CO2 trade jury is out

Despite the much celebrated second commitment period under the Kyoto Protocol, there is a mood of despondency sweeping global carbon markets.

This is due to a serious imbalance in supply and demand in the market, which is likely to persist until 2015, and should correct by 2020.

While long-term prospects for carbon trading remain good, most market players cannot find a way around the short-term hiatus, and have laid off staff or are looking to exit the market.

Carbon markets leapt into prominence with the first commitment period under the Kyoto Protocol (2008 to 2012). The protocol generated demand by setting binding emission reduction targets for developed countries that had subscribed to the protocol (known as Annex 1 countries).

Annex 1 countries were allowed to meet a portion of their emission reductions by trading with or purchasing credits from either developing countries that did not have emission reduction targets of their own, or developed countries that had met their targets and could trade their excess emission reductions.

The mainstay of the carbon trading system is the UN-regulated Clean Development Mechanism. CDM is a project-based system generating Certified Emission Reductions in developing countries, which are the primary commodity in carbon markets. CERs are measured in tons of or equivalent greenhouse gas removed from the atmosphere.

CERs are bought by Annex 1 countries or companies in countries that are required to meet domestic targets.

At the time these mechanisms were negotiated, they all seemed highly theoretical and unreal. But they have resulted in some very tangible results.

There have been more than 3600 projects initiated in developing countries, collectively responsible for removing the equivalent of 800 million tons of from the atmosphere.

And some very real money has changed hands. The amount invested in CDM projects has grown from $40-million in 2004 to a total cumulative investment of $140-billion to date.

The pipeline for developing CDM projects is now well developed, and projects totalling a billion tons of additional emission reductions are expected over the next 10 years - about 200 to 300 million tons a year.

The pipeline has been expanded by recent decisions at COP17 in Durban. CDM now includes emission reductions from carbon capture and storage, and from projects that prevent deforestation.

The problem is that there isn't demand to support these projects.

Traditionally the European emissions trading system has been the main buyer of credits.

The economic recession has affected the growth of emissions from European industry, making it easier for them to achieve their 20% emission reduction target (on 1990 levels).

It appears that Europe will soon have already largely purchased all the credits they will need for the second commitment period.

With Japan and Canada unlikely to participate in the second commitment period, it seems there will be constrained demand for CERs.

There have also been concerns about the quality of CERs issued under the CDM. About 69% of the CERs generated come from industrial gas projects in India and China, which have been quick to take advantage of the CDM mechanism.

Apart from the technology transfer and investment benefits, these projects have had limited development impact on local communities, and have resulted in what some see as unduly high rates of return.

To compound this there have been some high-profile cases of human rights abuses linked to projects.

The European Union has now taken the unprecedented step of restricting future CER purchases to least-developed countries and countries with which they have bilateral agreements.

The EU decision has major implications for the carbon markets, segmenting the market into LDC and non-LDC CERs, and severely limiting the market and price for credits from the larger developing countries (including South Africa).

There is some hope. The EU may increase their target to 30%, provided that other countries shoulder their share of the global emission reduction burden, and a new international treaty gets under way.

The Australian carbon pricing mechanism will allow international off-setting of emissions from 2015. The Japanese will be buying some credits through bilateral mechanisms. And there are a number of domestic and regional trading schemes under development, including in China and India.

While these might not result in demand for off-set credits beyond their borders, they will at least soak up the excess domestic carbon credits that will otherwise flood the market.

Estimates of demand for credits (compiled by the World Bank in 2011) for 2013 to 2020 are 2.7 billion to 3.6 billion ton s of .

At the same time, countries are negotiating a long-term climate treaty that will take effect from 2020, which will need to involve a much broader set of countries, taking on a much deeper set of emission reductions.

This will clearly create a buoyant market for off-sets between countries in the long term.

Also under negotiation is a new market mechanism that will either replace or operate alongside CDM. CDM is not particularly well suited to crediting national policy interventions such as energy-efficient building standards, or economy-wide sectoral measures.

We clearly need to take a long, hard look at the successes and failures of CDM, so that we can both improve the mechanism and take on the lessons in designing other market-based instruments.

For this reason, a high-level review panel has been set up by the CDM Executive Board and the UNFCCC to evaluate the mechanism and make recommendations for its future. The panel is due to release its report in September.

Olver is the director of Linkd Environmental Services