In 2005, the Kyoto Protocol came into force, bringing with it the Clean Development Mechanism (CDM), a system intended to allow developing countries to profit from reducing their emissions by selling Carbon Emissions Reduction (CER) credits to firms in developed nations.
In theory, the policy would stimulate the transfer of green technology to developing countries while simultaneously encouraging developed world companies to upgrade their facilities, producing a net reduction in carbon emissions globally. In practice, however, the system has yet to mature, and most CDM-focused firms are in a holding pattern, waiting for the renegotiation of the Kyoto Protocol, to begin with talks in Copenhagen in December.
British companies have a strong presence in markets created by the CDM system, having been involved in either the development or financing of 21% of CDM projects worldwide. In China, the UK has an even stronger lead. More than 20 UK CDM companies have established representative offices in China and are involved in about 31% of all local projects. This puts British investment at particular risk should negotiations in Copenhagen take a turn for the worse.
The pre-existing financial expertise of UK firms accounts for their position in the market, according to Patrick Birley, chief executive of the European Climate Exchange (ECX).
"Carbon markets are no different than any other commodities market. British companies dealing in commodities and finance are very strong, so it follows that they would take their share of the market,"he said.
James McGuire, consul for trade and investment at UK Trade and Investment, agrees, and noted another advantage: The European Union Emissions Trading Scheme (ETS), which was created by the EU to facilitate the trading of CERs, is based on the UK ETS, with which a number of UK trading companies already had experience.
Late start, fast growth
China’s experience with CDM, on the other hand, has been more recent. Global preparations for Kyoto’s cap-and-trade system started around 2001, but China got off to a slow start. While it idled, India, Indonesia and Brazil began to develop CDM projects, and received most of the first wave of investment.
Starting in 2005, however, China quickly began building high-quality, large-scale CDM projects. It is now the largest supplier of carbon credits and provides 58% of the world’s CERs. The World Bank estimates that CDM will bring an additional US$475.2 million in foreign direct investment to China by 2010.
But like most financial markets these days, carbon markets are shaky. Declines in industrial output engendered by the financial crisis led to reduced emissions from European manufacturers, putting most of them well within their carbon quotas. This, combined with excess carbon credit allowances, pulled the price of CERs down by over two-thirds.
CERs on the European Climate Exchange dropped from highs of US$47 per ton to lows of US$11. Now the price has settled around US$17. The fall has made CDM projects look less attractive, and investment is decreasing drastically, according to Wu Changhua, Greater China director of the Climate Group. The number of registered CDM projects in China dropped from 144 in the first quarter of 2009 to 62 in the second quarter.
"The secondary market price is quite low. Over the last several years of development there are less qualified projects than before. It’s not a very good time for a new company to enter the market,"said Alex Wang, head of the business development department at UK-based Arreon Carbon, which invests in CDM projects.
The situation is exacerbated by an approval process that consumes much time and money. Guo Benchi, program officer for Energy and Climate Change for the Global Environmental Institute (GEI), estimates that getting CERs produced by their cement waste recovery projects certified takes one year and costs US$70,000-80,000 per project. "The cost increases every year, every month,"he said.
The CER price collapse has had a marked impact on investors, but several factors insulate CDM project developers.
"Developers don’t follow fluctuations in CER prices very closely, especially since many projects generate power revenues,"said Philip Napier-Moore, lead energy advisor at Mott MacDonald, a management, engineering and development consultancy based in Surrey, England.
He also notes that carbon dioxide or renewables projects that take longer to develop are looking to the future and are less concerned with the current price. And even in the current climate, there have been areas where project developers have made gains, such as biogas programs for methane capture.
However, because the entire carbon market is the product of a political agreement, the Kyoto treaty, it is uniquely subject to geopolitical forces. The low price of CERs has led some in the EU to call for a suspension in trading of CERs from China and other "advanced developing countries."They claim that China benefits from selling CERs from wind and hydro projects that would have been developed without CDM incentives.
"There were too many low-hanging fruit,"said the Climate Group’s Wu.
Cutting the availability of Chinese CERs would severely reduce the supply of carbon offsets, raising their price and forcing some EU companies to cut emissions instead of buying cheap credits.
