David Hone

Two recent publications highlight the challenges ahead in the multilateral process that continues to seek an equitable global approach to the issue of growing CO2 emissions. But comparing and contrasting them illustrates the contradictions that exist as negotiators attempt to maintain existing structures and work within the spirit of the Durban agreements.

Two weeks ago, a major report issued by the High Level Panel on the CDM Policy Dialogue recommended a very broad range of actions for stabilizing and reversing the ongoing price collapse in the CER market (Certified Emission Reduction, the carbon unit within the CDM), with a view of re-establishing the CDM as the cornerstone of the global carbon market and thereby kicking off a further round of emissions mitigation action.

This week, the Harvard Project on Climate Agreements issued a policy brief  which outlines the shape of the new paradigm that the UNFCCC process has hopefully entered following the creation of the Durban Platform for Enhanced Action at COP 17 last December. Their ambitious interpretation of the agreement sees the Berlin Mandate effectively consigned to history (which enshrined the notion that emission reduction was effectively the responsibility of developed countries and which led to the 95-0 vote on the Byrd-Hagel Resolution in the United States Senate) and a new order emerging which results in all countries acting to manage emissions. There is no doubt that the latter interpretation is the only one that makes sense, but only time will tell if this represents the new reality. The Harvard think piece ends with the challenge;

Having broken the old mold, a new one must be formed. A mandate for change exists. Governments around the world now need fresh, outside-of-the-box ideas, and they need those ideas over the next two to three years. This is a time for fundamentally new proposals for future international climate-policy architecture, not for incremental adjustments to the old pathway.  We trust that this call will be heard by a diverse set of universities, think tanks, and advocacy and interest groups around the world.

Rescuing the CDM as recommended by the Policy Dialogue is a laudable ambition, but perhaps falls into the category of “incremental adjustments to the old pathway” rather than “outside of the box ideas”. Conversely, the Policy Dialogue proposal is attempting to stave off the collapse of the very idea of “carbon markets” by rescuing the one global example of their application. While “out of the box” thinking is certainly welcome, it is also hard to argue that we are done with carbon pricing/markets and now need something new. In fact, carbon pricing remains core to the solution.

As such, we end up with the dichotomy of needing new ideas but not wanting to see the structures of the past slip through our fingers; but should we mind that they institutionalize some of the ideas within the Berlin Mandate?

The CDM was a bold idea when conceptualized in the Kyoto Protocol, starting with the simple phrase;

A clean development mechanism is hereby defined.

But has it reached its use-by date and should it be consigned to the dustbin along with the Berlin Mandate? Unfortunately the answer is both “yes” and “no”. It does represent an era of action and financing being the responsibility of developed countries only, which is no longer a tenable paradigm within which to operate. It was designed to help developed countries meet their mitigation goals and to channel funding from developed to developing countries for the purpose of sustainable development. Yet it did demonstrate a mechanism which allowed a broader range of actors to get involved in the carbon market than those immediately impacted by the cap on allowances. This has become a design feature of more recent cap-and -trade systems, albeit with home grown offset systems.

The solution for the CDM, both to rescue the market today and to prepare it for the “out of the box” solution of tomorrow, must be to disentangle it from the Kyoto Protocol and make it available as a general offset resource under the UNFCCC, perhaps even one that any nation could use when it wants to involve part of its economy in the market without actually applying a cap to it (such as the farming sector in Australia).

Considerable resource is required to establish an offset mechanism, both in design and operation. Reinventing this multiple times around the world hardly seems like the best use of government resources, but that is what is happening. Unshackling the CDM wasn’t discussed in the Policy Dialogue report, perhaps because it then enters into the complex realm of Kyoto Protocol politics. The closest it got to this was a proposal to broaden the use of CERs.

To unlock the full potential of the CDM, all countries should be enabled to use CERs, not only those with mitigation targets under the Kyoto Protocol.

But the Kyoto Protocol represents the Berlin Mandate and, according to the Harvard Project, the new paradigm is a world without such a legacy. It also makes little sense under the accounting rules of the Kyoto Protocol to have other parties dipping into that market when their compliance obligation may be governed by another system. This leaves only the more radical approach of decoupling the CDM from the Kyoto Protocol, but then following the recommendations of the Policy Dialogue to broaden its scope and expand its use.

