55419 State and trendS of the Carbon Market 2010 Alexandre Kossoy Philippe Ambrosi Senior Financial Specialist Environmental Economist Carbon Finance Unit Climate Change Team Environment Department the findings and opinions expressed in this report are the sole responsibility of the authors and should not be cited without permission. they do not necessarily reflect the views of the World Bank Group, its executive directors, the countries they represent or of any of the participants in the carbon funds or facilities managed by the World Bank. this report is not in- tended to form the basis of an investment decision. All photo credits: Shutterstock Images LLC, except page 4 by (c) George hammerstein/Corbis Cover design: Patricia hord Graphik design Layout and typesetting: the Word express, Inc. Printing: Westland Printers aCknoWLedGmentS We, the authors, would like to acknowledge our editor, Andy Stone, whose countless insightful contri- butions ensured the quality and clarity of this report. We are also grateful to our many colleagues in the carbon market who provided their written contribu- tions and perspectives: Imtiaz Ahmad, Claudia Barrera, Benoit Bosquet, Rodney Boyd, Lance Coogan, Lex de Jonge, John Kilani, Werner Kornexl, Aditi Maheshwari, Taisei Matsuki, Grzegorz Peszko, Alex- andrina Platonova-Oquab, Monali Ranade, Milo Sjardin, and Jari Vayrynen. Finally, we also wish to extend our thanks to those who offered their cooperation and insights during the elaboration of this report: Luz Abusaid, Agnes Biscaglia, Veronique Bishop, Eron Bloomgarden, Anna-Maria Bogdanova, Martina Bosi, Jean-Christophe Bougle, Alban Brindle, John Buckman, Scott Cantor, James Cantrell, Marcos Castro, Dougal Corden, Isabelle Curien, Karen Degouve de Nuncques, Eduardo Dopazo, Nadine Dulac, Patricia Ephraim, Emmanuel Fages, Justin Felt, Francisco Fernandez Asin, Sonia Medina Gomez, Pierre Guigon, Isabel Hagbrink, Takashi Hongo, Lenny Hochschild, Pedro Huarte-Mendicoa, Robert Hunt, Carollyne Hutter, Masaya Inamuro, Friso de Jong, Yvan Keckeis, Ted Kennedy, Solvita Klapare, Daigo Koga, Anita L. Kossoy, Benoit Leguet, Martin Lawless, Mark Lewis, Gautier Le Maux, Vincent Monteux, Lucy Mortimer, Ken Newcombe, Shahyar Niakan, Akiko Nishi- mae, John O'Brien, Ian O'Donohue, Roon Osman, Christian de Perthuis, Neeraj Prasad, Saima Qadir, Brice Quesnel, David Rapin, Frank Rasmussen, Pontus Ripstrand, Fabrice Le Sache, Geoff Sinclair, Chandra Shekhar Sinha, Laurent Segalen, Ash Sharma, Trevor Sikorski, Sara Stahl, Barry Sterland, Charlotte Streck, Endre Tvinnereim, Laurent Valiergue, Jan-Willem van de Ven, Ariane Verbeeck, Ales- sandro Vitelli, Emilio Weldon, Yevgen Yesyrkenov, Bernhard Zander, Elizabeth Zelljadt, and Susann Zimmer. State and Trends of the Carbon Market 2010 received financial support from the CF-Assist Program, managed by the World Bank Institute (WBI), as well as from the Carbon Finance Unit of the World Bank. iii LISt of aCronymS and aBBrevIatIonS AAU Assigned Amount Unit ETS Emissions Trading Scheme AAUPA AAU Purchase Agreement EU European Union ACR American Carbon Registry EUA European Union Allowance AWG-KP Ad Hoc Working Group on Further EU ETS European Union Emissions Trading Commitments for Annex I Parties Scheme under the Kyoto Protocol EURIBOR Euro Interbank Offered Rate AWG-LCA Ad Hoc Working Group on Long- GDP Gross Domestic Product term Collaborative Action GHG Greenhouse Gas CAPEX Capital Expenditure GIS Green Investment Scheme CAR Climate Action Reserve HFC Hydrochlorofluorocarbon CCS Carbon Capture and Storage IEA International Energy Agency CCX Chicago Climate Exchange IMF International Monetary Fund CDM Clean Development Mechanism IRR Internal Rate of Return CER Certified Emission Reduction J-VETS Japan-Voluntary Emissions Trading CFL Compact Fluorescent Lamp Scheme CH4 Methane JI Joint Implementation CMM Coal Mine Methane JISC Joint Implementation Supervisory CMP Conference of the Parties serving as Committee the Meeting of the Parties KM Kyoto Mechanism CO2 Carbon Dioxide LDC Least Developed Country CO2e Carbon Dioxide Equivalent lCER Long-term Certified Emission COP Conference of the Parties Reduction CPA CDM Programme Activities LFG Landfill Gas CPRS Carbon Pollution Reduction LoA Letter of Approval Scheme LULUCF Land Use, Land Use Change and CP1 First Commitment Period under the Forestry Kyoto Protocol MOP Meeting of the Parties CRT Climate Reserve Tonne MRET Mandatory Renewable Energy DNA Designated National Authority Target DOE Designated Operational Entity MRV Monitoring, Reporting, and EB Executive Board Verification EC European Commission N2O Nitrous Oxide ECX European Climate Exchange NAP National Allocation Plan EE Energy Efficiency NPV Net Present Value ESS Energy Savings Scheme NSW GGAS New South Wales Greenhouse EIT Economy in Transition Gas Reduction Scheme EITE Emission-intensive, Trade-exposed NZ ETS New Zealand Emissions Trading ER Emission Reduction Scheme ERPA Emission Reduction Purchase NZU New Zealand Unit Agreement OECD Organisation for Economic ERU Emission Reduction Unit Co-operation and Development ESC Energy Savings Certificate OTC Over-the-Counter v State and Trends of the Carbon Market 2010 pCER Primary Certified Emission SF6 Sulfur hexafluoride Reduction SME Small and Medium-size Enterprise PDD Project Design Document tCO2e Ton of Carbon Dioxide Equivalent PFC Perfluorocarbon tCER Temporary Certified Emission PIN Project Idea Note Reduction PoA Programme of Activities UN United Nations PP Project Participant UNEP United Nations Environment RE Renewable Energy Programme REC Renewable Energy Certificate UNFCCC United Nations Framework REDD Reduced Emissions from Convention on Climate Change Deforestation and Forest VAT Value-added Tax Degradation VCS Voluntary Carbon Standard RET Renewable Energy Target VER Verified Emission Reduction RGGI Regional Greenhouse Gas Initiative WB World Bank RMU Removal Unit WTI West Texas Intermediate sCER Secondary Certified Emission Reduction vi taBLe of ContentS 1 EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 EU ETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2 .1 At a glance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 2 .2 Successes of the EU ETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 2 .3 EUAs: growing volumes, changing patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 2.3.1 EUA resiliency faces its greatest test since the inception of the ETS . . . . . . . . . . . . . .8 2.3.1.1 Carbon prices vis-à-vis other energy commodities . . . . . . . . . . . . . . . . . . . . . .10 2.3.1.2 The many curves of the EUA market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 2.3.1.3 Déjà-vu in the EUA pricing pattern . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 2 .4 Spot and secondary CERs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14 2.4.1 Secondary market volume increases, prices fall . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14 2.4.2 Rising liquidity causes offset price segregation to widen . . . . . . . . . . . . . . . . . . . . . .15 2.4.3 A shortage of CERs forces market players to adjust . . . . . . . . . . . . . . . . . . . . . . . . . .15 2 .5 The options market: rising volume and sophistication . . . . . . . . . . . . . . . . . . . . . . . . . .15 2.5.1 Sellers turn to call options to manage risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 2.5.2 A broader perspective on the options market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 2.5.3 Structures proliferate as players look to manage risk . . . . . . . . . . . . . . . . . . . . . . . . .17 2 .6 What lies ahead for the EU ETS? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 2.6.1 Rules governing the use of CERs and ERUs in Phase III: still uncertain . . . . . . . . . .18 2.6.2 Auctions and benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 3 EMISSIONS TRADING IN OTHER ANNEX B REGIONS AND BEYOND . . . . . . 23 3 .1 New Zealand: at last! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 3.1.1 Progressive extension of ETS scope to cover the entire economy . . . . . . . . . . . . . . . .23 3.1.2 No emissions cap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 3.1.3 Allocation rules and transition assistance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 3.1.4 Cost control: full supplementarity for Kyoto-compliant offsets . . . . . . . . . . . . . . . . .25 3.1.5 Interest in the forestry market takes root . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 3 .2 Australia: on hold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 3 .3 Japan: considering market mechanisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 3 .4 North America: waiting for K-G-L and getting K-L . . . . . . . . . . . . . . . . . . . . . . . . . . . .29 3.4.1 The Waxman-Markey Bill raised hopes... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29 3.4.2 ...but momentum is at risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31 3 .5 Emerging alternative market instruments and exchanges beyond Annex B countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31 4 KYOTO FLEXIBILITY MECHANISMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 4 .1 At a glance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 4 .2 pCERs: another tough year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38 4.2.1 Pre-2013 ERPAs: layering, syndicating, and much more . . . . . . . . . . . . . . . . . . . . . .38 4.2.2 Who, how, and what in 2009? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 vii State and Trends of the Carbon Market 2010 4.2.3 Projects wanted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41 4.2.4 A close-up on issuance time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42 4 .3 The relevance of carbon finance in the transition to a low-carbon economy . . . . . . . . .42 4.3.1 Investment barriers can be disproportionately large. . . . . . . . . . . . . . . . . . . . . . . . . .43 4.3.2 CDM cannot overcome all investment barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43 4.3.3 Frontloading future carbon revenues remains a challenge . . . . . . . . . . . . . . . . . . . . .44 4.3.4 Leveraging carbon finance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .45 4 .4 Post-2012 market: "EU ETS CERs" surge as a new asset . . . . . . . . . . . . . . . . . . . . . . . .45 4.4.1 A silver lining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46 4 .5 Scaling up with Programmes of Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46 4.5.1 Evolution of PoAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46 4.5.2 Status and analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47 4.5.3 And finally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47 4 .6 Moving ahead with CDM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47 4 .7 JI: A market moved by one auction and one tender . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50 4 .8 AAUs: some gains as offsets sour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51 5 OUTLOOK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 5 .1 Demand and supply balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55 5.1.1 Government demand for Kyoto assets falls .... . . . . . . . . . . . . . . . . . . . . . . . . . . . . .55 5.1.2 ...and so does private sector compliance demand . . . . . . . . . . . . . . . . . . . . . . . . . . .57 5.1.3 Supply through the three Kyoto mechanisms: CDM & JI down, AAU up . . . . . . . .59 5.1.4 A residual demand of 230 million tons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .59 5 .2 Markets and a post-2012 international regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .60 ANNEX I: SUPPLEMENTARITY UNDER THE EU CLIMATE AND ENERGY PACKAGE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 ANNEX II: AUSTRALIA'S DIVISIVE CPRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 METHODOLOGY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 GLOSSARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Figure 1 Carbon prices, 2008­09 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Figure 2 Monthly volumes for each contract modality since 2005 . . . . . . . . . . . . . . . . . . . . . . . . . .8 Figure 3 Transactions on exchanges versus OTC since 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Figure 4 Comparison of carbon, oil, and coal prices, Sept. 06­Dec. 09 . . . . . . . . . . . . . . . . . . . . .11 Figure 5 EUA and CER forward curves and fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 Figure 6 EUA average prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14 Figure 7 CER options volumes, Oct. 08­Dec. 09 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 Figure 8 Quarterly average prices of CER strike options, Oct. 08­Dec. 09 . . . . . . . . . . . . . . . . . .17 Figure 9 EUA options volumes, 2006­Q1'10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 Figure 10 Volumes and prices for Kyoto offset transactions (CERs and ERUs) since 2002 . . . . . . .37 Figure 11 Primary CDM sellers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40 Figure 12 Primary CDM sectors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40 Figure 13 Primary CDM & JI buyers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41 viii table of Contents Figure 14 Number of projects entering the CDM pipeline each month, Jan. 04­Feb. 10 . . . . . . . .41 Figure 15 Average time (days) necessary for projects to reach registration . . . . . . . . . . . . . . . . . . . .42 Figure 16 Average time (days) necessary for projects to move from registration to first issuance . . . .42 Figure 17 Ratio of investment to net present value of ERPA in the World Bank CDM portfolio. . .43 Figure 18 Incremental IRR from carbon revenues in the World Bank CDM portfolio . . . . . . . . . .44 Figure 19 Shortfalls shrinking and length building-up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .56 Box 1 An overview of VAT fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 Box 2 The economic downturn deeply scarred Europe's emissions market . . . . . . . . . . . . . . . . . .12 Box 3 The contentious history of Estonia and Poland's allocation plans . . . . . . . . . . . . . . . . . . . .18 Box 4 Recycled CERs: one ton is one ton . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 Box 5 Focus on North America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30 Box 6 REDD-plus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33 Box 7 Two points of view on CDM reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48 Box 8 GIS lessons learned and prospects for new mechanisms post 2012 . . . . . . . . . . . . . . . . . . .52 Box 9 Main features of the proposed Carbon Pollution Reduction Scheme (CPRS) . . . . . . . . . . .66 Table 1 Carbon market at a glance, volumes, and values, 2008­09 . . . . . . . . . . . . . . . . . . . . . . . . .1 Table 2 North American carbon market ­ traded volumes and values, 2008­09 . . . . . . . . . . . . . .30 Table 3 Annual volumes and values for project-based transactions, 2008­09 . . . . . . . . . . . . . . . .37 Table 4 Supply and demand in perspective ­ Kyoto market balance, 2008­12 . . . . . . . . . . . . . . .57 Table 5 Analyst expectations for the EU ETS through 2020 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .58 Table 6 Potential demand, contracted supply, and residual demand, 2008­12 . . . . . . . . . . . . . . .60 ix 1 SeCtIon exeCutIve Summary The carbon market endured its most challenging year to date in 2009. The global economic crisis, which started in late 2008 and intensified early in 2009, negatively impacted both the demand and supply sides of the mar- ket. As industrial output plummeted the demand for carbon assets fell. On the supply side the financial crisis spurred financial institutions and private investors to deleverage and redirect their positions away from risky investments and toward safer assets and markets. Capital inflow to de- veloping countries fell dramatically, while already internalized resources flowed out. As a result, many project developers found it impossible to lock in finance and project origination effectively ground to a halt. 2008 2009 table 1 Volume (mtCo2e) Value (uS$ million) Volume (mtCo2e) Value (uS$ million) Carbon market at a glance, volumes and Allowances Markets values, 2008­09 EU ETS 3,093 100,526 6,326 118,474 Sources: World Bank, and NSW 31 183 34 117 Bloomberg New Energy CCX 69 309 41 50 Finance and Ecosystem RGGI 62 198 805 2,179 Marketplace for data on the voluntary market AAUs 23 276 155 2,003 Subtotal 3,278 101,492 7,362 122,822 Spot & Secondary Kyoto offsets Subtotal 1,072 26,277 1,055 17,543 Project-based Transactions Primary CDM 404 6,511 211 2,678 JI 25 367 26 354 Voluntary market 57 419 46 338 Subtotal 486 7,297 283 3,370 Total 4,836 135,066 8,700 143,735 Subtotals and totals may not exactly add up because of rounding. Yet even as global GDP declined by 0.6% in 2009, resilience. The total value of the market grew 6% and at a more perilous rate of 3.2% in industrial- to US$144 billion (103 billion) by year's end ized economies,1 the carbon market demonstrated with 8.7 billion tCO2e traded (see Table 1). 1 International Monetary Fund, 2010, World Economic Outlook (April). 1 State and Trends of the Carbon Market 2010 players exited the market or significantly reduced box Residual demand for Kyoto assets through 2012 will total their activity and, as a result, project-based trans- 230 MtCO2e actions declined by 54%. analysts have continuously revised downward their Cer issuance projec- China remained the largest Clean Development tions and now forecast a total of just one billion tCO2e by 2012. although an increasing number of JI projects have begun to deliver assets, slightly Mechanism (CDM) seller, although Africa and less than 200 million emission reduction units (erus) will be available Central Asia, historically overlooked regions, in- for compliance buyers prior to 2013. Potential aau supply has risen to 1.8 creased their share as buyers sought diversification. billion tCO2e thanks to the significant progress several countries have CDM contracted severely, by 59%, to US$2.7 made in implementing Green Investment Schemes (GIS). billion (1.9 billion). The Joint Implementation as emissions projections have also been revised downward, expect- (JI) market fared no better. Finally, the number of ed gross demand for kyoto assets from governments of industrialized Assigned Amount Unit (AAU) deals increased as annex B countries through 2012 has fallen to 475 MtCO2e. eu-15 remains the health of the offset market declined, with the the chief source of demand with more than 70% of volume or about 350 Czech Republic and Ukraine as the major sellers. MtCO2e. Japan is now believed to be well on track to comply with its kyoto commitment and gross demand from the government remains on Structural issues hobbled the CDM market as the level of 100 MtCO2e. well. The complexity and changing nature of reg- Gross demand from private entities is estimated at 750 MtCO2e. ulations, inefficiencies in the regulatory chain and the projected Cdm and JI demand from european entities over Phase II of the eu etS is about 540 MtCO2e. Private sector companies in Ja- capacity bottlenecks caused delays and negatively pan were among the hardest hit by the global economic downturn and impacted project finance. As a result, it now takes the corresponding fall in industrial output. their demand should not total over three years for the average CDM project more than 200 MtCO2e. to make its way through the regulatory process taking into account what was contracted through 2009, the estimat- and issue its first Certified Emission Reductions ed residual (net) demand for kyoto assets over the next three years is 230 (CERs). MtCO2e, virtually all of which is attributable to european governments. Yet the same problems that have hindered the project-based market may ultimately be the silver lining that sets the stage for a stronger post-2012 The European Union Emissions Trading Scheme market. EU installations will have used fewer (EU ETS) remained the engine of the carbon CERs and ERUs than allowed under their import market. A total of US$119 billion (89 billion) limit during Phase II of the ETS, thus, theoreti- worth of allowances and derivatives changed cally, sustaining future demand. Under this sce- hands. Futures trades continued to account for nario sound upcoming projects and programs, the bulk of transactions with a 73% share, while mainly in emerging regions and sectors, should spot market volume swelled to 1.4 billion tons as have greater opportunity to sell their assets. In- cash-strapped EU companies monetized allow- creased competition for eligible primary CERs ances to raise funds in a tight credit environment. should also prevent their prices from falling in Sophistication also increased in the options mar- coming years. ket, which grew 70% to 420 million tons. How- ever, trading volume in the secondary market for Nonetheless, clear policy and regulatory signals Kyoto offsets leveled off at one billion tons and must be urgently provided if a stronger global value fell by one third to US$18 billion (13 bil- market is to emerge. As things stand, the Copen- lion) as prices declined. hagen climate conference's inconclusive outcome has deepened the sense of uncertainty over the fu- Market consolidation accelerated in 2009 as fi- ture of the global emission reductions effort and nancial players that had weathered the economic the likelihood that international policymakers storm chose to acquire undervalued portfolios will be able to reach a legally binding agreement rather than engage in project origination. Other next December in Cancún. 2 seCtIon 1 Executive Summary In the United States, the Regional Greenhouse New Zealand provided a glimmer of hope in Gas Initiative (RGGI) grew almost 10-fold to 2009 when it became the first country outside US$2.2 billion (1.6 billion) in expectation of of Europe to adopt a mandatory, economy-wide federal carbon regulation; it now appears unlikely ETS. In addition, new initiatives in developing that such regulation will emerge anytime soon. To and developed countries have emerged that ex- make matters worse, Australia's effort to develop plore innovative market approaches to climate a national scheme has stalled. These challenges, finance. Still, considerable effort, ingenuity, combined with more limiting import rules un- and capacity will be required for carbon finance der Phase III of the EU ETS, threaten to erode mechanisms, along with other policy and finance the long-term interest of major actors in carbon instruments, to address the immense scale of the finance despite the strong support of developing climate challenge. countries for the Kyoto mechanisms. 3 2 SeCtIon eu etS 2.1 AT A GLANCE The total value of European Union Allowance (EUA) transactions in 2009 rose 18% to US$118.5 billion (88.7 billion), due to a robust 105% increase in trading volume over 2008. The growth in overall transaction value occurred despite the fact that average EUA prices fell 42% to US$18.7 (14.0), versus US$32.5 (22.1) the year before. The second year of Phase II of the EU Emissions By May, however, after what seemed an eternity Trading Scheme (EU ETS) started with a crash for players that had endured the worst of the cri- in EUA prices, continuing the decline that had sis, the market began a quick rebound and allow- begun in the second half of 2008 as the financial ance prices stabilized within a narrow range of crisis widened and stoking fear among market 13 to 16 for the remainder of 2009. participants of a repeat of the end of Phase I. Prices fell to record lows during the first quar- The financial turmoil led to substantial changes in ter as EU companies found themselves long on the market. Financial institutions that had been EUAs and sold heavily, mainly on the spot mar- active players, such as Lehman Brothers and Bear ket, to generate cash and shore up their balance Stearns, had collapsed. Other important banks sheets. By February 2009 EUA prices had plum- significantly reduced their activities in the carbon meted to 8, versus 30 nine months earlier (see space while few new companies dared to enter the Figure 1). market during the downturn. 33 fIgure 1 31 Carbon prices, 29 2008­09 27 Source: ECX, BlueNext, 25 IDEAcarbon, and World 23 Bank 21 Daily prices () 19 17 15 13 11 9 7 5 Se 9 Oc 9 De 9 Ma 8 Ju 8 Ju 8 Se 8 Au 8 Oc 8 No 8 De 8 Ja 8 Fe 9 Ma 9 Ap 9 Ma 9 Ju 9 09 No 9 Ja 9 Au 9 Fe 0 Ma 0 Ap 0 0 0 0 0 0 0 r ­0 r ­0 0 t­0 0 l­0 0 0 0 r­0 l­0 0 t­0 0 0 1 1 r­1 r­1 n­ b­ n­ y­ g­ p­ v­ b­ n­ c­ y­ n­ g­ p­ v­ c­ Ju Ap Strip EUA prices Strip sCER prices Spot CER prices pCERs prices 5 State and Trends of the Carbon Market 2010 The EU ETS was also marked by controversy dur- on London's European Climate Exchange (ECX), ing 2009. The European Court of First Instance primarily through a small number of trades of annulled the European Commission (EC) decision large EUA lots. Japanese players were also ac- to withhold EUAs from the National Allocation tive although in lower proportion. Private sector Plans (NAPs) of Poland and Estonia, evidence sur- participation from both countries may have been faced of "carousel" Value-added Tax (VAT) fraud motivated by the expectation of future obligations in countries like France and the United Kingdom under federal schemes as well as short-term profit and a phishing attempt was made on Germany's making. national EUA registry (see Box 1 and Box 3 for details). More recently, the "recycling" of surren- dered CERs added to the challenges faced by the 2.2 SUCCESSES Of ThE EU ETS2 European ETS (see Box 4 for details). The successes of the European ETS are both mea- Ironically, however, these controversies provide surable and diverse, and lessons learned during evidence that the emissions market is maturing the scheme's first five years will help guide its ex- and becoming mainstreamed within the Europe- pansion as well as the likely development of new an economy. Entities don't seek out loopholes in greenhouse gas reduction programs around the insignificant markets, fraudsters do not focus on globe. small businesses, and disputes over NAPs demon- strate that carbon has become very important to (i) The scheme has thus far succeeded in its the involved countries. Through these challenges main goal of reducing overall carbon emis- the EU ETS has demonstrated resilience and the sions. Available data point to a 2­5% decline capacity for swift self-adjustment. in emissions (40­100 MtCO2e annually) attributable to the ETS during the trial pe- As a market mechanism, the EU ETS should riod of 2005­07.3 The decline was probably be evaluated according to how accurately it has considerably larger in 2008, when allowance reflected macro-economic trends. The fact that prices increased vis-à-vis 2007.4 The fact that carbon prices fell along with the prices of mature companies have achieved true emission re- energy commodities as the global economic crisis ductions regardless of trade volumes and in deepened, and rebounded amidst signs of recov- the presence of sophisticated financial instru- ery, suggests the market is both efficient and ratio- ments is critical to the political viability of nal. The price of carbon reflected expectations for the EU ETS. the amount of abatement required to limit emis- (ii) As a result of the ETS, European power com- sions under a changed economic scenario. panies have begun to fully integrate the cost of carbon into their investment decisions and Finally, last year U.S. funds and trading compa- include more low-carbon technologies, such nies participated substantially in the EU ETS for as combined cycle gas turbines, high-efficien- the first time. Evidence strongly indicates that cy coal and renewable energy (e.g., wind) in U.S. players represented 10­15% of trade volume their future plant mix. 5 2 This section has benefitted from thoughtful contributions and publications of CDC Climat, Barclays Capital, and Deutsche Bank. 3 The electric utility sector accounted for the bulk of emission reductions through increased use of clean generation tech- nologies. Utilities brought online lower emitting, more efficient coal plants while replacing some coal generation with cleaner natural gas. Anecdotal data also suggest improvements in energy efficiency. 4 A. D. Ellerman, F. J. Convery, C. de Perthuis, 2010, Pricing Carbon: The European Union Emissions Trading Scheme, Cambridge University Press. 5 Research shows that carbon prices are encouraging European power companies to build cleaner power stations. Source: New Energy Finance, 2009, Impact of the EU ETS on power sector investments--a survey of European utilities. 6 seCtIon 2 EU ETS (iii) The ETS provides assurance to utilities that these successes show that a there will be a long-term carbon price, help- ing drive the shift to lower CO2 emitting multi-national emissions trading technologies. scheme can exist despite significant (iv) Europe's ETS has promoted the development of low-carbon projects worldwide by creat- differences among participating ing a framework that allows the utilization nations, and provide a viable of assets generated through the Clean Devel- model for a potential global trading opment Mechanism (CDM) and Joint Im- plementation (JI) for compliance purposes regime for the reduction of GhG within the ETS.6 emissions. (v) The ETS has created a cost-effective, scalable infrastructure of registries, accounting meth- ods, and monitoring, reporting and verifica- market then establishing a price that is con- tion systems that will be ready to serve the sistent with that level of scarcity). It does ambitious emissions schemes of the future. not guarantee a fixed price (if a fixed price (vi) These successes show that a multi-national is targeted, a tax scheme is more appropri- emissions trading scheme can exist despite ate). While progressive migration from free significant differences among participating allocations to auctioning should strengthen nations, and provide a viable model for a po- price signals and further reduce EUA volatil- tential global trading regime for the reduc- ity, prices will continue to reflect reasonable tion of GHG emissions. expectations of supply and demand over the short and long terms. Nevertheless, concerns about the EU ETS have (ii) While some have questioned whether the been raised by market players, observers and skep- EU ETS has been worthwhile given wind- tics. We discuss some of the highest-profile issues fall profits, the more important question below: concerns how allowance value created by the carbon cap has been spent. If European (i) There has been concern that the high price governments had auctioned EUAs the ques- volatility of carbon assets will discourage in- tion of proper use of funds would be direct- vestment in low-carbon/emission reduction ed towards those governments rather than projects. While the price volatility in the pilot towards businesses. The fact that emissions phase reflected, in part, the inability to carry have declined under the ETS more than over unused allowances into the subsequent would have otherwise occurred indicates that period (banking is already allowed for Phase at least some portion of the proceeds has in- II onwards), the price volatility in Phase II deed been constructively invested. has correctly reflected macro-economic fun- In addition, it is unlikely that the EU damentals. Prices in Phase II reflected the de- ETS would have come into being without mand for carbon assets as determined by the free allocation, which owners of affected in- level of the emissions cap and the actual level stallations view as compensation for abate- of emissions. When emissions fell due to the ment costs. worst recession in a generation, carbon prices (iii) Concern has arisen that European industrial fell in tandem. It must be remembered that companies could choose to relocate their op- the EU ETS, as any cap-and-trade scheme, erations outside the ETS rather than reduce limits the quantity of emissions (with the emissions, thereby causing leakage in the 6 It is expected that, should the supply side permit (i.e., the offsets will be created), the entire import cap for offsets de- fined under the EU Revised Directive (about 1,700 GtCO2e) will be used by the ETS installations by 2020. 