Background To Kyoto Protocol

In response to concerns raised about the effects of Greenhouse Gases ("GHG"), more than 150 nations came together to sign the United Nations Framework Convention on Climate Change ("UNFCCC") at The Earth Summit held in Rio de Janeiro in 1992. This included an agreement that the developed nations would reduce the greenhouse emissions to 1990 levels by the year 2000. Unfortunately this pledge was voluntary and non-binding.

However the treaty included provisions for updates (called "protocols") that would set mandatory emission limits. The principal update is the Kyoto Protocol, which has become much better known than the UNFCCC itself. It was agreed on 11 December 1997 at the 3rd Conference of the Parties to the treaty when they met in Kyoto. It entered into force on 16 February 2005 when Russia ratified it on November 18, 2004.

According to a press release on the Kyoto Protocol from the United Nations Environment Programme:

"The Kyoto Protocol is an agreement under which industrialized countries will reduce their collective emissions of greenhouse gases by 5.2% compared to the year 1990 (but note that, compared to the emissions levels that would be expected by 2010 without the Protocol, this limitation represents a 29% cut). The goal is to lower overall emissions of six greenhouse gases - carbon dioxide, methane, nitrous oxide, sulfur hexafluoride, HFCs, and PFCs - calculated as an average over the five-year period of 2008-12. National limitations range from 8% reductions for the European Union and some others to 7% for the US, 6% for Japan, 0% for Russia, and permitted increases of 8% for Australia and 10% for Iceland."

As of November 2007, the US, Australia and Kazakhstan are the only signatory nations, not to have ratified the protocol. Singapore ratified the protocol on 12 April 2006.

The first commitment period of the Kyoto Protocol expires in 2012 and the Bali conference concerns a future treaty to succeed the current one.

Emission Targets in Kyoto Protocol

The Protocol requires developed countries (known as Annex I countries) to reduce their GHG emissions below levels specified for each of them in the Treaty. These targets must be met within a five-year time frame between 2008 and 2012, and add up to a total cut in GHG emissions of at least 5% against the baseline of 1990. Review and enforcement of these commitments are carried out by United Nations-based bodies. The Protocol places a heavier burden on developed nations under the principle of “common but differentiated responsibilities.” This has two main reasons. Firstly, those countries can more easily pay the cost of cutting emissions. Secondly, developed countries have historically contributed more to the problem by emitting larger amounts of GHGs per person than in developing countries.

In order to give Annex I countries a certain degree of flexibility in meeting their emission reduction targets, the Protocol developed three innovative mechanisms - known as (a) Emissions Trading; (b) Joint Implementation ("JI"); and (c) Clean Development Mechanism ("CDM"). These so-called ”market-based mechanisms” allow Annex I countries to earn and trade emissions credits through projects implemented either in other Annex I countries (for JIs) or in developing Non-Annex I countries (for CDMs), which they can use towards meeting their commitments. These mechanisms help identify lowest-cost opportunities for reducing emissions and attract private sector participation in emission reduction efforts. Developing Non-Annex I countries benefit in terms of technology transfer and investment brought about through collaboration with industrialized nations under the CDM. Greater details on CDM and JI can be found below.

What this means in practice is that Non-Annex I economies have no GHG emission restrictions, but when a greenhouse gas emission reduction project (a "Greenhouse Gas Project" or "Carbon Project") is implemented in these countries, that Greenhouse Gas Project will receive carbon credits which can be sold to Annex I buyers.

Carbon Trading

CDM projects produce Certified Emission Reductions ("CERs"), and JI projects produce Emission Reduction Units ("ERUs"). CERs/ERUs are overwhelmingly bought from project developers by funds or individual entities. One CER or ERU signifies an emission reduction of one tonne of CO2 equivalent. The CERs or ERUs can be traded.

Kyoto also enables a group of several Annex I countries to join together to create a so-called 'bubble', or a cluster of countries that is given an overall emissions cap and is treated as a single entity for compliance purposes. The European Union is one such group and has created the EU Emissions Trading Scheme ("ETS"). The ETS’s currency is an EU Allowance ("EUA").

Several non-Kyoto voluntary carbon markets are already in existence as well. These include the New South Wales Greenhouse Gas Abatement Scheme, the Regional Greenhouse Gas Initiative ("RGGI") in the United States and the Chicago Climate Exchange. They trade in what are commonly known as Verified Emission Reductions ("VERs").

