In the first two months of 2013, there were only 58 requests (according to the United Nations Framework Convention on Climate Change, UNFCCC) to register  Clean Development Mechanism (CDM) projects in the world, compared to 280 requests in January and February 2012. CDM is one of the three flexible mechanisms defined in the Kyoto Protocol that provides for emissions reduction projects with Certified Emission Reduction (CER) units, essentially credits that can be traded in emissions trading schemes. Developed countries can fulfill their commitments to reduce emissions by buying CERs from developing countries, which, in turn, achieve sustainable development by building emissions reduction projects.

The CDM provides a solution for financing low carbon projects in developing countries, as CDM projects can derive revenue from two sources: operational revenue, such as selling electricity or decomposition product, and selling the CERs from the project to Annex I (industrialized) countries under the Kyoto Protocol. For example, a wind power plant can sell its generated electricity to domestic grid companies while gaining extra income from selling CERs after achieving a certain amount of CO2 emission reductions.

However, as shown by the lack of new CDM projects, the mechanism is failing. Due to oversupply of CERs, the price for each unit is falling rapidly. Two years ago, the CER price was above €12/ton of carbon dioxide equivalent (tCO2e) (US$15.46/tCO2e). At present, it is less than €0.5/tCO2e (US$0.64/tCO2e) (See Figure 1).

China is especially hard hit as it dominates the CDM market with the largest investment of CDM projects in the world ($220 billion, or 61.8 percent of total registered CDM projects globally). These Chinese CDM projects have supplied 738 million CERs, or 61.2 percent of all 1,200 million CERs issued from 2005 to present.

For many projects that provide emissions reductions in China, the CDM mechanism is a critical financing component, on top of an important driver of emissions reductions. Take, for example, the Shaanxi Fanshigou Wind Power Plant, which would only gain a 6.82 percent investment return by selling electricity to grid companies; a return that would be too low to attract investors given the average investment return in the wind power industry in China is 8 percent. However, with a CER price of €12/tCO2e (US$13.50/tCO2e), the income from selling CERs can increase the return to 9.53 percent (40 percent higher), making the project much more appealing to investors.

The income from selling CERs is even more important to trifluoromethane (HFC-23) decomposition projects. HFC-23 is a by-product of chlorodifluoromethane (HCFC-22), which is widely used as refrigerant. Due to its high global warming potential (11,700 times that of CO2), HFC-23 CDM projects contributed nearly 10 percent of  total CO2 emission reductions achieved by all China-based CDM projects while accounting for less than 0.5 percent of all CDM projects in the country.

These projects barely make a profit by selling decomposition product to other companies. The return on these projects mostly comes from selling CERs and is so sensitive to CER price that CDM developers around the world would not estimate investment returns in their project description documents when registering their projects under the UNFCCC. However, given the massive global warming potential of the compound, the emissions reductions achieved by these projects are crucial.

Under the current low CER price, Chinese CDM projects are having a hard time maintaining their businesses. According to Thomson Reuters Point Carbon, CER credit buyers are demanding price renegotiation or even terminating their contracts with Chinese CDM projects because the agreed upon price was much higher when they enrolled. More than ¥40 billion (US$6.44 billion) worth of CDM projects in China face default and carbon assets deflation. Credit Suisse, an investment bank, has downgraded China Longyuan Power Group, one of the biggest clean energy companies in the country, to “Neutral” due to low CER prices and the oversupply of CER in the European Union (EU) CDM market.

Excess supply is a major reason behind the low carbon price today. As more and more projects were registered with the UNFCCC, the number of CERs issued increased dramatically. Under basic economic theory, there are two options for dealing with oversupply and boosting the carbon price to restore a healthy market: reducing supply and (or) increasing demand.

The EU Commission decided to target supply as a short-term solution, by postponing the auctioning of 900 million allowances from the years 2013-2015 until 2019-2020. However, increasing demand will be the solution for the long-run, as the EU Commission plans to increase its greenhouse gas emissions reduction target and retire some allowances permanently.  CERs are also expected to be accepted in more carbon markets in the future; a full two-way link between the Australian emissions trading scheme and the EU Emissions Trading System is set to start no later than July 2018.

China itself is another emerging carbon market. Although the Chinese carbon market will not link to other markets in the near future, it will issue Chinese Certified Emission Reduction (CCER). Projects in China scheduled for CER could be transferred into CCER, thus reducing supply of CERs and helping to boost CER prices in the world market. In 2011, China’s National Development and Reform Commission (NDRC) initiated pilot programs for carbon emissions trading in two provinces and five municipal cities, with five of the programs having already published their implementation plans. GreenStream, a Nordic carbon asset management company, has executed emission reduction purchase agreements for approximately 1.2 million CCERs and plans to increase the portfolio ten-fold during 2013.

NDRC and the Chinese State Council have issued a number of important policies to strengthen planning and guidance on addressing climate change and promoting low-carbon development. Under the support of national policy, China’s carbon emission trading markets may have a bright future; China’s domestic carbon markets has the potential to absorb 600 million CER credits annually in the future, which should be enough to help initiate domestic emission trading.. There are many uncertainties on the UNFCCC end which would hopefully be cleared in the coming years of climate negotiation.

Lihuan Zhou is an intern with the China Program at Worldwatch Institute. 

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Carbon Markets, China, Climate Change, emissions reductions, emissions trading, green economy, low-carbon, sustainable development