The Clean Development Mechanism: Kyoto Comes Home to Roost

The Clean Development Mechanism - a cornerstone of the Kyoto Protocol which allows industrialised nations to invest in emission reduction projects in the developing world - is inching towards reality. This summer, the European Commission unveiled plans to let companies buy CDM credits to help meet their targets under the EU emissions trading scheme. But long-running controversies over the CDM's environmental integrity show no sign of abating - leaving potential purchasers facing huge uncertainties about the likely availability of CDM credits, the impact on prices in the EU carbon market, and the risk of attracting criticism from environmental groups.

Many environmental professionals are aware, at least in outline, of the Kyoto Protocol's 'flexible mechanisms' - the Clean Development Mechanism and Joint Implementation. Only now, however, are the complex issues surrounding these mechanisms starting to become real to the vast majority of players.

'There's a relatively small group who have been following this all along, who can use all the acronyms - JI, CDM, CERs, ERUs, RMUs - like a second language,' says Benedikt von Butler of brokers Evolution Markets. 'Then you have the new entrants who are waking up to all this, decide to come to a conference and are horrified at the jargon.'

Jonathan Thomas of the UK Government's Climate Change Projects Office told ENDS that 'the general business perception is that the CDM is a bit theoretical at the moment. People are looking for more certainty.'

Growing focus on CDM
The main barrier facing the CDM is a fundamental one - the ongoing uncertainty over whether and when Russia will ratify the Kyoto Protocol, so bringing it into force. If Russia does not ratify, the whole architecture of the Protocol, including the CDM, will come tumbling down - hardly a recipe to inspire business confidence.

Despite this, interest in the CDM and, to a lesser extent JI, is beginning to mount. A growing number of countries - including the Netherlands, Denmark, Belgium, Italy and Finland - have announced that imported credits will form a key part of their strategies to meet national targets under the Protocol.

The other key driver is a proposed EU 'linking' Directive issued this summer which would allow more than 10,000 installations in the EU to use JI and CDM credits to help meet their targets under the second phase of the EU emissions trading scheme, which runs from 2008-12.

The immediate focus in the EU is on drawing up national allocation plans for the trading scheme. 'Once companies understand what their targets are and assess the cost implications of meeting them, they'll start to look seriously at where they can get project credits,' says the CCPO's Jonathan Thomas.

Under both the JI and CDM, a company can generate tradeable credits if it can demonstrate that its project reduces emissions below a 'business as usual' baseline. The key difference is that JI projects are carried out in industrialised nations with emission targets under the Kyoto Protocol, whereas the CDM applies to projects in the developing world.

In practice, CDM projects are likely to be the main source of imported credits. The European Commission expects the CDM to account for perhaps 80% of the market.

The prospects for JI are less encouraging. The main problem is that the most fertile ground for JI projects is in Eastern European states which are about to join the EU. Projects which reduce emissions from electricity generation in these countries, directly or indirectly, will be unable to qualify for the JI because of double counting of emission reductions under the EU emissions trading scheme. In other sectors, EU regulatory standards will form the baseline - leaving little scope for additional emission reductions.

'The EU trading scheme filters out about 80-90% of JI projects in accession countries,' says Benedikt von Butler of Evolution Markets. 'If you want a large-scale JI investment, you'll need to go to Russia or the Ukraine where the climate for investors is not much better than in many developing countries.' Add in the fact that, unlike JI, CDM projects can generate credits before 2008 and the CDM starts to look attractive despite the higher transaction costs.

Looking to the linking Directive
The linking Directive is being pushed through on a fast track, with the European Commission hoping to secure political agreement from Member States in December. In September, the UK Government launched a consultation to inform its negotiating position.1However, the proposal seems likely to get a frosty reception from the European Parliament. In the summer, MEPs made a series of concessions to allow agreement on the main rules for the trading scheme. They are widely expected to seek payback in the form of tighter restrictions on the use of project credits.

There are two main pressure points. The first is whether the EU should seek to limit the types of projects which will be eligible. At present, the draft Directive would not permit the most controversial types of projects - nuclear power or 'sinks' projects using forestry or land use change.

