Whatever happens at the UN meetings in Copenhagen this December, the carbon markets will have to re-examine the structures put in place by the Kyoto Protocol, not least the Clean Development Mechanism. But is it beyond repair or just in need of a tune-up? Writer Jim Kharouf

In a perfect world of carbon finance, clean projects around the globe would be well thought out, measured flawlessly in a standardised fashion and passed through the UN approval process with certainty and without delay. Sadly, this bears little resemblance to the UN's Clean Development Mechanism (CDM).

What was created by the UN Kyoto Treaty has seen its ups and downs over the years, with project developers and carbon financiers appreciating the concept but getting increasingly frustrated with the delays and uncertainties that are now part of the process.

"The technical simplicity of the CDM is the beauty of it," says Henry Derwent, president and CEO of the International Emissions Trading Association (IETA). "It takes a non-economically viable project and makes it viable by the monetisation of the emissions reduction. And that's absolutely at the heart of what the whole issue of this carbon crisis is about."

The CDM was created to allow industrialised countries to invest in projects abroad to offset their emissions at home. The result would provide those companies and firms with Certified Emission Reductions (CERs) that could be traded in the EU Emission Trading Scheme and elsewhere. And among virtually everyone in the carbon project and finance space, the CDM is considered a strong mechanism for the real goal, which is meaningful projects that help fight global warming. Yet Mr Derwent and others in the industry say the execution is fraught with multiple problems.

"There are a lot of downsides," says Mr Derwent. "The governance of this is complicated, bureaucratic and is really not getting any better in the ways that it should. The regulatory risk associated with a CDM risk is considerably greater than the risk most bankers or project financiers are used to in many other areas. If you can't get your project through, you haven't got a project."

Rise in complaints

Among common complaints from bankers and project developers is that the CDM is appallingly slow. Projects that should be approved in months are delayed for years, so projects in the CDM pipeline have grown to form an embarrassingly long queue. Of the 1834 projects registered, only 566 have been issued credits, with the entire pipeline totaling 4673 CDM projects. Another 581 projects have been rejected, 122 of them by the UN executive board, while 40 other projects have been withdrawn, according to October reports from derivatives house MF Global and the UN.

Adding more delays to the process, the UN suspended verification firm Det Norske Veritas in December 2008, the largest single verifier of CDM projects, for allegedly authorising five projects for CDM without surveying them. The UN then suspended SGS UK in September for failing to prove it had audited projects. Some say suspending the entire firm, rather than the individuals responsible, is short-sighted and part of a broader problem facing the CDM structure.

Confusion reigns

The CDM executive board, which oversees the CDM, has no full-time executive running the programme and board members are rotated periodically so continuity is a major problem. On top of that, there is no clear consistency for project approvals and some projects that had been approved have been reversed, with the project or amount of CERs re-examined. Wind power projects in China that had been approved on a very regular basis have suddenly been delayed.

Others are baffled by hydro-electric projects, some of which were approved but are now increasingly being rejected. At issue is whether some of these projects were already in operation, or would have occurred without the additional incentive of emission credits, known as 'additionality'. There are also socio-economic impacts from dams on local communities which need to be accounted for.

There are good arguments for putting the brakes on the CDM. If the mechanism were to lose its credibility, the entire market could lose the confidence of participants, not to mention government support.

"The UNFCCC [United Nations Framework Convention on Climate Change] has got a difficult balancing act," says Patrick Birley, chief executive officer of the European Climate Exchange, which offers CER futures on its exchange. "They have to maintain the quality of the currency. And they only do that by ensuring that the rules are imposed very, very carefully."

Every bank and project developer interviewed for this story supports the idea for verification of real projects, with real and measurable reductions. However, it is no doubt frustrating for the financial sector to deploy capital towards a project and then watch it sit there for months.

