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The carbon market
Besides the development of an international climate change policy framework, two main factors have contributed to the growth of the carbon market:
- Corporate action in response to governmental progress: Many of the world's largest corporations (e.g. BP Amoco, AEP, Texaco, Shell, Ford, Tokyo Electric Power, GM) have already invested in projects that reduce the build-up of GHGs in the atmosphere, in advance of the final ratification of the Kyoto Protocol. A second tier of smaller companies is also pursuing this strategy. With the mounting awareness that climate change is a serious problem, few companies with high levels of GHG emissions can hold a public position that they do not need to take any action. Many are moving forward with proactive strategies.
- Unilateral governmental action: A handful of national governments have moved forward on developing national and regional trading systems. Denmark, the UK, and Canada are developing trading schemes, and the European Union is planning a regional trading scheme for 2005. Even the USA, though currently opting out of the Kyoto Protocol, is proposing legislation for national GHG emission caps.
In 1995 a pilot phase program known as Activities Implemented Jointly (AIJ) was launched in the climate negotiations, which allowed countries to experiment with projects that would provide GHG emission reductions or avoidance. AIJ enabled the private sector, the public sector and other stakeholders to learn about the complexities of developing and implementing carbon projects including: designing baselines, measuring costs and opportunities of such activities, and quantifying GHG emission reductions, etc. (for more information on these issues see the feasibility and implementation sections of this chapter).
In 1997 the Kyoto Protocol introduced three flexibility mechanisms (ET, JI, and CDM). These mechanisms allow countries to meet their emission reduction targets through cost-effective measures. As the KP negotiations evolved, governments established national programs, while private companies developed private market schemes, which contributed to the progress of the carbon market. Individual countries have also developed climate change policies and schemes independent from the international process. Although avoided deforestation (i.e. forest protection) is not included in the Kyoto Protocol it may eventually be part of the carbon market under national and/or bilateral schemes.
Programs following the international climate change regime include:
- Prototype Carbon Fund (PCF): developed by the World Bank, this program's objective is to mitigate climate change. Governments and private companies contribute to the PCF which in turn uses fund resources to support energy and forestry projects designed to produce carbon offset credits fully consistent with the Kyoto Protocol's CDM and JI.
- Private investors: some GHG emitting companies already invest directly in the development and implementation of CDM and/or JI projects for the purposes of meeting their emission reduction commitments.
- The Biocarbon Fund: It is a fund developed by the World Bank to finance carbon projects that sequester or remove greenhouse gases in forest and agro-ecosystems. The fund will support projects that fall under mandatory measures (the Kyoto Protocol or other domestic policies) or voluntary efforts to manage GHGs. It will aim to deliver cost-effective emission reductions, while promoting biodiversity conservation and sustainable development. In addition, the Fund seeks to gain practical experience in order to guide governments and other market players with a wider range for cost-effective tools for reducing GHGs.
- Carboncredits.nl: Through this Web site the Dutch government buys carbon credits from projects to meet that country's commitments under the Kyoto Protocol.
There are various estimates of the potential size of the carbon market. Many analysts anticipate that the global trade in carbon emission reductions, driven by national and global emission policy shifts such as the Kyoto Protocol, will amount to tens of billions of US dollars by 2010. Estimates based on the size of the potential carbon trade in North America and Europe indicate that it could be worth US$30 to US$100 billion when fully operational. However, even if these estimates are realized, and the Kyoto Protocol goes into effect, it is likely that only a small portion of the carbon traded will come from conservation projects because there is significant competition from offsets produced through improvements in technology, renewable energy, and other forms of sequestration.
The carbon market continues to evolve rapidly. In many of the examples cited in this chapter, forest-based carbon offset projects have been complex one-off deals aimed at gaining experience for project developers and generating favorable publicity for investors. In these cases, companies have made large up-front investments to pilot-phase carbon projects, with the expectation that viable and valuable carbon credits may one day result. These early investors were willing to pay for project start-up costs and to assume many of the risks associated with production of the offsets. Once the Kyoto Protocol is ratified and becomes legally enforceable, or other policy regimes are put into place, a more systematic trading scheme will be required to keep up with demand for carbon credits. The implication is that investors will want to purchase offsets rather than pay for projects. Project developers will need to identify significant sources of funds to start projects and produce the offsets to sell in the market. Investors will ask project developers to assume offset production risks, and provide guarantees on the timing and magnitude of offset production.
The shift to carbon credit exchanges that enable regular and high-volume trading has already begun. By bringing multiple buyers and sellers together in a central trading platform, exchanges offer a transparent and efficient system for determining a fair price for both buyers and sellers. One example is the Chicago Climate Exchange (CCX), a voluntary cap-and-trade program for reducing and trading greenhouse gas emissions in North America. Under the CCX, companies in multiple industries will make a voluntary binding commitment to use a rules-based market for reducing their greenhouse gas emissions. CCX will enable them to receive credit for such reductions and to buy and sell credits in order to find the most cost-effective way of achieving reductions.