However, the Commission has left the door open to bringing in sinks at a later date. In December, parties to the Protocol will try to reach agreement on rules for the use of forestry projects - although they face formidable problems in drawing up credible rules to quantify carbon storage and deal with the impermanence of many sinks. Even the UK Government, in its consultation on the linking Directive, observes that 'in the timescale of climate change it is not particularly useful to sequester the carbon only for it to be released in 100 years time.'

Environmental groups are lobbying hard for tougher restrictions on the use of CDM credits under the EU trading scheme. Just two years ago, they point out, the EU was seeking to restrict the CDM to a 'positive list' of project types which prioritised renewable energy and energy efficiency - and excluded sinks, large-scale hydroelectric projects and most large fossil fuel projects.

NGOs have written to national governments across the EU urging them not to source credits from sinks, large hydro schemes, 'clean coal' projects or projects being developed by companies based in countries which have not signed the Protocol - particularly the USA. The draft Directive appears to give Member States scope to ensure that credits represent real and additional reductions - but does not explain whether they should duplicate the existing infrastructure for approving CDM projects.

However, industry representatives attack 'attempts to renegotiate the Protocol after the event.' Another concern is whether restrictions on project types would achieve much in the context of a global emissions market. Even if the EU sets up stricter criteria, the danger is that developers may be able to 'launder' credits from more dubious projects.

Putting a cap on credits?
The second key pressure point in the linking Directive is whether it should set a ceiling on the use of project credits. Many argue that this is needed to retain the environmental integrity of the EU trading scheme, and also to deliver the Kyoto Protocol's requirement that use of the flexible mechanisms should be 'supplemental' to domestic action.

Earlier drafts proposed limiting credits to 6% of the total quantity of allowances issued by Member States. However, the final version merely proposes a review if the 6% level is reached which will consider setting a cap at 'for example 8%'.

Climate Action Network Europe, a coalition of environmental groups, accused the Commission of 'shooting its own emissions trading system full of holes' and undermining incentives for real emission reductions and technology development in Europe. Campaigner Jason Anderson commented: 'We'd like to see a firm ceiling reinstated - ideally set at 0%.'

However, industry bodies oppose a ceiling in principle. John Scowcroft of the electricity trade body Eurelectric called for 'unrestricted access' to project credits. He argued that implementing a ceiling - presumably on a first come, first served basis - would raise numerous practical difficulties.

If the supply of CDM and JI credits reaches the 6% level, the pressure on companies to reduce emissions within the EU would be greatly reduced. The figure corresponds to well over 500 million tonnes of CO2 - roughly one-third of the EU's total emission reduction target under the Protocol.

Prospects for prices and volumes
Companies planning how to comply with their caps under the EU trading scheme face two related questions. First, is it credible that such a significant volume of credits could become available by 2012, the end of the second phase of the EU scheme? Second, what impact will credits have on the price of allowances in the EU emissions market? Clear answers to both questions are thin on the ground.

In background papers to the linking Directive, the Commission says that JI and CDM credits could reach 7% of the total quantity of allowances allocated. It goes on to claim that this would cut allowance prices from €26 per tonne of carbon dioxide equivalents (tCO2e) to less than €13/tCO2e. Ironically, this reduction is unlikely to be welcomed by those Member States, including the UK, which stand to become net sellers.

Market analysts are highly sceptical about the Commission's price forecasts. Evolution Market's Benedikt von Butler says 'they're a joke - it's basically impossible to predict prices even four years out, given all the uncertainties.' However, Point Carbon says that if imported credits reach the 6% level, prices could be cut by as much as 85% - a much more dramatic impact than foreseen by the Commission.

Both Evolution Markets and Point Carbon believe it highly unlikely that the 6% review level will be reached. They point out that volumes may be further restricted by the CDM Executive Board's tough line on environmental integrity (see below), and that buyers in Japan and Canada will also be competing for credits.

The view is borne out by data gathered by CDM Watch, an environmental organisation set up to scrutinise projects. So far, it is aware of 47 projects for which project design documents have been drawn up. More than half of the potential credits come from just eight projects in Brazil. The total is dominated by fuel switching and projects to capture non-CO2 greenhouse gases.

The total number of credits expected from these projects is 100 million tCO2e, mostly from fuel switching and projects to capture non-CO2 greenhouse gases. However, even if all the projects are approved, perhaps only half of the expected credits will become available by 2012 because the crediting lifetimes range from 7 to 21 years.

