Page 1 1 Using Forest Carbon Credits in the Carbon Market Focus on the European Emission Trading Scheme – Technical Workshop, Brussels, March 29, 2006 Summary The World Bank hosted a technical workshop on the role of forests in the carbon market, focusing on the European Union Emission Trading Scheme (EU ETS). The workshop took place at the British Council in Brussels on March 29, 2006. The workshop was co-chaired by representatives of the United Kingdom, France, the Netherlands, Spain, and The World Bank. The agenda can be found in Annex 1, and the full list of participants in Annex 2. The following paragraphs summarize what was discussed during the workshop and some of the key themes that emerged. The Scope of the Problem The challenge of limiting increases in the global average temperature to +2 degrees Celsius is monumental. Signs suggest that the pace of global climate change is accelerating. Hence the widest possible array of mitigation activities is needed. In particular, sequestering carbon in and avoiding the release of carbon from biomass —the so-called land use, land-use change and forestry (LULUCF) activities 1 —must play a role in the mitigation of climate change. LULUCF in the Global Carbon Market The EU ETS has created a large demand for carbon credits from Clean Development Mechanism (CDM) and Joint Implementation (JI) projects. In fact, the EU ETS accounts for more than half of the demand for CDM and JI credits. At the same time, the current exclusion of LULUCF credits from the EU ETS has resulted in a decrease of global demand for LULUCF CDM and JI credits. The market share of LULUCF has progressively declined from around 20% in the pre-Kyoto trades at the end of the 1990s, to 7% in 2002-2003, and less than 4% in 2005. Not only are European firms under the EU ETS not buying, but buyers under other regimes also refrain from acquiring LULUCF credits to keep their options opened to be able to resell the credits they purchase into the EU ETS. On the other hand, a recent survey by EcoSecurities suggests that European firms would like to purchase LULUCF credits if the EU ETS allowed them. This would increase demand for LULUCF credits and most probably lead to a price increase for these credits. Governments from Annex I countries, and in particular European Governments, can use credits from afforestation and reforestation (A/R) projects in the CDM to meet their Kyoto Protocol commitments (up to 1% of their 1990 emissions). However, with the exception of the Prototype Carbon Fund and BioCarbon Fund, LULUCF projects are in general not included into the massive public CDM and JI purchase programs of national governments and multinational banks, for two main reasons. First, credit purchase programs are often opened to both the public and private sectors, and the rules are set to satisfy both groups of buyers. Second, Governments may have less incentive than the private sector to purchase temporary LULUCF credits (see the Replacement Obligation section below). 1 Deforestation is responsible for about a quarter of the world’s current carbon dioxide emissions and for about one-third of historical emissions and atmospheric concentrations. 40427 Page 2 2 LULUCF Credits in the EU ETS The workshop discussed the pros and cons of including credits from CDM A/R projects in the ETS and how the associated technical and legal challenges that would have to be dealt with. Policy Process and Timing The European Commission ’s primary concern is to ensure the stability of the EU ETS in order to give the participants in the scheme legal and investment security. An amendment to the EU ETS, even with strong support from the Member States and the Parliament, would likely take between 1 and 3 years (depending on the number of readings) from the time the legislation was drafted before it became law. It is also unlikely that an amendment would be processed for a single issue. If at all, it is more probable that the Commission would prepare one consolidated amendment proposal addressing a number of issues and sectors simultaneously. It is very unlikely that such an amendment could enter into effect before the start of the 2008 trading period; although it was recognized that a LULUCF amendment that did not affect the National Allocation Plans could, in theory, become effective some time between 2008 and 2012. The workshop participants acknowledged the existence of procedural challenges. Still, a majority of the workshop participants supported the inclusion of forestry credits in the EU ETS as soon as possible, provided that environmental integrity of the scheme and the CDM was ensured. Environmental Concerns Workshop participants agreed that the reasons for excluding temporary credits when the EU ETS Linking Directive was adopted