Carbon Markets or Climate Finance?

Low Carbon and Adaptation Investment Choices for the Developing World

Axel Michaelowa

• Publisher: Taylor & Francis
• Year: 2012
• Print ISBN: 9781849714747
• eBook ISBN: 9781136471254
• Edition: 1
• Topic: Economics
• Subtopic: Sustainability in Business
• Index: Economics

This book builds on a decade-long experience with mechanisms provided by the Kyoto Protocol and the UN Framework Convention on Climate Change. It discusses the challenges of climate finance in the context of the post-Copenhagen negotiations and provides a long-term outlook of how climate finance in developing countries could develop. Written by climate finance experts from academia, carbon finance businesses and international organisations, the book provides background, firsthand insights, case studies and analysis into the complex subject area of climate finance.

1 The Clean Development
Mechanism gold rush

Axel Michaelowa and Jorund Buen

1 The CDM: from Cinderella to fairy princess

The Clean Development Mechanism (CDM) is the only market mechanism of the Kyoto Protocol that involves developing countries without emissions commitments.¹ It allows emissions mitigation projects in those countries to generate emissions credits – the so-called Certified Emission Reductions (CERs) – that can be used by industrialized countries to fulfil their Kyoto targets. After a slow start related to the set-up of the institutions required to approve projects on the international and host country levels between 1997 and 2005, the CDM has become a resounding numerical success. Since late 2003, when the first project was formally registered by the CDM Executive Board (CDM EB), over 3,000 projects have been registered. Another 3,000 projects are on their way towards registration and each month more than 100 new projects are submitted (Figure 1.1).

Since 2006, many observers have forecast an imminent downturn in the number of new projects entering the CDM pipeline. Reasons for this expectation were the reduction in pre-2013 crediting time of projects and the impact of the 2008 economic crisis; also, since the failure of the Copenhagen conference in late 2009, there has been general uncertainty about the future of international climate policy. However, the inflow of projects in the validation pipeline remains stubbornly high and has even been increasing to new peaks.

Figure 1.1 Inflow of projects in the CDM pipeline until July 2011 (numbers per month) (source: own illustration based on UNEP Riso Centre 2011a).

This resilience could be due to four main reasons, as well as two minor reasons. The first major one would be the fact that now in all large CDM host countries, there is a wealth of consultancies who have made a good living by identifying CDM projects, and who continue to ‘unearth’ renewables and energy-efficiency projects. While in 2005 and 2006, only a few bold and risk-loving enterprises got involved in the new markets in India, China and Brazil, in 2009 any modern entrepreneur in advanced developing countries takes the CDM seriously.

The second main trend is that China and India continue to provide attractive subsidies to renewable energy, with a continuously growing domestic manufacturing capacity, especially for wind power (see Chapter 3 for more details on wind in China). These subsidies make projects attractive but do not lead to rejections by the CDM regulators, because they do not have to be assessed in the determination of a project’s ‘additionality’, and they can be relatively easily financed in a unilateral way (see the discussion below). We have also seen a broadening of the host countries involved. Southeast Asia is progressing well, and even the Middle East is starting to discover the benefits of the CDM together with renewable-energy promotion programmes. Generally, the good experience with the CDM has bolstered trust that it has a bright future, even after the Copenhagen shock.

Third, a CDM project can be quite economically attractive even without CDM, as long as other options can be shown to be more attractive. The test to ensure that a CDM project is not common practice excludes other CDM projects, although CDM itself has become common practice for some project types in some areas (see the discussion about additionality, below). Hence, the lack of clarity on future CER demand does not necessarily mean a termination of all projects.

Fourth, although CER revenues do make projects more financially attractive and less financially risky to implement, prospective CER revenues are in most cases not taken into account in the financing of the underlying project (more detail on this follows below, as well as in Chapter 3), as the main outputs of most CDM projects started nowadays (bar some methane-reduction projects) is power or some other product or service, not CERs. Hence, if CER demand dwindles, the project may still be financially sound.

Fifth, project owners believe in additional demand emerging from other developed countries than EU member states and Australia, and see the voluntary market as a potential outlet for their carbon credits in the meantime. The sixth, more negative, interpretation of the current trend would be that we are seeing a last-minute rush to embark on CDM projects before the EU closes the door, as current EU legislation only allows CDM projects formally registered by the end of 2012 to continue exports into the EU. Only projects in least developed countries are exempt from this rule; its effects will be assessed below in more detail.