As the market develops carbon credit buyers increasingly want to diversify their risk by investing in a portfolio of projects, rather than depend completely on a single project. Investment funds such as the World Bank's Prototype Carbon Fund and Biocarbon Fund (described above) help address this concern by acting as a pooling mechanism that will enable a range of investors to hold a stake in a number of carbon offset deals. This will reduce risk and allow individual investors to move their equity in and out of projects as they wish.
Confidence in the market continues to expand. As policy progress is made, the number of market service providers such as investment funds and exchanges is growing, increasing the trade in credits. Ahead of the regulatory curve, some companies are already developing in-house carbon reductions plans, and purchasing carbon offsets.
Snapshot of carbon projects
The following section provides brief overviews of some forest-based carbon offset projects.
The Coastal Rainforest Carbon Offsets Project in Ecuador was begun in March 2002 to restore native hardwoods to 275 ha (680-acre) of land degraded by poor agricultural practices. The Project is located within the Bilsa Biological Station, a 3000 ha (11.5 sq. mile) private reserve managed by the Jatun Sacha Foundation, a non-profit organization in Ecuador that works to protect this critical remnant of Ecuador's coastal premontane wet forest, of which less than one percent remains. Located in northwestern Ecuador in the State of Esmeraldas, restoration of this remnant forest, administered by Jatun Sacha and Conservation International, will sequester an estimated 65,000 tons of CO2 over the life of the project (100 years). In addition to mitigation of carbon, the project will restore connectivity of Bilsa with the larger 110,000 ha Mache Chindul Ecological Reserve and preserve habitat for rare animals such as the Jaguar, the Long Wattled Umbrella Bird, the Giant Anteater and abundant populations of the threatened Mantled Howler Monkey. The project will also continue the work of the Jatun Sacha Foundation to integrate local farmers in reforestation efforts.
Financing for the Project has come from The Climate Trust, a nonprofit trust established in the state of Oregon (in the US) that manages a CO2 fund. The Oregon state legislature has required that new power plants reduce their CO2 emissions. One of the ways power plants can do so is by purchasing CO2 offsets through the Climate Trust, which in turn can invest the money into various offset projects.
One of the earliest carbon offset projects was undertaken in Belize by The Nature Conservancy and local partner Programme for Belize. This project involves conservation and sustainable forest management of more than 58,400 ha (225 sq. miles) of lowland tropical rainforests that were slated for conversion to agriculture. At a cost of US$5.6 million, the project will sequester an estimated 2.4 million tons of carbon over 40 years. Financing has come from a consortium of energy companies: Wisconsin Electric, PacifiCorp, Cinergy, Detroit Edison, Suncor and Utilitree.
One of the largest carbon offset projects to date is in Bolivia, where the borders of the Noel Kempff Mercado National Park were extended after logging rights on neighboring forest concessions were retired. This US$9.6 million project, which protects 600,000 ha (2300 sq. miles) of tropical rainforest, will sequester an estimated 6-8 million tons of carbon emissions over 30 years. Industry investors include AEP, PacifiCorp, and British Petroleum. The land is owned by the Government of Bolivia and managed by Bolivian NGO, Fundacin Amigos de la Naturaleza (FAN). Fifty percent of carbon offsets will be credited to the Government of Bolivia and fifty percent to investors. For an in-depth look at the Noel Kempff project see the case study in the Annex to this chapter.
For the latter two projects it should be noted that any carbon sequestration due to protection of standing forest, avoided deforestation, are non-Kyoto compliant at this time.
Key Actors and Motivations
Whether the key actors in carbon projects are the private sector, the public sector or NGOs, each group can play multiple roles under varying conditions as credit buyers, sellers, or investors. The role that each group assumes and their potential motivations are summarized in Table 1. Other specific actors such as GHG emitters, consultant firms, carbon market brokers, and local communities are discussed later.
Table 1 - Carbon Market Actors and Motivations
Investor - Invests capital in the start-up and implementation of a carbon project in order to eventually use credits produced to fulfil GHG emissions limits, or profit from the trade of carbon credits.
GHG-emitting companies seek to identify projects that give a good return (in terms of carbon credits), with manageable risks.
Demonstrate corporate responsibility.
Build good will with stakeholders and customers as well as enhance public reputation.
Governments of developed countries will want to invest in projects to produce carbon credits and meet their commitments under the Kyoto Protocol. This accruing of credits can allow those governments to bank some credits for future commitment periods or to trade them in the carbon market.
Early investments to demonstrate viability of forest-based carbon offset projects; and demonstrate best practices for public relations.
Buyer - Purchases carbon credits.
Comply with their emission reduction targets.
Some companies will purchase carbon credits to resell in secondary markets.
Governments of developed countries will want to purchase credits to meet their commitment with the international regime.
