MARKETS:

Is the Clean Development Mechanism slumping toward extinction?

NEW YORK -- A perfect storm of bad economic and political trends could spell doom for the Clean Development Mechanism, the often criticized yet also lauded U.N. program created by the Kyoto Protocol that allows developed countries and their corporations to offset greenhouse gas emissions by making reductions in the developing world.

The serious threat that the CDM is facing so far doesn't appear in the most visible statistics. The number of new projects entering the validation process of the CDM's Executive Board is averaging about 110 per month, down only 15 percent from last year's average of 130 per month. That number is expected to slide further, as only 75 projects were added to the Executive Board's backlog of applications last month.

"This has brought an end to the upward trajectory in origination activity that has characterized the CDM market since its inception," said Barclays Capital analyst Trevor Sikorski in a note to clients.

But others warn that the situation is more serious than that. It can take a year or more from start to finish for projects to get awarded Certified Emission Reductions (CERs), the tradable instruments developers sell to make projects profitable. Projects already in the works will move forward, but market watchers see signs that the number of new CDM projects could fall off a cliff in the near term.

In a poll released this week by the market tracker Point Carbon, 60 percent of carbon market players said they are scaling back, delaying or outright canceling their investments.

"Those who are in the carbon markets and the industries who have obligations to buy allowances to meet their targeted emissions in the future are doing the best they can to continue to prepare for what we know will be a real and meaningful price on carbon coming down the pipes within a few years," said David Hunter, U.S. director for the International Emissions Trading Association (IETA). "It's difficult, no doubt about it."

The weak pricing environment for CERs is a chief concern -- spot prices are trading at about €12 per tonne of CO2 equivalent at Europe's BlueNext exchange platform these days, down from more than €20 per tonne before October.

But the biggest problem for the CDM is the sharp economic downturn in the European Union, where collapsing industrial activity is cutting nations' emissions of greenhouse gases, resulting in less need for the E.U. allowances (EUAs) mandated under the European union's cap-and-trade program and less need for CERs.

"Tight credit markets and policy uncertainty are driving prices down," said Jasmine Hyman, director of programs and partnerships at the Gold Standard Foundation, an organization that certifies CERs.

European companies further depressing prices with a sell-off

The most troubling sign now for the future market for CERs, analysts say, is that European emitters are selling off their holdings of EUAs even at record low prices in a desperate bid to raise capital, as those companies still face real trouble accessing fresh credit or loans. Companies may have to buy them back later at higher prices to meet future compliance rules, but they generally don't care, betting that the economy will rebound and credit markets will open up again by that time.

In other words, many companies in Europe that are in trouble are basically abandoning the carbon markets as they focus solely on the survival of their core business, making the rational calculation that the future risk of getting slapped with costly greenhouse gas compliance measures won't matter if a business ceases to exist in two years' time. Anecdotal evidence suggests firms are making the same calculation in the United States, turning away from the market for voluntary carbon offsets in larger numbers as the economic slump drags on.

Private industry isn't the only sector abandoning environmental integrity for the sake of expediency and economic survival, insiders report.

Speaking on background, one CDM analyst noted that national governments are turning away from the now relatively cheap CERs in favor of even less expensive Assigned Amount Units (AAUs), carbon credits most experts concede don't amount to any actual greenhouse gas reductions.

Back when the Kyoto Protocol was being negotiated, Russia and Eastern European states won the right to an allocation of a certain volume of AAUs deemed necessary to help them meet mandated emission reduction targets, benchmarked on the Eastern bloc's 1990 emission level. But an economic crisis that swept the former Soviet Union pushed those nations' emissions levels far below 1990 levels. Meanwhile, AAUs were allocated anyway. This set the stage for trading instruments that environmental groups have dismissed as little more than "hot air."

Annex I parties to the Kyoto Protocol, those facing the stiffest reduction targets, have so far avoided buying low-quality AAUs in favor of higher-quality CERs from developing states like China and India. But now countries facing tight budgets are buying AAUs to meet compliance targets even if they resulted in no net emission cuts.