7 State and Trends of the Carbon Market 2010 scheme. However, a study7 that examined 2.3 EUAS: GROWING VOLUMES, import and export data for goods whose ChANGING PATTERNS production now incurs a carbon cost (i.e., cement and steel) found no leakage. By and 2.3.1 EUA resiliency faces its greatest large, net import trends prior to 2005 con- test since the inception of the ETS tinued unchanged during 2005­07. This is not surprising since the cost of carbon has EUA transactions in 2009 reached US$118.5 bil- been just one of many costs that determine lion (88.7 billion), making the EU ETS the larg- industrial production and location; the car- est existing carbon market. Over 6.3 billion tCO2e bon price alone has not been a determining changed hands in 2009 through spot, futures and factor. options contracts. A substantial portion of the (iv) Some support governmental intervention in growth came from the spot market, which totaled the cap and trade market to maintain the 1.4 billion tons, an increase of 450% over 2008. price of carbon assets at a level sufficient to Over 70% of spot transactions occurred during incentivize industry to reduce emissions. the first half of the year, when cash-strapped EU EU ETS essentially rations the use of atmo- companies monetized allowances to raise funds spheric storage of Greenhouse Gases (GHGs) in the midst of a tight credit environment (please through property rights and a price mecha- refer to Section 2.3.1.3). Spot volumes in the first nism. It relies upon uninhibited market half of 2009 increased 75-fold over the year-earli- forces to enable efficient pricing of assets. er period (see Figure 2). Thus, external interventions would be coun- terproductive because they would increase In addition to the industry sell-off of allowances, uncertainty rather than reduce it. However, many trading and financial companies took the for the very limited and specific purpose of opportunity to gain free, temporary funds via the prudently reducing market volatility a for- VAT levied across the EU on spot transactions, mulaic intervention that is not arbitrary and which contributed substantially to the growth of unpredictable, and can be anticipated by the spot volume. A VAT-evasion scheme known as market, could be considered. "carousel" VAT-fraud also emerged. Evidence of fIgure 2 800 Monthly volumes for each contract 700 modality since 2005 600 Source: World Bank 500 (in millions) 400 300 200 100 0 05 5 6 6 07 7 7 7 08 8 8 8 09 9 9 9 10 5 5 06 6 r-0 l-0 t-0 r-0 l-0 t-0 l-0 t-0 r-0 l-0 t-0 r-0 r-0 l-0 t-0 n- n- n- n- n- n- Ju Ju Ju Ju Ju Oc Ja Ap Oc Oc Oc Oc Ap Ap Ap Ap Ja Ja Ja Ja Ja Options Futures Spot 7 A. D. Ellerman, F. J. Convery, C. de Perthuis, 2010, op. cit. 8 seCtIon 2 EU ETS VAT fraud led the Paris-based carbon exchange in terms of system linkage and infrastructure in BlueNext to temporarily halt trading during the the EU ETS. second quarter while tax authorities launched a series of measures to combat the problem (for fur- A recent, extensive report commissioned by the ther details, refer to Box 1). French Government assesses regulatory issues in the carbon market. This is timely, as the EC in- In 2009 market players sought greater contrac- tends to finalize its carbon market regulation be- tual transparency as the business environment fore the EU ETS enters Phase III. The report calls became increasingly risky and concern grew for a harmonized regulatory framework and mar- over the rising potential for defaults of futures ket surveillance system, including: (i) a unified contracts. As a result the number of Over-the- legal, accounting and taxation framework across Counter (OTC) bilateral contracts cleared on the EU; (ii) stricter access to registry accounts to the European exchanges increased compared to avoid fraud and market abuse; (iii) greater trans- 20088 (see Figure 3). parency on market fundamentals; (iv) sanctions to discourage and punish market abuse; (v) a As the worst of the economic storm passed, market surveillance authority; (vi) greater coor- however, it became clear that economic recovery dination with upcoming international carbon would move slowly in the EU. In response, the markets.10 number of spot contracts fell in the second half of 2009. Spot volumes have since stabilized and Improved regulation is required to sustain confi- during the first months of 2010 they accounted dence in market mechanisms and enhance their for 10­15% of total EUA volume. efficiency, and could ultimately facilitate market growth, increase liquidity and promote a long- Although robust and resilient, recent challenges9 term price signal. indicate that there is still room for improvement 100% fIgure 3 90% Transactions on exchanges versus 80% OTC since 2005 70% Source: World Bank 60% 50% 40% 30% 20% 10% 0% 0 05 05 06 06 7 07 5 7 08 8 09 09 6 8 9 -0 y-0 y-0 y-0 y-0 -0 y-0 n-1 p- n- p- n- p- n- p- n- n p Ja Ma Se Ja Ma Ma Ma Ma Se Ja Se Se Ja Ja Se Ja Exchanges OTC 8 Motivated by the increasing volumes traded and cleared in the European exchanges and in anticipation of the Phase III auctioning of allowances, the U.S.-based Green Exchange announced in April 2010 its intention to open an office in London. Some of the most active European financial players are among the owners of the Exchange. 9 VAT fraud, phishing, recycled CERs, etc. These topics are addressed in different sections of this document. 10 République Française Ministère de l'économie, de l'industrie et de l'emploi, 2010, La régulation des marchés du CO - 2 Rapport de la mission confiée à Michel Prada. 9 State and Trends of the Carbon Market 2010 2.3.1.1 Carbon prices vis-à-vis other box 1 An overview of VAT fraud energy commodities The economic downturn caused industrial output In countries that adopt the vat, goods are taxable. euas traded on a and emissions to fall in 2009, considerably easing spot basis are treated as actual goods and thus are subject to vat, while the compliance needs of regulated entities. In fact, futures and options carbon asset trades are considered financial transac- emissions fell 11.2% among the ETS installations tions and thus are exempted from vat within the european union. In many european jurisdictions, in cases where buyers and sellers that reported their data prior to the publication of are in different countries, the buyers (importers) are either exempted this report (see Box 2). from vat charges or are only invoiced for the vat amount by their local tax authorities at some later stage (1­3 months). on the other hand, if In industries that suffered most during the reces- buyers and sellers are in the same country the vat is payable in cash sion, such as steel and cement, companies took on the transaction date of the purchase of euas (and Cers). thus, an advantage of the one to two month overlap be- entity that imports from another eu country and subsequently sells the tween the issuance of 2009 allowances (Febru- same assets domestically would effectively raise free finance equal to ary 2009) and the 2008 deadline for compliance the vat amount for a certain time period, i.e., from the date of the sale (April 2009) and quickly sold their 2008 EUA until the receipt of the vat invoice for the purchase from the tax au- allocations to raise cash (while relying on their thorities. 2009 allocations to cover their 2008 emissions). note that, although executing high volumes of trades with the pur- The most desperate industrials, in a move to roll pose of maximizing the value of the vat-based funding raised is an ag- over current liabilities and regain liquidity, bor- gressive trading practice, it is not illegal and does not constitute fraud. vat fraud only occurs when a fraudster does not declare the vat rowed against their 2010­12 allowances. As a to the relevant government and disappears. Spot carbon trades became result EUA spot and front contract prices fell fur- an easy target due to their relatively high value and ease of import and ther and faster than the prices of other commodi- export (similarly to mobile phones and silicon chips). euas, in particular, ties, breaking the strong price correlation between are easily transferred across member states' borders through registries. carbon and crude oil (see Figure 4).11 In addition, transactions in the "carousel" typically happen in swift suc- cession, thus maximizing the value that is generated as in spot trades, 2.3.1.2 The many curves of the EUA which intrinsically have rapid turnover. on december 9, 2009, europol market estimated that fraud resulted in a total of approximately 5 billion in lost In 2009, in addition to the sale of spot and tax revenue in several countries. however, experienced market analysts prompt vintages, many entities, in particular utili- maintain that, based on the actual volume of asset transactions in the ties, sought to buy the tail EUA vintages under market and prevailing prices, fraud could not have reached that sum. the assumption that they would no longer receive In response, by mid-2009 some of the countries that were most ex- free allocations after 2012, and that they would posed to eua transactions--including france and the united kingdom-- decided to take unilateral actions to deal with the problem and either therefore need to hedge their exposure to Phase reduced their vat to zero, abolished it outright or introduced domestic III. As a result, the EUA price curve steepened reverse charging (i.e., the domestic purchaser, rather than the seller, is significantly and at certain times resulted in a responsible for paying the relevant tax). contango12 that effectively yielded up to 250 ba- In September 2009, in a more coordinated response, the eu gave sis-points over the EURIBOR out to December countries the option of applying a temporary reverse charging mecha- 2012. Nevertheless, during the recession funding nism that would operate until 2014. however, such a solution would be costs rose dramatically (when funds were available subject to implementation challenges, making it likely that a broad re- at all), and few players had access to cheaper lend- form of the eu vat collection procedures might ultimately be needed to ing alternatives from local financial institutions. eliminate the risk that vat fraud will proliferate. The curve began to flatten out only during the In addition to the regulatory actions, member States also took crimi- nal measures and several states, including the united kingdom, france, 1 Spain, and norway have reportedly made several arrests. 11 Bloomberg: Brent crude oil and EUA prices correlated at 95% in 2008 and 82% in 2007. 1 although norway is not an eu member, it participates in the eu etS. 12 Contango is a term used in the futures market to de- scribe an upward sloping forward curve (i.e., futures prices are above spot prices). Antonym: backwardation. 10 seCtIon 2 EU ETS 350 fIgure 4 Comparison of 300 carbon, oil, and coal prices, 250 Sept. 06­Dec. 09 Source: World Bank Indexed Value 200 150 100 50 0 29 09 9 28 09 14- 06 1 3 - 06 12- 7 13- 07 9-N 7 14- 07 7-M 8 6-J 8 2-J 8 2-M 9 1-J 9 8-J 7 8- 8 3-N 8 3-M 9 7 4-S 8 09 y-0 p-0 -0 l-0 -0 -0 -0 -0 r-0 -0 -0 -0 -0 0 r- n- g- ct- p- v- ul- ul- ov ec ay an ar ay ov an ep Ju Ma Ma Ma -Se No Ja -Au Se -O -D 15- 10 30 Carbon Oil Coal second half of 2009, when liquidity increased and starting to hedge their forward electricity sales. the cost of funding declined. As the major price supporters in the Scheme, power companies' shortage hedging decisions The steepness of the curve can be seen in the will determine how quickly prices recover in first of the next three graphs (see Figure 5), from coming months. March 2009. The second graph shows how the curve flattened out in September 2009. The third In general, with recovery fragile and weak, and graph, from March 2010, will be discussed later amid concern that the recent crisis in some EU in this report, in the context of the secondary countries could lead the region into an economic CER (sCER) market. "double-dip", growth prospects are low for 2010 and not much better for 2011. 2.3.1.3 Déjà-vu in the EUA pricing pattern EUA prices stabilized in the second half of 2009, Nevertheless, industrial activity is on the rise and, only to fall again at year's end after the Copenha- accordingly, demand for EUAs should grow mod- gen Climate Conference ended indecisively. Op- estly. In the near term power companies that are erators sold EUAs in the absence of a clear view short on EUAs should drive the buyers' side since of the environment in which the EU ETS would carbon prices are relatively low. Assuming that function post-2012. As a result, 2009's yearly the economy and European energy market con- pricing pattern took on a concave shape that mir- tinue to recover, most analysts agree that carbon rored that of 2008 (see Figure 6). asset prices will rise at a moderate but steady rate throughout 2010, finally replacing the concave In the more stable economic environment of EUA graph of the last two years with an upward early 2010, industrials that have relatively strong trending curve (forecasts from market analysts are cash positions have held their EUA surpluses provided in Section 5.1.2). (i.e., kept their length) in expectation of a short Phase III and a price increase in the near future. Cancún has a role to play in the materialization Dec13 EUA contracts have traded very actively of this trend; another inconclusive international since the beginning of the year, driven by de- meeting might depress the market and lead to a mand from power companies that will no lon- new decline in prices. ger receive free EUAs in 2013 and are therefore 11 State and Trends of the Carbon Market 2010 box 2 The economic downturn deeply scarred Europe's emissions market the recession led to a more dramatic decline in emissions as anticipated, Germany had the greatest drop in absolute than most players could have imagined. Based on data re- emissions in 2009. German emissions fell by almost 40 million 1 leased on april 1, 2010, GhG emissions from reporting eu etS tons (or ­8.4%) for those installations that reported data for installations fell more than 11% in 2009, which is the biggest both years. estonia had the greatest percentage reduction in year-on-year drop since the eu etS began in 2005. the data emissions at 23.8 percent. Luxembourg was the only country to 3 from 9,866 installations show that their total emissions de- report an increase in total year-over-year emissions. creased to 1.69 billion tons in 2009, 214 million tons less than In 2008, market analysts forecasted that eu industrials in 2008. the same installations had an allocation of 1.75 billion would be long for Phase II. those forecasts have been borne allowances. out in fact, as verified emissions have declined 18.3% vis-à-vis Polish utility PGe's Belchatow plant topped the list as the their 2008 levels. among industrials, the steel sector was hit most emitting installation in the eu etS for the second year particularly hard by the recession, with total eu output declin- 4 running. In fact, the top 10 emitters were all power plants. to- ing by 33% year-over-year as of november 30, 2009. In 2009, gether, these 10 installations emitted over 10% of the total the eu cement industry contracted by 21% while the level of 5 expected emissions for 2009. emissions under the etS are activity of other sectors covered by the eu etS fell by 15.4%. known to be heavily concentrated in a few companies. accord- In absolute terms the greatest declines were recorded by ing to numbers provided by the eC on april 6, 2010, the eu etS steel (­35 million tons), cement (­34 million tons) and refin- now covers around 11,000­11,500 installations owned by some eries (­7 million tons). utilities experienced relatively modest 5,000 companies. While the 25 largest participating compa- declines in demand, although they are still potentially short in nies accounted for more than 50% of 2008 eu-25 emissions this Phase and will need to hedge their future electricity sales under the etS the smallest 80% of installations accounted beyond 2013. total generation is expected to have fallen 5% 6 for about 10%. however, the generous allocations by Poland, in 2009 to 1,675 tWh, from 1,761 tWh in 2008. reported GhG Greece, and Italy shielded their industry from high compliance emissions fell by 8.3% vis-à-vis 2008. costs. Installations in Germany and the united kingdom had to Germany's power sector has healthy margins (installed ca- pay the most (i.e., 8 German power plants were among the 10 pacity/peak demand) that will be further secured if extensions installations with largest allocation deficits, as were 2 united (delays) are made in the country's nuclear phase-out program. kingdom power plants). at the other end of the scale, the 10 In addition, Germany is heavily promoting the installation of ad- installations with the biggest surpluses were, not surprisingly, ditional wind capacity. as a result the country will not need new 2 all steel plants. capacity, apart from what is already being built, over most of the numbers released on april 1, 2010 do not represent the coming decade. the degree of oversupply forecast for the all etS installations. the community independent transaction system might encourage older coal plants to either merge or log (CItL) shows that over 1,400 installations have yet to re- close. once the free allocations of euas disappear, the closure port data for 2009. Still, the installations that reported their decision will be easier. verified emissions accounted for 90% of emissions volumes in the demand for power fell in the united kingdom as well, 2008 and constitute a good sample for projecting final 2009 causing generation to decline by 5% in 2009. Industrial recov- numbers, which will be fully released by may 15, after comple- ery in the united kingdom will likely proceed slowly--analysts tion of this report. as of the date of this writing, market ana- predict a modest 0.4% increase in activity in 2010--so that any lysts forecast that etS emissions will total 1.87­1.88 billion tons decisions to add capacity will be undertaken against a backdrop 7 in 2009. of moribund demand. 1 http://ec.europa.eu/environment/climat/emission/citl_en_phase_ii.htm 2 Point Carbon, Carbon market daily, april 1, 2010. 3 data provided as of april 1, 2010. 4 http://www.worldsteel.org/pictures/newsfiles/1109%20Production%20figures.pdf 5 Information obtained from deutsche Bank 6 Barclays Capital, monthly Carbon Standard ­ do the right thing, march 17, 2010. 7 Barclays Capital, monthly Carbon Standard ­ do the right thing, march 17, 2010. 12 seCtIon 2 EU ETS March 2009 fIgure 5 15.0 EUA and CER forward 14.5 curves and fair value 14.0 Source: ECX and World Bank 13.5 13.0 per ton 12.5 12.0 11.5 11.0 10.5 10.0 2009 2010 2011 2012 September 2009 15.0 14.5 14.0 13.5 13.0 per ton 12.5 12.0 11.5 11.0 10.5 10.0 2009 2010 2011 2012 March 2010 15.0 14.5 14.0 13.5 13.0 per ton 12.5 12.0 11.5 11.0 10.5 10.0 2009 2010 2011 2012 EUA CER EUA ­ Fair value CER ­ Fair value Note: Fair value was calculated based on a rate of 1.3% per annum. 13 State and Trends of the Carbon Market 2010 fIgure 6 $45 EUA average prices $40 Source: World Bank $35 $30 $25 $20 $15 $10 $5 $­ Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 2.4 SPOT AND SECONDARy CERS and raise capital--and redirect their positions from risky investments toward safer assets and 2.4.1 Secondary market volume increases, markets (for additional information, please refer prices fall to Section 4.3). After the boom in 2008, sCER trading volume In addition, the narrowing of the spread between stalled in 2009, remaining just above one billion primary and secondary CER prices no longer tons.13 The heavy decline in the price of spot and properly rewarded financial institutions for taking sCERs caused overall market value to drop more on balance-sheet risk.14 than 30% to US$17.5 billion (12.5 billion). The average price of a CER fell by 32% to US$16.6 As the number of financial institutions active (11.9), versus US$24.5 (16.8) in 2008, follow- in the emissions market decreased, origination ing the same pattern as EUAs. Futures accounted activity slowed down accordingly. Faced with a for 85% of transaction volume in 2009, while the shortage of CERs, players that came out of the nascent spot CER market grew substantially to economic storm in relatively healthy condition 63.4 million tons and approached the volume of acquired undervalued portfolios from the likes of option contracts, which totaled 91.4 million tons. struggling intermediaries and aggregators instead of dealing with the well-known burdens intrin- Despite the fact that overall secondary CER vol- sically related to CER and Emission Reduction umes remained unchanged in 2009, origination Unit (ERU) origination activities. Under these activity declined as the financial crisis spurred circumstances the rate of market consolidation financial institutions to deleverage--shed assets intensified. 13 The numbers include 3.0 million tons sold by the Adaptation Fund (AF). The World Bank, as Trustee for the AF, is responsible for monetizing the 2% CER share of proceeds for the Fund in the spot market. Through early May, 2010, the AF sold 5.3 million tons, totaling US$91 m (65.5 m). Although most transactions have taken place on BlueNext, almost 75% of volume has been traded on an OTC basis. While the primary source of financing for the AF is the 2% share of proceeds, it also accepts financing from other sources. The first two donations to the AF were actually made in person--and in cash--during AF Board meetings held in Bonn during 2009, by a group of students from a German school (the donations amounted to about US$150 and US$170 respectively, denominated in Euro coins and notes). On April 29, 2010, the Government of Spain announced a 45 billion contribution to the Fund. 14 The sCER business appeared as a needed market niche in which final buyers (e.g., Kyoto signatory countries, but main- ly EU ETS installations with short-term--annual--compliance obligations) transferred underdelivery risk to healthy and creditworthy intermediaries, which took on that risk in exchange for a premium over primary market prices. 14 seCtIon 2 EU ETS 2.4.2 Rising liquidity causes offset price CERs were issued during the first quarter of 2010. segregation to widen A total of 400 million tons of CERs has been is- sued to date, well below the 700 million tons of European exchanges have primarily traded offsets CERs that the market forecast in 2007.16 The sus- generated from reductions in industrial gases such pension of Tüv Süd during the 53rd meeting of the as HFCs and N2Os, which constitute the bulk CDM Executive Board (EB) served to accentuate of CERs issued so far. The major exchanges have the bearish European outlook on the capacity of not traded ERUs due to the limited availability of CDM to generate compliance assets for the EU those assets, nor have they traded assets that have ETS.17 By March 2010 the CER curve moved into been excluded due to eligibility issues. full backwardation18,19 (the EUA curve flattened but remained in contango) and price discounts In July 2009 the EU Member States adopted com- deepened for each subsequent delivery year (see mon rules for importing credits from large hydro the third graph in Figure 5). The spread between projects (larger than 20 MW). The guidelines did the tail of the sCER and EUA curves widened to not ensure, however, that EU governments would its greatest margin since the third quarter of 2009. approve the credits using the same standards. The resulting uncertainty regarding the eligibility of The ongoing backwardation of the CER curve large hydro credits led ECX to ban those assets reflects the deepening shortfall in the issuance of from its platform.15 As a result, those CERs have CERs and leaves sellers in the secondary market traded on an OTC-basis, at a reported discount of continuously in a short position to be rolled for- tens of Euro cents. A lack of liquidity and regula- ward. In other words, due to the underdelivery in tory certainty has led to similar discounts in the the project-based market the sCER sellers, includ- price of spot ERUs versus CERs. ing intermediaries and aggregators, do not have enough CERs to honor their delivery obligations On the other hand, owners of the most desirable and are forced to buy CERs on the spot market to green assets, such as CERs from small renewable cover their obligations. energy and energy efficiency projects in least devel- oped countries, have preferred to bypass exchange platforms to avoid having their natural premium, 2.5 ThE OPTIONS MARKET: RISING reported to reach up to 0.50, from being diluted. VOLUME AND SOPhISTICATION20 In general, those assets have been traded OTC and 2.5.1 Sellers turn to call options to subsequently cleared at the exchanges. manage risk 2.4.3 A shortage of CERs forces market As discussed above, CER sellers have often found players to adjust themselves short in their delivery obligations In 2009 CER issuance fell to 132 million tons, and at risk of having to purchase CERs some- 10% less than in 2008, and only 30 million tons of where else at the last minute at a loss. The loss 15 After consulting its carry members, on March 24, 2010 ECX opted to continue a ban on trade of large hydro CERs, reiterating its previous decision. 16 Point Carbon, CDM & JI Monitor, March 31, 2010. 17 The suspension of Designated Operational Entities (DOEs) is another blow to registration and issuance. The first suspension (e.g., DNV) occurred in December 2008--with reinstatement in February 2009. The second (e.g., SGS) happened in September 2009 with reinstatement three months later. Tüv Süd has been recently suspended (February 2010) as well as Kemco (partial suspension in March 2010). Together, DNV, Tüv Süd and SGS process almost two-thirds of the projects in the CDM pipeline. 18 CER prices decreased as they moved further into the future. 19 Backwardation: a downward sloping forward curve (i.e., the price of the future is less than the spot price of the underly- ing commodity). Antonym: contango. 20 This section strongly benefitted from the input of several market players, in particular the generous and thoughtful insight provided by Lance Coogan of Gemini Carbon. 15 State and Trends of the Carbon Market 2010 occurs when prevailing prices are higher than they 9). The share of calls declined from 89% of total were when the sellers sold the CERs forward. To options volume in 2006 to 59% in 2009. In the manage against this risk sellers have increasingly first quarter of 2010 the share of calls fell further chosen to buy call options ("calls"), causing the to 54%. With the confirmation of a long Phase II proportion of calls to grow in relation to put op- in the EU ETS the volume of puts could continue tions ("puts") since late 2008 (see Figure 7). In to rise as participants attempt to manage their 2009, 56% of the 91 million tons of CER options downside risk. transacted were calls. 2.5.2 A broader perspective on the options market fIgure 7 20 CER options 18 The volume of the carbon options market passed volumes, 16 Oct. 08­Dec. 09 the 500 MtCO2e mark and reached nearly 14 (in millions) US$10.6 billion in value in 2009.21 EUAs ac- 12 Source: ECX counted for 417 million tons while CER volumes 10 totaled 91 million tons. EUA options prices were 8 higher than those of CERs, and the market for 6 EUAs was more liquid. EUA market value to- 4 taled US$8.9 billion in 2009, or 83% of the total 2 options market value, while CER market value 0 reached US$1.8 billion.22 Q4 08 Q1 09 Q2 09 Q3 09 Q4 09 Calls Puts In addition the market, which used to be domi- nated by banks and utilities, witnessed a growing presence of funds, energy-trading firms, and in- Looking at the prices of CER strike options, the creasingly sophisticated utilities and industrials strike prices of puts (which provide downside risk that used the options market for hedging (both insurance if prices go down) are lower than the volumes and prices) and profit-making transac- strike prices of calls (which provide upside risk tions. As volumes spiked and dedicated players ze- insurance if prices go up). While the former re- roed in on profit opportunities a number of heavy flects the break-even all-in costs from the CER in- losses were registered as well. vestors, the latter can mostly be attributed to the large amount of `collars' transacted, in which the As liquidity and sophistication have increased, the premium received from the sale of calls is used to carbon options market has matured to the extent pay for the premium in buying puts. Put and call that it now behaves like many other options mar- strikes straddle market prices (see Figure 8). kets. The bulk of activity now comes from vola- tility and other relative value trades rather than On the EUA side the volume of calls has histori- asset-backed trades (i.e., financial and technical cally exceeded that of puts, although the differen- trades now account for a greater portion of market tial has fallen steadily over the years (see Figure activity than do trades for compliance purposes). 21 The authors, after consulting several market players, decided to evaluate the options market based on the strike price for each transaction. The approach is based on the fact that in most options markets the bulk of transactions are at-the- money options where the strike prices are similar to prevailing market prices. The authors also realize that this approach could lead to a skewed figure if a significant portion of those options are deep out/in the money options with strikes significantly higher or lower than the prevailing market prices. Frequently, however, the out-the-money strikes are traded symmetrically balanced around the at-the-money, hence giving a reasonable representation of market volumes. Using last year's methodology, 2009's options market would be valued at US$1.8 billion. 22 Discrepancies in the values above are due to rounding. 16 seCtIon 2 EU ETS 2.5.3 Structures proliferate as players 30 fIgure 8 look to manage risk Quarterly average 25 prices of CER strike options, A multitude of structures on the options market 20 Oct. 08­Dec. 09 have become increasingly common as players look 15 Source: ECX to manage risk or take positions. They include: 10 (i) The purchase of calls by utilities with com- 5 pliance needs, sCER sellers that are short for delivery and market players that are bullish ­ Q4 08 Q1 09 Q2 09 Q3 09 Q4 09 on prices or are simply using options as part of larger trading strategies (i.e., collars, stran- Calls Puts gles, straddles, volatility trades, relative value trades and inter-asset trades); 300 fIgure 9 (ii) The sale of calls by players that are long (a so- EUA options called "soft hedge"), since the upfront premi- 250 volumes, um from the sale reduces the downside risk, 2006­Q1'10 200 as well as the sale of calls by players that are Source: ECX bearish on future prices; 150 (iii) The purchase of puts by long EU entities (entities that are overallocated), project de- 100 velopers who only locked in ERPAs for a 50 portion of their offsets, financials or interme- diaries that purchased offsets at fixed prices 0 2006 2007 2008 2009 2010 and want to lock in profit and project asset Call volume(Mt) Put volume(Mt) value, and players that are bearish on future prices; (iv) The sale of puts by entities that are short for compliance (a so-called "soft long"), since the so much time and political capital construct- premium from the sale of puts may help re- ing, the question remains as to how long the EU duce the cost of compliance for installations will continue to make a real effort to control its vis-à-vis the purchase of calls, as well as sale of emissions while those of other regions grow un- puts by players with bullish views (they will checked. not get exercised if correct on future prices but still collect the premium). Within the EU doubts are rising that other re- gions will take concrete steps to reduce their emis- sions. As a result, EU policy makers have begun to 2.6 WhAT LIES AhEAD fOR ThE EU explore alternatives to level the playing field, in- ETS? cluding proposals to impose border carbon taxes on imported goods and progressive restrictions to The EU ETS is the only framework that cur- the acceptance of Kyoto offsets entering the EU rently promises to reduce greenhouse gasses after ETS (primarily from Non-Annex I OECD coun- 2012, and Europe's political resolve may waver if tries and large emitters). In addition, sector-based other regions of the world fail to participate with restrictions to the import of credits from coun- their own carbon reduction schemes. Although it tries that do not undertake their own domestic is unlikely that the EU and the EC will unravel actions seem to have gained acceptance amongst the market mechanism that they have invested policymakers. 