Back in 2004, the Suwung landfill site outside Denpasar on the Indonesian island of Bali resembled any other refuse dump in the developing world. Up to 800 tonnes of solid waste were being added daily, edging into urban areas and diminishing the mangroves so beloved of tourist picture postcards. Then, a new source of funding enabled people who had crawled over the waste searching for scrap to sell to be employed sorting organic waste. This, in turn, was tapped for methane that supplied local villages.

The money came from the Clean Development Mechanism (CDM), the global scheme that lets developed nations offset their carbon emissions by funding low-carbon projects in developing countries. This, the first biogas project on Bali, is cited by the UN as one of the shining examples of the CDM.

The CDM is one of the world’s two major carbon markets. The other was launched by the EU in 2005, and is known as the Emissions Trading Scheme (ETS). At first glance, the ambition of these schemes looks quite noble: carbon trading imposes a market price on carbon, forcing huge industrial polluters to factor emissions into their business plans; as they do so, they become increasingly aware of the effect of polluting not just on the planet, but on their bottom line. Fossil-fuel guzzling societies not only pay their dues for polluting the environment, they encourage other countries to pursue a path to clean technology.

Complex system
Sadly, it hasn’t worked out that way. Trading in carbon emissions is fabulously complicated. Bewildering regulations, ambiguous definitions of sustainable development, the vexed issue of verifying and trusting governments to be truthful about emissions, and the uncertain future for carbon trading in the wake of the failed Copenhagen climate talks have created gaping loopholes for sharp practice and outright abuse.

‘ETS has created a market, it has created a commodity, but in terms of reducing emissions, it’s clear that it isn’t working,’ says Belen Balanya of Corporate Europe Observatory (CEO), a European environmental research group. ‘Companies will only accept something that is beneficial to them. ETS makes government and industry look as though they are doing something, but in fact they haven’t been forced into making structural changes. They are continuing as before.’

Even environmentalists, some of whom initially gave carbon trading a degree of wary, if watchful, endorsement, are now almost universally critical. ‘ETS has fundamental flaws,’ says Sarah-Jayne Clifton, international climate campaigner for Friends of the Earth. ‘Apart from anything else, it has failed to bring down emissions. It hasn’t really worked, and it has had plenty of time to try to work.’

Carbon markets were central to the Kyoto Protocol and produced the EU and UN carbon-trading systems that were originally separate and distinct from one another, but since 2008 have overlapped. The trading rights approved at Kyoto established the principle that companies buy allowances that enable them to emit a given amount of carbon dioxide. Governments, or international bodies, issue a limited number of these – notionally less than enough to cover all carbon emissions; companies can purchase these to continue polluting; or sell them if they cut emissions. Over time, the number of permits shrinks, forcing up the price of carbon and making it good business sense to pollute less. In both the EU and UN schemes, one allowance, or certificate, amounts to one tonne of CO2 equivalent.

The EU’s cap-and-trade programme represents around 80 per cent of the global carbon-trading market. ETS aims to cut CO2 output by at least 20 per cent from 1990 levels by 2020. It seeks to cut carbon emissions among big polluters – chemical, steel and energy plants – by reducing the availability of permits by 1.74 per cent a year. ETS covers around 2.2 billion tonnes of carbon emissions a year, representing around half of EU emissions, although it excludes those from transport, agriculture or domestic use.

Meanwhile, the UN and the World Bank operate a scheme based on Certified Emissions Reductions (CER) credits. This allows developed nations to pay for carbon reductions in developing nations under the CDM; in turn, developing countries agreed to reduce carbon emissions and sell carbon credits in international markets. Companies in industrialised countries can then buy the credits in lieu of their own emissions.

Since the CDM began, 439.6 million CERs have been issued, equivalent to a CO2 saving of 439.6 million tonnes, according to the Risoe Centre at the UN’s Environment Programme, which collects this data. By 2012, this is expected to rise to 2.83 billion tonnes. In all, 2,400 CDM projects have been approved and a further 5,529 await implementation.

