The Clean Development Mechanism in China

Tauna Szymanski

China may emerge as the world's largest market for investment projects that reduce greenhouse gas emissions, so companies should start planning their projects now

ost existing and potential foreign investors in China assume that the Kyoto Protocol is irrelevant to their business, particularly if they are US-based companies. Indeed, many people believe the treaty imposes economic constraints on corporations. But the protocol's Clean Development Mechanism (CDM), created to promote and facilitate investment in greenhouse gas emissions-reduction projects, will provide business opportunities and encourage economic growth. CDM projects in China, in particular, promise to generate revenue and other benefits for companies from industrialized countries that invest in qualifying projects.

China ratified the protocol in August 2002. With Russia and Canada leaning toward ratification, the protocol may take effect within the year. When it does, the demand and premium for viable CDM projects will escalate rapidly.

What is the CDM?

Article 12 of the Kyoto Protocol establishes the CDM to foster sustainable development in

developing countries and to help developed countries meet their mandated greenhouse gas emissions-reductions targets cost-effectively (see below). Investment in emissions-abating CDM projects, therefore, will generally be undertaken by entities from developed countries within developing countries. Developed-country entities may in turn use the certified emissions reductions (CERs) accumulated through such projects to meet their national commitments under the protocol. Only nations that have ratified the protocol will receive CERs--thus precluding official participation in the CDM by the United States and US entities. US companies need not sit on the sidelines, however--they can undertake CDM projects and transact CERs through foreign subsidiaries or other avenues.

Though protocol rules dictate precisely what projects will qualify to earn CERs, any project that results in fewer greenhouse gas emissions than before will potentially qualify. For example, a 600 MW wind farm in Inner Mongolia, replacing coal-fired power in the region, would abate carbon dioxide emissions by about 500,000 tons per year, according to PricewaterhouseCoopers's climate change services. The developed-country entity investing in the wind farm, assuming it structured the project to retain ownership of the CERs, could opt to sell these credits on the international market to a company anticipating a regulated reduction in its own emissions. Thus the buyer continues to emit greenhouse gases at an equivalent level and the seller could generate an added revenue stream of up to $25 million over 10 years (at an estimated carbon dioxide reduction price of $5 a ton).

The operational details of the CDM were to be finalized in October 2002 at the Eighth Conference of the Parties to the United Nations Framework Convention on Climate Change in New Delhi (after CBR went to press). In the meantime, CDM projects established after January 1, 2000 are creditable and governed by existing rules.

China's role in climate change and the CDM

China is the world's second-largest emitter of greenhouse gases, behind the United States, and its growing economy and large population are becoming wealthier and more consumption-oriented by the day. Electricity demand is expected to grow 5.5 percent per year through 2020. With its thirst for foreign investment and its dependence on carbon-intensive coal as a primary source of energy, China may become the largest single recipient of CDM projects. In fact, the China Council for International Cooperation on Environment and Development forecasts that China will draw 60 percent of the CDM's potential benefits, because of the comparatively low cost of emissions abatement in China. The Asian Development Bank estimated that the Chinese market for carbon emissions reductions could amount to $13 billion per year.

China is playing an active role in negotiating both the details of the broader Kyoto treaty and the operational establishment of the CDM Executive Board under the treaty's Secretariat. Indeed, one of the alternate members of the first CDM Executive Board is Lu Xuedu, a Ministry of Science and Technology official who has long been active in the Kyoto negotiations.

China also recognizes the negative domestic impacts of climate change. Officials in China's Meteorological Administration directly attributed last summer's heavy flooding, which killed more than 1,000 people, to climate change. The rains occurred in normally arid areas and caused at least $3.6 billion in damage to agriculture, transportation, power, and other infrastructure, according to official estimates. Worldwide, the effects of climate change are predicted to cost $300 billion annually by 2050, according to the German insurance company Munich Re.

Despite its reluctance to adopt binding targets, China is one of the few countries in the world to have delinked, on a long-term basis, its economic and energy emissions growth rates. Its energy intensity (the ratio of energy consumption to GDP) has fallen dramatically since the 1970s, largely as a result of energy efficiency measures. And its carbon dioxide emissions decreased 7.3 percent between 1996 and 2000, a period of high economic growth, according to the November 2001 issue of the journal Science, though these emissions seem to be on the rise again.

China likely considers the CDM as killing three birds with one stone, resulting in more economic development, mitigated global climate change, and less acid rain.

