Easier to lose than land (Source: Salisbury Area Plaques)

In anticipation of the centralised European registry for the EU ETS the Commission has turned its attention to the legal issues surrounding the traceability of stolen emissions allowances. The approach taken is deferential to the national laws of individual Member States rather than providing a harmonised EU-wide rule. However, the Commission’s proposals have done little to address the risks faced by market participants if found to be unwittingly holding stolen allowances. This is not particularly helpful for the overall health of the emissions market.

Identification and recording of emissions allowances

Much like a land registration system, each emissions allowance within the EU ETS is currently identified by a unique serial number (called a unique unit identification code in the EU ETS registry regulation) and is recorded in one of the national Member State registers, depending on which Member State it has been allocated to. The Community Independent Transaction Log (CITL) supervises and verifies all transfers of allowances between national registries to ensure that they comply with the EU ETS rules.

Phase III of the EU ETS (commencing in 2013) will see a centralisation of the registry system, with all emissions transactions being carried out through a single EU registry, the European Union Transaction Log (EUTL). The central registry will be operated by the European Commission and will replace the individual Member State registries.

Theft of emissions allowances

Since the start of 2011 the emissions market has witnessed several incidents of allowances being stolen from national registries. Eastern European Member States in particular were affected, with millions of euros’ worth of allowances being lost when fraudsters broke into the electronic registry systems. This brought the emissions spot market to a halt in January 2011.

A substantial number of these allowances have not been recovered to this day. This is in spite of each allowance having a serial number, which in theory at least should make its movement through the accounts in the registries easily traceable. However, the approach of the Commission has been to leave the recovery of stolen allowances to the legal systems of individual Member States, without attempting to draft any generally applicable rules in this respect.

Where have all the serial numbers gone?

That derogating to individual Member States represents official policy in this area has been confirmed recently by the Commission’s intention to amend the EU ETS registry regulation to make serial numbers confidential. This means that any stolen allowances will no longer be capable of identification; the responsibility for holding them rests with their owner at any particular time.

The Commission’s proposal is that unknowing purchasers of stolen allowances should be allowed to keep them, while the interpretation of “purchaser in good faith” should be left to the national laws of each Member State. However, Member States have different rules regarding the tracing of stolen property. Emissions market participants would be left uncertain as to what they are holding in their registry accounts. They would no longer be able to identify which allowances are stolen, and would also be potentially liable to losing them if the law of a particular Member State stipulated that the allowances should be returned to their original owner.

Effects on the market

This level of uncertainty does not bode well for the emissions market and could seriously undermine the viability of the EU ETS. There have already been objections to the Commission’s proposal not to publish serial numbers. Coupled with this are the recent closures by some financial institutions of their emissions trading desks, amid fears that the market is too unstable to merit involvement. While the Commission’s attempts to address the security issues in the EU ETS are in themselves commendable, the approach has not so far elicited the desired response from the market.

Editorial by Guest Contributor: Alan Andrews, ClientEarth

London traffic (Image by: Andrew Nesbitt)

On the 29^th September the government submitted its official report to the European Commission on levels of air pollution in the UK for 2010. It makes for pretty grim reading. The report confirms that 40 of the 43 air quality zones in the UK breached the annual limits for nitrogen dioxide. No other EU country has a higher proportion of non-compliant zones.

EU directives set legal limits on levels of harmful air pollutants in the air we breathe. One of these pollutants is nitrogen dioxide – a harmful gas emitted by burning fossil fuels. Road traffic fumes are the main source of this pollutant, with emissions from domestic boilers and industry also playing a significant part.

The situation is particularly bad in London, where an area of 91 km² breaches the annual limit, exposing nearly 700,000 people to illegal levels of air pollution. The air pollution monitoring station at Marylebone Road, just opposite Madame Tussauds, recorded over 500 breaches of a short term hourly limit. However, by not including data from other worse sites in the official report, the government are hiding the true severity of London’s air quality crisis. Data from the excellent London Air Quality Network, run by King’s College London, show that Brixton Road recorded a staggering 2,683 breaches of the hourly limit in 2010, closely followed by Putney High Street, with 2,481.

