Collapse of the Clean Development Mechanism scheme under the Kyoto Protocol and its spillover: Consequences of ‘carbon panic’

Kazunari Kainou 16 March 2022

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The Clean Development Mechanism (CDM) under the Kyoto Protocol is the world’s first international carbon finance scheme. It was defined in Article 12 of the Kyoto Protocol, adopted in Kyoto in 1997. Under the CDM, companies acquire certified emission reduction credits when it is confirmed that they have made investments in energy conservation and new energy projects in developing countries, according to the rules of the Conference of the Parties and the CDM Executive Board, and that the investments have contributed to reducing carbon emissions. 

The CDM scheme was originally intended to make it easier for the EU and Japan, which were obligated to reduce carbon emissions under the Kyoto Protocol, to achieve their emission reduction targets through investing in developing countries.

Certified emission reduction credits issued under the CDM have been traded and priced in major commodities exchanges around the world. In 2008, the first year of the first commitment period (2008–12), the credit price hit a record high of €25 per tonne of CO2

At first, the CDM scheme was successful. For example, between the launch of the CDM and 2012, nearly 6,600 projects were registered under the scheme, while certified emission reductions credits totalling around 1.2 billion tonnes of CO2 were issued. As more certified emission reduction credits were issued, the credit price gradually fell, down to €10 per tonne of CO2. But the price decline appropriately reflected the balance of supply and demand for the credits at the time.

However, in 2012 the credit price crashed, falling to a meagre €0.5 per tonne of CO2. Eventually, the market for certified emission reduction credits tumbled into a ‘carbon panic’ and the pricing mechanism broke down completely. The world’s first international carbo-finance scheme had collapsed, just five years after its launch.

In this column, I share my views on the collapse of the CDM and its spillovers as a member of the CDM Executive Board who was there 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 factors that led to the 2012 carbon panic were created mainly by emission credit buyers. The factors that led to the loss of the market’s confidence in the CDM scheme were:

  1. the EU’s isolationist carbon policy that prohibited the use of certified emission reductions in the EU area, and
  2. Japan’s retreat from the commitment to its numerical targets.

The European Commission was operating the EU Emissions Trading System (EU-ETS) alongside the CDM scheme, but the slumping price of the EU 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. The initiative would grant generous quotas of emission permits to the former-Soviet countries to induce capital investment, revitalise the economy, and mitigate unemployment. Instead, what happened was a nightmare: coal-fired power plants and coal mines eligible for the emission permits closed down one after another, as coal was replaced by cheap natural gas from Russia. The result was massive surpluses of emissions permits and swarms of jobless people across the region. 

Although the European Commission initially allowed certified emission reductions credits to be used in place of permits, it announced an isolationist policy reminiscent of the bloc-economy era. To raise the permit price1 through reducing supply, it banned the use of certified emission reductions credits, starting in 2012, for existing and future projects other than those in least developed countries.

In the case of Japan, all nuclear power stations were shut down after the accident at Fukushima Daiichi Nuclear Power Station following the 2011 Great East Japan Earthquake. A political decision was made to set no numerical target for the second commitment period from 2012 under the Kyoto Protocol. The Japanese government also decided it would not purchase certified emission reductions credits.

These actions of the European Commission and the Japanese government went against the apparatus of certified emission reduction credit trading, triggered the carbon panic, and resulted in the crash of credit prices and the collapse of the CDM scheme.

The beginning of the liquidation of the world’s first international carbon finance scheme

The atmosphere at the first meeting of the CDM Executive Board in 2013 was combative as if it were a gathering of distressed creditors of a failed company. Executives from developing countries directed harsh criticisms at the EU and Japan. 

I presented the following proposal based on the US trading system for sulfur emission credits.2 

(1) Establishing a voluntary cancellation system

At that time, only the EU and Japan could buy certified emission reduction credits under the CDM scheme. I proposed to establish a voluntary cancellation system whereby any country or individual around the world could directly purchase and cancel certified emission reductions credits. Of course, this would not restore liquidity for the whole 1.2 billion tonnes of CO2 of emission credits that had remained unsold. But the idea that the Executive Board should do what little it could resonated with the members.

The atmosphere of the meeting changed immediately. One after the other, executives and secretariat officials started to present their own proposals to facilitate the liquidation of the CDM scheme, including: 

(2) Allowing developing countries and international organisations to use certified emission reductions credits

(3) Selling certified emission reductions credits for carbon offsetting of football matches and other international events

Although we avoided using the term ‘liquidation’ as requested by executives representing developing countries, the board decided to go ahead with the de facto liquidation of the CDM scheme.

