By Mark Coker and Margaret E. Peloso

Under the Kyoto Protocol’s Clean Development Mechanism (CDM), projects in developing countries that reduce greenhouse gas (GHG) emissions can obtain certified emission reductions (CERs) from the United Nations’ CDM Executive Board. These CERs can be sold to entities with compliance obligations under the Kyoto Protocol and used for compliance purposes. Historically, all UN-approved CERs have also been available to demonstrate compliance with emission limitations imposed by the European Union’s Emissions Trading System (EU-ETS) as well as limitations imposed by the Kyoto Protocol. Because of their ability to be traded on the compliance markets, CERs have been heavily favored over voluntary credits, and numerous entities with compliance obligations have directly invested in projects that will ultimately produce CERs. However, recent developments in both the international climate change negotiations and the rules of the EU-ETS may undermine the future value of CERs. This article explains these trends and evaluates the potential future of CERs.

Compliance Under the Kyoto Protocol
The Kyoto Protocol split the world into two classes of countries: Annex I (developed countries) and Annex II (developing countries). Annex I parties to the Kyoto Protocol assumed legally binding emission reduction targets for the first commitment period, running from 2008 to 2012. Annex I parties can meet their emission reduction obligations under the Kyoto Protocol by reducing domestic GHG emissions or taking advantage of one of the Protocol’s “flexibility mechanisms.” By far, the most widely employed flexibility mechanism is the Clean Development Mechanism (CDM).

Under the CDM, an Annex II country may obtain carbon credits for engaging in projects that reduce GHG emissions, and sell these credits to Annex I countries to fulfill their compliance obligations. In essence, the CDM permits Annex I countries to finance lower-cost emission reductions in developing countries in lieu of reducing emissions at home. Because emissions reductions can be more cost-effectively accomplished in initial development (e.g., building a new power plant) than through retrofitting (e.g., repowering an old, inefficient plant), the CDM has been a popular mechanism to attain emission reductions.

In order for a project to receive credits on the CDM, it must go through a process of registration, validation, and verification in which a third party reviews the project.¹ The project will then be evaluated by the CDM Executive Board (EB) to ensure that it meets the programs’ requirements. The main requirements for approval under the CDM are that the project developer demonstrates compliance with an approved methodology and that the additionality requirement is satisfied.² “Additionality” is a concept employed under the CDM to demonstrate that a project would not happen in the absence of CDM.³ Typically, additionality is demonstrated by showing that the incremental costs to employ a cleaner technology could not be justified in the absence of the revenue generated from the sale of CERs.

Once a project is registered with the EB, it begins a crediting period.⁴ After a sufficient duration of operation in the crediting period, the project proponent can apply to the EB for carbon credits. The EB performs an additional check to verify that the CDM project has attained the claimed emission reductions, and then grants it CERs.⁵ These CERs can be sold on international compliance markets.

Beginning in late 2009, the international community raised questions about the validity of certain types of projects that were issued CERs. In particular, there was evidence that some industrial gas projects were not truly “additional.” As a result, the UN Executive Board temporarily halted the issuance of credits to investigate potential fraud.⁶ In late 2010, the Executive Board concluded that credits could be issued for pre-existing projects and resumed issuing credits.⁷ However, at the Cancun negotiations in November 2010, the executive board agreed to pause and revise crediting for projects that capture one particular gas, HFC-23. At its May 2011 meeting, the CDM Methodologies Panel, a technical body that reviews the approved CDM methodologies, approved a revision to the crediting methodology that will reduce the number of CERs issued to HFC-23 reduction projects.⁸ If adopted by the EB, the change in the methodology for crediting HFC-23 projects will result in a 50 percent decrease in the number of credits awarded for HFC-23 capture in the future.⁹

The EU Ban on Certain Types of CERs
In order to implement its emission reduction obligations under the Kyoto Protocol, the European Union established the EU-ETS. This requires industrial operators in member countries to meet greenhouse gas limitations by either directly reducing emissions or surrendering an appropriate number of emission allowances and carbon credits. Like the Kyoto Protocol’s first commitment period, the EU-ETS operates in multi-year blocks. The first phase of the EU-ETS ran from 2005 to 2008, and the second phase ran from 2008 to 2012. As the EU-ETS prepares to enter its third phase in 2013, the EU is planning to limit the types of credits that can be used for compliance.