For those of us who work in the field of air quality these figures come as no surprise. In fact, ClientEarth threatened the government with legal action in November 2010 over breaches of the limits in London. The government assured us that it was in the process of producing air quality plans for each zone which would show how the limits would be achieved by 2015 at the latest. However, when these plans were eventually published for public consultation in June this year, they revealed that for 17 zones, the limits would not be achieved until well after 2015. In the case of London, it could be as late as 2025.

ClientEarth therefore issued judicial review proceedings against the Secretary of State for Environment, Food and Rural Affairs. We are calling on the High Court to order Defra to draw up new plans which will achieve compliance by 2015, as required by law. On the 16^th September the High Court gave us permission to proceed, and we expect a full one-day hearing before Christmas.

So why are we so concerned by nitrogen dioxide? First and foremost, this is a health issue. In high concentrations nitrogen dioxide can irritate the eyes, nose and throat and cause shortness of breath. But for children, older people, or those with pre-existing health conditions, the effects can be far more damaging. A study published last week concluded that breathing in high concentrations of traffic fumes, including nitrogen dioxide, can trigger heart attacks. Another recent study has shown that living near busy, polluted roads could be responsible for some 15-30 per cent of all new cases of asthma in children; and of diseases such as bronchitis, emphysema and heart disease in adults over 65.

The European Commission will almost certainly launch enforcement proceedings against the UK for these breaches, probably in early 2012. Facing legal action at home and from Europe, the government has to start taking this problem seriously.

Alan Andrews is a health and environment lawyer for ClientEarth, an organisation of activist lawyers committed to securing a healthy planet.

This article originally appeared on ClientEarth and has been reprinted with permission. See the article in its original form.

Who will regulate? (Source: Sébastien Bertrand)

The EU ETS remains high on the UK Parliament agenda following a recent submission by Barclays Capital calling for an independent and separate regulator for the regime. The submission provides a much needed focus on some of the key peculiarities of the EU ETS which have been known to cause tension in the emissions market. In particular, the wide ambit of the EU ETS, open as it is to anyone who wishes to trade in emissions allowances (EUAs), is a potential cause for concern due to the inherent risks of market manipulation.

Who regulates?

The body currently in charge of managing the EU ETS is the European Commission, specifically the Directorate-General for Climate Action (DG CLIMA). Besides being responsible for developing and implementing climate change policy at the EU and international levels, DG CLIMA has the added task of supervising the workings of the EU emissions market.

What is somewhat surprising is the lack of express involvement of another Commission department that would logically have the requisite expertise in this area, namely DG Internal Market. After all, the bulk of the emissions market is made up not of spot trading, but rather of derivatives (specifically forwards) trading based on the EUAs as underlying assets, as this helps participants hedge against possible price volatility. The flexibility and openness of the emissions market has attracted large swathes of financial entities that trade in EUAs and EUA-based instruments for speculatory reasons rather than for compliance with the EU ETS.

The EU ETS – beyond environmental protection

The creation of such extensive emissions trading has taken the EU ETS from the purely environmental and regulatory sphere which it was initially intended to inhabit and placed it firmly in the realm of the financial markets. However, unlike other financial markets, the emissions market is not fully regulated as it is open to entities which are neither under EU ETS compliance obligations nor regulated as financial firms, notably under the Markets in Financial Instruments Directive (MiFID).

The risk of the Commission losing its grip over emissions trading has materialised on a number of occasions, with instances of VAT fraud and theft of EUAs from Member States’ national registries crippling the market. This is particularly damaging to investor confidence as it seriously undermines the credibility of emissions trading.

A sui generis regime?

This level of trouble has not been seen on any other commodities markets, and may suggest that emissions trading is in a class of its own and may require special treatment. The Barclays Capital submission suggests that participation in the market should be restricted to EU ETS and MiFID regulated firms, and that a separate regulator should be appointed that is independent of policymaking bodies. The latter measure would ensure that no public policy-based intervention would occur in respect of emissions prices. This point is particularly interesting given recent UK proposals to introduce a carbon price floor (see earlier Climatico post).

