Euromoney magazine, part of cover story, September 2007
China is well known for its opportunism, but it takes a special kind of entrepreneurial zest to make money out of your own pollution. In the curious world of carbon trading, China accounts for perhaps half of all credits traded with the west, as unseen utilities half a world away effectively pay to build windfarms and clean up freon plants the length and breadth of China.
China is at the heart of the clean development mechanism, or CDM. This is one of the key initiatives that came out of the Kyoto protocol, and is aimed at reducing greenhouse gas emissions while encouraging sustainable development in emerging markets. The idea is that any company or institution can invest in greenhouse gas-reducing projects in the developing world, for which they earn credits that can be used to offset their own emissions, or indeed sold in the open market. These credits are formally known as certified emissions reductions, and are often called carbon credits.
In essence: build something environmentally beneficial in China, offset your own pollution in Britain or America. And while it might sound odd, it does make sense. A greenhouse gas emission hurts the environment just the same no matter where it comes from, and reducing pollution in industrialising new economies is obviously to the greater good. If that creates a market in which some people, whether developers or brokers or banks, get rich, then so be it. And for Chinese businesses, it’s a bonanza: the rest of the world is paying them to clean up their act.
They have not passed up this opportunity. Today, estimates of the proportion of the CDM market that China accounts for vary between 40 to 60 per cent, partly a reflection of the amount of emissions the country produces in the first place (officially second in the world, and well on track for the top spot, probably by 2009), and consequently the many ways of achieving reductions. In particular, China produces and uses more coal than anywhere else in the world. “If you build a windmill in China you can generate a lot of carbon credits because what would have happened otherwise is they’d build a coal plant,” says Roger Raufer, director of engineering services at International Environmental Trading Group. “You could build a windmill in Costa Rica too, but the carbon credit is going to be much smaller.”
“At first, [Chinese] project owners were in complete disbelief,” recalls Leigh Fitzgerald, a senior specialist at Arreon Carbon, part of a growing private sector industry of project developers and brokers that has grown up in China to match buyers and sellers. “They said: ‘People are going to pay us money to do this, are you kidding?’ They were almost suspicious.” That initial bafflement was quickly replaced by a voracious appetite, then sophisticated opportunism.
It would be churlish, though, to call it a scam. Even if Kyoto were all to fall apart, and no carbon credits ever traded again under this mechanism, there is a great deal of renewable energy infrastructure in China that otherwise would not be there. More to the point, despite looking from a distance like a sure-fire recipe for an easy buck and a bit of manipulation, the system is in fact rigorously policed, by the United Nations Framework for Conventional Climate Change.
“The registration process is lengthy. It’s onerous. It’s not trivial by any stretch,” says Paul Ezekiel, head of global carbon trading at Credit Suisse in New York, and formerly the president and co-founder of a specialist merchant bank and advisory firm in the environmental industry, called Antipodean Partners. “Some people view it as potentially having a random construct behind it: I plant a tree and generate a credit. It’s nothing of the sort. It’s an environmentally rigorous market. And without that, there’s no way a financial institution like Credit Suisse would invest one dollar.”
Getting from signing a contract to seeing a credit takes 18 months to two years (which has already created a vibrant forward market). When a group like Arreon Carbon takes a look at a potential CDM project, it first asks its technical department to assess if it has a strong chance of UN approval. If it does, the technical department writes a brief called a product development document in English and Chinese. The Chinese one goes to the government, which then has to approve it for submission to the UN, and provides a letter of authorisation. Whichever foreign party is lined up to buy the credit has to do the same with its own government. There also has to be a third party validator – designated by the UN – which goes in and writes a report on the project assessing its viability. The whole lot goes back to the UN who, having approved it as being eligible for carbon credits, then goes back every year to check on it. (Arreon, active in this business for several years, is only now getting its first projects registered.)
Consequently, if there’s a criticism of the system it’s that it is overly strict, expensive and inefficient, not that it is laissez-faire or opaque. “From a liquidity provider’s perspective it is far more important for it to be very onerous than for it to be very lax,” says Ezekiel. “It’s good that it’s strict. I’d like to see it more streamlined, of course, but if it’s going to go one way or the other it’s better to be more strict than less.”
