EUAs vs crude oil update

I’ve updated the chart of EUAs vs crude oil (see below). I’ve included some comments based on an incomplete understanding of the dynamic between the two, so any comments would be gratefully received.

For the past year, EUAs have been rangebound between 12 and 16 euros. Oil, conversely, has trended strongly upward from $63 (EUR45) a year ago to a high of $80 (EUR63) a week ago. This is in contrast to the first period shown on the graph, between Jan 2007 and Spring 2009, where EUAs and crude were strongly correlated.

The relationship between EUAs and crude oil is partly that both are driven by overall demand for energy, but this changes over the long-term. The relationship observable in this graph is more likely driven by the ‘dark-spark’ mix of energy production in Europe. This refers to the mix of coal (dark) and gas (spark) in energy generation. Oil prices tend to drive the price of natural gas, which is clean relative to coal. When oil increases in price, energy generators switch to coal and therefore demand for carbon credits increases.

The increase in oil price over the past year would usually indicate a greater proportion of coal going into Europe’s energy supply. However, higher demand for carbon credits has not resulted. The sluggishness of EUAs in responding to oil prices is probably a reflection of poor industrial recovery following the credit crunch.

(click to expand)

Friends of the Earth report on carbon trading – risks burying its good points with garbled points

I just read the new report on carbon trading (pdf) from Friends of the Earth. Given the charity’s stance on anything related to carbon trading, the critical approach is unsurprising. The report makes some good points, but also makes some points that don’t seem well thought out. This is a shame because the charity could achieve much more by taking a reasoned position in the debate and focusing on the things that need changing.

One of my gripes is that the report contains some rash statements, like:

The EU ETS scheme has clearly failed to provide adequate incentives for European firms to reduce their emissions in Phase I;  Phase II is performing poorly and is likely to fail.

Is it? Last time I checked it was doing OK! Or:

The complexity of the carbon markets, and the involvement of financial speculators and complex financial products, carries a risk that carbon trading will develop into a speculative commodity bubble that could provoke a global financial failure similar in scale and nature to that brought about by the recent subprime mortgage crisis.

That’s not a good comparison. There is a lot of derivative trading in the EU ETS but we know exactly what the underlying asset is. The derivatives are simply tools to make trading smoother. The idea that carbon markets are a ponzi scheme run by speculators runs through the report, and some errors are made, including that most carbon credits are held by speculators (they aren’t; most credits are held by statutory market participants).

And the environmental economics get a bit shaky with the argument that cap and trade actually ‘locks in’ high emissions:

Polluters have an incentive to make extra emission reductions under emissions trading so that they can sell credits, therefore, emissions trading stimulates innovation. This model accurately explains the situation of sellers of credits. […But it ignores the buyers…] Carbon trading makes lower-cost credits available to these firms as an alternative to the higher-cost investments that they would otherwise have to make. Hence trading removes any incentive that they have for technological innovation.

This would be better explained as “cap and trade makes equally valuable emission reductions for less money”.

I do, however, agree with FoE’s stance on offsetting. The report says:

developed countries are using the prospect of increased carbon market finance to hide from their commitments under the United Nations Framework Convention on Climate Change (UNFCCC) to provide new and additional sources of finance to developing countries. Carbon market finance comes from offsetting developed-country emissions cuts which should be additional. Counting it towards the financial commitments of developed countries is double counting.

This is right. And the report makes a generally fair rehearsal of all the usual issues with offsetting and the CDM.

If the parties to the UNFCCC can turn the screw on carbon markets, by (a) using the cap to demonstrate greater commitment to more ambitious reductions and (b) cutting out offsetting, then carbon markets like the EU ETS can be an effective central tool in mitigation. There is no reason why cap and trade should exclude direct support for low carbon technologies where governments feel help is needed.

It’s not practical to ask the UNFCCC to throw out carbon markets, and I would like to see FoE take only its reasonable points to the negotiations.

Does the government need to provide guidance on the term ‘carbon neutral’?

