Expectations and the emerging picture of the GCF are creeping apart (source: UNclimatechange)

In advance of COP 17, the Green Climate Fund’s (GCF) Transitional Committee (TC) have passed the Parties a report, recommending it “take note” of the report’s findings. It is worth analysing this report since it  brings in to clearer focus the contrast between the expectations that some have for the fund – largely the private sector – and the the emerging picture of the fund.

Specifically, the overarching sentiment from the report is that the GCF will be a vehicle for aid-based disbursement. This is not necessarily consistent with the guiding principle of “catalyzing climate finance.” It is this apparent confliction – between the guiding principle of acting as a catalyst for climate finance, supposedly inclusive of the private sector, and the emerging picture of aid-based finance – that has recently attracted criticism from figures such as Yvo de Boer, and the frame in which we should view the suggested design of the GCF given to Parties at COP 17.

Sourcing the money

The report states that the finance will be delivered at a country level. This means that finance delivered by the GCF could, for example, be delivered to a sovereign-administered fund that lends to projects or programmes that aim to execute a particular objective arising from a national policy.

A natural consequence is that the GCF can be expected to deliver finance in much the same way as existing multilateral funds. Notably, it will place far more importance on public rather than privately sourced finance, since private investors would find it more difficult to contribute to a fund that’s lending criteria focus on promoting a particular national or regional policy, first and foremost, delivering returns as a somewhat more ancillary benefit.

The report, however, does state that the GCF should have a private sector facility that employs the private sector in fund contributions. It is unclear if the reference to a separate “facility” should be interpreted to mean that the privately sourced finance will be disbursed through mechanisms separate to those for public sector finance, nor if such a distinction should emerge, how the private finance will be delivered.

Disbursing the money

Inspecting the financial instruments recommended for disbursement of the funds gives perhaps no clearer demonstration of an aid-based picture. Disbursal will be focussed on grants and concessional lending. The instruments will be used to finance the additionality gap – taking the risky investments that the private won’t take alone in order to get a programme or project off the ground.

Clearly, grant-based disbursal limits the involvement of the private sector in the fund’s capitalisation. This also extends the earlier question: will concessional lending on a country level attract private investors to the fund, and if not, will the private sector facility employ delivery mechanisms that are different to grants and concessional lending.

A stark contrast

In contrast to the emerging picture of the GCF, the Green Climate Finance Framework (GCFF) suggested by BNEF is a manifestation of the expectations of the private sector. In this proposal the public sector contributions make up around 10% of the fund, are delivered by aid-based finance and used to leverage the remaining 90% from the private sector, i.e. fulfilling the mandate of catalysing finance for climate change from the outset.

It could be argued that the difference between the GCF and the GCFF is based largely on the level of the involvement of the private sector, and that both can catalyse finance by funding the additionality gap. This is true, but a design like the GCFF does far more catalysing from the outset, precisely because it is leveraging nine times more private than public sector capital.

The GCF, as it stands now, is the inverse of the GCFF – predominantly aid-based delivery of finance at a country level, with a small, but “non-negligible,” role for the private sector. This set-up, if justified properly, is not in-and-of itself objectionable. It is, however, of concern that the emerging picture of the GCF seems to contrast sharply with the expectations of the private sector, whilst also limiting the fund’s ability to catalyse private sector finance from the outset.

Emerging patchwork of supply important for REDD (source: Ken Bosma)

Last month, the second edition of State of the Forest Carbon Markets,was released. All in all, the report painted a positive picture for the forest carbon markets: the volumes, transaction value and average prices in 2010 were all up on the previous year at, respectively, 30.1MtCO₂e, $178 million and $5.50/tCO₂e.

Notably, REDD based transactions dominated the total volume contracted in the primary market – 67% of the 29MtCO₂e primary market, due to the methodologies developed for the voluntary market – whilst afforestation/reforestation projects declined in transactions across every primary and secondary market.

Moving away from multilateralism

Latin America contracted more than half of all projects in 2010, with the EU as the largest source of demand. Of interest, however, is the increase in localised demand: outside of Europe, most of the demand for a region’s credits was from within that region. In North America, for example, demand nearly equalled supply from the region.

