Climate credit mechanisms




Climate crediting mechanisms, like other carbon market mechanisms, enable entities, for which the cost of reducing emissions is high, to pay low-cost emitters for carbon credits that they can use towards meeting their emission-reduction obligations, or for voluntary or trading purposes. These mechanisms-e.g. the Clean Development Mechanism (CDM)-put a price on carbon, helping to internalize the environmental and social costs of carbon pollution, and permit trading, which lowers the economic cost of reducing emissions.
Key words: Climate change, greenhouse gases (GHGs) or carbon; carbon pricing: carbon tax; market mechanism; carbon markets; offset mechanism or crediting mechanism; emissions trading system (ETS) offsets; allowances; crediting period; reporting period; baseline; methodology; Designated National Authority (DNA); Designated Operational Entity (DOE); banking; safeguard; polluter pays; externalities; voluntary.
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Climate (often also referred as carbon) crediting mechanisms aim to lower the economic cost of reducing emissions by permitting the trading of instruments representing GHG emission reductions. This fiche focuses on the CDM and identifies how the Paris Agreement on Climate Change builds on it. International negotiations under the United Nations Framework Convention on Climate Change (UNFCCC) spearheaded the development of global carbon markets, first through the CDM and other “flexibility mechanisms” under the Kyoto Protocol (which entered into force in 2005), and more recently through a new market-based mechanism, established under the Paris Agreement (2015), which is slated to replace the Kyoto mechanisms in 2020.
The CDM, established under the Kyoto Protocol of the UNFCCC, is the largest global offset (or crediting) mechanism for greenhouse gases (GHGs). It provides the framework for developing-country projects that reduce, avoid or sequester carbon emissions to earn Certified Emission Reductions (CERs)—tradable offsets (also called carbon credits) which can be sold to enhance a project’s financial viability. Another Kyoto mechanism, Joint Implementation (JI), similarly provides for Emission Reduction Units (ERUs) to be sold by economies in transition. The Kyoto Protocol spurred the carbon market by:
Under the UNFCCC Bali Plan of Action (2007), developing countries were encouraged to put forward Nationally Appropriate Mitigation Actions (NAMAs) enumerating plans for verifiably reducing GHG emissions relative to business as usual, for the preparation and/or implementation of which they could seek support. The Paris Agreement builds upon the Kyoto instruments and NAMAs by:
The key differences between Kyoto and Paris are that the new mechanism:
Given the close similarities, the Paris mechanism is expected to build on the CDM and JI. The functioning principles of the CDM need to be explained, namely, 1. the creation of emission reduction certificates (CERs); 2. the role of market prices; and 3. the emergence of voluntary markets.
1. Creation of CERs. To generate CERs, a project must go through the CDM Project Cycle, a rigorous and public registration and issuance process designed to ensure that a project has produced real, measurable and verifiable emission reductions that are additional to what would have occurred without the project. This process, overseen by the CDM Executive Board, involves documentation of project design, host-country approval, validation, registration, monitoring and verification. CERs that have completed the cycle are issued and tracked by the Executive Board in the CDM Registry. The CDM project cycle includes:
A wide range of projects are eligible for the CDM. Methodologies have been approved for a range of activities, including renewable energy, energy efficiency, methane mitigation and afforestation/ reforestation. Simplified methodologies have been approved for small-scale projects. Programmes of Activities (PoAs) may be approved under which an unlimited number of eligible CDM project activities may be added without paying additional registration fees or undergoing the complete project cycle.
2. The role of market prices. Market prices for CERs peaked in 2008 at US$20/tCO2e, driven by demand from industrialized countries seeking to meet their targets under the Kyoto Protocol and the European Union Emissions Trading System (ETS), which allows covered installations (i.e. facilities that are required, under an ETS, to reduce emissions) to use CERs to help them fulfil their emission-reduction requirements, up to certain limits. These installations have contributed 1.45 GtCO2e of CERs. Given that these entities have used offsets equivalent to 90 per cent of the amount allowed through 2020, little additional demand is expected from the EU. In the absence of sustained demand after the end of the Kyoto Protocol’s first commitment period in 2012, market prices for CERs tumbled to an average of only US$0.19/tCO2e in 2014 and are expected to remain low until new demand emerges. Some of the slack has been taken up by other regimes that allow limited use of CERs for compliance, or domestically-generated CERs against carbon tax obligations (e.g. the Mexican and Republic of Korean ETSs), by voluntary cancellation of CERs and deregistration of projects, and by targeted funds.
3. Targeted funds and the voluntary market. A number of buyers and development programmes pay premium prices for CERs that deliver additional sustainable development benefits, under long-term contracts at set prices and/or with other provisions that facilitate financing. For example, several CER purchasing programmes have been developed despite and in response to low market prices, typically focusing on least developed countries and on promoting technologies that have strong poverty impacts. A number of these programmes also offer technical assistance for CDM-readiness and other offset markets. For example, the Forest Carbon Partnership Facility and the BioCarbon Fund provided US$13.6 million for Ethiopia’s REDD+ readiness, including support for project development. These include the following.