The Department for Energy and Climate Change has been running a consultation on the meaning of the term ‘carbon neutral’. Today they published their report. ‘Carbon neutral’ has been given the definition:

Carbon neutral means that – through a transparent process of calculating emissions, reducing those emissions and offsetting residual emissions – net carbon emissions equal zero.

The government is repeating the general mantra that carbon offsetting must be the last step in carbon management, following measurement and internal reduction.

I have always found this view a bit simplistic and also feel the government is sticking its oar in too far by giving a hard line in an area of voluntary corporate responsibility. There is no similar guidance for corporate foundations regarding which charities they should support, for example.

For most organisations, it is not clear what ‘residual’ emissions are. At some point the cost of internal abatement reaches an unbearable level and offsetting makes more sense. But this point is not obvious for any organisation. Very few have a full breakdown of the environmental projects available to them and the cost per tonne of each project. And even if they did, they would be unlikely to be able to decide on the threshold for which projects are affordable – particularly if they cannot compare internal projects with carbon offsets on the same terms (because internal projects should be prioritised).

The carbon offsetting industry supports a strict ‘measure-reduce-offset’ hierarchy because it is regularly accused of creating the moral hazard that it’s OK to keep on polluting. A self confident offsetting industry – an industry that believes its credits have environmental value – would position offsets as a legitimate tool that can be weighed against internal reductions.

Having made those criticisms, I would strongly advise any company wishing to claim it is ‘carbon neutral’ to follow DECC’s guidance. There is no point saying you are carbon neutral if you are going to be shot down by campaigners or switched on customers who believe you are making unsubstantiated claims. Following the guidance at least means you can point to a common methodology. Even better, avoid the term carbon neutral altogether.

EU 2008 Carbon Dioxide Emissions Exceed Permits by 25 Percent

The EC has published verified emissions data.

Bloomberg:

Power plants and factories in the European Union’s emissions trading program produced 25 percent more carbon dioxide than the amount of permits they received, according to Bloomberg calculations based on European Commission data.

The data is 91 percent complete, Stavros Dimas, the environment commissioner, said today in Brussels. The comparison between verified emissions and the allowances total is a like for like comparison, using only figures for installations that data is available for.

EU ETS: “No longer as short”

Point Carbon has just published its annual survey of people working in carbon markets. It’s full of useful insights and I can email you a copy if you want one.

In particular, I was interested in a chart on the expected trading positions of participants representing companies in the EU ETS (below). The proportion of companies with surplus EUAs has jumped about 10 ppts between 2008 and 2009, from 15% to 25%. The proportion that need more EUAs or CERs is something like half (the top four categories).

This tells a clear story: as recession bites, demand for carbon credits will be lower. But by this metric (which admittedly is a bit crude – it’s just the proportion of people who report being short/long and doesn’t account for the volume of emissions they represent), the movement is not so predicted to be big enough to sink the market.

Hot air deals should be linked to CDM

Last week Reuters reported the first ‘hot air’ deal, in which Ukraine sold 30 million AAUs to Japan. The cost was not disclosed. AAUs are the credits created under the Kyoto Protocol – if a country has a target of 1 million tonnes then it will be given 1 million AAUs by the UN.

Eastern European countries have far more AAUs than they need because their targets under the Kyoto Protocol are based on their emissions in 1990, before the Soviet Union collapsed and took Easten European industry with it. The chart below (courtesy of Global Warming Art) shows carbon dioxide emissions by region – you can see how emissions in Eastern Europe have declined since 1990.

This leaves the bloc with many more AAUs than they need – hence they are able to sell them to countries that find their targets more challenging, like Japan. These AAUs are often called ‘hot air’ and trades are felt to be immoral by environmentalists because they allow rich countries to buy themselves out of meaningful reductions.

Hot air deals are unavoidable under the Kyoto system. While Ukraine has pledged to spend the revenue on “six specific environmental measures”, the impact on emissions of these projects is very ambiguous.

Where AAUs are traded between countries, the revenue should go into projects that reduce emissions to the same extent as the AAUs, using the same rules as the CDM. This would allow AAU trades to continue without underminining the environmental integrity of the Kyoto system (at least to the extent that the CDM’s additionality test works), but would not necessarily inflate the AAU cost to the CER cost (if the seller was able to find cheap projects to spend the money on).

