Credit Where Credit’s Due: Understanding the Clean Development Mechanism

The Clean Development Mechanism (CDM) is a child of the Kyoto Protocol, the climate treaty that the U.S. did not ultimately ratify. As a result of that failure, many of those in the U.S are not familiar with the CDM, and the opportunities it offers to us and those in developing countries.

But perhaps we should be more informed. Some sort of cap and trade for carbon is coming to the U.S., and we may soon be part of a global system of cap and trade, creating new restrictions and new opportunities. To understand these new realities, one place to start is with a fly-over of the Clean Development Mechanisms (CDM).

CDM Revealed

Under Kyoto, signatories among the developed nations have carbon caps allocated to them. In turn, within these countries, these caps are allocated to — greenhouse gas or GHG emissions limits are placed upon — certain industries and companies. Companies report and are monitored, and for every tonne (CO2 equivalent) of emissions that is above the allowance, a penalty of 100 Euro [US $147] is paid.

That’s the “cap” part of cap and trade, or at least it is within the European Trading Scheme (ETS), the system in Europe that has grown out of Kyoto. The “trade” part shows up in a number of places. For example, if a company is emitting less than it is allocated, it can sell the difference. Likewise, in a Clean Development Mechanism project, money is invested in developing nations to effect a proven reduction in GHG emissions. The reductions can then be sold back to companies in the developed nations.

Suppose, for example, a solar oven is provided to a poor family somewhere in China. A consortium of NGOs, or private funding might pay for the oven — one of thousands in this imaginary project. Whereas before the oven was provided, that family might have gathered firewood for cooking, after the oven was provided, it would gather less, because some meals could be cooked in the solar oven. Where some portion of the wood previously used was “non-renewable biomass” — where, for example more wood is gathered and burned than can be re-grown, leading to deforestation and an increase in atmospheric CO2 — then those emissions will no longer be produced, post solar oven.

The difference between before and after is verified, and those savings are recognized by the UNFCCC, the United Nations Framework Convention on Climate Change, an agency which issues carbon credits that can be sold or traded to a private party, a government, or an entity such as the World Bank, monetizing the GHG savings.

And that’s CDM, in brief: effecting a reduction in GHG production in developing nations, proving that reduction, and selling it to the developed nations.

Does CDM Pencil Out?

And why would a funder engage in CDM? One answer to that is found in a document produced for a recent CDM project in India:

“In a country with half a billion cows, the conservative biogas potential could be around 25 million biogas plants generating 125 million [carbon credits] per annum.”
— PDD for Bagepalli CDM Biogas Programme

In this Indian project, 18,000 biogas digesters were proposed, but it might have been a small hydroelectric dam, or some similar GHG-reducing project. An analysis of the project documents, which must, under CDM rules, be publically available, shows that conservatively, the biogas project would regain its costs in a bit more than four years. The crediting period — the time during which the credits will continue to be issued — can be up to 21 years.

Other projects have different economics, and each would have to be evaluated on its own merits. In a yet-to-be funded biogas project we are currently developing for Sri Lanka, we will be using a digester design that is less than half the cost of the most popular model, which of course has a significant positive impact on project cost and rate of return.

Most experts assert that the value of these credits will increase over time. In sum, very good returns are possible, and in practice, CDM has proven to be a robust source of funding for thousands of projects.

The Character of CDM

While CDM offers interesting possibilities, potential project developers need to understand that CDM is (and must be) a strongly bureaucratic process. A carbon credit is a kind of currency, issued according to a process that is designed to offer a reasonable return in the majority of cases, while achieving certain goals.

When dealing with projects within CDM, certain ordinary market mechanisms that we might rely on to regulate things are essentially absent. Consider that those who are paying for a CDM project and those who are benefitting from a CDM project both gain where the number of carbon credits is higher. The project developers gain more credits, and the project beneficiaries — the folks that get the ovens or digesters — gain because those benefits are more certain where the number of carbon credits is larger. Therefore the third party to the transaction — the UNFCCC — has to have mechanisms in place to insure that the GHG reductions claimed are real, would not have been realized absent CDM funding, and that reductions made in one place do not cause increases in emissions somewhere else.

Consider too that the only reason that these carbon credits have any value is the same reason that any currency has value: trust. People trust that a bit of paper — or in this case, some bits in a computer — have value. Absent that trust, neither paper nor bits have any value. The issuer must be fair, as transparent as possible, evenhanded, it must insure that reductions are real — and it must accomplish all these things and more in a manner that is not too costly for project developers. The mechanisms have to be applied in a reasonably equal manner across projects, which is obviously in practice a very difficult thing to do.

All of this means that the CDM process necessarily has a certain character, and to be successful in applying for CDM credits, it is essential to understand that character.

To crystallize it, CDM carbon credits result from a regulatory process that is necessarily deeply concerned with precedent. Did it that way last time? Do it that same way this time.

Many people hate bureaucracy — Americans are famous for their love of freedom and suspicion of authority — but in fact if you understand the beast, then you can tame it, and it can work to your advantage. If, by contrast, you can’t get past a loathing for paperwork, then unless you also enjoy being miserable you should not pursue CDM projects — or unless you hire someone else to sweat the paperwork.

2012: Brick Wall or Spring Board?

Finally we should mention 2012. That is the year the Kyoto Protocol sunsets, and some fear that all structures under its umbrella will be folded up and swept away. A CDM project may take two years from concept to issuance of first credits, and this timing, coupled with the uncertainty about a new international agreement, has caused a recent reduction in project registrations.

All true: yet nearly all experts seem certain that there will be a new agreement, although it will not happen this year. Further, because of the enormous value of the lessons learned and the promises made — the annual market for carbon credits is 125 billion dollars, presently — it seems an easy bet that carbon credits established under Kyoto will be recognized under any new regime. (And if it is not, trust, which is the matrix of value, will suffer, suppressing prices going forward.)

Finally, with the United States becoming party thereto, many companies are likely to be caught without their carbon house in order. Thus a far larger demand for traded credits can be visualized, precisely in the timeframe when projects starting now will have their first credits issued.

Is it a good time to begin a CDM project? You be the judge.  

David William House has had a varied career, as his consulting website shows. He is the author of The Complete Biogas Handbook, said by some to be the bible of biogas, and he presently earns his daily bread as he has done, in various jobs, for a number of years: He solves interesting and complex problems for complex and interesting people.

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