Perverse Incentives in the Clean Development Mechanism: How Corporations and States can Circumvent Carbon Market Regulations

            On December 11, 1997 the Kyoto Protocol was initially adopted and on February 16, 2005 it entered into force.  The point of the Kyoto Protocol was to create an international regime that would multilaterally reduce greenhouse gas emissions.  Overall, the Protocol was a platform from which emissions reductions were supposed to happen.  In order to assist developing countries in continuing industrialization and modernization, and ease the burden of emissions reductions on developed countries, mechanisms were added to the Kyoto Protocol.  The Clean Development Mechanism (CDM) and Joint Implementation (JI) have allowed countries to continue emitting if they reduce future emissions through development projects that support tertiary sustainable development.  In some cases however, this has not reduced total emissions but created a situation where any company which emits GHGs under the jurisdiction of the Kyoto Protocol can rely on offsets to continue emitting GHGs on the same level or even increase emissions.  This situation is known as a perverse incentive, where the incentive to fund the sustainable development project comes from increased profits or rewards which work against or undermine the purpose of the CDM, Kyoto Protocol, and (in this case) climate change mitigation in general. Recently it has come to light that various European corporations and Western banks have been taking advantage of a perverse incentive within the CDM via HFC-23 destruction.  This has produced larger than normal emissions reductions for European corporations and substantial profits for HCFC-22 producers and their financiers.  As a result stricter regulations, credit allotment methodology, and oversight are needed to ensure such practices do not continue.  The integrity of the European Union Emissions Trading System, the Clean Development Mechanism, and the Kyoto Protocol rely on this.

            With this in mind, the CDM focuses on one of the most tenuous points in the establishment and implementation of international emissions reductions.  There is constant disagreement over the quantity of emissions reductions developed countries should make compared to developing countries.  Since the industrial revolution developed countries have been burning fossil fuels like coal and oil to provide energy and transportation for their societies.  The entire structure of Western society, our technology and standard of living, are built upon our historical emissions of greenhouse gases.  So, the argument goes that since developed countries have already had the opportunity to increase their standard of living, which they have done so, and as a result climate change is now happening, the burden of mitigation should fall upon the wealthy developed countries (United Nations 11).  This does not sit well with critics of the CDM because it would allow developing countries to continue polluting, possibly hindering American economic growth by necessitating a sudden large reduction in emissions or expensive retrofits.  There is a possibility such actions would give growing economies like China and India a leg up on the US since they would not have to make the same investments in GHG emissions.  The result of the negotiations for the Kyoto Protocol was a history-making egalitarian approach to emissions reductions aimed at allowing developing countries to continue expanding their economies.  A central component in this process was the CDM.

            The CDM is one of the most contested elements of the Kyoto Protocol.  In contrast to Joint Implementation, which allows for the creation of Certified Emission Reduction credits (CERs) through the funding of projects in developed countries, the CDM allows entities in developed countries to use CERs created in developing countries to limit the amount of emissions reductions they have to make.  They can do this by either funding retrofit or other emissions reduction projects in a developing country and having that project become certified by the United Nations Framework Convention on Climate Change (UNFCCC), through the CDM Executive Board (EB), or by buying CERs from projects that are already underway and certified.  In this way, developed countries are supposed to help in the creation of a sustainable economy in developing countries while easing the burden of emissions reductions in their home nations (CDM web).

            There is one central problem with the carbon markets however, in particular the European Trading System.  Carbon markets may not reduce total emissions; they may simply slow down the rate of GHG emissions growth.  There can be perverse incentives created through the carbon markets that either increase emissions, prevent the enforcement of emissions reduction goals, or both.  These problems pose major questions about the usefulness of carbon markets as emissions reduction tools.  Can the markets be regulated to an extent that prevents them from being subverted?  Are they only a step towards more stringent restrictions that can actually reduce emissions to levels that will prevent irreversible climate change?

