Climate Trading: Development of Greenhouse Gas Markets

CLIMATE TRADING

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Climate Trading Development of Greenhouse Gas Markets

DEBORAH STOWELL

ª Deborah Stowell 2005 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. The author has asserted her right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published in 2005 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire, RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world. PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 1–4039–1616–0 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data. Stowell, Debbie Climate trading: development of greenhouse gas markets / Debbie Stowell. p. cm. — (Finance and capital markets series) Includes bibliographical references and index. ISBN 1–4039–1616–0 1. Emissions trading. 2. Climatic changes – Economic aspects. 3. Air – Pollution – Government policy. 4. Greenhouse gases – Law and legislation. I. Title. II. Series. HC79.A4S76 2004 333.9 0 214—dc22 10 9 8 7 6 5 4 3 2 1 14 13 12 11 10 09 08 07 06 05 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne.

2004056537

Contents

List of Figures

vii

List of Tables

ix

List of Boxes

xi

Acknowledgements

xiii

Acronyms and Abbreviations

xiv

1 Introduction 1.1 What is Climate Change and Why is it a Problem? 1.2 Science: The Basis for Action 1.3 Addressing the Problem 1.4 From Market-based Incentive to the Kyoto Mechanisms

1 3 6 12 15

2 Climate Change and the UN Process 2.1 The UN Framework Convention on Climate Change 2.2 Negotiations on the Kyoto Protocol 2.3 The Kyoto Protocol

18 18 24 26

3 The Kyoto Mechanisms – A Framework for International Emissions Trading 3.1 Overview 3.2 Information Systems under the Protocol 3.3 International Emissions Trading 3.4 Joint Implementation 3.5 The Clean Development Mechanism

37 37 42 51 55 64

v

vi

CONTENTS

4

Building Markets 4.1 Political Decisions Define the Rules of the Game 4.2 US Experience with Trading Programmes 4.3 Emissions Trading in the Policy Mix 4.4 Domestic Emissions Trading Schemes 4.5 The EU Trading Scheme 4.6 Other Emissions Trading Schemes 4.7 Sub-national Trading Schemes

82 84 89 93 96 109 119 122

5

Managing Carbon 5.1 Carbon as an Asset 5.2 The Energy Challenge 5.3 Anticipated Impacts on the Power Sector 5.4 Challenges for Industry 5.5 Managing Risk

126 126 129 131 138 147

6

Programmes Targeting Project-based Mechanisms 6.1 CDM Developments 6.2 Costs and Risks Associated with Project-based Credits 6.3 The World Bank Carbon Finance 6.4 The Dutch Programmes 6.5 The Finnish Programme 6.6 Conclusion

159 160 171 177 182 189 193

7

The 7.1 7.2 7.3 7.4

194 195 200 204 210

8

Carbon Costs in an Uncertain World 8.1 The Allocation Process 8.2 Future Outlook for the Protocol 8.3 Prospects Beyond 2012

Carbon Market Tradable Instruments Market Formation Market Segments The Price of Carbon

211 212 216 218

Glossary of Terms

220

Notes

229

Bibliography

237

Index

244

List of Figures

1.1 The greenhouse effect 1.2 Carbon dioxide and methane concentrations in the atmosphere 1.3 Comparison of potential impacts to actual events and their costs

12

3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8

Communication between registries Review timeline for finalizing assigned amount JI First-track project cycle JI Second-track project cycle Simplified illustration of Stage 1 Simplified illustration of Stage 2 Simplified illustration of Stage 3 Simplified illustration of Stages 4 and 5

49 54 60 63 74 75 76 76

4.1 Danish CO2 emissions allowances 2001–2002 4.2 Gateway between absolute and relative sectors 4.3 Penalty for non-compliance

100 107 108

5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8

129 130 141 142 155 157 158 158

World primary energy demand Shares of aggregate emissions by sector, 2000 Timeline for large projects Timeline for small projects Target setting A near-term decision tree SO2 allowances banked, 1995 through 2002 Draw-down of banked allowances from SO2 programme

6.1 The Dutch CDM process

4 4

187

vii

viii

7.1 7.2 7.3 7.4 7.5 7.6 7.7

LIST OF FIGURES

Spot transactions Forward transactions Options contracts Commodities exchange Direct investment Volumes of emissions reductions transacted (1996–2003) Changes in major market buyers from 2001 through 2003

196 197 197 198 199 200 207

List of Tables

1.1 Scientific developments 1.2 Examples of impacts from projected changes during the twenty-first century 1.3 Comparison of direct regulation and market-based policies 2.1 2.2 2.3 2.4

National communications reporting requirements Meetings of the Conference of the Parties The EU Burden-sharing Agreement Countries included in Annex B to the Kyoto protocol and their emissions targets

3.1 The Kyoto mechanisms 3.2 Kyoto reduction units 3.3 Information requirements under the common reporting format 3.4 Example from the Common Reporting Format under the Convention 3.5 Elements of serial number of units 3.6 Source Categories in Annex A of the Protocol 3.7 The commitment period reserve 3.8 JI first and second track 3.9 CDM project cycle 4.1 Summary of range of policy instruments either implemented or planned in selected Annex I countries 4.2 Questions for consideration in assessing the potential for emissions trading 4.3 Types of policy instruments examined in INTERACT study

8 11 14 21 27 31 32 39 41 46 48 49 53 55 58 78 83 85 95 ix

x

4.4 4.5 4.6 4.7 4.8

LIST OF TABLES

European emissions trading schemes in force Example of Danish initiatives for meeting reduction target 2001 and 2002 allocations under Danish ETS Examples of domestic emissions trading schemes in planning stages NSW greenhouse gas abatement scheme

97 98 100 120 124

134

5.4

CO2 emission price levels and impacts on generation costs Survey of studies on power generation under trading schemes Eurelectric’s greenhouse gas and energy trading simulations Managing carbon

6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11

Partial list of CDM and JI programmes Examples of methodologies for CDM projects Comparison of CDM and JI second-track requirements CDM initial registration fees Overview of World Bank carbon funds PCF Project Cycle Features of the Dutch JI programme Dutch CDM project cycle Summary table of contracted intermediaries Summary of JI requirements Summary of CDM requirements

161 165 171 174 178 180 184 188 189 191 192

7.1

Comparison of market activity to policy development

202

5.1 5.2 5.3

133

135 145

List of Boxes

1.1 Global Warming Potentials 1.2 Flexibility requirements

5 16

2.1 Parties to the UNFCCC and the Protocol 2.2 Institutional structure of the UNFCCC

29 29

3.1 3.2 3.3 3.4 3.5 3.6

40 44 50 69 71 72

Terminology of the Kyoto trading system National inventory principles and definitions Message sequence for registry systems Panels to the CDM executive board CDM project activities Baseline methodologies

4.1 Design elements for emissions trading schemes 4.2 The Climate Change Levy and Climate Change Agreements 4.3 Auction and target setting process 4.4 Activities covered by the EU ETS Directive 4.5 Criteria for National Allocation Plans 4.6 Requirements for monitoring methodologies 4.7 Reporting requirements for installations 5.1 BP’s auditing process 5.2 The greenhouse gas protocol: A corporate accounting and reporting standard 5.3 Examples of direct and indirect emissions within a system boundary 5.4 Example of monitoring and reporting requirements under EU ETS

86 102 104 110 112 114 116 140 149 151 152

xi

xii

6.1

LIST OF BOXES

6.2

PCF legal instruments and relation to CDM and JI project cycles Contractual requirements under ERUPT

181 185

8.1

EU requirements for linking ETS

215

Acknowledgements

Writing a book on a subject that changes almost daily is a daunting task. I could not have accomplished it without the assistance and moral support of my colleagues, friends and family. In particular, this book would not have been possible without the support of my husband, Georg Børsting, who is an expert on climate issues in his own right. He not only spent countless hours reading through and commenting on different drafts, but gave me the time I needed to complete the book. I would also like to thank Rick Bradley for his thoughts and comments and for the initial encouragement to take on this task. A special thanks also goes to Carol Berrigan for an unending supply of moral support. I would also like to thank the following colleagues and friends: Clare Breidenich John Drexhage, Dirk Forrister, Chris McDermott and Jonathan Pershing. The author and publishers would like to thank the Organisation for Economic Co-operation and Development/International Energy Agency (OECD/IEA) for permission to reproduce copyright material in this publication (Figure 5.6, p. 157). I would like to dedicate this book to Alessandra and Vincent and my mom and dad. Deborah Stowell

xiii

Acronyms and Abbreviations

AGBM AA AAU AIJ CDM CER CFC CEMS CH4 CO2 COP COP/MOP DOE EIT ERU GHG GWP HFC IE IEA IET IPCC JI LULUCF N2O xiv

Ad Hoc Group on the Berlin Mandate Assigned Amount Assigned Amount Unit Activities Implemented Jointly Clean Development Mechanism Certified Emission Reduction units Chlorofluorocarbon Continuous emissions monitoring systems Methane Carbon Dioxide Conference of the Parties Conference of the Parties serving as the Meeting of the Parties Designated Operational Entity (under the CDM) Economy in Transition Emissions Reduction Unit Greenhouse Gas Global Warming Potential Hydrofluorocarbon Independent Entity (under JI) International Energy Agency International Emissions Trading Intergovernmental Panel on Climate Change Joint Implementation Land Use and Land Use Change and Forestry Nitrous Oxide

ACRONYMS AND ABBREVIATIONS

NGOs NOx ODA OECD OPEC PCF PFC RMU SBI SBSTA SF6 SO2 UNCED UNEP UNFCCC UNGA WMO

xv

Non-Governmental Organization Nitrogen Oxides Official Development Assistance Organisation for Economic Cooperation and Development Organization of Petroleum-Exporting Countries The World Bank’s Prototype Carbon Fund Perfluorocarbon Removal Unit Subsidiary Body for Implementation Subsidiary Body for Scientific and Technological Advice Sulfur Hexafluoride Sulfur Dioxide United Nations Conference on Environment and Development (1992) United Nations Environment Programme United Nations Framework Convention on Climate Change United Nations General Assembly World Meteorological Organization

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CHAPTER 1

Introduction Weather and climate have a profound influence on life on Earth. They are part of the daily experience of human beings and are essential for health, food production and well-being. IPCC Third Assessment Report Climate change has been heralded as the most serious environmental problem facing humankind, deserving urgent action to curb emissions of the greenhouse gases causing the problem. The scientific community is in general agreement that greenhouse gases are accumulating in the atmosphere, that temperatures are rising and it is most likely due to human activity. The Intergovernmental Panel on Climate Change (IPCC) (see Section 1.2.1) in its third assessment report (2001) suggested that there is new and stronger evidence that most of the warming observed over the last 50 years is attributable to human activities. But many uncertainties still exist about the causes and effects of climate change. They are acknowledged by the scientific community and used by sceptics to argue for a greater understanding of the science before concrete action is taken. One Uncertainty is the extent to which changes in temperature might be due to the natural variability of the climate system. A second is the ability of models to simulate the natural variability of the climate system over long time scales (decades and centuries). A third uncertainty exist over how accurate a picture we have of the global mean temperatures for the past millennium since it is reconstructed using proxy information. Despite such uncertainties, the majority of scientific opinion indicate that some action is needed to mitigate the potential effects of climate change. Because of the long-lived nature of greenhouse gases, policy makers cannot ignore the prevailing view in the scientific community. If the sceptics are correct, and we begin to act, then at worst economies will become more energy efficient. If the majority of the scientific community is correct, and we don’t begin to act, then the effects may be felt for centuries. By acting 1

2

CLIMATE TRADING

now, policy makers hope to reduce the effects of climate change, since scientific research indicates that levels of CO2 will continue to rise in the atmosphere long after emissions have been reduced. Many developed country governments have agreed to take on legally binding emissions reduction and limitation targets, and many are developing policies that ultimately will require action to reduce greenhouse gas emissions in a broad set of sectors and companies. Reducing the amount of greenhouse gases released in the atmosphere through the use of emissions trading, is likely to be the most economically efficient way of meeting targets set by countries. The nature of the climate change problem lends itself to the use of emissions trading. There is clear scientific understanding of why greenhouse gases are increasing in the atmosphere and general consensus on the impacts that this build-up will have if no action is taken. The geographic scope is well understood: climate change is a global problem, since greenhouse gases mix uniformly in the atmosphere. Causes of the build-up of greenhouse gases due to human activity are well understood, including the link to production and consumption of energy. Major sources of emissions are easily identifiable, and there are a sufficient number of sources within a country with a range of cost options. If the policies adopted by countries are to work, however, it requires that companies in particular have a clear understanding not only of what climate change is, but what it means for their bottom line. In recent years there has been an explosion of studies examining various facets of climate change issues and policies to mitigate its effects. In studies examining ways to mitigate the effects of climate change, one of the key themes has been the necessity to target energy intensive industry since these account for a large percentage of greenhouse gas emissions in industrialized countries. The focus of policy makers has shifted from direct regulation of an environmental problem to structuring policies that target a problem at least cost to society. This entails giving industry the flexibility to determine the most cost effective measures for it to meet a regulation. In order for industry to do this, however, it requires understanding (in this case) the implications of climate change and the effects that a carbon-constrained world will have on companies. The greenhouse gases that create the climate change ‘problem’ are becoming a commercial and tradable commodity with clear implications for the way companies conduct business. How industry deals with its greenhouse gas emissions in the present could influence its competitiveness later when tighter regulations are likely to occur (The Carbon Disclosure Project, 2003). The purpose of this book is to provide an understanding of the international climate change process as it relates to the development of greenhouse gas emissions trading markets, as well as information on the various markets that are forming. The information contained in this book is provided as succinctly as possible, covering a broad range of issues related to the developing carbon market. It is intended as an introduction to the issues

INTRODUCTION

3

facing investors, brokers, policy makers and individuals who will enter or simply want to know more about this market.

1.1 WHAT IS CLIMATE CHANGE AND WHY IS IT A PROBLEM? The weather and the climate are inextricably linked and are constantly changing. They vary from location to location, season to season and by time. When there are significant changes in the ‘average’ state of the climate, that is, an increase in the mean temperature of the earth’s surface, that last for long periods of time (decades or longer), this is considered ‘climate change.’ The climate system changes over time, due to interactions between its various components; external changes both naturally occurring (i.e. the release of aerosols into the atmosphere from volcanic eruptions), and manmade influences such as burning fossil fuels, changes in land use and destruction of forests1 (IPCC, 2001). In order to understand what climate change is, it is important to understand the relationship that exists between the climate system and the sun. The composition of the various components of the climate system also influences how the climate changes. It is a complex relationship that makes the earth liveable. Energy from the sun drives the climate system. Solar energy enters the earth’s atmosphere in the form of short-wavelength radiation, some of which is reflected away by the earth’s atmosphere and surface. Most of it passes straight through the atmosphere to warm the earth’s surface. Energy is emitted upwards from the surface in the form of long wavelength, infrared radiation. Most of this radiation is absorbed in the atmosphere by ‘greenhouse gases’,2 such as water vapour,3 carbon dioxide, ozone, methane, nitrous oxide, and halocarbons and other industrial gases (CFCs,4 HFCs and PFCs). With the exception of the industrial gases, all greenhouse gases occur naturally. These greenhouse gases make up only a small fraction of the atmosphere (about 1 per cent) but play a vital role in the earth’s climate system. Greenhouse gases serve much the same purpose as the blanket one uses in winter to keep warm – they help retain heat. Greenhouse gases help retain heat by preventing some of the infrared radiation from escaping straight back into space, and instead lets the energy flow through the atmosphere and escape slowly. This delicate and symbiotic relationship is known as the ‘greenhouse effect’ (Figure 1.1). With the ‘natural’ greenhouse effect, the average temperature of the earth is about 15 C, without it the average temperature would be 18 C, too low to sustain life.5 The climate system requires balance – the energy that comes into it, must also exit it. This balance is maintained through sources that emit greenhouse gases and sinks that sequester or store carbon (such as green plants or the ocean). Since pre-industrial times, however, emissions from carbon

4

CLIMATE TRADING

THE GREENHOUSE EFFECT Sun

Solar radiation passes through the atmosphere...

Most infrared radiation is absorbed into the atmosphere by greenhouse gases and some passes through the atmosphere into space.

...some solar radiation is reflected by the Earth and the atmosphere back into space.

Atmosphere

Most of the radiation is absorbed by the Earth’s surface

Earth

Infrared radiation is emitted from the Earth's surface

Figure 1.1 The greenhouse effect Source: The author.

dioxide (from burning fossil fuels and deforestation), methane (primarily from agricultural and land-use activities), nitrous oxide (from agriculture and changes in land-use), ozone (generated by the fumes in automobile exhaust) and industrial gases have increased dramatically. Since 1750, emissions of CO2 has increased 30 per cent while CH4 has increased some 150 per cent (Figure 1.2). The increase in emissions of greenhouse gases effectively creates a thicker blanket that makes it more difficult for energy to be released back Carbon Dioxide Concentrations (ppm) 380 360 340 320 300 280 260 240

Methane Concentrations (ppb) 2000 1750 1500 1250 1000 750 500

1000

1300

1600

1900

1000

1300

1600

1900

Figure 1.2 Carbon dioxide and methane concentrations in the atmosphere Source: Based on figures from UNEP and UNFCCC Climate Change Information Kit and IPCC’s Third Assessment Report.

INTRODUCTION

5

into space. This build-up of gases traps more energy than is released back into the atmosphere. In order to compensate for the added energy, the earth’s climate adjusts itself.6 These adjustments can include an increase in the global mean temperature, increases or decreases in precipitation, an increase in extreme weather events, as well as many other changes. This increase in gases creates what is known as the ‘enhanced’ greenhouse effect. Each greenhouse gas acts differently in the atmosphere. They have different lifetimes and different capacities for retaining heat. The major contributor to man-made climate change is carbon dioxide, which accounts for over 60 per cent of the enhanced greenhouse effect. It has a lifetime of approximately 100 years – meaning the CO2 we admit into the atmosphere today will remain there for at least 100 years. While CO2 is the most abundant greenhouse gas in terms of anthropogenic contribution, it is not as efficient in retaining heat as the other greenhouse gases. In order to compare the six greenhouse gases, the IPCC created global warming potentials (GWPs – see Box 1.1) where each gas is assessed relative to CO2. GWPs Box 1.1

Global Warming Potentials

The GWPs of greenhouse gases are established by the IPCC in order to compare the ability of these gases to trap heat in the atmosphere. They are based on the ability of each gas to absorb heat (radiative efficiency) in comparison to carbon dioxide, as well as the amount of a particular gas that is removed from the atmosphere over a given number of years relative to carbon dioxide. (For reporting purposes within the UNFCCC and for the mechanisms, a 100-year time horizon is used.) GWPs provide a common measurement and conversion rate between the gases with the common unit being CO2 equivalents. Global Warming Potential+

Greenhouse gas Carbon Dioxide Methane Nitrous Oxide Hydrofluorocarbons Perfluorocarbons Sulphur Hexafluoride

CO2 CH4 N2O HFCs PFCs SF6

1 21 310 100–12,000 6,500–9,200 23,900

Notes: + As derived from the IPCCs Second Assessment Report.  Depends on exact chemical composition. For example Perfluoromethane (CF4) has a GWP of 6,500, whereas Perfluouroethane (C2F6) has a GWP of 9,200. Source: IPCC, 2001.

6

CLIMATE TRADING

also paved the way for creating a basis for a tradable commodity based on a CO2 equivalent. For example, 1 tonne of methane is equal to 21 tonnes of CO2 (IPCC).

1.2

SCIENCE: THE BASIS FOR ACTION

In 1896, Swedish scientist, Svante Arrhenius identified the greenhouse effect. But scientific research on climate change, in particular of the buildup of greenhouse gases in the atmosphere, only developed in the latter half of the twentieth century. In 1952, the International Council of Scientific Unions, decided to establish the International Geophysical Year (IGY) in order for scientists from around the world to participate in coordinated activities of geophysical phenomena. From July 1957 through December 1958 scientists from 67 countries undertook various activities including for the first time continuous monitoring of carbon dioxide. This resulted in the discovery (in the early 1960s) that atmospheric concentrations of CO2 were increasing. Other trace gases were not monitored with any regularity until the 1970s and their effect on the atmosphere was not recognized until the 1980s. In the decades that followed the IGY, technological advances, including more powerful computers, enabled scientists to gain a better understanding of the interaction between greenhouse gases and the global climate. Environmental issues first moved towards the centre of the international stage in the 1970s when the UN held a Conference on Human Environment, although the focus on environmental issues tended towards more regional or local problems such as hazardous waste or oil spills. It was also at this time that the UN Environment Programme (UNEP) was established for the purpose of providing ‘leadership, and encouraging partnership in caring for the environment by inspiring, informing and enabling nations and peoples to improve their quality of life without compromising that of future generations’. The World Meteorological Organisation (WMO) along with UNEP helped to focus attention on and familiarize policy makers with climate change, and organized several scientific and Ministerial level conferences, from the late 1970s to the late 1980s. By the end of the 1980s, a flurry of activities was taking place within the international community in preparation for what would become the negotiating process for the UN Framework Convention on Climate Change. During the 1970s and 1980s, climate change was an area of concern relegated to the scientific and non-governmental communities. But as data accumulated and confidence grew in the science of climate change, scientists were able to focus policy makers’ attention on climate change as an environmental problem. In 1979, the WMO organised the first World

INTRODUCTION

7

Climate Conference attended primarily by scientists. In 1985 the scientific community stated that climate change was a concern for policy makers, and in 1987 called on states to limit temperature increases due to climate change to 1 C per century (first and second Villach Conferences). In 1988, the Government of Canada convened the ‘International Conference on the Changing Environment: Implication for Global Security’ in Toronto. Approximately 300 scientists and 50 policy makers attended it. Based on the outcome of the Villach Conferences, Toronto conference participants issued a ‘call to action’ for governments and industry to, among other things, reduce carbon dioxide emissions 20 per cent from 1988 levels by 2005. During the 1980s, the UN increased its focus on environmental issues. In 1983 it established the World Commission on Environment and Development that resulted in the 1987 Report Our Common Future (more commonly known as the Brundtland Report). The Brundtland Report put forward the notion of sustainable development – defining it as meeting the needs of the present generation without compromising the ability of future generations to meet their own needs. The following year, the UN General Assembly adopted a resolution recognizing climate as the ‘common concern of mankind’ and endorsed the establishment of the IPCC. Also during this time, countries began to focus on climate change as an environmental issue. In the early 1990s, the science of climate change played an important role in the development of the United Nations Framework Convention on Climate Change (the Convention). In 1990, the Second World Climate Conference called on countries to stabilize greenhouse gas emissions, and for developed countries to take on emission reduction targets and/or adopt national programmes or strategies. Many of the issues raised in this conference were later embedded in the Convention as principles. Climate science continues to be the basis for international negotiations on climate change. Although there is uncertainty involved in predicting the range and intensity of the effects of climate change, the general scientific consensus is that human activities have left an indelible fingerprint on the global climate.

1.2.1 The Intergovernmental Panel on Climate Change (IPCC) In 1988, the WMO and UNEP created the IPCC. The purpose of the IPCC is to develop a coordinated scientific assessment of climate change as well as assessment of possible responses. Members of the IPCC include climate scientists, economists, risk experts and policy makers. The IPCC does not undertake its own research, but bases its assessments primarily on published and peer reviewed scientific technical literature. Since its creation, the IPCC has become the foremost scientific body on climate change. The IPCC

8

CLIMATE TRADING

Table 1.1 Scientific developments Year

Event

1957–58

International Geophysics Year – start of continuous monitoring of carbon dioxide

1972

UN Conference on Human Environment &

UNEP established

1979

First World Climate Conference (WMO)

1985

First Villach Conference

1987

The Brundtland Report issued Second Villach Conference

1988

IPCC established by WMO and UNEP UN General Assembly adopts resolution recognizing climate change as a ‘common concern of mankind’.

1990

IPCC’s First Assessment Report published UN General Assembly establishes Intergovernmental Negotiating Committee (INC) to conduct negotiations on framework convention on climate change

1991 (February)

INC meets for first time

1992 (May)

Framework Convention on Climate Change adopted

1992 (June)

Convention opened for signature at UN Conference on Environment and Development (‘Earth Summit’)

1994

UN Framework Convention on Climate Change enters into force

1995

IPCCs Second Assessment Report published

1997

Kyoto Protocol adopted

2001

IPCCs Third Assessment Report published

publishes scientific assessments at five-year intervals. In 1990, the IPCC produced the report ‘Climate Change: The IPCC Scientific Assessment’. This increased focus by the scientific community and the findings helped push climate change onto the political agenda. The IPCC’s Second

INTRODUCTION

9

Assessment Report was released in late 1995 with much debate. While many Parties to the UN Framework Convention on Climate Change saw it as a comprehensive assessment on climate change, others felt it was incomplete and biased. The main reason for the controversy was the report’s conclusion that the balance of scientific evidence suggests a discernible human influence on the global climate. Because of its uniqueness and composition, the IPCC is likely to always be open to criticism, just as the research the IPCC assesses is open to interpretation. Regardless, the IPCC and its assessments are one of the driving forces behind governments, NGOs and individuals calling for more action to reduce the risks of climate change. In 2001 the IPCC released ‘Climate Change 2001: The IPCC Third Assessment Report’. The report produced the strongest statement to date concluding that there is ‘new and stronger evidence that most of the warming observed over the last 50 years is attributable to human activities’. More importantly, however, it points to the potential for climate change to influence every facet of society. The effects of climate change are broad and far reaching. Scientists project that the Earth’s average temperature could increase between 1.4 and 5.8 C by 2100 if no major efforts are undertaken to reduce emissions. This could result in a range of events, including:7 &

A rise in sea level between 9 and 88 cm leading to more coastal erosion, flooding during storms and permanent inundation;

&

Severe stress on many forests, wetlands, alpine regions and other natural ecosystems;

&

Greater threats to human health as mosquitoes and other diseasecarrying insects and rodents spread diseases over larger geographical regions;

&

Disruption of agriculture in some parts of the world due to increased temperature water stress and sea-level rise in low-lying areas (such as Bangladesh or the Mississippi River delta).

The above list refers to what some people might consider purely environmental issues. But even these have impacts that go beyond environmental damage. People living in areas that become permanently inundated will have to find somewhere to go, so flooding creates a migration problem. It could also affect farmlands, which could create a food production problem. But the costs of the impacts of climate change are difficult to quantify or even to specify specifically for one country or region. The impacts will vary. One example of this would be the impact of higher highs and higher lows in temperatures. An increase in higher temperatures (more hot days

10

CLIMATE TRADING

and heat waves) means that more people are likely to die or experience serious heat related illnesses. This would primarily affect those least able to cope with heat stress such as the elderly and urban poor. It would also affect food sources and production by increasing heat stress in livestock and could increase the risk of damage to crops. It would also increase demand for energy as people attempt to cool down and have an added effect of destabilizing energy supply due to the increase in demand. On the other hand, an increase in low temperatures (fewer cold days and cold waves) would decrease cold related deaths and illnesses, decrease the risk of damage to some crops while increasing the risk to others and decrease the demand for energy (see Table 1.2). Some countries or regions will be better able to cope than others – with developing countries less able to adapt to climate change than many developed countries (IPCC, 2001). All sectors of an economy would also feel the impacts from climate change: the insurance industry from economic losses due to weather related events; the agricultural sector from changes in food production and other changes; the energy sector from increased demand for heating or cooling and so on. Since the 1950s the number of extreme weather events, that is weather events that are rare or unusual for a particular place or particular time, has increased dramatically. During the 1950s 13 extreme weather events were recorded whereas there were 72 events from 1990 to 1998 (IPCC). The IPCC estimates that economic losses from catastrophic weather related events in the last 50 years has increased more than ten-fold, and in general the hardest hit are those who are uninsured. In 2003, for instance, Swiss Re estimates that total economic losses for man-made (such as explosions) and natural catastrophes (including weather related events) amounted to USD 70 billion, of which only USD 18.5 billion was insured (Swiss Re sigma No.1/ 2004). Insured losses have also increased since about 1970 as it has become more common to insure valuables, properties and business against potential losses. Development of coastal areas and floodplains, and increases in population density of these areas also accounts for some of the increase in economic losses. If current trends continue, economic losses could reach $150 billion in the next decade and may seriously affect the insurance and reinsurance industry (UNEP FI). The potential economic impacts of climate change events make it more than just an environmental issue. Recent extreme weather events have had significant economic consequences, and although they cannot be directly attributed to climate change, they are indicative of the costs associated with impacts projected by the IPCC during the 21st century (see Figure 1.3). This makes climate change not only an environmental issue, but an economic, energy, national security, food security and health issue. Indeed there is a growing body of literature showing the opportunities to virtually every sector and every country. What was once thought of as merely a weather related event (warmer temperatures) or

INTRODUCTION

11

Table 1.2 Examples of impacts from projected changes during the twenty-first century Potential events

Likely to result in

More hot days and heat Increased death rates and incidence of waves (higher maximum serious illness in the elderly and urban poor. temperatures), very likely Reduced reliability of energy supplies from over nearly all land areas higher summer temperatures. Increased heat stress in livestock and wildlife A higher risk for damage to crops. Fewer cold days (higher Decrease in cold-related (human) illness and minimum temperatures), mortality. that is fewer days with Increase in some crop yields in some regions frost and fewer cold but an increased risk to crops in other waves, very likely over regions. nearly all land areas Greater range and activity of some pests and vector-borne diseases (such as malaria). Reduced energy demand for winter heating. More intense precipitation Increased floods, landslides, avalanches and events, very likely over mudslides. many areas Increased pressure on governments and private flood insurance systems and disaster relief. A likely increase in summer drying over mid-latitude continental interiors and an associated risk of drought

Decreased crop yields. Decreased water availability and reduced water quality. Increased risk of forest fires. Increased damage to building foundations from ground shrinkage.

A likely increase in tropical Increased risks to human life, including risks of infectious disease epidemics. cyclone peak wind Increased coastal erosion as well as damages intensities, mean and to coastal buildings and infrastructure. peak precipitation Increased damage to coastal ecosystems intensities such as coral reefs and mangroves. Notes: The Third Assessment Report uses the following estimates of confidence for the likelihood of impacts: Very likely: 90 to 99 percent chance; Likely: 66 to 90 percent chance. Source: Adapted from Table SPM-1 from the IPCCs Third Assessment Report, Summary for Policy Makers (2001).

12

CLIMATE TRADING

Weather event

Actual event related to potential impacts

More hot days and heat waves/regional droughts

Crop failures in southern, central and eastern Europe in 2003

12.3

Forest fires in Portugal in 2003

1.6

Flash floods (in December) after summer heat wave in 2003

1.5 (of which 0.9 was insured)

Floods Europe in July and August 2002

15.6 (of which 3.3 was insured)

More intense precipitation events

Actual losses in USD billion

Figure 1.3 Comparison of potential impacts to actual events and their costs Source: Compiled by author with data contained in Swiss Re, sigma, No.1/2004.

confused with other environmental issues (i.e. ozone depletion) has in recent years taken on new significance.

1.3

ADDRESSING THE PROBLEM

While the science behind climate change has strengthened political action has been much slower to develop. Internationally, discussions on climate change as a global environmental issue have been ongoing for almost 30 years. Much of that time has been spent negotiating how and who should limit greenhouse gas emissions. The first step towards progress came in 1992 when the UN Framework Convention on Climate Change (the Convention) was opened up for signature, leading to the 1994 entry into force of the Convention. Although it did not establish quantitative commitments to limit or reduce emissions, it laid the ground for future negotiations. It was not until 1997 that the international community made real progress on taking steps to limit greenhouse gas emissions. In December of that year, Parties to the Convention adopted a unique agreement to reduce greenhouse gas emissions. The Kyoto Protocol to the Convention (Protocol) contains quantitative commitments to reduce or limit greenhouse gas emissions (targets) for developed countries equal to an overall reduction of 5 per cent from 1990 levels during the period from 2008 to 2012. It contains the basis for an international trading system by establishing three market-based mechanisms. It is the inclusion of these mechanisms that makes the Protocol one of the most innovative international agreements to date. The Kyoto mechanisms (international emissions trading, joint implementation and the clean development mechanism) were incorporated for two main reasons. First, it does not matter where greenhouse gas emission reductions take

INTRODUCTION

13

place. Once greenhouse gases enter into the atmosphere, they mix uniformly, meaning they do not create localized environmental problems, as do other gases such as sulphur dioxide (a precursor to acid rain). Because greenhouse gases have long life spans, they also remain mixed in the atmosphere for long periods of time. Reducing emissions in the UK or the US is as effective as reducing emissions in China. It does not matter to the climate system where the reductions occur. Second, by harnessing market forces, countries will be able to meet their greenhouse gas targets more efficiently and effectively than traditional command and control policies, that is, it lowers compliance costs. The rational for their inclusion was simply that without them, countries would have little flexibility in meeting their targets, which in turn increases costs that could make it more difficult for countries to meet their commitments. Market-based incentives, such as emissions trading, enables countries to put in place systems that encourage industry to innovate, while providing environmental certainty, credibility and cost efficiency in meeting a reduction target, and makes it possible for Parties to take on more stringent targets. Environmental policies generally combine a goal with means to achieve that goal (Stavins, 2001). Under a direct regulatory approach, a goal is identified and a technology standard or emissions rate is put in place. Market-based policies set a goal, but rely on market signals to encourage sources to change their behaviour. They create an environment where sources internalize the ‘environmental externalities’. Sources are encouraged to recognize the cost to society of their emissions and incorporate it into their decision-making (OECD/IEA, 2001). It attaches a monetary value to something that previously had no value. Market-based policies recognize that sources even within the same firm have different costs in controlling emissions. While the policy may set a reduction target or emissions level a firm must meet, it provides those affected by it with flexibility in how it meets the goal. This could mean adopting better control technologies, implementing energy efficiency measures or (in the case of a trading system) purchasing ‘reductions’ from a source whose internal costs for reducing emissions were lower. Direct regulation continues to play an important role in meeting environmental goals. In recent years, however, governments have expanded their policy tools to include the use of market-based instruments to reduce emissions of gases, such as sulphur dioxide, nitrous oxide (NOx) and greenhouse gases. The appropriateness of these policies is dependent on several factors (Table 1.3). Market-based policies work well in reducing emissions when the gas is widely dispersed in a region (and therefore it does not matter where the reduction occurs), it can be accurately monitored and reported, and the affected sources have different abatement costs. Since it is in the best interest of the firm to find efficient and low-cost methods for

14

CLIMATE TRADING

Table 1.3 Comparison of direct regulation and market-based policies Direct regulation

Market-based policy

Specific to limited location/ facility or emissions are toxic. Emissions must be reduced at specific location.

Emissions are dispersed over large area.

Sources

Specific location or facility.

Many sources.

Monitoring

No ability to monitor total mass emissions or sources cannot accurately and consistently measure emissions.

Emissions can be measured and affected sources have ability to accurately monitor.

Emissions cap

While a level may be set, various factors (increased usage, and new emission sources) can threaten the goal.

With cap and trade an absolute level can be set and met; with taxes, the ability to meet the goal can be hampered by various factors.

Compliance

Based on adherence to technology or process specifications.

Performance-based.

Emissions location

Location of reductions does not matter.

meeting a target, technology plays an important role in market-based policies (Stavins, 2001). Environmental taxes and cap and trade systems are two examples of market-based policy instruments.8 One of the major differences, however, is that an environmental tax sets a price for emissions but not a level or quantity that can be emitted, while a cap and trade system sets a level but not a price (OECD, 2001). Under an environmental tax, a fee is assessed per unit of emissions sending a price signal to the affected source to ensure that the cost of pollution on the environment is taken into account. Under a cap and trade system, a regulatory authority establishes an absolute cap on emissions, but the price adjusts according to the marginal abatement cost (the cost of controlling a unit of emissions). Although taxes can help reduce emissions, it is not guaranteed to do so since it is dependent on many factors including the tax level, increases in production and consumption, exemptions and the like. Cap and trade systems, if designed effectively, set a target

INTRODUCTION

15

that industry must meet, but enables covered sources to do so at minimal cost to society. The effectiveness of both policy instruments depends on how they are structured and implemented. One of the benefits of the Kyoto Protocol trading system is that it allows countries the flexibility to trade allowances in order to remain in compliance. For instance, Country A adopts an 8 per cent reduction target from 1990 levels, but institutes a trading scheme for its industry that only covers 50 per cent of the needed reductions. If it is to comply with the Protocol target it must ensure that the non-trading sectors of its economy reduce emissions through other policies and measures. If these sectors do not reduce emissions as needed, Country A has the option of buying allowances from other countries under the Protocol rather than facing non-compliance. Up until the end of the last century, the majority of experience with emissions trading systems resided in the US. Since then however, emissions trading has become a popular policy instruments for addressing environmental issues. Emissions trading programmes are used to address a range of environmental problems from SO2 (Canada, Slovakia, China, the US), NOx (Canada, the US, Denmark) and greenhouse gases (the UK, Denmark, the EU, with many other countries presently designing trading systems), to other pollutants such as volatile organic compounds (Canada and the US) and total suspended particulates (Chile).

1.4 FROM MARKET-BASED INCENTIVE TO THE KYOTO MECHANISMS Prior to the second session of the Conference of the Parties to the Climate Convention, the primary focus of the climate negotiations was on traditional policies and measures, such as those listed under Article 2 of the Protocol. Countries had their own particular approach to implementing policies and measures. The EU, for instance, favoured implementing harmonized policies and measures, while OPEC countries focused on subsidy removal and compensation for loss of any oil revenue due to climate change policies. But agreement on a prescriptive list of policies and measures was not possible, particularly since some developed countries, argued that national circumstances make a prescriptive list impossible to implement. Many key developed countries, including the US, were unwilling to discuss taking on legally binding commitments under such an approach. Part of the argument for moving away from lists of policies and measures was that marginal costs vary from country to country, from sector to sector and from source to source. Requiring all countries to meet a target using a proscriptive list was inefficient and ultimately did not provide sufficient flexibility to ensure that countries would be able to meet a legally binding commitment.

16

CLIMATE TRADING

In the fall of 1995, the US government decided to push for international emission trading to be included in a follow-on agreement to the Convention, and began designing a trading proposal. One year later, the US announced that it favoured legally binding commitments. It was at this time that the US made flexibility a cornerstone of its position in the negotiations, and the key requirement for accepting binding targets. It became the keyword in the short 18-month period that led up to the adoption of the Protocol. Prior to that time, negotiations had stalled and countries were backed into what seemed intractable positions with a majority of countries not agreeing on a way forward. ‘Where, when, what and how’ flexibility became the benchmark for taking on legally binding commitments (see Box 1.2). From this need for flexibility came the concept of international emissions trading. At the time the concept was relatively unpopular, except for a small group of ‘likeminded’ countries that later became known as the Umbrella Group.9 A good deal of the distrust could be attributed to the lack of practical experience Box 1.2

Flexibility requirements

Where flexibility ‘Where’ flexibility was directly linked to the reality that the atmosphere does not care where the reduction in greenhouse gas emissions occurs – as long as reductions take place. Unlike other environmental problems, such as acid rain, greenhouse gas emissions are not a localized problem; therefore a reduction in emission in New York is the same as a reduction in London, Delhi or any other location. The atmosphere does not make a distinction. When flexibility ‘When’ flexibility was linked to the need to incorporate multi-year periods in order to compensate for fluctuations in the economy, in weather and others. What flexibility ‘What’ flexibility was related to the ability to reduce more than just CO2 emissions. Although CO2 is the most important greenhouse gas, other gases are longer lived and therefore their reduction has greater impact on the atmosphere (see Box 1.1). How flexibility ‘How’ flexibility came from the argument that countries must be able to choose the course of action that best suits its national circumstances.

INTRODUCTION

17

with international trading or crediting systems. Prior to the Kyoto Protocol, the introduction of market-based policies as an international tool to address environmental issues had not been tested on a large scale.10 In fact, very few countries had experience in emissions trading as an environmental policy tool. The majority of experience resided in the US primarily under the Acid Rain trading programme and the Ozone Transport Commission (OTC) NOx budget-trading programme, although limited experience also existed with credit based trading. In terms of controlling greenhouse gas emissions, the main policy instruments in developed countries at that time focused on either traditional ‘command and control’ regulations or voluntary approaches and emission taxes. Attempts had been made to include an international credit-based trading programme under the UNFCCC; however, it was rebuffed by developing countries since they saw it as a way of shifting responsibility away from those who created the problem in the first place. The major selling point for flexible mechanisms, however, was US experience with emissions trading programmes, particularly for reducing SO2 and NOx emissions. This was used as a prime example of how the flexibility provided by market-based mechanisms could assist a country in meeting a binding commitment.

CHAPTER 2

Climate Change and the UN Process Much of the current development in climate change policies is a result of the adoption of the Convention and the Kyoto Protocol, including its mechanisms for emissions trading and project-based cooperation. While the Protocol is only a small step towards correcting a potentially dramatic environmental problem, the adoption of the Protocol was a major political breakthrough.

2.1 THE UN FRAMEWORK CONVENTION ON CLIMATE CHANGE In 1990, the UN General Assembly established an Intergovernmental Negotiating Committee (INC) to negotiate a framework convention on climate change. The Intergovernmental Panel on Climate Change’s (IPCC) First Assessment Report was the main scientific basis for the INC’s work. Between February 1991 and May 1992, five INC sessions were held, culminating in the adoption of the Convention on 9 May 1992. Some 150 states and numerous intergovernmental and non-governmental organizations participated in these sessions. The INC met in two parallel groups that submitted draft treaty elements to the full INC session. Working Group I focused on issues relating to commitments (limiting and reducing greenhouse gas emissions; protecting and enhancing sinks and reservoirs; financial mechanisms; technology transfer; and ‘common but differentiated’ responsibilities of developed and developing countries). Working Group II focused on legal and institutional mechanisms. One of the key issues, and areas of disagreement, was whether the agreement should include binding commitments. This affected how the agreement would be structured; and two models were considered. 18

CLIMATE CHANGE AND THE UN PROCESS

19

The first was a comprehensive framework that included specific targets and timetables, and the second was a step-by-step approach whereby a framework agreement with general obligations could be followed up by a more comprehensive protocol or other legal instrument. Since negotiations of a comprehensive agreement would have proven difficult, and resulted in limit participation (by countries choosing not to ratify), the INC ended up producing a consensus document with a framework agreement. One hundred and fifty-four states (plus the European Commission) signed the Convention at the Earth Summit in Rio de Janeiro in June 1992. The Convention entered into force on 21 March 1994, 90 days after the receipt of the 50th instrument of ratification11 (after signing a convention a state must also ratify in order to become a party to the agreement).

2.1.1 Objectives and principles of the climate Convention Although the Convention does not have a direct impact on the Kyoto mechanisms, it contains elements that are central to the Protocol. Key among these are the Convention’s objectives and principles. The ‘ultimate’ objective of the Convention is stabilization of greenhouse gases ‘at a level that would prevent dangerous anthropogenic interference with the climate system’.12 This level is to be achieved ‘within a timeframe sufficient to allow ecosystems to adapt naturally to climate change, to ensure that food production is not threatened and to enable economic development to proceed in a sustainable manner’. The objective applies to all follow-on agreements under the Convention, including the Protocol. How best to achieve ‘stabilization’ is left to debate since in part there is no agreed definition of ‘dangerous’, nor is there agreement on timeframes. The IPCC provided some input for policy makers in its Third Assessment Report. It determined that the basis for what constitutes ‘dangerous anthropogenic interference’ will ‘vary among regions, depending both on the local nature and consequences of climate change impacts, and also on the adaptive capacity available to cope with climate change. It also depends upon mitigative capacity, since the magnitude and the rate of change are both important.’13 The Convention process is guided by several general principles. These principles emerged early in the science and policy debates and are incorporated in the Convention and the Protocol. Although some would argue that these principles provide a common understanding of how the issues of addressing climate change is dealt with, in practice they constitute some of the largest areas for debate within the climate process, and

20

CLIMATE TRADING

interpretations of these principles vary depending on who is reading them. The Principles contained in Article 3 include: &

‘Equity’ and ‘common but differentiated responsibilities’. Article 3.1 states that all Parties should protect the climate system for the benefit of present and future generations, ‘on the basis of equity and in accordance with the common but differentiated responsibilities and respective capabilities’. Article 3.1 recognizes that developed countries should take the lead, but does not exempt any country from taking on some commitments. The principle of common but differentiated responsibilities is embodied in the types of commitments that Parties have. For instance, all Parties have reporting requirements, but only Annex I Parties have funding requirements. The Convention also recognizes the right of all countries, particularly developing countries, to economic development (Article 3.5), and acknowledges the vulnerability of these countries to the effects of climate change (Article 3.2).

&

Special needs of developing countries. Parties are to be guided in their actions by the needs and special circumstances of non-Annex I Parties (Article 3.2).

&

The ‘precautionary principle’. The purpose of this principle is to help insure that the lack of full scientific certainty should not be used as an excuse to postpone action. Article 3.3 states precautionary measures to ‘anticipate, prevent or minimise the causes of climate change and mitigate its adverse effects’ should be taken by Parties.

&

Sustainable development. Article 3.4 states that all Parties have the right to develop sustainably based on their national circumstances.

2.1.2

Commitments under the UNFCCC

Article 4.1 of the Convention contains commitments common to all Parties to the Convention. These commitments pertain to reporting on national inventories of greenhouse gases, developing and implementing domestic and regional climate change mitigation programmes, and promoting and cooperating on a broad range of issues including technology, and sustainable development. Under Article 12 of the Convention, all Parties are required to report on their activities under Article 4.1, to the extent a country’s capacity permits. These reports are known as national communications. The national communication process is critical under the Convention as the reports produced, in particular by Annex I Parties, are the

CLIMATE CHANGE AND THE UN PROCESS

21

Table 2.1 National communications reporting requirements Reporting category

Annex I Parties

Non-Annex I Parties

National inventories of anthropogenic emissions by sources and removals by sinks of all greenhouse gases not controlled by the Montreal Protocol.

Must report

Can report to the extent possible

Steps towards implementing the Convention.

Must report

Can report to the extent possible

Detailed description of policies and measures.

Must report

Not required

Estimates of the effects of the policies and measures.

Must report

Not required

Details of measures to funding and assistance to developing countries, and steps taken to assist in the transfer of environmentally friendly technologies.

Must report

Not applicable

Details of proposed projects for financing.

Not applicable

Voluntary

basis for COP review on the implementation of the Convention. Annex I and non-Annex I Parties have different requirements in terms of content and frequency of reporting, reflecting the ‘common but differentiated responsibilities’ of Parties (Table 2.1).

2.1.2.1

Reporting and review

National communications by Annex I Parties are submitted every three to five years. National communications are subject to an in-depth review by teams of experts and involve both desk reviews and in country visits. The Convention secretariat is required to compile and/or synthesis national communications and inventories on a regular basis. Annex I Parties have submitted three national communications since the Convention entered into force. The most recent national communication was due to the secretariat in April 2003.

22

CLIMATE TRADING

In addition to the national communication reporting requirements, Annex I Parties must submit annual inventories of their greenhouse gas emissions and removals (by land-use change and forestry). Guidelines for these inventories are developed and periodically updated by the IPCC and must be used by Annex I Parties in estimating and reporting all greenhouse gas emissions and removals not covered by the Montreal Protocol.14 National inventories consist of two parts. The first is the National Inventory Report (NIR) which contains detailed and descriptive information, including on assumptions, emissions factors and activity data. The second is the Common Reporting Format (CRF) in which the Parties provide quantitative information in a standardized format in order to facilitate data comparison across all Annex I Parties. Information is reported in six categories: energy, industrial processes, solvents and other product use, agriculture, land-use change and forestry, and waste. Inventories must include data on emissions for the base year or period and all years up to the year prior to submission (i.e. the inventory due in 2003 was to contain data up through 2001). Annex I Parties must also recalculate data from past years, including adding any data that was not previously available, which can make inventory data from one year to the next slightly different. The NIR and CRF are subject to technical review each year. Non-Annex I Parties have more leeway in their reporting requirements. Their reporting requirements are dependent on the availability of funding, and the least developed countries (LDCs) may report at their discretion.15 Non-Annex I Parties are not required to submit inventories and do not undergo an in-depth review. One effect of this differentiation of commitments is that there is a less clear overview of the emissions produced and activities to adapt or abate climate change in developing countries.

2.1.2.2 Development and transfer of technologies Article 4.5 of the Convention requires Annex I Parties to ‘take all practicable steps to promote, facilitate and finance, as appropriate, the transfer of, or access to, environmentally sound technologies and know-how to other Parties . . .’. The purpose of this commitment is to assist Parties, particularly non-Annex I Parties, in implementing the provisions of the Convention.

2.1.2.3 Joint implementation and activities implemented jointly Article 4.2(a) of the Convention states that Parties ‘. . . may implement such policies and measures jointly with other Parties and may assist other Parties in contributing to the achievement of the objective of the

CLIMATE CHANGE AND THE UN PROCESS

23

Convention . . . ’. Article 4.2(b) contains a reference to the aim of returning greenhouse gas emissions to 1990 levels either ‘individually or jointly’. Taken together, this was considered by some Annex I Parties as the basis for joint implementation under the Convention. Already from the mid-1990s, there were attempts by Annex I Parties to push for a project based trading programme under the Convention termed Joint Implementation (JI). It was argued by supporters of the idea that the basis for this was contained in Article 4 of the UNFCCC, which applies to commitments by all Parties. The subparagraph generally cited (Article 4.2 of the UNFCCC), however, applies to Annex I Parties. This caused a great deal of debate among the various grouping within the negotiations. Most Annex I Parties felt that Article 4 provided sufficient grounds for undertaking projects jointly between Annex I and non-Annex I countries. In addition, some Annex I countries wanted to create incentives for JI, by enabling project developers to earn credits from any emission reductions associated with these projects. Non-Annex I countries felt that the concept did not and should not apply to them, that it was an attempt by Annex I Parties to essentially divert their responsibilities for reducing emissions on to countries with no commitments. JI with crediting was seen by some Annex I Parties as a way to accomplish the objective of the Convention. It would provide industry with an incentive to reduce emissions, while at the same time providing industry with an incentive to transfer more environmentally friendly technology to developing countries. Regardless of the motives, it was a concept on which the COP was unable to find agreement. At COP-1, a compromise was reached in which the pilot phase under Activities Implemented Jointly (AIJ) was launched. AIJ allowed for non-Annex I participation on a voluntary basis, with specific criteria to be acknowledged as AIJ, included that funding would have to be additional to Official Development Assistance (ODA).16 Contrary to the concept of JI, AIJ was not open for crediting of emission reductions. Results of the AIJ pilot phase were less than overwhelming. Without crediting, there was little incentive for industry within Annex I Parties to participate. But it did provide a lesson that countries promoting JI could draw on in selling what became known as the ‘flexible mechanisms’.

