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China’s CDM market: Will Shanghai say goodbye to CERs? /// Energy Risk

Author: Lianna Brinded
Source: Energy Risk
03 Mar 2010

With China widely blamed for the failure of Copenhagen, some experts believe CDM investors could now shun the country in favour of India and Brazil, or that the EU may even take action again Chinese CDM certificates, creating a two-tier market. Lianna Brinded reports

The Climate Change conference in Copenhagen (COP15) rounded off 2009 on a sour note, following a lack of collective will to determine a binding agreement. Although, none of the 140 countries signed a much-talked about agreement, the blame for the de-railing of the Copenhagen talks was put mainly at the door of China.

Some analysts believe China may suffer a backlash as a result, with Clean Development Mechanism (CDM) project investors choosing to put their money into projects in countries that have a better green track record. The European Union may also take punitive measures intended to dilute China’s top slot in the CDM market in favour of other players such as India and Brazil, some analysts say. There is even talk that the EU could decide not to recognise certain Chinese CDM certificates (Certified Emissions Reductions – CERs) which would create a two-tier CDM market.

“China is no doubt the largest issuer of CERs on the market and some of its largest projects may be objected to by the EU in the future,” says Emmanuel Fages, head of market analysis at French emissions trading house Orbeo, when asked about whether the EU will be taking punitive measures on China following COP15. “Also, people may find that their portfolios are loaded with these kind of CERs and will be forced to diversify.”

Phase III (2012–2020) of the EU Emissions Trading Scheme (EU ETS) starts in less than two years and already analysts and law firms say this could be the turning point for the Chinese CDM market.

“CERs generated in Phase II can be carried over in Phase III up to 2020,” says Fages. “However, the issue now is what type of CERs will be eligible for the carry-over. The EU may force only CERs from certain countries to be eligible for compliance use in Phase III.”

If this were to happen, there would be glut of CERs left over that could not be used in the EU ETS system. This has caused a wave of concerns that a two-tier system may be implemented, leaving China out in the cold.

People are certainly upset with what has been seen as China’s lack of commitment at the Copenhagen talks.

“China behaved appallingly throughout the duration of COP15,” says William de Lucy, director at financial instrument trading house Amplify Trading. “Wen Jiabao, the Chinese premier representative at the conference, acted on two agendas. First, to limit the impact of any international agreement on China’s growth and second to make the point that they are to be respected and will not be coerced into deals under other nations agendas, especially that of the US and EU.”

If action, whether direct or indirect, were to be taken against China’s CDM market, it would certainly hurt the country and upset the existing balance in the CDM market. China is the largest supplier of CERs in the world, issuing 47.67% of all CERs, according to the United Nations Framework Convention on Climate Change (UNFCCC). Analysts say China will make $8 billion by 2012 from the sale of all CERs it issues.

In addition, the latest data from the China’s National Development and Reform Commission shows the Chinese government has approved 42 new CDM projects, estimated to generate more than 3.7 million CERs, with 67% purchased by Western buyers from December 24 to January 19 alone.

Some people believe that drastic action against China is very unlikely. “Excluding China as a whole would have negative effects on the markets, the cost containment functions of the mechanism and the ultimate objective of the CDM – fostering technology transfer and reducing global emissions,” says Alexander Sarac, General Counsel – Carbon Transactions Associate Director EcoSecurities. “In terms of the climate change debate, it would make little sense to ban China CDM generated CERs from the EU ETS market.”

Alternatively, analysts say that indirect ways for the EU to curb China’s hold over the CERs market is by allowing only CERs generated from new CDM projects, in the least developed countries, which would of course exclude China.

Analysts say this could be the key. While a complete ban on Chinese CERs seems very unlikely, despite market rumours, it appears that the EU could take this more indirect approach to “throttling back” CERs from the major developing economies, says Vitelli. “I can fully understand why the EU now feels that the Chinese do not deserve the rewards from the EU ETS, but I do not see a change in the rules as likely, as member states still need the CERs from China to commit to their targets,” says De Lucy.

Diluting China’s presence in the CDM markets is another focal point. According to the UNFCCC, China is still expected to provide the largest amount of CERs in the market, with an average annual forecast of CERs from registered projects by host party at nearly 60%. India comes in second with nearly 12% (see figure 1).

However analysts say that the EU may start concentrating on other participants, such as Brazil, which currently has over 6% of the market and is in third place, by developing its technology transfer and investments into CDMs, in order to cool off the Chinese stronghold.

The COP15 cop-out
China was an easy target to blame for the failure of the Copenhagen talks, but many believe the US is equally culpable. US President Barack Obama took the opportunity late last year to openly criticise China in a speech on the country’s lack of commitment. But here lies the problem.

“It is like the chicken and the egg situation. The US won’t do any more, if China doesn’t do any more and vice versa. Under the UNFCCC, the US is a developed country and China is not, so therefore they are not ‘equals’,” says Alessandro Vitelli, director at independent advisory and strategy for carbon finance group IDEAcarbon.

“But this is an advantage for China, as it does not need to participate in mandatory emissions cuts. So why would China want to agree to this if nothing is happening from the US, who is under obligation to cut emissions [due to the US being a major emitter and a developed country].”