Over 80 host countries are participating in the CDM, and registered projects are forecasting a volume of almost three billion emission credits by the end of 2012. This is all the more surprising as in the late 1990s researchers foresaw that a project-based mechanism based on reductions in developing countries would not be attractive and would be sidelined by the other Kyoto Mechanisms – Joint Implementation (JI) and International Emissions Trading (IET).² Some (e.g. Haites 2000) thought that zero-cost ‘hot air’ sold through IET would dominate the market, whereas others (e.g. Black-Arbeláez 2003) felt that the CDM would be much too risky for investors, transaction costs of the international bureaucracy required would be prohibitive and host-country governments would stifle projects due to their hostile attitude towards the mechanism. However, in contrast to the CDM, these mechanisms have languished and only recently seen some activity (Figure 1.2).

Why did the CDM transform from an unwanted Cinderella to a fairy princess? Why is it now seen as the cornerstone of the global carbon market and its continuation supported by a large majority of countries even if there is no agreement on a second commitment period of the Kyoto Protocol? Which technologies and countries have benefited the most from CDM so far? How can it be upscaled and reformed?

2 What were the reasons for the CDM gold rush?

The CDM gold rush did not only have one cause. Several levers had to be pulled before the CDM could be unleashed. This did not happen at the same time and some actions were completely unexpected.

2.1 The EU emissions trading scheme and Japan as key demand
sources taking over from the World Bank and European governments

While the Kyoto Protocol specified that CERs could be used to comply with the emissions commitments of industrialized countries, initially demand was rather sluggish. The first institution to set-up a dedicated CER acquisition programme was the World Bank. We cover this in some detail below, as it may provide important lessons for future climate finance. The World Bank set-up a ‘Prototype Carbon Fund’ (PCF ) in 1999 with capital of US$180 million, subscribed to by six governments and 17 companies. The PCF understood itself as a trailblazer of global carbon markets and set out to develop a detailed framework for this. By October 2003, the PCF had signed seven CER purchase contracts totalling 7.8 million CERs and received 420 project ideas (PCF 2003).

Figure 1.2 Volume of new activity in the CDM, JI and IET by the end of 2010 (source: UNEP Riso Centre 2011a, 2011b for CDM and JI; Point Carbon 2011 for IET).

Note

Million tCO₂-e pre-2013 for CDM and JI, transaction volume for IET.

The Netherlands was the first country to embark on a coordinated CER acquisition strategy to cover 50 per cent of its estimated reduction target under Kyoto, i.e. 67 million CERs. In November 2001 it established a tender programme called CERUPT, supervised by the Ministry of Housing, Spatial Planning and the Environment. This programme used the experience of the ERUPT tenders for emission credits from JI projects that had been launched in 1999. In CERUPT’s terms of reference (Senter International 2001), maximum CER prices were specified and differentiated by project types. Non-biomass renewables would receive up to €5.5/CER, biomass and energy efficiency €4.4/CER and all other types €3.3/CER. The CERUPT contract also introduced the magical threshold of 100,000 CERs, from which a purchase contract would be seen as attractive. In 2002 two contracts with the World Bank Group – leading to the setting up of a dedicated carbon fund at both the World Bank and the International Finance Corporation – and one with the Andean Development Corporation CAF were signed, totalling 36 million CERs, while a contract of ten million CERs was signed with Rabobank (Netherlands Ministry of Housing, Spatial Planning and the Environment 2004). CERUPT selected 18 projects in March 2003 which were expected to generate 16 million CERs, and the World Bank contract was increased by five million CERs in 2004. CERUPT did pioneering work with respect to definition of baselines and project emissions calculation, as well as the legal form of emission reduction purchase agreements. In the wake of the Dutch acquisition programme, Finland, Austria and Sweden set-up similar, but much smaller programmes in 2003 and 2004.

The collaboration between the Netherlands and the World Bank led to a flurry of follow-up activities; between 2002 and 2005 several other Annex I countries, including Italy, Spain and Denmark followed (see Danish Energy Agency 2010 for an overview of the Danish programme). Between 2002 and 2004, the World Bank was dominating the demand side of the CDM market, and the price for CERs was actually determined by the World Bank offers, set at US$3–4/CER.

Had this situation persisted, the CDM would today probably have generated a few hundred projects and be seen as an offspring of development cooperation with limited relevance. Why did this change?

