Kyoto Accord Compliance Markets: Can Emission Trading Offsets Work? (Pt.1 of 2)

The global market for carbon reductions is growing rapidly, having doubled in value in the last year alone to more than $64 billion.

The European Union Emissions Trading System (EUETS) comprises most of the market, with the Clean Development Mechanism (CDM) and other various offset markets valued at almost $14 billion. These latter offset markets primarily involve project-based investments in developing countries not subject to any greenhouse gas emissions cap.

At the core of the offset market is the idea of additionality, the assurance that the sale of carbon offset credits result in actual reductions of emissions, without which offsets would simply water down compliance targets through leakage. The rapid expansion of offset markets has awoken a chorus of critics concerned that additionality standards are being weakened or completely thrown by the wayside. Their critique has focused primarily on the large CDM markets, but others have lambasted the lack of clear standards in the small but growing market – about $265 million – in the U.S. for voluntary offsets.

There are two separate but overlapping markets for greenhouse gas emission reductions: the compliance market and the voluntary market. Both trade project-specific reductions in greenhouse gas emissions, standardized in units of carbon dioxide equivalent (CO2e), but they differ significantly in their requirements and market price. In general, compliance markets have considerably more stringent standards than voluntary markets, as they are directly regulated by the United Nations via the CDM Executive Board. Voluntary markets, on the other hand, are solely regulated by the consumer willingness to pay for offset projects.

This piece is part one of a two-part examination of carbon offset markets, with a primary focus on problems with additionality in compliance markets. A follow-up piece in an upcoming post will look more in-depth at voluntary carbon markets in the U.S.

Compliance Markets

The compliance market involves countries that are signatories to the Kyoto Protocol to the United Nations Framework Convention on Climate Change. Annex I countries (those in Western Europe and Canada, Japan, Russia, and Australia) are required to meet specific emission reduction targets, and are allowed to both trade credits between Annex I countries and purchase credits from specific projects in non-Annex I countries through the CDM.

The CDM was developed as a cost control mechanism to prevent the price of tradable permits from rising excessively while maintaining the general rigor of the cap for Annex I countries. Certified emission reduction credits (CERs) generated by CDM projects must include “real, measurable, and long-term benefits related to the mitigation of climate change … and reductions in emissions that are additional to any that would occur in the absence of the certified project activity.” This additionality criterion is essential to ensuring that the CDM does not allow carbon leakage from compliance markets.

In the early years of the CDM, projects focused primarily on industrial gases with high global warming potential (GWP) such as hydrofluorocarbons (HFCs). These projects represented the proverbial “low-hanging fruit,” where enormous amounts of CERs could be generated from relatively modest investments. It was relatively simple for companies undertaking HFC incineration projects to prove that their projects would not have been viable in the absence of CER revenue (and therefore met the additionality criterion), as the only revenue stream of the project was CER sales.

Over the past two years, however, with most industrial gas projects exhausted, the market has shifted toward energy efficiency and renewable energy projects (see Figure One below). Renewable energy projects, in particular, tend to be large undertakings in which CER revenue represents only a small fraction of total project revenue. This situation poses a substantial challenge to additionality: how can a large multi-million dollar power generation project prove that its viability is contingent on a revenue stream that comprises only 1 to 2 percent of total project revenue? Similarly, many energy efficiency projects save money even without consideration of carbon credit sales.

Figure 1
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CDM projects by project type and thousand certified emissions reductions expected by 2012 (2012 kCERs) by year of project initiation. Based on data from the CDM Pipeline.

While additionality was intended to be a firm criterion in determining if emissions would have actually occurred in the absence of the revenue generated by the sale of CERs, it is an increasingly “fuzzy” test in order to accommodate both the rate of expansion of the carbon market and the shifting portfolio of projects.

The realization that a strict financial-based additionality is no longer viable for most projects outside of industrial gases and methane has led the CDM Executive Board to expand the definition of additionality to encompass other tests. For example, projects can be deemed additional if their methods differ from prevailing practices in the industry (prevailing practices), or if there are specific barriers that can be identified as holding back development in the sector that would be overcome with the project (barrier analysis).

Critics contend that loosening the CDM requirements makes a mockery of the idea of additionality. They argue that barrier analysis and prevailing practices amount to awarding additionality to those who tell the best story, and that those analyses reflect a move away from objective financial measurements. At a recent workshop on additionality at the United Nations climate conference in Bali, participants from the major project development groups were surprisingly blunt in arguing that projects are probably not additional.

A recent paper by two Stanford researchers, Michael Wara and David Victor, has shone a public light on this debate.

Wara and Victor argue that the vast majority of current projects are likely non-additional, and they point to project development in China as an example of the fundamental flaws of the current system. China has a five-year plan for major investments in hydro and wind, and has established strong financial incentives for renewable energy development. Despite this strong government support, virtually every single renewable energy project currently under development has applied for CDM project status. Wara and Victor explain:

Taken collectively however, these individual applications for credit amount to a claim that the hydro, wind, and natural gas elements of the power sector in China would not be growing at all without help from CDM. This broader implication is simply implausible in light of the state policies described above.

Wara and Victor offer further criticism of structural problems in the CDM accreditation system:

The host governments and investors that seek credit have a strong incentive to claim that their efforts are truly additional. The regulator – in this case, the CDM Executive Board – can’t in many cases gather enough information to evaluate these claims. These problems of asymmetrical information are compounded in the CDM, to be sure, because the CDM Executive Board is massively under-staffed and the CDM system relies on third-party verifiers to check the claims made by project proponents. In practice, these verifiers, who are paid by the project developers, have strong incentives to approve the projects they check.

The CDM has come under criticism also from those who maintain it provides a perverse incentive to developing countries considering adopting limits on emissions. To be eligible for CDM investments, developing countries must not have their own binding targets and timetables for emission reductions. If, say, China were to adopt a carbon target, it could no longer sell carbon credits from domestic countries abroad, as those reductions could not be double-counted domestically and in the Kyoto market. Given the rapid expansion of financial flows through the CDM in recent years, there is a valid concern that the CDM could discourage developing countries from adopting climate policies in the future.

These concerns are prompting an important discussion on the future of the CDM. Some argue that the CDM needs to move away from a project-specific approach and instead focus on setting targets for broad sectors of the economy. This sectoral CDM would award credits to a sector if they surpass a particular negotiated emissions quantity or intensity target. Critics of this approach say they fear it would necessarily be somewhat arbitrary, and they say additionality would be dubious. Others say certain technologies in particular countries should be automatically additional if those technologies are not widespread. Still others advocate a benchmarking approach, only awarding credits, for instance, only to the most efficient 5 percent of performers in a particular sector.

This important policy debate is just beginning, and no clear viable alternative to the current system has yet emerged. What is becoming clear is that current system of additionality will need to be reformed.

 

Also see Part 2.

Zeke Hausfather

Zeke Hausfather, a data scientist with extensive experience with clean technology interests in Silicon Valley, is currently a Senior Researcher with Berkeley Earth. He is a regular contributor to The Yale Forum (E-mail: zeke@yaleclimatemediaforum.org, Twitter: @hausfath).
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