Clean Development Mechanism

The Clean Development Mechanism ("CDM") is an arrangement under the Kyoto Protocol allowing developed Annex I countries to invest in projects that reduce emissions in developing non-Annex I countries as an alternative to more expensive emission reductions in their own countries. The CDM is supervised by the CDM Executive Board and is under the guidance of the Conference of Parties to the UNFCCC /the Meeting of Parties to the Kyoto Protocol ("COP/MOP").

The CDM allows net global greenhouse gas emissions to be reduced at a much lower global cost by financing Carbon Projects in developing countries where costs are lower than in Annex I countries. However, critics argue that by allowing "business as usual" projects some emission reductions under the CDM are false or exaggerated.

Joint Implementation

Joint implementation ("JI") is an arrangement under the Kyoto Protocol allowing Annex I countries to invest in projects that reduce emissions in another Annex I country as an alternative to emission reductions in their own countries. Countries with relatively high costs for emission reductions can reduce costs of complying with their Kyoto targets by using credits from JI projects, as costs of emission reductions are significantly lower in some countries.

A JI project might involve, for example, replacing a coal-fired power plant with a more efficient combined heat and power plant. Most JI projects are expected to take place in the Annex I countries with economies in transition in Eastern Europe and the former Soviet Union, where the costs of reducing emissions are considered lower.

Unlike in the case of the CDM, the JI has caused less concern of spurious emission reductions, as the JI takes place in countries which have an emission reduction requirement.

CDM Project Cycle

Outline of the Cycle

An industrialised Annex I country that wishes to get credits from a CDM project must obtain the consent of the developing country ("Host Country Approval") hosting the project that it will contribute to sustainable development. Host Country Approval is given by the Designated National Authority ("DNA"). In Singapore, the DNA is the National Environment Agency ("NEA").

Then, using methodologies approved by the CDM Executive Board, the applicant (the industrialised country) must make the case that the project would not have happened anyway ("Establishing Additionality"), and must establish a baseline estimating the future emissions in absence of the registered project ("Establishing A Baseline"). The case is then validated by a third party agency, called a Designated Operational Entity ("DOE"), to ensure the project results in real, measurable, and long-term emission reductions.

The CDM Executive Board then decides whether or not to register (approve) the project. If a project is registered and implemented, the CDM Executive Board issues credits, called Certified Emission Reductions ("CERs" or commonly known as "carbon credits") to project participants based on the monitored difference between the baseline and the actual emissions, verified by the DOE.

A diagram of the CDM cycle is below.

Establishing Additionality

To avoid giving credits to projects that would have happened anyway ("free-riders"), rules have been specified to ensure additionality of the project, that is, to ensure the project reduces emissions more than would have occurred in the absence of the project. There are currently two rival interpretations of the additionality criterion:

(a) What is often labelled ‘environmental additionality’ has that a project is additional if the emissions from the project are lower than the baseline. It generally looks at what would have happened without the project.

(b) In the other interpretation, sometimes termed ‘project additionality’, the project must not have happened without the CDM.

A number of terms for different kinds of additionality have been discussed, leading to some confusion, particularly over the terms 'financial additionality' and 'investment additionality' which are sometimes used as synonyms. 'Financial additionality' is defined as an economically non-viable project becoming viable as a direct result of CDM revenues.

Many investors argue that the environmental additionality interpretation would make the CDM simpler. Environmental NGOs have argued that this interpretation would open the CDM to free-riders, permitting developing countries to emit more CO2 while failing to produce emission reductions in the CDM host countries.

It is never possible to establish with certainty what would have happened without the CDM or in absence of a particular project, which is one common objection to the CDM. Nevertheless, official guidelines have been designed to facilitate uniform assessment set by the CDM Executive Board for assessing additionality.

Establishing A Baseline

The amount of emission reduction, obviously, depends on the emissions that would have occurred without the project. The construction of such a hypothetical scenario is known as the baseline of the project. The baseline may be estimated through reference to emissions from similar activities and technologies in the same country or other countries, or to actual emissions prior to project implementation. The partners involved in the project could have an interest in establishing a baseline with high emissions, which would yield a risk of awarding spurious credits. Independent third party verification is meant to ameliorate this potential problem.

CDM Participants

Every CDM project involves a standard set of key participants. While the range and types of stakeholders may vary from project to project, the following discussion describes the key participants with specific roles in all projects:

Project developer/operators : The project developer identifies potential CDM project and makes initial assessment whether the project eligible under the CDM. They may or may not own the project.

CDM investors/CER purchasers: An investor is an entity that purchases CERs from a CDM project. The investor is usually from an Annex I country and can be a corporation, a government body or non-governmental organisation.

