Carbon markets as a source of long-term finance
Geneva Dialogue on Climate Financing
Geneva, 3 September 2010
The size of additional investment required for climate mitigation in developing countries is significant. Using public budgets as the primary source for these additional costs will not be feasible, in particular, in times of economic austerity. New predictable ways of generating additional finance, also from the private sector, will be necessary to fill the gap. The UNFCCC secretariat has estimated that private-sector investments already now constitute 86 per cent of investment and financial flows to address climate change (1).
The carbon market tool has huge potential: how does it work?
The carbon market has proven to be an effective tool to leverage private sector investment in developing countries, which we want, while at the same time allowing developed countries to achieve their emission reduction targets cost-effectively, which we also want.
In order to deliver a robust price signal for changing investment patterns, the market participants need a long-term perspective of the future market development to make efficient investment or policy decisions. This requires a transparent and predictable long-term policy framework, including on the ambition level.
The European Union's experience
The EU has gained first mover experience in setting up the world's largest company based cap-and-trade system. Since its launch in 2005 the EU Emission Trading System has rapidly established itself as the main driver of the emerging international carbon market. The total volume of transactions in carbon markets worldwide amounted to € 103 billion in 2009, of which € 89 billion was for trade under the EU ETS (2). This means that what happens in the ETS also matters for the international market.
The example of the EU ETS should be encouraging for those countries that are contemplating setting–up of domestic cap-and-trade systems, which then could be linked together to create a stronger international carbon market.
The EU provides a substantial demand for carbon credits. The EU ETS creates demand for credits amounting up to 1.6-1.7 bn of CO2 in 2008-2020. Additional demand for credits will come from the sectors outside the EU ETS amounting up to approximately 700Mt over period of 2013-2020.
How could the carbon market contribution be scaled up?
To scale up the carbon market the focus should be on reductions beyond low cost options. Low cost options should be undertaken by developing countries based on their respective capabilities.
To achieve this, a move away from the CDM towards new and more ambitious carbon market mechanisms is needed, in particular, in the economically more advanced developing countries and internationally competitive sectors. The CDM is a pure offsetting and project-based mechanism. Under such a system it is not possible to scale up effort to the level necessary to pursue emission pathways consistent with the 2 degrees target. Therefore a step-wise move to new market mechanisms, including at sectoral level, is needed in addition to incremental CDM improvements.
The Commission is looking to incentivise this development through its domestic legislation by exploring as a first step stricter quality requirements on the use of credits from industrial gas projects in the post-2012 EU ETS. In addition, we are interested in engaging with third countries on robust and well designed pilots in support of international rule making on sectoral market mechanisms.
What could be the size of the carbon market contribution to mobilising adequate climate finance?
The exact financial flows from the carbon market cannot be fixed in advance. However creating a stable policy framework that provides demand for international credits will induce financial flows in the long-term. The magnitude and direction of the financial flows induced by the carbon m arket will ultimately be triggered by market forces, including overall economic conditions, innovation and technological progress.
In addition, international aviation and maritime transport can provide an important source of innovative financing in support of developing countries' mitigation and adaptation efforts. The use of market-based instruments to address emissions from these sectors worldwide therefore needs to be further explored. The EU has already decided to include aviation in its ETS as from 2012 and is exploring how to best address emissions from maritime transport.
What are the conditions under which carbon markets will be successful?
The carbon market may induce financial flows of tens of billion of Euros. But these financial flows will not happen on their own. They depend on a number of key architectural elements of the international climate agreement:
- Ambitious emission reduction targets from developed countries;
- Ambitious own appropriate mitigation actions by developing countries;
- Properly taking into account or retiring the expected huge surplus of Assigned Amount Units from the first Kyoto commitment;
- Setting ambitious starting levels for the emission reduction paths for the period 2013-2020.
These elements are crucial for ensuring demand for the international credits. Our analysis shows that with current pledges, allowing the full banking of the Assigned Amount Unit surplus and choosing the Kyoto Protocol target as a starting level for the emission reduction paths for the period 2013-2020 would result in no demand for the international credits additional to what has already been enabled by the current legislation, and in the cap-and-trade systems planned by other developed countries. The price signal would not be sufficiently strong. Therefore, a larger share of abatement measures would need to be covered by public finance, which is not feasible in current circumstances and also questionable to succeed in better economic times.
Apart from ensuring demand as a fundamental driver of the carbon market, we must also ensure that the legal framework to underpin the market is in place. The EU's emissions trading scheme will continue post-2012, but we also have two important tasks before us for Cancún.
First, the Kyoto framework allows the CDM to continue beyond 2012, even in absence of a 2nd commitment period, or in case there is a gap before it enters into force. To reassure the market, we could signal in Cancún that the CDM will continue beyond 2012, albeit substantially reformed. Environmental integrity of CDM must be improved and its use as an offsetting mechanism should be increasingly focused on Least Developed Countries.
Second, to make progress on new market mechanisms, we need in parallel to the UNFCCC negotiations to develop pilot activities demonstrating how such advanced mechanisms could work most effectively.
A major goal for Cancún should therefore be to anchor the improved and new carbon market mechanisms in the future agreement, as means to reach ambitious mitigation objectives and generate financial flows on a larger scale to developing countries.