Download ASSESSMENT OF THE CREDIBILITY AND EFFICIENCY OF THE

ASSESSMENT OF THE CREDIBILITY AND EFFICIENCY OF THE
MARKET-BASED MECHANISMS ADOPTED IN THE CARBON
MARKET AND ITS TRENDS IN THE UPCOMING YEARS
Ticiano Costa Jordão
Institute of Public Administration and Law, Faculty of Economics and Administration,
University of Pardubice
Abstrakt: Příspěvek chce objasnit fungování flexibilních mechanizmů, které byly stanoveny
Kjótským protokolem a stanovit trendy trhu s CO2 při intenzifikaci problému změn klimatu a
úrovně nejistoty v projektech snižování emisí.
Klíčová slova: Kjótský protokol, trh s CO2, pružné mechanismy, mechanismus čistého
rozvoje, obchodovatelné emise, emisní poukázky, udržitelný rozvoj, společné zavedení, oxid
uhličitý, skleníkové plyny, změny klimatu.
Abstract: This contribution intends to clarify the functionality of each mechanism of
flexibility established by the Protocol and to estimate the trends of the carbon market taking
into account the intensification of the climate change problem in the upcoming years and the
level of uncertainty of the emissions reduction projects proposed so far.
Key words: Kyoto Protocol, Carbon Market, Flexibility Mechanisms, Clean Development
Mechanism, Tradable emissions, emission allowances, sustainable development, Joint
Implementation, carbon dioxide, greenhouse gases, climate change.
1 Introduction
The alterations in the Earth climate, consequence of the greenhouse effect is considered for
most of the specialists, one of the most serious environmental problems facing humankind.
Emissions of Greenhouse Gases (GHGs) have risen considerably due to fossil fuel burning,
deforestation, livestock farming and other human activities. Although the industrialized
countries are responsible for the greatest share of past and current emissions, an increasing
contribution from developing countries has been observed and is projected to match
industrialized countries’ current levels somewhere around 2020.1
Although the progress of the science related to climate change has been noteworthy during the
last decades, the international political action only gave an important step towards the
reduction of GHGs emissions in 1994 with the establishment of the UN Framework
Convention on Climate Change (UNFCCC - the Convention) which since 1995 have met
annually through their main policy-making body called the Conference of the Parties (COP)
to address matters related to the implementation and evolution of commitments aimed at the
reduction of GHGs emissions.
In December of 1997, the international Parties of the Convention adopted the Kyoto Protocol
(Protocol) which consisted of an agreement with quantitative commitments to reduce or limit
greenhouse gas emissions (targets) for developed countries equal to an overall reduction of 5
percent from 1990 levels during the period from 2008 to 2012.
The most important GHG is carbon dioxide (CO2) that is responsible for more than 60% of
the greenhouse effect not only due to its global warming potential (GWP) which is lower than
1
Compare: Yamin, F., 2005, p. xxxvi
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the others GHGs but mainly to its concentration in the atmosphere. Other important GHGs
covered by the Protocol are methane (CH4), nitrous oxides (N2O), and man-made chemicals:
hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), sulphur hexafluoride (SF6). Although
all these other gases are present in the atmosphere under much lower concentrations (in parts
per billion of volume– ppbv) than carbon dioxide, their GWP per unit of volume is much
higher than the GWP of CO2. The GWP of SF6, for example, is 24,000 higher than the GWP
of CO2. Validated on February 2005, the Protocol sets out three market-based mechanisms to
provide flexibility for the developed countries to meet their emissions targets at lower costs
through the international transfer of Kyoto units called Assigned Amount Units (AAUs). For
this reason, they received the name ‘Mechanisms of Flexibility’.
This contribution intends to clarify the functionality of each mechanism of flexibility
established by the Protocol and to estimate the trends of the carbon market taking into account
the intensification of the climate change problem in the upcoming years.
2 Mechanisms of Flexibility of Kyoto Protocol
2.1 International Emissions Trading (IET)
IET is a mechanism which arises from a system that imposes restrictions on the aggregate
amount of greenhouse gas pollutants that a party (e.g. owner of coal-fired power plant) may
emit from its facility. Through IET, emitters buy emissions reduction units from or sell
emission reduction units to other emitters or third parties. The buyers and sellers under this
system may be buying or selling for compliance purposes (i.e., because they are emitters who
have shortage or surplus of credits) or may be buying or selling for financial speculation. The
Protocol in its article 3 adopts the emission trading scheme which is based on the cap-andtrade system. Under this system, a group of emitters are provided with a quantitatively capped
and tradable emission credits called ‘allowances’. One ‘allowance’ is an allowance to emit
one ton of carbon dioxide equivalent (CO2e) during a specified period. The cap is established
through the concept of assigned amount which is calculated using the quantified emissions
limitation and reduction commitments contained in Annex B of the Protocol and estimations
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 previously mentioned and listed
in Annex A of the Protocol. An emitter who emits less than its allowed cap is able to sell its
“surplus” allowances under an emissions trading system to another emitter who may have
exceeded its cap and, therefore, is in shortage of allowances.
