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Will Europe open the door to sinks credits?

Mark Nicholls

Forestry experts were disappointed to see sinks credits excluded from use in the European Union’s Emissions Trading Scheme. But will a review in 2006 -as well as economic necessity- bring them in from the cold?

Forestry experts were disappointed to see sinks credits excluded from use in the European Union’s Emissions Trading Scheme. But will a review in 2006 -as well as economic necessity- bring them in from the cold? From 1 January next year, thousands of industrial installations across Europe will face caps on the amount of carbon dioxide (CO2) they can emit. The date marks the start of the European Union’s Emissions Trading Scheme (EU ETS), under which emitting sources accounting for around 45% of the EU’s CO2 emissions will be permitted to buy and sell emissions allowances to help them meet their targets (click here for more on how the scheme works). The EU ETS is the world’s first mandatory international greenhouse gas (GHG) trading scheme. It is designed both to help move the 25 member states of the EU towards the GHG reduction targets they assumed under the 1997 Kyoto Protocol on climate change, and also to help prepare companies and governments for the market in carbon allowances provided for in the protocol. The EU ETS begins three years ahead of the 2008-12 target period under Kyoto. But European politicians have made it clear that it will come into operation regardless of the entry into force of the protocol – which is still held hostage by Russia, which will cast the deciding vote on whether it lives or dies. As such, emissions trading specialists are hopeful that the scheme will provide a useful proving ground for the principles and practice of GHG emissions trading. This is particularly true of the Kyoto Protocol’s ‘project-based’ flexible mechanisms – the Clean Development Mechanism (CDM) and Joint Implementation (JI). These allow investors in projects in, respectively, the developing and industrialised worlds to earn carbon credits to the extent that the projects reduce or avoid GHG emissions. Officials at the European Commission – the executive arm of the EU – have stated that they hope to see the EU ETS speed the development of these flexible mechanisms. They have highlighted the possibility of investment in Russian JI projects as a carrot for Moscow to ratify Kyoto, and they are keen to see European companies invest in GHG reduction projects in the developing world – helping to fulfil a crucial sustainable development aspect of the Protocol. To this end, deliberations on a so-called ‘Linking Directive’ followed the agreement, in July 2003, on the directive establishing the overall rules for the EU ETS. Because of the tight timetable for drafting the original directive, it was decided to defer to this second Linking Directive the rules setting out how credits from JI and CDM projects could be used within the scheme. The completion of the Linking Directive, in April this year, proved a disappointment to supporters of the use of carbon credits from forestry projects – albeit not an unexpected one. The agreement struck between the European Parliament and the Council of Ministers (representing member state governments) excluded the use of sinks credits – at least until a review in 2006 reconsiders the issue. A Commission official says that the reasons for the initial exclusion of sinks credits were threefold: continuing uncertainties over the environmental benefits of sinks projects; technical issues about how to incorporate CDM sinks credits into the EU ETS; and, given the above, the tight timetable to reach agreement on the linking directive. European policy-makers were under heavy pressure from sections of the green lobby to ensure that the EU’s scheme had the environmental integrity they felt Kyoto had lost during a series of compromises designed to keep the agreement on track after the US pulled out in 2001. Most climate change-focused NGOs pressed European governments to restrict the type and amount of credits that could be imported into the EU scheme, in particular to prevent the use of huge volumes of ‘hot air’ – allowances from the former Soviet-bloc freed up by the collapse of its economy since the 1990 Kyoto Protocol base year – or credits from controversial sinks and large hydro projects. Concerns from NGOs over the environmental integrity of sinks projects are well-rehearsed. Rob Bradley, until June the Brussels-based energy specialist with the Climate Action Network, a worldwide alliance of NGOs working on climate issues, says that ‘permanence’ is the main worry. “Sinks are not permanent in anything like the way an emissions cut is permanent,” he argues. “If you don’t emit a tonne of carbon from fossil fuels, it remains locked a mile under ground. If you emit it, and then trap it in plant life, you’re swapping it for something that could decay year on year.” The risks of fire, disease or even the bankruptcy of the company managing the forest