This to be expected, if considered in the context of the wider move towards a patchwork approach to climate policy. The patchwork approach is the increasing preference to enact a patchwork of policies to tackle climate change on a sub-national, national and regional level. These efforts are, arguably, being prioritised over the global, multilateral efforts to address climate change by many countries. It seems that forest carbon is no exception; indeed this approach is becoming increasingly important for REDD.

A patchwork of supply

The report finishes by projecting a growth in supply to 373.1Mt over the period 2011-15, of which REDD projects will supply 335.3Mt, stating that the emerging picture is “fundamentally about a small—but growing—cadre of forward-looking buyers and investors making big bets on the future of the forest carbon markets.”

This is true; the bets are certainly “big”. However, with many countries moving towards a patchwork approach to climate policy, the international compliance market-mechanisms look increasingly unlikely to create significant demand – and in turn supply – for REDD, any time soon. In the Panama climate talks, for example, the focus of discussion still appeared to be on the how market-based mechanisms for REDD are to be included, if at all; demonstrating the absence of globally coordinated efforts to source REDD finance and the gap in financial mechanisms.

It’s possible, then, that “bets” are being made on the growth in REDD supply coming almost entirely from the voluntary markets and a patchwork of non-UNFCCC led unilateral or bilateral compliance mechanisms. The voluntary market is already seeing some significant movement in this area, as the report above demonstrates. In the case of unilateral or bilateral compliance mechanisms, however, the growth is more difficult to envision, precisely because it is a patchwork of mechanisms providing supply, but also because their existence is dependent on the need to offset emissions, i.e. the presence of an emissions cap.

The Governors’ Climate and Forests Taskforce (GCF) is attempting to create such a mechanism. The purpose of the GCF is to create compliance grade REDD credits, such that the entity complying with a cap will buy those emissions reductions in the future. This type of mechanism, whereby the sub-national or national entity that intends to cap emissions helps create methodologies for REDD project types, will become increasingly important for REDD over the coming years. This is because the GCF should, hopefully, demonstrate how REDD can work for projects in the compliance markets, but most importantly, it does so in the context of the emerging patchwork approach.

From the perspective of international climate policy, it may look ungainly, and be more difficult to quantify the emissions reductions on a global scale, but if national and sub-national entities with emissions caps and offsetting rules begin to create similar bilateral mechanisms to that being attempted by the GCF, the REDD market will develop far beyond that offered by voluntary markets alone, bridge some of the finance/supply gap left by the absence of a multilateral mechanism, and do so in the context of the bottom-up, patchwork growth in the REDD space.

Rimba Raya Project in Rapid Decline (Source: Timothy G. Laman, National Geographic)

Indonesia’s flagship Rimba Raya REDD project was registered this year under one of the Voluntary Carbon Standard’s REDD methodologies, aiming to preserve “91,215 hectares of tropical peat swamp forest,” equivalent to an emissions reduction of 104,886,254 tonnes of CO₂e over the crediting period of 30 years, according to the registration documents.

The project has long been an exemplar of early action on REDD, hoping to bring the field in to the carbon markets. Indeed many expected it to be the first to issue REDD based carbon credits in the voluntary markets, but this title was taken by the Kenya Kasigau Corridor Project earlier this year. Despite the early success, a recent report by Reuters outlines how hopes for the Rimba Raya project have declined rapidly over the course of the past year.

Back-pedalling and contradictions

At the heart of the controversy is a decision by the Indonesian Ministry of Forestry to cut the project area in just over half, and grant development rights to a palm oil company for some, if not all, of the newly available land, resulting in the economic viability of the project  now coming under review.

The reason for the decision is, unsurprisingly, unclear, but interviews by Reuters suggest that land ownership and competing potential uses of land were root causes for the sudden reversal. Indeed Reuters reports that the decree allocating the project’s land area to the REDD project developers was never formally signed by a Minister, allowing the original claimants – PT Best, a palm oil company – the development rights of the land that was originally allocated to them.

Most of those involved seem to be genuinely startled by the sudden turnaround of the government, particularly given the decision’s seeming opposition to the government’s purported stance. It appears to highlight deep divisions between the national government and the civil service, or perhaps even amongst ministers themselves, on the level of action needed to stop deforestation.