This also takes the CDM into the world of another discussion, that of the New Market Mechanism. Under such an approach, the CDM could migrate to become the NMM, but for all nations to use within the design of their emission trading systems.

Late last week Point Carbon reported that the Executive Board of the UNFCCC’s Clean Development Mechanism has (re)agreed to allow energy efficient coal fired power plants to be included under the mechanism. Point Carbon said:

The governing body of the U.N’s Clean Development Mechanism (CDM) has agreed to allow the most energy efficient coal-fired power plants to earn carbon credits under the scheme, causing outcry from green groups who claim the carbon market could be overrun by millions of low-quality offsets. The CDM Executive Board’s decision to lift its ban that prevented coal plants from seeking credits could allow some 40 projects, mostly based in China and India, to earn Certified Emission Reductions (CERs).

The credits are awarded to projects that cut emissions of greenhouse gases and can be used by companies and governments to meet carbon reduction targets.

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The Board approved six coal plants for CDM registration before agreeing in November 2011 to suspend and review the methodology that outlines how many credits the schemes could earn, effectively stopping new projects from earning credits.

While it is always good to use a resource more efficiently, this move has potentially negative consequences for the very issue it is setting out to address, a reduction in the total emissions of CO2 to the atmosphere.

In this instance the CDM is not acting as a carbon pricing mechanism, rather it is simply incentivizing energy efficiency. In a recent paper written by a colleague (featured in a July posting), the secondary impacts of energy efficiency policy as a climate change response are explored. This particular action by the CDM Executive Board falls right into one of the problem areas.

The paper presented the argument that energy efficiency action on its own could actually result in an increase in CO2 emissions. The diagram below explains this. On the vertical axis is the cost of providing an energy service, such as electricity. At the margin, this may be driven by non-fossil provision operating within the economy, such as a wind farm or the like. On the horizontal axis is a measure of the available carbon resource base. As the price of non-carbon alternative energy rises or falls, so too does the long term availability of the fossil alternative for a given technology set. At high alternative prices, more money is available to spend on expanding the fossil resource and vice versa. As the fossil resource expands, the cumulative number of tonnes of CO2 emitted will also grow, even if it takes longer for this to happen.

Assuming a given alternative cost of providing electricity (p_non-fossil), the more efficient the power stations that burn coal, the more the electricity provider can ultimately afford to pay for the coal that is used. As more coal is used and the price rises (all other things being equal), so the resource base expands (from UC₁ to UC₂ in the figure above) and so does cumulative CO2 in the atmosphere. Further, as the CO2 issue is basically an atmospheric stock problem, this then drives up long term warming, even if the rate at which CO2 is emitted happens to fall in the short term.

From a climate finance perspective the CDM has been a successful mechanism, albeit with some significant operational difficulties. It has paved the way for carbon pricing in many countries and has been an important catalyst for change in some areas (e.g. landfill methane). But subsidizing more energy efficient coal fired power plants, while well intentioned, may in fact have negative environmental consequences. The CDM needs to act in its purest sense, which is as a carbon price in the energy system of true developing economies.

N.B. Just prior to posting this, a colleague noted that the Executive Board may have only allowed the issuance of CERS against already approved projects to proceed, rather than allowing future projects to apply by releasing the current hold on the underlying methodology. Hopefully this is the case, but in any case the argument still stands.

While much of the focus in the recent UNFCCC meeting in Bonn was on the protracted discussion around agenda and chair for the ADP (Ad-Hoc Working Group on the Durban Platform for Enhanced Action), some progress was made in other meeting rooms. On the middle Saturday a workshop was held for initial discussions around the call for a “New market Mechanism” (NMM). A report out from the workshop can be found here.

So far, the discussion on a NMM has tended to focus on the crediting of mitigation activities in developing countries, such as the role performed by the CDM. The talk is often about up-scaling rather than having an initial discussion about the market conditions necessary for crediting to be effective or alternatively to ask what a market mechanism actually is. For some, the CDM can be represented as shown below. 

This is a very supply biased conversation, when in fact the full description of the mechanism must include both the creation of supply and the likely demand. The mechanism is much broader than the CDM and involves the core design of the Kyoto Protocol and the various elements within it. 

