London, 7 December 2009

Hopes for a legally binding successor to the Kyoto Protocol (KP) being agreed at the Climate Change Conference ( COP15) in Copenhagen have been dashed over the past few weeks. However, as a prelude to international legislation being finalised in 2010, an outline agreement in which carbon limits are agreed in principle is very much expected.

Eyes are focussed particularly on the emerging economies and in particular China and India. These two countries have witnessed the most incredible growth rates over the past decade and have become quite formidable in the global economy.

The history

When the Kyoto Protocol was agreed and industrialised nations accepted binding emission caps back in 1997, the emerging economies were spared from such constraints to their growth and development. The emerging economies were considered too fragile to bear the burden of carbon caps.

The Marrakesh Accords resulted in the advent of the Clean Development Mechanism ( CDM) which presented a fantastic opportunity for emerging economies. In essence, any emission reduction opportunity that existed in an emerging economy, but which was not being exploited, could be presented as a CDM project and would, on the face of it, qualify for emission reduction credits in he form of CERs ( Certified Emission Reductions). These CERs have a market value amongst companies or governments with compliance obligations under the various emission trading schemes that currently exist.

The CDM has resulted in tens of billions of Euro flowing from the industrialised world into emerging economies. Additionally, expensive state-of-the-art technologies have been introduced into the developing economies as a direct result of the CDM, bringing with them greater levels of efficiency, sustainability and thus prosperity.

The Copenhagen issues

The primary beneficiary of CDM has been China (estimated to have received over $2bn USD to date and expected to receive $8bn USD before 2012), closely followed by India and then the Latin American countries.

To date these benefits have been provided free of charge to developing economies. However, from 2012 the industrialised nations will expect the more robust emerging economies to pay a price in the form of accepting binding carbon caps on their emissions.

Having recently overtaken America as the world’s largest emitter, China is very much in the spot light. The general position of the developing economies is that the climate problem has arisen from the industrial revolution of the past 150 years. Consequently, they believe industrialised nations ought to bear the main responsibility for dealing with the issue.

The EU would argue that it has been doing just that for the past ten years: not only has it been focussed on pursuing emission reductions at home further to its “ supplementarity” principles, but it has also been funding CDM projects in the developing countries. The failings have come from the lack of commitment from other industrialised nations.

The average American, Canadian and Australian produces 20 tons of carbon dioxide equivalent per year. This number is only 8 in the EU, 5 in China and less than 2 in India and Brazil. Consequently, and quite rightly, the emerging economies are demanding big carbon reduction commitments from the industrial world as a part of the negotiation in Copenhagen.

The IPCC suggest that cuts in greenhouse gas emissions of 25% - 40% are required by 2020, with a full halving by 2050, if carbon dioxide concentrations in the atmosphere are to be capped at 450ppm (parts per million). To date the EU has set out it plans for achieving a 20% cut on 1990 levels by 2020 together with a promise to deliver a 30% cut if the rest of the world also commit to ambitious targets. Japan, although presenting no plans for doing so, has promised a 25% cut on 1990 levels by 2020.

The 17% cut promised by the USA (which has still to run the gauntlet in the Senate) is considered by many not to be enough (primarily because the 17% is measured from 2005 and equates to only a 4% cut relative to 1990 emission levels).

Canadian emissions continue to increase and the recent rejection of a climate change bill by the Australian Senate are also matters of grave concern.

The solution to the problem suggests itself from a top down analysis starting from where we need to be by 2020 and then working backwards. Ironically, most countries seem to be taking a bottom up approach to adopting targets. Presently the sum total of commitments promised by industrialised nations amount to about 15% cuts on 1990 levels, far short of what the IPCC have suggested is needed.

However, without the cooperation from the emerging economies, any efforts in the industrialised world to remedy the climate problem will be made in vain. According to figures released by the Energy Information Administration, carbon-dioxide emissions in the US have been relatively flat at about 6bn tonnes per annum for the past 20 years and, on a business as usual forecast, will remain that way for the next 20 years. By contrast, over the same period, Chinese emissions have more than trebled from 2bn to 7bn tonnes per annum and are forecast to double again by 2030.

In the past two weeks both China and India have suggested that they would happily accept carbon intensity caps. China have tabled a 40-45% carbon intensity reduction by 2020 (something the US argue is a business as usual path for China and so lacks any additional commitment), while India have suggested a 20-25% intensity reduction over the same period. While this is a welcomed development, it falls a long way short of what is needed.