17 State and Trends of the Carbon Market 2010 In addition, new entrants and new sectors, includ- box 3 The contentious history of Estonia and Poland's allocation ing aviation, could create demand for yet another plans 150 MtCO2e worth of credits over Phase III (about 50 MtCO2e each). The Commission will deter- In 2007 the european Commission decided that certain aspects of the esto- mine the exact volume ceiling through a consul- nian and Polish national allocation Plans (naPS) were not compatible with the eu etS directive. essentially, the Commission ruled that both coun- tation process ("Comitology")24 by the middle of tries had overstated the volume of Co2 allowances they required for their 2010. In summary, total demand for credits during 2008­12 national allocation Plans. Both member States brought an action 2008­20 should total 1,700 MtCO2e,25 based on for annulment against these decisions before the Court of first Instance. the Phase II 1,400 MtCO2e limit. on 23 September 2009, the Court of first Instance upheld the claims made in 2007 by Poland and estonia, annulling the Commission's Member States must also comply with the "effort decision. on 3 december 2009, the Commission appealed against these sharing decision", which sets individual targets judgments on a number of legal grounds but, as of the time of this report, for sectors not included in the EU ETS (non- no final judgment had been obtained. trading sectors). The annual credit limit for Mem- the Court of first Instance's 2009 ruling has increased overall regu- ber States is equal to 3% of 2005 emissions with latory uncertainty. In terms of supply-demand impact, its decision to al- some exceptions. On average, this translates into low estonia and Poland to maintain their initial naP proposals theoreti- a maximum demand of 700­800 MtCO2e over cally could have opened the door to over 80 million tons of additional 2013­20 (about 90­100 MtCO2e annually). euas annually. yet within the current context of economic recession, Poland and other countries now might not be able to justify their higher allocations. furthermore the ruling has created a precedent under which However, qualitative import restrictions may ap- six other member States from eastern europe (Bulgaria, the Czech re- ply. During Phase III credits will no longer be de public, Lithuania, Latvia, hungary, and romania) have challenged similar facto compliance units and their exchangeability eC decisions. those challenges, if successful, could add another 164 mil- into EUAs will be conditional. Absent a future lion tons per year to the market, an increase of 8% in allowance volumes international agreement, Article 11a (paragraphs to an eu etS Phase II that is already widely considered to be long. 2­6 and 8­9) of the Revised ETS Directive will In early april Poland decided to drop its claim for extra allowances govern the acceptance of credits during 2013­20. and submitted a naP with an overall cap that was unchanged from that In addition, CERs and ERUs issued before De- 1 defined in 2007 by the eC. estonia, however, has not accepted the re- cember 31, 2012 (CP-1) will have to be swapped vised allocation plan. with EUAs by March 31, 2015. Credits issued af- ter 2012 (CP-2), but generated from projects reg- 1 as of april 10, 2010 istered before December 31, 2012, will be fully exchangeable throughout Phase III (until 2020). Finally, CP-2 credits from projects registered 2.6.1 Rules governing the use of CERs and after December 31, 2012 will only be accepted ERUs in Phase III: still uncertain23 (and swapped) if coming from a Least Developed Country (LDC).26 The swap mechanism will be For existing installations 150 MtCO2e of additional available to operators only; banks will be excluded. credits will be allowed during the 2013­20 period (i.e., a total of 1,550 MtCO2e during 2008­20), Given the absence of an international agreement versus the 1,400 MtCO2e limit during 2008­12. in December 2009 in Copenhagen, however, the 23 For detailed information, please refer to the Annex I. 24 Comitology is a simplified decision-making procedure within the EU. Decisions are taken by the Climate Change Committee, which consists of the European Commission and Member States officials. The EU Parliament is consulted in the process. Source: Point Carbon, Use of CERs/ERUs in Phase 3: Questions and Answers, March 19, 2010. 25 This number corresponds to an average supplementarity limit of about 6% or less than half of the average supple- mentarity limit of Phase II, which average 13.4% of allocation or about 280 MtCO2e per year (1,400 million tons/5-y). 26 According to the UN definition found at http://www.unohrlls.org/en/ldc/related/62/ as of October 2009 there are 49 countries and small islands on the list of LDCs, including 33 in Africa, 15 in Asia, and 1 (Haiti) in Latin America and the Caribbean. 18 seCtIon 2 EU ETS Recycled CERs: one ton is one ton box 4 under kyoto rules, Cers can be traded until the date on which In addition to hungary, the Czech republic, Germany, Italy, signatory countries must comply with their obligations under the Lithuania, Luxemburg, the netherlands, Poland, Slovakia, and 1 kyoto Protocol and annex B Countries can choose to use a variety Spain have yet to transfer the surrendered Cers they received of compliance assets (aaus, Cers, erus, rmus) to meet their kyo- after 2008 from their national registries' temporary accounts to compliance obligations. however, once an eu installation sur- to their retirement accounts. a total of 61.8 million tons (out of renders a Cer to comply with its annual obligations, the Cer can- the 84.2 million) surrendered in 2008 are estimated to still be not return to the european carbon market. If it did, the Cer would in national registries. those assets are, in theory, still available 4 in effect serve to offset more than one ton of GhG emissions. for re-sale. one recent, high-profile event highlights the importance of on february 17, 2010 the eC, in agreement with the Climate the rules that govern the linkage between regimes that need to Change Committee, added an amendment to the registries interact harmoniously. on march 11, 2010 the hungarian govern- regulation that prevents the re-entry of surrendered Cers into ment announced that it had sold 1.74 million Cers that previously eu etS operator and personal registry accounts. the amend- had been surrendered for compliance to a hungarian firm, hun- ment achieves this by implementing automatic flagging of Cer 2 garian energy Power kft, for around 20 million (800,000 of the status (as surrendered or not) in the Community Independent Cers have been transferred). after subsequent trades those as- transaction Log (CItL) and on the main exchanges, i.e., eCx 5 sets ended up returning to the etS through spot transactions on and Bluenext. the exchanges. Some brokers and banks reported having bought Because the amendment is not scheduled to enter into the recycled offsets on Bluenext without knowing they could not force until august 2010, on february 18, 2010 the eC an- be used for eu compliance. the revelation that these assets were nounced an interim measure, effective march 19, that suspends in circulation led to a quick collapse in bidding for spot Cers, and the process for surrendering allowances, erus and Cers "... desperate sellers offered Cers for as little as 1.5 on Bluenext. until the application of the new rules in the amended regis- according to official statements from the hungarian tries regulation, except for the period between 19 april 2010, government and two subsequent traders, the deals were con- 8:00 CeSt and 1 may 2010, 8:00 CeSt. this allows for an ap- ducted on the condition that these credits would not be used propriate time period for the surrender of allowances or cred- 3 in the european carbon market. the hungarian environment its by operators for compliance with 2009 emissions by the ministry confirmed that a number of aaus, equivalent to the 30 april 2010 deadline, while protecting the integrity of the 6 number of surrendered Cers that were re-sold, have been can- european carbon market." celled to comply with eu regulations and the proceeds from the on april 16, 2010, by amending the eu etS registries reg- sale would be channeled to a Green Investment Scheme (GIS), ulation, eu countries hopefully brought to an end the issue of as occurs with aau transactions. recycled Cers. 1 a countries' cumulative emissions should not exceed its kyoto limit for the period 2008­12. 2 according to Point Carbon (march 22) the chief of the hungarian ministry of environment said three firms, including heP and asian companies, placed serious bids for the used Cers and the government sold the credits to heP, as its 9­9.50 bid was the highest. 3 according to the hungarian government the contract stated: "Buyer acknowledges that Cers that are the subject of the sale and purchase agree- ment cannot be sold and used in the emission trading system of the... eu etS." 4 Société Générale, Commodities weekly, march 15, 2010. 5 the loophole came from the fact that the built-in check is downstream in the transaction chain (i.e., at the point of surrender) and a compliant etS installation might unknowingly purchase a surrendered Cer, only to become aware after the fact. 6 http://ec.europa.eu/environment/climat/emission/index_en.htm, march 19, 2010 Directive opens the possibility for the acceptance boost demand for project-based credits. Provi- of CP-2 credits originating in non-LDC countries sions dealing with this scenario would also apply that have entered into bilateral agreements with under a new international agreement. the EU. If and when a new international agree- ment emerges, the provisions mentioned above 2.6.2 Auctions and benchmarking will still apply. In addition, more stringent EU reduction targets would apply in an ambitious In Phase III, 88% of allowances will be distrib- agreement scenario, which would consequently uted among the Member States according to 19 State and Trends of the Carbon Market 2010 their relative share of emissions and 10% will be The number of free allowances that will be given to distributed to the Member States with the low- industrial installations will be decided in 2011 on est income levels per capita and highest growth the basis of common performance benchmarks,31 prospects, for solidarity purposes. The remaining which should be determined by the end of 2010. 2% will be rewarded to the Member States with Under the Directive, industrial sectors will re- the greatest GHG emission reductions based on ceive 80% of benchmarked allowances for free in their Kyoto targets and on their 2005 benchmark. 2013, with the percentage decreasing annually to 30% in 2020. Full auctioning to all installations During the first trading period (2005­07), Mem- in all sectors will occur by 2027. Sectors that are ber States auctioned a very limited number of exposed to carbon leakage will receive 100% of carbon allowances. During Phase II the lion's the benchmarked allowances for free throughout share of allowances continues to be allocated for Phase III. free although generally larger quantities are being auctioned. Germany will auction an average of 40 The benchmarks will reflect the average perfor- million EUAs per year during Phase II,27 while the mance of the top 10% of installations in terms United Kingdom will auction 17 million allow- of efficiency (i.e., with the lowest greenhouse ances per year on average. The Netherlands, Aus- gas emissions) in a sector or subsector in the EU tria, Ireland and Hungary combined are expected over the years 2007­08. The benchmarks will to auction 6.9 million EUAs on average per year.28 be calculated by product and will take into ac- count "the most efficient techniques, substitutes, The Revised ETS Directive of December 17, 2008 alternative production processes, high efficiency foresees a fundamental change at the start of the cogeneration, efficient energy recovery of waste third trading period. Beginning in 2013 auctioning gases, use of biomass and capture and storage of will become the default method of allowance allo- CO2, where such facilities are available."32 Bench- cation, although sectors and sub-sectors that are at marks will therefore create additional incentives risk of carbon leakage29 will still be eligible for free for ETS installations to reduce emissions and im- allocation. These sectors account for an estimated prove energy efficiency. Given the stringency of quarter of total emissions covered by the EU ETS the benchmarks, only the most efficient installa- and around 77% of the total emissions from manu- tions have a chance of receiving all of their allow- facturing industry in the EU ETS.30 Fully 65% of ances for free. emissions covered by the ETS come from the power sector, which will cease to receive free allowances in The following are some relevant steps in the al- 2013, although there will be a limited number of location process33 and the latest on early auction- exemptions to aid the modernization of the elec- ing: tricity sector in some Member States. 27 Part of the proceeds (i.e., 120 million per year) is being used to support 180 climate-friendly projects in developing countries and economies in transition through the International Climate Initiative. 28 http://ec.europa.eu/environment/climat/emission/auctioning_en.htm 29 i.e., companies in sectors subject to strong international competition and that might relocate from the EU to third countries with less stringent constraints on greenhouse gas emissions. 30 EC press release of September 18, 2009 following approval by the Member States: http://europa.eu/rapid/pressReleas- esAction.do?reference=IP/09/1338&format=HTML&aged=0&language=EN&guiLanguage=en and http://ec.europa. eu/environment/climat/emission/pdf/wg3_16_sep_presentation.pdf 31 The community-wide ex-ante benchmark has been chosen as the allocation methodology to avoid perverse effects of grandfathering and because it has the potential to ensure a non-distorted carbon price signal. The benchmark re- wards early action and carbon efficiency (Centre for European Policy Studies): http://www.ceps.eu/system/files/task_ force/2009/07/ExSum%2520to%2520post%2520on%2520website.pdf. 32 Directive 2009/29/EC of the European Parliament and of the Council, April 23, 2009 (http://eur-lex.europa.eu/ LexUriServ/LexUriServ.do?uri=OJ:L:2009:140:0063:0087:EN:PDF) 33 All quotes are taken from the Revised ETS Directive. 20 seCtIon 2 EU ETS · "By 31 December 2009 and every five years around 1.2 to 1.4 billion EUAs to cover the CO2 thereafter, after discussion in the European exposure on their forward electricity contracts Council, the Commission shall determine a list for 2013 and beyond. Eureletric indicated that of the sectors or subsectors..." that are exposed 450­650 million Phase III EUAs would need to to a significant risk of carbon leakage and pos- be auctioned early (i.e., before 2013) to meet de- sibly will continue receiving free allocation. On mand.36 December 24, 2009 the EC provided a list of sectors and subsectors that are exposed to a sig- On December 15 the EC requested clarifica- nificant risk of carbon leakage. 34 tions37 and, on January 22, 2010, Eurelectric · "By 30 June 2010, the Commission shall adopt replied with a comprehensive document contain- a regulation on timing, administration and ing data from RWE and forecasts from Deutsche other aspects of auctioning..." and "submit to Bank and Société Générale38 that support the the European Parliament and to the Council need for early auctioning. In addition, the docu- an analytical report assessing the situation with ment presents Eurelectric's views on the differ- regard to energy-intensive sectors or subsectors ences between the carbon market and other that have been determined to be exposed to sig- commodities markets and points out the result- nificant risks of carbon leakage."35 ing pricing implications for carbon market play- · "By 31 December 2010, the Commission shall ers.39 It also concludes that the market is subject adopt Community-wide and fully-harmonised to significant political risk. implementing measures for the allocation of the allowances ...". In the initial Phase III Directive from October · "In order to ensure an orderly functioning of 13, 2003, the EC determined that 300 million the carbon and electricity markets, the auction- EUAs would be set aside from the Phase III New ing of allowances for the period from 2013 Entrants' Reserve (NER) to incentivize the de- onwards should start by 2011 and be based on velopment of innovative clean technologies and clear and objective principles defined well in Carbon Capture and Storage (CCS). Those EUAs advance." shall be available by December 31, 2015.40 How- ever, In February 2010, it was agreed that the On November 30, 2009 Eureletric, the associa- European Investment Bank (EIB) would sell 200 tion representing Europe' electricity industry, sent million of these EUAs in 2011 to fund demon- a open letter to the EU governments stating that stration plants across the EU. The EIB will sell the by 2012 EU utilities will need to have acquired remaining 100 million EUAs in 2013.41 34 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32010D0002:EN:NOT 35 On April 6, the EC sent a proposed Auctioning Regulation to the Member States (http://ec.europa.eu/environment/ climat/emission/pdf/proposed_auctioning_reg.pdf ), accompanied by an Impact Assessment (http://ec.europa.eu/ environment/climat/emission/pdf/ia_auctioning_final.pdf ), but no indicative auctioning volumes. 36 http://www2.eurelectric.org/DocShareNoFrame/Docs/1/KKMFHGJCJOONFCILJFFDIHJA3ASOQHU6U- 6434LUJ5E5T/Eurelectric/docs/DLS/Auctioning_-_EURELECTRIC_letter_to_EU_Governments_30112009-2009- 030-1017-01-E.pdf 37 http://ec.europa.eu/environment/climat/emission/pdf/auction_eurelectric.pdf 38 http://ec.europa.eu/environment/climat/emission/pdf/eurelectric.pdf 39 "Carbon is unlike other commodity products and this is reflected in the psychology of the carbon market--which dif- fers to that of other markets. The most obvious differences are that: there is no supply side response to price, externally imposed penalties apply for over-use and all operators with compliance obligations are naturally short in the long-run. As a consequence, operators with compliance obligations behave in a more conservative manner than would be the case for participants in any other market e.g. fuels. This has obvious implications for price formation as demonstrated by the fact that today a significant positive price applies to allowances despite the fact that the market in the current Phase 2 is known to be long." 40 http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:2003L0087:20090625:EN:PDF 41 http://www.ner300.com/wp-content/uploads/2010/02/DRAFT-NER300-Decision.pdf 21 3 SeCtIon emISSIonS tradInG In other annex B reGIonS and Beyond 3.1 NEW ZEALAND: AT LAST! On November 25, 2009, New Zealand's Parliament passed the Climate Change Response (Moderated Emissions Trading) Amendment of 2009, ending a year of uncertainty on the future shape of New Zealand's carbon regulation. New Zealand's ETS, which 42 had covered forestry since 2008, is now the first mandatory, economy- wide scheme outside Europe. The government recently announced, however, that full implementation could be delayed if adequate progress is not made in establishing similar regulations in other developed countries. International entities have already been major purchasers of New Zealand's forestry carbon assets. New Zealand's Amendment includes measures Zealand's ETS with Australia's now postponed that will ease the economic impact of the scheme. Carbon Pollution Reduction Scheme (CPRS). Government-issued NZ ETS allowances (New Zealand Units or NZUs) used for compliance 3.1.1 Progressive extension of ETS scope purposes during 2010­12 will have a fixed price to cover the entire economy of NZ$25 (US$18 or 13). Stationary energy, in- dustrial process and liquid fossil fuel installations The NZ ETS will progressively regulate emissions will need to surrender just one NZU per two tons of the six Kyoto gases in all sectors of the economy of CO2e emitted over 2010­12. Emissions-inten- by 2015. By July 1, 2010 the scheme will regulate sive industries that are exposed to international stationary energy, industrial process and liquid trade will receive the bulk of their allocations for fossil fuels for transport, which together account- free and agriculture, which will not be included in ed for nearly half of the country's emissions in the scheme until 2015, will receive free allowances 2008, excluding Land Use, Land Use Change and as well. These measures, most notably assistance Forestry (LULUCF).43 Synthetic gas and waste in the form of free allocation, closely align New will join the scheme by January 1, 2013 and ag- 42 Legislation for the NZ ETS was passed by Parliament on September 10, 2008, covering retroactively forestry (starting January 1, 2008). In November 2008, the newly-elected government suspended (except for forestry operations) the bare- ly started ETS, which it deemed too onerous, and launched a review of the country's climate change policy. By the end of August 2009, the Select Committee Review (a parliamentary review panel) concluded that a carbon trading scheme cov- ering all economic sectors was preferable to a carbon tax, although design recommendations remained relatively general. 43 New Zealand's emissions (excluding LULUCF) totaled 74.7 MtCO e in 2008, almost entirely from energy (including 2 transport) and agriculture, in equal parts. Sinks removed 26.2 MtCO2e and offset about one-third of New Zealand's emissions (excluding LULUCF). Source: National Inventory Submission 2010. 23 State and Trends of the Carbon Market 2010 riculture, which accounted for 48% of emissions ties will have time to familiarize themselves with excluding LULUCF in 2007, will join by Janu- the scheme and develop lowest-cost compliance ary 1, 2015. In the case of transportation fuels, strategies. The scheme will undergo a review in regulation will take place upstream at the level of 2011 that will take into consideration the overall refiners and importers to limit the complexity and effectiveness of ETS operations, the establishment cost of regulation.44 Agriculture will be regulated of new schemes in other developed countries and upstream at processing sites, fertilizer importers the potential for linking to those schemes, and the and production facilities. New Zealand continues extent of free allocations. No cap has yet been an- to refine its allocation rules. nounced for 2013 and thereafter. With uncapped assistance on an intensity-basis (see Section 3.1.3), 3.1.2 No emissions cap it could be challenging to keep the ETS target in line with New Zealand's international commit- During the transition period (2010­12) there ment, reiterated under the Copenhagen Accord, will be no cap on emissions since there will be to reduce emissions by 10% below 1990 levels by an unlimited supply of allowances. Entities will, 2020 or, if a comprehensive global agreement is however, be accountable for their emissions and reached, by 20%.47 will need to purchase allowances when emissions exceed their free allocation.45 3.1.3 Allocation rules and transition assistance For compliance during the transition period regu- lated entities will have the choice of surrendering Emission-intensive, trade-exposed industries (in- the free NZUs allocated to them (if applicable), cluding agriculture) will receive free allowances purchasing NZUs in the market (i.e., from the on an intensity basis with progressive phasing-out. forestry sector) or purchasing government-issued The intensity-based free allocation is intended to allowances at the fixed NZ$25 price. These gov- encourage efficiency improvements without penal- ernment-issued NZUs are available in unlimited izing increases in production or putting businesses supply. They can only be surrendered; they can- at a competitive disadvantage in the international not be banked or sold. New Zealand expects its marketplace. Free allowances will not be granted total emissions to be below its Kyoto Protocol to industries that are not trade-exposed, such as target (with a projected surplus of 11.4MtCO2e electricity generation and liquid fossil fuels. over 2008­12).46 The transition arrangements, in- cluding the "two-for-one" provision, should not The assistance package has been designed to close- change this. ly align with Australia's proposed CPRS rules (see Annex II), and will apply to activities rather than During the transition phase the NZ ETS will ex- installations or sectors. The scheme will grant two pand progressively and adjustments will be made levels of assistance, either 60% or 90% of the al- to optimize workability. Installation-level data location baseline,48 depending on the carbon-in- will be collected, rules governing allocations in tensity of output. The carbon-intensity test will widely differing sectors will be tested and enti- measure an installation's relative intensity for the 44 About 200 installations should be regulated by 2013, excluding forestry (where tenure may be fragmented), voluntary opt-ins, and synthetic gas. 45 This led some observers to characterize the NZ ETS as a hybrid between a cap-and-trade and a tax scheme. 46 See http://www.mfe.govt.nz/issues/climate/greenhouse-gas-emissions/net-position/index.html 47 This means: (i) the global agreement sets the world on a pathway to limit temperature rise to not more than 2°C; (ii) developed countries make comparable efforts to those of New Zealand; (iii) advanced and major emitting developing countries take action fully commensurate with their respective capabilities; (iv) there is an effective set of rules for LU- LUCF; and (v) there is full recourse to a broad and efficient international carbon market. 48 Agriculture will directly benefit from the 90% rate, irrespective of any test. 24 seCtIon 3 Emissions trading in other Annex B regions and beyond activity in question, and compare it both to the will not be bankable beyond 2012. During the activity's countrywide average and to intensity transition period non-forestry NZUs cannot be thresholds. exported, in order to avoid any possible arbitrage between domestic unlimited public supply at a Arguably, the scheme should send appropriate in- fixed price and demand in other markets. Export- centives to installations that pollute in excess of able NZUs are automatically converted to AAUs the national average. Furthermore, if the national for export (pending government approval, which average is below thresholds then the activity itself may be a risk for forward transactions); AAUs will not be eligible for assistance. Free allocations linked to forestry projects have already piqued the will be given in advance, based on the previous interest of foreign buyers (see Section 3.1.5). year's output with a reconciliation mechanism once the actual output is known. Phasing-out will The NZ ETS is open to linkage with other schemes start in 2013 (2016 for agriculture) at a rate of such as the EU ETS, but no decision has been 1.3% per year. Given the "two-for-one" rule in made on whether to bilaterally accept compliance effect during the transition period, the number of units. There are a number of issues to be consid- free allocations will be halved. ered before bilateral acceptance can occur: what will be the level of ambition of the foreign scheme 3.1.4 Cost control: full supplementarity and which partner will ultimately benefit from a for Kyoto-compliant offsets decreasing domestic price; which sectors will be covered and under what allocation modalities, in- In addition to the temporary fixed-price provi- cluding assistance; will there be price intervention sion, participants from stationary energy, indus- mechanisms that can propagate through linking, trial process and liquid fossil fuel sectors need such as a price cap; what types of credits will be surrender only one NZU for every two tCO2e allowed and will MRV standards be compatible. emitted during the transition period so that the maximum price they would pay would be half of 3.1.5 Interest in the forestry market takes the fixed price of NZ$25 or NZ$12.5 (approx. root US$9 or 7). Both measures will disappear after 2012. Full banking is allowed, although borrow- Forestry currently offsets about one-third of New ing will be prohibited. A NZ$30 make-good pen- Zealand's non-forestry GHG emissions. Howev- alty applies for non-compliance, with a waiver for er, by 2020, forestry is expected to become a net repentant installations.49 source of emissions as large areas of production forests planted in the 1990s start to be harvested.50 Certain international units can also be surren- Forestry, however, has played a very limited role dered for compliance in unlimited quantities, such in Kyoto-compliant markets internationally,51 and as CERs (excluding tCERs and lCERs), ERUs and the bulk of carbon finance activity in agriculture RMUs. No decision has been reached on whether and forestry has taken place within the framework foreign AAUs will be allowed. In any event, they of voluntary carbon markets.52 49 The NZ ETS Q&A reads: "Q: What happens if I fail to surrender emission units when I'm required to? A: If you fail to surrender emission units when you're required to or have surrendered less units than you were meant to, you'll have to surrender or cancel those units and pay a penalty of [NZ]$30 for each emission unit. This penalty may be reduced by up to 100 percent if you state voluntarily that you've failed to surrender the required emission units or made a mistake in your emissions return before the administering agency sends you a penalty notice or you're visited by an enforcement officer." 50 Source: Fifth National Communication by New Zealand. 51 Kyoto-compliant LULUCF assets have so far accounted for less than 1% of volume in the CDM and JI primary mar- ket, mainly because of their ban from the EU ETS (chiefly motivated by their non-permanent nature). 52 Historically, the voluntary OTC market dominated forestry carbon market, with close to three-quarters of volumes transacted. The forestry carbon market has continued to grow, with two-thirds of volumes traded in the last three years 25 State and Trends of the Carbon Market 2010 pre-compliance interest in forestry NZUs within By including forestry in its etS, New Zealand has been extremely limited while new Zealand hopes to rein in international buyers (essentially Europeans) that deforestation and encourage have been looking for AAUs with a high level of environmental integrity have shown much greater new plantations as well as more interest. In 2009 international public and private sustainable forest management buyers purchased a total of up to 600,000 for- practices. estry NZUs on the spot market at prices believed to be around US$14 (10). The Government of Norway purchased 520,000 AAUs in the largest By including forestry in its ETS, New Zealand transaction thus far. With more clarity now on the hopes to rein in deforestation and encourage domestic front in New Zealand, large compliance new plantations as well as more sustainable forest buyers (including utilities that won't be granted management practices. Experience from the first NZUs) have reportedly explored the option of two years of operations demonstrates that New buying forestry carbon assets.54 In 2010 the num- Zealand's unique approach to forestry helped sell- ber of NZUs is expected to increase significantly, ers receive the highest prices ever for compliance with up to 6 million to be issued into the registry forestry assets, almost on par with other project accounts of sellers; about 610,000 forestry NZUs types transacted in the CDM market. This is in were transacted in Q1'10. particular due to the permanent nature of these forestry credits that has resulted from a credible Although the NZ ETS is an incipient market with land-tenure system with long-term commitments uncertainty in terms of demand and choice of and liabilities for forest owners. compliance options, activity should pick up in the second half of 2010 when three new sectors join Under the NZ ETS, all major owners of pre-1990 the scheme (not all of which will receive generous forests (or vested third parties) incur a deforesta- assistance). However, the newly mandated instal- tion liability for harvesting and not replanting. lations may adopt a wait-and-see attitude, espe- NZUs will be granted to compensate for the re- cially in light of the government's announcement duced flexibility in the use of land.53 Post-1989 regarding the implementation of the NZ ETS. forest owners can voluntarily opt-in. They can They may take more time to explore and bargain receive NZUs for any increase in carbon stocks in the domestic forestry NZU market while the from January 1, 2008 onwards; in the meantime, NZ$25 price cap gives them the certainty they they face a liability whenever carbon stocks fall need to plan their overall obligation. below a previously reported level. Projects under the Permanent Forest Sink Initiative, a scheme that pre-dates the NZ ETS and allows partial har- 3.2 AUSTRALIA: ON hOLD vesting, will also be issued NZUs. Australia has been strongly divided on how to These credits can be sold at home or abroad (in progress with its stalled climate policy. Legislation the form of AAUs). Given the long-lived un- for the proposed Carbon Pollution Reduction certainty surrounding the fate of the NZ ETS, Scheme (CPRS), an economy-wide emissions (including in relation to NZ ETS). However, with just 20.8 MtCO2e transacted for a value of US$149.2 million, for- estry still accounts for a small fraction of the global carbon market. See: Katherine Hamilton, Unna Chokkalingam, and Maria Bendana, 2010, State of the Forest Carbon Markets 2009: Taking Root & Branching Out. Ecosystem Marketplace, Washington (DC). 