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Carbon markets struggling to emerge from communism's rubble

A surplus of U.N. carbon emission credits piling up across Central and Eastern Europe is threatening to destabilize nascent carbon markets across the world and dampen efforts to curb global warming, market experts and politicians say.

Already this year, sales of emission credits from countries like the Czech Republic, Latvia and most notably Ukraine have caused the price of a ton of carbon in Europe's cap-and-trade system to plunge by more than a euro, a significant drop, said Kevin James, the vice president of carbon finance at Climate Change Capital.

To date, some 147 million tons of the credits -- known in U.N. legalese as assigned amount units and in policy circles as "hot air" -- have been sold worldwide under the Kyoto Protocol, according to a recent analysis by Point Carbon. Ukraine alone is estimated to be in negotiations to sell an additional 450 million tons to Japanese firms, said Andreas Türk, a Kyoto consultant at Joanneum Research in Austria.

"It's a hot potato that no one wants to touch," said Peter Zapfel, an official at the environment directorate of the European Commission, the European Union's executive arm.

Credits are building up largely thanks to the economic malaise that afflicted Central and Eastern Europe in the 1990s. The rapid decline and deindustrialization of post-communist countries means they won't come close to using the amount of emission credits granted to them by the United Nations' previous round of climate talks last decade.

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Because of the gap between prediction and reality, these countries are expected to have a stockpile of 6.5 billion tons of CO2 credits by 2013, mostly held by Russia and Ukraine. For comparison, the United States emitted a total of some 6 billion tons of carbon dioxide in 2007.

While reputation concerns and several prescient decisions have kept the carbon market from collapsing -- notably, the partial decoupling of Europe's cap-and-trade system from Kyoto credits -- the looming conflict over the excess emissions is a prime example of how flawed policies, bad data and optimistic growth projections can undermine government-created trading.

Worries about the "hot air" credits have simmered for years in international circles, with regulators worrying that their purchase could theoretically allow countries to meet CO2 commitments without any emission cuts being made in the buying or selling nation. Japan, which is not close to meeting its CO2 commitments, has so far been the largest buyer of the credits.

Many of the post-communist E.U. countries, such as the Czech Republic, which has sold 68.5 million credits, have taken pains to show that these funds will go into energy efficiency programs, constructing elaborate "green investment schemes" to mollify Western critics.

"We know that the Czech Republic and Latvia have done a good job," Türk said. They have brought in international observers and are transparent in how the money is handled, he said.

But other deals have remained elusive in how the funds will ultimately be used -- for example, several of Slovakia's environment ministers have been consecutively fired over a scandalous deal the country made to sell its credits through Switzerland and Denmark to an unknown Japanese buyer. And most deals with corruption-ridden Ukraine are suspect, Türk said.

"Austria would never buy from Ukraine," he said.

As a show of their concern, European heads of state called late last month for world leaders to pay close attention to how these excess credits will be accounted for during the U.N. climate talks in Copenhagen, Denmark.

"This issue must be addressed ... so that the handling of the AAU surplus does not affect the environmental integrity of a Copenhagen agreement," they said.

Legacy of 'wall fall' profits

When the Berlin Wall fell, 20 years ago today, and the crowds pushed through -- first in a trickle and then a flood -- few could then imagine that one of the most lasting, if abstract, legacies of the popular revolt against communist governments across Europe would be a marked decline in CO2 emissions.

But it was. Exposure to market economies exposed the rabid inefficiencies in state-owned industries across the East, resulting in massive efficiency upgrades, widespread plant closures or the stripping of newly privatized companies for illegal profit.

A look at countries' individual greenhouse gas emissions makes this strikingly clear. Over the past two decades, while countries like Spain, Portugal and Ireland saw emissions rise, Poland's output dropped 30 percent; Bulgaria's plummeted 43.3 percent; Ukraine's, 52.9 percent; and Latvia's, 54.7 percent.

"These were just the low-hanging fruit," said Joachim Schleich, a climate economist at Germany's Fraunhofer Institute for Systems and Innovation Research. In those days, he said, "climate change was not on the top of their minds. That was not an issue in the early '90s."

