Five reasons the EU should not expect the UN to fix the carbon market (Newsletter #18)

In December 2011 the European Commission published its long awaited Study on the Integrity of the Clean Development Mechanism. The study summarises the merits of the CDM in five bullet points while allotting five entire pages to its shortcomings. The study also devoted a complete section to assessing demand-side reform measures including use restrictions to address shortcomings of environmental integrity and sustainability impacts for the hydro power sector.

The current debate does not focus on the quality of offsets but whether the European carbon market will experience a catastrophic collapse due to the economic crisis. Projections for the EU Emissions Trading Scheme (EU ETS) and the Effort Sharing Decision show that businesses and governments alike can comply with their carbon reduction obligations without additional efforts. Moreover, an enormous surplus will be carried over to the next phase of the EU ETS which risks undermining future commitments. The European Commission is facing increased pressure to put deep and structural demand-side interventions in place, including stricter caps and a set-aside. Given the current state of the EU carbon markets, using restrictions for certain carbon credits would not only boost the EU’s environmental integrity but also help stabilise the markets.

Following the publication of the CDM Integrity Study, the European Commission made it clear that the assessment on whether further action is necessary to potentially restrict the use of certain project categories will depend on the final report of the policy dialogue panel set up in December 2011 under the UN’s CDM Executive Board.

Here are five reasons why we think the EU should not expect the UN to fix the carbon market:

Reason 1: Policy dialogue’s mandate does not address important issues in the CDM integrity study

The panel comprises 12 distinguished members (though with limited CDM experience). It will focus on the CDM’s internal workings, future direction, and mitigation and sustainable development impacts and will produce a final report in September 2012. Its recommendations are expected to be directed at the UNFCCC level and will likely not look at demand-side reform options. In summary, it is unrealistic to expect the Panel to cure the CDM’s many diseases.

Reason 2: UNFCCC reform options face political challenges

Reform at UN level faces considerable political challenges. In the case of the HFC-23 scandal, it took the CDM Executive Board 12 months to adopt an unsatisfactory result. Albeit more stringent, the new rules still risk undermining the HFC-23 phase-out under the Montreal Protocol. Even worse, the UN rules still allow more than 300 million carbon credits to be issued to HFC-23 projects since the crediting rules had been suspended in November 2010. A demand-side ban against these projects was the only way to protect the environmental integrity of the EU ETS.

Reason 3: Supply-side reform options only relate to future CDM project registrations

Similarly, the Board suspended the crediting rules for CDM coal fire projects because of flawed crediting rules in November 2011. However, a new study by the Stockholm Environment Institute (SEI) highlights that several issues, such as the small efficiency gains and the large project emissions, the impact of other variables on plant efficiency and the lack of data quality cannot be completely resolved by a revision. The SEI study also shows that it is likely that none of the coal power projects are additional because fuel price pressures and numerous Indian and Chinese government policies already foster or require super critical and ultra super critical coal design. However, six projects have already been adopted and are expected to supply 89 million credits, adding more sub-standard carbon credits to the already over-supplied European carbon market. Even a revised methodology at UNFCCC level will not alleviate the threat of carbon credits from more than 45 coal power projects in the pipeline forecasting millions of carbon credits.

Reason 4: Supply-side reform options don’t address concerns about sustainability

The CDM Integrity Study adds a long list of both, supply-side and demand-side options. In particular, it analyses three general reform options to address concerns about non-additionality and sustainability impacts. It identifies standardised baselines and additionality testing as a supply-side reform option and assesses discount factors and negative lists from a demand-side perspective. While standardised baselines and improved additionality testing can improve additionality of future projects, they are facing fundamental technical challenges and cannot address problems related to sustainability impacts.

Reason 5: New mechanisms can only address shortcomings in the far future, and need demand

The study also assesses how new mechanisms (such as sectoral crediting mechanisms) can address identified shortcomings and scale up emissions reductions. However, functioning new market mechanisms are still far off in the future. They will also not address the problems of the CDM. More importantly, as long as there is no demand, new market mechanisms will not take off.

Discount factors and negative lists (imposed at demand-side level) can address both, sustainability and additionality concerns. They would increase the quality of carbon credits and help stabilise the carbon market by curbing supply.

In midst of the European carbon market crisis, waiting for the final report of the CDM policy dialogue panel to decide on a way forward is just delaying action. Over 80% of the credits generated by the CDM are purchased by the European Union. The EU is the only significant party to create demand after 2012 and is therefore in a unique position to influence the direction of the CDM, send signals on which kind of project types will be financed through the CDM and which projects could be better addressed with alternative or complementary mechanisms.

For a short analysis of the CDM Integrity Study, see this link