Other players have widely differing views of the potential for the CDM to generate significant volumes. Gareth Phillips of SGS, which hopes to become a validator for projects, believes that 'the CDM is going to really struggle... There will be a few tens of millions of tonnes of credits. For those who get involved at the right time and the right price, it could be useful.'

Pedro Moura Costa of Ecosecurities, a climate change consultancy and project developer, is much more optimistic about the potential. 'There is a lot of repressed supply waiting to participate in this market,' he says. 'There is the potential to come up with a vast number - we've already got 15 or 16 projects in our pipeline which could provide 100mtCO2.'

The prospect of healthy prices for credits in the EU emissions market may help to bring forward this repressed supply. So far, project developers have had to settle for perhaps $3-5/tCO2e. The low price - largely a consequence of the refusal of the USA, the main potential buyer, to sign up to the Kyoto Protocol - has done little to encourage high quality, 'additional' projects (see below).

But key barriers remain. Roon Osman, CDM specialist at Shell, says the lack of agreed international climate change commitments beyond 2012 puts considerable pressure on developers. 'There is no guaranteed market for credits generated after 2012 - they're of no use to anyone, let alone investors,' she says. 'You need to get your project up and running in the next couple of years to generate enough credits to make it worthwhile.'

Other barriers facing CDM developers include the lack of a registry and of accredited validators and verifiers to scrutinise baselines and monitoring data. Moreover, several potentially important host countries such as Thailand are proving reluctant to approve projects. Jason Anderson of CAN Europe says that 'a lot of developing countries are realising they aren't getting a very good deal. They're concerned about giving away their cheapest emission reduction opportunities for very little in return.'

Wrangles on additionality
Another key factor which will affect the availability of credits is the interpretation of the Protocol's rules on the thorny topic of 'additionality'. The Protocol says that credits or certified emission reductions (CERs) can only be awarded to CDM projects for 'reductions in emissions that are additional to any that would occur in the absence of the certified activity' - a simple principle, but one fiendishly difficult to apply in practice.

All project-based mechanisms face the inherent difficulty of knowing what would have happened in the absence of the project. Indeed, plans to allow projects in the UK emissions trading scheme ran aground largely because of the problems of identifying when savings are 'additional'.

The debate on additionality under the CDM has been raging for the best part of a decade - and more than any other issue exposes a gulf in perception between the NGO and business communities.

Developers fear that an unnecessarily strict approach to additionality will strangle the CDM by increasing bureaucracy and transaction costs. They are particularly opposed to so-called 'financial' or 'investment' additionality, which would require a developer to demonstrate that the project would not be financially viable without the extra revenue from the sale of credits. They argue that, for many large projects, the additional revenue is unlikely to tip the balance, especially when CER prices are so low. Others say that an investment additionality test is vulnerable to being adjusted to support any desired outcome.

In contrast, environmental groups fear that without a strict additionality test the CDM will lead to an increase in global emissions. They have criticised many early projects as mere relabelling of 'business as usual' activities.

Ben Pearson of CDM Watch says that the majority of the 47 projects it has assessed 'are either non-additional or their additionality is unproven by the documentation that they have provided... When we talk about bogus credits we're talking about [developed] countries avoiding their Kyoto commitments, that's the real issue.'

Shock for developers
Project developers thought they had won the battle in late 2001, when detailed rules on the CDM were agreed in the so-called Marrakesh accords. Most interpreted the accords as requiring only an 'environmental additionality' test, which would simply require them to show that the project offered lower emissions than a baseline scenario. This phrase was widely discussed in negotiations - but does not appear in the text itself.

In June, however, developers received a nasty shock. The CDM Executive Board withheld approval for all 14 of the initial baseline methodologies put before it.

Six developers were told that their methodologies may be accepted subject to recommended changes. But eight methodologies were rejected outright - in many cases because the Board was unhappy with the approach to additionality. Its methodology panel has also asked developers to avoid using the term 'environmental additionality'.

Hans Jurgen Stehr, chairman of the Executive Board, told ENDS that 'we take the Marrakesh accords seriously, it's our constitution... But if we're talking about additionality, it makes no sense if the project would take place anyway in the most likely baseline scenario.' He denied developers' claims that the Board is reintroducing an investment barrier test - although he noted that 'of course, that is one way to do it.'

