Beyond 2012

One of the key successes of the European Union Emissions Trading Scheme (EU ETS) has been to drive momentum to the Clean Development Mechanism (CDM). Providing regular annual demand for CDM credits has given project developers a relatively stable and predictable slice of annual demand on which to base their investment decisions.

By contrast, government demand for CERs may occur at any point from now until 2015 when the final Kyoto true up period occurs obliging countries to surrender credits equivalent to their emissions over 2008-2012. Given this disparity in the frequency of CER demand between the government and EU ETS sectors, the EU ETS has become the key market for CERs. Therefore, it has been with some trepidation that the CDM community has been watching the negotiations around Phase III (2013-2020) of the EU ETS.

Emission reductions targets

The broad post-2012 approach, advocated by the European Commission (EC), sets two emissions reduction targets for the European Union (EU); a 20% reduction against 1990 emissions levels in the absence of an international agreement, and a 30% reduction in the presence of an international agreement with no clear cut-off point for when the target has to be reached. Member States (MS) in the form of the Council of Ministers and European Parliament subsequently approved this approach.

Volume of CERs/ERUs allowed

One of the key features of last year's European negotiations around Phase III was the heated debate in the European Parliament that revolved around the use of CERs. In Phase II of the EU ETS (2008-2012) the use of CERs by industrial installations is capped at 270 megatonnes/year (Mt/year). For Phase III, under the 20% pathway, the limit for existing installations is somewhere in the region of 40Mt/year and under the 30% pathway it is even harder to get an exact figure but seems to be approximately 120Mt/year.

Political spin

The import limits represent a substantial reversal from the EC's previous commitment to CDM. In response to questions about the use of CERs post-2012, the EC will respond that the import limit is 1.7 billion tonnes. This is correct if you count from 2008-2020 but disingenuous in response to questions about the Phase III import limit. This figure has been calculated by taking the annual Phase II (2008-2012) CER import limit of 270Mt and aggregating it for the whole of Phase II to circa 1.4 billion tonnes, aggregating the circa 40Mt figure over 2013-2020 and then adding them together to arrive at 1.7 billion tonnes.

However, the actual figure for Phase III CER imports is more in the region of 300Mt in total. The developing world is gradually waking up to the fact that the EC is apparently attempting to pull the wool over their eyes in this fashion. This cannot be a helpful contribution for building trust in Europe's commitment to the new trading mechanisms that it will attempt to negotiate at the climate change talks in Copenhagen in December this year.

Implications for investment

For investment in the CDM, this sends a very clear signal - Europe is no longer a significant future market. The reversal in position coupled with current depressed CER prices means the previous Eurocentric momentum of the primary CDM market is rapidly falling away.

Potential solutions

Unless CDM host countries form an alliance to reverse Europe's position at Copenhagen there is little prospect of the CDM import limits improving. If this were to happen, the US would likely take over from Europe as the hub of global emissions trading. The latest version of the US Congress' Waxman/Markey bill allowed for the import of some 800Mt/year of 'international offsets'. The bill introduces a discount rate on international offsets of 1.25, where 1.25 CERs or other international offsets would be worth 1.00 US domestic unit. The discount rate coupled with the US' unwillingness to pay for offsets will steer the US market towards high-volume, low-cost projects, such as industrial gas projects or forestry, rather than smaller scale renewable energy projects that have clearer developmental benefits.

Qualitative limits

In addition to drastically restricting the CER import limit, the amended EU ETS regulations also restrict the type of CERs that can be used. Currently the key restriction is that projects registered post-2012 are only eligible if they are in what the UN defines as a 'least developed country' (LDC). The key abatement opportunities in LDCs lie in the land use, land use change and forestry (LULUCF) sectors. The EC has already banned these credit types from use in the EU ETS so there is little prospect of the apparent largesse towards them bearing any dividends.

Comitology

In addition to the restrictions outlined, there will be further restrictions on the types of CERs that can be used via a process called comitology. Comitology is a regulatory process whereby a committee chaired by the EC decides on standards. In the case of the CDM, the committee is free to ban CERs from the EU ETS in Phase III on any grounds, whether it be project type, host country, and so on.

The prime candidate for being banned from use in the EU ETS are CERs from waste Hydro Flouro Carbon (HFC) destruction projects. In the event that a project type is banned, the CERs are usable for a grace period of 6 months to 3 years. The 6-month to 3-year margin appears to have been arrived at randomly and which end of the spectrum the grace period falls at is entirely at the discretion of the committee.

Large hydro-projects, which have also been a source of considerable controversy, will in all likelihood not be banned but a currently voluntary EU standard will probably be made arbitrary. However, projects that fall outside of this standard will have their market removed and projects that fall inside will benefit from the increased certainty.

Economic efficiency versus political aims

To steal a German phrase, the CDM has always been an egg-laying woolly milk sow. The CDM is designed to: ensure economic efficiency by locating the cheapest available emissions reductions opportunities; promote sustainable development; encourage the transfer and development of new and innovative technologies; build climate change capacity in the developing world; engage the developing world in the fight against climate change; and transfer capital from the developed to the developing world. Remarkably, given its short lifespan, all of these objectives have been achieved to varying degrees.

The qualitative restrictions currently being imposed by the EC run counter to the aim of economic efficiency. HFC is the cheapest abatement opportunity available. The fact that HFC projects have drawn so much flak suggests that, contrary to public declarations, economic efficiency is at best a secondary political consideration. This is highly significant as the CDM and indeed all emissions trading systems are politically created and driven systems. In the absence of political motivation, demand will dry up, as it has with the CDM in Phase III.

The EC is currently proposing some novel solutions to run alongside the CDM post-2012. However the details are sketchy and seemingly mutable depending on the inclination of their audience. For a greatly needed second wave of investment to reach the developing world, the EC must decide and clearly articulate what it wants emissions trading and offsetting to achieve, how it can be achieved, whether it be restricting projects to particular types or locations, and then stick to its words. Making up policy on the hoof as has been done with CER-import limits from Phases II to III - and now appears to be happening on the road to Copenhagen - undermines investor confidence, which in ordinary circumstances will starve the fight against climate change of vital private capital. In a global recession it will be disastrous.

Miles Austin, head of European regulatory affairs at EcoSecurities

Email: [email protected].

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