EU fires first shot in new round of the global CO2 struggle

The European Commission’s recent proposal to ban carbon credits from emission reductions of certain controversial projects in China and India from the EU carbon market is more than just an attempt to fix a defect in the system. Brussels has a much broader goal in mind, namely a thorough overhaul of the international carbon market. In the meantime it does not expect a significant impact of the ban on the EU’s own carbon market, an assessment not everyone agrees with. Get ready for the next round of the global CO2 war.

The EU is not known for playing hardball. But on 25 November the Commission did just this with a proposal to ban controversial HFC-23 and adipic acid nitrous oxide (N2O) credits from the EU’s Emission Trading Scheme (ETS). These credits, which mostly derive from projects in China and India, account for around three-quarters of the 430 million CDM credits that have been issued so far by the UNFCCC (the UN body in charge of the implementation of the Kyoto protocol). The EU allows European companies to engage in these international projects and use the resulting CDM credits to meet their emission caps under the ETS.

Having by far the most comprehensive climate legislation in the world, Europe is by far the largest investor in the CDM market. European companies account for around three-quarters of demand – and energy utilities for three-quarters of that again. Under ETS rules, companies can use CDM credits to cover up to half their total emission reductions from 2008-20, relative to 2005. According to estimates from carbon market analyst Point Carbon, this equates to around 1.8 billion credits. European governments, which also have obligations under the Kyoto protocol, account for much of the remainder of the CDM market. Point Carbon expects EU government demand of 400-500 million credits for 2008-2020. With a market price of around €12 per tonne, the CDM market is currently worth some €20-30bn.

The EU, however, is not satisfied with the way the CDM market is working. First of all, the Commission has come to the conclusion that credits from projects involving the destruction of HFC-23 and nitrous oxide (N2O) from adipic acid production are not delivering the environmental benefits they are supposed to. These projects have been criticised for some time. A coalition of NGOs led by CDM Watch in June published findings alleging that chemical plants in developing countries may have increased their HFC-23 emissions merely to destroy them and sell more carbon credits. They cited various lines of evidence, including the fact that such plants emitted less HFC-23 when they were not able to sell credits. In October, CDM Watch called for an end to “phantom” N2O credits from adipic acid production. It said Chinese and Korean producers were receiving large subsidies through the CDM even though ‘large sections of this industry are already voluntary abating at least 90% of their N2O emissions’. Moreover, CDM support abroad was enticing adipic acid producers out of the EU, it said. CDM Watch did give N2O from nitric acid production a clean bill of health.

Discriminatory regulation

The Commission essentially backs the conclusions from CDM Watch. Commissioner for Climate Action Connie Hedegaard said in a statement on 25 November that the Commission is concerned about the ‘environmental integrity’ of the projects in question, and therefore also of ‘the carbon market at

The lowest-cost industrial gas credits which dominate the market are highly concentrated in a few advanced developing countries
large’. She also said that ‘the lucrative nature of HFC-23 projects appears to discourage countries hosting these projects to support cheaper and more direct action to cut these emissions, e.g. through the Montreal Protocol or as part of their own appropriate mitigation actions’. This is a direct criticism of the way in which countries like China and India profit from the CDM. The Commission estimates that revenues from the sale of HFC-23 credits in the EU ETS represent up to 78 times the initial capital investment and operational costs of these projects.

Hedegaard added that the Commission’s own impact assessment ‘demonstrates that the lowest-cost industrial gas credits which dominate the market are highly concentrated in a few advanced developing countries.’ Continued recognition of these industrial gas credits ‘would deprive many other, poorer countries of the benefits from the demand generated in the EU ETS.’ She concluded that the EU wants ‘to see a more diverse market for carbon credits, including from projects which bring more sustainable development benefits to the developing countries and communities that host them.’

Hence the Commission is proposing – as a first step – to restrict the use of HFC-23 and adipic acid N2O credits in the EU ETS from 2013 onwards. These are not the first restrictions to the ETS market, incidentally. Credits from nuclear projects and land use, land-use change and forestry (LULUCF) projects have been excluded from the ETS since the start.