While an absolute carbon cap imposes a ceiling on the level of emissions that a country may produce, a carbon intensity cap simply introduces a quantitative limit on the emissions produced indexed to GDP (i.e. per unit of output). In fast growing economies such as China and India, this lesser commitment would result in a situation whereby emissions would continually be allowed to increase. Settling for carbon intensity commitments in place of carbon caps would be pure folly.

Therein lies the rub. It is believed that China and India are positioning themselves for a negotiation around money. Unfortunately for the environment, coal is in no short supply and it is relatively cheap. China depends on this cheap fuel for approximately 70% of its power generation. Moving to a cleaner alternative will be expensive and China will look towards the industrialised world to cover that cost.

The problem seems to be that the “road-map” agreed in Bali in 2007 set out that developing countries are not required to take numerical caps but instead are simply required to propose a nationally appropriate mitigation and adaptation action plan. This highlights a fundamental problem with the Kyoto Protocol: it pigeon holes countries into one of two classifications. The richer industrialised countries are known as Annex 1 countries and the rest are conveniently termed Non-Annex 1 countries. This binary arrangement fails to take into account that there is a middle ground and that much has changed in the 17 years since the 1992 UN Framework Convention on Climate Change ( UNFCCC) . Middle income countries such as Mexico are far better placed to deal with the climate change issue and despite being classed as a Non-Annex 1 country, to their credit, Mexico have voluntarily committed to a halving of their carbon emissions by 2050.

If agreement is reached in Copenhagen, it will hinge upon the cost issue. China will take comfort in the fact that the industrialised world was bearing the financial burden for the problem that it had created historically, while the industrialised world will be assuaged if China (and other emerging economies) accepted carbon caps in return.

The cost of dealing with climate change

Lord Stern was commissioned by Tony Blair, then Prime Minister of the UK, to assess the economics of dealing with the climate change issue. The finding of that report (which has subsequently been supported by analysis undertaken by the IPCC, the International Energy Agency and the consultant McKinsey) is that the cost is of tackling the anthropogenic greenhouse gas problem would be 1% of global GDP.

Let’s look at it the other way around. If you could be 1% richer by polluting the atmosphere to the extent that tens of millions of lives would be placed at risk, would you take that environmental risk for the sake of a 1% return?

This is arguably a small price to pay as an insurance policy against possible catastrophic consequences in the future. The insurance analogy is useful since it places the matter in perspective and counters the sceptics that question whether this is indeed an anthropogenic problem. We take insurance to cover low probability but high cost risks: we do not wait until the car has crashed before addressing the crisis and we should not wait for unequivocal evidence of environmental disaster before acting on climate change. Such insurance will not be free, but it is affordable.

Gordon Brown, Prime Minister of the UK suggested the cost would be $100bn USD per year while the EU estimates that it is closer to $150bn USD per year. China is looking for a commitment closer to $400bn USD per year from the industrialised world which is closer to the 1% of global GDP.

The problem is political. First, governments do not as a rule pay for insurance; and second, politicians are not accustomed to spending vast amounts of money for the benefit of future generations. Instead they like to spend money where it will have an immediate impact upon the electorate. By way of example, there was little hesitation in relation to the global bank bail out last year which amounted to 5% of global GDP. The environmental cost of dealing with climate change pails into insignificance by comparison and yet, except in the EU, very little has been achieved in the 12 years since the Kyoto Protocol was agreed.

Moreover, through the deployment of cap-and-trade mechanisms for achieving carbon caps, much of this cost will be borne by the private sector rather than from the public purse. The underlying principle is that the emitter pays. Public funds will likely be applied to leverage private investment by underwriting the risks of those investments against the political, economic and currency risks that has in the past deterred private funds from flowing into many emerging countries. Such policies are not without precedent and something similar was applied under the Marshall Plan to rebuild Europe after the Second World War.

The cost assessment is almost certainly a worst case scenario as it does not account for technological developments that, given the catalyst of a new climate change accord, will materialise in the future. By way of example, the Montreal Protocol that was agreed in 1987 aimed to reduce ozone depleting CFC gasses by 50% in 12 years: in the event such gases were eliminated entirely in only 10 years. The same levels of efficiency will be seen in the fight against greenhouse gases if the politicians are able to provide certainty in relation to policy over a sufficiently long period of time. The principle problem to date was that infrastructure changes necessary to bring about the requisite levels of carbon abatement required more than the 5 years of certainty afforded by the Kyoto Protocol.