NGOs can purchase carbon credits and retire them, or take them off the market, in order to reduce the overall limits to GHG emissions.
Sellers - Sells carbon credits to gain profits while helping other actors to comply with the emission reduction targets.
Opportunity for a financial return in a new commodity market.
Serve as brokers and gain income or profit form services rendered.
To be involved and influence the development of a new commodity market.
Raise funding for compatible project goals (e.g. conservation, development, etc.)
Facilitate entry of developing countries or small projects to the market.
These are companies that are either voluntary participants in emissions reduction efforts or have to comply with national or international regimes that set limits on GHG emissions. These companies, as mentioned in Table 1, can be carbon credit investors, buyers or sellers depending on their needs. While most project investors might be concerned with the green image of the project (i.e. biodiversity or socio-economic values) they are more concerned with meeting their carbon emission limits at the lowest cost. Public relations for the company can be an important aspect of the project and should not be overlooked for marketing purposes. Investors may seek out projects if they are interested in further business investment in a particular country or are interested in gaining market access. The advantage for these companies to invest in forestry projects is that LULUCF activities may provide the most cost-effective carbon credits and other co-benefits. While these may be the most cost-effective carbon credits, they usually entail higher risks than energy projects, because of uncertainties associated with permanence and leakage aspects specific to LULUCF projects (please refer to the carbon market section 1.1.3). For this reason, carbon credit buyers currently favor projects in the energy and industrial sector. The perception is that credits from the energy sector are more secure. They are therefore more sought after than carbon credits from LULUCF projects. Under market circumstances, this could also mean that credits from energy projects would trade at higher prices than those from LULUCF projects.
Consulting firms offer various kinds of service and expertise to stakeholders in the public and private sectors. Some consulting firms guide stakeholders on the development and implementation of a project, including technical services such as: developing baselines, quantifying carbon benefits, developing monitoring plans, verifying carbon credits, legal advice, and policy expertise. These consulting firms play a valuable role in the development of carbon market schemes. As private entities these firms receive payment for their services.
These groups broker (facilitate) transactions of carbon credits between buyers and sellers, and as such provide a fundamental market service by lowering transaction costs through economies of scale. They provide this service for a profit to private companies, governments, and NGOs. They help stakeholders with the technical and legal procedures of selling and buying in a new market. They are active players in the design and development of the carbon market.
The CDM offers developing (host) country governments the opportunity to attract investment in land-use (and renewable energy) projects as suppliers of carbon credits. Developed countries can demand and supply credits depending on their needs. Governments also represent their country's interests at international climate change negotiations, which in turn shapes the international process and the agreements achieved. Certain countries such as Canada, the US and many Latin American countries are keen on including more LULUCF activities in the process. Other countries such as those in the European Union are against the inclusion of further LULUCF activities. Therefore, governments will invest in forestry projects according to where they stand at the negotiating table.
Once the Kyoto Protocol is ratified, governments that are a Party to it will be responsible for shaping the national policies that allow countries to implement it. For example, countries that want to participate in the CDM process will need to develop sustainable development criteria (especially in the case of developing countries) and implement policies that will allow for those practices to take place. Furthermore, the government will be a key player is designing the National Authority, which will be the body that approves the initial stage of CDM projects.
Under the Kyoto Protocol each country has an assigned National Authority responsible for endorsing carbon offset projects. Unless projects are approved by such agencies, they are not accepted as part of the Clean Development Mechanism (CDM).
Environmental NGOs play several roles in the process. Often they help companies and/or governments to design project activities and provide guidance through the different steps. Environmental NGOs are also a key player at the international negotiations and policy design at the domestic level. Due to the potential catastrophic consequences of global climate change on natural ecosystems, environmental NGOs are concerned that the development of policy ensures effective long-term climate change solutions. It would be short sighted to view carbon offset projects merely as a conservation finance mechanism if they were not truly effective in reducing atmospheric GHG concentrations.
The CDM mandates that projects contribute to sustainable development. Well-designed projects should therefore benefit local communities, for example, by supplementing and diversifying income, increasing forest access to goods and services and transferring skills and knowledge. Conversely, if local livelihoods are not taken into consideration, forest-based carbon projects could have negative impacts on local livelihoods by restricting access to resources that local communities depend upon. In some cases, there will be a trade-off between the amount of carbon benefits sought and providing benefits to local livelihoods.
Given the complexity and high transaction costs of designing and implementing a carbon offset project, it will be very difficult for small-holders or community groups to establish projects and derive direct benefits themselves. In some instances governments and NGOs are working with local communities to encourage project bundling, in which the coordinating organization assists small holders with the various complexities of developing a carbon project. The carbon benefits from multiple participants are then combined and jointly marketed in order to lower transaction costs. Without such collaborative projects, however, the impact of carbon projects on local livelihoods is most likely to be determined by the sustainable development component of projects implemented by governments, large companies, or large organizations. For a further discussion of the sustainable development requirement of projects see section 2.3.
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