Initial error
By general consent, one of the major failings of carbon trading was the decision to issue the first round of ETS permits for free, and to base allocations on high, historical records of pollution. This created startling anomalies: until 2008, permits were allocated for 130 million more tonnes of carbon than were actually emitted, causing the price of carbon to crash from €30 a tonne to €10 and then to just €1 by 2007.

According to the CEO, the EU’s steel sector was allocated permits for 185 million tonnes of carbon last year, but emitted just 94 million tonnes. By 2013, the CEO says, the biggest steel firms can each expect to hold up to €100million worth of surplus permits, worth around €1.5billion at current market prices. ‘It’s scandalous,’ says Balanya. ‘They will be able to bank those permits or sell them for a profit. They won’t make any reductions in carbon emissions – they will continue as normal and actually make a vast profit
from doing so.’

Balanya believes that this is unlikely to improve under the next round of credits, known as Phase Three, which will run from 2013 until 2020. Power companies must pay for permits in future, but Balanya points out that they are likely to pass this cost on to consumers. Heavy industry will still get permits for free up to 2020, as will three quarters of all manufacturing companies.

Another concern is the way in which carbon trading has shifted the debate on climate change. ‘It has dominated discussions on how to tackle climate change,’ says Clifton. ‘The cap was set way too high and the system is so incredibly opaque and complex, it’s very difficult to expose what’s going on. Relying on the UN and the EU as our main tools to bring down emissions is a very high-risk strategy. Carbon trading is being pushed as a silver bullet, overshadowing more cost-effective forms of cutting emissions. It also further locks us into high-carbon infrastructure rather than lessening society’s dependence on fossil fuels to generate its energy.’

Freedom of information requests to the European Commission have revealed evidence of the furious – and successful – lobbying of the commission by industry, which ultimately overturned the ambition to force companies to buy permits from 2008. ‘The problem with ETS is that it’s completely permeable to lobbying,’ says Balanya. ‘Many companies, such as BP, supported the creation of ETS because, at the time, there was talk of carbon taxes. Steel, cement, oil and chemical companies took part in massive lobbying. They said that if they were forced to buy permits, they would have to relocate outside the EU, and that [would have] involved huge job losses. Even if that wasn’t true, as a political argument, it worked very well.’

Emissions impact
Even advocates of carbon trading admit that the system is under severe strain. ‘These are pretty dark days for anybody supporting emissions trading across the world,’ says Henry Derwent, chief executive officer of the International Emissions Trading Association, which advocates business participation in cap and trade. ‘There’s a feeling that there isn’t much support for trading and market mechanisms in the UN negotiations. That lends itself to a grim determination to keep up the ETS, if not to extend it.’

Yet Derwent argues that, despite its failings, cap and trade does work. Emissions dropped by 11.6 per cent in 2008–09, and the European Environment Agency reported this autumn that EU emissions have already dropped by 17.3 per cent on 1990 levels, although green groups say that this is mainly down to the recession, vehicle and building efficiency, and, just as important, an extraordinary 60 per cent drop in steel production.

Calculating the true impact of the ETS on carbon emissions is difficult, because consistent emissions data don’t exist. But, according to the European Commission’s climate action office, emissions among the 500 largest polluters – all of whom are in the ETS – declined by 17.8 per cent between 2005 and 2009.

Derwent, meanwhile, cites academic appraisals of the first phase of the ETS, which he says concluded that between three and five per cent of emissions reductions couldn’t be attributed to any other reason than carbon trading. ‘It’s fair to say that ETS does do what it says on the packet,’ he says.

Market-based approach
As you read this article, carbon is being traded in the same ways as wheat, cocoa, sugar or any other commodity: the price of a tonne of the stuff was around €16 in mid-October, and IETA reckons that it will rise to €30 or €35 by 2020. This, according to advocates of cap and trade, is a sign of success. ‘It has created the first international environmental currency,’ says David Abbass, spokesman for the secretariat of the UN’s Framework Convention on Climate Change (UNFCCC), which runs the CDM.