are all too great to allow sinks projects to claim credits, Bradley argues. And he adds that climate change itself adds to the problem, leading as it will to changes in forestry ecosystems that may see them store less -or unexpectedly release more- carbon than what is currently anticipated by scientists. He adds that other difficulties with emissions reduction projects in general are particularly acute when it comes to sinks. He cites the ‘leakage’ problem, whereby the reduction of emissions by one project leads to an increase in emissions elsewhere. “Take the clearing of Amazonian rainforest, which is often done to create farmland. An area may be ring fenced, and replanted, but the displaced farmers will simply go elsewhere. “At best, the project has a neutral climate effect, but at worse it’s negative, because the credits can be used to offset emissions elsewhere,” he says. On the face of it, NGOs had more success with their arguments on the types of credits eligible than with their concerns over the volumes of Russian ‘hot air’ credits entering the market. On the latter, the Linking Directive leaves it up to the member states to set any limits as to the numbers of JI and CDM credits that companies in their jurisdictions can use – and most analysts believe these are likely to be generous. However, a partial victory was won on credits from large hydro projects – which NGOs argue cause so much social and environmental disruption that crediting them with emissions reductions is perverse. According to the Linking Directive, such projects must follow the social and environmental recommendations set out by the World Commission on Dams if their credits are to be admissible. Still, the environmentalist’s victory on sinks was, at best, only partial. While sinks credits are out for the scheme’s first phase (2005-07), supporters of forestry carbon credits are hopeful that the review will see them allowed as of 2008. The wording of the review clause gives both sides reasons for optimism. On the one hand, Jan Fehse, a senior consultant at EcoSecurities, a UK-based carbon finance advisory firm, says that the actual wording in the directive implies that the review should look at how sinks credits could be incorporated in the scheme, rather than whether or not they should be. However, another reading of the directive gives hope to those opposing sinks credits that any review would start from a position of scepticism as to their inclusion. So the review leaves all avenues wide open. To a certain degree, some of the concerns over the climate benefits of sinks were addressed at the last meeting of the Conference of the Parties (CoP 9) to the Kyoto Protocol which met in Milan, Italy in December of 2003. Then, parties reached agreement on a solution to the permanence issue. It was decided to create two new types of CDM carbon credits – long-term and temporary certified emission reductions (lCERs, tCERs). Projects can opt to issue either tCERs, which must be reissued every five years, or lCERs, which have a 20-year life-span but which must be re-verified (to ensure the carbon stored by the project has not been released) at five-year intervals. Parties to Kyoto – strictly defined as governments – can use these temporary credits towards their reduction targets in any one commitment period. However, they do not discharge an emission reduction obligation – they simply defer it. They must eventually be replaced by credits from ‘permanent’ reductions, such as those from renewable energy, or from switching to a less-polluting fossil fuel. “Much of the concerns around the science of sinks were solved at CoP 9,” says Joachim Schnurr, a Hamburg, Germany-based department head at GFA Terra Systems, a consultancy. “We need sequestration to fill the gap until we find alternative energy concepts.” But the lack of time between the CoP 9 meeting and the deadline to reach agreement on the Linking Directive mitigated against the inclusion of sinks credits. “The introduction of lCERs and tCERs may have added to the confusion,” says Fehse. “It’s such a new thing, that people aren’t sure of their impacts – it added to the reluctance to include sinks credits from 2005.” Indeed, the Commission source adds that concerns remain about how to integrate these temporary credits into the EU scheme. He notes that it’s one thing for a government to defer permanent reductions by using lCERs ot tCERs – it’s highly likely that the government entity will still be in place when it is time to replace the credits. With companies, however, it’s a different matter. “There is a technical issue around how to bring time-limited credits into a regime based on permanent reductions,” he says. “There are ways around this, but so far there hasn’t been much discussion of the issues.” But many NGOs – particularly those for whom climate is the most pressing environmental issue – remain unconvinced. They argue that those projects most likely to receive financing, and earn credits, would be large-scale, mono-culture plantations, that would do little to