            With the creation of the CDM two goals were set forth.  First, the mechanism was supposed to foster sustainable development in the developing world.  Second, it should provide a cost-effective means of reducing carbon emissions in developed countries.  There are clear trade-offs between sustainable development as a result of CDM programs and profit maximization for investors (CDM 65).  Since the CDM is a market mechanism there is an inevitable trend towards profit optimization.  When the types of registered projects are broken down by quantity projects focusing on sustainable development far outweigh the number of projects involving cost-effective carbon emission mitigation (CDM 61).  Investment in emission mitigation is more lucrative however, so the volume of credits dispensed for the small number of emission mitigation projects far outweighs those for the sustainable development ones (CDM 61).  For instance, HFC destruction projects, the topic of this paper, account for 34% of the CERs allotted annually while biomass projects, which account for 22% of all registered projects, receive 7% of a year’s credits (CDM 61).  Another common criticism of the CDM is that additionality is not adequately addressed.  Additionality refers to when revenue or emissions are created from a CDM project that would not have been there if the mechanism had not been introduced.  In the case of HFC destruction this is especially pertinent.

            Allowing HCFC-22 production to become a CDM project created both additionalities, making it a perfect example of how additionality works and is persistent despite regulators being aware of its presence.  Without the inclusion of HCFC-22 manufacturing within the CDM abatement of HFC-23 would not take place.  With abatement however, came overproduction of emissions, both HFC-23 and the European emissions provided by the sale of CERs, and also added revenue because the sale of CERs costs substantially more than the production and sale of HCFC-22.  One possible reason for this is that the CDM EB felt forced into a position where it has to distribute credits in order to institute abatement in the first place.  However, in actuality the process produced more carbon emissions than would have been present to begin with.  This constitutes the major perverse incentive within the CDM.

With the advent of the Montreal Protocol, which entered into force on January 1st, 1989 to stem the manufacture and release of chlorofluorocarbons (CFCs), HCFCs were determined to be a suitable replacement to CFCs.    CFCs were widely used as refrigerants when, in the 1980s, it was discovered that they collected in the upper atmosphere around the poles.  There the gas reacted with the ozone layer destroying the molecules of O3 and allowing increased amounts of UV radiation to reach Earth’s surface.  Although HCFCs are an adequate replacement as a refrigerant they are also a greenhouse gas.  Many HCFC-22 plants, especially in the developing world, would vent the production byproduct of HCFC-22, another greenhouse gas named HFC-22, into the air.  One may wonder why this is a problem since the climate change debate centers around carbon dioxide, nitrous oxide, and methane emissions.  HFCs and HCFCs are more potent GHGs than the other aforementioned GHGs, they are just not produced in large enough quantities to foster much public attention.  Their global warming potential (GWP) however is very high.  HCFC-22, the refrigerant, has a GWP of 1,810, which means that one ton of HCFC-22 would warm the atmosphere as much as 1,810 additional tons of CO2.  The lifespan if HCFC-22 is only 12 years though so its effects are not nearly as long-lived as the byproduct of its manufacture, HFC-23.  HFC-23 has a GWP of 14,800.  Additionally, HFC-23 has an atmospheric lifespan of 270 years (Forster 212).   These makes HFC-23 an incredibly potent greenhouse gas and its emissions must be subject to strict regulation.

            Being that HFC-23 is such a potent GHG, the structure for the awarding of credits for the destruction of HFC-23 is very important.  By July 2010 there were 19 HFC-23 decomposition projects registered with the CDM, of which 11 are located in China.  This is important for China in particular because the Chinese government “substantially taxes the sale of HFC credits” (Walravens 2), As a result, the methodology governing the manufacture of HCFC-22 and the allotment of CERs deserves special attention.  Firstly, the HFC-23/HCFC-22 ratio is capped at the lower value between 3% and the lowest annual value “observed in the three-year historical period between 2000 and 2004” (Schneider, 2011).  Second, HCFC-22 production is capped at “the maximum historical …production in the most recent three years within the period from 2000 to 2004, including an equivalent amount of CFC production in the case of swing plants that can produce HCFCs or CFCs” (Schneider, 2011).  So, if there are production caps why is there reason to think that through the production of HCFC-22 there is a perverse incentive that is benefiting HCFC-22 producers and European financiers?