are mostly no longer valid. The uncertainty regarding the CDM has been eliminated now that the rules governing LULUCF projects have been defined. The 9 th session of the Conference of the Parties to the UNFCCC (CoP9) has established a regime of temporary crediting; the A/R Working Group of the CDM Executive Board; and rules to develop baseline and monitoring methodologies (three methodologies have already been approved) 2 . Through a modular approach, various project scenarios will soon be covered by a manageable number of approved methodologies. The LULUCF projects so far developed under the CDM and JI show a wide array of environmental benefits (such as the restoration and protection of soil and water resources and biodiversity habitat) beyond global climate change mitigation. The Climate, Community, and Biodiversity Standards, as presented at the workshop, are an example of how the environmental and socio-economic benefits of LULUCF projects can be ensured. Development Concerns A number of workshop participants stressed that climate change is not just an environmental problem – it is also a development problem. The carbon market, including the CDM and the EU ETS, represents a powerful and innovative complement to aid as it enables developing countries to build their “carbon mitigation” and “carbon sequestration” assets and trade the carbon credits on a new international market. The CDM therefore represents a market-based complement to aid that can be used to enhance sustainable development and help attain the Millennium Development Goals. LULUCF projects are particularly well suited for this as they deliver multiple development benefits, particularly to poor rural communities that would otherwise miss out on the benefits of the CDM. Many African countries do not possess fossil-fuel-intensive industries – for these 2 At the time of the workshop, one methodology had been approved. Two more have been approved since then, which underscores the progress that is being made in methodological development. Page 3 3 countries, LULUCF activities are the principal way they can benefit from the carbon market and contribute to global climate change mitigation . Africa’s current share of the global carbon market is less than 0.5%, partly because LULUCF is excluded from the EU ETS and otherwise limited in the CDM. Another setback for African countries is that energy projects to improve or replace traditional fuelwood and charcoal use are also banned from the CDM. On the other hand, the dependence on agriculture and forestry in African economies is much greater than in other regions of the world. By surveying the limited number of LULUCF projects under development it is clear that only a small portion of the 1%-of-1990-emissions cap on LULUCF CDM credits will be filled by 2012. This represents significant foregone revenues for developing countries – the 1% cap could represent flows of roughly 500 million per year for land restoration projects in rural areas of Africa, Latin America and Asia. 3 Equally, not filling the 1% cap represents foregone cost savings for European firms. LULUCF credit purchases by European governments will not come close to filling the 1% cap; indeed, by some estimates, the supply of CDM LULUCF credits may be able to fulfill only about one-tenth of the 1% cap. 4 Therefore, additional purchases by European firms could make a big difference. Most LULUCF projects can bring real benefits to the participating communities. In contrast to some large-scale industrial projects, the community benefits from LULUCF projects are direct. They include new or better jobs (i.e., sustainable livelihoods), new and more stable sources of income (from employment, and the sale of carbon credits and forest related products), and better management practices (i.e., technology and know-how transfer). The existing rules of the Kyoto Protocol go a long way to ensure that CDM projects, including LULUCF projects, are additional, respectful of the local people and their environment, voluntary, and contribute to sustainable development. In addition, tools such as the Climate, Community & Biodiversity Standards can help screen projects and minimize risks. Temporary Crediting Credits from LULUCF CDM projects (tCERs and lCERs) are temporary, they must be re-verified every 5 years, and in case of loss of carbon or failure to re-verify the carbon stock, they need to be replaced by other temporary or permanent credits. Their temporary nature makes LULUCF credits akin to carbon leases, even though the new forests may themselves become permanent carbon sinks. In contrast, LULUCF JI credits are not temporary. ERUs from LULUCF projects share all the characteristics of ERUs from energy projects. They are treated as permanent and do not need to be replaced. If there is a loss of carbon, the liability stays with the seller in the form of a loss of AAUs for the host country, to be reported under Article 3.3 or whatever takes its place after 2012. For this reason, there are no technical barriers to the immediate inclusion of ERUs from JI LULUCF projects in the EU ETS. JI LULUCF can include more than just A/R, in particular forest and agricultural management and avoided deforestation. 