In 2013, nobody imagined that the CDM scheme would ever see a revival. Fed up with the scheme’s dismal prospects, many executives left the Executive Board. I remained because I was interested in the unusual situation of a United Nations scheme being liquidated.

Relief from unexpected quarters and revival of the CDM scheme

Liquidation of the CDM scheme, which centred on the cancellation system, was almost completed by 2020. The greatest factor aiding the liquidation was the fact that many investing companies begrudgingly accepted loss-cutting cancellation of certified emission reduction credits upon expiry of the project period (ten years, or seven years with two possible renewals). 

However, quite unexpectedly, the CDM scheme was revived thanks to unexpected support from the US and developing countries.

The volume of certified emission reductions cancelled under the voluntary cancellation system amounted to 77 million tonnes of CO2, larger than expected. Surprisingly, US companies and citizens accounted for most of the users. In terms of purchase volume, companies eligible for the emission credit trading systems of California and 13 East Coast states accounted for most of the total, while for the number of purchases, US citizens were by far the largest user group. It is a unique case where citizens were willing to buy certified emission reductions at their discretion despite the government avoiding engagement with both the Kyoto Protocol and the Paris Agreement.

Many developing countries, including China, Mexico, and South Africa, decided to allow the use of certified emission reductions credits 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/tonne of CO2 but are exempted from paying taxes for the portion of their emissions that is covered by voluntarily cancelled certified emission reductions.

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 of 2 billion tonnes of CO2 certified emission reduction credits issued. Most of those new projects and newly issued credits represent investments by companies in China, Mexico, and South Africa who want to accumulate certified emission reductions for future use. For example, a financially struggling South African electric power utility is snapping up certified emission reduction credits, which are available at a ‘very affordable price’ according to a company official, and building up holdings of certified emission reduction credits as intangible assets for emergencies, including extreme weather events and abrupt tax hikes.

However, it would be misguided to assume that prospects for the CDM scheme are bright. The current favourable outcomes for the CDM scheme are nothing more than accidental. Given that the certified emission reduction credit price has remained in the range of €1–2/tonne of CO2, the present situation should be regarded as a temporary phenomenon.

At a fundamental level, the world of carbon finance, including the CDM scheme, remains 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 with the arrival of the Paris Agreement in place of the Kyoto Protocol.

Spillovers of the CDM collapse: Why have negotiations over the Paris Agreement remained deadlocked?

Under the Framework Convention on Climate Change, negotiations over the Paris Agreement (which came into force in 2016) are ongoing. One reason why negotiations have remained deadlocked is the EU’s proposal to restrict the carryover of certified emission reduction credits to the Paris Agreement regime.

As already mentioned, companies in developing countries such as China, Mexico, and South Africa have been major investors in CDM projects since 2013. They have assiduously amassed holdings of certified emission reduction credits for future use, in anticipation of their upcoming participation in the Paris Agreement. Naturally, the EU’s proposal to invalidate certified emission reduction credits 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 certified emission reduction credit 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 a party to.

On the other hand, from the viewpoint of people involved in international carbon finance, it is doubtful whether emission credits will have buyers beyond 2030 under the Paris Agreement because the compliance system, through which the target achievement of targets is assessed, is much more lenient compared to the Kyoto Protocol. In particular, concerns have been raised that if the massive holdings of cheap certified emission reduction credits are not carried over to the Paris Agreement regime, credit prices may become volatile, 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 argument that only developed countries, including the US, should be committed to emission reduction targets, was accepted widely among developing countries, allowing the EU to exercise leadership in negotiations. However, the US has already withdrawn from the Paris Agreement, and it has become clear that the EU’s true objective under the agreement is realising 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 will remain out of reach.

Editor’s note: This column first appeared on the website of the Research Institute of Economy, Trade and Industry.

Endnotes

[1] The EU’s isolationist carbon policy 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 price rose to €30 per tonne 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.

[1] Under California’s sulphur emission credit trading system, anyone can purchase or cancel sulphur emission credits. Environmental conservation groups buy credits with donations from individuals when the price falls. Unfortunately, environmental conservation groups in the EU or Japan do not seem to be engaging in similar activities at any significant level.

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Topics:  Environment

Tags:  Clean Development Mechanism, China, CO2 emissions, developing countries, emissions, emissions reductions, environment, EU, Kyoto Protocol, Mexico, paris agreement, South Africa

RIETI Fellow and Executive Board Member, UNFCCC Clean Development Mechanism

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