Voluntary Offsets and the Backloading Brouhaha

My previous posts about "backloading" and the EU ETS have focused on the implications for the compliance markets in Europe and elsewhere. In compliance markets, government regulators set the rules governing the supply of emission reduction allowances and offset credits.  They also govern demand by setting the emissions targets that firms must meet by making internal reductions or purchasing permits and offsets.

Now I'd like to focus on what the backloading debate means for the voluntary carbon markets.  The short answer is that backloading will have little direct impact, but the reasons are worth a longer discussion.

The voluntary market is much smaller than its government-created sibling, but it is difficult to overestimate its importance. The voluntary market is self-regulating.  Its carbon offset credits are issued by independent standards bodies, and an increasing number of its largest market makers  follow a Code of Practice governing how they do business.

This self regulation makes the voluntary markets exceptionally flexible and a source of innovation that helps improve the slower and more bureacratic compliance markets.  All four of the protocols initially approved in California's cap-and-trade system were developed initially under the Climate Action Reserve, a voluntary carbon standard. A number of the carbon credit innovations that were pioneered by bodies such as the Gold Standard and the Verified Carbon Standard have allowed the United Nations carbon credit system to expand beyond large, industrial project types like refrigerant destruction, large hydropower and waste heat recovery. The project types favored by the voluntary carbon market, like clean cookstoves, village lighting, forest conservation and water purification can deliver greater sustainable development and have helped bring the benefits of carbon finance to poorer nations.

Voluntary market innovation is not limited to the projects. It's notable that California's fledgeling carbon market California has decided to use for its cap-and-trade transactions two private sector registries that were created for  the voluntary carbon market to - due in large part to their responsiveness, quality and cost-effectiveness.  And when the British government launched a short-lived effort to develop its own voluntary offset quality scheme, the market launched a more thorough and far-reaching system, twelve months faster, and for only one-tenth of the cost.

But perhaps the most important point that helps understand what makes the voluntary market special is that its carbon offset buyers choose to buy carbon credits! Voluntary market buyers take action of their own accord beyond or in advance of legislation to tackle their climate change impact. 

This difference more than anything helps explain why the backloading brouhaha has little direct impact on the voluntary market. In the compliance market, emitters tend to reduce their emissions just enough to avoid paying penalties. If they cannot meet their reduction targets, they tend to buy just enough offset credits (called CERs) and allowances (EUAs) to avoid those penalties. And when those firms find they have exceeded their reduction targets? They sell their surplus allowances, even if their footprint is still far above zero.  The economic recession made it very easy for many companies in the EU ETS to meet their reduction targets, nearly eliminating demand for allowances and offsets.  Supply and demand - too many permits and insufficient demand drives CER and EUA prices in the compliance markets towards zero.

Compare that to buyer behaviour in the voluntary carbon market.  The demand drivers for carbon credits could not be more different. Here companies pledge to reduce their net emissions - often
to zero - through a combination of internal reductions and voluntary offset credits. When voluntary customers fail to meet their reduction targets, they must buy more carbon credits to make up the difference.  When they exceed those targets, they buy fewer credits - but they keep buying.  Their reduction goals are sufficiently ambitious that it would be nearly impossible to reduce demand for offset credits to zero - at least for the foreseeable future.

Buyer behaviour in the voluntary market differs from the compliance market in another way.  Absent the carrot and stick of government regulation, buyers use their carbon management programmes as a way to demonstrate good citizenship.  As a result, many companies seek carbon offset credits from projects that do much more than reduce greenhouse gas emissions.  Emission reduction projects that improve local livelihoods help corporate offset customers achieve their broader CSR goals.  After all, which would you rather have on the cover of your CSR report, a photo of an industrial gas destruction project, or a photo of a family enjoying the benefits of solar powered lighting and safe drinking water? It is the value of these co-benefits that helps maintain prices in the voluntary carbon market, even during an economic recession.

With such different motivations for buyer behaviour compared to the compliance market, it is little wonder that the impact of policy measures like backloading would have little direct impact on the voluntary market.

However, compliance market policy failures can have an indirect impact on prices in the voluntary market. Actors in the compliance market have begun to take notice of the relative buoyancy of voluntary prices.  In September 2012 the UN Framework Convention on Climate Change included the following statement in its meeting notes:

"Project participants and others engaged in the [Clean Development Mechanism] will soon be able to voluntarily cancel their CERs into an account in the CDM registry at the UNFCCC secretariat in Bonn, Germany. This could encourage expanded use of CERs for voluntary emission reduction, such as by companies using credits as part of a social responsibility programme, by event organizers wanting to offset their emissions, or even by individuals wishing to reduce their carbon footprint."

