Europe proposes restrictions on emissions trading

The European Commission is proposing trading restrictions on trifluoromethane (HFC-23) and nitrous oxide (N2O) credits starting on Jan. 1, 2013. The body says that carbon emissions trading is controversial and can potentially be exploited.

Some are reporting the move as part of a general backlash toward traders that is gaining steam in a post-crisis regulatory environment, while others say the move will undermine investor confidence in the concept of using free markets to control pollution.

Exchanges expected to list futures contracts in related markets include The Green Exchange and ICE Futures Europe.

The Commission published the following Q&A on the proposed restrictions:

Questions & Answers on Emissions Trading: Use restrictions for certain industrial gas credits as of 2013

1. What types of credits are proposed to be restricted, what kind of restriction will apply and when will the use restrictions enter into force?
The Commission proposes full use restrictions as of 1 January 2013 on trifluoromethane (HFC-23) and nitrous oxide (N2O) credits from adipic acid production from Joint Implementation (JI) and Clean Development Mechanism (CDM) projects for compliance in the EU Emissions Trading System (EU ETS).

2. Are these the first use restrictions applied in the EU ETS?
No. Full use restrictions have already been applied in the EU ETS to credits generated from projects at nuclear facilities and from credits generated from LULUCF activities since the start of the EU ETS.

3. Why is the Commission proposing further use restrictions focusing on industrial gas credits?
There are a number of reasons for adopting use restrictions on some industrial gas projects. The acceptance of credits from industrial gas projects has been controversial for some time. Certain gases have a very high global warming potential and abatement is very cheap. This can create huge financial rewards for project developers. The main concerns over these projects are:

a) Additionality – is production and subsequent destruction of the gas higher than what would have happened without a CDM project?
HFC-23 is produced as a by-product during production of another greenhouse gas, HCFC-22 which is also an ozone depleting substance. HCFC-22 is covered by the Montreal Protocol. Crediting the abatement of HFC-23 can create a perverse incentive to produce more HCFC-22 than would have happened without the CDM, and consequently produce credits that are not additional.

Also, the EU considers that cheap emission reductions, such as those from certain industrial gas projects, should not be done through the carbon market, but instead should be the responsibility of developing countries as part of their appropriate own action or possibly funded based on incremental costs only (e.g., based on the actual abatement costs).

b) Obstacles to development of sectoral crediting mechanisms
The EU favours a gradual move away from crediting projects on the basis of "do nothing" to crediting sectoral reduction on the basis of a "do something" benchmark. A concern around new sectoral mechanisms is that there would be insufficient demand for credits to justify the investments in these mechanisms. By introducing use restrictions on HFC-23 and N2O from adipic acid production credits in the EU ETS, demand can shift from JI and CDM towards sectoral credits.

c) Obstacles to phase out of gases under the Montreal protocol.
The current incentive structures for HFC-23 undermine attempts under the Montreal Protocol to implement the accelerated phase-out of HCFC-22 for non-feedstock use, and to consider financing the destruction of HFC-23 on an incremental cost basis via contributions to the Multilateral Fund.

d) Imbalance in the geographical distribution of projects
The dominance of industrial gas projects distorts the geographical distribution of projects under the Kyoto Protocol's flexible mechanisms in favour of some advanced developing economies. The EU has called for a better geographical distribution of projects in the CDM, in particular for Least Developed Countries (LDCs). Use restrictions may encourage investment in projects in LDCs.

4. How can use restrictions on industrial gas credits give new impetus to reform of the CDM and the creation of new sectoral market mechanisms at UN level?
The EU has been advocating a move away from crediting mechanisms based on the "do nothing" baseline. The Commission favours the creation of new sectoral carbon market mechanisms with a "do something" baseline as an interim step towards the development of (multi-sectoral) cap and trade systems. Similarly, the Commission believes that JI should be phased-out and participating sectors should be covered by cap-and-trade. A continuation of the recognition of credits from JI would slow down such a move because beneficiaries resist the loss of revenues from the sale of credits.

Use restrictions on credits from HFC-23 and N2O destruction from adipic acid production may improve the prospects in the UN negotiations to agree CDM reform and the creation of new mechanisms.

5. How can use restrictions improve value for money?
Revenues from the sale of HFC-23 credits in the EU ETS represent up to 78 times the initial capital investment and operational costs of these projects. In other words, the rates of return of these projects are excessive. These projects are not reducing global emissions in an efficient manner. The EU considers that cheap emission reductions, such as those from industrial gas projects, should not be done through the carbon market, but instead should be the responsibility of developing countries as part of their appropriate own action to keep global warming below 2 degrees Celsius.

6. Which countries are the main suppliers of industrial gas credits?
80% of HFC-23 credits and 60% of N2O credits under the CDM come from China1. The majority of the remainder of these projects are generated in India and a few advanced developing countries (some of them OECD-members). Use restrictions would therefore be fully in line with an increasing focus of the CDM on LDCs. The EU considers that OECD countries, such as South Korea and Mexico, should contribute to mitigation through measures such as sectoral market mechanisms or emissions trading, rather than through CDM projects.

7. Why has the Commission made this proposal now, i.e. more than 2 years ahead of the start of the third trading period in the EU ETS?
The timing of this proposal is motivated by calls from project developers for more clarity on the quality provisions in the EU ETS for CDM credits post 2012.

8. Why is the Commission proposing full use restrictions rather than a multiplier?
The measure considered most appropriate for HFC-23 and adipic acid N2O credits is to introduce a full use restriction as of 1 January 2013. This will give the strongest signal to developing countries that appropriate own action is needed. Likewise, full use restrictions on ERUs from these projects would best encourage a move towards cap-and-trade.