Yet when countries gathered last decade to craft what would become the Kyoto Protocol, 1990 was chosen as the baseline for emissions reduction -- just prior to the collapse of a huge portion of the world's economy. While negotiators were aware of this decline, they failed to account for its depth and severity, said Thomas Legge, a climate and energy expert at the German Marshall Fund.

"There was also a sense that you didn't want to constrain those particular economies," Legge said. There was a concern to "keep countries that really had no interest in environmental issues at the time, you wanted to keep them in the game."

It is a little understood fact that the European Union is currently meeting its ambitious CO2 commitments largely because of the reconstruction of Central and Eastern Europe, Schleich said.

"The E.U. is on track, but that's mainly because of the contribution of the new member states," he said.

A recent report by the Sandbag Climate Campaign, a British advocacy group, seeks to make this inheritance clear. The European targets "may appear ambitious but this is largely due to the accounting rules the E.U. has chosen to adopt in describing its ambitions," it says.

West European emissions have dropped 4.3 percent compared to 1990, a figure that more than doubles when emissions from post-communist states are factored in, the report says. And much of this drop can be attributed to the gasification of the United Kingdom and, even more so, the fall of the Berlin Wall.

Thanks to its reunification, Germany includes one of the world's most ambitious renewable subsidies and the remains of a decayed post-communist state. Reflecting this, Germany took on aggressive targets during the Kyoto negotiations, pledging to reduce its emissions 21 percent from 1990 levels by 2012.

Even with these targets, many complained about the potential for "wall fall" CO2 cuts from the former East Germany. And sure enough, three years after Kyoto was signed in 1997, Germany already sat at a 17 percent reduction, half of which was due to the East's decline, Schleich said.

It should not be ignored that Germany was also a leader in adopting renewable energy subsidies like feed-in tariffs, which guarantee higher electricity rates for wind and solar power, Legge said.

The wall-fall profits have "certainly helped them," Legge said. "But it's sometimes mischaracterized as the only reason."

Power of reputation

Currently, the only thing keeping Europe's carbon market afloat is reputation. No European country wants to be seen as buying "hot air" that does little to reduce emissions, experts say.

"Buying 'hot air' from Russia or Ukraine is not something that would go down well politically, especially if you're trying to position yourself as the No. 1 region fighting climate change," Schleich said.

Without such concerns, the market would immediately crash, Legge added.

"My prediction is a lot of the hot air credits will go unused," he said. "If there was really an open market for them, the price would drop to zero."

For the most part, the Kyoto credits are only purchased by countries. After much discussion, the European Union opted to use its own internal credits for its cap-and-trade system. This decision is the subject of much relief today, as otherwise, European companies would be able to buy "hot air" credits to cover their emissions -- a regulatory nightmare.

The underlying problem with the credits is that while they were intended as a trading mechanism, they have instead become an accounting system, the European Union's Zapfel said. European companies trade in E.U. credits, and then, at the end of the year, the countries pass Kyoto credits around to reflect these sales, he said.

Countries have used the credits for ulterior motives, as well, Türk said. Austria has bought modest credits from the Czech Republic and Latvia partially because it wants to sell Austrian technology, he said.

Similarly, countries "may buy Russian AAUs just to get their foot in the door," he said.

In the face of increasing international pressure, Japan has slowed its purchases of the credits. But as part of a voluntary program to cap CO2 emissions, Japanese companies have purchased $1 billion worth of Kyoto CO2 credits over the past fiscal year. While most of these have gone toward funding clean energy in China or similar projects, some have also been "hot air" credits.

The opportunity to buy credits from Ukraine won't last, Türk added.

"It's becoming increasingly difficult for Japanese companies to buy hot air," he said, thanks largely to government pressure.

Perhaps the greatest legacy of the excess credits will be the additional negotiating clout they will give Russia and Ukraine in the climate talks in Copenhagen. Russia will seek to bank its credits, sparing painful cuts to its economy, which is practically indentured to fossil fuels.

"I can understand Russia's position would require some kind of compensation to go along" with cuts in Copenhagen, Schleich said.

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