‘It has assisted countries in pursuing their sustainable-development goals. The number of projects registered has been much higher than anticipated. It has done a great deal.

‘Tackling climate change is going to take a lot of resources and there’s a need for the engagement of the private sector,’ he continues. ‘That’s the rationale behind pursuing a market-based approach. CDM’s aim is to engage the private sector in developing countries. It’s pretty straightforward. The amount of carbon within the EU that is permitted is prescribed. Those companies that go below that level have something to trade; those that are above have to go to the market. The question is how you engage people and companies who aren’t under that cap – those in developing nations.’

There is a feeling – even among supporters such as Derwent – that carbon trading is treading water because of the lack of progress of cap-and-trade legislation in the USA. ‘There is no consensus on the view that you need to even reduce emissions,’ he points out. ‘American voters aren’t persuaded that man-made climate change is a reality. Until that happens, it won’t be the driver for the rest of the world. Other countries don’t want to move more rapidly than the USA.’

The decision to issue ETS permits for free was an error, supporters admit, and from 2013, half of permits will be auctioned. ‘We have had a few hiccups,’ acknowledges Jos Delbeke, director general for climate action at the European Commission. ‘Issuing the permits for free was a mistake. But carbon trading was a new instrument, and we were all jumping into the water for the first time. We’ve learnt the lessons of the first phase of ETS and won’t be repeating those mistakes.’

‘Escape hatch’
Many CDM projects themselves have come under scrutiny. Windmills, geothermal schemes and energy-saving technologies would seem unobjectionable; yet according to International Rivers, 1,525 hydro projects have been registered or are seeking registration with the CDM, of which 971 are in China. ‘The definition is so broad as to what constitutes a CDM project,’ says FoE’s Clifton, who argues that companies and countries exploit the CDM as an ‘escape hatch’ to avoid reducing pollution at home, and pushes the burden of emissions cuts onto developing countries. ‘You can have a coal-fired power station that, with investment, produces slightly less carbon than it would otherwise have done, but it’s still a coal-fired power station.’

Such projects also undermine the concept of ‘additionality’ – the idea that cuts in carbon emissions happen on both sides of the deal. Instead, critics point out that emissions cuts were often going to happen anyway, but that energy producers view CDM as a source of funding. ‘In India, China and elsewhere, governments and businesses know about the CDM and can incorporate it into their business plans, building plants because they can get the project partly funded by CDM.’

Such loose interpretations, according to WWF, mean that between 88 and 100 per cent of the nine highest-polluting European countries’ emissions restrictions could be met simply by buying credits from outside the EU. Sandbag, an NGO that focuses on emissions trading, argues that the ongoing availability of cheap offsets could allow Europe’s domestic emissions to grow by a third between 2010 and 2016.

Forest carbon sinks are another worry, and there is increasing industrial pressure to use CDM credits to enable carbon emitted in the West to be offset by afforestation schemes that convert CO2 into harmless oxygen and wood. But estimates of the amount of CO2 that a forest can absorb differ vastly. ‘Carbon sinks are still incredibly difficult to calculate,’ says Oscar Reyes, a researcher with Carbon Trade Watch who is concerned at the prospect of reduced deforestation being part of the CDM. ‘Forest carbon would become a commodity; there would be less emphasis on discouraging logging or deforestation per se. You also see jatropha plantations for biofuel that are claiming to be forests.’

While 335 CDM projects have been rejected by the UNFCCC, Abbass counters that the vast majority of such schemes are valid.

