United States: Three Central And Eastern European Countries Suspended From Kyoto Protocol Carbon Trading

Three Central and Eastern European countries have been recently suspended from international carbon trading for violating Kyoto Protocol emissions reporting rules. Bulgaria was suspended in June 2010 for seven months. Romania was suspended on August 27. The ban will be lifted when Romania has rectified the breach, which is anticipated to take at least six months.¹ The UNFCCC Compliance Committee preliminarily found Ukraine non-compliant with guidelines for national inventory systems on August 25, a finding that was upheld on October 12. The ban will likely remain in effect until the middle of 2012.²

Suspension affects a country's ability to participate in Kyoto Protocol's flexibility mechanisms. The Protocol set quantified commitments for limiting or reducing anthropogenic greenhouse gas emissions in 39 countries that are developed or in transition towards a market economy for the 2008 to 2012 period. To help achieve these commitments in a cost effective way, three flexibility mechanisms were designed. Two project mechanisms— Joint Implementation (JI) and the Clean Development Mechanism (CDM)—allow an investor country to obtain emission credits by investing in projects that reduce or limit greenhouse gas emissions in a host country. A third market mechanism allows for international emissions trading. Eligibility to participate in the mechanisms depends on a country's compliance with the Protocol's methodological and reporting requirements.

Joint Implementation

Mandated under Article 6 of the Kyoto Protocol, Joint Implementation applies only to the 39 Annex I countries with quantified emissions caps. Developed countries are particularly urged to partner with those transitioning to a market economy.³ Under JI, an investor country transfers technology and provides financing for an emissions reduction project in a host country. The host country benefits from the economic and social development resulting from the project, while the investor gains carbon credits from the emission reductions achieved, termed Emission Reduction Units (ERUs).⁴ JI became operational in 2008. Although Annex I countries could host JI projects prior to that date, ERUs could only be transferred starting that year. Both public and private entities are eligible to develop JI projects, but JI is voluntary and mainly intended for the private sector.⁵

There are two procedures for developing JI projects, with different eligibility criteria. Track 1 is simpler and allows the host country to register projects. Track 2 requires additional checks by placing the Joint Implementation Supervisory Committee in charge of approving projects. The two tracks differ mainly in how rigorously additionality—the requirement that any reduction of emissions resulting from the project is "additional to any that would otherwise occur"⁶—is proved.

An Annex I country can develop a JI project under Track I if it satisfies all of the following eligibility requirements:

1. the country is party to the Kyoto Protocol;

2. the country has calculated its assigned amount;

3. the country has set up a national system to estimate greenhouse gas emissions;

4. the country has set up a national registry;

5. the country has submitted the most recent required annual inventory of emissions to the Secretariat; and

6. the country has submitted any supplemental information that the Secretariat may require.⁷

Under Track 1, the host state itself verifies that reductions in emissions are in fact additional to what would otherwise occur. For this reason, some view Track 1 as having less environmental credibility because proving that projects are additional under this track is subject to the varying standards employed by each country. Upon verification, the host country can issue the appropriate number of ERUs.⁸ To do this, it converts, in its national registry, a portion of the assigned amounts that it holds equivalent to the emission reductions generated by the project into ERUs, and then transfers them from the host country's registry to that of the investor country. No new emission rights are created in the process.

If a host does not meet the above requirements, then verification that reductions are additional must occur through Track 2, which involves an accredited independent entity. Under this procedure, JI project participants submit a project design document to the independent entity, which then determines whether:

1. the project has been approved by the countries involved;

2. the project would result in an emissions reduction that is additional to any that would otherwise occur;

3. the project has an appropriate baseline and monitoring plan; and

4. project participants have submitted documentation on the analysis of the environmental impacts of the project activity.⁹ Note that a host that meets the Track 1 requirements may nevertheless elect to use the Track 2 procedure.¹⁰ Additionally, even under Track 2, the host country may only issue and transfer ERUs if it is a party to the Kyoto Protocol, has calculated its assigned amount, and has in place a national registry.¹¹ So far, only 10 million ERUs have been issued through Track 2, compared to 80 million under Track 1, partly because of greater oversight requirements in the former procedure.

Clean Development Mechanism

Like JI, the Clean Development Mechanism (Article 12) provides emission credits to Annex I countries that invest in emission reduction or prevention projects in another country. In the case of CDM, however, the host country is a developing nation not included in Annex I of the Kyoto Protocol, and the resulting emission credits are called Certified Emission Reductions (CERs).¹² The procedure for CDM is similar to that for JI Track 2, except here, the certifying body is called a "designated operational entity." The designated operational entity's role is to independently evaluate proposed CDM project activities against requirements set out in decision 17/CP.7; verify the emission reductions that have occurred as a result of the project; certify in writing that the project activity achieved the verified amount of reductions; and request for the issuance of CERs equal to the verified amount of reductions.¹³

Similar to JI Track 1, an Annex I country must satisfy the same above six eligibility criteria to be able to use CERs to contribute to compliance.¹⁴ A country is considered to meet the requirements until the enforcement branch of the Compliance Committee has suspended the country's eligibility.¹⁵

International Emissions Trading

The Kyoto Protocol also allows the trading of carbon credits known as assigned amount units (AAUs),¹⁶ which are credits for each country's allotted cap on greenhouse gas emissions. Under Article 17's international emissions trading, the Protocol's third flexibility mechanism, Annex I parties that have difficulty complying with their reduction commitments can purchase AAUs from other Annex I parties that have a surplus. Because AAUs do not represent real emission reductions, their worth on the carbon market depends significantly on their linkage to Green Investment Schemes, which commit the seller to invest the proceeds in projects that will reduce emissions.