53 The Pre-1990 Forest Land Allocation Plan, still under consultation, is expected to be finalized this year. 54 See forward purchase of NZUs by the generator Mighty River Power http://www.mightyriverpower.co.nz/News/De- tail.aspx?id=2288 26 seCtIon 3 Emissions trading in other Annex B regions and beyond trading scheme that could become Australia's cen- Prime minister rudd announced tral instrument to manage GHG emissions, was defeated twice in the Senate last year. Citing both on april 27, 2010 that plans for domestic political deadlock and uncertainty on emissions trading in australia would future international climate policy, Prime Minis- ter Rudd announced on April 27, 2010 that plans be postponed and re-examined by for emissions trading in Australia would be post- the end of 2012. poned and re-examined by the end of 2012. The CPRS would have covered approximately 75% of Countermeasures", an overall climate change Australia's emissions and put the country on track policy framework that is in line with its mid- and to meet its mid-term commitment of reducing long-term GHG emissions reduction goals.55 In a GHG emissions by at least 5% below 2000 levels major shift of Japan's climate policy (which thus by 2020. Annex II describes in more detail the far has mainly excluded market-based approaches CPRS legislation as introduced for the third time and price instruments), the Basic Act considers into Parliament, in February 2010. establishing a mandatory ETS, introducing a car- bon tax and putting in place a feed-in tariff for all The Renewable Energy Target (RET) scheme, which renewable energy sources. The ETS would start the government implemented in August 2009, may within one year after the Basic Act comes into be the only de facto environmental market currently force, and the carbon tax would become active in active at the federal level that could deliver emission April 2011. reductions. The RET aims to achieve a 20% share of electricity supply from renewable energy sources The Basic Act also sets a goal of increasing do- by 2020 (a doubling of its current level). This was mestic energy generation from renewable sources a four-fold increase over the goal of the Mandatory to 10% of total primary energy supply by 2020.56 Renewable Energy Target (MRET) scheme intro- The Basic Act, to date just an outline, was sub- duced in 2001, and it has stimulated the market for mitted to the current Diet Session, which should Renewable Energy Certificates (RECs). RECs cur- end in June. Under the outline the government rently trade above AU$40 per kWh (US$37, 27), would prepare a series of implementation laws which roughly corresponds to AU$47 per tCO2e that would lay out a master plan and detailed de- (US$43, 32). The RET scheme will be enhanced sign for each measure prior to the start of the next further from January 2011 to stimulate additional Diet Session in the fall of 2010. participation from households, large-scale renew- able energy projects and installers of small-scale Opposition to the proposed bill is growing, fu- renewable energy systems. elled by concerns about costs to the economy and a lack of extensive consultations with indus- try groups. Three leading business organizations, 3.3 JAPAN: CONSIDERING MARKET including the Japan Business Federation (Nip- MEChANISMS pon Keidanren), have already announced their overt opposition. Observers expect a fierce battle On March 12, 2010, the government of Japan over the ETS and believe that it could take more proposed the "Basic Act on Global Warming than the originally scheduled one year to iron 55 As is: a 25% reduction in GHG emissions below 1990 levels by 2020, premised on a fair and effective international framework in which all major economies participate and on an agreement by those economies on ambitious targets (as reiterated under the Copenhagen Accord). There is also a long-term target of reducing GHG emissions by 80% below 1990 levels by 2050. 56 In 2007, Hydro, Geothermal, Solar sources as well as Combustible Renewables and Waste accounted for 3% of Japan's total Primary Energy supply (IEA). 27 State and Trends of the Carbon Market 2010 the Keidanren Voluntary Action Plan, plans for a In a major shift of Japan's climate domestic offsets scheme and the Japan-Voluntary policy (which thus far has mainly Emissions Trading Scheme (J-VETS), which tar- excluded market-based approaches gets smaller emitters. Potential participants must apply to take part in the Experimental Integrated and price instruments), the Basic ETS and submit their own emission reductions act considers establishing a targets (either absolute or intensity-based) for re- mandatory etS, introducing a view. In addition to their own internal abatement efforts, participants can meet their compliance carbon tax and putting in place objectives using domestic allowances, offsets from a feed-in tariff for all renewable domestic projects or Kyoto Mechanisms. The energy sources. scheme covers about 70% of CO2 emissions from industry although targets and the level of effort to be invested in the scheme are not yet known. out legislation. However, implementation of the It is therefore difficult to assess whether the trial carbon tax and feed-in tariff system could hap- scheme could generate significant demand for in- pen sooner. ternational offsets. Transaction activity is reported to be extremely limited so far. One of the most contentious issues so far has been whether participants under the mandato- While plans for a national mandatory ETS are ry ETS could choose an intensity-based target. under development, the Tokyo metropolitan While the draft bill did not initially make any area launched its own mandatory cap and trade reference to an intensity-based approach, such scheme on April 1, 2010 that targets office and text was inserted at the last minute as the result commercial buildings (including universities) of inter-ministerial coordination. The Basic Act and factories. Altogether, the scheme covers considers setting the caps as absolute amounts of approximately 1,400 installations and 1% of emissions in principle, but it would also require the country's emissions. Unlike other ETS, the the government to consider intensity-based re- scheme covers the service sector and regulates duction targets in terms of units of production its energy use (rather than power generation or some other measure of output. While it is upstream), and thus is likely to include a large hoped that a Japanese ETS would generate large number of installations with small liabilities. To demand,57 the types of emission reductions that ease compliance and transaction costs, smaller would be eligible have yet to be determined. Ob- businesses are likely to receive subsidies to im- servers believe that Japan would take an open prove their energy efficiency. The scheme will stance toward offsets in terms of volumes and help Tokyo achieve its target of slashing emis- types (including REDD). sions by 20% below their 2000 levels by 2020. Over 2010­14, participants will be required to In October 2008 a voluntary Experimental Inte- achieve reductions of 6­8% (6% for industrial grated ETS was launched. As of July 2009, 715 sites) below a baseline set as the average emis- organizations had applied to participate, of which sions from three consecutive years during 2002­ 521 supplied targets. The trial scheme aims to 07. This will be followed by deeper cuts (17%), bring together several existing initiatives such as from 2015 to 2020. To meet their targets, instal- 57 At 1,282 MtCO e, Japan's GHG emissions in 2008 were 7% above its Kyoto target (6% below 1990 levels). While use 2 of Kyoto Mechanisms by the government of Japan and promotion of carbon sinks could close two-thirds of the gap, use of Kyoto Mechanisms by the private sector could close a large part of the remainder. Average expected GHG emissions over 2008­12 in Japan could thus range around the base year level while the 2020 target calls for reducing them by one quarter, generating hopes of a significant demand for offsets. 28 seCtIon 3 Emissions trading in other Annex B regions and beyond lations can reduce emissions internally, purchase ...the window of opportunity for credits from entities that overperform, surrender RECs or acquire domestic offsets from SMEs. A passing federal climate legislation in maximum of one-third of the reduction attrib- 2010 is closing fast. utable to offsets can originate outside the Tokyo metropolitan area. Trading is expected to start in the next fiscal year after emissions data are col- 3.4.1 The Waxman-Markey Bill raised lected in 2010. Failure to attain a reduction goal hopes... will be sanctioned during the next phase at 1.3 times the default amount. In a narrow vote on June 26, 2009, the U.S. House of Representatives passed the American Clean Energy and Security Act of 2009, or ACES 3.4 NORTh AMERICA: WAITING fOR (proposed by Congressmen Henry Waxman and K-G-L AND GETTING K-L Ed Markey), which would impose a mandatory economy-wide cap-and-trade scheme aiming to Market activity grew four-fold in North America reduce emissions from covered sources to 17% during 2009 in response to mounting expecta- below 2005 levels by 2020.59 The Waxman-Mar- tions of federal carbon regulation and the grow- key Bill also includes companion provisions to in- ing momentum of regional initiatives, chiefly crease renewable energy generation and enhance the Regional Greenhouse Gas Initiative (RGGI), energy efficiency, such as a federal renewable the only mandatory cap-and-trade scheme in energy standard,60 energy-saving standards and the United States (see Box 5). The passage of the funding for low-carbon technologies and energy Waxman-Markey Bill in the U.S. House of Rep- efficiency. resentatives in June 2009 considerably increased interest in U.S. domestic offsets. However, slow ACES leaves ample room for offsets as a key cost- subsequent progress on Federal legislation caused containment option,61 allowing up to 2 billion enthusiasm to fizzle by the end of 2009. Hopes tons of offsets per year (or close to 40% of the now hang on a multi-partisan bill sponsored by average annual cap over 2012­20) equally split Senators Kerry and Lieberman (K-L), although between domestic and international activities, al- the window of opportunity for passing federal cli- though international offsets will be discounted at mate legislation in 2010 is closing fast given other a 1:1.25 ratio starting in 2018. Recent analysis by legislative priorities and upcoming mid-term elec- the EPA indicates that demand for offsets could tions in November. In Canada, Alberta continued be significant, on the order of 0.76­1 billion tons its intensity-based program while other Canadian annually for international offsets, while the use of provinces agreed to implement their own carbon domestic offsets would ramp up progressively.62 reduction plans.58 With regard to international offsets, activities that 58 Since July 2007, facilities in Alberta that emit more than 100,000 tCO e per year are required to reduce their carbon 2 intensity by 12% annually. To comply, they can, among other options, purchase Alberta-based offset credits. 59 In line with a 15% reduction (below 2005 levels) in total U.S. emissions by 2020. The U.S. long-term emission reduc- tion goal is 83% below 2005 levels by 2050. 60 The Renewable Energy Standard requires that 20% of the electricity sold by retailers be produced through renewable energy sources in 2020. Energy efficiency and conservation measures (with possible crediting and trading under a market mechanism) as well as Renewable Energy Certificates (RECs) can be used towards this target. Alternatively, regulated entities can opt for a compliance payment of US$25 per MWh. 61 Other cost containment provisions include unlimited banking, unlimited borrowing from the immediately following year, limited borrowing (15% of obligation) with an 8% interest rate for future vintage years 2 to 5 years into the future, and buying allowances from a strategic reserve through auction. Finally, allowances from other trading programs at least as stringent as the U.S. scheme can be used. 62 EPA (2010). EPA's January 2010 supplemental H.R. 2454 analysis. 29 State and Trends of the Carbon Market 2010 box 5 focus on North America kindly provided by Bloomberg new energy finance, ecosystem an average of uS$3.3 per tCo2e during 2009 (or significantly marketplace less than euas) in an over allocated market--a situation that rGGI was by far the most prominent market in north could continue for many years unless the caps are revised. ac- america with 805 mtCo2e traded for an overall value of almost tivity was greatest during Q3'09 in the wake of the passage of uS$2.2 billion in 2009, its first full year of operations. this rep- the Waxman-markey Bill in the u.S. house of representatives, resented a 10-fold increase over (pre-market) activity in 2008 yet fell markedly in Q4'09 when the Senate failed to maintain in terms of both volume and value. rGGI allowances traded at momentum for a climate change bill. table 2 North American carbon market ­ traded volumes and values, 2008­09 Average Price (uS$/tCo2e) Volume (mtCo2e) Value (million uS$) 2008 2009 2008 2009 2008 2009 rGGI (allowances) 3.9 3.3 61.9 805.2 198.2 2,178.6 alberta (offsets/ePCs) 10.0 13.5* 3.4 4.5 33.5 60.8 CCx (CfIs) 4.4 1.2 69.2 41.4 306.7 49.8 voluntary offset market 6.8 4.9 15.4 29.0 104.1 143.4 of which Car 8.8 7.1 5.3 14.9 46.6 104.5 of which CCx 4.8 0.8 1.0 7.4 4.8 5.9 of which vCS 5.5 4.6 1.5 3.3 8.3 15.2 of which aCr 3.8 3.4 4.3 1.8 16.3 6.1 of which other 8.5 7.3 3.3 1.6 28.1 11.7 Total market 149.9 880.1 642.5 2,432.5 Source: Bloomberg New Energy Finance, Ecosystem Marketplace. Notes: RGGI includes quarterly auction figures, * Alberta price is an estimate. the passage of Waxman-markey also created a flurry of although congressional deliberation of the Waxman-mar- activity in the offset market as many companies focused on key Bill during the first half of 2009 created momentum for the procuring offsets that might become eligible in a future fed- u.S. offset market, it did not spur equivalent growth for CCx. eral compliance market. as a result, transactions of u.S.-based CCx had grown consistently from its start in 2004, but it suf- project credits nearly doubled in 2009. In particular, the Cli- fered a 40% decline in trade volume during 2009 (from 69 mt- mate action reserve (Car) protocols proved to be very popular Co2e to 41 mtCo2e). Prices dropped sharply, from uS$4.8 per as they are considered very likely to become eligible under a tCo2e to uS$0.8 per tCo2e, as did overall value, which was only federal scheme. as table 2 shows Car credits were the main 16% of that of that in 2008. Interest in the exchange seemed to growth driver in the u.S. carbon market with volumes nearly wane when CCx credits were not explicitly mentioned for future tripling (180% growth). Car credits represented 51% of the off- eligibility in a federal compliance regime and general market set market in terms of volume at an average price of uS$7.1 per over-allocation. tCo2e--much higher than many of the other u.S. carbon credits (e.g., CCx, vCS or aCr). reduce deforestation at national, state or project offset regulation (e.g., a list of eligible activities levels are explicitly mentioned as being eligible, and existing accepted methodologies, guidelines in contrast to their status in other existing or for the establishment of new methodologies and proposed ETS (see Box 6).63 However, complete eligibility conditions for international offsets) 63 ACES also provides for a mechanism whereby allowances are set aside to fund deforestation reduction activities in developing countries. Such activities are not eligible to generate offsets. 30 seCtIon 3 Emissions trading in other Annex B regions and beyond remains to be developed, raising some concerns as the world strives to scale up regarding the actual availability of offsets in the early years of the scheme. global mitigation efforts, many developing countries are in the As the first comprehensive climate legislation adopted by a house of Congress, the Waxman- process of formulating their Markey Bill created significant momentum. Pre- national climate strategies and compliance interest rose quickly in the domestic aligning them with their overall offset market, notably around the Climate Action Reserve (CAR) protocols, which are very likely to development plans. be compatible with a future federal compliance market. for passing federal climate legislation in 2010 is 3.4.2 ...but momentum is at risk closing fast, given other legislative priorities and mid-term elections in November. State and re- With slow progress toward companion legislation gional initiatives are also impacted by the elec- in the Senate, momentum faded through the end toral deadline. In California, a state that has been of 2009 and into early 2010. Over this period, a leader in climate action and that could be an an- prices of RGGI allowances and Climate Reserve chor of the Western Climate Initiative (WCI), a Tonnes (CRTs), which are project-based emission leading gubernatorial candidate is openly against reductions issued under the CAR, continued to AB32.64 WCI has experienced serious setbacks as fall, reflecting declining market expectations. In Arizona and Utah have pulled out of its trading an effort to overcome dissent within the Senate, program, while necessary legislation in Montana, Senators Kerry, Graham and Lieberman (K-G- Oregon and Washington won't likely be in place L) prepared a multi-partisan bill through a series until 2012.65 of compromises. The draft American Power Act (APA) was finally released on May 12 by Senators Kerry and Lieberman only as Senator Graham 3.5 EMERGING ALTERNATIVE withdrew in April on disagreement over immigra- MARKET INSTRUMENTS AND tion reform. APA seeks to reduce U.S. emissions EXChANGES BEyOND ANNEX B economy-wide by 17 percent below 2005 levels COUNTRIES by 2020, and creates a cap and trade scheme that covers utilities starting in 2013 and expands to As the world strives to scale up global mitiga- manufacturing in 2016. Emitters are allowed to tion efforts, many developing countries are in use annually up to 1.5 billion of domestic offsets the process of formulating their national climate and 500 million of international offsets. strategies and aligning them with their overall development plans. These strategies will identify Observers are divided on the likelihood of suc- and frame their nationally appropriate mitiga- cess, pointing optimistically to a number of ear- tion actions (NAMAs) that are expected to be the lier concessions on nuclear power and oil drilling primary vehicles for them to contribute to global but at the same time aware of the political capi- mitigation efforts while achieving domestic pri- tal cost of having passed health care reform. All orities. Creating adequate incentives to support agree, however, that the window of opportunity these mitigation actions remains a challenge. 64 See glossary for more information on regional initiatives. 65 A thorough analysis of regional North American market potentials can be found in Point Carbon, 2010, Plan B ­ Doing it alone: Regional Programs in North America. 31 State and Trends of the Carbon Market 2010 While public sources of finance will likely remain · The China Beijing Environmental Exchange crucial to the delivery of such support, there is (CBEEX) provides a market platform for trad- broad recognition that market instruments could ing various environmental commodities in- have a complementary role in supporting and en- cluding CO2.68 Its current operations include abling the cost-effective achievement of national developing the voluntary `Panda standard' for priorities. This is now evident through the devel- the creation of domestic GHG offset assets in opment of trading schemes/exchanges, often with the agriculture and forestry sectors with social indirect links to GHG emission reductions, and co-benefits. The CBEEX also facilitates CDM overall preparation for introducing market instru- transactions and is generating market demand ments in many countries. for VERs through the China Carbon Neutral Alliance and a VER Carbon Fund of RMB0.5­ Brazil: Policy makers are considering introducing 1 billion capitalized by the member companies. a domestic cap and trade scheme, primarily cover- · The Tianjin Climate Exchange (TCX) is Chi- ing the energy, transport, industrial and agribusi- na's first integrated exchange for the trading of ness sectors. This is intended to help Brazil meet environmental financial instruments. Its focus its voluntary national target of reducing emissions is similar to the CBEEX, but also promotes en- by up to 38.9% by 2020.66 The scheme would al- ergy efficiency through an intensity-based emis- low both polluters and investors to trade allow- sions trading, particularly for heating suppliers. ances. Most sectoral targets are still to be defined, The first sale was in February 2010. After the although it is likely that thermal power plants will pilot phase, the Tianjin plan may be extended be capped first. Implementation would be sup- to cover all public, commercial and residential ported by creating a new regulatory body and buildings and their heating suppliers. accrediting auditors to monitor and verify data. · The Shanghai Environment Energy Exchange The proposed scheme continues to face internal (SEEE) provides a platform for trading asset opposition but is expected to progress by COP rights, creditor's rights, stock rights, and intel- 16 in Mexico. lectual property rights, focusing on environ- ment and energy. It is exploring a new market China:67 Three voluntary environmental exchang- mechanism aligned with the requirements of es were established in Beijing, Tianjin and Shang- the Clean Development Mechanism. The ex- hai in 2008 through private sector collaborations change is intended to reduce transaction costs with approval from municipal governments. and bring more transparency to CER pricing. These are pilots for testing the use of domestic emission trading as a tool to support China's cli- India:69 The National Action Plan on Climate mate change mitigation strategy, but do not in- Change included several programs on energy, and volve the central government. specifically the use of market-based instruments to increase energy efficiency and the use of renew- 66 A range of domestic actions will contribute towards this voluntary target, including signification reduction of defores- tation (80% for the Amazon and 40% for the "Cerrado"), restoration of grazing land, diversification of energy sources (notably hydro and biofuels) and improvement in energy efficiency. Source: http://unfccc.int/files/meetings/application/ pdf/brazilcphaccord_app2.pdf 67 China will endeavor to lower its carbon dioxide emissions per unit of GDP by 40­45% by 2020 compared to the 2005 level, increase the share of non-fossil fuels in primary energy consumption to around 15% by 2020, increase for- est coverage by 40 million hectares and forest stock volume by 1.3 billion cubic meters by 2020 from the 2005 levels. Source: http://unfccc.int/files/meetings/application/pdf/chinacphaccord_app2.pdf 68 This is a partnership with BlueNext and two other co-founders, Winrock International and China Forestry Exchange (CFEX). 69 India will endeavor to reduce its emissions intensity by 20­25% by 2020 compared to 2005 level. The emissions from agriculture sector will not form part of the assessment of emissions intensity. Source: http://unfccc.int/files/meetings/ application/pdf/indiacphaccord_app2.pdf 32 seCtIon 3 Emissions trading in other Annex B regions and beyond REDD-plus box 6 CoP15 confirmed that forests would play an important role in key topics, e.g., the place of redd-plus in national develop- future climate change mitigation. In particular, reducing emis- ment, and the environmental and social safeguards that need sions from deforestation and forest degradation, the conser- to be taken into consideration when undertaking redd-plus vation of forest carbon stocks, sustainable management of activities. overall, only a few undecided (i.e., bracketed) pas- forests, and enhancement of forest carbon stocks in develop- sages still remain in the aWG-LCa text. nevertheless, these ing countries (a package now referred to as "redd-plus") is may prove important as the private sector decides whether likely to receive a significant portion of the fast-start money to engage in redd-plus on a large scale. In particular, the dis- announced in Copenhagen. It is also expected that, in the long cussion about the level at which redd-plus should be imple- term, both public and private funding will be directed toward mented and accounted for is still unfinished. forests, including possibly through carbon market mecha- for now attention is focused on the public sector's re- nisms. But before a market for redd-plus credits appears, im- sponse, including through the financing pledges announced. portant preparatory steps must be taken, what is commonly at Copenhagen, six countries (australia, france, Japan, nor- known as "redd-plus readiness". way, the united kingdom, and the united States) pledged the international community has built enormous ex- uS$3.5 billion of fast-start support for redd-plus between pectations for redd-plus, in particular developing countries 2010 and 2012. Since then, additional countries have joined which see the potential for financing development policies (including the european union, Germany, Slovenia, and Spain), and programs in return for reducing forest-related emissions bringing total fast-start pledges for redd-plus to over uS$4.5 and for maintaining or increasing forest carbon stocks. mean- billion. In parallel, france and norway built on the momentum while, private sector initiatives are cautiously starting to en- created at Copenhagen and convened a large number of coun- gage, as they are both perceiving investment opportunities in tries to design a non-legally binding interim "redd-plus part- the redd-plus area but also mindful of the lack of clear sig- nership", which is designed to confirm and detail the financial nals about the future rules and criteria of regional, national, pledges and set up an institutional structure for redd-plus to and international climate change regimes, including those of coordinate action through 2012, and would be replaced or sub- the unfCCC, the united States, the european union, austra- sumed by a future unfCCC mechanism including redd-plus. lia, Japan, and others. Currently, therefore, public interest and most countries agree that whether or not sub-national finance are dominating the agenda and concerted efforts will implementation is permitted, accounting will ultimately have now be needed to design systems that also attract private to be conducted at the national level to account for the pos- capital to support national efforts to reduce emissions and sible displacement of emissions (leakage). In reality, most enhance stocks. countries already allow the design and implementation of despite the limited breakthroughs achieved at the Co- voluntary redd-plus projects. however, there is still no guid- penhagen conference, the redd-plus agenda did progress ance on how these sub-national programs should link up to a significantly in technical and political terms. a number of im- national accounting system and how they will be managed and portant issues were agreed upon, starting with the scope of coordinated to address issues such as permanence, coherent redd-plus, which now covers all major components of forest- reference emission levels, and measurement, reporting and based climate change mitigation. While this is good news for verification (mrv). forest countries and the overall climate-change agenda, this the great variety of regulatory and technical issues that comprehensive approach requires a more complex national need to be addressed during redd-plus readiness has moti- framework (e.g., in terms of monitoring systems) to accommo- vated most of the countries to start organizing their readiness date the three additional activities, and also more ambitious process in a cross-sectoral manner, including relevant line financial support packages form the international community. ministries and non-governmental stakeholders. many redd In Copenhagen, methodological guidance on redd-plus countries show unprecedented commitment to, and expecta- was agreed upon by the Subsidiary Body for Scientific and tions of, redd-plus and are working towards the development technological advice. With respect to policy approaches and of a common vision of how best to manage their forest estate positive incentives, the Parties deliberated in the context of and shape their redd-plus strategies. While some countries the ad hoc Working Group on Long-term Collaborative ac- are making quick progress, each country is advancing through tion (aWG-LCa). the working group reached agreements on redd-plus readiness at its own pace. Some countries may Continues on the following page 33 State and Trends of the Carbon Market 2010 box 6 REDD-plus (continued) well take several years to fully address the regulatory and united States might generate a large demand for such credits. mrv requirements associated with redd-plus. however, the prospect of passage of a similar bill by the u.S. forest countries are supported in their redd-plus readiness Senate has become a lot less certain recently, including the efforts by a number of bilateral donors and several main mul- question whether federal legislation would eventually make tilateral initiatives, namely the forest Carbon Partnership fa- room for redd-plus credits (offsets). Pending the passage of cility (fCPf), the un-redd Programme, the forest Investment legislation in the united States or elsewhere, the demand for Program (fIP), and the Global environment facility (Gef). redd-plus is limited to the public sector and the voluntary these initiatives aim to provide forest countries with technical market. and financial support as they progress from redd-plus readi- Currently, a number of voluntary redd-plus programs ness to investments and results-based activities. are being developed, though most of them are at a very early the inclusion of Indigenous Peoples and other forest- stage and follow different methodologies, standards and ap- dependent communities in the redd-plus context also repre- proaches. Standards such as the voluntary Carbon Standard sents noteworthy progress, recognizing their critical role and and the Climate, Community and Biodiversity alliance are be- special knowledge in protecting and monitoring forest areas. ing used for project development. It is not clear how these the magnitude of finances required for redd-plus (on standards will be integrated into the logic of a national ac- the order of billions of dollars per year) requires the involve- counting system for redd-plus. ment of the private sector. official development assistance In the current interim finance and readiness phase for alone will not be able to carry the weight. the question is redd-plus, it will be important for regional, national, and in- therefore what will motivate the private sector to contribute ternational regulators not to lose sight of the private sector's to scale. the carbon market could provide one of these incen- interests, as it seems obvious that a large portion of funding tives if redd-plus credits were declared eligible in regulatory for redd-plus will have to come from private sources in the regimes. the passage of a cap-and-trade bill by the u.S. house future. the public sector should ideally help design frame- of representatives in 2009 initially raised hopes that the works that will catalyze private funding.1 1the Carbon fund of the World Bank's forest Carbon Partnership facility (fCPf), which is aimed at testing and demonstrating first-of-a kind, large- scale redd-plus emission reductions transactions, is designed to be such a public-private partnership. able energy. The government is also exploring · The Renewable Energy Certificate (REC) mech- linking these two schemes. anism is intended to support an increase in in- stalled renewable capacity from 15­65 GW in · The Perform Achieve and Trade (PAT) mecha- five years and is expected to become operational nism for trading energy efficiency certificates is in 2011. RECs will only be issued to renewable expected to become operational in 2011, with energy generators, but will be freely tradable. an initial commitment period of three years. RECs will be traded through regulator approved The scheme will cover 714 installations in 9 power exchanges, within a price band. energy-intensive sectors. By 2014 the scheme is expected to generate 98 million tCO2 in emis- Mexico:70 The voluntary program for greenhouse sion reductions per year. gas accounting and reporting (Programa GEI) 70 Mexico aims to reduce its GHG emissions by as much as 30% with respect to the business as usual scenario by 2020, provided that adequate financial and technological support from developed countries is provided as part of a global agree- ment. Source: http://unfccc.int/files/meetings/application/pdf/mexicocphaccord_app2.pdf 71 The Republic of Korea intends to reduce its national GHG emissions by 30% from the business as usual emissions scenario by 2020. Source: http://unfccc.int/files/meetings/application/pdf/koreacphaccord_app2.pdf 34 seCtIon 3 Emissions trading in other Annex B regions and beyond covered 98 companies in 2009 accounting for based GHG reduction program operated by the 21% of national emissions. The program oper- government. This has been introduced to assist ates a validation/certification system of GHG with meeting the 30% below BAU by 2020 vol- inventories, establishes baselines, and develops untary mitigation target. KCERs are issued by standards, thereby providing essential capacity the government for five-year crediting periods building for future participation in the carbon to projects with annual reductions of 500 tCO2e market. In the next two years the coverage will be or more and benchmarked using CDM and ISO expanded to 80% of national GHG emissions. standards, and IPCC guidelines. The KCERs are Sectoral crediting is expected to complement either purchased by the government for US$5 per CDM as the source of carbon market finance for KCER, sold into the voluntary market or banked Mexico. in preparation for emissions trading. A trading scheme is being developed through the Basic Act Republic of Korea:71 The Korean Certified Emis- for Low Carbon Green Growth and will be final- sion Reduction (KCER) Program is a project- ized by the fall of 2010. 