New Zealand forest (image by: Southern Forests Ltd.)

New Zealand’s Conservative government has released its first annual report on its New Zealand Emissions Trading Scheme (NZ ETS), and the general assessment is that it is working well. In the report, released August 1^st, climate minister Nick Smith implied that he was pleased with how smoothly the scheme is progressing in achieving its twin goals of reducing emissions and promoting low carbon investment in forestry and cleantech. “This report shows the ETS is working as intended, that the implementation has gone smoothly, and that New Zealand is now on target to meet its Kyoto obligations,” said Smith.

Going forward, however, the New Zealand government faces significant challenges surrounding its openness to international carbon trading. The NZ ETS also requires an increased political commitment before it has any discernable impact on low carbon investment decisions in New Zealand.

With the review panel due to release its recommendations over the coming weeks; it seems timely to look at how successful the NZ ETS has been since its inception. Before proceeding, it is important to clarify which issues were up for review. These issues include:

• The tightening of the scheme post-2012;
• The inclusion of waste-and-refrigerant and agricultural sectors from 2013 and 2015 respectively; and
• Whether New Zealand is acting too aggressively or too timidly on emission cuts.

So Far So Good

The abovementioned report released on Monday revealed a marked increase in business support of the NZ ETS, with submissions to the review panel showing 63% of businesses were now in favour of it, compared to 78% being opposed to the scheme two years ago. The skepticism towards emissions trading is somewhat understandable in light of some bad press from Europe’s established scheme.

The champions of emissions trading have had to contend with somewhat chequered outcomes: oversupply of allowances, accusations of windfall profits and instances of criminality (in the form of VAT fraud and sophisticated phishing scams) have left many proponents of the European Emissions Trading System (EU ETS) feeling a little bewildered and let down. To date, New Zealand has avoided these problems.

The Challenges of International Trading

The government’s glowing appraisal fails to include all the challenges that their tiny trading system will face. Perhaps the most critical problem concerning the NZ ETS is its willingness to partake in the international trading regime.

The decisions from both the and the European Commission on industrial gas Clean Development Mechanism (CDM) projects involving reductions of hydrofluorocarbon-23 (HFC-23) and nitrous oxide from adipic acid plants are set to radically reconfigure the global market for offsets. The European Commission has proposed a ban to come into force from January 1^st 2013.

The Meth Panel (a group of technical experts who give strategic advice to the CDM Executive Board) recently met and made recommendations regarding methodology AM0001 for HFC-23 projects. If these recommendations are ratified it will lead to a 50% reduction in Credit Emission Reductions (CERs) originating from HFC-23 projects post-2012. According to the Meth Panel this will reduce the total issuance of HFC-23 CERs to 634 million for the renewed crediting periods (see chart below). None of this output would be eligible for use in the EU ETS. New Zealand is currently the only established market place for these decreasingly relevant CERs.

Industrial gases currently comprise 68.4% of CER output to date. Disturbingly, regulated entities within the NZ ETS are allowed virtually unlimited use of CERs to meet their compliance. These industrial gas CERs could soon overshadow the New Zealand market, since post-2012 it will be the only established marketplace for industrial gas CERs. If the review panel ignores this issue and does not ban industrial gas CERs in-line with the EU ETS, the effects could be disastrous. Considering the review panel has limited trading experience, one can only hope they listen to NZ ETS market participants.

A Victim of Short-termism

Moreover, of fundamental concern is the short-termism of their governance. The purported success of the NZ ETS needs to be tempered. The NZ ETS in its current form is largely immaterial: the successes are a result of their renewable energy standards and booming logging prices from Chinese demand (which has caused a forestry boom in New Zealand), rather than their price on carbon.

New Zealand has made it clear that it has no intention of leading on emission cuts, but rather it has advocated a “follow the leader” approach. The country’s position is somewhat understandable considering their reliance on agriculture – the country’s mainstay revenue generator – which faces huge technological barriers to reducing methane emissions and is subject to intense international competition. However, there needs to be a paradigm shift in regulatory efforts if New Zealand is to incentivize and ensure the development of cleantech. To achieve this, the NZ ETS needs to be linked to federally regulated carbon budgets.

