CDM Benefits:

Coming closer to Indian industry

V. Ranganathan
Professor
IIM, Bangalore

A big market in Clean Development Mechanism (CDM) is opening up; it is worth about
$50-60 billion. China is the major beneficiary now. The question is whether India can
cash-in in this emerging market?

The Kyoto Protocol is an agreement made under the United Nations Framework
Convention on Climate Change (UNFCCC). Countries that ratify this protocol commit to
reduce their emissions of carbon dioxide and five other greenhouse gases, or engage in
emissions trading if they maintain or increase emissions of these gases. The Kyoto
protocol covers more than 160 countries globally, and 55% of the emissions. US and
Australia are the significant non-signatories. On the argument that it was the developed
countries, which originally contributed to global warming initially, only they are required
to reduce the emissions, while the developing countries are not required to do so (till they
reach the near about per capita emission levels of developed countries).

The Protocol has lead to development of Carbon (and GHG) market consisting of three
components:

1. European Emission Trading Scheme (ETS) which proposes to cut emissions from 5
dirtiest industries in Europe. Some 13,000 factories and power stations in five
different industries may emit carbon only if they have a permit. At the start of the
scheme, they were given permits worth around 2.2 billion tones of carbon dioxide per
year. These permits may be used up—as fuel is burned and carbon is generated—or
they may be traded.

2. Joint Implementation (JI) between developed countries that trade their offsets with
each other. Country A is emitting more than its quota and country B is emitting less
than its quota.

3. Clean Development Mechanism (CDM) whereby the excess emissions of developed

It is noteworthy that the first two do not actually reduce emissions, while the last one
does.
The Kyoto linking mechanisms are in place for two reasons: 1. Emission reductions in
developed countries (called Annex 1 countries) are very costly, and they are better off
buying emission credits from developing countries. The JI mechanism addresses the
situation when emission reduction is costly in one developed country but not in another,
and how they can trade among themselves. 2. Developing countries get some funds in
the process. However the motivations of the developed and developing countries in the
carbon trading are opposite: the former want low carbon prices, while the latter want
high carbon prices.

One of the key issues in implementation of CDM in spirit, is that emission reductions
must be real and additional; i.e. there should not be free rider phenomenon. Suppose a
project promoter is setting up a gas based power plant in a developing country. Against a
base line of coal based power plant, emissions will be less. But the question is : Would
s/he have set up the gas based power plant anyway, even in the absence of CDM
benefits? In that case, CDM benefit should not be given. In reality, this difficulty of
pinning down additionality, provides opportunities for consultants to claim CERs on
behalf of their developing country clients.

The CDM market is worth (at current prices of $12-15 per tonne) about $40 billion for
CO2 and another $10-20 billion of other GHG gases like Hexa Fluro Carbons. The
impact, and hence the price, of GHG gases other than CO2 is about 5-6 times that of
latter. In the first half of 2006, $15 billion worth of carbon was traded, 5 times that in the
corresponding period in 2005. The Annex 1 countries are expected to produce 3.5 billion
tones in excess of their target by 2012. At present there are two Carbon Exchanges in
Europe, one head quartered in Amsterdam but operating from London, and another from
Leipzig, Germany. There is also the Chicago Climate Exchange (CCX) in the US and
one in Singapore.

There is a criticism that doling out of allowances under ETS (instead of auctioning of
pollution permits) has done more to enrich power generating companies—one estimate
says UK power companies alone made extra profit of £800 million per year—than
reducing emissions. Moreover, once the trading took off, price of allowances shot up to
about $40 per tonne. Developing countries, in the meanwhile have been selling their
CDM permits (CERs) at about half the price (because they cannot yet be traded, and are
regarded riskier, because of monitoring issues). So, polluters have been buying cheap
CERs and selling their allowances, and pocketing the difference! However, with the
publication by European Governments of the actual amounts that they actually emit,
which is far less than what they presumed they emitted, the market for allowances has
crashed!

There is also the regulatory risk, in the sense that the ETS targets are there only for 3
years, and no one know what the future targets will be. In this ambience, no one wants to
invest in emission reduction technology. Like Multi Year Tariffs (MYT) promoting
innovation and cost reduction, the duration of ETS must be longer for polluters to mend
their ways. In July 2006, EU countries proposed allocations for 2008-12. It seems
they foresee little change; Germany has set planned reduction of Carbon emissions at a
mere 1.25%, much like the T&D loss reduction targets ‘competitively bid’ in New Delhi
electricity privatization.

A third worry is the fact that Chinese Government levies a tax of 65% on emission
reduction credit receipts, and China is also the most major beneficiary of the CER
market, reaping 2/3rd of the credits. The marginal cost of GHG abatement in developing
countries is about $1 per tonne of Carbon or equivalent, while the marginal benefit that
they receive is about $24 per tonne. The European companies which pay this would pass
it on to their customers, depending on how much they can absorb. These customers will
eventually revolt when they realize how much money they pour into Chinese coffers.

There is a market for these surrogate emission reductions, called offsets, i.e. carbon
reduction by B to offset carbon emission by A. Both buyers and sellers of ‘offsets’ are a
varied lot. Their motivations include: improving their corporate image, gaining insight
into a nascent industry, preparing for future regulation or to appease green shareholders
or customers. Swiss Re, a reinsurance company is in the business so that it can
understand the business risk of companies emitting, and later provide insurance for them.
Similarly sellers are also diverse, including firms, charities, NGOs, community groups
and international organizations like the World Bank. Some plant trees to soak up carbon
dioxide. Others prevent existing ones from being felled. Replacing fuel inefficient
stoves in China and India and installing wind turbines also offer offsets. The price of
offset may vary too, from a few cents to around $27 a tonne. The crux of the matter is
that offsets are voluntary and so a plethora of standards of measurement have emerged.

The difference between the offset market (that is there mainly in the US) and the CDM
market is that the former is voluntary at the firm level, while the latter is voluntary at the
country level—in the sense that the Kyoto protocol itself is voluntary—but mandatory at
the firm level. Some people criticize this way of becoming carbon neutral by buying
offsets by likening it to buying forgiveness for sins, promoted by the sale of indulgences
by the Church in the early 16th century. Only, in that case, it was a monopoly market for
the Church, which had an abundant divine dispensation of forgiveness, like the munna
from heaven, without having to produce it through offsetting good deeds!

The whole thing is evolving. Methodologies for offset determination are not yet on firm
grounds and are indexed in terms of firm specific applications, much like the case law
precedents. One firm has claimed offsets for producing electricity out of gas, and another
firm has claimed credits for producing electricity out of its byproduct in the manufacture
of steel, viz. Korex gas. The general methodology requires additionality to be
established; viz. the project would not have come up, or would not have been financially
viable, in the absence of CDM benefits. The challenge is how to avoid free riders? My
colleagues in the campus go to office in car; I walk. Am I eligible for carbon credit?

Individual companies line up for the gravy assisted by consultants. However, each
country has to have a nodal agency. India has designated Ministry of Environment and
Forests as the nodal agency. It is not clear if MoEF is nimble enough and has the
commercial savvy to exploit this market. A recent study found electricity sector
accounting for 52% and energy sector accounting for about 80% of the emissions. In that
context one is not sure if MoEF is the right choice for being the nodal agency. Even
Ministry of commerce may have been a good choice, since it is acquainted with
exchanges and trading.

1550 words