Perspectives for Latin America and the Caribbean
of Carbon Markets

The Russian government has given the green light to the Kyoto Protocol. This is the most important news over the last week regarding climate policy. We expect the Duma, the Russian Parliament, to vote in favour of the government's proposal so that Russia's President Putin can ratify it in due time. The Russian decision paves the way for a treaty, whose fate has long hung in the balance, to take effect throughout most of the world.

The European Union feels relieved by the Russian decision because Europe is strongly committed to the objectives of a stringent climate policy. When the European Parliament voted on the Ratification of the Kyoto Protocol only four out of the more than 600 members were against. The overwhelming consent expressed reflects the general mood of the European population. Contrary to American public opinion Europeans broadly agree on a policy to mitigate the effects of global warming by reducing the emissions of all six greenhouse gases and are willing to pay a price for such a policy.

Climate policy is part of environment policy and falls under the responsibility of the Treaty of the European Union. In other words, climate policy is European policy. Europe, not the member states, takes decisions. The European Parliament and the Council of Ministers decide together. We call it the co-decision process. The European Commission proposes a directive and Parliament and Council decide by qualified majority. Even if one or two countries were not in agreement they would be overruled by the majority of the others. This happened e.g. with the two directives concerning emissions trading.

In Kyoto the EU agreed to reduce its emissions by 8% in the period between 1990 and 2010. This self-commitment was confirmed several times and lead to a policy of sustainable development. You should know that sustainable development is a legal requirement of the Treaty of the Union. Sustainable development has to be the “red thread” of our industrial policy. Another important article in the treaty refers to the precautionary principle. Applied to climate policy it forces us to act although we are not a hundred percent sure whether we are right. We rely on the recommendations of the climatologists, knowing very well that they are based on models, not on experiments. Climate policy is based on a hypothesis, not on a scientific truth. But it seems highly probable that they are right and therefore politicians have to act.

Already in the past the ministers of the environment agreed on a burden sharing between the member states. Each of the then 15- now 25- member states of the European Union get a share of the common responsibility. There are countries who are allowed to increase their emissions; others are obliged to reduce them. To give you an example, Spain is allowed to emit 15% more, Germany and Denmark have to reduce their emissions by 21%. Altogether we have to reduce emissions by 8%.

These emissions include all six greenhouse gases. According to the international rules all the gases are calculated in CO₂ equivalents.

On several occasions the European Institutions- Commission, Parliament and Council- repeated their commitment to reduce greenhouse gas emissions in the 21st century by 70%. In other words, we know that after Kyoto comes post-Kyoto, then comes post-post-Kyoto, etc. We are only at the beginning of a huge reconstruction of our economy. As emissions get a price tag in the future you can easily understand that this policy will have radical consequences for our economy. Climate policy is not cheap.

How big the task is may be shown by an example. The CO₂ content of the atmosphere is currently roughly 370 ppm which corresponds to roughly 24 billion tonnes of CO₂ emissions worldwide and per year. The climatologists tell us that we should not exceed 550 ppm, a figure that corresponds to 30 billion tonnes of CO₂ yearly. 550 ppm corresponds to a global warming of 2 degrees. In a business-as-usual scenario this figure will be reached in 2015. Now, if we agree with the climatologists’ recommendations, we have to stabilize our emissions by 2015 in the range of 30 billion tonnes of CO₂ equivalent. In 2015 there will probably be 7 billion people on the globe. If you divide 30 billion tonnes by 7 billion people you will end up with 4.2. In other words, from 2015 on we are not allowed to emit more CO₂ equivalents per person and per year than 4.2 tonnes.

Assuming that all men and women are equal- which is the common rule in a democracy- this short calculation has revolutionary consequences. Today the ordinary German emits 10, the French citizen 6.5, the American 18 and the Chinese 1 tonne per year per capita. The Latin Americans are also well below the 4.2 tonnes CO₂ equivalent. So in some countries we must reduce our emissions. Others are still allowed to increase them.