alleviate poverty or support biodiversity. “If you see the behaviour of those [countries arguing for sinks] in the CDM negotiations,” Bradley at CAN Europe says, referring to the CoP 9 meeting. “They wanted GMOs [genetically modified organisms], invasive species. The reality would be large-scale industrial plantations.” But the NGO community is far from united on this issue. Balancing the near-unanimous opposition from the climate change community are those that focus more on conservation, biodiversity, and rural development. US-based Conservation International (CI) is one of the members of the Climate, Community and Biodiversity Alliance (CCBA), which includes fellow NGO the Nature Conservancy, chip-maker Intel, oil giant BP and a number of research institutions. As Mike Totten, senior director of CI’s climate and water program, explains, the alliance is developing standards to certify that land use, land use change, and forestry (LULUCF) projects generate biodiversity and poverty-reduction benefits as well as sequestering carbon. In May, CCBA sent out for comment draft standards that would require projects to score a certain number of points across three criteria, covering climate, biodiversity and community benefits (see www.climate-standards.org). “The idea should strike a chord with European governments, and especially bilateral agencies that are looking at how extreme weather impacts poor communities, for example,” Totten believes. “There could be huge gains for the Millennium Development goals and the Convention for Biodiversity” if carbon finance could be tapped for such projects, he adds. This is an objective that the World Bank is also pursuing. In May, the World Bank’s BioCarbon Fund (BCF) became operational. (to read an article by the World Bank on the BioCarbon Fund, click here). The BCF follows other groundbreaking carbon funds that the Bank has launched in an effort to show the way for the private sector. Such funds buy credits from GHG reduction projects, repaying their investors in credits rather than cash – and generating a wealth of experience in how to develop such projects. Unlike earlier funds, the BCF will only invest in sequestration projects, and is designed to show that such investments can offer social and environmental benefits in addition to their potential to store carbon. Here, sinks supporters will be looking to generate evidence – from ‘real world’ projects underway in time for the 2006 review – that sinks can generate tangible benefits beyond their carbon storage, or at least not result in negative social and environmental impacts. “The main thing that’s needed is actual project experience,” says Benoit Bosquet, senior natural resource management specialist in the World Bank’s carbon finance business. “Unless we can show that sinks projects can be good for local people, and good for the environment, there won’t be a great deal we can do to persuade the Europeans.” Bradley remains unconvinced that rules can be written in such a way that they will accept credits from ‘good’ projects while keeping out those that confer little, if any, benefit to local ecosystems or communities. “None of this is to say that you can’t find good projects, which account properly for carbon, and bring social benefits, but if you institutionalise this, you unfortunately open the floodgates. Bosquet, however, also argues that the requirement under the CDM rules -that projects contribute to the sustainable development of the host country- will provide some quality control. “Any sinks credits included in the EU ETS will be using the same rules as the CDM”. He believes that the oversight provided by the Executive Board will, therefore, ensure that ‘bad’ projects are kept out of the system. “If they fail on the CDM sustainable development criteria, then they won’t be passed. I don’t see why the EU should impose further tests.” There is little prospect of the two sides’ arguments being reconciled anytime in the near future. For all the technical, scientific, social and environmental arguments, some observers believe it is likely that the review process will come down to essentially political and economic considerations. And forestry specialists are hopeful that the political mood in Europe is shifting in favour of forestry credits. “The movement [towards sinks] is fairly easy to see today as compared to COP 6,” says one. He argues that the French government is taking “a more pragmatic” view about the use of sinks credits, and the election of a centre right government in Denmark removed a key opponent. He adds that Germany has commissioned research – from GFA Terra Systems – into the use of sinks credits to help meet its government Kyoto target (as opposed to their use by German companies to meet EU ETS targets). Furthermore, late last year the Italian government became one of the first participants in the World Bank’s BioCarbon Fund. At the March 29 meeting when EU environment ministers considered the Linking Directive, sources close to the discussions say that the bulk of the