Tiempo Climate Cyberlibrary

The Clean Development Mechanism and Sustainable Development

Ben Pearson argues that the Clean Development Mechanism is failing in its mandate to promote sustainable development. The author is director of CDM Watch, based in Sydney, Australia. CDM Watch is a non-governmental organization that monitors and analyses the Clean Development Mechanism and individual Clean Development Mechanism projects and helps civil society groups engage with the Clean Development Mechanism process.

The current discussions on possible extension, or replacement, of the Clean Development Mechanism (CDM) must be based on an acknowledgement that the CDM in its current form is failing in its mandate to promote sustainable development, most notably by not financing projects that help in the long-term transition of developing country energy sectors towards renewable energy technologies.

The problem is fundamental and stems from the CDM structure as a project-based market mechanism in which the search for least-cost carbon credits is the paramount consideration. This sidelines projects like renewables by not rewarding the multiple benefits they provide. Ultimately, the CDM's first mandate to help reduce Kyoto compliance costs is all but making impossible the fulfilment of its second mandate to promote sustainable development.

The current status of the CDM

The question of whether the CDM is promoting sustainable development can be framed primarily in terms of whether it is promoting renewables in developing countries and thus assisting in the transition away from fossil fuels.

The evidence to date, however, is that most industrialized country governments and corporations are using the CDM merely to reduce the costs of complying with their Kyoto targets and as such are searching for projects that deliver large volumes of cheap credits.

These are most commonly projects that capture or destroy gases with high global warming potentials like methane, nitrous oxide and hydrofluorocarbons (such as HFC-23) at existing facilities. Yet these projects merely shift the location at which emissions reductions are made through the Kyoto Protocol without delivering additional sustainable development benefits to host countries and do not help catalyze fundamental shifts in energy production and use. (This is not to ignore, though, that landfill gas projects can result in improvements in local air quality from the reduction of noxious odours.)

Projects based on renewables are numerous; indeed they are the most common project type. (The renewables category only includes hydropower projects below 10MW.) Yet these projects are generating only about eleven per cent of all carbon credits through the CDM, which amounts to around 32 million in total. This is less than the credits resulting from the two HFC-23 projects amounting to 40 million and about one half the credits that will be generated by a nitrous oxide project in South Korea which is 70 million.

It is these credit volumes which provide the most meaningful comparison: the CDM involves industrialized countries buying carbon credits as a commodity so the percentage of credits indicates the proportion of total carbon investment flowing through the CDM to particular technologies.

It is also clear that many of the renewables projects are intended merely to 'green' portfolios that rely on less attractive technologies for the majority of their credits.

In June 2004, the World Bank’s Carbon Finance Business Unit published the report Estimating the Market Potential for the Clean Development Mechanism. The report noted of the CDM that "the current distribution of projects may not be representative of the mature CDM market." In future, the Bank suggests that participants may concentrate on proven project types that are cost-effective and have an approved methodology, citing as an example the concentration on landfill gas projects by Japanese corporations.

The steady increase in landfill gas projects suggests this is correct. At the time of writing, landfill gas projects alone were claiming more carbon credits than all renewables projects combined. Up to 2012, 15 landfill gas projects are claiming 28 million credits whilst 52 renewables projects are claiming 25 million credits.

A prophesy fulfilled?

The problems besetting renewables can hardly be seen as unexpected. The experience of renewables in liberalized energy markets has not been positive, and it can come as no real surprise that they have not flourished in a market mechanism like the CDM. Indeed, alongside the early hype that accompanied the CDM’s birth were more sober analyses of how renewables would fare under the new mechanism.

Only months after the 2001 Marrakech Accords that finalized the CDM’s rules, Ecofys, in the report Opportunities for Renewables under the Kyoto Mechanisms, concluded that "various studies indicate a limited role for renewable energy projects under the Kyoto Mechanisms." Moreover, they predicted that "Kyoto Mechanisms dominated by least-cost approaches only would seriously limit the scope for renewable energy projects," although noting a range of other influencing variables.

