Lessons from controversy (1)

The United Nations’ decision to deny a clutch of Chinese wind farms Clean Development Mechanism status has exposed structural failures in this carbon-cutting device, argue He Gang and Richard Morse.

China’s wind-power has expanded rapidly in recent years, almost doubling in size every 12 months since 2005. According to the Global Wind Energy Council, China had wind-power capacity of 25.1 gigawatts by the end of 2009. The Clean Development Mechanism (CDM) – the world’s leading carbon market and an important tool for the promotion of carbon cuts, climate protection and sustainable development – has played an important role in this growth. As of the end of 2009, 32% of China’s wind-power capacity was registered as CDM projects, with accumulated carbon cuts by 2012 predicted to be 82.5 million tonnes. 

As a result, China’s wind-power development has been held up as a model of successful CDM application, and these projects have become popular low-risk options in international carbon markets. But the CDM Executive Board’s (EB) recent refusal to grant CDM status to 14 wind-power projects in China has cast this success story into doubt. 

The refusal was caused by a debate over “additionality”: whether or not offsets from Chinese wind represent “real” emissions reductions beyond what would have occurred in the absence of the project.

In mid-2009, the EB’s 47th and 48th meetings found and considered uncertainties over power tariffs in the Project Design Documents (PDDs) of Chinese wind-power projects, in some cases requesting clarification or corrections. At the board’s 49th meeting, which took place in the run up to the Copenhagen climate-change conference, it rejected applications from 10 Chinese projects, causing deep concern among developers, project owners and even buyers, sellers and intermediaries. In 2010, the EB’s 52nd meeting saw two projects registered after clarification, but another six rejected.

At the centre of the controversy is the Chinese power tariff for wind, the most important factor in determining additionality. As more Chinese wind-power projects have applied for CDM support and the EB has gained more data, the board has observed that, in some provinces, the tariff has been falling. Former head of the EB Lex de Jonge indicated in an interview with market analysis Point Carbon that the EB was not clear if the Chinese were reducing the tariff to obtain CDM subsidies or if there was some other cause, and that he had therefore asked the developers to provide further information.

The EB decision set off a chain reaction. The International Emissions Trading Association (IETA) issued three open letters stating that this would increase market uncertainty and hence affect investment; and that the EB should raise these issues with the Chinese government – which sets the tariffs – rather than the developers. The IETA also complained about a lack of transparency and fairness in the EB’s decision-making process. It said that uncertainty over rules would impact on investment and that the EB had not fairly applied its own policies to China’s domestic policy.

The Chinese stakeholders also objected strongly. Representatives of China’s wind-power sector issued a statement describing the refusal as a “wrong signal that will seriously damage the enthusiasm and confidence of investors”. At Copenhagen, Chinese experts commented that “the EB is prejudiced against Chinese wind-power projects” and that the process that led to the refusals was opaque and unfair.

The issue is so important because it does not only affect Chinese wind farms. It could spread to other countries and project types, impacting on the overall credibility and stability of the CDM and international carbon markets. The crux of the debate – the difficulty of establishing additionality – may seriously wound the integrity of the CDM system itself if it is not examined and resolved.

CDM funding rules state that projects need to prove their additionality, a crucial CDM concept. The Kyoto Protocol establishes CDM as an emissions-reduction mechanism required to bring about “additional efforts to reduce emissions”. According to the Marrakesh Declaration, additionality exists when the emissions-reducing project can only take place with CDM funding. If the project would happen regardless, additionality cannot be demonstrated. 

Defining additionality is easy, but proving it is not. Currently, the core of the EB’s “Tool for the demonstration and assessment of additionality” judges it according to free-market profit logic, assuming that investment will go to projects with the highest internal rate of return (IRR), for example. Developers therefore need to show that, under the baseline scenario, the project does not provide the best rate of return, but that the CDM funds will make it the most competitive.

This set of IRR tools is based on a market economy and effective application requires two major conditions. First, the baseline used for comparison must be representative of the actual scenario in the host nation and be credible, stable and verifiable. Second, the IRR must be the main factor in investor decision-making – in other words, there must be a functioning market. And so these tools fail when applied to the reforming, complex and emerging wind-power sector we find in China. Some divergence in application from design is no surprise. However, it is regrettable that, when the desired results are not achieved, the response has been to criticise those applying it, rather than examining and improving the design of the mechanism itself.