Camp for Climate Action has a common sense failure

I strongly support the Camp for Climate Action. I attended the camp at Heathrow in 2007 and saw that the participants were engaged with policy in a relevant and radical way, and that they were exploring new and more sustainable ways of living and organising.

So I was dissapointed to see that the camp is organising a demo at the European Climate Exhange on the 1st of April.

ECX is the biggest exchange for EUAs (the permits traded in the EU Emmission Trading Scheme), and during February an average of 15m tonnes were traded there per day (1 EUA = 1 tonne of CO2. To put that into perspective, the annual carbon footprint of the UK is about 500m tonnes).

The Climate Camp’s website says:

By creating a brain-bending system of carbon pollution licenses, fossil fuel companies and trading firms have found a way to keep on churning out global warming gases and to reap huge windfall profits at the same time … [The UK government is] handing control of our climate over to the same people and systems that caused the financial collapse … Don’t let the financial and fossil fools make the rules!

This is wrong, of course – the Directives behind the EU ETS were written by the European Commission, not the traders and polluters, making the EC the most successful environmental regulator in history. The EU ETS will effectively limit carbon dioxide emissions within its perimeter to a known amount. Billions of Euros have already been invested in energy efficiency as a result of the carbon price this creates. This investment is the net economic effect of the scheme – not the windfall made a minority of companies.

Cap-and-trade is not viewed by anyone as the single solution to climate change, and it is not incompatible with the technology and lifestyle changes that the Climate Camp endorses. There’s not much to be gained from dismantling the EU ETS.

Finally, ECX is just one of several private exchanges that facilitates trade in EUAs – it has nothing to do with European or member-state level environmental policy.

The Climate Camp’s targetting of ECX is poorly informed and unconstructive. It panders to activists’ natural distrust of the market and establishment. As climate change moves into the mainstream and becomes more of a concern for governments, effective activists will need to engage with mainstream initiatives like the EU ETS rather than instinctively rejecting them.

EUA sell-off is a natural reflection of economic recession

Carbon prices have been falling recently. Since July 2008, EUAs have lost over 60% of their value and are one of the worst performing commodities in 2009. The chart below (click to expand) shows the EUA price indexed to January 2007. I have also included the oil price, which has been converted from dollars to euros, for comparison.

As you can see, carbon has largely followed oil. The main mechanism at work is that oil prices drive gas prices, which in turn determine the cost of switching energy generation from coal to gas. Burning gas produces less carbon dioxide per unit of energy than coal, so demand for EUAs goes down when gas gets cheaper. Levels of industrial production also drive both markets, of course, which leads them to correlate.

But in the past couple of weeks oil and carbon seem to have ‘decoupled’ (as you can see from the sharp drop-off in EUAs in January, while crude has recovered from a low at the end of last year). A new factor seems to be at play: industrial companies in distress selling their stockpile of EUAs, now surplus as their output shrinks, on the spot market to raise funds they cannot find in the credit market.

Many environmental commentators and journalists are saying that this demonstrates an inherent weakness in cap-and-trade. An article in Reuters last week said that:

companies from some of the European Union’s most polluting industries are now raising funds on the carbon market to help them weather the credit crisis.

That has raised some uncomfortable questions about a scheme meant to fight climate change rather than subsidize companies during a downturn.

“This was not designed as a scheme to give corporates cheap short-term funding options in the face of a credit crunch meltdown where banks are not lending,” said Mark Lewis, Deutsche Bank carbon analyst. “But that appears to be what’s happening.”

The first thing to get straight is that the through the EU ETS, the members states are transferring a liability to the regulated industries, not an asset. EUAs only have a value if there is a cost to complying with the emissions cap they represent. The EUA ‘windfall’ in this situation is better described as a reduced burden of compliance across the whole market, which pushes some companies long while most remain short. There must still be buyers out there no ‘windfall’ would be possible.