2.1.2.4

Other commitments

The Convention also contains several other commitments related to exchange of information (for instance on the impacts of climate change and response measures), and national adaptation programmes of action for LDCs.

24

CLIMATE TRADING

2.2 NEGOTIATIONS ON THE KYOTO PROTOCOL The Convention provides two ways in which commitments can be reviewed. Article 4.2 (d) required the first session of the COP to review the commitments contained in paragraphs (a) and (b) of Article 4.2 – pertaining to Annex I Parties, to undertake a second review by 31 December 1998 and thereafter to keep these commitments under regular review. The second way in which commitments can be reviewed is through Article 7.2 (a), which enables the COP to ‘periodically examine the obligations of the Parties . . . in light of the objective of the Convention, the experience gained in its implementation and the evolution of scientific and technological knowledge’. Thus far, only the first review of the adequacy of commitments contained in Article 4.2 has occurred (at COP-1 in 1995), which ultimately resulted in the adoption of the Kyoto Protocol. No other reviews have occurred. The Berlin Mandate Discussions on the adequacy of commitments at COP-1 resulted in the adoption of ‘The Berlin Mandate’. It called for negotiations on a protocol or other legal instrument to begin, and for those negotiations to conclude by COP-3 in 1997. It was to begin a process to enable Parties to take appropriate actions for the period beyond 2000. The process was to aim to strengthen commitments for Annex I Parties, elaborate policies and measures and set quantified limitation and reduction objectives within specific timeframes. In addition, no new commitments were to be introduced during this process for non-Annex I Parties. For some Parties (particularly non-Annex I Parties) an earlier proposal for a Protocol put forward by small island developing countries (AOSIS) was seen as a starting point. This proposal called for Annex I countries to reduce CO2 emissions 20 per cent below 1990 levels by 2005.17 But there were many Annex I Parties who felt that strengthened commitments required strengthening developing country commitments as well. An Ad Hoc Group on the Berlin Mandate (AGBM) was established to negotiate text under the Berlin Mandate. The first year of negotiations produced very little in the way of progress. Since Parties could not agree on whether there should be targets and timetables, the major focus was on policies and measures. There was, however, no agreement on how to address policies and measures; Parties were divided over whether there should be a proscriptive list or, as was incorporated into the Protocol, a suggestive list that Parties themselves could determine according to their own domestic needs and requirements. Because of this impasse, little progress was made during the first year of negotiations.

CLIMATE CHANGE AND THE UN PROCESS

25

The second session of the COP was a turning point in these negotiations. Two things occurred that made the adoption of the Kyoto Protocol possible: &

A ‘Geneva Declaration’ was drafted and taken note of by the Parties,18 and among other things, called on negotiators to complete a protocol that included binding targets and timetables.

&

The US ‘wholeheartedly’ endorsed the Declaration, but stated that the outcome of the AGBM process would have to ensure maximum national flexibility of Parties in order to meet the medium-term ‘legally-binding’ targets.

Essentially, the US expressed support for ‘legally-binding’ commitments as long as flexibility, that is, emissions trading, was incorporated into the agreement. This became a prerequisite for accepting legally-binding commitments. The introduction of emissions trading in the AGBM process created a great deal of concern among non-Annex I Parties and the EU. These Parties argued that the majority of emissions reductions must occur domestically. One of the reasons for this concern was due to the drop in emissions in countries with economies in transition since 1990. It meant that given emissions trends in these countries they would have allowances in excess of their required reductions and could sell them to Parties that were unable or unwilling to reduce emissions at home. The concept of supplementarity, that emissions trading should be supplemental to domestic action, was introduced as a way to ensure that at least part of the reductions occur at home. Because there were opposing views on how to implement such a concept, Parties left the specifics for later negotiations. Agreement in December 1997 In practical terms, the Kyoto Protocol provides a framework for action. It sets out the targets, and provides options for how countries may meet their commitments. The operating rules, however, were left to subsequent COP and COP/MOP sessions. Many developing countries sought to keep focus on existing commitments under the Convention, while Annex I countries sought to complete the outstanding issues related to the Kyoto Protocol, including the rules for the emissions trading system (the Kyoto ‘rulebook’). COP-4, in 1998, reached a compromise by drawing up the Buenos Aires Plan of Action – a rather unwieldy work plan aimed at completing the Protocol and advancing Convention issues, such as transfer of technologies to developing countries. Between COP-4 and COP-6 in 2000, deep divisions arose between and within Annex I and non-Annex I Parties. Tensions between Annex I and non-Annex I Parties increased as a result of continued pressure by Annex I Parties for discussions on expanded commitments, that is, developing country commitments, and by non-Annex I

26

CLIMATE TRADING

Parties for discussions on the impacts on developing countries of the implementation of response measures (prior to COP-3, this was primarily an issue pushed by OPEC countries seeking to receive ‘compensation’ for any potential losses in oil revenues due to emissions reduction measures taken by Annex I countries). As for the Kyoto ‘rulebook’, Annex I Parties were especially divided on the issue of how to interpret the requirement that the use of the Kyoto mechanisms is to be supplemental to domestic action, with the EU calling for a quantitative ceiling on the use of the mechanisms, and the Umbrella Group seeking a qualitative definition. In the end, a qualitative approach was adopted. Parties are required to provide information on how its use of the mechanisms is supplemental to domestic action, and how its domestic action thus constitutes a significant element of the effort made to meet its quantified limitation and reduction commitments.19 At COP-6 negotiations on the Kyoto rulebook ended in what seemed an unbreakable deadlock. Since resolution of remaining political issues was impossible, a second meeting of COP-6 was scheduled for six months later, in July 2001. Many observers, however, felt that an additional meeting was not likely to resolve the deep political divide that existed between Parties. In March 2001, however, US President Bush rejected the Protocol. While some speculated that this would mean the end of the Protocol, the US announcement had an unintended effect. Instead of serving as the Protocol’s death knell, it galvanized the remaining Parties enabling COP-6 part II to reach a political agreement that led to the adoption of a large portion of the Kyoto ‘rulebook’. A few months later, at COP-7 in Marrakech, decisions were adopted through the Marrakech Accords that almost fully completed the Kyoto ‘rulebook’. Some technical issues remained, including rules for afforestation and reforestation project activities in the Clean Development Mechanism (CDM), but decisions were complete enough for Parties to complete their ratification processes. In Marrakech, Parties agreed to a ‘framework for meaningful and effective actions’ covering five areas: assessing technology needs, establishing an efficient technology information systems, promoting enabling environments to facilitate and remove barriers to technology transfer, and capacity building. An expert group reporting to SBSTA oversees this process (Table 2.2).

2.3

THE KYOTO PROTOCOL

In 1997, at the third session of the Conference of the Parties to the Convention, the Parties adopted the Kyoto Protocol. One of the major achievements of the Protocol was the agreement by developed country Parties to collectively reduce their overall emissions by at least 5 per cent below 1990 levels in the period 2008–2012. During the AGBM process

CLIMATE CHANGE AND THE UN PROCESS

27

Table 2.2 Meetings of the Conference of the Parties Session

Date

Outcome

COP-1

1995

Adoption of the Berlin Mandate, beginning of negotiation process leading up to the Kyoto Protocol.

COP-2

1996

US statement and the Geneva Declaration.

COP-3

1997

Adoption of the Kyoto Protocol, and last minute inclusion of the CDM.

COP-4

1998

Adoption of a work plan on Convention and Protocol issues, including on the Kyoto mechanisms. Known as the Buenos Aires Plan of Action or BAPA.

COP-5

1999

Some progress on technical issues related to the mechanisms was made but little progress on political issues.

COP-6

2000

COP-4 set a COP-6 deadline for adoption of decisions under the BAPA, but agreement could not be reached on important political issues. Since agreement could not be reached an extra meeting of the COP was called.

COP-6 part II

2001 (July)

Political agreement reached minus the US.

COP-7

2001 (October/ November)

Adoption of the Marrakech Accords containing the prompt start of the CDM and the majority of rules necessary for emissions trading and joint implementation.

COP-8

2002

COP-9

2003

Source: Compiled by author.

Decision on land-use change and and forestry issues under the CDM.

28

CLIMATE TRADING

flexibility in meeting binding commitments was a requirement for several key Parties. In the end, flexibility was incorporated in the Protocol in several ways: &

A basket of six gases were included, giving Parties a wider range of options for reducing and sequestering emissions. These gases are carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulphur hexafluoride;

&

Market-based mechanisms, the Kyoto mechanisms, were established to enable Parties to meet their commitments in the most cost-effective manner possible;

&

Countries and economic regions such as the EU have the ability to ‘bubble’ their commitments, meaning they can take on one target and redistribute it within themselves. The collective target must be met. If it is not, then each individual Party covered by the ‘bubble’ must meet their specific target and those Parties not in compliance will face penalties rather than all countries within the bubble;

&

A multi-year commitment period was included in order to allow countries to account for fluctuations in weather, economies and other variabilities;

&

Parties retained the ability to determine which policies and measures they would adopt; and

&

Countries with economies in transition are also provided flexibility in choosing their base year or period.

2.3.1

Institutional structure

The governing body of the Protocol is the COP serving as the meeting of the Parties, (COP/MOP) and is composed of Parties to the Convention who have ratified the Protocol. The Protocol and the Convention use the same groupings of countries (see Box 2.1) and share the same supporting bodies (see Box 2.2).

2.3.2

Framework structure

The Protocol and its rulebook, are composed of five main elements, four of which are essential to international emissions trading: commitments; implementation of commitments; accounting, reporting and review; and compliance. The fifth element, which is not elaborated further here, relates

CLIMATE CHANGE AND THE UN PROCESS

Box 2.1

29

Parties to the UNFCCC and the Protocol

Countries that are party to the Convention are divided into two main categories: Annex I and non-Annex I. Annex I Parties consist of 41 industrialized countries that committed to the aim of reducing their emissions to 1990 levels by the year 2000. This grouping is further divided to distinguish between the wealthier OECD countries and through countries with economies in transition. Annex II Parties are composed of 23 countries (EU countries, the US, Canada, Japan, Norway, New Zealand, Australia, Iceland, Switzerland) plus the European Community. Countries with economies in transition (commonly referred to as EITs) include countries from the former Soviet Union and Central and Eastern Europe. All remaining countries are Non-Annex I Parties, and are primarily developing countries. Under the Kyoto Protocol, the majority of Annex I Parties took on emissions limitation or reduction targets. These countries are sometimes referred to as Annex B countries. The List of countries in Annex I, Annex II and Annex B can be found at www.unfccc.int. Annexes I and II are annexes to the UNFCCC and Annex B is an Annex of the Kyoto Protocol.

Box 2.2

Institutional structure of the UNFCCC

The Conference of the Parties (COP) is the ‘supreme body’ of the Convention. The COP meets on a yearly basis. It is to regularly review implementation of the Convention and any related legal instrument it adopts. The COP is assisted by two permanent subsidiary bodies, but can establish other bodies as it finds it necessary to do so. The first permanent body provides advice to the COP on scientific and technological matters – subsidiary body for scientific and technological advice (SBSTA). The second assists the COP in assessing and reviewing the implementation of the Convention – subsidiary body for implementation (SBI). A permanent secretariat assists the COP and subsidiary bodies. The Convention’s financial mechanism, which is responsible for channelling funds on a grant or concessional basis, is operated by the Global Environment Facility (GEF) under the policy guidance of the COP.

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to minimizing impacts on developing countries. Provisions are included to help address the needs and concerns of developing countries, particularly those most vulnerable to the adverse effects of climate change and the economic impacts of response measure. The Protocol contains differentiated commitments. The focus below is strictly on those commitments and requirements that directly relate to the Kyoto mechanisms.

2.3.2.1 Annex B commitments Article 3 of the Protocol places a cap on the amount of emissions an Annex B Party may emit during the commitment period. The cap is established through the concept of the assigned amount which is calculated using the quantified emissions limitation and reduction commitments contained in Annex B of the Protocol and estimates of emissions from the base year or period. In addition, this Article enables Parties to meet their commitments by controlling any of the six greenhouse gases listed in Annex A of the Protocol. Article 3 also lays out the basic provisions that enable Parties to trade parts of their assigned amount (by emissions trading under Article 17 and joint implementation projects under Article 6) as well as add ‘credits’ generated from CDM projects (under Article 12). Limitation and reduction commitments vary by Parties. For example, Member States of the EU are collectively expected to reduce their emissions by 8 per cent compared to 1990 levels, the US by 7 per cent and Japan by 6 per cent. Only Australia, Iceland and Norway are allowed to increase their emissions, albeit at reduced rates from business as usual. These commitments only become binding on countries once they have ratified the Protocol and once the Protocol enters into force. The EU has, however, devised an internal burden-sharing scheme redistributing targets between EU Member States. The EU and its Member States notified the secretariat in its instrument of ratification of the terms of the burned sharing agreement, as required under Article 4 of the Protocol (for ‘bubbling’ targets). Under the terms of this Article, any changes to regional economic integration organizations, that is, countries acceding into the EU, are not covered by the bubble, that is, until a second commitment period is agreed. In addition, if the EU and Member States do not reach the overall 8 per cent reduction, then each country must meet the reduction target specified in the EU’s burden-sharing agreement (see Table 2.3). The commitment period begins in 2008, and Parties must achieve their respective targets for the entire period by the end of the commitment period in 2012. The targets inscribed in the Protocol are the basis for establishing a Party’s assigned amount – this is the amount of emissions that Parties may emit over the commitment period (see Table 2.4). It is also the basis for the

CLIMATE CHANGE AND THE UN PROCESS

31

Table 2.3 The EU Burden-sharing Agreement Country

EU Burden-sharing Agreement (reduction or limitation from base year or period in per cent)

Austria

13

Belgium

7.5

Denmark

21

Finland

0

France

0

Germany

21

Greece

25

Ireland

13

Italy

6.5

Luxembourg

28

Netherlands

6

Portugal

27

Spain

15

Sweden

4

UK

12.5

European Community

8

Source: EC Directive 2002/358/CE.

trading system established under the Protocol. The assigned amount is calculated based on emissions data for the Party’s base year, that is, 1990 for most OECD countries.

2.3.2.2

Implementing the commitments

All Parties are likely to implement some domestic policies and measures (including emissions trading schemes) in order to meet their targets. The Protocol provides an indicative list that Parties may choose to consult, but it is up to each Party to determine its own path to compliance. The list includes activities such as enhancing energy efficiency, promoting renewable energy

32

Table 2.4 Countries included in Annex B to the Kyoto Protocol and their emissions targets Country

Target (1990 –2008/2012) reduction or limitation percentage from base year or period (in per cent)

Australia

þ8

Austria

8

Belgium

8

Bulgaria

8

Canada

6

Croatia

5

Czech Republic

8

Denmark

8

Estonia

8

Finland

8

France

8

Germany

8

Greece

8

Hungary

6

Iceland

þ 10

Ireland

8

Italy

8

Japan

6

Latvia

8

Liechtenstein

8

Lithuania

8

Luxembourg

8

Monaco

8

Netherlands

8

CLIMATE CHANGE AND THE UN PROCESS

33

Table 2.4 Continued New Zealand

0

Norway

þ1

Poland

6

Portugal

8

Romania

8

Russian Federation

0

Slovakia

8

Slovenia

8

Spain

8

Sweden

8

Switzerland

8

Ukraine

0

UK

8

US

7

European Community

8

Notes:  Some economies in transition have a base year other than 1990.  The US has indicated its intention not to ratify the Kyoto Protocol. Source: UNFCCC secretariat.

and other environmentally friendly technologies. Two additional options are the use of the Kyoto mechanisms and offsetting emissions through landuse change and forestry activities such as carbon sequestration (see below). Emissions from international aviation and marine bunker fuels used in international transport are not included in Parties emissions and therefore are not included as activities under the Protocol. One reason for this is the difficulty in coming to agreement on allocation between countries of emissions from these sources. The Protocol requires Parties to work with the International Civil Aviation Organisation (ICAO) and the International Maritime Organisation (IMO) in curbing emissions from these sources.

2.3.2.3

Land-use change and forestry

Parties may also rely on land use, land-use change and forestry sector activities in meeting their commitments. The Protocol recognizes three

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activities that Parties could use in meeting their targets. These are afforestation, reforestation and deforestation.20 The Marrakech Accords designates four additional activities: forest management, cropland management, grazing land management, and re-vegetation. Parties must choose the activity they will use; once that choice is made it will remain fixed. In order to minimize the uncertainties related to land-use change and forestry activities (for example, release of greenhouse gas emissions due to damage or destruction of a sink), rules governing these activities have been adopted. They include: &

A set of principles to guide activities in this sector;

&

A list of eligible activities;

&

Common definitions; and

&

A four-tier capping system limiting the use of land-use change and forestry activities to meet emissions targets.

Land-use change and forestry activities that remove greenhouse gases and that can be used to assist a Party in meeting its target, generate removal units (RMUs). Expert review teams under the Protocol’s reporting and review procedures must first verify removals. If the activity that a Party chooses increases emissions, those emissions must be offset by emission cuts or removals elsewhere. Limits have been placed on the extent to which Parties can account for emissions and removals from land-use change and forestry activities during the commitment period. They are controlled by a four-tier capping system, including caps on units generated under the CDM and JI projects.21

2.3.3

Reporting, review and compliance

The backbone of the Protocol is the monitoring, reporting and review requirements with which Annex B Parties must comply. Fulfilling these requirements are also critical to the calculation of the assigned amount (or cap), determining allocations to the trading sector and understanding what additional measures will be needed in any sectors not covered by a trading scheme. Compliance with the commitments and the integrity of the system are achieved through several processes. These include yearly reporting of emissions and removals (inventories), and transactions under the Kyoto mechanisms, as well as the use of experts to review and verify the results contained in these reports. The secretariat is tasked with maintaining databases and coordinating review teams.

CLIMATE CHANGE AND THE UN PROCESS

2.3.3.1

35

Reporting and review

One of the first steps in meeting eligibility requirements for participation in the Kyoto trading system is for Annex B Parties to complete their inventories of anthropogenic emissions by sources and removals by sinks for their base year or period. These inventories will be based on inventory requirements under the Convention process. Parties must then calculate their assigned amount. Calculations are based on a Party’s inventory, its choice of land-use change and forestry activities, and other relevant data. In addition, a Party must submit information on national systems for estimating emissions and a description of its national registry. Expert review teams review this report, and if no questions are raised (or once they are resolved) the assigned amount is recorded in a database (compilation and accounting database) by the Convention secretariat. The assigned amount remains fixed for the entire commitment period. Similar to the Convention inventory reporting requirements, Annex B Parties are thereafter required to submit annual inventories. Inventories will play an important role in an Annex B Party’s ability to trade under the Protocol trading system. Other information such as on transfers and acquisitions of reduction units must also be reported in the inventory. Expert review teams will review the inventories, checking for completeness, accuracy and conformity with the guidelines. The expert review team can recommend changes. However, if a dispute arises between the review team and the Party, it is referred to the Compliance Committee (see below) for resolution. Inventories will also be submitted on a ‘delayed’ schedule, with the 2012 inventory, for instance, due in April of 2014. It is unclear how this process will work in combination with the trading system since a Party’s entire inventory will not become available for trading until the final inventory for the commitment period is delivered (see Chapter 3 on rules for trading under the Kyoto emissions trading system). Parties will also be required to submit national communications on a periodic basis. Among other items, a Party’s national communications will include information on: &

Details of its national system and national registry;22

&

How its use of the Kyoto mechanisms is supplemental to domestic action; and

&

Policies and measures implemented to meet its target.

National communications will also be subject to in-depth reviews by expert review teams.

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2.3.3.2 Compliance The Protocol’s compliance system consists of a Compliance Committee composed of a facilitative branch and an enforcement branch. Both branches are composed of 10 members based on the UN regional groups. This gives non-Annex I Parties a majority on both committees. However, voting practices on the enforcement branch require a double majority (a majority of both Annex I and non-Annex I members present and voting) in order for decisions to be taken. The compliance committee meets in plenary sessions composed of members of both branches and is supported in its work by a bureau composed of the chair and vice chair of each branch. The Facilitative Branch is to serve as an ‘early warning system’ to Parties in cases where they are in danger of not meeting their target. In addition, it is tasked with reviewing issues such as ‘supplementarity’ that Parties are required to provide information on but not to quantify. Parties may seek advice from the facilitative branch about its compliance or the compliance of another country. In cases where there is some concern or a problem is identified, this branch can provide recommendations or mobilize financial or technical support to assist the Party with its compliance. The Enforcement Branch determines whether a Party is in compliance with its emissions target, has met the methodological and reporting requirements as well as the eligibility requirements for participation in the Kyoto mechanisms. In order to determine compliance with its target, an Annex I Party must submit a final emissions inventory for the commitment period. An expert review team reviews the inventory and the Party then has a 100-day grace period in which to purchase additional reduction units, if needed. If at the end of this period the Party has not met its target, it must make up the difference in a second commitment period with a 30 per cent penalty. The penalty for non-compliance is thus 1.3 tonnes of CO2 equivalent for every excess tonne of CO2 equivalent. In addition, the Party will be unable to sell reduction units under the trading system until it has come into compliance. It can, however, purchase units.

CHAPTER 3

The Kyoto Mechanisms – A Framework for International Emissions Trading . . . Policies and measures to deal with climate change should be cost-effective so as to ensure global benefits at the lowest possible cost. (Article 3.3 of the UNFCCC)

3.1

OVERVIEW

Cost considerations have been one of the key concerns for Annex I Parties when considering taking on reduction and limitation targets under the Kyoto Protocol. Incorporating an international emissions trading system into the Protocol was one of the key requirements for several countries within the climate negotiations. Without it, the adoption of an agreement with legally binding reduction and limitation targets probably would not have been possible. Or, at a minimum, the levels of the reduction and limitation targets would have been much lower. Although the targets seem relatively low, they are in fact significant when seen against the back drop of the amount of reductions an individual country will have to reduce. Some countries will have to reduce current emissions by up to 20 per cent to reach their target. The emissions trading system recognizes that countries have different abatement costs and options. By providing flexibility in how, when and 37

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by which gases countries meet their targets, overall compliance with the Protocol is more likely. In addition, the benefit to the environment is the same, regardless of where the reduction occurs. Unlike SO2, whose effects are localized, greenhouse gases enter the atmosphere and mix uniformly. The Kyoto emissions trading system incorporates three market-based mechanisms. The three mechanisms have specific functions, but serve the same purpose: to assist Annex B Parties in meeting their targets cost efficiently. Two of the mechanisms are aimed Annex I countries: a cap and trade programme and project-based trading (under the cap and trade programme), while the third provides a way for developing countries to participate in the carbon market through project-based trading. For many Annex I Parties, it was important to establish a mechanism for developing countries to participate in some meaningful way in reducing greenhouse gas emissions. During the negotiation process on the Convention, Joint Implementation (JI) was introduced as a way for all countries to participate in emission reduction projects, similar in intention to the Clean Development Mechanism (CDM). Many developing countries, however, felt that JI did not apply to them since they were not required to reduce emissions. As mentioned previously, attempts by Annex I Parties to codify JI under the Convention process led to the implementation of the pilot phase of Activities Implemented Jointly (AIJ) with crediting of projects explicitly not allowed. JI continued to be viewed with suspicion by many non-Annex I Parties as a way for Annex I Parties to divert their responsibilities for reducing emissions. Despite this lingering sentiment, JI was introduced into the Protocol negotiations; as the negotiations progressed, JI changed from an all-inclusive mechanism to one targeted solely towards Annex I Parties. Joint implementation was established under Article 6 of the Protocol. The CDM was introduced during the final week in Kyoto. It is an amalgam of two positions, one seeking a clean development fund in which countries with targets would pay if they did not meet their obligations, and the other seeking credits for emisions reductions in developing countries. Established under Article 12 of the Protocol, the CDM has been seen as one of the more innovative mechanisms to come out of the climate negotiations. Emissions trading is established under Article 17 of the Kyoto Protocol. It enables countries to meet their targets in part by purchasing reductions from countries that achieve emissions reductions beyond their targets. It is under this framework many governments are presently designing domestic trading systems.

3.1.1

Use of the mechanisms

After the adoption of the Protocol, implementation of Convention issues and the CDM became a high priority for non-Annex I Parties. Annex I Parties,

THE KYOTO MECHANISMS

39

on the other hand needed a completed rulebook for the Protocol, including for the Kyoto trading system in order to begin ratification processes. Without having the necessary framework in place, that is, rules for the Kyoto mechanisms (see Table 3.1), compliance, monitoring and reporting requirements, registry requirements, most Annex I Parties would have been unable to ratify the Protocol. One of the issues that created some tension between Parties was the timing of the rulemaking process. The Protocol only provides for early development of the emissions trading, with the CDM and JI requiring elaboration under the COP/MOP. In order to accommodate progress on all fronts, the decision on the CDM provided for a ‘prompt-start’ (i.e. to start before the Protocol has entered into force), and the remaining elements necessary for trading under Article 17 were completed. Some progress was made on JI, but many technical issues will only be resolved by the COP/MOP. Since the CDM is the first of the mechanisms to start, so far it has been given the greatest amount of focus at least internationally. It is also the most developed of the three mechanisms. There are several requirements that Parties with targets must meet in order to transfer and/or acquire, that is, trade units under the Protocol’s trading system. In the case of the CDM, Annex I Parties must meet these requirements in order to bring Certified Emission Reduction Units (CERs) into their accounting system (i.e. in order to use them). Rules for (private Table 3.1 The Kyoto mechanisms Mechanism

Timing for rulemaking

Targeted Parties

Article 6 Joint Implementation

COP/MOP responsible for rulemaking, lesser priority for Annex B Parties

Annex B Parties

Article 12 Clean Development Mechanism

COP/MOP has authority

Non-Annex I and Annex B Parties

COP provided for prompt start under its guidance since it was priority for non-Annex I Parties Article 17 International Emissions Trading

COP given authority to draft rules Priority for Annex B Parties, but not for non-Annex I Parties

Annex B Parties

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sector) participation in the CDM, in terms of engaging in project activities, are less stringent. This is mainly governed by domestic CDM programmes. Requirements for Annex B Party participation in the Kyoto trading system (Box 3.1), in terms of being able to transfer or acquire Kyoto reduction units, are: &

The country must be a Party to the Kyoto Protocol;

&

It must have calculated and recorded its Assigned Amounts;

&

There must be a national system for estimating greenhouse gas emissions;

&

There must be a national registry in place;

&

The country must have submitted annually the most recent required greenhouse gas inventory; and

&

The country must submit the necessary supplementary information on its Assigned Amount, as required under Article 7 (communication of information). Box 3.1

Terminology of the Kyoto trading system

The assigned amount places a cap on the amount of greenhouse gases an Annex B Party may emit during the commitment period. Units used for the transfer and acquisition of emissions reductions under the Protocol emissions trading system are: Assigned Amount Units (AAUs) derived directly from the assigned amount, Emissions Reduction Units (ERUs) also derived directly from the assigned amount, Removal Units (RMUs) derived from land use change and forestry activities under the assigned amount, and Certified Emission Reduction Units (CERs) that can be added on to the Party’s assigned amount for compliance purposes. Parties must maintain a reserve of Kyoto reduction units; this reserve is known as the commitment period reserve (CPR). The CPR is composed of AAUs, ERUs, CERs and RMUs and must be at a level of either 90 per cent of its recorded assigned amount or 100 per cent of five times its most recently reviewed inventory which ever is lowest. All Kyoto reduction units are tracked through a Party’s national registry and through a transaction log maintained by the UNFCCC secretariat. The purpose of the transaction log is to verify that transactions occurring in the national registries are valid, that is, that the unit to be transferred has not been previously transferred or cancelled.

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41

These requirements have different timelines, although much of the information must be contained in a report that will be used to determine eligibility, due on 1 January 2007. Parties must have their national system for estimating emissions in place no later than 2007, but Parties are urged to put them in place as soon as possible in order to gain experience. If Parties are unable to meet the compliance requirements by that date, their use of the mechanisms during the commitment period may be limited – depending on the scope of non-compliance. An Expert Review Team and the Enforcement Branch of the Compliance Committee will assess compliance with the above requirements.

3.1.2 Defining the commodity – Kyoto reduction units (AAUs, ERUs, CERs and RMUs) The decisions on the rules for the Kyoto mechanisms in the Marrakech Accords (COP-7 in 2001) specify four types of reduction units that can be traded. Each mechanism and all land-use change and forestry activities lead to distinct types of units, with each unit being equal to one metric tonne of carbon dioxide equivalent, and calculated using global warming potentials (see Table 1.1).

Table 3.2 Kyoto reduction units Unit

Source

Effect on assigned amount

Banking

AAU

Assigned amount

None

Yes

RMU

Land use and Forestry activities under the assigned amount

None

No

ERU

Converted from AAUs or RMUs and tied to projects that reduce or sequester emissions

None

Limited to only a maximum of 2.5 per cent of the assigned amount

CER

Project-based credits

Additional to the assigned amount

Limited to only a maximum of 2.5 per cent of the assigned amount

Source: Compiled by author.

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Three of the units are derived from a Party’s assigned amount. These are the AAU specific to emissions trading, the ERU specific to JI projects, and the Removal Unit RMU specific to land-use change and forestry activities. Transfer and acquisition based on these units is a zero-sum game within the overall Annex B target under the Kyoto Protocol (see Table 3.2). Parties will be obligated to hold a sufficient amount of units to cover their assigned amount by the end of the commitment period. Beyond the units derived from the assigned amount, projects under the CDM create CERs that can be added to a Party’s assigned amount. Each of the units will be tracked through national registries and a transaction log. See Section 3.2.2.

3.2 INFORMATION SYSTEMS UNDER THE PROTOCOL The quality and effectiveness of the Kyoto emissions trading system is dependent on the quality of the measuring, monitoring and reporting systems. Two important features of the Protocol will be used to determine a Party’s compliance under the Protocol commitments. These are the national systems for estimation of greenhouse gas emissions and the national registry for tracking Kyoto reduction units.

3.2.1

Measuring and monitoring under the protocol

The Protocol requires Annex B Parties to have in place a national system for estimating greenhouse gas emissions as a requirement for trading. A national system is defined as all institutional, legal and procedural arrangements made by an Annex B Party for estimating greenhouse gas emissions and removals by sinks, as well as the reporting and information archiving systems. A national inventory, composed of the National Inventory Report and the Common Reporting Format, is the official method for reporting emissions under the Convention and the Protocol. Under the Convention process, national inventories are developed using national statistical data from which emissions are then estimated. The Protocol inventory process builds on the same process, and will likewise have the same reporting delays. Statistical/activity data from which the estimates are calculated is generally not available until about six months after the end of a calendar year; calculation of the estimations generally take from two to six months more (Breidenich, 2004). One clear difference between reporting under the Convention and the Protocol, however, is that Protocol reporting requirement must be followed if a Party wishes to trade.

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43

Inventory reporting under the Protocol is similar to the Convention reporting process. A key difference, however, is that the inventory will affect whether, how and what a Party can trade, and will be reviewed for compliance purposes instead of learning purposes. In some cases the national system could be broader than current inventory systems, since the not all Annex I Parties report emissions under all inventory categories. Protocol requirements stipulate that any Annex A source that is more than 7 per cent of aggregate emissions must be reported in the inventory. Parties must also submit inventories within six weeks of the date of submission (15 April) in order to comply with the requirements. For the 2003 inventories, 29 of 40 submissions were received on time, that is, within the six weeks. Under the Convention there are no consequences for late submission, under the Protocol it could affect a Party’s ability to trade for at least a short time since it will delay the review process. In order to improve the overall quality of inventories, COP-8 (in 2002) adopted revised guidelines for the reporting and review of national greenhouse gas inventories that are to be used beginning in 2004. The guidelines are designed to improve the quality of inventories and institute procedures such as developing quality assurance and quality control checks, improving comparability and consistency. Parties are to use the Revised 1996 Intergovernmental Panel on Climate Change (IPCC) Guidelines for Inventory Development and the IPCC good practice guidance which provides information on a range of inventory issues including choices of methods for estimation. The purpose of these revisions is two-fold: to improve the general quality of inventories under the Convention process, and to prepare for reporting requirements under the Protocol. Once the Protocol enters into force, Protocol reporting will replace Convention reporting on national inventories (Box 3.2). One of the major differences between a domestic trading scheme and the Kyoto trading system is the way in which emissions will be measured and reported. Unlike domestic trading scheme, such as the US SO2 programme where there are a specific number (i.e. about 2300 units) of sources that can measure actual emissions, national inventories cover a range of emissions sources and sinks that are not (and in some case cannot be accurately) measured directly, and are therefore estimated using various national data statistics such as national fuel consumption. The choice of methodology, the emissions and activity factors developed and used can influence the quality of the inventory. Emissions measurement under domestic emissions trading systems can require data collection at several different levels: the plant of facility level containing several emitting activities; the point source or stack level where emissions exit into the air; the unit level of specific source categories; and unit level. The SO2 trading system, for example, requires that continuous

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Box 3.2

National inventory principles and definitions

Transparency means that the assumptions and methodologies used for an inventory should be clearly explained to facilitate replication and assessment of the inventory by users of the reported information. The transparency of inventories is fundamental to the success of the process for the communication and consideration of information; Consistency means that an inventory should be internally consistent in all its elements with inventories of other years. An inventory is consistent if the same methodologies are used for the base and all subsequent years and if consistent data sets are used to estimate emissions or removals from sources or sinks. Under certain circumstances an inventory using different methodologies for different years can be considered to be consistent if it has been recalculated in a transparent manner, in accordance with the IPCC Good Practice Guidance and Uncertainty Management in National Greenhouse Gas Inventories; Comparability means that estimates of emissions and removals reported by Annex I Parties in inventories should be comparable among Annex I Parties. For this purpose, Annex I Parties should use the methodologies and formats agreed by the COP for estimating and reporting inventories. The allocation of different source/sink categories should follow the split of the Revised 1996 IPCC Guidelines for National Greenhouse Gas Inventories, at the level of its summary and sectoral tables; Completeness means that an inventory covers all sources and sinks, as well as all gases, included in the IPCC Guidelines as well as other existing relevant source/sink categories which are specific to individual Annex I Parties and, therefore, may not be included in the IPCC Guidelines. Completeness also means full geographic coverage of sources and sinks of an Annex I Party; Accuracy is a relative measure of the exactness of an emission or removal estimate. Estimates should be accurate in the sense that they are systematically neither over nor under true emissions or removals, as far as can be judged, and that uncertainties are reduced as far as practicable. Appropriate methodologies should be used, in accordance with the IPCC good practice guidance, to promote accuracy in inventories. Source: UNFCCC, Decision FCCC/CP/2002/8.

emissions monitoring systems (CEMS) are used at the point source. CEMS continuously measure and record hourly emissions concentrations of SO2, and CO2 and exhaust gas flows for NOx. Any domestic emissions trading scheme under the Kyoto trading system is likely to require a more specific level of detail in their inventory process.

THE KYOTO MECHANISMS

45

National Inventories are likely to be used as a basis for determining a Party’s strategy for trading in the international market, including whether and how much they are likely to buy, what kind of reductions can be undertaken domestically and by how much other sectors will need to reduce their emissions. It will also assist Parties in determining the extent to which they will need to import reduction units in order to remain in compliance. It is also likely to be a tool for policy development for reducing emissions, since all reporting categories are included in a Party’s assigned amount. They are likely to influence any domestic emissions trading scheme and reporting requirements under the Protocol. While bottom-up reporting (i.e. company level data) is not likely to be used in developing a national inventory, it may be used as a quality check of the national inventory. From that perspective, it is beneficial for any sector that will be impacted by a domestic trading scheme to know and understand the national inventory process, especially the categories in which emissions are reported (see Tables 3.3 and 3.4).

3.2.2

National registries

All Annex B Parties regardless of whether they will have a domestic emissions trading scheme must have a national registry in order to account for its assigned amount. The registry is basically an accounting tool that will facilitate and record transactions related to Kyoto reduction units, including issuance and conversion of units (ERUs and RMUs), and internal (such as retirement and cancellation) and external (i.e. to another Party) transfers. To facilitate tracking of units, all units within a registry are required to have unique serial numbers. Each unit will be labelled to identify the originating Party, the compliance period for which it was issued, whether it is from a land-use change activity and other identifiers (see Table 3.5). Once an assigned amount has been calculated and reviewed, Parties can issue its initial allocation of AAUs and RMUs into its registry. It can then convert specific units into ERUs, while removing the appropriate AAUs and RMUs. The transaction log checks for discrepancies and then records the transaction. The registry tracks the total number of Kyoto reduction units in the national account, accounting for any transfers or acquisitions, and any changes that affect the level of allowances within the registry. Parties are required to maintain a specific amount of Kyoto reduction units within its Registry in order to trade; this amount is called as the commitment period reserve (see Section 3.3). Parties are also required to maintain an account for retiring units during the process of complying with the emissions target at the end of the commitment period and removing or cancelling units from the system.

46

Table 3.3 Information requirements under the common reporting format Energy

Industrial Processes

Table 1 Sectoral Report for Energy

Table 2(I) Sectoral Report for Industrial Processes

Sectoral Background Data for Energy

Sectoral Background Data for Industrial Processes

Table 1.A(a) Fuel Combustion Activities – Sectoral Approach Table 1.A(b) CO2 from Fuel Combustion Activities – Reference Approach Table 1.A(c) Comparison of CO2 Emissions from Fuel Combustion Table 1.A(d) Feedstocks and Non-Energy Use of Fuels Table 1.B.1 Fugitive Emissions from Solid Fuels Table 1.B.2 Fugitive Emissions from Oil, Natural Gas and Other Sources Table 1.C International Bunkers and Multilateral Operations

Table 2(I).A–G Emissions of CO2, CH4 and N2O Table 2(II) Sectoral Report for Industrial Processes – Emissions of HFCs, PFCs and SF6 Table 2(II).C, E Metal Production, Production of Halocarbons and SF6 Table 2(II).F Consumption of Halocarbons and SF6

Solvent and Other Product Use

Agriculture

Table 3 Sectoral Report for Solvent and Other Product Use Table 3.A–D Sectoral Background Data for Solvent and Other Product Use

Table 4 Sectoral Report for Agriculture

Sectoral Background Data for Agriculture Table 4.A Enteric Fermentation Table 4.B(a) CH4 Emissions from Manure Management Table 4.B(b) N2O Emissions from Manure Management Table 4.C Rice Cultivation

47

Table 3.3 Continued Table 4.D Agricultural Soils Table 4.E Prescribed Burning of Table 4.F Field Burning of Agricultural Residues Land-use Change and Forestry

Waste

Table 5 Sectoral Report for Land-use Change and Forestry

Table 6 Sectoral Report for Waste

Sectoral Background Data for Land-use Change and Forestry

Sectoral Background Data for Waste

Table 5.A Changes in Forest and Other Woody Biomass Stocks Table 5.B Forest and Grassland Conversion Table 5.C Abandonment of Managed Lands Table 5.D CO2 Emissions and Removals from Soil

Table 6.A Solid Waste Disposal Table 6.B Waste-water Handling Table 6.C Waste Incineration

Summary Tables

Other Tables

Summary 1.A Summary Report for National Greenhouse Gas Inventories (IPCC Table 7A) Summary 1.B Short Summary Report for National Greenhouse Gas Inventories (IPCC Table 7B) Summary 2 Summary Report for CO2 Equivalent Emissions Summary 3 Summary Report for Methods and Emission Factors Used

Table 7 Summary Overview for Key Sources Table 8(a) Recalculation – Recalculated Data Table 8(b) Recalculation – Explanatory Information Table 9(a) Completeness – Information on Notation Keys Table 9(b) Completeness – Information on Additional Greenhouse Gases Table 10 Emissions Trends (CO2) Table 10 Emissions Trends (CH4) Table 10 Emissions Trends (N2O) Table 10 Emissions Trends (HFCs, PFCs and SF6) Table 10 Emissions Trends (Summary)

Source: UNFCCC, Decision FCCC/CP/2002/8.

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Table 3.4 Example from the Common Reporting Format under the Convention Table 1 Sectoral Report For Energy

Country

Sheet 1 of 2

Year Submission

Greenhouse gas source and sink categories

CO2 CH4 S20 NOx CO NMVOC NO2 (Gg)

Total Energy A. Fuel combustion activities (sectoral approach) 1. Energy Industries a. Public electricity and heat production b. Petroleum refining c. Manufacturing of solid fuels and other energy industries 2. Manufacturing Industries and construction a. Iron and steel b. Non-ferrous metals c. Chemicals d. Pulp, paper and print e. Food processing, beverages and Tobacco f. Other (as specified in table 1.A(a) Sheet 2) 3. Transport a. Civil Aviation b. Road Transportation c. Rail ways d. Navigation e. Other Transportation (as specified in table 1.A(a) sheet 3) Common Reporting format for the provision of inventory information by Annex I Parties to the UNFCCC

Source: UNFCCC, Decision FCCC/CP/2002/8.

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Table 3.5 Elements of serial number of units Element

AAU

RMU

CER

ERU

Commitment period

Yes

Yes

Yes

Yes

Unit type

Yes

Yes

Yes

Yes

LULUCF

No

Yes

Yes

Yes

Project identifier

No

No

Yes

Yes

Unique number

Yes

Yes

Yes

Yes

Originating Party identifier

Yes

Yes

Yes

Yes

Source: UNFCCC Documents, FCCC/CP/8/Add.3 page 51.

Any units transacted will carry a transaction number, but this will not alter the original serial number, making it possible to trace units back to the originating Party. The transaction number will identify the Party initiating the transaction as well as a number unique to that transaction for the commitment period and initiating Party. The secretariat will maintain an automated transaction log that works in conjunction with the national registries. The transaction log serves as a communications hub between national registries as well as the CDM registry (see Figure 3.1). It relays transaction messages and responses between registries. It also verifies that transactions occurring in the national registries are valid, that is, that the unit to be transferred has not been previously transferred or cancelled. When a transaction occurs within a national registry, a notice is automatically transmitted to the transaction log, and the log in turn verifies that the transaction is valid, and notifies the national registry of all Parties involved in the transaction (see Box 3.3). In cases where the transaction log identifies a problem, the issuing registry must stop the transaction. National inventories and data collected through the national registry will form the basis for annual reports on a Party’s activities. These reports will be

Party A sends proposal for transfer National Registry Party A

Log checks proposal and forwards for response National Registry Party B

Transaction log

Log sends response, logs and forwards to Party A

Party B accepts proposal, sends response

Figure 3.1 Communication between registries

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Box 3.3

Message sequence for registry systems

Minimum standardized message sequence types for registry systems Transactions 1. Issuance of units in a national registry or the CDM registry. 2. Internal transfer of units (a) from the CDM registry pending account to another account or (b) from an account to a cancellation or retirement account. 3. External transfer of units to a national registry. 4. Carry-over of units, as appropriate, to the subsequent commitment period. Other activities 1. Reconciliation of data between registries and the transaction log. 2. Testing of connections between registry systems. 3. Notification of change to online status of the transaction log. 4. Notification of change to offline status of the transaction log. Source: UNFCCC, FCCC/CP/8/Add.3 page 49.

submitted to the secretariat and reviewed by expert review teams to ensure that the Parties are in compliance with all requirements. CDM Registry The executive board of the CDM is tasked with establishing and maintaining a CDM registry. This registry will process standard transactions, including: issuance of units, internal transfers between accounts within the registry, external transfers to and from national registries for cancellation to compensate any excess issuance of units, and separation of units to cover the share of proceeds. The registry will provide information for each transaction to the transaction log for a validity check. Until the transaction log is operational, the CDM registry will issue and forward CERs on an interim basis. Once it is operational, it will interact with the transaction log to check validity of all interim processes, basically finalizing the transactions.

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The registry will be electronic and communicate with the transaction log in a secure manner and using the same data exchange standards as those required for national registries and the transaction log. It will undertake the same record keeping functions as national registries; maintain records of account holdings, transactions, internal activities and interactions with the transaction log. It will also generate reports for use by the registry administrator, executive board, account holders and general public. Since it is an electronic registry, it is anticipated that it will be available as close to 24 hours a day as possible, will be user friendly and be a secure system. Once the international system is up and running, the CDM registry will work in conjunction with the transaction log that will be maintained by the secretariat. The functions of the CDM registry will be compatible with national registries, and will be similar to the UK registry system. The CDM registry is likely to be up and running by 2005.

3.3

INTERNATIONAL EMISSIONS TRADING

Article 17 of the Protocol provides a mechanism that allows a Party to participate in international emissions trading in order to meet its commitment. The ability to trade, however, is embedded in Article 3 of Protocol in which Parties with targets may add and/or subtract from its assigned amount.23 This double entry bookkeeping system allows Parties to meet their targets in part by purchasing reductions from countries that achieve emissions reductions beyond their own targets. The rational for this system, as with the US SO2 trading programme, is that by allowing trading to occur the entities participating in by the trading system will have the option of either undertaking reductions directly or by purchasing reductions from another entity, whichever proves more cost effective.

3.3.1

Explanation of the international ‘Rules’

The intention of the rules set out in the Protocol and the Marrakech Accords,24 is to provide the framework upon which Parties and/or their entities (i.e. industry) can trade reduction units as part of a Party’s option for complying with its commitments. The framework enables Parties to decide how best to achieve their target, including through the use of domestic emissions trading schemes, and whether it should allow their private sectors to participate. For Parties instituting emissions trading schemes, the rules set out the minimum parameters that all Parties must meet in order to trade internationally, limiting the need for extensive negotiations on linking domestic schemes. In this respect it is somewhat similar to the EU process in developing its emissions trading scheme. The participation requirements

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provide the minimal criteria for a multi-jurisdictional trading scheme: calculation of the cap, monitoring and estimation requirements, reporting requirements, and systems for allowance tracking. Methods for allocating allowances, sectors that can trade, integration of non-trading sectors through policies and measures are issues left to the Party to determine. Determining a Party’s overall reduction or limitation commitment is not a straightforward exercise. A Party’s assigned amount is equal to the percentage listed in Annex B of its total greenhouse gas (in CO2 equivalent) emissions from the gases and source categories listed in Annex A25 of the Protocol (see Table 3.6) that are in the base year or period. This is multiplied by five (for each year in the commitment period) and then adjusted to account for the choice of base year for total emissions of HFC, PFC and SF6 (Parties may use 1990 or 1995 as the base year for these gases), and land-use change and forestry activities (where activities constitute a net source of greenhouse gas emissions). EU Member States must calculate their assigned amount based on the burden-sharing agreement, instead of the 8 per cent reduction listed in Annex B, since the reallocation based on this agreement was reported in at the time of ratification by the EU. In order to have the assigned amount ‘recorded’ (finalized) Parties are obligated to provide a two-part report no later than 1 January 200726 to the secretariat that contains information on: Part I – the completed inventory, base year selection for the halocarbons and SF6, calculation of the assigned amount; Part II – calculation of the commitment period reserve; choices related to land-use change and forestry, a description of the national system for estimating sources and removals of emissions and a description of the national registry (see Figure 3.2). The report is reviewed by an expert review team that forwards its report to the Enforcement Branch of the Compliance Committee.27 The expert review team has 12 months to complete its review. After 16 months from the date of the Party’s submission, the eligibility requirements are considered to have been met if no questions of compliance arise during that time. The Enforcement Branch also has the option of determining that the Party is in compliance with requirements for trading based on the report by the expert review team. After this process is complete, the assigned amount is fixed for the commitment period. One potential area of delay, however, is the timeframe that initial reviews may take. Under the rules, expert review teams are given one year from the date of submission to conclude reviews and submit final reports to the Enforcement Branch. Since Parties have until one year prior to the commitment period to put in place their national system, if a question is raised about an element of the report, it is possible that the ability of some countries to trade will not be made clear until after the start of the commitment period.

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Table 3.6 Source Categories in Annex A of the Protocol Energy

Fuel combustion: Energy industries Manufacturing industries and construction Transport Other sectors Other Fugitive emissions from fuels: Solid Fuels Oil and natural gas Other

Industrial processes

Mineral products Chemical industry Metal production Other production Production of halocarbons and SF6 Consumption of halocarbons and SF6 Other

Solvent and other product use Agriculture

Enteric fermentation Manure management Rice cultivation Agricultural soils Prescribed burning of savannas Field burning of agricultural residues Other

Waste

Solid waste disposal on land Wastewater handling Waste incineration Other

Once a country has calculated and recorded its assigned amount, it can issue a quantity of AAUs equivalent to its assigned amount into its national registry. Parties, however, are required to continuously maintain a reserve of reduction units (composed of AAUs, ERUs, CERs and/or RMUs) of either 90 per cent of its recorded assigned amount or 100 per cent of five times its most recently reviewed inventory which ever is lowest. This is known as the ‘commitment period reserve’.