A special regulator in charge of the EU ETS would dilute DG CLIMA’s control over emissions trading as a tool of environmental protection as this goal would presumably have to be balanced against the merits of developing and maintaining a viable market in emissions in its own right. This may be a healthy outcome as it could enable the new regulator to harness the expertise of the EU financial regulation regime while bearing in mind that the EU ETS is a creature of public policy, and as such should pursue the environmental goal of emissions reductions. Whether the EU Commission has the resources or willingness to fashion this hybrid regulatory regime is of course another question.

What about the market? (Source: Financial Times)

As part of the latest budget the UK government announced its intention to introduce a price floor for the emissions market. It is hoped that this move will encourage low carbon investment by disincentivising regulated entities from emitting at current levels.

How this proposed unilateral measure will interact with the EU ETS remains to be seen. The purpose of emissions trading is to give polluters the discretion to decide whether to buy more EU emissions allowances (EUAs) in the market or invest in greener technologies, depending on which avenue is more cost-efficient. Having to pay a pre-set price for EUAs effectively removes this choice and distorts the emissions market as the cost-benefit calculation has already been performed by the regulator.

A tax by any other name…

The effect of the carbon price floor would be akin to that of a tax on emissions, since it would guarantee a minimum price level which UK polluters would have to pay to the government irrespective of the real market price of EUAs. It has not yet been clarified how this would operate in conjunction with trading under the EU ETS; one option would be to require polluters to make up the difference between the market price and the minimum set price. This would provide the UK with a hybrid tax-trade approach to emissions reductions, whilst the other EU Member States remain wedded to the EU ETS only.

A key advantage of a carbon tax over a trading system is the guarantee that the revenues from the former accrue to the national government rather than to polluters. This makes it more likely (at least in theory) that the money will be spent on low carbon initiatives rather than simply being reinvested in the polluters’ business or helping to boost their profits. The flipside is that regulated entities do not enjoy the cost-balancing flexibility associated with emissions trading. A proposed EU-level carbon tax was in fact rejected by industry in the 1990s.

Design issues

A cap-and-tax system could work well to reduce emissions if appropriately designed. Specifically, the price would have to be set at a level which is neither excessively high (so as not to seriously stall productivity) nor woefully low (which would be of little help in motivating polluters to reduce their emissions).

Of course, the price level would also have to take into account the fluctuations in the emissions market and would thus have to be crafted in a way which allows for any requisite adjustments.

What hope is there left for the market?

The proposed hybrid system makes the regulator’s job easier as it removes the uncertainty associated with fluctuations in the market price of CO2, which has recently fallen to around €12/tonne. This has been caused by overallocation of EUAs to polluters and decreased levels of productivity due to the difficult economic climate.

On the other hand, the whole point of having a market in emissions is that the price level is left to be freely valued by supply and demand, as with conventional markets. A cap-and-tax system would enable the UK government to artificially manipulate the price of EUAs and thus unilaterally interfere in the EU-wide emissions market as national environmental policy dictates. This is concerning as it undermines the very notion of market freedom on which the EU ETS is premised.

Either one or the other

Paradoxical as it may seem, if the EU emissions market is to function effectively, some level of price volatility is in fact desirable in order to incentivise entities engaged in emissions trading for investment rather than compliance purposes to take part. Tying the EU-wide price of carbon to Member State national environmental policy sends out the wrong signals as it strongly suggests that the market may not be genuinely free.

The UK government may be rightly concerned about the adequacy of the market price for carbon as a tool of environmental policy aimed at achieving emissions reductions. However, it cannot have it both ways without significantly diverging from the uniformity of the EU ETS.

While Ontario’s ambitious feed-in-tariff (FIT) policy is being put to the test by domestic and international opposition, including a challenge from Japan, Japan has just achieved a major breakthrough for its own FIT policy as it continues to recover from the tsunami and nuclear disaster this past March. Both examples will have implications for renewable energy policies and trade worldwide.