Host governments and designated national authorities : The Marrakech Accords state that in order to participate in the CDM, a country needs to be a Party (signed and ratified) to the Kyoto Protocol. CDM host countries also have to specify a domestic institutional body – the DNA –for approving CDM projects. The host country, via the DNA, must approve each CDM project and ensure that it conforms to their sustainable development criteria.

Designated operational entities : Designated operational entities, or DOEs, are domestic or international legal entities that have been accredited by the CDM Executive Board. They are responsible for various stages of the CDM project development process including: (a) Validation of CDM activities at the outset of the project; (b) Making publicly available CDM project design documents; (c) Receiving public comments on the CDM documents; (d) Incorporating stakeholder comments; and (e) Verification and certification of CERs during the operation of the project. The same designated operational entity can carry out both the validation (at project outset) and verification (during project operation) only if a specific request is made to the CDM Executive Board. Although this is allowed under the rules of the Marrakech Accords, it can result in conflicts of interest, and should therefore be considered carefully.

The CDM Executive Board : The CDM Executive Board supervises the CDM and reports directly to the COP/MOP. The Executive Board was elected at COP-7 and has ten members representing both industrialised and developing countries. The CDM Executive Board is responsible for the eventual issuing of CERs.

Other stakeholders : The CDM project cycle calls for two rounds of stakeholder comments. Project developers must invite local constituencies who will be affected by a project to review and comment on the Project Design Document before it is submitted for Host Country Approval. Later, subsequent to project approval, the Project Design Document must be posted for 30 days to allow interested parties at the local, national or international level to comment on it.

The Project Design Document

The project design document, or PDD, is the key documentation in the CDM project cycle, and completing it is complex undertaking. The PDD contains all relevant information concerning the CDM Project. The PDD is submitted to a DOE for validation, and once validated, to the CDM Executive Board for registration. A project design document is a necessity – no project can earn CERs without the development, validation and CDM Executive Board acceptance of it. The PDD can also be a valuable sales tool for potential investors.

Host Country Approval

CDM projects have to be approved by the host country. Host country approval is one of the key components to ensure that governments retain all sovereignty over their natural resources, including over their ability to mitigate emissions. Apart from approving the development of the proposed CDM Project, it is also the host country’s responsibility to confirm whether a CDM project activity will help it meet its own sustainable development criteria. A host country is accorded an enormous amount of leeway in choosing to accept or reject the CDM component of particular projects.

There is no specific guidance on the form or content this approval should take, except that it should be a ‘written’ approval from its DNA. An official Letter of Approval from the DNA will serve as evidence of host country acceptance. The letter should state that the host country accepts the project as well as recognises its contribution to sustainable development.

A sample of such a letter is as follows:

As the Designated National Authority (DNA) for the implementation of Clean Development Mechanism (CDM) in [Country], I am pleased to inform that your project proposal for [GHG Project] as defined in the Project Design Document is found to be in compliance with the national criteria for the CDM activities and will assist [Country] to achieve sustainable development.

2. I hereby confirm that:
(i) [Country] has ratified the United Nations Framework Convention on Climate Change on [date] and Kyoto Protocol on [date]; and
(ii) [Country] participates voluntarily in this proposed CDM activity.

3. In this regard, your project can now be submitted to the CDM Executive Board for registration as a CDM project activity.

4. As [Country] does not support unilateral CDM projects, this approval is considered void if this project is found to be a unilateral project by the CDM Executive Board.

5. This approval is valid if it is submitted to the Executive Board for registration within 3 months from the date of this letter and is independent of the time taken by the Executive Board to register the project.

6. You are required to submit a written report to the DNA on the stages and progress of the project implementation at least twice a year.

Validation by the DOE

Once the PDD has been completed and the host country approval has been received, all documents have to be submitted to a designated operational entity, or DOE, for review and approval – a process called validation.

Validation is the process of evaluation of all relevant documents for a CDM project activity against the requirements for CDM as set out in the Kyoto Protocol, the Marrakech Accords and the Delhi Declaration. Validation occurs at the outset of a project and is distinct from verification, which occurs during the operation of the project. In effect, the validation process confirms that all the information conveyed and assumptions made within the project design document are accurate and/or reasonable. The DOE will validate data on greenhouse gas emissions, as well as data and assumptions made regarding technical, social, political, regulatory and economic impacts of the project activity, as included in the Project Design Document.