There are many definitions of “market mechanism”, but all talk about the process of the whole market rather than just a sub-part within it. Here are three;

1. Means by which the forces of demand and supply determine prices and quantities of goods and services offered for sale in a free market.
2. The use of money exchanged by buyers and sellers with an open and understood system of value and time tradeoffs to produce the best distribution of goods and services.
3. The process by which a market solves a problem of allocating resources, especially that of deciding how much of a good or service should be produced, but other such problems as well. The market mechanism is an alternative, for example, to having such decisions made by government.

As the NMM discussion matures and eventually becomes part of the ADP, a much broader discussion on the need for a viable carbon market will be necessary. This cannot be limited to a discussion on crediting mechanisms because these, if standing alone, are not market mechanisms. A working mechanism requires some means of establishing price and particularly demand, a feature not inherent to the CDM.

The assumption that demand for credits will somehow be created is arguably a flawed one. The Kyoto Protocol addressed this by assigning AAUs to certain countries and making the CER (from the CDM) a fungible instrument, thereby allowing interchange for compliance. The AAU approach created demand in countries that had compliance obligations which in turn completed the market mechanism. Nations that held AAUs tended to cascade the instrument directly into their economies or if not, a proxy (e.g. the EUA under the EU ETS). Either way, the compliance obligation remained and allowed private investors to participate in the market.

There was a certain elegance in the market mechanism design of the Kyoto Protocol, one that shouldn’t be lost in the transition to a new international agreement. While it may not be smart politics in some quarters to highlight the benefits within the KP, the NMM discussion will do well to learn from what was developed in years gone by and not throw the baby out with the bathwater.

What started in Copenhagen as an aspiration for $30 billion in fast-start financing and up to $100 billion per annum by 2020 in North-South financing flow has been translated into the Cancun agreements as the beginnings of long term arrangements for specific funding purposes. In particular there is the Green Climate Fund in the AWG-LCA text;

 Decides to establish a Green Climate Fund, to be designated as an operating entity of the financial mechanism of the Convention under Article 11, with arrangements to be concluded between the Conference of the Parties and the Green Climate Fund to ensure that it is accountable to and functions under the guidance of the Conference of the Parties, to support projects, programmes, policies and other activities in developing country Parties using thematic funding windows;

Although the Green Climate Fund and the $100 billion per annum are not necessarily the same thing, many commentators quote them in the same breath. In reality, much of the $100 billion per annum will be delivered through the market and not as direct funding. But the Cancun Agreements do create a link at least to some extent in paragraph 100 of the AWG-LCA text, appearing in the Long-Term Finance section of the document;

Decides  that a significant share of new multilateral funding for adaptation should flow through the Green Climate Fund.

Given that this is mentioned just two paragraphs after the $100 billion reference, it at least establishes the notion that many billions of dollars will flow through the Green Climate Fund on an annual basis by 2020. But actually achieving this may be considerably more challenging.

Recent experience in the EU shows that even a highly focused, clearly defined funding mechanism for large scale mitigation takes many years to actually deliver real reductions. In 2007 the EU Council of Ministers agreed to the goal of 10-12 large scale CCS demonstration projects, although offered no insight at the time as to how this might be funded. Even then, with a carbon market in the range € 20-30 it was clear that the carbon price was insufficient to do this. So began the development of what is now the NER-300, a set aside of 300 million allowances in the EU-ETS for award to CCS projects. The mechanism itself was defined progressively throughout 2008 and eventually passed into EU law in December of that year. It then took two years (until December 2010) for the Commission to define the rules of operation of the mechanism to the extent that they could issue a call for projects, which has now been done. The closing date for project sponsors to submit application forms to their Member States is 9^th February 2011. The deadline for Member States to complete an eligibility assessment and forward the application with the submission forms to the European Investment Bank is 9 May 2011. EIB will conduct its assessment of projects in 15 months (by October 9, 2012). Finally, the Commission will have to approve and submit projects to Member States. If all goes well, projects will be awarded funding by end 2012/early 2013.

From concept to first award, the above process will have taken 5-6 years and as noted that is for a very specific set of projects on a defined timeline. Concept to mitigation will therefore be at least 8 years.