Limitation and reduction commitments vary by Parties. For example, Member States of the
EU are collectively expected to reduce their emissions by 8 percent compared to 1990 levels,
the US by 7 percent and Japan by 6 percent. Only Australia, Iceland and Norway are allowed
to increase their emissions, albeit at reduced rates from business as usual. It is important to
note that these commitments only become binding on countries that ratified the Protocol.
The EU has, however, devised an internal burden-sharing scheme called European Union
Emissions Trading (EU ETS) which consists of a “cap-and-trade” regime covering the EU
countries. The scheme commenced on January 1, 2005 and redistributes targets between EU
Member States under the terms of ‘bubbling targets’ which does not cover any new acceding
country to the EU until a second commitment period is agreed. In addition, if the EU and
Member States do not reach the overall 8 percent reduction during the first Protocol
commitment period, then each country must meet the reduction target specified in the EU’s
burden-sharing agreement.
Under the EU ETS, each EU country must adopt a National Allocation Plan (NAP) for the
proposed periods which are divided into two phases: phase 1 from January 1, 2005 through
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December 31, 2007 and phase 2 from January 1, 2008 through December 31, 2012. Even if
the Kyoto Protocol is not extended beyond 2012, it is anticipated that the EU ETS will be
extended for additional five-year periods.
Each NAP specifies a total number of emissions allowances to be allocated and allocates them
among the various installations within that country’s jurisdiction. Each NAP must be
approved by the European Commission for consistency. The allowances are being allocated
for free. However, if any installation holds insufficient allowances to cover its emissions, it
will be able to purchase additional allowances from other installations. Conversely, if a given
installation holds allowances which exceed its emissions, it will be able to sell those excess
allowances to other parties. At the end of each reporting year, each installation must surrender
sufficient allowances to offset its carbon emissions for such year, and these surrendered
allowances are cancelled. If an installation is unable to surrender sufficient allowances to
cover its carbon emissions for that year, it is subjected to a penalty of €40 per ton of carbon
emissions in the first phase (2005-2007) or €100 per ton of carbon emissions in the second
phase (2008-2012). In addition, installations that are short allowances will be required to
purchase allowances on the open market to meet their deficit.
Under the Linking Directive of the EU, which went into force in September of 2004, CDM
credits may be used for compliance from 2005 forward, and JI credits may be used for
compliance from 2008 forward.
Today, only about half of the EU members are active participants. Nevertheless, over 90
million allowances have been traded so far this year under the plan, representing some 70
percent of the volume of carbon credits traded globally. The financial value of this amount,
over 1.38 billion of Euros is even more impressive.2
Several other Annex B countries besides those from EU are in the planning stages of their
own ETS as for example, Canada and Norway.
It is important to remind that all volumes of emission reductions exchanged in the
International Emissions Trading Scheme are expressed in metric tons of carbon dioxide
equivalent (tCO2e). Therefore, the emission reductions occurred for other GHGs than CO2
must be converted to an equivalent amount of CO2 taking into account their Global Warming
Potential.
2.2 Joint Implementation (JI)
Joint Implementation is a project-based mechanism that allows emissions reduction targets to
be met through joint projects between ‘Kyoto capped’ countries. Investors such as
governments, companies or funds participate in a greenhouse gas reduction project in one of
the countries listed on Annex B to the Kyoto Protocol and, in return for the investment
provided; they receive emission credits known as Emission Reduction Units (ERUs). The
pilot phase of this mechanism proposed at COP-1 (Berlin, 1995) under the name Activities
Implemented Jointly (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). Contrary to the concept of JI, the AIJ was not
open for crediting of emission reductions.3
2
3
Sychrovský, P., 2005
Compare: Stowell, D., 2005, p. 23
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Although the results of the AIJ pilot phase were not so impressive due to little incentive for
industry within Annex I Parties to participate, it did provide a lesson that countries promoting
JI could draw on in selling what became known as the ‘flexible mechanisms’.4
It is known that the JI projects can be developed with more feasibility in the countries with
economies in transition where there are more possibilities to reduce the GHG emissions at
lower costs. In all cases, the JI projects must respect the additionality criterion to be eligible to
obtain the ERUs; that means, the emission reductions or removals must be additional to any
that would have occurred without the project.