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Submission to secretariat of report for inscribing assigned amount

End of expert review Beginning of Enforcement Branch review

1 January 2007

1 January 2008

Deadline for any question of implementation to be raised

30 April 2008

Start of the commitment period

Figure 3.2 Review timeline for finalizing assigned amount

The Kyoto trading system is based on seller liability, meaning that a Party selling (transferring) AAUs to another Party is liable for any shortfall in its account, not the buying (acquiring) Party.28 The liability rules were established to help deter overselling of Kyoto reduction units. Buyers who purchase units from a Party that goes into non-compliance retain the ability to use these units for its compliance purposes. The selling Party, however, must make up for any short fall through purchases on the international market or face non-compliance with its commitments under the Protocol. The commitment period reserve is an extension of seller liability. It restricts the amount of units a Party or their entities (if the Party develops a trading scheme transacting Kyoto reduction units or transacting a domestic allowance in parallel with Kyoto reduction units) may trade through the commitment period until all five inventories have been submitted and reviewed. The intended purpose is to help deter overselling by Parties through emissions trading. It is not, however, a measure for ensuring compliance. In 2003, the majority of planned emissions trading schemes cover no more than 50 per cent of CO2 emissions. This means that the remaining emissions would be covered by sectors that are not subject to an absolute cap, but are covered by other policies. Decreases in emissions by sectors under a trading scheme (and the corresponding ‘freeing-up’ of emissions in the CPR, could be offset by emissions in a non-trading sector which could unintentionally lead to the Party being in non-compliance). The total tradable amount will vary from year to year depending on the latest inventory. In the example in Table 3.7, the tradable amount for 2008 and 2009 would be 50 AAUs, while in 2010, 55 AAUs could be traded. The commitment period reserve will be maintained until all five inventories are in place – meaning they have been submitted and reviewed. The CPR covers all AAUs, ERUs, CERs and RMUs held in a national account that have not been cancelled. ERUs that are verified through the verification procedures under the supervisory committee are not subject to CPR limits, that is, they can be freely traded. If a Party goes below its CPR,

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Table 3.7 The commitment period reserve 2008

2009

2010

Initial assigned amount

500

Unchanged

Unchanged

Inventory

90

94

89

90 per cent of assigned amount

450

450

450

100 per cent of 5x inventory

450

470

445

CPR

450

450

445

50 þ ERUs

50 þ ERUs

55 þ ERUs

Tradable amount

the secretariat notifies the Party, who then has 30 days to correct the imbalance. It can reinstate the CPR level by buying additional units. The inventory process poses two challenges for trading as well as for the commitment period reserve. First, there is an issue of when inventories are submitted and reviewed. Timing for inventory submissions does not coincide with timing for trading in that there is currently a delay between a trading period and when the emissions inventory for that trading period is submitted. Under the current process in April 2008, Parties will submit inventories from 1990 up through the year 2006. Time must also be allotted for the review process, which means that another year from the date of submission must be added. This means that in 2008 an individual inventory review may not be completed until 2011. Second, since the inventory process under the Convention and Protocol relies on estimates, these numbers are also subject to revision (or recalculation) as new data or new methods are employed to improve the quality of the inventory. Adjustments occur in two ways: if the expert review team finds a shortcoming or inconsistency in the inventory or methodology used than it may result in an adjustment; or if a Party recalculates a portion of its inventory and the expert review team agrees with the recalculation. The adjustments must be included in the 2012 inventory at the latest.

3.4

JOINT IMPLEMENTATION

Article 6 of the Kyoto Protocol is commonly referred to as Joint Implementation or JI.29 JI provides Parties in Annex I with the ability to trade (transfer and/or acquire) ‘credits’ based on a project’s ability to reduce or sequester emissions. These projects are to be undertaken between Annex I countries with targets under Annex B of the Protocol. Projects can be hosted

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in any Annex I country. Presently, the potential for projects is generally seen to be largest in countries with economies in transition (central and eastern European countries). Although JI and the CDM are both project-based mechanisms, they differ in several important ways. First, JI is more closely linked with emissions trading under Article 17. Unlike the CDM where the credit is created, ERUs are part of a Parties overall assigned amount. Parties’ transferring ERUs are required to convert AAUs or RMUs from their national registries into ERUs. Second, JI has a vastly different start date from the CDM. The CDM rules adopted in Marrakech provide for the prompt start of the CDM. The bodies that are to provide guidance (the COP acting for the COP/MOP until it established) and supervision (the executive board) have been established and the bodies that are to provide for independent ‘auditing’ (Designated Operational Entities) are in the process of being established. JI, on the other hand, will not officially begin until the Protocol enters into force, and the commitment period begins. ERUs generated under JI cannot physically be transferred before the commitment period, since the assigned amount must first be calculated and confirmed.30 Both mechanisms, however, provide for projects to be grandfathered into the relevant mechanisms, that is, projects that begin generating emissions reduced or sequestered from 2000 may be eligible if they meet all relevant criteria.31 Although there is a supervisory body for JI, the scope and purpose of this body varies greatly from that of the executive board under the CDM. The supervisory committee, and therefore the remaining ‘rules’, will not come into being until at least the first meeting of the COP/MOP. Participation and eligibility requirements Article 6 of the Protocol and Decision 16/CP.7 of the Marrakech Accords provides a legal framework for JI. As with emissions trading and the CDM, Annex I Parties participating in JI must meet the eligibility requirements specified in the Marrakech Accords (see Section 3.1.1), in order to trade ERUs. This requirement, however, does not preclude projects from taking place before a host party has met all requirements. It is possible for Parties who do not meet any of the eligibility requirements for participation in the Kyoto trading system to participate in JI projects. Any emissions reduce or sequestered would have to go through verification procedures by the supervisory committee, but because the host country Party is out of compliance no verified ERUs could be transferred. Once a Party were to meet the eligibility requirements, however, the transfer could occur. Parties wishing to participate in JI must inform the Convention secretariat that it has designated a focal point for JI, and inform them of their

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national guidelines and procedures for approving JI projects. In addition, Annex I Parties are to ‘refrain’ from using ERUs generated from nuclear energy projects in meeting their targets. Timing Although projects under JI can begin any time after 2000, it is unclear when JI will start. There are three triggers at the international level before JI (trading ERUs under the Protocol) can start: the Protocol must enter into force, the enforcement branch must be established so that eligibility can be determined, and the Conference of the Parties serving as the meeting of the Parties (COP/MOP) must establish the supervisory committee (a requirement for second track and a necessity for any country not meeting all of the eligibility requirements). The ability for a Party to trade ERUs is dependent on whether: a Party ratifies the Protocol, and meets the eligibility requirements and submits a report for review by the expert review team (for a green light by the Enforcement branch of the compliance committee – a 16-month process).

3.4.1 Transfer and acquisition of ERUs – the two-track approach The transfer of ERUs is tied to the reduction or removal of greenhouse gases through a specific project. JI provides a two-track system for achieving this (see Table 3.8). Under the first track, host Parties are free to apply their own criteria, and determine the additionality of the emissions reduced or removed. For host Parties who only meet some of the eligibility requirements, transfers of ERUs from a host to investor party/entity can occur, but they must go through a verification procedure that is overseen by the supervisory committee. Parties meeting all of the eligibility requirements may also opt to use the second-track process. One advantage to using the second track is that it exempts the ERUs from the CPR limit, and can therefore be traded regardless of the status of the CPR in a national registry. Parties must design national guidelines and procedures for approving JI projects, and must include a process for seeking stakeholder input as well as a process for verification and monitoring of reductions or removals associated with the project. In addition, there are several project-related requirements that must be met: &

All Parties involved in a project must approve it. Party involvement is not defined under the rulebook. This has been a point of discussion under the CDM process since investor Party involvement is sometimes difficult to assess. Two approaches are possible, one in which a Party decides in

The country must have submitted annually the most recent required greenhouse gas inventory; and

The country must submit the necessary supplementary information on its assigned amount, as required under Article 7 (communication of information).

&

&

Host Party free to issue ERUs.

There must be a national registry in place;

&

Issuance of ERUs

A national system for estimating greenhouse gas emissions must be in place;

&

Host party applies own criteria for project approval, including additionality assessment.

&

It must have calculated and recorded its assigned amounts;

&

The Country must be a Party to the Kyoto Protocol; It must have calculated and recorded its Assigned Amounts; and There must be a national registry in place.

Host Party free to issue ERUs after verification procedure if no supervisory committee review is triggered.

Project developers must follow verification procedures under the supervisory committee, including development of Project Design Document. Independent entities determine whether projects meet all JI requirements.

&

&

The Country must be a Party to the Kyoto Protocol;

Second track

&

Project approval process

Eligibility requirements for transferring and acquiring ERUs

First track

Table 3.8 JI first and second track

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its national guidelines that it must review and approve each project where the primary investor brings ERUs into the national registry for compliance purposes; and one in which the national guidelines give blanket approval to all projects undertaken by organizations or industry within their borders. Once a secondary market for ERUs develops (where the primary purchaser of the ERUs sells them to other purchasers) Party involvement becomes a murky business. &

Emission reductions or removals must be additional to any that would have occurred without the project, which means that the only appropriate test is on the emissions or removals. Determining additionality, even what additionality means, if a difficult issue. Different tests have been used such as whether the project would not have happened ‘but for’ the investment, or ‘but for’ the JI mechanism. The only test however is on whether the emissions or removals would have occurred or whether they will only occur through the existence of the project. The additionality criterion under JI is applicable to all projects. But how it is assessed is vastly different under the two tracks. Under first-track JI, it is the host country that determines whether the project is additional to business as usual. For second-track projects, an independent auditor assesses the additionality of the emission reduced or sequestered.

&

Sinks projects must conform to rules on land-use change and forestry.

&

Projects starting from the year 2000 that meet all the rules may be eligible under JI, but ERUs may only be issued during the commitment period.

3.4.2

First-track JI

For Parties in full compliance with the eligibility requirements for participation under the Kyoto trading system, there are no internationally imposed requirements for JI projects, other than those stated above. The Parties must inform the UNFCCC secretariat of their national guidelines and procedures for project approval. The Parties involved must determine whether the projects meet their guidelines (see Figure 3.3), and the amount of emissions reduced or sequestered by the projects. The host Party can verify whether the emissions reduced or sequestered are additional. The host Party must make information on the project ‘publicly available’ both directly, or by sending project information, including on baselines and monitoring to the

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Project development

Project approval

Monitoring

Transfer of ERUs

Project Developers prepare project to host and investor country specifications, baseline and monitoring plans required, PDD may be required. Information is made publicly available.

Project is approved by host and investor countries, including whether emission reduced or sequestered are additional.

Project developers monitor project emissions according to monitoring plan.

Host country transfers ERUs from national registry to account(s) in investor country national registry based on agreement.

Figure 3.3 JI First-track project cycle

secretariat. It is unclear whether these projects will be required to send information in the format of a project design document (PDD). Although Parties could choose to design their own format for submitting project information, it is just as likely that Parties may choose to adopt the project design document that the supervisory committee is to design. Finally, the host country has the responsibility for transferring ERUs to the investor Party/Parties.

3.4.3

Second-track JI

If a Party does not meet all of the eligibility requirements for trading it can still participate under JI,32 however the host country must meet three of the requirements in order to issue and transfer ERUs: &

It must be a Party to the Protocol;

&

The Assigned Amount must be calculated and recorded; and

&

It must have a national registry in place.

Many of the requirements and procedures for second-track JI projects have yet to be defined. The supervisory committee has been left with the responsibility for determining these procedures. It is likely that the

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procedures will be similar in nature to the CDM, since the supervisory committee is asked to take the CDM rules into consideration. As mentioned, establishment of the supervisory committee is contingent on the entry into force of the Protocol, and a decision to establish it by the COP/MOP. Although the JI rules in the Marrakech Accords states that the supervisory committee will be established at the first COP/MOP, it is unclear whether Parties can or will let this happen. For many Parties, particularly non-Annex I Parties, JI is not and will not be a priority issue. Therefore, it is possible that the establishment of the supervisory committee will occur later than the first session of the COP/MOP. Some JI-type projects have already begun, although it is unclear whether these projects will be eligible under a second-track system. Many of these projects are being assessed against the CDM rules, particularly since most host Parties are not expected to fulfil the eligibility requirements before at least 2007. It is important to note that host countries and project participants can opt to use the second-track system even if the host country meets all of the eligibility requirements. This, however, is likely to increase transaction costs since the administrative costs involved with using the second-track system are likely to be borne by the project participants.

3.4.4 Governance of second-track JI and its project cycle Second-track projects will be administered through the following principal bodies: The COP/MOP The COP/MOP provides guidance over the JI mechanism, and ‘exercises authority’ over the Supervisory Committee. The Supervisory Committee The primary responsibility of the supervisory committee is to supervise the verification procedure of emissions reduced or sequestered by projects under the second track of JI. In addition it is responsible for: &

Accrediting independent entities;

&

Reviewing standards and procedures for accreditation and making recommendations to the COP/MOP;

&

Reviewing and revising guidelines for baselines and monitoring;

&

Designing a project design document; and

&

Developing review procedures and rules of procedure.

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The Supervisory Committee is also responsible for suspending or withdrawing accreditation of Independent Entities if the action of the Independent Entity so warrants, that is, it fails to meet the accreditation standards set out in the JI rules. The Supervisory Committee will consist of ten members and ten alternate members who are to serve in their individual capacity. They will be nominated by the various regional UN groupings and elected by the COP/ MOP. There will be 12 members/alternate members from within Annex I countries (with six of the members/alternate members coming from countries with economies in transition), and eight from non-Annex I countries (with two coming from small island developing states). Independent Entities Independent Entities (IE) under JI are responsible for making ‘determinations’ at two separate points during the project cycle. First, they determine whether all project eligibility requirements have been met. Once the project begins reducing or sequestering emissions, the IE determines (based on the monitoring plan) whether the emissions reduced or sequestered have been monitored and calculated in accordance with the PDD.

3.4.5

Second-track JI project cycle

There are three main stages in the second-track JI project cycle: (see Figure 3.4).

3.4.5.1 Stage 1: project development Project developer identifies and develops a project, conducting an initial evaluation of the eligibility and feasibility of developing the project. A PDD must be developed. This will involve development of emissions baseline, monitoring plans and compliance with any host country requirements. Project developers must seek the approval of all Parties involved and determine whether the project is additional. Project developers must also conduct an analysis of environmental impacts, and if these are considered significant (by the developer or host country), conduct an environmental impact assessment, in accordance with the host countries’ national laws.

3.4.5.2 Stage 2: verification procedure 1. Determination: The PDD and any supporting information are submitted to an IE who must make it publicly available for comment for 30 days. The IE then makes a determination as to whether the project meets all of the necessary requirements. This ‘determination’ is then sent forward to the Convention secretariat who makes it publicly available. The

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determination will contain an explanation of reasons for its determination, a summary of comments received and how due account of those comments were taken. Forty-five days after the determination is made public it is considered final, unless either three members of the supervisory committee or the Parties involved request a review. A review must be completed within six months or by the second meeting after the review has been requested. Procedures for a review, including under what grounds a review can be requested will be developed by the supervisory committee. Unlike the CDM, there is currently no requirement for registration of JI projects. 2. Project Monitoring: Monitoring is conducted according to the monitoring plan drawn up as part of the PDD. The data collected is to be incorporated into a report on the emissions that have been reduced or sequestered and submitted to the IE for ‘determination’. This report is to be made publicly available although the current rules do not stipulate by

Project development

Verification procedure Determination

Monitoring

Determination

Transfer of ERUs

Project developers prepare project to host, investor and international specifications, baseline and monitoring plans required. PDD required. Information is made publicly available.

Full PDD and supporting materials sent to IE to determine project meets all requirements. Supervisory Committee involvement only in cases of request for review.

Project developers monitor project emissions according to monitoring plan.

Independent Entity periodically verifies project has monitored emissions reduced or sequestered and calculated reduction correctly.

Host country transfers ERUs from national registry to account(s) in investor country national registry based on agreement.

Figure 3.4 JI Second-track project cycle

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whom, presumably it is the IE who makes it available upon receipt. It is likely to be up to the project developers and the Parties involved to determine how frequently this report will be submitted to the IE. 3. Determination: The IE will at this point ‘determine’ whether the emissions reduced or sequestered were monitored and calculated correctly. The IE submits its results and an explanation to the secretariat that then makes it publicly available. If no review is requested, this determination is considered final after 15 days. If a Party involved in the project or at least three members of the Supervisory Committee requests a review, it must be completed either at its next meeting or 30 days after receipt of the request. Any decision by the Supervisory Committee is considered final.

3.4.5.3 Stage 3: issuance and transfer of ERUs Following the second determination, and once the commitment period has begun host Parties that meet the minimum requirements may issue and transfer ERUs.

3.5

THE CLEAN DEVELOPMENT MECHANISM

The CDM is the most well developed of the three Kyoto mechanisms. It is also the most intricate. The CDM, as with JI, is a project-based mechanism that requires ex-post verification of emission reductions in order to generate credits. Unlike JI, however, the CERs generated are not a part of the overall cap on emissions under the Protocol. The CDM is open to participation by non-Annex I Parties, making it the global component of the Kyoto emissions trading system. In order to ensure it remains a fair and transparent mechanism with a high level of credibility, a significant amount of international ‘rules’ have been developed. The CDM rulebook is an important feature in ensuring that the emissions reduced or sequestered through CDM projects are real and verifiable, and that the projects themselves assist host countries with their development interests. The CDM also contains provisions for a ‘tax’ for an adaptation fund (2 per cent of CERs generated by a project activity) and to cover administrative costs, called the share of proceeds (see Section 6.2). For some host countries the CDM has appeared to be a way of attracting significant new resources into countries and areas that sorely need it, such as for improving access to energy. For project developers, however, the amount of time, energy and resources that goes into setting up a CDM project might be a real barrier to

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investment. As long as the future of the Protocol is uncertain, and the market limited by the number of potential investor countries that will utilize the CDM, it is not likely to meet the needs or expectations of all potential host countries. Even with a vibrant market, host countries are likely to find that it will not bring in the types of investments some early discussions of the CDM seemed to give rise to. The CDM cannot be all things to all countries and is not meant as a cure to the limitations of international development policies. The CDM will provide additional investment resources for energy development and other areas. But it will not provide the resources required to solve all development issues. The success of the CDM is likely to vary from region to region since national (and regional) capacities vary, that is, in terms of infrastructure and ability to utilize technologies.

3.5.1

The CDM concept

In order to understand the complexity involved in this mechanism, it is important to understand its origins and its purpose. The CDM is generally considered an ambitious and unique mechanism. In addition, it is the only mechanism that the Parties agreed to implement immediately upon adoption of the rules in Marrakech, and regardless of the status of entry into force of the Protocol. The rules governing the operation of the CDM, the CDM modalities and procedures, are neither simplistic nor is the meaning or intention always clear. Since negotiations by their very nature require compromise, the CDM is in fact a series of compromises agreed to by all Parties based on two proposals discussed under the negotiation process for the Protocol: the Brazilian compliance fund and the US JI proposal. It was also a last minute add on into the Protocol negotiating text which meant that many of the concepts provided for in the Article establishing the CDM were not well defined and required detailed elaboration at a later date. The CDM has three objectives: &

To assist Parties not included in Annex I (i.e. developing countries) in achieving sustainable development;

&

To contribute to the ultimate objective of the Convention, that is, to reduce greenhouse gas emissions to a ‘safe’ level; and

&

To assist Parties included in Annex I (industrialized countries) in achieving compliance with their quantified emission limitation and reduction commitments under Article 3 of the Kyoto Protocol.

It is this last objective that makes it possible for CERs to enter into the cap and trade system to which emissions trading and JI belong. Since CERs are

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credits generated from outside of the cap, particular diligence has been placed in meeting the first two objectives. In order ensure that the emissions reductions tied to the CERs are ‘real’ and that it assists the host Party in meeting its needs, the COP instituted a governance process and specified criteria that projects under the CDM must meet. The two primary criteria that all projects under the CDM must meet are the development of a baseline and a test of the additionality of the projects’ emissions. The baseline is the single most important criterion since it governs how many CERs a project will earn. The CDM rules define a baseline as the ‘scenario that reasonably represents the anthropogenic emissions by sources of greenhouse gases that would occur in the absence of the proposed project activity’. The baseline, therefore, is an estimate of a hypothetical situation; it is used to show what would most likely have happened to emissions if the project had not occurred. In order to develop a baseline that is acceptable under the CDM rules the following criteria must be met: &

The baseline must include any greenhouse gas emissions from any sectors and sources contained in Annex A of the Protocol within the project boundary;

&

The baseline must be developed using the methodologies developed under the CDM; and

&

The baseline must be transparent and conservative.33

The second criterion that projects must adhere to is that of additionality. It is one of the most difficult issues to define. As with a baseline, additionality is not always a clear cut issue. When basing decisions on a hypothetical situation that cannot be precisely measured the results may not always be to everyone’s standards. The CDM rules only require, however, that projects must reasonably demonstrate that the emission reductions are additional to those that would have occurred in the absence of the CDM project. In other words, project developers will need to show that the project goes beyond business as usual. This can mean business as usual in the direct vicinity, in the direct vicinity for a particular technology or process, or in a particular region. Codifying one method for determining additionality has proven difficult. The aim of the CDM is to promote primarily private sector investments by developed countries in projects that reduce or sequester emissions of greenhouse gases in developing countries. Since developing countries are not required to limit or reduce their emissions, credits generated under the CDM can be added to an Annex B Parties account in its national registry for compliance purposes with its Kyoto target. Although the CDM is principally designed to promote partnerships between developed and developing

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countries, the CDM rules do not explicitly exclude projects from being undertaken by partnership between one or more developing countries; these are referred to as ‘unilateral’ or ‘South-South’ projects. Participation and project requirements The CDM rules specify two criteria for Party participation in the CDM. The first is that participation must be voluntary. The requirement for voluntary participation is a hold over from negotiations that resulted in the AIJ pilot phase. It is not clear how this requirement will be fulfilled by Annex B Parties since participation is a broad concept and not all project activities are likely to have direct involvement of inventor country Parties. The other participation requirement is for all Parties to designate a national authority (DNA) for the CDM. The function of a DNA is left to the Party setting it up, but in most cases is likely to be the office that coordinates approval and develops any national criteria that projects may have to meet. Parties participating in the CDM can authorize legal entities, that is, businesses, non-governmental organizations and other groups, to participate in the CDM. CDM project activities are required to meet the following: &

Any emission reductions resulting from CDM project activities must be certified by operational entities. Certification requires that the Designated Operational Entity (DOE) has some proof of voluntary participation by each Party involved (primarily by the host country but may be dependent on the structure of the contract), the emission reductions are real, measurable and long-term (baseline requirement), and that emission reductions are additional to any that would have occurred (additionality test).

&

It must assist the host country in meeting its sustainable development priorities, and the host country must confirm this before the DOE can submit a validation report of CDM Executive Board.

&

Project developers are required to seek stakeholder input on proposed CDM activities, and if required by host country law, undertake an environmental impact assessment.

Eligibility requirements for use of CERs In order for an Annex B Party to transfer CERs into its national registry, it must be in compliance with all requirements for use of the mechanisms, namely: &

The Country must be a Party to the Kyoto Protocol;

&

It must have calculated and recorded its Assigned Amount;

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&

A national system for estimating greenhouse gas emissions must be in place;

&

There must be a national registry in place;

&

The country must have submitted annually the most recent required greenhouse gas inventory; and

&

The country must submit the necessary supplementary information on its Assigned Amount, as required under Article 7 (communication of information).

It is up to each Annex I Party to determine the amount of CERs that they will allow into their system for compliance purposes. Parties will also have to decide whether they wish to restrict the type of project activities they approve, with different countries having different requirements. Some may decide to limit or exclude CERs derived from particular project categories, that is, land-use change and forestry or large hydro. No countries, for instance, are likely to allow CERs generated from nuclear projects into their system since there is a general ‘ban’ on using CERs that have been generated from nuclear projects.

3.5.2

CDM governance and its project cycle

The CDM is administered through three principal bodies, namely, the Conference of the Parties serving as the Meeting of the Parties, or COP/MOP (prior to the establishment of the COP/MOP the COP will act in its place), the CDM executive board and DOEs. In addition, countries participating in the CDM must designate a national authority (DNA) to act as a CDM focal point within a country. Although not discussed in depth here, DNAs play an important role in the CDM project cycle, particularly within host countries. Project operators/developers need to consult with and/or report to these DNAs during the project approval and/or implementation process. DNAs are likely to have additional requirements and an internal project cycle. The primary responsibilities of the principal bodies are outlined as follows. The Conference of Parties/Meeting of Parties (COP/MOP) The Conference of the Parties serving as the Meeting of the Parties to the Kyoto Protocol, holds ultimate authority over the CDM. It is responsible for taking major decisions related to rules and is the only body that can ‘designate’ an

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operational entity (see below). Because the COP agreed to ‘prompt-start’ the CDM, it will act in place of the COP/MOP until the Protocol enters into force, the COP/MOP convenes. Executive Board The CDM executive board is comprised of ten members and ten alternate members (alternate members function as full members of the executive board, but lack voting rights) who are to have relevant technical and policy expertise. Parties to the Protocol nominate members.34 The executive board is responsible for providing guidance in the following areas: &

Methodologies regarding baselines (including standardized baseline setting) and monitoring, to ensure that such methodologies are explicit, consistent, transparent and predictable;

&

Determination of appropriate project boundaries for accounting of greenhouse gases to be included in project baseline;

&

Provision of simplified modalities and procedures for small scale project activities; and

&

Accreditation of operational entities (first step in becoming a DOE).

In order to accomplish this, the executive board has the ability to set-up expert panels (Box 3.4) and call on additional experts as needed. In addition, the executive board is responsible for registering CDM project activities and issuing (CERs) – the commodity generated under the CDM.

Box 3.4

Panels to the CDM executive board

The CDM executive board established three panels its first year of operation. The first is the methodology panel whose role is to provide advice to the executive board on a broad range of issues related to baseline and monitoring methodologies. This includes advice on the PDD, tools and guidance to assist project developers in developing baselines and monitoring plans, and to make recommendations on the approval of methodologies. The second panel is an accreditation panel that is responsible for setting up the accreditation system and for accrediting entities as validators and verifiers (the first step in becoming a DOE). The third panel assisted the executive board in establishing its simplified modalities and procedures for small-scale projects.

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Designated Operational Entities The CDM requires that projects undergo independent auditing. This occurs during two phases of the project activity cycle: once in order to attain CDM status (through validation) and then periodically once the project begins reducing or sequestering emissions (verification and certification). These entities must have requisite skills to carry out validation, verification and certification tasks and meet standards for accreditation of operational entities.35 Once the entities apply for accreditation, they become ‘applicant entities’ and undergo an accreditation process according to procedures that have been developed by the executive board. The procedures involve an accreditation panel and assessment teams composed of accreditation experts. The executive board accredits operational entities through these procedures to ensure that common and consistent standards are applied. The COP/MOP must approve the accreditation (or ‘designate’ the operational entities) at which time they become ‘Designated Operational Entities’ (DOEs) under the CDM. DOEs are supervised by the executive board, but are contracted by project participants. Project participants contract the DOEs of their choice.36 The primary tasks of DOEs are to: &

Validate proposed CDM project activities on the basis of set criteria and guidelines;

&

Verify and certify reductions in anthropogenic greenhouse gas emissions from CDM projects. This will involve auditing the project operator and his management systems to ensure credibility and transparency of the projects, report to the executive board and request issuance of CERs;

&

Maintain a publicly available list of all CDM projects for which it has carried out validation, verification and certification.

3.5.3

CDM project cycle

Potential CDM project activities have requirements that are additional to similar projects that lay outside the CDM system (see Box 3.5). It is these additional layers along with the governance system that are intended to protect the environmental integrity of the CDM. The five main stages of the CDM project cycle are: (1) Project Development, (2) Project Validation and Registration, (3) Project Monitoring, (4) Verification and Certification, and (5) Issuance of CERs (see Table 3.9).

3.5.3.1 Stage 1: project development Project developers must design the project and obtain financing. DNAs are critical at this stage of planning in order to ensure that the project gains host

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Box 3.5

71

CDM project activities

Projects under the CDM are called project activities. The CDM ‘rules’ make a distinction between a project and a project activity. Although the division may seem arbitrary, it provides a useful division of activities under a larger project. This division could enable a portion of a larger project to be eligible for the CDM in cases where an entire project would not be eligible due to various reasons, for instance official development assistance (ODA) funding, or the inability for the overall project to meet the additionality test.

country acceptance. In order for the project to be validated and registered, a PDD must be completed, providing comprehensive and accurate information on the project, including the calculation of emission baselines, monitoring plans and the project’s crediting period (see Figure 3.5). Project developers must develop a baseline using an approved methodology based on one of the following approaches: &

Existing actual or historical emissions, as applicable; or

&

Emissions from a technology that represents an economically attractive course of action, taking into account barriers to investment; or

&

The average emissions of similar project activities undertaken in the previous five years, in similar social, economic, environmental and technological circumstances, and whose performance is among the top 20 per cent of their category.37

If an approved methodology is not available, project developers must put forward a methodology for approval (see Box 3.6). Once approved, this methodology can be used by other project developers undertaking similar projects. In addition to developing baselines, project developers will need to determine whether the emissions that the proposed project activity will reduce or sequester are ‘additional’. This means that the project developer must be able to reasonably show that the project will reduce greenhouse gas emissions below those that would have occurred in the absence of the registered CDM project activity (i.e. without the project being registered as a CDM project activity). The estimated emissions from a potential CDM project activity must be shown to be lower than the baseline in order to demonstrate the additionality of the emission reductions.38 The Executive Board, in the course of reviewing individual projects, will

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Box 3.6

Baseline methodologies

Developing project specific baselines can be costly. One way in which the CDM attempts to deal with reducing transaction costs associated with baseline development is through the use of baseline methodologies. Methodologies are a way to give guidance to project developers in the assumptions and parameters they must use in developing their baselines. It also provides DOEs with a framework for evaluating baselines and validating projects, and assurances to stakeholders that the CDM process provides environmental integrity by limiting the number of registered CDM project activities whose emissions do not pass the additionality test. A baseline methodology must be useable by more than one project. It specifies the steps a project must develop go through and the assumptions that must be included in developing a baseline for a particular type of project, such as a land-fill gas capture project in a country with no existing requirements for gas capture. The baseline scenario is developed through the application of the methodology and is specific to that project. Baseline methodologies do not contain project specific information. A baseline methodology uses one of the approaches listed in the CDM rules (see Stage 1) as the basis for how the baseline should be developed and each approach has specific data requirements that must be fulfilled. The approval process for methodologies last approximately four months and involves several steps. In order for a methodology to be approved, the project must be fairly well developed since a draft PDD must be submitted to a DOE. The DOE does not assess the PDD, but checks it for completeness (against draft PDD requirements) fills out a form and forwards it to the CDM secretariat of the Climate Convention. The secretariat checks the form for completeness (based on draft PDD requirements), forwards it to the executive board and the Methodology Panel, and makes the methodologies available on the CDM website. The Methodology Panel selects two independent desk reviewers (within five days) who then have ten days to complete their reviews. Each reviewer works independently and submits their reviews to the Methodology Panel. During this 15-day period, the methodologies are available for public comment. Any public comments are submitted to the Methodology Panel who then assesses the methodologies based on their own reviews, the expert reviews and public comments. The panel’s recommendations are consolidated into one document and forwarded to the executive board at least two weeks prior to the next executive board meeting. During this two-week period, executive board members review the methodologies, the Methodology Panel and expert reviewer

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recommendations and any public comments, in order to discuss options and make their recommendations at its meeting. Illustration of the methodology approval process: DOE submits new methodology to secretariat

Secretariat forwards to EB and Meth Panel. Makes Meth available for public comment 5 days Meth Panel selects 2 Experts

4 months 10 days Experts submit recommendations to Meth Panel

15 days

Public Comments

5 weeks

2 weeks Meth Panel meets, makes recommendations to EB EB approves, approves with changes or rejects methodology

approve new methodologies and modifications to existing methodologies. Once a new methodology or a modification is approved, other projects may use it. The crediting lifetime of the project activity is determined during the project development stage. The CDM rules provide for two possible crediting periods: (i) A maximum of seven years which may be renewed no more than twice, provided that the DOE determines that the original project baseline is still valid or has been updated (for a total of 21 years); or (ii) A maximum of ten years with no option of renewal. Stakeholder participation is an important part of the CDM project development cycle. Project developers will need to show (in the PDD) that they have invited stakeholder comments on the project and taken ‘due account’ of those comments. There are no guidelines as to how stakeholder comments are solicited, but it is advisable to take a broad approach in soliciting them. For instance, questioning a limited number of stakeholders (ten) will produce (ten) comments, but it limits the amount and types of comments the project developers receive. A DOE could find that stakeholder participation in this instance was insufficient to know whether a broader or possibly more representative group of stakeholders exists. If on the other hand

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Identify and formulate project

Including: Selection of baseline methodology, Baseline Scenario, Assessment of additionality of emission reductions, Estimation of emissions to be reduced or sequestered, Monitoring methodology.

Develop PDD

Invite stakeholder comments

Obtain host country approval

Figure 3.5 Simplified illustration of Stage 1

advertisements in the local popular newspaper are taken out, or if hearings are held in conjunction with an environmental impact assessment, then a wider variety of stakeholder input can and will have been sought out, although the number of responses will of course vary. Project developers will need to show that they have made some effort in obtaining stakeholder input, regardless of the end result.

3.5.3.2. Stage 2: validation and registration Projects must be validated by DOEs and registered by the executive board in accordance with the CDM rules. Validation provides assurance that the project complies with all CDM and host country requirements. DOEs will need to determine the applicability and correct application of baseline methodologies and projected emissions to be reduced or sequestered, before the project activity can be validated and registered (see Figure 3.6). If a positive validation report is made by the DOE and accepted by the executive board, the project will be registered as a CDM project activity. The DOE conducting the validation will, at a minimum, take account of the following issues: &

Comments invited and received from local stakeholders, and how due account was taken of any comments received;

&

Analysis of the environmental impacts of the project activity, including trans-boundary impacts, and whether the project participants or the host country considers those impacts ‘serious or significant’;

&

The project baseline and monitoring plan;

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PDD submitted to DOE

DOE validates project against CDM criteria

Including: Appropriateness of baseline and monitoring methodology choice, Ensure monitoring plan and baseline calculation are adequate Additionality of emissions reduced or sequestered, Stakeholder commenting process and EIA. EB or Party involved can request review

DOE sends validation report to EB

EB registers CDM project activity

Figure 3.6 Simplified illustration of Stage 2

&

The quantity of emission reductions expected to be achieved by the project activiy during crediting lifetime, taking account of its possible indirect emission effects (in particular, any increase of greenhouse gases outside the project boundary due to the implementation of the project activity, commonly known as ‘leakage’ effects); and

&

Any relevant UNFCCC and/or Kyoto Protocol criteria, as well as host country requirements, such as sustainable development priorities.

3.5.3.3

Stage 3: project monitoring

Monitoring is the systematic surveillance of a project’s performance by measuring and recording performance-related indicators relevant to the project activity (see Figure 3.7). A monitoring and verification plan (MVP) must be described in the PDD. The DOE uses the information and data collected through the MVP to verify the emissions reduced or sequestered by a project activity. The monitoring system should be capable of producing records on reported greenhouse gas emissions reduced or sequestered, social and environmental impacts and on project management, including monitoring, data collection and management systems.

3.5.3.4

Stage 4: verification and certification

Emissions reduced or sequestered must be verified and certified by a DOE before the executive board can issue CERs (see Figure 3.8). Verification is the process of periodic auditing of monitoring results, the assessment of achieved certified emission reductions and of the project activity’s

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Implement project and begin monitoring

OR

Track project performance during operation Collect data and keep records to ensure transparency

For grandfathered projects monitoring emissions according to approved plan

Periodically report data to DOE for verification of emissions reduced or sequestered

Figure 3.7 Simplified illustration of Stage 3

DOE periodically verifies that emissions have been reduced or sequestered

DOE sends certification report to EB, stating that the project has achieved the emissions reduced or sequestered

Verification includes examining monitoring report and on-site inspections and any other information the DOE feels is appropriate

EB issues CERs in accordance with certification report to project participants per contract

Figure 3.8 Simplified illustration of Stages 4 and 5

continued compliance with all relevant project criteria. The monitoring and verification process is therefore the basis for the production and delivery of CERs to the project operator (or other project participants) and for any related revenue stream that the operator expects to receive. The audit process during verification is expected to be interactive, iterative and participatory. The DOEs may use spot checks of data measurement and collection systems and interviews with key project participants to determine the credibility and accuracy of the reported performance. Certification is the written assurance by the DOE that, during the specified time period, the project achieved the reductions in anthropogenic emissions of greenhouse gases by sources or their removal by sinks that were verified.

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3.5.3.5

77

Stage 5: issuance of CERs

If the executive board is satisfied with the certification report, it issues CERs to the project owners/developers or other parties, as specified by contractual agreement. For developing country participants, CERs would be issued into the appropriate account in the CDM registry. The CDM project cycle described above applies to all CDM project activities, excluding those that fall within the ‘small-scale’ project categories (see Section 3.5.4). Timing The timing of the CDM project cycle will depend in part on the particular project in question. Following is a general guide to the duration of the CDM project cycle: &

Project participants complete a project design document (no specified time).

&

DOE makes the PDD publicly available for comment – 30 days.

&

DOE validates the project activity (no specified time period). The validation report is submitted to the executive board for registration. If a new methodology is used, it is forwarded to the executive board (who in turn has a methodology panel review it) – up to four months.

&

Project registration automatically occurs eight weeks after receipt by the executive board of the request for registration.

&

Project monitoring is undertaken (no specified time period).

&

Emissions reduced or sequestered are verified and certified by DOEs (specific time periods apply to each project).

&

CERs are issued by the executive board, 15 days after receipt of certification report, unless a review is requested by a Party involved or at least three members of the executive board. If review requested, executive board must inform applicants of its decision within 30 days.

3.5.4

Other criteria/issues

The CDM rules do not explicitly list project types or categories that are considered eligible under the CDM. The CDM rules do, however, set some limitations on project eligibility. They require that Annex I Parties ‘refrain’

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Table 3.9 CDM project cycle Process/step

Description

Key institutions

Project development

Identify and formulate project.

Project Developers DNAs NGOs Development banks Other investors

Validation and Registration

Approve project baseline/ additionality. Ensure adequate monitoring provisions. Ensure public comments. Register project with the CDM executive board.

DOEs

Project monitoring

Track project performance during operation. Collect data and keep records to ensure transparency.

Project participants

Verification, Certification

Verification is the periodic independent assessment determining the quantity of emission reductions achieved. Certification is the written assurance that the emission reductions have been verified.

DOEs

Issuance of credits

Issuance of CERS occurs after certification of emissions reduction has been received by the executive board.

CDM executive board

Conduct feasibility studies, develop baseline and monitoring methodologies. Develop PDD. Arrange for necessary financing Seek government approval and assurance that project meets sustainable development goals of host.

Source: Adapted from WRI and UNFCCC website.

CDM executive board

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from using CERs generated from nuclear projects.39 Second, projects relating to land-use change and forestry activities must be limited to afforestation (tree planting on previously non-forest land) and reforestation (rehabilitation/regeneration of recently logged or deforested areas) activities. Definitions and modalities for afforestation and reforestation projects under the CDM for the first commitment period (2008–2012) were decided at COP-9 (December 2003). Small-scale project activities The CDM rules distinguish between smallscale projects and other projects. This distinction recognizes that smallscale projects are less able than larger projects to absorb the transaction costs associated with the CDM project cycle. To address this issue, the executive board developed simplified procedures. Small-scale projects are defined as: &

Type I: Renewable energy project activities with a maximum output capacity equivalent of up to 15 MW (or an appropriate equivalent);

&

Type II: Energy efficiency improvement project activities which reduce energy consumption, on the supply and/or demand side, by up to the equivalent of 15 GW/hours per year; and

&

Type III: Other project activities that both reduce anthropogenic emissions by sources and directly emit less than 15 kilo tonnes of carbon dioxide equivalent annually.

The simplified procedures include: &

The ability to bundle project activities at the following stages of the project cycle: during project design, validation, registration, monitoring, verification and certification. The total size of the bundle cannot exceed the limits listed above;

&

A simplified PDD;

&

Simplified baseline methodologies by project category to reduce costs of developing a project baseline;

&

Simplified monitoring requirements; and

&

A single DOE may perform the validation, verification and certification of these project activities and their emission reductions.

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In addition, 14 categories under the three definitions for small-scale project activities have been defined: Type I Electricity generation by the user/household Mechanical energy for the use/enterprise Thermal energy for the user Electricity generation for a system Type II Supply-side energy efficiency improvements – transmission and distribution activities Supply-side energy efficiency improvements – generation Demand-side energy efficiency programmes for specific technologies Energy efficiency and fuel switching measures for industrial facilities Energy efficiency and fuel switching measures for buildings Type III Agriculture Switching fossil fuels Emission reductions in the transport sector Methane recovery Types I–III Other small-scale projects not listed above Grandfathering CDM projects activities may be able to claim credits for emissions reduced or sequestered before the Protocol is ratified, and while the institutional structures for the CDM continue their development. Projects starting between 2000 and COP-7 (November 2002) may be eligible under the CDM provided they are registered before 31 December 2005. Projects starting after the adoption of the Marrakech Accords (COP-7) do not require grandfathering into the system since the CDM is considered to have been up and running as of the adoption of the prompt-start decision. Sustainable development and the CDM The CDM has as one of its objectives to assist developing countries in achieving sustainable development, but it is up to the host country to decide whether the proposed project activity is in line with its priorities for sustainable development. Many countries wishing to host CDM project activities have begun developing sustainable development criteria and requiring it as part of their CDM programmes. There are, however, no international criteria or requirements

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to monitor or report on the effects of CDM project activities in this regard. Some CDM programmes (such as the World Bank’s Prototype Carbon Fund) require project operators to monitor and report on sustainable development indicators. It is unclear, however, how the DOE will treat this data or whether it will be examined as it is not part of the verification and certification process, and ultimately is not needed in order for CERs to be issued. At most, host countries may require that the project operators monitor and report on these indicators. But in order for the DOE to specifically assess this information, some agreement would have to be reached between the host country and project developers (possibly through host country CDM requirements) that obligate project developers to contract a DOE to examine the data provided under any sustainable development criteria in addition to their official requirements under the CDM. Any assessment of this data would have to be fed back to the host country since the executive board is not likely to examine this information. It would also be incumbent on the host country to question whether the project activity is meeting its national requirements and based on that assessment whether it should intervene in the process of certification and issuance of CERs. Project financing CDM project activities can be financed through a variety of sources both private and public. There is, however, a general understanding that public funding should not lead to diversion of ODA.

CHAPTER 4

Building Markets Since the 1990s, many Annex I countries have implemented some type of climate change policy or instituted other policies that affect greenhouse gas emissions (see Table 4.1). These policies range from direct regulation (for instance, landfill gas capture, labelling requirements and support for renewable energy) to voluntary agreements with industry. Very few Annex I countries managed to meet the Convention aim of reducing their individual emissions to 1990 levels by 2000. The Convention aim was reached overall but this was due to a steep decline in greenhouse gas emissions in countries with economies in transition (emissions in other Annex I countries rose by some 6 per cent). And within these countries a very limited number of industry undertook unilateral voluntary reduction programmes since there was insufficient incentive to justify adding on costs to production. The lack of clear intention on the part of government, in terms of implementing greenhouse gas emission reduction policies has made it difficult for many in industry to justify investments in technology or other measures to reduce emissions. Some early actors initiated programmes specifically to learn more about market-based mechanisms and to help inform the public policy debate on domestic emissions trading schemes. With the adoption of the Kyoto Protocol, strengthening of the climate science and a greater focus on sustainable development, this has begun to change. Since 2000, many Annex I countries have begun developing emissions trading schemes as one of the measures they will rely on in meeting their Kyoto targets. Given the uncertainty that surrounded the Protocol none of the schemes are explicitly dependent on entry into force of the Protocol. Many of these schemes are scheduled to come on-line in 2005, although two have been operational since 2001/2002. As part of the policy development process, countries will need to decide whether they will meet their Kyoto commitment regardless of the fate of the Protocol and if so, determine to what extent they intend to use a domestic trading scheme to meet the reductions they have taken on. 82

83

Table 4.1 Summary of range of policy instruments either implemented or planned in selected Annex I countries Taxes Voluntary approach

Energy or CO2

Trading

Industry specific

Emissions

Renewable energy or energy efficiency

ü

ü

Australia

ü

Austria

ü

ü

ü

Belgium

ü

ü

ü

Canada

ü

ü

Czech Republic

ü

ü

Denmark

ü

ü

Estonia

ü

ü

Finland

ü

ü

France

ü

ü

Germany

ü

ü

Italy

ü

ü

Japan

ü

Netherlands

ü

New Zealand

ü

Norway

ü

ü

ü

ü

ü ü ü

ü

ü

Slovakia

ü

ü

ü

ü

ü ü

Sweden

ü

ü

Switzerland

ü

ü

ü

UK

ü

ü

ü

ü

US

ü

ü

ü

Notes  At State level only.  Plans currently suspended. Source: OECD, IEA (2002).

ü

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4.1 POLITICAL DECISIONS DEFINE THE RULES OF THE GAME In designing domestic policies to meet Kyoto targets, many governments are choosing to implement emissions trading schemes to meet at least part of their target. The Convention and Protocol processes have helped to define the scientific basis for undertaking market-based policies. But governments must analyse a number of other issues prior to implementing a trading scheme. Regardless of whether emissions trading is a more efficient method for addressing the problem of climate change, designing and implementing such a policy creates a considerable amount of debate (Table 4.2). Unlike the cap under the Kyoto trading system which essentially covers all sources and sectors in a National Inventory, domestic emissions trading schemes (regardless of whether they are linked to the Protocol or are done only for domestic purposes) are likely to cover only a limited number of sources and sectors due to the administrative costs of implementing an economy wide system. Domestic schemes often will instead focus on capturing large energy-intensive industries (the EU emissions trading scheme – ETS) or target energy-intensive groups not covered by other policies (Norway’s proposal early trading scheme). The EU ETS, for instance, captures a certain percentage of total greenhouse gas emissions, but can be expanded during its second phase.

4.1.1

Design elements of an ETS

Whether designing a trading scheme to meet their Protocol commitment or to compliment the domestic policy mix, one of the most important elements is to establish a baseline from which emissions must be reduced (see Box 4.1). For many governments, the inventories under the Convention process are likely to be one source of information. If a Kyoto target is to be met, the greenhouse gas inventory could be used to estimate the potential amount of reductions needed to meet a target. They will need to determine the percentage of the cap that will be passed down into a trading system, and the portion that will be covered by non-trading sources (such as the automotive manufacturing sector or land-use change and forestry sectors). It is unlikely that countries will incorporate the majority of sources (small, medium and large) within a trading system, as it would be administratively costly to implement. But this poses a potential problem for countries implementing a trading scheme whether domestic or as part of an international system. Governments will have to determine what additional measures will be needed to meet their objectives or commitments, how much tighter a second phase target should or could be, and how to optimize interactions between policies. This also implies that at the international level, governments will

85

Table 4.2 Questions for consideration in assessing the potential for emissions trading Environmental Scientific issues

Economic issues

What is the nature of the problem? What is the geographic scope?

Are there available emissions reduction options?

Can emission sources be linked to the problem?

Do different sources face different costs?

What are the major sources of emissions?

What do different marginal costs imply about where to expect reductions?

Are there accurate measurement methods for the sources identified?

What are the overall costs and benefits? Are there any adverse environmental implications to using trading? Are there sufficient sources for a fluid market?

Institutional and technical issues

Other considerations

Is there sufficient enforcement authority to make a trading programme work?

Are there any social or economic factors limiting fuel choices?

Is there an infrastructure to measure, report and manage source specific emissions data?

Is emissions trading politically acceptable?

Are there adequate resources to manage emissions data? Is there a system and central authority that can be used to determine compliance? Does legal authority exist for an emissions trading programme? How can an emissions trading programme be integrated with existing policies? Source: Adapted from Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, US EPA.

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Box 4.1

Design elements for emissions trading schemes

Legal authority A legal authority is needed and must have the ability to determine the basic components of the emissions trading scheme and/or administer the system. Under the US SO2 programme, the US Congress delegated legal authority to the US EPA to administer the programme including how to allocate the cap. Within EU countries, Member States identify a Competent Authority. Basic components Setting an emissions cap. This can either be set by a legal authority or at a higher level. In the US SO2 programme, the US Congress set the cap. For EU countries, the cap is determined in part by the burden-sharing agreement related to the Kyoto Protocol targets. Setting implementation dates, the compliance period(s). In general, domestic trading schemes are following the pattern set under the Protocol, with the addition of a pre-commitment period phase from 2005 to 2007. Sources to be covered. The sectors that will be covered by the emissions trading scheme must be clearly defined, and within each sector the emissions sources that will be targeted. The number of sources covered by the trading system is important as a larger number of participants help ensure cost efficiency, but this must be balanced against managing administrative costs and environmental efficiency. Including all sources may be unfeasible, but excluding larger sources reduces the environmental integrity of the emissions trading scheme. In addition, it is important that sources have a range of abatement costs, and have the ability to monitor emissions. An emissions trading scheme that only captures 10 per cent of emissions as opposed to one in which 40 – 50 per cent are captured will result in an inefficient domestic system. Pollutants to be covered. Under a greenhouse gas emissions trading scheme, countries must decide which of the gases included in Annex A of the Protocol will be covered. Decisions on coverage are likely to be determined by the accuracy with which emissions can be measured. A high degree of accuracy is required if the environmental integrity of the scheme is to remain intact. Tradable allowances. The legal authority must define the unit (i.e. one allowance provides the right to emit X tonnes of YY), provide participants the ability to trade, and decide how and to whom allowances will be distributed. Banking. Are allowances bankable (can be carried over to another period) and under what terms. Registries. Who can hold accounts within a registry, how will trades be tracked.