Raufer adds: “One thing Kyoto has done is take all the compliance and put it outside of the host countries. You can do a project anywhere in the world, Asia or Africa, and [the verification] will be issued by an agency in Bonn. It’s obviously more expensive to do transactions that way, but it does mean there is internationalised compliance.”
The projects themselves can cover all sorts of areas: the creation of renewable energy projects such as wind farms, solar or biomass, which qualify for carbon credits because they displace energy that would otherwise have been generated by coal; the implementation of technologies to reduce emissions in existing plants; even methods of improving energy efficiency in buildings or transportation.
There are, though, anomalies. One of the problems with the CDM is that there is a sense that some people play the market, creating an effect quite contrary to what Kyoto intended.
A clear example of this came in China with the pollutant HFC-23. This is a by-product of the manufacture of a refrigerant called HCFC-22, and is the most potent gas covered under Kyoto. Under the protocols established at that treaty, different emissions are considered to be equivalent to set amounts of carbon dioxide, and so lethal is HFC-23 that it is considered to be worth 11,700 times more than a tonne of CO2.
Getting rid of this stuff is clearly a good thing, and it’s pretty easy to do, too, with a straightforward revamping of facilities. But here’s the thing: the tradable value of HFC-23 so dramatically outweighs the cost of fixing the problem, that it makes economic sense to develop these plants just in order to fix their own pollution and pocket the revenue. Stanford University Professor Thomas Heller told a forum in Hong Kong in July that the market price of HFC-23 is nine euros per ton, and the cost of abatement, just 10 euro cents – with the difference between the two mainly being profit for the company doing the polluting in the first place.
Seeing this, China intervened to stop new plants being built by levying a 65 per cent tax. (Where this money goes is a moot point, but the United Nations Development Programme says it goes into a new CDM Fund launched by the Ministry of Finance. Kishan Khoday, assistant country director and team leader for the energy and environment team at the UNDP in Beijing, says his organisation has been approached by the ministry “to help analyse how to make use of this new fund. It’s an innovative model whereby China could use tax revenues from CDM credit sales to do broader sustainable development projects,” achieving not only emission reductions but broader development goals.)
Besides, markets aren’t supposed to be ethical, just efficient. “These markets are artificially designed,” says Raufer. “In this case the market did what markets are supposed to do: found the easiest, fastest way to generate credits.”
HFC may just be a teething problem necessary in an evolving market. “Most of the developers in CDM feel that HFC is done: there are no projects left and it was the low hanging fruit that got snatched up first,” says Fitzgerald. “The projects being developed now tend to cost more and there’s a lot more renewable energy projects. There are about 8 to 10 HFC projects and 250 renewable energy.”
Now, China is on track to move from this system of bilateral trades to a more formal exchange. The UNDP, which since 2002 has provided capacity building support to China in building its CDM markets, launched a new initiative in February to advise the Chinese government on how climate exchanges operate and whether one would be beneficial in China. Specifically, the Ministry of Science and Technology – a key member of China’s National CDM Board – will implement the project, and has spent the time since the launch identifying experts to undertake research, which will now get underway.
Officially there is no plan for the Chinese government to establish a climate exchange system. The research “is meant to explore how such exchanges work in the west, and explore the value such a mechanism could have in the future for expanding China’s role as a major supplier of carbon credits to the global market,” says Khoday. China has no commitment to reduce emissions under Kyoto, and “such a mechanism would not involve the type of domestic cap-and-trade systems present in Europe and other western countries,” says Khoday. It would instead focus on a more effective supply of credits from China to the west.
Broadly, the benefits of a formal exchange are likely to be that it brings market efficiencies, makes it easier to match buyers and sellers, and to keep a balance between different project types. It facilitates the availability of information too. The challenge is that the entire global market is only really a couple of years old, and as the European experience has shown (so much supply that credits have dropped to a value where it becomes economically sensible to pollute) there is plenty of learning and experimentation to be done.
