Save the carbon markets!

Energy expert Joan MacNaughton on why it is vital to prevent the Clean Development Mechanism – and the EU Emission Trading Scheme – from collapsing

Save the carbon markets!

By Karel Beckman

If the battle cry of Greenpeace once was "Save the whales", the battle cry of Joan MacNaughton, President of the Energy Institute in the UK, senior advisor to the World Energy Council and former Chair of the Governing Board of the International Energy Agency (IEA), might well be: "Save the Carbon Markets". As Vice-Chair of an independent, high-level panel set up by the United Nations to take a good hard look at the Kyoto Protocol's Clean Development Mechanism (CDM), MacNaughton has come to the conclusion that carbon markets, and the CDM that ties them together, are far too valuable to let go to waste – despite all the troubles that they face. She says that "the CDM and carbon markets are essential tools to generate investment in emission reduction projects at the scale that is needed." EER talks with the woman who for many years was the top energy civil servant in the UK and who is still on a mission to save the world from climate and energy disaster.

Joan MacNaughton (c) Nora Tam

The EU has had one since 2005. New Zealand has one. California will have one from the 1st of January 2013. Australia will have one in 2015. China is experimenting with it and will probably have one as well in 2015. The same goes for South Korea. We are talking about carbon emission trading schemes.

So far, these have not been wildly popular in the world, the EU being the only major economic power to base its climate policy on a carbon trading market. But the EU's example does seem to be catching on. According to the International Energy Agency's Energy Technology Perspectives, an important report published in June 2012, interest in carbon trading is growing across the world. "Carbon pricing could become the norm rather than the exception", writes the IEA, noting that countries like Brazil, South Africa, India, Turkey, Indonesia and Mexico are also showing increasing interest.

At the same time, it is no secret that most existing carbon markets, particularly the world's largest one, the EU's ETS, are not functioning very well. The ETS is plagued by consistently low carbon prices, which do not give any incentives to businesses to invest in low-carbon technologies.

The same can be said for the global emission trading system that was set up under the Kyoto Protocol: the Clean Development Mechanism (CDM). The CDM allows emission-reduction projects in developing countries to earn "certified emission reductions" (CERs), which can then be traded and sold to industrialized countries, which can use them to meet part of their emission reduction targets under the Protocol. Private companies – at least those in Europe that are subject to the ETS – can also buy CERs to help them meet their obligations under the ETS. In future, as other regional carbon markets are developed, they may be linked to the CDM system as well as to each other.

Weakness

In theory there is a lot to say for the CDM system. It helps industrialized countries meet their reduction targets at much lower cost. At the same time it encourages investors from developed countries to invest in energy efficient and climate-friendly projects in developing countries.

In practice, however, things are rather more complicated. First of all, the system, which is overseen by the UNFCCC (United Nations Framework Convention on Climate Change), headquartered in Bonn, is plagued by great bureaucracy. There are long delays in approving projects, leading to high transaction costs.

One problem is that projects need to prove "additionality", i.e. to show that the investment would not have been made under normal circumstances, without the CDM framework.

"There are 4,500 projects. How can they assess them all?"

This requirement is sensitive to fraud and difficult to meet in any case (you can't prove a negative). Moreover, project developers do not merely need to prove additionality, they are also required to propose the methodology which they aim to use to demonstrate the additionality for their particular project. This methodology has to be approved in each individual case by the UNFCCC board.

A second weakness in the CDM scheme, according to many critics, is that it tends to favour large-scale projects, such as clean-coal facilities, large-scale hydropower and HFC-23-reduction projects, whose environmental benefits are sometimes questionable. A sizable part of all CERs has been issued to this type of project. In particular projects to reduce emissions of HFC-23 ((hydrofluorocarbon), which alone are good for 42% of all CERs issued under the CDM, have come under heavy fire, so much so that the EU has banned the use of HFC-23-based CERs in the ETS.