Although the UN Executive Board concluded its investigation and decided to resume the issuance of CERs for industrial gas projects, concern over the validity of their emission reductions remains in the EU. As a result, the European Commission (EC) has voted to ban the use of credits from certain types of industrial greenhouse gas projects beginning May 1, 2013.¹⁰ In addition, an EC official publicly stated that additional offset bans, including restrictions on the use of CERs from supercritical coal plants, are possible in the future. Beyond the banning of the use of particular types of CERs for compliance, the EU has signaled its desire to move away from the current emissions trading system to a sector-based approach in which various industrial sectors would be forced to comply with emission limitations.¹¹

Concern over new EU-ETS credit bans drove expectations that European entities with compliance obligations would surrender far more CERs for compliance with 2010 emission limitations.¹² In essence, these entities are uncertain about the ongoing value of CERs and have decided to turn them in now while the CERs still have certain value and hold other emissions allowances for future compliance use. Generally conforming with this expectation, a record number of CERs were used to demonstrate compliance with EU-ETS emission limitations in 2010.¹³ However, it has been reported that 78 percent of CERs turned in for 2010 compliance were from industrial gas projects, a drop from 83 percent in 2009.¹⁴

Uncertainty Over the Future International Climate Regime After the Parties to the Kyoto Protocol and United Nations Framework Convention on Climate Change failed to reach a legally binding agreement in Cancun, it is generally anticipated that there will be no new international agreement to replace the Kyoto Protocol when its first commitment period ends in 2012.¹⁵ Instead, it appears likely that national emission trading systems and smaller multilateral agreements will be the key efforts to limit greenhouse gas emissions.¹⁶

Although there is no international agreement to limit emissions beyond 2012, the Kyoto Protocol parties did enter into an agreement that permits the CDM to continue.¹⁷ However, in the absence of a unified international agreement, it is not clear where CERs will be accepted for compliance and whether, like the EU, other countries with compliance systems may choose to accept only some types of CERs. Furthermore, several emission trading systems, including California’s proposed market and New Zealand’s ETS, have expressed an interest in including credits from sources not traditionally covered by the CDM, such as land use carbon.¹⁸ As a result, it appears likely that individual GHG management systems will have their own protocols for, and accept different types of, credits. While there is currently no evidence that any emissions trading system will refuse to accept all types of CERs, it may be difficult for investors to determine which types of projects will produce CERs with broad compliance value.

In addition, under the Cancun Agreements, the parties decided to defer consideration of the establishment of additional market mechanisms to supplement the current flexibility mechanisms at the seventeenth Conference of the Parties in Durban.¹⁹ While it is not yet clear what form these new market mechanisms will take, these alternatives to CDM may impact later demand for CERs.

Conclusions
The EU’s ban on certain types of CERs and the failure of the UN process to achieve consensus on new legally-binding agreement to limit GHGs create significant uncertainties in the market for carbon credits. It is likely that certain CERs will be excluded by particular national or regional emissions trading systems and that a variety of other types of carbon credits not recognized by the CDM may become available. However, as the EU deepens its emissions cuts in the third commitment period and new national emissions trading systems come online, demand for carbon credits is likely to increase. Therefore, projects that generate CERs from sources other than industrial gases may be able to command a premium for their credits. This potential increase in demand has led some analysts to conclude that patterns of CDM investment are likely to shift, and that CDM projects in less developed countries, particularly in African nations, will become more attractive.

The other dynamic that is likely to influence the value of CERs going forward is the move by various emissions trading systems to accept credits from sources not recognized under the CDM. It is possible that some of these other carbon credits, such as credits generated from particular types of land use practices or forestry, can be produced at much lower costs per credit than credits on the CDM. In these situations, entities with compliance obligations may have significant incentives to shift their patterns of project investment and purchasing to obtain the lowest-cost emission credits that will be accepted on the system under which their emission limitations are imposed.

