Special Report

Can markets count on Copenhagen?

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Special Report: The COP 15 climate summit in Copenhagen


There is uncertainty aplenty about the post-2012 carbon market as Kyoto Protocol targets reach their expiry date. Paul Hatchwell looks at the implications

One of the most important and urgent tasks for negotiators in Copenhagen is to secure the future growth and good order of the world’s carbon  markets. Dominated until now by the EU emissions trading scheme (EU ETS), these markets have already grown large. Turnover reached $119bn in 2008 having almost doubled since 2007, according to analysts New Energy Finance.

They could soon become huge. And in so doing, they would help emitters in developed countries curb emissions economically while transferring vast sums of money to help developing nations cut carbon and adapt to unavoidable climate change.

Carbon markets are now emerging in the US, Japan and Australia. These will all share the basic features of Europe’s pioneering scheme: each year greenhouse gas emitters must surrender allowances, each of which covers one tonne of carbon dioxide, equal to their annual emissions. These allowances are either given to them free or sold, usually by auction.

The total number of allowances distributed each year is set at a maximum level – the cap – which falls over a set period to bring down total emissions. Companies which can easily and cheaply reduce their emissions end up with unused allowances which they can then sell to companies that find it harder and more costly to curb their CO2 output. This trade in allowances puts a price on each tonne of carbon emitted and helps industry to lower emissions in the most cost-effective way.

Allowances can also be traded between the various carbon markets in different nations and regions. If developing countries can cut their emissions more cheaply than developed ones, then the former can benefit from selling allowances – or carbon credits – into rich world carbon markets.

This is now happening on a modest scale thanks to the Clean Development Mechanism (CDM), one of the ‘flexible mechanisms’ established under the UN’s 1997 Kyoto Protocol.

The UN Environment Programme estimates the 1,168 CDM projects already operational or in the pipeline will have delivered more than a billion tonnes of CO2 emissions cuts by 2012. The mechanism accounts for about a seventh of global carbon market trades, according to New Energy Finance.

The growth driver for CDM projects and revenues is targets for wealthy countries to cut their emissions; this is what creates the demand for CDM credits. But after 2012, there are no further reduction targets because Kyoto’s first commitment period expires. Developed countries that ratified the protocol agreed to cut their emissions during the period 1990 to 2008-12.

Copenhagen is meant to sort out what happens next. The future of global carbon markets, and the flow of climate money from north to south, depends on real progress on post-2012 carbon targets for developed countries being made in Denmark.

But Copenhagen also needs to radically improve the flawed CDM for the post-2012 period and to start developing bigger, better alternatives for using carbon markets to pay developing nations for cutting emissions.

Carbon trading here to stay

Whatever happens, the EU ETS will continue. In 2008 it covered more than 3 billion tonnes of CO2e; some 40% of the bloc’s total emissions.

The world’s premier carbon trading scheme will play a crucial role in delivering the EU’s legal commitment to reduce its emissions by 20% between 1990 and 2020 (ENDS Report 407, pp 4-5, 408, pp 40-41). The same will be true if the EU decides to commit to a 30% cut for that period, a likely outcome of the Copenhagen summit even in the event of a fairly weak deal (see pp 4-5).

The proposed US cap-and-trade scheme, agreed by the House of Representatives and now passing through the Senate, could also be launched without a global deal at Copenhagen.

But the EU ETS is already in trouble, with carbon prices unlikely to reach more than €20-30/t of CO2 equivalent by 2020 even with tighter caps (they currently trade at about €14/t). The recession (which cuts demand for allowances) and a fundamental over-supply of free allowances to emitters are being blamed. The banking forward of these excess allowances could dilute prices and therefore incentives to invest in low-carbon technology.

The European Commission has rejected calls for a carbon floor price, preferring to work for tighter targets under a global deal. But without these, the future allowance market looks shakier and demand for international offsets could slacken.

The US carbon trading scheme is also likely to deliver large quantities of free allowances to US emitters, which could undermine carbon prices there and eventually more widely (ENDS report 407, pp 6-8 and 412, p 34).

So what would failure to cement agreement on carbon markets at Copenhagen, followed by years of irresolution, mean for existing and planned cap-and-trade schemes? One concern is there would be a fragmentation. Regional schemes within developed countries could harm each other’s orderly development and create additional long-term uncertainty about carbon prices.

Emitters in any one country or bloc who need allowances will always prefer to import them from any overseas emissions trading scheme where they are cheaper than at home. But regulators may seek to restrict the flow between markets. Why? Because it pushes carbon prices down (in the importing country, thereby weakening the incentive to cut emissions) or up (in the exporting country, loading higher costs onto local industry).

