation data [10, 11] as well as socio-economic data on the basic drivers and pressures for deforestation at national and international levels.

Data may include historical deforestation area measurements, estimates of the associated emissions and their uncertainties, current forest carbon stocks and carbon stock-change maps partitioned by the various carbon and nitrogen pools (e.g. soil, litter), and forest stand structure (e.g. species, age structure). These data can be sourced from a multitude of independent remote sensing instruments and their derived products such as http://www.geo-wiki.org[12], as well as from in situ data (primarily forest inventories) and possibly biophysical ecosystem models. What is important is that the data used by different countries should be publicly known, and models should be applied in a consistent manner by those countries, according to specific data and interoperability standards as well as to the respective greenhouse gas (GHG) accounting rules (e.g. Intergovernmental Panel on Climate Change and the Global Earth Observation System of Systems). The modelling tools themselves should also be standardized and certified.

Other types of input, necessary for countries to undertake consistent development of reference scenarios and planning of REDD policies, include activity data relating to the respective pressures and drivers of deforestation, as well as information on forest management planning, forestry supervision and inspection. Depending on the overall policy context of REDD implementation, such information should inter alia include not only forest ownership information, forest management plans with associated annual allowable cuts (AACs), and forest protection, but also information such as transportation infrastructure development, agricultural management data and food consumption projections. Such country-specific driver and governance information would have to be in line with scenarios of environmental and social change in a globally consistent manner. Consequently, emission pathways would also be generated in a consistent manner, addressing the issue of international leakage and possible GHG leakage to other sectors. An example would be land use related leakage in terms of N₂O emissions to the agricultural sector where REDD constraints land expansion, which must be compensated by intensified cultivation.

Both earth observation data and deforestation driver information could either be collected by national constituencies, according to a negotiated standard, or by international agencies in cooperation with national entities. In many countries, substantial capacity-building efforts would have to be undertaken to provide this information according to globally applicable standards, with sufficient quality and in a geographically explicit manner - if possible. Most importantly, earth observation data on past and the current state of the forest as well as DD driver information have to be collected, reported and subsequently processed in a globally consistent manner.

To achieve this globally consistent use of data and models, and thereby to arrive at fair and efficient REDD reference scenarios, a specific international institutional entity will be needed for the collection, interpretation and consistent processing of various sources of DD-related information at national and international levels. Figure 1 depicts a possible constellation of stakeholders and associated information flows.

The International Emission Reference Scenario Coordination Centre

To overcome the mentioned challenges we propose an International Emission Reference Scenario Coordination Centre (IERSCC) to assist countries in developing internationally recognized and accepted reference levels. It would act as a clearing house for harmonized data use in reference scenario modelling. The IERSCC, hosted by an independent forestry or land resources research institution of international status, will be tasked to develop global integrated assessment model(s) to deliver sector-specific national scenario information (e.g. trade flows, prices, socio-economic development information) to the respective REDD host countries. The latter would use this information as exogenous variables driving their national reference scenario model/algorithms. Ideally, these scenarios would, in turn, be determined by using geographically explicit, economic, bottom-up type models, whose methodologies could be validated by this or another international validation entity. Such international quality assurance would ensure internationally recognizable REDD reference scenarios of a national model(s) by providing confidence and information security to parties.

Our proposed IERSCC would receive inputs from the respective UNFCCC bodies, in the form of agreed GHG accounting rules, as well as rules (possibly in algorithmic form and parameterization) of the computation procedures for globally consistent national reference scenarios. In this way, the IERSCC would function as an independent technical implementation body to the UNFCCC policy process by supporting and validating consistent collection of earth observation and other DD driver data, based on rules defined by the UNFCCC policy process. The body could also be tasked with developing and applying calibration routines of global top-down modelling with national bottom up modelling to generate consistency between the two.

National-level emission reference scenarios should, as far as possible, be based on geographically explicit data and analysis and allow for down-scaling of national scenarios to assist regional or project level activities. The latter would allow for tailored and targeted national and international REDD actions, since the quantity and the location of deforestation drivers would be better understood [6]. Furthermore, consistent RL setting will be essential for the economic efficiency of international REDD-related compensation mechanisms. Finally, the IERSCC could help in building capacity for REDD response strategies through additional scenario analysis and training of national experts on these issues. It will enable them to conduct their own analysis on national implementation strategies, but also to use part of the IERSCC's data to inform their negotiation strategies in a global context. Furthermore, the IERSCC model results could be used on the individual national level for many other land-use related planning purposes ranging from the analysis of agricultural development strategies all the way to infrastructure planning.

