The Hindu Business Line : The currency for carbon trading

Developed countries have agreed that if their industries cannot reduce carbon emissions themselves in their own countries, they will pay others like India (a signatory to the Kyoto Protocol) to do it for them. The `currency' for trade in carbon-reduction obligations is a Carbon Emission Reduction (CER). A smaller, but quickly maturing, market is Verified Emission Reduction (VER) aimed at smaller projects with a strong sustainability story backing it. Even small carbon savings projects become viable and attractive through VERs.

It is fascinating to see how the market mechanism has in a strange way evolved a solution to partially mitigate the negative environmental effects of market capitalism by creating a market in emissions.

The countries of the world (with the exceptions of the US and Australia), in their enlightened self-interest, signed the Kyoto Protocol, realising the danger of global warming from increased emissions of carbon-dioxide, methane (21 times worse as a greenhouse gas (GHGs), compared to carbon-dioxide) and similar GHGs.

Clean Development Mechanism

One of the mechanisms developed under the protocol is the Clean Development Mechanism (CDM), to create and sustain a "carbon market" in emissions. This covers developed and developing countries.

Simply put, the developed countries have agreed that if their industries cannot reduce carbon emissions themselves in their own countries, they will pay others like India (a signatory to the Kyoto Protocol) do it for them and help them meet their promised reduction quotas in the interest of worldwide reductions of greenhouse gases. The projects, for example, could be: Using renewable energy, thereby not burning fossil fuel, savings in heat/thermal energy consumption or through afforestation — reforestation sequestration projects.

The `currency' for this trade in carbon-reduction obligations is called a Carbon Emission Reduction (CER). One unit is one tonne equivalent of carbon dioxide emission. A smaller, but quickly maturing, market is Verified Emission Reduction (VER) aimed at smaller projects with a strong sustainability story backing it. Projects, which reduce GHG emissions and meet the criteria for CDM projects, have to go through a cycle of preparation.

The Project Design Document (PDD) gives the details, the stakeholders, the duration, site details or the project boundary for GHG reduction and estimates the baseline against which the reduction in GHG emission can be calculated — based on the fossil fuel, thermal, electrical, mechanical energy replaced by any renewable (such as solar, wind, biomass, biofuel, biogas from animal or municipal waste) or less polluting fossil fuel.

The PDD also documents the monitoring mechanisms. It then has to get the approval of the Designated National Authority (DNA), which in India is the Ministry of Environment and Forests.

Simultaneously, it is validated by internationally-recognised process audit firms such as BVQI, SGS, DNV, which act as intermediaries between the Geneva-based United Nations Framework Convention on Climate Change and the project owner. The validation is an independent check on the claims made by the project owner.

The United Nations Framework Convention on Climate Change (UNFCCC) then registers the project, taking into account all comments about the projects from the designated operations executive and the public at large. Once successfully registered, it can offer the CER to be produced by the project to a prospective buyer. Depending on the market condition, it can either sell all or part or even bank the CERs.

CER transaction

The actual CER transaction transfers it from a project registry to the national registry of the country purchasing the CER. A CER can only be traded once it is `certified', which typically happens after a stage of `verification', a secondary check on the project claims. CER transactions are fairly complex as the agreements need to be negotiated, volumes decided upon, and so on.

Depending on various factors, the quantity of CERs earned varies. For example, one million units of electricity saved can entitle the project owner in a particular State to varying numbers of CERs, depending on the proportion of thermal (not hydel) power generation avoided in that State. Thus, Karnataka, with about 50 per cent hydel, may earn only 760 CERs per million units of power saved, vs about 820 CERs in Andhra Pradesh and 960 in the East of India.

In March 2006, bulk CERs of 50,000 and above are trading at $12-14 per CER, worth Rs 2.7 crore per year. As non-compliance after 2008 in the OECD countries will attract steep national penalties, the price will continue to rise. Large-scale buyers (such as the World Bank), which offer a purchase price (for projects of minimum 30,000 CERs) of only $5-7 per CER, try and deflate the prices by claiming high project risks.

This, unfortunately, is a strategy employed to keep the prices artificially low, as the funds can then sell at real market prices when spot markets for CERs develop in a few years time. Luckily, since CER supply is practically non-existent, it is a sellers market. Hence they can command higher, more realistic prices, without falling into the buyers' trap. Moreover, heavy competition among the buyers has also ensured more realistic market prices being offered to project developers.

Developing projects in the CDM way are expensive, for both the project developer (in the developing nation) as well as the buyer (from the developed nation). A typical project in the Indian context would cost around Rs 10 lakh from inception to registration. A typical buyer would spend around $100,000, a majority of which would be on administrative costs such as travel and legal cost associated with drafting contracts.

Thus, though as many as 200 CDM projects, out of 600 in the pipeline worldwide, are with parties in India — the leading CDM project developer worldwide — most of them are likely to end up on contract with intermediary buyers (such as funds and banks) and not the end-user in the developed nation.

Small carbon projects

This results in artificially reduced prices as it is in the interest of the fund to buy at the lowest possible price. An end-user (like a polluting industry in, say, the UK) would typically pay a price more related to compliance than on market movements. In contrast, even small carbon savings projects become viable and attractive through VERs. For minimal or near-zero transaction costs but a much lower traded price of $ 6-7 per VER, even small projects can directly match VER buyers and sellers through a mutual auditor who certifies annual savings achieved.

Normally, even small carbon savings can be viably traded. For example, a small firm in the UK purchased credits directly from a rural solar electrification project in India, through an intermediary. The UK firm benefited from reduced transaction prices and prices lower than what it would have to pay for CERs from the market.

The Indian project benefited from a direct purchase from a buyer giving it a realistic price and almost no transaction cost.

(The author is a Member of the Supreme Court Committee on Solid Waste Management.)