Although New Zealand does not intend to lead on the international stage, this does not negate the need for long-term low carbon development. Until New Zealand adopts a green growth strategy, like that articulated by the recently formed lobby group Pure Advantage, New Zealand’s economic and environmental performance will continue to slide, and with it a great opportunity to generate wealth worth having.

Cylinders (sourced from Tony Spencer)

In 1989, the Montreal Protocol laid out an extensive set of environmental rules that regulate and phase-out gases which contribute to the depletion of the ozone layer: including hydrochlorofluorocarbons (HCFCs), chlorofluorocarbons (CFCs) and halons.

Coming only 10 years later, the United Nations’ were able to build on that success when the Kyoto Protocol (KP) provided a legal basis on which developed countries could actively pursue reductions in greenhouse gases (GHGs) economically and sustainably. One such GHG was a group called hydrofluorocarbons (HFCs): a set of gases that have global warming potentials many thousand times the potency of carbon dioxide and were excluded from the MP (HFCs can be direct bi-products from HCFC productions).

This time however, Parties under the KP were able to take advantage of the Clean Development Mechanism (CDM) to receive many millions of Euros in exchange for destroying HFCs. As a result, projects that generate offsets from destroying HFC (specifically HFC-23 from HCFC-22 productions) have sat uneasily in the CDM.

A Fluorinated EU?

The HFC sector in the CDM has been the target of much criticism (see previous Climatico blog) that questions the underlying environmental credibility of HFC Certified Emission Reductions (CERs – the currency of the CDM).

Since each avoided ton of HFC-23 generates 14,800 CERs (worth €170,000 at current prices), the recent announcement that the EU Emission Trading Scheme (ETS) will no longer accept HFC CERs for compliance from May 2013 to some extent highlights the EU’s position on discouraging HFC tolerance despite its worth.

In an effort to curb HFC use further, several countries (US, Canada, Mexico and Micronesia) proposed extending the MP to also cover HFCs, paving the way for rapid de-fluorinisation.

Replacements

Some environmental groups including CDM-Watch and Greenpeace, however, feel that the political inertia could place the wider realm of fluorinated gases (a set of potent GHGs that include HFCs, perfluorocarbons – PFCs, and sulphur hexafluoride – SF₆) under heavier regulation.

After the success of the Montreal Protocol to ban HCFCs and CFCs, the so-called F-gases were widely applied to fill the void of various industrial uses such as refrigeration, air conditioning and electrical transmission.

Despite their low toxicity, low flammability and non-ozone depleting properties, F-gases have global warming potentials many times that of carbon dioxide meaning they contribute to anthropogenic climate change. Moreover, the climate effect of these gases is relatively short-lived compared to carbon dioxide; meaning that action can return prompt benefits, helping to reduce atmospheric temperature increases.

A Low-Carbon Future

Since 2006, EU legislators have implemented a set of regulations and one directive to ensure the so-called F-gases remain subject to strict controls. These regulations only resulted from a conciliation procedure since the European Parliament and the Council of Ministers were unable to reach an agreement on two separate occasions.

Only last week did the European Commission publish a proposal to take the EU on a track to reduce emissions 80-95% by 2050 from 1990 levels (Roadmap 2050). To reach the target, the report recommends that comprehensive economy-wide policy changes should be required.

For instance, emissions in the industrial sector will need to be reduced by some 40% by 2030 and then 80% by 2050. The power sector will need to undertake a major and rapid change: at least 60% reduction in sector emissions by 2030 with almost full decarbonisation by 2050.

The Council is expected to debate the Roadmap today (March 14). While the scope of the proposal and effort required to implement the recommendations is colossal, some groups believe that addressing the EU’s use of F-gases cannot be underestimated and should not be overlooked as the EU lawmakers discuss potentially momentous proposals.

While F-gases account for approximately 4% of EU annual carbon dioxide equivalent emissions, their potential climate change toxicity means that their future regulation in the EU, or under a suitable international treaty, remains an important part of the solution in a move to a low-carbon and sustainable economy.