What does it mean?

Always assuming that we follow the recommendations of the climatologists, we have to make a Herculean effort. We have to invest in new technologies, save as much energy as possible, perhaps even more than possible, switch from a carbon-based economy to a non-carbon policy, we have to increase our research efforts, in other words, we have to change the material base of our economy. We must replace energy by intelligence. The task is enormous and costly. Optimists say that the costs will be much below 1% of our GDP, others, more pessimistic, assume figures above 1% of GDP. As a comparison, the current investments in the energy sector are in the range of 0.7% of GDP in the industrialized countries of Europe. In Latin America the figure is much higher.

It is not impossible to reach the goal of a less energy-intensive society. Some say that we may even easily reduce our energy consumption by a factor of four. A society where every citizen needs no more than 2000 Watts seems possible without giving up our standard of living.

Imagine our European society in 1800 when more than 90% of the population were peasants. Although there were so many of them they still could not feed the whole population. Famines were no exception. And many Europeans had to emigrate in order to survive. Today not more than 2% of our population toils the earth and we produce more than we can eat and drink. Agriculture has increased its efficiency enormously. Why can't we have the same efficiency revolution in the energy sector?

We know that it is possible in principle. But there is a big gap between principles and reality. A look at the real emissions in the EU shows how far away we are from our objectives.

CO₂ emissions in the EU of the 15 are today higher by roughly 2% compared with 1990. Only if we take all greenhouse gases together do we arrive at a reduction of about 2%. But given our objective we should have arrived at 5%. Spain emits 40% more than in 1990 and is only allowed 15%. Others have similar problems. The only countries in line with their commitments are Germany, Britain, Sweden and Luxembourg. The 10 new countries also emit less than in 1990, but this is mainly due to a process of deindustrialisation. Many old plants have been scrapped, new ones replaced them. On the whole, CO₂ emissions fell dramatically in the former communist countries.

But this process cannot be repeated. With higher economic growth emissions will again increase. Europe, although committed to reducing greenhouse gas emissions, faces difficulties complying with Kyoto.

This brings us back to our main subject, because emission trading is one of the ways of reducing emissions at a lower cost.

The European Union adopted two directives on emission trading. In these two directives we concentrate on CO₂. As it is still difficult to measure exactly the emissions of the other gases this restriction seems reasonable. For practical reasons the directives apply only to the big energy producers and consumers, e.g. the cement and steel industry, part of the chemical sector, the gas and electricity sector, the coal industry, etc. The directives cover nearly 50% of industry as a whole.

The first directive introduces emission trading within the 25 member states from 2005 onwards. The principle is relatively simple. As the member states have to reduce their emissions of CO₂ the above mentioned companies get CO₂ allowances from their respective governments. Let us take a hypothetical example. A steel company needed in the past 100 units of CO₂ to produce a certain amount of steel. They now get a figure of 99 for the following year. In order to reduce the emissions from 100 to 99 they have to make additional investments. After a year or two they have to give back the allowances and they get new ones, perhaps only 98. Again, they have to improve their efficiency and invest in new technologies. If they over-fulfil their goal they may sell their unused emission rights, if they remain below their objective they must buy emission rights. The companies have therefore a choice. They may invest in technology or in emission rights. Modelling the trade between companies shows however that companies who refuse to invest and prefer trading as the only strategy end up bankrupt.

Informally such trading has already started. The current CO₂ price lies between 6 and 8 € per ton. In London a first Emission Rights Exchange has opened. Other cities like Leipzig in Germany will follow. Emission rights are traded like stocks but it is not yet clear whether they are legally regarded as stocks.

From 2005 the trade will start officially. In a few years time we have to decide whether we will integrate Methane or N2O into the emission trade, or whether it will be extended to other sectors like transport or households. And we will see whether the National Allocation Plans will work or whether we need European-wide allocations.