3 Annex I countries emitted 13.7 Gt CO 2 e in 1990. They are allowed to buy up to 1% of their 1990 emissions from LULUCF CDM projects each year between 2008 and 2012, i.e. 137 Mt CO 2 e. Assuming only 100 Mt CO 2 e since the United States and Australia out of the system, and using prices of around $4-5/t CO 2 e, this would bring developing countries annual revenues in the range of $400-500 million for afforestation and reforestation -- a significant boost for land and habitat restoration. Even a quarter of that sum for Africa would be considerable. 4 Assuming sequestration rates of 50 t CO 2 e/ha by 2012, 5,000 ha per project and as many as 100 projects, the total number of carbon credits generated by 2012 would equal 25 Mt CO 2 e. This represents one- twentieth of the 1% annual cap extrapolated to the first commitment period (500 Mt CO 2 e). In other words, it would take about 2,000 average projects to be launched successfully, or approximately $2.5 billion of carbon finance, to fill the 1% cap. It is extremely unlikely that such high amounts could be reached. Page 4 4 Biomass and Forestry The workshop highlighted the linkage between A/R, biomass energy and forest protection. The afforestation of today will meet the bioenergy needs of tomorrow. Without an appropriate level of afforestation, the growing bioenergy needs will have to be met by withdrawals from existing stocks, which will negate the climate benefits of switching from fossil fuels to bioenergy and compound the deforestation, degradation and devegetation problem. Avoided Deforestation The greatest challenge to the LULUCF sector is deforestation. Avoided deforestation is not eligible under the current Kyoto Protocol framework, and rules governing any crediting or valuation of this activity are many years away. Testing A/R projects will build experience on how to value ecosystem services and sustainable land use —essential components of avoided deforestation. Furthermore, by generating timber, fuelwood and other forest products, A/R projects typically reduce deforestation pressure on existing forests. Therefore, experience with these projects now will lead to more informed and productive discussions on how to tackle the bigger problem of deforestation. In light of this, it makes good sense for the EU to include A/R credits in the ETS before deciding which incentive structure might be most appropriate for reducing deforestation. The Objective of the EU ETS The question was raised whether investments in forestry projects may deter investments in energy efficiency and fuel switching within Europe, thereby defeating the main objective of the ETS. In fact, this question applies not only to LULUCF, but to any investment in CDM or JI. The prime rationale for providing flexibility is to minimize the costs of meeting the EU ETS emission reductions objective. However, if there is a credible signal that the constraint on emissions is not likely to go away, and in fact likely to become tighter in the future, firms have a strong interest in reducing their domestic emissions. Investing into JI and CDM projects allows them to do so at the time it is more efficient, for example when long-lived capital is scheduled to be replaced. While prices of CERs and ERUs are likely to come close to those of EU allowances in the future, temporary credits will continue to be priced at a discount because they need to be replaced. Using temporary LULUCF credits helps certain operators gain time until their investments are economically justified. 5 A private entity using a temporary credit would be required to replace the credit upon expiration. When it undertakes the necessary investments into energy efficiency measures it frees up the allowances to “pay back” its credit liabilities. Using temporary credits would never release an operator from its liabilities; it would merely allow it to buy time. Allowing the use of temporary credits therefore responds to one of the most commonly expressed concerns of industry regarding the EU ETS, namely that the allocation periods are too short to trigger the required investments in energy efficiency and fuel switching measures. Replacement Obligation 5 For example, if an operator plans to replace a coal-fired boiler with a gas-fired boiler to reduce its emissions, it will be unlikely to do so before