Project-based carbon offsetting is like a lottery with no prizes

At Carbon Retirement, we have just published a short piece of research into the efficiency of carbon offsetting through the Clean Development Mechanism, covered today by the BBC. It shows that for every £1 spent on CERs by voluntary buyers, 28p goes to the project’s capital expenditure and maintenance costs.

The chart below, from the report, summarises the costs per CER, with the grey chunks representing project expenditure. Project costs total £3.78 per CER, or 28% of the price paid by the final buyer.

Costs in the CDM market, per CER

This isn’t a study of profitability for any of these actors and the costs at each stage might be reasonable. The big chunk taken by the pCER buyer in our model, for example, may be a fair reflection of the risk it holds that the project will not deliver CERs.

However, the research shows that the efficiency of the overall system is very poor. While some transactional costs are inevitable and you could never expect 100% of your money to go to project funding, 28% seems far too low. Imagine if a development charity told you that 72% of your donation went to middlemen and admin fees!

Co-incidentally, 28% is also the proportion of UK national lottery revenue that goes to charity. So, buying carbon offsets to mitigate climate change is like buying lottery tickets to give money to charity. With carbon offsetting, you don’t even win a prize!

Why does carbon offsetting struggle with its reputation?

Carbon offsetting has a reputation problem. Some parts of the ‘carbon’ industry act dishonestly or are not environmentally motivated, and people outside the industry tend to lump the diverse organisations involved in carbon trading together. When an exposé story appears in the media, we all suffer.

This week there was a story about suspected VAT fraud in carbon markets. Dodgy brokers were buying carbon credits abroad (which does not attract VAT), and then selling them in the UK and applying VAT. They are thought to have made £38m. It’s called carousel fraud or ‘missing trader’ fraud (because the broker disappears with the tax). One funny thing about this story is that none of the coverage says which market the fraud was in. Were these CDM credits (the carbon offsets that the UN allows governments to use)?

Twitter was full of people saying that this story confirmed carbon trading to be a con. Several newspapers referred to “so-called carbon credits”. Why “so-called”?

Another example is the campaigns by NGOs like Friends of the Earth and WWF against the use of offsets in statutory carbon trading schemes. Under the Kyoto Protocol, governments of rich countries can offset some of their emissions by funding projects in the developing world. The NGOs feel this allows them to wriggle out of their responsibilities.

Friends of the Earth said:

Dangerous climate change will be unavoidable if the UK, EU and USA succeed in increasing the use of carbon offsetting, Friends of the Earth is warning in a new report released today [Tuesday 2 June 2009] that exposes carbon offsetting as ineffective and damaging.

WWF:

The problem with carbon offsetting is that at best it robs Peter to pay Paul – with no net benefit for the planet. All too often, offsetting is simply used to justify business-as-usual behaviour in the UK and other countries.

These charities are referring to the CDM or whatever succeeds it when the Kyoto Protocol expires in 2012. While both have misgivings about voluntary carbon offsetting, neither would object to its use by a company or individual who is doing all they can to reduce their own footprint. Unfortunately most people are not aware of the difference between voluntary and statutory carbon markets and articles like the above cast the whole sector in a poor light.

The challenge for organisations involved in carbon trading is to help their market understand what happens to their money. No customer can be expected to spend their money if they believe it will be appropriated by fraudsters.

Lack of CDM progress at Poznan will be the major sticking point for negotiations over the next year

CDM reform didn’t get anywhere at Poznan. To me, this is the most worrying outcome of the conference. Although technical discussions and low-level negotiation planning were all anyone expected, there is now very little time to do something about the CDM before the Kyoto Protocol runs out.

There was a lot of discussion about Forestry and CCS. Forestry is unsuitable for the CDM – partly because there are issues with calculating the volume of carbon dioxide a forest absorbs, and mainly because forests would produce far more CERs than Annex I countries could buy (essentially we wouldn’t be able to buy enough carbon credits to protect the forests).

The situation with coal is similar in that the CDM couldn’t support the volumes required (I haven’t done the maths on this but the IEA forecasts that to stabilise at even 550ppm we will require 10 new CCS plants every year), except that CCS will be neither operational nor affordable before 2020. Most estimates show that a carbon price of EUR 40 – 75 will be required to make CCS commercially viable, and CERs are unlikely to enter that range.

There was also discussion on making the CDM more transparent and efficient. These discussions didn’t progress either, but we really need a new approach to technology transfer and funding rather than tweaks to a process that can’t demonstrate additionality.

Despite encouraging statements from China, Brazil and Mexico, the developing world will not sign up to quantified emission reductions without a clear understanding of how rich countries will support them. The ethos behind the CDM needs to switch from reducing the cost of compliance endured by Annex I to structural funding for the developing world to pay for abatement.

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.