Can restriction talk be more than hot air?
CHINA IS RENOWNED for its opportunism but it takes a special kind of entrepreneurial zest to make money out of your own pollution. In the curious world of carbon trading, China accounts for perhaps half of all credits traded with the west, as unseen utilities half a world away effectively pay to build wind farms and clean up freon plants the length and breadth of China.
China is at the heart of the clean development mechanism, or CDM. This is one of the key initiatives that came out of the Kyoto Protocol, and is aimed at reducing greenhouse gas emissions while encouraging sustainable development in emerging markets. The idea is that any company or institution can invest in greenhouse gas-reducing projects in the developing world, for which they earn credits that can be used to offset their own emissions, or be sold in the open market. These credits are formally known as certified emissions reductions, and are often called carbon credits.
In essence: build something beneficial to the environment in China, offset your own pollution in the UK or the US. And while it might sound odd, it does make sense. Greenhouse gas emission hurts the environment just the same regardless of where it comes from, and a reduction of pollution in industrializing new economies is obviously for the greater good. If that creates a market in which some people, whether developers or brokers or banks, get rich, then so be it. And for Chinese businesses, it’s a bonanza: the rest of the world is paying them to clean up their act.
They have not passed up this opportunity. Today, estimates of the proportion of the CDM market that China accounts for vary between 40% and 60%. That is partly a reflection of the amount of emissions the country produces in the first place (officially second in the world, and well on track for the top spot, probably by 2009), and consequently the many ways of achieving reductions. In particular, China produces and uses more coal than any other country. “If you build a windmill in China you can generate a lot of carbon credits because what would have happened otherwise is they’d build a coal plant,” says Roger Raufer, director of engineering services at International Environmental Trading Group. “You could build a windmill in Costa Rica too, but the carbon credit is going to be much smaller.”
The Chinese were initially wary about the CDM. “At first, [Chinese] project owners were in complete disbelief,” recalls Leigh Fitzgerald, a senior specialist at Arreon Carbon, part of a growing private sector industry of project developers and brokers that has grown up in China to match buyers and sellers. “They said: ‘People are going to pay us money to do this, are you kidding?’ They were almost suspicious.” That initial bafflement was quickly replaced by a voracious appetite, then sophisticated opportunism.
It would be churlish, though, to call it a scam. Even if Kyoto were to fall apart, and no carbon credits were ever traded again, there is a great deal of renewable energy infrastructure in China that otherwise would not be there. More to the point, despite looking from a distance like a sure-fire recipe for an easy buck and a bit of manipulation, the system is in fact rigorously policed, by the United Nations Framework for Conventional Climate Change.
“The registration process is lengthy. It’s onerous. It’s not trivial by any stretch,” says Paul Ezekiel, head of global carbon trading at Credit Suisse in New York, and formerly the president and co-founder of a specialist merchant bank and advisory firm in the environmental industry called Antipodean Partners. “Some people view it as potentially having a random construct behind it: I plant a tree and generate a credit. It’s nothing of the sort. It’s an environmentally rigorous market. And without that, there’s no way a financial institution like Credit Suisse would invest one dollar.”
Getting from signing a contract to seeing a credit takes 18 months to two years (which has already created a vibrant forward market). When a group like Arreon Carbon takes a look at a potential CDM project, it first asks its technical department to assess if it has a strong chance of UN approval. If it does, the technical department writes a brief called a product development document in English and Chinese. The Chinese one goes to the government, which then has to approve it for submission to the UN, and provides a letter of authorization. Whichever foreign party is lined up to buy the credit has to do the same with its own government. There also has to be a third-party validator – designated by the UN – which goes in and writes a report on the project, assessing its viability. The whole lot goes back to the UN which, having approved it as being eligible for carbon credits, then goes back every year to check on it. (Arreon, active in this business for several years, is only now getting its first projects registered.)
Efficient, not ethical markets
Consequently, if there’s a criticism of the system, it’s that it is overly strict, expensive and inefficient, not that it is laissez-faire or opaque. “From a liquidity provider’s perspective it is far more important for it to be very onerous than for it to be very lax,” says Ezekiel. “It’s good that it’s strict. I’d like to see it more streamlined, of course, but if it’s going to go one way or the other it’s better to be more strict than less.”
Raufer adds: “One thing Kyoto has done is take all the compliance and put it outside of the host countries. You can do a project anywhere in the world, Asia or Africa, and [the verification] will be issued by an agency in Bonn. It’s obviously more expensive to do transactions that way, but it does mean there is internationalized compliance.”
The projects themselves can cover all sorts of areas: the creation of renewable energy projects such as wind farms, solar or biomass, which qualify for carbon credits because they displace energy that would otherwise have been generated by coal; the implementation of technologies to reduce emissions in existing plants; even methods of improving energy efficiency in buildings or transportation.
There are, though, anomalies. One of the problems with the CDM is that there is a sense that some people play the market, creating an effect quite contrary to what Kyoto intended.
A clear example of this came in China with the pollutant HFC-23. This is a by-product of the manufacture of a refrigerant called HCFC-22, and is the most potent gas covered under Kyoto. Under the protocols established at that treaty, different emissions are considered to be equivalent to set amounts of carbon dioxide, and so lethal is HFC-23 that it is considered to be worth 11,700 times more than a tonne of carbon dioxide.
