Position Paper: Overcoming the obstacles facing new carbon market mechanisms

The following position paper was published in Environmental Finance.

02 February 2018

Junji Hatano reviews practical challenges for international carbon markets under the Paris Agreement and explores how they could be overcome in a way that will ensure private sector participation.

The provisions of Article 6 of the Paris Agreement (PA) are interpreted as accepting the use of international carbon markets for the implementation of nationally determined contributions (NDCs), despite the absence of direct reference to the term “market” in the text of the agreement. Furthermore, most observers believe that Article 6 allows for the creation of a mechanism similar to the Clean Development Mechanism (CDM) and Joint Implementation (JI) of the Kyoto Protocol.

However, the notion of Article 6 is yet to be followed up with specific guidance, rules, modalities and procedures. While deliberations at COP23 in November 2017 made progress in laying the foundations for the next steps, the current lack of a clear picture has raised questions about how market mechanisms will work in practice under the Paris Agreement.

This concern is aggravated by two factors. One is the inherent difficulty associated with internationally transferring mitigation outcomes under the PA. The other is the uncertainty as to whether the rules and procedures to be eventually developed will be consistent with a key Article 6 objective of facilitating private sector participation in climate change mitigation activities.

The practical challenges discussed in this article are relevant to both of the two international carbon market mechanisms of the Paris Agreement – international “cooperative approaches that involve the use of internationally transferred mitigation outcomes (ITMOs)” set forth in Article 6.2 and a “mechanism to contribute to the mitigation of greenhouse gas (GHG) emissions and support sustainable development” created in Article 6.4. They are independent of each other in some respects but interconnected in other ways. As this article deals with practical challenges common to both mechanisms, it will not examine their similarities and differences or the relationship between them.

Prohibition of double counting

The Paris Agreement emphasises the need for strict avoidance of double counting in Article 6.2 and elaborates on it in Article 6.5 by stating that “emission reductions … shall not be used to demonstrate achievement of the host party’s NDC” if used by another country for its NDC achievement. This requirement logically follows the PA’s fundamental concept of having all countries commit to reduction targets. Attempts to refute or circumvent the rule would contradict the PA’s central principle and should be avoided.

A natural approach to complying with the regulation (and the most practical one in our view) is a partial transfer that involves the host country transferring some of the emission reductions and keeping the remainder for its own NDC achievement. The question then is whether such an arrangement is economically acceptable for both seller and buyer.

This is examined for three specific examples, assuming 50% of the emission reductions are transferred.

Example 1

CDM project ref. 2938 was registered in February 2010 and pertains to a 9.9MW biomass power plant. It is a typical small-scale renewable energy project and displaces grid electricity with carbon intensity of 0.51 tCO₂e/MWh.

Based on the feed-in-tariff relevant at the time, the project expected an internal rate of return (IRR) of 12.63% without carbon revenue, slightly less than the hurdle rate of 15% adopted in accordance with publicly available information. The chart below shows how, at various carbon prices, transactions pursuant to the CDM and PA partial transfer (PAPT) will contribute to improving profitability.

Example 1

There are three points to note about this example:

• As a project undertaken during the prosperous years of the CDM, ref. 2938 expected a price of $15/tCO₂e that would have given the project a meaningful increase of 2.54% for the project IRR. Naturally, securing the same increase with PAPT at the 50:50 transfer ratio entails a price of $30/tCO₂e for the portion to be transferred. There is little chance of this price being accepted by buyers at the moment.

• On the other hand, at the price of $7.5/tCO₂e, which is closer to the range acceptable to buyers in the immediate future, a PAPT transaction at a 50:50 transfer ratio will achieve too small an increase in profitability (a 0.66% improvement in project IRR) to interest project owners.

• A PAPT transaction at $15/tCO₂e at a transfer ratio of 50:50 results in a 1.30% rise in project IRR and will be a borderline case for project owners, in terms of profitability augmentation relative to internal and third-party transaction costs the PAPT process will inevitably involve. Some project owners will accept the price, while others will not. In the same way, some buyers will accept the price while others will balk.