Indeed, just recently, the Stockholm Environment Institute (SEI) issued a report calling on the UNFCCC to stop issuing CERs for all large-scale power supply projects. This would have the effect of reducing the "oversupply" of CERs that is currently in the market, says the SEI, thereby touching on a third problem with the CDM system – indeed, the major problem: the low price of CERs. The price of CERS in the CDM has collapsed from some $20 per tonne to less than $1 per tonne at this moment.

The most important reason for the low prices of CERs are the low prices paid for emission credits in the ETS, by far the largest carbon market in the world. The ETS, as is well known, has been struggling because of the economic crisis in Europe and because too many credits have been allocated in the past. The low demand emanating from Europe has also undermined the price of CERs in the CDM market.

Complete disaster

It is no exaggeration to say that the situation is pretty desperate. The Economist recently called the CDM system a "complete disaster in the making". Joan MacNaughton agrees. "The CDM is in danger of collapsing", she states straightforwardly when EER speaks with her in the offices of the World Energy Council in London.

"I worry that we will see a continuing exodus of capacity which, once lost, will not readily be regained"

MacNaughton was Vice-Chair of a high-level panel set up by the UNFCCC which spent most of the past year investigating the future of the CDM. Indeed, whether the CDM has a future at all. MacNaughton, who worked for the UK government for 35 years, the last 5 years as Director-General for Energy, before she switched to French technology company Alstom, emphasizes that the aim of the panel was not to "save the CDM". "We were totally independent", she says. "We could conclude what we wished."

Personally, she says, she was open to any conclusion when she started with the investigation. "If we decided the CDM is effective, so be it. If not, again, so be it."

But that the CDM is worth being saved is, in the end, the conclusion the panel drew. "We had a very open discussion within the panel. We had 11 members, including representatives from NGO's and from the private sector. Our conclusion was that the CDM has delivered important benefits and that it can continue to do so, if it is properly reformed." In particular, MacNaughton is convinced that to limit CO2 emissions as cost-effectively as possible, carbon markets have an important role to play. The CDM, she adds, is "an effective tool to link individual carbon markets, and to deliver the benefits of low-cost mitigation opportunities."

Looking at what the CDM has achieved so far, the panel concluded that it has "facilitated $215 billion of investments" and that "it has saved developed countries $3.6 billion in delivering a billion tonnes of greenhouse gas emissions". MacNaughton concedes that "no doubt some projects were approved that were not additional. But I am satisfied the majority of the projects does appear to have been additional."

Teething problems

Speaking to MacNaughton, who has retired from her job at Alstom and now works as independent advisor for that company and for a wide range of other energy institutions, it is clear that in the course of her investigation she has become positively enthusiastic about carbon markets in general and the CDM in particular. "It is a very innovative global mechanism", she says. "But it's still quite young. It has gone through teething problems."

Bad teething problems, to be sure. "The transaction costs involved in the CDM, the delays and inconsistencies and the lack of transparency in decision-making are very serious",

"If the CDM is not reformed, we will lose the only global mechanism we have for CO2 mitigation"

MacNaughton states. For one thing, the panel has recommended that the requirement for project developers to come up with a methodology to evaluate their project be dropped. "The UN should develop methodologies. Procedures should be much more standardized. Many small projects, particularly in the energy efficiency area, are not happening because costs are too high."

Another reason for the delays in decision-making is that currently the UNFCCC board has to make a decision about every proposed project. That is unworkable, says MacNaughton. "There are 4,500 projects. How can they assess them all? Of course they delegate the work to the Secretariat, which hires consultants, but the Board is still responsible. What we suggest is that the Board should be responsible for strategy and policymaking, but that the Secretariat should be responsible for technical and project decisions."

More ambitious

However, even if these design flaws are fixed, the simple truth is that the CDM will not work unless countries set much more ambitious targets to sustain demand for CERs, says MacNaughton. "Unless you take steps to tackle the demand issue, the CDM will wither and cease to function." If this were to happen, MacNaughton adds, it "would be damaging to the overall perception of carbon markets. And we need carbon markets. Most investments in emission reductions will have to come from the private sector. So we had better have a good framework for private investments."

