REEEP

The Importance of the Offset Market for High Sustainable Development Carbon Projects

South Africa, 11.06.2007 - Emily Tyler

The Rise of the Carbon Offset

Public awareness of climate change has seen a dramatic increase over the past six months.  Al Gore’s “An Inconvenient Truth”, the Stern review of the economics of climate change, the IPCC’s latest updates on the science, have all contributed to a consumer and shareholder awakening, and with this awakening, a call to respond.

The international policies and regulations in place as a result of the Kyoto Protocol are neither able to go fast nor deep enough to satisfy this growing public need.  The complexities of the issue and the implications of the required climate change mitigation activities are not easily conveyed to the layperson.  Carbon offsetting has therefore emerged as a way in which individuals and companies can respond whilst governments and technology get into place to enable the major economic and lifestyle changes required. 

Offsetting involves investing in projects which reduce greenhouse gas emissions and receiving credits in return for this investment to “offset” the emissions one can’t cost effectively or conveniently reduce oneself.  The offsetting mechanism is revealing itself to be an effective tool for generating public awareness, thereby stimulating domestic individual and corporate action on climate change and lobbying of governments to focus on the issue.  

The rapid growth of the offset market in recent months has also seen a rise in its critics.  The market is unregulated, has no clear standard, and as such is accused of allowing false emission reductions to proliferate: the environmental integrity of the mechanism has rightly been called into question.   Certain projects which would have gone ahead in the absence of the offsetting mechanism are claiming credits, contravening the principle of additionality. The scientific and auditing rigor of other projects is less than desirable. The timeframes of emission reductions are not transparent and not clearly defined.  Purchasers of forward credits (those not yet generated) are claiming carbon neutrality, without clearly stating the conditions surrounding this claim.

This situation is a direct result of a market which is growing too fast, without the necessary standards and infrastructure in place.  Intentionally or unintentionally, all types of market players are implicated, with the confusion and criticism threatening to precipitate the mechanism’s collapse.   

A lesser known function of the offset market

Apart from the role that carbon offsetting plays in fostering consumer awareness about climate change, and the potential it has to divert funding into mitigation projects, offsetting serves an additional and lesser known purpose: It provides an important source of revenue for valuable mitigation projects occupying a niche which the current international response to climate change, the Kyoto Protocol, is bypassing.

These niche projects are identified primarily as those comprising many small point sources of emissions, and which deliver rich local sustainable development benefits. The emission sources can be spread over a large area, and are often situated remotely.  Their stakeholders include disparate and often less well organised (from a mainstream financial risk perspective) groupings such as rural and low income communities, commuters, or inhabitants of a city.  Apart from their current emissions mitigation effect, these projects are important as they prevent the addition of new generations of consumers in developing countries addicted to high emissions lifestyles.  Many of these projects also have a high poverty alleviation contribution, with achievement of the millennium development goals closely associated with their successful implementation.  For the purposes of this article, these projects are termed ‘high sustainable development (SD) carbon projects’. 

Examples of these project types are commonly found in the transport, domestic energy use, energy efficiency and land use sectors.   The total emission reduction volume delivered by these projects varies but tends to be below 8,000 tonnes of carbon dioxide equivalent (tCO2e) per annum.  A solar water pumping project in Mozambique generates as little as 36tCO2e per annum. The carbon revenues associated with these volumes typically represent only a small percentage of the upfront capital costs of these projects.  Considering that transaction costs can amount to over $80,000, this percentage contribution is further reduced, with projects generating emission reductions below 8,000 unlikely to breakeven in their carbon endeavours.

The compliance carbon market is generally failing high sustainable development carbon projects

High SD carbon projects are being bypassed by Kyoto for a number of reasons.  Kyoto enables developing countries to participate in the carbon market through the Clean Development Mechanism (CDM).  This mechanism allocates carbon credits to projects which are registered with the United Nations and these credits are then sold to developed country purchasers.  Given the bureaucratic, complex and costly process required to register a project with the UN, it generally takes a large, low-cost and well financed project to benefit from the undertaking. 

Purchasing carbon credits is also a costly business, and again purchasers favour high volume transactions from projects presenting low delivery risk.   The compliance carbon market (trading in Kyoto compliant carbon credits) has therefore to date mostly allocated finance to projects which involve end-of-pipe solutions to emissions reductions, or are of a sufficiently large scale and volume to generate a sizable portion of carbon revenues. 