Imtiaz Ahmad, executive director at Morgan Stanley's carbon desk in London, says the process needs to be more transparent and ticks off a litany of potential CDM risks, including project risk, country or political risk, credit risk with the counterparty, commissioning risk, technology risk, volumetric risk and natural disaster risk, for events such as earthquakes or floods. And now, more than ever, there is regulatory risk. Without better communications with the CDM executive board, it is difficult to determine the risks that are involved with any given project.

"We're already taking a lot of risks," says Mr Ahmad. "As long as we know from day one what that regulatory system is, then we can try to assure that the projects we engage in adhere to those rules. But if half way through that project we find that the rules are changing, that makes managing those risks a lot harder. What we want is a system that makes it clear what needs to be done."

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Sascha Lafeld, executive board member and founder of First Climate

CDM Fixes

UN officials understand the CDM process and structure need to be fixed. Those issues are likely to be addressed during the UN meetings in Copenhagen. Heading into the meetings, banks, project developers and organisations such as IETA say that a number of improvements need to be made if the CDM is to continue attracting private capital for carbon projects. One of the solutions is to improve communications between the executive board and UNFCCC employees with project developers and banks.

Sascha Lafeld, executive board member and founder of First Climate, who is also an official advisor to the Uniter Nations Environment Programme Finance Initiative, says there is also a lack of resources for the CDM. He, and others such as IETA, recommend a permanent chairman of the CDM along with a well-funded, full-time staff who can better communicate with project developers. The CDM process and its staff are often referred to as a black box.

"This black box problem needs to be solved," says Mr Lafeld. "There is almost no informal communication between board members and project developers. We would suggest the possibility of weekly conference calls between project developers and individuals from the UNFCCC or executive board employees so as a project developer, you know who to talk to so you can get an answer in one or two days, not five or six months."

Mr Lafeld also believes that there should not be "retroactive decisions" which reverse approved projects or credits. Such moves can scare off investors and harm market growth, he says.

Despite these complaints, participants believe in the CDM and that the UNFCCC will improve the mechanism.

"We do believe in it," says Mr Lafeld. "But it needs to be more professional. It will take time but I think we're headed in the right direction."

Global currency

Such improvements are critical for the CER market going forward, as more countries move towards adoption of their own domestic carbon markets and offset programmes. Even though the CDM market has slowed to a trickle, that could change quickly if US carbon legislation is passed, creating the world's largest carbon market with estimates in the $1000bn range by 2020.

The US House of Representatives passed a bill in June that included a provision which would allow 50% of the offsets to come in internationally, with the potential to raise that to 75%. The Senate draft bill, currently being debated in Congress, called for 25% of allowances to come from international projects with some triggers for more.

Australia's pending climate legislation would allow for an unlimited number of CERs to be imported. And in Japan, it is still too early to tell what the new government will do, but its carbon market could increase CER demand as well.

Meanwhile, demand for CDM projects has virtually dried up in Europe. This is partly due to the CDM's operational problems. But the global economic crisis has also reduced emissions and thus demand for CERs. Another factor has been EU restrictions on certain types of CDM projects post-2012.

What could also help bolster the CER market is the allowance of new offset projects such as forestry, also known as Reducing Emissions from Deforestation and Forest Degradation (REDD) and soil sequestration, ideas that will likely be considered and maybe approved in Copenhagen.

"The CDM market has certainly reached a pivotal point," says Abyd Karmali, managing director and global head of carbon markets at Bank of America Merrill Lynch. "On the one hand, we might look back and say this won't be the mechanism and it's a shame we couldn't have made it work. With the more optimistic scenario, you end up with a reformed CDM along with new mechanisms such as REDD, and they become the means through which we get some degree of price convergence in a disparate set of carbon trading markets."

Louis Redshaw, head of environmental markets at Barclays Capital, falls on the bullish side of the question as to whether CERs will continue to hold their position as the global carbon currency.

"The UN can give consistency that no one else could," she says. "There's enormous investment capacity and it would be a waste to revert to something else."

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