Currently in place in more than 40 countries – most notably in Germany, whose early leadership made it the world’s leading solar power – FIT policies boost initial development in renewable technologies by providing developers with above-market rates guaranteed over a long-term contract, usually 15-20 years. When designed well, they deliver long-term emissions reductions while providing a stable rate of return for clean-tech developers and reasonable costs for the consumer. When costs are not controlled over time, however, an FIT can be doomed to follow the example of Spain, whose program created a rush of solar development that ultimately led to a bust.

Ontario’s FIT Program Faces Many Challenges

The Green Energy Act (GEA) was passed in 2009 in Ontario, Canada, by the Liberal Party as a way to position the province as a long-term renewable energy leader while phasing out coal, spurring clean-tech investment and boosting the economy by creating jobs through domestic content requirements. The Act’s FIT program covers biomass, biogas, landfill gas, on-shore wind, solar photovoltaics (PV) and waterpower. So far, it has created 13,000 jobs and attracted $20 billion in private-sector investment.

Two years later, however, it is facing three international challenges. First, in a dispute initiated under the World Trade Organization (WTO) last year, Japan is calling the Act’s domestic content requirements a prohibited subsidy that discriminates against imported products and violates key elements of international trade law. Europe likewise objects to the domestic requirements in its own complaint it initiated in the WTO last month. The third challenge comes from Mesa Power Group, owned by T. Boone Pickens, who filed a compaint in July under the North American Free Trade Agreement (NAFTA), alleging that Ontario made last-minute, discriminatory changes to its FIT rules, preventing the company from winning contracts for two wind projects it was hoping to build in the province.

The Act also faces significant domestic opposition in Ontario. Some of the opposition comes from communities fighting the construction of wind turbines in their neighborhoods. Some of it comes from a $7 billion deal made in 2010 between the Ontario government and South Korean-owned Samsung, which has sparked anger and which oddly dismisses Ontario’s own goal of promoting local over foreign companies.

Much opposition comes from the Act’s purported role in rising household energy bills. Conservative Leader Tim Hudak, in advance of a provincial election in October, has promised to cancel the FIT program and the Samsung contract, hoping he can oust the Liberals on the perception that the Act’s rising costs hurt the economy. Yet as Pembina Institute shows, the rising prices are due to such factors as the introduction of smart metering and the much-needed replacement of aging infrastructure – and prices would rise even without renewable investment. Others note that prices are expected to fall in the long-term.

As Japan Challenges Ontario’s FIT, it Passes its Own

Meanwhile, as the composition of the Ontario-Japan WTO dispute panel got underway, Japan passed a renewable energy FIT law that will go into effect next July. Some details of the policy remain undecided, but the tariff will cover solar PV, wind, biomass, geothermal and small hydroelectric generation. An overall review will occur every three years, and tariffs and contract terms will be reviewed annually.

Given the long-standing political strength of the nuclear industry in Japan, the measure would not have passed if it weren’t for the Fukushima disaster, as well as the controversies surrounding the government’s handling of it. The powerful but heavily criticized Ministry of Economy, Trade and Industry (METI) will not be responsible for implementing the FIT system; rather, that responsibility will go to a special parliamentary committee.

The law reflects the large shift in public opinion on nuclear energy since the tsunami and disaster at Fukushima, as well as the pressure government officials have been under to phase out atomic power. While it may be considered a victory for long-silenced renewable energy supporters, Prime Minister Yoshihiko Noda is attempting to convince a fearful public that Japan’s precarious position cannot be overcome without any nuclear in the mix.

Implications – and Questions – From Both Cases

The implications of these related examples are likely to be significant. For example, Japan’s new policy could help it recover its leadership in solar PV technology, along with Germany, and place it in competition with China, which last month established its own solar FIT program. (In another parallel example, China’s wind FIT program is currently being challenged by the United States for its support of domestic wind turbine manufacturers, considered also to be an illegal protective subsidy).

