Draft										1995

Only for comments

Joint Implementation:  

Transaction Cost Analysis of some Scenarios

Anil K Gupta

When externalities are diffused, non-point and irreversible, the institution solutions cannot be easily devised bilaterally.  They have to be through the global arrangements.  However, when externalities are sources specific, quantifiable, and reversible, a wide variety of institutional solutions can be developed.  Joint implementation can be only one of them.  

The characteristics of externalities and their implication of institution design have been discussed elsewhere (Gupta & Prakash, 1993, Prakash & Gupta, 1994, Gupta & Prakash, 1994).  In this note, I wish to draw the attention to the arrangements made under joint implementation for reducing ex-ante, ex-post and total transaction costs.  My contention is that global negotiations can help provide a framework for generating expectations of various actors.  But, if you want to reduce transaction costs of bilateral negotiations, then we should consider several strategies of influencing mutual expectations.  For instance, industry associations or chambers of commerce in different countries should negotiate and generate basic conditions under which bilateral negotiations can be pursued.  Theoretically, it appears that if ex-ante transaction cost, particularly, for negotiation increases within reasonable limits, ex-post cost of enforcement may come down, thereby reducing total transaction cost.  The other component of total costs including the ones for management and technology acquisition and adaptation may also covary with the transaction costs.  Therefore, systematic reduction of transaction costs under joint implementation may require developing professional as well as inter organizational norms for basic ground conditions.  These conditions refer to the level, process and time frame in which externalities are internalized through a joint arrangement.  

Transaction costs for internalizing externalities

Externalities arise due to incomplete delineation of property rights over public resources.   e.g. ‘A’ burns coal resulting in emission of carbon-di-oxide. This causes respiratory problems to ‘B’. If property rights over air to which ‘A’ emitted smoke were well defined, ‘externality would not have arisen as ‘A’ would have known consequences of her action. Assume ‘B’ to have property rights over air, then ‘A’ would have had to fully compensate ‘B’ for the injury. Alternatively if ‘A’ were to be have property rights, ‘B’ would have had to bribe/persuade ‘A’ for not emitting smoke.

Opschoor (1991,6) has observed that interests of the party, on whom costs have been shifted, do not get adequately reflected if the party does not have means to exert ‘countervailing power’ (Galbraith) through the political system. Thus inter specie equity and inter generation equity may be violated.

A Typology of Externalities

We can try to predict with low/high certainty, the occurrence of externalities w.r.t.  Actors, Space, Time and Quantity. Given a certainty level of occurrence, externalities have low/high  measurability of impact. 

Schematically

					CERTAINTY OF GENERATION

			ACTORS		SPACE		TIME			QUANTITY

			Low	High		Low 	High 	Low	High		Low	high

		LOW
	ACTORS
		High

		Low
	SPACE
		High

		Low
	TIME
		High

		Low
	QUANTITY
		High

Now a word of caution. Characterizing certainty of occurrence or measurability as high or low is a value loaded act. This characterization depends on availability of technology for such a task and on institutional factors. Are there institutions to undertake such measurements? If yes then ,socio-political factors (ruling coalition defines what is high/low), will decide the space and the time perspective over which this definition would operate.

Attributes of an Externality

We can identify various attributes of an externality depending on whether it is prior to actual occurrence or subsequent to it ( Gupta & Prakash,1992,12-13,16).

Pre occurrence

Technological 

1. Preventable/Non Preventable

Externality can/cannot be prevented from occurring by modifying process or machine design. 

2. Unidirectional/Reciprocal

Is the generator of the externality  also affected by it or not ?

3. Insulable/Non Insulable

Given that the externality is reciprocal, polluter may/may not be able to insulate herself.

Post Occurrence

Spatial

1. Localized/Non Localized

Is the effect of the externality limited to a specified geographical area  or not. The definition of ‘local’ would depend on the perspective of the decision maker. e.g a national externality becomes local in a global perspective.

Polluter 

1. Identifiable/Non Identifiable 

Can the source/s of pollution be identified (Thermal plant in the hinterland causing air pollution) or not identified .

2. Single/Multiple Source

If the source/s of pollution are identified, how many are they ?

Time

1.Regular/Sporadic

Is the pattern of occurrence regular (effluents discharged by a chemical factory at a fixed time every day) or is it sporadic (radiation leaks in a nuclear plant). If it is sporadic, then is it catastrophic (Bhopal disaster) or is it within the ‘tolerable/permissible’ range (unexpected seepage from the water treatment tank of a fertilizer factory).

Technological 

1. Reversible/Irreversible

Reversibility can further be evaluated along following lines.

- Reversibility over what time period ?

- Reversible through the process of nature (forests acting as a   sink for carbon-di-oxide) or through human intervention (Ganga Action Plan to clean up the river Ganga). In fact to enable nature to correct damage, human non intervention (fencing of a forest so that it can regenerate itself) may be necessary in certain cases.