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Monitoring and reporting. Monitoring and reporting lies at the heart of a credible and effective ETS. Standardized procedures for emissions measurement, collection and reporting are critical to the success of the programme. Compliance. How many allowances must the source hold in its account during the compliance period, how and when will accounts be reconciled to determine compliance. Establishing and enforcing compliance. The ability to set, impose and enforce penalties on sources that fail to comply with the rules. Emissions inventories and measurement: Emissions inventories are one of the key steps in creating a trading programme. The inventory can help determine which sectors and sources to include, what type of cap to set and at what level, what effects different allocation methods will have on effected sources and how allowances should be allocated. Guidelines will have to be produced for measuring emissions by companies under a trading scheme. This will include determining the level at which emissions must be measured and the technological options or alternatives (i.e. plant level, process level, unit level emissions measured through the use of continuous emissions monitoring systems or when cost prohibitive other accepted alternatives). Considerations might include cost of data collection and availability of data, and measurement method. Standardized procedures provide a way to compare data across sources as well as to assess compliance. Emissions and allowance tracking systems are the two tools necessary to determine compliance with a reduction target. Point of obligation: Allowances can be allocated to sources either upstream or downstream in the production and consumption chain: &

In an upstream system, the obligation is placed on the producers and importers of fossil fuels. The traded commodity in this case is the carbon content of the fossil fuels. Upstream systems function similar to a tax since producers and importers pass down the costs of allowances onto consumers in the fossil fuel markets and create a change in price for consumers and eventually a reduction in emissions (OECD/IEA 2002).40

&

Downstream systems target direct emitters. The point of obligation is on sources that directly emit emissions from the fossil fuel consumed, that is large power generators.

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Allocation methods: Although several methods for allocation exist, two main methods are considered under most greenhouse gas emissions trading schemes: auctioning and grandfathering, and can be combined (by grandfathering a certain percentage and auctioning the remaining). &

Auctioning requires participants to decide how many allowances it will need to cover its emissions and purchase them from the government instead of the government determining the number of allowances they will receive.

&

Grandfathering entails the free distribution of allowances based on historic emissions levels. Emissions levels are determined through either the base year/period or some other reference year for which reliable data is available. For instance, under the BP and Shell trading programmes, 1998 was used as the reference point for distribution of allowances since that was the year for which reliable data existed.

Opt-in and Opt-out provisions Opt-in provisions allow companies not covered by an ETS to voluntarily enter the trading scheme. They are subject to the same requirements as other sources under the cap. Opt-out provisions allow sectors or companies to opt-out of a trading scheme dependent on established criteria. For instance, if a company is covered by another trading scheme or some other policy with similar reduction targets, it could seek to be excluded from the greenhouse gas emissions trading scheme. Compliance process The compliance process needs to be simple and straightforward. Rules need to be clear prior to the start of the compliance period with specified reporting requirements and deadlines. Grace periods (also called reconciliation or true up periods) are also necessary. Once the compliance period concludes, accounts must be reconciled with inventories, and transaction logs to determine whether an affect source has sufficient allowances to cover its emissions. Ideally this period should be short, that is, 60 days, and allow for any required verification or review procedures. Any affect sources would have the time allocated during the grace period to make any trades necessary to remain in compliance. Source: Adapted from EPA, OECD/IEA.

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need to determine whether they are likely to be net buyers or sellers in an international trading scheme. If an emissions trading scheme covers only a percentage of its greenhouse gas emissions, the remaining sectors are subject to more direct regulatory approaches that do not necessarily place an express limit on the amount of greenhouse gases it can emit. Emissions from these sectors, if they increase more than projected, could cause a Party to find itself out of compliance even though it has put in place policies to meet its target.

4.2 US EXPERIENCE WITH TRADING PROGRAMMES One of the most widely sited examples of a successful emissions trading programme is the US SO2 trading programme. The early policy development process has several parallels to current domestic policy development for greenhouse gas emissions trading. During the 1970s acid rain became an area of public concern due to environmental damage to lakes and forests. In 1980 the US Congress established a National Acid Precipitation Assessment Program (NAPAP) to conduct a ten-year research, monitoring and assessment study on the causes and effects of acid rain.41 The result showed SO2 was a major contributor to acid rain, and that electric power generators were a major source. In 1980, approximately 70 per cent of SO2 emissions came from electric utilities. As a result of the study, the US Congress established the Acid Rain Programme under Title IV of the 1990 Clean Air Act Amendments (1990 CAAA). This legislation built on existing regulatory requirements under the 1970 Clean Air Act Amendments covering fossil fuel burning generating units. Many of the regulations imposed emissions rate limits or technology mandates on individual units. Acid rain occurs when SO2 and NOx react in the atmosphere with water, oxygen and other chemicals to produce acidic compounds. Since then scientists have discovered and confirmed that SO2 and NOx emissions damage human health, ecosystems, visibility and materials such as building and statues.

4.2.1

The US Acid Rain programme

The 1990 CAAA required fossil-fuel burning power plants in the 48 contiguous states to reduce SO2 and NOx emissions below 1980 levels. The most innovative part of the legislation was the establishment of a two-phased cap and trade system for SO2 emissions. It was introduced as a way to reduce compliance costs associated with reducing emissions while ensuring that environmental goal was met. The SO2 cap and trade programme is

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a centralized emissions trading programme run by a governmental authority, in this case the US Environmental Protection Agency (EPA). The SO2 cap and trade system began in 1995, with an overall target of reducing emissions to 50 per cent below 1980 levels, from 17.5 million tonnes to 9 million tonnes of SO2 by 2010. Phase I, from 1995 to 1999, affected 263 of the largest and highest emitting generating units (units with a generating capacity of more than 100 MWe). Phase II, from 2000 onward, tightened the requirements on the larger units and set restriction on units with generating capacity greater than 25 MWe placing an annual cap of roughly 9 million tonnes on emissions. Phase II encompasses virtually all fossil fuel electricity generating units. The SO2 cap is achieved by issuance of tradable allowances, with one allowance equal to the right to emit 1 tonne of SO2 emissions. Issuance of allowances is based on historical data – the average annual heat input during the three-year baseline period of 1985–87. In order to receive allowances, the owners of the affected units must first apply for an Acid Rain Permit. In the application, the owners must provide information on the affect source and the affected units. It must also provide a compliance plan or plans for each affected unit. The application must also state that the units will hold sufficient allowances to cover annual SO2 emissions. Permit applications are submitted to permitting authorities that in turn issue the permit. The permit specifies the requirements applying to each affected unit at the source; each allowance allocation; and the compliance plan(s) for the affected source. Allowances are allocated to the owners of affected units free of charge for 30 years, with allowances received on a yearly basis. Owners of the affected units are given the flexibility to determine how best to reduce its emissions in order to meet its cap. At the end of each year, owners of the units surrender allowances for every tonne of SO2 emitted that year. If a unit does not have sufficient allowances to cover it emissions, additional allowances must be acquired from other sources. If on the other hand the unit reduced emissions below the cap it would be able to sell or bank the excess allowances for use or sale in future years. In cases where units are not in compliance by the end of a 60-day grace period, a penalty is automatically assessed. The penalty for non-compliance is $2000 per tonne of excess SO2, and the operators of the unit can either immediately surrender future allowances or submit an offset plan of how the cutbacks will be achieved.42 Compliance with the SO2 programmes has been nearly 100 per cent. In 2002, for instance, one company was short 33 allowances. The allowances were taken out of the 2003 allocation and the company fined US$90,000. The accurate measurement of total emissions is one of the underlying features of the Acid Rain programme’s success. It provides assurance that one tonne of emissions from one source is equal to a tonne of emissions

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from another. Most units covered under the Acid Rain programme are required to install and maintain CEMS that measure and record hourly emission concentrations of SO2, NOx and CO2. CEMS are tested yearly to ensure its accuracy. In cases where data is missing, sources are required to provide a substitute value based on either an average value or a conservative one depending on how long the CEMS was offline. Smaller sources for which CEMS are costly use conservative estimations of emissions. Another key feature of the cap and trade system is the ability of sources not covered under Phases I and II to opt-in. During Phase I, an additional 111 units voluntarily opted into the system. These units received allowances for the year in which they participated and were subject to the same compliance requirements as the mandated units. Cost savings for the first 13 years of this programme have been estimated at $20 billion, a cost reduction of about 57 per cent from more traditional command and control measures.43 The success of the SO2 programme is due, at least in part, to the following: &

Clear and simple rules without the need for pre-approval of individual trades.

&

Requirement for CEMS for coal power units. CEMS send continuous information to the US EPA, and sources must have sufficient allowances to cover the emissions as recorded and reported by the CEMS.

&

Clear penalties for non-compliance. Automatic penalties are assessed, future year allowances must be surrendered to cover the shortfall, and criminal charges can be filed against utility employees.

&

Banking encouraged early reductions during Phase I in anticipation of higher costs during Phase II.

4.2.2

NOx trading programme

A more recent US emissions trading programme, the NOx trading programme has its foundation in the same legislation as the SO2 trading programme. The 1990 CAAA established the Ozone Transport Commission (OTC)44 to help States in the Northeast and mid-Atlantic region reach National Ambient Air Quality Standards for ground level ozone.45 It also created a joint Federal and State governance structure in which the US EPA sets air quality standards, and creates and enforces emissions standards for

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new sources. States are responsible for controlling emissions from existing sources and from operational maintenance such as automobile inspections. The OTC is composed of representatives from each State and was charged with ‘developing recommendations for additional control measure to be applied within all or part’ of the transport region if the commission deemed it necessary. In meeting federal requirements, States are required to file State Implementation Plans (SIPs) that detail the steps they will take to meet air standards. The EPA has oversight authority and must approve the SIPs. The EPA also has enforcement capabilities in cases where States do not meet the standards. In 1994, the OTC (minus Virginia) signed a Memorandum of Understanding (MOU) that committed states to reducing emissions in two phases: 55 – 65 per cent in 1999 and 75 – 85 per cent in 2003. The MOU included the ability to develop an emissions trading programme. The States and EPA then developed a ‘model rule’ that set out the framework for a multijurisdictional cap and trade programme. The framework included common elements that must be consistent among state programmes: &

Programme applicability. These included standards for determining which emissions sources and sectors would be required to participate, namely electric utilities (25 MW or larger) and large industrial boilers.

&

The budget or cap. The cap was set by applying the reduction targets in the OTC MOU to each source that contributed to the 1990 baseline for NOx emissions. This ‘budget’ was then divided among the participating States who were responsible for allocating allowances to sources within their jurisdiction. (States are responsible for identifying its budget sources.)

&

Tradable unit. One allowance provides a source with the ability to emit one tonne of NOx emissions during the control period.

&

Control Period. Emissions are capped from May through September, when sources are required to have sufficient allowance to cover their summertime emissions.

&

Emissions monitoring and reporting. Common measurement protocols and reporting requirements were used to ensure comparability and accuracy of emissions data. CEMs are used for measuring emissions from larger sources; estimation methods are used for smaller sources.

&

Registries. The EPA maintains data systems including an electronic registry tracking system for allowance transfers, and providing end of season compliance reports.

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Banking. Banking is allowed, however, a flow control restricts use of banked allowances when the number of banked allowances exceeds 10 per cent of the annual budget. The first ten per cent of the banked allowances can be surrendered on a one to one basis. After the flow control is in effect, however, allowances must be surrendered on a two to one basis (two allowances for each tonne of NOx emitted).

The NOx SIP Call In October 1998, the EPA issued the NOx SIP Call, which expands the OTC NOx Budget program to a total of 21 States. The SIP call included a model NOx budget trading programme rule and sets a budget of 3.3 million tonnes NOx per year, down from 4.4 million tonnes per year in 1995. The programme is set to begin in May 2004. The features of the NOx SIP Call are identical to the NOx Budget Programme, except that allowances issued before 2003 will not be accepted.

4.3

EMISSIONS TRADING IN THE POLICY MIX

As countries begin to develop and implement their emissions trading schemes it will be important for government and industry to understand the potential interactions and implications of their expanded set of policy instruments. The nature of the climate change issue implies a potentially dramatic shift in the way business is conducted. Current climate mitigation policies will produce an insufficient amount of greenhouse gas reductions, requiring new policies to supplement or replace existing policies. Governments currently rely on a range of policies and measures to reduce greenhouse gas emissions (see Table 4.1). Many of these policies serve multiple objectives, for instance to reduce emissions, to build experience, to promote specific energy types and/or to spur research and development, and so on. Emissions trading schemes are likely to target specific industry. In doing so, governments will need to assess the positive and negative interactions between these instruments and other policies. The effects of emissions trading schemes in the policy mix are unclear. Johnstone (2003) and Sorrell (2003) both point to the potential for increased abatement and administrative costs by overlapping policy instruments, when policy objectives are unclear. Reasons for introducing different policies include reducing abatement cost uncertainty, overcoming technology market failures, increasing behavioural responsiveness and addressing local environmental impacts46 (Johnstone, 2003). However, governments will have to consider whether the interactions between policies subvert the purpose of the emissions trading scheme. Emissions trading provides environmental certainty, cost efficiency, and should provide sufficient

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incentive for industry to innovate technologically in order to further reduce abatement costs. The introduction or existence of complimentary or competing policies could increase compliance costs without bringing further environmental benefits. Governments will also have to decide whether to introduce or limit policies that attempt to ‘pick winners’, such as policies to overcome technological market failures. Emissions trading schemes are generally policy neutral in prescribing the direction for technological innovation, relying instead on sources to provide that innovation (Johnstone, 2003). Introducing policies to overcome a perceived barrier, either within the emissions trading scheme or as a policy aimed at another target group, could have unintended consequences or at least produce unanticipated results. The US SO2 programme, for instance, included an incentive programme designed to encourage electricity generators to invest in demand-side energy efficiency and renewable energy generation programmes in the form of a special set-aside of allowances. Generators could apply for these allowances based on information they submitted to the EPA.47 The EPA awarded the generators with allowances based on a rate of one allowance to 500-MWh of energy saved or renewable energy generated based. Because the award formula was too conservative and allowance prices were low, the programme did not produce actions that would not have occurred anyway. Another example is the Danish CO2 trading programme. It contains a penalty for excess emissions that, because of its low set price, functions as an upper limit or price cap on allowances. Price caps are generally introduced as a way to provide assurances to industry for planning purposes. The uncertainty related to the cost of compliance is a major concern to industry; however, setting a particularly low cap is likely to hinder the development of a liquid market. Depending on how the cap is instituted this could leave the government with either a large fiscal bill (either through covering the difference between the cap and the cost of carbon on the market and/or through purchasing additional allowances from another source). A study in 2003 examined the interaction of EU climate policy (INTERACT) within five Member States; it examined various policies within each State and its potential interaction with the EU ETS.48 In examining these policies, the study raised four issues that policy makers would have to account for/consider: double regulation, double counting, differential treatment and equivalence of effort, and trading interaction/ fungibility. How various policies interact within the EU emissions trading scheme, and the extent to which they affect other sectors will have to be taken into account when developing national allocation plans, as should next steps, that is, second trading periods. The UK is cited in the study as an interesting example of the potential interaction between policy instruments. Virtually all policies within the

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categories in Table 4.3 have some interaction with the EU ETS. Sorrell (2003) categorizes interaction between policies in three ways: indirect, direct and trading. All policies indirectly affect a target group that is either directly or indirectly affected by a second policy, for instance, electricity generators will pass down costs due to the trading scheme to consumers who are covered by a revenue-neutral energy tax for business and the public sector. Directly affected groups are directly targeted by two policies, that is, sources included in an ETS that are also liable for a tax on fuel use such as the UK’s Climate Change Levy. Trading interactions occur in two ways. The first is linking two separate greenhouse gas ETS, and the second is linking different trading schemes with different units and making them interchangeable (Sorrell, 2003). The UK ‘gateway’ mechanism serves this function. It enables sources under a rate-based trading programme to purchase allowances from sources under the greenhouse gas emissions trading schemes. Governments will have to address how other climate policies affect sources under the emissions trading schemes, and to limit double counting and double regulation. Governments will also have to consider the extent to which it will link with other trading schemes. Trading schemes are likely to differ by sectoral coverage, gases, number of sources, and any number of other features. Linking provides greater abatement options; it can reduce compliance costs and increase market liquidity. But linking also requires that basic systems such as emissions measurement and reporting data be met. If there is uncertainty in the quality of the inventory, in the monitoring,

Table 4.3 Types of policy instruments examined in INTERACT study Category

UK Netherlands Germany France Greece

Carbon/energy taxes

ü

ü

ü

Negotiated agreements

ü

ü

ü

ü

Support mechanisms for renewable electricity

ü

ü

ü

ü

ü

Industrial pollution control

ü

ü

ü

Green house gas (GHG) Emissions trading

ü

ü

Promotion of energy efficiency

ü

Source: Interaction in EU Climate Policy: Project Summary.

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verification and reporting standards, then systems and those operating under the system open themselves up to a risk of non-compliance. Under domestic schemes, penalties will be accessed on the sources found in non-compliance. One of the advantages to the Kyoto trading system, is that it provides the basic elements that must be in place in order for different domestic emissions schemes to recognize each other and provides assurances that any units brought in from another Party is valid and can be used for compliance purposes. For European countries outside of the EU, linkage issues are somewhat more complicated. The options are three-fold: design an independent system, design an independent system and seek to link with the EU ETS or join the EU ETS. Norway, for instance, has considered a domestic ETS broader than that of the EU both in terms of gases and participants during the commitment period from 2008 to 2012. The Norwegian Parliament approved a cap and trade system to cover all greenhouse gases and sectors.49 If implemented it would capture approximately 80 per cent of its emissions. Since the adoption of the EU ETS, however, there have been discussions on whether it would be more advantageous to join the EU system. Some in industry have preferences for the EU system since it would exclude certain sectors of the Norwegian economy. In the early trading period, from 2005 to 2007 this would mean that only about 10 per cent of emissions is captured in the scheme. Under the Protocol, Norway has a limitation target – to limit emissions by 1 per cent over 1990 levels. A broad ETS may allow Norway to meet this commitment with very little additional cost, particularly if the ETS can be implemented prior to 2008. As with many of the EU Member States, the EU ETS is not likely to enable Norway to meet its Protocol target without additional reduction from other sectors or significant purchases from outside its borders.

4.4

DOMESTIC EMISSIONS TRADING SCHEMES

Emissions trading systems have gained significant popularity in recent years, whether they are for SO2 and NOx or greenhouse gas emissions. Although the majority of experience with SO2 and NOx trading programmes resides in the US, global experience is quickly overtaking it particularly in the area of greenhouse gas emissions trading (see Table 4.4). Two countries within the EU have established greenhouse gas trading systems, and many other Annex I countries are in the design phase for their ETS. Despite the US’s withdrawal from the Protocol, State level emissions trading programmes are in the works and there is increasing pressure in legislative branches of US government to implement greenhouse gas emission reduction programmes that would include emissions trading.

CO2 from 2005, with possible expansion to all Kyoto gases after 2008. Approximately 40 per cent of EUs CO2 emissions covering more than 10,000 installations. Specific sectors targeted.

To run from 2002 through 2006.

Voluntary basis for firms committing to binding targets, choice of CO2 only or all Kyoto gases.

Source: COM/ENV/EPOC/IEA/SLT(2003)2.

EU

UK

During 2005–2007, 5 per cent of allowances can be auctioned by Member States, and 10 per cent during 2008–2012.

Free allocation of allowances. Direct participants bid for reduction commitments in an auction for incentive monies.

Specific installations may be opted out, subject to approval until 2007 – but will still be required to monitor report and pay noncompliance fees. Scope for linking with other trading schemes.

Firms that negotiate Climate Change Agreements qualify for 80 per cent discount on Climate Change Levy and eligibility for baseline and credit trading. This is integrated into cap-and-trading programme through gateway.

Trading covers electricity generation, supplementing the tax covering others.

Grandfathering.

CO2 from electricity production only, about 30 per cent of 1997 CO2 emissions.

Denmark

To run from 2000 – 2003.

Interface with other instruments

Initial permit allocation

Coverage

Country

Table 4.4 European emissions trading schemes in force

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4.4.1

CLIMATE TRADING

Denmark

Carbon dioxide is by the far the most important greenhouse gas in Denmark, accounting for some 78 per cent of total aggregate national greenhouse gas emissions in 2001 (excluding land-use change and forestry activities). The Danish energy sector accounted for a similar percentage. Denmark has stated that it intends to meet its Kyoto target, which under the EU burdensharing scheme requires a reduction in emissions of 21 per cent relative to 1990 levels. Although Denmark’s national inventory shows a slight decline in emissions, these reductions are not sufficient to meet its target, nor are they necessarily expected to continue to decline. Denmark is part of the Nordic power market, along with Finland, Norway and Sweden. Unlike Norway and Sweden where power generation is primarily hydro-based, Denmark’s power generation (like Finland’s) is primarily fossil based. In years where

Table 4.5 Example of Danish initiatives for meeting reduction target Initiative for fulfilling climate commitments (large potential)

Reduction potential per year, million tonnes CO2 equivalent

Unit cost estimates, DKK per tonne of CO2 equivalent

Heat pumps, replacing decentralized CHP

1.5

 60

Reduction of electricity production

2–8

20–60

Kyoto mechanisms

1

50–100

Conversion from coal to natural gas

3

150

Heat pumps – replace centralized CHP

5

250

Offshore wind parks

2

270

Further conversion from coal to natural gas

5

280

Conversion to biomass plants

2.5

290

1

150–310

Underground CO2 storage

Source: Adapted from Danish Government Proposal 2003.

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there is little rainfall in Norway and Sweden, Denmark increases its production and exports electricity to cover the shortfall, and emissions increase correspondingly. Analysis by the Danish government shows that without any further action, Denmark faces a yearly shortfall of up to 25 million tonnes of CO2 equivalent each year during the period 2008–2012. Emissions trading will therefore play a central role in its climate policies. The CO2 Quota Act Denmark launched a CO2 emissions trading scheme as part of its 1999 Electricity Reform legislation. It was to run from January 2000 through December 2003, but because it did not gain EU approval until April 2000, it came into effect only in January 2001.50 The scheme targets CO2 emissions from power producers that were not covered by CO2 taxes. Small producers, emitting less than 100,000 tonnes of CO2 per year, were exempt from the trading scheme. A total cap of 22 million tonnes of CO2 was set for 2001, decreasing to 20 million tonnes in 2003. Caps were not set beyond 2003 and the trading scheme is expected to be subsumed into the EU ETS. Denmark has numerous (approximately 500) electricity producers but the participation threshold limited the number of participants in the trading scheme to eight companies (see Table 4.6). These eight companies covered more than 90 per cent of CO2 emissions from electricity generation production (Pedersen, 2002). Unlike the EU ETS, allowances in the Danish ETS (called Quotas) are allocated on a company basis rather than by installation, and grandfathering was used as the method for initial allocation. Emissions from existing electricity producers during the period from 1994 to 1998 served as the baseline, with special consideration given to combined heat and power (CHP) plants since co-generation constitutes almost 50 per cent of the electricity produced. Allowances were allocated in a two-step process. Electricity producers with CHP plants were allocated allowances first, and included a recognition that they had already contributed to a reduction in Danish emissions and were under constraints to reduce more. Electricity producers with CHP plants faced a less stringent reduction target than other producers who received allowances in the second step of the allocation process. Notification of allocation of allowances is given in form of a letter, with the allowances containing no unique identifiers/serial numbers. Transactions are primarily bilateral agreements with the assistance of brokers. In order to trade, the Danish Energy Authority must be notified no later than four weeks after any trade has occurred. Notification must include the volume of allowances, the vintage and price. Trades are then entered into an electronic registry and confirmed by the trading parties. Since the ETS has a limited number of participants, there have been few trades.

100

Table 4.6 2001 and 2002 allocations under Danish ETS Unit: million tonnes of CO2 producer

Final allocation 2001

Final allocation 2002

8.221

7.577

10.533

9.873

EON/PreussenElektra

0.965

0.838

I/S Avedøreværket 2

0.094

0.527

Østkraft Produktion A/S

0.062

0.060

Energi Randers Prod. A/S

0.198

0.198

Dansk Shell A/S

0.102

0.102

NRGI Amba (Anholt)

0.001

0.001

Without permits

1.825

1.825

22.000

21.000

Energi E2 A/S Elsam A/S

Total cap

Source: Pedersen, Danish CO2 cap and trade scheme update (2001).

12000

1000 tonnes

10000 8000 6000 4000 2000

øe le Av kt e ra (V dø at re te væ nf r Ø st al ke kr l+ t 2 af t p E2) ro du kt En io n er gi Ra nd er Da s ns k S he (A ll nh A/ ol N S tE R lfo GI W A ith rsyn m ou in ba g) ta llo w an ce s

I/S

EO

N/

Pr

eu

ss

en

El sa

En er

gi E

2

m

0

2001

2002

Figure 4.1 Danish CO2 emissions allowances 2001–2002 Source: Pedersen, Danish CO2 Cap and trade scheme update(2001).

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Key features of the scheme

Legal authority The Danish Energy Authority is responsible for administering the trading scheme and for operating the registry. An administration fee of 0.079 DKK per tonne of CO2 allowances is paid to the Danish Energy Agency covering various administrative costs. An Energy Complaints Board handles complaints. Banking Allowances could be banked between compliance periods. Denomination of allowances One Danish allowance is equal to one metric tonne of CO2. Measurement and reporting Emissions are measured using existing continuous monitoring of fuel consumption and then converting it to CO2 using standardized fuel to CO2 conversion factors. Electricity producers report fuel consumption, type of fuel, electricity production, useful heat production and CO2 emissions. Reports are submitted to the Danish Energy Authority in March for the preceding year and an assessment of compliance is made no later than 1 July (for 2001, for instance, a compliance decision was made by July 2002). Penalties A non-compliance penalty of 40 DKK (approximately d5) is assessed for each tonne of excess CO2. Once the penalty is paid, the company is not required to cover the shortfall in allowances. Allowance prices seemed to have remained below the penalty level. Given the penalty’s low level, it functions as a price cap. If allowances were to go above 40 DKK, it becomes more cost effective to pay the penalty than purchase additional allowances. Transitioning into the EU ETS The EU ETS is now the primary focus of Danish trading. Under the EU ETS, Denmark will have a significantly higher number of trading participants. It is expected that 355 ‘production units’ will participate. The electricity and heat sector accounts for the majority of Danish participants, (235 while the remaining 120 are from the industrial and offshore sectors).

4.4.2

The UK ETS

In 2001, CO2 accounted for almost 85 per cent of all greenhouse gas emissions in the UK (excluding emissions and removals from land use change and forestry activities). Overall, greenhouse gas emissions have declined since the 1990 due mainly to restructuring in the energy sector. The UK climate change action plan calls for reducing emissions 12.5 per cent below 1990 levels (the EU burden-sharing agreement), in line with their

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Kyoto target. Internally, however, the UK has taken on a more ambitious target to reduce emissions 20 per cent below 1990 levels by 2010. In April 2002, the UK launched the first economy-wide greenhouse gas emissions trading scheme as a main feature of its Climate Change Programme. The objectives of the scheme include achieving significant amounts of absolute emission reductions in an economically efficient manner, and enabling business to gain practical experience in emissions trading ahead of an EU system. The UK ETS is a voluntary trading programme. Participation is open to all UK-based legal entities with direct (energy generated and used on-site) and indirect (energy used on-site that is generated off-site) greenhouse gas emissions not covered by other Agreements or Directives. The government made available a financial inventive of £215 million for companies agreeing to reduce emissions over a five-year period (2001–2006) that are not covered by a Climate Change Agreement (CCA). Companies pledge to reduce emissions by a certain percentage from a baseline period in return for a financial incentive provided by the Government. Targets and incentives are determined through an auction process. In addition, the scheme is open to the 6000 companies with emissions or energy targets through CCAs.

Box 4.2

The Climate Change Levy and Climate Change Agreements

In April 2001, the UK government introduced the Climate Change Levy which levies a tax on the energy used in the business and public sectors. The levy is differentiated by fuel source, with oil, combined heat and power, and renewables exempt from the levy. The levy is equivalent to approximately an d11/tonne CO2 tax for natural gas, d6/tonne CO2 tax on coal and a d13/tonne CO2 tax for primary fuel input. Revenues from the levy are recycled back to reduce employer’s National Insurance Contributions and support for energy saving measures. Energy intensive sectors are eligible for a discount from the levy if they agree to take on an energy efficiency or greenhouse gas reduction target through a Climate Change Agreement (CCA). CCAs are negotiated between the government and company and cover a period from 2001 to 2013. In return for taking on a binding target, companies receive an 80 per cent discount from the levy. Targets under the CCA are either absolute (CO2) or relative (energy efficiency) targets from a base year set out in individual agreements. Compliance runs on a consecutive 12-month period during a two-year time span. If a company is not in compliance in a two-year time span it is ineligible for the discount in the following two years.

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The scheme distinguishes between four types of participants; two types of target holders and two types of non-target holders. Non-target holders can enter the scheme either through an approved UK-based emissions reduction project or simply opening an account in the national registry for trading purposes. Target holders in the UK ETS are Direct Participants with absolute caps or CCA Participants with targets established through their agreements. Direct Participants Direct Participants voluntarily take on an absolute emissions reduction target in exchange for a ‘financial incentive’. The allowance allocation is determined through an auction in which Direct Participants bid their reductions. In March 2002, the UK government held a ‘descending clock’ auction in which Direct Participants submitted bids on reductions based on the opening price of £100/tonne of CO2. With each new round, the price fell and the bidders either maintained their bids or decreased them based on their perceived ability to meet reductions at a particular price (see Box 4.3). The auction went for nine rounds with the total bids in the first round equalling £490 million. The auction ended in the ninth round with a clearing price of £53.37/tonne of CO2 equivalent, at which point total bids equalled the total amount of the financial incentive, £215 million. For the Direct Participants bids in the final round became the absolute target for the five-year period, beginning in 2002. There were 34 Direct Participants at the close of the auction from a diverse set of firms: oil companies, car manufacturers, supermarket chains and a national museum. In order to bid, companies were required to develop a baseline based on the average annual emissions for the period 1998–2000. If data was not available for the full three year, then two years (1999 and 2000) could be used or failing that 2000. Steps to develop a baseline for the UK ETS include:

1. Identifying all sources under management control.51 2. Separate sources by industrial sector and decide which will enter into the ETS. 3. Identify sources with verifiable data. 4. Identify which sources with verifiable data may enter the ETS. 5. Either use sources as greenhouse gas sources or identify a subset that emits greenhouse gas emissions. 6. Compare list from step five with reporting guidelines to see whether any sources should be excluded.

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Box 4.3

Auction and target setting process 1050 1000 950 900 850 800 750 Base

2002 2003 2004 2005 2006 Reduction

Baseline

Company AA has a baseline of 1000 tonnes of CO2 equivalent. In the final round of bidding it entered a reduction of 150 tonnes of CO2 equivalent. This total (the absolute cap over the trading scheme) is divided by five and applied as a yearly target, that is, Company AA must reduce emissions 30 tonnes each year, including the first year of the trading scheme for a total reduction of 150 tonnes of CO2 equivalent. Total Emissions Cap is 150 tonnes of CO2 equivalent. For 2002, the cap is set at 970 tonnes, for 2003 it is 940, for 2004 it is 910, for 2005 it is 880 and for 2006 it is 850. With a clearing price set at £53.37, the company receives a yearly incentive payment of £16,001 for a total incentive of £8005 for the five-year period.

7. Calculate the baseline. Sources that are either less than the size threshold (sources whose individual annual emissions are less than 10,000 tonnes of CO2 equivalent or less than 1 per cent of total emissions from the source list which ever is less) can be excluded from the baseline. Changes may be made to the baseline to accommodate for structural changes (acquisitions or divestitures of assets) if the change threshold is triggered (25,000 tonnes of CO2 equivalent or 2.5 per cent of the total verified baseline emissions at the time of auction, which ever is less). In order to receive allowances, direct participants must first verify that their baselines require verification by a third party. This was a timely process which delayed distribution of allocations. Climate Change Agreement Participants Companies in the CCA are eligible to participate in the trading scheme, but are not allocated allowances

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upfront. CCA participants enter into the trading scheme on a baseline and credit basis, meaning that they must first reduce emissions or energy use beyond their target and have those reductions verified for credit. If the CCA Participant does not meet its target it may purchase allowances in order to comply. Smaller CCA participants that exceed their target may hold back the ‘overachievement’ (or ring fence it) in one year and combine it with overachievements in subsequent years before verifying the overachievement. In this case it can either convert it into allowances or use it to meet its target at a later date.

4.4.2.1

Key features of the scheme

Legal authority Administration of the UK ETS is by the Emissions Trading Authority, located in the Department of Environment, Food and Rural Affairs (DEFRA). Administrative activities include maintaining a national registry, transaction log, verifying emissions and others. Trading period The trading period runs from January 2002 to December 2006. Following each compliance period there is a three month ‘reconciliation’ or grace period in which companies will have time to purchase any allowances necessary to remain in compliance with their targets. The UK ETS is scheduled to conclude on 31 March 2007 at the end of the final reconciliation period. Coverage of gases Direct Participants may either choose to include only its CO2 emissions or emissions of all greenhouse gases from its sources. Allowances Allowances (UKA) are based on the same unit of measurement as an Assigned Amount Unit (AAU) under the Protocol – one allowance is equal to one tonne of CO2e. Allowances exist only in electronic form and have a unique serial number in accordance with emerging international requirements. The serial number includes: &

The vintage year (year of issue within the UK scheme).

&

The commitment period under the Protocol. For pre-2008 allowances this will be set at zero.

&

Information on origin (allowance or credit based); and

&

An individual number.

Direct Participants are allocated allowances at the start of the compliance period in accordance with their emissions reduction target. Agreement

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Participants are allocated allowances at the end of the compliance period as long as it has reduced its emissions beyond the agreed target. Measurement and reporting Emissions must be measured and reported using measurement and reporting protocols recognized under the trading scheme. When an appropriate protocol is not available, Direct Participants may draft a new protocol and submit it for approval. Reporting guidelines are based on the Revised 1996 Intergovernment Panel on Climate Change (IPCC) Guidelines for National Inventory Reporting and guidance on good practices. Compliance period There are two compliance periods: &

Direct Participants are on a twelve-month (calendar year) compliance period.

&

Agreement Participants are on a twelve-month compliance period (called the milestone period) within a two-year time span. The compliance period can begin anywhere from 1 October to 1 January).

At the end of a compliance period, Participants must calculate their total emissions for the year after which they will have 60 days to reconcile their accounts, that is, to purchase any additional allowances needed for compliance purposes, if the Participants hold insufficient allowances to cover their target. The final deadline in which compliance assessments are made follows the 60-day reconciliation period. The UK ETS recognizes allowances from other systems, including Kyoto reduction units. Participants may purchase Kyoto reduction units subject to approval by the Emissions Trading Authority. Pooling Participants can pool targets and have allowances and the financial incentive allocated on that basis. Baselines and reductions are calculated on an individual basis. ‘Gateway’ In order to ensure the ETS is not destabilized by an influx of allowances from participants with relative targets, a gateway was set up (Figure 4.2). Its purpose is to count up the cumulative transfers into and out of the relative sector. Transfer of allowances into the absolute sector can only occur when there has been a net flow into the relative sector. New and late entrants Companies may enter the trading scheme as Direct Participations after the auction as either late or new entrants. Late entrants are companies that have a baseline of at least one year from the period 1998 to 2000 (either all three or 1999 and 2000, or 2000). New entrants must have a baseline for three years including the year prior to entry into the trading scheme. New and late entrants will not receive any incentive payments.

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105 UKA Absolute sector

100 UKA

Relative sector

Gateway Open

105 UKA Absolute sector

105 UKA

Relative sector

Gateway Closed

Figure 4.2 Gateway between absolute and relative sectors

Banking Unlimited banking is permitted until the end of 2007. For participants with absolute targets, allowances can be banked equivalent to the number of actual emissions reduction achieved (and verified). Allowances held beyond emissions reductions actually achieved may be banked into 2008, but are likely to be subject to a discount. Registries All Direct and CCA Participants and any non-target holders (individuals or organizations that do not have a reduction target) who wish to trade allowances must hold a valid account in the national registry. The registry records: &

Account information for each Participant;

&

Initial allocation of allowances by UK Government;

&

Credits from projects or international transfers (i.e. allowances from other ETS or Kyoto reduction units);

&

Changes to holdings as a result of transfers;

&

Retirement and cancellation of allowances; and

&

Any allowances banked for future use.

The scheme differentiates between two types of transactions: transfers and trades. Transfers entail the transfer of allowances among target holders, and trades are financial transactions including forward contracts and options

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that do not necessarily result in the immediate transfer of allowances between participants. If an account holder purchases an option to buy allowances at a future date, the transfer will only occur if the option is exercised and the allowances are purchased and transferred into a different account. Transfers are recorded in the registry, but a trade will not be recorded unless or until it results in a transfer between account holders. The registry also does not record information such as the purchase price of allowances. The registry works in conjunction with a transaction log that monitors all transactions and records the accounts involved in the transfer and the serial numbers of the allowances. The registry and transaction log will be used to generate management reports that are made publicly available. The registry is compatible with requirements under the Kyoto Protocol. It is an internet-based system that will serve as the registry for both the EU ETS and the Kyoto emissions trading system under the Protocol. International transfers are done manually until other National registries or linkages between systems are functioning. Reconciliation Direct Participants have until 31 March to surrender allowances equal to its target. Allowances can be purchased if insufficient reductions were realized during the preceding year. Under no circumstances, however, can participants use future year allowances to meet current targets, that is, no borrowing is allowed. Penalties Penalties for non-compliance: &

Direct Participants: Incentive payment is withheld and the number of allowances allocated in the next compliance period is reduced. Until a financial penalty is instituted, the shortfall is multiplied by a penalty factor of between 1.1 and 2. In essence, this is a form of borrowing on which an interest rate is charged. If in the Figure 4.3 Participant AA had 1020 1000 980

Reduction

960

Actual reduction

940

Target less penalty

920 900

Baseline 2003

2002

Base

880

Figure 4.3 Penalty for non-compliance

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a reduction target of 970 for 2002 but only reduced emissions by 15 tonnes of CO2 equivalent in 2002 and cannot make up the short fall, its 2003 allocation (assuming a penalty factor of 1.3) would be 921 instead of the agreed 940. &

Agreement Participants: CCA Participants are eligible for an 80 per cent discount on the Climate Change Levy. If the target is not met during the milestone period within the two-year period, the discount is removed during the next two-year period.

Links with other UK trading programmes Scope exists for conversion of renewables obligation certificates in cases where a supplier over-achieves its target. The overachievement would be converted into a credit that can be traded in the UK ETS. Such allowances cannot be used to meet the supplier’s target. Links with other ETS Scope is provided for linking-up with other domestic ETS, provided that agreement is reached to ensure ‘mutual recognition’.

4.5

THE EU TRADING SCHEME

With the adoption of the EU Directive on an Emissions Trading Scheme for Greenhouse Gas Emissions, the EU laid the groundwork for the largest greenhouse gas emissions trading system in the world. The Directive creates a system of domestic trading systems in the 15 EU Member States and the 10 accession countries. Countries joining the EU will be required to comply with this Directive. The EU ETS could also include European EFTA countries (Norway, Iceland and Lichtenstein). In addition, the Directive enables the Commission to negotiate linking agreements with other emissions trading systems that will provide for mutual recognition of allowances. Countries that are likely to seek to ‘link-up’ with the EU ETS include Norway (if it does not implement the Directive), Canada, New Zealand and Switzerland. It is unclear how soon such linking agreements could be negotiated, particularly since many of the trading schemes of these countries are still in the design phase. Although the EU ETS may influence their design choices, it is just as likely that the systems will differ in many elements, for example, cover more activities and gases. If the systems diverge greatly from the EU ETS, negotiations on linking schemes are likely to be protracted. In addition, since many of these countries are expected to be net buyers of allowances, it is unclear how motivated they will be to compromise their designs to meet any requirements the EU might place on them.

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4.5.1

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Structure of the ETS

The EU ETS is a downstream system targeting CO2 emissions from four specific activities (see Box 4.4). It will begin in 2005 and will affect approximately 10,000 installations across the EU, and cover over 40 per cent Box 4.4

Activities covered by the EU ETS Directive

Energy activities Combustion installations with a rated thermal input exceeding 20 MW (except hazardous or municipal waste installations). Mineral oil refineries. Coke ovens. Production and processing of ferrous metals Metal ore (including sulphide ore) roasting or sintering installations. Installations for the production of pig iron or steel (primary or secondary fusion) including continuous casting, with a capacity exceeding 2.5 tonnes per hour. Mineral industry Installations for the production of cement clinker in rotary kilns with a production capacity exceeding 500 tonnes per day or lime in rotary kilns with a production capacity exceeding 50 tonnes per day or in other furnaces with a production capacity exceeding 50 tonnes per day. Installations for the manufacture of glass including glass fibre with a melting capacity exceeding 20 tonnes per day. Installations for the manufacture of ceramic products by firing, in particular roofing tiles, bricks, refractory bricks, tiles, stoneware or porcelain, with a production capacity exceeding 75 tonnes per day, and/or with a kiln capacity exceeding 4 m3 and with a setting density per kiln exceeding 300 kg/m3. Other activities Industrial plants for the production of (a) pulp from timber or other fibrous materials. (b) paper and board with a production capacity exceeding 20 tonnes per day. Source: Annex I of the EU ETS Directive.

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of the EU’s CO2 emissions.52 It is one in a mix of policy tools that the EU will use to meet its commitment to reduce greenhouse gas emissions by 8 per cent from 1990 levels, but it is expected to be the key to enabling the EU to meet its target in a cost-effective and efficient manner. The ETS is similar to the US OTC NOx Budget Program, whereby a regional trading programme contains several harmonized elements in order to ensure consistency across trading programmes. These elements include criteria for developing allocation plans (see Box 4.5), method of allocation, monitoring and reporting requirements and registry requirements. The EC is responsible for monitoring the scheme and maintains the authority to veto allocation plans. Member States are responsible for setting caps for this scheme through their national allocation plans (NAP). The EC has not set limits (or a cap) on the amount of allowances a State can allocate but States are required to allocate no more than is deemed necessary to put it on the right track to meeting its commitment under the Protocol. Member States will have to take into account its internal burdensharing target, Kyoto target as contained in Annex B of the Protocol, and the percentage of emissions covered in the ETS versus the percentage not covered by the system. NAPs are required for each period and will lay out the total quantity of allowances to be allocated and how they will be allocated. In the first period, countries may auction up to 5 per cent of its allowances with the remaining issued free of charge. During the second period up to 10 per cent of allowances can be auctioned. Installations are required to hold a greenhouse gas permit, which in turn sets an obligation on the operator to hold allowances equal to the actual emissions of that installation. Operators must apply to the relevant State authority for the permit. State authorities grant a permit to the site operator (a permit can cover one or more installations), authorizing the installation to emit greenhouse gas emissions in amounts equal to the quantity of allowances it holds. In other words, as long as an installation surrenders a sufficient number of allowances at the end of the compliance period, no limit is placed on the amount of CO2 it can emit. The permit will contain monitoring and reporting requirements and an obligation to surrender allowances equal to total emissions of installation in each calendar year. Permits are site-specific and non-transferable.

4.5.2

Key features of the scheme

Legal authority The Directive requires that Member States identify a Competent Authority to administer the ETS within the Member State. In addition, the Commission will play a role in supervising and receiving reports from Member States as well as updating criteria and structural

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Box 4.5

Criteria for National Allocation Plans

1.

The total quantity of allowances to be allocated for the relevant period shall be consistent with the Member State’s obligation to limit its emissions pursuant to Decision 2002/358/EC and the Kyoto Protocol, takinginto account,ontheonehand,theproportionofoverall emissions that these allowances represent in comparison with emissions from sources not covered by this Directive and, on the other hand, national energy policies, and should be consistent with the national climate change programme. The total quantity of allowances to be allocated shall not be more than is likely to be needed for the strict application of the criteria of this Annex. Prior to 2008, the quantity shall be consistent with a path towards achieving or over-achieving each Member State’s target under Decision 2002/358/EC and the Kyoto Protocol.

2.

The total quantity of allowances to be allocated shall be consistent with assessments of actual and projected progress towards fulfilling the Member States’ contributions to the Community’s commitments made pursuant to Decision 93/389/EEC.

3.

Quantities of allowances to be allocated shall be consistent with the potential, including the technological potential, of activities covered by this scheme to reduce emissions. Member States may base their distribution of allowances on average emissions of greenhouse gases by product in each activity and achievable progress in each activity.

4.

The plan shall be consistent with other Community legislative and policy instruments. Account should be taken of unavoidable increases in emissions resulting from new legislative requirements.

5.

The plan shall not discriminate between companies or sectors in such a way as to unduly favour certain undertakings or activities in accordance with the requirements of the Treaty, in particular Articles 87 and 88 thereof.

6.

The plan shall contain information on the manner in which new entrants will be able to begin participating in the Community scheme in the Member State concerned.

7.

The plan may accommodate early action and shall contain information on the manner in which early action is taken into account. Benchmarks derived from reference documents concerning the best available technologies may be employed by Member States in developing their National Allocation Plans, and these benchmarks can incorporate an element of accommodating early action.

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The plan shall contain information on the manner in which clean technology, including energy efficient technologies, are taken into account.

9. The plan shall include provisions for comments to be expressed by the public, and contain information on the arrangements by which due account will be taken of these comments before a decision on the allocation of allowances is taken. 10. The plan shall contain a list of the installations covered by this Directive with the quantities of allowances intended to be allocated to each. 11. The plan may contain information on the manner in which the existence of competition from countries or entities outside the Union will be taken into account. Source: EU Directive 2003/87/EC.

changes. The Commission also will maintain a transaction log to record transactions between Member States Registries. Trading periods The ETS contains two distinct periods, the first is a pre-Kyoto period from 2005 to 2007, and the second coincides with the Kyoto commitment period (2008–2012). Subsequent periods will follow in five-year increments starting in 2013. Allowances EU Allowances (EUAs) will be recognized community-wide and based on the same unit of measurement as AAUs under the Protocol – one allowance is equal to 1 metric tonne of CO2 equivalent. AAUs and Removal Units (RMUs), however, will not enter into the EU ETS, and it is unclear whether transactions based on Kyoto reduction units (provided the Protocol enters into force) can be made. Allowances will be electronic, that is, no paper copies; they have a lifetime equal to the period in which they are issued (three years, then five). Unused allowances within a given period must be cancelled, but can be reissued (see below). Anyone can hold and/or trade allowances as long as they hold an account in a national registry. It is likely that EUAs will contain unique serial numbers similar to that proposed under the Protocol registries system in order to facilitate tracking. Allowances must be issued by 28 February of each compliance year, and surrendered by 30 April following the end of a compliance year. Monitoring, verification and reporting requirements Monitoring methodologies (Box 4.6) are required in order to receive a greenhouse gas permit. In order to develop monitoring methodologies, operators will need to identify

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Box 4.6

Requirements for monitoring methodologies

A description of the following elements must be included in the monitoring methodology: &

Exact definition of the installation and activities carried out by the installation to be monitored;

&

Information on responsibilities for monitoring and reporting within the installation;

&

A list of sources for each activity carried out within the installation;

&

A list of fuel and material streams to be monitored for each activity;

&

A list of tiers to be applied for activity data, emission factors, oxidation and conversion factors for each of the activities and fuels types/ materials;

&

A description of the type, specification and exact location of the metering devices to be used for each of the sources and fuels types/materials;

&

A description of the approach to be used for the sampling of fuel and materials for the determination of net calorific value, carbon content, emission factors, and biomass content for each of the sources and fuel types/materials;

&

A description of the intended sources or analytical approaches for the determination of the net calorific values, carbon content or biomass fraction for each of the sources and fuels types/materials;

&

A description of continuous emission measurement systems to be used for the monitoring of a source, that is, the points of measurement, frequency of measurements, equipment used, calibration procedures and data collection and storage procedures (if applicable);

&

A description of the quality assurance and quality control procedures for data management;

&

Where applicable, information on relevant links with activities undertaken under the Community eco-management and audit scheme (EMAS).

Source: Commission Decision 29/01/2004.

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activities listed in Annex I of the Trading Directive that emit greenhouse gas emissions (see Box 4.7). Operators of installations affected by the EU ETS will then need to decide on the methodology it will use. Installations have two options for monitoring emissions. Emissions may either be estimated using calculations or measured using approved methodologies such as CEMS. In order to measure emissions, however, installations must show that it will provide more accurate data than calculation methodologies, and measurements must be backed up by calculations. Calculation of emissions is based on the formula: CO2 ¼ Activity Data  Emissions Factor  Oxidation Factor where activity data is based on either fuel consumption for combustion emissions or material consumption, production rate and others, for process emissions. As mentioned, the permit will list the monitoring requirements and frequency of reporting. The Monitoring methodology must be approved by the Member State or its competent authority, which will also ensure that the methodology is applied and the installation meets all terms specified under the permit. Changes to the monitoring methodology can occur in several ways: the Member State can request a change in the methodology, a change in activities necessitates a change in methodologies (i.e. a new emissions source), and error in the methodology is discovered or a more accurate method is found for determining emissions. Emissions information collected through the monitoring methodology is reported yearly and must be verified by an independent third party. The verification process can include desk reviews, on-site inspections and spot checks to determine whether the information in the monitoring report is reliable. In addition, the verifier is responsible for ascertaining the level of certainty/confidence in the data reported and identify any areas for which there is a high risk of error. Once complete, a validation opinion on the monitoring report is submitted to the Member State or its competent authority. Opting-in (expansion of the ETS), opting-out, pooling From 2005, Member States can apply to the Commission to have installations or activities with thresholds lower than those contained in Annex I included in the EU ETS. From 2008, Member States can apply to include activities and installations not listed in the Annex as well as other greenhouse gases. The Commission has the option to deny Member States requests for expansion. The NAPs must contain information on allocation of allowances to installations falling under these categories. Member States can choose to exclude certain installations (opt-out) in the first period of the ETS, dependent on EC approval. Installations will only be

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Box 4.7

Reporting requirements for installations

A. Data identifying the installation, including: &

Name of the installation;

&

Its address, including postcode and country;

&

Type and number of Annex I activities carried out in the installation;

&

Address, telephone, fax and email details for a contact person; and

&

Name of the owner of the installation, and of any parent company.