It is not certain, however, that Japan’s policy, if successful, will affect other countries’ nuclear policies, given that each country’s nuclear energy needs and capacities are different.  It is also not certain whether Japan will implement its own domestic requirements as part of its FIT policy, but this is unlikely while its own case against Ontario remains open.

With regard to Ontario, it is unclear whether its FIT program is more at risk from the three international challenges or from domestic opposition. Certainly, however, a repeal of the Act would render the WTO and NAFTA challenges moot, leaving the protective subsidy question unanswered.

Are these emissions real? (Source: Pavel Ahmed)

Emissions trading continues to court controversy following recent events which have seen Romania, an EU ETS country, suspended from trading its Kyoto Protocol emissions units by the UN. The knock-on effect has been to exclude Romania from the spot market in EU ETS allowances (EUAs) for a predicted period of six months.

This incident highlights the ease with which EUAs can be fashioned out of unverified emissions. In Romania’s case, a substantial surplus of Kyoto units (which can translate into EUAs) was created on the basis of inadequately reported emissions. It is therefore understandable that the UN has stepped in to prevent flooding the market with these “tainted” instruments. However, the actual existence of the units in the first place raises questions as to the verifiability of what feeds into the EU ETS.

Emissions reporting failures

The UN’s Kyoto Protocol enforcement branch found that Romania’s standards for monitoring and verifying projects which generated emissions units fell short of the UN-mandated requirements. Estimating emissions from forest management was identified as a particularly serious issue as they formed the bulk of the country’s greenhouse gas emissions.

As previously discussed on Climatico, the EU ETS has already experienced a host of problems generated by Member States’ shortcomings in adequately administering the trading of EUAs. However, the problem goes even deeper: the very emissions on which the EUAs are based are not always properly monitored. This means that EUAs do not necessarily guarantee the existence of corresponding efforts to cut down the release of greenhouse gases in the atmosphere. On the basis of figures not backed by properly verified and transparent reporting, Romania would have been able to use some of its allocated Kyoto units for compliance with the EU ETS. This could have had serious negative consequences for the scheme’s emissions reduction credentials.

Damage to the EU emissions market

The failures in verification have a potentially wider impact on the EU emissions market. The UN’s suspension of Kyoto units trading translates into Romania’s exclusion from spot trading of EUAs under the EU ETS. This may turn out to have grave effects on the EU emissions market as it causes uncertainty (since the date for lifting the suspension has not yet been firmly set) and could undermine general investor confidence in the market, according to the Joint Implementation Action Group. Since the viability of the EU ETS is premised on a liquid and functioning emissions market, this could deal another serious blow to its environmental goals.

More specifically, the suspension also hurts Romanian firms which are regulated by the EU ETS. This regime aims to incentivise polluters to reduce their emissions by allowing them to do so at the lowest cost. In theory at least, regulated firms can choose to cut emissions either by installing greener technologies or by trading EUAs in the market in order to cover their greenhouse gas output. Since a substantial part of the Kyoto units would have been allocated to Romanian firms for use within the EU ETS, the suspension has the effect of temporarily excluding these firms from the emissions market and thus damaging their reputation as market participants. This is another way to damage the EU emissions market as a whole by depriving it of valuable and much needed volumes of trade.

What is the alternative?

The UN’s apparently drastic response can be justified in view of the blow that would have been dealt to the Kyoto Protocol if unverified (and potentially ungrounded) emissions units would have been allowed into the market. On the other hand, credible arguments have been made that the damaging effects of this decision on the international market in emissions and the EU ETS far outweigh the risk of affecting the Protocol’s environmental integrity. Each path comes with its own caveats. It must not be underestimated how difficult it is to achieve a generally acceptable trade-off between successful environmental protection and a viable emissions market.

Support without supervision? (Source: Ian Chou)

Emissions trading sceptics will feel that they have been proven right in the wake of the latest news on the emissions market; the UK Financial Services Authority (FSA) has recently issued an official warning on carbon scams. The warning follows an increasing number of complaints from people who have been approached with potentially fraudulent emissions trading schemes.