No Gas (sourced from: The U.S. National Archives)

The United Nation’s flexible mechanisms were introduced as a cost-effective and efficient method to help poorer countries develop sustainably, whilst providing developed countries another option to meet commitments under the Kyoto Protocol.

The Clean Development Mechanism (CDM) and the Joint Implementation (JI) have progressed at different rates, with different levels of engagement and varying degrees of scope in the ensuing emission reductions. One project sector has benefited more than others and recently, has come under fire for its environmental credibility. But what is the issue and why is it so politically toxic?

A Failure or Success?

The Montreal Protocol was established to regulate a certain type of gas: ones that are believed to be responsible for ozone depletion. Difluoromonochloromethane, better known as HCFC-22, is one such gas that is still used in refrigeration and air conditioning processes in many developing countries. It is a by-product of HCFC-22 in which we are interested: HFC-23 (another hydrogen-based gas also called fluoroform).

HFC-23 has a 100-year global warming potential of between 11,700 (UN) and 14,800 (Intergovernmental Panel on Climate Change), meaning that over 100 years, one metric tonne of this gas has the equivalent global warming impact of 11,700 tonnes of carbon dioxide. Its use is not currently governed by the Montreal Protocol, but the UN Framework Convention on Climate Change (UNFCCC) realised that the potential impact to the atmosphere was too significant to ignore. As a result, they chose to include the destruction of HFC-23 in the CDM and JI via the Kyoto Protocol.

Because reducing one tonne of CO₂ equivalent by a project generates one Certified Emission Reduction (CER – the currency of the CDM), destroying one tonne of HFC-23 generates 11,700 CERs. Consequently, the emission reductions generated through the CDM by destroying HFC-23 have outstripped all others: out of the 421 million CERs issued to date, HFC-23 contributes 52% from only 18 projects.

To some, CDM projects that destroy HFC-23 have been a great success, by increasing liquidity and bulking up the volume of CERs that are generated. But to others, the vast amounts of CERs which have been generated are windfall profits to polluters, and can perversely incentivise the increased production of HFC-23.

Rocking the Boat

Environmental NGO, CDM-Watch, proposed last month an amendment to the methodology which CDM HFC-23 projects conform. CDM-Watch alleged that some operators of HFC-23 projects could be “gaming” the system in order to gain more CERs (which on the secondary traded market are currently worth approximately €12).

The group questions the adequacy of the ratio of HCFC-22 to HFC-23 that is used by projects to calculate their emission reductions. Currently, the rules set the maximum ratio at 3%, so 0.03 tonnes of HFC-23 to 1 tonne of HCFC-22. But the proposal sees this reduced to a minimum of 0.2%

The CDM’s Methodology Panel, the body charged with overseeing the methodologies of the CDM, chose to ask the higher-profile CDM Executive Board (EB) to decide on the issue. There remains a good chance that the EB fails to reach a verdict and instead passes the issue up to the UNFCCC because of how politically charged this topic has become.

Indeed, CDM-Watch appears more than aware of the politically sensitivity that surrounds the HFC-23 controversy. CDM-Watch warned that EB members from China, India, Netherlands, UK, Japan and Norway should abstain from voting on the proposed methodology revision due to conflicts of interest. These countries either host the projects or have vested interest in the CER generation.

In any case, the proposal has caused a stir in the CDM and participants are looking for certainty. The EU and the US have both made suggestions that offsets generated by the destruction of HFC-23 may be banned from their respective carbon reduction plans after 2012 (if one is ever enacted in the US). So investors in HFC-23 reduction projects are right to be concerned.

If restrictions are approved, it is still unclear when they will take place. Current project contractual agreements indicate that the EB may have to wait until a project requests an extension to their crediting period (usually seven years, with the possibility of two extensions) before amending the methodology. In fact, a request to extend the crediting of a certain HFC-23 in South Korea was postponed last month by the EB until a later date, certainly until something more concrete has been decided.