International emissions trading is also subject to the above six eligibility requirements: a party is eligible to transfer or acquire AAUs only if all six requirements are me.

The Consequences of Suspension

In the most recent suspension cases, both Romania and Ukraine's 2010 annual submissions were found not sufficiently complete, accurate, and transparent as required by UNFCCC reporting guidelines for national systems.¹⁷ Both failed to meet the eligibility requirement under Articles 6, 12, and 17 of the Protocol to have in place a national system for estimating greenhouse gas emissions and were therefore suspended from participation in the flexibility mechanisms. Suspension has been likened to a freezing of carbon assets,¹⁸ and has different implications for each mechanism.

Least relevant to the three Central and Eastern European countries is Article 12's Clean Development Mechanism. This is so because these countries have generally served as hosts providing a source of carbon credits for other developed Annex I countries rather than investors seeking extra credits. Nevertheless, were they to participate as investors in CDM projects, they would be ineligible to transfer or acquire CERs,¹⁹ and also ineligible to use CERs to contribute to compliance with their overall emission reduction commitments once the suspension is in place.²⁰ Additionally, private and public entities authorized by the countries to participate in Article 12 project activities also could not transfer or acquire CERs while the authorizing country is ineligible to do so.²¹

Suspension would implicate Article 17 international trading of AAUs to a limited degree. Ukraine and Russia have the biggest forecasted AAU surpluses, representing over 75 percent of the global excess.²² Romania, which only enacted legislation to sell carbon credits last year, has yet to sell any of its 300 million spare AAUs.²³ Once suspended, these countries and any legal entities under their authorization will no longer be eligible to transfer or acquire AAUs,²⁴ although future transactions can continue to be negotiated and prepared. If Romania and Ukraine are suspended for the estimated six-month period, they will be reinstated in mid-2012, at which point there will only be a few months left before the Kyoto Protocol expires at the end of the year. This generates a great deal of uncertainty as the value of AAUs after 2012 is yet unknown.

Note, however, that the impact of suspension on the AAU trade is limited because the market is already saturated. The value of AAUs has plummeted from the market peak of around 10 euros per credit in 2008, and Romania is expected to receive a fraction of that price when the trading ban is removed later this or early next year.²⁵ As a result of the financial crisis, industrial powerhouses such as Japan, Spain, and Portugal—traditional buyers of carbon credits—are no longer making large purchases.²⁶ For Ukraine, suspension is unlikely to delay or prevent any AAU sales because the government is not expected to sell any of its surplus over the coming year.²⁷

After preliminary findings about its likely imminent suspension were publicized, Ukraine scrambled to put through a number of carbon transfers. The government handed out over 14 million AAUs to 13 projects under the JI mechanism for emission reductions made before 2008.²⁸ These twelfth-hour transfers are legal under Kyoto Protocol's trading provisions so long as both parties are eligible to enter into the transaction at the time the transfer is made. This is because a transfer of carbon credits is deemed complete once specified steps are taken: a party orders a national registry to issue credits—whether AAUs, ERUs, or CERs—to a specific account; the Secretariat certifies that the parties are eligible to participate in the flexibility mechanisms and that the credits proposed for transfer are valid; and the credits are removed from the transferring account and recorded in the acquiring account.²⁹ The flip side of this bright-line rule is that carbon credits not delivered prior to suspension will likely be delayed and contractual commitments stalled, making it harder for suspended countries to cash in on their Kyoto permit surplus.

Lastly, suspension would affect issuance of Track 1 ERUs, but not that of Track 2 credits, which are verified through an accredited independent entity. This is provided for in both 9/CMP.1 and 11/CMP.1, which stipulate that limitations to transfer "shall not apply to transfers by a Party of ERUs issued into its national registry that were verified in accordance with the verification procedure under the Article 6 Supervisory Committee." ³⁰ The rationale presumably is that an investing entity should get credit for emission reductions that have been independently verified by a third party and should not be penalized for deficiencies in the host country's reporting system. Thus, suspension could mean late delivery of Track 1 ERUs, but will not impact Track 2 transfers.