Collectively, these factors suggest that increased fragmentation of the global carbon markets is likely in the future. Such fragmentation may increase uncertainty for parties who are trading credits as individual markets begin to discriminate between different types of emission reduction credits. However, the new carbon markets also present significant opportunities for new types of carbon credits, particularly forestry and land use carbon, to grow. While it is likely that some of these project types will ultimately be included on the CDM, it may be the case that national crediting schemes provide more streamlined processes or additional opportunities for investment that are more attractive than the CDM. For example, Blue Source Carbon recently announced a forest carbon project in North Carolina that is designed to produce carbon credits that could be delivered to California’s emission trading system.²⁰ Even if the U.S. were a signatory to the Kyoto Protocol, such credits could not be produced through the CDM. In addition, Australia has recently announced its plans to award carbon credits under its Carbon Finance Initiative for the Management of Uncontrolled Savannah Fires.²¹ These are a few examples of how the proliferation of smaller carbon trading schemes will present both challenges and opportunities in the carbon credits market.

For more information, please contact Vinson & Elkins lawyers Mark Coker or Margaret E. Peloso. Visit our website to learn more about V&E's Climate Change practice, or e-mail one of the practice contacts.

¹See Decision 3/CMP.1, Modalities and Procedures for a Clean Development Mechanism as Defined in Article 12 of the Kyoto Protocol ¶¶ 35-36 (2006).
² If there is not a pre-existing approved methodology, a project developer may apply for a new methodology to be approved.
³See EB39 Report Annex No. 10, Tool for the Demonstration and Assessment of Additionality.
⁴ Decision 17/CP.7, Modalities and Procedures for a Clean Development Mechanism as Defined in Article 12 of the Kyoto Protocol ¶ 12 (2001).
⁵ EB54 Report Annex No. 35, Procedure for the Request of Issuance of CERS (Ver. 1.2, 2010)
⁶See Susanna Twidale, “HFC 23 Probe to Cut CER Supply by up to 130m,” Point Carbon News, Aug. 24, 2010; “U.N. Panel to Examine Possibility of Fraud in HFC-23 Projects,” ClimateWire, June 23, 2010.
⁷See Nathanial Gronewold, “U.N. Panel Rejects Fraud Claims in Emissions Trading Involving Refrigerant, but Suspends Some Incentives,” ClimateWire, Nov. 29, 2010.
⁸ CDM Methodologies Panel, 49th Meeting External Report, ¶ 14
⁹ IDEA Carbon, HFC-23 Issuance Post 2012 – Implications of the Proposed Methodology Change (May 2011)
¹⁰ Press Release, Emissions Trading: Commission Welcomes Vote to Ban Certain Industrial Gas Credits (Jan. 21, 2011).
¹¹ Jørund Buen, Axel Michaelowa, and Kjetil Roine, “New Market Mechanisms: Any Role for the UNFCCC?,” Point Carbon News Analysis, March 15, 2011.
¹² Andrew Allan, “Europe Uses Record Number of U.N. Credits to Meet Caps,” Point Carbon News, May 2, 2011
¹³Id.
¹⁴ John McGarrity, “Industrial Gas Offsets Account for 78% of CER Use in 2010,” Point Carbon News, May 16, 2011
¹⁵ “Durban Climate Deal Is Impossible, Say Envoys,” ClimateWire, April 29, 2011
¹⁶ “The Post 2012 Framework – What You See Is What You Get,” Carbon Market Analyst (2011)
¹⁷ Decision 1/CMP.6 ¶ 6
¹⁸ California Air Resources Board, Forestry Greenhouse Gas Accounting Protocols, http://www.arb.ca.gov/cc/forestry/forestry_protocols/forestry_protocols.htm; Oliver Sartor, “Tackling Greenhouse Gas Emissions from Forestry and Agriculture: What Can We Learn from New Zealand?,” CDC Climate Research Climate Brief No. 2 (2010)
¹⁹ Decision 1/CP.16
²⁰ Rory Carroll, “Blue Source Registers California-Complaint Forestry Project,” Point Carbon News, May 16, 2011
²¹ Stian Reklev, “Australia to Grant Carbon Credits for Controlling Savannah Fires,” Point Carbon News, May 25, 2011