It all comes down to price

More importantly, however, it draws attention to the magnitude of the political risk faced by those investing in a new, politically unstable market, and demonstrates with painstaking lucidity the potential losses facing an investor, should a project either not sit well with the government or should there be more profitable, competing uses of the land. And herein lies the fundamental problem: the existence of more profitable uses for land often result in REDD offset credits being unable to compete with the alternative uses of land, since profits are dependent on a low carbon price.

The number of participants, presence of willing buyers and the involvement of Gazprom all seem to suggest that, over the 30 year crediting period, the project is likely to be profitable. But the Ministry of Forestry seems to disagree, exemplified by the Secretary-General of the Ministry of Forestry, asking “who will pay for the dream of Rimba Raya? Who will pay? Nobody, sir!” Although a legitimate question to ask, this apparent rationale does beg the question of how the government expects the project to pay for itself if it is slashed in half.

Nevertheless, it seems that the Rimba Raya project may have fallen victim to the whims of political infighting. Irrespective of the reason, the presence of an economic case that argues against the implementation of a REDD project will never sit well with governments handing out permits. Perhaps more importantly, it allows any number of potentially illegitimate reasons for derailing the halt of deforestation to mask behind this inconvenient – albeit legitimate – concern.

Finally, turning back to the price, it is worth reiterating an obvious but important point: if the carbon price were at a level that demonstrates clear economic viability for REDD projects over and above alternative environmentally destructive uses of the land, these kind of problems would be far less likely to arise in the first place.

GCF needed for more than mitigation (Image by: USFWS Headquarters)

One of the purported successes of the talks in Cancun last year was the creation of the Green Climate Fund (GCF). This year the GCF’s Transitional Committee (TC) was created, with forty members, twenty-five of which are from developing countries. The TC is tasked with no less than designing the GCF itself. It must be an institution that is capable of handling vast sums of “new and additional” funding from the $100 billion promised annually by 2020, and that can target investment across many different fields of climate change related investment.

The GCF as a “recipe for failure”

The TC has agreed on some guiding principles, one of which is that the GCF should be designed in a way that subordinates private sector finance to public sector funding. This is the approach favoured by many developing countries and is line with the GCF’s objectives of providing more direct, reliable and streamlined access to climate finance. Last week, however, Bloomberg New Energy Finance (BNEF) released a white paper that forcefully argues the TC’s current approach is “a recipe for failure.”

The paper’s author, Michael Liebreich, claims that the GCF will never be able to raise a large portion of the $100 billion from the public sector. This, Liebreich states, is because many of the donor countries are under extreme fiscal strains and because many would face political difficulties in passing the revenue raising mechanisms in to law.

Liebreich argues that instead efforts should be focussed on the creation of a Green Climate Finance Framework (GCFF). The GCFF would raise approximately ninety percent of funds from the private sector, channelling money through existing financial mechanisms, whilst investment is largely used to target mitigation or, more specifically, infrastructure projects. The GCF still exists in Liebreich’s scenario, but plays a smaller role, administering the funds needed to leverage private sector money – in this case subsidising the gap left between the cost of clean and dirty energy.

A more complex issue

Liebreich’s arguments are compelling, but there are four immediate objections. First, although donor countries are indeed facing fiscal constraints, the funds they are capable of contributing is unclear. The ambiguity surrounding availability, or willingness, of funding is part of a larger problem: the lack of follow through on financial commitments by developed countries.

It seems premature – or even far-fetched – to state unequivocally at this stage that donor countries are incapable of providing the finance, although the author is correct to draw attention to the difficulty in ensuring the pledged funds are in fact received and spent, and to reaffirm the contention that the private sector will have to play a non-negligible part.

Second, many in the TC may disagree with the sentiment that a large majority of GCF expenditure should be on mitigation. Adaptation is under-funded yet considered equally important as mitigation by developing countries. Moreover, adaption activities are far less likely to be funded by the private sector on a large scale, since they are unlikely to generate revenues – if any at all – of the same scale, stability and longevity as mitigation projects. As the role of the private sector increases in the GCF, the available funding for adaptation decreases.