the old boiler has reached the end of its economic lifetime. Thus, if the boiler is scheduled for replacement in 5 years, the firm can elect to buy temporary credits (tCER) to cover this liability, and replace these tCERs at the time it invests in the new gas-fired boiler. The allowances that the firm would have otherwise used can now be released to another firm with a more immediate need for allowances, or the system can simply include fewer allowances. This flexible system makes it possible to allocate allowances more efficiently across the economy and limit the economic costs while achieving the same environmental benefits. Page 5 5 A government that uses tCERs or lCERs to meet its Kyoto obligations will be liable for their replacement. This liability is a serious issue for governments, particularly if they also chose to allow the private sector to use tCERs or lCERs. Analysis was performed on three possible ways for a government to deal with this liability: (1) Member States could require private users to surrender more tCERs or lCERs than required, and then manage the resulting liability themselves; (2) Member States could charge a fee (or premium) to private sector users; or (3) Member States could simply pass the replacement liability onto the operator that uses them. The economic modeling found that a Member State would need to charge a high surrender ratio or fee to comfortably reduce its risk. This is because it would be very difficult for a Member State to assess the replacement risk and calculate an appropriate surrender ratio or fee. On the other hand, factoring in the replacement costs is relatively easy to manage for the private sector, in particular where the private sector can count the benefits of purchasing temporary credits against investments and emission reductions realized in the future. For this reason, of the three scenarios examined, transferring the replacement liability onto the private sector user is the safest and least risk way for a Member State to mitigate the replacement liability since the private firms that will buy the temporary credits are better informed about (and better able to influence) the risks involved in the projects. Legal Issues The workshop also discussed the legal and transactional scenarios of how LULUCF credits could be used in the EU ETS. These include: (1) amending the EU ETS; (2) swapping LULUCF credits with allowances from a dedicated reserve account set aside under national allocation plans; or (3) through independent contracts between Member States and the private sector involving an exchange of LULUCF credits (such as tCERs) for permanent credits (such as CERs or ERUs). At the request of the participants, the legal experts at Climate Focus drafted an amendment to Directive 2003/87/EC, which would make it possible to include LULUCF in the EU ETS (see the draft amendment in Annex 3). Workshop participants insisted that they were not in a position to endorse or refute the proposed amendment, and that they participated in the workshop in their personal capacities without representing the official position of their respective countries or organizations. However, as a group, the workshop participants expressed the desire to continue to discuss inclusion based on this concrete proposal. Next Steps and Broadening Input The World Bank was requested to continue facilitating the discussion by providing technical input and helping organize follow-up meetings. It is proposed that another meeting on the theme of inclusion be organized in the fall of 2006 in Brussels, where a broad range of stakeholders, including NGOs, private firms and industry groups, would be invited to participate. In the meantime, all the presentations and background papers from the workshop, together with the videotaped message by Prof. Wangari Maathai, have been posted on the BioCarbon Fund’s website ( http://carbonfinance.org/Router.cfm?Page=BioCF&FID=9708&ItemID=9708&ft=FeaturedReso urces&FeatResID=26935 ). Last revised April 18, 2006 Page 6 6 Annex 1 Workshop Agenda 1 0:00 Welcome ƒ Stephan Roman, British Council 10:10 Introductory Remarks ƒ Gerhard Dieterle, World Bank ƒ Henry Derwent, Department for Environment, Food and Rural Affairs, United Kingdom ƒ Teresa Ribera, Ministry of Environment, Spain ƒ Jean-Claude Gazeau, Interministerial Task-Force for Climate Change, France ƒ Maurits Henkemans, Ministry of Economic Affairs, The Netherlands 10:35 The Current Framework for Land Use, Land-Use Change and Forestry (LULUCF) ƒ The Kyoto Protocol: Clean Development Mechanism and Joint Implementation (Valérie Merckx, Office National des Forêts, France) ƒ Approval of Methodologies for CDM projects (Bernhard Schlamadinger, Joanneum Research, Austria) ƒ The EU ETS (Bas Clabbers, Ministry of