The directive is binding. Companies who do not comply with the points given have to pay a fine. The directive stipulates € 40 per ton in the first three years, then it will be increased to € 100 per ton.

As renewable energy sources and nuclear power plants do not emit greenhouse gases they are not included. To promote renewables we have different support schemes and as long as they exist we need not insert renewables into the emission trading scheme. It may be different in the future when our directive on renewables has to be revised and when the price for emission rights will be higher. One could imagine our financing renewables with the credits from saved CO₂. If you build a wind power station instead of a gas-powered one you save CO₂. The CO₂ credits could be used to finance at least part of the investment. But this is a subject for the future.

Emissions trading has an impact on our energy policy. The more CO₂ you emit the more expensive electricity will be. Coal or lignite, both still relatively cheap sources of energy, will be penalized. Gas will be favoured. And renewables-like nuclear- will get a new advantage.
As fossil fuels are still very competitive, particularly lignite which is an indigenous energy source, we have to make an effort to reduce their emissions. Soon we will launch an ambitious programme with the working title „Clean Coal“. The idea is to gasify coal, separate CO₂ and bury it under ground. We know that this technology of capture and sequestration of CO₂ is technically possible but we have to reduce the costs. It is our objective to improve the efficiency of coal fired power stations up to 55 or 60%. Currently they operate at between 30 and 40%. The most modern ones have an efficiency of 46%. Sequestration would reduce efficiency by 10%, but 55 minus 10 would still give a good overall efficiency of 45% - and that without CO₂. A CO₂-free coal or lignite power station is therefore possible. It would give coal and other fossil fuels not only a new image; we could also imagine producing hydrogen from coal without emitting CO₂.

It is very difficult to forecast the impact of emissions trading on the power sector. All what we can say is that it makes economic sense to produce less CO₂. This consideration also applies to nuclear. There is no doubt that in Europe a new debate on nuclear energy has started, in some countries less, in others more. Finland has decided to build a fifth nuclear power station and the decision was also triggered by considerations about CO₂. Bulgaria is also building a new nuclear power plant. Other countries like France will soon follow. Several countries are extending the lifetime of their nuclear power plants. Countries like Germany, on the other hand, still think that the phasing out of nuclear power is compatible with a stringent climate policy. Personally, I am rather sceptical about that assumption.

The decision process was not without conflicts. Countries with a large coal or steel sector or with a big chemical industry like Germany or Finland were more than reluctant about emissions trading. They still construe it as a competitive disadvantage and are not very happy about it. But as public opinion is very much in favour they do not dare to make it a big issue. And the ratification of the Kyoto Protocol by Russia will facilitate their task.

That brings me to the second directive. We call it the linking directive. It deals with CDM – Clean Development Mechanism - and JI – Joint Implementation, in other words, it allows companies to buy carbon credits in other countries than the European Union. These credits are transferred to Europe and transformed into emission rights so they can be traded. The impact of this directive on the carbon market is difficult to foresee but in my opinion it will be important.

As in the first directive trading is restricted to CO₂. Sinks and nuclear installations are excluded. The directive is addressed to companies, not to countries. But under the Kyoto protocol countries are allowed to trade emissions from sinks provided they sign an agreement, like for example France and Colombia.

Informally, a series of examples exists already because CDM has been allowed since the year 2000. But so far the credits from CDM measures could not be transformed into emission rights because the latter did not yet exist. From 2005 on they will exist in the European Union which is by far the biggest single market in the world.

To give you just two examples. The first one relates to JI. The German gas company Ruhrgas is upgrading the compressor stations of the Russian gas pipelines so that a lot of methane is saved. The CO₂ equivalent is calculated and the amount of CO₂ is certified. Ruhrgas invests in the gas pipeline and is paid in part with carbon credits. As the price for carbon credits is still low – between five and ten € per ton of CO₂ – the business is interesting but not yet very lucrative. But Ruhrgas gets cheap carbon credits, Russia gets investments. And the environment is improved.