The response of the UNFCCC to the industrial gas controversy has been more ambiguous. The UN’s CDM Executive Board at the end of November asked its methodological panel to revise the crediting methodology for HFC-23 projects, but it is not clear yet what this revision will look like. Proposals are expected next year. (There has been no formal revision request for adipic acid N2O projects so far, but market observers expect this to follow the HFC-23 request.) At the same time, the CDM Board approved some 20 million credits from twelve HFC-23 projects that had been put on hold at various times since the summer as concern over their environmental integrity mounted.

China, which hosts 80% of HFC-23 projects and 60% of adipic acid N2O projects – with a 65% and 30% tax on credit revenues from each respectively – has reacted furiously to the EU and UN moves. Wang Anle, who runs an N2O reduction project at the Henan Shenma Nylon Chemical Company, said the EU’s proposal was based on ‘flawed data and analysis’. A ban, in his view, would be ‘true discriminatory regulation, which breaches the market principle of fair trading’. Moreover it would lead to the release of more than 820 million tonnes of CO2 into the atmosphere after 2012 as industrial gas emissions are left to spew out into the atmosphere, he says.

CDM Watch in turn has accused the CDM Board of failing to take action under pressure from Japanese, Chinese and Indian board members.

Shouldering a share

The European Commission does not appear to be too impressed by the criticism of the Chinese. In fact, its proposal is going much further than just banning HFC-23 and N2O projects. The Commission is going for, as Hedegaard puts it, a ‘major overhaul’ of ‘the UN-based carbon market mechanisms’. The CDM should, she says, ‘make a real contribution to addressing the climate challenge and to sustainable development in the world’s poorest regions and countries’.

What this ‘major overhaul’ should look like is, however, not clear yet. What is clear is that the Commission wants advanced developing countries such as China and India to start shouldering a share of the burden for emission reductions after 2012. Under the Kyoto Protocol, developing countries are not bound to any emission reduction targets. Instead, their contribution to global emission cuts comes through the CDM. This must change, the Commission says.

Brussels proposes that in advanced developing countries the CDM should be replaced with emission reduction projects that cover whole sectors, but which are only partially creditable to foreign funders. Part of the cuts would count towards the host nations themselves, which would also partly pay for them. For example, a sectoral project could apply to the cement sector, where it would generate credits equal to emission reductions across the sector relevant to some kind of baseline. The sectoral approach would in turn be followed by full-fledged cap-and-trade systems in those countries, just like the ETS in Europe.

But the details of how sectoral approaches could work are far from clear. It is not even clear who should undertake this major overhaul. According to one knowledgeable source EER spoke to, the Commission wants the reform to take place at the ‘international level’, but, if that does not work, Brussels might take things into its own hands. It might, for example, proceed on a bilateral basis and make deals with specific countries.

Short of credits

Another question is what impact the EU proposal will have on the European carbon market. Point Carbon expects 3.7 billion CDM credits to be generated from 2008-20, according to head of CDM analysis Arne Eik. The EU is effectively putting restrictions on 1.6 billion of these in two ways. One, through its recent proposal to restrict HFC-23 and adipic acid N2O credits and two, because according

to the revised ETS directive, from 2013 only projects started up in the Least Developed Countries (LDCs) will be recognised as providing eligible credits for the EU ETS, unless projects are covered by a bilateral agreement between the EU and the country involved. Thus, a project started up in China after 2012 will not be able to provide EU companies with credits unless a bilateral agreement is signed between the EU and China to authorise this.

So, the number of CDM credits eligible to enter Europe will be around 2.1 billion. Demand, as we have seen, is estimated by Point Carbon to be 1.8 billion from the private sector and some 400 to 500 million from governments. Thus, the EU ‘might be short of credits’, says Eik. This could drive up the EU carbon price.