This new factor of spot sell-offs is really just a particularly rough piece of volatility reflecting rapid changes in expected demand over the next few years.

Given that EUAs can be banked into Phase III of the EU ETS (which will run from 2013– 2020), it is unlikely that the recession will hit manufacturing and energy so severely that the carbon price will collapse in the way it did in 2006. If this were to happen, does anyone really think a carbon tax, which would continue to brake output regardless, would fare better politically than cap-and-trade?

No-one seems to like aviation in the EU ETS. :-( I do.

So, airlines will be in the EU ETS from 2012. No-one seems to like it.

Airlines of course argue that this is bad timing given the looming economic recession and rising fuel costs.

Crisis is not the time for rubber stamps. But that is exactly what the Council of Justice and Home Affairs Ministers used today – without a word of debate – to seal into law the EUR 3.5 billion cost of bringing airlines into the European ETS. It’s Brussels acting in a bubble – even in the middle of a global economic crisis,” said Giovanni Bisignani, IATA’s Director General and CEO.

Instead of a cap, IATA argues that member states should focus on liberalising European airways to improve flight efficiency:

While Brussels has been fast to introduce its regional ETS scheme, it has been slow to improve efficiency. We need the same urgency to deliver an effective Single European Sky that would save billions of Euros in cost and 16 million tonnes of CO2 annually. That we have been waiting decades for this is Europe’s biggest environmental embarrassment.

Campaigning NGOs are no happier with the decision, arguing that emissions from aviation will continue to grow rapidly under the EU ETS.

IATA: the cap will be tough if no-one does anything to meet it. The argument for better air traffic control is not an argument against a cap. Further, as demand weakens compliance with the cap will become cheaper. Witness the carbon price slipping more than 20% over the past month. If recession cuts demand by more than 3% before 2013, no additional cuts will be necessary.

Greenpeace et al: emissions from aviation may continue to grow after inclusion in the EU ETS but only if consumers decide that they want to cut emissions elsewhere instead. The allocation to airlines will decrease from a 2004/6 baseline.

Unlike carbon, tropical forests are not commodities

I’ve been meaning to write something about tropical forests for a while. There is not much doubt that they are worth more standing than cut down, and there is some debate about how to make sure they stay where they are.

Deforestation across the world is thought to be responsible for a fifth of greenhouse gas emissions. Tropical forests also contain half the world’s known species and play important roles in all kinds of ecosystems.

The debate on protecting tropical forests seems to have moved from purchase and retirement of land by wealthy individuals and charitable foundations to how tropical forests can be preserved with carbon money.

Organisations preserving forests would be allocated offset credits that regulated companies in developed countries could buy instead of reducing their own emissions. This is not a good idea for two reasons:

• It’s theoretically zero-sum and probably worse. Preserving forests as carbon sinks is not an accurate way to mitigate carbon emissions. Where offsets are sold into cap and trade schemes, the accuracy of the reduction behind the offset is essential to the integrity of the cap.
• It’s an expensive way to preserve forests. While almost certainly better value than the industrial gas destruction projects that have historically delivered a lion’s share of the CER pipeline, preserving forests does not need to cost 20 euros per tonne of CO2.

So how can the ‘ecosystem services’ that forests provide be valued and paid for, if not through carbon markets?

This is the wrong question. The human ROI of protecting tropical forests is a no-brainer. There is no need to let the market determine the value of forests as CO2 sinks – we just need to find the cheapest way to preserve them.

This is why I favour a fund that would be allocated to organisations preserving forests through reverse-auction type processes.

The current plans for the role of the Global Forest Carbon Mechanism in the post-Kyoto UNFCCC framework are half right – the fund will channel money to forest preservation, but will also allow Annex I countries to buy credits from the forest managers.

EUAs are a natural hedge against equities

The particular situation that the European carbon market is in makes EUAs a natural hedge against equities.

While credit restrictions could reduce consumption and therefore emissions, a greater factor in EUA demand is the reduced availability of finance for emission reduction projects, both within and outside of Europe.