Example 2

Projects with higher carbon intensity for the baseline should derive greater benefits from PAPT transactions. To gauge this effect, Example 2 adopts grid carbon intensity of 0.8 tCO₂e/MWh (as opposed to 0.51 tCO₂e / MWh in Example 1), while keeping all other parameters unchanged. This example is relevant when the grid includes substantial amounts of coal-based power generation, in contrast to the grid for Example 1 that is largely fuelled by natural gas.

For Example 2, a price of $15/tCO₂e raises the project IRR by 2.02% and seems attractive, instead of being a borderline option as in Example 1.

Example 2

Example 3

The effect of baseline carbon intensity described above is most pronounced when a project reduces methane emissions. This is demonstrated by the following chart that pertains to CDM ref. 8004, registered in November 2012, which involves extracting biogas from industrial wastewater and using it for energy generation (1.063MW).

The project IRR was estimated to be 5.37% without a carbon transaction. The project IRRs after CDM or PAPT revenue are markedly higher, as can be seen in the following chart.

Similar results can be expected for solid waste management projects.

Example 3

To summarise these analyses, for a price of up to approximately $15/tCO₂e, considerable numbers of high-quality projects are likely to be available for PAPT transactions with the 50:50 transfer ratio. It is acknowledged that this price range is more than prospective buyers have in mind at the moment. But it will still be distinctly lower than the cost of domestic emission mitigation measures in most buyer countries.

Assessment of additionality

The CDM additionality assessment process has been subject to criticism on two different points. Some maintain that the current procedures are excessive and onerous, while others take the view that the current approach, despite its lengthiness, fails to identify large numbers of non-additional projects and lets them pass as additional.

Theoretically, the Paris Agreement should be able to develop a simpler and more effective process for confirming the additionality of emission mitigation projects. This argument is based on the reasoning that if an emissions reduction project is non-additional then, by definition, it will be undertaken on a business-as-usual (BAU) basis, with its emission reductions reflected in the country’s NDC.

Internationally transferring (some) emission reductions from the project will remove that amount from the country’s NDC achievement and run counter to its own interest. Thus, the theory goes, no country will sell emission reductions from a non-additional project, obviating the need for an intricate process of additionality assessment.

Rational as the theory is, it is disputed due to the risk of so-called ‘hot air’, referring to an informal English expression to describe promises, etc. that are exaggerated, empty and lacking real value. Under the Paris Agreement, hot air can emerge if a country’s NDC is such that overachievement is assured. This includes NDCs that set a respectable reduction target relative to the BAU emission level which, however, is grossly overestimated because of unrealistic or inappropriate assumptions.

Hot air will also arise by default when a country’s economy experiences a significant decline (with a corresponding reduction in emissions) after its NDC target has been set based on a year(s) of economic prosperity. This was the case that afflicted the Kyoto Protocol in relation to former Soviet bloc countries.

The presence of hot air means that a country has surplus emission reductions. This will allow it to sell emission reductions from a non-additional project, without unfavourable effects on the country’s NDC achievement. All that will happen is a diminished surplus. For such a country, the theory outlined above will not apply.

The theory is also challenged from another perspective. This relates to countries with reasonable NDC targets (i.e. no hot air) that have internationally transferred some of their emission reductions. The concern has been raised that the selling countries may fail to fulfil their NDC commitment subsequent to the international transfer having taken place. In such a case, the transfer would add to the level of global GHG emissions, by permitting buying countries to cut their own emissions less, without corresponding reductions in the selling countries.

In view of the long time that will elapse before an agreement can be reached about the best way to deal with such issues as hot air and the seller country’s failure to fulfil its NDC commitment, it is deemed more practical for Article 6 of the Paris Agreement to start with activity-based additionality assessment, in common with current CDM practice.