Combining fund and market strength under an 'International Investment Reserve'

While the risks of direct carbon market inclusion of REDD credits are widely acknowledged, a fund approach might run short of the necessary financing to significantly reduce deforestation. Market-linked approaches like the TDERM [13] and Dual Markets approach [14] do not solve this dilemma, since they provide little incentives for Annex-1 governments to commit to ambitious REDD targets (and thus costs) besides their fossil fuel targets. In the light of current financial constraints on public spending due to the economic crisis and at the same time the overwhelming financing need for climate change adaptation and technology transfer, funds - no matter if originating from AAU earmarking, taxes or other sources- will be constrained.

An interesting alternative is provided by a so-called 'International Investment Reserve' (IIR) for REDD, based on the idea of a "Carbon Federal Reserve" (CFR) [15]. Under the IIR approach REDD providers (developing country governments and/or private carbon projects) would sell their, yet to be created, REDD units to the IIR at an agreed price. The REDD unit price should be below the carbon market credit value and possibly be discounted due to implementation risk and measurement uncertainties [16, 17]. The IIR would be financed and managed by Annex-1 governments and possibly private investors. Contributions to the IIR could either be on a voluntary or mandatory basis. Participation for investments would be driven by the economic attractiveness of this scheme. Basically the IIR serves as investment bank for REDD, in which investors provide finance to buy REDD units. These units are then verified and banked, until market conditions are favorable to resell them as fungible MRV-based REDD credits to the carbon market. Given the long-term global emission reduction requirements many models project rising carbon credit prices [18]. This will allow considerable reselling profits - making the IIR an attractive investment option. To avoid market flooding the reselling can be made conditional, e.g. upon a maximum amount of credits per year and/or sufficient market demand signals to maintain competitive carbon prices. Similar to a stock market the IIR members would have an interest in reselling at high carbon market prices to increase the revenue compared to the buying price and thus to limit the risk of credit devaluation. In this way the banking and reselling conditions under the IIR can also contribute to a regulating effect in favor of price floors and caps in the carbon market. Additionally, to ensure environmental integrity reselling can also be made conditional on the overall allowable GHG concentration in the atmosphere, following a global emission budget approach [19].

The reserve would also provide a clear advantage for industrialized country governments for increasing their emission reduction commitments. Under the current situation governments would have to increase their national abatement targets in advance to avoid the risk of REDD credits flooding the carbon market. However, by doing so they take a high risk of belated or insufficient supply of REDD credits in the future. Given the unfavorable governance and capacity situation in many developing countries to successfully implement REDD [20] this risk is real. As a consequence these governments would have to substitute the lacking REDD supply with other emission abatement options which would increase the overall emission reduction costs considerably. Thus, from a strategic perspective governments would not choose higher abatement targets as dominant strategy for REDD, because the supply uncertainty would leave them in a situation of "first mover disadvantage". Under the IIR approach supply uncertainty would diminish, allowing governments to react to supply dynamics more flexible. Investment risks due to delivery failure would still be possible. However, they could be limited, if REDD unit payments from the IIR are divided into up-front financing and continued payments. In case fewer units are provided than initially offered, the difference is subtracted from the remaining payment obligations. Developing countries would also benefit from the IIR approach, since large financial flows could be generated in a timely manner. To increase their confidence in the mechanism, industrialized countries could commit a certain minimum financing amount for each auctioning period.

This is possible, since the IIR is compatible with nationally-obtained contributions in form of AAU earmarking and tax revenue finance for REDD as proposed by the European Commission [21]. At the same time governments or private investors can use other forms of investment. According to their financial share in the IIR each party (i.e. the respective government or private investor) obtains emission units from REDD suppliers. IIR members could either pool all units in a joint portfolio or differentiate them according to different criteria. For the first option they would be bought and collected in a common REDD unit portfolio. For the second option unit pools could be differentiated, e.g. by environmental and social co-benefit level. The latter option might require separate investment pools, if not all members agree on additional incentive payments for higher standards. These REDD units are then transferred into fungible, adjusted REDD credits to be sold at the international carbon market or used for increasing/meeting domestic abatement targets. The IIR approach would also have the advantage that risks of supply failure of REDD units as well as delivery failure of MRV standards could be minimized by pooling large REDD portfolios over time. By validating REDD units through the IERSCC before they are finally transferred the IIR can serve as quality catalyst for the carbon market or for national compliance.

Auctioning of MRV REDD units to account for sustainability co-benefits

Under a purely carbon-focused REDD approach, national-, regional- or project-level actions would be tailored to maximize emission reductions. However, aggressive implementation of REDD policies could run into conflict with basic food security issues [22], create social conflict and, under certain conditions, lead to further environmental degradation on a total landscape level [7, 23]. Such conflicts can only be avoided if REDD policies are appropriately designed and implemented. In this respect, REDD policies can be treated in a similar manner as biofuels, as both are competing for land resources. Thus, it seems paramount that any action under the international REDD mechanism should simultaneously recognize the different ecological and social co-benefits that forests provide. Funds and hybrid-market approaches can better accompany such co-benefits than markets since they could differentiate rules and criteria for REDD co-benefits without being restricted to the carbon value or by credit buyer preferences. However, such approaches are prone to inefficiency in incentive distribution, because they will most likely operate based on fixed co-benefit premiums instead of individual opportunity costs.