            The cost of producing HCFC-22 is miniscule.  In 2008 the market price of HCFC-22 dropped from 15 thousand RMB per ton to 8 thousand RMB per ton, cutting the cost in half.  Historically, this was HCFC-22’s lowest price (Schneider, 2011).  This is much lower than the cost of a CER on the European Union Emissions Trading Scheme (EU ETS).  According to the Environmental Investigation Agency, a small environmental NGO based in London that has been essential in bringing this issue to light, “CERs on the EU ETS…can easily command as much as €12, some 70 times more than it costs to destroy the gas” (Walravens 2).  This gives producers of HCFC-22 an enormous incentive to over manufacture the gas just to earn revenue off of selling CERs on the ETS.  So how can this be proven?

            The caps on HCFC-22 production are regularly disregarded bringing in excess revenue for a certain period of time.  Most producers hover around producing 100% or a little over 100% of the limit.  This would seem abnormal on the surface, but would not give regulators a reason for further inquiry since the caps were designed for the producers to meet those production limits.  However, once some factories hit the point in production where they will stop earning credits for the destruction of additional HFC-23, they slow production considerably or stop all together.  For instance, for CDM project 767 production hovered around 18 tons of HCFC-22 per day for most of the 2007-2008 regulatory year, until they received their maximum allotment of credits. Once the limit was reached, production dropped to zero and the plant closed for the remainder of the year.  The plant reopened on May 1^st of the new crediting period.  When the regulatory period started, the plant produced HCFC-22 again (Ethically 9).  In other plants the HFC-23/HCFC-22 ratio went down during non-crediting periods.  CDM project 1105 had a HFC-23/HCFC-22 ratio of 2-2.25% during periods when credits were being allotted for HFC-23 destruction.  As soon as the project had reached its credit limit the HFC-23/HCFC-22 ratio dropped to 1.1%, and as the new allotment period began the ratio went up again.  The same occurrence was evident with project 151.  Throughout 2007 and 2008 the HFC-23/HCFC-22 ratio fluctuated between 2.7 and 2.98%.  At the end of the allotment period the ratio dropped to 1.8%, only to be raised once credits were reinstated (Schneider, 2011). 

            In all, twelve CDM plants ceased producing HCFC-22 once they reached had reached their cap and credits for HFC-23 were no longer being dispersed and six HCFC-22 facilities surpassed their HCFC-22 cap (Ethically 8).  As a result, excess GHGs with GWPs thousands of times greater than carbon dioxide have been produced and either sold as refrigerant, or because it is excess, vented into the atmosphere.  This is not the only evidence that should lead one to believe there has been malfeasance on the part of HCFC-22 manufacturers.  During a period when HCFCs are supposed to be being phased out, as a result of provisions within the Montreal Protocol regarding its potential to further ozone degradation, there has been a drop in the HCFCs price.  Generally one would think that an increase in price would follow an increase in demand.  However, as a result of HCFCs being phased out appliance manufacturers are finding alternative refrigerants so as to not worry about compliance issues in the future.  HCFC-22 production has gone up though while prices have gone down, indicating that HCFC-22 was being produced for a market that didn’t exist.  This is in direct contradiction to Article 12 of the Kyoto Protocol which “requires that emissions reduction CDM projects be real, measurable, and additional” (Schneider, 2011).  In doing this HCFC-22 manufacturers have skewed the ETS to an incredible extent and have defeated the whole point of the market.  The market is supposed to replace supposed future emissions in developing countries with abatement or renewable energy projects, and transfer that reduction in future emissions to developed countries which already have unsustainable infrastructure, so they can keep emitting while being assured they have maintained a minimum of greenhouse gas cuts.  By flooding the market with CERs HCFC-22 manufacturers have allowed European corporations and businesses to continue polluting at a rate far above what they should have been allowed to do.  This is especially true because of the enormous amount of credits the thermal oxidation of one ton of HFC-23 brings in.

            Finally, the most blatant red flag of this whole ordeal is the make up of the ETS itself.  Due to the high GWP of HFC-23 “11,700 CERs are issued for the abatement of just one tonne of" the gas (Walravens 2).  As mentioned before the high rate of return on sales of CERs from HFC-23 destruction is enough to more than make up for production costs of HCFC-22.  What’s more surprising however, and should cause one to question the CDM EB’s oversight abilities, is the ratio of CERs in the ETS derived from HFC-23 destruction.  “While HFC-23 decomposition projects represent just 2.5% of the CDM projects that have CERs issued so far, they account for 214 million of the 407 million credits issued (52.6%)” (Walravens 2).  Over half of all credits issued have been for HFC-23 destruction.  This is an enormous oversight on the part of those charged with regulating the CDM and warrants a closer look at who stands to benefit from the profiteering besides the HCFC-22 manufacturers.