If it launches one, it may well be beaten to it by Hong Kong. On July 18 Hong Kong Exchanges and Clearing appointed Australian law firm Mallesons Stephen Jaques, and consultants International Environmental Trading Group and Climate Focus, to study the trading of emissions-related products, expecting the study to take four months. “The US has developed sophisticated markets on pollutants; Europe has a large and aggressive market. It’s pretty clear Asia’s going to be next,” says Raufer at IETG. “The question is how do you evolve into that, and deal with development issues and pollution problems.”
Key to it will be the regulatory framework. “You need an institutional basis for structuring these markets,” says Raufer. “They are artificial markets created by government requirements. They’re not like widgets or cellphones where people want to buy them. You buy them because you have to. So you need that regulatory infrastructure, and it takes a while to establish.”
Even before an exchange has been launched in the region there’s a slight sense of overkill. “I have had conversations with six up and coming regional exchanges for carbon,” says Ezekiel. “It begs the question, what’s the role of a futures exchange in any up and coming commodities market? There’s a role for a local exchange but I’m not sure if every country needs a carbon exchange.”
Moving China forward on this or any other climate change decision is complicated by the fact that Kyoto, under which China (like all developing countries) has no obligations to reduce emissions, is coming to an end, and that nobody really knows what the successor agreement will look like from 2012. If the establishment of an emissions exchange were to be interpreted as a willingness to accept an emissions cap, that might not be in China’s immediate interests.
Anyone involved in carbon trading with China also has to think about issues of enforcement. As projects and credits get rolling, and as the Kyoto protocol enters into what is called its “compliance period” from 2008 when developed world countries with emission commitments will have to start reporting to the UN on how they have done, this is going to be very important. “The next big issue which the international community will be dealing with in the near future is that of compliance under the UN Kyoto protocol,” says Khoday.
China does not have the rule of law, and previous local pilot projects in China (see box) have been criticised for placing far more emphasis on written laws than is appropriate in a country that does not hold them as sacrosanct. Also relevant are the great power of local government, and the power of contract.
“In the US, the information flow and legal process is well understood between the parties trading,” says Christine Loh of Hong Kong-based NGO Civic Exchange. “In China, it is much less so, which is why there is a heavy administrative component to Chinese schemes.” Fitzgerald says Arreon puts all its contracts under English or Hong Kong law.
Would they be enforceable in China? “We’ll see. For the most part everyone seems to think it’s the best we can do.”
BOX: TAIYUAN, AN UNLIKELY PIONEER
The industrial town of Taiyuan doesn’t look much of a place for landmarks. True, the capital of Shanxi province is often compared in environmental literature to Los Angeles, but only because it is surrounded on three sides by mountains to create a similar trap for smog. But this coal mining city, largely unknown to the west despite having the same population as Rome, has a claim to fame: it is the birthplace of emissions trading in China.
In 1998 the World Bank gave Taiyuan the unhappy accolade of being one of the world’s most polluted cities. China was sufficiently concerned about this to put in to its 10th Five Year Plan, for 2000 to 2005, a call for sulphur dioxide emissions in the city to be halved over that timeframe. Shanxi’s provincial government applied to the Asian Development Bank for a loan and technical assistance, aiming at bringing in the use of market-based instruments for air quality management, and strengthening the ability of provincial agencies to implement them.
Sulphur dioxide trading is very different to carbon trading, for a simple reason: carbon emissions create a global issue, sulphur dioxide local. The whole premise for carbon trading is that a greenhouse gas wrecks the environment just as much if it is emitted in Beijing or Bradford. That’s why it is considered legitimate to offset your own emissions by supporting clean energy development on a completely different continent, the idea that underpins the Kyoto protocol’s clean development mechanism (see main story).
Sulphur dioxide, on the other hand, causes problems locally but not elsewhere in the world. Sure, there are environmental and political issues when wind blows Chinese fumes across to Korea and Japan, but in essence measures to curb these sorts of emissions rely upon fixing the problem in a local area. And since China is the world’s largest producer and user of coal, whose principle by-product is sulphur dioxide, this is a big challenge indeed.
