INCEPTION BRIEFING NOTE
REDD SCENARIOS AND CARBON MARKETS
Carbon markets are similar to markets for any other traded commodity, but with some important differences: carbon is invisible and therefore hard to track and measure compared to other commodities, giving rise to complex technical processes and high risks; and public regulation has played an extremely important role in creating a market for carbon and in driving demand, particularly since the Kyoto Protocol came into force in 1997.
There are two main markets for trading carbon: the regulated market and the voluntary markets. The regulated market consists of different trading mechanisms operating under the globally agreed rules of the Kyoto Protocol. The most important mechanism for developing countries is the CDM, in which Annex 1 (developed) countries can claim credits from emissions reduction projects in non-Annex 1 (developing) countries. The value of the CDM market was 3.9 million Euros in 2006 and it is growing rapidly. The smaller voluntary carbon markets operate outside internationally agreed rules but use similar mechanisms to the regulated markets, including project-based crediting mechanisms in developing countries like the CDM. Individuals, corporations and other organisations without mandatory emissions targets enter into these markets, driven by social responsibility concerns to reduce emissions. The value of voluntary carbon markets has been estimated at US$92 million in 2006 and is expected to double in size during 2007.
The current Kyoto Protocol does not contain adequate mechanisms for addressing forest loss and degradation in developing countries, despite the fact that approximately 20% of greenhouse gas emissions come from these sources. Forestry in the CDM is limited to afforestation and reforestation projects. REDD projects have been excluded because of complexities over quantification and monitoring, sovereignty issues, concerns about flooding the carbon markets with cheap credits and concerns that investment in REDD will detract from efforts to move towards a low carbon economy in Annex 1 countries. Despite these difficulties REDD has recently resurfaced in debates about the future of the international climate change regime after the Kyoto Protocol ends in 2012. This follows a proposal for such ‘compensated reductions’ led by Papua New Guinea and the Coalition of Rainforest Nations in 2005 and increasing concerns about the urgent need to tackle climate change. Carbon markets are growing and REDD could be a relatively cost-effective way to harness market potential to reduce emissions on a large scale.
REDD systems could be designed in a number of different ways and various options have emerged in the international debate. These differ mainly in relation to four main aspects: (1) whether an international agreement is reached or not; (2) whether emissions reductions in a future agreement are credited in a market mechanism or through payments to an international fund; (3) whether payments for REDD are made at the national/sub-national levels or to individual projects; and (4) whether credits in a market mechanism are exchangeable with credits in other carbon markets. Different options have different implications for how national REDD systems are established. For example, if no agreement is reached internationally, then REDD is likely to remain an option only in the voluntary carbon markets, which are much smaller in scale, use project crediting in which the sellers are more likely to be private project developers rather than governments, and operate with different standards. If agreement is reached and market-based, national crediting mechanisms are chosen, then the scale is likely to be bigger (globally USD 2-31 billion by some estimates), national governments themselves might be the sellers and standards will need to be similar across different countries and across scales within countries.
Despite this uncertainty, existing knowledge about the interests of buyers and sellers in the carbon markets can give useful insights into how an Indonesian REDD system should be set up and the implications for different players. Buyers’ criteria relate mainly to different types of risk associated with purchasing credits, including risks in the planning, construction and operation of projects and risks in the market itself. Operating risk, for example, is the risk that a project does not perform as expected. Market risks relate to price fluctuations in the marketplace, which could result in much lower returns for buyers or sellers. Forestry carbon projects have particularly high risks, as project failure can result from natural (e.g. pests or fire) or anthropogenic (e.g. illegal encroachment on plantations) causes. Political and governance issues and issues surrounding land titles and tenure rights pose some of the highest risks. These are likely to be even more important factors in REDD systems, so it will be essential that they are addressed in order to attract investment in Indonesia.
Risks can be managed to some extent through insurance schemes, using temporary instead of permanent credits, standards schemes and through contracts between buyers and sellers, which spread liabilities in different ways. These approaches can have implications for both buyers and sellers, which need to be carefully managed. For example, poor project performance can be managed by setting minimum performance requirements and introducing financial penalties and corrective measures to be implemented by sellers. The message for REDD is that contractual arrangements between buyers and sellers in national systems will be important to consider to ensure that sellers of credits are not disadvantaged or subject to large liabilities for failure to deliver emissions reductions.
Carbon projects also raise financial issues for sellers, which relate to transaction costs, implementation costs, the proportion of finances generated from carbon sales and the availability of upfront capital. Transaction and implementation costs for carbon projects can be high given the complex technical issues surrounding carbon projects. They also tend to occur upfront, whilst credit issuance occurs after emissions reductions have been verified. This can cause problems for smaller producers to access carbon markets, especially if they do not have access to sources of upfront funding. In any case additional sources of funding will be required, as carbon finance generally makes up only a small proportion of project costs. Upfront funding and operational costs can be generated from international carbon funds, donors, the private sector, national revenues and projects themselves (e.g. through the sale of SFM timber). Costs can also be reduced through, for example, introducing small-scale, simplified methodologies for projects or by bundling projects together.
There are already moves to develop REDD projects in advance of any international agreement on the post 2012 climate change regime. These include both pilot initiatives to gain experience before a formal REDD mechanism is established and independent private sector organisations setting up projects for trading in the voluntary carbon markets. The issue with both is how these might overlap with the rules and regulations established for a future system (e.g. to avoid ’double-counting’ of credits from these early initiatives after a national system of crediting is established) and the terms under which early action can be rewarded (i.e. whether emissions reductions generated before 2012 can be sold under a future regime). These issues make it increasingly urgent that regulations relating to REDD activities are established as soon as possible.