35 4 SECTION kyoto fLexIBILIty meChanISmS 4.1 AT A GLANCE For the second year in a row, the level of activity of the Kyoto offsets market declined substantially (see Table 3 and Figure 10). 2008 2009 table 3 Annual volumes and Volume Value Volume Value (mtCo2e) (uS$ million) (mtCo2e) (uS$ million) values for project- based transactions, Primary Cdm 404 6,511 211 2,678 2008­0972 JI 25 367 26 354 voluntary market 57 419 46 338 Sources: World Bank, and Bloomberg New Energy Total 486 7,297 283 3,370 Finance and Ecosystem Marketplace for data on the voluntary market On the demand side, the EU ETS was buffeted Simultaneously, many buyers exited the market by global economic turmoil in 2009. As emissions (e.g., primarily EU compliance "naturals" with fell demand for Kyoto assets declined, leading to lower demand needs and EU financials heavily hit an overall surplus in allowances over the remain- by the financial crisis and credit crunch), while der of Phase II. At the same time, most Annex those that remained became much more risk B Parties suddenly found themselves on track to averse and stringent in their choices. meet or overachieve their commitments under the Kyoto protocol. 700 18 fIgure 10 Annual average prices On the supply side, origination activity declined (US$ per tCO2e) 16 Volumes and prices 600 in 2009 as the financial crisis spurred financial for Kyoto offset Annual volumes 14 institutions and private investors to deleverage 500 transactions (CERs (MtCO2e) 12 and ERUs) since and redirect their positions away from risky in- 73 400 10 2002 vestments and toward safer assets and markets, 8 Source: World Bank leading to a major reduction in the capital inflow 300 to developing countries, as well as an outflow of 6 200 resources already internalized. The combination 4 made it impossible for many CDM and JI project 100 2 developers to lock in finance, and as a result, proj- 0 0 ect origination ground to a halt during H1'09. 2002 2003 2004 2005 2006 2007 2008 2009 72 Please note that small differences between the numbers reported this year and last reflect additional information ob- tained after the last report was released concerning earlier transactions. 73 Although not specifically mentioned throughout the text, an evaluation of the primary market purely based on year- to-year volumetric comparison can be misleading since the volumes provided in this report refer to the remaining potential delivery through 2012, which declines every year. Therefore, in order to provide an accurate overall evaluation of market behavior in the primary market, other aspects such as the number of project-based transactions concluded, potential post-2012 volumes, level of engagement and appetite for risk (based on contractual clauses) have to be taken into consideration. 37 State and Trends of the Carbon Market 2010 Buyers sought to reduce risk by ETS threaten the market for post-2012 assets. Fi- nally, in a major setback to aspirations for a robust focusing on projects that attained compliance market, the inconclusive Copenhagen financial closure. however, sellers summit failed to provide post-2012 visibility. could not secure underlying finance, Without greater visibility the primary market will an unfortunate catch-22! become increasingly directionless and prone to following speculative actions, rumors, short-term commodity trends and the actions of the few Delays in asset creation (e.g., validation and registra- who will seek to close their positions. Under this tion of CDM projects) are an inherent risk equally scenario it is likely that even lower volumes and distributed across the CDM portfolio and beyond higher short-term price volatility will emerge. the control of buyers. Therefore, buyers sought to reduce risk by focusing on projects that attained fi- nancial closure. However, sellers could not secure 4.2 pCERs: ANOThER TOUGh yEAR underlying finance, an unfortunate catch-22! 4.2.1 Pre-2013 ERPAs: layering, In addition, reasonably healthy EU financials saw syndicating and much more greater opportunity in acquiring undervalued CER portfolios from distressed and liquidity-short ac- With no room for additional financial losses, the tors than in seeking new projects, leading to fur- market became very risk-averse. Buyers focused ther contraction in demand and the intensification their attention on the few remaining large projects of the market consolidation process that had begun that were in advanced stages of development and in 2008. After the economic storm subsided, activ- run by well capitalized and experienced project ity resumed in the second half of 2009. Although developers. The number of advance payments de- portfolio diversification remained a major goal for clined as risk aversion increased and, critically, the buyers, as it had been in 2008, China retained the window of opportunity to generate enough assets lion's share of the offset origination market, due in to repay the amount advanced closed. Simultane- part to the difficulty in finding equivalent business ously, appetite for innovative financial structures environments in other countries. backed up by carbon assets, which were explored by a few financials in the past, disappeared. The JI market fared no better, with only a few deals being confirmed, primarily from the Rus- Delivery guarantees from primary CER sellers sian Federation and Ukraine. As the health of the have proven very difficult to enforce (almost all offset market declined the volume of AAU deals projects have underdelivered and it is too costly increased, with the Czech Republic and Ukraine for financials and intermediaries to run after the as the major sources. guarantee). Thus, the practice of requesting such guarantees has lost traction. Instead, for the larger There is a growing sense among market players deals, buyers have sought risk mitigation through that the CDM market has reached a crossroads. "layering" (i.e., umbrella agreements that include We remain too far from an international agree- several potential projects at a single site and/or are ment, which is needed to provide long-term price managed by a single project proponent) and syn- signals, and we are coming too close to 2012, dication (i.e., two or more buyers share risk by when the certainty of offset demand disappears. splitting the assets to be generated by a project). Additionally, pessimism has grown regarding the likelihood that the U.S. and Australian emissions The few capitalized buyers that during the crisis markets will emerge anytime soon, while restric- remained in the market, Japanese firms included, tions in the import rules under Phase III of the EU relied on a spectrum of package solutions to fur- 38 seCtIon 4 Kyoto Flexibility Mechanisms ther dilute their carbon risk. Solutions included fears abound that the exit of purchasing a portion of a project's offsets and bro- kering the remaining offsets on a tentative basis, additional players will send supplying equipment, offering services and provid- strong signals to investors and ing finance which, alongside creative ERPA com- mercial terms based on a combination of different lead to a severe demobilization prices for firm volumes and options, allowed buy- of market infrastructure, as ers to purchase in China at "all-in" carbon condi- teams and expertise flee to tions below NDRC's floor price thresholds. other businesses. The vast majority of deals were contracted at fixed prices, which ranged from 8­10 for primary dramatic 62% decline vis-à-vis 2007). However, CERs (pCERs) in 2009. In addition, a few buy- as both supply and demand were similarly hit by ers that maintained origination activities during the economic downturn competition for the best H1'09 reportedly fetched good bargains by tak- assets kept prices from falling as much as volumes. ing advantage of the lack of competition and the Prices averaged US$12.7 per ton (9.1), a still rel- desperation of some sellers. evant 21% decline compared to the US$16.1 av- erage in 2008. Summing both impacts, the total Many buyers exited the market, while some inves- value of the primary CDM market in 2009 fell to tors, such as pension funds, expressed interest in US$2.7 billion, 59% less than the US$6.5 billion entering, yet refrained from doing so due to the transacted in 2008. poor visibility in the offset market. There were, however, a couple of courageous large entrants Buyers often found it prohibitively difficult to ar- that sought to diversify their activity at the mar- range deals in developing regions: the South East gin of their energy and commodity activities. Asian market was extremely competitive, the In- dian market was too commercially aggressive and Fears abound that the exit of additional players dealing with the Latin American market was too will send strong signals to investors and lead to time-consuming. Thus, for many players China a severe demobilization of market infrastructure, remained the most viable large-scale seller, main- as teams and expertise flee to other businesses.74 taining its overall dominance with a 72% share In the future, decisions to rebuild shredded infra- of the market (Figure 11). Nevertheless, China's structure and reengage in the market will likely market share did decline from 2008. require much more certainty and time than they did a few years ago, when the business environ- ment was upbeat. ...the total value of the primary 4.2.2 Who, how and what in 2009? Cdm market in 2009 fell to uS$2.7 billion, 59% less than All-in, 211 million tons were contracted on the primary CDM market in 2009, a significant 48% the uS$6.5 billion transacted in decline from 2008 volume (and an even more 2008. 74 HSBC has measured the return of global climate-related investments through its Global Climate Change Index, designed to track and reflect the stock market performance of companies it believes are best placed to profit from a changing climate. Based on the return of those investments since September 2009 and more specifically, due to the poor behavior of the stocks classified as Carbon Trading-related in the same period, in March 2010, the Institution informed that "Carbon Trading no longer meets the minimum market capitalization criteria [of US$400 million] for inclusion in the HSBC Climate Change Index". HSBC, Climate Change ­ March 2010 quarterly index review: Carbon Trading loses out post-Copenhagen, March 16, 2010. 39 State and Trends of the Carbon Market 2010 fIgure 11 2002­09 2009 600 Primary CDM sellers75 Primary CDM annual volumes transacted Source: World Bank 500 India, 2% R. of Asia, 5% 400 Africa, 7% (MtCO2e) China 300 Other & 72% Unsp., 2% 200 Central Asia, 5% 100 Brazil, 3% R. of Latin America, 4% 0 2002 2003 2004 2005 2006 2007 2008 2009 Other & Unsp. Africa Latin America R. of Asia China With the exhaustion of the low-hanging-fruit buyers were forced to choose from the best of the projects in early-mover regions and the difficult remaining sectors. Renewable energy and energy business environment in others, regions that pre- efficiency sectors gained market share, with 43% viously had been largely bypassed by the scheme and 23%, respectively (clean energy thus account- saw their long-term efforts begin to pay off. Africa ed for two-thirds of 2009's primary market), al- and Central Asia doubled their market shares in though volumes declined (Figure 12). 2009 to 7% (15 million tons) and 5% (10 million tons), respectively. With an eye on the EU ETS, private sector buy- ers purchased the largest portion of both CDM Preferred seller sectors (i.e., the sectors with the and JI projects (Figure 13), which totaled 237 largest volumes under contract) were, indeed, the million tons in 2009.76 Given the fact that most sectors that did not manage to secure all their sales financial players in the ETS operate in the United previously. With the low-hanging fruit, namely Kingdom, regardless of their actual nationality, industrial gases, quickly becoming exhausted, the country appears to be the largest buyer with fIgure 12 2002­09 2009 Primary CDM 600 sectors77 Other, 4% Primary CDM annual volumes transacted 500 N2O, 3% Source: World Bank Hydro, 20% CMM and other 400 fugitive, 16% (MtCO2e) 300 LFG and other Wind 200 waste mg't, 11% 16% 100 Agro-forestry Biomass 1% energy, 6% 0 EE+Fuel s. Other Renewables 2002 2003 2004 2005 2006 2007 2008 2009 23% 0% Other & Unsp. LFG + waste EE+Fuel s. Renewables Industrial gas 75 Based on volumes purchased through 2012. 76 One single utility firm in Europe reportedly holds over 15% of all (about 400 million tons) issued CERs. 77 Based on volumes purchased through 2012. 40 seCtIon 4 Kyoto Flexibility Mechanisms 2002­09 2009 fIgure 13 600 Primary CDM & JI Netherlands Annual volume of CDM&JI transactions Germany, & other Europe buyers78 500 Sweden & other 22% Baltic Sea, Source: World Bank Other & 400 20% Unsp., 1% (MtCO2e) 300 Japan 13% Spain, 200 Portugal & Italy, 7% 100 0 2002 2003 2004 2005 2006 2007 2008 2009 UK, 37% Other & Unsp. UK Netherlands & Germany, Sweden other Europe & other Baltic Sea Spain, Portugal Japan & Italy a nearly 40% share of volumes purchased. How- The monthly average number of new CDM proj- ever, in reality those assets pass on to end users ects increased consistently from 2005 to 2008, throughout Europe. reaching an average of 116 per month during the first 10 months of 2008 (see Figure 14).81 From 4.2.3 Projects wanted that high, however, the number subsequently fell by 10% through February 2010.82 Figure 14 As already discussed, the flow of private capi- shows the reduced flow of new CDM projects tal to developing regions began to fall substan- into the pipeline. The high level of uncertainty re- tially in the second half of 2008. Capital inflow garding a post-2012 framework, CDM eligibility reached US$1.16 trillion in 2007 only to fall restrictions in ETS Phase III, long delays and high sharply by 39% to US$707 billion in 2008. Pri- vate capital is estimated to have fallen another 200 fIgure 14 49% to US$360 billion in 2009 (a 222% de- 180 Number of projects crease from 2007 to 2009).79 A cascade effect ap- entering the CDM 160 pipeline each month, plies at a country level to investments in riskier 140 Jan. 04­Feb. 10 Number of Days sectors, which include underlying CDM and JI 120 Source: UNEP Risoe and sustainable energy projects (for further informa- 100 World Bank tion, see Section 4.3).80 80 60 Uncertainty over the future demand for carbon 40 and the lack of access to finance has resulted in a 20 considerable reduction in the number of CDM -- projects entering the pipeline. Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 78 Based on volumes purchased through 2012. Purchases by the World Bank-managed family of funds have been attrib- uted to the fund participants' countries at a pro rata basis. "Netherlands & other Europe" includes Ireland, France, Swit- zerland, Austria, and Greece; "Germany, Sweden & Baltic Sea" also includes Finland, Norway, Denmark, and Iceland; "Others" includes the United States, Canada, Australia, and New Zealand; "Unsp[ecified]" refers to purchases where we could not verify the origin of the buyer. 79 World Bank, 2009, Global Development Finance. 80 When access to capital becomes limited riskier sectors traditionally suffer the most. Data show that the share of those resources directed towards developing regions has historically been less than a third of total investment (UNEP, SEFI, New Energy Finance, 2009). 81 The monthly average number of new projects increased from 36 in 2005, to 53 in 2006, to 90 in 2007. 82 UNEP Risoe, CDM/JI Pipeline Analysis and Database, March 1, 2010. 41 State and Trends of the Carbon Market 2010 fIgure 15 700 that chronically impact projects, while it underes- Average time (days) timates the substantial impact of operational con- necessary for 600 straints after registration (e.g., financial closure, projects to reach 500 project commissioning and operations). registration Number of Days Source: UNEP Risoe and 400 World Bank While in 2007 the average project needed 316 300 days to move from registration to first issuance, 200 that time lengthened to 505 days in 2008 and to 607 days in 2009, for a total increase of 92% over 100 two years (Figure 16).83 ­ Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 During the same period, the time required for projects to reach registration rose significant- fIgure 16 800 ly less, from 373 days in 2007 to 572 days in Average time (days) 2009,84 an increase of 53%. Figure 15 shows the 700 necessary for average time needed to develop a project from projects to move 600 from registration to start to registration and from registration to is- 500 Number of Days first issuance suance. 400 Source: UNEP Risoe and World Bank 300 200 4.3 ThE RELEVANCE Of CARBON fINANCE IN ThE TRANSITION TO A 100 LOW-CARBON ECONOMy ­ Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 The Clean Development Mechanism has been an important catalyst of low-carbon invest- transaction costs have clearly contributed to the ment in developing countries. By complement- decline in the number of projects. ing and leveraging other resources, it catalyzed the shift of much larger amounts of (essentially 4.2.4 A close-up on issuance time private) financial and investment flows toward climate-smart development. During 2002­08, When evaluating delays in the asset creation pro- about 1.9 billion CERs worth US$23 billion cess, the most common type of analysis looks at were contracted forward from projects that, if all the time needed to develop a project from its ear- implemented, would require US$106 billion in liest stages up to issuance. low-carbon investment, primarily in clean energy (see Figure 17).85 In comparison, sustainable en- However, this practice can mask some important ergy investment in developing countries totaled findings. It overemphasizes the regulatory delays approximately US$80­90 billion over the same 83 The analysis could also be impacted if the number of projects from different technologies issuing CERs would have dramatically changed over the years (i.e., as the issuance time can vary per technology, notably large projects that may request issuance more than once per year). Thus, to avoid misinterpreting the data, the authors confirmed that the pro- portion of first issuance requests per technology has not significantly changed, thus not impacting the confidence of the analysis. 84 The time does not include the time required to develop the PDDs, which varies according to the nature of projects and can reach several months depending on the availability of consultants. 85 More generally it is estimated that active projects that entered the CDM pipeline during 2002­09 could represent, should they all materialize, an investment of more than US$150 billion (two-thirds of which is in renewable energy, equally led by hydro- and wind power). Source: UNEP Risoe, CDM/JI Pipeline Analysis and Database, March 1, 2010. 42 seCtIon 4 Kyoto Flexibility Mechanisms period.86 Additional revenues from carbon finance fIgure 17 HFC 0.02 Ratio of investment enhance the overall financial viability of low-car- bon projects. As performance-based payments, to net present value EE Households 0.76 of ERPA in the World these revenues create a positive incentive for good Bank CDM portfolio91 management and operational practices that will LFG 1.04 Source: World Bank. sustain emission reductions over time. Other waste Mg't 3.84 4.3.1 Investment barriers can be LULUCF 6.95 disproportionately large87 Biomass energy 12.22 Despite these impressive numbers, most develop- ing countries face significant investment barriers Wind 11.60 that limit the transformational impact of carbon Hydro 16.47 finance. Consequently, where investment barriers have been relatively low CDM projects have been most successful. reached US$36.6 billion, or 31% of the US$118.9 Securing sources of funding--both equity and billion in global investment in the sector. Africa debt finance--sufficient to meet investment capi- received less than 1% of these resources.90 In the tal needs has proven to be a major constraint in ad- same year, Brazil accounted for 88% of the total vancing most CDM projects. Long-term finance investment in South America, while China and from local financial institutions is inadequate and India jointly accounted for 80% of investment often costly. Even for qualified entrepreneurs, the in Asia and Oceania. The strong concentration high cost and stringent commercial conditions88 of investment in the wealthiest nations within of loans frequently do not match project needs developing regions confirms the presence of dis- and often become unsustainable. Access to in- proportionately high and skewed barriers faced by ternational funding is an even greater challenge, the poorest countries. Unsurprisingly, the uneven particularly for the poorest countries where risky geographic distribution of CDM mirrors these in- business environments and economic instability vestment patterns, albeit on a much smaller scale. discourage private sector investment. 4.3.2 CDM cannot overcome all In addition to the overall investment barriers faced investment barriers by all businesses, capital-intensive investments with modest Internal Rates of Return (IRRs) and Carbon revenue streams are based on the volume of long pay-back periods, as well as sectors exposed credits generated, the length of the purchase agree- to currency risk89 such as clean energy, face even ment and the carbon price. However, the impact of greater financing constraints. In 2008, investment carbon finance is not the same across the spectrum in sustainable energy in developing countries of technologies. In some sectors, the CDM contri- 86 Source: after UNEP, SEFI, New Energy Finance, Global Trends in Sustainable Energy Investment 2009. Estimates of clean energy investments that benefit from CDM tend to be higher than actual sustainable energy investment in develop- ing countries since many CDM projects are neither operational, nor commissioned nor even at financial closure when CERs are transacted. 87 Source: Kossoy, 2010, Managing Expectations, Trading Carbon, February 2010, Point Carbon 88 Including high interest rates and fees, short tenors, strong guarantee and collateral requirements, and stringent cov- enants. 89 Sectors that produce and sell goods in domestic markets and/or are unlinked to hard currencies. 90 Source: UNEP, SEFI, New Energy Finance, Global Trends in Sustainable Energy Investment 2009. 91 The nominal value of the ERPA is discounted at 10% per year, assuming all future payments occur in a period of five years. 43 State and Trends of the Carbon Market 2010 bution to an underlying project's cash flow can be Bank's projects as an example, is quite low (see constrained by external factors beyond its control, Figure 18).93 Thus, as very few renewable energy ranging from policies and regulations to operations. projects have IRRs higher than 10­11% without carbon, an incremental IRR of 1­2% from car- For example, in the case of clean energy projects bon would be insufficient to promote a technol- the volume of credits can be particularly low in ogy switch since fossil-fuel alternatives would, in countries with clean energy grids. Additionally, most cases, still compare favorably on a cost basis. the length of purchase agreements has been largely In the same portfolio of projects, the net present constrained by uncertainties related to the extent value of the future carbon revenue streams to- and design of any future regime. Finally, carbon taled 6.3% of the capital expenditures (CAPEX), pricing signals are, once again, linked to the level which is substantial in many countries since it of ambition from policy makers92 and delivery represents almost half of the initial 15% in equity risk (e.g., lower prices for new technologies and commonly needed by project developers before less commercially attractive projects). Thus, low securing the remaining 85%. But carbon revenue volumes, short contracts and low prices prevent does little to help secure financial closure in the carbon from substantially improving the econom- poorest countries, where unfavorable business en- ics of clean technologies. vironments make it much more difficult to bridge funding gaps. The incremental IRR from future carbon revenues in renewable energy projects, taking the World 4.3.3 frontloading future carbon revenues remains a challenge fIgure 18 IRR - Carbon Revenues Carbon finance does not naturally address capital Incremental IRR from Purchase period carbon revenues in ER Prices investment needs as payment for credits usually 5y 10y the World Bank CDM occurs on delivery, once the project is opera- portfolio Renewable Energy Impact per Unit tional. Although there have been some advance $10.0 1.0% 1.7% $ 6.3/MWh payments in the market (10­20% of the nominal Source: World Bank. $20.0 2.2% 3.6% $ 12.7/MWh ERPA value), financial institutions have made few Solid Waste attempts to monetize ERPA receivables. The first 0.58 tCO2e/tSW 0.93 tCO2e/tSW monetization was reported in 2001,94 although it $10.0 52.3% 62.4% $20.0 123.7% 128.6% has rarely been replicated because of the relatively *tSW = ton solid waste high inherent risk in underlying projects, carbon HFC23 finance regulatory risks, and chronic market un- $10.0 176.7% 177.4% certainties. Although carbon prices have increased $20.0 270.0% 270.2% three- or four-fold since the early 2000s, ERPA *65% tax applied on carbon revenues tenors have shortened up to 6 fold in the same 92 Major industrialized economies should be encouraged to increase the scope for offsets to achieve at lower costs more ambitious emission reduction targets, in line with the 25­40% reductions below 1990 levels that have been called for by the IPCC in the 2020 timeframe. 93 Source: World Bank. Sensitivity analysis scenarios were based on the projections of the projects' cash flows in the World Bank's carbon funds. Only the investments leading to GHG emission reductions were considered. 94 Source: Kossoy, 2006, The Role of Carbon Finance in Project Development. In the structure, Rabobank financed a pig- iron project in Brazil (Plantar). The nominal value of the ERPA contract between the World Bank (as trustee of the Pro- totype Carbon Fund) and the project sponsors (Plantar) was monetized and anticipated by Rabobank Brazil to Plantar (i.e., the latter was both the recipient of the loan provided by Rabobank and the seller of the emission reductions to the World Bank). The loan was structured to mirror the proceeds of the ERPA contract between the project developer and the World Bank. The hard-currency denominated proceeds of the ERPA (carbon offsets) and the loan's repayment to be made directly by the Word Bank (outside Brazil) allowed Rabobank to significantly reduce the capital reserves in the transaction and revert the benefit to the borrower, providing longer-term funding at below-market terms. 44 seCtIon 4 Kyoto Flexibility Mechanisms period, reducing the overall value of ERPA con- commercially unattractive low-carbon tech- tracts for monetization purposes. 95 nologies and the development of new ones; (iv) use financial engineering to frontload fu- 4.3.4 Leveraging carbon finance ture demand: accelerate the transition to low-carbon investments (e.g., the issuance of All said, carbon revenues have not altered histori- bonds and monetization of future receivables); cal macro-economic development trends or over- (v) wisely combine (blend) limited financial re- come the sectoral and regional investment barriers sources: maximize the impact of investments faced by underlying projects. Carbon revenues related to climate change (e.g., the Global have instead made relatively low-risk investments Environment Facility, the to-be-implement- in proven technologies with marginal rates of re- ed Copenhagen Green Climate Fund, the turn more attractive and profitable, enhancing Climate Investment Funds, revenues from their chances of being developed and remaining project-based emission offsets, etc.) and foster operational. additional private sector investment. A number of actions can help maximize the transformational impact of carbon finance and 4.4 POST-2012 MARKET: "EU ETS mobilize both climate and development finance. CERs" SURGE AS A NEW ASSET In tackling the most prominent constraints and supporting low-carbon development at scale, the A glimpse of good news came in 2009 as the post- following actions can ultimately make carbon fi- 2012 market finally emerged, although it remains nance better fit into public and private sector in- thin. A small number of firm deals materialized vestment decision-making: that went beyond the right of first refusal clauses seen in the ERPAs signed through 2008.96 Indian (i) scale up: expand the demand side of the mar- sellers, who historically have opted for unilateral ket by implementing more stringent emis- asset creation in their pre-2012 vintages, report- sion reduction targets, and build a credible edly started selling forward their post-2012 CERs. supply at scale by adopting a programmatic While most contracts were reportedly signed for a approach and moving toward large-scale sec- few years only (usually no longer than the end of toral and policy-based mechanisms; the projects' first crediting period), a handful of (ii) provide long-term predictability: enable deals extended until the end of the third phase of lengthier contracts and provide long-term the EU ETS in 2020. pricing signals; (iii) develop comprehensive insurance/guar- Nevertheless, prices and commercial conditions antee products: underwrite political risks reflected the lack of post-2012 clarity and refer- inherent in international negotiations and ences. A spectrum of pricing formulas emerged, collective international actions, as well as the ranging from fully fixed to fully variable, as buyers contract-frustration risk at country and sec- and sellers tested numerous trade strategies and tor levels. The combined efforts of multilater- accommodated varying risk profiles. Post-2012 al development banks, international financial assets were contracted at a 2­3 discount over institutions and insurers/re-insurers might be pre-2012 assets. Fixed prices generally ranged required to create a sustainable business envi- from 6­8, although in a limited number of cases ronment, enable the deployment of existing prices ranged as low as 4, or as high as 9. 95 ERPA lengths in the primary CDM market have shortened with the proximity to the end of the Kyoto's first commit- ment period in 2012. 