In a bold move by a small group of EU Commission officials, the attempt to introduce an EU-wide carbon tax was replaced by a move towards an EU-wide emission-trading system in 2000, with a view to get the system in place within five years. This had made surprisingly good headway by 2002 (see Skjaerseth and Wettestad 2010 for a good discussion), but industry lobbies had made it clear that they wanted a safety valve in case EU allowances were scarce. Thus, from late 2002 onwards, a ‘Linking Directive’ was prepared by the EU Commission, whose first draft leaked in June 2003. At that time it was already clear that the EU Emissions Trading Scheme (EU ETS) would have a first trading period from 2005 to 2007, followed by a second one covering the commitment period of the Kyoto Protocol (2008–2012). The draft did not accept CER use before 2008 and limited imports to 6 per cent of allocated EU allowances. After an outcry by industry, the final version entered into law in late 2004 (EU 2004) allowed CER use from 2005 and did not contain any quantitative import limitation. When, in 2004, the first forward prices for EU allowances were quoted at over €8, it led to an immediate upward pressure on CER prices; the further massive increase of the EU allowance price to reach up to €30 in July 2005 completely reshaped the CDM market, with companies covered by the EU ETS embarking on CER purchases. Michaelowa and Michaelowa (2010) discuss how the World Bank, due to its good relationships with developing country governments, initially could still sign CER purchase agreements below market prices. The main author of this chapter personally witnessed such a situation in Tunisia in February 2006, when the World Bank offered US$5.25/CER for a bundle of landfill gas recovery projects (ANGED and World Bank 2006) and pressurized officials to rapidly sign the contract, when the price paid by companies from the EU reached at least 50 per cent more. When asked today, the Tunisian officials regret having sold to the World Bank.

Ever since its introduction, the EU ETS has remained the key demand driver for CERs. Its introduction led to the emergence of a large number of carbon funds and other CER acquisition vehicles administered by private financial institutions. The CER price has always remained below the price for an EU allowance, except for the pre-2007 EU allowances, which could not be banked. During the February 2009 crisis, in which the EU allowance price plunged, primary CER prices for a short period remained at the same level as, or even above, the EU allowance price, but only a few CDM deals were concluded during this period. Generally, the price differential or ‘spread’ varies according to the perception of import possibilities and overall demand for CERs outside the EU (see Sikorski 2010 for a good discussion of the various factors influencing the spread).

The second largest demand driver after the EU ETS was Japan. Since the late 1990s, the government had lavishly subsidized more than 100 feasibility studies for offset projects in developing countries through the New Energy and Industrial Technology Development Organization (NEDO), with up to US$400,000 per study. In April 2005, the Japanese cabinet agreed to acquire at least 100 million t CO₂ through the Kyoto Mechanisms. The government acquisition programme was to be administered by NEDO. In the two financial years between March 2006 and 2008, NEDO acquired 23.1 million CERs. In 2005, the Japan Kyoto Mechanisms Acceleration Programme brought together a host of Japanese institutions to promote CDM and JI project development; the Ministry of Economy, Trade and Industry (METI) budgeted US$40 million, while the Ministry of Environment budgeted US$22 million. The Japanese industry federation, Keidanren, allowed member companies to use CERs to comply with their emission targets specified under the voluntary agreement specified in 1996 and to be reached in 2010. In contrast to voluntary agreements in other countries, this is taken very seriously; electric utilities planned to buy 120 million CERs, and steel companies 44 million thro...

Table of contents

• Front Cover
• Carbon Markets or Climate Finance?
• Routledge explorations in environmental economics
• Title Page
• Copyright
• Contents
• List of boxes
• List of figures
• List of tables
• Notes on contributors
• Preface: climate finance at the crossroads between market mechanisms and public funding vehicles
• Acknowledgements
• Acronyms and abbreviations
• 1 The Clean Development Mechanism gold rush
• 2 Development cooperation and climate change
• 3 How Brazil and China have financed industry development and energy secturity initiatives that support mitigation objectives
• 4 The Adaptation Fund
• 5 Fast-start finance
• 6 New market mechanisms for mitigation
• 7 Mobilizing mitigation policies in the South through a financing mix
• 8 Market mechanisms for adaptation
• 9 Harnessing the financial markets to leverage low-carbon technology diffusion
• 10 Climate finance and backstop technologies
• 11 Manoeuvring climate finance around the pitfalls
• Glossary
• Index