Dian Phylipsen, Edgar Hernán Cruz Martínez and Monique Voogt, SQ Consult
Renewable energy (RE) is widely seen as a worth wile cause to support as a society. One important reason for this is its strong potential contribution to meeting climate change targets as it has been recently reiterated in the European Commission’s Roadmap to a low-carbon economy in 2050. The Roadmap foresees a strong role of renewable energy as well as the recent IPCC special report on Renewable Energy Sources and Climate Change Mitigation. This is however not the only reason to be supportive of renewable energy. It can also contribute to other important policy objectives, such as increasing the security of energy supply, reducing the dependence on imported energy sources, increasing access for users via a more distributed energy supply and reducing other environmental, health and safety risks associated with some of the other energy sources available.
Current carbon markets provide insufficient incentives for renewables
When the Kyoto mechanisms (especially JI, CDM) were introduced as a first step towards a global carbon market, hopes were high regarding the positive impact that these mechanisms could have on the uptake of renewable energy technologies across the world. However, the results have been rather modest in terms of realised new capacity as the role of renewable energy projects in CDM and JI has remained limited (see Text box). Also, the carbon price in the EU Emissions Trading system – the largest mandatory cap-and-trade system in the world – is too low illustrated by the various plans to build new coal-fired power plants in the EU. It is only fair, however, to emphasise that both CDM/JI and emissions trading were designed as market mechanisms. In this respect, it should not come as a surprise that investment decisions are based on cost efficiency considerations. Renewable energy as such is increasing around the world, but this is largely attributable to dedicated renewable energy policies.
Although renewable energy projects account for a large share of the number of CDM projects (around 60%), their share in generated credits amounts to only 13%. In JI, the RE contribution is even lower (6% of the total amount of ERUs issued so far). This is due to the generally smaller size of RE projects (in terms of credit generation) compared to CDM projects that for example focus on methane avoidance or emission reduction of industrial gases.
The share of RE projects under the CDM has been increasing in recent years, but renewable energy projects are usually still more expensive per generated carbon credit than other emission reduction projects, i.e. a larger carbon price incentive would be needed to make RE projects attractive under the CDM. In addition, transaction costs can be relatively high for CDM projects due to complex requirements in e.g. baseline development and the small project size.
Tweaking existing mechanisms to support renewables
Various ‘fixes’ have been attempted over time to strengthen the role carbon markets, and especially CDM, can play in stimulating the uptake of renewable energy. This includes the so-called ‘positive list’ of technologies eligible in CDM , the development of rules and modalities for micro small-scale CDM projects (aimed to reduce transaction costs for small projects), the development of the Gold Standard and other high quality labels that highlight projects with a stronger contribution to sustainable development, qualitative limitations to the type of credits accepted in trading systems (or funds), such as the ban on projects reducing industrial gases in the EU ETS and the establishment of Programmes of Activities, aimed at lowering transaction cost for distributed projects and reducing additionality issues when project implementation rates increase in a country. Also CDM host countries have implemented preferential treatments for RE projects. China and Malaysia for instance have given priority to RE projects in their CDM programs, and in the case of China has even strongly lowered transaction costs for these projects. China also introduced variable tax levels on the proceeds of credit sales, where RE projects are taxed at 1-2% while HFC-23 projects are taxed at 65%.
However, so far experiences indicate that:
- Other emission reduction projects benefit more strongly from the carbon price incentive provided by JI/CDM than renewable energy projects;
- The carbon price incentive is insufficient for promoting renewable energy on a large enough scale;
- The benefits of the carbon price are only felt in a relatively small number of countries.
- An explanation for the observed effects can be found in the following barriers facing RE projects:
- Renewable energy projects often face higher investment costs while generating a lower amount of credits when compared to other reduction projects such as industrial gases and landfill projects. Where low-cost credits are available in abundance, RE projects are largely pushed out of the CDM market;
- Renewable energy projects often have a considerable longer economic lifespan than most other emission reduction projects. Wind power for instance has an economic lifespan of 10-15 years, hydropower and geothermal energy even up to 30 years, while for other projects this is considerably shorter. This means that the political uncertainty on the future of CDM after 2012 affects RE projects more strongly than others;
- Renewable energy projects are more dependent on a stable local policy environment than more established technologies. This legislative uncertainty adds to the financial risks as perceived by investors, resulting in a preference for more conventional investments;
- Transaction costs on the carbon market are relatively high for the smaller-sized RE projects.