The EU already limits the import of CDM credits into its emissions trading scheme. There are fears that if the EU ETS were linked to the US cap-and-trade scheme, a flood of cheap American allowances could further depress European carbon prices.

But if, on the other hand, carbon prices rose, some energy-intensive industries in the developed world would be at a competitive disadvantage compared with their developing world rivals who pay no carbon price. The ‘carbon havens’ of most concern are China and India.

In that case, free allocation to affected industries as proposed in the EU ETS (ENDS Report 414, p 12) would provide short-term protection.

If there was no prospect of a global climate agreement embracing developing countries, pressure would grow in the EU and US for controls on imports of carbon-intensive products; for instance  carbon tariffs or an obligation to buy emissions offsets. This prospect has already led to discussion at the World Trade Organization (WTO), where it is causing tension with developing countries.

The WTO’s Technical Barriers to Trade Committee says such measures could only be allowed if they were non-discriminatory, applying equally to imports and domestic products. They would also have to be transparent and based on scientific evidence of need. Even so, any attempt by rich countries to introduce such measures would be controversial and prone to challenges in the WTO.

So Copenhagen needs to make progress on securing and developing carbon markets to avoid troubles ahead. Orthodox economic theory also favours the idea of nations moving towards one global carbon market and carbon price. A recent report by Mark Lazarowicz MP, carbon market adviser to Gordon Brown, found a linked group of markets could cut compliance costs by up 70% compared with domestic efforts alone (ENDS Report 414, p 13).

But for many, the strongest argument for carbon market expansion is the large resources it can provide for reducing emissions and adapting to climate change in the developing world. To date, the only real game in town has been the CDM. The alternative, voluntary (non-Kyoto Protocol) carbon offsets from third world nations, have played only a minor role in global carbon markets.

The CDM enables organisations in developed countries to buy CO2 offset credits from projects in developing countries which reduce emissions relative to a business-as-usual baseline. These offsets can then be used to comply with Kyoto Protocol targets. Detailed procedures and methodologies, overseen by the UN-appointed CDM Executive Board, try to ensure these projects are additional to developments which would have occurred anyway.

But the EU wants to phase out the CDM in all but the poorest developing countries in favour of new forms of sector-wide developing country offsets (ENDS Report 409, pp 49-50 and 410, pp 4-5). This  adds to the post-2012 uncertainty.

Sticking points

Developed countries agree there is an urgent need for reform of the CDM, but attempts to discuss this at UN climate talks in Bali in 2007 and in Poznan´, Poland in 2008 were largely talked out (ENDS Report 395, pp 4-5, 407, pp 6-8), and were delayed again at the latest preparatory talks in Barcelona.

So what is the problem? Developed countries such as those in the EU and US object to paying for low-cost carbon-cutting projects in wealthier developing economies like China that have no emission reduction targets. These countries are prime competitors and the rich nations believe they should be making the cheaper emissions cuts – plucking the low-hanging fruit – without financial help.

Market for CDM offset credits booms
Market for CDM offset credits booms
They also point out that only a few richer developing countries, notably China, India, Brazil and Mexico, have benefited from the CDM. Greenhouse gas offset schemes in poorer countries, notably in Africa, often with weak governments, are more complex and risky and have been shunned by CDM project developers.

HFC reductions still dominate credits
HFC reductions still dominate credits
Large volumes of money have flowed into high profit industrial projects such as HFC destruction in China that should have happened even without CDM (see figure 1). NGOs also point to projects such as small hydroelectric dams that can often conflict with sustainable development principles.  

There are also concerns that the independence of certification bodies, which are meant to guarantee that a CDM project delivers genuine carbon savings, can be compromised when their certification work is paid for by developers.

CDM financers, project developers and consultants support the mechanism overall but have a wide range of longstanding concerns of their own and are pushing for procedural reform. They complain that the approval process is too slow and cannot deal with large enough volumes of projects to satisfy business demand. The CDM’s executive board is under-resourced, drawing upon part-time experts, with relatively little staff support.

The board’s decision-making on whether to approve projects  is also seen as opaque and unresponsive, with no appeals process. It has been prone to retrospective rule changes and occasionally inconsistent judgment, say critics.

In October, the board committed to addressing many of these concerns, including governance and professionalism, notably proposing an appeals system and simplified, clearer procedures. But stakeholders are concerned there is no timeline for approval by the UN; indeed, the CDM’s future depends on agreement at or soon after Copenhagen.

