Collapse of the CDM Scheme under the Kyoto Protocol and Its Spillover: Consequences of "Carbon Panic"

KAINOU Kazunari
Fellow, RIETI

Collapse of the First International Carbon Finance Scheme

The Clean Development Mechanism (CDM) under the Kyoto Protocol represents the world's first international carbon finance scheme that was prescribed under Article 12 of the Kyoto Protocol, which was adopted in Kyoto in 1997. This is a scheme whereby investing companies acquire CER (certified emission reduction) credits when it has been confirmed that they have made investments in energy conservation and new energy projects in developing countries in accordance with the rules and methodologies determined by the Conference of the Parties and the CDM Executive Board, and that the investments have contributed to reductions in carbon emissions. The initial objective of the CDM scheme was to make it easier for the EU and Japan, which were obligated to reduce carbon emissions under the Kyoto Protocol, to achieve emission reduction targets by enabling the acquisition of credits through investments in developing countries.

CERs issued under the CDM scheme have been traded and priced in major commodities exchanges around the world. In 2008, the first year of the first commitment period, the CER price hit a record high of 25 euros per ton of CO2. At first, the operation of the CDM scheme was successful. For example, between the launch of the CDM scheme and 2012, the final year of the first commitment period, a total of around 6,600 projects were registered under the scheme, while CERs totaling around 1.2 billion tons of CO2 were issued. In line with an increase in CER issuance, the CER price gradually fell, down to 10 euros per ton of CO2, but the price decline is considered to have been appropriately reflecting the CER supply-demand balance at the time.

However, in 2012, at the end of the first commitment period, the CER price crashed, falling to a meager 0.5 euro per ton of CO2 or so. Eventually, the CER market tumbled into a situation of "carbon panic," with its pricing mechanism breaking down completely. This was how the world's first international carbon finance scheme collapsed just five years after its launch. In this article, I would like to offer my personal opinions on the background to the collapse of the CDM and its spillover as viewed from my perspective as a member of the CDM Executive Board who experienced the scheme's collapse from the beginning to the end and who is still dedicated to the scheme's operation.

Background to the "Carbon Panic" of 2012

The primary background factors of the carbon panic that struck the CDM scheme in 2012 are problems created mainly by emission credit buyers, namely 1) the EU's isolationist carbon policy that prohibited the use of CERs in the EU area and 2) Japan's retreat from the commitment to its numerical targets. These problems led to the loss of the market's confidence in the CDM scheme.

The European Commission was operating the EU-Emissions Trading System (EU-ETS) alongside the CDM scheme, but the slumping price of the EUR intra-regional emission permits became a cause for concern for the Commission against the backdrop of economic stagnation in the former Soviet bloc countries in Eastern Europe. The EU was aiming to implement a "European Green Economy" initiative under which generous quotas of emission permits granted to the former Soviet bloc countries would induce capital investment and help to promote economic revitalization and mitigate unemployment. However, what actually occurred in those countries was a nightmare situation: coal-fired power plants and coal mines eligible for generous quotas of emission permits were closed one after another, with coal replaced by cheap natural gas from Russia, resulting in massive surpluses of emissions permits and swarms of jobless people on the streets across the region. Therefore, although the European Commission initially allowed CERs to be used in place of EURs, it announced an isolationist policy reminiscent of the bloc economy era, under which the use of CERs was banned, starting in 2012, for existing and future projects other than those in least developed countries (LDCs) as part of efforts to raise the EUR price (Note 1) through a supply reduction.

In case of Japan, as all nuclear power stations were shut down due to the accident at Fukushima Daiichi Nuclear Power Station following the Great East Japan Earthquake in 2011, a political decision was made to set no numerical target for the second commitment period from 2012 under the Kyoto Protocol. Naturally, it was also decided that the Japanese government would not purchase CERs.

Consequently, those actions of the European Commission and the Japanese government, which happened to counter the CER trading apparatus, triggered the carbon panic, resulting in the CER price crash and the collapse of the CDM scheme.

The Beginning of the Liquidation of the World's First International Carbon Finance Scheme

The atmosphere of the first meeting of the CDM Executive Board in 2013 was combative, as if this was a gathering of distressed creditors of a failed company. Executives representing developing countries directed harsh criticism at the attitudes of the EU and Japan. As I felt compelled to speak up, I presented the following proposal in reference to the U.S. trading system for sulfur emission credits (Note 2).

1) Establishment of a voluntary cancellation system: At that time, only the EU and Japan were intended to purchase CERs under the CDM scheme. My proposal called for the establishment of a voluntary cancellation system under which restrictions on the scope of purchasers would be fully abolished, allowing any country or individual around the world to directly purchase and cancel CERs. Of course, this would not restore liquidity for the whole 1.2 billion tons of CO2 of emission credits that had remained unsold. But the idea that the Executive Board should at least do what little it could do appeared to have gained sympathy from other board members.

The atmosphere of the Executive Board's meeting changed immediately, perhaps because my proposal had a disarming effect. One after the other, executives and secretariat officials started to present proposals of their own for facilitating the liquidation of the CDM scheme, including 2) recommending the use of CERs by developing countries and international organizations and 3) selling CERs for use in carbon offsetting of soccer and other international events. Even though the use of the term liquidation was avoided as requested strongly by executives representing developing countries, the board decided to go ahead with the de facto liquidation of the CDM scheme, which started in 2013.

Therefore, at least in 2013, nobody imagined that the CDM scheme would ever achieve a revival, as it has actually done thanks to support from unexpected quarters. Fed up with talk about dismal prospects for the CDM scheme, many executives left the Executive Board. However, I remained on the board, despite the fact that doing so felt like sitting on a bed of thorns, because I was somewhat interested in the unusual situation of a U.N. scheme being liquidated.