Most analysts seem to be saying that the CDM pipeline is facing restrictions as projects find it difficult to find funding – and even that Phase 2 compliance buyers will not be able to fill their quota of CERs (collectively, EU ETS participants can use UN-regulated offsets, called CERs, to cover up to 13.4% of their emissions). This will make higher internal reductions necessary, exerting upward pressure on EUAs.

Within Europe, a higher cost of capital makes clean technology more expensive, so a higher carbon price will be necessary to make the business case for the same capital investment.

While tighter credit tends to send stock downwards, it will tend to send EUAs up.

Solid start for Reggie

The Regional Greenhouse Gas Initiative – a statutory cap-and-trade programme covering power stations in 10 north-eastern US states – published the results of its first auction today (a few forward trades have been happening over the summer).

The clearing price was $3.07 – well above the $1.86 floor – suggesting that participants feel the scheme will cut emissions in 2009 (the year the credits will be used in). Environmentalists are quick to point out that RGGI actually allows a 5% increase in emissions from 2008 and credits have come out at $3 because the allowed increase is likely to be smaller than the desired (or baseline) increase.

RGGI is great. It’s the first statutory cap on GHGs in the US. At this stage it is miniscule (Thursday’s auction revenue was about $39m – compare the current value of phase 2 EUAs allocated in 2008: EUR 52bn) and it has to ramp up quickly to be a meaningful part of climate policy. Getting the infrastructure in place is important – but with a non-trade exposed industry like power generation there is every reason for stringent 2010 cap.

(At $3 at least we don’t have to worry too much about the offsets that will be allowed into RGGI…)

Forests should be protected with carbon money – but not through cap-and-trade schemes

There have recently been a few reports in the media about using carbon finance to protect the world’s forests.

Forests provide the world with ‘ecosystem services’ (like biodiversity or absorbing carbon dioxide), which should be valued and paid for. If communities in forested countries can only survive by clearing the forest for timber and farming, it will be impossible to stop deforestation without paying them.

MEPs involved in the EU ETS are arguing that forestry could be protected by giving land owners EUAs if they leave the forest alone. A recent Panorama programme argued something similar – corporations should offset their carbon footprint by paying people to preserve forests.

The CDM has resisted forestry based CERs because it is too difficult to prove the reductions and their additionality. But there is an even better reason why a CDM type approach is wrong: the main market for the forestry credits would be cap-and-trade schemes (i.e. the EU ETS at this stage), so preserving forests would allow increased internal emissions and no net emission reduction.

The right approach would be provisions under the UNFCCC for a forestry fund. Forest owners would receive freely tradable credits when their management of the forest is verified. Anyone would be allowed to sell credits to the fund, either at a fixed price or through regular reverse auctions. Under this system, the market would provide upfront cash to forest owners (assuming we have emerged from financial meltdown, of course).

The fund would be comprised of national donations from rich countries. Those with working cap-and-trade schemes could use their auction revenues – which would effectively mean carbon consumers in rich countries pay for forests to be preserved in poor countries.

That’s what it comes down to: someone just has to pay up.

Broadsheet sensationalism?

The Guardian on Saturday published a feature on the EU Emission Trading Scheme, highlighting that some companies stand to make a windfall from the scheme.

This is true, but the article is wrong to suggest that the scheme isn’t working yet.

Some companies do have more EUAs than they initially need – but, as environmentalists, it is the overall cap that concerns us. The Guardian’s analysis shows that the UK’s allocation is 60 million tonnes below baseline emissions.

And what really matters is that the scheme as a whole is not over-allocated. As the World Bank’s Carbon Markets 2008 report (pdf) shows, the annual allocation across Europe in phase 2 (2008 – 2012) is 7.1% below 2007 CO2 emissions, which are trending upward.

The distribution of EUAs among installations is a financial issue for individual companies. To some extent this type of economic disruption is inevitable while the government is giving out a large proportion of EUAs for free (see previous post on why the government has to allocate free credits in the early stages). It is not a significant environmental issue and it is a shame that such a respected voice is potentially undermining support for a successful scheme that is not well understood by the public.