2.3 Clean Development Mechanism (CDM)
The CDM is a mechanism by which Parties may receive emission credits (known as Certified
Emission Reductions, or CERs) for their investment in GHG reducing projects in developing
countries (such as India, Latin America, China, and Africa) which do not have their own
emissions reduction targets. The CERs obtained can be used for Kyoto-target compliance and,
since beginning of 2005, also in the EU ETS. CDM projects are designed to meet two main
objectives: to assist Parties not included in Annex I (i.e. developing countries) in achieving
sustainable development and to assist Parties included in Annex I (industrialized countries) in
achieving compliance with their quantified emission limitation and reduction commitments of
GHGs under Article 3 of the Kyoto Protocol.
The CDM, as with JI, is a project-based mechanism that requires a verification process 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 mechanisms of flexibility are based on two principles: first, it does not matter where
GHG emission reductions take place. Once GHG enter into 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). Additionally, they have long life spans, so they
remain mixed in the atmosphere for long periods of time. Second, market-based mechanisms
can prove to be more efficient and effective for meeting their GHG targets than traditional
command and control policies.
Most of the regulations constraining GHG emissions and most of the voluntary actions take
advantage of this substitutability and allow for the purchase of emission credits both within
and outside of the regulated area, thereby laying the ground for the so-called "carbon market".
The emerging carbon market is one of the few markets for environmental services currently in
operation; and the only one, to our knowledge, with worldwide reach. Because abatement
costs are thought to be lower in transition economies and developing countries, the carbon
market is the occasion not only to generate global efficiency gains, but also to contribute to
sustainable development by bringing new public and private investment in clean technologies
to economies in transition and developing countries.
Each flexible mechanism has its own rules, credits of trading – carbon currency – and market
expectations. Nevertheless, basically, they serve the same purpose: to assist Annex B Parties
in meeting their targets costs efficiently. Two of the mechanisms are aimed Annex I countries:
a cap and trade programme (IET) and a project-based trading under the cap and trade
programme (JI), while the third (CDM) provides a way for developing countries to participate
in the carbon market through project-based trading.
4
Compare: Stowell, D., 2005, p. 23
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The inclusion of these mechanisms makes the Protocol one of the most innovative
international agreements to date once it provides the countries a flexibility to meet their
emissions targets at lower costs.
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 and other environmentally friendly technologies. Two additional options
are the use of the Kyoto mechanisms and offsetting emissions through land-use change and
forestry activities such as carbon sequestration.
3 Conclusion
3.1 Trends and progress of the carbon market
The major findings of the state and estimations of the trends of the carbon market so far
highlighted by the World Bank in its Working Paper released in 2005 are:
- The carbon market is growing steadily, notably in Asia and Latin America. A total of 64
million metric tons of carbon dioxide equivalent (tCO2e) has been exchanged through projects
from January to May 2004, nearly as much as during the whole year 2003 (78 million). The
vast majority of this volume is from project-based transactions intended for compliance with
the Kyoto Protocol.
- HFC23 destruction projects represent nearly a third of the volume supplied in 2003-2004from only two project sites (add info about HFC23). Landfill gas to energy projects are the
second largest suppliers of emission reductions, with 18 percent. This is a dramatic change
compared to the previous period (2002-2003), which underlines the important potential of this
technology, which has low mitigation costs, an approved and published methodology, and a
large total supply per site.
- The demand remains heavily concentrated. Japanese companies now represent the single
largest group of buyers in the carbon market, before the World Bank Carbon Finance
Business and the Government of the Netherlands. These three groups of buyers accounted for
nearly 90 percent of the demand from January 2003 to May 2004.
- Asia is now the largest supplier of emission reductions, followed by Latin America,
developed economies, and Eastern Europe. Five countries (India, Brazil, Chile, Indonesia, and
Romania) represent two thirds of the supply in terms of volume. Increased concentration of
CDM flows to a limited number of countries continue to leave Africa essentially bypassed,
raising concerns about the long-term distribution of the benefits of the Clean Development
Mechanism. The potential HFC23 destruction projects are heavily concentrated in a handful of
countries, reinforcing this concern.
- Prices of project-based emission reductions in early 2004 have remained essentially stable
compared with 2003, and depend strongly on the segment of the market, and on the structure
of the transaction. They reflect the distribution of risks between buyer and seller. For
example, when the buyer assumes the risk that the ERs might ultimately not be registered
under the Clean Development Mechanism or Joint Implementation, it commands a significant
premium.