For instance, Reuters reports that Japan is closing in on a purchase of 30 million AAUs from Ukraine. The European nations of Spain, Belgium and Ireland are also reportedly shopping for AAUs to help meet their Kyoto Protocol targets.

Project developers face rapidly shrinking profitability

CDM project developers -- especially those active in Brazil, Mexico, China and India -- are also pulling back as they face much weaker to nonexistent profitability, but also largely because of uncertain political winds that suggest the CDM as it's known today could be coming to an end.

With the large developing and developed nations as far apart as ever on which nations must adopt commitments to reduce their greenhouse gas emissions, market players are speculating that the CDM may cease to exist in those four giant nations after the Kyoto Protocol expires in 2012. China, India, Brazil and Mexico together account for more than three-quarters of total CDM projects.

E.U. policy is fueling this uncertainty. In a bid to pressure major polluters from the developing world to adopt binding emission reductions, E.U. regulators are threatening to ban the import of CERs from all but the poorest nations and small island states in future rules proposed for the European Union's own Emission Trading Scheme, by far the world's largest cap-and-trade program and the main market for CDM credits.

The use of the CDM as a political football had already encouraged project developers to slow down even before the current economic crisis forced an even swifter pullback. The slow pace of international negotiations on a successor to the Kyoto Protocol hasn't offered them any solace, as China, India and others repeatedly say they refuse to be made subject to any binding commitments in a new global treaty.

"If no post-2012 deal is reached, the volume of new projects started in 2010-12 could be reduced substantially because 1-3 years of CDM revenue will not justify the initial investment," analysts at Point Carbon said in a reply to questions.

CDM players are also noticing less-than-encouraging signs from Washington even as many climate change activists are optimistic that the new Obama administration will finally bring the United States into an international carbon control regime.

Analysts report that both Democratic and Republican lawmakers on Capitol Hill are still deeply skeptical of the CDM, mindful of some early criticisms of the program and the stigma associated with the unregulated voluntary offset market. CDM project developers are becoming more aware of this hurdle, and of the reluctance of officials to allow a system that transfers wealth from the struggling U.S. economy to China.

Congress must climb 'a huge learning curve' to accept CDM

"If you go and talk to folks on the Hill, there's just a huge learning curve to come up to speed on what CDM is, how it works, and to be honest, just what an offset is," said Michael Gillenwater, co-founder of the Greenhouse Gas Management Institute. "What they've heard is that they're all bogus, not reductions, that we're just shifting money overseas and not getting anything for it."

Project developers are suffering serious cash flow problems as weak CER prices persist. And many projects already under way can't generate as many CERs as before because of weaker industrial activity, further hurting companies' pocketbooks.

Many projects are financed through arrangements whereby a buyer agrees to purchase the CERs generated from a methane capture facility or other greenhouse gas abatement scheme at a set price, often higher than what prices are now. With customers drying up, sellers are either forced to offload their CERs at a loss or hold onto them, hurting their ability to finance future projects.

And developers are still facing a lack of capital in the ultra-tight credit markets forcing many of their industrial customers to sell off emission allowances and raise cash to survive. To make matters worse, CDM watchers say prospective project funders that would otherwise fill in the gap are now pulling out en masse, wary of volatile carbon prices.

The combined force of a bad economy and weakening political support for the Clean Development Mechanism has led many observers to speculate that, barring a positive outcome to international climate talks in Copenhagen at the end of this year, only the World Bank may keep the CDM program alive to 2012 through programs it funds.

"The question now is whether we will see a quick rebound if and when commodity and carbon prices move upwards again, or whether the downturn lasts," said Point Carbon analyst Jørund Buen. "Those sellers that have just been sitting on the fence waiting for better prices could re-enter immediately, while those seeking financing might be gone for a long time still, or will never return."

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