There is also a tension between business, which wants projects scaled-up to drive larger investment flows, and sustainability advocates who worry this could lead to loss of quality control.

The CDM has slowly been responding to these concerns, evolving to become more business-friendly and larger in scale. Small-scale projects can now be ‘bundled’ – assessed as one project – reducing processing time and cutting the need to duplicate baseline research and other project expenses.

In addition, programmatic CDM initiatives or ‘programmes of activities’ (PoAs) have recently been approved, after long debate. These allow large-scale programmes with multiple projects associated with them to be registered in a defined area.

Two PoAs covering household energy efficiency projects have been registered in Mexico, and another 25 schemes are being validated, varying from promotion of compact fluorescent lighting in India to irrigation and water supply in China.

These at least partially answer the call for scaling-up, but baseline assessment and methodology are complicated, approval takes much longer and national-level programmes are more likely to fall foul of government bureaucracy. Many developers have pulled out as a result.

CDM reform

So the CDM needs significant reform as well as a guarantee it will continue. People look to Copenhagen for that.

And here, US support will be crucial. The American negotiators have indicated they are in favour of the CDM carrying on, not least because US emitters covered by the country’s new cap-and-trade scheme will want to be able to import large quantities of overseas carbon credits. But progress is not helped by the CDM being part of the Kyoto Protocol, which the US never ratified.

Even if the climate summit in Denmark makes good progress, implementation of a radically revised CDM will take time. Steven Gray, a carbon finance expert at Climate Change Capital, says technical follow-up, ratification and national implementation will mean that any new flexible mechanisms agreed at Copenhagen will be unlikely to generate credits for some six years.

Tim Baines, a carbon markets specialist at London-based law firm Norton Rose, warns that if CDM credits dry up without reform, effective transitional arrangements or new forms of offsets “this would be a hazard for the carbon markes internationally”.

But what of alternatives to the CDM, different ways of generating huge volumes of carbon credits in the south for sale to the north?

In the run-up to Copenhagen, the EU has proposed a national sectoral crediting mechanism to provide tradable carbon credits in return for constraining emissions growth in major industrial sectors below business as usual within individual developing nations (ENDS Report 409, pp 49-50). But the EU says to participate, each country would have to commit to a broad, multi-sectoral strategy for controlling emissions. This has met strong resistance.

A sectoral crediting scheme would operate on a larger scale than the CDM and could benefit from economies of scale. Electricity generation is a strong candidate; most power station emissions are set to come from developing countries by 2030, and electricity generators have better emissions data than other industries.

The national sectoral target would be agreed with a UN overseeing body. This would represent a lowered level of emissions intensity by a set date than would otherwise have occurred. Higher cost, additional measures to cut emissions would be financed by climate-change-linked overseas aid.

First, the sector in question would need to establish the business-as-usual emissions pathway and any emissions cuts to be made through current and planned measures. Even so, emissions from a sector such as power generation will usually be rising in developing countries – at least for the next 10-20 years, due to industrialisation, economic growth and, in some, population growth.

Next, the sector would have to agree to best practice benchmarks, which will set the targets for lowering emissions below business as usual. If it misses the targets it will not receive the carbon credits. But the OECD has said that without tight quality controls, such mechanisms risk putting huge volumes of offsets into the global market. And business worries that government control of large schemes within developing countries would increase regulatory risk and delays.

Carbon trading alternatives

There are other potential carbon trading schemes which could generate large revenue flows from north to south, covering aviation and shipping and forest conservation. The global carbon market is standing at a crossroads in Copenhagen. Where to next?

The low road of no strong global agreement to tackle climate change would see fragmented development of emissions trading schemes and probably more voluntary schemes. Growth would be complicated by a lack of agreed standards and offset markets would suffer.

The high road would see strong developed country targets for cutting carbon, faster linkage of trading schemes between blocs and countries, and a huge expansion of trade in carbon offsets with the developing world accompanied by large transfers of climate-change-linked aid funding. It would probably also see rising US dominance of the global carbon market, displacing Europe.

Carbon prices are now depressed, following the crash induced by global recession at the end of last year. But despite all the recent pessimism and uncertainty surrounding Copenhagen’s outcome, they have held up well in recent weeks.

Most traders seem to believe that carbon markets have a long-term future beyond the Kyoto first commitment period’s expiry in 2012. Somehow, sometime, nations will reach the agreement required to keep this particular show on the road.