‘People have very different ideas about what constitutes sustainable development,’ he admits. ‘Some people picture wind farms or cooking stoves. It’s fine that expectations are so high. The scale of the problem is such that people should have high expectations. But Kyoto says countries can use CDM to cover only a part of their commitment under Kyoto. The projects must show that they reduce emissions in a way that is real, measurable and additional – the reduction would not otherwise have occurred.’ Attempts to scale back the abuse of the CDM have included the creation of a gold standard of projects that have a high level of environmental integrity, an initiative pushed by WWF and others.

The ETS and the CDM have also been beset by a succession of scandals. Carbon trading creates a fiendishly complicated paper trail, sometimes handled by undisclosed intermediaries. WWF and FoE believe a number of CDM projects have not been properly verified – a claim that the UNFCCC rejects – but in some instances, pollution permits have merely been recycled, instead of being taken out of the system when they’ve been sold. In March this year, the Hungarian government was accused of ‘double-capping’ when CERs were exchanged in a transaction, even though they had been previously surrendered by Hungarian firms to comply with their emission constraints. ‘It looks dreadful,’ admits Derwent. ‘It’s difficult to disagree with the statement that there seems to be a lot of fraud around the ETS.’

Derwent prefers to call such incidents ‘a terrible run of bad luck’, and points to a lack of co-ordination between the ETS and CDM. Others are less diplomatic, and FoE has consequently lost patience with the way loopholes are manipulated. ‘Some FoE groups held that carbon trading could work if you took out offsets and tightened the cap – that there then wouldn’t be too much harm in allowing trading within business,’ says Clifton. ‘But in the past couple of years, we’ve seen that this theoretical market doesn’t happen in practice.’

Harsh choices
Yet the problem with emissions trading, says Derwent, is not that it doesn’t work, but that it has the potential to work all too well – and that it shines a light on the harsh choices that humanity must confront in the face of climate change. Describing cap and trade as ‘a cold bath’ delivering a shock to the economic system, he adds: ‘The problems with cap and trade are entirely political. Cap and trade looks like being the way that we are most likely to address the cost of electricity and energy-intensive manufacturing.

That’s what has made it the focus of every political lobby you can think of. The problem is not about cap and trade, but everything to do with imposing costs on carbon – that’s why it was objected to so ferociously.

‘At the moment, a lot of the world is in denial about climate change,’ he continues. ‘Cap and trade is caught right in the firing line of this anger and denial. But when we get a succession of extremely unpleasant physical catastrophes, in which denials that they are linked to climate change sound increasingly hollow – people will start to come around.’

Delbeke also suspects that the complaints coming from industry suggest that carbon trading may, belatedly, be starting to bite. ‘The decision to auction permits, and for them to be governed by benchmarks from the ten per cent lowest emitters, is causing some emotion within industry,’ he says. Emissions trading, he argues, is something of a slow burner, but will work, given time, pointing out that aviation will be included from 2013.

‘Emissions trading is the only tool for big industry,’ he says. ‘We started industrial emissions legislation more than 20 years ago and it’s still being formulated – carbon trading is working much more quickly. I don’t disagree that carbon taxes are effective, but we all know how difficult taxes are politically and it’s difficult to get them adopted.’

Slow change
By reducing allowances by 1.74 per cent a year, the EU will, by 2050, have cut carbon by 71 per cent of 1990 levels, says Delbeke. ‘That’s not a fantastic amount every year; it isn’t revolutionary, but it works effectively and gradually. In company boardrooms, chief executives now bother about the price of carbon. Action against climate change has taken place more decisively in industry than would otherwise have been the case. Awareness has been raised at every level of every company – their bosses know that the price of carbon will rise.’

Environmentalists, however, feel that the pace needs to be quickened. ‘I don’t think that that is either quick enough or credible enough to ensure the wheels don’t come off along the way,’ says Keith Allott, WWF’s head of climate change. ‘We don’t have any ideological aversion to carbon markets – we think they are an important part of the policy mix – but in their present form, they aren’t delivering what we need.’