Beginners’ guide to emission trading

David Hone, Shell’s climate change advisor, broadcast a good overview of emission trading systems today.

One thing David makes a big thing of is the system for allocating credits. The carbon cost imposed by emission trading schemes permeates markets at different rates, depending on their international competitiveness. Electricity suppliers in Europe, for example, passed carbon costs onto consumers very quickly because there is no risk of those consumers switching to foreign suppliers with lower carbon costs. Industries that are able to pass on carbon costs will be sold their allowances through auctions, while those that cannot will be given theirs for free. In theory, the carbon cost will eventually permeate the whole economy and all allowances will be auctioned.

Correctly applied, this process creates “profit neutrality”.

I think the only missing part of the story is the cost of the reductions for industries exposed to trade. For an emission trading scheme to be worthwhile, it has to require its participants to reduce their emissions, which costs money. Even if you give them all their allowances for free, they still have to pay for the reductions or buy more allowances at their market value. Industries that cannot pass carbon costs onto their customers would probably show small amounts of leakage as a result of these costs.

I don’t have an opinion on Shell’s approach to environmental responsibility, but it’s dialogues series (that David Hone’s webchat was part of) is a great piece of engagement.

CDM giving excessive amounts of money to big factories – is it a problem?

Environmental capital today commented on a “marginally economical” chemical factory making 97% of it’s profit from selling CERs generated by destuction of nitrous oxides:

The company, Rhodia SA, manufactures hundreds of tons a day of adipic acid, an ingredient in nylon, at its factory here. But the real money is in what it doesn’t make. The payday, which could amount to more than $1 billion over seven years, comes from destroying nitrous oxide, or laughing gas, an unwanted byproduct and potent greenhouse gas. It’s Rhodia’s single most profitable business world-wide. […] The Rhodia factory in [South Korea] alone is slated to bring in more money, under the U.N.-administered program, than all the clean-air projects currently registered on the continent of Africa.

The post suggests there must be something wrong with a system that means factory owners can make more money from cleaning up pollution than their normal business. It does intuitively seem like a very expensive way to make a factory in a industrialised country do something that would be business as usual for a similar plant in Europe.

If the CDM is operating perfectly, it shouldn’t be a problem. The value of CERs is determined by markets and, in climate change mitigation terms, reductions generated this way are just as good as any other. There are two key questions to think about:

1. Would the gases have been cleaned up anyway? The CDM would argue it makes a reasonable judgement of this issue. Many disagree and believe it’s too difficult to work out. A quick thought I will consider more carefully later: could additionality as a binary concept (all emission reductions will be eligible for CERs if the project wouldn’t happen without them) be replaced with a sliding scale in which a project is only eligible for a number of CERs that would push it above the line?
2. Is awarding CERs for this kind of activity encouraging more factories to open, just so they can clean up the pollution? The CDM has responded to this by saying that only old factories will be awarded CERs. The difficulty is the same – in theory it makes sense but it’s just too difficult to establish whether pollution is new or old.

Is it possible to rate pre-issue CDM projects?

Someone along the line in the CDM process has to accept the risk that the CDM board might not award CERs to projects in time or at all. Last autumn Ecosecurities lost almost half its share price as the CDM process could not keep up with applications.

IDEACarbon yesterday launched the Carbon Ratings Agency to help investors separate investment grade and sub-prime projects. It will award instruments backed by pre-issue projects with grades from AAA to D. AAA means that it is highly likely a project will deliver its promised emission reductions and be awarded carbon reduction credits (primarily CERs, but also voluntary offsets).

Carbon Rating Agency may make allocation of capital in carbon markets more efficient and reduce volatility in CER prices (an event like the Ecosecurities crash causes sudden supply concerns). The important thing to remember is that it will not address environmental concerns – particularly around additionality – within the CDM and other offset quality regimes. It assesses the risk of a projects successfully getting through the regimes.

And on what basis should investors trust the ratings? CERs are not a tested product and no-one really knows where the CDM is going long term. Plus – look where our AAA-rated mortgage backed securities ended up.