A multiplier could impede such moves, if set too low, and agreeing an appropriate level would moreover be very challenging.

Full use restrictions will be easier to administer and allow for a simple adjustment by market operators

9. What is the timeframe for the adoption of the use restrictions by the Climate Change Committee?
The Commission's proposal will be first discussed in the Climate Change Committee of 15 December, with a vote following thereafter. The adoption of the Regulation will be subject to three months of scrutiny by the European Parliament, and Council in accordance with the regulatory procedure set out in the Directive.

10. Are the proposed use restrictions not "retroactive"?
No. The EU ETS Directive (2009/29/EC) allows for measures to be applied restricting the use in the EU ETS of credits from certain project types. This by no means affects the issuance of units, which is managed by the CDM Executive Board. The Directive foresees a notice period of 6 months to 3 years for the application of the restriction from the time the restrictions are formally adopted in order to allow sufficient time for market participants to adapt.

11. What will be the market impacts of these use restrictions?
There are expected to be enough credits available from the 2300 other projects (non HFC-23, non- N2O) to supply the EU ETS up to the limit allowed over the next 10 years, without including any new credits from sectoral crediting. Therefore allowance prices should be relatively unaffected.

An early decision on these use restrictions will provide certainty for the market a stimulus for investment in alternative projects that can deliver credits for the EU ETS from 2013 to 2020. The impact assessment shows that even assuming developed and developing countries commit to their high pledges under the Copenhagen Accord there would still be sufficient reduction potential in developing countries in areas other than industrial gases at prices below the prevailing European carbon price.

This is confirmed by e.g., a recent study by Bloomberg New Energy Finance.2

12. Will the restrictions result in the fragmentation of the international carbon market?
The EU makes up the vast majority of the international carbon market and other developed countries want changes too. The impact of the restrictions on market fragmentation is therefore likely to be minimal.

13. Is this not a matter for the UNFCCC?
As the largest purchaser of JI and CDM credits in the world, and to safeguard the integrity of its Emissions Trading System, the EU has provided leadership in the UNFCCC process to reform the CDM in order to improve its environmental integrity, effectiveness, efficiency, regional distribution and contribution to sustainable development. The EU will continue to work in the UNFCCC process towards this end. Nonetheless, it is for the EU to decide which credits to allow into its own domestic trading system.

The restrictions proposed would not replace the function of the CDM Executive Board or the Joint Implementation Supervisory Committee. The restrictions applied would be on the use of these units for compliance purposes in the EU ETS. Any restrictions would be applied in accordance with the EU ETS Directive (2009/29/EC) in order to harmonise the use of international units in the EU ETS, while ensuring its integrity.

14. Isn't the CDM Executive Board also investigating HFC-23 credits?
The assessment of the Board is related to the allegations of non-additionality of HFC-23 credits. We strongly support action of the CDM Executive Board to eliminate these concerns, but this is not the only reason for restrictions in the EU ETS. There are concerns related to the environmental merits, cost-effectiveness and competitive distortions of these projects and the EU must strive for coherence of its domestic position with its demands internationally. Finally, the same concerns apply to JI projects of these categories.

15. Will the European Commission propose to apply further use restrictions beyond industrial gases for phase 3?
The revised ETS Directive provides for use restrictions to be introduced as part of the implementing provisions for credits which are otherwise usable during phase 3 of the EU ETS, running from 2013 to 2020. There may be further use restrictions added to the ones proposed now. However, the European Commission is not currently considering any specific use restrictions beyond industrial gases.

16. Are HFC-23 projects not crucial to create sufficient liquidity in the carbon market?
Overall liquidity is guaranteed by the fungibility between CERs/ERUs and EU allowances. The economic recession has produced a situation where many EU companies accumulate and hold sizeable surpluses of allowances. In the light of this, there will be sufficient liquidity in the market for the coming years.

17. What is the "major overhaul" of the CDM that the EU is envisaging?
To keep global warming below 2 degrees Celsius, the EU has taken the position that commitments by industrialised countries should be complemented by appropriate mitigation actions by developing countries, in particular the most advanced developing countries. The CDM is a pure offsetting mechanism, where a tonne of greenhouse gas emissions reduced in a developing country creates a right to emit a tonne of greenhouse gas in a developed country. Such a system would not be possible to scale up at the level necessary to pursue emission pathways allowing us to stay within the 2 degrees target. The European Union has therefore been advocating an overhaul of the CDM and the creation of a new generation of sectoral market mechanisms. The CDM should be reformed in such a way that its environmental integrity is improved while focussing on Least Developed Countries, and should over time be replaced in more advanced developing countries by sectoral market mechanisms and ultimately cap-and-trade systems.

18. How could stakeholders contribute?
During the preparations of the Commission proposal and accompanying impact assessment, stakeholders were invited to submit their views on the design of use restrictions for industrial gas credits. Many stakeholders responded and provided valuable written input. These views and opinions will be made available on the DG CLIMA website.

19. Do these restrictions bind also Member States when they buy international credits for compliance with non-ETS emissions?
No. Use restrictions applied in accordance with the revised EU ETS Directive are only applicable to companies covered by the EU ETS. However, if Member States intend to use credits which are restricted in the EU ETS, for compliance with their targets in 2013 to 2020 of emissions not covered by the EU ETS under the Effort Sharing Decision, they will have to communicate the reasons for this to the European Commission.

1 :

2 : Bloomberg New Energy Finance (2010): "Impact of CER import restrictions on the EU ETS and international carbon market", Carbon Markets - Global - Research Note 20 October 2010.

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