In reality, there is little that the FSA can do, unless the investments offered fall within the (relatively restricted) list of instruments covered by the UK and EU financial regulation regimes. Letting most of EU emissions trading fall through the regulatory net could seriously distort this market at a time when environmental regulators are working hard to incentivise firms to invest in the EU ETS. Without investor confidence, the EU ETS cannot function to pursue its environmental goals.

The emissions market

Emissions allowances can be bought and sold by anyone, not just EU ETS regulated polluters; this is called the emissions spot market. Spot trading does not fall within the EU financial regulation regime as emissions allowances themselves are not considered financial instruments. It is only if the allowances traded take the form of instruments such as futures that EU financial supervision is triggered, as the activity may be a regulated investment service and would also be covered by market abuse legislation.

It follows that large swathes of the emissions market remain untouched by financial regulation, despite the potential for fraud against investors that the FSA warning has highlighted. The risk of unsavoury behaviour such as insider trading and market manipulation is therefore rife.

Does it matter?

This loophole has not gone unnoticed. In France, legislation was passed in late 2010 which would cover the emissions spot market in the same way as the market in emissions-based financial instruments, following recommendations in a government-commissioned report. Unfortunately, to date this has not been extended to other Member States or the EU in general.

Problems have already been experienced in the emissions spot market where fraudsters have managed to avail themselves of the lack of financial regulation. 2009 saw a number of widespread and very serious instances of VAT fraud which temporarily brought the Parisian carbon exchange BlueNext to a halt. The exchange experienced an inexplicable increase in trades which led to the exchange being closed and the French authorities declaring emissions allowances exempt from VAT. This measure caused trades to drop significantly, which may indicate the extent to which VAT fraud was driving a substantial number of them.

The effects of this uncertainty on the EU ETS could be considerable. Without investor confidence in the quality of the emissions market, the EU ETS, premised as it is on the continued ability to trade valuable allowances which are genuine and verifiable, would not work.

EU-level action

These occurrences may justify the classification of emissions allowances as financial instruments under EU financial regulation, which would mean that traders in the spot markets would be subject to considerably more stringent regulatory requirements. This means more compliance costs for firms and more supervisory costs for regulators. However, this would arguably be a small price to pay to safeguard the integrity of the emissions market and thereby ensure the continued success of the EU ETS.

It is encouraging that the EU Commission has recognised the gravity of the incidents and has been running a consultation process to identify ways to improve market oversight. It remains to be seen what improvements will materialise.

Grounded? (Source: David Jones)

The EU’s commitment to taking serious action on aviation emissions has been courting controversy of late due to its proposed inclusion of the international transport sector in the EU ETS. From 2012 all arriving and departing flights in the EU will have to be covered by corresponding emissions allowances (EUAs).

Regulating flight operators will be entrusted to individual Member States. This raises the issue of effective enforcement by countries who have a less than satisfactory track record in preventing fraud in the emissions market. Added to this is the problem of increased administration costs as levels of EUA allocations will have to be decided for a substantial number of airlines. International operators have been left feeling alienated and sceptical of the EU’s ability to direct resulting funds towards pursuing environmental goals.

Monitoring and enforcement

Each of the 27 Member States will be responsible for administering the application of the EU ETS to a number of designated operators. Once the EU Commission has decided how many EUAs will be allocated to each country, the Member States will be charged with calculating and allocating the appropriate levels of allowances to the airlines.

The number of operators within each Member State’s jurisdiction is significantly higher now that international operators are also included. While some countries have a good history of administering the allocation and trading of EUAs, in the past others have been hit by incidents of theft of EUAs from national registries and large-scale VAT fraud. The emissions market was brought to a standstill following attacks in early 2011. Competent registration and monitoring of EUAs is therefore paramount if the EU ETS is to work in its extended format.

Only time will tell if we can trust the Member States to live up to their task. The introduction of a new, centralised emissions registry at EU level from 2012 will hopefully address this concern, as managing the emissions market will no longer be within the ambit of individual Member States. However, this in turn may create its own problems of increased bureaucracy. The EU Commission could be in danger of spreading itself too thin in an attempt to regulate an overly challenging number of aviation operators.