It seems that the workhorse of the CDM is under threat. Just less than 50% the world’s HFC-23 is included in the CDM (since no HFC-23 projects were eligible after 2004). A proposed amendment to the Montreal Protocol could cover the rest, essentially sealing off HFC from further commercial interest. But how the CDM, JI and their participants react to its current piece-of-the-pie remains to be seen.

(Image by: bslmmrs)

Founded in 1919, Société Générale de Surveillance, commonly known as SGS, are now potentially the world leading Designated Operational Entity (DOE) working within the remit of the United Nation’s Clean Development Mechanism (CDM).

But did they become so well established through raw business acumen, taking the ‘first mover’ advantage in a fledgling industry, or being at the right place at the right time with the right connections?

Experience Always Helps

SGS were fortunate to be in a position to possess all of the above.

The responsibilities of the DOEs are extensive: verifying the emission reductions of projects and ultimately ensuring that this verification leads to the all-important Certified Emissions Reduction (CER) issuance.

In many cases, CER issuance will be the principal income stream during a project’s lifetime, so the choice of DOE is an important one.  Historically however, this decision has been somewhat restricted, with the market taking on a distinct oligopolistic structure.

The most recent CDM performance data, supplied from the UNEP Risø centre, reveals that 93% of issued CERs came from five DOEs – from over 365 million CERs in total since 2005.  Interestingly, and rather poignantly, 49% of all issuances were verified by SGS, with the next largest holding only 23%.

The dominant share that SGS accounts for in terms of issuance volume can be partially explained by the fact that it holds most of the large industrial gas projects in the CDM as clients.  These sectors deliver around 75% of the total CER volume, and do so with relative frequency, i.e. once every 2-3 months.

Delving further into the CDM pipeline shows that SGS has projects operating in more countries than any other DOE.  Importantly, these are predominantly projects located in China and India, the two most productive locations in the CDM.

In the relatively short CDM lifetime, SGS picked up a wealth of experience in the right areas: sectorally and geographically.  It was a primary business aim to quickly establish themselves as the DOE of choice for any project in any location.  SGS were performing well and leaving many in their wake.

Does Experience Always = Best?

In September 2009 however, the legitimacy of the CDM suffered a severe shock following the CDM Executive Board’s decision to suspend SGS for three months, after it was unable to prove its staff had adhered to inspection rules or that they were qualified to do so in the first place.

During this time, SGS was not permitted to upload any further project reports to the UNFCCC website, or submit any further requests for issuances.  Despite this, it was only until 12 January 2010, after the suspension had finished, that issuances from SGS-verified projects ceased; such was the volume of their future issuance pipeline.

But this was not the first time that a large project auditor has been found failing to follow Executive Board procedures.  SGS was the second such company to be suspended.  Norwegian-based Det Norske Veritas (DNV) was found wanting during a spot check in November 2008 for comparable reasons as the above, and was similarly suspended for approximately three months also.

With a reputation comes a pressure to sustain business demand.  During this suspension, a ‘gentlemen’s’ agreement was installed to help prevent other DOEs from poaching clients from DNV.

It is credible to assume that this approach was also adopted during the suspension of SGS, much to the relief of the company shareholders.  Any delay in CER issuances as a result, particularly involving large volumes, would likely test the patience of sizeable project owners and their clients, who may not be as forgiving should it happen again.

As such, critics were quick to conclude that the suspension only further highlights the inadequacies of the CDM, and that such actions do nothing to allay any fears that the CDM is a risky venture.  After all, project proponents already have many risks to deal with that span political, regulatory and eligibility boundaries.

Conversely, supporters of the flexible mechanisms suggest that these suspensions emphasize that the processes installed are working and that the credibility of the CDM is upheld because of it.  Contracting is a required part of the project process and goes some of the way to safeguard CER buyers and in some certain circumstances, sellers.

In any case, until competition in the DOE market begins to show signs of improvement, it appears that SGS may yet hold onto their place as the most experienced of the CDM verifiers.  And with project developers holding onto their mantra of ‘experience experience experience’, who can blame them?