Gareth Phillips says the European Commission is wrong to exclude international emission reduction credits from the EU carbon market after 2021.
Many of my colleagues in the climate investment space were shocked by the European Commission's proposal to exclude international emission reductions from the fourth phase of the EU Emissions Trading System (ETS) starting in 2021. Here is a handful of reasons why it's a short-sighted proposal and why it is taking a very big gamble.
The concept of a cap on emissions is only acceptable if there is flexibility to cope with a situation where the cap becomes a limit on economic growth. In a situation where the cap is reached and there are no additional permits to emit, then the price of emissions will rise excessively and strangle the growth.
Emission reduction units from Clean Development Mechanism (CDM) and Joint Implementation (JI) projects and international emissions trading provided this flexibility under the Kyoto Protocol. In its new proposal, the Commission has thrown out emission reductions and made their use conditional upon strong commitments from other governments in Paris in 2015. In the absence of such commitments, the Commission is calling on the EU to reduce its greenhouse gas (GHG) emissions in 2030 to 40% below 1990 levels.
The chances of international agreement on 2020 actions in Paris are not high
Based on past performance, the chances of international agreement on 2020 actions in Paris are not high which means that, for any investors who are still holding on, there won't be any positive news before 2015 at the earliest, and the best that could be expected in 2015 is an agreement to use some kind of emission reduction unit (for example, from CDM projects or some other new mechanism). For an industry which is already on life support, that's not much of a lifeline to hold on to.
Providing flexibility
As noted above, there are two sources of flexibility in the Kyoto Protocol – emission reduction units and international emissions trading. After dispensing with emission reduction units, the Commission's proposal relies on using linkage with other schemes to provide flexibility – the ETS equivalent of international emissions trading. Unfortunately, this is where the plan may fail.
First, one might ask which domestic emissions trading schemes the EU ETS plans to link with? There are plans for emissions trading in a number of countries, and a small number are already operating, but how many are currently compatible with the EU ETS? There are many issues which need to be aligned before linkage can occur, not least of which is the process of allocation.
The EU ETS is nine years old and well into its third phase and is still wrestling with the consequences of over-allocation. A solution of sorts is at hand via the plan to 'backload' the allocation of emission allowances but it will be another 5-10 years before the excess is worked out of the system. We should also ask which schemes want to or could link with the EU ETS?
The EU is hardly in a position to specify that not using emission reductions is a condition of linkage
Secondly, if there are other schemes to link with, will they be using emission reductions as offsets or not? The EU is hardly in a position to specify that not using emission reductions is a condition of linkage, and if a linked scheme uses emission reductions then they will simply buy cheap emission reductions and sell their allowances on to EU buyers and pocket the difference.
An alternative reason why the European Commission might gamble with the future of the international emission reduction units is that they are not concerned about the possibility of breaching the cap, in other words, the economy can achieve the 40% reduction target for 2030 relatively easily. Critics have said that 40% is not ambitious, while the Commission maintains that it is. Either way, it's short-sighted because, at some stage, caps will get tighter.
Back to those other ETSs that might want to use the international markets as a source of flexibility. The existing mechanisms of JI and CDM have had their share of challenges but we know a lot more about how to manage them today.
Attractions of the CDM
The CDM has become a beacon of transparency and a tool for sustainable development and, for many, its role in engaging developing countries in climate change action is clear. From the perspective of emission reduction units, the CDM offers a single comparable standard to be applied independently and with transparency in multiple sectors around the world. The alternative to the CDM is a plethora of local standards transacted in local languages without international oversight. How can the EU ETS propose to link to a scheme which uses its own domestic emission reduction standard?
The CDM offers a single comparable standard to be applied independently and with transparency in multiple sectors around the world
Finally, I am not suggesting that it is the EU's responsibility to stand up for climate action in the rest of the world but the EU has assumed a leading role and its citizens probably do not realise how much they have to lose from climate change induced instability. It is in the EU's interests as much as any other nation's to see the climate negotiations succeed.
Developing countries that are unlikely to implement ETS need some sort of mechanism to get involved and, after close to 15 years of capacity building, the CDM is performing that function. Developing and developed countries that will implement ETS will need to look for flexibility mechanisms, but self-defined emission reduction standards could be a barrier to linkage.
The CDM has provided a single mechanism which has enabled, on paper and for a short period, two schemes to link – the EU ETS and Australia's Carbon Pricing Mechanism. Without that common emission reduction standard, flexibility will be much harder to find. And a cap on an economy without any breathing room is not good economic policy.
So why is the Commission's proposal so important? The EU really kicked off investment in the CDM through the 2004 Linking Directive which allowed entities covered by the ETS, and not just governments, to import emission reductions to meet their compliance obligations.
Financing the UNFCCC infrastructure
This opened the door to investment and triggered demand for infrastructure, in particular the Designated Operational Entities who validate and verify projects and Designated National Authorities in Non-Annex 1 countries (mostly developing nations) who approve projects. It also spawned much of the work of the secretariat of the UN Framework Convention on Climate Change (UNFCCC).
A significant proportion of the UNFCCC ecosystem survived off the registration and issuance fees of CDM projects while DOEs were paid by project developers. DNAs were left to fund their own activities (which in retrospect may have been a mistake – they would have benefitted from more support).
The Commission proposal is neutral to negative for the CDM, even in least developed countries
Without a steady stream of projects, this infrastructure will disappear – in fact much of it already has. The industry has been on life support hoping for a positive signal. The Commission proposal is neutral to negative for the CDM, even in least developed countries. Without a definite and quantified role in the future there is no interest in maintaining the CDM and our efforts to combat human induced climate change will be significantly worse off without it.
Gareth Phillips is a partner at Climate and Sustainability Partners and chairman of the Project Developer Forum. Email:gbpphillips@gmail.com
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