B. For each Annex I activity carried out on the site for which emissions are calculated: &

Activity data;

&

Emission factors;

&

Oxidation factors;

&

Total emissions; and

&

Uncertainty.

C. For each Annex I activity carried out on the site for which emissions are measured: &

Total emissions;

&

Information on the reliability of measurement methods; and

&

Uncertainty.

D. For emissions from combustion, the report shall also include the oxidation factor, unless oxidation has already been taken into account in the development of an activity-specific emission factor.

able to opt-out if they can show that they will reduce emissions as much as would have been required under the ETS. In addition, they will be subject to monitoring, reporting, verification and non-compliance penalties. Member States have the option of allowing installations carrying out the same activity to form pools for the purpose of participating in and

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complying with the ETS. Again, the EC retains the ability to reject a State’s request to allow particular pools. Provisions for pooling remain in effect until the end of the second period. Banking Within the specified periods, surplus allowances can be banked. Banking between the two periods is, strictly speaking, not provided for. Instead, Member States have the prerogative to cancel unused EUAs and re-issue new ones for use in the second period. For any follow-on periods, Member states must reissue unused allowances cancelled from the previous period. Grace periods and borrowing Installations will have four months in which to surrender allowances equal to their actual emissions during the past year (30 April). Since new allowances must be allocated by 28 February, installations technically have the ability to borrow allowances in order to meet prior year emissions limits; this will not however affect current year requirements. Therefore any installation choosing to ‘borrow’ allowances for compliance with the prior year target will either have to purchase additional allowances or reduce emissions more than required in order to make up for the shortfall in current year allowances. The ability to borrow does not exist between periods. Registries Each Member State is required to maintain a national registry for issuing, holding, transferring and cancelling allowances. Member States may also use a consolidated system for maintaining registries. The registry is to be an electronic database with standardized formats for tracking transactions. Any person may hold an account within a registry. Registries will work in conjunction with a transaction log maintained by the Commission (Central Administrator) to track issuance, transfers and cancellation of allowances. Penalties Penalties for non-compliance vary with the periods. During the first period, non-compliant installations must pay d40 per tonne of CO2 equivalent over its cap, and d100 per tonne in the second period. In addition, installations must make up for the shortfall in allowances in the following compliance period. New entrants Under the Directive, Member States have two options for new entrants into the EU ETS. The first option is to allow new entrants to buy allowances on the market. The second option is to set aside a reserve of allowances for new entrants. Linkage with project-based mechanisms ERUs and CERs will be allowed into the EU ETS. A Directive linking the project-based Kyoto

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mechanisms to the EU ETS was agreed to in April 2004, detailing EU requirements for use of the credits generated by the project-based mechanisms. CERs may be used from 2005, and ERUs from 2008. The use of CERs and ERUs is up to each Member State. They must also determine what percentage of an installation’s allowance allocation may be converted into CERs and ERUs. Member States will report every two years on the use of the Clean Development Mechanism (CDM) and Joint Implementation (JI), and the extent to which that use is supplemental to domestic action. The Commission retains the possibility of instituting measures if it finds that the use of the project-based mechanisms is not ‘supplemental’ in the way that the EU defines it. CERs and ERUs can be held in a national registry and used for compliance purposes as long as the installation has not exceeded the percentage cap that the Member State imposes on it. In order to do this, however, the Member State must issue an EUA which is surrendered in exchange for the CER or ERU. CERs and ERUs are exchanged on a one to one basis. In the 2005 and 2007 period, CERs can be used for compliance with targets. CERs must also be exchanged with EUAs, but in this case Member States are required to cancel the CERs used by an operator. This means that any CERs entering into the EU ETS during the first phase could not be used for compliance purposes if the Kyoto Protocol enters into force since they would also be cancelled within the CDM Registry. The Directive also places some limits on the types of credits that can be brought into the EU ETS. CERs and ERUs from land-use change and forestry projects are not eligible for entry into the EU ETS during the first trading period, but may be eligible in the 2008–2012 period. CERs and ERUs generated from nuclear projects are excluded during the 2008–2012 period. CERs and ERUs generated from hydro projects can be used but must ‘respect’ relevant international criteria and guidelines, including those of the World Commission on Dams. This means that it is up to each Member State to determine whether they find such projects acceptable. JI projects can be undertaken by any Annex B country, meaning any two countries within the EU can undertake a JI project. In order to prevent double counting of emissions reductions, Member States cannot issue ERUs from any installation covered by the EU ETS unless a corresponding number of EUAs are cancelled in the originating Member States national registry. This remains in effect until the end of 2012. Finally, the Commission will consider ways to link the EU ETS with sub-national trading systems in countries not ratifying the Kyoto Protocol, that is, the US and Australia, but only after the Protocol enters into force through Article 25 of the Directive.

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119

Implications of the EU ETS

During 2004, one of the main focus of industry covered by the EU ETS was on the NAPs. Governments and industry alike have a vested interest in the outcome of this process. Since grandfathering is the main method for allocating allowances, who gets what and how large the overall cap will be is a competitive issue. In addition, the process from finalizing the NAP to implementing the trading scheme is likely to go very quickly. The inventory process, both in establishing the baseline of activities eligible under the trading scheme and familiarity with the methods for conducting the inventory can be time consuming. Industry not affected by the ETS should also look at their options. The ETS is only a part of the solution the EU and Member States will implement to meet the goal of reducing emissions by 8 per cent below 1990 levels. Businesses and individuals are likely to feel the affects of the EU ETS as it is likely that energy prices will reflect the new reality of a carbon constrained economy. Additionally the EU ETS is likely to expand in 2008, covering a broader range of activities and gases.

4.6

OTHER EMISSIONS TRADING SCHEMES

Several other Annex B countries are in the planning stages of the ETS (see Table 4.7). For some countries, the EU Directive will influence design choices. Under the EFTA, countries such as Norway may be required to take on the EU ETS. For other countries national circumstances will play a greater role. Canada for instance must contend with a trading partner that will not be bound by the Kyoto Protocol. Competitive issues and political processes require a different approach from that of the EU.

4.6.1

Norway

Under the Kyoto Protocol, Norway has a commitment to limit its greenhouse gas emissions to 1 per cent above 1990 levels. In 2002, greenhouse gas emissions increased 6 per cent above 1990 levels, and emissions continued to increase in 2003. Unlike many other European countries, the majority of Norwegian emissions come from the offshore petroleum sector and from process industries, with almost no emissions from electricity generation (which is based on hydro). In 2000, the Government of Norway put forward an emissions trading proposal to the Storting (the Norwegian Parliament) based on a report by the Norwegian Quota Commission. The Government decided it could not wait for a final EU Directive since ‘the emissions trading scheme proposed by the [European] Commission does not meet Norway’s needs, particularly in

Norway

All GHG from large industrial emitters including thermal electricity, oil and gas, mining, pulp and paper, chemicals, iron and steel, smelting and refining, cement, lime, and glass.

Canada

From 2008, may possibly institute a broader scheme that would include all Kyoto gases and all sectors possible; over 80 per cent; to be captured, from 2008.

Early phase, from 2005 to 2007, likely to be similar to the EU ETS, covering only about 10 per cent; of emissions.

Based on original proposal by the Norwegian Quota Commission:

Start-up pre-2008 possible.

Coverage

Country

To be determined by partial auctioning, partial grandfathering.

Possible integration of previous voluntary domestic credit-based systems. Development of an offsets system, involving initially forestry and agriculture, and possibly landfill gas, is underway.

Free allocation determined through sector specific covenants with regulatory or financial backstop.

In parallel with carbon tax from 2005, eventually to replace it after 2008.

Links to other trading schemes envisaged.

Interface with other instruments

Initial permit allocation

Table 4.7 Examples of domestic emissions trading schemes in planning stages

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relation to the Kyoto Protocol’ (Report No. 15 to the Storting (2001–2002) ). In 1999, the Quota Commission delivered a report to the Ministry of Environment on elements for a greenhouse gas emissions trading scheme. The proposal called for an emissions trading scheme that would cover approximately 30 per cent of emissions in the period from 2005 to 2007 and almost 90 per cent from 2008. Under existing Norwegian climate policy, approximately 65 per cent of total CO2 emissions are covered by a tax on CO2 emissions. Approximately 30 per cent of energy and emission intensive industries are exempt from the tax. The early system would cover the unregulated sources, and from 2008 the ETS would replace the CO2 tax. Development of a Norwegian ETS was ongoing in parallel with the EU Directive for an ETS. In commenting on the EU proposal for a Directive, Norway stated that they intended to use emissions trading as its main policy instrument, which made coverage under the EU ETS problematic under the Kyoto commitment period. Other areas where Norwegian positions diverged from the EU was on the need to include sources producing energy at less than 20 MW, the need to include upstream sources in the trading scheme, and that no limits should be placed on the use of the Kyoto mechanisms (Government of Norway Promemoria, 2001). Since the proposal was put forward, discussion between various Ministries and industry occurred on whether Norway should implement its own system or adopt the EU Directive (or whether it would be required to adopt it under the EFTA). In early 2004, the Norwegian Government announced that it would take on an emissions trading system (for the period 2005–2007) similar to the EU ETS which would consequently cover only about 10 per cent of emissions. It is unclear what the ETS might look like for the 2008–2012 period.

4.6.2

Canada

Canada also has issues particular to its national circumstances. Canada is a trading partner with a country that does not intend to take on a reduction target, which implies there are serious competitive issues that the Government must incorporate in developing its climate policy. In 2002, Canada put forward its plan for meeting the reduction commitments under the Protocol. The Climate Change Action Plan for Canada set out a three-pronged approach: &

targets for reductions established through covenants with a regulatory or financial backstop (55 megatonne reduction);

&

access to a domestic emissions trading system, domestic offsets and international permits to provide flexibility; and

&

complementary measures (an additional 11 megatonne reduction).

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Unlike European trading schemes that are based on an absolute cap on emissions, the proposed Canadian ETS is a rate-based system. Compliance with the ETS will be assessed by comparing actual emissions per unit of output to a business as usual emissions intensity projection. Participation is required by large final emitters in the thermal electricity, oil and gas, and mining and manufacturing sectors, approximately 650 firms.53 An additional feature unique to the Canadian ETS is the inclusion of a price assurance by Government that industry will not have to pay more than CN$15 for an allowance. The price assurance functions as a price cap. If the price of allowances on the market go above CN$15, then the Canadian government is responsible for the additional costs/or for providing allowances at the price cap (for example, by purchasing additional allowances on an international market). It is unclear how the price assurance will be implemented. The Government has proposed using forward contracts, but is also examining other ways to implement it.54 The price assurance raises a number of issues, including how to limit the cost to Government in the event allowance prices rise above the cap, how to implement contracts for these allowances without damaging market liquidity or obligating Government or industry to purchase allowances unless absolutely required. Canada has also stated it is interested in linking with other ETS beginning in the period 2008. The basis for linking would be the agreements reached under the Marrakech Accords since they provide a basic framework for ETS under the Protocol trading system. At COP-9, the Canadian Environment Minister stated that Canada has had initial exploratory discussions with the EU on the general topic of linking emissions trading schemes. The Canadian ETS is to be a Protocol-based trading scheme, allowing in all Kyoto reduction units. The EU ETS, however, was designed to be in line with the framework in the Marrakech Accords and the Kyoto Protocol, but does not allow Kyoto reduction units into its system. It does, however, provide for conversion of CERs and ERUs into EUAs. The EU requirements for linking with other ETS are specific to design elements, which differs from the Canadian position of using the Marrakech Accords as the basis for linking. The EU considers its ETS as a process parallel to Kyoto, one that is not dependent on entry into force of the Protocol. It is unclear, however, whether the EU will require linking agreements with other trading systems when trading takes place under the Kyoto Protocol.

4.7

SUB-NATIONAL TRADING SCHEMES

Despite rejecting the Kyoto Protocol at the national level, greenhouse gas emission reduction programmes are a being adopted at the State and local level in the US and Australia.

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4.7.1

123

The United States

State and local action on reducing greenhouse gas emissions is growing, and is one way in which the US could enter a global carbon market. As domestic US markets grow and companies and local governments gain experience in greenhouse gas emissions trading, pressure could be exerted on the Federal government to adopt a national trading scheme. Several States have adopted multi-pollutant legislation requiring reductions in SO2, NOx, CO2 and Mercury (Massachusetts, New Hampshire, New Jersey, North Carolina, Michigan and Illinois); other States are developing climate change action plans (Connecticut and Maine) and New York established a Greenhouse Gas Task Force to examine how it can reduce greenhouse gas emissions. And Governors in New England are examining a greenhouse gas cap and trade programme with their eastern Canadian counterparts. In 1997, the State of Oregon adopted legislation requiring new power plants to offset CO2 emissions by approximately 17 per cent in order to receive site certificates. They instituted a rate-based standard that is 17 per cent more efficient than the most efficient US gas powered plant. Carbon dioxide standards have not been set for base load plants using fossil fuels other than natural gas. Non-base load standards are applicable to all types of fossil fuels. In applying for a site certificate, plant operators must specify how they will comply with the standards. Choices include offsetting emissions through cogeneration or by taking a ‘monetary path’ meaning the facility pays the Oregon Climate Trust for offsets from projects. Some programmes such as California’s Climate Action Registry promotes voluntary measurement and reporting of greenhouse gas emissions. The California Registry helps companies and organizations record emissions and establish baselines in the event that an emissions trading programme is instituted at a later date. Participants in the Registry report emissions at either the State or national level (meaning if they operate in five States they must report emissions from all five States and not a sub-set of the five). Companies must report all direct and indirect sources, and can report non-certified sources (equivalent to the GHG Protocols Scope 3 sources, i.e. employee travel or transportation of products). Participants must report CO2 emissions; although after three years of reporting participants must report all six greenhouse gases.

4.7.2

Australia

In January 2003, the State of New South Wales (NSW) launched its Greenhouse Gas Abatement Scheme for electricity retailers and other parties. The scheme sets a State level benchmark of 8.65 tonnes of CO2 equivalent per capita in 2003 with a progressive drop to 7.27 tonnes in 2007.

Large User Abatement Certificates (LUACs)

NSW Greenhouse Abatement Certificates (NGACs)

Reducing on-site fugitive greenhouse gas emissions.

Reducing on-site greenhouse gas emissions from industrial processes.

Switching to lower emission intensity fuels.

Increasing the efficiency of on-site fuel use.

Forest management (carbon sequestration). LUACs can only be used by the Large User generating the certificate in its capacity as a benchmark participant.

NGACs can be purchased by benchmark participants and surrendered for compliance.

Reducing greenhouse gas intensity of electricity (generation).

Reducing consumption (demand-side management).

Targeted use

Activity

Table 4.8 NSW greenhouse gas abatement scheme

No

Yes

Transferable

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The annual electricity sector benchmark is derived by multiplying the State benchmark by the total State population; the total represents the amount of emissions allowable for the consumption of electricity in NSW. The Scheme has two types of participants, mandatory participants consisting of electricity retailers, electricity generator that supply directly to retail customers and certain market customers; and elective participants (or Large Users) including customers with electricity loads greater than 100GWH. In order to reduce the costs of compliance, participants may purchase or use abatement certificates to offset emissions. The Scheme provides two types of abatement certificates, one, which is tradable, and one, which is not (see Table 4.8). Each certificate is equal to one tonne of CO2 equivalent. In order to generate certificates, companies must be accredited to provide greenhouse gas reductions in certain activities. In addition, participants may count Renewable Energy Certificates towards the greenhouse gas benchmark. Compliance is calculated on the basis of the participant’s benchmark minus NSW Greenhouse Abatement Certificates (NGACs) and Large User Abatement Certificates (LUACs) minus RECs. Participants can carry over up to a 10 per cent shortfall of the benchmark into the next compliance year, every year except in 2007 and 2012. If the shortfall is carried over it must be made up that year or a penalty of Australia $10.50 per tonne of CO2 equivalent is assessed.

CHAPTER 5

Managing Carbon In recent years emissions trading schemes that aim to reduce greenhouse gases, has been the principal focus of government, industry and nongovernmental organizations. A great deal of emphasis has been placed on what the schemes should look like but less on what companies must do in order to participate in a trading scheme. Since the EU Directive on emissions trading was adopted, greater emphasis has been placed on the methods and tools that will be needed in order for companies to succeed in a carbon constrained economy. Thus far, industry’s main focus has been on limiting any potential negative impact of an emissions trading scheme (i.e. by either challenging the allocation process, attempting to limit the industry effect by a potential scheme or by attempting to influence the stringency of a cap). Developing strategies for coping with limitation on emissions has been a secondary concern. Since the adoption of the Kyoto Protocol, more companies have engaged in activities designed to bring understanding of what managing carbon means in a business context. Many more, however, have waited for more certainty about the outcome of domestic political processes. This chapter examines issues surrounding carbon management, including the uncertainties inherent in the current process, the context under which reductions will occur, and elements that companies will need to address in preparing for emissions trading.

5.1

CARBON AS AN ASSET

Managing assets and trading commodities is not a new concept for industry or the financial services sector. Managing environmental problems through market creation has also gained popularity. But unlike the NOx and SO2 markets, the carbon market or, more precisely, the greenhouse gas market is set to become the largest global environmental market, potentially 126

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encompassing the majority of the world’s economies. Annex I countries have begun laying the groundwork for the creation of a new commodity through policies that limit the amount of emissions from some companies and sectors. Unlike other markets based on tangible commodities, such as currencies, oil or wheat, a market based on the limitation of greenhouse gas emissions requires commitment and definition through regulatory policy. Companies are facing new challenges due to climate change. Not only must they examine their risk exposure due to regulatory policies, but increasingly investors have begun to examine how the companies in which they invest are incorporating carbon into their value chain. In 1999, institutional investors (pension funds, mutual funds, insurance companies) had over US$26 trillion in assets under management. Just as abatement costs vary between companies and units within companies, shareholder value is also likely to vary. The degree to which companies develop strategies to manage carbon now could provide a competitive advantage later which is of particular interest to investors. The Carbon Disclosure Project (CDP), a coordinating secretariat for 35 institutional investors is examining the way in which some of the world’s largest companies (from the FT 500) have incorporated carbon management into their corporate goals, and analysed how it may affect shareholder value.55 The CDP presents yearly reports, on the risks and opportunities presented by climate policies. In developing their reports they have sent surveys designed to gauge awareness of climate change impacts and the extent to which companies (regardless of sector) have incorporated carbon management policies into their planning process. For its 2003 report, the CDP received responses from roughly half of the companies. Approximately 80 per cent of respondents felt climate change presented business risks, while less than 40 per cent had adopted policies to reduce emissions. The survey covers companies in a broad range of sectors: auto manufacturers, integrated oil and gas, electric utilities, banks, metals and mining, transportation and food retailing. The CDP has found that there are growing risks to their investments from climate change. First, extreme weather-related events have already impacted some companies’ earnings. While these losses may not be directly attributed to climate change, any change in the severity or frequency of weather events such as those anticipated as a result of climate change will impact a broad range of sectors and company earnings.56 Second, the effects of carbon regulation, particularly capping emissions, and the expected increase in fuel costs affect the potential for growth if companies are not prepared to manage the risks appropriately. Third, corporate accounting irregularities in recent years have placed new emphasis on governance and disclosure which will in turn lead institutional investors to place more pressure on companies to respond to climate change issues. Fourth,

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instituting carbon management techniques is time consuming, taking up to several years. This corresponds with several other initiatives focusing on the inventory process. Therefore, the longer companies delay, the more likely they are to loose a competitive edge in the market. A study by the UN Envirnoment Programme’s (UNEP’s) Finance Initiative (FI) looked at the extent to which financial institutions have begun to adapt their business practices to account for the impacts of climate change. Extreme weather events influence not only company earnings, but the finance and insurance industry directly (see Section 1.2). In addition, the financial services sector plays a major role in facilitating market solutions, that is, greenhouse gas trading markets and financing cleaner technologies. In examining the threats and opportunities posed by climate change, the UNEP FI identified barriers to proactive participation by financial institutions which also hold for many other sectors of the economy. The first has been the political uncertainties that surround the Kyoto Protocol and domestic processes. The second is the lack of information many companies have on the likely impacts of climate change issues, as well as the lack of information on how companies will manage the risks associated with greenhouse gas reduction policies. With the implementation of regulatory policies for greenhouse gases, governments are signalling that companies must incorporate the effects of the emissions they produce into their products and services. Emissions trading is a means for complying with greenhouse gas reduction requirements, but it does not by itself ensure compliance. Virtually every activity, every action produces greenhouse gas emissions. Understanding where and how much is the first step in understanding how a company should proceed in the carbon market.57 The decisions companies make in detailing a carbon management strategy, in identifying and quantifying its emissions, in identifying areas for investment in new technologies or equipment upgrades, in detailing possible reduction projects, are all elements that will ultimately ensure a company has the ability to comply. The price of carbon, and therefore the cost of complying with reduction targets, is dependent on many factors. Experience from the SO2 and NOx trading programmes show that it is difficult to estimate precisely the impacts of introducing emissions allowances prior to the start of the programme with any precision. Prior to the start-up of the SO2 trading programme, compliance cost estimates ranged from US$2.3 billion to $6 billion. Compliance costs for 2010 are now estimated at between US$1.0 billion and $1.4 billion. Trading SO2 allowances was not the major factor in the revision of these figures. The price of low-sulphur coal, which was lower than anticipated in the first estimates, accounted for an 80 per cent reduction in the marginal abatement cost of a unit of reduction, and the remaining 20 was due to technological innovation (Ellerman, 2003). Investment decisions and

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technological innovation are only two elements in determining the cost of compliance.

5.2

THE ENERGY CHALLENGE

Virtually every facet of modern society is tied to the production and consumption of energy. It is the driving force in every economy, and particularly in developing countries, a much sought after commodity. Demand for services drives the production of energy, ensuring that the computer we use turns on; the telephone works and the car/train/plane or bus we take gets us to where we need to go. In developing countries, as populations continue to grow, industrialization, personal incomes and standards of living increase, so will greenhouse gas emissions. Globally, energy demand is expected to grow by 1.7 per cent per year over the next 30 years (see Figure 5.1). Greenhouse gas emissions are expected to rise 1.8 per cent per year through 2030; a 70 per cent increase over current emissions. Fossil fuels will continue to be the dominant source of energy production over the next 30 years, and without any further policy intervention, power generation will be the single largest emitting sector by 2030. Oil will remain the dominant fuel, but within Annex I countries its primary use will be in the transportation section. Coal use for electricity use (within Annex I countries) will decrease and natural gas use will increase since combined cycle gas turbines are more efficient and emit less greenhouse gas emissions. Globally, however, coal use will increase some 1.5 per cent per year, with India and China accounting for about 85 per cent of this increase. 40 35 30 25 20 15 10 5 0

Coal

Oil

Gas 2000

Nuclear Hydro Other Renewables 2030

Figure 5.1 World primary energy demand Source: Adapted from IEA World Energy Outlook 2002.

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Emissions in OECD countries are expected to increase some 0.9 per cent per year through 2030, increasing overall emissions to 16,397 million tonnes of CO2 equivalent from the 2000 level of 12,369 metric tonnes (IEA, 2003).58 The industrial sector accounts for a significant portion of Annex I emissions; direct (fuel combustion) and indirect (electricity use) emissions each accounted for about 15 per cent of CO2 emission in 2000 (see Figure 5.2).59 The industrial sector also emits process-related emissions of CO2, N2O, CH4 (methane), HFC, PFC and SF6 which account for approximately 5 per cent of Annex I emissions. While emissions from fuel and electricity use have increased, process-related emissions showed a decrease of 21 per cent from 1990 levels during the 1999 to 2000 timeframe. Some gases, N2O and PFC, have declined in use, while HFC has increased. While overall these emissions account for a small percentage, the importance of them varies between countries. For a country like Norway which is relatively low in terms of carbon intensity, process-related emissions account for a higher portion of the countries overall emissions, that is, approximately 20 per cent of Norway’s emissions are process related (Bygrave and Ellis, 2003). If government intention is to reduce emissions from a business as usual course, then policy packages must be designed to reduce the amount of energy consumed and/or improve the efficiency with which it is consumed. At the outset, it means changing the course of greenhouse gas emissions from the largest emitters. The power generation sector is crucial to enabling

Waste 3%

Industrial bunkers 3%

Agriculture 7%

Energy industries 31%

Industrial processes 5%

Transport 23%

Fugitive emissions 3%

Energy use in industry 14% Energy use in other sectors 11%

Figure 5.2 Shares of aggregate emissions by sector, 2000 Source: UNFCCC 2002.

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countries to meet their domestic and Kyoto targets. The economic and technical issues related to emissions trading make energy intensive industries prime candidates for emissions trading: sources face a range of compliance costs and control options, there are a sufficient number of sources to create a fluid market, and these sources will be able to provide the emissions monitoring data that an emissions trading system requires.

5.3 ANTICIPATED IMPACTS ON THE POWER SECTOR Reducing emissions means changing the way energy is produced and consumed. It also means that costs will increase depending on the price of carbon allowances and the type of fuel used. Impacts are likely to be felt over a broad range of energy consumers – from the fuels that are consumed directly, such as gas used for transport, or from higher electricity prices for the energy consumed. Higher electricity prices also mean that price of producing goods could increase. The potential impacts of the Kyoto Protocol and in particular of emissions trading has been the subject of much analysis since the Protocol was first adopted. In 1998, US analysis showed that introduction of a carbon price would substantially increase the price of coal, while the price of natural gas and oil increased on a much lower scale (from 346 to 368 per cent compared to 64 to 74 and 25 to 29 per cent, respectively). Electricity prices would increase some 47 to 50 per cent, reflecting the higher cost of the fuels used and added investments in order to reduce emissions. Carbon prices in this analysis were projected to range from US$65 to 290 per tonne of CO2 equivalent. In 2005 the EU trading scheme will be the largest international emissions trading system on line, until the trading takes place under the Protocol. The EU trading scheme will link 25 domestic trading schemes with a mix of buyers and sellers. The extent to which carbon price impacts the power generation sector and other energy intensive industries, will to some extent be dependent on resolving some of the uncertainties at the political level. If the Protocol enters into force and countries like Russia meet the requirements for trading, then the costs associated with reducing greenhouse gas emissions could be substantially lowered.

5.3.1

Near term impacts

Carbon dioxide reduction policies are expected to alter the generation mix, since fuel type matters; coal emits more than twice the amount of CO2

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compared to gas, while hydro and renewables emit very little and nuclear emits none. Other factors, however, come into play in technology choices. Renewable technologies are currently not competitive with coal or gas plants, and are expected to compliment rather than replace fossil fuels or nuclear in energy production for the foreseeable future (WEC, 2003). Within the EU, targets for renewables are set at increasing the market share to 12 per cent of gross energy consumption and 22 per cent of electricity production by 2010. In order for wind power (which has a larger share of the EU market compared to other renewables) to compete with gas-powered plants, CO2 prices will have to reach between D 30 and D 160 per tonne of CO2 (see Table 5.1). It is unlikely, given the projected market share of renewables by 2030, that it will play a major role in reducing CO2 particularly during the first phase of the EU ETS.60 Unless companies have already incorporated plans for introducing renewable technologies on-site, companies are more likely to look to less expensive methods for reducing emissions, such as energy efficiency measures. Wholesale electricity prices are expected to increase although there is no uniform agreement by how much (Reinaud, 2003). Different modelling exercises produce different results, based on the assumptions used. Regulatory pricing mechanisms, competitive pressure, price elasticity of demand, market concentration, allocation methods and price of allowances can all influence pricing. Estimated increases in electricity prices range from 19 per cent to 30 per cent (see Table 5.2). In addition, a forecast survey of wholesale electricity price in EU countries by Dresdner Bank projects increases from 3 per cent for Spain up to 22 per cent for Germany (in a low carbon cost scenario – D 7.5/t CO2), and ranging from 7 per cent to 57 per cent for the same countries (under its high carbon price scenario – D 20/t CO2). The various features of a trading scheme also affect compliance costs, and therefore the strategies companies implement. The European power association, Eurelectric, organized several trading simulations to better understand how different design elements could affect the electricity industry in Europe, as well as other key energy intensive sectors (in parallel with design elements of the EU ETS), particularly as it relates to compliance costs. Several key lessons can be drawn from the various simulations: (1) emissions trading requires a clear set of rules, (2) trading reduces compliance costs, (3) investment decisions determine compliance, not trading, (4) the length of the trading programme affects investment decisions, since companies are hesitant to invest when the future of the trading scheme is unknown and (5) banking increases companies ability to comply. Table 5.3 summarizes some of the issues and results from the simulations. Detailed information on all simulations is available at www.eurelectric.org.

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Table 5.1 CO2 emission price levels and impacts on generation costs CO2 emissions D /tonne of CO2

Impact on the generation sector

0–18.5

Scale up of the merit order but no significant impact on competitiveness ranking of power generation technologies expect at the margins, and if gas prices fall relative to coal prices.

18.5

CCGT and coal plans are equal in terms of short-run marginal costs including carbon emissions costs.

18.5–23.2

Arbitrage between running coal and CCGT power plants. Reordering of coal and CCGT plants on the merit order.

Investment in upgrading coal plants’ existing equipment, switch from coal to biomass in existing boilers.

23.2

Becomes more profitable to shut down fully amortized coal plants and build modern CCGT plants.

Closure of more inefficient fully amortized coal plants, investment in modern CCGT plants.

30

On-shore wind plants could become competitive with new CCGT and new coal plants.

80

High load offshore wind technologies become as competitive as CCGT.

107–180

Renewable technologies such as biomass and low capacity wind technologies become competitive.

Source: Adapted from Reinaud, 2003.

Investment decisions

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Table 5.2 Survey of studies on power generation under trading schemes CO2 price (per tonne of CO2)

Effects on electricity price

McKinsey

D 25 (modelling result, no time limit)

þ30 per cent average wholesale þ15 per cent average end-use

ICF Consulting

D 5 in 2005–2007 D 10 in 2008–2012

þ19 per cent (wholesale base-load)

IEA

D 20 (no time limit)

þ21 per cent average wholesale

Source: Adapted from Reinaud, 2003.

5.3.2

Long-term impacts

Over the long run, emissions trading schemes will impact investment decisions in capital stock, but only when policy makers have provided a clear framework from which to operate. The uncertainties listed above are clearly relevant for investment decisions that will influence emissions for the next two to three decades and perhaps longer. In many energy intensive industries the lifetime of plants and equipment can run well beyond the limited timeframe of current carbon abatement policies. In order to influence investment decisions, governments will need to send clear signals on the longevity of its policies. It is not uncommon to find plants that have been in existence for well over its rated lifetime. Paper mills, electricity generators, chemicals manufacturers and others are more likely to invest in routine maintenance and new equipment or decommission facilities (until some later date when they may be needed) rather than invest in new technologies and plants unless there is some external force that makes this investment a competitive necessity. Opportunities for reducing emissions exist by retiring older more polluting power plants. However, this is only likely to happen when there is a market for (in this case) cleaner energy. Switching to new cleaner technologies carries risks in the absence of clear regulatory policies aimed at reducing greenhouse gas emissions. New technologies would have to provide exceptional performance improvements in order for a company to retire existing equipment whose capital costs are already paid. Companies

Pre-compliance: 2000–2004

GETS 1 (1999)

Trading: 2005–2007 2008–2012

Periods trading

Simulation run

&

&

market for CO2 in 2008.

futures market. Spot

Prior to 2008, CO2 in

market.

Electricity traded on Spot

Electricity and CO2 markets:

Programme features

The effect of electricity prices relative to CO2 prices affected strategies. Where CO2 prices were low and electricity prices were high, some participants increased power production since it was cheaper to purchase allowances to cover emissions. As arbitrage opportunities became more frequent, the carbon content of the electricity traded began to be reflected in its price. Shift in fuels with new capacity based on natural gas, either fuel switching coal to gas or installing co-generation and CCGT. Since no targets were set after 2012, companies had little or no incentive to undertake action beyond 2010. The lack of long targets creates a disincentive for long-term action.

&

&

Price signal crucial factor in elaborating strategies.

Investment decisions and not emissions trading determine compliance – but investments needed earlier rather than later in order to comply.

&

&

&

Key lessons

Table 5.3 Eurelectric’s greenhouse gas and energy trading simulations

135

Pre-compliance: 2000–2004

GETS 2 (2000)

Trading: 2005–2007 2008–2010 2011–2015

Periods trading

Simulation run

Electricity, oil and gas, glass, cement, chemicals and paper and pulp.

Electricity sold on spot and futures contracts.

Project-based credits allowed into system.

Demand-side management projects included as options for reducing emissions.

Different allocation methods used for different simulations.

&

&

&

&

Electricity and CO2 markets:

&

Sectors included:

Programme features

&

&

Foreknowledge of longer time horizon (trading up to 2015) affected investment decisions, although investment during last trading period was limited. But activity during second trading period was more active compared to the GETS 1.

Allocation method did not alter investment patterns, but did affect financial situations. Depending on the allocation method used, some companies that were sellers under one method became buyers under another allocation method (from grandfathering to benchmarking, for instance).

Key lessons

Table 5.3 Continued

136

Same as GETS 3

GETS 3 bis (2002)

Examined effects of auctioning and recycling routes.

Examined effects of limits on CO2 allowances to offset renewables obligations and the effects of increasing power plant retirement periods.

Examined different caps and inclusion of nonCO2 gases.

Examined ‘no trading’, EU-like trading scheme, and full trading.

Source: Compiled by author from GETS reports.

Trading: 2005–2007 2008–2012 2013–2017

GETS 3 (2002)

Early retirement of thermal plants imposes costs on the system and also increases compliance costs. Costs vary, however, by country. Countries with high renewables penetration or large proportion of thermal plants are likely to have higher compliance costs. Auctioning has significant impacts on the distribution of compliance costs by sector with the percentage auctioned determining sectoral effects. Recycling also has distributional effects, which are larger when those paying for the auctioned allowances do not receive the recycled revenues.

&

&

&

&

Flexible start to trading and early knowledge of the rules of the game reduces overall compliance costs.

&

Limiting the ability to use CO2 allowances to meet renewables obligations increases compliance costs.

No trading, however, leads to the highest increases in compliance costs and ability to meet targets are not guaranteed.

&

&

Limiting participation or placing limits on flexibility, such as by placing limits on the amount of reductions that can be achieved through the trading scheme increases compliances.

&

137

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will adopt new technologies or processes, but only when other factors drive the decision to invest, particularly regulatory requirements or changes in market demand (Lempert, Papper, Resetar and Hart, 2002).

5.4

CHALLENGES FOR INDUSTRY

Despite the uncertainty surrounding the regulatory process, some companies have felt sufficient cause to adopt environmental goals aimed at reducing greenhouse gas emissions. There are any number of voluntary programmes within companies or run by non-governmental organizations aimed at understanding the mechanics of emissions trading. In some cases these programmes involve direct emissions trading programmes (such as Shell or BPs), in others it is by taking on a voluntary emissions reduction target (such as the programmes run by the Pew Center for Climate Change or Environmental Defense’s Partnership for Climate Action). Reasons for early action vary. Many companies have seen reduction targets as a way to improve their competitive edge in the face of anticipated regulatory action, in order to influence the design of domestic and international trading schemes, and/or to enhance their public image as environmental leaders (Margolick and Russel, 2001).

5.4.1 Industry experience in reducing greenhouse gas emissions Information is one of the keys to success in a carbon-constrained world. With the majority of OECD countries designing, implementing or conducting emissions trading schemes, it is likely that any medium to large company will come in contact with an emissions trading schemes. Indirect effects of emissions trading, such as increased electricity prices, will impact even larger segments of society. Additionally, as countries prepare for second and perhaps additional phases, there is a higher likelihood that participation will become broader as the targets become stricter. In order to maintain competitiveness, manage the risks and exploit any opportunities, companies must first know how, where and how much carbon they emit, that is compile an inventory. The primary driver behind inventorying emissions is generally a commitment either by a company (in the case of a voluntary programme) or by government (in the case of mandatory programmes). Without a clear commitment to reduce emissions, however, little progress on this front is likely. This section examines some of the topics that companies will have to address in preparation for emissions trading. It incorporates lessons learned by various companies in their commitment to reduce emissions, improve efficiency and learn more about emissions trading.

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Taking on a target requires establishing a baseline. Establishing a baseline requires knowing the emissions for the base year. Under the Kyoto Protocol, the base year for the majority of OECD countries is 1990.61 However, translating that to a company within a domestic emissions trading schemes can be difficult for two reasons. First, very few companies monitored greenhouse gas emissions in 1990 making an accurate historical baseline difficult. Second, without an historical baseline, a company must be able to establish a reliable estimate, but an estimate can introduce a high degree of uncertainty (The Partnership for Climate Action, March 2002). In addition, setting a baseline requires examining others factors that could influence or change emissions levels, including: &

The acquisition or divestiture of assets

&

Greenfield growth (new facilities)

&

Brownfield growth (existing facilities)

&

Decreased capacity or output

5.4.1.1

Baseline setting – BP

The BP internal trading programme is arguably one of the most wellknown corporate greenhouse gas trading schemes to date. Reasons for this include their prominence on this issue before many others in industry had taken a stance, and their success at meeting their target. It is also a prime example of the difficulties associated with setting and verifying a baseline; although as BP has shown these are not insurmountable challenges (see Box 5.1). In 1998, BP set a target to reduce its ‘direct equity share’ of greenhouse gas emissions (globally) by 10 per cent from its 1990 levels. The company intended to reach this target by 2010, including through the use of a trading scheme. Initially BP launched a trial trading scheme that ran from September 1998 to December 1999 covering 12 business units, and then expanded it globally throughout the entire company for 2000 and 2001. In designing its trading programme, BP established two baselines. An overall target was set using 1990 as the base year (a reduction of 10 per cent from 1990 levels), but 1998 was used as the starting point from which yearly reduction were assigned/allocations to business units were made. Its 1990 baseline was also altered when at the end of 1998, it merged with Amoco; the BP Amoco 1990 baseline was set at 78.7 million tonnes. BP continued to examine at what point changes in its portfolio would require changes to its baseline, and in 2000, BP readjusted its baseline to

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Box 5.1

BP’s auditing process

BP commissioned independent audits of its 1990 baseline and of its 1998, 2000, 2001 and 2002 data. The auditing process fulfils multiple functions including serving as a learning tool for other organizations as well as other parts of industry, ensuring credibility of its internal trading system, confirming that progress was made towards the stated target, and establishing credibility to internal and external stakeholders (PCA, BP web pages). It also helped BP refine their greenhouse gas monitoring and verification process by providing input on how it could improve its data collection. From 1998 Audit Opinion by DNV, KPMG and ICF on BPs 1990 baseline and 1998 data: 1990 Group baseline A key problem is the difficulty in estimating emissions for 1990 based on retrospective information. This arises not only from a lack of systems for data measurement and collection at that time, but also from changing operational and ownership status. Whilst improvements in the overall quality of the data could be made, there remains significant uncertainty in respect of the 1990 Group baseline. Source: Compiled by author from information on BP website.

account for the acquisition of ARCO. The new 1990 baseline was set at 90.1 million tonnes. In its ‘Climate Change: Our performance in 2001’, BP states that the process of establishing a baseline provided them with a ‘greater understanding of the significant uncertainties in the baseline data and the difficulty of producing an accurate inventory based on historical estimates of emissions’. As a result of its activities, BP reduced their emissions from 90.1 to 80.5 million tonnes by 2001. This represented a 10.6 per cent decrease from its baseline emissions that were met well ahead of the projected target date of 2010. In 2002, BP UK joined the UK emissions trading scheme, and while also participating in other voluntary programmes.

5.4.1.2 Allocation and project timing – The Shell Group Similarly, Royal Dutch/Shell Group of Companies took on a commitment to reduce its emissions 10 per cent by 2002 relative to its 1990 levels. Shell also instituted an internal emissions trading system, the Shell Tradable Emissions Permit System (STEPS), to help meet this target. Shell set a reduction target of 2 per cent of its emissions relative to the base year, over

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the lifetime of the programme. STEPS ran for three years, from the beginning of 2000 through the end of 2002, and covered CO2 and methane. Participation in STEPS was open to Shell companies operating in Annex I countries, on a voluntary basis. As with the BP system, allocations (and the reduction target) were based on actual historical emissions from 1998. The method of allocation was based on ‘grandfathering’ (i.e. based on a percentage of the participants share of emissions from that year). Allowances were allocated prior to the start-up of the programme, with one allowance equal to the right to emit 100 tonnes of CO2 equivalent annually. Allowances were assigned for a particular (vintage) year, with a small portion of allowances withheld each year. In designing STEPS, Shell included the ability to adjust overall and individual caps, which occurred when it became apparent that limited participation made the target unrealistic within the short timeframe. This created a complex allocation process that created uncertainty and hindered the liquidity of the internal market. The limited timeframe also made it difficult for companies to implement projects that would help reduce emissions during STEPS (and thereby enable Shell companies to meet their target without relying solely on ‘purchasing’ allowances on their internal market). The primary reason for this is the length of time required from the planning to construction phase, particularly for large projects (at least three years). This was further complicated by the need for construction to occur simultaneously with scheduled shutdowns of the company’s facilities. These shutdowns typically occur on a three to four year basis. Timing became a key issue since the decision-making process prior to project implementation can be time consuming. This meant that for facilities with a scheduled shut down in the first year of STEPS, there was no opportunity to implement a project and only limited opportunity during the second year. In the third year there was likely to be more opportunity but little incentive since there were no remaining years in which allowances could be traded. See Figures 5.3 and 5.4 for large and small project timelines. Fuel switching project: oil to gas in large refinery potential for 10% emissions saving at site Design, Tender, award Construction, costing, final contract, order testing, start-up Internal phase, phased with approval, equipment evaluation and planning shutdown schedule approval

2005

2006

2007

Figure 5.3 Timeline for large projects

2008

2009

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Equipment upgrade: furnace air pre-heater potential for 1 to 2% emissions reduction at site

Internal evaluation and Design approval

2005

Construction, Tender, award testing, start-up contract, order phase, phased with shutdown schedule equipment

2006

2007

2008

2009

Figure 5.4 Timeline for small projects

5.4.1.3 Planning process – DuPont For DuPont, a chemical manufacturer operating in 70 countries, the first step in investing in projects to reduce greenhouse gas emissions was setting corporate environmental goals that could be integrated into its environmental management system.62 DuPont uses a corporate environmental planning database that tracks greenhouse gas emissions and energy-use data from its business units. The database tracks emissions from internal energy generation, CO2 from both external sources (energy consumption) and internal processes (process reaction chemistry), nitrous oxide from adipic acid and nitric acid manufacturing and fluorocarbons from fluorocarbon manufacturing. In 1991, DuPont set two greenhouse gas emission reduction goals; the first was to reduce 1990 level emissions 40 per cent by the year 2000 from direct and indirect emissions and the second was to reduce global energy use per pound of production by 15 per cent compared to 1991 levels. DuPont began inventorying major sources of its greenhouse gas emissions; business units and sites responsible for the emissions were also identified through this process. Following the inventory process, business units were given the ability to decide the best course for reducing their emissions. Projects were identified and information entered into the database. As part of the process of identifying the most efficient projects (in terms of reduction and cost), units are required to develop forecasts covering a three to five-year period of specific reduction projects including data on all costs. Projects are then ranked according to ‘greatest benefit’ the most reductions at least cost or best savings. DuPont then implements the most efficient projects, enabling it to ‘achieve 80% of potential reductions for 20% of the cost of all the process projects’. The first projects were implemented in the late 1990s. In 1999, DuPont took on more stringent targets: to reduce greenhouse gas emissions 65 per cent compared to 1990 levels and to hold energy use flat at 1990 levels. In addition to taking on a stricter target in 1999, DuPont also took on a pledge to supply 10 per cent of its energy needs from renewables by 2010.

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A key feature of this pledge was to purchase energy from renewable sources that would be cost competitive with best available energy alternatives derived from fossil fuels. In 2003, 2 per cent of its global energy supply was derived from renewables. It expects to increase this to 5 per cent in 2005 and 10 per cent in 2010. DuPont is also a member of the World Resources Institutes Green Power Market Development Group whose aim is to develop 1000 MW of green energy by 2010. In 2000, DuPont had reduced its emissions by 63 per cent from 1990 level, a reduction of 56.2 million tonnes of CO2 equivalent. It met its reduction target the following year, nine years ahead of schedule. DuPont estimates that if it had been part of a trading scheme (with a 10 per cent reduction target from 1990 levels, and with allowances trading at US$10) the potential market value of their reductions as of 2000, would have been US$472 million per year. Dupont also estimates that in meeting their energy consumption target (which was met through energy efficiency measures) that in 2000 it avoided consumption of 16.2 million barrels of crude oil (at an estimate cost savings of US$325 million). In 2003, global energy use was 9 per cent below 1990 levels, with an estimated cost savings of US$2 billion. An important follow-on step to the planning process is monitoring progress. Dupont does this in two ways. The first is through meetings of the DuPont environmental policy committee and the sustainable growth leadership council; and the second is a review (on a two-year cycle) between the general manager of each business unit and the vice president of Safety, Health and Environment. Dupont has found that creating a sense of ownership and accountability among the business heads has been a key part of their success in meeting reduction targets.

5.4.2

Influencing change

Instituting the processes necessary for trading is time consuming. Environmental goals have to be incorporated into the broader corporate goals. Commitment has to be made at a high level and flexibility has to be provided to those participating in making the reductions. In the case of international or domestic trading, it is the government that needs to set the target and clear rules for inventories, monitoring, reporting and tracking of trades. Policies need to be integrated so that companies are able to innovate and find the most cost-effective solutions. Longer-term goals need to be spelled out, as it is a time consuming process simply to get the inventory right. One of the major difficulties companies face is incorporating greenhouse gas reduction goals into their planning process. Companies that have already done so are in a much better competitive position for entry into emissions trading markets than those who have yet to begin. As countries prepare for emissions trading schemes, a greater range of consultancy

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services is available to assist businesses in transitioning to a carbonconstrained economy, and new tools are being tested to assist companies in developing inventories. The function of these activities is to assist companies in understanding the link between their emissions and their business activities, and to place a price on the carbon that they will be required to reduce. Regardless of whether the focus is on managing risks, managing carbon, or developing an inventory, the process aims to create an understanding and acceptance of carbon as a commodity with financial, legal and competitive implications, and to provide the tools necessary to limit risks. Emissions trading schemes currently target mainly energy intensive industries and the power generation sector. However, the effects of a trading scheme will be felt beyond these sectors, particularly as governments prepare for subsequent and possibly more rigorous trading periods. Industry must examine how it can manage its risk exposure to a carbonconstrained world. For many companies, emissions trading schemes are likely to provide new opportunities in new market areas. But these will only become apparent once a company gains sufficient information on its carbon inventory. The process of conducting and verifying a greenhouse gas inventory therefore becomes a key source of information. It can be a bargaining point for emissions allocations or for positioning as a new entrant into a trading scheme. It can be a way to attract or keep investors, or to keep insurance rates in check. In other words carbon becomes an asset. As regional and domestic markets progress from the design phase, industry continues to face uncertainty and risk associated with the emissions trading schemes. EU member states are in the process of developing national allocation plans; other countries have yet to reach that stage. Although the design of an emissions trading scheme reduces the uncertainty industry faces, it is the interplay of a country’s policies, the allocation of allowances, the state of a country’s/companies inventory, and foreknowledge of the stringency of any follow-on trading periods that will reduce uncertainties even further. Clearly, policy makers must provide clarity on these issues. But industry in order to stay on top of developments must become proactive. Without a clear understanding of the issues (scientific, political and technical) industry may not fully appreciate their potential for reducing emissions and will be at a disadvantage as policy formulation for future periods occurs. Emissions trading is not likely to go a way and ultimately it is a more cost-efficient policy than direct regulatory policies aimed at achieving a reduction. Table 5.4 details the barriers discussed in this section as well as possible steps for reducing or removing the barriers, some of which will be discussed in the following section.

Uncertainty of country level commitment in the absence of Russian participation.

Uncertainty of stringency of second and subsequent trading periods.

Delays in delineating policy packages.

&

&

&

&

An information deficit exists both in terms of what climate change is and what it means to a company or investors assets.

Informational:

Uncertainty surrounding the entry into force of the Protocol.

Raise awareness of at all levels, create atmosphere of ownership in order to allow for innovation.

Reduce uncertainty.

Political:

&

Action needed

Barriers to action

2. Detail risks and opportunities related to carbon management.

1. Develop understanding of climate change.

3. Define emissions trading, developing and agreeing to an overall objective and approach.

1. Define the rules of the game including allocation plans, use of project based crediting programmes. 2. Decide on long-term climate policy.

Steps to be taken

Table 5.4 Managing carbon

Industry and financial sectors

Governments

Primary responsibility

145

&

Political uncertainties carry over to operation of markets by delaying investment decisions in new cleaner technologies; delaying in development of carbon management strategies and therefore delaying financial implications of carbon management.

Market Operational:

There is a lack of availability of climate strategies at all levels.

Financial services sector must develop carbon risk management tools.

Given the high likelihood that emissions trading schemes will be implemented between 2005 and 2008: Companies must monetize carbon as an asset.

