Carbon Credit Watch

The Offsetters’ Paradox: Wind mills in China highlight incurable problem with international carbon credits

(May 7, 2010) Carbon credits given to Chinese wind projects are part of a much larger problem with the UN’s carbon market, writes Brady Yauch.

The controversy last December over the awarding of carbon credits to Chinese wind projects highlights one of the core problems with the United Nation’s international carbon credit program, say researchers Richard K. Morse and Gang He at Stanford University. Unless what Morse and He call the ‘Offsetters’ Parardox’ is solved, regulators in the developing world—particularly China and India—will be able to game the carbon market by manipulating domestic policies.

An ‘Offsetters’ Paradox’ occurs when regulators in the developing world (the offsetters) have an incentive to lower their subsidies and tweak power prices to make their country’s CO2-reducing investments look uneconomic—allowing them to qualify for international funding from UN carbon credits to pay for those investments. Such manipulation has the effect of replacing domestic subsidies with international ones.

This paradox made international headlines in December when the body in charge of overseeing UN-issued carbon credits—the Clean Development Mechanism’s (CDM) Executive Board (EB)—decided to review Chinese wind projects after it observed that Chinese regulators might be intentionally lowering wind tariffs (subsidies) so wind developers could become eligible for international carbon credits.

Until that time, Chinese wind projects had been considered a great success story, the gold standard of carbon credits, often commanding a premium to credits from other projects.

The decision by the Executive Board to not award carbon credits to wind farm projects in China sent shockwaves through the carbon market. “CDM investors reeled as the safest CDM bet (Chinese wind farms) became the riskiest,” Morse and He say. “The Chinese government publicly attacked the UN’s oversight of CDM markets; and the CDM EB prepared itself for an unprecedented fight over how carbon offsets could be verified in the world’s largest CDM market.”

In February, the board reviewed their earlier decision—deciding to grant approvals for two of the 10 previously rejected projects, but adding six more Chinese projects to the rejection list, bringing the total to 14.

The EB’s decision brought international scrutiny to a central component of the carbon credit scheme: additionality.  All projects receiving financing from the UN’s CDM must prove that the emission reductions are “additional,” meaning they would not have happened in a “business-as-usual” scenario.

The criterion for establishing additionality is that the “green” projects must be less profitable than alternative power projects, or would not have secured financing under a business-as-usual scenario.

Morse and He say the largest determinant of the profitability, and therefore the “additionality,” of wind projects in China is the country’s power tariff for wind. When UN regulators noticed a decrease in the wind tariff set by China’s National Development and Reform Commission (NDRC), they became concerned that regulators were intentionally lowering the tariff in order to “decrease the financial attractiveness of wind projects, thereby enhancing their additionality claim and ability to earn substantial revenues from carbon credits.”

Morse and He point out that, “the structure of the current additionality test makes Chinese regulators the real arbiters of additionality, whether they want to be or not. Wind additionality is largely determined by power tariffs.” But because Chinese regulators set the tariff in “a non-market based manner…there is no real way to know what is business as usual and what constitutes gaming of the CDM” by Chinese regulators.

For example, the authors argue, it’s impossible to determine a real, or a market-based, internal rate of return (IRR)—which is always used as a test for additionality—for wind projects, because the IRR for all power projects in the country is ultimately determined by the electricity tariffs and those tariffs are highly influenced by central government policy, which “often supercedes profit logic.”

“Therefore, as goes the power tariff, so goes additionality…. As long as additionality is highly dependent on decisions made by the Chinese regulator, the CDM validation process might as well move from Bonn to Beijing,” Morse and He conclude.

Their analysis also suggests that wind mills in China are just the tip of the iceberg.  Any time carbon credits are used to finance emission-reducing projects in a country dominated by “non-market power sectors”—which is most of the developing world, including the two biggest benefactors of the program, China and India—domestic regulatory policies will be the biggest factor determining who gets international carbon credit subsidies.

“We don’t know what is going on. Is the CDM replacing government subsidies? That is not what it was meant to do,” said, Lex de Jonge, the former Chair of the CDM EB. “If tariff levels would show to be orchestrated in order to win CDM approval, the board will not accept it. […] This is a very important issue and could have quite an impact on the credibility of the whole CDM,” Mr. de Jonge added.

The implications are huge, say Morse and He. “If the Chinese government were controlling additionality, then the CDM’s ability to validate ‘real’ carbon offsets would be dealt a near-lethal blow.”

The role of government officials in determining additionality through the use of subsidies has the potential to destabilize the entire carbon market, which “can become a real cancer on the integrity of the market if not addressed properly,” Morse said in a March 10 interview [PDF].

“Uncertainty will undermine sustainable investment and undermine the carbon market.”

Ge and Morse admit that additionality and carbon offsets “are at best imperfect in the real world,” especially given that most power sectors in the world, and certainly in the developing world, are state-controlled. To address those imperfections, they propose partial fixes to conjure a real market out of one that is inherently politically manipulated in order to enable “the largest transfer of climate finance in history” to continue.

It won’t work, says carbon market watcher, Patricia Adams at Probe International.

“Ge and Morse’s analysis of the Chinese wind controversy has highlighted a fatal flaw in the global carbon market,” she argues, adding, “political control of power sectors in carbon offsetting countries means that carbon credit markets will always be prone to ‘gaming’ and their integrity always suspect.”

Brady Yauch, Probe International, May 7, 2010

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