The US is an Annex 1 country and China is a non-Annex 1 country under the UNFCCC definition. Annex 1 countries mainly refer to developed nations and carbon emission limitations are only placed on these parties. However, non-Annex 1 refers to developing countries and these nations only participate in the Kyoto Protocol by investing in CDMs or Joint Implementation (JI) projects that earn them CERs. These CERs are subsequently sold onto Annex 1 countries, in order for them to fulfil their compliance obligations.

“If we look at the large political picture, what was clear was that the EU and UN were marginalised in Copenhagen,” says Bjarne Schieldrop, head commodities analyst at SEB Bank. “The US concentrated on large emitters like China and Brazil rather than a broad UN agreement.”

While many UNFCCC-defined ‘developed countries’ continue to focus on China to agree on a deal, analysts say its economic backdrop stops it from inking an agreement.

“The living standards for the majority of China’s population are below the world average and the per capita GDP is lagging behind that of other nations,” says Armand Cao, consulting analyst and Chinese CDM specialist at research consultancy Frost & Sullivan. “So for European countries to try to compel China to bear more obligation than its capability is unreasonable. The Chinese government and people can not afford it. Therefore, there is nothing wrong in China’s position.”

Analysts say combined with this and its awareness of how the EU ETS depends largely on its CER input, China holds political clout and is ‘confident’ it will not be left out of the EU ETS system.

One analyst who did not want to be named says: “China knows it’s the largest supplier in the market. However because of this, it knows it has an inseparable position in the CER market and the EU ETS will really lose out if it excludes them.”

China’s economy expanded 10.7% in the fourth quarter of 2009 from a year earlier, picking up from 9.1% growth in the third quarter and bringing full-year growth to 8.7%. Some analysts argue its exponential growth should allow it to be considered as an Annex 1 country.

And despite the argument that China is staying within its means as a developing country, analysts say that China could prevent the EU limiting, removing or cooling down its CDM development and market stronghold and therefore CERs, by agreeing to a deal.

“If the Chinese sign a legally binding agreement, it is likely that most of their CERs will be eligible post-2012,” says Fages. “However, if there is no bilateral agreement, certain CERs and certain CDM projects may be banned.”

Investment digression
While the lack of clarity over Phase III of the EU ETS is enough to make investors wary, China, which is the cornerstone of the CER market and depends heavily on Western money to develop projects, could see the fear of uncertainty suppress developing the market further.

“The wider issuer is not just the Chinese CDM market but CDM projects in general,” says Vitelli. “It will all depend on whether investment into new projects will still be flowing and whether CERs generated from these will be used as a compliance tool.”

Project specialists and analysts say that the fate of the Chinese CDM project will be more determined by the flow of investment, rather than by fears that the EU ETS will disallow a large number of China-generated CERs.

“We are going to see a major shift. I do see investments moving away from CDM projects and being diversified elsewhere, such as in renewable and sustainable energy with no reliance on carbon credit-based revenue,” says Richard Burrett, partner at environmental investment advisors Earth Capital Partners. “Financial capital is relatively fungible and can be earmarked to wherever delivers the best return.”

Burrett sees investors looking beyond the CDM and eyeing up forestry and renewable energy sectors for a more “sustainable” return.

According to a report by Bank of America Merrill Lynch, after years of sustained growth, 2009 saw companies cut back aggressively on spending to reduce carbon emissions, which means the offsets from CDM or JI offsets stalled last year. So to tackle this, some analysts say that China will find a way of seeking revenue elsewhere in the green sector.

“If China’s revenue from CERs is impacted in the long term, they will no doubt find others ways to broaden their emissions securities, like more development in renewable energy and finding other routes for technology transfers,” says Fages.

The future of the Chinese CDM still hangs in the balance.

If China does leave the CDM sphere, as the EU tries to promote CDM development in other countries, analysts predict project investments will flow into other countries and therefore other CDM projects, which would further dilute China’s market presence.

“If China leaves the market, other countries such as India, South Africa, will look to take up the market,” says Cao. “India is one of the biggest CER suppliers now, so it will take up the proportion where China leaves off. Without a mature market of their own, technology and adequate funding, emerging markets are a good helper for many countries developing CDMs to solve the problem of emission reduction.”

“Also, the governments of these countries encourage their companies to apply for CDM projects,” he adds.

The CER futures market price currently does not inspire much confidence in the long term.

CER future prices have taken a hit following COP15. The December 2010 CER futures contract, the most liquid on the market at the moment, traded at €11.78 per tonne of carbon dioxide equivalent (/tCO2e) at the time of going to press, and between €10.98 and €13.27/tCO2e during the month before Copenhagen.

The United Nations (UN) agency UNEP Risoe also cut by 5% its forecast for the total volume of CERs likely to be available up until the end of 2012 for the sixth time. The UN issued 123.4 million CERs in 2009, 11% less than the 137.9 million distributed in 2008 (see figure 2).

While China may have another fight on its hands to maintain its relative freedom in the CDM and therefore CER market placement, the country may be forced into a corner for a legally binding deal under the Kyoto Protocol. Although, a two-tier system has been discussed in the markets, this seems unlikely in the end.

The uncertainty of Phase III has only exacerbated the situation, but it could be the ticket for China to diversify its revenue base in the environmental arena and see it broaden into different sectors to maintain its rapid economic growth. And if China does take a step back from its CDM participation, it could pave the way for many other countries to develop and heavily contribute to the EU ETS system.

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