Carbon complexities mount as Kyoto comes to town

Years of uncertainty over the fate of the Kyoto Protocol appear to be at an end, with the near certainty that Russia will ratify the treaty by the end of the year. The move is a tonic for international efforts to combat climate change, and ensures a much firmer foundation for the infant EU carbon market. But the implications for European companies are highly uncertain - with key variables being the scale and availability of Russia's emissions surplus, the prospects for the Kyoto "flexible mechanisms" and the likelihood of Europe becoming increasingly dependent on Russia to meet its demand for both natural gas and carbon credits.

The Kyoto Protocol was signed nearly seven years ago (ENDS Report 275, pp 16-20 ) - but the struggle to bring it into force has been long and painful.

The Protocol has now been ratified by 125 parties. The key barrier to entry into force is the requirement for ratification by countries representing more than 55% of industrialised nations' CO2 emissions. The USA, which holds 36% of the deck, withdrew from the game in 2001 - leaving Russia, which accounted for 17.4% of 1990 emissions, in control of the Protocol's fate (see box ).

Russian roulette
Several years of conflicting signals from the Kremlin came to an end in late September, when the Russian cabinet agreed to send the Protocol to the Parliament, or Duma, for ratification. The Duma is now expected to vote on the treaty by November - and observers are confident that approval should be a formality. The Protocol itself will come into force 90 days later.

The announcement was greeted with much relief in EU and United Nations institutions. Environment Secretary Margaret Beckett expressed "delight" at the move, which she saw as "a timely boost for Britain's plans for international dialogue on climate change in 2005".

Greenpeace said that Russian President Vladimir Putin "has brought us to a pivotal point in human history. The Bush administration is out in the cold and the rest of the world can move forward as one."

Professor Michael Grubb, director of policy at the Carbon Trust and a leading expert on Kyoto, is "slightly bemused" by the excitement. "This was always going to happen - Russia just wanted to play it out," he says. "The most important thing is the timing. It allows the global process to move forward, including the launch next year of negotiations on commitments beyond 2012."

Professor Grubb points out that Kyoto ratification has important implications for the future of the EU emissions trading scheme (EUETS) (see pp 3-4 ). Indeed, the decision will provide renewed impetus for planned trading schemes in Canada and Japan - and may lead them to link with the EU scheme.

"Allocation for the first phase [of the EUETS] still looks very weak," Professor Grubb says, "partly because of a vague hope in the industrial community and in economics ministries that the Protocol would unravel. Certainty on Kyoto makes it more likely that allocations are going to be toughened up a lot in the second period."

Impacts on the EU trading scheme
Kate Hampton of merchant banking firm Climate Change Capital stresses that Russia's decision "doesn't change the fundamentals" of the first phase of the EUETS. The main impact may be increased competition for credits from the Protocol's Clean Development Mechanism.

However, Ms Hampton says, "targets for the second phase are now more serious and there are a lot more ways of meeting them. There is increasing complexity in the market - and that makes it much more difficult for companies to work out what they're going to do."

One key question is whether EU Member States are likely to buy up surplus allowances, called AAUs, from Russia to meet their Kyoto targets - easing the pressure for tough allocations in the EUETS' second phase.

Guy Turner of consultants Enviros says that "in the short term, the drive for actual carbon reductions in Europe may be muted because of Russian 'hot air'. It's not something to be afraid of - you always need to mop up loose allowances in the early stages of any trading scheme."

However, Professor Grubb downplays the risk. "Governments will want to deliver what they can domestically," he says. "Nobody likes spending money abroad if they can avoid it."

Kate Hampton says the impact will also depend on the interpretation of the Protocol's poorly defined requirement for imported credits to be "supplementary" to domestic action. So far, the European Commission has stuck to the line that Member States should not rely on future purchase of AAUs when setting allocations under the EUETS. "Member States will be looking to see who's taking the mickey, and working out what they can get away with," says Ms Hampton.

The other route for the EU to access Russian carbon credits is by investing in emission reduction projects under the Protocol's Joint Implementation (JI) mechanism. Governments such as the Netherlands already have active programmes to purchase JI and CDM credits - but companies will also be able to buy credits directly to meet their targets under the EUETS.

There is undoubtedly massive potential for low-cost JI abatement projects in Russia's antiquated industrial base - but as discussed below, there are huge uncertainties over whether it can be realised in practice.

Investment bonanza?
An understanding of Russia's position is key to determining how these complexities are likely to play out.

Professor Grubb says that President Putin's decision appears to have been driven by two key considerations. First is the strong suspicion that the EU has agreed to help Russia's bid to join the World Trade Organization - probably though energy-related JI investments to help Russia adjust to higher gas prices. Second is the political desire to engage with a multilateralist approach.