- If reversible through human intervention, is collective effort required or it can be done at an individual‘s level.

Internalizing Externalities

Traditional literature discusses internalizing externalities either through state intervention (Pigou, 1932) or through a process of bargaining between the ‘polluter’ and the ‘victim’ of pollution (Coase, 1960). State intervention is either through state imposed taxes/subsidies (market mechanism) , through ‘command and control’ policies or a mix of both.There is also another route of internalizing externalities - through evolution of self-managed institutions which impose a code of conduct on its members. “Responsible Care” code of operation ethics adopted by major chemical companies of the United States is an example of this process (Leighton, 1992).

Transaction Costs 

Transaction Costs are costs associated with transfer, capture and protection of property rights. They arise when property rights are not fully delineated ( Barzel, 1989, 2 ).They can also be viewed as the cost of organizing resources across firms ( Demsetz, 1988,143).

Transaction costs can arise before contracting for the technology (ex ante) and subsequent to it (ex post) (Eggertsson, 1990 Ch.-1; Nooteboon, 1992b, 66-69).

Ex Ante Costs 

1. Information collection.

2. Search for supplier.

3. Negotiating with the supplier.

4. Framing the contract.

Ex Post Costs 

1. Enforcing and monitoring the contract.

2. Conflict resolution.

3. Renegotiating with the supplier.

Cost of Management/ Organization

Post purchase, the technology has to be made functional i.e. the management has to install it on the production floor. For this to happen successfully, management has to sell this concept to the internal organization. This may entail modification in organization design, retraining, side payments to the coalition which may be hurt ( Libecap, 1989, 4-6). Thus (management) costs arise for  organizing resources within a firm as distinct from transaction costs which arise from organizing resources across firms.( Demsetz, 1988,143).

Are the Three Costs Related ?

There are some elements of the three costs which are related. e.g. If cost of buying the technology is high, it is probable that the new technology would significantly change the production process. To ensure a smooth changeover, internal organization will have to be managed. Hence cost of management may be high. However it is difficult to postulate the direction of relationship between the elements of various costs e.g. If cost of technology is high, cost of negotiation may be low ( only limited suppliers who offer standardized products e.g. commercial aircrafts) or may be high ( small number of suppliers with non standardized products). We cannot therefore hypothesize any straightforward functional relationship between the three heads of cost.  

However, within the ex-ante and ex-post costs, there could be an inverse correlation.  Let us look at two or three scenarios of joint implementation.  

Joint Implementation ( JI) here is defined drawing upon Bohm, 1994, as a ‘mechanism for helping parties to the framework Convention on Climate Change ( FCCC) meet either ( unilaterally or otherwise imposed) net emissions limits by financing green house gas reductions in other countries.’

Scenario 1:

A company ‘X’ in a developed country having high carbon emissions enters into a contract with a company ‘Y’ in developing country to plant given area under fresh forest.  

Following issues may arise:

a.	If company ‘X’ had to internalize the externality by protecting the existing forests in the native country, in another country or in country where company ‘Y’ is located, what would be the cost for 20 - 30 years time frame.

b.	How does this cost differ when compared with the cost of planting fresh forest in each case?

c.	If the company ‘X’ had to follow certain base line conditions in country of company ‘Y’, what is the probability that it would move its operations of sequestering the carbon dioxide to another country.  Will this shift mean an opportunity lost for company ‘Y’ and its native country?  Could that increase the rate of deforestation in that country?

d.	If a global market of bids operates just like a stock market, is it possible that competition among developing countries to attract foreign investment may reduce the cost for company ‘X’ considerably than would be the case under joint implementation?  It is, of course, important to note that bids from different developing countries and developed countries will be of different sizes, constrained by different rules, requiring or entitling different pay-off values.  The difficulty may arise in deciding a mechanism by which a pay-off is decided on technical and/or institutional basis.  For instance, plantations in one country are easier to put in place, but difficult to maintain as against difficult to put in another country, but easier to maintain.  The institutional conditions thus may determine the pay-offs.  

e.	Once the opportunity costs of maintaining a forest in country ‘Y’ increases, a secondary market may emerge for plantations.  Thus, a company ‘Z’ from a developed country may like to buy the sequestering contribution of a forest (fresh planted or old) from company ‘Y’.  In such a case, the company ‘Y’ may like to come out of the contract with company ‘X’ by paying whatever fees.  It is possible that the new deal would more than offset the fees paid.  

f.	The countries in which infrastructural capacity is low may not be able to negotiate attractive terms and thus may either accept unfavorable conditions or may forgo the opportunity.  

