Three types of "flexibility mechanisms" are included in the Kyoto Protocol:

• Joint Implementation (JI), which allows developed countries (sometime referred to as "Annex B" or "Annex 1" countries) to transfer or acquire emission reduction credits resulting from projects in other Annex B countries. This is a project-based mechanism that measures reductions against a baseline.
• Clean Development Mechanism (CDM), which allows developed countries to obtain emissions credits by financing emission reduction projects in developing countries.
• Emissions trading, which allows a country with an excess of emission units, presumably from reducing emissions below commitment levels, to sell its credits to another country unable to meet its commitments. This is a "cap and trade" type of mechanism.

There are broad issues relating to international emissions trading as well as more detailed issues relating to domestic trading programs. In order for an international carbon trading system, and related domestic trading programs, to work effectively, the following general design objectives must be addressed:

• Clear methodology for quantification and verification of emissions reductions.
• System for program operation and reporting that is public and transparent.
• Means of holding participants accountable for meeting limitations.
• Minimal constraints on trading transactions.
• Objective and consistent application of rules.

The overall goal of the project is to raise the profile of DHC/CHP with key policy makers using the exploration of greenhouse gas trading as an implementation mechanism.

The specific objectives of this project are to:

• Develop persuasive information on the GHG emission reduction benefits of DHC and CHP, and communicate this information to policy-makers in order to advance DHC as a climate change strategy;
• Develop recommendations for design of greenhouse gas trading programs such that the emission reduction benefits of DHC and CHP are recognised and rewarded; and
• Communicate the information and recommendations to district energy organisations and policy-makers to encourage both reliance on DHC as a GHG reduction strategy and appropriate design of GHG trading programs.

There are six key elements to the work program:

1. Monitor and assess climate change policies and trading scheme development processes and identify and prioritise opportunities for intervention
2. Develop supportive analytical data
3. Develop promotional information on the benefits and potential of DHC/CHP relative to reducing pollution and GHG
4. Develop recommendations relative to emissions trading structure
5. Intervene to promote DHC and key trading provisions
6. Report on project outputs and intervention success

These elements will not necessarily take place in strict sequence, because we will to a certain extent be reacting to events. For example, there will be near-term opportunities to promote DHC and make recommendations regarding trading scheme development, prior to full development of supportive analytical data and comprehensive recommendations.

DHC/CHP benefits
DHC and CHP provide a variety of opportunities to reduce emissions of greenhouse gases (GHG) and air pollution and increase energy security. The fundamental idea of DHC is to use local fuel or energy resources that would otherwise be wasted in order to satisfy local customer thermal energy requirements. Examples of local energy resources include thermal energy from combined heat and power (CHP) plants, refuse incineration plants, waste heat from industrial processes, natural geothermal heat sources, wood waste, and cold sea or lake water.

The ability of DHC networks to use local heat sources is of great national and international value in achieving reductions in emissions of air pollution and GHG such as carbon dioxide (CO2).

• increasing fuel supply reliability by using indigenous fuels like biomass or waste;
• strengthening power grid reliability by generating power near load centres;
• reducing power demand by supplying heating or cooling energy through DHC systems rather than the power grid; and
• shifting power demand to off-peak periods through thermal energy storage.

Annually, about 11-12 EJ heat are generated and delivered to district heating systems in the world. The corresponding heat deliveries represent about 5 % of the total final energy demand in the industrial, residential, public, and commercial sectors. This fraction is lower in the OECD-countries (2 %) and higher in the non-OECD-countries (7 %).

Globally, DHC/CHP including industrial CHP reduces existing CO2 emissions from fuel combustion by 3-4%, corresponding to an annual reduction of 670-890 Mton compared to 1998 global annual emissions of 22700 Mton. The lower estimate is based on IEA Energy Balances for 1998. The higher estimate considers the lack of adequate information in the IEA Energy Balances about heat generation from industrial CHP in the EU and USA and power generation from CHP plants in China. The highest fractions of avoided carbon dioxide emissions from DHC/CHP occur in Russia (15%), in the former USSR outside Russia (8%) and in the EU (5%).

For the future, DHC/CHP can make further reductions of global carbon dioxide emissions.