The mechanism outlined below describes how the provision of essential co-benefits of REDD can be made attractive and how at the same time incentives can be allocated in a cost-efficient way using auctioning. For illustrative purposes we discuss here a 'sealed bid second price auction' mechanism, where potential buyers classically submit their price bid in sealed envelopes. The buyer with the highest price offered wins the bid, however, only has to pay the second highest bid price submitted. Since the winning bidder wins the difference between both prices it is a dominant strategy for the bidder to bid her true value in a 'sealed bid second price auction'. In a simple ' open ascending price auction' bidders would not bid their true value, as this would eliminate their profit margin.

In the REDD context a 'sealed bid second price auction' can work in a slightly different way. Here, we define the seller to be the supplier of REDD emission reduction units, whereas the buyer is the IIR. The IIR will initially distribute its available investment into a fixed amount of auctioning tranches. Emission reduction unit sellers will then submit sealed bid proposals with a minimum selling price per REDD unit and its targeted selling quantity to the REDD IIR. The IIR selects the best bidder, who then can sell its proposed quantity to the second-minimum selling price. If the tranche still contains money, the next best bidder can sell to the next lowest conditions. This continues until the finance is exhausted.

This auction can then be repeated in tranches of decreasing finance quantity, until the provided finance portfolio is exhausted or the targeted emission reduction quantity of the IIR is reached. The decreasing tranches provide incentives for REDD bidders to engage early in the auction to be able to sell all offered units and thus supply REDD credits at a price which better reflects their true cost of production.

Such an auctioning approach can ensure that a fixed quantitative REDD supply cap is achieved in a competitive setting. It also avoids excessive producer rents by minimizing a REDD arbitrage gap (this is the difference between the REDD costs and the potential revenue from Annex I emission reduction credit supply). Furthermore, auctioning allows for flexibility in targeting the allocation of supply by geographic or thematic areas [24, 25].

Co-benefit dimensions cover thematic areas such as the retention of high conservation value forests and biodiversity and the provision of social benefits such as maintenance of employment or cultural services. What is needed for quantifying co-benefits prior to the auction is the identification (and verification) of the absolute or relative magnitude of these co-benefits. The measurement can be orientated on current, widely applied certification processes, or through other means of measuring and verifying sustainability co-benefits.

Using an auctioning approach there are two main options to account for ancillary benefits in the auctioning mechanism. Co-benefits could either be used as a qualifier criterion or as a criterion for the pricing. The qualifier criterion enables to participate in the financial compensation mechanism by achieving a certain quality standard. Besides the overall qualifier criterion to deliver measured, reported and verified (MRV) REDD units, additional social and environmental standards could be set for all REDD credit providers. If the REDD provider fails to achieve them, he would be excluded from the auction. Alternatively, where the aim is maximizing sustainability co-benefits of emission reductions under REDD, the competitive criterion can be the relative provision of sustainability co-benefits. They can be measured as the quantified and certified amount of ecosystem value points and social value points. It can be calculated according to pre-specified co-benefit assessment rules associated with the fungible REDD unit. Ideally, such a value system would be negotiated under the umbrella of a number of UN conventions and charters. However, since a political consensus on this issue is difficult to achieve, the determination of the assessment rules could alternatively be restricted by the parties involved in the financing of such co-benefits. The relative co-benefit performance would then be translated into a co-benefit factor. Such factor can for example range from 0.5 to 1.5. When provided REDD credits ensure maximum co-benefit maintenance then the offered price for the winning bidder would be increased by the factor 1.5. If the winning bidder only provides the lowest possible co-benefit protection his offered price could be discounted by 0.5.

An alternative approach to use the relative co-benefit performance as criterion for the pricing can be realized. Here, the offered REDD units are distinguished into different tranches according to the provided sustainability co-benefit value points.

After a certain amount of REDD units of the highest tier (determined by a minimum amount of co-benefit value points) has been purchased, the auctioneer lowers the minimum points (and the provided finance) to qualify for the next tier of REDD units in the next auction tranche and collects bids at this lower sustainability co-benefit value level. The IIR continues to lower the points (and finance) until the targeted REDD units are bought or the finance portfolio is exhausted.

For both options where sustainability co-benefits are used for the pricing of REDD credits, the sealed bid second-price auction allows maximizing the total sustainability benefit value of a REDD action. This would shift the incentive structure for REDD policy action designs from the simple maximization of emission avoidance to a more comprehensive approach of both emission-avoidance and ecosystem co-benefit maximization.

The introduced novel design elements of IERSCC for monitoring and RL development and the IIR for auctioning and catalysing REDD credits are interrelated and can help to overcome current methodological and political challenges. Their connections and interdependencies are summarized in Figure 2.