Just a few months later Christiana Figueres, the head of the UNFCCC, made the following Tweet:

It appears that a number of people are hoping that the relatively buoyant voluntary market can support CDM  by serving as a source of demand for compliance credits.  This is a great idea in theory.  However, the primary CDM market was created to feed national and regional compliance schemes.  The promise of CDM has mobilised a tremendous amount of climate finance to feed the compliance market.  In 2011, the latest year for which figures are available, CDM was five times larger than the voluntary carbon market.  Since that time, we have seen record issuances of carbon credits on the CDM.

It would be wonderful if demand in the voluntary market expanded rapidly enough to absorb the surplus from the CDM (or at least from the CDM's more community-oriented and renewable energy projects).  The short-term impact of such an influx, however, would be to overwhelm completely the absorptive capacity of the voluntary market, driving prices towards zero and removing incentives to develop new and innovative voluntary projects.  It would be akin to fitting all the passengers from the Titanic into one lifeboat.  Rather than rescuing the compliance market, we would damage the voluntary carbon market, perhaps irreparably.

It's clear, then, that for all its inherent strengths, the voluntary carbon market remains vulnerable to poorly executed attempts to rescue elements of the compliance market. The most robust and sustainable fix for the compliance market's woes remains in the realm of politics. More specifically, national and regional leaders must show the courage to set ambitious reduction targets that accelerate the pace of action to fight climate change.  The depressed prices on the EU ETS show that companies have been able to meet their current emissions reductions obligations more easily than we ever thought possible.  Deepening emission reduction targets will accelerate the transition to a lower-carbon economy and strengthen the carbon markets by driving demand for compliance carbon credits and provide a sustained boost to prices.

Meanwhile, the voluntary carbon markets will continue doing what they do best: driving innovation and providing a vehicle for companies who want to take action beyond compliance to demonstrate their environmental leadership.

(Jamal Gore is Managing Director of carbon management firm Carbon Clear.)

More on Fixing the EU ETS

The other day, I pointed out that the collapse in the carbon price on the EU ETS compliance market was down to politics, not an inherent failing of cap-and-trade.  I concluded by pointing out that we need courageous political leaders willing to take faster action against climate change.

It seems I'm not alone in reaching this conclusion.  Here's the article lead from yesterday's Point Carbon news website:

Of course, the voluntary carbon markets are relatively less likely to be held hostage by politics.  Companies around the world increasingly are going beyond any compliance obligations to set ambitious emission reduction targets and buy quality carbon offset credits that reduce GHG emissions outside their organisational footprint boundaries.  Carbon Clear is committed to helping companies control their carbon impact - we look forward to working with you.

The EU ETS, Backloading and the End of the Carbon Markets

According to the news reports, the carbon markets are in trouble.  Prices on the world's largest market, the EU Emissions Trading Scheme (ETS) are at an all-time low.  Generic compliance-grade offsets from the United Nations Clean Development Mechanism trade for pennies.  And the European Parliament just voted on April 16th to reject a move called "backloading" that would have helped to prop up carbon prices.  Investment banks are closing their carbon trading desks, and clean energy project developers are looking at other revenue streams beyond carbon to support their activities.

What went wrong? And does this spell the end of the carbon markets?

The first thing to note about the carbon markets is that they are an artificial construct.  Climate change is a problem mainly because governments, companies, and households normally are unaware of the cost their own environmental pollution.  Carbon dioxide is colourless, and odourless, and the warming effects of greenhouse gas emissions can take fifty years or more to become evident.  Absent many direct feedback mechanisms, few organisations would put a price on their emissions without government intervention.

Building on the experience of air pollution emissions trading in the US, governments around the world have begun setting up greenhouse gas emissions cap-and-trade schemes.  Regulators create carbon markets by setting an overall cap on emissions (thus stimulating demand) and by setting rules on how emissions allowances and carbon offset credits can be used (thus creating a regulated source of supply). This basic approach has been the same whether the carbon markets are set up in California, Australia, China, New Zealand or the European Union. Remember, emissions anywhere contribute to climate change everywhere, and a reduction anywhere has the same general climate change benefit.

In the EU, regulators established an overall emissions cap and then set companies free to meet that cap in the most cost-effective manner, so long as they followed the rules.  The goal was to fulfil the European Union's greenhouse gas reduction targets under the Kyoto Protocol at the lowest overall impact to the economy.  The EU ETS is a price discovery mechanism that allows firms covered under the cap to determine who can reduce emissions most easily.  Those firms that can cost-effectively meet and exceed their reduction targets can sell any savings below their cap on the market.  Firms that for whatever reason are unable to meet their targets must buy excess permits from their more carbon-efficient counterparts, purchase certain allowable types of international offsets (which represent certified reductions in developing economies' GHG emissions), or else pay a hefty fine.