Despite its reluctance to adopt binding targets, China is one of the few countries in the world to have delinked, on a long-term basis, its economic and energy emissions growth rates. Its energy intensity (the ratio of energy consumption to GDP) has fallen dramatically since the 1970s, largely as a result of energy efficiency measures. And its carbon dioxide emissions decreased 7.3 percent between 1996 and 2000, a period of high economic growth, according to the November 2001 issue of the journal Science, though these emissions seem to be on the rise again.

Understandably, China views the CDM as a way to attract more foreign investment, with the added (though perhaps secondary) benefit of obtaining a cheap fix for some of its domestic environmental problems. Since coal is not only the primary source of China's contribution to global climate change, but also the cause of China's major domestic environmental menace—acid rain—China likely considers the CDM as killing three birds with one stone, resulting in more economic development, mitigated global climate change, and less acid rain.

PRC authorities

As early as 1990, China established a National Coordination Group on Climate Change, made up of 13 ministries and agencies. The Ministry of Foreign Affairs represents China at the multilateral Kyoto Protocol and CDM negotiations while the State Development Planning Commission (SDPC) takes the lead on domestic climate change and CDM issues.

If China imposes onerous requirements and large taxes on projects, it may lose CDM investment to other large developing countries such as India and Brazil

SDPC will also likely serve as the lead coordinating agency for China's eventual CDM National Authority, which is in the process of being established. This authority will draw up any additional eligibility requirements for CDM projects in China and will grant the required "national approval" letter, which certifies that proposed projects promote sustainable development.

For the moment, the government appears both tentative and noncommittal about formally endorsing CDM projects. Chinese officials repeatedly emphasize the preliminary nature of the government's work on the CDM and are still studying its potential costs and benefits. The government has not yet issued formal guidelines indicating what types of projects it might approve to generate CERs. Officials also appear to be debating internally a number of difficult technical and political issues, such as how to establish project emission baselines and whether or not to tax or retain ownership of some CERs. Though a few other countries have discussed the possibility of a CER tax, foreign corporations warn that such a tax will likely hurt the financial viability of CDM projects, thus diminishing investor interest.

If China imposes onerous requirements and large taxes on projects, it may lose CDM investment to other large developing countries such as India and Brazil. Michael Molitor, director of Climate Change Services for PricewaterhouseCoopers, foresees direct competition among "super-CDM" countries to lure plum investment dollars. As soon as the protocol enters into force, Molitor predicts that a "bulge" of investment monies will rush to structure CDM projects in the most welcoming and cost-effective areas with the fewest barriers to entry.

Nevertheless, a CER tax could serve as a significant source of revenue at a time when the Chinese government is facing huge revenue shortfalls. Several foreign government representatives have observed hints of political infighting among Chinese ministries—virtually all of whom are facing budget cuts—over the inflow of CDM projects and thus the power to levy and collect portions of CERs as taxes.

The early bird...

There is no guarantee that the Kyoto Protocol will enter into force and that CERs or other verified emissions reductions will become valuable commodities under a formal regime. Forward-looking companies are not deterred by the lack of formal institutional mechanisms, however, and are structuring current projects to reduce emissions even in the absence of a regulatory framework requiring them to do so.

Multilateral bank and governmental funding is often available to support CDM projects, as long as it does not displace existing overseas development assistance. The Asian Development Bank, the World Bank, the Global Environment Facility, and others have financed the CDM and other emission-reduction projects in developing countries. In addition, the Dutch Government and the World Bank's Prototype Carbon Fund are purchasing emissions reductions from eligible projects, often providing additional up-front financing.

How to pursue a CDM project in China

The October 2001 Marrakech meeting of signatories to the climate change convention established the main rules governing CDM operation and CER issuance. The CDM project cycle begins with the investor and host entity drawing up a project design document that includes a quantified estimate of greenhouse gas reductions. The project participants then establish the "business-as-usual" emission baseline and the "project boundaries" to demonstrate that the project brings additional environmental benefits. Host countries may set more specific guidelines regarding emission baselines, sustainable development, financing, and other issues. At this point the project must also obtain any necessary financing. The project proponents must also obtain a letter of approval from the CDM National Authority of the host country.

Forward-looking companies are not deterred by the lack of formal institutional mechanisms, and are structuring current projects to reduce emissions even in the absence of a regulatory framework requiring them to do so.