- The approval of the EU Emission Trading Schemes (EU-ETS) and the "Linking Directive"
which connects the EU-ETS to the world of project-based opportunities create a welcome and
appropriate structure for managing and pricing carbon. The EU-ETS sends a strong signal to
the markets and can be a driver of additional volume of carbon trades achieving climate
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mitigation in the future. Until May 2004, most EU Member States had published their
National Allocation Plans for the scheme's pilot phase (2005-2007) which were less stringent
than expected. This has apparently contributed, along with the approval of the Linking
Directive, to a significant drop in the price of European allowances on the early market,
although the early market for EU allowances is still very thin and does not "a priori" reflect a
long-term equilibrium between supply and demand.
Taken together, the use of renewable energy sources account for 31 percent of the total
volume of project-based ERs transacted; and a small majority of projects (53 percent) are
related to power generation.
3.2 Observed Prices of Emission Reductions
There is a big gap between the value of emissions allowances and credits from JI and CDM
project prices. In general, the price differential is caused by the uncertainty connected to
JI/CDM projects and the actual delivery of ERU/CER units. Once these units are actually
issued and their delivery is guaranteed, the price differential should decrease.
There is a price disparity between GHG allowances and credits from CERs or ERUs because
of the uncertainty connected to JI/CDM projects and the actual delivery of ERU/CER units
once the CDM credits must receive Designated National Authority (DNA) approval as well as
approval by the CDM Executive Board. There has been a lag time of as much as 18 months
between submission of a project design document and approval. In addition, CDM and JI
credits are only available when the projects are complete. Taking into account the risks
associated with the non validation of JI or CDM projects, the price of ERUs/CERs which
were purchased on a forward-delivery basis have been quite low in comparison to the prices
of EU allowances.
The prices of Project-based Emission Reductions (ERs) are expressed in nominal U.S. dollars
per ton of CO2e. First, not for Kyoto compliance ERs command a price between USD 0.37
and USD 3.00 (weighted average, by volume, USD 1.34). Within the transactions intended for
Kyoto compliance, we observe that with registration risk on the buyer, Verified Emission
Reductions (VERs) sell at USD 3.00 to USD 4.25 (weighted average USD 3.85), while
registration risk on the seller commands a higher value of USD 3.00 to USD 6.37 (weighted
average USD 5.52). 5
The prices of JI and CDM transactions do not appear to have evolved significantly compared
with previous analysis in the December 2003, except when the buyer requires delivery of
compliance-grade credits. The weighted average price of credits in these transactions has
increased from USD 4.88 (as reported in 2003) to USD 5.52.6
Recent forward trading of EU allowances shows prices from EUR 5/tCO2e to EUR 15/tCO2e.
Since the volume traded is limited thus far, these figures do not necessarily reflect the future
EU market price. Future price expectations show a wide range due to the uncertainties
surrounding the volume and value of the future carbon market. Brokers and market analysts
give an average expected market price of EUR 5-10/tCO2e for the ETS in 2005-2007,
however, with a large uncertainty (EUR 2-45/tCO2e). Most specialists assume that prices will
be higher during the second phase of the EU ETS (2008-2012).7
5
6
7
Compare: Lecocq, F., 2005, p.21
Lecocq, F., 2005, p.22
Climate Change Projects Office (CCPO), 2005, p.3.
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References:
[1] Yamin, F., Climate Change and Carbon Markets: a Handbook of Emission Reduction Mechanisms, London,
UK, 2005.
[2] Stowell, D., Climate Trading: Development of Greenhouse Gas Markets (Finance and Capital Markets
Series), New York, USA, 2005.
[3] Lecocq, F.: State and Trends of the Carbon Market – 2004 (World Bank Working Paper no. 44),
Washington, USA, 2005.
[4] The Kyoto Protocol to the Convention on Climate Change, the Climate Change Secretariat and the UNEP
Information Unit, UNEP/IUC/99/10.
[5] The UN Framework Convention on Climate Change, the UNEP/WMO Information Unit on Climate Change
(IUCC).
[6] http://www.unfccc.int from 2.6.2006, website of United Nations Framework Convention on Climate Change.
[7] National Allocation Plan of the Czech Republic 2005-2007, Czech Republic, 29th September 2004.
[8] Sychrovský, P., Czech Business Weekly,
PricewaterhouseCoopers in Czech Republic.
at
http://www.pwcglobal.com/cz
from
22.8.2005,
[9] Svoboda, Z., Steffens, R., Green House Emission Trading: the Czech Model, at
http://www.buyusa.gov/czechrepublic/en/68.html from 20.3.2006, U.S. Commercial Service Czech Republic:
Emission Trading.
[10] Climate Change Projects Office (CCPO), Department of Trade and Industry, Carbon Prices: a Climate
Change Projects Office Guide, UK, April, 2005.
Contact:
Ing. Ticiano Costa Jordão
Institute of Public Administration and Law
Faculty of Economics and Administration
University of Pardubice
e-mail: [email protected]
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