UN Clean Development Mechanism isn't perfect, but it works

Implications: Recent reports provide fuel for the claim that billions of dollars spent subsidising projects to reduce greenhouse gas emissions in developing countries are being 'wasted', because projects would have gone ahead anyway. The underlying facts are essentially correct, but readers should beware drawing hasty conclusions. There are good reasons why some existing projects and projects which are implemented under national emission reduction policies should still get carbon credits.

Analysis: The article cites two recent reports which are critical of the UN Clean Development Mechanism (CDM) - an instrument of the Kyoto Protocol that gives carbon credits to projects that reduce emissions in developing countries. These credits can then be used by countries which have signed up to emission limits, effectively allowing them to emit an extra tonne of carbon dioxide for every tonne saved in a developing country.

One report, by Stanford academics David Victor and Michael Wara,  concludes that between one third and two thirds of all the CDM projects currently under development would have happened anyway, without the incentive provided by carbon credits. The point is made that virtually every new hydro, wind and natural gas plant expected to be built in China over the next four years is applying for CDM credits, even though it is Chinese policy to encourage these industries.

The second report, by US watchdog International Rivers, points out that three quarters of the CDM projects registered to date were already complete at the time of approval, suggesting that the additional revenue from carbon credits was not really necessary to finance the project.

The implication of the press article is that billions have been 'wasted', since money is going to projects which would have gone ahead anyway. There are two issues with this.

First, we have to remember that developing countries are under absolutely no obligation, at present, to reduce their emissions. Most of the rise in greenhouse gas concentrations in the atmosphere since the Industrial Revolution has been due to the activities of developed countries. Per capita emissions in developing countries are much lower than in developed countries (e.g. about 2 tonnes per person in India versus about 25 tonnes per person in the US), and most people would agree that poor countries have a right to economic development and a higher standard of living. Until we succeed in totally 'de-carbonising' economic development, that implies an increase in developing country emissions.

For a country such as China, which has vast reserves of coal, the cheapest route to economic development would be to exploit coal-fired power exclusively. So while it may be Chinese policy to develop alternative energy resources, that doesn't stop this from being - in the international context - a voluntary action that goes beyond their international commitments. On this basis, one can certainly argue that it's fair enough for them to get carbon credits for this.

In fact, if the CDM excluded any project which came under a voluntary national policy to reduce emissions, it would actively discourage developing countries from developing any such policies. This perverse incentive has long been recognised. It led to the development of the 'E -plus, E-minus' rule, which states that national and/or sectoral policies that give comparative advantage to lower emissions technologies, if implemented since the adoption of the CDM rules in 2001, should be treated as if they didn't exist, for the purposes of crediting emission reductions. In other words, the scenario against which a project's emission reductions should be measured is the hypothetical situation without the low-emissions policy, rather than the situation with the low-emissions policy in place.

Second, while it is true that most of the currently registered CDM projects were already built at the time of approval, there is a good reason for this. When the Kyoto Protocol was signed in 1997, it was known that it would still take some time to come into force (which it eventually did in 2005). While the commitments for developed countries were expressed in far-off terms (2008-2012), it was recognised that every year's delay in 'de-carbonising' the economies of developing countries would lock in higher-emissions technologies for many years to come. Therefore a 'prompt start' to the CDM was agreed. In practice, this meant that developing countries could start implementing projects from as early as 1 January 2000, and get credit for them later, once the necessary rules and institutions were in place.

Therefore it is not surprising that the first projects to be registered were typically 'prompt start' projects which already existed. Clearly any existing project has managed to get financing anyway, but that doesn't necessarily mean that the expectation of carbon credits hasn't played a key role in the decision to go ahead. As the CDM matures, more new projects are developed and the proportion of existing projects will fall.

The CDM certainly isn't perfect, and there will always be attempts to exploit the system. But we mustn't lose sight of its achievements. In 2006 alone, it is estimated that the CDM leveraged US$25 billion in emissions-reducing investment in developing countries - twice as much investment as achieved by the Global Environment Facility over 10 years. US$5.7 billion of this was in renewable energy and energy efficiency - more than triple the total aid and direct foreign investment in these fields, to the same countries in the same year (UNFCCC statistics). Compared with aid, compared with global funds raised by donor countries, the CDM works.

Readers from the investment community should perhaps be more concerned with the steep and sustained rise in reviews and rejections of applications to register CDM projects. This shows that the system of checks and balances is working better to exclude poorly substantiated projects, and investor due diligence will certainly need to take this increased risk into account.