Ben Pearson of CDM Watch commented: 'It is excellent that the Board are insisting on a credible additionality test... These decisions are crucial - the CDM works on a case-law basis so the first methodologies set precedents that other projects can use.'

CAN Europe agreed: 'Some project developers sent signals to the market early that there would be lax project approval criteria, and stuck to interpretations of the Marrakesh accords that were clearly self-serving.'

However, one leading project developer, who asked not to be named, told ENDS that 'the Board's ruling created tremendous disappointment. People have been working on these projects for over two years with no proper guidance, they were sticking their necks out. It seems there is no reward at all for being an early mover.'

Going Dutch
The Board's approach is a particular embarrassment to the World Bank and the Dutch Government. These have been the main movers in stimulating early CDM activity - and also the main targets for NGO criticism (see box below).

The Netherlands decided some years ago to meet half of its Kyoto target through imported credits. It expects the CDM to meet two-thirds of its total demand of 100mtCO2e. The centrepiece of Dutch policy was public procurement of credits from potential JI and CDM projects under its ERUPT and CERUPT tendering programmes at prices of €4-5/tCO2e.

One of the two CERUPT methodologies put before the Executive Board, for a hydro scheme in Costa Rica, was rejected. Both projects are now on hold. A spokeswoman for the Dutch Government said that 'all developers are now very scared and demotivated. They've spent a lot of energy - when we started our programme we expected the CDM life-cycle to take a year. It's turned out to be at least two years, and we haven't got any projects registered yet.'

'I'm very angry with the NGOs who are killing the CDM by pushing for financial additionality through the back door,' said Maurits Blanson Henkemans, manager of the Dutch emissions trading programme. 'We need the CDM to work to engage developing countries in the Kyoto process and get them on board for future commitment periods.'

In 2000, the World Bank set up a $180 million Prototype Carbon Fund (PCF) to buy CERs from up to 30 potential CDM projects, with the idea of taking on a large part of the project risk. It has now completed contracts for nine projects, and agreed terms for a total of $100 million.

The CDM Executive Board asked the World Bank to resubmit two methodologies - but rejected its methodology for a hydroelectric scheme in Guatemala which was seen as a test case for many other power projects.

The PCF's Chandra Shekhar Sinha insists that the World Bank's approach, which involves a dynamic baseline, is environmentally credible. He warned that investors in the PCF - which include six governments and 17 companies - 'are in real danger of losing their money if we can't get methodologies through.'

As well as the PCF, the bank is administering a range of CDM investment funds on behalf of several governments. This summer it launched a Community Development Carbon Fund, with $35 million from both public and private sector participants, to support small-scale projects in the least developed countries.

Eyes turn to non-CO2 gases
Some developers have retreated to lick their wounds, but many aim to resubmit methodologies to the Executive Board this autumn. The Board is under considerable pressure to approve the revised methodologies - and there is a chance that the current difficulties facing developers may dissolve over the next few months.

In late July, the Board approved the first two resubmitted methodologies. Crucially, these concern projects for the abatement of potent greenhouse gases such as HFCs and methane. The additionality test for these projects is relatively simple - there is little economic incentive to abate the gases without the CDM, and their high global warming potential makes it relatively easy to accumulate large numbers of CERs.

'Because end-of-pipe technology is so much easier on additionality, there is suddenly a huge interest in that type of project,' says Mr Sinha of the World Bank. 'So far we've been avoiding projects with industrial gases because they aren't very attractive in terms of wider sustainable development benefits.'

Jason Anderson of CAN Europe accepts that a shift towards industrial gases rather than additional renewable energy projects is 'a catch-22 for NGOs'. He also warns that the CDM may create perverse effects by discouraging developing nations from introducing regulatory standards for the abatement of industrial gases and landfill gas.

However, things are much trickier in the energy sector - widely seen as the main potential source of CDM projects. Developers need to find a way of demonstrating that their choice of fuel - be it renewable energy, biomass, gas or more efficient coal - represents a departure from business as usual. This is difficult to achieve without an assessment of relative fuel costs, patterns of recent and predicted developments in the host country and the economic case for the project.

