How additionality could drive the carbon market

Interpretation of the CDM’s additionality criteria by the CDM Executive Board could have profound implications for the global supply of carbon credits. Derik Broekhoff and Mark Trexler summarise the findings of unique research into the relationship between additionality rules and credit supply

Many observers have predicted that, if the Kyoto Protocol is ratified, the global market for greenhouse gas (GHG) reductions will become the largest environmental commodity market ever seen. Some observers have questioned, however, whether the Protocol’s market (or ‘flexibility’) mechanisms – particularly the Clean Development Mechanism (CDM) – will deliver the ‘real’ emissions reductions needed to accomplish the Protocol’s objectives to combat global warming.

The GHG market is unique in the degree to which it is a ‘policy construct’. Like other environmental commodity markets, such as the US sulphur dioxide allowance market, policymakers will determine the market demand for emissions reductions by setting national and global emissions reduction targets.

Unlike other environmental commodity markets, however, policymakers also will determine the key elements of the GHG reduction supply curve. They will do so primarily through rules governing the CDM, through which credits can be ‘created’ by emissions reduction projects in those (developing world) countries that have not agreed to emissions caps under Kyoto, and traded into capped industrialised countries.After the setting of emissions targets, CDM crediting rules will be the most important determinant of where market prices clear.

The policy-driven nature of the GHG market raises important questions. To what extent will rules governing the generation of credits from CDM projects directly influence the supply curve and indirectly influence the future price of CDM credits and other emission reduction units? How will policy decisions governing the Protocol’s flexibility mechanisms influence the environmental effectiveness of the Protocol itself? The answers to these questions, and others, could affect the future of global climate change mitigation efforts.

Setting the analytical stage
To address these questions, one must delve into the global supply curve of GHG emissions reduction opportunities and study how the CDM rules will affect the shape and magnitude of this curve. This task should be distinguished from the more difficult goal of forecasting future GHG credit prices. Improved understanding of the global supply curve is only one component of the price forecasting puzzle – but it is a key component, since it can result in crucial insights into how the GHG market may develop.

Efforts have been made to estimate global cost curves for emissions reductions. Most efforts, however, have significant weaknesses. For example, some are derived from top-down modeling efforts and are highly abstracted. Most are ‘social cost’ rather than ‘private cost’ based, and many do not clarify their assumptions about technology penetration rates or sectoral coverage. None consider the implications of flexibility mechanism decision-making on the supply curve; indeed, generally it is not an issue the models are in a position to address. The result is that the debate over mitigation costs remains confusing.
In its Third Assessment Report (TAR), released in July 2001, the Intergovernmental Panel on Climate Change made what is perhaps the most comprehensive effort to date to derive an internally consistent estimate of global emission reduction opportunities.
Using a bottom-up sectoral approach and accounting for implementation barriers and other limiting factors, the TAR estimated technical potentials and emissions reduction cost ranges for 2010 and 2020. The TAR’s survey, however, did not attempt to convert its projections into a global reductions supply curve. It also did not provide comprehensive sectoral coverage and did not consider the potential implications of CDM trading rules on the supply of emissions reduction opportunities.

Why policy matters
CDM-based emissions reductions will originate in countries without emissions reduction targets and involve sources not subject to emissions restrictions. A key challenge for policymakers under the CDM, therefore, is determining the ‘additionality’ of the claimed reductions, ie, how much a proposed CDM project reduces emissions from a no-project baseline (the ‘but for’ or ‘business-as-usual’ case).
The catch with almost any potential approach to additionality is that one never actually knows what would have happened ‘but for’ a specific project. It is almost impossible to develop an empirically objective methodology by which to make additionality decisions. Nevertheless, as long as emissions trading occurs between capped and uncapped countries, it is an inevitable problem.
Conceptually, policymakers are confronted with a trade-off similar to the trade-off in experiments between “Type I” and “Type II” error. Type I error occurs when one mistakenly accepts a hypothesis that is not true; in CDM terms, this is equivalent to granting credit for emission reductions that would have happened anyway. Type II error occurs when one rejects a valid hypothesis; in CDM terms, this is equivalent to denying credit for emission reductions that would not have happened anyway and thus are additional.
It is impossible to eliminate both sources of error. In fact, it will be difficult to severely restrict Type I error without also inflating Type II error. Set the additionality bar too low, and you risk flooding the market with ‘anyway tons’ that undercut the trading system’s environmental integrity. Set the bar too high and you foreclose many beneficial and cost-effective reduction opportunities.
Some observers argue that the CDM already faces being overwhelmed by Type I error. CDM Watch, a non-governmental organisation, has declared “non-additional” most projects that proponents have submitted for CDM approval. CDM Watch uses a“timing test” to reach this conclusion, arguing that any project moving forward before implementation of CDM rules is ‘business-as-usual’. Like other simple-to-explain additionality tests, this will likely result in a great deal of Type II error. Moreover, it does not help manage Type I error after the rules are in place.
The CDM Executive Board, which is setting the rules for CDM projects, is tackling these issues through decision-making targeted at baseline protocols and additionality tests and standards, among other things.
The Board’s recent guidance on the first 14 baseline methodologies submitted by project developers illustrates the role CDM policy will play in determining the supply of GHG credits. It is thus surprising how little attention has been devoted to the implications of CDM policies on the available supply, and ultimately price, of emission reduction credits. One possible reason for the lack of attention has been the lack of analytical tools with which to undertake the task.