member states wanted sinks credits to be included at some point – but considered the technical concerns too great to be resolved in time to reach agreement. And, as they approach the Kyoto commitment period, the challenge of meeting their reduction targets will incline them towards accepting sinks. “One concern will be the cost of making reductions, especially in those countries with heavy reduction requirements,” believes CI’s Totten. “Rejecting sinks would artificially constrain the options available for them to pursue. And they offer a cheap source of reductions – second only to energy efficiency.” Schnurr at GFA Terra Systems adds that European governments will also come under pressure in favour of including LULUCF credits from the developing world. “There will be pressure from CDM countries, the host countries,” he says. “If you look at the Latin American countries, they have built up a pipeline of projects.” In other words, what is likely to play prominently in the EU’s considerations of sinks credits – at least privately – will be the potential costs of Europe meeting its Kyoto targets. If there is any sense that sinks projects can provide low-cost credits, they are likely to be endorsed by governments. “There are some very desperate countries [in Europe] that will be looking at all the possibilities,” Fehse says. “As the market gets going,” says Bosquet, “there will be a growing realisation that you need all the help from the CDM you can get to supply reductions to the market at a reasonable cost. Sinks are part of that equation.” However, he adds that any fears of hundreds of millions of tonnes of sinks credits flooding the market are unfounded. In 2001, at COP 7 in Marrakech, it was decided that sinks credits from the CDM equivalent to no more than 1% of a country’s 1990 emissions could be used to meet its targets. For example, this would mean that Spain – which has a mountain to climb to meet its Kyoto target – could use no more than 3 million tonnes of sinks CERs in each year of its Kyoto commitment to meet its obligations; by all accounts, a small amount. It seems, then, that while the climate change NGOs may have made most of the running to date, supporters of sinks projects are slowly but surely addressing the concerns that have thus far kept sinks out of the EU ETS. Besides, in the future the argument that is most likely to finally swing the debate in favor of sinks credits is an economic one: i.e. the possible costs to the EU of not allowing access to every climate change mitigation option available. Mark Nicholls, a regular contributor to The Ecosystem Marketplace, is the London-based editor of Environmental Finance magazine, and consulting editor to its sister publication, Carbon Finance.

How the scheme works

First proposed in 2001, the Emissions Trading Scheme is widely regarded as one of the European Union’s most ambitious environmental policy initiatives to date. It is analogous to the greenhouse gas emissions market envisaged under the Kyoto Protocol, and is designed to help the EU meet its Kyoto targets at least cost. Starting in 2005, around 10,000 installations across the 25 countries of the EU will be awarded allowances permitting them to emit a certain amount of carbon dioxide. (The Kyoto Protocol includes the six major GHGs, but for reasons of simplicity, the EU ETS focuses first exclusively on CO2.) These installations account for roughly half of the EU’s total emissions of CO2. Those installations that emit less than their total allowances can either hold their surplus allowances for use in future years, or sell them in the market. This should encourage those companies for whom it is cheap to reduce emissions to do so. On the other hand, those companies for whom reducing emissions internally would be expensive, or who need to increase production, can buy allowances. The Linking Directive, covered above, also allows companies in the scheme to use carbon credits from Kyoto Protocol projects to count towards their targets, with some limitations. Five sectors are explicitly covered by the scheme – electricity generation, pulp and paper, oil refineries, building materials (such as cement, glass etc) and ferrous metals. Combustion plants in other sectors greater than 20 megawatts in capacity are also included, bringing in on-site heat and power generation, and certain chemical processes, for example. Target setting is left to national governments, who are in the process of putting together plans – within certain criteria set out in the directive establishing the scheme, which are policed by the Commission. These so-called National Allocation Plans, which are supposed to be finalised by October, are proving highly controversial. Most governments have fought shy of imposing tough targets on industry – and are claiming, somewhat implausibly, that sectors outside the scheme (including transport and households) will help generate the required reductions to move them on a path towards their Kyoto targets.

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