The China Carbon Forum 2008 was held at the Renaissance Capital Hotel in Beijing on October 15 and 16. The Green Leap Forward was on site to measure the pulse of China’s carbon markets, but did not leave terribly optimistic. In truth, the speakers at the forum did a good job of highlighting a lot of the problems facing carbon markets, but offered little in the way of solutions. We start first, though, with a primer on carbon markets, but if you are already a pro, skip ahead over this introductory section.
Carbon Markets 101
It is useful to think of the carbon markets as being divided into the primary markets and secondary markets. In the primary markets, carbon credits are generated through the development of energy, forestry, agricultural or other related projects that reduce greenhouse gas (GHG) emissions compared to a baseline. The most common way such credits are generated is through the Clean Development Mechanism (CDM), a project development framework governed by the Kyoto Protocol which was crafted to allow developed countries to meet part of their emission reduction obligations by purchasing carbon credits called “Certified Emissions Reductions”(CERs) generated by CDM projects in developing countries that have no such obligations, while at the same time providing a carrot for such developing countries to participate in sustinable development activities.
Sometimes, the foreign purchaser of the credits, or even some other foreign entity, may take an equity stake in the CDM project. In China, however, no foreign entity may take a majority stake in a CDM project, a rule frustrates foreign developers. The CDM regime is governed by a complex body of rules, as the volume of this online CDM Rulebook indicates. Another much less used alternative to the CDM is the Joint Implementation scheme, whereby developed countries can make similar investments into other fellow-developed countries to purchase carbon credits called “Emission Reduction Units” (ERUs).
Outside of the Kyoto framework, projects modeled upon CDM and JI have emerged within a voluntary framework as an important source of carbon credits called “Verified Emissions Reductions” or “Voluntary Emissions Reductions” (VERS). VERs are rising in importance for two basic reasons. First, the complexity of the CDM approval process, which typically take 12 to 18 months, and sometimes even longer, have created a huge administrative bottleneck. Indeed, Akhiro Kuroki, a member of the Executive Board (EB), the body in Bonn, Germany that reviews CDM applications after they have been approved at the national level of the project’s host country, told the audience of the forum that 70% of new applications can expect to experience a one to two month delay in getting reviewed at the EB, while the remaining 30% can expect as long as a five to six month delay.
Second, there is some uncertainty as to what extent CDM and JI will be continue in the successor regime to the Kyoto Protocol, which expires in 2012. In the worst case scenario, negotiations collapse and Kyoto expires without heir, allowing the void created by CERs and ERUs to be replaced with VERs, the issuance of which is not administered by any central body like CERs and ERUs are, but are instead governed by certain best practices. Thus, the creation of VERs is a more flexible and streamlined process. But because the VER regime is less regulated, leaving their robustness of bona fide emissions reductions questioned, VERs usually sell for a discount compared to CERs/ERUs.
The secondary carbon markets are where these CERs, ERUs or even VERs are bought and sold after the initial sale transaction at the project (primary) level. There are already a few secondary carbon markets in place. The biggest is the EU Emissions Trading Scheme (EU-ETS), which is a beneficiary of the mandatory compliance to emissions reduction obligations as a result of EU members binding themselves to the Kyoto Protocol. In North America, where the U.S. has not ratified the Kyoto Protocol, a more fragmented pattern of exchanges have emerged, with the Chicago Climate Exchange first being established as a voluntary exchange amongst corporations, while exchanges in California and the Northeast are now being started as a result of state and regional legislation. As for Asia, readers of this blog will already be familiar of ongoing efforts underway in Singapore, Hong Kong and various other cities in China to establish carbon exchanges (see prior post). An international effort to integrate all these disparate exchanges into a harmonized global cap-and-trade system is being undertaken by the International Carbon Action Partnership.
Who would buy credits on a secondary market? Parties seeking to offset their own emissions so as to comply with their obligations under Kyoto, also known as “compliance buyers,”may want to purchase credits on these carbon exchanges if they have not been able to participate in the primary market. Another class of buyers are the liquidity providers, or as some might term in less flattering terms, speculators. These group of carbon traders participate in the carbon market to “buy low and sell high”and profit from the price volatility of carbon permits. As in the case of equity securities in the stock market, prices of carbon permits on secondary market tend to be more expensive than those originating from the primary market.
The following is not meant to highlight the more interesting points raised in the two-day forum rather than to serve as a comprehensive summary of the forum’s events. [GLF note: Any mispresentations of speaker's viewpoints is purely the fault of the author of this blog. Apologies in advance.]