2. Monitor progress and effectiveness in delivering objectives.

1. Develop overall implementation plan including reduction targets and measurement.

3. Prioritize ideas.

2. Develop ideas for reducing emissions cost effectively.

Industry and financial sectors

Industry and financial sectors

1. Establish a company-wide inventory of emissions assets and liabilities.

Develop and communicate strategies to public, financial investors and government.

Analytical:

&

Primary responsibility

Steps to be taken

Action needed

Barriers to action

Table 5.4 Continued

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5.5

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MANAGING RISK

Companies will have to assess the risks and opportunities that climate change policies pose, as well as determine the stage of policy development that may affect it. Companies will have to formulate a strategy. This could entail determining whether to take a wait and see attitude on the outcome of negotiations on trading schemes, of the fate of the Kyoto Protocol, and (for companies within the EU and other European countries) of allocation plans, lobbying government on how the structure of a trading scheme, methods for allocation and other design elements, or developing inventory and greenhouse gas reduction strategies in anticipation of planned emissions trading schemes. Company strategies are likely to vary depending on the country it is located in and the stage of policy development. Industry within the EU, for instance, will be affected by an emissions trading scheme beginning in 2005. The EU Directive on emissions trading specifies very explicit requirements that Member States must fulfil. If they do not, they risk infraction (noncompliance) proceeding under Article 226 of the EC Treaty. The main area for influence under the EU ETS is allocation of plans for the first and second trading periods, structure of the second period, percentage cap on usage of CERs and ERUs by an installation, etc. Member States on the other hand must turn the Directive into domestic law by 31 December 2003, submit NAPs by 31 March 2003 and have domestic trading schemes on-line by 1 January 2005. Companies in Norway are likely to have to do little that is new or additional to what they are currently doing given the relative ease of their trading scheme. Canadian companies will not be affected by trading schemes until 2008, but must begin reporting emissions in 2004. In setting out a strategy, companies must weigh the benefits of acting early (and potentially lowering compliance costs) against knowing or influencing the rules of the game (and facing potentially higher compliance costs), although companies can develop strategies that not only begin the inventory process, but attempt to influence the policy making process as well. The major risks, however, are time and cost. Developing strategies to manage risk exposure requires time. If the tactic chosen is to delay until more certainty exists, the lowest cost opportunities may have passed and companies could loose a competitive edge relative to those in its market that have already begun to implement their strategies.

5.5.1

Strategy development

For companies anticipating regulatory obligations in the period from 2005 to 2007, as well as 2008 to 2012, emissions trading will be one of the most effective risk management tools available. Regardless of when a company expects to enter a trading scheme, there are steps that will have to be taken

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prior to entry into the market. The first step is developing a strategy for entering into the carbon market (see Box 5.2). This entails understanding the larger implications of climate change. The impacts of climate change span a broad spectrum of sectors and activities, and in order to stabilize greenhouse gas emissions, it will require significant shifts in the way governments, businesses and individuals operate. National policies are likely to vary significantly from country to country. Companies operating in multiple jurisdictions may have to develop different greenhouse gas emission reduction strategies for different locations, since policy makers are not likely to treat policy interactions the same way. In the UK emissions trading scheme, voluntary participants receive an 80 per cent exemption from the Climate Change Levy whereas the Norwegian proposal for an emissions trading scheme would exempt industry covered by the current CO2 tax prior to 2008. In 2008, however, the tax would be replaced by the emissions trading scheme. Policies will reflect a range of national factors, including: abatement options available to the country as a whole, the energy intensity of the country, the energy mix, environmental policies and public opinion. Understanding the roles policies play in meeting targets set by government and the options open to companies for meeting any regulatory requirements imposed by government are all necessary elements in developing a strategy. Different approaches have different cost implications, but it also requires establishing strategies that are unique to the circumstances of the company in the country it operates and based on the options open to it. A carbon management strategy serves multiple purposes. It identifies the risks and opportunities from a carbon-constrained economy, including ways in which emissions can be reduced and options for hedging carbon risk, such as emissions trading. It can be used as a way to gain stakeholder buy-in for new investment strategies. It can be used as a public relations tool to increase brand recognition as a socially conscious company. It is a method for defining a company’s carbon liabilities, and can help determine its marginal abatement costs for reducing greenhouse gas emissions. Finally, a key component of a carbon management strategy is an emissions inventory, a necessity for participating in any emissions trading scheme. For companies not currently affected by an emissions trading scheme, developing and implementing an emissions reduction strategy, including undertaking inventory and reporting procedures, can serve as a basis for which credit under a future compliance scheme could be granted. Uniform measurement and reporting requirements do not currently exist for corporate level emissions. At the international level, Annex I countries are required to report emissions to the Climate Convention but these are national top-down inventories based on estimates derived from economic data whereas national inventories required for domestic purposes (and in

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Box 5.2 The greenhouse gas protocol: A corporate accounting and reporting standard The GHG Protocol is a collaborative initiative between the World Business Council for Sustainable Development and the World Resources Institute. The initiative is designed to develop and promote an internationally recognized greenhouse gas accounting and reporting standard. In developing a strategy for carbon management, the GHG Protocol recommends adopting principles to ensure an inventory is as accurate, fair and credible as possible, and have developed five principles for strategy development. GHG accounting and reporting principles Relevance

Define boundaries that appropriately reflect the greenhouse gas emissions of the business and the decision-making needs of users. Boundaries are the substance and economic reality of the business not the legal form.

Completeness Account for all greenhouse gas emissions sources and activities within the chosen organizational and operational boundaries. Any specific exclusion should be stated and justified. Consistency

Allow meaningful comparison of emissions performance over time. Any changes to the basis of reporting should be clearly stated to enable continued valid comparison.

Transparency

Address all relevant issues in a factual and coherent manner, based on a clear audit trail. Important assumptions should be disclosed and appropriate references made of the calculation methodologies used.

Accuracy

Exercise due diligence to ensure that greenhouse gas calculations have the precision needed for their intended use, and provide reasonable assurance on the integrity of reported greenhouse gas information.

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Since carbon will be an asset/liability on companies’ books, it should be reported using existing financial accounting procedures whenever possible. Examining the degree of control and influence in the various operations can help identify the emissions that should be reported, that is, whether to report 100 per cent of emissions or an equity share of the emissions. In many cases, financial policies and practices will specify what is wholly controlled, jointly controlled or whether significant influence exists.

particular for emissions trading) will be aggregated bottom-up company level data. National inventories for the purposes of meeting Kyoto Protocol targets will also be based on estimates and will cover a much wider range of sources and activities than a company level inventory. Policy makers will implement measurement and monitoring procedures as part of the compliance measures for emissions trading, however, these will primarily focus on calculating emissions related to the trading scheme. Data from company level emissions monitoring could be used to control the quality of national inventories under the Protocol, but are not likely to be used to construct these inventories. Company level inventories are likely to be affected by the reporting process under the Convention and may use some of the same methodologies for calculating or estimating emissions as those contained in Annex I national inventory reporting guidelines. Familiarity with the Convention reporting guidelines such as the structure, and categories in Intergovernmental Panel on Climate Change (IPCC) reporting guidelines and good practice guidance is likely to be helpful in developing company level inventories. Once a company has a clear understanding of the regulatory landscape, it will need to examine how the activities and products within its boundaries influence emissions. System boundaries will need to be determined, taking into account both the operational and organizational structure of the company, its geographic locations, the activities that produce emissions and the sectors in which they occur. Under the EU ETS, an ‘operator’ is responsible for identifying the sources and gases emitted at an installation. An operator is defined as ‘any person who operates or controls an installation or, where this is provided for in national legislation, to whom decisive economic power over the technical function of the installation has been delegated’. This is similar to the GHG Protocol approach of determining the degree of control and influence in financial and policy decisions. It is also important to understand the impacts and potential interactions of different policies. In order to understand the full range of abatement options, a company must have a complete picture of its carbon liabilities. Identifying all direct and indirect sources required

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under domestic policy, and any other sources that the company deems relevant for internal purposes is critical (see Box 5.3). It is also necessary to determine the best method for developing inventories. Emissions can either be measured or estimated, and monitoring requirements are likely to require one or both methods. As mentioned previously, the EU ETS allows for the direct measurement of emissions, but estimates must also back up any calculations. One reason for requiring both methods is that estimations can be as efficient as measurement methods, depending on the greenhouse gas. For CO2 from fossil fuel combustion, emissions can be accurately estimated based on data input from the amount of fuel burned, the carbon content of the fuel, and the fraction of carbon in the fuel that is converted to CO2. This is generally as effective as direct measurement because the amount of CO2 emitted is directly proportional to the amount of carbon in the fuel. Once system boundaries have been determined and sources identified, companies will have to develop emissions inventories based on domestic requirements for reporting as well as methods for monitoring. Box 5.3 Examples of direct and indirect emissions within a system boundary Direct emissions

Indirect emissions

Activities that produce direct emissions include:

Indirect emissions are generally associated with the generation of imported or purchased electricity, heat or steam.

&

Production of electricity, heat or steam.

&

Development of industrial products, that is, cement, aluminium.

&

Transportation, that is, of materials, products, waste and employees.

&

Fugitive emissions, including leaks, methane emissions from coal mines, and methane leakages for gas transport.

Other sources include: business travel, transportation of products or waste.

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Box 5.4 Example of monitoring and reporting requirements under EU ETS Monitoring requirements for general combustion activities at installations with a rated thermal input exceeding 20 mw (except hazardous or municipal waste installations) with total annual emission  50 ktonnes: Boundaries for general combustion activities are to include emissions from all fuels combusted at the installation as well as emissions from scrubbing processes, that is, to remove SO2. All greenhouse gas emissions produced through fuel combustion at the installation must be accounted for regardless of whether heat or electricity is exported to other installations, likewise any emissions associated with heat or electricity imported into a station is not included within those installations boundaries, but is accounted for in the exporting installations boundaries. Sources of CO2 emissions from combustion installations and processes include: &

boilers

&

heaters

&

burners

&

turbines

&

engines

&

furnaces

&

incinerators

&

kilns

&

flares

&

ovens

&

dryers

&

scrubbers (process emissions)

&

any other equipment or machinery that uses fuel, excluding equipment or machinery with combustion engines that is used for transportation purposes

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Calculation of CO2 emissions for each activity is calculated by multiplying the energy content of each fuel used by an emission factor and an oxidation factor: CO2 emissions ¼ activity data



emission factor



oxidation factor

Where activity data is expressed as the net energy content of the fuel consumed during the reporting period and is calculated using the following formula: Energy content of fuel consumption [tj] ¼ fuel consumed [t or m3]  net calorific value of fuel [tj/t or tj/m3] EU recommended tiers for activity data:

Combustion (gaseous, liquid)

Tier 2a/2b

Tier 2a: Fuel consumption is metered without intermediate storage before combustion in the installation applying metering devices resulting in a maximum permissible uncertainty of less than 5.0 per cent for the metering process. Tier 2b: Fuel purchase metered applying metering devices resulting in a maximum permissible uncertainty of less than 4.5 per cent for the metering process. Fuel consumption is calculated using a mass balance approach based on the quantity of fuel purchased and the difference in the quantity held in stock over a period of time using the following formula: Fuel C ¼ Fuel P þ (Fuel S  Fuel E)  Fuel O Where: Fuel C: fuel combusted during the reporting period Fuel P: fuel purchased during the reporting period Fuel S: fuel stock at the beginning of the reporting period Fuel E: fuel stock at the end of the reporting period

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Fuel O: fuel used for other purposes (transportation or re-sold) Combustion (solid)

Tier 1

Fuel consumption is metered without intermediate storage before combustion in the installation resulting in a maximum permissible uncertainty of less than 7.5 per cent for the metering process.

Flares

Tier 2

See above

Scrubbing: carbonate and gypsum

Tier 1

See above

Source: Commission Decision of 29/01/2004.

Understanding domestic regulations is important since it affects how inventories are developed and reported. Under the EU ETS, for example, the monitoring and reporting requirements specify the use of a tier approach for determining activity data, emissions factors and conversion factors (see Box 5.4).63 The tiers correspond to levels of accuracy with tier 1 approaches being the most accurate. In cases where the recommended approach is not technically or economically feasible, operators will have to justify reasons for using less accurate approaches. During the first trading period, Member States are to ensure that operators use at least the tiers specified for various categories of sources in the guidelines. Monitoring reports are verified by an independent third party, similar to the Expert Review Team process under the Protocol compliance process. The verification process examines the reliability and credibility of the information, and determines whether it is free of any material misstatement. If a verifier finds that the report contains errors or other problems the Member State where the installation is located will be unable to transfer allowances. A verifier has to find a report to be satisfactory before the installation is able to resume transfering allowances. In addition to being a prerequisite for trading, an inventory will provide an understanding of where the installations emissions levels are, (1) relative to any reduction target and (2) relative to any future emissions projections. This should help identify the amount of reductions required or the amount of emissions reductions that could potentially be sold if emissions are below target. Companies will need to identify potential emissions reduction projects in the value chain, and prioritize them by cost and benefit, that is, the greatest emissions reductions for the least amount of money, in order to determine the most efficient way in which to meet their

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190 170 150 130 110 90 70 50 1990

1998

1999

2000

2003

2008

155

2012

Company Zeta: 8% reduction from 1990 levels. Estimated emissions in 1990 100mt/CO2.

Company Zeta is located in an Annex B Party that has set a reduction target of 8 per cent from 1990 levels. The Party has implemented an emissions trading scheme beginning in 2005, with two trading periods (2005 to 2007 and 2008 to 2012). The baseline chosen for companies in existence prior to 2000 is the average annual emissions from 1998 to 2000. Baseline emissions for Company Zeta are 117 tonnes of CO2. Emissions are projected to increase from 2003 levels (120 tonnes of CO2) by 5 per cent through 2012 for a total of 126 tonnes of CO2. The company anticipates that it will have to reduce emissions some 8 per cent by 2012. Its intermediate target (2007) requires the company to hold sufficient allowances to cover a reduction target of 112 tonnes of CO2. Emissions reduction options

Through its inventory process, Company Zeta has determined it can meet half of its reduction target through energy efficiency measures and equipment upgrades. In addition, it has invested in a CDM project that should begin generating CERs in mid-2005. It expects to receive CERs that will cover 20 tonnes of its shortfall, but it will purchase the remaining reductions in the carbon market. 100% 80% 60% 40% 20% 0% Company Zeta Energy Efficiency Investments Purchase on Market

Equipment Upgrades CERs

Figure 5.5 Target setting

commitment (see Figure 5.5). Projects with a marginal cost well above any public allowance price could be placed on the back burner until such a time as the economics of the project make it feasible to implement. It is also critical to understand the options available through domestic and international emissions trading schemes, including using other trading mechanisms such as the CDM and renewable energy certificates (or other renewables programmes).

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5.5.1.1

Entering the market

Once companies have assessed their carbon liability under a trading scheme, they will have to define a strategy for entering the carbon market. If a company’s emissions are above its target a company generally has three options: reduce emissions, purchase extra allowances, and/or invest in or purchase project-based credits such as CERs. If emissions are below the target, options include banking allowances for future use when prices may be higher or selling excess allowances. See Figure 5.6. Reduction/market strategies are likely to take a short-term perspective given that targets currently exist only through 2012. Decisions will be dependent on the cost of abatement versus the cost of allowances or credits on the market, and will have to incorporate the risks associated with the various options available. Companies will also need to identify a broad range of activities that will enable them to comply with requirements and reduce risks of non-compliance in the event that a particular activity produces lower than expected emission reductions. Non-compliance also possesses a risk to reputation since the legal authority for ETS are likely to make available the results of compliance periods. A broadly defined strategy will also help compensate for any increase or decrease in prices or demand for allowances. The ability to reduce emissions will be influenced by the cost of allowances as well as the cost of electricity and primary fuels. If a company anticipates that the price of electricity or primary fuels is likely to increase in the future, it may hedge against this risk by securing the commodity at a fixed price now for delivery at a future date by entering a future’s exchange trading electricity or primary fuels. Another option is to bundle commodities, such as allowances with primary fuels. Under the US SO2 programme, for example, high sulphur coal producers sell coal along with SO2 allowances in order to remain competitive with low sulphur coal (CO2e.com). Some companies have also begun creating carbon neutral products in which they purchase emissions reductions to offset emissions related to a particular activity, that is, conference organizers who offset conference emissions through purchase of emissions reductions on the retail market or companies that purchase reductions to offset business travel. Carbon neutral products are becoming a marketing tool that can be used to offset any potential risk to reputation. Banking is also likely to be an important part of any strategy.64 Banking provides an incentive for early reductions to offset an expected increase in emissions during future compliance years or to help meet a target at a time when the commitments become more stringent. In the US SO2 programmes, banking provided significant incentive for early reductions by utilities in the first phase of trading, in which affected sources were able to reduce emissions below their allocations (see Figure 5.7). In 2000, the first year of Phase II in which more stringent reduction targets are set, 11.62 million allowances were carried forward from previous years. The bank of

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Are GHG emissions above target? no

Excess permits. Could emissions be above in the future?

yes

no Sell. Seek best possible price: national, international, spot, futures...

yes Are permit prices higher no than projected marginal abatement cost?

Bank excess emission permits to offset future increase in emissions

yes Sell. Retain part of revenues for future abatement

Can existing units deliver same amount of power with lower emissions? – dual firing capacity – shifting load towards less carbon-intensive units

yes Assess marginal cost of reductions needed to bring emissions down to target

Buy emission permits and/or temporarily reduce output

Is the cost higher than market price of permits?

yes Marginal cost at target > price Reduce emissions until margian cost reaches market price Buy permits to cover emissions above target

no

no

Marginal cost at target < price Reduce emissions until marginal cost reaches market price and generate excess reductions

Figure 5.6 A near-term decision tree Note: For clarity the tree is best read starting from the ‘yes’ branch of the first alternative; some of its elements should be, but are not, repeated in the ‘no’ alternative. ‘Buy’ and ‘sell’ refer to the acquisition of any valid form of emission permit, including emission permits generated from projects to reduce emission in other facilities/companies/countries. Source: R. Baron, # OECD/IEA 2001.

allowances is slowly being drawn down as companies use these allowances to meet their reduction commitments (see Figure 5.8). The ability to bank has been one of the features that have enabled the programme to maintain an almost 100 per cent compliance response. In 2002, for instance only one unit was short by 33 allowances. The allowances were deducted from 2003 allowances and included in the 2002 compliance year. In addition, the unit was assessed a penalty in excess of US$90,000.65 Project investment is also an option for generating additional credits for use with compliance. The flexibility this option provides is dependent on the domestic ETS. For companies participating in the EU ETS, use of the credits

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Allowable Emissions (million tons)

25.0 Allowances allocated that year Unused allowances from previous year (Bank) Emissions from affected sources 16.6 15.0 13.5

20.0

15.0

21.6 19.9

18.8

11.7 10.0

8.7

5.0

0.0 1995

1996

1997

1998

1999

2000

2001

2002

Figure 5.7 So2 allowances banked, 1995 through 2002 Source: US EPA, 2003. 14 12 10 8 6 4 2 0 1996

1998

2000

2002

Banked allowances

Figure 5.8 Draw-down of banked allowances from SO2 programme Source: Adapted from US EPA, 2003.

from CDM and JI projects is subject to a percentage cap by installation that will be set by Member States in their National Allocation Plans. Once CDM project activities begin generating CERs, it will be possible to purchase them through a secondary market instead of investing directly in a project. A secondary market for CERs will reduce the risks associated with direct investment in a project, such as host country or CDM executive board approval, whether the project will generate emission reductions as projected or the like. An additional advantage of purchasing CERs is that once they have been issued by the CDM executive board, they cannot be rescinded, and can be traded until they are cancelled in a national registry (or in the CDM registry if they are retired for the benefit of the environment and not for compliance purposes).

CHAPTER 6

Programmes Targeting Project-based Mechanisms Joint Implementation (JI) and the Clean Development Mechanism (CDM) have been looked upon with a great deal of interest and speculation since the adoption of the Kyoto Protocol. Prior to the adoption of the Marrakech Accords potential CDM and JI projects were in development, but the risks associated with those projects were very high – in part because rules governing the projects were not yet defined. It has also been difficult to assess the level of risk associated with investing in a project since it has been unclear how these two Kyoto Protocol mechanisms would interact with domestic emissions trading schemes. The Protocol provides for projects starting in the year 2000 to be eligible for both mechanisms, and the Marrakech Accords provided for the prompt start of the CDM. The CDM is up and running and there are governing bodies that can improve the rules as the system evolves. The rules for JI projects, however, are incomplete and the governing bodies will not be established until after the Protocol enters into force. Through 2003, the carbon market for project-based reduction units remained small in terms of potential buyers. There are at least two reasons for this. First, very few investor countries had set up CDM and JI programmes, and rules for inclusion of project-based credits into emissions trading schemes had been unclear. Without clear rules and an understanding of how project-based credits can enter an emissions trading schemes, the risks associated with developing projects and/or purchasing credits were high. This is particularly true for JI where entry into force of the Protocol is more of a necessity than for the CDM. Second-track JI in particular is dependent on not only entry into force of the Protocol, but the ability of Parties to agree on the establishment of the supervisory committee.66 Until then, JI projects are being developed in conformity with the CDM 159

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rules, which may alleviate some risk, but ultimately it is difficult to prejudge whether the supervisory committee will adopt the entire body of work developed by the CDM executive board. Prior to the prompt start of the CDM, JI seemed a much less risky investment course than the CDM. Since ERUs are part of the assigned amount, investors seemed to feel there was more certainty in developing a JI project and tying the transfer of early streams (prior to 2008) of emission reductions (ERs) to AAUs instead of ERUs. As uncertainty over the fate of the Protocol continued, this began to change. But the distinction between an AAU and an ERU is somewhat arbitrary. Prior to 2004, AAUs were perceived to be a more certain currency (or harder currency) than ERUs. But the creation of AAUs and ERUs require that the same rules be met. In April 2004, the EU linking Directive sent a clear signal that CERs are a viable currency by enabling their use in the EU ETS from 2005. The Linking Directive is also likely to renew interest in purchasing ERUs since they can be used beginning in 2008.67 For the CDM, which is already up and running this is likely to mean even greater interest in investing in potential CDM project activities. Despite uncertainties, purchasing programmes were set up by governments and intergovernmental organizations as early as 2000. More recently, industry, non-governmental organizations and financial institutions have become increasingly involved in CDM and JI project development and finance. In the closing months of 2003, at least three private and private/public funds and organizations were announced or launched, for example, the private sector Spanish Carbon fund, the private/public sector lending facility for India, and the Climate Investment Partnership which aims to provide debt, equity, credit guarantees and delivery insurances for greenhouse gas reduction projects. See Table 6.1 for a partial list of programmes and funds aimed at JI and CDM projects.

6.1

CDM DEVELOPMENTS

The CDM experienced significant growth in 2003 as the CDM executive board began the process of accrediting operational entities and approving methodologies. Baseline development is the most critical element under the CDM and JI. It is the basis upon which CERs and ERUs are measured and issued. The baseline and additionality tests have been open to interpretation by third party auditors (potential operational and independent entities under the two project-based mechanisms) verifying projects under various

161

Table 6.1 Partial list of CDM and JI programmes Country/programme

Description

Size

The World Bank carbon funds

JI and CDM projects

US$380 million (target)

Multilateral public and private sector funding The Netherlands – ERUPT, JI and CDM projects CERUPT and CDM programmes

Over D 113 per year

Governmental purchasing programme Austria

CDM and JI

D 72 million

CDM and JI

D 25 – 50 million

JI and CDM small-scale projects

D 20 million

Denmark

CDM and JI projects

D 27 million

Governmental purchasing programme

50% to international funds, 50% to Danish run portfolio. At least half going to purchasing CERs.

Italian Carbon Fund

CDM and JI

Governmental purchasing programme Germany KfW Public/private purchasing programme Finland Governmental purchasing programme

Governmental purchasing programme

$20 million

162

Table 6.1 Continued Asian Development Bank CDM Facility

Assist non-Annex I members in locating CDM investors and meeting CDM rules.

(three year pilot phase)

Japanese Carbon Funds

CDM and JI

D 31.3 million and D 23.5 million

Lending Facility for project preparation activities (developing PDDs) for the CDM. CERs will be marketed in Canada.

CN$300,000

Greenhouse Gas-Credit Aggregation Pool (buyers pool)

Buyers can purchase high quality ERs from Canadian projects as well as CDM and JI projects.

US$200 million

Private Sector: Natsource

The Pool expects to target projects that will deliver high volume, forward streams of projectbased reductions (operational in early 2004), contracting from 30 to 50 million tonnes of GHG reductions.

Japan Bank for international Cooperation and Development Bank of Japan CDM Project Development Facility in India

Private/public: Natsource and the Canadian CDM/JI Office

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163

Table 6.1 Continued Spanish Carbon Fund

Targeted towards public and private sector entities with greenhouse gas reduction commitments under the Kyoto Protocol and the EU Emmissions Trading Scheme (ETS). The fund will target projects that reduce greenhouse gas emissions in line with CDM and JI requirements. Investors will receive reduction units that can be used under the Protocol system and the EU ETS.

Private Sector: CO2e.com and CO2 Spain Source: Point Carbon CDM Monitor, 6 November 2004; CO2e.com; Natsource.

purchasing programmes (and in the absence of complete rules), but the CDM executive board has sought to codify the methods for developing and assessing these critical elements of the project-based mechanisms. Approximately 50 methodologies were submitted to the CDM executive board in 2003. The CDM executive board approved 17 methodologies covering a range of large-scale activities by March 2004. This brought the total to 29 methodologies approved for use by project developers, including methodologies for small-scale activities adopted at COP 8 in 2002. The executive board rejected 10 methodologies and the remainder where either pending review or pending changes before resubmission to the methodology panel. Methodologies for small-scale projects include standardized baselines. The purpose of these is to help reduce transaction costs for projects that meet the small-scale definitions.68 Each methodology covers baseline development and monitoring requirements for a particular project type. In applying a methodology to baseline development, different elements specific to the project type and

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the area where the project is located will have to be taken into account. The development of a body of monitoring and baseline methodologies is likely to have an impact on how JI projects are structured. Because methodologies are adaptable to different host country circumstances, JI project developers are likely to use them (or adapt them for use) in developing JI projects. While it will not ensure verification under second track JI it is likely to increase the probability of verification since the JI supervisory committee will have to take into consideration the work done by the CDM executive board in determining further guidance to project developers. Baseline methodologies are indirectly related to a project’s emissions additionality. Using an approved baseline methodology does not automatically confer additionality on the projects’ ERs. But in developing a methodology, the developer must state how through the application of the methodology, the additionality of the emissions reduced can be determined. The CDM and JI rules require that the ERs of project activities be additional to what would have occurred in the absence of the registered CDM project activity, that is, project developers must examine what would have happened in the region the project is located and try to determine, within reason, what would have happened if the project were not implemented.71 In some cases, the answer may be easy; in others it may require development of a baseline scenario. Table 6.2 shows two examples of the varying degree of difficulty in assessing additionality under the CDM. In some cases it will be straightforward, based on one element such as specifications listed in a contract, in others it can only be assessed through the development of a baseline. The executive board began accrediting operational entities in early 2004. Accredited operational entities will gain experience in validating project activities according to the CDM rules and with the guidance of the CDM executive board. The first CDM project activities are likely to be registered in 2004. This process may affect the way JI projects are shaped since they must meet similar criteria. In addition, many purchasing programmes require some form of verification in line with the CDM process for JI projects. As operational entities and project developers gain experience with the validation and verification processes under the CDM, it is likely to help development of baselines and assessment of additionality under the second-track JI process. Under the second track system JI projects are likely to go through a similar review process to that under the CDM (see Table 6.3 for comparison of CDM and JI). In the absence of detailed rules for JI projects and the JI supervisory committee, CDM guidance on a range of issues is likely to influence the development of JI projects, as well as how third parties undertake verification procedures.

165

Table 6.2 Examples of methodologies for CDM projects Methodology

AM0002/ Version 169

Baseline Methodological Approach

‘Emissions from a technology that represents an economically attractive course of action, taking into account barriers to investment.’

Project requirements for using baseline methodology (Applicability)

This methodology is applicable to landfill gas capture and flaring project activities where: &

There exists a contractual agreement that makes the operator responsible for all aspects of the landfill design, construction, operation, maintenance and monitoring;

&

The contract was awarded through a competitive bidding process;

&

The contract stipulates the amount of landfill gas (expressed in cubic metres) to be collected and flared annually by the landfill operator;

&

The stipulated amount of landfill gas to be flared reflects performance among the top 20 per cent in the previous five years for landfills operating under similar social, economic, environmental and technological circumstances; and

&

No generation of electricity using captured landfill gas occurs or is planned.

It is assumed that the amount of landfill gas to be collected and flared under the terms of the contract meets or exceeds any regulatory requirements. The landfill is also assumed to meet all other environmental regulations and conditions of its operating permit. The Designated Operational Entity verifying the emission reductions achieved will need to check whether there have been

166

Table 6.2 Continued changes to environmental regulations that become effective during the crediting period and that increase the required amount of landfill gas flaring. In the event of such changes to environmental regulations, the baseline will need to be adjusted appropriately. Applicability

This monitoring methodology can be used for project activities that reduce greenhouse gas emissions through Landfill Gas Capture and Flaring where the Baseline is established by a Public Concession Contract.

Additionality treatment within the methodology (How application of methodology will determine additionality in the baseline scenario)

If the actual quantity of methane flared is greater than the baseline quantity flared, the project activity is additional. The emissions reductions will be zero if the project activity is not additional. Since the baseline quantity flared is determined by the contractual requirement, which is established through a competitive bidding process the baseline reflects what would occur in the absence of the project activity. The project activity should also state whether there are any other additional economic considerations to be taken into account (e.g. such as additional costs relating to the project activity or that no additional revenues are expected).

Methodology

AM0004/Version 170

Methodological approach

‘Emissions from a technology that represents an economically attractive course of action, taking into account barriers to investment.’

167

Table 6.2 Continued Applicability

Additionality treatment within the methodology (How application of methodology will determine additionality in the baseline scenario)

This methodology is applicable to biomass-fired power generation project activities displacing grid electricity that: &

Use biomass that would otherwise be dumped or burned in an uncontrolled manner;

&

Have access to an abundant supply of biomass that is unutilized and is too dispersed to be used for grid electricity generation under business as usual (BAU);

&

Have a negligible impact on plans for construction of new power plants;

&

Not be connected to a grid with suppressed demand;

&

Have a negligible impact on the average grid emissions factor; and

&

Where the grid average carbon emission factor (CEF) is lower (and therefore more conservative as the baseline) than the CEF of the most likely operating margin candidate.

Additionality is established using paragraph 48(b) of the CDM modalities and procedures. The methodology first determines whether the project is plausible as a BAU project (Step 1). Then determines what will happen in the absence of the project – the baseline scenario – in Step 2. If any of the questions posed in the following steps are answered with a no, this methodology is not applicable, and another methodology shall be applied to the proposed project activity.

168

Table 6.2 Continued Step 1: Is the project different from BAU? Some grid-connected biomass power generation projects are implemented as BAU and so may constitute the baseline. However, many projects do not materialize due to the presence of barriers. This step ascertains whether any of the following barriers exist for the proposed project activity: (a) Investment barrier (b) Technological barrier (c) Barrier due to prevailing practice (d) Other barriers Examples of barriers typically faced by gridconnected biomass power generation projects include: (a) Investment barriers &

Return on equity is too low compared to conventional projects;

&

Real and/or perceived risk associated with the unfamiliar technology or process is too high to attract investment;

&

Funding is not available for innovative projects.

(b) Technological barriers &

The project represents one of the first applications of the technology in the country, leading to technological concerns even when the technology is proven in other countries;

&

Skilled and/or properly trained labour to operate and maintain the technology is not available, leading to equipment disrepair and malfunctioning.

169

Table 6.2 Continued (c) Barriers due to prevailing practice &

There is a lack of will to change the current biomass disposal practice with or without regulations. If so, indicate how the biomass used for power generation by the project would be used in the baseline scenario;

&

Developers lack familiarity with stateof-the-art technologies and are reluctant to use them.

(d) Other barriers &

Management lacks experience using stateof-the-art technologies, so such projects require too much management time and receive low priority by management;

&

The local community may fail to see the environmental benefits of biomass power generation and so may oppose the project;

&

Experience and/or procedures for collecting the biomass from dispersed sources may be lacking.

Step 2: Determine the appropriate CO2 emission actor for electricity supplied to the grid First, determine whether the project activity will displace the electricity supply from the operating margin or the build margin. The operating margin usually is more relevant for grid-connected biomass generating units even if the demand for electricity is growing rapidly because: &

The relatively small size of the biomass power generation project means that it has little impact on plans for constructing major new power stations;

&

Due to the priority accorded to renewable energy sources by the energy sources by the

170

Table 6.2 Continued energy policies of many host countries and the small size of the biomass project, the project is unlikely to cause the cancellation of another planned renewable energy plant of similar size (build margin displacement). They will both be built. If the proposed project activity is located in a country/region with suppressed demand, the project participants may use a CO2 emission factor based on the ‘build margin’. Then calculate the appropriate CO2 emission factor for the electricity supplied to the grid. Where particular units can be identified as the operating margin for the grid, the weighted average CO2 emission factor for those units is the factor for the operating margin. Where particular units cannot be identified as the operating margin for the grid, the grid average CO2 emission factor can be used. If both are available, use the lower of the grid average CO2 emission factor or the operating margin CO2 emission factor. The CO2 emission factor for the electricity supplied to the grid is calculated ex post each year to determine the emission reductions achieved. The project developer must indicate which plant(s) constitute the operating margin. This is done ex post so in the Project Design Document it is sufficient to demonstrate that accurate information will be available to calculate the operating margin and/or grid average emission factor for each year of the crediting period. The plant(s) that constitute the operating margin may change over the crediting period. Source: UNFCCC website. CDM Approved Methodologies.

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Table 6.3 Comparison of CDM and JI second-track requirements CDM

Second track JI

International governance

COP/MOP, but COP in interim

COP/MOP

International day-to-day supervision

CDM executive board

JI supervisory committee

Independent auditors

Designated Operational Entities

Independent entities

Domestic

Designated National Authorities

Focal points

Requirements for review prior to recognition as a project activity

DOEs to validate projects against CDM rules

Independent entities verify project meets JI rules

Registration

Yes

No

Monitoring

Yes

Yes

Verification of emissions reduced or sequestered

Emissions verified andcertifiedbyDOEs

Emissions verified by independent entities

Issuance of reduction units

CERs issued by executive board in accordance with certification report

ERUs issued by host country

Institutional requirements

6.2 COSTS AND RISKS ASSOCIATED WITH PROJECT-BASED CREDITS Compared to cap and trade systems, project-based credit trading entails higher transaction costs, and a range of risks peculiar to CDM and JI projects. CDM projects for instance must develop baselines, and if no applicable methodology is available, they must first develop the methodology. Two Designated Opernational Entities (DOEs) must be contracted (except for small-scale project

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activities) for validation and for certification, PDDs must be prepared, a process for stakeholder input has to be developed and carried out, the project must pay a levy called the share of proceeds which is a two part tax based on the emissions a project is expected to reduce. Additionally, project developers must seek host country approval and meet any additional requirements that the host country sets, such as sustainable development criteria. CDM projects, however, do provide an additional source of income for up to 21 years for emission reduction projects and 60 years for reforestation and afforestation projects. ERUs on the other hand are tied to a host country’s assigned amount and require that additional commitment periods exist if transactions of ERUs are to continue beyond the five-year period from 2008–2012. While the emissions reduced or sequestered by projects can provide a future source of investment, their value is highly dependent on prices in the carbon market. In 2003, market prices were set by buyers, with the majority of emission reduction purchasing agreements setting prices between D 2.5 and 5.5 per tonne of CO2 equivalent. Transaction costs (both actual costs and time lost for preparation) for projects can be substantial compared to expected revenue streams from credits.72 Large projects are better able to absorb these costs, where as they may be prohibitive to developing smallscale projects with expected low streams of CERs or ERUs (and low market prices).73 In cases where transaction costs are too high or the price of credits is very low, it will affect project feasibility. The market price of reduction units can have a significant impact on projects. If for instance transaction costs prior to CDM registration is estimated at D 50,000 a small-scale project would have to generate a minimum of 16,000 reduction units to cover these transaction costs, whereas if the market price were D 5 or D 10 per tonne of CO2 equivalent, they would have to generate a much lower minimum to cover these costs, 10,000 and 5000 units, respectively. Transaction costs associated with the operational phase of a project is dependent on the size of the project, and the monitoring requirements, including whether onsite checks are conducted, whether operational or independent entities are located within the same region as a project, and so on. A projects ability to absorb transaction costs is directly related to the price of reduction units on the market. Transaction costs for CDM projects (as well as JI projects, except the share of proceeds requirement) include the following: &

Feasibility study;

&

Negotiating with DNA for host country approval;

&

Document preparation related to the Project Design Document, including developing the baseline and monitoring plan;

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173

&

Validation of project by a DOE/verification by an Independent Entity;

&

Stakeholder input process;

&

Legal fees associated with negotiating contracts (emission reduction purchase agreements);

&

Administrative fees; and

&

Levy to the adaptation fund.

The share of proceeds: The CDM requires that a share of proceeds from project activities be paid to cover administrative costs and to fund an adaptation fund to assist develop country Parties that are particularly vulnerable to the effects of climate change. All projects must pay the administrative costs, but projects located in the least developed countries are exempt from the share of proceeds to the adaptation fund. The COP/MOP is charged with determining the level of the share of proceeds. At COP-7, the Parties set the level for the adaptation fund at 2 per cent of the CERs from the project activity. It did not set the administrative fee, but left it to the CDM executive board to determine the level, until the COP/MOP can determine what an appropriate level will be. The CDM executive board has set a registration fee that varies according to the amount of emissions the project is likely to reduce or sequester per year over the crediting lifetime of the project (see Table 6.4). In this way it differentiates between small- and large-scale projects, reducing at least some of the transaction costs of the smaller projects. Once a project is validated as a CDM project activity, then additional costs are incurred once it is operational. These include: &

Monitoring activities according to the approved monitoring plan and any additional monitoring required by the host country;

&

Verification of ERs including possible onsite inspections (this could occur yearly);

&

Brokerage fees if used.

6.2.1

Risks

The success of CDM and JI projects are dependent on mitigating the risks associated with undertaking a project activity. In 2003, purchasing

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Table 6.4 CDM initial registration fees Average tonnes of CO2 equivalent reductions per year over the crediting period (estimated/approved)

Registration fee US$

Less than 15,000

$5,000

Between 15,000 and 50,000

$10,000

Between 50,000 and 100,000

$15,000

Between 100,000 and 200,000

$20,000

More than 200,000

$30,000

Source: CDM Executive Board, 2003. Note:  The registration fee paid will be deducted from the share of proceeds for administration due at issuance of CERs. Project developers provide an estimation of emission reductions by the project activity in the PDD. The DOE confirms the estimation and includes in the validation opinion a statement that the project activity is likely to achieve the anticipated emission reductions. The registration fee is set according to the validation estimation.

programmes were the main drivers in the development of the carbon market, influencing the choice of projects developed and prices for CERs and ERUs. Since some of the larger purchasing programmes were up and running before international systems were fully functional, these programmes implemented risk reduction strategies in order to ensure that they are likely to see a return on their investment. One strategy employed was to require third party ‘validation’ of project’s prior implementation, another involves diversifying investments by type of projects (by mechanism and by project category) and geographic locations. The relative stability of host countries and the level of infrastructure and capacity also plays an important part in minimizing risks. Recently the private sector began developing financing mechanisms for CDM and JI projects to minimize the risks associated with non-delivery of product, including insurance products.

6.2.1.1 Project risks For CDM projects and particularly for second track JI projects, there is a risk that projects already generating emissions reductions before they are validated/verified could run the risk of loosing the early streams of credits. This is primarily due to the need for using ‘approved’ baseline and monitoring methodologies. If the methodologies and therefore the baseline

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175

scenario and monitoring plan require significant alteration, then it will affect the amount of credits the project will earn. Projects are highly dependent on approval by the host country. In instances where there is no clear point of contact, seeking approval can be an expensive and timely process since in many governments there are multiple ministries that may have an interest in approving a project. If a host country does not have a clear point of contact for project approval, then there is an added risk that once it has been established the project developer will have to seek approval from that authority if the previous approval is not recognized under the designated national authority. JI projects also face the added risk of when the Protocol enters into force and when the JI supervisory committee can be established. The regulatory structure of the country can also have an affect on a project. Project developers will need to ensure they are entitled under host country law to hold and transfer reduction units. This is a critical issue under the CDM where CERs are not derived from a cap. Some programmes have entered into agreements with host countries that make clear a project developer’s ability to hold and sell CERs. Projects developed prior to the start up of the CDM and JI face uncertainty in whether the projects meet the rules (and in the case of the CDM be registered as a CDM project activity). For JI this is further complicated by the need for the supervisory committee to be in place before the remaining rules can be established. Because participation in JI can occur in one of three ways (two of which result in transactions of ERUs), an additional risk to these projects is the ability of the host country to meet eligibility requirements for participation in the mechanisms. For this reason, JI projects have been developed using the CDM model, since it is more closely related to the JI second track system. It is also more likely that host countries will meet the minimum requirements for JI second track participation. Because emissions reductions are estimated prior to project implementation and actual emissions reduced are verified expost against the baseline, there is some risk that projects will not deliver the anticipated reduction units. Private sector initiatives such as the Climate Investment Partnership are developing insurance schemes against the risk of non-delivery. As mentioned, market price has a significant impact on projects, regardless of the long-term reductions anticipated by a project. Market prices will be sensitive to a number of issues including when Protocol trading requirements are met by countries, the price of CERs relative to ERUs, demand and policy development of buyer countries (whether and how many units can be brought into a domestic trading scheme).

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6.2.1.2 Mitigating risk Since the carbon market is in its infancy with no ERUs or CERs available for immediate purchase, the most common method for transacting reduction units and to reduce risks associated with these projects is through emissions reduction purchasing agreements. Standardized contracts are under development, but the various purchasing programmes base their contracts around similar terms. Until a secondary market develops, the majority of contracts are likely to be based on the ability to purchase forward streams of emissions reductions through an Emission Reduction Purchasing Agreement. The purpose of the agreement is to reduce the risks associated with these projects for both the buyer and the seller, and to ensure that the buyer is protected in the event that the seller will not or cannot meet the terms of the contract. ERPAs set out the following issues: &

The prices of the units. Since there have been few buyers, the large purchasing programmes have set the terms of the purchase price, as more investors enter the market it is likely to become more competitive within certain countries or regions. Within Africa, the majority of projects are located in southern Africa, and particularly in South Africa. In Asia there is a wider selection of countries although China and India have a large proportion of projects.

&

Estimation of reductions by project. The baseline is sometimes attached as an appendix. The estimation of reductions by the project is generally a conservative figure in order to ensure the sellers ability to deliver a sufficient number of reduction units. It is the basis for determining the number of units that will be purchased/sold.

&

Requirements for ensuring delivery of reduction units, such as monitoring requirements, carrying out the agreed monitoring plan, equipment maintenance, setting time schedule for verifying ERs and by whom.

&

Determining who takes responsibility for validation and registration of CDM project activities and verification of JI project activities, generally this is the seller’s responsibility. If the buyer assumes this responsibility there has generally been a corresponding drop in purchase price.

&

Determine procedures for additional ERs generated by the project. ERPAs set out how additional verified ERs are handled. For instance, some buyers may want a right of first refusal.

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177

&

Penalties for non-delivery or delivery that is short of the agreement. One method for ensuring delivery is to set aside a portion of the expected reduction units as a buffer against any shortfall in delivery. ERPAs contract for delivery on 80 per cent of expected reductions, with the remaining 20 per cent as a buffer on which the buyer has a right of first refusal.

&

Conditions for termination of the agreement.

&

In some cases, purchasing programmes will pay some of the up front costs associated with project development. If this is the case, then terms for this are specified in the ERPA.

The following section briefly examines three purchasing programmes. The first is the carbon funds run by the World Bank, the second and third are national purchasing programmes in which the return on investments will be used to comply with commitments under the Protocol.

6.3

THE WORLD BANK CARBON FINANCE

The World Bank became the first institution to specialize in carbon funds. Their first fund, the Prototype Carbon fund, is the largest and one of the most well known. The World Bank has also created two additional funds: one targeted at small-scale projects in rural poorer communities in developing countries and the other are sequestration projects in forests and agricultural ecosystems (see Table 6.5). In addition, it runs a project development facility for the Dutch Government.

6.3.1

The Prototype Carbon Fund

In 2000, the World Bank launched a fund aimed at developing carbon reduction and sequestration projects under the CDM and JI. The Prototype Carbon Fund (PCF) was designed to: produce high-quality ERs; gain experience, that is, learning by doing; and build public–private partnerships. Six governments and 17 private sector companies have provided a total of US$180 million to the PCF. In return, investors receive a pro rata share of the credits generated by the projects. The PCF is scheduled to terminate in 2012. By the close of 2003, the PCF had concluded 13 emission reduction purchase transactions totalling US$45.5 million and approximately 21million tonnes of CO2e. In 2003, the PCF also submitted methodologies to the CDM

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Table 6.5 Overview of World Bank carbon funds Fund

Targeted projects

Fund size

Status

The Prototype Carbon Fund

Any project that is likely to meet CDM and JI rules

US$180 million

Operational since 2000

The Community Development Carbon Fund

CDM small-scale projects in poorer rural areas in developing countries

US$100 million

Operational since 2003

The BioCarbon Fund

CDM and JI LULUCF projects

US$100 million

Expected to be operational by mid-2004

Source: World Bank, www.carbonfinance.org.

executive board as the first step in registration and validation of the project as a CDM project activity. The PCF Project Cycle was designed to mirror the then emerging rules under the international negotiations on the CDM and JI. PCF projects must undergo validation by independent third parties, and the ERs generated by projects are required to undergo ex post verification, creating an asset known as verified ERs. The PCF intends to bring projects in their portfolio into the CDM and JI systems; ultimately these projects are expected to generate CERs and ERUs rather than ERs. ERs can be traded, and there have been early trades in ERs (not associated with the PCF). Until the Protocol enters into force, domestic emissions trading schemes will have to recognize the validity of ERs within a scheme in order for it to become a tradable unit for compliance purposes. With entry into force of the Protocol, the PCF expects that ERs will be ‘transferred’ into corresponding Kyoto reduction units, with the CDM executive board issuing CERs and host countries issuing ERUs. It is unclear whether the PCF can expect to have all ERs transferred into CERs, since these projects (including the entire PDD package) are required to undergo additional scrutiny in the CDM process particularly in the area of baseline and monitoring methodologies. If the CDM executive board requires extensive changes to a methodology, it will likely impact on the estimation of ERs that a project will generate during its lifetime. This in turn could affect the stream of ERs or in this case CERs that a project activity is likely to earn. This is a problem that all institutional purchasers and project developers are likely

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to face in the first years of the CDM. The issue of transferring ERs into ERUs may be less complicated, particularly if the host country is in compliance with all participation requirements under the Protocol. The transferring ‘issue’ is also on two separate timelines. The CDM executive board has the ability to issue CERs as soon as ERs have been verified and certified, regardless of the status of Protocol. ERUs require entry into force of the Protocol, establishment of an inventory, an assigned amount, a national registry, and in some cases verification by the Article 6 supervisory committee.

6.3.1.1

PCF Project Cycle

In the run up to COP-7, the project cycle of the PCF provided more certainty than the CDM. Since the PCF was designed before the CDM rules were finalized, the World Bank created structures to fill in the gaps, in some cases anticipating decisions by negotiators. As the CDM and JI rules evolved, the PCF modified its structure, updating its requirements for legal documents, updating its project cycle and reducing transaction costs. It has also been in operation for sufficient time to develop a fairly accurate timeline (excluding time associated with the CDM Project Cycle) (see Table 6.6).

6.3.1.2

Reducing risks, creating assets

The PCF developed a series of legal documents to reduce risks associated with projects in their portfolio, and to help insure delivery of verified emissions reductions and their transfer into the appropriate Kyoto reduction unit. When fully met, these requirements reduce the regulatory and policy risks by establishing not only the commodity but also the terms and conditions for purchase and sale of the ERs. It makes clear that the project has host country approval, and sets out ownership of the ERs. (See Box 6.1). Generally, the PCF contracts directly with project developers, financing only the part of the project that can be considered ‘additional’. In 2002, the PCF reached agreements with the Development Bank of Southern Africa and the Infrastructure Development Finance Corporation of India in order to enable small- and medium-sized businesses to bundle smaller projects to help reduce costs and reduce the risks of purchasing ERs from smaller projects. PCF project requirements include: &

Projects are to be operational before 2008;

&

The host country must be a signatory to the UNFCCC and the Protocol. Once the Protocol has entered into force, they will be required to be a Party to it, and have met all Protocol requirements for participation;

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&

The PCF contribution to each project is to range from US$3 to 15 million (approximately between 2 per cent and 10 percent of the fund’s assets), directed at the portion of a project that is additional to business as usual;

&

The project should be replicable and/or facilitate technology transfer;

&

The cost for emissions reductions should be in the range of US$3 per tonne of CO2e; and

&

The project should result in improvements to the local environment and be consistent with the sustainable development priorities of the host country.

Table 6.6 PCF Project Cycle CDM Project Cycle

PCF Project Cycle

Timeline

Project Development

Preparation and review of the project

approximately 3 months

Baseline study and Monitoring and Verification Plan (MVP)

approximately 2 months

Validation process

approximately 2 months

Validation and registration under the CDM

unknown

Negotiation of project agreements

approximately 3 months

Construction and start up

approximately 1–3 years

Project monitoring

Periodic monitoring based on contract agreement

up to 21 years

Verification and Certification

Periodic verification and certification

up to 21 years

Validation and Registration

Issuance of CERs

up to 21 years Project completion

Source: Adapted from 2001 Annual Report, PCF.