There is a useful role model for sulphur dioxide reduction: the US Acid Rain Program, set up in 1990 to reduce SO2 and nitrogen oxides from power plants. It involved demanding cuts in emissions from industry, and giving allowances to plants for a certain amount of those emissions, with these allowances able to be bought, sold or banked. A power plant able to cut more emissions than required was able to profit by selling the additional allowances; a plant unable to cut the emissions was able to buy those allowances, thus staying on the right side of the law but incurring a clear financial penalty. It has been considered a great success.
The ADB elected to follow a similar model, known as “cap and trade”, in Taiyuan, whose municipal government passed a new regulation for emission trading in 2002. Twenty-six enterprises became involved in the scheme, with the first trade of credits going through between two industrial enterprises in December 2003. Although other trading projects in Nantong, in Jiangsu province, and Benxi, in Liaoning province, kicked off earlier, Taiyuan is considered the most ambitious and instructive of the pilots.
“It was successful to a degree,” says Anthony Maxwell, environment specialist at the Asian Development Bank in Manila, who became involved in the project late in the day and formally closed it in January 2005 after the conclusion of its mandate. “It was too small to be self-fulfilling for a long period, because it required very strong advocacy from the government to push the trading. But it was a useful tool for learning, and for the national scheme.” Following other pilot projects in China, government enterprises including the National Development and Reform Commission and the State Environmental Protection Agency are believed to be looking at a national scheme.
The Taiyuan project did, however, come under strident criticism from Ruth Greenspan Bell, a noted scholar on the environment, who took it to task in an address to the OECD Global Forum on Sustainable Development. She credited it with enacting a regulation providing the legal basis for emission trading, and enabling an allowance and emission tracking system, but called the emission reduction targets unrealistic and said that the lack of any serious efforts to pursue compliance and enact enforcement reduced any motivation for industry to set up the scheme. In large part, Bell’s complaint was about the relative meaninglessness of written law in China, which is hardly within the remit of an ADB technical assistance program on acid rain, but is an important point when considering any emissions market development on the mainland.
A new emissions trading scheme underway in Hong Kong also takes the local approach. That’s natural: Hong Kong’s air quality has deteriorated appallingly over recent years, and much of the blame is aimed at factories in neighbouring Guangzhou.
The new Emissions Trading Pilot Scheme provides a platform for thermal power plants in the Pearl River Delta to trade emissions for sulphur dioxide, nitrogen oxides and respirable suspended particulates pollutants. It is a voluntary programme “based on the power companies’ own commercial considerations,” says a spokesperson for Hong Kong’s Environmental Protection Department.
It will work like this. Power plants can propose emission reduction plans – use of cleaner fuels, perhaps, or better energy efficiency – to the local government environmental protection authorities. If those authorities approve the emission reduction projects, and the reductions are verified by both governments, then the reductions can be transferred between a buyer and a seller under a trading contract. The spokesperson says the programme is intended to “promote the use of market based tools in the region, to enable both Hong Kong and Guangdong governments to gain experience in the implementation and management of emissions trading schemes, and to lay the foundation for the further development of emissions trading systems in the future.”
Anything that reduces pollution in the area is welcome, but the project clearly faces many challenges, among them persuading industry to take part in a voluntary scheme. A seminar was held in Guangzhou in May to promote the scheme to local power companies. “The general responses are positive towards the introduction of the pilot scheme,” says the spokesperson, though as yet none has formally joined it. “I think they [companies] are cautious, and you would expect that,” says Raufer. “It’s a normal corporate response, especially from electric utilities.” Christine Loh at Civic Exchange adds: “I am frankly not sure how this will be develop. There have been meetings between Hong Kong and Guangdong where the various utilities had apparently participated but I am not sensing a lot of speed on progress.”
In the meantime, the Hong Kong and Guangdong authorities are trying to raise awareness of the scheme, promote it as an attractive option for industry, and Hong Kong is putting through legislative amendments to facilitate it. On the Hong Kong side of the border at the very least, there is consensus that something has to be done: more and more people are leaving the city with their families for the cleaner air of cities like Singapore, taking their business with them. And from Hong Kong’s perspective, few things hurt more than that.