In the LCA discussion, the Green Climate Fund is in its infancy. There is some description as to the makeup of the Board, the nature and responsibility of the trustee and an invitation to the World Bank to serve in that capacity for the initial years. But that is far from a going concern which is actively distributing significant levels of financing to very large scale projects. The Global Environment Facility (GEF) has been operating for 20 years now, yet large projects take many years to move from proposal to completion. For example, a $300+ million South African public transport project which first entered the GEF pipeline in January 2005 should be completed at the end of this year, a seven year process. Such a project would probably take even longer under the proposed Green Climate Fund because of the likely startup lag as terms of reference are developed, people appointed, rules agreed and implemented and finally projects called for.

This means that major developing countries (e.g. South Africa) could struggle to develop the necessary projects in time for their 2020 pledges to be met. In the case of South Africa, they have offered the following in a letter to the UNFCCC at this time last year:

South Africa reiterates that it will take nationally appropriate mitigation action to enable a 34% deviation below the ‘business as usual’ emissions growth trajectory by 2020, and a 42% deviation below the ‘business as usual’ trajectory by 2025,” said Environmental Affairs DDG Alf Wills in the letter to the UNFCCC. “The extent to which this action will be implemented depends on the provision of financial resources, the transfer of technology, and capacity building support by developed countries,” he added.

While the intention is to provide the necessary funding, the reality of doing so through a Green Climate Fund to facilitate the delivery of the 2020 pledges is very challenging. A stepped up approach under the existing Clean Development Mechanism offers an alternative, but is largely defeated by the lack of potential buyers for the credits that it would generate. There is now little medium term prospect of a market based approach to mitigation in the USA, which removes them as a significant potential buyer (there will of course be California and perhaps some scope for offsets under the EPA). If China or Japan were to step into the arena with new project mechanisms driven by domestic trading systems, a considerable lag would still exist before projects began, simply because of the time it will take to define the domestic systems and create the attached mechanisms. Even if all this happened to come together quickly, there would still be a lag as developing countries identify the necessary mitigation projects.

Dozens of large scale mitigation projects will be needed in South Africa (and similarly for other countries) to meet their 2020 pledge as well as many hundreds of smaller scale initiatives. The current likely timelines for the development of the necessary financing facilities, their start-up and then use give little room for optimism that this will happen in time to create the reductions necessary to meet the pledges. Nonetheless, the fund will no doubt be successful – in the end  - in terms of making available much-needed monies to mitigation projects.

Recently Reuters reported that the Japanese government is looking at developing its own version of the Clean Development Mechanism (the offset / project mechanism instrument within the Kyoto Protocol). Japan has been a significant buyer of CERs (Certified Emission Reduction Units) in recent years, both directly and through voluntary agreements with Japanese industry but like many participants in this market has reportedly been frustrated by the bureaucracy of the CDM and the specific requirements placed on a project such that it is eligible. Nevertheless, with Japan and the EU as the principal buyers of CERS, the CDM system will have issued some 1.8 billion CERs by the end of 2012, which in turn equates to about $25 billion in carbon value and certainly more in overall project investment. Whilst the same investment may well have gone to developing countries anyway, it would not have been so focused on low carbon projects such as land-fill methane capture, wind and hydro.

To its credit much has been achieved under the CDM, but it remains an instrument of the Kyoto Protocol and subject to the jurisdiction of the CDM Executive Board (EB) which in turn operates through the Meeting of the Parties to the Kyoto Protocol. Above all else, the CDM has shown that a project mechanism can work and importantly can enable a targeted low carbon investment stream into developing countries. As a result, the idea of an offset / project mechanism of some sort exists in many government’s plans for legislation. But therein lies what is becoming a problem – each government wants a “made at home” solution. The latest incarnation of this is Japan.

Apart from government-to-government AAU transactions (under the Kyoto Protocol), the CER is the pretty much the only single fungible carbon price instrument globally. It can be utilized by all the Kyoto Annex 1 countries for compliance and in some cases that compliance has been cascaded down through the economy such that business trades CERs. This in turn links the carbon price those economies and allows at least some measure of optimization between them, albeit limited today. Optimization in turn means a lower cost of compliance for the economies in question. Multiple, jurisdiction specific offset mechanisms would prevent this from happening. The accreditation of a given project would typically be against one set of rules and therefore the resulting credits could only be used for compliance where those rules originate. Project developers would find the cost of multiple jurisdiction accreditation prohibitive. This means that there would be no linking mechanism between the systems and no opportunity to optimize. The result – a lost opportunity and a higher cost outcome. There will also be additional costs for the governments involved. Establishing the necessary monitoring and accreditation bodies is a complex and expensive task, just look at the CDM EB. Finally, it may be wrong to assume that it will all somehow be easier if done at home – even local solutions will have teething problems and will likely face all of the issues all over again that have been dealt with by the CDM EB.