Tackling the challenge

As part of our efforts to track and explain the developing GHG market, we have assigned quality rankings to hundreds of real-world mitigation projects and proposals since 1994. We have characterised quality as a function of project additionality, reliability, leakage, quantifiability and ancillary benefits. More recently, as part of our GHG market price forecasting work, we have built upon this ‘offset quality’ approach in developing global GHG supply curves.We believe the express consideration of offset quality to be a crucial component of developing a forward-looking GHG price curve.

Using the TAR’s recent estimates as a foundation, our current supply curves start with technical potential estimates for more than 50 sectors, from which we estimate the ‘practical potential’ for emissions reductions from each sector based on the perceived severity of sector-specific informational and implementation barriers.We draw upon the economics of ‘typical’ mitigation projects to estimate the ‘typical’ cost for a specific sector, and then build ranges around that estimate by changing key project variables.To address the key questions introduced previously, our supply curve work seeks to go beyond the TAR in several respects:

• It distributes the sector cost-range across the sector’s practical potential, based on an assessment of whether mitigation costs will be biased toward the lower or higher end of the potential range.
• It assigns an additionality rank to every ton of practical potential, reflecting estimates of the likely distribution of business-as-usual versus additional reductions within a given sector. An additionality rank of 1, for example, suggests that even modest additionality restrictions would reject the tonne in question (eg, crediting a project as a gas-for-coal substitution, when it is clear that gas is the marginal fuel of choice in that power market); a rank of 5 suggests that even severe additionality restrictions would approve the tonneas additional (eg, small-scale high-cost renewable energy projects or forestry projects without revenue streams).
• It defines the estimated relationship between the additionality and cost for each sector, ie, whether the least additional reductions will also be those that are least expensive.
• It is more comprehensive in its sector coverage, including sectors that the TAR does not incorporate.

Predicting GHG reduction supply
By building supply curves in this way, we have found it possible to roughly assess the implications of different policy decisions regarding additionality for the global supply curve of emissions credits. Some sectors are not represented; for others, large blocks of low-additionality reductions are still missing.The practical potential of many sectors is not yet split between capped and non-capped countries, so the supply curve is not CDM-country specific (although it does seek to exclude US emission reduction opportunities). Notwithstanding these limitations, the results are instructive.

The red line in the figure shows the estimated global supply curve in 2010 based on a very loose additionality standard.All curves intentionally exclude sales of ‘hot air’ (surplus allowances awarded to countries such as Russia and Ukraine under the Kyoto agreement) and include an across-the-board estimated transaction cost of $1.50/tonne of carbon dioxide or equivalent. Even with these two assumptions (which have the effect of reducing global supply and significantly increasing per tonne costs), there is a sizeable low-cost emissions reduction potential. With a loose additionality standard, nearly 2 billion tonnes are available below $5/tonne (including a $1.50/tonne transaction cost).

The orange and purple lines show the results of imposing stricter crediting restrictions (ie, only emissions reductions with an additionality rank of 3 or higher and 5 respectively). In these cases, the total estimated supply falls by almost 30% and 70% and the estimated supply below $5/tonne falls by 50% and 88%, respectively.

As noted above, the figure seeks to illustrate the range of possible supply curve outcomes and the importance of key policy inputs to the shape of the curve. It is not intended to suggest any particular additionality approach or to show what the supply curve ‘should’ look like.

Conclusions

The figure, based on sector-specific economic and additionality analysis for more than 50 mitigation sectors, demonstrates that the definition of a legitimate reduction under GHG trading systems will have a major impact on the global GHG supply curve and future credit prices.How policymakers balance Type I and II error can affect the supply of creditable project-based reductions by as much as 70%.

These results, while rough, illustrate the practical importance of policy decisions regarding the Protocol’s flexibility mechanisms. They also suggest the importance of developing a coherent additionality policy, rather than approaching it on a piecemeal basis. The early precedents policymakers set may profoundly affect the ultimate shape of the market. It may prove difficult to change the additionality course later.

This is a key issue for industry.The private sector wants to see policies that maintain low Protocol compliance costs. Yet, the consequences of a public backlash against market mechanisms due to a perceived lack of environmental integrity could have dire consequences for industry, particularly if stronger global climate change mandates become a reality. Promoting the development of the GHG market is an important objective – so is protecting its long-term credibility.

Derik Broekhoff is a policy analyst and Mark Trexler is president at Trexler and Associates, a Portland-based consultancy.
E-mails: dbroekhoff@climateservices.com; mtrexler@climateservices.com