            One entity that stands to benefit from additional HFC-23 destruction is the World Bank.  The World Bank was established to fund development projects around the world after World War Two, focusing primarily on formerly war torn regions.  Recently however, the primary recipients of its loans have been developing countries and, with climate change growing in importance, sustainable development is beginning to play a large role in its business model.  “The World Bank’s Umbrella Carbon Facility is invested in two of the most lucrative HFC-23 incineration projects.  In 2006, the Carbon Facility contracted to purchase almost 130 million CERs, worth 775 million Euros (US $980 million) from two HFC-23 incineration projects in China” (Ethically 1).  In light of their investment, when the CDM methodology was called into question as a result of the aforementioned abuses the World Bank came to the defense of the HFC-23 projects.  On August 5, 2010 the bank posted a five page Q&A on investing in HFC-23 destruction to its website.  In the document they deny that there is the possibility of perverse incentives being created by the allotment of credits for burning HFC-23.  The document does not address the issue of plant shut-down in the event of achieving its credit allotment despite the fact that the Environmental Investigation Agency and other independent reviews have documented this behavior at at least twelve sites.  Their main point seems to be that Chinese HCFC-22 manufacturers are not and can not make a profit off of burning HFC-23 and receiving CERs for it.  Firstly, they “point out that revenues from CDM do not exceed the revenues associated with HCFC-22 itself” and “in China, where the majority of the projects are located, the government has established a Clean Development Mechanism Fund to use the income from the sale of CERs” (World Bank 4).  The Chinese government “taxes 65% of the CER revenues” which is transferred to the nation’s CDM fund for investment in climate change activities (World Bank 4).  With regards to whether phase-out under the Montreal Protocol should have an immediate effect on HCFC-22 production, the document states that the Protocol does not affect the manufacturing of the gas for use as feedstock to create products like Teflon (World Bank 4).  As a result the World Bank states that demand for HCFC-22 is going up and therefore rising levels of credits diverted to HCFC-22 projects is normal.  They do not however address the core of the perverse incentives argument that the production of HCFC-22 and the ratio of HFC-23/HCFC-22 went down when plants had reached their credit limit at twelve different plants.  Their failure to acknowledge this fact is either misleading or deliberately deceitful.

            In order to counteract the wholesale manipulation of the Emissions Trading Scheme through the illegal flooding of the market with HFC-23 credits several steps will have to be taken.  The first option is not to allow HFC-23 destruction to garner CERs.  Allow existing frameworks like the Montreal Protocol deal with the HFC-23 abatement so that there can not be an issue of perverse incentives leading to the overproduction of an incredibly potent greenhouse gas.  In addition the EU should “apply additional quality assessment of HFC-23 credits in Phase II of the EU ETS (2008-2012) for credits not yet surrendered to ensure that fraudulent credits are not used to count towards the EU’s climate targets in the current phase; prohibit the carryover of HFC-23 CERs from Phase II into Phase III from HFC-23 credits; and wholly prohibit the use of CERs from HFC-23 in Phase III of EU ETS” (Walravens 4).  There are options outside of completely barring HFC-23 credits from the ETS.  CERs could be assessed for only a proportion of the HFC-23 reduction; revenues that exceed the cost of the project could go directly to a fund that is set up for funding sustainability initiatives, have an independent intermediary financial institution finance the projects so that the abatement is paid for but there is no revenue funneled to the manufacturer as a result, or have “a multilateral institution (such as the Global Environment Facility or Multilateral Fund under the Montreal Protocol) fund HFC-23 destruction” (Schneider, 2011).  Lambert Schneider of Öko-Instuitut, a non-governmental, non-profit environmental research organization based in Germany, pushes for the first option because he believes it could be rather easily implemented, considering that the rules in place already use similar benchmarks to determine the cut off points for credit issuance.  He acknowledges there may still be a minor perverse incentive but that it would be under greater control.  I disagree.  Granted HCFC-22 producers would have to ramp up production to levels unheard of to make the same types of profits they were before, but with a little time and shoddy regulatory oversight that’s possible, especially since HCFCs don’t have to be phased out in developing countries till 2030.  Instead I would prefer it if a multilateral organization funded HFC-23 incineration and HFC-23 was not involved in the CDM or EU ETS at all.  That way, HCFC-22 producers can not make ungodly profits off of ill-conceived methodologies and regulatory structures, and a potent gas like HCFC-22 will not be created needlessly in mass quantities.
            To understand the size of the impact the fraudulent HFC decomposition credits had of the CDM one needs to understand the proportion of CDM CERs made of unnecessary HFC credits.  We can do this through looking at the proportion of HFC produced to HCFC produced and at the CDM projects and compare that to the potential proportion that would be gained from best use of the HFC decomposition equipment.  For example once the credit limit had been reached for one HCFC project the proportion of HFC/HCFC produced dropped from ~2.8% to ~1.1%.  That’s a decrease of over a half.  Typically the proportion can be brought much lower than 1%.  Since there are generally 3 extra months of production time for that the HCFC producers could not receive credits for as a result of the CDM’s cap, if HCFC producers had not overproduced HFC and maintained an HFC/HCFC proportion of 1.1% they would have produced less than half as many credits.  Since CERs originating from HFC decomposition projects accounts for half of all CERs it is safe to say that over a quarter of the CDM’s CERs have been produced fraudulently.