Analysts from Deutsche Bank have also predicted that the Commission’s proposed ban would drive up the carbon price. In a report issued before the Commission’s proposals came out, they predicted a price of €37 rather than €30 per tonne in 2020 if the Commission restricted HFC-23 use.

The Commission, however, has a different view. In its own impact assessment, it predicts no significant impact on the EU carbon price and on compliance costs. ‘[EU] allowance prices should be relatively unaffected,’ it says in a memo accompanying its proposal. ‘There are expected to be enough credits available from the 2,300 other projects (non-HFC-23, non-N2O) to supply the EU ETS up to the limit allowed over the next ten years’, and that is without including possible new credits that could emerge from the EU’s proposed new sectoral approach.

Even assuming developed and developing countries carry through with their emission reduction pledges under last year’s unofficial Copenhagen Accord, there would still be enough cheap credits available for the EU from developing countries, the Commission says. This assessment, it adds, is confirmed by an independent study from Bloomberg New Energy Finance. Interestingly, in its impact assessment the EU executive is envisaging a very low carbon price of only €16.50 by 2020, less than half Deutsche Bank’s €37 estimate.

Simone Ruiz, European Policy Director at the International Emissions Trading Association IETA, which represents companies active on the carbon market, agrees with the Commission’s optimistic outlook. ‘In almost all scenarios’, she says, ‘there is still a sufficient amount of supply. We agree with the European Commission on this.’

Good for the market

Observers predict that apart from possible repercussions on the EU carbon price, the Commission’s proposal will fragment the international carbon market. They expect that there will be two prices for CDM credits in future, one for HFC-23 and adipic acid N2O credits, which they think other countries such as Japan will continue using, and another for other CDM credits. The former are expected to decline in price as EU demand for them is taken away. Eik expects a ‘significantly lower’ price for them in future than for credits from other projects.

As HFC-23 and adipic acid N2O prices decline, the second category of CDM credits, those from renewables and efficiency projects, is expected to rise in price in line with EU carbon credits. ‘In many ways it could be good for the carbon market,’ says Eik. ‘Investors will have to look at other project types.’ Point Carbon expects this second category to overtake industrial gas credits in volume in 2015. Over the period 2005-20 it expects industrial gas projects on the one hand and renewables and efficiency projects on the other to account for about 1.1 billion credits each.

The Commission’s proposal now has to be voted on in the Climate Change Committee (consisting of representatives of the Member States), which will meet on 15 December. There are some outstanding disagreements e.g. on the starting date of the new restrictions, which some Member States want to see postponed from 1 January to 1 May 2013 to avoid an impact on the current ETS trading period of 2008-12 (credits for emissions in 2012 must be handed in to the Commission by April 2013). There is also a push for CDM credits issued in 2013 for reductions in 2012 still to be considered eligible for use. But observers suspect the proposal could be accepted without too many problems. It will then be subject to a three-month ‘scrutiny period’ by the European Parliament, before it can be formally adopted.

On additional layer of complexity is that EU governments will not be bound by the new restrictions, which will only apply to companies in the EU ETS. Member State governments could in theory continue to use the controversial CDM credits for their own Kyoto Protocol obligations, although it would be very odd, to say the least, if EU governments continued to use credits which they have just agreed to ban for their own companies.

Once the Commission’s proposal is agreed to, the international struggle for the future of the CDM will really take off. The outcome is uncertain – the EU’s attempts at reform have so far not generated much enthusiasm internationally – but given the prominent position of the EU in the carbon credit market, it seems reasonable to assume that the days of the CDM, at least in the most highly developed emerging economies, are numbered.

Enel calls on EU: don’t change the rules of the game unilaterally

‘The criticism by environmental groups of CDM-projects is not based on factual evidence.’ Giuseppe Deodati, Head of Carbon Strategy of the Italian energy company Enel, is confident that all CDM-projects approved by the UNFCCC, the body in charge of the CDM market, do what they promise to do: reduce greenhouse gas emissions in the most cost-effective manner.

