Carbon finance and the new economy

As delegates meet in Poznan for international climate-change talks, Steven Gray argues that carbon trading could play a positive role in a new deal on global warming.

The climate-change community is now gathered for a meeting in Poznan, Poland, which serves as a bridge between Bali and Copenhagen on the road towards a international agreement for addressing global warming. Government officials, business people, environmental and development NGOs from all over the world are attending the two-week session.

Climate science is compelling and the situation critical: the Intergovernmental Panel on Climate Change (IPCC) indicates that for an atmospheric carbon dioxide (CO2) concentration of 445 to 490 parts-per-million (ppm), resulting in a “best estimate” temperature increase of 2.0 to 2.4˚C, global emissions have to peak before 2015 and decline by 50% to 85% by 2050 from 2000 levels. This level of ambition is needed to avoid “dangerous levels” of CO2 concentrations that could lead to serious consequences for humanity. The challenge is clear: any effort should be led by all developed nations — which have historically emitted the most — rather than just the European Union (EU), which has been largely alone in seeking to implement its Kyoto Protocol targets.

In the context of international negotiations, one of the multiple issues that need to be balanced is achieving an agreement that is perceived as both differentiated and fair. The framework of the climate-change regime is anchored to the principle of “common but differentiated responsibilities” [pdf] towards climate change and the recognition of different national circumstances and capabilities. These are equity-based principles which, applied to a contemporary international community that is evermore heterogeneous, call for differentiation between countries in terms of mitigation and adaptation activities.

At the same time, countries taking emissions reduction targets in a future agreement have to respond to national constituencies that are concerned with international competition. In light of other countries not having caps, energy intensive industries in these countries perceive emission caps as a commercial disadvantage. Solutions to competition concerns always push toward creating a level regulatory playing field.

The principle of “common but differentiated responsibilities and respective capabilities” can be interpreted to require greater differentiation: just as OECD countries have different responsibilities and capabilities compared with China, so China has different responsibilities and capabilities compared with sub-Saharan Africa. The most commonly cited bases for differentiation are emissions per capita, GDP per capita and historic responsibility for atmospheric concentrations for greenhouse gases. These metrics suggest a greater contribution from countries like Korea, Singapore and Mexico. However, US opinion formers tend to focus more on absolute emissions levels, rather than per capita or historic metrics, highlighting the important role of large developing countries like China.

How do we move to a low- or zero-carbon economy? We need to do this at scale, and as soon as possible. But who will pay?

The key elements of a post-2012 climate-change regime identified in the Bali Action Plan are: emission mitigation actions, adaptation to climate change, technology transfer, addressing emissions from deforestation and financial flows.

The Kyoto Protocol created the possibility of emissions trading between countries with a mitigation target. Countries have then designed national trading schemes to pass down the obligation to polluters in their jurisdiction and create the incentives for private capital to go out and find the most economically efficient reductions. The leader has been Europe, in designing an EU-wide emissions trading scheme that has effectively created the carbon market. Other developed countries like South Korea, New Zealand, Japan and Australia are also in the process of designing national trading schemes as a tool for complying with their national emissions reduction targets. Unilaterally the US is also debating the elements for a nationally binding cap and trade system.

The Kyoto Protocol allows for certified emissions reductions (CERs) from approved Clean Development Mechanism (CDM) project activities in developing countries to be used for compliance by developed countries. This allows for flexibility in a cap-and-trade scheme and guarantees that emissions reductions are tackled in an economically efficient manner.

The World Bank’s latest report on the subject, State and trends of the Carbon Market 2008[pdf], estimates that there has been US$7.9 billion invested in projects under the Kyoto Protocol between 2006 and 2007. Transactions around the EU emissions trading scheme were worth US$50 billion. This is a great achievement for carbon finance given that the Protocol only came into force in 2005.