What are the problems?

Fundamentally, the reason that the CDM is not promoting renewables projects is that despite the rhetorical trimmings the CDM is a market, not a development fund nor a renewables promotion mechanism. Its aim is to provide tradeable emission reduction credits at the lowest cost in a limited timeframe, primarily up to 2012. Its aim is not to direct funding to projects that provide the greatest environmental and social benefit or that help direct a developing country down a sustainable development path in the long term.

An increasingly frequent complaint about the CDM, not just in the non-governmental organization community, is that the CDM is not 'working', in that it is not driving sustainable development and not funding renewables. But the real problem is conversely that it is working perfectly in doing what a market-based mechanism is designed to do: discover and direct funding to projects that will produce the maximum volume of carbon credits for every dollar invested. The problem for renewables is that they require more investment to produce a carbon credit than most other available options.

While the CDM is rhetorically mandated to assist in achieving sustainable development and this should benefit renewables, no part of the CDM’s architecture specifically monetizes those benefits and as such they play a very limited role, if at all, in directing investment.

For all the rhetoric about sustainable development, projects generate revenues through the CDM by reducing or storing a quantity of greenhouse gas emissions which are commodified as carbon credits and sold. The various co-benefits that these projects may create are not commodified and do not directly produce revenues through the CDM.

Arguably, the CDM project-based structure makes it almost impossible for the broader sectoral or national benefits provided by a renewables project to be rewarded because they are so difficult to quantify on a project level.

Judging how many tonnes of a specified greenhouse gas have been reduced or stored by an individual project in a delineated project boundary as compared to a theorized business as usual scenario is complex enough. Yet quantifying and commodifying the additional benefits that a renewables project provides outside that boundary would be extremely difficult and prohibitively expensive for each individual project. Some developers do, of course, assert broader benefits.

Fundamentals

The dominance of large non-carbon dioxide projects in the market- and project-based CDM is inevitable. They involve relatively inexpensive, quick and common-practice additions to existing facilities, which in return generate huge volumes of carbon credits because of the global warming potential of the gases they capture. In contrast, renewables projects have a financial profile that is the exact opposite of that favoured by the CDM. They are greenfield developments which are capital intensive, providing low rates of return and generating relatively small volumes of carbon credits.

Given the current low price for credits and the fact that renewables only displace carbon dioxide emissions, the revenues from the sale of carbon credits are usually small and do not significantly improve the project’s Internal Rate of Return.

Moreover, the prevalence of a commodity model for the purchase of the carbon credits – in which the credits are bought as they are delivered over the 10- or 21-year crediting period – does not directly address the major financial barrier for renewables projects, their high upfront costs.

Experience is also showing that most banks, which are already wary of developing country renewables projects, do not currently see carbon credits as enhancing a renewables project’s appeal and are reluctant to lend against a carbon credit purchase agreement. Indeed, as the recent report from the Organisation for Economic Cooperation and Development (OECD), Taking Stock of Progress under the Clean Development Mechanism (0.3Mb download), has observed, if a renewable project’s viability is dependent on carbon credits it may actually be adjudged even more risky.

Smaller credit volumes mean that renewables also suffer disproportionately from the transaction costs associated with approving a CDM project and monitoring its ongoing reduction of emissions. Transaction costs are generally similar regardless of project size. Thus, for projects with smaller credit volumes they are significant while for large projects they are often negligible. While a small-scale CDM project category exists to streamline the process for renewables and reduce these costs, they are still a disproportionately greater burden than for large projects.

Boutique credits

Some buyers will undoubtedly be prepared to reward projects with additional sustainable development benefits by paying a premium for their credits, mainly for public relations reasons. It is unlikely, however, that such 'boutique' CDM credits will be more than a fraction of overall investment and credit volumes.

