Max Horstink from Mindshift Matters defends carbon markets as an imperfect but potentially powerful tool to realise a low carbon future.

Carbon markets are at a crossroads. At scale they have been around for almost a decade. During that time they have seen bad press, scandals, fraud, and carbon prices dropping to €0. I will however argue that they are one of the best potential tools we have to fight climate change, given the current international political and economic system.

A brief history of “hot air”

Many concerns about carbon markets are justified, but most people, including the press, often do not really know how carbon credits are created, or what is meant with the term “carbon market.” Media attention and criticism have been directed mostly at three distinct systems (there are others): emissions trading schemes, the Clean Development Mechanism (CDM) in the regulated market, and the unregulated Voluntary Carbon Market. I will give a brief overview of these three.

Initially when the countries that signed up to the Kyoto Protocol negotiated targets, it resulted in many Eastern European countries (especially Russia) receiving billions of tons of free allowances which they could sell on the market. Reduction targets were based on country-driven emissions forecasts with 1990 chosen as reference year. Most of these countries had experienced economic collapse shortly after the fall of the Berlin Wall and before the negotiations of targets (1997), drastically reducing industrial and energy output. Rapid economic recovery was expected, so that targets would be justified. This did not happen. Most Western European countries, however, declined to buy this “hot air” from Russia and focused on carbon credits from the CDM and domestic abatement efforts. Russia has bailed out of the second commitment period of the Kyoto Protocol, where they may not have received these free allowances. Politicians cannot afford to make this mistake again. This can be avoided in future agreements by choosing sensible base years, not only for Russia, Ukraine and Poland, but also for countries such as the USA, China, India and Brazil that are likely to join in future. Any surplus allowance from previous commitment periods should be cancelled if we want to achieve climate goals.

In the European Emissions Trading Scheme (ETS), a cap-and-trade scheme for Europe´s largest carbon emitters, the first phase (2005-2007) saw carbon prices drop to zero when the market turned out to be oversupplied with allowances to emit. Over-allocation occurred because allocations were not based on real data but estimated historic emissions and growth figures. The European Commission had to rectify this in Phase II (2008-2012) by setting a tighter cap. However, the reduction mostly affected the power sector while industry, on average, received more than they needed (hot air). This effect was partially caused by a decrease in production following the economic crisis, and probably partly to protect the competitiveness of Europe´s industry. Meanwhile, the power sector was able to pass on the cost of carbon to consumers. The Commission has again set a stricter overall cap for Phase III, which started this year, although the economic crisis might still have an influence. Ironically, the financial crisis has been good for the climate change battle, as we managed to reduce emissions around the globe by simply switching off machines.

The Clean Development Mechanism and the Voluntary Carbon Market have had a rough ride over the last decade as well. Cases have been cited where projects were non-existent or not additional, i.e. would have happened without revenues from carbon credits (additionality is a requirement under the UNFCCC as well as for most established voluntary carbon standards).

From the point of view of compliance markets, the principle of a cap-and-trade scheme is that on the whole emissions are reduced down to a certain target. It does not matter how that target is achieved, i.e. companies are free to buy allowances either from their peers, or from cheaper emissions reductions from developing countries (CDM). However, in order to achieve the target there should always be companies that invest in and implement abatement measures in-house (if the targets are adequate). And the less companies would reduce emissions in-house, the higher the carbon price would become making in-house abatement more economic than buying on the market. So there could be companies who increase production and choose to keep using dirty technologies, but if the targets are stringent enough that does not matter from an environmental point of view. And it will not make sense to do so from an economic point of view if prices go up to €100 per tonne CO2.This is possible although it seems a long way off at current prices of around €3-4/tCO2 in the EU ETS, and well under €1/tCO2 for the CDM.

Criticisms and some responses

Fraud and faulty reporting: There have been cases of fraud and theft in the EU ETS and fraud in the CDM. However, there has always been fraud and theft in economic sectors, private and public, where enforcement measures are not sufficient. This is not peculiar to carbon markets.The former citations stem from the early days of the voluntary market when there were no project registries, third-party certifications or standards. We can safely say that such faulty reporting has been confined to history as the voluntary market has evolved.

Additionality is arbitrary: Additionality of projects however has been a problem and is an arbitrary exercise as it is. It is difficult to prove that a wind farm project would not have been economically viable without the revenues of carbon credits, considering the rather small share of income from carbon credits compared to the electricity revenues, and compared to other technologies. The UNFCCC has made amendments to- and is still reforming the CDM rules and requirements to deal with these concerns. Media attention focusing on malicious practises has increased scrutiny on projects. Several third-party verifiers have been suspended for not adhering to the rules. Ensuring additionality is subject to a slow bureaucratic process, which in turn has received criticism for the associated costs and limited turnover of emissions reductions (as a project will not receive start-up capital and thus create emissions reductions until it is approved). Additionality in the CDM is an issue, but cap-and-trade schemes are limiting the amount of CDM credits that can be imported, and the UNFCCC is putting significant efforts into ensuring integrity. If anything, the CDM is preparing developing countries to take on targets of their own.