            The EU Emissions Trading Scheme has been deemed by many as a way to allow markets to move our societies part of the way to sustainability.  It is said that by allowing developed nations to fund the creation of sustainability projects, like HFC-23 abatement, in developing countries we are allowing for sustainable development in the developing world and a slow descent into sustainability for the developed world.  The flooding of the ETS with HFC-23 credits so that nearly 52% of all credits come from HFC incineration should have immediately raise a red flag for regulators.  This misstep seems so obvious it is incredible there has not been more of an ordeal made out of it.  The entirety of the emissions market was undermined by the fraudulent HFC credits.  CERs were being bought to line the pockets of HCFC manufacturers and the ETS was glutted with excess CERs from overproduction of HFC.  As a result, European emissions cuts were far below the level they should have been.  This calls the entire emissions trading scheme into question.  In order for legitimacy to be reinstated in the regime the EB must stop granting CERs for emissions they know are fraudulent.  Additionality must be have strict attention paid to it or else the system will fail leaving in its wake an example for climate change deniers and big government critics to point to.

Bibliography

"CDM: About CDM." CDM: CDM-Home. United Nations Framework Convention on Climate Change. Web. 21 Nov. 2011. .

Ethically Bankrupt: World Bank Defense of the HFC-23 Scandal. Issue brief. London, UK: Environmental Investigation Agency. Print.

Forster, P., V. Ramaswamy, P. Artaxo, T. Berntsen, R. Betts, D.W. Fahey, J. Haywood, J. Lean, D.C. Lowe, G. Myhre, J. Nganga, R. Prinn, G. Raga, M. Schulz and R. Van Dorland (2007). "Changes in Atmospheric Constituents and in Radiative Forcing.". Climate Change 2007: The Physical Science Basis. Contribution of Working Group I to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change.

Schneider, Lambert R. "Perverse Incentives Under the CDM: An Evaluation of HFC-23 Destruction Projects." Climate Policy 11 (2011): 851-64. Print.

United Nations. United Nations Development Programme. Energy Research Centre. Climate Change Mitigation Negotiations, With an Emphasis on Options for Developing Countries. By Harald Winkler. University of Cape Town. Web. 21 Nov. 2011. .

Walravens, Ronnuala, and Eva Filzmoser. HFC-23 Offset in the Context of the EU Emissions Trading Scheme. Issue brief. Print.

World Bank. Q&A for CDM HFC-23 Incineration Projects. World Bank, 2011. Print.

 

Glossary of Acronyms

CDM Clean Development Mechanism

CDM EB CDM Executive Board

CER Certified Emission Reduction

CFC Chlorofluorocarbon

EIA Environmental Investigation Agency

EU ETS European Union Emissions Trading System

HCFC Hydrochlorofluorocarbon

HFC Hydrofluorocarbon

GWP global warming potential

JI Join Implementation

UNFCCC United Nations Framework Convention on Climate Change