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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 61 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 62 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 63 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 64 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 65 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. 66 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] 67