Faith in the future
But the CDM community doesn’t seem too alarmed by the threat of losing access to one of the few markets with obligatory buyers. One UK investor dismissed the EU’s statements as posturing for the G8 Summit in Italy; another said it was all about positioning for December’s talks in Copenhagen for negotiating an agreement to follow the Kyoto Protocol’s expiration in 2012.
And they claim that China is not to blame for the system’s flaws. "It’s not a Chinese problem; it’s a mechanism problem,"said GEI’s Guo.
Nevertheless, carbon market participants don’t seem pessimistic about its future prospects. One investor said that so long as Europe is involved in CDM there will be demand, and he cites the prospect of aviation entering the EU scheme as an additional reason for optimism.
Ghislain De Mareuil, partner at DLA Piper who specializes in CDM, thinks carbon markets will recover in advance of the rest of the world economy. Rumors that the EU would scrap its system entirely due to the economic crisis have abated. Additionally, the US is close to passing its own cap-and-trade system, potentially doubling the demand for CERs overnight.
Green shoots are already appearing. According to data provided by New Energy Finance, a London-based clean energy and carbon markets research firm, market volume has continued to grow, rising 37% year-on-year in the first quarter of 2009.
The ECX alone, which accounts for over 75% of all carbon market trading, has grown exponentially in volume since its inception. Trading only 94 million tons of carbon dioxide in 2005, volume rose to 450 million in 2006, 1 billion in 2007 and 2.8 billion in 2008. In 2009, 7 billion tons of carbon have been traded to date.
Additionally, Société Générale has upped its prediction of CER prices and estimates they will rise to an average US$27 this year and US$38 by 2012 in anticipation of reductions in the number of approved CDM projects and a corresponding decrease in supply of CERs.
Off the sidelines
CDM investors are still are hoping the US and China buy in, given the development in attitudes towards climate change in both countries. Whether they enter the fold is the determining factor of the ultimate trajectory of the carbon market. "Everyone is waiting on post-2012 guarantees. The market is at a turning point and could go in either direction,"said one UK investor. "If the US starts buying, there [will be] a huge boost in demand."
But just because the US adopts a domestic cap-and-trade scheme does not mean it will allow US firms to buy CERs abroad. Given the protectionist mood in the US, allowing CER purchases from China seems particularly unlikely. "Buying Chinese carbon offsets is a big question with the US plan, but it’s not included at this moment. There is dialogue, but that’s not going to happen,"said Wu.
There is greater risk of the US cap-and-trade bill harming Chinese exports if the tariff on imports from countries without carbon caps remains in the final language, although some analysts say such a tariff is a clear WTO violation.
Others fear that the US and China may sign a bilateral side agreement with lower standards, which would likely weaken, not strengthen, the effect of agreements reached in Copenhagen.
Whatever new deal is reached, there will be some losers. Incentive structures, for one, will need to be shifted to close a few very lucrative loopholes. De Mareuil said that some EU chemical companies are earning more with carbon credits then they are from the rest of their operations. Sectors that have become too dependent on CERs are vulnerable to reform. "Firms that are relying too much on any given sector may be hit. Specific markets may disappear,"said De Mareuil.
Copenhagen also provides an opportunity to tweak the carbon trading system for the benefit of those involved in CDM, and all parties would like to see some changes.
"There are many good projects out there that can’t be included in the CDM framework, like biomass utilization in rural areas,"said Wu of the Climate Group. Mott Macdonald’s Napier-Moore says that CDM developers would like more predictable approval timelines and cleaner and consistent guidance on what constitutes "additionality"– the reduction of emissions that would not have occurred without CDM incentives.
Even if no agreement is reached in Copenhagen, the four independent markets in the EU, US, Australia and Japan will survive, says John Romankiewicz, carbon markets analyst at New Energy Finance. He believes each market will show willingness to pay for different types of offsets, with the US choosing a different form of carbon credit and operating outside the CDM framework.
Unfortunately, investors’ long-term optimism in the future of CDM is qualified by short-term caution, said Napier-Moore: "People are generally confident, but they are not willing to put down money."Firms that are buying are purchasing options, not making commitments, he said.
Wu agrees: "Companies need a clear policy signal from the global framework. They won’t take too much of a risk."