Adding to project costs is the requirement that an independent third party validate the project as eligible to participate under the CDM. Some organizations already active in validating, monitoring, and certifying emissions reductions include DNV, Ecosecurities Ltd., IT Power, KPMG, and PricewaterhouseCoopers. Investors may also need the assistance of auditors, lawyers, and consultants to locate the most appropriate project partners, accurately establish emission baselines and boundaries, clearly define ownership of credits generated, and monitor the project's emissions reductions (see below). These are potentially significant costs—the World Bank recently estimated that validation, monitoring, and verification could easily cost $250,000 per project. Thus, budgets must consider and account for this outlay in ascertaining financial viability. Yet a number of companies are swallowing these costs to gain experience, take advantage of the low competition, develop relationships, and improve public and community reputations (see below).

Investors must register the project with the CDM Executive Board under the protocol's Secretariat. If the project meets all requirements, implementation of the project proceeds, with project participants hiring independent monitoring and certifying entities. The CDM Executive Board then issues CERs and deposits them in the investor country's national registry, which will contain accounts for private and public entity investors.

Article continued below.

The Basics of Emissions Reductions: A New Commodity?

More than 160 nations met in December 1997 to negotiate the Kyoto Protocol, which commits its industrialized-nation parties to reduce their contribution to global climate change. The protocol will likely enter into force within the next year, without the participation of the United States.

The Kyoto Protocol confers on its ratified parties both a right to emit and a right to trade verified emissions reductions. Developed countries are assigned legally binding reduction quotas for six greenhouse gases: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, chlorofluorocarbons, and sulfur hexafluoride. National reduction targets range from 8 percent below 1990 emissions levels to 10 percent above by the year 2012.

After 2012, developed countries can buy and sell these greenhouse gas emission allowances to meet their commitments more efficiently. The standard unit of this new commodity is measured in tons of "carbon dioxide equivalent." If the gas at issue is not carbon dioxide but one of the other greenhouse gases, the "equivalent" is calculated as a standard multiple of the "global warming potential" of the gas. Trading thus easily incorporates all six gases.

Most developed-nation parties, to reach their protocol targets, will likely allocate quotas among their largest-emitting industries and will establish domestic greenhouse gas emission-trading programs.

Accordingly, trading is expected to take place among national governments as well as among private and public entities within a developed country. Experts estimate that the greenhouse gas emissions trading market will climb to $100 billion a year after the trading provisions of the protocol enter into force.

In the meantime, the protocol mechanisms of Joint Implementation (for projects in developed countries) and the Clean Development Mechanism (for projects in developing countries) enable public and private developed-country entities to undertake emissions reduction projects in other countries and to apply these credits, known as certified emissions reductions, against their own domestic targets imposed under the protocol.

—Tauna Szymanski

Sectors for investment

Because China relies on coal to generate almost three-quarters of its power, the electricity sector contains perhaps the largest potential source of viable CDM projects. But Scott Roberts of consulting firm Cambridge Energy Research Associates downplays the short-term potential of generating CERs in this sector. He notes that the massive and complex restructuring of the State Power Corp. (SPC) has distracted regulators from environmental goals and has discouraged foreign investors from exploring traditional coal-fired power plants, not to mention more advanced environmentally friendly power projects that are usually less commercially viable. In addition, in recent years foreign investors have lost enthusiasm in this sector after local players reneged on power purchase agreements. Another disincentive to introduce cleaner and more efficient technologies to China's power sector lies in the fact that SPC regularly reviews the financial performance of generators and ratchets prices downward if they become more efficient.

In the shorter term, CDM investment in China will likely involve incremental projects such as the introduction of highly efficient boilers, energy-efficient buildings, coalbed and landfill methane recovery and utilization, biomass gasification, wind energy, solar heat, electric and natural gas-fired public transportation, and district heating improvements (ideally with natural gas boilers). If projects like these can demonstrate greater efficiency and lower emissions, CDM potential exists.

In the shorter term, CDM investment in China will more likely involve incremental projects such as the introduction of highly efficient boilers, energy-efficient buildings, coalbed and landfill methane recovery and utilization, biomass gasification, wind energy, solar heat, electric and natural gas-fired public transportation, and district heating improvements (ideally with natural gas boilers).

Qinghua University's Global Climate Change Institute has estimated the financial benefits of one such project. A few years ago, roughly 500,000 industrial boilers existed in China, consuming about 400 million tons of coal each year. Retrofitting 15 percent of these, they predicted, would require an initial, one-time investment of $205 million and result in a carbon dioxide emissions reduction of 16.2 million tons a year. Fuel savings would be 7.5 million tons of coal per year, saving $226 million annually. By structuring the project under the CDM, revenue generated from the sale of CERs would provide significant extra income to the investors.