Relief Coming from Unexpected Quarters and Revival of the CDM Scheme

Fortunately, the liquidation of the CDM scheme, which centered on the abovementioned cancellation system, was almost completed by 2020. The greatest factor of the completion of the liquidation was the fact that many investing companies begrudgingly accepted loss-cutting cancellation of CER upon expiry of the project period (10 years, or 7 years with two possible renewals). However, it was quite unexpected that the CDM scheme would be revived thanks to unexpected support coming from the United States and developing countries as explained below.

1) The volume of CERs cancelled under the voluntary cancellation system has amounted to 77 million tons of CO2, larger than expected. Surprisingly, U.S. companies and citizens account for most of the users of this system. In terms of purchase volume, companies eligible for the emission credit trading systems of California and 13 East Coast states account for most of the total, while in terms of the number of purchases, U.S. citizens are by far the largest user group. It is a unique case where citizens are willing to purchase CERs at their own discretion despite the government having avoided engagement with both the Kyoto Protocol and the Paris Agreement.

2) As a result of the recommendation of the use of CERs by developing countries and international organizations, many developing countries, including China, South Africa and Mexico, decided to allow the use of CERs under domestic environmental tax systems and emission credit trading systems. A typical example is South Africa's carbon tax system, which came into force in 2019. Under this system, major carbon emitters, such as electric power and mining companies, are taxed according to their emission volume at a nominal tax rate of around 8 U.S. dollars/ton of CO2 but are exempted from tax payment for the portion of their emissions that is covered by voluntarily canceled CERs.

As a result, in recent years, the CDM scheme has been on the path of recovery. Since 2013, 1,200 projects have been newly registered with a cumulative total CER issuance amount at 2 billion tons of CO2. Most of those new projects and newly issued CERs represent investments made by companies in China, South Africa and Mexico in order to accumulate CERs for future use as the use of CERs is allowed under those countries' systems. For example, a financially struggling South African electric power utility is snapping up CERs, which are available at a "very affordable price," and building up holdings of CERs as intangible assets, as it is necessary to make some preparations for unforeseen emergencies, including extreme weather events and abrupt tax hikes, according to an account given by an official of the utility.

However, assuming that prospects for the CDM scheme are bright is misguided. From my point of view, the current favorable outcomes for the CDM scheme are nothing more than accidental. Given that the CER price has remained stuck in the range of 1 to 2 euros/ton of CO2, the present situation should be regarded as a temporary phenomenon.

At a more fundamental level, there has been no change in the fact that the world of carbon finance, including the CDM scheme, is structurally prone to panic because supply is potentially much greater than demand. Moreover, as the world is full of investing companies that were forced to swallow huge losses and financial institutions that had a frightening experience with carbon finance, it is overly optimistic to assume that the situation has taken a turn for the better overnight following the arrival of the Paris Agreement in place of the Kyoto Protocol.

Spillover of the CDM Collapse—Why do Negotiations over the Paris Agreement Remain Deadlocked?

Under the Framework Convention on Climate Change, negotiations over the Paris Agreement, which came into force in 2016, are ongoing. One reason why the negotiations have remained deadlocked is the EU's proposal for restricting the carryover of CERs to the Paris Agreement regime.

As I already explained, companies in developing countries such as China, South Africa and Mexico have been major investors in CDM projects since 2013. They have assiduously amassed holdings of CERs for future use in preparation for developing countries' upcoming participation in the Paris Agreement. Naturally, the EU's proposal for invalidating CERs all at once in the name of "environmental integrity" has invited a firestorm of opposition. After all, the EU is one of the culprits of the carbon panic of 2012. Moreover, developing countries have now become major players in the CER market on both the buying and selling sides. Therefore, in the eyes of developing countries, the EU is simply a bully trying to ruin a system that they are no longer party to.

On the other hand, from the viewpoint of people involved in international carbon finance, it is doubtful whether emission credits will be able to find buyers in the period beyond 2030 under the Paris agreement because the compliance system through which the achievement of targets is assessed is much more lenient than under the Kyoto Protocol. In particular, concerns have been raised that if the massive holdings of cheap CERs are not to be carried over to the Paris Agreement regime, credit prices may become volatile under the agreement, prompting developing countries to refuse to purchase credits as a means of compliance and triggering a new carbon panic.

Under the Kyoto Protocol regime, the EU's argument that only developed countries, including the United States, should be committed to emission reduction targets, was accepted widely among developing countries, allowing the EU to exercise leadership in negotiations. However, the United States has already withdrawn from the Paris Agreement, and it has become clear that the EU's true objective under the agreement is realizing and protecting its own "green economy." In this situation, it is entirely misguided to assume the EU can again exercise leadership within negotiations. As long as the EU tries to bind the hands of developing countries under the pretext of environmental integrity, the negotiations over the Paris Agreement will continue to become more complicated and the conclusion of negotiations will remain out of reach.

September 7, 2021
  1. ^ The EU's isolationist carbon policy still continues to have negative effects. I have heard that as a series of policy measures taken by the European Commission to limit the supply of quotas of emission permits worked too well, the EUR price rose to 30 euros per ton of CO2 in 2020 and that this is burdening low-income earners through general price inflation. The European situation is an indication of how difficult it is for governments to control prices and the market, and Japan should learn from the EU's problem.
  2. ^ Under California's sulfur emission credit trading system, as anyone can purchase or cancel sulfur emission credits, environmental conservation groups purchase credits using donations collected from individuals when the price falls. Unfortunately, environmental conservation groups in the EU area or Japan do not seem to be engaging in similar activities at any significant level.

September 29, 2021