This implies that if the right signals are given by governments, the private sector has the capacity and incentive to move fast. As stated previously, the challenge is scale and urgency. Sir Nicholas Stern, in the Stern Review and Key Elements of a Global Deal on Climate Change[pdf], acknowledged the power of a cap-and-trade scheme and estimated that it should be used to generate significant financial flows to developing countries, of around US$20 billion to $75 billion per year in 2020 and US$50 billion to $100 billion per year by 2030.

So, how does carbon finance need to evolve in order to play a significant role in the move towards a low-carbon economy?

Carbon finance is technologically impartial by nature. It creates the incentive for private investment to go out and look for the most cost-effective emissions reductions. Currently the United Nations Framework Convention on Climate Change (UNFCCC) expects that CDM projects in the pipeline will produce 2.7 billion certified emission reductions (CERs) by 2012. Thus far, 1,253 projects have been registered and it is expected that they will deliver 1.3 billion CERs by 2012.

The concept of “additionality” is fundamental for guaranteeing environmental integrity of the system. The additionality test consists of proving that the project in question would have not happen without the CDM. Additionality thus far has to be demonstrated by each and every project before it is registered (approved) by the UN. Although there is guidance on how to carry out the “additionality test” it is still a rather subjective exercise and in many cases difficult to document rigorously.

The above, together with unclear and slow administrative due process and an insufficient institutional design, has allowed for critics of the CDM to question its integrity and call for its reform. Some critics of the CDM maintain that its rules are too complex, that they change too often and that the process results in excessively high transaction costs. Other critics question whether certain projects are truly additional, or whether the CDM can create perverse incentives.

What is evident is that the efficiency of the CDM needs addressing. The system has recognised this and is addressing the problem. Parties at the international negotiations are trying to address immediate governance issues that can directly help to deal with some of the problems.

There are different proposals with regard to a more substantive reform of the CDM. The fact is that the CDM, with all its achievements, has not reached all sectors. Within the current system the following sectors have not benefited from emissions reduction projects: energy distribution, energy demand reduction, chemical industry, construction sector, transport, metal production solvent use, as well as afforestation and reforestation activities. Geographic distribution of the CDM is also a major problem. Thus far China, India, Brazil and Mexico account for 74.49% of CDM projects.

One of the main constraints around CDM projects comes from the way in which additionality has been defined. There are different proposals for the system to evolve from the current use of project additionality, to an emissions reduction additionality approach.

Some recommend a move towards a standardised baseline approach, where benchmarks (for sector or programme baselines) would apply to project types. Transparently set, reliable baselines that are below business-as-usual for specific sectors can provide emissions additionality, helping overcome the current constraints and difficulty of ensuring project additionality. This approach would simply require entities implementing projects to demonstrate that emissions reductions are occurring below the set baseline.

A fundamental aspect is to create a dynamic system that will reward early movers and regulate the low-cost reductions out of the system (through a combination of domestic and international regulation) so that carbon finance can move up the abatement curve, not financing end-of-pipe solutions for decades.

The idea is really to evolve the CDM and carbon finance into a more dynamic system to enable large-scale sectoral programmes. Once technology has penetrated a specific sector, other policies should be implemented to facilitate carbon finance reaching other sectors and technologies. In this context, carbon finance can help pay for structural change in sectors and function as a policy catalyser.

There are, however, some barriers to the implementation of standardised baselines. Data is a major barrier: accurate historical emissions data and projections of growth will be fundamental to guarantee environmental integrity. The design of institutions to govern and supervise the system is also critical. Governments need to ensure that when they design the system they do not disengage the private sector. At the national level, governments have to start as soon as possible to overcome these barriers and implement policies that will create an environment where carbon finance and other complementary approaches may develop. 

As negotiations get underway at Poznan, mitigation is one of the building blocks and carbon finance one of the many tools to help us achieve our ambition. At the end of 2009, developed countries, the United States included, will need to come up with a long-term target and intermediate steps on how to get there. Developing countries will also have to contribute if we are to save the planet. The challenge is daunting and complex, but if everyone is willing to play a role there is hope.

Steven Gray is an associate at Climate Change Capital

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