	In this scenario much will depend upon how the negotiations are conducted.  In case sufficient information is available to both the companies about each other’s vulnerability, they may be able to negotiate an agreement better than in the absence of the information. It can be suggested that in cases without information asymmetries, greater cost of negotiation may be justified in order to generate trust and accountability. Once the agreement is arrived at through a transparent process, the monitoring and enforcement costs may come down considerably.  It is also possible that the cost of renegotiating an agreement may be higher in cases in which the original agreement was executed with informational asymmetries.   

Joint implementation of various conservation projects in bilateral agreements will suffer from the externality of other agreements simultaneously talking place at the same time between different partners involving at least one of the countries. It is possible that every time a better bargain is struck between any two partners, the earlier deal comes under strain. This may not happen in commercial contracts but in the present case several communities may also have stake. One community may not like why it was receiving different compensation or incentives than other for providing similar services. Conflicts on this account have to be anticipated and allowance for the same have to be made. Transaction costs for negotiating contracts among companies may be lesser some times than the similar costs involved in negotiating agreements with the communities in each country. In country of company ‘x’, the stake holders should consider the sequestering effect as sufficient. In the country of company ‘y’, the communities affected directly by the project should consider pay off adequate but the governments and other constituents of the political environment should also consider the contracts reasonable. Again, the conflicts may arise but cost of dealing with them have to be anticipated. 

Scenario Two:

Company ‘x’ enters into a contract with a national or international funding organization and offers to provide management support for plantation projects in developing countries and in return wants to have the right to incorporate these plantations in its quota for sequestering. It is possible that some of the developing countries may agree to such an arrangement in view of foreign exchange shortages. 

The crucial issues that may arise here are:

a) 	how will the responsibilities of joint implementation constitute additionality in this. 

b)	to what extent the sequestering additionality be counted when the same forest may be planted any way under catchment area planning or some other long term plan? Can one say that reduction of uncertainty in plantation through ensured funding may constitute credits of lesser weights but of longer duration? That means that some companies may like to have a portfolio of sequestering assets of different values, weights and duration along with varying uncertainty quotient. 

c)	The funding agency in developed host country of company ‘x’ may extend finance for a project which otherwise may or may not warrant funds on various economic or institutional grounds but may agree to invest because of the (a) likely sequestering benefit which people in donor country may appreciate ( as suggested by Bohm under incentive effects of JI) or (b) the management advantage of the partner company ‘x’ may be actually overrated. Both the situations may produce adverse long term effects if plantations are not sustained properly. 

d) The market may emerge with in different states in the federal 
country an hidden subsidies to attract investment may be contributed toward the funded projects. Studies have shown that foreign funded project often attract the most efficient staff, much better infrastructural support and counterpart financial support. By implication in a situation of chronic budget deficit, this also means that this additionality may be achieved by withdrawing resources from existing projects and program in non project areas. The adverse environmental consequence of such withdrawal can theoretically be higher than the benefit claimed through carbon sequestering through fresh project. Such calculations are often not done and thus the real impact of JI in such a scenario remains masked.

The transaction costs of securing such an augmented support for externally funded project may have to be properly estimated so as to calculate the externality of such project related withdrawal of resources and the consequent effect on the transaction cost of securing survival funds by those bypassed projects.

Summing Up:

It is obvious that JI has to address a large number of theoretical and empirical questions dealing with  estimating sequestering credits, conditionality of funding under joint implementation among developed and developing countries but also with developed countries, valuation of sink effects of forest of various kinds ( species mixes) and under varying management and institutional structures, externality of externally funded project on non funded forests or other such projects in fund starved developing countries etc.

The decision about what institutional arrangement will work best may require crossing several more theoretical hurdles. I have argued that transaction cost framework may help in addressing some of the challenges. I have also suggested that utility of JI under varying assumptions of global negotiations or arrangements may require some scenario building to appraise relative benefits and costs.

Different kinds of externality conditions may generate varying kinds of sequestering obligations. Carbon emissions of all kinds may or may not produce same green house effect depending upon intensity, diurnal and seasonal distribution, distance from the sinks etc. The Joint Implementation Projects with all these uncertainties can only be taken up as policy experiments and nothing more. That will mean that these projects have greater pay off in terms of learning value rather than just sequestering benefits. That also implies that design conditions of such projects will require much more rigorous monitoring with reference  to base line data base. Such data bases do not exist in most countries despite remote sensing technology being quite cheap now compared to past.

It has also been suggested that rather than requiring JI to take place through entirely bilateral negotiations, some basic framework conditions may be developed through internal dialogue among industry associations and other such bodies. While it may be necessary to have a clearing house for validating the reference values of sequestering credits under different technological, ecological and institutional conditions, some global reference points may still be necessary. 

Should policy experiments be delayed  till we have resolved all the uncertainties? I suggest not. Because in such a case institutional models with limited information would not emerge. And absence of such models may itself be a deterrent to reduction in uncertainly in the feasibility of JI.