Whilst the ‘transaction costs’ of CDM projects have come down significantly over the past few years and are anticipated to fall further, economies of scale in credit volume still currently presents a sizable barrier to smaller projects[1].  Within the CDM architecture, the concept of programmatic projects has emerged, partly to address this issue.  Programmatic projects enable the crediting of a programme of activities, which means that many small projects can register under an umbrella programme, opening up the possibility of capturing economies of scale.  However, this project type is still in its early stages, with many legal and procedural issues still to be ironed out before it can be cost effectively accessed by high SD carbon project developers.

Apart from transaction costs and credit volumes, the CDM currently prohibits two types of projects which are likely to encompass many high SD carbon projects.  Land rehabilitation and avoided deforestation projects protect vital carbon sinks, yet are not yet permissible under the CDM. Clean cooking (e.g. through solar cookers) is also prohibited, a technology with high sustainable development potential.  These project types rely on the definition of a non-renewable biomass baseline, which is subject of ongoing debate.  Steve Thorne, a member of the Gold Standard Technical Advisory Committee argues for the inclusion of these high SD projects in the CDM through the use of a suppressed demand baseline.  “Solar cookers can be seen to be replacing stoves using kerosene rather than firewood, giving the scarcity of residual wood in many rural areas”.  The registered Gold Standard Kuyasa project pioneered the concept of suppressed demand, which credits communities for developing along clean lines before they have a chance to advance along business as usual, ‘dirty’ routes.

High SD carbon project proponents are often unaccustomed to accessing market or commercial financing, and are generally inexperienced or not aware of the carbon market.  These projects are mostly initiated by NGOs or local and regional government.  Combined with factors such as the project’s numerous small stakeholders, low financial returns, high risk country and technology profiles, need to overcome bureaucratic hurdles and reliance on political will for their prioritisation, these projects represent very high risk from a commercial financial perspective.  This risk is not compensated by the potential of high reward, and therefore compliance carbon purchasers whose primary objective is achieving volume at low cost will therefore steer clear of them.

Why is the offset market able to support high SD carbon projects?

The offset market has significantly different characteristics to those of the compliance market.   Firstly, offsetting is a voluntary activity, it does not directly arise in response to targets and penalties.  The motivations of offset purchasers are therefore far more subtle than achieving lowest cost compliance.  Individuals need to feel like they are ‘doing something’ in response to their emitting activities, and therefore are offsetting their flight emissions through internet based portals.  Companies are building corporate brands and reputations around climate change action; HSBC announced their intention to go climate neutral in 2004, with Marks and Spencers following suit early in 2007. 

Governments are demonstrating leadership through their offsetting of events and individual departments emissions, such as the UK’s EU Presidency offsetting of the G8 summit in 2005, and the UK Foreign Ministry’s offset of annual air travel emissions with a South African wind project.  The organisers of sporting events are responding to the needs of their fans by offsetting events such as the 2006 World Cup Soccer championship.   The public face of these emission reductions is therefore a large portion of the emission reduction product that is being acquired; i.e. the story of the project generating the emission reductions is important.  Offset purchasers generally have a far smaller volume requirement than compliance purchasers, where annual demand of 100,000 CERs (Certified Emission Reductions, CDM credits) is fairly standard.  This purchasing motivation and lower volume demand finds a perfect fit with high SD carbon projects.

Because offset purchasers are not primarily interested in compliance with Kyoto targets, they are less bound by its procedures and restrictions.  Project types which are currently prohibited by the CDM such as avoided deforestation and solar cooking can generate credits under a voluntary offset scheme.  Steve Kaufman of Green Markets International says that “those kinds of projects, especially clean cooking, can be very important and could get a big boost from the carbon market, but only through the voluntary offsets market (at least for now)”.    

A large portion of the value of purchasing and retiring an offset credit is the marketing and recognition that goes with this action.  Projects which sell offset credits receive greater profiling than those selling credits into the compliance market.  This profiling can be very valuable for putting pressure on developing country governments, donors or financiers to find the grants and financing required to implement the project.  This is what has happened in the case of the Kuyasa project involving sustainable energy interventions in a low income housing community in Cape Town, South Africa.  In addition, the attention which the use of carbon revenues in this project has received has motivated for the government’s support in financing the replication of these interventions in low income housing at a national level.

Additionality and the financing challenges of high SD Carbon projects

One of the main critiques of the voluntary offset market is that there is no rigorous assessment of additionality.  The CDM requires that projects demonstrate that they would not have occurred in the absence of the CDM.  The financing challenges facing high SD carbon projects are worth exploring further in the context of both the additionality critique as well as the importance a feasible, high profile and lucrative carbon revenue stream can play in reaching financial close.