Let's go to Latin America. In Bolivia they built a hydro power station instead of a gas power station. The initial investment in hydro is more expensive than in gas. But the difference can partly be financed by the CO₂ saved. In this case an American company which is voluntarily committed to Kyoto is buying the credits.

There are already many voluntary examples of emissions trading. But in the future CDM and JI will be part of the legal system in Europe.

What’s in it for the Europeans?

Since European companies and countries will face difficulties reducing their CO₂ emissions at a reasonable price it is in their interest is to provide themselves with relatively cheap carbon credits. Countries like Spain, Ireland, the Netherlands and others will only comply with their Kyoto commitments with carbon credits bought in third countries.

What’s in it for the developing countries or countries like Russia or Ukraine?

They want to see investment in the energy sector. Unlike us in the European Union they are interested in high prices for carbon credits. In the end the market will decide.

A recent survey of the Chinese market shows that there is still a modest market potential. For China it is estimated that the market for CDM is actually of the order of € 300 Mio per year. But the volume increases with the rising price and the opportunities. A previous study by the European Commission came to the conclusion that CDM and JI could soon reach the volume of development aid, that is 0.3 to 0.6 % of our GDP. Emissions trading could become a new instrument to combat poverty. At least it transfers money from Europe to the developing world.

Where are the problems?

First of all we do not yet have a great deal of experience. We are still in the learning phase. Therefore much of what I am saying is speculation. But my speculation is soundly based on European law. Our directives are not resolutions, they are binding law.

Secondly, the certification process is still costly. Experts tell me that it costs at least € 200,000 per project. That cost makes small projects uneconomic. We have to find solutions to reduce these costs.

Thirdly, SME's and even bigger firms in Europe don't have the potential to develop CDM or JI projects. To solve this problem we have created or are in the process of creating so-called carbon funds. You invest in a carbon fund and then the fund buys carbon credits in developing countries. Your access to the carbon credits depends on the size of your investment. The fund does the work for you.

Fourthly, there is a risk that developing countries might sell their carbon credits too cheaply. As you do not yet need much money to save CO₂ in developing countries Europeans have an interest in buying now as much as possible because CO₂ saving is still cheap but in five or ten years when the cheap solutions will be exhausted and the developing countries have to make investments on their own the price they will then have to pay to save CO₂ will be relatively high. Therefore developing countries are sometimes wary about opening their market now, preferring to wait until carbon credits are more expensive. It is like oil. The less oil a country produces now and the more it produces in the future when the price is high the higher will be the profit. The only problem is that many countries need the money now.

And fifthly, there is a problem of measuring and controlling. Let us assume an error of only 5% in a deal concerning one million of tons of CO₂, let us further assume a CO₂ price of € 20 per ton, then the error is of the order of magnitude of € 1 Mio.

Now let us speculate about the future. And let us assume the year 2015 with a global emission of 30 billion tons of CO₂. Europe will probably emit some 4 billion tons of CO₂. And she has to reduce the emissions by another 20% at an assumed price of 20 € per tonne. Europe might perhaps be able to reduce half of the amount by technical improvements. The other half must be bought from third countries in the form of credits. A short calculation shows that Europe will have to buy credits at an annual cost of € 8 billion. If the price goes up to perhaps € 40 a ton then the 8 billion will turn into € 16 billion annually.

This simplified calculation shows you the order of magnitude for the foreseeable future. Emissions trading will become a major element in north-south relations. It will change our mentality because with emissions trading we are not spending and you are not receiving anything. No, we will be trade partners of equal stature. We will trade carbon credits against investments. And there will be a common winner – the environment.

It is therefore important that we prepare each other for the next round. Emissions trading must be on the agenda of our meetings, we must speak about our experience, we must improve the system where it needs improvement.