So whilst it is good news that governments continue to favour market mechanism approaches to emission reductions, it may be bad news if they each try a home grown solution. At a very minimum, a global deal on project mechanism design and implementation, ideally building on but learning from the CDM, would be a solid achievement from the UNFCCC process in Cancun.

As the current round of UNFCCC talks continue this week in Bonn, albeit with little real chance of an immediate or even medium term breakthrough, progressive industry groups are picking up the pieces left behind after Copenhagen and seeking ways to move the debate forward. One particular challenge is to find a substantive mechanism to drive investment into developing countries, given the Copenhagen Accord pledge to channel $100 billion per annum in that direction by 2020. The reality of a post-recession developed world is debt, less government spending and general belt tightening all around which means that such funding is unlikely to come from the public purse. Although the Clean Development Mechanism will have issued some 1.8 billion CERs by the end of 2012, which in turn equates to about $25 billion in carbon income and probably more in overall project investment, the finance flow is naturally limited by the project by project approach of the CDM and the uncertainty related to CER issuance.

Recently the International Emissions Trading Association (IETA) floated a concept paper that addresses this issue head on. The paper scopes out the design of a sectoral Green Bond, which delivers financing to developing countries through the sale of bonds that return both interest payments and a flow of carbon credits. Although the interest payment is relatively low, the bond becomes attractive thanks to the potential value of the credits. One of the important design elements is a mechanism within the overall structure that limits total bond issuance by a given economy, effectively capping the flow of credits and therefore ensuring their value in the longer term. An international organisation such as the UNFCCC or World Bank would be charged with overall management of the approach, particularly given the need for sectoral benchmarking, issuance approval and monitoring, reporting and verification(MRV).

The Green Bond is sectoral based, or potentially linked to a NAMA (Nationally Appropriate Mitigation Action). Should the green sectoral bond’s underlying sector fail to deliver an agreed-upon level of reductions, carbon credits would not be issued to bondholders; as a result, the interest rate payable by the host country would increase. If reductions failed to materialize for a pre-defined number of subsequent years – post-issuance of the sectoral bond – the host country would be obligated to make an early pay-back of the bond. In the case of default by the host country, the guarantor(s) would stand behind the issued sectoral bond and repay investors accordingly, either on pre-determined higher interest rates or principal payments. These guarantee mechanisms supporting the bond will facilitate the financing of projects.

But at the core of the bond is the carbon credit. The Green Bond relies on there being demand for these, which in turn means cap-and-trade systems running in developed countries. Although there are other approaches that may also create demand for credits, sustainable demand is only likely to come from these systems. Therein lies the challenge – recently we have seen the demise of the CPRS in Australia and a broadly based cap-and-trade approach in the USA is looking unlikely, although still not impossible. If the latter happens, then the potential for instruments such as Green Bonds becomes huge, particularly as other countries follow the US lead and move back to cap-and-trade (e.g. Canada). Widespread uptake of cap-and-trade in tandem with a revised target in the EU-ETS could lead to demand for bond-linked credits of some 5+ billion by 2020 (on a cumulative basis). That means some $100-150 billion in carbon income and perhaps as much as $500 billion to 1 trillion in project investment during the period (NB: much of that investment will see its income generated in the period 2020-2030). This means that the bond mechanism can operate on a scale that is commensurate with the finance pledges made and the potential demand for credits.

With the second week of Copenhagen now upon us and the days rapidly counting down to the conclusion of the summit, the true meaning of climate change politics is showing its hand – money. At issue are two things; how much should developed countries effectively compensate developing countries for past emissions by helping them adapt to the changing climate and how much should developed countries pay developing countries to get them to reduce future emissions. The first of these I find impossible to make any judgement on at all, in part because I struggle to understand just what such money might be spent on (save for the expatriation of residents of some island states now literally disappearing) and then how it might be divided so that the world gets meaningful benefit that is actually related to the issue at hand.