World Service on additionality

I just got round to listening to the programme on the World Service last week about the CDM. It contains some gems on additionality:

An Indian company that has set up a biomass generator that runs on rice husks.

World Service: “The carbon credits, then, were they important for your decision to go ahead with the project?”

Interviewee: “Not really, basically. Six months after starting the project we applied for the CDM.”

WS: “So this is a project you would have done anyway, but now the numbers are a just a little bit more favourable?”

I: “Yes, the numbers are more favourable”

WS: “So you would have done it anyway”

I: “Yes”

WS: “So if the authorities at the CDM are silly enough to give you a million dollars extra for it, you’ll take the money?”

I: “Why not.”

Or a spokesman for SRF, an Indian company eligible for 3.8m CERs per year from HFC destruction,

Interviewee: “We were already sensitised to the greenhouse effect of HFC23 and the board gave us approval [to destroy the gas] irrespective of the ratification status of the Kyoto Protocol.”

World Service: “This is something you might well have done anyway?”

I: “Yes, we would have done it anyway.”

WS: “You would have done it anyway, even if the CDM scheme hadn’t been set up.”

I: “That’s right.”

CDM criticism heating up – non additionality could wipe out reductions in the EU ETS

The Clean Development Mechanism is receiving criticism from high profile quarters. The cover story in yesterday’s Guardian was “billions wasted on UN climate programme”, which drew evidence from studies by International Rivers (pdf) and Stanford University’s David Victor and Michael Wara (pdf).

Victor and Wara’s study is worth reading. Once again, additionality is identified as the main issue.

All new hydro, wind, and natural gas fired capacity [in China] is applying to claim credit for emissions reductions under the CDM… Under the rules of the CDM, each new dam, wind farm, or natural gas power plant applies individually and makes the argument that it would not have been constructed but for the financial incentives produced by the sale of carbon offsets… Taken collectively … these individual applications for credit amount to a claim that the hydro, wind, and natural gas elements of the power sector in China would not be growing at all without help from CDM. This broader implication is simply implausible in light of the state policies [to support clean generation].

…At root, the CDM and other offset schemes are unable to determine reliably whether credits are issued for activities that would have happened anyway while also keeping transaction costs under control and assuring investor certainty…The CDM is structurally unable to engage developing countries in ways that would actually make a dent in emissions.

Victor believes that between one and two thirds of reductions made by the CDM would have happened anyway. The EU ETS allows the EU to purchase 278 million CERs per year, or 13.4% of the overall cap. If one to two-thirds of those CERs are not additional, between 93Mt and 186Mt of CO2e would leak out per year. To put that in perspective, the reduction between 2005 emissions and the annual Phase 2 cap – 131Mt – is well within that range.

Yvo de Boer’s climate bonds – how are they different to normal government bonds?

Yvo de Boer, the head of the UNFCCC, told the FT yesterday about his idea for ‘climate bonds’.

Such bonds would involve a developing country government setting a national target on emissions or energy, for example a goal of producing a certain amount of renewable energy by 2020. It could count on receiving carbon credits equivalent to this renewable energy under a successor to the Kyoto protocol, which would enable the finance ministry to issue “climate bonds”. These would raise money from investors based on the promise that they would receive returns from the sale of the resulting carbon credits.

This is not possible under the Kyoto protocol because the system for awarding carbon credits requires would-be investors to put their money into emission-cutting projects, often small-scale and carrying big investment risks.

I can see that the formal Kyoto mechanisms don’t include provisions for up-front finance for emission reduction projects – the CDM requires projects to have reached a fairly advanced level of maturity before it awards credits. But if there are people out there who are prepared to take on the risk associated with CDM projects, couldn’t the market already deliver debt instruments like de Boer’s climate bonds?

Mr de Boer believes government-sponsored climate bonds would reduce the investment risk, because governments could act as a guarantor, and encourage much greater investment in carbon reduction in the developing world.

If the government takes on the risk of the CDM project, surely the coupon would be the same as one of that government’s normal bonds. How would that be different to a government raising debt money and deciding to spend it on national CDM projects?