Market power: Can Clean Development Mechanisms work?

Market-based credits can help control emissions alongside other instruments, though the system needs more work. And time. 

Climate change is a global challenge and must be  fought on many fronts, but where to start? After all,  some countries and sectors emit more greenhouse gases than others, and reducing emissions does not cost the same everywhere. A sensible approach would be to start  mitigation efforts wherever reducing emissions can be  made for the least cost.

This is what the Clean Development Mechanism (CDM) aims to encourage, as well as  promoting sustainable development. Set up under the Kyoto Protocol, the mechanism seeks to reduce greenhouse gases by allowing firms in developed nations to meet some of their emissions targets by initiating greenhouse gas reduction projects in developing countries where reduction costs are lower.

How does it work? The CDM is market-based, allowing projects in developing countries to generate "credits", corresponding to their emission reductions. There are several conditions that a project has to fulfil before it can qualify as a CDM project, including approval by the host country government. Projects are developed either unilaterally, i.e., by a project developer in a developing country, or with funding from a party whose credits count towards greenhouse gas limitation or reduction targets in developed countries.

Projects are vetted for their  "additionality" to ensure that any reductions in carbon are new and would not have occurred anyway. An "emissions baseline" is also established to help calculate the level of greenhouse gas emissions that would have been generated if the CDM project had not gone ahead.

Does the market work? The answer is a "yes, but".  Though set up in 2005, at latest count for 2007 before the UN Climate change conference in Bali in December, over 850 CDMs had been registered, with 1,700 in the pipeline. (For updates, see cdm.unfccc.int, click "project activities".) This is a positive sign, but there are question marks, not least about the quality of some of the projects and whether they deliver real cuts in emissions.

One issue has been a tendency to target projects that  deliver high volumes of credits, but that are not widely replicable.  The CDM has proved effective in cutting emissions of one particular
hydrofluorocarbon (HFC-23), notably in China where output was high and relatively cheap and easy to correct.

While this focus on low-hanging fruit may be normal in new markets, it nonetheless highlights a challenge: how to channel investment in widely-replicable GHG-reducing projects that also have significant sustainable development benefits.

For example, energy efficiency, sustainable transport and non-hydro renewable energy projects are still a small part of the CDM portfolio. This is for several reasons, including that these types of projectsoften generate relatively low numbers of credits, have a high investment cost, and/or generate low returns.

Some say this risk aversion reflects the uncertain future of the CDM after 2012, when the current Kyoto Protocol is due to expire. An extension over a longer timeframe would incite investments with a longer payback.

There are other structural issues in the CDM market to resolve. Largesse  in setting baselines for carbon should be tightened up, as should procedures in deciding whether reductions are truly additional.{?} And there is a concern about whether the market has not driven up the price of some credits for quite straightforward projects, such as removing HFC-23 or N2O, which could have been removed by other cheaper means.

Another criticism surrounds the uneven geographical concentration of credits. By 2012, China, India, Brazil, Korea and Mexico are expected to account for 84% of CDM creditsChina alone accounts for 53%! Three-quarters of HFC-23 credits concern Chinese projects, as do half of all landfill gas projects. Sure enough, China is a major emitter, but investment is needed to promote sustainable development elsewhere too.

How can the Clean Development Mechanism direct buyers towards projects with high overall benefits in terms of sustainable development and carbon reduction, even if with lower initial returns? One problem is that the mechanism’s architecture does not specifically reward returns on downstream benefits, such as revenue from electricity, or cost savings from recycling, for instance. Some market players complain about the complexity of procedures, too: a tonne of carbon may be obviously cheaper to remove in a project in a developing country, but when assessment and approval is added on, the costs rise. A simpler procedure would keep compliance costs down and those returns attractive.

In other words, the CDM market has the potential to deliver more real emissions cuts, but it has to work in tandem with regulatory approaches. And this also supposes ironing out incoherent policies. For instance, renewable energy projects should not be scuppered by limitations on the amount of electricity independent producers may feed into national grids, or by red tape affecting foreign investment and ownership. And subsidies for fossil fuels or heating can cancel out efforts to produce cleaner energy.
CDMs have other positive spin-offs. They promote transfers of technology to poorer countries, and also focus minds on how to tackle climate change in acost-effective manner.

The CDM was designed to help OECD governments and corporations fight climate change more affordably, and it is growing fast to be a significant instrument. It is expected to reduce more than 2 billion tonnes of emissions by 2012, and those gains could be built on. Such market instruments clearly have a role to play and policymakers must do more to improve the framework so that the Clean Development Mechanism can deliver genuine emissions cuts.

References

For more on OECD work on the CDM, contact Jane.Ellis@oecd.org

For more on OECD work on climate change in the framework of the United Nations Framework Convention Climate Change, see www.oecd.org/env/cc/aixg

©OECD Observer No. 264, December 2007




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