Finally, it is worth noting that that a recent McKinsey report suggests that one third of all greenhouse gas reductions will actually save money rather than costing anything. Consider the cost of leaving electrical appliances in standby mode or having lights burning in empty commercial premises at night and one is easily able to comprehend such a finding.

The Future of the Clean Development Mechanism

CDM has, to date, presented a good solution to achieving the desired objective: through the sale of CERs the industrialised world, primarily the private sector, has paid for the implementation of cleaner technology in the developing world. However, a pre-requisite of an emission abatement project qualifying for carbon credits under the CDM is that the project must meet the test of “ additionality”. This is a term of art and introduces a test by which it must be shown that, but for the existence of CDM, this project would not have otherwise occurred, i.e. the mechanism tips the balance of commercial viability of the investment in the cleaner technology.

But if emerging economies accept binding caps on emissions, as they are being asked to do, then such emission abatement projects will be brought into being pursuant to the new obligations being undertaken by the developing world and will, on the face of it, no longer be additional.

Could this mark the end of big scale CDM?

Perhaps CDM would only continue in the least developed countries that will not be subject to carbon caps?

Alternatives to CDM for consideration in Copenhagen

If CDM is rendered redundant, what mechanism would be deployed in the place of CDM to ensure that funds flow efficiently from the emitters in the industrialised world in order to cover the cost of the introduction of cleaner technology in the developing world?

The best solution would be to introduce cap-and-trade in the big emerging economies. Mexico has been considering this option. This would see absolute caps on emissions introduced and the introduction of a carrot and stick approach to bringing about emission abatement. If a cap-and-trade system were introduced, then in order to bring about the requisite flow of cash from the industrialised world into the emerging economies, such a system would need to link into existing emission trading schemes in the industrialised world. Cap-and-trade is the conduit through which money flows to the lowest cost abatement opportunities and so naturally, if the low hanging fruit is to be found in the emerging economies, that is where the cash will go. In essence, projects that presently qualify for CERs under the CDM would then, under the new regime, generate emission allowances that go by a different name but which still represent the reduction of one tonne of carbon dioxide equivalent from the atmosphere.

An alternative but solution would be a “no penalty cap system” which works by introducing a country level cap which, if achieved or surpassed by that country, would result in credits being granted. This is a carrot without a stick approach because no penalty exists if the target is not met. Policing such a system would be difficult: it would be almost impossible to verify the emission data that a country provided as evidence of its achievement. Moreover, the credits would be granted to the country and not to the industrial installation that had achieved the emission abatement. While common sense would dictate that the country should pass on the financial benefit of the achievement in order to encourage further emission reductions, the risk of leakage and corruption is all too real.

Finally, a carbon intensity approach based on sectoral benchmarks is favoured by China and India, but as argued above, rather than capping emissions it would allow them to grow albeit at a slower rate. While this is preferable to no constraints at all, it is counter intuitive if the environmental objective is to prevent carbon dioxide in the atmosphere exceeding 450ppm (parts per million).

Conclusion

We must assume that the industrialised nations are ready, willing and able to accept more ambitious carbon reduction targets if the emerging economies agree to play ball.

Rather ironically, while the emerging economies are playing hardball in negotiations, it is they that will almost certainly fair worst as a result of the effects of climate change (falling crop yields, increased flooding, displacement of communities, drought, etc).

Additionally, outright refusal to participate in the effort to combat climate change by the emerging economies is likely only to provoke an unwelcome response from the industrialised world. The US has considered the imposition of carbon tariffs on imports from jurisdictions with no limit on carbon emissions. The EU has threatened that cash will cease to flow from Europe into recalcitrant jurisdictions as CERs from carbon abatement projects in those areas will be disallowed under the EU Emission Trading Scheme.

Optimists hope that these factors will win the day in Copenhagen and encourage the governments of developing economies to make the right choices. If an outline agreement can be reached in Copenhagen then a legally binding Protocol should be finalised either in Bonn in 6 months time or else at the very latest in December 2010 or COP 16 in Mexico City.

Ends --

By James Emanuel, Commercial Director at CantorCO2e Ltd

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