Traditionally ERUs have traded at a discount to other credits because of a lack of liquidity on the buying side, but more participants are getting comfortable with the trade, leading some to believe that the value of ERUs will rise.³¹ Ukraine is the world's largest supplier of ERUs, having issued about a third of all ERUs to date: around 25 million out of 74 million units.³² It is estimated that suspension could lead to delays in the issuance of 3 million Ukrainian Track 1 ERUs and one million Romanian ERUs.³³

In conclusion, suspension of the three Central and Eastern European countries will have differing effects on the nations' ability to participate in each of the three flexibility mechanisms. Its effect on CDM is largely irrelevant; its effect on the AAU trade is limited by the fact that relatively little buying is occurring; and its effect on Track 1 ERU transfers is mainly to delay some transactions. The impact on the AAU and ERU trade is mitigated by the relatively short anticipated duration of the suspension and by the legality of last minute transfers in anticipation of suspension.

Footnotes

1 Jeff Coelho, Romania ban to hit December delivery, AAU reputation, Point Carbon, Aug. 30, 2011, http://www.pointcarbon.com/news/1.1574309?date=20110830&sdtc=1.

2 Ben Garside, Ukraine faces CO2 trade ban after breach upheld, Point Carbon, Aug. 26, 2011, http://www.pointcarbon.com/news/1.1573100?date=20110826&sdtc=1.

3 U.N. Framework Convention on Climate Change, Report of the Conference of the Parties serving as the meeting of the Parties to the Kyoto Protocol on its first session, held at Montreal from 28 November to 10 December 2005, Addendum Part Two: action taken by the conference by the Conference of the Parties serving as the meeting of the Parties to the Kyoto Protocol at its first session, Decision 9/CMP.1, ¶ 6. FCCC/KP/CMP/2005/8/Add.2 (Mar. 30, 2006).

4 One ERU is equal to one metric ton of carbon dioxide equivalent.

5 Ministère de l'Économie, des Finances et de l'Industrie, Guide to the Kyoto Protocol project mechanisms: The Joint Implementation (JI) mechanism 20 (2003).

6 Kyoto Protocol to the United Nations Framework Convention on Climate Change, art 6, 1(b), Dec. 10, 1997, 37 I.L.M. 22 (1998).

7 U.N. Framework Convention on Climate Change, supra note 3, Decision 9/CMP.1, ¶ 21.

8 Id., Decision 9/CMP.1, ¶ 23.

9 Id., Decision 9/CMP.1, ¶ 33.

10 Id., Decision 9/CMP.1, ¶ 25.

11 Id., Decision 9/CMP.1, ¶ 24.

12 A CER is equal to one metric ton of carbon dioxide equivalent.

13 See U.N. Framework Convention on Climate Change, Report of the Conference of the Parties serving as the meeting of the Parties to the Kyoto Protocol on its first session, held at Montreal from 28 November to 10 December 2005, Addendum Part Two: action taken by the conference by the Conference of the Parties serving as the meeting of the Parties to the Kyoto Protocol at its first session, Decision 3/CMP.1, FCCC/KP/CMP/2005/8/Add.1 (Mar. 30, 2006).

14 Id., Decision 3/CMP.1 ¶ 31.

15 Id., Decision 3/CMP.1 ¶ 32(b).

16 An AAU is equal to one metric ton of carbon dioxide equivalent.

17 Enforcement Branch of the Compliance Committee, Final Decision, Party concerned: Romania, ¶ 12, CC-2011-1-8/Romania/EB (Aug. 27, 2011); Enforcement Branch of the Compliance Committee, Preliminary Finding, Party concerned: Ukraine, ¶ 12, CC-2011-2-6/Ukraine/EB (Aug. 25, 2011).

18 Coelho, supra note 1.

19 U.N. Framework Convention on Climate Change, supra note 3, Decision 11/CMP.1, ¶ 2.

20 U.N. Framework Convention on Climate Change, supra note 13, Decision 3/CMP.1, ¶ 31.

21 Id., Decision 3/CMP.1, ¶ 33.

22 Ovidiu Posirca, Kyoto ban could leave Romania with 537 million unsold AAUs, Business Review, Sept. 5, 2011, "http://business-review.ro/power/kyoto-ban-couldleave- romania-with-537-million-unsold-aaus/12203/" .

23 Coelho, supra note 1.

24 U.N. Framework Convention on Climate Change, supra note 3, Decision 11/CMP.1, ¶ 2, 5.

25 Posirca, supra note 22.

26 Id.

27 Garside, supra note 2.

28 These credits are labeled AAUs because under Ukrainian law, JI projects earn AAUs for emission cuts made before 2008, the start of the five-year Kyoto phase, and ERUs after 2008.

29 U.N. Framework Convention on Climate Change, supra note 3, Decision 13/CMP.1, ¶ 40.

30 Id., Decision 9/CMP.1, ¶ 41; Id., Decision 11/CMP.1, ¶ 10.

31 Andrew Allan, Russia, Ukraine account for 90 pct of ERUs issued: Barcap, Point Carbon, Sept. 12, 2011.

32 Garside, supra note 2.

33 Ben Garside & Marton Kruppa, Romania banned from Kyoto carbon trade, Point Carbon, Aug. 28, 2011.

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