Apart from the carbon credits, the revenues these projects generate can be low or non-existent.  Many serve subsistence communities, or displace grid electricity and are restricted as to what they can charge over and above this.  These are conventional development projects, relying on grant or public sector financing in order to be designed and implemented.  In some cases though, sustainable technologies are financed by regional rural banks and end users, with the carbon revenue supporting micro-financing structures. Because emission reduction, sustainable energy and land use solutions have not been high priority amongst developing country governments, these projects struggle to find suitable grants or budget line items to support them. 

Donor poverty alleviation funding is increasingly becoming ‘climate proof’ (ensuring that the spend contributes towards climate mitigation and adaptation activities, or at the very least is not in conflict with them), but this is not yet standardised across all donor portfolios.  Partnerships such as REEEP are providing grant funding for the development of Gold Standard Voluntary Emission Reductions (VERs) from developing countries.

A perception seems to exist amongst some developed country purchasers that the price of an emission reduction credit is the true cost to the developer who reduced emissions.  The difficulty of designing and implementing a high SD carbon project should not be underestimated, particularly when needing to satisfy a market investor that the project will deliver credits within a specific timeframe.  Should the price reflect the true cost of this process and capture the lack of other revenues flowing to the project, the credits from these projects would be prohibitively expensive.  Already the projects can’t compete with the high volume, low cost credits from end of pipe projects. 

In the absence of carbon prices in excess of €30, the role of carbon revenues in high SD carbon projects tends to be limited to that of leveraging other funding sources.  This can happen through pressure on public funding sources, as mentioned above, or through leveraging social corporate responsibility funds.

Risk diversification through holding a portfolio of emission reduction projects may enable high SD carbon projects to attract underlying finance.  This may be something host country governments, especially those likely to take on caps under future international negotiations, might be interested in exploring.  Governments are well placed to purchase credits from high SD carbon projects, and sell them on risk free, thereby generating additional funding for social programmes. 

Strengthening the ability of the offset market to realise its potential to support High SD Carbon Projects

The need for standards, registries and regulation in the offset market is undisputed.  But this article argues that during this market development process, consideration should be given to the valuable function, both existing and potential, that the offset market plays in supporting high SD carbon projects.

Whilst rigor is important, replicating the expensive and bureaucratic procedures of the CDM will not add value for high SD carbon project developers.  Retaining the integrity of the mechanism and keeping access costs low for projects which meet certain criteria presents a challenge which requires a high degree of creativity and innovative thinking.  Positive lists of project types present one form of solution.  Another is to carefully word what is being claimed:  a ‘carbon donation’ does not have the implications of a ‘carbon offset’, and may enable a company, individual or organisation to feel they are contributing to the long term solution without necessarily claiming carbon neutrality – in itself a contested concept.

Tony Knowles, a land-use change carbon expert from Genesis-Analytics comments that “the voluntary market increases the potential and scope of land rehabilitation and avoided deforestation projects considerably.  The CDM framework has proved restrictive in terms of project type, vegetation types and accountable carbon pools”.  However, he also cautions against the danger of the voluntary market becoming too loose and losing its credibility.  For example, awarding credits at the seedling stage of a sequestering project is fraught with delivery risk and permanence issues which need to be resolved.  In addition, a formal, universal accounting framework for avoided deforestation initiatives is urgently needed to avoid the perverse issue of avoided deforestation credits.

The offset market could also be perceived as an interim measure to the development of a globally accepted carbon currency.    Whether this is the CDM or a post-Kyoto mechanism, efforts to build a rigorous set of methodologies defining carbon credits are, and should be, ongoing.  The benefit of using market mechanisms to achieve global emissions reductions is widely accepted. Programmatic and sectoral approaches which show potential for supporting high SD carbon projects should be fast tracked within this agenda.

A market’s function however is to realise least cost reductions first, which the early years of the CDM is demonstrating.  Hence the relevance of the interim offset market to drive the more expensive, ‘deeper cuts’ whilst we wait for the political will to set the types of targets which will drive compliance credit prices to the €30 plus mark which will make these deep cuts feasible.

The offset market is the only access many high SD carbon projects currently have to carbon finance.  Whilst increased standardisation and regulation of this market is necessary for its integrity and longevity, it is important that at the same time, measures are taken to support high SD carbon projects.