• increasing the market penetration of DHC through new and expanding existing DHC systems;
• increasing the share of CHP in existing DHC generation, since only 48% is currently produced from CHP; and
• fuel substitution in existing DHC/CHP plants, since coal constitutes 38% of fuel supplied.

Future competitiveness of DHC and CHP
In the short term, the combination of DHC and CHP is a carbon-lean technology that will gain initial competitive strength from emissions trading systems. Hence, the contribution from DHC and CHP can be significant for fulfilling the Kyoto commitment for 2008-2012. An effective international system for carbon trading will facilitate realisation of this potential, since the marginal production in the current international electricity markets has high carbon dioxide emissions, due to the extensive use of coal as fuel (38% globally) and the low power plant efficiencies (33% is the global average).

This advantage with respect to carbon dioxide emissions will be weaker in the longer term. When the marginal production in international electricity markets achieves higher efficiencies and lower emissions, conventional district heating using CHP plants with fossil fuels will lose competitive strength. However, this is not a unique situation for DHC and CHP; it will apply to all carbon-lean technologies, since the future competition will not come from carbon-rich technologies, but from other carbon-lean technologies.

Emissions trading systems
GHG emissions trading will be a key element in the implementation of Kyoto Protocol, based on the legal and political basis established in the Marrakesh Accords. Although the United States has opted out of the Kyoto process, other nations have moved toward implementation including progress toward development of GHG emissions trading. International emissions trading will take place under a cap-and-trade system, although the Protocol has also established two project-based mechanisms under which emission reduction credits can be generated through comparison of project emissions to a baseline of estimated emissions without the project.

The European Commission (EC) has published a directive on greenhouse gas trading following input from stakeholders, including this IEA project, on the EC "Green Paper" on emissions trading. The EU trading scheme is expected to begin operating in 2005. The sectoral coverage of the Directive builds on the framework arising from the Integrated Pollution Prevention and Control (IPPC) Directive. However, power and heat generators of a smaller size (20-50 MW) will also be included in the trading scheme, as urged in the comments provided by this IEA project.

Denmark and the United Kingdom have already begun operating national emissions trading schemes. National trading systems have been investigated in other countries including Sweden, Norway, Germany and Canada. Some companies, such as British Petroleum and Shell, have developed their own internal trading systems.

Recommendations for emissions trading program design
When energy from DHC and/or CHP flows from one legal entity or sector to another, there is the potential that the emissions trading scheme will not recognize or credit the related emission reduction.

• whether or not the sector is included in the trading scheme; and
• whether an entity initiating an action that results in GHG reduction has ownership and/orcontrol over the facilities in which the emission reduction takes place.

Without some mechanism for crediting offset building boiler emissions, emissions trading will place DHC at a disadvantage unless strong policies and measures applied to the buildings sector (which is not expected to be included in most emissions trading schemes). Emission trading schemes will constrain CHP without a means of crediting CHP projects developed by third party CHP developers (who then sell the power to the grid and heat to a DHC company or other entity).

The most important issue relates to quantification of emission reductions resulting from reduced demand on the power grid (often called "indirect emission reductions"). This is an important issue not only for CHP but also for demand-side management and renewable power generation technologies. In an increasing complex, dynamic and market-based power supply system, it is increasingly difficult to determine the emissions implications of reduced power demand on the grid plant mix. Establishing an appropriate value for indirect emission reductions is a key issue for project-based trading schemes, for CHP as well as other efficiency and renewable technologies.

Other recommendations
As policy initiatives, such as the European Union's CHP Directive, the UK CHP initiative and the US CHP Challenge are developed, it is essential that these initiatives include strong and effective measures that address barriers to implementation of DHC and CHP.

Steps should be taken now to internalise the environmental and energy security benefits of DHC and CHP.

• mitigate the environmentally negative impacts of energy market liberalisation;
• internalise in the marketplace the GHG reduction benefits of DHC/CHP in advance of a fully functioning GHG emissions trading scheme; and
• internalise air pollution and energy security benefits of DHC/CHP.

• establish CHP implementation targets;
• ensure access, under transparent and non-discriminatory terms, to the power grid; and
• encourage energy and CO2 tax schemes that at the very least do not discriminate against DHC and CHP, and preferably would provide positive incentives.