CDM Capital of the World
The raw numbers make clear that China is the CDM capital of the world. Of the 1,184 CDM projects that have been approved and registered by the EB, 281, representing 23.7%, are from China. While this is second to India at 358 projects (30.2%), China’s projects account for 52.7% of expected CER volume, far and above India which comes in second at 13.7%. According to Akhiro Kuroki, a member of the EB who was speaking at the forum, a look at the CER pipeline of projects pending approval puts China at a whopping 70% market share.
A Question of Quality
One of the criticisms of the CDM application process is that approval standards have been rather lenient. Indeed, it was only [recently] that the first Chinese CDM application was denied by the EB. This rejection is being construed by carbon analysts as a sign that the EB is ready to raise the bar on CDM project proposals that pass through their desk. The is an important warning for Chinese authors of CDM applications, which was criticized at the forum by Gao Guangsheng, Director of the Office of National Coordination Committee on Climate Change at the NDRC, for their low quality, lack of thoroughness, and adopting a “copy-and-paste” approach of drafting new project proposals from existing precedent documents. But Mr. Gao was candid and balanced about NDRC’s own shortcomings in sometimes providing less than accurate advice to project applicants and that its own approvals standards have sometimes been lax. Mr. Gao added that the NDRC will be issuing new national regulations on the operations of CDM projects soon. Clearly, the institutional capacity in China has been struggling to keep pace with China’s preeminence in the CDM market.
With regards to developing secondary markets for carbon trading in China, Mr. Gao of the NDRC was remarkably cool about the idea, asserting that “conditions were not mature” enough and that the appropriate capacities were not in place for carbon trading to be transacted. Further, he reasoned that since China is not bound by any emissions reduction targets under the Kyoto Protocol, nor are Chinese entities required to directly limit carbon emissions by domestic law, there is no demand for carbon credits domestically, creating uncertainty for the need of domestic carbon exchanges. These statements by Mr. Gao are curious for at least two reasons.
First, as readers of this blog will know, there have been across various Chinese cities a flurry of announced openings of emissions rights exchanges with plans to transact carbon emissions trading once regulatory approval is granted. All these exchanges (in Beijing, Tianjin, Shanghai and even Changsha, Hunan) have some governmental support or another. This press release even suggest that the China Beijing Environmental Exchange will work with the NDRC to develop its products. Second, the lack of domestic demand for carbon credits does not obviate the role of an exchange to facilitate transactions between domestic and foreign entities or among foreign entities themselves. Just as the New York Stock Exchange lists the securities of many non-US companies, there is no reason why a carbon exchange in say, Beijing, could not list carbon credits generated in, say, Indonesia, for trading. If Mr. Gao‘s views represent the official NDRC stance, then obviously such a view as been a minority one as far as the State Council is concern, which has lent support to the Tianjin exchange, just by way of example. Yet, it could be important for these nascent environmental exchanges to win over NDRC support as some sources tell The Green Leap Forward that NDRC permission is needed for any sort of carbon trading to be carried out.
Yet Another Climate Exchange
Speaking of nascent exchanges, The Green Leap Forward was surpised to learn of the existence of yet another climate exchange called the Green China Exchange (GCX or 绿色中国环境权益网), which set up an informational booth right outside the conference hall. Details on its website and promotional materials are scarce and the one marketing agent that The Green Leap Forward spoke to was rather evasive of questions put forth. What is known is that the GCX, based in Beijing, claims to have opened in July of this year (even before the announced openings of the other Beijing exchange and the Shanghai exchange, both in August), will concentrate solely on CO2 emissions trading and plans to kick off, as its pilot program, a listing of some 100 CDM projects all based in the coal-intensive province of Shanxi through GCX’s partner organization called the Shanxi Lvliang Energy Saving and Emissions Reduction Center (SLCDM or 山西吕梁节能减排项目交易中心). Like all the other announced exchanges, when it will get the green light to commence carbon emission trading remains a waiting game.
ADB as Time Machines
Yao Xianbin, a Director General at the Asian Development Bank (ADB) explained the unique role of ADB in helping project developers manage the timing risk of carbon credit revenue. Essentially, Mr. Yao made the point that because CERs abide to a “payment-on-delivery”system, CDM financing cannot be used as a form of project financing; it merely contributes to revenue after the project is developed and is in operation. What ADB does is act as a financing intermediary, offering to finance a project at the project development phase in return for the carbon credit revenue that is generated later on in the project life cycle. This time-shifitng mechanism allows project developers to use CDM financing as a project financing tool and may help marginal projects become viable. The ADB, in turn, manages its risks (the obvious one being the scenario where the carbon credit revenue generated later fails to measure up to the upfront financing it provides) by participating in good projects after a vigorous due diligence process.