Companies make millions from these systems: The steel and cement sectors participating in the EU ETS have seen the biggest surpluses of allowances between 2008 and 2010. During this period, ArcelorMittal, one of the most energy-intensive companies in the world, may have made over €1.4 billion as a result of its obligations under the EU ETS. This is equivalent to over 16% of its net income over these three years. In 2010, the value of the surplus was equal to 19% of Lafarge´s (cement), 21% of ArcelorMittal´s (steel), and almost 30% of Heidelberg Cement´s net income (using the 2010 weighted-average EUA carbon price of €14.64/tCO2). Companies in these sectors relate their surplus to the decreased production during the economic crisis. Other companies however were short, i.e. had to buy allowances on the market, or reduce in-house. There are companies who have financially benefitted from carbon markets possibly without even having invested a penny in low-carbon technologies. That means that they either did not have stringent enough targets, or that they reduced production, or a combination of both.

Carbon markets are an excuse to emit more: The CDM is seen as a zero-sum game, i.e. is meant as an offsetting mechanism. Because of additionality issues some argue that the CDM increases emissions. Projects that would have happened anyway deliver carbon credits to companies and governments that in turn allow them to emit more. The same can happen when baselines for CDM projects (i.e. the emissions that would occur without the project) are overstated.

Dirty technologies earn carbon credits: In theory all approved technologies under the CDM should reduce (or perhaps rather offset) carbon emissions. However, there are controversial technologies that may have detrimental socio-environmental effects approved under the CDM. Such projects make carbon markets controversial, especially when they receive media attention. However, they represent a fragment of the technologies that are being used, and should not blur the fact that the CDM is mostly about clean technology and renewable energy. The UNFCCC has so far been receptive to criticism and has made reforms and amendments to the rules, phasing out controversial technologies or applying strict rules to prevent detrimental effects. Certain technologies have so far not been approved by the UNFCCC because of such doubts. Biofuel production potentially conflicts with food crops and has sparked controversy, especially regarding the (continuous) cutting of rainforest for palm oil exploitation in Malaysia and Indonesia. It has been a hot topic for years and no methodology (except for one limited to biofuel derived from waste biomass) has so far convinced the regulator.

Carbon markets do not result in emission reductions: To assess this criticism, we need to run through the various carbon market systems at different political levels. The hot air issues discussed before offer clear examples that emissions are not being reduced on national level in countries such as Russia, the Ukraine and Poland. On sectoral level, the EU ETS, the largest carbon market in financial terms, is not doing much better, apart from the power sector. The Voluntary Carbon Market does reduce emissions, but currently only on a small scale compared to the overall size of the carbon market. In cascading targets down to their economic sectors, governments will need to get tougher on their industries if we want to minimise the harmful effects of anthropogenic climate change. On the whole, the EU is taking a leadership role, even if the pace is too slow and eight years of the ETS have not properly engaged industry. The US and China still have to follow suit. Most governments that implement cap-and-trade schemes have and will gradually increase the stringency phase by phase to protect participants from competitive disadvantages with respect to international trade. The EU ETS, as a first of its kind, has mostly learned by doing. Hopefully domestic schemes, of which many are planned or have recently started in Australia, China, South Korea, and the state of California, will take note and do it right from the start.

Further thoughts

The above issues paint a gloomy picture, but all new markets have start-up problems. Will the designated authorities deal with these problems adequately? I argue that the basic concept of a carbon market is not the problem, it just needs to be perfected gradually.

Most of the problems associated with carbon markets that have been discussed are implementational and can be improved. A major condition is political will. In general, it is difficult for people to think long-term, even more so for politicians who have perverse incentives to think short-term. A new international climate change agreement for 2020, after two Kyoto commitment periods, will need to show ambition, and not hot air. All major emitters, including the USA, China, the EU, Russia and India, have now indicated they are willing to take on targets from 2020, a major step. Before 2015 we will know how serious they are about this. It is however always a game of compromise, which is why Russia and the eastern European countries got their hot air. Next in line may be the developing countries that have not had the chance to “grow.”

Whether we like it or not, we are living in a capitalist world and we cannot wait for radical political or economic change to address the threat of climate change. We need to give companies financial or strategic incentives to do the right thing, as ultimately they need to answer to their shareholders. Carbon markets could be our best bet to engage corporates in the climate change battle. Carbon markets are non-exclusive tools on our way to a low carbon world. More solutions are needed, but it’s a matter of “and”, rather than “or”. Ideally, a global carbon market should be created with sectoral targets for all countries. This would eliminate competitiveness issues, providing clarity, continuity, a global carbon price for private investment, and enable governments to be ambitious. Sadly there are probably too many political and economical discrepancies for that scenario. If, however, we establish a global climate treaty involving all countries and we keep on expanding, strengthening and linking up the patchwork of local and regional carbon markets and other carbon pricing mechanisms out there, we may sufficiently boost low carbon development and domestic action. Let´s continue to criticise and optimise carbon markets. It’s either that or sustaining the financial crisis.

This blog was adapted by CDKN from the author's website. For more information, contact Max Horstink.

We occasionally invite bloggers from around the world to provide their experiences and views. The views expressed here are those of the author, and not necessarily those of CDKN.