Third, the guiding principles of the GCF – which reflects the sentiment of those creating the fund – states that recipients wish to use the funding to promote ownership of climate activities within their countries. Although this can be interpreted in many different ways, one is to say that recipient countries wish to ensure the money is spent in a way that does not entrench dependence on foreign money and expertise.

However, since the majority of programmes and projects in a GCFF would be financed and/or owned by private investors, likely to be overseas investors, and that capacity building and technology transfer are both understandably unlikely to be funded by the private sector, domestic ownership of climate change related activities is significantly undermined.

Finally, a guiding principle of the GCF is the desire to make delivery of finance results-based, whilst ensuring it is not wholly conditional on results. Clearly, the delivery of finance by the private sector is based almost entirely on results, and thus runs contrary to the sentiment of those participating in the creation of a climate finance mechanism.

There is no reason why a GCFF cannot be created; indeed it is a good idea. However, suggesting that it should replace the GCF entirely – and therefore that the majority of the $100 billion should come from the private sector – would result in only a sub-section of the types of projects in need of funding, receiving funding. Moreover, it opposes the sentiment and guiding principles of those attempting to create a climate finance mechanism, in that it reduces the domestic ownership of emissions reductions activities and ensures that delivery of finance is almost entirely conditional on results.

Commodities Futures (Image by: Lars Plougmann)

As already discussed on Climatico, using REDD+ as a private sector offsetting mechanism runs the risk of creating perverse incentives, exposing land to market price volatility and causing supply-induced price suppression. However, for the purposes of a deeper exploration into the market-related issues of REDD+, let’s assume these problems are solved and that forest carbon can, in theory, be commoditised and traded. This begs the question of whether forest carbon can be treated and traded like any other commodity.

A report by the Munden Project earlier this year attempts to answer this question. The authors’ conclusion was that forest carbon is not suitable for commodity trading. In response, trade association the Carbon Markets and Investors Association (CMIA) this month issued a response to the report.

Don’t commoditise forest carbon

Turning initially to the findings of the original report, first, the report highlights the risk of creating a monopsony structure, largely due to the limited number of organisations capable of verifying carbon measurements to IPCC standards. This results in the homogenisation of prices offered by the credit buyer to a project developer. More importantly, it also diverts the benefits of REDD+ away from communities and towards the middle men, in contrast to REDD+’s stated developmental objectives, whilst increasing the costs of REDD+.

Second, the high level of complexity and uncertainty surrounding forest carbon greatly increases the delivery risk for buyers. In short: there is no universally agreed process for carbon accounting; the costliness of an accounting method influences its use and consequently the mass of carbon that’s measured; and baselines can be manipulated. This affects the volume of credits that can be used to meet contractual obligations, whilst also leaving traders somewhat befuddled on the exact nature of the underlying physical asset.

Third, the uncertainty arising from the issues highlighted above, combined with the unavoidably high margin of error inherent in carbon measurements, is unacceptably high for commodity trading. If forest carbon transactions are executed on an exchange, they will be cleared by a clearing house, the latter of which takes on the counterparty risk. A clearing house will ensure that it can cover 99% of potential losses on a single day. However, the margin of error in carbon measurements is an order of magnitude higher than the uncertainty tolerated by a clearing house. Therefore, forest carbon will either not be exchange traded or a sub-standard commodity will be created instead.

Do commoditise forest carbon

Turning now to the CMIA’s responses, the CMIA first argue that primary market prices will not be homogeneous since the demand for credits is determined by the size and design of a compliance regime that permits offsetting via REDD+. And since any compliance regime has more than one compliant entity, there will always be more than one buyer. There is ample evidence from existing carbon markets to support this contention.

The Munden report is correct, however, to point out that there are only a limited number of organisations capable of verification to IPCC standards. This will almost certainly lead to higher costs and price manipulation by a limited number of organisations, subsequently diverting money away from communities and inflating the total cost of REDD+.

In response to the Munden report’s conclusion that uncertainty and complexity in verification causes problems meeting contractual obligations, the CMIA stresses this can – and currently is, in existing carbon markets – mitigated by the prices and volumes stipulated in the contract. This is true, but mitigation to the level of accuracy that a clearing house demands, this is unlikely. However, the assumption by the Munden report authors that primary market transactions need to be cleared via a clearing house is incorrect.