The World Bank Community Development Carbon Fund (CDCF), for example, expects to generate about seven million credits in total with about 60-70 per cent available by 2012 (information provided by the World Bank Carbon Finance Helpdesk, 21st July 2004). This is about half the 10 million credits that the Prototype Carbon Fund coal bed methane project will produce in that timeframe (information provided 4th November 2004).

Early experience with allegedly high quality funds also shows that, even with a higher price and political incentive, renewables do not necessarily come out on top. The first two projects unveiled by the CDCF are another landfill gas project and another large hydropower project. Moreover, both have had their registration blocked by the CDM Executive Board over their eligibility as small-scale projects and additionality concerns.

Furthermore, the large hydro project does not even mention the principles and guidelines of the World Commission on Dams' final report, published in the year 2000, which is widely accepted as the benchmark for sustainable hydro development.

Ultimately, these funds will be marginal in terms of credit generation and their existence can be seen as a tacit admission that left to itself the market will not finance high quality projects.

Race to the bottom

The primary focus of the CDM on producing a tradeable commodity in a specific project boundary at the lowest cost frustrates environmentally-superior outcomes by directing investors and buyers away from projects with the most overall benefits. Buyers and investors favour projects that require the least investment, least technology transfer and that provide the least sustainable development co-benefits as these produce the cheapest credits.

CDM on the margins

Any discussion about the future of the CDM must also address the fact that it, and the carbon market itself, exist on the margins of huge financial flows to carbon-intensive energy projects in the South. Globally, North-South flows of investment and governmental support through export credit agencies and international financial institutions overwhelmingly favour fossil fuels, locking them into developing country energy systems to a degree that makes the new financial flows achieved by the CDM and emerging carbon market largely irrelevant.

More broadly, Point Carbon has estimated, in the report Removing Subsidies: Levelling the Playing Field for Renewable Energy Technologies (0.7Mb download), that the value of contracts in the global carbon market could reach US$10 billion a year by 2008. Yet annual subsidies to fossil fuels are estimated at up to US$235 billion, of which US$162 billion is in non-OECD countries.

If the amount of new money for climate-friendly technologies mobilized by the global carbon market continues to be less than five per cent of annual fossil fuel subsidies then it will exist merely to enrich traders and consultants.

What is to be done?

There are obviously variables which could improve the usefulness of the CDM for all projects, including renewables. But if the CDM continues to function as a market, in which least-cost considerations dominate, then it will continue to be technology neutral and if there are cheaper options than renewables projects then they will be given preference. The market will seek out the cheapest credits, not the best environmental outcome.

If the aim of a future CDM-type mechanism is to continue finding cheap carbon credits for countries with reduction targets then perhaps few changes are needed beyond simplifying the project approval process. But the pretence that it will do more than that must stop.

If Parties to the Climate Convention want a mechanism within the Kyoto framework that promotes sustainable development in the South then it must be a targeted technology transfer mechanism, not a technology neutral commodities market. Its point of departure must be the promotion of projects that contribute to sustainable development, such as renewables, with the rules and modalities being designed to deliver this outcome.

A range of action plans for the promotion of renewables in the South exist, originating from the G8 to Greenpeace. The new economics foundation has provided a useful summary in The Price of Power.

More important still is to address the context in which this future mechanism will function. If it operates within the current policy perversity in which the Kyoto Protocol and CDM exist alongside massive North-South financial flows to fossil fuels then it will fail. As the report The Climate of Export Credit Agencies, from the World Resources Institute, has noted: "Governments pursue one set of objectives through climate negotiations, while their finance and trade arms ignore the global environmental implication of their activities." A real solution to climate change and sustainable development must divert these flows, not create carbon markets alongside them.

Further information
Ben Pearson, CDM Watch, 42/177 Glenayr Ave, Bondi Beach, Sydney NSW 2026, Australia. Email: cdmwatch@ozemail.com.au. Web: www.cdmwatch.org.

On the Web
The Tiempo Climate Cyberlibrary provides a listing of theme sites on the Clean Development Mechanism. See also the special issue of Tiempo on this topic, available as a low (O.6Mb) or high (3Mb) resolution download.