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“Some people view it as potentially having a random construct behind it: I plant a tree and generate a credit. It’s nothing of the sort. It’s an environmentally rigorous market” |
Getting rid of this stuff is clearly a good thing, and it’s pretty easy to do, too, with a straightforward revamping of facilities. But here’s the thing: the tradable value of HFC-23 so dramatically outweighs the cost of fixing the problem that it makes economic sense to develop these plants just in order to fix their own pollution and pocket the revenue. Stanford University Professor Thomas Heller told a forum in Hong Kong in July that the market price of HFC-23 is €9 per tonne, and the cost of abatement just 10 euro cents – with the difference between the two mainly being profit for the company doing the polluting in the first place. Seeing this, China intervened to stop new plants being built by levying a 65% tax. (Where this money goes is a moot point, but the United Nations Development Programme says it goes into a new CDM Fund launched by the ministry of finance. Kishan Khoday, assistant country director and team leader for the energy and environment team at the UNDP in Beijing, says his organization has been approached by the ministry “to help analyse how to make use of this new fund. It’s an innovative model whereby China could use tax revenues from CDM credit sales to do broader sustainable development projects,” achieving not only emission reductions but broader development goals.)
Besides, markets aren’t supposed to be ethical, just efficient. “These markets are artificially designed,” says Raufer. “In this case the market did what markets are supposed to do: found the easiest, fastest way to generate credits.”
HFC might just be a teething problem necessary in an evolving market. “Most of the developers in CDM feel that HFC is done: there are no projects left and it was the low -hanging fruit that got snatched up first,” says Fitzgerald. “The projects being developed now tend to cost more and there’s a lot more renewable energy projects. There are about eight to 10 HFC projects and 250 renewable energy.”
Climate exchanges evolving
Now China is on track to move from this system of bilateral trades to a more formal exchange. The UNDP, which since 2002 has provided capacity-building support to China in building its CDM markets, launched a new initiative in February to advise the Chinese government on how climate exchanges operate and whether one would be beneficial in China. Specifically, the ministry of science and technology – a key member of China’s national CDM board – will implement the project, and has spent the time since the launch identifying experts to undertake research, which will now get under way.
Officially there is no plan for the Chinese government to establish a climate exchange system. The research “is meant to explore how such exchanges work in the west, and explore the value such a mechanism could have in the future for expanding China’s role as a major supplier of carbon credits to the global market,” says Khoday. China has no commitment to reduce emissions under Kyoto, and “such a mechanism would not involve the type of domestic cap-and-trade systems present in Europe and other western countries,” says Khoday. It would instead focus on a more effective supply of credits from China to the west.
Broadly, the benefits of a formal exchange are likely to be that it brings market efficiencies, makes it easier to match buyers and sellers, and to keep a balance between different project types. It facilitates the availability of information too. The challenge is that the entire global market is only effectively a couple of years old, and as the European experience has shown (so much supply that credits have dropped to a value where it becomes economically sensible to pollute) there is plenty of scope for learning and experimentation.
If China launches an exchange, it might well be beaten to it by Hong Kong.
On July 18, Hong Kong Exchanges and Clearing appointed Australian law firm Mallesons Stephen Jaques, and consultants International Environmental Trading Group and Climate Focus, to study the trading of emissions-related products, expecting the study to take four months. “The US has developed sophisticated markets on pollutants; Europe has a large and aggressive market. It’s pretty clear Asia’s going to be next,” says Raufer at IETG. “The question is how do you evolve into that, and deal with development issues and pollution problems.”
Key to it will be the regulatory framework. “You need an institutional basis for structuring these markets,” says Raufer. “They are artificial markets created by government requirements. They’re not like widgets or cellphones where people want to buy them. You buy them because you have to. So you need that regulatory infrastructure, and it takes a while to establish.”
Even before an exchange has been launched in the region there’s a slight sense of overkill. “I have had conversations with six up-and-coming regional exchanges for carbon,” says Ezekiel. “It raises the question, what’s the role of a futures exchange in any up-and-coming commodities market? There’s a role for a local exchange but I’m not sure if every country needs a carbon exchange.”
Moving China forward on this or any other climate change decision is complicated by the fact that Kyoto, under which China (like all developing countries) has no obligations to reduce emissions, is coming to an end, and that nobody really knows what the successor agreement will look like from 2012. If the establishment of an emissions exchange were to be interpreted as a willingness to accept an emissions cap, that might not be in China’s immediate interests.
Enforcement through compliance
Anyone involved in carbon trading with China also has to think about issues of enforcement. As projects and credits get rolling, and as the Kyoto Protocol enters into what is called its “compliance period” from 2008 when developed-world countries with emission commitments will have to start reporting to the UN on how they have done, this is going to be very important. “The next big issue that the international community will be dealing with in the near future is that of compliance under the UN Kyoto protocol,” says the UNDP’s Khoday.
China does not have the rule of law, and previous local pilot projects in China have been criticized for placing far more emphasis on written laws than is appropriate in a country that does not hold them as sacrosanct. The great power of local government and the power of contract further clouds the issue.
“In the US, the information flow and legal process is well understood between the parties trading,” says Christine Loh of Hong Kong-based NGO Civic Exchange. “In China, it is much less so, which is why there is a heavy administrative component to Chinese schemes.” Fitzgerald says Arreon puts all its contracts under English or Hong Kong law.
Would they be enforceable in China? “We’ll see. For the most part everyone seems to think it’s the best we can do.”
