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.

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.

The UK’s Secretary of State for Energy and Climate Change, Ed Milliband, addressed  the UN Conference of Parties (COP) here in Poznan today, delivering the UK’s ministerial statement on climate change.

Ed Milliband, UK Sectretary of State for Energy and Climate Change, speaking in Poznan today

Echoing sentiments of Gordon Brown and other EU member states over the last week in Brussels, he stressed that the UK must overcome the challenge posed by the global finiancial crisis. The costs of adaptation and mitigation continue to rise the longer we wait – we must up the pace along the road to less discussion and more negotiation for an agreement at Copenhagen next year.

He praised the efforts of developing countries and stressed the need for developed nations to take on stronger targets, based upon the concept of common but differentiated responsibilities. Developing nations must consider substantial deviations from business as usual (BAU) and we must ensure that strong transfer mechanisms exist to support this effort.

The UK’s spirit of intent is reflected in the commitments they have made through the Climate Change Act, adopting challenging targets of 80% carbon reduction and 20% for generation of renewable energy, by 2050. The UK will adopt further commitments as part of the European Climate Package, which is expected to be decided in the next 48 hours. As part of the EU’s recently announced  Renewables Directive (20-20-20) the UK will adhere to plans to increase targets for generation of renewable energy from, 20% to 30% if other countries make significant contirbutions.

Milliband, stressed that “We must go further than 50% by 2050″  as the UK (and Obama) has committed. In addition, the UK is commiting further resources to the UN’s Adaptation Fund, and £100m to forestry issues (a statement on deforestation will be released tomorrow).

Milliband delivered a strong statement in amongst China and Austria, reflecting the UK’s vision to be a pioneer in the fight against climate change, and the large commitments the UK has adopted in the Climate Change Bill. The Committee on Climate Change released their first report (Building a low-carbon economy – the UK’s contribution to tackling climate change) on 1^st December, setting out the analysis which underpinned the target reductions and details of the level of the first 3 carbon budgets – up to 2022.