But the second issue is not quite as difficult, so I will venture an opinion on it. A view on this comes from considering the abatement curve (a chart of cost and volume for emission reduction activities, see below) for the potential emission reduction opportunities in developing countries.

The left side of the chart (A) shows a range of projects that give positive returns over time. They are largely energy efficiency plays in one form or another and are things we should be doing anyway at current energy prices, but we shy away from them for all sorts of reasons ranging from capital allocation to plain laziness. Such projects exist in every country (well perhaps not Denmark which seems to thrive on finding energy efficiency opportunities) and are found in every sector. They range from home insulation to excellence in operation of industrial facilities.

The right hand side of the abatement curve (C) features projects that really need a carbon price to deliver positive returns over time. The best example is carbon dioxide capture and storage (CCS), which can never be revenue positive without a carbon market. A number of renewable energy technologies will continue to need the additional revenue that a carbon market can deliver, at least for some years, as might advanced biofuels with their low carbon footprint and more distant technologies such as hydrogen.

Coming back to the issue at hand, money, the abatement curve offers a mechanism for judging just what type of help should be given to the rapidly developing economies (for the poorest countries help is desperately needed simply to provide energy in the first place, which is yet again another issue and arguably not one for a climate change conference). Energy efficiency projects should not really be funded by the developed economies given that they are attractive projects to do anyway. So the emphasis here needs to be on accelerating the uptake of such actions through loans, foreign investment and domestic policy initiatives.

But projects requiring a carbon price are different. A carbon price is an artificial construct, which effectively delivers actions that the economy would not otherwise take. This does impose a cost on the economy and it is this cost that could be borne for a period of time by the developed countries for developing country projects. With per capita incomes often a fraction of those in developed economies it is a big ask to expect a developing economy to do this itself. But as incomes rise there should also be an expectation that developing countries eventually implement their own carbon price policies.

Looking at a technology such as CCS, this would mean developed country cap-and-trade systems accepting credits from CCS projects in developing countries as well as providing some up-front capital for the early projects (depending on the cost of abatement and the prevailing cost of carbon). The story would be similar for some renewables. Possibly the simplest way to steer this is to focus the money flow to developing countries on the electricity sector only, with the aim of accelerating decarbonisation. This has a number of benefits; results are likely to be very tangible for questioning voters in developed economies (e.g. xx coal fired power stations in South Africa had CCS fitted this year),  major project opportunities result for technology companies and it has limited impact on competitiveness concerns emanating from developed countries – i.e. there is little appetite to fund projects in developing economies which simply enhance their industrial competitiveness. All of this means that future offset mechanisms should be targeted on the electricity sector and not across all emission activities within a developing economy.

Finally, there is the major issue of forestry / deforestation (B). This will also require assistance from developed economies in that it is really about land and land has a value. Dictating how land should be used changes its value, so some compensation will be necessary in that area. This can come both through government-to-government deals and via the private sector using carbon markets.

As the debate in Copenhagen continues, there is some sense of this structure. Developing country NAMA (Nationally Appropriate Mitigation Actions) are broadly seen as A, although the AWG-LCA draft text does link the transfer of money with their implementation. The REDD discussion is of course B. Finally, there is the discussion about the carbon market mechanisms, but important technologies like CCS and Nuclear are hotly contested as being suitable, yet these are the two big low carbon electricity base-load technologies. A distinct focus on electricity in developing countries is also lacking.

So much remains to be done in just four days.

A tectonic shift may be underway in Japan, but not of the sort normally associated with this country and its frequent earth tremors. Rather, a new era in climate politics may dawn as a result of the recent win by the DPJ in the national elections. This is because within the manifesto pledges of the DPJ sit two key policy choices, now (Monday September 7^th) formally announced by incoming Prime Minister Yukio Hatoyama;

1. A commitment to reduce national emissions by 25% by 2020, relative to 1990 – this compares with the proposal by the LDP of an 8% reduction, one which was heavily criticised internationally as being insufficient support for the developed country contribution to an agreement in Copenhagen.
2. A commitment to implement a cap-and-trade system within the Japanese economy. Although the previous government had talked about this policy instrument, little progress was made in implementing it given the negative position that some business groups took towards it.