Copycatting the CDM

It is far more likely that primary market transactions will be executed in the same way as those in the CDM. This means that the delivery risk will be taken on by the two parties that drew up the contract, and that the transaction is very unlikely to be executed on an exchange and cleared through a clearing house. Meeting the high level of accuracy demanded by a clearing house is therefore immaterial.

This leaves a somewhat more familiar landscape. A compliance market will create demand from multiple buyers and result in price differentiation. The high level of uncertainty regarding the potential volume of issuable credits will be accounted for in the unique structure of each contract, and the transaction will be cleared bilaterally. The secondary markets can then trade a commodity that, crucially, already exists – since it has been issued and contains no delivery risk – on an exchange, using a clearing house.

It seems that the Munden report is correct in highlighting the risk of inflated costs caused by there being only a narrow group of capable verifiers, and the consequent diversion of benefits away from communities and the increased costs of fighting deforestation. It fails, however, to properly appreciate the primary-secondary market distinction that currently exists in the carbon markets, and how this is likely to be replicated in a private sector compliance market for REDD+, should one ever exist.

Remembering the rainforests (Image by: Ben Britten)

As the number of public sector financial mechanisms targeting REDD+ has increased, and consequently the volume of money flowing in to REDD+, observers are increasingly pointing out that the public sector alone cannot supply the huge sums of money needed to combat deforestation. The private sector is thus needed to share the cost and supply some of the money.

The most commonly proposed mechanism of engaging the private sector is via some sort of carbon market offsetting scheme. However, the world’s largest emissions trading scheme (ETS), the EU ETS, explicitly disallows the use of REDD+ offsets as compliance units in the EU ETS, and seems unwilling to allow offsetting for REDD+ on a large scale before 2020.

This is largely because the EU ETS is concerned that monetising the huge sums of carbon stored in tropical forests could quickly flood the carbon markets with credits, pushing down the price of carbon and further compounding the EU ETS’ ongoing price issues.

Despite this objection, there is still a large drive to engage the private sector in REDD+ financing as soon as possible. Much of the discussion for attracting private finance has focused on creating investable conditions for private actors. High transaction costs, political and regulatory risk, and the absence of any clarity on the monetary value of credits within a compliance carbon market post-2012 must be mitigated, it is said, before private money will flow to REDD+.

However, much less attention has been given to the safeguards that must be put in place to ensure that private sector engagement does not compromise the environmental integrity of a project, credit, or damage the reputational issues of the financial mechanism.

Reputational and Functional Problems

The CDM is an example of how these exact problems have materialised. The reputation of the CDM has been compromised by private sector participants that previously increased the generation of pollutant gases – and subsequently destroyed them – in order to generate more credits. Moreover, the environmental integrity of the credit has been undermined since the credit is treated – although not necessarily priced – in the same way as a credit generated from a project that is genuinely contributing to sustainable development.

Although the specific problems with the CDM are not directly transferable, abstract slightly from the CDM, and the potential for similar problems with a market-based REDD+ mechanism become fairly evident.

First, should perverse incentives exist, they will be exploited. For example, assuming that REDD+ payments can override the opportunity costs of logging, palm oil, mining, etc., there still remains the possibility that virgin forest could be logged and replaced with trees that have higher carbon content, are easier to measure or have a dual revenue stream, such as plantations. The proper restrictions must be in place to ensure the forest’s existence prior to monetisation.

Second, exposing deforestation reductions to market price volatility – often subject to the whims of speculative traders – can quickly result in the revenue gained from a REDD+ project shifting in favour of alternative forms of revenue generation. This causes investors to pull out of projects and private sector funding to slow down. Indeed this is happening right now in the CDM: the exchange-traded price is dropping below the price that project developers are willing to sell the credit, squeezing profit margins for buyers of credits and halting new funding of CDM projects.