And it worked! While early predictions were that the marginal cost of emission reductions under the ETS would be at least €25 during the current compliance period, prices are instead hovering just above €3. Put another way, companies in the European Union have been able to  meet their GHG emission targets during this period at minimal overall cost to the economy. Cutting carbon has been cheaper and easier than we ever thought possible.  That's the good news story.

The bad news is that this low price has done little to spur low-carbon investment.  €3/tonne is equivalent to barely half a Euro cent or 0.4 pence per kWh on household and business electricity tariffs.  When buying pollution permits becomes the cheapest option for meeting regulatory targets, few firms will spend the money to improve energy efficiency or switch from coal to natural gas and renewables. Such a state of affairs is particularly troubling for investments in energy infrastructure.  A company that builds a coal fired power plant instead of a series of wind farms is locking in 30-50 years of carbon-intensive energy production.  What we need, then, is a carbon price that is high enough to provide incentives for green investment, but not so high that it creates economic hardship.

So how did this happen? What went wrong?

Put simply, regulators did not anticipate the recession of the past five years. The emission targets set in 2007 assumed that economic growth - and GHG emissions - would continue to rise each year in the absence of the Emissions Trading Scheme.  In the real world, the housing market collapsed, companies shed employees and closed offices, and output from the emissions-intensive steel and cement industries collapsed.

The result was like asking an Olympic sprinter to run 100 meters in 20 seconds - it was far too easy.  Those challenging emission reduction targets suddenly became achievable with little or no effort, which meant that few companies needed to buy excess permits and many had surplus allowances for sale.  Supply and demand - when sellers outnumber buyers, expect the price to fall.

What's the solution? If achieving a higher carbon price is the goal, regulators can either boost demand for emission reduction credits or restrict supply.  Increasing demand is best accomplished by setting even stricter carbon targets.  If a firm can easily achieve a 1.4% annual reduction, regulators could set a 2% or even 3% reduction instead.  This approach has the added benefit of accelerating emissions reductions in the near term - when we most need them - while providing greater incentives for long term investment.

For various reasons EU regulators decided that boosting demand was a political impossibility in the near term and that a better short term fix was to focus on supply.  The preferred tool, "backloading", restricted the number of allowances members states could sell into the current depressed market.  This would create a modest shortfall, forcing firms to use up some of their excess allowances.  Member states would sell those "backloaded" allowances several years from now when, presumably, the economy had improved and increased corporate GHG emissions would better soak up some of the supply without depressing prices.

Notice that the backloading proposal did not propose to change the EU's overall emissions reduction ambition.  It merely shifted in time the overally supply balance of emission allowances.  Even this move, however, creates winners and losers and EU parliamentarians argued bitterly on behalf of their respective constituencies' short-term interests. Some even argued that the EU Parliament should not meddle in the market - ignoring the fact that the EU ETS is itself a creation of the EU Parliament.

In the end, the backloading proposal was rejected. With no prospects for increasing near term demand for carbon credits or decreasing supply, prices on the EU ETS have continued to slide. [Update 24April - prices have recovered slightly on news that the backloading proposal may be reintroduced this summer.]

The important point here is that the current problems with the EU ETS are not due to the carbon markets.  They are working exactly as they were designed, finding the lowest-cost emissions that can meet government targets.  The problems facing the EU ETS are political.  The market has shown that it can meet current targets much more cheaply than envisioned.  Just imagine what could be achieved with a cap that drove the carbon price to €25-€30, a price that was politically palatable just a few years ago.  But the European Parliament has not set a more ambitious target.

Imagine how many investment decisions might be swayed with the slightly higher carbon price that would come from backloading.  But the backloading vote failed.  The decisions about more ambitious emission reduction targets, backloading and other approaches are being made not by carbon traders but by country governments and EU parliamentarians.

The lessons for other governments that are contemplating or implementing market based emission reduction schemes are clear:

1. Do not abandon carbon trading - it  gives companies the flexibility to meet emission reduction targets at least cost, and often cheaper than you can imagine.
2. Don't be afraid to set ambitious targets.
3. Remember that the carbon market is a regulatory construct.  Companies crave certainty and do not want rules to change too often, but success fighting climate change requires regulators to leave enough flexibility to respond to unforeseen events.

As I've noted previously, fixing the compliance carbon market in the EU will require inspired political leadership. Citizens are calling for urgent action on climate change.  The carbon market has the tools to deliver this action.  What is needed now is the political will.