Whilst much domestic “nemawashi” is still to take place, this shift could be critical for the success of an agreement in Copenhagen.

But Japan already finds itself an international leader in energy management, given the energy legacy inherited from the previous administration. However, the CO₂ story in Japan, whilst positive, has not delivered an overall drop in emissions. Whilst energy diversity and efficiency have been key policy objectives for many years now, absolute CO₂ emissions have risen by nearly 15% from 1990 (to 2006, IEA). At the same time emissions in the EU-27 have fallen, but only slightly. Over the same time period CO₂ emissions in the USA have risen by just over 19%. 

A big difference lies in the power sector, with Japanese power emissions staying at around 430 gms CO₂ per kWh over a 20 year period, but EU power emissions falling from over 430 gms per kWh to some 350 gms per kWh in the same period. This is due to the continuing rise of nuclear power in the EU, the influx of natural gas and the more recent aggressive build of renewables in countries such as Germany and Denmark.  By contrast, Japan has seen emissions from coal grow by 45% over the same period, much of that in the power sector.

With a transport sector already one of the most CO₂ efficient in the world and an efficient manufacturing base, the power sector will become a particular area of focus.  But efficiency alone is not going to deliver the necessary change, so fuel switching (i.e. more natural gas), renewables and international offsets will all play important roles.

The last item above will be critical to the strategy. But to be truly effective, the tougher target must be backed by an emissions trading system, which is also a preferred policy position of the DPJ. A Japanese emissions trading system, with very open access to international markets will allow the domestic target to be met but importantly will direct significant funding to developing countries.

Some quick numbers – let’s assume domestic emissions in 2013 are down to 1100 MT (with the Kyoto target met through CER and AAU purchases) and that the country can reduce this to 1000 MT by 2020 (i.e. a ~20% reduction from 2006 to 2020). Therefore, meeting a 2020 target of 810 MT CO₂ (i.e. 25% lower than 1990) could mean the purchase of over 800 million tonnes of international credits from projects between 2013 and 2020.

Between Japan, the USA, the EU, Canada, Australia and New Zealand, six cap-and-trade systems could be buyers of some 10 billion tonnes of international reductions in the period 2013-2020, giving rise to not only a very large and liquid global carbon market but also an ability to fund very significant step changes in developing country emissions. In tandem, new avenues of supply would have to be rapidly developed, including a mechanism that supports some kind of sectoral crediting, although this will likely be more successful as an outgrowth of the CDM through the creative use of methodologies rather than an entirely new approach.

The announcements by the new government in Japan, if put into practice over the next three years, could have very far-reaching effects. Rather than facing the prospect of a lone EU-ETS struggling to hold the fort for this powerful market instrument, we instead head rapidly into the brave new world of a global carbon market.

This week has seen a report produced for the British Government which details pathways towards a global carbon market and the benefits of doing so. A series of policy recommendations are put foprward in the report along with supporting analysis. The report makes excellent reading.

A fully functioning global market for carbon is essential for many reasons. First and foremost, it will drive the reduction of emissions globally in an organised and equitable manner, always picking off the next best project along the abatament curve and therefore giving us a lowest cost solution to meeting reduction targets. The resulting carbon price will also act as an incentive to spur the development of a range of new technologies, such as carbon carbon and storage. The overall global cost of meeting, say, a 2050 target can be reduced significantly with a fully fungible global market, compared to the alternative of many separate stand alone systems.

But such a market will not be something that policy makers will ever be able to create in one swoop, rather it will evolve as individual systems are linked together, as sectoral approaches mature and begin to deliver credited reductions and as new policy mechanisms are introduced in areas such as land use and forestry. Today, we have just the beginnings of such a system, with the EU-ETS buying certified reductions via the CDM, thereby projecting the EU carbon price into many developing countries.

We can already see the dawn of other approaches, such as in the USA, Australia and New Zealand. But whilst both the Australian and New Zealand systems are underpinned with Kyoto AAUs, as is the EU, this is clearly not the case in the US Waxman-Markey case. The USA system, whilst architecturally very similar to the other systems, does not immediately recognise the same project mechanism nor present the possibility of fungible (AAU based) allowances, so discontinuities are already appearing. What is missing is the notion of a common currency for carbon.