10 to 21 years

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In addition to implementing various agreements ensuring proper operation, maintenance and deliver, the PCF employs several other tactics to reduce the risks to its portfolio. This includes ensuring a split between CDMand JI-type projects, geographical diversity and technological diversity.

Box 6.1 PCF legal instruments and relation to CDM and JI project cycles Letter of project endorsement or no objection: Once a project is identified, the PCF requires a general consent from the host country to develop the project as a CDM or JI project. Additional to CDM/JI requirements. Letter of intent: First step in negotiating an emission reductions purchase agreement. This document declares the intent of the owner of the emissions reductions (i.e. project developer or owner or host country) to sell them to the World Bank as trustee of the PCF; and the PCF’s intention to purchase the reductions generated by a specific project. Additional to CDM/JI requirements. Letter of approval: This letter provides formal approval of the project as a CDM or JI project by the host country, including confirmation that the project assists in meeting its sustainable development priorities. The Letter of approval is a prerequisite for signing an ERPA with the PCF. In order to meet CDM requirements this letter will have to be issued by a DNA or focal point and will need to state that its participation is voluntary. Emission reductions purchase agreement: This agreement details contractual arrangements between the seller of emissions reductions and the buyer, the PCF trustee. It also provides the PCF with all rights, title and interests in and to all or a part of the emission reductions or removals generated by the project. It also stipulates the purchase price, provides for payment upon delivery of the contracted amount and other provisions to ensure satisfactory implementation of the project. The CDM executive board will use agreements of this nature to determine to which accounts CERs will be issued. Host country agreement: For JI-type projects the PCF requires host country agreements. This agreement requires the host country to set aside a sufficient portion of its assigned amount to cover the emissions reductions generated by the project and purchased by the PCF, and to transfer the amount as soon as it is legally able to do so. It is not a specific requirement under JI, but is a legal necessity in ensuring delivery of ERUs. Source: Adapted from the 2002 Annual Report, PCF.

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The PCF strives to achieve a ratio of three renewable projects to two energy efficiency projects. In marketing their programme, the PCF claims to be pioneering ‘ER (credit) purchase transactions under the emerging rules of the CDM and JI, demonstrating how such transactions can lower the cost of compliance with the Kyoto Protocol, and sharing its practical experience with decision makers, host countries and market players.’ The PCF, as one of two major purchasers in today’s carbon market, is clearly one of the pioneers in this area. However, as the CDM and particularly JI, are still evolving, the PCF remains in a ‘learning-by-doing’ phase. As with all project developers, the PCF must comply with all rules and decisions taken by the CDM executive board, and as such some risk still remains attached to their projects and the expected stream of credits they are expected to generate. For instance, during the first round of CDM executive board approvals of baseline methodologies a PCF methodology was sent back for revisions before it could be approved. The PCF, however, was not alone since only one of 13 methodologies was approved in that round.74 This is indicative of the risk projects face as the CDM process moves from the design phase to implementation. The CDM rules are vague, with many interpretations possible. As the CDM matures, and the rules are tested, the process will become more certain. Until then, projects come under scrutiny in many areas, both practical issues such as whether a project is additional and meets all CDM requirements to more theoretical issues such as how ‘validation’ performed by organizations before the CDM technical details were concluded and particularly before any ‘operational entities’ have been accredited or designated under the CDM should be treated.

6.4

THE DUTCH PROGRAMMES

CDM and JI are central to the Dutch governments plan to reduce its greenhouse gas emissions by 6 per cent from 1990 levels. This target represents a reduction of 200 million tonnes of CO2 equivalent during the period from 2008 to 2012. The Dutch government intends on using CDM and JI to meet half of this reduction, the other half will be undertaken domestically. The Dutch have set up separate programmes for the two mechanisms; both programmes result in the acquisition of credits from projects that are selected by ‘intermediaries’ contracted by the Dutch government. The Dutch government does not participate in the projects; it merely provides the resources for purchasing ERUs and CERs. The JI programme is under the responsibility of the Ministry of Economic Affairs. The Ministry of Housing, Spatial Planning and the

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Environment (VROM) has been designated as the CDM DNA, and oversees its CDM programme. The Dutch government is also a participant in the PCF.

6.4.1

Joint implementation

Although the JI programme has scope for several intermediaries, during the first two and a half years, the Dutch have only established one contract. Terms of references for agreements with financial institutions have been developed but are not operational. For major features of the Dutch JI programme see Table 6.7. Features of the Dutch JI programme. Senter, a Dutch governmental agency running public procurement programmes, has been the primary organization contracted to purchase verified ERs from JI projects. Senter’s Emissions Reduction Unit Procurement Tender (ERUPT), resulted in four completed tenders by end of January 2004. Senter aims for a purchase price of between D 3 and D 5, however, purchases can be based on higher prices. During the first tender for instance some prices went as high as D 8.46 per tonne CO2 equivalent. The third tender resulted in an agreement to purchase 2.6 million tonnes of CO2 equivalent at an average price of D 5.5 per tonne, including agreement on a wind project located in New Zealand. As with the PCF, the Dutch government developed its programme in the absence of completed international rules. It has developed a governance system meant to be compatible with Article 6 modalities and procedures. The Dutch have put forward guidelines aimed at helping project developers put in place projects that they feel have a high likelihood of achieving credible ERs and its corresponding (and predictable) stream of ERUs.

6.4.1.1

ERUPT Project Cycle

Once Senter issues a tender, project developers submit Expressions of Interest (EoI). The EoI contains several components meant to show the developers are stable (financially, ethically and environmentally), have the ability to deliver ERUs, and have host country support. Another key component of the EoI is the Project Idea Note containing the estimated amount and cost of ERUs associated with the project. Projects are short listed, and developers invited to submit proposals for the contract-awarding phase. Proposals are submitted to Senter for assessment and contain, among other items, PDDs, host country letter of approval, a business plan, a validation report and an offer for a ‘claim on ERUs’ generated by the project. Projects

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Table 6.7 Features of the Dutch JI programme Budget

D 34 million per year

Programme description

The Dutch Ministry of Economic Affairs contracts intermediaries to run emission reduction purchasing programmes. Senter is the primary intermediary. The Netherlands also participates in the PCF.

Project path

Contracts stipulate a second track approach although a clause is provided that would allow use of JI first track in the event that both host and investor countries are in compliance with the Protocol.

Project categories

Projects reducing emissions of any of the six ghgs that are not derived from nuclear activities are eligible.

Country eligibility

All Annex I countries that ratify the Protocol, the Netherlands negotiates MOUs with host countries, but projects are required to be developed within these countries.

Purchase price

From D 3–5 per tonne CO2e

Transacted commodity

ERUs from emission reductions are generated during the commitment period. One credit (claim on ERUs, early credit) is equal to one tonne of CO2e.

Claim on ERUs

Developers sell ‘claims on ERUs’ which are similar to verified emission reductions currently traded on market.

Early credit

Projects can reduce emissions prior to the commitment period. These ‘early credits’ are transacted by transferring AAUs in a corresponding amount to the verified emission reductions, but can only be transferred during the first commitment period.

Credits

Credits or ERUs are transacted when the government exercises its right to the ‘claim on ERUs’ with the host country who is to transfer the appropriate amount of ERUs into the Dutch registry.

Failure of the Protocol

In the event the Protocol does not enter into force, the Dutch government will honour all contracts entered prior to that time and purchase all verified emission reductions.

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must be ‘validated’ by a firm accredited for such activities by the Dutch Board for Accreditation. Contracts are awarded on the basis of certainty of delivery and lowest credit price.

6.4.1.2

Credit acquisition

The Dutch approach to credit acquisition differs from the PCF. While PCF contracts focus on purchasing verified ERs and having the host country transfer an equivalent amount of ERUs, Senter contracts directly with the project developer for ‘claims on ERUs’ (see Box 6.2). The host country letter of approval that project developers are required to submit as part of its proposal contains reference to both ‘claims on ERUs’ and ERUs, but seems to make a direct link between the two. It is unclear how smoothly ERU transactions under the ERUPT programme will go since the transfers of

Box 6.2

Contractual requirements under ERUPT

Expression of interest: Components of the EoI are intended to show the developers are stable (financially, ethically and environmentally), have the ability to deliver ERUs, and have host country support. Key components of the EoI include: a Project Idea Note containing the estimated amount and cost of ERUs associated with the project; Letter of Endorsement by the host country showing it intends to approve the project and agree with the terms of the contract (i.e. it will allow the Dutch government to collect ERUs and AAUs). Proposal: Contracts are awarded on the basis of the proposal, with contracts going to those who are able to show they can deliver emissions reductions with a high degree of certainty and at a low cost. Key components of the proposal include: the PDD, the host country Letter of Approval, a business plan, a validation report by an independent entity and an impact assessment if required by national law. Letter of approval: The Letter of Approval is the key link between the project developer, Senter, the Dutch government and the host country. In it, the host country not only approves the project under JI, but agrees to comply with all participation requirements under the JI rules; transfer ERUs to the Dutch based on the ‘claim on ERUs’ agreement; transfer AAUs for any emission reductions generated prior to 2008; and if both countries are fully compliant with JI requirements, to trade under first track JI. Project developers are required to obtain the LoA, without assistance from the Dutch government, despite the majority of the letter containing national level requirements.

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ERUs cannot occur until the first commitment period has begun. ERUPT programme requirements include: &

Projects require pre-validation (prior to submission of proposal) and a final validation after contract is granted.

&

Projects must be registered (Note: It is unclear with whom this will occur since there are no international requirements for JI project registration).

&

Contracts are for delivery of ERUs during the 2008–2012 period.

&

Senter makes payments on delivery of monitoring/verification reports.

&

Dutch government exercises ‘claims on ERUs’ with host country in order to receive appropriate amount of ERUs; host country transfers ERUs to Dutch national registry.

&

ERs occurring prior to the first commitment period require the transfer of AAUs instead of ERUs.

6.4.2

The CDM

The Dutch CDM programme essentially has three paths open to it for development of projects and acquisition of ensuing streams of CERs. The primary vehicle is through financial institutions contracted to develop portfolios and purchase CERs on behalf of the Dutch government. The second is through participation in the PCF (and potentially other carbon funds), and the third is through direct bilateral CER purchase agreements. This section will focus on acquisitions through its intermediaries, since as of mid-2003 no direct bilateral CER purchases have taken place. The Ministry of Housing, Spatial Planning and the Environment (VROM) was designated the National Authority (DNA) in April 2001. To carry out its programme, the government set aside non-ODA money to implement its programme.75 In 2001 D 90 million was budgeted and in 2002, D 135 million.76 These funds go to capacity building and creditpurchasing programmes. VROM contracted several ‘intermediaries’ in 2002 to carry out its credit acquisition programme; they include: the International Finance Corporation (IFC), the International Bank for Reconstruction and Development (IBRD), the regional development bank for the Andes (CAF) and Rabobank, a private Dutch bank. Although VROM maintains control over the projects selected, the intermediaries have a good deal of flexibility in the projcts they choose to put forward into their portfolios. The Dutch have termed the approach used in their contracts with

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187

VROM

IFC-Netherlands Carbon Facility

Netherlands CDM Facility (IBRD)

CAF-Netherlands CDM Facility

PROJECT DEVELOPMENT Project developer reaches agreement with facility and develops projects, with approval from VROM for go ahead

DOE for validation and registration Final Dutch Approval CDM process: periodic monitoring and verification of emission reductions and issuance of CERs

Figure 6.1 The Dutch CDM process

financial institutions as the detailed approach. This entails negotiating a ‘preferred’ total of CERs to be generated by the portfolio, with the total amount of CERs a project delivers negotiated between the project developer and the intermediary. VROM maintains some control over project selection as it approves projects (it provides a ‘go’ or ‘no go’ decision and a final declaration of approval).77 (See Figure 6.1 and Table 6.8.) In addition to financial institutions, the Dutch can and have run tender programmes, similar to ERUPT (see Table 6.9). In 2001, the Dutch contracted Senter to run a tender programme that concluded in 2002 with the approval of 18 projects. Under CERUPT, like its JI counterpart, projects are assessed against pre-set criteria. Project assessment under other intermediaries provides more flexibility as discussions revolve around specific projects/project attributes.

6.4.2.1

Programme criteria

Through its intermediaries, the Dutch government hopes to acquire what it feels are high quality CERs from projects that meet its criteria. Eligible project categories include: &

Renewable energy such as wind, solar, geothermal, hydro;

&

(Clean) biomass;

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&

Energy efficiency improvement;

&

Transportation improvement;

&

Recovery and utilization of methane (e.g. from waste landfills and coal mines); and

&

Fossil fuel switching to less carbon-intensive sources. Table 6.8 Dutch CDM project cycle

CDM Project Cycle Dutch Project Cycle

Action

Project development

Project idea note sent to intermediary.

Intermediary assesses against VROM criteria, successful projects go to next stage.

Project concept note (precursor to PDD) sent to intermediary, including host country Letter of Endorsement.

VROM gives ‘go/no go’ decision, successful candidates go to next stage.

PDD developed, and DOE assesses PDD, enters CDM project cycle. forwards validation report to CDM executive board. Validation and registration

Validation and registration VROM gives formal under the CDM. Dutch project approval. Negotiation of project agreements.

Project monitoring

Periodic monitoring based on contract agreement.

Verification and certification

Periodic verification and certification reductions.

Issuance of CERs

Intermediary and project developer finalize Emission Reduction Purchasing Agreement.

EB issues CERs based on ERPAs.

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Table 6.9 Summary table of contracted intermediaries Intermediary

Facility/Activity

Amount and time frame

CERUPT

Senter

IFC

IFC-Netherlands Carbon Facility

D 44 million over a three year period

IBRD

The Netherlands Clean Development Facility

D 35 million for each of four years

10–16 MtCO2e

CAF-Netherlands Corporacion CDM Facility Andina de Fomento (CAF) RaboBank

Expected tonnes

32 MtCO2e

10 MtCO2e

Two year period

10 MtCO2e

Source: Senter.nl, VROM, www.carbonfunds.org, CAF, Point Carbon.

The Dutch programme also interprets the additionality clause in a rather broad manner and require projects to examine three specific areas: nondiversion of ODA, environmental additionality and best available technology.78 It is unclear how these additionality tests will be treated when Dutch projects go through the review process for validation and registration. During the first round of methodology reviews, the CDM executive board made clear that emissions additionality is the only additionality test recognized under the CDM. In general, VROM is willing to pay D 2–5.5 per tonne of CO2e. The purchase price can be affected, however, by project type with renewables achieving a higher price than fuel switching and methane recovery. Nuclear projects will not gain Dutch approval and afforestation and reforestation projects are not considered highly desirable. In general, the criteria by intermediaries eliminate afforestation and reforestation projects. The Dutch aim to receive up to 500,000 tonnes of CO2e reductions up through 2012.

6.5

THE FINNISH PROGRAMME

In 1999, the Finnish government launched a CDM and JI pilot programme. Unlike the Dutch programme, the Finnish programme takes a direct bilateral approach to purchasing ERUs and CERs from projects. Project developers

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CLIMATE TRADING

can submit Project Idea Notes (PINs) to the pilot programmes, or in the case of the CDM, Finland will issue a public tender. The purpose of the programme is in part to develop internal administrative capacity that will help the government in developing CDM and JI guidelines. In total, D 20 million have been allocated, and the Finns hope to earn credits for up to 1.4 million tonnes of CO2e. The estimated price per tonne of CO2e is between D 2.5 and D 6. The Ministry of Foreign Affairs manages the pilot programme, and a steering committee oversees development of guidelines as well as project selection. The steering committee consists of government representatives from the Ministries of Foreign Affairs, Environment, Trade and Industry, Agriculture and Forestry, and Finance. As of mid-2003, the Finnish portfolio consisted of six CDM and six JI projects. Project developers interested in the Finnish pilot programme are required to submit a PIN or a draft PDD along with a host country letter of endorsement. The steering committee assesses the documentation against all pertinent criteria and gives its approval in the form of a ‘no objection’ decision. Project developers then proceed to develop the project and enter into the respective CDM or JI Project Cycle. Crediting periods differ somewhat with agreements for purchasing ERUs generally running up through 2012, where as agreements for purchasing CERs can run through the entire crediting period, that is, up to 21 years.

6.5.1

JI

In general, the Finnish programme seeks to develop projects in the neighbouring countries of Estonia, Latvia, Lithuania and Russia. It will also consider projects in other central and eastern European countries with which it has signed Memoranda of Understanding. The primary requirements are those listed in the JI rules under the Marrakech Accords. There are no restrictions on project categories or gases. Projects are assessed against several criteria, including: &

Complying with host country legislation, or any other host country requirements related to JI projects.

&

The benefits, that is, the ERUs, should be cost effective.

&

The project must go through an environmental assessment, projects with significant negative environmental impacts will not be approved.

&

Public participation (in the form of stakeholder input) is required.

&

The project should support Finnish Policy on environmental cooperation with neighbouring countries.

191

Table 6.10 Summary of JI requirements Programme description

Bilateral JI programme, whereby the Finnish government selects and approves projects

Project path

Project cycle is based on a second track approach although use of first track is likely in the event both host and investor country are in compliance with the Protocol.

Project categories

All projects reducing all six greenhouse gas eligible except for nuclear.

Country eligibility

All Annex I countries that ratify the Protocol. Preference is given to projects in countries with which Finland has signed an MOU.

Key legal requirements

In addition to MOUs Finland requires legal documentation that binds the host country to transfer an appropriate amount of ERUs into the Finnish registry, as well as the project developers to deliver emissions reductions according to specific terms.

Framework agreement on joint implementation

This document commits the host country to transfer ERUs equivalent to the amount of emission reductions generated and verified by the project.

Emission Reduction Purchase

Agreement

The ERPA is signed between the government of Finland and the project developers and includes the price, amount of emission reductions to be delivered and the delivery schedule.

Transacted commodity

ERUs based on verified emissions reductions. One ERU is equal to one tonne of CO2e.

Early credit

Finland will purchase verified emission reductions generated during the period 2003–2007. These ‘early credits’ are transacted by transferring AAUs in a corresponding amount to the verified emission reductions, but can only be transferred during the first commitment period.

Advance payments

Scope exists for payment in advance of delivery of emission reductions.

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Table 6.11 Summary of CDM requirements Programme description

Bilateral CDM programme, whereby the Finnish government selects and approves projects

Project categories

Small-scale projects as defined in the CDM rules.

Country eligibility

All non-Annex I countries that meet international eligibility criteria.

Key legal requirements

Finland has negotiated MOUs promoting cooperation on the CDM, but they are not prerequisite for undertaking a project in a developing country.

Letter of Approval

The host country must give final project approval once the project has been successfully validated.

Emission Reduction Purchase Agreement

The ERPA is signed between the government of Finland and the project developers and includes the price, amount of emission reductions to be delivered and the delivery schedule.

Transacted commodity

CERs based on verified and certified emissions reductions. One CER is equal to one tonne of CO2e.

Advance payments

Pre-delivery payment schedules for up to 50 per cent of the total purchase price can be negotiated.

6.5.2

The CDM

The pilot programme aims at purchasing CERs from small-scale projects in developing countries (see Table 6.11). It uses the CDM rules for small-scale projects as the basis for its decision-making. Projects can be located in any developing country that meets international eligibility requirements. The primary criteria are those listed in the CDM rules pertaining to smallscale projects. In addition, Finland requires: &

The project has to assist the host country in achieving sustainable development.

&

It must comply with host country legislation, or any other host country requirements related to CDM projects.

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193

&

The benefits, that is, the CERs, should be cost effective.

&

The project must go through an environmental assessment.

&

Projects with negative social, economic or environmental impacts will not be approved.

&

Public participation (in the form of stakeholder input) is required.

&

The project should support Finnish policy on cooperation with developing countries.

Projects reducing poverty, promoting environmentally sustainable development and enhancing social equality, democracy, human rights and good governance are given priority.

6.6

CONCLUSION

The above programmes are only a few examples of the existing, mainly government driven programmes on the CDM and JI. More programmes are on the way, and depending on the development of domestic regulations, the number of private sector programmes and funds are likely to expand. This will be of assistance to public or private sector actors who are not interested or capable of engaging directly in project activities. As the number of programmes and funds increases, so will the possibility of investors finding one that fits their individual needs.

CHAPTER 7

The Carbon Market

Once a company has assessed its carbon liability and determined whether (and how) it will participate in emissions trading, it will have to decide which segment of the carbon market to enter. The carbon market is in its formative stage and is segmented by type of commodity and buyer motivation. In addition it is not likely to be fully liquid or integrated for some time. Although companies and countries have a great deal of experience in trading, market development is a process. The US SO2 market, for example, took up to six years before it reached maturity. Given that trading infrastructure exists and trades have occurred since as early as 1996, it may not take as long for the greenhouse gas market to mature.79 The remaining elements necessary for trading to occur are related to market infrastructure, which is already well advanced since the main elements have been active since emissions trading was introduced in the Protocol process. Brokers, consultants and legal services specifically aimed at assisting companies with greenhouse gas emissions trades have played an important part in developing the current market, using the experiences gained through other markets such as the NOx and SO2 market. Several energy and environmental brokers have expanded their businesses in anticipation of a fully functioning greenhouse gas emissions market, and consulting firms have developed portfolios that include project development, strategic carbon management, inventory development and capacity building on various aspects of climate change. In addition, carbon reporting services, carbon exchanges and other services have emerged in anticipation of a fully liquid market. The number of trades and the amounts transacted are difficult to assess since transactions have mainly been private sector trades where little information is made public. In instances were governments or intergovernmental organizations have contracted emission reductions (ERs), volume and pricing information is generally more transparent. An estimate 194

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195

on the overall size varies by source. PCFplus Research estimates that 288 project-based transactions have occurred since 1996, contracting about 220 million tonnes of CO2 equivalent. PricewaterhouseCoopers estimates that approximately 350 trades have occurred totalling almost 400 million tonnes of CO2 equivalent. Differences can be attributed to the way in which transactions are categorized as well as by brokers providing information on trades within their portfolios. The 220 under the Prototype Carbon Fund (PCF) refers primarily to project-based ERs in the non-retail market as opposed to all possible volumes transacted within the various market segments. In developing its State of the Carbon Market reports, the PCF relies on information from at least two brokers and one reporting service, but much of this information is confidential. Unless otherwise specified, the numbers referred to in the sections below are derived from the 2002 and 2003 State of the Carbon Market. The numbers are used only as an indication of market activity and are not meant as a definitive source on greenhouse gas market activities.

7.1

TRADABLE INSTRUMENTS

As with any trading market, greenhouse gas trading markets are composed of buyers and sellers, hedging risks against supply, demand and price expectations. Unlike many other trading markets, the commodity upon which transactions are based is created through regulatory processes. Since very few greenhouse gas markets exist with an established commodity, be it a quota, permit, allowance or credit, the majority of transactions through 2003 were based on ERs from projects, although some exploratory transactions in commodities whose existence is somewhat uncertain have occurred.

7.1.1

Transacting carbon

In trading markets, commodities are transacted through either organized exchanges (i.e. The New York Mercantile Exchange) or through bilateral negotiations between companies that rely on intermediaries, know as ‘overthe-counter’ or ‘OTC’. Derivatives are instruments that derive their value from an underlying product. Derivatives are commonly used by companies to manage and hedge business risks. In the carbon market, the derivative is based on an allowance, a Certified Emission Reduction Unit (CER), Emission Reduction Unit (ERU) or ER, and is used to hedge against future exposure to higher carbon prices and to manage costs associated with a carbon constrained economy, including expected higher electricity prices. The majority of transactions in the carbon market are OTC transactions, since as of late 2003 only one self-regulating exchange existed.

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Contracts can be structured for immediate or future delivery of the commodity, or as options for the possibility of purchasing reductions by some specified date, including cash and forward contracts, financial derivatives or through direct investment in a project in exchange for ERs. Transactions can be coupled with other tradable commodities such as electricity, renewable energy certificates (RECs) or allowances from other trading schemes covering non greenhouse gases (i.e. SO2 or NOx), depending on regulatory restrictions, market activity, and so on. The EU emissions trading scheme will limit the number of RECs that can be used in its scheme. Different types of trading systems can co-exist such as the UK trading scheme with its direct and agreement participants, or given the political will, different national and/or regional trading schemes. The flow of allowances from one system to the other is simply controlled via a gateway. Other methods of control could include discounting ‘foreign’ allowances brought into a system.

7.1.1.1 Derivative instruments Spot trades, also called Immediate Settlement, are contracts in which all terms are agreed to up front and delivery of the commodity purchased occurs within a few days (three to five) of the contract date (see Figure 7.1). Few spot trades are made in the carbon market since the market is still immature and domestic trading schemes have not begun operation, nor have any CERs been generated. This may change once emissions trading schemes are on-line and in particular when compliance periods near their end. Forward settlements are contractual agreements between a buyer and seller for forward streams of a particular greenhouse gas commodity (e.g. an AAU, EUA, CER, ERU or ER). The price and quantity is typically determined at the date of the trade (when the contract is agreed) and delivery of the commodity (settlement date) is generally according to a pre-determined delivery schedule80 (see Figure 7.2). In commodities related to a specific project, forward contracts will sometimes include an option to purchase any additional streams of ERs generated at a pre-determined or market price. Forward contracts have been a common instrument for transacting greenhouse gas ERs since they provide buyers with a market price that is $ 250 Buyer

Seller 50 tCO2e

Figure 7.1 Spot transactions

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$250/year for 10 years Buyer

Seller 50 tonnes/year for 10 years

Figure 7.2 Forward transactions

Buyer

Premium payment of $250

Seller

If Option exercised then: $250/year for 10 years Buyer

Seller 50 tonnes/year for 10 years

Figure 7.3 Options contracts

below estimates for prices during trading periods. It also assures buyers access to a specific quantity of reductions that they should be able to use for compliance purposes during the trading period. Options contracts provide buyers and sellers of the option the opportunity but not the obligation to enter into a transaction by a specific date some time in the future (see Figure 7.3). Option buyers can be either a buyer or seller of the greenhouse gas commodity. In a Call option the buyer of the option has the right but not the obligation to purchase a specific amount of a greenhouse gas commodity at a price (Strike Price) agreed to at the trade date. In this case the buyer of the Call option is the buyer of the commodity. In a Put option the buyer of the option has the right but not the obligation to sell a specific amount of a greenhouse gas commodity at a set price agreed to at the trade date. In this case, the buyer of the option is the seller of the commodity. In both cases, the buyer must exercise the option by the date agreed to in the contract (Strike Date). There is a difference, however, in how options can be exercised. In a European option, the option must be exercised or terminated on the Strike Date. In an American option, the option can be exercised at any time up to the Strike date. An options buyer pays a premium for the flexibility provided by the seller of the option. The premium is a payment to the seller, compensating them for guaranteeing a market price to the buyer. In the carbon market, the premium is determined by supply and demand, and seller desire to capture the guaranteed cash flows from the premiums. Options have been a popular instrument for transacting ERs. They provide buyers of Calls with the ability to hedge against rising carbon prices during a trading period without

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Buyer

Exchange

Seller

Figure 7.4 Commodities exchange

obligating them to purchase a commodity that may have no or little value in the future depending on the outcome of political processes. For the buyer of Puts it enables them to hedge against falling prices and to lock in a sale in case the market for reductions fails to materialize. Futures contracts and options on futures differ from options and forwards in that the contract itself has value and is transferable between parties through an Exchange. A Futures contract is a legally binding agreement between a buyer and seller for a particular commodity at a specific price for a date in the future that is transacted through a particular exchange (see Figure 7.4). An option on a Futures contract gives a buyer the option (but not the obligation) to execute a contract by a particular date in exchange for a premium. Transactions occur on an organized Futures Exchange. The point of entry is through a broker or other person registered to trade on the Exchange. Futures and Options trading is complex and can be risky. Participants and their brokers must have a clear understanding of the participant’s financial situation, experience in trading futures and options, tolerance for risk and risk management or investment goals. Investors in a Futures Exchange typically fall into one of two categories. Hedgers use the Exchange as a way to minimize risk, that is, the cost of business operations. Speculators seek profits on their investments. Trading occurs in two ways: through an ‘open outcry’ where floor traders announce their bids and offers and brokers respond; or through an electronic platform. The Exchange serves as a counter party to both sellers and buyers of a contract, since it simultaneously purchases the Future from the seller and sells it to the buyer. A party holding a Futures contract can also sell it back to the Exchange and a previous seller can also buy it back. Futures are likely to be more common once the carbon market has established itself and it is clear that the commodity will have a clear cash value.

7.1.1.2 Direct investment Another option open to a buyer is direct investment into a project in return for a future stream of CERs or ERUs. From the seller point of view,

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$2500 today Buyer

Seller 50 tonnes/year for 10 years

Figure 7.5 Direct investment

an upfront payment has many advantages, but buyers tend to prefer forward contracts since there is less risk that the future stream of CERs or ERUs won’t materialize (see Figure 7.5).

7.1.1.3

Hybrid approaches

Contracts for streams of ERs associated with potential Clean Development Mechanism (CDM) and Joint Implementation (JI) type projects have used a combination of forward settlement and options. In many of these contracts, specific (conservative) numbers of ERs are contracted through forward settlement. Additional ERs generated beyond this specified amount can either be contracted through an option, with the buyer of the ERs having an option to purchase at least a certain percentage of the additional ERs at a specified price or through a right of first refusal if the price of additional ERs is at market price. This combination provides project developers with assurances of future investment income in order to ensure the viability of the project, while giving investors access to low cost ERs or credits (assuming the ERs are verified) for future compliance purposes.

7.1.1.4

Carbon contracts

Master Agreements covering OTC derivative transactions under emissions trading schemes are developing as emissions trading schemes come online. Because negotiating an agreement for each OTC derivative transaction would be burdensome, Master Agreements have been developed to streamline paperwork and facilitate trades.81 Master Agreements govern the legal relationship between two parties entering into derivative agreements, including events that trigger default or termination of the agreement, method and form for confirming transactions. Master Agreements cover one or more transactions and specify how they occur and how and in what form they are confirmed. Individual transactions and their terms are attached in schedules that are considered part of the Master Agreement. If a particular transaction is complex, confirmations can be negotiated prior to transaction occurring.

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The way in which transactions occur is generally through a telephone or some other electronic format where the terms of the transactions are negotiated and agreed. This can be done through the use of a broker or direct bilateral discussions. The terms of the transaction, including price, quantity and payment or delivery dates, are confirmed through a ‘confirmation’. Companies receiving the confirmation would have to review it to confirm that it contains the detail of the transaction and must agree to the terms within a specific time period (the IETA EU ETS Master Agreement82 requires response within three days).

7.2

MARKET FORMATION

7.2.1

The early years

In the period from 1996 to 2000, the majority of transactions were ERs generated by specific projects either in Annex I or non-Annex I countries. Motives for the transactions varied, including anticipation of regulatory requirements, to meet voluntary commitments, ‘learning-by-doing’ and using the experience gained as a public relations tool to show good corporate governance. Major actors during this period were Canadian and US firms, followed by Australian and Japanese firms. Because many of the transactions occurred within the private sector, very little is known about them. Transactions of greenhouse gas emission reduction credits have occurred since the markets inception in 1996 (see Figure 7.6). Since then, the number of trades and the number of market participants has fluctuated with

80

60

40

20

0 1996

1997

1998

1999

2000

2001

2002

2003

Figure 7.6 Volumes of emissions reductions transacted (1996–2003) Source: Derived from numbers provided in State of the Carbon Market 2003, PCF.

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the uncertainty surrounding domestic and international processes. The progress or the lack thereof at the various Convention of Parties (COP) sessions for the Climate Convention, seems to influence at least to some degree how the market behaved the following year. For instance, almost half of the total known volume of ERs transacted since 1996 occurred between 1996 and 2000. This is during a time when the Protocol was adopted and negotiations preceded on the rules for the Kyoto emissions trading system. The volumes transacted between 1999 and 2000, however dropped significantly as the international political process became bogged down and seemed as if it would grind to a halt. Up until 2003, 1996 seems to have been the most optimistic in terms of the volumes transacted (see Table 7.1). According to research conducted for the PCF over 100 million tonnes of CO2 equivalent ERs were transacted during this period, and primarily between companies within Annex I. It is difficult to determine price and the method of transactions, but it seems the majority of contracts were structured as call options followed by spot transactions; many of the call options seem to have not been exercised due to the uncertainty surrounding international and domestic processes. One of the first transactions occurred between two US utilities, Niagara Mohawk and Arizona Public Service in which APS exchanged SO2 allowances for CO2 credits. APS used the credits to meet its voluntary commitment to reduce its 2000 emissions to 1990 levels. The SO2 allowances were retired by Niagara Mohawk. In 1998, Niagara Mohawk also entered into an agreement with Suncor to deliver 100,000 tonnes of CO2 equivalent. In 1999, the Greenhouse Emissions Management Consortium (GEMco) purchased 2.8 million tonnes in purchases and options from US farmers, primarily in Iowa. Government activities during this period are more transparent. In 1997, for instance, Norwegian investors, including the government of Norway provided US$2 million to Costa Rica for an AIJ project in which the Norwegian partners would receive Costa Rican Certified Tradable Offsets in return. The value of these offsets was estimated at US$2.72 per tonne of CO2. Because the project was developed under the AIJ pilot phase Norway did not claim any of the offsets.

7.2.2

A growing market

Since 2001, the carbon market has continued to grow with an increasing number of transactions aimed at meeting compliance requirements, and an increasingly smaller percentage devoted to non-compliance transactions. Several events influenced this. The Bonn agreement at COP-6bis increased the certainty that agreement would be reached in Marrakech on the majority of rules for the Kyoto emissions trading system. The Danish emissions trading scheme came online in 2001 and the UK emissions trading scheme

202

Table 7.1 Comparison of market activity to policy development Year

Market activity

1995

International and/or domestic policy The US announces willingness to take on legally binding commitment if flexibility is built into agreement.

1996 Less than 40 million tonnes Negotiations on Kyoto Protocol CO2 equivalent transacted. begin in earnest, but not all Annex I countries support emissions trading. 1997 Very small volumes transacted.

Protocol adopted at COP-3

1998 Less than 20 million tonnes of CO2 equivalent transacted.

Rules for emissions trading system under the Protocol proceed slowly but some progress made at COP-4.

1999 About 35 million tonnes of CO2 equivalent transacted.

Negotiations on rules continue, but little progress made at COP-5.

2000 About 20 million tonnes of CO2 equivalent transacted.

Deadlock at COP-6.

2001 Less than 15 million tonnes of CO2 equivalent transacted.

Agreement reached at COP-6 bis and Marrakech Accords adopted at COP-7. Danish trading scheme implemented. But US rejects Protocol in early 2001.

2002 Less than 30 million tonnes of CO2 equivalent transacted.

The CDM prompt-start fully underway, Danish and UK emissions trading schemes under way with trades occurring, the EU Directive on the way to becoming law.

2003 More than 70 million tonnes of CO2 equivalent.

CDM institutions and structures developing/gaining experience. National programmes developing.

Source: Compiled by author.

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came online in 2002. In 2002, the CDM executive board began the difficult process of implementing all of the systems and requirements needed to allow the CDM to function. Institutional investors such as the PCF and the Dutch government also launched purchasing programmes during this time. Finally, the EU adopted its emissions trading Directive. Estimates of transactions for 2003 are double that of 2002, showing increased interest in emissions trading as a tool for mitigating the risk companies and countries face in carbon reduction policies. In 2001, 13 million tonnes of CO2 equivalent were transacted. In 2002, it increased to 29 million tonnes, and in 2003, over 70 million tonnes of CO2 equivalent were transacted. The commodities traded mirror to some degree the Kyoto reduction units, although they are not necessarily directly tied to them, that is, allowances from one scheme are not interchangeable with allowances from other schemes. The unit of measure, however, is the same with one allowance generally permitting affected sources to emit one tonne of CO2 or CO2 equivalent during a specific timeframe, that is, a year. Credits are equal to one tonne of CO2 reduced or sequestered by a project, using the modalities and procedures for CDM project activities. Although the majority of these credits are meant to be transferred into Kyoto reduction units, they are currently transacted as emission reduction (see section on pre-compliance market segment). Prior to the adoption of the CDM rules projects were developed according to buyer specifications with the anticipation of meeting CDM and JI requirements once those systems were/are up and running. Through 2003, project-based ERs accounted for the largest volume of trades, although in 2003 allowance-based transactions surpassed transactions of ERs in numerical terms. The projects from which ERs have been contracted were located in developing countries or countries with economies in transition; these are projects that are likely to go through the ‘approval processes’ under the CDM or through one of the two tracks under JI. Up until 2003, buyers of ERs from projects in developing countries assumed much of the risk associated with bringing them into the CDM process. Since 2003, sellers are assuming much of the risk of registration since the CDM is functioning. Until the Protocol enters into force, or countries develop guidelines for JI type projects, buyers are likely to continue assuming the risk of converting ERs into ERUs. Although, as Annex B countries continue delineating purchasing policies (Denmark, Netherlands, and Norway, for example, have all stated they will use ERUs to meet part of their commitment – Denmark and the Netherlands have explicit governmental purchasing programmes/budgets) for ERS to meet part of their Protocol commitments, the uncertainty surrounding their ‘usability’ will lessen. Transactions are expected to increase as allocation plans solidify

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within the EU and countries outside the EU continue development of their trading schemes. Currently the carbon market is segmented with prices varying by market segment and tradable commodity. In general prices reflect the risks inherent in the process and instrument type. Risks include the political uncertainty surrounding the international and national processes, although within the EU resolution of the NAP processes in mid-2004 should resolve some of these issues.

7.3

MARKET SEGMENTS

There are five market segments: a market transacting allowances and Kyoto reduction units, a credit-based market transacting ERs, a small voluntary market, a sub-national market and a retail market. The commodities traded within these segments are allowances and Kyoto reduction units used for compliance within national trading schemes, and pre-compliance ERs that may or may not be used for compliance.

7.3.1

Allowance markets

National and international allowance markets trade allowances for compliance with regulatory obligations. The UK and Danish markets are the primary markets, although the UK market is more vibrant than the Danish for various reasons, including the number of market participants. Allowance prices vary and reflect market characteristics, such as the number of participants in the market, the mix between supply and demand, compliance penalties, the use of a price cap and so on. The UK ETS Thus far, the UK greenhouse gas emissions trading scheme is the largest in existence, and accounts for the majority of traded allowances. In 2002, approximately 500 company to company trades transacting 2.48 million tonnes of CO2 equivalent were recorded.83 In the first three quarters of 2003, at least 140 transactions covering an estimated 500,000 tonnes were recorded. Since the end of the compliance period falls at the end of the calendar year, there was great deal of activity prior to the end of the year and during the reconciliation period of January to March. Market activity slowed as the reconciliation period ended, and was not expected to pick up again until the end of the 2003 compliance period. Spot prices for UK allowances shot up in the period from April to September 2002 from £4 to £12, as a result of two activities. First, supply was tight since allocations purchased in the April 2002 reverse auction were delayed. Second, Agreement participants (with milestone periods that begin in

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October)84 were putting further demand on the limited supplies. Prices fell down to approximately £2 where it remained through 2003. The Danish ETS The Danish allowance market was characterized by few market actors and transactions. The market was dominated by two main power companies who received the majority of allowances. Despite this some trades did occur, although not enough to develop a sustainable market. In 2001, nine spot transactions occurred for a volume of 260,000 tonnes of CO2 for 2001 vintages at prices below the 40DKK cap. An additional 200,000 tonnes of CO2 were brought into the system through five swaps of Danish allowances for VERs. In 2002, at least ten transactions took place including a swap of Danish and UK allowances. The EU ETS Some EU allowances have been transacted through forward contracts during 2003 for the 2005 to 2007 vintage years, for delivery at a future date and after allocations have been made. There have been approximately 20 deals for at least 500,000 tonnes of CO2.85 As National Allocation Plans from Member States solidify, there are likely to be ever increasing volumes transacted since companies will be better to judge their position as buyer or seller within its domestic market. In addition, the EU Linking Directive is expected to give companies the opportunity to invest in CDM projects as part of their compliance options in its first phase starting in 2005. The price of EUAs fluctuates with the stability of the political process. In May 2003 prices were around d6 per tonne of CO2 equivalent but increased to around d13 in early 2004 for EUAs of the 2005 to 2007 vintages. Prices however, are not indicative of what is likely to occur once the trading scheme comes online since there is still much uncertainty over the allocation process. Emission trading under the Kyoto Protocol At least one transaction of AAUs has occurred. In 2002, The Government of Slovakia entered into an agreement with a Japanese brokerage firm to transfer 200,000 AAUs from its commitment period budget. Once its registry is up and running, Slovakian allowances will be transferred to a domestic engineering firm who will then transfer them to the Japanese buyer. The funds from the sale of AAUs will be used to identify further reduction projects.86 Several programmes have been structured to purchase forward stream of AAUs based on JI projects. The Testing Ground for Joint Implementation in the Baltic Sea Region is one such example. Although still in the development phase in late 2003, legal documents for the Testing Ground require that contracts for ERs based on JI projects transfer forward streams of AAUs, until the commitment period begins. Given the evolution of the EU Linking Directive and the uncertainty surrounding the Protocol, it is unclear how these contracts would work since it seems more likely that ERUs as opposed to AAUs will be a more certain commodity.

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CERs are likely to come on the market in the 2004/2005 timeframe since many of the institutions and processes needed to verify and certify ERs are in place and projects that have been grandfathered in (projects that began reducing emissions after 2000) could begin generating CERs in the very near future.87 Until projects can be registered as CDM project activities, meaning that Operational Entities are accredited by the CDM executive board, the majority of project related transactions in developing countries (as well as projects in countries with economies in transition) are for ERs with buyers or sellers assuming registration risks (depending on when the contract was entered). Transacting ERUs requires entry into force of the Protocol , and for countries to meet at least the minimal eligibility requirements for secondtrack JI. Until that happens, transacting ERUs requires assuming more risk than with CERs since they may not materialize. In addition, once CERs have been issued, a secondary CER market is likely to develop where the CER holders transfer them to other buyers. The CDM Registry is likely to be up and running in 2004 which should help facilitate market development.

7.3.2

The ERs market

The largest carbon market is the pre-compliance market. This consists primarily of ERs from projects located either in developing countries or in countries with economies in transition. There are two categories of ERs. The first is ERs that are not intended for compliance and the second is ERs verified by a third party, in conformance with the CDM rules and intended for compliance with Annex B Party commitments. The latter are commonly referred to as VERs (verified emission reductions). VERs differ from CERs and ERUs in that there is no guarantee VERs will be transferable into Kyoto reduction units. VER contracts reflect this risk. Contracts for VERs are generally structured to purchase a forward stream of ERs that must be verified by an independent third party, and must also be brought into the CDM and JI processes. Institutional purchasers such as the PCF and the Dutch CDM and JI programmes dominated this market in 2001 and 2002; however, 2003 saw more active private sector participation, particularly by Japanese companies (see Figure 7.7). Pricing information is somewhat more transparent since governments and other public/private institutions have played a larger market role and must provide complete accounting to their constituents. As with the allowance market, there is no public price for ERs. Prices reflect a range of issues and risks including: Whether the ERs will be used for compliance purposes ERs that will not be used for compliance are generally cheaper unless they are of a high

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35 30 25 20 15 10 5 0 Canada

US

Netherlands Japan

2001–2002

PCF

2002–2003

Figure 7.7 Changes in major market buyers from 2001 through 2003 Source: Adapted from State of the Carbon Market 2003, PCF.

quality or meet a particular market niche (meeting a buyer’s definition of a high standard for sustainable development) and can be sold in the retail market. Uncertainties related to the ability to use ERs for compliance purposes (domestic uncertainties): In this case the uncertainties relate to whether the project from which the ERs are generated will be registered as a CDM project activity (when located in a non-Annex I Party) or meet the appropriate JI rules for verification (when located in a country with an economy in transition). A follow on issue involves the acceptance of CERs and ERUs into domestic and international trading schemes. CERs provide more certainty for several reasons: at least one trading scheme (the EUs) will allow CERs into its system beginning in 2005. CERs, absent any objections from developing countries, can be issued as soon as the registered CDM project activity has led to ERs that are verified and certified. Uncertainties related to the Protocol: Regardless of when the Protocol enters into force, uncertainties remain as to whether or when countries will meet requirements for trading and when the bodies governing, JI for instance, will be established.

The ability of the project to meet the requirements under the CDM or JI is an important determinant in the price of the ER. If there is some doubt about the viability of the project, the methodologies upon which the project is based or the host country is unwilling or unable to support/approve the project, then the ERs will have less value. This is not to say that projects that have gone through a CDM type approval process with ERs verified by an independent third party will automatically be eligible under the projectbased mechanisms. Since the CDM prompt-start is a ‘learning by doing’ process, interpretations of the CDM rules by project developers and

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potential DOEs may require project developers to re-examine their projects to ensure they are in line with current understanding of the CDM procedures or face greater costs in restructuring the project for resubmission. JI projects face greater uncertainty since it will not (and may not) be known what criteria the supervisory committee adopts when (and if ) it is established. Other factors that influence price are the experience and credit worthiness of the project developers, the viability of the project, transaction costs (for CDM project activities this includes costs for methodology development and approval, validation, registration, verification and certification), and the structure of the contract. Structural issues include delivery risks, such as whether sellers receive an up front payment for future deliveries which places greater risk on the buyer and is likely to result in a lower purchase price, or penalties for shortfalls in deliveries; timing of deliveries, such as contracting for a future delivery scheme in which the seller must delivery a specific amount of ER each year or whether the contract allows for fluctuations within the contract period such as a multi-year delivery period. Country risks also influence contract prices as the stability and infrastructure of a given country may affect a projects ability to deliver ERs. In addition, some buyers are willing to pay a higher price for projects that meet particular environmental and social benefits. Non-compliance ERs range from just under US$2.00 up to US$3.00 per tonne of CO2 equivalent, while pre-compliance ERs range from around US$3.00 to just under $6.50 per tonne depending on who assumes risk for registration (CDM) or the verification procedures (JI) of the project. Projects in which sellers assume the risk command a higher price, from around US$3.00 to $6.50, while projects in which the buyer assumes the risk are in the range of $3.00 to just over $4.00.

7.3.3

Sub-national markets

More recently, sub-national markets have begun operating although little pricing information is available. These markets are located in Australia and the US in conjunction with State programmes. In the US, several states and regions are considering implementing trading schemes. The State of Oregon has capped on emissions for new power plants, but trading is not part of the requirement. Instead plants must meet the required reduction or pay for offsets that are retired as a benefit to the environment. The New South Wales GHG Abatement Scheme, in Australia, began trading in January 2003. Some transactions have occurred but volumes are low and prices are assumed to be in the range of $US3–4/tonne of CO2 equivalent.

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7.3.4

209

Voluntary markets

The Chicago Climate Exchange is a self-regulating exchange that was launched in October 2003. Members of the exchange are from a cross section of private and public sectors primarily from North America that have voluntarily agreed to reduce their emissions during the period of the pilot phase, 2003 to 2006. Reductions are measured against a baseline of average annual emissions from facilities in the baseline in 1998, 1999, 2000 and 2001. The instruments used in the Exchange are Exchange Allowances and Exchange Offsets. Allowances are allocated to Members based on their baseline and reduction targets: 1 per cent reduction from baseline emissions in first year, 2 per cent second year, 3 per cent third year, 4 per cent fourth year. Exchange Offsets can be generated by projects that meet Exchange rules and requirements. The Exchange has three main components: a Registry that records member’s baseline emissions, allowance allocation, offset projects and compliance status, a Trading Platform for bids and offers of allowances and offsets, and exchange-cleared and bilateral trades; and a Clearing and Settlement Platform that reconciles data received from the Trading Platform and notifies the Registry of any changes to a Members holdings. Trading on the Exchange began in December 2003. In January 2004, a total of 82,800 tonnes of CO2 equivalent was transacted and in February it increased to over 475,000. Prices for 2003, 2004 and 2006 vintages were US$.91 and US$.71 for 2005.

7.3.5

Retail market

Increasingly, companies, organizations and individuals are looking for ways to become ‘carbon neutral’ by offsetting their activities through purchases of ERs that are typically considered ‘high quality’ meaning they meet environmental, sustainable and socially beneficial criteria. These projects are generally designed to meet the CDM criteria, but are not necessarily intended for compliance purposes and may not go through a formal CDM registration process. The ERs are usually retired and are used as a way to communicate social responsibility and to promote a brand. In late 2003, for instance, the insurance company Swiss Re announced a ten-year programme to become fully carbon neutral. It expects to reduce 15 per cent of its emissions directly and purchase the remainder through the World Banks Community Development Carbon Fund, which supports project in the least developed countries aimed at improving the environment and livelihood of local communities.88 Transactions in this market segment tend to be small, between 5000 and 10,000 tonnes of CO2 equivalent, and are either spot or forward contracts

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(with a two to three year stream of ERs). Prices generally range from US$5 to $12 per tonne of CO2 equivalent which is a much higher range than prices in the ER market.

7.4

THE PRICE OF CARBON

The price of allowances on the carbon market will help determine the marginal cost of abatement options for companies. Until emissions trading schemes are up and running, however, it is difficult to estimate what the price of carbon allowances or credits will be. Differences in pricing reflect the risks associated with the commodity transacted, the market targeted and buyer motivation. Until emissions trading schemes come online and the remaining elements for a trading infrastructure are put in place, that is, registries and reporting mechanisms, a public price for CO2 will not emerge. This does not imply, however, that a carbon price will develop quickly. The price of carbon will continue to differ by market segment and commodity type. Prices will reflect the market from which they originate (assuming linkages with both project-based offsets and linkages between trading schemes). EU allowances are likely to develop one price, Canadian allowances will be no more than C$ 15 given the government ‘price assurance’, and other domestic emissions trading schemes are likely to develop prices that reflect national circumstances, at least to some degree. Countries such as Japan and Norway, with higher marginal costs of abatement are likely to depend heavily on importing reductions since it will be less costly to offset emissions elsewhere than to reduce a large percentage domestically. The EU allowance price, however, is likely to influence other prices since it will be the largest international trading scheme. CER prices are likely to vary by project and intention. Some buyers and some project developers have developed project to meet specific aims for which they are willing to pay a higher premium, that is, boutique CERs that meet a particular definition of sustainable development or that meet some other criteria not specifically required under the CDM (secondary benefits such as poverty reduction or improved local environment).

