David Hone

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).

As this year unfolds, most industry groups are turning their mind towards Copenhagen and the position they should take and they are running seminars for their members to help them understand what is happening. In addition, as the US starts to draw up the final (!!??) design of its cap-and-trade system, it cannot be oblivious to the shape of a future international agreement.

I was involved directly and indirectly in all such aspects this week. On Thursday I presented the Shell view of the key elements of the design required from Copenhagen to VNO-NCW (The Confederation of Netherlands Industry and Employers), on Friday I was at a meeting of the European Round Table of Industrialists in which the position that organisation should adopt for Copenhagen was discussed. Again on Friday a colleague in Shell Trading presented our position on cap-and-trade offsets at a Pew Center organised seminar on Capitol Hill.

The common link here that warrants further discussion (in this and future postings) is the role of international offsets in domestic cap-and-trade systems. This might seem somewhat arcane, but the implementation of this is pivotal to a successful international agreement. So first of all, a paragraph of background (some may wish to skip this bit in italics).

An offset in a cap-and-trade system is carbon instrument that can be obtained outside the capped sectors and used for compliance under the cap. These are typically generated by executing, outside the cap, a project that reduces emissions and having that reduction certified as valid. The best example of this practice is the Clean Development Mechanism (CDM) of the Kyoto Protocol. The CDM allows emission-reduction (or emission removal) projects in developing countries to earn certified emission reduction (CER) credits, each equivalent to one tonne of CO2. These CERs can be traded and sold, and used by industrialized countries to meet a part of their emission reduction targets under the protocol.

There are two reasons that I can see for having offsets;

1. As a mechanism to contain costs within the cap-and-trade system by offering an additional supply of compliance instruments (”credits“) over and above those issued by the government.
2. As a mechanism to project the cost of carbon that exists within the cap-and-trade system to sectors outside the cap, such that they see it as an opportunity on which to act. The offset is effectively a proxy for the price of carbon that would exist had that sector also been covered –  possibly as a pre-cursor to real cap-and-trade being implemented.

Whilst I find that most people agree on this, divergence of opinion then occurs. Some see offsets as a route to low-cost reductions that aren’t available within the cap-and-trade system. At the same time, others complain about the ease with which reductions can be generated through CDM projects and then imported to Europe (into the EU-ETS) at higher prevailing prices, effectively arbitraging the system. So why should we have international offsets and how should the international offset system be designed?

First of all, let’s not forget that cap-and-trade is designed to put a market price on CO2 emissions and to therefore incentivise projects that reduce emissions. If we look at this from the perspecive of an abatement curve, the cap-and-trade system is designed to operate on the left hand side where a price for CO2 is actually needed – such as for carbon capture and storage, which would never be implemented without a price for CO2. Looking at the image below, cap-and-trade is designed for Zone B. 

Whilst energy needs (and hence emissions) can be reduced through Zone A type projects, they shouldn’t need a cap-and-trade system to encourage them to happen. Other policies might be needed to tease them out, but not cap-and-trade. Yet many projects being considered as potential for future offsets exist in this region of the abatement curve. It isn’t in the interests of a solid international agreement on climate change to simply encourage projects in non-capped sectors / countries to generate credits in Zone A for compliance in Zone B.

Rather, the international agreement should encourage all countries to act on Zone A of their own accord, since this is in the national interest anyway as it typically means energy savings. In addition, those countries without absolute reduction targets are also incentivised to operate in Zone B through an offset or project mechanism. This then generates an additional supply of compliance units for countries with absolute targets and begins the process of introducing specific low emission technologies into economies without targets in preparation for a future with targets.

Although this is generally the idea behind the CDM, it hasn’t quite functioned like this in practice, but I would argue that just having it has generated much experience and useful learning about offsets. The next generation of CDM will have to operate on a much larger scale, but also sit squarely in Zone B of the abatement curve.