This then brings into focus one of the key deliverables from Copenhagen – somehow merging the Kyoto negotiating track and the Long Term Cooperative Action track. Unless this can be achieved we may end up with emission trading systems that simply can’t link together because they are built on different platforms. Although Waxman-Markey does offer an open door for recognition, it won’t be possible to use it as it will present an unrecognised source or sink for allowances within the other systems.

Such a discontinuity will drive up the overall cost of compliance for everyone. Alternatively, we can ensure that the various systems are built on a common platform, recognising the same underlying units, thereby ensuring the shift towards a global market.

Towards a global carbon market

This week has seen the United States table draft negotiating text to the United Nations in the lead up to Copenhagen, or more formally “United States Input to the Negotiating Text for Consideration at the 6th Session of the AWG-LCA“. I should say that this text appears very preliminary at the moment, but it does recognise the key elements that most parties are now discussing.

Importantly, the text highlights the need for assistance to developing countries, with the paragraph;

The development of low-carbon strategies and the implementation of mitigation actions of developing country Parties will, as appropriate, be supported by financing, technology, and capacity-building, as set forth in Section 4 and Appendix 3.

At this early stage though, Section 4 and Appendix 3 don’t really contain much. The US negotiating team are also seeking input, particularly from business, given the expectation that private finance and project investment will play a significant role.

This then brings me to some ideas in this area. There are some useful lessons in the EU that can be applied more broadly. Rather than simply relying on the CO2 market to deliver reductions, the EU has also focussed on certain classes of technology and structured programmes and targets to promote and develop them. This is most apparent for carbon capture and storage where the EU has set a strong agenda;

• Established a 10-12 project demonstration programme, with an incentive structure that stretches through to 2015.
• Ensured that the CO2 market recognises CCS as a viable mitigation technology.
• Implemented an incentive structure to augment the financing provided by the carbon market (the use of 300 million allowances from the ETS New Entrant Reserve). This additional funding is in recognition of the higher cost demonstration stage that now faces CCS as a new technology.

Whether it is CCS or some other technology area, the idea of establishing specific programmes of activity, setting timelines and ensuring adequate funding needs to make its way into the international agreement.

One idea which has been put forward by the World Business Council for Sustainable Development, repackages the original notion of sectoral agreements. They have proposed a large-scale sector-based approach introduced into the framework. The approach would give rise to agreements, each negotiated for a specific sector by a limited number of parties (i.e. governments), as “satellites” to the main agreement, but utilising the infrastructure (crediting mechanisms, clean technology funds, MRV etc.) offered by the overall framework. Each agreement would have a specific purpose and would operate by encouraging wide spread business-led project development in the target countries, incentivised by the mechanisms and the availability of targeted funding and financing. The projects would typically result in the introduction of infrastructure and new technologies into developing countries together with the capacity for ongoing operation and future expansion.

This then puts developing countries on a pathway towards substantial future action. Ideally, each agreement would lead to the sector within the developing country involved to then adopt a long term binding mitigation target. Importantly, the adoption of a target in a developing country is then specifically linked with the necessary funding and capacity building such that those countries can then realistically manage CO2 emissions going forward.

Such agreements would be structured as follows:

• Each represents a quantifiable and manageable mitigation or adaptation action plan. Unlike developed economies that have the capacity for structures such as economy-wide “cap-and-trade” systems, a more clearly definable project based programme could be initially used to tackle developing country emissions.
• Each would be negotiated separately, typically by a limited number of parties (e.g. parties to an agreement on emissions from coal fired power stations might include China, India and South Africa as those nations taking specific action and the USA, Japan, the EU and Australia as those gearing their emissions trading systems to accept credits as a funding mechanism) as a “satellite” to the main agreement.
• Each agreement would have a clear purpose and end point. The scope would be clearly defined and the objectives would be agreed upfront.
• Each agreement would be able to draw on the supporting “cocoon” for funding, such as the creation of credits (offsets) through a project mechanism, MRV capacity and so on.
• Each agreement should include the eventual implementation of a long term binding target for the sector or sectors in question.

The approach has broad application and could be extended into areas such as avoided deforestation and afforestation (i.e. as envisaged under REDD).