Optimal Monitoring for Project-Based Emissions Trading Systems Under Incomplete Enforcement

Abstract

Project-based Emissions Trading Schemes, like the Clean Development Mechanism, are particularly prone to problems of asymmetric information between the project parties and the regulator. Given the specificities of these schemes, the regulator’s optimal monitoring strategy significantly differs from the one to be applied for cap-and-trade schemes or environmental taxes. In this paper, we extend the general framework on incomplete enforcement of policy instruments to reflect these specificities. The main focus of the analysis is to determine the regulator’s optimal spot-check frequency under the plausible assumption that the submitted projects vary with respect to their verifiability. We find that, given a limited monitoring budget, the optimal monitoring strategy is discontinuous, featuring a jump within the set of projects with lower verifiability. In this region, actual abatement is low and can fall to zero. For these cases, the sign of the slope of the strategy function depends on the actual relationship of the abatement cost and the penalty function. We conclude that, in a real-world context, project admission should ultimately be based on the criterion of verifiability.

Keywords: environmental regulation, emissions trading systems, audits and compliance

JEL Classification: K32, D42, D82