The EB’s additionality tool is a standardised process used to determine if a project does or does not possess additionality. First, alternative scenarios are identified. For example, if the proposed wind power project is not built, what realistic and credible alternatives are available that can provide comparable service? Would a coal-power plant be built? Would another renewable source of energy be utilised? Or would more power from the existing grid be used? Legally or technically unfeasible projects are then filtered out to produce a list of possible alternatives for the host nation. 

Investment analysis is then used to compare the IRR of the project and its alternatives to decide if CDM funding support is required to attract investors. Investment analysis consists of simple cost analysis; investment-comparison analysis and benchmark analysis. This produces feasible alternative projects, which are used as a baseline. For wind-power projects, the aim of investment analysis is to eliminate situations where the project would be implemented without CDM.

But problems arise when this tool is applied in China, which is also the source of the current controversy. Our observation and analysis of the 143 wind-power PDDs registered by the EB up to the end of 2009 shows that almost none of these projects were compared with coal power, as government policy restricts construction of coal-fired power stations of less than 135 megawatts. It seems counter-intuitive that, in a market that is 80% coal-fired, wind power is not compared to coal. 

There may be several reasons for this. First, it may be difficult to obtain and calculate IRR data for coal-generated power, due to the scattered and complex nature of the coal market, generating technology and power-plant types. Second, even if IRR data was obtained, the sector is led by state-owned enterprises and not governed by profit – its goal is maintaining low electricity costs to ensure economic growth, social stability and energy security. 

IRR may therefore be extremely low and, where coal costs are high, may even be negative. If this is used as a baseline, some government-subsidised wind-power projects may look like more profitable investments, and are unlikely to pass additionality tests. The use of an electricity market which may have a negative IRR as baseline is clearly unreasonable. The current tools do not reflect or meet the demands of China’s complex coal-led power sector and electricity market.

That leaves baseline analysis. Most of these PDDs use as an industry baseline the 8% level set in 2002 in the “Temporary Method for Economic Evaluation of New Electricity Projects”. This has not changed in the five years since China’s first CDM wind-power project was built in 2006, presenting obvious flaws. There are no details of how this baseline was arrived at and, even if we assume it was a realistic figure at the time, the electricity market has in the last five years seen a series of reforms, including coal-market reform and restructuring of the electricity sector. 

With China maintaining annual economic growth of over 8%, it is hard to accept that profits from an investment project would remain unchanged for so long. So why do the PDDs still use it? Primarily it is a case of learning from others – since other projects have used this baseline and passed, why not re-use it? Secondly, with no better data around, it seems safer to use publicly available and reasonably authoritative figures.

These are flaws in implementing “additionality”. A more serious issue lies within the nature of additionality itself, which we call the “offsetter’s paradox”. CDM is an international offsetting mechanism that helps developed nations to reduce emissions at low cost while developing nations obtain the funds to develop low-carbon technology. But what looks like a win-win situation has a deep underlying problem: perverse incentives. In order to promote low-carbon technology such as renewable energy, developing nations need to apply stimulus policies such as special tariffs and renewable-energy quotas. But this makes proof of additionality harder and reduces the chances of CDM assistance. So what will be chosen – strong domestic policy, or the CDM? This puts certain countries in a quandary and fails to meet the international community’s aim of encouraging certain domestic policies.

To relieve this difficulty by reducing reliance on domestic policy, the EB introduced the E+/E- rule, which stipulates that regulatory changes at a national level should not be incorporated into baseline calculations if the regulation favours a less or a more emissions-intensive technology over the other. For example, any renewable-energy project that reduces emissions can be considered as possessing additionality. It is worth wondering why, in the controversy over China’s CDM wind-power projects, the EB has not been able to apply the E+/E- policy. Clearly, additionality is not an easy job.

He Gang and Richard Morse are research associates at Stanford University’s Program on Energy and Sustainable Development.

This is a summary of the full report, “Making offsets work in developing countries: lessons from Chinese wind controversy”, published by Stanford University Program on Energy and Sustainable Development.

PART2Addressing design flaws

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