96 Right of first refusal refers to the buyers' right to purchase vintages under contract at their own discretion. 45 State and Trends of the Carbon Market 2010 Ironically, the economic downturn begun to include broader eligibility clauses in their contracts in preparation for potential future car- and delays in Cer issuance that have bon regulation in the United States and Australia. hindered the project-based market 4.4.1 A silver lining may ultimately end up being good news for post-2012 demand. Ironically, the economic downturn and delays in CER issuance that have hindered the project- based market may ultimately end up being good Variable pricing formulas were also seen, which news for post-2012 demand. These factors will normally established a fixed floor price and shared lead EU installations to use fewer CERs and upside between buyers and sellers. In most con- ERUs than the 1,400 MtCO2e limit during Phase tracts, future prices will be determined by the pre- II of the ETS. Thus, as long as the price of off- vailing BlueNext spot CER prices or ECX front sets remains lower than that of EUAs, the short contract prices at the time of delivery with a cer- Phase III, combined with the increased limit for tain discount based on a project's stage of devel- offsets, should encourage EU installations to ex- opment at the ERPA signature. Discounts ranged haust their import limits and thus sustain some from 20% to 30% for projects at the validation demand. Under this scenario sound upcoming stage, and from 10% to 20% for projects at the projects and programs, primarily in emerging re- back of validation or at registration. Only sporad- gions and sectors, will probably be able to trans- ic links to EUAs (i.e., pCER prices equivalent to act their assets. Competition for eligible primary about 60% of the EUA prices) have been reported. CERs should also prevent their prices from falling in the coming years. Given current restrictions on the import of offsets into Phase III of the EU ETS (please refer to Sec- tion 2.6.1 for further details) and the uncertainty 4.5 SCALING UP WITh surrounding the eligibility of certain sectors and PROGRAMMES Of ACTIVITIES countries, EU installations have sought contrac- tual clauses that exempt them from purchasing Strategically aggregated programs could become the assets at delivery if those assets prove ineligible good vehicles to scale up mitigation efforts. Suc- under the European Scheme, thereby passing eli- cessful approaches will include a combination of gibility risk to the seller. Buyers perceive eligibility policy-based and technological interventions, and risk as particularly relevant to projects in the most will require capacity building to assess opportuni- industrialized economies and in non-Annex I ties and develop necessary infrastructure. OECD countries (i.e., Brazil, South Africa, India, and China--aka BASIC, Mexico, and South Ko- 4.5.1 Evolution of PoAs rea)97 as well as to projects that involve industrial gases. The practices of layering and syndicating The concept of Programmes of Activities (PoAs) deals, and of purchasing and/or brokering project was developed in response to calls to simplify assets on a tentative basis, have also been used to project preparation and registration procedures mitigate post-2012 ETS eligibility risk. and expand the scale of CDM project activities. The CDM EB launched its first call for public Although the EU ETS is more than ever the engine inputs on definition of policy and PoAs in May that drives primary offset deals, some buyers have 200698 and published the guidelines in July 97 Chile has been recently included in the group of OECD countries. 98 EB 28, Annex 15 99 EB 32, Annex 38 and 39 46 seCtIon 4 Kyoto Flexibility Mechanisms 2007.99 The first set of guidance on PoA proce- Simplification of methodological requirements dures raised several regulatory, methodological and assessment of additionality would have the and program design issues and resulted in seri- strongest impact on the ability of stakeholders ous concerns that PoAs would be dead on arrival. to develop and implement PoAs. It is too early In response, through a public input process, the to derive lessons from the implementation of the PoA rules were comprehensively revised in May CDM programmatic approach. It is clear, howev- 2009. While the new procedures address the ma- er, that programmes, even within the same sector jority of the barriers to development of PoAs, a and using the same technology, are very differ- few key issues such as the liability clause contin- ent as they need to be modified to suit country ue to linger. specific circumstances, the capacity and mandate of the coordinating entity, and the appropriate 4.5.2 Status and analysis incentive mechanism. In early discussions, programmatic CDM was Practitioners need to move from a narrow ap- perceived primarily as a tool for promoting proach that measures each ton of GHG emission CDM in less-developed regions, in particular reductions to a holistic approach that estimates, for widely dispersed micro-scale activities and with appropriate justification and confidence, the for demand-side energy efficiency or renewable total GHG impact of a PoA. This will encour- energy activities. This was reflected in the fact age the involvement of more stakeholders and that a majority of the PoAs developed in the first support the scaling-up of sector, sub-sector, and year focused on distribution of cook-stoves, ef- system-wide emission reduction efforts. ficient light-bulbs, biogas plants, and solar water heaters. Supply-side activities were fewer and further between, with two large-scale hydro- 4.6 MOVING AhEAD WITh CDM power PoAs and three PoAs to improve energy efficiency in distribution systems. The trans- Complex and evolving regulations, regulatory port sector will receive a significant boost from inefficiencies, and capacity bottlenecks have the programmatic approach, however complex caused delays that have a negative financial im- methodologies, multipart institutions, and pact on projects. It now takes an average of 572 modest emission reduction volumes continue days for a CDM project to go through valida- to limit the development of PoAs in this sector. tion and registration and another 607 days until Forestry is another sector that lends itself well to first issuance (i.e., over three years in total). De- this approach. However, issues similar to those lays and uncertainties lead to higher transaction in the transport sector continue to hinder the costs, declining CER volumes, and lower market development of PoAs. As of March 24, 2010, 42 values. These issues penalize LDCs in particular PoAs were published on the UNFCCC website, by making it harder for them to access the car- out of which 3 were registered and the remain- bon market and threaten to erode project spon- ing were in validation. sors' interest in carbon finance mechanisms over the long term. 4.5.3 And finally Market players have not yet agreed on how to ad- The programmatic approach could enable scal- dress the major constraints in the CDM market. ing up of mitigation efforts. However, this scale- We provide two different views on this topic in up would continue to depend on regulatory Box 7. As the international community works on signals and the ability of the CDM EB and the effective and practical solutions to mitigate GHGs DOEs to assess and ensure environmental integ- on a large scale, it is imperative that it makes full rity without requiring excessive cost and effort. use of accumulated experience, knowledge, and 47 State and Trends of the Carbon Market 2010 box 7 Two points of view on CDM reform kindly provided by Lex de Jonge of the netherlands' ministry of environment, who is closely involved in the Cdm regulatory process, and by Imtiaz ahmad of morgan Stanley. 1 Lex de Jonge, head of CDM Unit, Netherlands' Ministry of Environment the Cdm has developed over time into a massive success, much now this number has increased to over 600 requests per year, bigger than expected at the time it was conceived. over 2,000 thereby causing delays to increase. the Board is working hard projects have been registered and an equivalent number or more to implement the CoP15 improvements, but if the volume of the are still in the pipeline. the flip side of this success has now also inflow remains at the current high level it may take some time to come to the surface: a multitude of delays in registration and is- reduce the delays. suance, in many cases starting with insufficient quality Pdds, fol- even more important, this experience shows that the actual lowed by does not catching all irregularities, which has resulted system with all its (unfortunately necessary) checks and balances in a relatively high number of requests for reviews and reviews. will never be able to cope with a volume of 1,000­2,000 yearly add to all of this an over-burdened (because it is under- project submissions for registration in a post-2012 regime, irre- staffed) support system, the unfCCC Secretariat, and it is clear spective of whether this would be under the kyoto or another why many Cdm participants have asked for reforms. regime. It is not an option for the executive Board to be "easy" on It seems obvious that we will need new approaches to ad- the irregularities and low quality Pdds, since this would set un- dress such volumes. the options here are standardized baselines controllable precedents. and a more standardized assessment of additionality, which to a In recent years several measures have been taken to im- certain extent could only be efficient if applied on a larger scale prove here: the development and release of the vvm (validation than the actual project-by-project assessment required by the and verification manual), a new set of criteria and procedures kyoto rules. to accredit does, new procedures which recognize that projects Since mid 2009 the Cdm has faced some other challenges compared to their Pdd may change over time, and the introduc- as well, which many have referred to as "the Chinese wind proj- tion of an enhanced completeness check, meant to catch irregu- ects". Let me emphasize that, though the entire discussion start- larities even before submission of Pdds for registration, there- ed with projects in China, the fundamental issues have nothing to by reducing the number of requests for review. and the Board do with this country. those who would accuse the Cdm executive started to transparently present its compliance with self-imposed Board of discriminating against China are totally wrong. the real timelines, clearly showing that the volume of requests for regis- difficulty here is that at eB22 the Board adopted rules on how to tration, issuance, clarifications, revisions and deviations is only deal with policies which existed before the adoption of the kyoto further increasing, which--apart from the frequently poor qual- Protocol (e+ policy) and after the adoption of the marrakech ac- ity of submitted Pdds--is one of the reasons for the increasing cords (e- policy); the basic philosophy here is that "low carbon delays. policies" adopted after november 2001 are not held against Cdm In addition the CoP15 in Copenhagen instructed the Board to project developers. however, it has been unclear how to interpret further streamline--and where possible shorten--its procedures changes in e- policies and in tariffs; this was simply not envis- and to introduce the possibility of appeals. aged at eB22. Some even say a decrease in a tariff for renew- the initial results of the improvements are promising, as re- ables can be considered providing a comparative advantage for quests for review (registration) have been reduced from 70% to carbon intensive power production, which makes this change an 60%. But much remains to be further improved here, bearing in e+ policy. Since the project developers and the does were not mind that it is never acceptable to compromise the environmen- able to explain and quantitatively substantiate how to interpret tal integrity of the Cdm. these tariff changes the problem is not yet resolved. as said, this Since 2006 the Cdm regulatory system has been able to pro- is not about China. the Board has received signals about pres- cess 500 requests for registration per year. during 2009 up to sure in other major economies to modify the tariffs, which could 1though Lex de Jonge was Chair of the Cdm executive Board during 2009 and is still a member now, the opinion in this article does not necessarily reflect the views of all Board members. 48 seCtIon 4 Kyoto Flexibility Mechanisms Two points of view on CDM reform (continued) box 7 strongly affect the eligibility of power projects under the Cdm. odology. Set the benchmark high, by all means, but ensure that Perhaps ultimately here the way out could be a much broader ap- it is clear and prescriptive in terms of eligibility for successful proach than the project-by-project assessment only. We will learn registration. Such a benchmark should be stable for a set period in the time to come. of time and then maybe the eB could review the benchmark after the predetermined timeline has expired, provide for the sake of Imtiaz Ahmad, Executive Director, Morgan Stanley argument a six month grace period for projects applying for reg- istration using the same benchmark standard for registration and the Cdm has been successful in enabling the initial flow of capi- then, using the same methodology, determine for future projects tal into abatement projects around the world, and in creating a whether or not the standard needs to be set higher or lower given new mechanism that has led to the actual generation of emis- existing experience. sion reduction credits. the challenges facing the Cdm now relate the alternative of the current system is ambiguity and un- to scaling up the system, post-2012 uncertainty and regulatory certainty, none of which bodes well for making the case in favor continuity. of the deployment of new investment into Cdm projects. Private sector investors in abatement projects require reg- additional constraints in the system have related to the fact ulatory certainty. regulatory flux is not something that private that the eu etS may potentially introduce qualitative restrictions sector investors are well equipped to deal with. If a given method- post 2012, pending the specific outcome of international negotia- ology has been successfully deployed in a particular host country tions and also the question mark of a new international agree- and investors witness these projects successfully obtaining regis- ment and whether, if such an agreement were achieved, it would tration and generating credits then naturally this leads to others continue the Cdm. seeking to emulate the existing projects. this has been the case these uncertainties have led to an ongoing reduction in new with wind projects in China over the last 4 years. for investors project activity as it takes around 2 years to get a new early stage to suddenly find out that these projects have been successfully project from Project Idea note/feasibility study stage to a regis- registered and implemented over a number of years yet now face tered project, and then additional time before Cers actually get additional scrutiny and barriers creates regulatory uncertainty. generated and issued. a stable and predictable regulatory framework for the Cdm Given the timelines entailed this means that we are already mechanism is essential if additional private sector capital is to be approaching a wall in terms of investing in and sponsoring new deployed into abatement projects. the risk where this unravels projects. is that investors question not only additional investments into there is scope for the eu to announce what types of projects the Chinese wind sector but also ask about other sectors within and geographies it would definitely allow (a positive list of Cdm) China and ask a next step question whether such barriers may be in the event of a unilateral scenario where no international agree- introduced in the future for investments in other geographical lo- ment is reached, even if at this stage the eu does not wish to cations. the net effect of this is to reduce the deployment of new produce the list of project methodologies and geographies that capital into Cdm projects, in particular in the renewable energy would be disallowed by the eu pending a unilateral scenario. a sector at a time when power demand in parts of the developing clear indication of at least a base case positive list would allow in- world has been growing rapidly and, consequently, so have emis- vestors to know what they can deploy capital into with certainty. sions from the underlying power sector. In addition, whilst I am in favor of Cdm being reformed and Investors do recognize the need for environmental integrity succeeding, at the same time it is important that politicians and and we do not wish to engage in projects that are not in line with regulators give due consideration to new mechanisms that can the intent and rules of the system. however the rules need to access established capital markets such, as bonds, and link them provide clear and unambiguous direction as to what is and is not with carbon financing to enable the scaling up of financing made allowable. It may well be that the eB should adopt a benchmark- available and deployed into clean technology and GhG abate- ing type system of approving projects using a particular meth- ment post 2012. 49 State and Trends of the Carbon Market 2010 the solution to current might have to wait until early 2011 before the first issuance occurs. challenges will certainly require a comprehensive approach in order The primary JI market transacted 26.5 million tons in 2009, slightly more than the 25.2 mil- to gain broad acceptance from lion tons transacted in 2008. ERU average prices all actors who have a stake in the fell by 8% to US$13.4 per ton, leading JI market success of the Cdm market. value to decline to US$354 million from US$367 million in 2008. In 2009, ERUs traded at a capacity.100 The solution to current challenges will 1­1.5 discount to CERs. However, our analy- certainly require a comprehensive approach in or- sis found that a larger percentage of ERUs were der to gain broad acceptance from all actors who traded at the tail end of the registration process, have a stake in the success of the CDM market. pulling average prices closer to the spot market and distorting asset-to-asset price comparisons. 4.7 JI: A MARKET MOVED By ONE So far, track two accounts for about 60% of the AUCTION AND ONE TENDER 368 visible projects102 in the JI pipeline103,104 and for 80% of ERU volume expected by 2012. Climex held a pilot ERU transaction of one thou- However, only 16 track two projects have been sand tons on September 30, 2009.101 On January registered so far, a disappointing completion rate 8, 2010 BlueNext held its first ERU auction, sell- of less than 10%. In comparison, there are 142 ing 400,000 tCO2e that came from three projects: registered track one projects, almost 10 times the two in Ukraine that involved coal-mine methane number in track two. capture and the modernization of a steel mill, and one project in Hungary that mitigates landfill gas. In light of this situation, buyers, who used to sup- The offsets represented almost 10% of all ERUs port projects that would be approved under the issued at the time and were sold at 11.21 per ton UN process to ensure environmental integrity,105 (i.e., 0.19 lower than the prevailing spot CER have reportedly redirected their priorities towards price of 11.40). delivery and are now much more inclined to accept ERUs from track one (Ukraine, which has proven However, the biggest JI news was the Russian ten- its ability to issue LoAs, is a favored source). This der for project developers that was organized by is of particular relevance for EU compliance buy- state-owned Sberbank on February 17, 2010. The ers who rely on having their JI projects registered tender, which was opened to energy, industrial and ERUs issued before December 2012 due to processes, agriculture, forestry, and waste projects the EU ETS eligibility restrictions (please refer to only, was limited to 30 million ERUs. Yet it re- Section 2.6.1 for details). So far, 12 projects have ceived 44 project proposals for 75 million ERUs formally switched from track two to one, with by the time it closed on March 12. The winners seven of these projects located in Ukraine.106 100 The World Bank is contributing to this effort by leveraging ten years of practical experience with carbon markets to provide insights and recommendations. Bosi et al., 2010, Ten years of experience in carbon finance: Insights from working with Kyoto mechanisms, World Bank, Washington, DC. 101 According to Climex, the ERUs were transacted at a price of 11.95 each. 102 We also understand that projects following the track one route will not necessarily become visible until approval from the host country is provided. 103 http://ji.unfccc.int/JI_Projects/ProjectInfo.html (as of April 22, 2010) 104 There are 33 track two projects that appear as withdrawn in the UNFCCC website. Those projects were kept in the overall count however, as most represented projects moving from track two to track one. 105 Determination from the JI Supervisory Committee (Jisc). 106 http://www.iges.or.jp/en/cdm/report_cdm.html#ji 50 seCtIon 4 Kyoto Flexibility Mechanisms 4.8 AAUs: SOME GAINS AS OffSETS In 2009 Ukraine developed an innovative climate SOUR finance structure that uses the country's largely untapped AAU reserves as collateral in JI projects AAUs, which many players used to view primar- established by state-owned Naftogaz. The proj- ily as a means to fill the gaps created by delays in ects aim to cut emissions of methane by patching the delivery of CERs and ERUs, enjoyed a cap- holes in Ukraine's leaky gas networks. U.S.-based tive market in 2009. Several countries made sig- project developers agreed to perform the repairs nificant progress in implementing GIS schemes, on the condition that 20 million AAUs would be thus attracting governments and Japanese com- provided as collateral. Upon ERU delivery, AAUs panies that sought sizeable and predictable vol- are returned to the Ukrainian account.109 Ques- umes at attractive prices (see Box 8).107 The AAU tions remain regarding the Ukrainian government market grew seven-fold to US$2.0 billion (1.4 intention to extend the scheme to other local billion) on 155 million tons transacted, primar- projects seeking underlying finance as a tool to ily through purchases by Japan from the Czech entice investors. Republic and Ukraine.108 While AAU transaction volumes increased substantially, CER and ERU Similar schemes could be leveraged to ensure volumes simultaneously declined sharply, thus the development of many more environmentally corroborating the direct competition between sound GIS programs. Existing climate-funding those assets. resources could be used to finance GIS projects prior to the sale of the AAUs that would ultimate- The increased demand somehow helped to sus- ly back them up. Proceeds from the future sale of tain prices. While a few deals that lacked clear AAUs would be used to replenish the resources evidence of an attached GIS plan were confirmed used for the implementation of new projects or at prices between 8­9 per ton, most deals were to support the long-term viability of established reportedly signed at 10. Following Copenhagen, ones. These structures should ultimately attract and in light of the possibility that AAUs will no additional buyers who fear reputational backfire longer be acceptable for international trade be- for their goodwill compliance actions. yond 2012, prices have declined. 107 Although there have been rumors that Japanese firms have explored arbitrage opportunities between previously ac- quired CERs and cheaper AAUs (with soft or no GIS plans attached), this practice seems unlikely to the authors. Dis- regarding reputational reasons, the fall in residual demand should discourage buyers from seeking lower prices to the detriment of environmental standards. 108 The figures include one secondary transaction of 15 million tons, purchased by Japanese utilities from Slovakia. 109 http://www.pointcarbon.com/news/1.1298854 51 State and Trends of the Carbon Market 2010 box 8 GIS lessons learned and prospects for new mechanisms post 2012 In countries such as Latvia, the Czech republic, and Poland Good implementation and governance arrangements the first batches of projects are being tendered, while in other · It is essential to appoint as GIS operators strong and autono- countries implementation of GIS has faced delays or has been mous institutions with experience in project finance; 1 plagued with difficulties including alleged misuse of proceeds. · GIS can serve as a platform to integrate, combine and lever- however, successful transactions demonstrated that GIS be- age funds from a variety of sources: dedicated public bud- came a practical modality to strengthen the environmental gets such as environmental and energy efficiency funds, integrity of aau trading. Still, a longer history is required to resources from international financial institutions and addi- fully assess merits of GIS. experience so far shows that three tional financial resources from the private sector; elements are crucial for a successful GIS: · the proceeds from the sale of aaus provide upfront payment for the implementation of GIS and can leverage investments Good contracts more effectively than other carbon finance mechanisms; · aau Purchase agreements (aauPas) should specify and · the participation of aau buyers in designing GIS (e.g., tech- allocate greening obligations, mrv requirements, define nical assistance, governance) may facilitate the delivery of eligible projects and their selection procedures, and specify credibly greened aaus; what to do if greening defaults occurs (including sanctions). · Critical elements of a successful GIS include: project design, It should include the timeframes within which the aau pro- transparent management, accounting and disbursement pro- ceeds must be used for the agreed greening activities and cedures for aau proceeds (escrow accounts, treasury budget intermediate milestones, which should be covenanted and accounts, special fund accounts, etc.), financial products that monitored. use public resources appropriately and do not distort markets, and procedures for monitoring, reporting, and verification Good projects (mrv) of both environmental outcomes and financial flows. · aauPa should include criteria for the eligible greening pro- grams to reach sectors that are not covered by the eu etS or though emerging, experience with GIS could provide in- have transaction costs that are too high for JI; sights for scaling up of mechanisms and other mitigation ef- · GIS provides sponsors that are not familiar with carbon fi- forts in the post-2012 era. for example, GIS experience may be nance with a good model for the design and implementation useful for the realization of nationally appropriate mitigation of programmatic approaches for small projects; actions (namas) in terms of structuring priorities and project · the projects should contribute to the decarbonization of pipelines, benchmarking, sectoral and programmatic approach- an economy, but be cost-effective and quickly imple- es, mrv practices and financial structuring (e.g. fundraising, mentable. developing blended grant-loan financial products, fund alloca- tion, and traceability of the fund flows). 1 In april 2010, Japan filed a complaint with ukraine over the missing money it paid for the purchase of 30 million aaus in 2009. although ukraine had pledged to invest the revenues in environmentally friendly projects, its recently elected president accused the previous administration of misus- ing the proceeds from the transaction and said the money has gone missing (Point Carbon, april 27, 2010). 52 5 SeCtIon outLook 5.1 DEMAND AND SUPPLy BALANCE Recent economic turmoil has led to a substantial decline in compliance needs over 2008­12 and a reduction in overall market activity. At the same time, the lack of long-term signals from regulators and policy makers has denied market players long-sought visibility, causing them to be more conservative. 5.1.1 Government demand for Kyoto take into account the full impact of the global assets falls... financial and economic crisis, compliance needs could be further eased.112 EU-15 governments have With emissions projections revised downward, announced their intention to use about 465 Mt- the likely gross demand for Kyoto assets from CO2e under the KMs over 2008­12, with Spain industrialized Annex B governments has been and Italy accounting for about half of these pur- adjusted to 475 MtCO2e through 2012, a chases, although total need could ultimately fall decrease of 95 million tons from last year's to 330­370 MtCO2e.113 These governments have estimate. EU-15 remains the chief source of de- already contracted about 240 MtCO2e CERs and mand, accounting for more than 70% of volume ERUs (nominal) and 40 million AAUs. (see Table 4). The EU is currently halfway to reaching its uni- In 2008, EU-15 GHG emissions (excluding LU- lateral target of reducing emissions by 20% below LUCF) continued to decline, totaling approxi- 1990 levels in 2020. The implementation of ad- mately 3.98 billion tons (or 6.7% below the base ditional planned measures could lower emissions year).110 EU-15 members (and the EU as a whole) to 14% below 1990 levels by 2020 while further now expect to collectively meet, and possibly over- measures, including flexibility mechanisms, will achieve their Kyoto target. This outcome will rely be required to bridge the remaining gap. However, on full implementation of all existing and addi- in light of the great uncertainty surrounding a fu- tional policies and measures, particularly in sectors ture climate regime, sovereign buyers have made not included in the EU ETS, and on the use of fewer post-2012 purchases than could be expected the Kyoto Mechanisms (KMs) and carbon sinks from their likely demand over 2013­2020, which as planned.111 As emissions projections do not yet would be around 100 MtCO2e per year. 110 Source: UNFCCC, National Inventory Submissions 2010. 111 Source: European Environment Agency, 2009, Greenhouse gas emission trends and projections in Europe 2009: Tracking progress towards Kyoto targets. 112 Following 2009 projections reported by the European Environment Agency, about one-third of EU-15 countries could comply with their commitments under the EU Burden sharing agreement on the sole basis of existing policies and measures, while the remaining two-thirds could be short by about 700 million tons. Revised emissions projections now suggest that around half of EU-15 Member States could meet their target on the sole basis of existing policies and measures while the other half is short by about 540 million tons. 113 Depending on actual emissions levels and performance of policies and measures as well as removals by carbon sinks. 55 State and Trends of the Carbon Market 2010 fIgure 19 5,690 Shortfalls shrinking and length Potential gap (2008­12) Potential surplus (2008­12) building-up114 in MtCO2e in MtCO2e (with existing measures) (with existing measures) Spain, Italy, and other EU-15 includes: Austria, Denmark, Ireland, Italy, Demand for KMs Green Investment Scheme Luxemburg, the Nether- ~ 1,222 MtCO2e > 1,800 MtCO2e lands, Portugal, and Spain. Other Europe and New 2,576 Zealand includes: Iceland, 2,230 Lichtenstein, Monaco, New Zealand, Norway, and Switzerland. United Kingdom, Germany 1,030 923 893 and other EU-15 includes: 536 Belgium, Finland, France, 413 75 195 128 148 Germany, Greece, Sweden, and the United Kingdom. Canada Spain, Japan other CDM JI Belarus, Australia UK, EU-10 Ukraine Russia Italy and Europe Croatia Germany and other EU-15 and N.Z. other EU-15 GHG emissions in Japan dropped by 6.4% in CO2e. This is lower than announced in procure- 2008 to 1,282 MtCO2e (slightly below 1990 lev- ment plans as actual need may prove to be less els) as the country was among the hardest hit by than anticipated. the global economic downturn.115 Contracting energy demand, primarily from industry, was the · Updated projections from H2'09 confirm that main cause of declining emissions. While eco- Australia should succeed in bridging its Kyoto nomic recovery is picking up and should further gap solely through domestic policy and mea- solidify next year, Japan nevertheless appears to be sures, in particular due to significant contri- on track to comply with its Kyoto commitment, butions from LULUCF activities.116 Australia factoring in the use of KMs by both public and pri- would meet its goal even without accounting for vate entities (see Section 5.1.2) and the promotion lower emissions due to slower economic growth. of carbon sinks that will remove about 50 MtCO2e · New Zealand's position under the Kyoto Pro- per year. At the end of March 2009, Japan's govern- tocol has improved vis a vis last year's estimates. ment announced that it had so far purchased 96 The country now has an excess of about 11.4 MtCO2e under the KMs, for the most part AAUs, MtCO2e over 2008­12, which is primarily at- nearing its 100 MtCO2e public procurement goal. tributable to lower emissions from agriculture and increased carbon removal by forests.117 Public demand under the KMs in other Annex B · With the EU ETS a major instrument, Nor- countries should remain limited to about 25 Mt- way is well on the way to meeting its Kyoto 114 Net positions under the existing measures scenario; does not include the effect of additional policies and measures, removals by carbon sinks and use of KMs. Projections based on Fifth National Communications, adjusted for revised economic outlook. Emissions projections have been revised using GDP forecasts by EC (European Economic Forecast - autumn 2009), World Bank (Global Economic Prospects 2010: Crisis, Finance, and Growth), and IMF (World Economic Outlook Update, January 2010) and assume an elasticity of emissions to GDP of 0.55 (average over 2005­08). 