Enel, the world’s largest player in the CDM market, is upset that the European Commission is putting restrictions on CDM projects reducing emissions of HFC-23 and other industrial gases in countries like India and China. This means that the credits from these projects cannot be used anymore by companies in the European Emission Trading System (ETS).

Enel has invested many millions in CDM projects since it became active in this market. Investment in carbon credits is one of the ‘five pillars’ of the company’s climate strategy, says Deodati. (The other four are: improving the efficiency of its generation capacity, investing in renewable and nuclear energy, in smart grids and energy efficiency, and in new technologies such as carbon capture and storage and thermal solar power capacity.) The company so far has had 50 million tonnes of carbon-credits approved by the UNFCCC. That is no less than 13% of the total number of UNFCCC-approved “certified emission reductions” (CER’s). At a current market value of some €12 per ton, they represent €600 million in value. Enel’s total portfolio of potential emission reductions is about 200 million tonnes of CO2 up to 2020, both by direct participation and through international funds.

According to Deodati, Enel long ago decided to become an ‘early mover’ in the CDM-market, to ‘minimise the costs of our carbon-reduction obligations’. Enel’s first CDM-project took place in China in 2004 and was aimed at reducing emissions of the hydrofluorocarbon HFC-23, a waste product in the production of the refrigerant HCFC-22, and an extremely powerful greenhouse gas. HFC-23 projects are a major critical target of environmental organizations, of which CDM Watch is the best known. ‘As it is very cheap to install a destruction facility, the HFC-23 destruction CDM projects have resulted in huge windfall profits for HCFC-22 plants as well as a perverse incentive to artificially stimulate the production of HCFC-22’, CDM Watch states on its website.

But according to Deodati, these claims are spurious. ‘The projects are truly additional’, he says. ‘The emission reductions would not have taken place if we had not invested in them. There are real climate benefits here.’ He also rejects the charge that the projects have brought ‘windfall profits’. ‘I don’t know what this means. We are talking about a normal market mechanism here, which sets prices according to supply and demand. The ideological approach of criticizing the cost structure of a market based framework is against the core principle of having a carbon market, where investors will naturally have the incentive to look for the most cost-efficient way to reduce emissions, thereby lowering compliance costs.’

The Enel man is confident that the executive board of the UNFCCC, which is now investigating the projects at the request of CDM Watch and other NGO’s, will reconfirm their soundness. He also notes that the World Bank has expressed confidence in the UN-approved schemes.

Enel is concerned that the European Commission now wants to limit the use of carbon credits from these projects ‘merely on the basis of claims of environmental organisations’, as the company puts it. Strictly speaking the Commission has no authority to rule on CDM projects, but it can rule out the use of CDM-derived carbon credits (CER’s) in the EU’s Emission Trading System (ETS). For companies like Enel, limiting the use of CER’s in the ETS would drive up compliance costs. By how much, is difficult to predict, says Deodati. ‘That depends on market circumstances’. Currently, market prices for the EU Allowances traded within the ETS are very low. Could that be a reason why the Commission wants to limit the use of CER’s? To drive up the prices? ‘If so, that would be the wrong reason’, says Deodati.

Enel is particularly concerned that the EU’s ‘unilateral’ action adds ‘additional uncertainty’ in the CDM-market. Deodati: ‘It sets a dangerous precedent, as it could pave the way for further restrictions on other asset groups in the future. This will discourage investments in the future. It will also lead to market fragmentation, as markets will come to accept different types of carbon credits.’

The whole idea of the CDM-system under the Kyoto protocol, says Deodati, was to stimulate investments from the private sector in emission reduction efforts in emerging economies. In this it has succeeded admirably, he says. ‘85% of the reductions that have been made under the Kyoto protocol come from the private sector.’

Enel is not necessarily against the creation of a new mechanism to replace the current CDM mechanism, if that is the outcome of an international agreement. A new mechanism might even make it easier for companies like Enel to comply with the rules. The current compliance process through the UNFCCC is notoriously slow and complex. ‘We are willing to cooperate on that. But we think it would be very harmful if the European Commission now unilaterally changed the rules of the game.’