Stakeholders
Potential in monetary terms
Potential revenues from the sale of carbon credits depend on carbon prices, the volume of credits generated, and the length of the period of time over which credits may be generated (i.e. the crediting period) and sold. Nearly 8,000 CDM projects have been registered, of which energy projects comprise over 75 per cent and waste handling and disposal projects comprise 11 per cent. CERs have been issued for 2,824 project activities, totaling over 1.6 billion tCO2e of emission reductions. China is the largest issuer accounting for over 60 per cent of issued CERs.
Carbon prices depend on supply and demand. Annual average market prices fell from a peak of US$20/tCO2e in 2008 to US$0.19/tCO2e in 2014). The higher the “level of ambition” and the scarcer the supply of credits, the higher the prices (e.g. CER prices plummeted when demand dropped and supply rose). Under the new Paris mechanism, demand will come from both industrialized and developing countries, which suggests prices will rise; however, given that the NDCs are non-binding, high prices may encourage some countries not to abide by their commitments, which would put downward pressure on the price.
The volume of credits generated depends on the crediting rules applied. Technologies that reduce emissions of gases with high global warming potential (e.g. biomass digestion, which reduces methane with a global warming potential 25 times that of CO2) tend to be able to generate CERs at lower cost than those which reduce CO2 (e.g. renewables). Some methodologies heavily discount the emission reductions generated when CERs are calculated, e.g. to adjust for uncertainties. Default values for emission factors under small-scale CDM methodologies, for example, tend to be lower than for standard methodologies. It is expected that under the new market mechanism, ITMOs could be generated through a range of policy and regulatory mechanisms, rather than only through projects (as under CDM and JI).
Legal and/or other feasibility requirements
The legal and regulatory infrastructure for the CDM is fully developed but continues to be enhanced. For example, approaches have been developed to facilitate CDM projects in least developed countries, which have made limited use of the CDM to date. These include simplified, standardized baselines, default emission factors, small-scale methodologies, Programmes of Activities (PoAs) and methodologies that give credit for suppressed demand.
Programmes supported by concessional finance have been developed to promote and help finance these projects. A new framework is to be developed for the new Paris mechanism, which is likely to build on the CDMs but with provisions for policy-based crediting and other methodological simplifications.
Requirements for CDM project development and registration are complex, but assistance to project developers is available through many DNAs, through the UNFCCC (e.g. its Regional Collaboration Centres) and from a range of consulting and other specialist firms. Some of this support infrastructure, however, has been dissipating as the volume of new CDM projects has dried up.
Minimum investment required and running costs
Transaction costs for CDM projects vary significantly by type of project, with CDM Programmes of Activities (PoAs) and large projects that use complex methodologies at the high end, and CDM Project Activities under an existing PoA at the low end. Introducing a new methodology adds to the cost and time required to develop a project. In addition, monitoring and periodic verification costs, which again vary by project type and methodology need to be added. Verification reports can be produced at low incremental cost if monitoring is straightforward and verification can be done as an add-on to a broader audit engagement with a DOE.
From the host country’s perspective, participating in the CDM incurs the cost of operating a DNA to vet projects, plus any costs associated with assisting project sponsors and/or developing programmes of activity. The DNA’s work usually dovetails with other work, such as preparing National Communications to the UNFCCC and developing NAMAs and Intended Nationally Determined Contributions (INDCs). Project development costs can however be defrayed in a number of ways.
In what context it is more appropriate
At market prices (as of 2014/2015) for CERs, and given the cost and time associated with project preparation, only projects that generate substantial emission reductions at low cost, qualify for simplified procedures, fall under PoAs, and/or are eligible for carbon purchasing programmes that offer above-market prices, long-term contracts and/or assistance with development costs (see above), are likely to benefit from the CDM. Previously-developed CDM projects may be candidates for such programmes if the incremental cost of completing registration and delivering CERs is low enough to render the project viable at the offered prices. Successful CDM projects tend to have strong project sponsors and champions, robust project design and planning, committed project financing, and clear potential to meet their objectives.
CDM project activities under existing PoAs with substantial sustainable-development benefits are good candidates for scale-up given their relatively low up-front cost and their attractiveness to many carbon procurement programmes that pay premium prices for CERs from projects with broader benefits.
CDM should not be considered when the costs of development exceed the expected proceeds, particularly if there is uncertainty about CDM project approval, when financing cannot be secured, or when project implementation and monitoring exceeds the sponsors’ capacity.
Pros
Cons
Risks
The primary goal of climate credit mechanisms such as the CDM is to reduce greenhouse gas emissions and halt climate change. This entry does not provide a review of the vast literature that explains why halting climate change is good for the economy and the people, but it rather focuses on climate credit mechanisms' specific and measurable impacts.
The mandate of the CDM is already dual, as it--in principle--includes the delivery of sustainability benefits. In addition to the greenhouse-gas emission reductions (2,824 project activities have issued CERs, totalling over 1.6 billion tCO2e of emission reductions), CDM projects can and should deliver positive social/environmental impacts. However, less attention has been given to the question of how far the CDM will advance sustainable development goals. The range of sustainable development benefits provided by CDM projects depends on the sector and technology, but may include:
These above-mentioned impacts can be enhanced in the following ways.
Guidance
Case Studies