Increased administration costs

Since Member States will have to decide on the levels of allocation to each operator, they will need to expend significant resources on analysing large amounts of unfamiliar emissions data from operators. This information is likely to be in a non-standardised format which may well differ between airlines and thus increase the administrative burden. To what extent the Member States will have the capacity to verify the accuracy of the data is also something that remains unclear.

How to achieve real results?

International operators have been complaining about the lack of transparency prevalent in the EU regarding the destination of the income raised from auctioning allowances. They are particularly worried that the revenues raised will simply be absorbed by individual Member States rather than spent on green technology R&D or emissions reductions. This is in addition to general opposition to the application of the EU ETS in a way which is perceived as illegal in its disregard for non-EU states’ sovereignty.

The combination of mistrust on the part of operators and the questionable capacity of the EU mechanisms to adequately police the extension of the EU ETS outside its territorial remit is a potentially toxic one. In reality, is it really likely that the EU will apply the ultimate sanction of excluding non-compliant operators from its airspace? Without the possibility of effective enforcement, the expansion of the EU ETS may only serve to antagonise instead of achieving environmental results.

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.

Polluting away (Source: Alex E. Proimos)

A recent report by Sandbag, a leading emissions trading think tank, has revealed that under the EU ETS leading industrial firms have amassed a surplus of 240m emissions allowances (EUAs) between them during the 2008-2010 period. The surplus is estimated to be worth €4.1bn in the market, and is due to the combined effects of over-allocation and the economic downturn.

The crux of the EU ETS is the tradability of EUAs; firms can supplement or divest of their initial allocation in the market. The risk is that they can profit from over-allocation without making any real efforts to cut emissions. If the EU wants to act fast to reduce the surplus, it may have to cancel already allocated EUAs, something which is not addressed by the EU ETS legal framework.

The goal of the EU ETS

The purpose of the EU ETS is to allow firms whose levels of emissions fall below the number of allocated EUAs to sell spare ones in the market. However, the EU ETS envisages that this reduction in emissions levels would occur as installations develop greener, more innovative technologies of production which would pave the way towards low carbon economies in the Member States.

It is questionable whether selling surplus EUAs on a large scale complies with the environmental goals and spirit of the EU ETS. The long-term goal of emissions trading is not limited to trying to achieve reductions wherever possible without a concerted strategy and in reliance upon incidental decreases in industrial production. A recent report by the UK Committee on Climate Change highlighted the risk that reduced production caused by the economic recession would reduce the price of EUAs. This may disincentivise investment in green technologies by making it more attractive to continue purchasing EUAs without any effort to improve the environmental credentials of production.

Effects of the surplus on the emissions market

The EU emissions market has grown from $7.9bn in 2005 to $119.8bn in 2010 and now makes up over 80% of the worldwide carbon market value. Selling the considerable EUA surplus on the open market would increase the supply of EUAs and potentially drive down the market price without corresponding improvements in technology. Without a viable market, the very premise of the EU ETS, the entire regime would collapse.

What can the EU do?

The EU is faced with increased pressure to reform the EU ETS and remove at least some of the excess EUAs from the market. However, the EU Parliament has recently voted against an increased level of reductions from 20% to 30% from 1990 levels by 2020.

The EU ETS Directive is silent on whether EUAs, once allocated, can be cancelled despite their validity. It may well be that the EU wishes to retain the discretion to cancel EUAs if environmental policy so dictates. This is concerning for those firms that have been stockpiling EUAs which they are not using to cover their emissions. Cancelling valid EUAs at will could effectively amount to setting more stringent emissions targets through the back door. The effects of this uncertainty on the workability of the emissions market remain yet to be seen.

Does it matter how emissions reductions are attained, so long as they are attained? Arguably, yes. The danger posed by the EU ETS as it currently stands is that it may be disincentivising polluters from self-scrutiny and technological innovation in favour of taking the easy way out. Absent genuine emissions reductions through the development of green technologies, the effectiveness of the EU’s environmental policy in the fight against climate change could be seriously called into doubt.