115 Source: UNFCCC, National Inventory Submissions 2010. Japan's economic output contracted by 1.2% in 2008 and further by 5.2% in 2009. Source: National Accounts of Japan at www.esri.cao.go.jp/en/sna. 116 See: Department of Climate Change and Energy Efficiency (2009). Tracking to Kyoto and 2020: Australia's Greenhouse Emissions Trends 1990 to 2008­2012 and 2020. 117 See: New Zealand's net position under the Kyoto Protocol (updated: April 15, 2010). http://www.mfe.govt.nz/issues/ climate/greenhouse-gas-emissions/net-position/index.html. 56 seCtIon 5 Outlook Potential Demand from table 4 Industrialized Countries (mtCo2e) Supply and demand Potential Supplies Country or entity Kyoto assets demand (mtCo2e) in perspective -- 1 Kyoto market EU 890 Potential GIS >1,800 balance, 2008­12 Government (eu-15) 350 russian federation 100 Private sector (eu etS) 540 ukraine 400­500 Japan 300 eastern eu 1,325 Government of Japan 100 Japanese private sector 200 Rest of Annex B 32 CDM & JI 1,225 range: 1,155­1,290 Government 25 Cdm 1,030 975­1,085 Private sector 7 JI 195 180­205 TOTAL 1,222 Government 475 Private sector 747 1 These numbers correspond to the amounts of AAUs governments intend to sell (adapted from A. Tuerk et al., 2010, Green Investment Schemes: First experiences and lessons learned. Working Paper, Joanneum Research, Austria). They are much lower than the whole amount of excess AAUs, now estimated at more than 10 billion tCO2e over the first commitment period, with Russia accounting for half, Ukraine one-quarter, and Poland one-fifth. target. In line with its long-term commitment The EU ETS is now expected to be long over to carbon neutrality (which includes an over- Phase II, with an overall surplus on the order of achievement of its Kyoto target), Norway plans 970 million tons to be banked, either in the form to acquire about 27 MtCO2e under the KMs of allowances or unused offsets. This banking for use over 2008­12, of which about 12 Mt- will ease the compliance challenges of installa- CO2e had been contracted by the end of 2009. tions during Phase III, although internal abate- This could be more than enough to cover any ment efforts complemented by offsets will also liability under the Kyoto Protocol. be required. · Switzerland intends to take delivery of 10 Mt- CO2e from CDM and JI projects. However, the Emissions from EU ETS installations dropped by country will contract for slightly more than 12 more than 11% year-to-year in 2009 following MtCO2e to account for delivery risk. The Cli- the most severe contraction in industrial output in mate Cent Foundation, which is funded by a recent times. Although recovery has started, emis- CHF1.5 cent per liter levy on gasoline and die- sions will likely remain below the cap until the sel imports, has been extremely active in the end of Phase II. Analysts estimate that this could market and has already sourced 11.5 MtCO2e.118 lead to an average overall surplus of 300 million EUAs over 2008­12, comprising the unused por- 5.1.2 ...and so does private sector tion of the new entrant reserve and other reserves, compliance demand as well as excess allowances from industry. How- ever, some installations, primarily utilities, are Demand from private entities is now estimated still short on allowances. They face an estimated at 750 MtCO2e, down 30% from last year. The compliance gap of 660 MtCO2e over 2008­12 to greatest drop has come from EU ETS operators be filled by allowances and offsets, depending on (see Table 5). availability and price.119 Additional demand could 118 Not all may be ultimately required to comply with the 8% below 1990 level target of Switzerland under the Kyoto Protocol. 119 Source: Deutsche Bank. The Generation Gap: How Many Phase-3 EUAs Are Needed by 2012?, March 25, 2010. 57 State and Trends of the Carbon Market 2010 table 5 Analyst expectations Projections for Phase II Projections for Phase III (20% target) for the EU ETS position position through 2020 (+ short/ sCER (+short/ sCER ­long) CDM/JI banking price EUA price ­long) CDM/JI price EUA price (mtCo2e) (mtCo2e) (mtCo2e) (/tCo2e) (/tCo2e) (mtCo2e) (mtCo2e) (/tCo2e) (/tCo2e) Barclays ­410 400 810 12­18 13.5­24 2,116 1,000­ 20 35 1,400 Deutsche ­225 750 975 n.a. 25 1,878 871 n.a. 48 Bank * Orbeo ­312 837 1,004 15.9 18.8 2,829 916 n.a. 30.1 net of expected reductions from CCS and energy efficiency policies. by 2012. * of which 472 million will be surrendered, including 145 million to cover compliance shortfall. come from generators that start to hedge their Private sector companies in Japan have reportedly future exposure in Phase III, when they will face contracted more than 300 MtCO2e in CERs, tighter caps and increased auctioning. ERUs, and AAUs that can be surrendered to com- ply with their targets under the Keidanren Vol- European private sector entities, which have so far untary Action Plan, a voluntary commitment by contracted about 1.5 billion tCO2e (nominal), can 34 industrial sectors to stabilize CO2 emissions decide to bank unused CERs and ERUs or surren- from energy production and use.121 Among the der them and bank more EUAs to Phase III. The main end-users, electric power companies have strategy that EU ETS operators choose will likely announced purchases of 250 MtCO2e (of which depend on the relative prices and availability of 64 MtCO2e were redeemed at the end of FY08) these assets, and on how quickly the uncertainty while iron and steel companies have contracted lifts over the rules that will govern the use of off- about 56 MtCO2e. Overall, the private sector has sets beyond 2012. Estimates of CDM and JI de- purchased an estimated 54 million AAUs. No mand over Phase II now range from 400 to 750 major additional contracting activity is expect- MtCO2e and average 540 MtCO2e, of which com- ed from private companies, since the economic pliance needs may represent only a fraction.120 This downturn has significantly reduced their compli- is much lower than the current supplementarity ance challenge (with demand revised downward limit of about 1,400 million tons in Phase II and to 200 MtCO2e) and legislation for a mandatory keeps intact a large portion of the supplementarity post-2012 ETS is at an early stage. However, a limit in effect over 2008­2020, estimated at 1,700 stronger than expected recovery, coupled with million tons. Although some banking of unused a lower utilization rate of nuclear power plants, offsets will likely occur, this still leaves substantial could very quickly pull generators back to the car- future demand to be contracted. bon market. 120 Société Générale estimates that only one-third of the 472 million CERs and ERUs surrendered by operators during Phase II corresponded to compliance needs. Of that third, 82 million tons were surrendered for compliance in 2008. Source: Société Générale. Kyoto CO2 market: increasing AAU length, decreasing market power of AAU sellers, April 13, 2010. 121 Reuters News, Japan Steelmakers buy 3 million fewer CERs than expected in 2008­12, November 17, 2009. 122 In operation since 2008, the Swiss ETS covers those installations (around 350+) that took a binding commitment to reduce their emissions in lieu of paying a CO2 tax on emissions from the use of fossil fuel. The tax is initially set at CHF12 (US$11 or 8) and could ramp up depending on emissions levels. In the event of non-compliance, the CO2 tax is to be paid retroactively for each ton of CO2 emitted since exemption was granted. To comply, installations can internally reduce emissions, trade allowances freely issued to them or acquire CERs or ERUs. So far the Swiss ETS has seen limited activity. 58 seCtIon 5 Outlook Exploratory demand from installations covered projects in Russia should soon be issued through by the incipient NZ ETS, the Swiss ETS,122 and a tender process, which includes only 30 million other initiatives under development, such as Aus- tons. All in all, analysts project that 180­205 mil- tralia's CPRS, might reach 5­10 MtCO2e over lion ERUs (average 195 million ERUs) will be 2008­12, depending on price levels and visibility issued through 2012. beyond 2012.123 With buyers seeking sizeable and predictable vol- 5.1.3 Supply through the three Kyoto umes at attractive prices, the AAU market grew mechanisms: CDM & JI down, AAU up more than seven-fold in 2009 to US$2.0 billion (1.5 billion) on 155 MtCO2e transacted. Several In recent years analysts have steadily revised countries have made significant progress in imple- downward their projections for CER supply, menting Green Investment Schemes (GIS), and which now range from 0.97 to 1.09 billion CERs the potential has grown to 1,800 million AAUs issued by 2012, or 1 .03 billion CERs on aver- (50% of the total comes from Ukraine and Po- age.124 Multiple factors have pushed supply down, land), which is much larger than the anticipated including the smaller size of recent projects, re- demand. Uncertainties regarding the bankability duced output from projects impacted by lower of AAUs, which could play a decisive role in de- economic activity, growing delays along the proj- termining the commitment ambition of Parties ect cycle resulting from capacity bottlenecks and under a future international climate change agree- procedural inefficiencies, the increasing difficulty ment, are likely to further reinforce this imbal- in securing finance, and the lack of clarity on the ance and negatively impact market dynamics. post-2012 front. Many of these factors lowered the expected flow of new projects into the CDM 5.1.4 A residual demand of 230 million pipeline and discouraged new investment. Delays tons and uncertainties lead to higher transaction costs, losses in CER volumes, and lower market values, Expected gross use of KMs now stands at 1.22 potentially eroding the interest of project spon- billion tCO2e over 2008­12, with approximately sors for project-based mechanisms over the long 61% of demand coming from the private sector. term. This is a 25% (410 million tons) decrease from last year's estimate, matched by a similar 30% (440 JI has begun to deliver as an increasing number million tons) decline in the forecasts for pre-2013 of projects have been determined and reached CER and ERU supply, which coincidently now issuance. Over the past year the number of de- stands at the same 1.22 billion tCO2e level (al- termined projects has more than tripled to 114, ready adjusted for delivery risk). Although most while the total number of issued ERUs now Kyoto asset demand could be met in principle stands at 5.4 million, versus just 651,000 at the through CERs and to a lesser extent ERUs, AAUs end of April 2009. Importantly, regulatory and will be needed to address the remaining shortfall, institutional uncertainties are also being resolved which could widen if deliveries from CDM and JI in Russia, which has one of the largest JI poten- are lower than anticipated, if the performance of tials and represents a significant share of JI supply domestic policies and measures disappoints, or if under contract. The first letters of approval for economic recovery is stronger than expected. 123 For instance, with a price cap at NZ$12.5 (approx. US$9 or 7) through 2012, NZ ETS installations today have only a limited appetite for CDM. 124 Source: Barclays Capital. Monthly Carbon Standard, April 20, 2010: 1.09 billion CERs and 200 million ERUs over 2008­12; Société Générale. Kyoto CO2 market: increasing AAU length, decreasing market power of AAU sellers, April 13, 2010: 974 million CERs and 205 million ERUs over 2008­12; UNEP Risoe CDM/JI Pipeline Analysis and Database, March 2009: 1.04 billion CERs and 180 million ERUs over 2008­12. 59 State and Trends of the Carbon Market 2010 table 6 Contracted CERs and ERUs Potential demand, Potential adjusted for Residual contracted supply demand nominal performance AAUs demand and residual demand, (mtCo2e) (mtCo2e) (mtCo2e) (mtCo2e) (mtCo2e) 2008­12 EU 890 1,736 829 38 198 Government (eu-15) 350 238 114 38 193 Private sector (eu-etS) 540 1,498 715 0 0 (­175) Japan 300 372 177 125 12 Government of Japan 100 34 16 72 12 Japanese private sector 200 338 161 54 0 (­15) Rest of Annex B 32 25 12 0 20 Government 25 22 10 0 15 Private sector 7 3 1 0 6 Total 1,222 2,133 1,018 163 231 Government 475 294 140 110 225 Private sector 747 1,839 878 54 6 Note: Numbers may not add up due to rounding. A portion of the purchases attributed to the European private sector relates to portfolios of intermediaries that are available for secondary transactions. In addition to the volumes reported above, about 173 million tons (nominal) are contracted but not attributed, and are very likely in the hands of intermediaries. They could represent about 83 million tons also available for secondary transactions, with public or private entities. About 2.17 billion CERs have been contracted of intermediaries (about 300 million), govern- over 2002­09 for pre-2013 delivery. We assume ments may also wish to secure some volumes that all 2012 volumes from registered projects through secondary transactions, with the advan- (nominal PDD values: 1.76 billion CERs) have tage of being able to choose the type of projects been transacted by now125 while the remainder (or generating them as is already the case under a 400 million CERs) comes from projects at vali- number of procurement programs. The price and dation or registration, transacted more recently. quality of assets will likely determine their com- Registered projects are expected to deliver about pliance strategy. Some EU governments and EU one billion CERs pre-2013, a 57% delivery rate, ETS companies are already sourcing assets be- while projects still at validation or registration yond 2012. However, with a lack of traction on have an anticipated delivery rate of 2%. This leads the post-2012 front, origination activity could to an overall delivery factor for CDM of 47%. remain limited as growth in the pipeline of proj- For JI, we directly apply the delivery rate from the ects continues to slow. UNEP Risoe pipeline, coincidentally also 47%.126 All together, that leaves an estimated residual de- mand of 230 MtCO2e of Kyoto assets over the 5.2 MARKETS AND A POST-2012 next three years, virtually all from European gov- INTERNATIONAL REGIME ernments (see Table 6). Kindly provided by John Kilani, Director of the Sus- CDM projects contracted in the next few years tainable Development Mechanisms programme in will be unlikely to deliver large volumes be- the UNFCCC secretariat. fore 2013, and thus governments may have to purchase AAUs to cover their residual Kyoto While the UN Climate Change Conference in shortfalls and underdelivery of CDM and JI. Al- Copenhagen last December achieved much less ternatively, as a number of CERs are in the hands than was hoped, its accomplishments on markets 125 This comes to consider that un-contracted supply from unilateral projects will eventually reach the market. This vol- ume is also accounted for in the analysis. 126 UNEP Risoe CDM/JI Pipeline Analysis and Database, March 2009. 60 seCtIon 5 Outlook should not be dismissed. Copenhagen set down The negotiations on further commitments for an ambitious work plan for the CDM, clarified Annex I Parties under the Kyoto Protocol (AWG- options for scaling up the use of markets after KP) have generally undertaken to keep CDM, 2012 and injected the Copenhagen Accord into JI and emissions trading going in the future, the debate on the use of markets. yet such references depend on agreement being reached on the legal form for capturing emission CDM reform was high on the agenda, as demon- commitments beyond 2012. In resolving this strated by the annual report given by the CDM larger issue, governments will also need to decide EB to the conference and the decision taken on other mechanisms issues on the table: should there on the CDM. Together, these documents the CDM make more use of standardized base- establish a comprehensive work plan of strategic lines; can co-benefits be made to count for more reforms aiming to improve the efficiency of the when deciding on projects; should CCS, nuclear CDM process while maintaining its quality. or other forestry activities be allowable? Key expectations include streamlining proj- Under the broad-ranging negotiations on long- ect procedures, allowing for appeals against the term cooperative action under the Convention Board's rulings on projects, consolidating the (AWG-LCA), the topic of markets has largely Board's guidance, strengthening DOE perfor- been left hanging while political focus has been mance, enhancing the objectivity of project base- directed to other issues that need to be resolved lines, and instituting loans for developing projects first. In particular, these issues have included in countries under-represented in the CDM. emission reduction commitments and the public These reforms complement well our own work to finance to be provided to developing countries. strengthen the secretariat's support of the Board and the CDM as a whole. What appears to be emerging is a recognition that the private sector cannot be neglected in any new On wider issues in Copenhagen, as is well known, international agreement that might be formulated. the conference showed a diversity of political Market mechanisms can have a role in shifting pri- interests in how an overarching climate regime vate sector investments and other decisions from a should look in the future. In the end, there was browner path to a greener one. They can also make more clarity on how various elements can be a substantial contribution to the delivery of sup- brought together and the conference extended port--finance, technology, and capacity-build- the mandate of the negotiating groups to present ing--from developed to developing countries. their results to the next climate conference in De- cember this year in Cancún, Mexico. Several specific ideas have been raised. The best known seek to complement the CDM by estab- The specific role to be played by the market still lishing other market mechanisms that focus on needs clarifying. Those Parties rallying behind the larger scale, "aggregated" sources of emissions, "Copenhagen Accord" have declared their intent such as crediting and trading approaches that tar- to pursue opportunities to use markets to enhance get entire sectors of economies. Controversy re- cost-effective mitigation actions and have also mains however on how much developed countries confirmed that private sources will contribute to should use credits generated by such instruments the long-term financing goal of US$100 billion to offset their own domestic emissions. per year for developing countries. 2010 is a crucial year for the UN's market mecha- Though these references may reflect an emerging nisms, both for the CDM EB in implementing consensus on markets, they are set against difficult an ambitious reform agenda and for governments discussions in the UNFCCC negotiating groups on in overcoming the negotiating impasse to build the specific issue of markets over the last two years. on today's engagement of the private sector in cli- 61 State and Trends of the Carbon Market 2010 mate action. Above all, the market needs certainty in their negotiations, recognition is growing that on its long-term direction in order to scale up its they must form an integral part of the interna- contribution. While markets are just one aspect tional climate solution. of the complex balance sought by governments 62 annex ISuPPLementarIty under the eu CLImate and enerGy PaCkaGe In accordance with the supplementarity principles enshrined in the Kyo- to Protocol (i.e., "the acquisition of emission reduction units shall be supplemental to domestic actions for the purposes of meeting commit- ments..."), the total import volume of credits in the EU ETS 20-20-20 127 scheme should equal 50% of the "reduction effort" over 2008­20, which corresponds to the difference between 2005 emissions and the caps in Phase II and Phase III, respectively. For existing installations, the volume of credits period (i.e., a total of 1,550 MtCO2e), versus the from projects allowed in ETS Phases II and III 1,400 MtCO2e limit during 2008­12. combined will be equivalent to the greater of the volume of CERs and ERUs allowed during Phase For new entrants and sectors, during Phase III the II, or a specific percentage of Phase II allocation allowed volume of CERs and ERUs will be at least that will not be less than 11%. Operators with a 4.5% (each) of annual verified emissions. CER limit higher than 11% in Phase II will keep the and ERU volumes for the aviation sector will rep- higher limit (e.g., Spain, Italy, etc). In addition, a resent 1.5% of annual verified emissions.128 All to- higher limit is provided to operators classified as gether, these three categories could create demand "most short in Phase II" (i.e., the entities with the for another 150 MtCO2e worth of credits over lowest ratio between their allocation and 2005­ Phase III (about 50 MtCO2e each). The Com- 07 emissions). This category includes entities such mission will determine the exact volume ceiling as power plants in Germany and the United King- through a consultation process ("Comitology") 129 dom that have a smaller provision for offsets and by the middle of 2010. already face auctioning. Using information in- cluded in National Allocation Plans for Phase II, In summary, total demand for credits during this change could result in 150 MtCO2e of addi- 2008­20 should total 1,700 MtCO2 e, 130 based on tional credits being allowed during the 2012­20 the Phase II 1,400 MtCO2 e limit, an additional 127 http://unfccc.int/resource/docs/convkp/kpeng.html (Article 6.1 d) 128 Over 3,000 operators will automatically become involved in the EU ETS from 2012 onwards. Operators had to start monitoring emissions from January 1, 2010. The current year's figures will define how many emissions rights each company will receive from the total number of certificates allocated to the sector, which is being forecast to account for around 10% of the entire ETS. 129 Comitology is a simplified decision-making procedure within the EU. Decisions are taken by the Climate Change Committee, consisting of the European Commission and Member States officials. The European Parliament is consulted in the process. Point Carbon Use of CERs/ERUs in Phase 3: Questions and Answers, March 19, 2010. 130 This number corresponds to an average supplementarity limit of about 6% or less than half of the average supple- mentarity limit of Phase II, which average 13.4% of allocation or about 280 MtCO2e per year (1,400 million tons/5-y). 63 State and Trends of the Carbon Market 2010 150 MtCO2e from existing entities during Phase the limit is raised to 4% of 2005 emissions for III, and 50 MtCO2 e each from new sectors, new credits generated from certain projects, with ad- entrants and aviation during Phase III.131 ditional restrictions.133 On average, this translates into a maximum demand of 700­800 MtCO2e Member States must also comply with the "ef- over 2013­20 (about 90­100 MtCO2e annually). fort sharing decision", which sets individual This is roughly comparable to the most recent es- targets for sectors not included in the EU ETS timates of annual demand for Kyoto assets from (non-trading sectors). The annual credit limit EU-15 governments under the burden-sharing for Member States is equal to 3% of 2005 emis- agreement. sions. In 12 of the member countries,132 however, 131 According to Deutsche Bank (Carbon Emissions: Chapter & Verse: EU-ETS Rules for CER/ERU Use Beyond Co- penhagen, November 16, 2009), the supplementary quotas will likely add 250­500 MtCO2e, leading to a total CER/ ERU demand of 1,640­1,890 MtCO2e from ETS installations in the 27 EU Member States over 2008­20. 132 Austria, Finland, Denmark, Italy, Spain, Belgium, Luxembourg, Portugal, Ireland, Slovenia, Cyprus, and Sweden. 133 Allowed credits can be sourced only in LDCs and Small Island States and are neither bankable nor transferable. 64 annex II auStraLIa'S dIvISIve CPrS134 Australia's CPRS legislation, which has been in the making for two years, has reached an impasse that appears likely to carry on for some time: plans for emissions trading in Australia have been recently postponed by the government to 2013. Following a year of planning, draft legislation was Copenhagen's mixed success in prompting inter- introduced in March 2009 that initially aimed to national action. start Australia's ETS on July 1, 2010. A number of changes were announced in May 2009 to ac- As an interim measure to an effective emissions commodate concerns related to recovery from the trading scheme the Green Party proposed levying global economic downturn. The changes included a tax on carbon beginning this July, one year ahead delaying by one year the start of the CPRS to July of the scheduled start of the CPRS. Carbon would 1, 2011, setting a fixed price of AU$10 (US$9, be taxed at AU$23 (US$21, 15) per tCO2e, twice 7) during the first year of operations and offer- the fixed price in the legislation. The tax would ing additional assistance to industry and power rise to AU$24 (US$22, 16) in mid 2011. generators, essentially by increasing the scope for free allocation. Despite these revisions the Senate Meanwhile, the opposition recently proposed twice rejected the legislation.135 a dramatically different approach that would involve the creation of a government fund that In February, following negotiations between the would stimulate voluntary domestic emissions government and opposition in late 2009,136 ETS reductions by targeting mitigation potential in legislation was introduced for the third time into soil carbon and renewable energy. Recent analysis Parliament (see Box 9), which included a num- questioned this approach's cost-effectiveness (as ber of additional amendments that focused on many low-cost abatement options could remain assistance to industry and households. The gov- untapped under a voluntary approach), certain- ernment, which championed the climate change ty (will activities deliver the expected volume of effort, lacks a majority in Parliament's upper abatement?) and scalability (how might the grant- house. At the same time, public support for cli- based approach trigger more significant changes mate change legislation is on the wane following once low-hanging fruit have been picked?). The 134 This section benefited from written contribution kindly provided by Rodney Boyd, IDEAcarbon. 135 Rudd's governing Labor Party holds a majority in the lower House of Representatives, which has so far passed the set of CPRS bills on three occasions without many difficulties. Conversely, in the Senate Labor is seven seats short of a ma- jority, and gaining those seven votes needed to pass legislation has proven challenging. Resistance to the CPRS originates from two parties who are ideologically opposed to each other. Members of the opposition National-Liberal coalition and the Greens are both prepared to vote against the CPRS but for very different reasons. The Coalition believes the CPRS does not sufficiently protect industry, and characterizes the CPRS as a `great big new tax'; the Greens say it does not do enough to make polluters pay. 136 On December 1, 2009, the leadership of the Liberal-National Party coalition was challenged and was handed from Malcolm Turnbull, who worked to negotiate these amendments with the Government, to Tony Abbott, a fierce oppo- nent to emissions trading. On December 2, 2009, the Senate voted against the CPRS Legislation for the second time. 65 State and Trends of the Carbon Market 2010 box 9 Main features of the proposed Carbon Pollution Reduction Scheme (CPRS)1 the CPrS differs from the eu etS in three major respects: it pro- australia's. following recent projections by australia, GhG emis- vides a much wider scope (including, in particular, fuels used for sions (including LuLuCf) would be about 20% above 2000 levels 2 energy production and transport), a gateway system (or range) to in 2020, implying that CPrS could well be short. Caps would be announce future caps and unlimited supplementarity. set five years in advance with proposed ranges (or gateways) up CPrS will have a comprehensive scope. the CPrS is expected to 10 years, an approach that would provide medium-term visibil- to regulate approximately 75% of australia's emissions (about 430 ity while preserving flexibility to adjust the level of effort in light mtCo2e today, from around 1,000 mandated installations). GhGs of scientific evidence, technological progress or international de- included under the kyoto Protocol from industrial processes, sta- velopments. tionary energy, transport (upstream point of obligation), waste and the majority of allowances will be auctioned, while there will fugitive emissions would be covered, but agricultural emissions be specific assistance provisions. assistance will be in the form of would be excluded. non-covered sources that count towards aus- free allocations for emissions-intensive trade-exposed Industries tralia's international commitment (i.e., reforestation, waste legacy) (eItes), the coal sector (mining operations) and coal-fired electrici- could opt-in through a baseline-and-credit mechanism (with aus- ty generators. about 70% of allowances would be auctioned at the tralia emissions units, aeus, issued) while others (e.g., soil carbon) outset of the scheme. the percentage would decrease to 55% as would be encouraged to access the voluntary carbon market. the proportion of allowances granted for free under assistance pro- the cap will be consistent with a mid-term commitment of visions is expected to increase. Proceeds from auctioning (about reducing GhG emissions by at least 5% below 2000 levels by au$16 billion over the first two years of the scheme, uS$15 or 11 2020. the long-term GhG reduction goal would be 60% below billion) would be spent domestically to assist households and busi- 2000 levels by 2050. australia would scale-up its 2020 target nesses to adjust to the scheme and to invest in the transition to a to 25% below 2000 levels pending an ambitious global agree- low-carbon economy. Primary measures would include direct as- ment (in line with stabilization at 450 ppm Co2e), or to 15% within sistance to households (au$50 billion over ten years) through tax the context of a global agreement under which major developing benefits or cash transfer, a Climate Change action fund (au$1.97 economies would commit to substantially restrain emissions and billion over seven years) that would target Small and medium en- advanced economies would adopt commitments comparable to terprises (Smes) or particularly impacted industries or regions, re- analysis concluded that the CPRS would better ited pre-compliance activity under the proposed address these three criteria.137 Similarly, the Stra- CPRS has become non-existent. A state initiative tegic Review of Australian Government Climate intended to end on the commencement of the Change Programs (Wilkins Review)138 empha- CPRS, the New South Wales GHG Reduction sized the "disappointing" experience with grant Scheme (NSW GGAS), will continue for at least programs to support GHG abatement via proj- for one more year. However, certificates under the ect-based mechanisms in Australia. The review NSW GGAS would not be eligible under a fed- highlighted difficulties in finding suitable proj- eral scheme. As a result, there has been a decline ects, issues with transaction and operational costs in the number of applications for accreditation and uncertainties regarding delivery. by abatement certificate providers. The supply of GGAS certificates has also tightened following With uncertainties mounting as to the future of the launch of the Energy Savings Scheme (ESS)139 a Federal ETS in Australia, the previously lim- in July. Ironically, this did not have much impact 137 Seb Henbest, 2010, "The Coalition offer sits alternative to the CPRS, but it needs to come up with something better and get the numbers right", Carbon Markets-Australia-Research Note, Bloomberg New Energy Finance. 