Derwent also argues that the markets require time to become more sophisticated. ‘Markets will look to do what is cheapest first,’ he says. ‘Carbon trading will only truly take off when business believes that governments – and the people who vote for them – genuinely want, and intend, to cut carbon. An awful lot of decision makers are still not really convinced that the EU and the rest of the world are serious about increasing the price of carbon beyond 2020. If they knew that the price of carbon was going to go up to €60 a tonne, they would come forward with ideas to reduce emissions.’

For most environmentalists, however, carbon trading has had its chance, and, according to Balanya, direct regulation is the only effective tool. ‘You just implement binding regulations to reduce carbon,’ he says. ‘It isn’t simple, and you have to calculate emissions factory by factory, company by company, but it can be done. The subsidies to dirty energy such as coal can be removed. The reductions achieved by ETS – involving 12,000 factories – could have been achieved by strict regulation of a single factory. I find that shocking.’

Proposals for a global feed-in tariff scheme, outlined by the UN’s Department of Economic and Social Affairs, may have some role to play, according to Clifton, as it would fund such projects in developing countries, but she feels that a large role remains for regulation of major polluters. ‘There’s no other place to go,’ she says. ‘It’s not a question of whether or not they cut back; rich countries are being forced to face up to their responsibilities.’

The answer, however, according to Reyes, is probably more fundamental. ‘Regulations and financial incentives will get you some of the way, as will UN and regional action, but beyond that there’s a broader question of what kind of society we want,’ he says. ‘We need to develop ideas of a good society that involve living within our means.’

HFC-23
Carbon dioxide is one of six gases and groups of gases traded through CDM. The others are methane (CH4), nitrous oxide (N2O), perfluorocarbons (PFCs), hydrofluorocarbons (HFCs) and sulphur hexafluoride (SF6).

HFCs have gained particular notoriety within the CDM because of HFC-23, a by-product produced during the manufacture of HCFC-22, an ozone-destroying refrigerant. HCFC-22 can only be produced in developing nations, and only until 2030, but HFC-23 is 14,800 times better at trapping heat than CO2, according to the Intergovernmental Panel on Climate Change.

Because of the potency of HFC-23, and the fact that it’s relatively cheap to destroy it by fitting incinerators to production factories, it’s easy to generate large quantities of credits, and HFC credits now dominate the CDM market. According to the UN Environment Programme’s Risoe Centre, 219 million out of the 439.6 million CERs issued come from HFC projects. Under the CDM, firms enjoy lucrative credits for destroying the gas – and the more of the gas they destroy, the more credits they earn, to the point where they can earn more money from these credits than they do from selling HCFC-22.

‘The CDM is meant to deliver sustainable development objectives, but that’s often forgotten in practice,’ says Keith Allott, head of climate change at WWF. ‘All too often, CDM supports schemes that simply destroy industrial gases, such as HFC-23, from a handful of large chemical factories – which may have little to do with genuine sustainable development. Chemical companies can destroy HFC-23 very easily and cheaply, and then make very large windfall profits from selling the credits.’

Even worse, says Allott, there are strong concerns that the CDM creates a perverse incentive to produce more of the gas in the first place. ‘It’s one of many fundamental problems with the CDM – we have to stand back and ask how this really helps the climate,’ he says.

Other cap-and-trade schemes
The UN and EU schemes may be the largest cap-and-trade systems, but others are emerging or will come into force within the next few years. New Zealand already has a national carbon-trading scheme, and there is a state-led scheme in the Australian state of New South Wales. Japan, Taiwan and South Korea are compiling national carbon-trading markets; India’s scheme is in the latter stages of the country’s legislative process; and China is evaluating provincial or state-led schemes. Tokyo launched a city-led trading market in April this year, and Sao Paulo in Brazil and Tianjin in China are considering similar ideas. And while the US federal government has yet to buy into the idea of cap and trade, an internal carbon-trading market, known as the Regional Greenhouse Gas Initiative, exists in the northeastern USA.

December 2010