It is generally the responsibility of the project developer to arrange for validation and to contract, and pay for, the services of a DOE. Though there are purchasers who will absorb these costs, it should be expected that those costs will ultimately be subtracted from the eventual CER transaction.

The project developer must use one of DOEs as listed and accredited by the CDM Executive Board for validation. As they become accredited, a list of DOEs will be made available on the CDM website (http:// unfccc.int/cdm).

The Marrakech Accords specifically require CDM consultation at the international level. The responsibility for managing this consultative process lies with the DOE. To undertake this, the DOE issues invitation for comments from all interested parties, generally simply by posting a validation on its website. This component is required and is in addition to the participation of local stakeholders (which is the project developer’s responsibility) in the earlier stages of project development.

Registration

Registration of the project with the CDM Executive Board is the act of formal acceptance of the validated project. The request for registration of a CDM project is the responsibility of the DOE. The DOE submits the validation report and host country approval to the CDM Executive Board for registration. The registration of the project with the CDM Executive Board will be final after a maximum of eight weeks after validation and the submission of the project, unless a review is requested. It is recommended to ask the DOE for a copy or confirmation of its request for registration.

The review by the CDM Executive Board must be related to issues associated with the validation requirements for CDM projects. Until the review is finalised by the CDM Executive Board, the decision for validation is not final and thus the project cannot be registered. Apart from the mandatory registration of the CDM project with the CDM Executive Board, the host country may also require registration of the project. It is advised to check with the DNA in the host country for requirements regarding registration of CDM projects.

Implementation and monitoring

Once the project has been registered, it can be implemented. From the point of implementation, the project developer needs to start monitoring the project performance, according to the procedures laid out in the validated monitoring plan of the Project Design Document. The monitoring results have to be submitted to a DOE for verification and certification. The project developer is responsible for monitoring the project’s performance according to the requirements set out in the validated monitoring plan.

At the very minimum, technical project performance, including the project output and the related greenhouse gas emissions, has to be monitored. In addition, environmental impacts and leakage effects of the project have to be monitored. Where possible, the monitoring should be carried out in accordance with existing monitoring activities, to the extent possible. For example, the monitoring of a power generation project should be linked with activities related to the sales of electricity.

Although the monitoring plan should specify the frequency of monitoring activities, no specific frequency is required. However, CERs can only be issued after verification of the monitored data. The frequency of monitoring does not necessarily have to be equal to the frequency of verification. Based on the monitoring results, the greenhouse gas emission reductions from the CDM project activity can be calculated and submitted for verification as CERs. CERs are based on reductions during the specific time period for which the monitoring results are provided.

Verification

The project developer is responsible for contracting a DOE to carry out the verification process. Verification is the periodic review and ex-post determination of the monitored greenhouse gas emission reductions that have occurred as a result of the CDM project. The DOE verifies the data collected by the developer according to the monitoring plan. As previously noted, the DOE contracted for verification should not be the same one that carried out the validation process, except in the case of small-scale projects or when specific approval has been granted by the CDM Executive Board. The verification process confirms the total number of CERs resulting from CDM projects during a specific period of time.

The frequency of verification is mainly a choice of the project developer, assuming the DOE accepts the decision. Frequent verification (for example, every year instead of every three years) increases transaction costs, but also allows for more frequent transfer of CERs.

The DOE shall make the monitoring report publicly available and submit a verification report to the CDM Executive Board. This report is also to be made publicly available.

Certification of CERs

Certification is the written assurance by a DOE that during the specified time period, a project activity achieved the reductions in greenhouse gas emissions as stated and verified, in compliance with all relevant criteria. This process of certification is required for CDM projects. The DOE also conducts validation and verification and is liable for eventual mistakes, misrepresentations, and fraud in this process. Certification is effectively a form of liability transfer; once the DOE has signed off, any underperformance of the CDM project with respect to the quantity or quality of the CERs is the responsibility of the DOE. Consequently a DOE must carry adequate liability insurance.

Issuance of CERs

The certification report prepared by the DOE has a request to the CDM Executive Board to issue the amount of emission reductions that have been verified by the DOE as CERs. When the CDM Executive Board approves the issuance of CERs, the CDM registry administrator, working under the authority of the CDM Executive Board, will forward the CERs into the appropriate accounts. This includes, if applicable, the account for the share of proceeds, for administrative expenses and forwarding the remaining CERs to the project developer, and the 2 per cent of the CERs required to go into the adaptation fund.

As can be seen above, the process of issuing CERs is complex with many parties involved and processes to be completed. It is only when all such processes have been successfully completed that CERs are issued. Thereafter the CERs can be traded.