CHAPTER 8

Carbon Costs in an Uncertain World Introduction of policies to reduce greenhouse gas emissions will impose costs, but emissions trading should help reduce the overall cost of compliance, especially compared to a direct regulatory approach. Emissions trading will enable companies (at the domestic level) and countries (at the international level) with high marginal costs to purchase reductions from companies and countries with lower marginal abatement costs. Even with emissions trading, however, costs will be incurred and impacts felt. Impacts will include a change in the generation mix and the price of electricity, but the extent of the impact is dependent on many other factors, including the composition of a country’s power generators, the primary fuel used, the cost of the primary fuel used, and domestic energy policies. The extent to which these impacts can be predicted, or felt during the trading periods, depends in part on the uncertainties surrounding the process of implementing an emissions trading scheme. Although many OECD countries have committed to implementing emissions trading schemes even without the Kyoto Protocol, uncertainty exists in many areas of the current process. These uncertainties present potential barriers to the development of a fully functional and liquid market, in that the uncertainties could influence the development of the market itself and how players perceive the risks of climate change policy. Politically, continued uncertainty surrounds the Kyoto Protocol. Russia continues to be one of the great ‘unknowns’ in climate policy and in market development. Entry into force of the Protocol is dependent on Russia. The longer it takes for Russia to ratify, the greater the uncertainty for the Protocol process and the more delay there will be in establishing the governance bodies that are to determine whether countries are eligible to trade under the Kyoto trading system. Even if Russia ratifies some time before 2007, it remains to be seen whether or when they will be able to meet requirements for participating in emissions trading or even joint implementation. In 2005, the UN climate process may begin assessing the progress Annex I countries have made towards fulfilling commitments 211

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under the Protocol. This assessment is likely to influence discussions over a second commitment period, in which many Annex I Parties have stated that participation at a more global level is required, that is, that the US must come on board and at least some of the larger developing countries will need to take on some type of commitment. Under the Protocol framework, emissions trading is only one of the possible measures countries can implement to meet their targets. While domestic trading schemes are aimed at the company level, trading under the Protocol requires that countries remain responsible for their commitments. Governments can devolve their ‘cap’ and authorize companies to trade. They can also retain all or part of their ‘cap’ and trade at the government level. Current designs for domestic emissions trading schemes do not call for allocation of the entire Kyoto cap. This implies that under the Protocol, governments are likely trade any allowances that are not distributed to trading sectors. Countries that have developed emissions trading schemes will need to detail what level of commitment they intent to keep in the event the Protocol does not enter into force. With the exception of the Norwegian proposal for 2008 to 2012, very few trading schemes intend to allocate their entire Kyoto ‘cap’ into the trading schemes. The EU scheme during the first trading period (2005–2007) covers approximately 40 per cent of its overall target, whereas if the Norwegian proposal were put into place, it would cover almost 90 per cent. If countries are to abide by their Protocol targets, they will have to work out details on how they intend to meet targets, how stringent the cap will be for the 2008 to 2012 period and for follow-on periods.

8.1

THE ALLOCATION PROCESS

Perhaps one of the most difficult issues governments face in designing and implementing an emissions trading scheme is how to allocate the cap on emissions. Allocation plans determine the amount of emissions each participating company must reduce, and the total cost of the reductions. Different methods imply different costs, and can create different ‘winners and losers’ depending on the allocation formula. This makes allocation plans a politically charged issue. In deciding on an allocation plan, governments examine a number of issues. The first is determining whether to distribute allowances free of charge or to auction them, or some combination of the two. Under current trading schemes, countries are primarily distributing allowances free of charge since this is politically more acceptable than requiring source to

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purchase their allowances through an auction. Auctioning involves added up front costs to sources, since sources must purchase any allowances they anticipate will be needed to be in compliance in the trading period. Revenues from an auction could be recycled to offsetting a tax or could be used to reduce administrative costs. But it tends to be unpopular among companies since any windfall profit is collected by government as opposed to affected sources. Auctioning is also simpler than grandfathering since the latter requires developing formulas for distribution that can also be politically charged. Different allocation formulas create different outcomes, which is what makes it a more complicated and potentially time consuming option than auctioning allowances. In deciding on an allocation plan for the SO2 programme, for instance, the US went through 40 different formulae reflecting different considerations, the US NOx trading programme, RECLAIM,89 also went through various formulae. There is any number of combinations that could be used to determine how allowances should be allocated. It could be based on historic emissions which rewards the largest and least efficient emitters, or historic production output or fuel input which favours those that produced the most or used the most fuel. The choice is in part dependent on the quality of data available and political considerations. It is also possible to use historic data plus a standard; the US SO2 programme combined the historic level of heat input and an emissions standard. In this way, the largest emitters were required to reduce but it also rewarded those who had taken early action by requiring them to reduce less or none at all. The process of developing allocation plans based on grandfathering is politically difficult. The EU process for NAP development is a good example. Member States began developing NAPs in 2003 with a deadline of March 2004. Most countries did not meet the deadline. Some countries barely manage to come to agreement just prior to the deadline. One of the big problems is determining on what basis to set the cap. Member States have a reduction target under the burden sharing agreement, some have other domestic targets and then there are agreements with industry. Not all agreements or targets use the same base year making interpretation of the numbers a complex exercise. The EU criteria specify allocation plans must ensure that Member States distribute allowances in line with their internal burden sharing and Kyoto targets. This means that the Kyoto cap will have to be divided between the trading and non-trading sectors in such a way as to allow the Member State to meet its target. The EU will then review NAPs to determine whether the criteria have been met. Determining whether a Member State has met the criteria is likely to be as politically charged a process as developing the NAPs. Under the burden sharing agreement,

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Germany for instance, must reduce emissions 21 per cent below 1990 levels. In 2000, the government entered into voluntary agreements with industry to reduce 1998 emissions by 20 million tonnes of CO2 (Mt CO2) by 2005 and 45 Mt CO2 by 2010. The baseline for industry under the German ETS is the average emissions in the period 1 January 2000 to 31 December 2002 for industry generating before 31 December 1999. For industry beginning activities between 1 January 2000 and 31 December 2003, the base period is 1 January 2002 to 31 December 2003. German CO2 emissions for 2002 are estimated at 505 Mt CO2. In Germany’s 2003 National Inventory Report (covering emissions through 2001), total emissions in CO2 equivalent (excluding land use change and forestry sectors) were 18 per cent below 1990 levels. All of this information, plus how the non-trading sector is likely to cover its emissions reductions will have to be considered in reviewing the NAP. In examining options for Norway’s emissions trading scheme, a ‘Quota Commission’ was established to examine different design elements for its ETS. One of the issues examined was allocation of allowances. The Commission was unable to come to an agreement on the best method for allocation. While a thin majority favoured auctioning and recycling revenues to reduce taxes, industry and environmental representatives felt grandfathering was the most appropriate method, and government representatives felt this issue was outside the mandate of the Commission since it is ultimately a political decision. The Norwegian Government is expected to allocate allowances free of charge.

8.1.1

Linking trading schemes

The current political process is based on the development of domestic markets in the absence of the entry into force of the Kyoto Protocol. One of the benefits of the Protocol system is that it enables a larger number of countries and companies to trade without the difficulties of negotiating linking agreements between domestic systems. Without the Protocol in place, agreements on linking become a necessity. From a market perspective, linking with other trading schemes provides greater liquidity and should help reduce compliance costs. But if different schemes have vastly different systems and quality controls, then it could affect the environmental integrity of the schemes. It is unclear, however, how quickly negotiations between countries with different systems can proceed, and whether trading through linked systems could begin before 2008. Although technical issues could be resolved, there are likely to be political issues that could protract negotiations, including influencing design choices (expanding trading

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coverage during subsequent trading periods) and how subsequent linking agreements might affect the first agreement. In the Directive establishing the EU ETS, the EC has included the ability to link with other national emissions trading schemes (Article 25 of the Directive) through bilateral agreements. From the EU perspective, linking with other schemes has the advantage of increasing market liquidity and efficiency, ensuring that industries that compete internationally are more likely to be covered by schemes that have similar requirements, and will make it more likely for countries not currently planning to trade greenhouse gas emissions to consider joining a fully functioning and liquid market. EU requirements for linking to other trading schemes fall into two categories: those that could be considered of greater importance such as the quality of the monitoring and reporting provisions and those that could be considered of lesser importance such as sectoral and gas coverage (see Box 8.1). Other countries are likely to have different approaches to linking which complicates an EU approach. As stated previously, the Canadian government finds that the framework provided under the Marrakech Accords is a sufficient basis for linking beginning in 2008. When linking outside the Protocol, the process for linking means that independent reviews of the systems required for trading are not likely to occur and therefore assurances of the overall quality of the systems are left to those negotiating the linking agreement. Box 8.1

EU requirements for linking ETS

Of more importance

Quality of monitoring and reporting provisions Level of sanctions Currency Registries conform to Kyoto Protocol standards Type and stringency of environmental target Private sector creates market without governmental intervention

Of lesser importance

Sector and gas coverage Trading periods Allocation method Direct vs. indirect emissions approach (as long as double counting is avoided)

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The EU and Canadian schemes will look very different. Canada and the EU have vastly different approaches to the level of sanction with the Canadians choosing to limit the costs to companies and providing greater flexibility in meeting reduction targets. The targets are relative as opposed to absolute, there is a price cap on allowances ( the Canadian government has given its assurances to industry that it will be able to purchase allowances at prices no higher than CN$15) and the Canadian scheme is open to all Kyoto reduction units. Another example is the Norwegian trading scheme. In the first trading phase of 2005 to 2007 it is likely to look similar to the EU ETS. In both the Canadian and Norwegian cases, the level of sanction is unclear. For Canada and Norway, recognition of the Marrakech Accords is likely to be one way to move forward on linking, but given the EU view that the EU ETS is parallel to the Protocol trading system, it is unclear how they will proceed. An additional difficulty that Norway and Canada (as well as other Annex B countries outside the EU) are likely to face in linking with the EU ETS is that both countries are net buyers and add little in the way of available low cost reductions for the EU.

8.1.2

Other factors

The policy mix within a country also plays an important role in enabling a country to meet its target and influences the cost of complying with reduction targets. Within the EU, there are Directives on, for example, increasing the share of renewables in the energy mix. Several countries within the EU have policies aimed at phasing out nuclear power stations.90 In addition many countries and regions, including the US and the EU, have policies aimed at achieving energy security, in part by reducing reliance on imported fossil fuels. How countries implement energy security strategies affects the amount of greenhouse gas emissions a country is likely to produce and the costs associated with reducing these emissions. Different technology choices imply different reduction paths and different marginal abatement costs. Finally, decisions on subsequent trading periods will not only affect prices, but will impact investment decisions. The uncertainty of whether follow-on periods will occur and if so, whether they will be more stringent than a first trading period could delay investments in technologies or other improvements that would reduce greenhouse gas emissions more cost efficiently.

8.2

FUTURE OUTLOOK FOR THE PROTOCOL

Despite the uncertainties surrounding the Protocol, countries are instituting trading schemes as a way of meeting the greenhouse gas emissions

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reductions or limitations targets. Market mechanisms will be part of policies and measures countries put in place in order to abate emissions cost effectively regardless of the Protocol. It will also be part of future international and domestic regimes. It is therefore interesting to consider the potential for involving actors outside the present regime, in particular the US Government and US business and industry in trading activities in short and long term. In A Strategic Assessment of the Kyoto-Marrakech System, Grubb et al. (2003) pose three scenarios for the future of the Protocol: &

The ‘Stillborn’ Protocol. The Protocol either fails to enter into force (Russia does not ratify) or the commitment period requirements are not met. Despite the collapse of the Protocol, however, the structures for the Kyoto mechanisms remain in tact and useable.

&

The Protocol enters into force, the commitment period succeeds, but a second commitment period must be negotiated. There are two subscenarios. The first in which there is an impasse on negotiations under a second period, and the second in which negotiations on second period succeed. Under either sub-scenario, US participation is necessary.

&

Re-entry of the US. This scenario is based on the success of internal domestic pressures, and reaching agreement with some of the EITs (Russia and Ukraine) on obtaining the bulk of their excess assigned amount. With the US participating, it might help pave the way for a smoother second commitment period negotiation.

The assessment highlights the importance the US continues to have over the potential success or failure of the Protocol. A second commitment period will have to be negotiated in the absence of knowing whether the first commitment period will be successful, unless there is a gap between periods. Without US participation, developing countries are even less likely to discuss taking on commitments especially since the economic benefits of taking on a target will not have been fully realized. If developing countries are unwilling to discuss future commitments, then there is a high likelihood that Annex I countries will be unwilling to take on more stringent commitments. US participation under the current Bush administration is highly unlikely, and if Bush wins a second term they are unlikely to have a shift in position91 before the second commitment period negotiations must conclude. Industry within the US, however, continues to participate in developing CDM and JI type projects, they participate in voluntary trading programmes and take on reduction targets and report emissions. Activities at the State

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level are likely to require industry to reduce emissions regardless of US ratification of the Protocol. Despite the absence of leadership on the climate change issue at the federal level, the US is active and at least some segments of it are likely to participate in the carbon market either through projectbased crediting or emissions trading. The greatest affect they may have, is on the shape and outcome of negotiations for a future commitment period.

8.3

PROSPECTS BEYOND 2012

Negotiations for a second commitment period under the Kyoto Protocol are scheduled to begin at the end of 2005 with an intention of concluding negotiations prior to the start of the commitment period in 2008. It is unclear how long negotiations on a second commitment period could be delayed without negotiations essentially disintegrating before they are able to start. In addition, progress on implementation of the Protocol is to be assessed in 2005, and this will be key to showing developing countries that Annex I countries have indeed taken the first step in reducing emissions. The US administration’s position, however, complicates an already complicated situation. It is important to remember that prior to the withdrawal of the US from the Protocol negotiations, the state of North–South (and even North–North) relations were such that it seemed highly unlikely the Protocol would enter into force. The negotiations were nearly at a standstill, and it was due to the US’s ‘new stance’ that the process moved forward; the withdrawal of the US provided a focal point on which the remaining countries could converge and unite. Unless there is a sea change on the issue of expanded (including developing country) commitments, the same impasse is likely to occur. As Grubb et al. (2003) point out it could be possible for negotiations to successfully conclude on a second commitment period, further isolating the US. But with the largest greenhouse gas emitter and wealthiest country refusing to participate, it may be impossible for negotiations on a second commitment period to proceed as the distrust between developed and developing countries is likely to grow more acute, and the already difficult issue of developing country commitments could become untenable. Although a successful first commitment period would benefit such negotiations, the timing does not allow for that. If negotiations continue into the commitment period, the certainty that the process was intended to establish, particularly for industry, will diminish, and the perception is likely to be that the negotiations are a failure. Even if the Protocol falters, the legacy of Kyoto has already been created. The mechanisms and the accompanying regulations that make trading an effective economic and environmental tool are nearly complete. The CDM,

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with its early start-up, continues to develop at a rapid rate, and these rules will affect how JI projects are developed. Ultimately the design of the CDM will shape the JI infrastructure. In addition, current negotiations on national registries and transaction logs will affect design elements of domestic trading systems in the event (and under the hope) that emissions trading under the Protocol will begin in 2008. Negotiations on national systems for estimating emissions and removals, and guidelines for inventories of emissions are also likely to influence how domestic programmes are structured, how caps are set and allowances allocated. All of these negotiations are scheduled to conclude before the negotiations on a second commitment period begins. The evolution of the systems required for emissions trading under the Protocol, in the event the Protocol does not enter into force, provide a starting point and common ground for countries developing domestic trading systems. This could in theory make it somewhat easier for domestic systems to link up and recognize reductions and removals units from other systems.

Glossary of Terms

Activities Implemented Jointly (AIJ)

The pilot phase under Activities Implemented Jointly (AIJ) was established through a compromise agreement at COP-1 that resulted from a debate on whether to include Joint Implementation with crediting under the UNFCCC. AIJ enabled governments and businesses within non-Annex I and Annex I countries to jointly undertake projects to reduce or sequester emissions without the ability to earn tradable credits.

Afforestation

The direct human-induced conversion of land that has not been forested for a period of at least 50 years to forested land through planting, seeding and/or the human-induced promotion of natural seed sources.

Annex I Parties

Annex I Parties consist of 41 industrialized countries that committed to the aim of reducing their emissions to 1990 levels by the year 2000, including all the developed countries in the Organization for Economic Cooperation and Development, and economies in transition.

Annex II Parties

Annex II Parties are composed of all developed countries in the Organization for Economic Cooperation and

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221

Development (23 countries plus the European Community). Annex B Parties

Countries included in Annex B in the Kyoto Protocol that have agreed to a target for their greenhouse gas emissions, including all the Annex I countries (as amended in 1998) except Turkey and Belarus.

Anthropogenic

Resulting from or produced by humans. Anthropogenic greenhouse gas emissions are emissions associated with human activities, such as burning fossil fuels or land use changes that increase net greenhouse gas emissions.

Assigned Amount (AAs)

The total amount of greenhouse gas emissions that each Annex B country has agreed will not exceed during the commitment period from 2008 to 2012. The AA is calculated by multiplying a country’s total greenhouse gas emissions for its base year or period by five (for each year under the commitment period), and then by the reduction percentage contained in Annex B of the Kyoto Protocol.

Assigned Amount Unit (AAU)

AAUs are derived directly from the assigned amount. One AAU is equal to 1 metric tonne of CO2 -equivalent emissions calculated using Global Warming Potentials.

Atmosphere

A gaseous component of the climate system that surrounds the Earth. The atmosphere consists almost entirely of nitrogen and oxygen, and a number of trace gases including greenhouse gases such as carbon dioxide and ozone. The atmosphere also contains water vapour, clouds and aerosols.

Banking

Under the Kyoto Protocol, Annex B Parties may save excess emission allowances or credits (subject to certain limitations)

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GLOSSARY OF TERMS

from the commitment period for use in any subsequent periods. Biosphere

A component of the climate system that comprises all ecosystems and living organisms in the atmosphere, on land (terrestrial biosphere), or in the oceans (marine biosphere), including derived dead organic matter such as litter, soil organic matter and oceanic detritus.

Carbon Dioxide (CO2)

One of the six greenhouse gases under the Kyoto Protocol. It is a naturally occurring gas, as well as a by-product of burning fossil fuels and biomass, and land-use changes and other industrial processes.

Certified Emission Reduction Unit (CER)

Project activities under the CDM can generate Certified Emission Reduction units (CER) based on the amount of greenhouse gas emissions reduced or sequestered by a project activity. CERs are added to a Party’s assigned amount. One CER is equal to 1 metric tonne of CO2 -equivalent emissions reduced or sequestered.

Chlorofluorocarbons (CFCs) Greenhouse gases covered under the 1987 Montreal Protocol and used for refrigeration, air conditioning, packaging, insulation, solvents, or aerosol propellants. Since they are not destroyed in the lower atmosphere, CFCs drift into the upper atmosphere where, given suitable conditions, they break down ozone. These gases are being replaced by other compounds, including hydrochlorofluorocarbons and hydrofluorocarbons, which are greenhouse gases covered under the Kyoto Protocol. Clean Development Mechanism (CDM)

Article 12 of the Kyoto Protocol established the Clean Development Mechanism. It has three objectives: (1) to assist Parties not included in Annex I in

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achieving sustainable development and in contributing to the ultimate objective of the convention; (2) to contribute to the ultimate objective of the Convention; and (3) to assist Parties included in Annex I in achieving compliance with their quantified emission limitation and reduction commitments. Climate

The IPCC defines climate in two ways. In a narrow definition it is as the ‘average weather’ or a statistical description in terms of ‘the mean and variability of relevant quantities over a period of time ranging from months to thousands or millions of years’. In a broader sense it is the state, including a statistical description, of the climate system.

Climate Change

Under the UNFCCC, climate change is defined as ‘a change of climate which is attributed directly or indirectly to human activity that alters the composition of the global atmosphere and which is in addition to natural climate variability observed over comparable time periods.’

Climate System

The climate system is made up of five major components. The first is the atmosphere which changes constantly. The second is the hydrosphere composed of liquids (i.e., oceans, rivers, lakes); the third is the cryosphere composed of sea ice, ice sheets and glaciers. The biosphere is composed of all ecosystems and living organisms, in the atmosphere, on land (terrestrial biosphere) or in the oceans (marine biosphere), including derived dead organic matter, such as litter, soil organic matter and oceanic detritus. The fifth component is the land surface. These are affected by various external forces, the most important of which is the sun. Human activities that affect the climate

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GLOSSARY OF TERMS

system are considered an external forcing. Other naturally occurring external forcing includes volcanic eruptions. Conference of the Parties (COP)

The Conference of the Parties (COP) is the ‘supreme body’ of the Convention and consists of countries that have ratified or acceded to the UNFCCC.

Conference of the Parties Serving as the Meeting of the Parties (COP/MOP)

The governing body of the Protocol is the Conference of the Parties serving as the Meeting of the Parties (COP/MOP), and is composed of Parties to the Convention who have ratified or acceded to the Protocol.

Cryosphere

It is a component of the climate system consisting of all snow, ice and permafrost on and beneath the surface of the earth and ocean.

Deforestation

Direct human-induced conversion of forested land to non-forested land.

Economies in Transition (EITs)

Countries with economies in transition (commonly referred to as EITs) include countries from the former Soviet Union and Central and Eastern Europe.

Emissions Reduction Unit (ERU)

JI projects generate ERUs based on the amount of greenhouse gas emissions it reduced or sequestered. ERUs are converted from RMUs or AAUs, and one unit is equal to one metric tonne of carbon dioxide equivalent.

Emission Trading

A market-based approach to meeting environmental goals, where a target is set in order to reduce emissions below a certain level. Sources affected by the target have the flexibility of deciding how best to meet the target. Sources have the option of reducing emissions, reducing emissions beyond its target and selling or banking excess reductions, purchasing excess emissions reductions from another

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225

source or failing to comply and pay penalties. Emissions trading systems can occur at the company, national and international levels. Article 17 of the Kyoto Protocol sets out an international emissions trading system in which parts of a country’s assigned amount can be transferred and/or acquired in order to meet its target. Extreme Weather Event

Weather events that are rare or unusual for a particular place or particular time. The IPCC defines rare as ‘rare or rarer than the 10th or 90th percentile’.

Global Warming Potential (GWP)

An index established by the IPCC to compare the ability of greenhouse gases to absorb heat in the atmosphere in comparison to carbon dioxide.

Hydrofluorocarbons (HFCs)

One of the six greenhouse gases under the Kyoto Protocol. They are produced commercially as a substitute for chlorofluorocarbons. HFCs are used primarily in refrigeration and semiconductor manufacturing.

Hydrosphere

The component of the climate system composed of liquid surface and subterranean water, such as oceans, seas, rivers, freshwater lakes, underground water, etc.

Joint Implementation (JI)

Article 6 of the Kyoto Protocol provides Annex I countries or their companies the ability to jointly implement greenhouse gas emissions reduction or sequestration projects that generate Emissions Reduction Units.

Kyoto Mechanisms

The Kyoto mechanisms include Joint Implementation (Article 6), the Clean Development Mechanism (Article 12), and international emissions trading (Article 17). The mechanisms provide countries with limitation or reduction

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GLOSSARY OF TERMS

targets under the Kyoto Protocol with some flexibility in how, when and where they reduce their emissions. Kyoto Protocol

Adopted in December 1997 by the third sessions of the Conference of the Parties to the United Nations Framework Convention on Climate Change (UNFCCC) in Kyoto, Japan. The Kyoto Protocol to the UNFCCC contains an agreement for Annex B Parties to reduce overall emissions collectively by at least 5 per cent below 1990 levels in the period 2008–2012. Emissions limitation and reduction commitments for Parties are contained in Annex B of the Protocol.

Land use

All activities or actions directly attributable to humans on a unit of land.

Land-use change

A change in the use or management of land directly attributable to humans that may lead to a change in land cover.

Methane (CH4)

One of the six greenhouse gases under the Kyoto Protocol. Methane is produced through anaerobic (without oxygen) decomposition of waste in landfills, animal digestion, decomposition of animal wastes, production and distribution of natural gas and oil, coal production and incomplete fossil-fuel combustion.

Montreal Protocol

The Montreal Protocol on substances that deplete the ozone layer controls the consumption and production of chlorineand bromine-containing chemicals that destroy stratospheric ozone, including chlorofluorocarbons (CFCs).

Nitrogen oxides (NOx)

Any of several oxides of nitrogen.

Nitrous oxide (N2O)

One of the six greenhouse gases under the Kyoto Protocol. It is emitted through soil cultivation, especially the use of commercial and organic fertilizers, fossil-fuel

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227

combustion, nitric acid production and biomass burning. Non-Annex I Parties

Non-Annex I Parties are countries that have ratified or acceded to the United Nations Framework Convention on Climate Change that are not included in Annex I of the Climate Convention.

Ozone

Ozone is a gaseous component in the atmosphere. In the troposphere it is created both naturally and by photochemical reactions involving gases resulting from human activities (photochemical ‘‘smog’’). In high concentrations, tropospheric ozone can be harmful to a widerange of living organisms. Tropospheric ozone acts as a greenhouse gas. In the stratosphere, ozone is created by the interaction between solar ultraviolet radiation and molecular oxygen (O2). Its concentration is highest in the ozone layer. Depletion of stratospheric ozone, due to chemical reactions that may be enhanced by climate change, results in an increased ground-level flux of ultravioletB radiation. See also Montreal Protocol.

Perfluorocarbons (PFCs)

One of the six greenhouse gases under the Kyoto Protocol. PFCs are by-products of aluminium smelting and uranium enrichment. They are also used to replace chlorofluorocarbons in manufacturing semiconductors.

Reforestation

The direct human-induced conversion of non-forested land to forested land through planting, seeding and/or the humaninduced promotion of natural seed sources, on land that was forested but that has been converted to non-forested land. For the first commitment period under the Kyoto Protocol, reforestation activities are limited to reforestation occurring

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GLOSSARY OF TERMS

on lands that did not contain forest on 31 December 1989. Reservoir

A component of the climate system, that has the ability to store, accumulate or release a greenhouse gas or a precursor of a greenhouse gas. Examples of reservoirs are oceans, soils and forests.

Sinks

Any process activity or mechanism that removes a greenhouse gas (increases a carbon reservoir), an aerosol or a precursor of a greenhouse gas from the atmosphere, for instance by enhancing soil carbon in agricultural lands, reforestation or long-term storage of carbon dioxide in underground reservoirs.

Source

Any process, activity or mechanism that releases a greenhouse gas into the atmosphere.

Stratosphere

The region of the atmosphere above the troposphere.

Sulfur hexafluoride (SF6)

One of the six greenhouse gases to be curbed under the Kyoto Protocol. It is largely used in heavy industry to insulate high-voltage equipment and to assist in the manufacturing of cable-cooling systems.

Troposphere

The lowest part of the atmosphere.

United Nations Framework Convention on Climate Change (UNFCCC)

Adopted in May 1992 and signed at the 1992 Earth Summit in Rio de Janeiro by more than 150 countries and the European Community and entered into force in March 1994. Its ultimate objective is the ‘stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system’.

Vector-borne diseases

A disease transmitted between hosts by a vector organism such as a mosquito or tick, for example malaria or dengue fever.

NOTES

Chapter 1. Introduction 1. The climate system is made up of five major components. The first is the atmosphere which changes constantly. The second is the hydrosphere composed of liquids (i.e., oceans, rivers, lakes); the third is the cryosphere composed of sea ice, ice sheets, and glaciers. The biosphere is composed of all ecosystems and living organisms, in the atmosphere, on land (terrestrial biosphere) or in the oceans (marine biosphere), including derived dead organic matter, such as litter, soil organic matter and oceanic detritus. The fifth component is the land surface. These are affected by various external forces, the most important of which is the sun. Human activities that affect the climate system are considered an external forcing. Other naturally occurring external forcing includes volcanic eruptions. 2. There are thousands of gases in the atmosphere but only a few have the ability to spread through the atmosphere and mix uniformly. 3. Water vapour is the largest component of the ‘natural’ greenhouse effect but is not directly affected by human activity, and its influence in the enhanced greenhouse effect is difficult to capture in models. 4. Although considered a greenhouse gas, CFCs are covered under the Montreal Protocol. 5. For further information on greenhouse gases or the greenhouse effect see the Climate Info Kit (2002, UNEP And UNFCCC) at www.UNFCCC.INT and the IPCC website at www.IPCC.ch. 6. In its ‘Climate Change Science: An Analysis of Some Key Questions’, the US National Academy of Sciences describes climate as the ‘average state of the atmosphere and the underlying land or water, on times scales of seasons and longer’. The statistics used to describe it include temperature, precipitation, wind, humidity, cloudiness, soil moisture, sea surface temperature and the concentration and thickness of sea ice. 7. Climate Change 2001: The IPCC’s Third Assessment Report.

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8. Cap and trade is one form of emissions trading. Two other examples are project-based trading such as the clean development mechanism and ratebased trading using a performance standard for a particular sector. 9. The Umbrella Group was formed at COP-3 in Kyoto and consisted of Australia, Canada, Iceland, Japan, New Zealand, Norway, Russia and the US. The Ukraine was also a member of the Umbrella Group for a short time. 10. Trading has occurred under the 1987 Montreal Protocol on Substances that Deplete the Ozone Layer, although not to the extent that would occur under the Kyoto Protocol. The Montreal Protocol requires industrialized countries to phase out chlorofluorocarbons and other ozone-depleting substances according to binding timetables, but does not specify specific policies or measures nor does it set up an accounting procedure for emissions trading. Some countries, such as the US did however use these requirements to issue tradable allowances to producers and importers of these chemicals. And some international trades did occur. Chapter 2. Climate Change and the UN Process 11. It is important to note that there is a clear distinction between signing, ratifying and the entry-into-force of an agreement. Signatories to an agreement do not have the same legal status as Parties to an agreement. In order to become a Party, countries must ratify, accept, approve or accede to a treaty. Ratification, approval and acceptance are done prior to the entry into force of a treaty. Approval or acceptance is done in cases where a state’s national law does not require the treaty to be ratified by the head of state. Accession occurs when a country accepts the offer to become a Party to a treaty. This is usually done after a treaty has entered into force. In the case of the Kyoto Protocol, entry-into-force is triggered by a specific number of ratifications plus a specific percentage of Annex I emissions. 12. Article 2 of the UNFCCC. 13. IPCC, Climate Change 2001: Synthesis Report, Question 1, page 38. 14. In addition to the six greenhouse gases, Annex I Parties may also report on carbon monoxide, nitrogen oxide, non-methane volatile organic compounds as well as sulphur oxides. 15. Funding is provided by through the GEF. 16. Non-Annex I countries have consistently argued that cooperative projects (AIJ or CDM) not divert funding from ODA. 17. In addition, this proposal called for no new/additional commitments for developing countries; development of a comprehensive approach to phasing in other greenhouse gas emissions; and development of a coordination mechanism for cooperation on economic, administrative and other implementation measures. 18. Not all Parties, a few Annex I Parties as well as many oil producing countries, felt the Declaration should not be adopted due to objections over the Declaration’s content – reference to targets and timetables and endorsement of the IPCC’s SAR – and the perceived lack of transparency of the process.

NOTES TO CHAPTER 3

19. 20. 21. 22.

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Decision 22/CP.7 of the Marrakech Accords (Section II.F.21). Article 3.3 of the Protocol. See www.unfccc.int. The national system is the inventory data collection, calculation, recalculation, and reporting process.

Chapter 3. The Kyoto Mechanisms – A Framework for International Emissions Trading 23. Article 3.10 and 3.11 of the Protocol cover additions and transfers of ERUs and any part of an assigned amount. Article 3.12 covers the addition of CERs to an assigned amount. 24. See Decision 18/CP.7. 25. Any individual source category that accounts for 7 per cent or more of a Party’s total emissions must be included in its inventory. 26. The most recently submitted inventory would be the April 2006 submission which would include emissions through 2004; although Parties could provide an updated inventory for 2005 if the information is complete. 27. Only portions of the inventory related to greenhouse gases in Annex A and land-use change and forestry sections are reviewed. 28. Under buyer liability, trades could be cancelled or devalued if the seller is out of compliance. 29. The term JI is not used in the Protocol. 30. This of course does not mean that forward streams of ERUs cannot be purchased; it simply means that investors must purchase ERUs with a considerable amount of risk attached to them. 31. Some clarification of this issue is still required under both project-based mechanisms. 32. FCCC/CP/2001/13/Add.2 Decision 16/CP.7 Article 6/Annex D, paragraphs 21, 23 and 24. 33. The definition of transparent and conservative: ‘assumptions are made explicitly and choices are substantiated. In case of uncertainty regarding values of variables and parameters, the establishment of a baseline is considered conservative if the resulting projection of the baseline does not lead to an overestimation of emission reductions attributable to a CDM project activity (i.e. in the case of doubt, values that generate a lower baseline projection shall be used).’ 34. The Executive Board shall comprise ten members from Parties to the Kyoto Protocol, as follows: one member from each of the five United Nations regional groups; two other members from the Parties included in Annex I; two other members from the Parties not included in Annex I; and one representative of the small island developing States, taking into account the current practice in the Bureau of the Conference of the Parties. The ten alternates are elected from the same constituencies. 35. The standards for accreditation of DOEs are set out at Appendix A of the Marrakech Accord.

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NOTES TO CHAPTER 4

36. Two DOEs will need to be contracted, unless permission is granted by the executive board to use one. One DOE would carry out project validation while the second would verify and certify the emission reductions generated by the project. Small-scale projects are only required to contract one DOE. 37. In using this approach the executive board issued the following clarification: project developers must elaborate how they determine ‘similar social, economic, environmental and technological circumstances’ and how they assess the ‘performance among the top 20 per cent of their category’ defined as greenhouse gas performance in terms of CO2 equivalent (CO2e) emissions per unit of output. The more conservative of the following should be used: &

The output weighted average emissions of the top 20 per cent of similar project activities undertaken in the previous five years in similar circumstances

&

The output weighted average emissions of similar project activities undertaken in the previous five years under similar circumstances that are also in the top 20 per cent of all current operating projects in their category.

38. The emissions baseline has to be established in a transparent manner with regard to the choice of approaches, assumptions, methodologies, parameters, data sources and key factors, including relevant national and/or sectoral policies and circumstances such as sectoral reform initiatives, local fuel availability, power sector expansion plans and the economic situation in the project sector. 39. Although nuclear is not strictly excluded from the CDM it is unlikely that a nuclear project would be registered under the CDM.

Chapter 4. Building Markets 40. COM/ENV/EPOC/IEA/SLT (2005)5. 41. The NAPAP is an interagency organization composed of six Federal agencies, and serves a coordinating function among its members as well as other governments, States, academia and the private sector. The NAPAP reports to Congress on research and monitoring of emissions as well as the costs, benefits and effectiveness of the Acid Rain Programme. 42. This figure is adjusted for inflation yearly. 43. Ellerman et al. (2003). 44. The OTC consists of Connecticut, Delaware, the District of Columbia, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont and Virginia. 45. Ground level ozone is created when NOx and volatile organic compounds react with sunlight, particularly in warm summer months. 46. Addressing local environmental impacts may be more practical for pollutants with more localized or regional impacts such as SO2 or NOx.

NOTES TO CHAPTER 5

233

47. The SO2 programme also set-aside allowances for direct sale to new sources at a fixed price of $1500, which was projected to be two to three times the allowance price at the start of the programme. The price of allowances, however, was much lower than expected so the programme was eliminated in 1997. The set-asides were taken from the cap. 48. Sorrell S. 2003, Interaction in EU Climate Policy, SPRU; Sijm, J, and van Dril A., 2003, Interaction between the EU emissions trading Scheme and Energy Policy instruments in the Netherlands: Implications of the EU Directive for Dutch Climate Policies, ENC. 49. From 2005 to 2007 it would work in parallel with the carbon tax, but would replace it in 2008. 50. Approval was delayed over the issue of whether free distribution of allowances constituted state aid. 51. Management control is defined as exerting dominant influence over emissions from a source (i.e. the ability to direct financial and operating policies related to a source’s emissions). 52. In 2001, CO2 accounted for 82.4 per cent of total greenhouse gas emissions (excluding land-use change and forestry activities). The energy sector accounted for 81.4 per cent of total greenhouse gas emissions (excluding CO2 and other gases related to land-use change and forestry). 53. Large final emitters are defined as companies with annual average emissions of 8 kt CO2e per establishment or more; and annual average emissions of 20 kg CO2e per $1000 gross production or more. 54. Forward Settlements are contractual agreements between a buyer and seller for forward streams of a particular greenhouse gas commodity. Chapter 5. Managing Carbon 55. The institutions involved in the CDP collectively represented assets in excess of US$4.5 trillion in 2003. Their complete report is available at www.cdproject.net. 56. These economic losses are in part attributable to an increase in economic development as well as population growth. 57. Carbon is generally used to describe the type of market instead of greenhouse gases. It is a simplification of CO2 equivalent, since all greenhouse gases can be put into CO2 equivalents through GWPs. 58. These estimates took into account policies that had been adopted by governments prior to mid-2002. 59. COM/ENV/EPOC/IEA/SLT(2003)2. 60. Renewables in the energy mix can also have an unintentional affect of increasing emissions if the back-up capacity is either diesel or coal based (WEC, 2003). 61. Under the EU NAP process, at least some Member States are choosing to use an average or base year other than 1990 for which sufficient data is available. 62. PCA. Positive Returns on GHG Investments: The DuPont Experience with Advancing Environmental Goals, December 2002.

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63. The EU monitoring and reporting guidelines are compatible with and utilize the IPCC national inventory reporting. 64. Banking is one form of temporal flexibility. The other form is borrowing which many ETS do not explicitly allow. The only form of borrowing that occurs is through non-compliance with current year targets where allowances are taken from the next compliance year with an attached interest rate of additional allowances that must be surrendered from the compliance period. 65. The penalty in 2002 was $2849 per tonne. Chapter 6. Programmes Targeting Project-based Mechanisms 66. JI first track would be dependent on entry into force and the ability of the host country to meet all requirements. This would be another concern as it is unclear whether some of the countries with economies in transition will be able to meet all or even most of the eligibility requirements. Inventory quality should be of major concern in this respect. 67. This is the only real distinction between AAUs and ERUs. ERUs will now have some value, but it remains to be seen how ERUs would be generated if the Protocol does not enter into force. 68. Type I: Renewable energy project activities with a maximum output capacity equivalent of up to 15 megawatts (or an appropriate equivalent); Type II: Energy efficiency improvement project activities which reduce energy consumption, on the supply and/or demand side, by up to the equivalent of 15 giga watt/hours per year; Type III: Other project activities that both reduce anthropogenic emissions by sources and directly emit less than 15 kilo tonnes of carbon dioxide equivalent annually and Type IV other small-scale projects activities not listed in the other categories. 69. Methodology was derived from the Salvador Bahia Landfill Gas Capture project prepared by ICF Consulting. 70. Methodology was derived from the A.T. Bio Power Rice Husk Power Project prepared by Mitsubishi Securities. 71. Marrakech Accords. Decision 17 /CP.7. Section G. para 43. 72. Transaction costs are those costs that go beyond production costs, such as contract negotiation document preparation, registration fee, etc. 73. The CDM executive board put in place simplified modalities and procedures for small-scale activities in order to reduce transaction costs for projects that fall within these specifications. See Chapter 3 for more information. 74. It is important to note that rejection of a methodology is not an indicator of the potential for a project to be registered under the CDM. It is merely a rejection of the methodology and project developers can restructure a methodology and submit it for approval or use an approved methodology if one exists. 75. In its document entitled Implementation of the Clean Development Mechanism by The Netherlands, it simply states ‘in 2000, the Dutch government assigned considerable non-ODA budgets to VROM’.

NOTES TO CHAPTER 7

235

76. Ecofys, The Netherlands Country Profile Report, JOINT Programme. 77. The Dutch antithesis of this approach is the general approach where specific and guaranteed amounts of CERs would be negotiated for the portfolio, specifying the average price of CERs in the portfolio and the minimal quality of the CERs purchased. 78. The CDM contains one additionality test and that is whether the emissions reduced or sequestered are additional to what would have happened in the absence of the project activity (the environmental additionality test under the Dutch project is an equivalent of this additionality). The CDM rules require that the PDD contain an affirmation that public funding does not result in a diversion of official development assistance and does not count towards that Party’s financial obligations; this is not considered an additionality test by CDM rules. Chapter 7. The Carbon Market 79. Some consultancies estimate it may take up to five years to reach market maturity. 80. Forward contracts can either be for a fixed price or a floating price that is reset each year based on an index. A floating price, however, injects a great deal of uncertainty into the sellers planning process. The seller would be faced with an uncertain cash flow stream since yearly payments can be much less than anticipated, that is, due to falling prices. 81. A typical OTC derivative agreement covering one transaction can run 10 to 15 pages. The International Swaps and Derivatives Association provide a Master Agreement for a range of different derivatives. Emissions trading organizations such as the International Emissions Trading Organisation have also developed Master Agreements for particular emissions trading schemes. 82. See www.ieta.org. 83. The total number of transactions is much larger if intra-company transfers are included. DEFRA’s preliminary Report showed that (excluding allocations, cancellations, and retirements) 7.2 million allowances were transferred. 84. For a 12 month compliance period during a two year time span, that is, during a two-year period beginning January 2002 and ending December 2003, the compliance or milestone period would be 1 October 2002 through end September 2003. 85. The State of the Carbon Market 2004, PCFplus Research. 86. See www.evomarkets.com. 87. As stated previously the CDM executive board’s authority to issue CERs exists regardless of the fate of the Protocol. The prompt start decision does not hinge on the ability of the Protocol to enter into force. Although the CDMs modalities and procedures were drafted on the premise that the Protocol would enter into force, the ‘prompt start’ decision does not carry an expiration date. Absent any objections from non-Annex I Parties, the CDM executive board is likely to register project activities and issue CERs once ERs are verified and certified. It is also possible that the CDM could continue

236

NOTES TO CHAPTER 8

under the auspices of the Convention as the next phase of the pilot phase of Activities Implemented Jointly should it become clear that the Protocol will not enter into force. 88. Swiss Re press release dated 30 October 2003. Chapter 8. Carbon Costs in an Uncertain World 89. RECLAIM is the NOX regional trading programme in Southern California. 90. Approximately 35 per cent of the EU electricity is produced by nuclear, and does not emit any CO2. 91. There is growing pressure at the State and Local level to address climate change issues. It is unclear, however, when a sufficient threshold will be reached that would require the White House to address the issue in a proactive manner.

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Index

Acid rain, 89 see also US SO2 trading programme, US NOx budget trading Activities Implemented Jointly, 22–3 Ad Hoc Group on the Berlin Mandate (AGBM), 24–5 adaptation fund, 64, 172–3 see also CDM share of proceeds allocation methods, 88, 90, 97, 99, 112–13, 120, 213–14 allowance markets, 204–5 assigned amount, 40 Assigned Amount Units (AAUs), 41–2 transactions, 205 Australia, State of New South Wales, 123–5, 208 BP internal trading programme, 139–40 Buenos Aires Plan of Action, 25–6 California Climate Action Registry, 123 Canada, 120–2, 210 price assurance, 216 capital stock turnover, 134–8 carbon dioxide, 4–6 Carbon Disclosure Project, 2, 127–8 carbon management strategy, 156–8 carbon neutral products, 156 carbon transactions, 200–3 CDM, 64–81, 159–77 additionality, 71, 73, 164–70 afforestation and reforestation, 79 baseline, 66, 72, 260 baseline methodologies, 71–3, 163–70 DOEs, 70 executive board, 69 expert panels, 69 issuance of CERs, 76–7 244

participation and project requirements, 67 project categories, 77, 79 project cycle, 70–8 project monitoring, 75–6 project validation and registration, 74–5 registration fee, 174 share of proceeds, 172–3 small scale project activities, 79–80 stakeholder participation, 73 sustainable development requirements, 80–1 use of ODA, 23, 81 verification and certification, 75–6 CDM and JI programmes, 161–3, 177–93 CDM registry, 50–1 Certified Emission Reduction Units (CERs), 41–2, 158 CERUPT, 187, 189 climate change impacts, 9–11 climate system, 3–4 commitment period reserve, 40, 45, 53–5 Conference of the Parties (COP), see UNFCCC, corporate target setting, 155 COP/MOP, see Kyoto Protocol Danish emissions trading scheme (CO2 Quota Act), 97–101 allowance allocations, 100 emissions, 98 penalties, 94, 101 derivative agreements, 199–200 derivative instruments, 196–9 forward settlements, 196 futures contracts, 198 options contracts, 197 spot trades, 196 direct and indirect emissions, 150–1 DuPont, 142–3

INDEX

Dutch CDM programme, 182–3, 186–9 additionality, 189 intermediaries, 189 project criteria, 187–8 project cycle, 188 emissions inventories, 42–5, 149–54 domestic versus international, 150 principles and definitions, 44 emissions projections, 130 emissions reduction purchase agreements, 176–7 Emission Reduction Units (ERUs), 41–2 emissions trading design elements, 84–8 environmental taxes, 14, 83 ERUPT, 183–6 contractual requirements, 185 credit acquisition, 185–6 programme requirements, 184 EU burden sharing agreement, 30–1 EU emissions trading scheme, 109–19, 122, 152–3, 213 activities covered, 110 banking, 117 EUAs, 113 grace period, 117 linking agreements, 119, 122 linking Directive, 118 monitoring requirements, 113–16, 152–3 National Allocation Plans, 112–13, 213 new entrants, 117 opt-in, opt-out provisions, 115–16 penalties for non-compliance, 117 registries, 117 trading Directive, 109–10 trading periods, 113 Eurelectric trading simulations (GETS), 132, 135–7 Finish CDM and JI programmes, 189–93 CDM requirements, 192–3 JI requirements, 190–1 global warming potentials (GWPs), 5 greenhouse effect, 3–5 greenhouse gases, 3–6, 12–13, 28 insurance and reinsurance industries, 10, 12 INTERACT, 94–5 Intergovernmental Panel on Climate Change (IPCC), 1, 7–11 international aviation and marine bunker fuels, 33 International Civil Aviation Organisation (ICAO), 33

245

international emissions trading (Article17), 51–5, calculation of assigned amount, 52 commitment period reserve, 40, 45, 53–5 compliance process, 52 eligibility requirements, 40 International Geophysical Year (IGY), 6 International Maritime Organisation (IMO), 33 Joint Implementation, 55–64, 159–77 additionality, 59 eligibility requirements, 56, 60 first track, 59–60 Independent Entities, 62–4 issuance and transfer of ERUs, 64 second track, 61–4 supervisory committee, 60–2 two-track approach, 57–8 Kyoto mechanisms, 12, 37–51 liability rules, 54 Kyoto Protocol, 12, adoption of, 25–6 Annex B, 29–30 commitment period, 30–1 compliance system, 34, 36 COP/MOP, 29 governing bodies, 29 land use change and forestry, 33–4 monitoring, reporting and review, 35 regional distribution of target (bubble), 28 supplementarity, 35–6 market-based policies, 14–15 Marrakech Accords, 26 methane, 4 national registries, 45, 50–1 Norway, 96, 119–21, 216 climate policies, 83 emissions, 119 emissions trading proposal, 96 Norwegian Quota Commission, 121 reduction target, 96 OPEC, 15, 26 power sector, 131–8 Prototype Carbon Fund (PCF), 177–82, 195 Legal Instruments, 181 PCFplus Research, 195 project cycle, 179–80 Removal Units (RMUs), 41–2 retail market, 209–10

246

INDEX

SBI, 29 SBSTA, 29 Senter, see also ERUPT, 183 Shell Tradable Emissions Permit System (STEPS), 141–2 sub-national markets, 208 sub-national trading schemes, see US and Australia transaction costs, 171–4 UK emissions trading system, 97, 101–9 auction and target setting process, 104 Climate Change Agreement, 102, 104–5 Climate Change Levy, 102 compliance periods, 106 Direct Participants, 103–4 gateway, 106 registries, 107 Umbrella Group, 26, 42 UN Conference on Human Environment, 6 UN Environment Programme (UNEP), 6–7 UN Framework Convention on Climate Change (UNFCCC), 18–26 adequacy/review of commitments, 24 Annex I Parties, 29 Annex II Parties, 29 Berlin Mandate, 24 Commitments, 20–3 Conference of the Parties (COP), 28–9 COP sessions, 24–7

Geneva Declaration, 25 INC, 18–19 national communications, 20–2 non-Annex I Parties, 21–2, 29 objective and principles, 19–20 UN General Assembly, 7 UNEP FI, 10, 128 US, 42, 89, 186–7, 213, 217–18 multi-pollutant legislation, 186 Oregon Climate Trust, 187 RECLAIM, 213 see also US NOx budget trading, US SO2 trading programme US NOx budget trading programme, 91–3 Ozone Transport Commission, 91 NOx SIP Call, 93 US SO2 Trading Programme, 43–4, 89–90, 128–9 reduction targets, 90 cost savings, 128 opt-in provisions, 91 allowance allocation, 90 penalties, 90 Villach Conferences, 6–7 World Bank Carbon Finance, 177–8 see also PCF World Climate Conference, 6–8 World Commission on Environment and Development, 7 World Meteorological Organisation (WMO), 6–7