To prop up demand in the CDM, the panel has recommended the establishment of a fund that would be used to purchase and retire CERs. Alternatively, the existing Green Climate Fund, which was set up by the at the 16th UN Climate Conference in Cancun, Mexico, in 2010, could be used for this purpose. At the same time, the panel calls for the establishment of a "de facto reserve bank" that would be responsible for "the health of global carbon markets generally". Similar suggestions have been heard in the EU about the ETS, although the European Commission has said it has no intention of setting up a carbon bank.

MacNaughton says that reactions to the panel's report have been overwhelmingly positive so far. The Executive Board of UNFCCC will implement the recommendations that fall within its mandate next year and there will be a further review of procedures next year.

Doha 2012 - UN Climate Change Conference (c) Mohammed Dabbous / Reuters

Unfortunately, the UN Climate Conference in Doha that has just ended, did not do much to boost the CDM, notes MacNaughton. "I am most disappointed by the refusal to allow parties who do not sign up to targets under Kyoto Protocol 2 [the period 2013-2020, editor] to use the CDM. This would have been a good way to support demand for CER's, and hence their price; and to give confidence to participants to stay in the market. Now, I worry that we will see a continuing exodus of capacity which, once lost, will not readily be regained."

Doha did not see any progress either on the the idea of a fund or facility to purchase CERs, but, says MacNaughton, "it is not yet too late for this. Certainly it could buy us some time until countries' pledges are enhanced to what is needed." As to those pledges, no major countries increased their mitigation targets at Doha, but that was not a surprise, says MacNaughton, as they were not really expected to move on this point.

Carbon taxes

So with all this bad news can we conclude that the CDM and ETS are headed for inevitable failure? MacNaughton does not think so. In fact, she remains optimistic about the prospects of carbon markets in the longer term. "Despite everything, I see a growing realization in the world that carbon markets are our best bet to address the climate problem. There are now pilots going on in some of the key countries, like India, China and Brazil. The CDM has been very instrumental in getting these countries to take a positive view on carbon markets. To help them understand that this mechanism is compatible with economic growth."

According to MacNaughton, the private sector has a big interest in promoting carbon markets. The alternative eventually would be carbon taxes, which, she says, would be much worse. "Then you are subject to much greater political and regulatory risk. Companies should prefer to be in control of their own destiny rather than be subject to political whim."

The challenge, she concludes, is "huge". "We have to get real about the scale of the effort required. If the CDM is not reformed, we will lose the only global mechanism we have for CO2 mitigation. That would be a big loss."

Joan MacNaughton on the ETS About the troubled EU's Emission Trading Scheme (ETS), MacNaughton says it is "essential" that it be fixed. "It is the leading example of carbon markets in the world. It is a tremendous achievement." MacNaughton tells how she went to the White House in Washington in 2004 to brief the US Administration on what was about to happen (the ETS started in 2005). Their reaction, she says, was disbelief. "They did not believe it was going to happen." To improve the functioning of the ETS, MacNaughton would like to see an institution set up that could periodically review the market and take measures if necessary. "You don't want to do this all the time, but at predictable periods, so that investors will know."

Who is Joan MacNaughton? Joan MacNaughton has been an influential figure in energy policymaking for many years in a variety of roles. From 2002-2006 she was Director-General Energy and from 2006-2007 Director-General International Energy Security at the UK Department of Trade and Industry. From 2004-2006 she was Chair of the Governing Board of the International Energy Agency (IEA). In 2007 she became Senior Vice-President Environmental Policies and Global Advocacy at Alstom. Since 2012 she is Global Advisor Sustainable Policies for Alstom. She is also a member of the Board of Governors of the Argonne National Laboratory, President of the Energy Institute in the UK, a Fellow of the International Emissions Trading Association (IETA), a Member of a Steering Group of the Global Carbon Capture and Storage Institute (GCCSI) and Executive Chair of Energy and Climate Policy Assessment at the World Energy Council (WEC).