Third, limits would need to be put in place to avoid supply-induced price suppression. Limitless offsetting via REDD+ would result in an oversupply as developers attempt to monetise the vast volume of carbon stored in existing forests, causing the exact problem that the EU ETS is concerned with, and resulting, again, in alternative uses of land becoming more profitable. A REDD+ based crediting scheme would thus require a carefully thought-out limit on REDD+ offsets so as to not depress the price of carbon – and in turn deter additional REDD+ projects – simply by its inclusion.

The momentum behind the discussion on the private sector’s inclusion in REDD+ finance is gaining. However, without serious attempts to mitigate the problem highlighted above, the momentum can quite easily be turned on its head. It therefore seems sensible to posit that REDD+ will be reliant on public sector funding for some time, not just because the private sector is hesitant about investing in an unknown market, but because the regulators are unsure of how to adequately overcome these concerns.

(Image by: Green Antilles)

In recent years the transfer of climate finance has emerged as a policy response to equitably addressing climate change mitigation and adaption in developing countries. Much attention has been given to setting up the multilateral or bilateral mechanisms needed to classify, transfer and disburse the funds pledged by donor countries. Of those that have sprung up, thirteen out of the twenty-four major funds focus on REDD+ as the sole or a major objective.

For some observers it has been difficult to keep track of the progress made by the new funds, not least because all thirteen emerged in the space of three years. Nevertheless, using the UK government’s recently commissioned analysis of existing REDD+ targeted funds as a springboard, some preliminary analysis on the progress made by the REDD+ targeted funds can be carried out.

What is being financed?

As a starting point, progress can be defined as the stage at which the most funding for REDD+ has been applied. The three phases that denote the proximity of a country to full implementation of REDD+ based emission reductions are readiness, demonstration and roll out at scale.

At present there has been very little funding applied beyond phase one, with only three countries – Norway, Australia and the USA – targeting phase two, and one country – Norway – targeting the final phase. Rather than an inherent unwillingness to fund beyond readiness, however, this is likely a result of the fact that both the bilateral and multilateral mechanisms have a strategic focus largely on the first two phases.

How much has been spent?

The level of disbursement at each phase perhaps gives a greater insight in to the progress being made. For the multilateral funds the disbursement has a range from zero to twenty per cent of the funds committed, with the Global Environment Facility at zero and the UN-REDD programme at twenty per cent, with all other multilateral funds lying in-between.

The multilateral fund to which the largest amount has been pledged, the Forest Investment Programme, has disbursed a total of £2 million or 3% of the total £335 million pledged. The World Bank’s flagship REDD+ fund, the Forest Carbon Partnership Facility, with its Readiness Fund dedicated to investing in phase one and the Carbon Fund dedicated to investing in phases two and three, has spent 11.4% of its Readiness Fund and none of its Carbon Fund as of FY10.

When considering the rates of disbursement, it is worth remembering that disbursement does not necessarily mean expenditure. As an example, take the UN-REDD programme. Funds are disbursed to the forest country offices of the United Nations Environment Programme, Food and Agriculture Organisation and United Nations Environment Programme, who then administer expenditure on behalf of the UN-REDD programme.

The move away from multilateralism

Possibly in response to the slow progress made by multilateral mechanisms, or perhaps due to domestic political motivations, bilateral approaches seem to be emerging as the preferred funding channel for REDD+. According to the UK government’s analysis, to date 67% of committed REDD+ funding has passed through bilateral mechanisms.

The implementation of phases II and III also appears to be moving ahead much quicker through bilateral mechanisms. Take Norway’s Internal Climate and Forest Initiative as an example: it’s currently developing a results-based payment scheme whereby the government of Guyana can receive up to US$250 million over 5 years from 2010 for REDD+ based emissions reductions.

Scratching at the surface

The reasons for low funding levels and the move towards bilateralism are unclear. Multilaterals often cite poor forest governance and a difficulty in establishing clear monitoring, reporting and verification (MRV) guidelines as the prime reasons for the low funding follow through. The move away from multilaterals is often attributed to ill-equipped organisations with anachronistic disbursement procedures.

However, the greater speed of implementation of phases II and III through bilateral mechanisms, the apparent preference for bilateral funds and the slow progress made by multilateral funds suggest that the reasons above only scratch at the surface. Moreover, they hint towards the idea that determining the real reasons may require some introspective analysis by the funds themselves.