This does not mean, however, that the current CDM procedures for additionality can continue with only incremental improvements. Instead, they will require some profound changes, two examples of which are given below.

Streamlining the process

As early as November 2012, the CDM Executive Board (EB) made a significant, though not widely known, decision. It pertains to the small-scale methodology AMS-III-D for “Methane recovery in animal manure management systems” and affirms that additionality can be demonstrated by “showing that there is no regulation in the host country, applicable to the project site, that requires the collection and destruction of methane from livestock manure“.

There is no doubt that this rule involves the risk of accepting as additional some projects that are, in fact, non-additional. It is assumed that the EB evaluated the risk and judged its potential harm to be less than the benefit of simplicity. This type of simplification – based on managerial judgement of risk vs. benefit – is highly welcome and can be expanded for PA carbon market mechanisms for which the potential risk is expected to be lower. As outlined above, seller countries’ self-interest under the Paris Agreement motivates them, except under special circumstances, to refrain from selling emission reductions from non-additional projects.

Combining the approach outlined above with programme of activities and standardised baselines will facilitate scaling up by enabling the PA’s carbon market mechanisms to be applied to groups of projects, as well as individual projects.

Misleading comparisons with the hurdle rate

Junji Hatano, Tokyo-based chairman, consultancy Carbon Partners Asiatica

A salient characteristic of the current CDM process for additionality assessment is its heavy reliance on the comparison of a project’s profitability (typically measured by its IRR) with the hurdle rate. The rationale is that those projects with an IRR higher than the hurdle rate can be implemented on a BAU basis. They are therefore judged as non-additional and disqualified from engaging in CDM transactions.

But this is misguided, as it fails to take into account the chronic shortage of funds suffered by most developing countries. When operating under financial constraints, companies are not able to proceed with a project simply because its profitability is above the hurdle rate. A choice must be made between it and other projects that also exceed the hurdle rate in terms of profitability, if they can only garner sufficient funds for one.

For example, a plan to introduce a renewable energy captive power plant will face competition from other potential uses of the same amount of funds that have also passed the profitability criteria. When they include such projects as expansion of a factory’s manufacturing capacity, the management’s decision in most cases will be in favour of the capacity expansion. If this is the case, the renewables project is additional (i.e. cannot be implemented on a BAU basis), despite its IRR being above the hurdle rate.

Conversely, it would be a mistake to consider as additional all the projects with an IRR below the hurdle rate. Some of them can be implemented on a BAU basis and are therefore non-additional, even when their IRR is slightly below the hurdle rate.

For the management of private companies, the absolute size of their companies’ profits is as important as the profitability measured in ratios. A few big companies not subject to severe financial constraints will find it attractive to undertake large projects slightly below the hurdle rate, in view of the sizeable profits they offer. For them, additional revenue from an international carbon market transaction is nice to have, but not essential.

In this sense, the projects are not additional, notwithstanding their profitability that is estimated to be below the hurdle rate. Such projects are few in number, but they warrant mention as they are large, high-profile projects and may have contributed to the criticism that the current process fails to identify and reject non-additional projects.

Without doubt, efforts will be made to improve the real and perceived reliability of the additionality assessment process, in preparation for the PA carbon market mechanisms. It is hoped that this will be done with sufficient input from project owners and host country government officials, to ensure the right balance between rigour and simplicity.

In conclusion, it is acknowledged that excitement about international carbon markets under the Paris Agreement is somewhat limited at the moment. Nonetheless, the situation may change, depending on the final decisions about the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) and other factors, not least the possible ratcheting up of NDC targets. Given that climate change is a global issue, we can ill afford not to have well-functioning international carbon markets, which are considered a leading tool for international cooperation on climate change.

Admittedly, there is no lack of hurdles to overcome. But, in this context, it is recalled that the early days of the CDM saw enthusiasm for ‘learning by doing’. That spirit needs to be revitalised.

Junji Hatano is the Tokyo-based CEO of consultancy Carbon Partners Asiatica.