Interestingly, a dose of fire was added to the forum a few speakers later when Zheng Kexin of the Shanxi CDM Center passionately criticized multilateral agencies such as ADB and the World Bank for attaching too many onerous conditions to their aid.
It was clear from the speeches as a whole that the CDM remains a work in progress. It is the general feeling that CDM will continue to be a key feature of a post-2012 climate regime, but that innovations on methodologies and institutional capacity are needed to keep pace with conditions on the ground. Mr. Magnis Gislev, First Secretary for Environment at the European Commission Delegation to China stated that in looking ahead to a post-2012 regime, the EU‘s official position is to push for developing countries to move away from the carbon offset approach (i.e. CDM) and towards binding certain high carbon sectors, such as the steel or cement industry, to hard emissions caps. This approach is viewed as a robust alternative to binding developing countries such as China to wholesale emission reduction targets that the developed country signatories to the Kyoto Protocol are currently bound to.
Mr. Kuroki of the EB would provide additional flexibility, envisioning a hybrid secotoral-cap-and-CDM approach whereby emission caps are set on a sector basis and any projects that result in reductions below the cap automatically meet the additionality test, which has been the core principle governing the validity of CDM projects. This approach is also dubbed the “portfolio approach” and is supported by Ken Newcombe, the founder of the World Bank’s carbon finance unit and now of Goldman Sachs.
A Dissenting View
Taking a step back, however, it is clear that the complexities of the primary and secondary carbon markets have taken a life of their own. The Green Leap Forward left the China Carbon Forum with more questions rather than answers about how well carbon markets were really working. One needs to seriously question, and Mr. Zheng of the Shanxi CDM Center was one of few at the forum that outspokenly did, if the environmental benefits of CDM truly outweigh the costs. In terms of climate regulation, the free marketeers have, for now, won out the battle of ideas, introducing so-called “market-based instruments” such as emissions trading (complemented with CDM/JI), charging that alternative policy tools such as carbon taxes are blunt, inefficient and are create environmental uncertainty because emissions quotas are not set as they are in a cap-and-trade system. Emissions trading, its proponents argue, not only set a hard cap, but also allow parties to determine for themselves, whether it is cheaper to cut emissions, or to purchase emission credits in the market, so the efficiency argument goes. Such arguments are fine and good, as long as the transaction costs are low and information is transparent.
In reality, the transaction costs in the carbon markets, both primary and secondary, have proven to be enormous, at least is this early going. Think of the time it takes to get projects approved, and the lawyers, engineers and consultants that have to be paid, and the uncertainty of validation and issuance in the carbon credits, just to name a few challenges. Information asymmetries have also been the norm rather than exception. And the so-called “hard caps” are anything but hard; “carbon leakage” is a serious problem where validation of claimed emissions reductions in CDM projects have remained an administrative challenge.
While the sustainable development projects that CDM has promoted in the developing world is undeniably success story, it is the opinion of The Green Leap Forward that carbon market proponents have not met their burden of proof with respect to the claim that a cap-and-trade system is more effective than a straight-up carbon tax. In our last post, Stanford University’s David Victor expressed his skepticism on the ability of emissions markets to send the proper price signals to emitters to switch to cleaner modes of production and voiced support for a carbon-tax, which is so much simpler to administer and sends a clearer price signal. Such taxes is also easily adjustable so as to allow policy makers to achieve a desired amount of emissions based on proper monitoring. It is of course crucial that the government plough back these collected tax dollars to environmental and clean energy initiatives.
It should come to no surprise that the advocates of market-based systems hail from the private sector, for it is the private sector will directly gain from fees generated in market-based transactions that require brokers, consultants and exchange platforms. These private sector stakeholders would not benefit in a regime of a carbon tax, where the money all flows straight to the government. Free marketeers will insist that these are still early days and in time, transaction costs will fall and information asymmetries dissolve.
The problem is, how much time do we need for that to happen? When scientists are now telling us that we have 50 years to cut carbon emissions by 50 to 80% (depending on who you ask) to avert climate disaster, it is clear that we need clear and forceful actions today, and results quickly. It was thus heartening to hear Su Ming, the Deputy Director of the Fund Research Center of the Ministry of Finance, say at the forum that the central government is carefully studying the possible implementation of consumption-based VAT taxes (in addition to the production-based VAT taxes already in place), resource extraction taxes, environmental pollution taxes, carbon taxes, and environmentally-friendly government procurement schemes. (See also a previous post under sub-header “Green Taxes”.)
The battle of ideas, it seems, is far from over.