Taking a step back
In light of the above, it is time to take a step back and ask ourselves the question whether a carbon price can or should be the only incentive to achieve a sufficiently large uptake of renewable energy. The potential ‘fixes’ discussed above only address these issues to a certain extent. Small scale procedures and Programmes of Activities can reduce transaction costs, and the latter can improve eligibility of renewable energy projects in terms of additionality. However, neither can address the relatively high cost of emission reduction credits of renewable energy projects. Qualitative bans on certain types of credits helps in limiting the flood of cheap credits that compete with those from renewable energy projects, but they are only applied on a limited scale.
While the above fixes can help reduce some of the barriers to renewable energy under the CDM, it is insufficient to achieve a sufficiently large-scale deployment of renewable energy. New types of measures may therefore be needed to achieve large-scale deployment of renewable energy, where the price competition between RE projects and other emission reduction options is less an issue.
Alternative mechanisms to promote renewable energy
Alternative mechanisms such as a separate global trading mechanism for RE projects, hybrid systems or NAMAs could provide a better solution for RE projects. These alternative mechanisms would either create a separate carbon market for RE projects or improve the competitive position of RE projects compared to other projects. Efforts to limit cheaper credits and offer premium prices for RE credits did not bring the expected results as they were either too small in scope or mostly of a voluntary nature. Turning these approaches into an obligation would certainly help. An example would be to include a minimum share of RE projects in a post-Kyoto deal, but achieving such an agreement at a global level is quite a challenge.
Introduction of a separate global trading mechanism such as a renewable energy certificate scheme would avoid competition with non-renewable energy projects altogether and could be more successful, especially if attributes of RE projects other than emission reductions would also be valued in such schemes. A one-way fungibility between a renewable certificate scheme and the GHG markets could allow for renewables to count against GHG reduction targets. Another option would be to introduce hybrid systems such as the New South Wales GGAS system in which greenhouse gas abatement certificates as well as green certificates are allowed to be used against the agreed targets. An alternative route could be based on the carbon offsets that are allowed in various emissions trading schemes to meet part of the obligations. As these systems are national or regional systems they can in principle determine their own rules and requirements for accepted credits. Potential options to support RE development via this route would be to limit the type of eligible credits to those of RE projects or to adopt preferential treatment of RE projects.
Starting from the notion that RE projects serve more than the goal of GHG mitigation the multiple benefits could represent a financial value to parties in different crediting schemes. For instance the value of GHG reduction for parties operating in carbon markets, a value of increasing access to energy for a national government and the value of improving local air quality for a local government. By selling the various benefits of a RE project in different schemes an investor could ‘stack’ the various credits and therewith access additional funds.
Finally the various mechanisms discussed under a post-2012 climate agreement may offer additional development potential for RE projects. In the so-called ‘NAMAs’ (National Appropriate Mitigation Actions, a developing country commits voluntarily to emission reductions, which may be supported by international climate finance (‘internationally supported NAMAs’) and potentially accepted in carbon market schemes (‘credited NAMAs’). Whereas these NAMAs were designed to accelerate developing country participation in global GHG reductions, they allow the host countries to build upon nationally preferred projects and hence can also provide a basis for stimulating RE projects in these countries if such a preference for RE development exists. Funders and credit buyers could have a stronger preference for more sustainable NAMAs, especially in case this will be decided by a different type of funder/financier (multilateral banks, national governments). Currently, developing countries are preparing or have announced NAMAs and national strategies for RE that aim to be fully compatible to access international climate finance (e.g. Brazil, Mexico and India).
For all alternatives discussed a careful design is a pre-condition, securing environmental integrity and transparency, while avoiding perverse incentives and windfall profits.