In the following section we introduce a novel financing approach for REDD, which is able to use the advantages of current proposals while minimizing their disadvantages.
Additionally we specify its functioning under an auctioning mechanism. We will show that this innovative approach optionally allows maximizing social and biodiversity co-benefits (in the following referred to as sustainability co-benefits) while ensuring economic efficiency.
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.