Roon Osman of Shell says that the Executive Board is 'in a really difficult position'. However, she says that 'the next few decisions will be crucial as they will have to take a stance on a CO2-based energy project.'

Towards a Gold Standard?
In the meantime, NGOs are taking other steps to try to improve the environmental integrity of CDM projects. Over the past year, WWF has been working with other NGOs, academics and project developers to produce the 'Gold Standard' - a quality assurance scheme for CDM and JI projects.

WWF's Mark Kenber says the idea was formed after several large financial institutions approached NGOs for advice on how best to engage in the emerging greenhouse gas market.

'Businesses want to know how to manage risks, including the exposures attached to more controversial projects,' he says. 'At the same time, NGOs are looking for a vehicle to ensure projects that really do provide benefits actually get financed, rather than letting the market get swamped with free rider business-as-usual credits.'

The Gold Standard was developed with funding from the European Commission's Environment Directorate, and WWF is currently seeking formal endorsement from Climate Action Network and other NGOs.

The standard would be restricted to renewable energy and end use energy efficiency projects. Developers would need to pass an explicit additionality test and use the most conservative baseline. They must also use a set of environmental and social indicators to demonstrate the project's contribution to sustainable development.

WWF says its market research shows that at present projects capable of meeting the Gold Standard requirements are likely to account for just 10% of the CDM market. However, it claims that the standard could increase this proportion to 25%.

Mark Kenber says that CERs from Gold Standard projects may command a premium price in the market if buyers prefer them for reasons of corporate reputation. But he says that the standard may also help to reduce transaction costs by 'securing NGO buy-in in advance' - and that the tougher criteria on additionality will give investors greater assurance that the project will deliver the expected number of CERs.

Keeping it in-house
All of this uncertainty gives potential buyers of CERs plenty to chew on. If a company - or indeed a country - decides to rely on imported credits to meet its emission targets, it faces a significant risk that the CDM may struggle to meet the potential demand.

In light of this, says Benedikt von Butler of Evolution Markets, 'large multinationals with assets in developing countries, like BP, Shell, Heidelberg Cement and Lafarge, are looking to develop their own in-house CDM projects.'

Such companies are well placed to identify emission reduction opportunities on their own facilities, and also to understand energy markets in host countries. By controlling the whole CER supply chain, and potentially financing the project off balance sheet, they may be able to reduce many of the risks associated with delivery of CDM projects.

Shell has dipped its toes in the water with a small geothermal project in El Salvador contracted under the CERUPT programme. However, Roon Osman told ENDS that the company 'doesn't have many projects in the pipeline right now. We're waiting for some of the uncertainty to resolve itself.'

Mark Akhurst, BP's climate change manager, also expressed caution. 'Any CDM projects we look at developing are mainstream business opportunities for us,' he said. 'I can't see how the revenue stream from carbon credits would lead us to do any projects that are bad business.'

However, Mr Akhurst added, 'we're looking at a number of projects that are already in planning to see if they could be progressed as CDM projects.' Whether this approach will survive the CDM Executive Board's line on additionality remains to be seen.

Last year, BP's chief executive Sir John Browne suggested that the company wanted to gain credit for the sale of less carbon-intensive products. As anexample, he noted that BP is hoping to sell increasing quantities of liquefied natural gas to China and other countries - and suggested that it should receive credits for some of the associated reduction in CO2 emissions.

The prospects of large energy companies earning potentially huge quantities of CERs for selling gas to China goes right back to the heart of the debate about additionality and environmental integrity. Many observers would say that the move is a 'business as usual' commercial opportunity in its own right.

Mark Akhurst maintains that BP's use of the term 'credit' does not necessarily refer to CERs. Instead, the company is trying to develop an internal carbon accounting system to offset its own direct emissions against reductions arising from its efforts to shift to less carbon-intensive products. However, he could not rule out the prospect that BP may also claim CERs for selling gas to China.

On another level, the move towards emissions trading and project mechanisms is flushing out awkward questions about the interface with corporate environmental policies, targets and reports. Many large companies seek to apply the same environmental standards worldwide, and pride themselves on taking voluntary action.

Jason Anderson of CAN Europe says that all that may be about to change. 'Part of the problem with introducing a tradeable credit system is that suddenly everybody wants to claim credit for everything. It crowds out other good practice.'

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