Many observers insist that Russia is also set to profit financially from Kyoto. Analysts Point Carbon claims that "Russia could earn up to $10 billion by developing a sales strategy and restricting supply of quotas to sell into the global emissions trading market."

Key players within Russia appear unconvinced. Economic Development Minister German Gref - a supporter of ratification - told Reuters that the Protocol "is fairly symbolic", and would not affect Russia's economic development "in any substantial way".

Andrei Illarionov, President Putin's economic advisor, offered a contrasting view - not surprising in view of his recent claim that Russian ratification would be an "international Auschwitz". He warned that "Kyoto will cripple our economy and make our country less able to achieve badly needed economic growth" - and claimed that it would divert financial resources away from local environmental problems.

An independent view
A more considered view is provided by a report for the Department for Environment, Food and Rural Affairs (DEFRA) completed earlier this year. The assessment, conducted by Cambridge Economic Policy Associates, was only made available in October.

The report concludes that the overall benefits of ratification to Russia are "likely" - but not certain - "to be positive even assuming non-participation by the US". The size of the benefit is "uncertain" - and depends greatly on the policies adopted by the EU and other Kyoto participants (see table).

The first key issue is the likely size of Russia's surplus. On the face of it this appears huge. Under the Protocol, Russia is expected to keep emissions below the 1990 level of 831mtC (million tonnes of carbon) - a figure later supplemented by an allowance of 37mtC for absorption from its forests.

Russia's emissions slumped in the 1990s with the collapse of the Communist regime. In 1999, the most recent year for which figures are available, emissions were a massive 38% below the base year. The gap is roughly equivalent to the entire annual CO2 emissions of the UK, France and Italy combined.

Emissions are expected to rise in the coming decade - but the degree to which they approach the 1990 level will depend on the rate of economic growth and energy intensity improvement. President Putin has set a challenge to double GDP in ten years - an annual increase of 7.2%. If high growth is achieved with little or no improvement in energy intensity, there is a chance that Russian emissions could exceed the 1990 level.

In practice, the report for DEFRA says, this is "very unlikely". Most observers believe that a 4% growth in GDP is a more realistic ambition - and even this depends on major economic reforms - while high growth rates can be expected to go hand in glove with big improvements in energy intensity.

Under most scenarios, the report expects an annual surplus of roughly 100-300mtC over the period 2008-12. Most studies have suggested that Russia can maximise its income by restricting the supply of credits to about half of this level.

However, the value of Russia's surplus has been slashed by the withdrawal of the US, the main potential buyer, from the market. The report says that likely annual income from AAUs has been slashed from $4 billion to less than $1 billion.

The second main impact of ratification is the impact on Russia's sales of oil and gas - worth a huge $70 billion last year alone.

The report for DEFRA argues that Kyoto ratification could have a significant effect on global oil consumption, with corresponding impact on Russia's oil revenues.

However, the EUETS is likely to have a substantial positive impact on Russian gas exports, potentially outweighing the loss of oil revenue. The EU has, with some wobbles, promised to implement the trading scheme regardless - but Russian ratification clearly reinforces the market for its gas exports. It may also open up the prospect of a new pipeline to carry gas exports to Japan.

Joint Implementation
The third potential benefit to Russia is the opportunity to lever in investment to help restructure the economy. The International Energy Agency estimates that the Russian energy sector needs investment of $250 billion over the next ten years.

The report sees "no reason why a substantial proportion of these investment needs cannot be met through JI projects." In the current poor investment climate, however, "the volume and value of JI is likely to be limited."

Jonathan Thomas of the Government's Climate Change Projects Office - set up to promote JI and CDM investments by UK companies - told ENDS that "no company I'm aware of wants to rush into Russia at the moment. There is a view that JI is too complicated."

Kate Hampton of Climate Change Capital points out that at present any JI project in Russia would have to follow the more cumbersome "Track 2" procedure which is designed for countries with poor greenhouse gas reporting and inventory systems. This would require a new supervisory board and approval procedures similar to those for the CDM - leading EU business organisation UNICE to warn that "onerous" and "bureaucratic" systems may stifle investment.

However, Ms Hampton points out that other Kyoto signatories have a strong incentive to offer significant technical assistance to help build key infrastructure such as emissions registries and inventories, so easing the path for JI projects. If this occurs, the report for DEFRA says, JI in Russia "could be very substantial".

The move to ratify the Protocol removes perhaps the biggest uncertainty in climate change policy. However, it has introduced numerous other variables - and potentially made the job of developing a carbon management strategy even trickier.

"I don't know how anyone can say what the carbon price is going to be [in 2008-12]," says Tony White of Climate Change Capital. "The only way is to ask Putin. He is now the controller of gas supplies and allowance supplies - and he's going to manage things to his benefit."

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