Give offsetting some credit

Public awareness of climate change has dramatically increased. Last year’s Stern Review and the IPCC’s latest updates on the science have all contributed to a consumer and shareholder awakening – and 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 while 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 cannot 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.

Apart from this fostering role of 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. I call these projects, 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 less than 8,000 tonnes of carbon dioxide equivalent (tCO2e) a year. A solar water pumping project in Mozambique generates as little as 36tCO2e a year. 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 more than £40,000, this percentage contribution is further reduced, with projects generating emission reductions below 8,000 unlikely to break even in their carbon endeavours.

Complexities

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 projects presenting low delivery risk and ensuring high-volume transactions. 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.

While 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 present a sizable barrier to smaller projects. 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. But 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 to 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. Combined with factors such as the project’s numerous small stakeholders, low financial returns, high-risk country and technology profiles, the 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.

So, why is the offset market able to support these high-SD carbon projects? Well, 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 its intention to go climate neutral in 2004, with Marks and Spencer following suit last year. Governments are also demonstrating leadership through their offsetting of events.

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.

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. Such profiling can be very valuable for putting pressure on developing countries’ governments, donors or financiers to find the grants and financing required to implement the project.

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 closure.

Apart from 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 priorities among developing countries’ 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 spending 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 the Renewable Energy & Energy Efficiency Partnership (REEEP) are providing grant funding for the development of Gold Standard Voluntary Emission Reductions from developing countries.

The need for standards, registries and regulation in the offset market is undisputed. But 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.

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. The offset market is the only access many high-SD carbon projects currently have to carbon finance. While 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.

Emily Tyler is from SouthSouthNorth

www.southsouthnorth.org