Agriculture, Nature and Food Quality, The Netherlands) ƒ Questions & Answers 11:15 Views from the European Parliament ƒ Anders Wijkman, European Parliament ƒ Carl Schlyter, European Parliament 11:45 The View of the European Commission ƒ Artur Runge-Metzger, Environment Directorate-General 12:00 Views from Member States ƒ Henry Derwent, United Kingdom ƒ Teresa Ribera, Spain ƒ Jean-Claude Gazeau, France ƒ Maurits Henkemans, The Netherlands ƒ Antonio Lumicisi, Italy 12:45 Lunch on site 13:30 Social and Environmental Benefits of Afforestation/Reforestation Projects ƒ An African Perspective (Prof. Wangari Maathai, Green Belt Movement, Kenya – taped message) ƒ A Latin American Perspective (Henri Kistler, Ministry of Finance, Brazil) ƒ Experience with A/R Projects to Date (Benoît Bosquet, World Bank) ƒ A Screening Tool for A/R Projects (Toby Janson-Smith, Climate, Community and Biodiversity Alliance) ƒ A/R and Bioenergy (Bernhard Schlamadinger, Joanneum Research) ƒ Questions & Answers 14:30 Technical Solutions to Inclusion of A/R Credits in the EU ETS ƒ Three Scenarios: A Legal Analysis (Charlotte Streck, Climate Focus) ƒ The Replacement Question (Franck Lecocq, Ecole Nationale du Génie Rural, des Eaux et des Forêts) ƒ Questions & Answers 15:15 Coffee break 15:30 What Next? Inclusion in the EU ETS? When? Continued Exclusion? Why? ƒ Roundtable discussion moderated by Richard Burge (Kimberley Burge) 17:00 Reception Page 7 7 Annex 2 List of Workshop Participants Mr Alain Bellot Ministry of Finance Luxembourg Mr Benoit Bosquet World Bank USA Mr Matthias Braun Ministry of Environment Austria Mr Richard Burge Kimberley Burge United Kingdom Mr Bas Clabbers Ministry of Agriculture, Nature and Food Quality The Netherlands Mr Stéphane Couture Ecole Nationale du Génie Rural, des Eaux et des Forêts France Ms Claudia Croce Ministry for the Environment and Territory Italy Mr Henry Derwent Department for Environment, Food and Rural Affairs United Kingdom Mr Gerhard Dieterle World Bank USA Mr Thomas Frisch Ministry of Economics and Labour Germany Mr Jean-Claude Gazeau Mission Interministérielle de l’Effet de Serre France Mr Hervé Gouget British Council Belgium Mr Heikki Granholm Ministry of Agriculture and Forestry Finland Mr Maurits Henkemans Ministry of Economic Affairs The Netherlands Mr Greg Janetos Sustainable Forestry Management United Kingdom Mr Toby Janson-Smith Climate, Community and Biodiversity Alliance USA Mr Henri Kistler Ministry of Finance Brazil Mr Franck Lecocq Ecole Nationale du Génie Rural, des Eaux et des Forêts France Mr Antonio Lumicisi Ministry for the Environment and Territory Italy Mr Oscar Mascagni EuropeAid, European Commission Belgium Ms Valerie Merckx Office National des Forêts France Mr Klas Osterberg Environment Protection Agency Sweden Mr Robert O'Sullivan Climate Focus The Netherlands Mr Jim Penman Department for Environment, Food and Rural Affairs United Kingdom Mr Zoltan Rakonczai DG Environment, European Commission Belgium Ms Teresa Ribera Climate Change Office, Ministry of Environment Spain Mr Stephan Roman British Council Belgium Ms Flavia Rosembuj World Bank USA Mr Artur Runge-Metzger DG Environment, European Commission Belgium Mr Bernhard Schlamadinger Joanneum Research Austria Mr Carl Schlyter European Parliament Belgium Mr Joachim Schnurr GFA Consulting Group Germany Mr Tom Spencer Institute for Environmental Security United Kingdom Ms Mirjam Stegmann GFA Consulting Group Germany Ms Charlotte Streck Climate Focus The Netherlands Mr Anders Wijkman European Parliament Belgium Mr Tomasz Wojcik State Forest Agency Poland Page 8 8 Annex 3 Proposed Amendment Directive 2003/87/EC is hereby amended as follows: Amendment 1: Amend Article 3 on definitions to add para (o): (o) “temporary certified emission reduction” or “tCER” means a unit issued from afforestation or reforestation project activities and will expire at the end of the commitment period following the one during which it was issued pursuant to Article 12 of the Kyoto Protocol and the decisions adopted pursuant to the UNFCCC or the Kyoto Protocol. Amendment 2: Delete Article 11a(3)(b) and renumber. (Removes ban on use of LULUCF credits in EU ETS) Amendment 3: Add new Article 11(a)(4): An operator that has used a tCER shall surrender a CER, [tCER] ERU, or allowance at least 30 days before the tCER expires to cover the emissions which had been covered by the expired tCER. If the operator has not replaced any tCERs it has used to cover its emissions by the time it expires, the operator shall be held liable for the payment of the excess emissions penalty in accordance with Article 16. (Institutes operator liability for replacement of temporary credits). [The explanation of the proposed amendment will be circulated separately by Climate Focus.]