138 Roger Wilkins AO, 2008, The Strategic Review of Australian Government Climate Change Programs (Wilkins Review), http://www.finance.gov.au/publications/strategic-reviews/docs/Introduction.pdf 139 The Energy Savings Scheme (ESS), launched July 1, 2009 and to continue until 2020, is intended to progressively stimulate energy efficiency and lead to a 4% decrease in electricity sales. It targets energy retailers as well as parties such as 66 annex 2 Australia's divisive CPRS Main features of the proposed Carbon Pollution Reduction Scheme (CPRS) (continued) box 9 search and development assistance to sectors such as agriculture, flation. the price cap would not exempt non-compliant entities and a Green Carbon fund for ecosystems adaptation. from paying a penalty and of making good on their shortfall. other eItes would receive a large share of the allowances need- cost control mechanisms would include unlimited banking, limited ed to cover their liability for free. the number of allowances borrowing (to 5% of liability using units from the following year) would be based on the carbon intensity of output (initially 66% and the unlimited use of international carbon units. or 94.5% of a 10% best practice carbon intensity benchmark, there would be unlimited imports of eligible international declining by 1.3% per year). Compensation to eItes would also units. eligibility would initially be restricted to kyoto units, includ- account for direct and indirect electricity and steam emissions ing Cers (except t/lCers), erus, and rmus. aaus would not be costs from carbon regulation. the assistance program could be included initially. other carbon units could be made eligible in the adapted later to reflect, among others, progress in reaching an in- context of linking with other schemes. So far however, the export ternational agreement or the existence of broadly similar carbon of CPrS allowances is not allowed. constraints internationally. the coal sector (mining) would also receive assistance during the first five years of the scheme, most- 1 as of early march 2010. for more information, see explanatory memo- ly through free allocations that would cover approximately 36% randum and for a recent analysis, o. Sartor, 2010, Climate Change Policy of the sector's annual liability. Coal-fired electricity generators in australia: towards a Cap-&-trade market for Greenhouse Gases, Climate report #19, CdC Climat research. would additionally receive assistance over ten years in the form 2 the cumulative shortfall from scheme inception to 2020 could range in- of free allowances (around 15% of annual liability), although this between 580­1,020 mtCo2e, depending on the national target. estimate assistance would be subject to a windfall review. assistance could obtained as the difference between CPrS caps and baseline emissions projections for regulated entities. assumptions on the caps schedule fol- be cut in half during 2018­2021 if windfall profits appear likely. low the announcement by the government that CPrS caps would be cal- during its first year, the CPrS would operate under a fixed culated as the difference between the indicative national trajectory and the emissions projections from sources not covered by the scheme. CPrS price of au$10 (uS$9 or 7). the measure would be equivalent shortfall could ultimately be lower depending on policies and measures to a carbon tax. full trading under the CPrS would commence in implemented in non-CPrS sectors (which, absent additional intervention, remain flat in the baseline scenario). Source for baseline emissions: track- 2012­13, with a transitional price cap in place for four years, start- ing to kyoto and 2020: australia's Greenhouse emissions trends 1990 to ing at au$40 (uS$37 or 27) and rising 5% per annum above in- 2008­2012 and 2020. on the NSW GGAS market because supply has estimated AU$151 million (US$117 million or nevertheless remained at a comfortable level. In 84 million), two-thirds of last year's value.140 fact, total market value has declined further to an electricity generators in NSW. Participants can meet their obligations by surrendering energy savings certificates (ESCs). There has been an automatic transition for energy efficient projects under the NSW GGAS--though some activities (e.g., CFL) may no longer be eligible. 140 These numbers correspond to movements of certificates in the registry. Futures contracts are thus not taken into ac- count, leading to a potential under-estimation of market activity. 67 methodoLoGy Monitoring the activity of the primary project market is a challenging task given the number of transactions and the diversity of participants. In ad- dition, prices and contract structures are confidential in an increasingly competitive market. The authors have surveyed major carbon-industry received a high level of cooperation from market publications141 and conducted interviews with a players, the authors were not able to obtain com- broad range of market players: analysts and intel- prehensive information for all reported transac- ligence providers, project developers and aggrega- tions. The authors are relatively confident that the tors, exchanges and trading platforms, financial database captures most transactions entered into institutions and brokers, regulators, managers of by governments and a representative proportion carbon purchasing funds and facilities, including of the activity of private sector buyers in the pri- public procurement programs and carbon portfo- mary market. In between the periodic reports in lios of companies facing compliance obligations. this series, the authors have occasionally become This report focuses on regulatory compliance; aware of unrecorded transactions from previous therefore its coverage of the voluntary market is years as well as of the cancelation or postpone- not exhaustive. The information on the volun- ment of previously recorded transactions. Adjust- tary market (including pre-compliance activity ments have been made in the database, explaining in North America) has been kindly provided by why data for former years may be slightly differ- Bloomberg New Energy Finance and Ecosystem ent from previous publications in this series. Marketplace. Data for transactions on the so-called secondary Only signed ERPAs are included in the project- CDM (& JI) market including spot transactions142 based transaction database and volumes are ac- and forward transactions with delivery guarantees counted for through 2012. Although the study from a creditworthy seller, were obtained from ex- 141 Including online sources such as Carbon Finance (www.carbon-financeonline.com), Joint Implementation Quarterly (www.jiqweb.org), PointCarbon (www.pointcarbon.com) as well as Bloomberg New Energy Finance (www.newenergy- finance.com), Carbon Positive (www.carbonpositive.net), CDC Climat Research (www.cdcclimat.com), the Climate_L list (www.iisd.ca), IDEAcarbon (www.ideacarbon.com), Ecosystem Marketplace (www.ecosystemmarketplace.com) or Thomson Reuters, the CDM, and JI pipeline databases and analyses maintained by UNEP Risoe and IGES and websites of market players (DNAs, DOEs, project developers and aggregators, exchanges and trading platforms, financial institu- tions and brokers, regulators, carbon purchasing funds and facilities, public procurement programs, companies facing compliance obligations). One should also mention other resources, such as reports prepared by financial institutions, including analyses by Barclays Capital, Deutsche Bank, and Société Générale, that have been made kindly available to the authors. 142 Some of these spot transactions relate to sales of issued CERs directly by project sponsors, either those who have cho- sen to develop their projects unilaterally or those who have been issued more CERs than they had sold through forward transactions. These spot transactions could be arguably considered to be primary transactions although commercial conditions including prices are aligned with the secondary market. It is not possible however to extract those from the broader secondary market activity. 69 State and Trends of the Carbon Market 2010 changes and trading platforms.143 This is also the puts, this coefficient is applied to volumes and case for transactions of EUAs and derivatives.144 values of spot and forward transactions to com- The authors have also obtained detailed informa- pute the entire value of the EUA and secondary tion on transactions conducted under CCX and CER markets. RGGI as well as aggregate information on trans- actions under the New South Wales Greenhouse In consultation with several market players, the Gas Reduction Scheme (NSW GGAS).145 With options market in this report was valued as total regard to AAU transactions, several sources have volumes times strike price, assuming that the bulk been used and cross-checked: public announce- of transactions are at-the-money options where ments, interviews with some buyers and sellers as the strike price is similar to prevailing market well as examination of Kyoto Parties' registries, prices. when possible. Prices and values are primarily expressed in nomi- To estimate the volume of "pure" bilateral trans- nal US$ per tCO2e, unless indicated otherwise.146 actions of EUAs and CERs (i.e., those deals that An average annual exchange of 1 = US$1.39 are not closed through brokers or exchanges--in- for 2009 was applied, unless data were available cluding cleared OTC), the authors surveyed sev- with a finer granularity, in which case an average eral market players. The answers vary depending exchange rate over the period considered (e.g., on respondents (financials or naturals), with an Q1'09, June 2009) is applied. The cut-off date for average of 15% of volumes transacted or cleared information is April 30, 2010. A ton (abbreviated through exchanges. Taking into account all in- as "t") refers to a metric ton (1,000 kg). 143 For 2009, such exchanges and trading platforms were: BlueNext, Climex, European Climate Exchange (ECX), Eu- ropean Energy Exchange (EEX), Green Exchange, London Energy Brokers Association (LEBA), Multi Commodity Exchange of India Ltd. (MCX), and Nord Pool. 144 Data on EUA transactions in 2009 (Spot, Futures and Options) were obtained from the following sources: BlueNext, Climex, Energy Exchange Austria (EXAA), European Climate Exchange (ECX), European Energy Exchange (EEX), Ital- ian Power Exchange (IPEX), Green Exchange, London Energy Brokers Association (LEBA), and Nord Pool. 145 For RGGI, source is Chicago Climate Futures Exchange (CCFE); for NSW GGAS, data come from registry (vol- umes) as well as Ecosystem Marketplace (prices). 146 Exchange rates from oanda.com 70 GLoSSary Accredited Independent Entity (AIE): Accredited bon constraints. In addition banking brings market independent entities (AIEs) are independent auditors continuity. Banking between Phase I and Phase II of that assess whether a potential project meets all the the EU ETS is not allowed but is allowed between eligibility requirements of the JI (determination) and Phase II and further Phases. Some restrictions on the whether the project has achieved greenhouse gas emis- amount of units that can be carried over may apply: sion reductions (verification). for instance, EUAs may be banked with no restriction while the amount of CERs that can be carried over by a Additionality: A project activity is additional if an- Kyoto Party is limited to 2.5% of the assigned amount thropogenic GHG emissions are lower than those that of each Party. would have occurred in the absence of the project ac- tivity. Baseline: The emission of greenhouse gases that would occur without the policy intervention or project activ- Afforestation: The process of establishing and growing ity under consideration. forests on bare or cultivated land, which has not been forested in recent history. Biomass Fuel: Combustible fuel composed of a bio- logical material, for example, wood or wood by-prod- Annex I (Parties): Annex I Parties include the indus- ucts, rice husks, or cow dung. trialized countries that were members of the OECD (Organisation for Economic Co-operation and De- California Global Warming Solution Act AB32 velopment) in 1992, plus countries with economies (AB32): The passage of Assembly Bill 32 (California in transition (the EIT Parties), including the Russian Global Warming Solution Act AB32) in August 2006 Federation, the Baltic States, and several Central and sets economy-wide GHG emissions targets as follows: Eastern European States. Bring down emissions to 1990 levels by 2020 (consid- ered to be at least a 25% reduction below business-as- Annex B (Parties): The 39 industrialized countries (in- usual) and to 80% of 1990 levels by 2050. Covering cluding the European Economic Community) listed about 85% of GHG emissions, a cap and trade scheme in Annex B to the Kyoto Protocol have committed to (still under design) would be a major instrument, along country-specific targets that collectively reduce their with renewable energy standards, energy efficiency GHG emissions by at least 5.2% below 1990 levels on standards for buildings and appliances as well as vehicle average over 2008­12. emissions standards. Assigned Amount Unit (AAU): Annex I Parties are is- Cap and trade: Cap and trade schemes set a desired sued AAUs up to the level of their assigned amount, maximum ceiling for emissions (or cap) and let the corresponding to the quantity of greenhouse gases they market determine the price for keeping emissions with- can release in accordance with the Kyoto Protocol (Art. in that cap. To comply with their emission targets at 3), during the first commitment period of that proto- least cost, regulated entities can either opt for internal col (2008­12). One AAU represents the right to emit abatement measures or acquire of allowances or emis- one metric ton of carbon dioxide equivalent. sion reductions in the carbon market, depending on the relative costs of these options. Backwardation: A downward sloping forward curve (i.e., the price of the future is less than the spot price of Carbon Asset: The potential of greenhouse gas emis- underlying commodity). Antonym: contango. sion reductions that a project is able to generate and sell. Banking or carry over: Compliance units under the various schemes to manage GHG emissions in exis- Carbon Finance: Resources provided to activities gen- tence may or may not be carried over from one com- erating (or expected to generate) greenhouse gas (or mitment period to the next. Banking may encourage carbon) emission reductions through the transaction of early action by mandated entities depending on their such emission reductions. current situation and their anticipations of future car- 71 State and Trends of the Carbon Market 2010 Carbon Dioxide Equivalent (CO2e): The universal for transactions involving registries of at least one EU unit of measurement used to indicate the global warm- Member State, such as the issuance, transfer, cancella- ing potential of each of the six greenhouse gases regu- tion, retirement, and banking of EUAs. lated under the Kyoto Protocol. Carbon dioxide--a naturally occurring gas that is a byproduct of burning Conference of Parties (COP): The supreme body of fossil fuels and biomass, land-use changes, and other the Convention. It currently meets once a year to re- industrial processes--is the reference gas against which view the Convention's progress. The word "conference" the other greenhouse gases are measured, using their is not used here in the sense of "meeting" but rather global warming potential. of "association," which explains the seemingly redun- dant expression "fourth session of the Conference of Certified Emission Reductions (CERs): A unit of the Parties." greenhouse gas emission reductions issued pursuant to the Clean Development Mechanism of the Kyoto Conference of the Parties serving as the Meeting of Protocol, and measured in metric tons of carbon di- the Parties (CMP): The Convention's supreme body is oxide equivalent. One CER represents a reduction in the COP, which serves as the meeting of the Parties to greenhouse gas emissions of one metric ton of carbon the Kyoto Protocol. The sessions of the COP and the dioxide equivalent. CMP are held during the same period to reduce costs and improve coordination between the Convention Chicago Climate Exchange (CCX): Members to the and the Protocol. Chicago Climate Exchange make a voluntary but le- gally binding commitment to reduce GHG emissions. Contango: A term used in the futures market to de- By the end of Phase I (December, 2006), all Members scribe an upward sloping forward curve (i.e., futures will have reduced direct emissions 4% below a base- prices are above spot prices). Antonym: backwardation. line period of 1998­2001. Phase II, which extends the CCX reduction program through 2010, will require all Crediting period: The crediting period is the duration Members to ultimately reduce GHG emissions 6% be- of time during which a registered, determined or ap- low baseline. Among the members are companies from proved project can generate emission reductions. For North America as well as municipalities or U.S. States CDM projects, the crediting period can be of either or Universities. As new regional initiatives began to seven years (renewable twice) or of ten years (non-re- take shape in the U.S., membership of the CCX grew newable). from 127 members in January 2006 to 237 members by the end of the year while new participants expressed Designated Focal Point (DFP): Parties participat- their interest in familiarizing themselves with emissions ing in the Joint Implementation (JI) mechanism are trading. required to nominate a Designated Focal Point (DFP) for approving projects. Clean Development Mechanism (CDM): The mech- anism provided by Article 12 of the Kyoto Protocol, Designated National Authority (DNA): An office, designed to assist developing countries in achieving ministry, or other official entity appointed by a Party sustainable development by allowing entities from An- to the Kyoto Protocol to review and give national ap- nex I Parties to participate in low-carbon projects and proval to projects proposed under the Clean Develop- obtain CERs in return. ment Mechanism. Climate Action Reserve (CAR): The Climate Action Designated Operational Entities (DOEs): Designat- Reserve is a U.S.-based offsets program that establish- ed operational entities are independent auditors that es regulatory-quality standards for the development, assess whether a potential project meets all the eligibil- quantification, and verification of greenhouse gas ity requirements of the CDM (validation) and whether (GHG) emissions reduction projects in North Amer- the project has achieved greenhouse gas emission re- ica; issues carbon offset credits known as Climate Re- ductions (verification and certification). serve Tonnes (CRT) generated from such projects; and tracks the transaction of credits over time in a transpar- Determination: Determination is the process of evalu- ent, publicly-accessible system. ation by an independent entity accredited by the host country (JI Track 1) or by the Joint Implementation Community Independent Transaction Log (CITL): Supervisory Committee (JI Track 2) of whether a proj- The Community Independent Transaction Log (CITL) ect and the ensuing reductions of anthropogenic emis- conducts "supplementary checks" to those by the ITL sions by sources or enhancements of anthropogenic 72 glossarY removals by sinks meet all applicable requirements of ly utilities). Over 2008­12, emissions from mandated Article 6 of the Kyoto Protocol and the JI guidelines. installations (about 40% of EU emissions) are capped on average at 6% below 2005 levels. Participants can Eligibility Requirements: There are six Eligibility Re- internally reduce emissions, purchase EUAs or acquire quirements for Participating in Emissions Trading (Art. CERs and ERUs (within a 13.4% average limit of their 17) for Annex I Parties. Those are: (i) being a Party allocation over 2008­12). The EU ETS will continue to the Kyoto Protocol, (ii) having calculated and re- beyond 2012, with further cuts in emissions (by 21% corded one's Assigned Amount, (iii) having in place a below 2005 levels in 2020 or more, depending on national system for inventory, (iv) having in place a na- progress in reaching an ambitious international agree- tional registry, (v) having submitted an annual inven- ment on climate change). tory, and (vi) submit supplementary information on assigned amount. An Annex I party will automatically First Commitment Period: The five-year period, from become eligible after 16 months have elapsed since the 2008 to 2012, during which industrialized country submission of its report on calculation of its assigned have committed to collectively reduce their greenhouse amount. Then, this Party and any entity having opened gas (or "carbon") emissions by an average of 5.2% com- an account in the registry can participate in Emissions pared with 1990 emissions under the Kyoto Protocol. Trading. However, a Party could lose its eligibility if the Enforcement Branch of the Compliance Commit- Green Investment Scheme (GIS): A GIS is a volun- tee has determined the Party is non-compliant with the tary mechanism through which proceeds from AAU eligibility requirements. transactions will contribute to contractually agreed environment- and climate- friendly projects and pro- Emission Reductions (ERs): The measurable reduc- grams both by 2012 and beyond. tion of release of greenhouse gases into the atmosphere from a specified activity, and a specified period of time. Greenhouse gases (GHGs): Both natural and anthro- pogenic, greenhouse gases trap heat in the Earth's at- Emission Reductions Purchase Agreement (ERPA): mosphere, causing the greenhouse effect. Water vapour Agreement which governs the transaction of emission (H2O), carbon dioxide (CO2), nitrous oxide (N2O), reductions. methane (CH4), and ozone (O3) are the primary green- house gases. The emission of greenhouse gases through Emission Reduction Units (ERUs): A unit of emis- human activities (such as fossil fuel combustion or de- sion reductions issued pursuant to Joint Implementa- forestation) and their accumulation in the atmosphere tion. One EUA represents the right to emit one metric is responsible for an additional forcing, contributing ton of carbon dioxide equivalent. to climate change. The Kyoto Protocol regulates six GHGs: carbon dioxide (CO2), methane (CH4), and Emissions Trading Scheme (ETS): see cap and trade. nitrous oxide (N20), as well as hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulfur hexa- EU-10: Bulgaria, Czech Republic, Estonia, Hungary, fluoride (SF6). Latvia, Lithuania, Poland, Romania, Slovakia, and Slo- venia. Global Warming Potential (GWP): An index rep- resenting the combined effect of the differing times EU-15: Austria, Belgium, Denmark, Finland, France, greenhouse gases remain in the atmosphere and their Germany, Greece, Ireland, Italy, Luxembourg, the relative effectiveness in absorbing outgoing infrared Netherlands, Portugal, Spain, Sweden, United King- radiation. dom. Internal rate of return: The annual return that would European Union Allowances (EUAs): the allowances make the present value of future cash flows from an in use under the EU ETS. An EUA unit is equal to one investment (including its residual market value) equal metric ton of carbon dioxide equivalent. the current market price of the investment. In other words, the discount rate at which an investment has European Union Emission Trading Scheme (EU zero net present value. ETS): The EU ETS was launched on January 1, 2005 as a cornerstone of EU climate policy towards its Kyo- International Transaction Log (ITL): the ITL links to commitment and beyond. Through the EU ETS, together the national registries and the CDM registry Member States allocate part of the efforts towards their and is in charge of verifying the validity of transactions Kyoto targets to private sector emission sources (most- (issuance, transfer and acquisition between registries, 73 State and Trends of the Carbon Market 2010 cancellation, expiration and replacement, retirement, of exiting installations or the process of allocation (free and carry-over). It is the central piece of the emissions allocation or auctioning). trading under the Kyoto Protocol. New South Wales Greenhouse Gas Reduction Japan-Voluntary Emissions Trading Scheme (J- Scheme (NSW GGAS): Operational since January VETS): Under the J-VETS, companies receive sub- 1, 2003 (to last at least until 2012), the NSW Green- sidies to implement mitigation activities in line with house Gas Abatement Scheme aims at reducing GHG voluntary commitments and can resort to emissions emissions from the power sector. NSW and ACT trading (incl. offsets) to meet their commitments with (since January 1, 2005) retailers and large electricity more flexibility. Though growing, impact remains lim- customers have thus to comply with mandatory (in- ited: over the first three years of the scheme, partici- tensity) targets for reducing or offsetting the emissions pants (288 companies) have reduced their emissions by of GHG arise from the production of electricity they about one million tCO2e. The J-VETS has contributed supply or use. They can meet their targets meet their to the development of MRV system, third-party verifi- targets by purchasing certificates (NSW Greenhouse cation system, and the registry system. The J-VETS has Abatement Certificates or NGACs) that are generated been incorporated to the Experimental Integrated ETS through project activities. as one of participating options. New Zealand Emissions Trading Scheme (NZ ETS): Joint Implementation (JI): Mechanism provided by The NZ ETS will progressively regulate emissions of Article 6 of the Kyoto Protocol, whereby entities from the six Kyoto gases in all sectors of the economy by Annex I Parties may participate in low-carbon projects 2015. Forestry is covered since 2008 and by July 1, in hosted in Annex I countries and obtain Emission 2010, stationary energy, industrial process, and liquid Reduction Units in return. fossil fuel will be phased-in. The government recently announced, however, that full implementation could Kyoto Mechanisms (KMs): the three flexibility mech- be delayed if adequate progress is not made in estab- anisms that may be used by Annex I Parties to the Kyo- lishing similar regulations in other developed countries. to Protocol to fulfill their commitments. Those are the Joint Implementation (JI, Art. 6), Clean Development Offsets: Offsets designate the emission reductions Mechanism (CDM, Art. 12) and International Emis- from project-based activities that can be used to meet sions Trading (Art. 17). compliance--or corporate citizenship--objectives vis- à-vis greenhouse gas mitigation. Kyoto Protocol: Adopted at the Third Conference of the Parties to the United Nations Convention on Cli- Primary transaction: A transaction between the origi- mate Change held in Kyoto, Japan in December 1997, nal owner (or issuer) of the carbon asset and a buyer. the Kyoto Protocol commits industrialized country signatories to collectively reduce their greenhouse gas Project Design Document (PDD): A central docu- emissions by at least 5.2% below 1990 levels on average ment of project-based mechanisms, the PDD notably over 2008­12 while developing countries can take no describes the project activity (including environmental regret actions and participate voluntarily in emission impacts and stakeholders consultations), the baseline reductions and removal activities through the CDM. methodology and how the project is additional as well The Kyoto Protocol entered into force in February as the monitoring plan. 2005. Project Idea Note (PIN): A note prepared by a project Monitoring Plan: A set of requirements for monitor- proponent presenting briefly the project activity (e.g., ing and verification of emission reductions achieved by sector, location, financials, estimated amount of ERs a project. etc.). National Allocation Plans (NAPs): The documents, REDD plus: All activities that reduce emissions from established by each Member State and reviewed by the deforestation and forest degradation, and contribute to European Commission, that specify the list of installa- conservation, sustainable management of forests, and tions under the EU ETS and their absolute emissions enhancement of forest carbon stocks. caps, the amount of CERs and ERUs that may be used by these installations as well as other features such as Regional Greenhouse Gas Initiative (RGGI): Un- the size of the new entrants reserve and the treatment der RGGI, 10 Northeast and Mid-Atlantic states aim to reduce power sector CO2 emissions by 10% be- 74 glossarY low 2009 levels in 2019. Within this 10-year phase, Verified Emission Reductions (VERs): A unit of there are three shorter compliance periods. During the greenhouse gas emission reductions that has been veri- first and second compliance periods (2009­2011 and fied by an independent auditor. Most often, this desig- 2012­2014) the cap on about 225 installations is set nates emission reductions units that are traded on the at 171 MtCO2e (or 188 M short ton CO2e). This is voluntary market. followed by a 2.5% per year decrease in cap during the third compliance period (2015­2018). Verification: Verification is the review and ex post de- termination by an independent third party of the mon- Reforestation: This process increases the capacity of itored reductions in emissions generated by a registered the land to sequester carbon by replanting forest bio- CDM project, a determined JI project (or a project ap- mass in areas where forests have been previously har- proved under another standard) during the verification vested. period. Registration: The formal acceptance by the CDM Ex- Voluntary market: The voluntary market caters for the ecutive Board of a validated project as a CDM project needs of those entities that voluntarily decide to reduce activity. their carbon footprint using offsets. The regulatory vacuum in some countries and the anticipation of im- Removal unit (RMU): RMUs are issued by Parties to minent legislation on GHG emissions also motivates the Kyoto Protocol in respect of net removals by sinks some pre-compliance activity. from activities covered by Article 3(3) and Article 3(4) of the Kyoto Protocol . Western Climate Initiative (WCI): The WCI covers a group of seven U.S. states (Arizona, California, Mon- Secondary transaction: A transaction where the seller tana, New Mexico, Oregon, Utah, and Washington) is not the original owner (or issuer) of the carbon asset. and four Canadian provinces (British Columbia, Man- itoba, Ontario, and Quebec), with an aggregate emis- Supplementarity: Following the Marrakesh Accords, sions target of 15% below 2005 levels by 2020. Other the use of the Kyoto mechanisms shall be supplemental U.S. and Mexican states and Canadian provinces have to domestic action, which shall thus constitute a signif- joined as observers. icant element of the effort made by each Party to meet its commitment under the Kyoto Protocol. However there is no quantitative limit to the utilization of such mechanisms. While assessing the NAPs, the European Commission considered that the use of CDM and JI credits could not exceeded 50% of the effort by each Member State to achieve its commitment. Supplemen- tarity limits may thus affect demand for some catego- ries of offsets. United Nations Framework Convention on Climate Change (UNFCCC): The international legal frame- work adopted in June 1992 at the Rio Earth Summit to address climate change. It commits the Parties to the UNFCCC to stabilize human induced greenhouse gas emissions at levels that would prevent dangerous man- made interference with the climate system, following "common but differentiated responsibilities" based on "respective capabilities". Validation: Validation is the process of independent evaluation of a project activity by a Designated Op- erational Entity (DOE) against the requirements of the CDM. The CDM requirements include the CDM modalities and procedures and subsequent decisions by the CMP and documents released by the CDM Execu- tive Board. 75 State and Trends of the Carbon Market 2010 notes 76 glossarY notes 77 State and Trends of the Carbon Market 2010 notes 78