In this uncertain, pre-protocol stage, a number of institutions are undertaking studies of CDM project feasibility, market opportunities, and policy recommendations. The Asian Development Bank, the German Development Cooperation organization, Qinghua University, SDPC's Energy Research Institute, the World Bank, and organizations under the Canadian, Dutch, British, German, and Italian governments are all involved in studies of the future operation of the CDM in China.

Likely constraints on CDM projects

China's government will likely consider a number of factors in evaluating CDM projects for approval: the project's contribution to economic development, including job creation; environmental benefits, including mitigation of greenhouse gas emissions and more localized pollution reduction; conditions placed on technology transfer, including accounting for local capacity and localization of the technology; and the scope and scale of investment, including the extent to which it involves state-owned enterprises. China's priority CDM projects will lie in the areas of energy efficiency, renewable energy, and the substitution of fossil fuels.

The central government's initial skepticism toward CDM projects and the issuance of CERs is likely to result in an assertion of control not only over project approval, but also monitoring, verification, and granting of credits. An imposition of strict oversight could be an additional deterrent to foreign CDM investors in China's otherwise promising market.

US firms shut out?

US entities face a potentially deal-breaking obstacle because their current government refuses to ratify the Kyoto Protocol. This could result in a virtual shutting-out of US entities from worldwide CDM projects, in protest of or retribution for US intransigence on the treaty, or for the simple practical reason that project partners and hosts want as much certainty as possible with regard to earning additional income from the eventual sale of CERs. And, as mentioned earlier, if the United States remains a non-party, US entities by definition cannot generate CERs.

US entities may get around this rule by structuring CDM projects in developing countries and transacting CERs through their foreign subsidiaries. They may also be able to undertake a "unilateral CDM" project. In such a project, the contract would assign all emission-reduction rights to the host country entity, for later private contractual transfer to the US investor. A few projects have already adopted this arrangement, and investors appear quite willing to accept any risks associated with its uncertainty under future CDM rules.

In the meantime, before the protocol enters into force and emissions trading begins, an active speculative market for emissions reductions has emerged. Companies, particularly those in the European Union already facing domestic and regional regulatory constraints on greenhouse gas emissions, have been buying and selling verified emissions reductions created by various investment projects worldwide. Brokers and platforms like Natsource LLC, CO2e.com, and Cantor Fitzgerald LP have been active facilitators of these trades, which have ranged between $4 and $8 a ton for carbon dioxide emissions reductions. China presents an attractive market for generating even speculative emissions reductions because of the range and low price of emissions abatement options.

Adapting to a "carbon-constrained" future

Potential investors should be open-minded but cautious about the costs of structuring their project within the CDM framework, but if the project meets China's basic criteria and will generate a large number of CERs, then costs will be less of a deterrent. A "carbon-constrained future" is virtually inevitable, and all investors in China should begin thinking now not only about how they will adapt to legal restrictions on emissions imposed by their home countries, but also how they might benefit financially—and gain early experience—by participating in the CDM.

Worldwide, the possibility of generating credits from CDM projects has only existed for three years. The status of the CDM is particularly new and uncertain in China. Nevertheless, the active speculative market in verified emissions reductions, coupled with the probable future entry into force of the Kyoto Protocol, suggest that project investors should seriously consider emissions-reduction aspects of their projects in developing countries. China's size, economic growth, and energy mix offer huge opportunities for generating revenue from the sale of CERs. Given its absence of binding emissions-reduction obligations, the CDM is also China's best bet to reduce its own considerable contribution to global climate change.

A "carbon-constrained future" is virtually inevitable, and all investors in China should begin thinking now not only about how they will adapt to legal restrictions on emissions imposed by their home countries, but also how they might benefit financially—and gain early experience—by participating in the CDM.

Important Questions for Potential CDM Project Participants

Martijn Wilder, the Asia-Pacific regional director for climate change for the global law firm Baker & McKenzie, notes that companies need to appreciate the opportunities and liabilities that the CDM creates before committing to a project. He adds, however, that the CDM is a key mechanism by which multinational corporations in certain jurisdictions can obtain additional revenue and government support. Wilder has advised potential CDM project participants in China, at a bare minimum, to answer the questions listed below before finalizing project contracts and side agreements on emissions reductions rights.

Baselines What are the current emissions levels from the standard facility of your project type in the region? This information will serve as the baseline above which emissions reductions by the planned project will be "additional."

Reduction   potential How do the existing emissions profiles alter with the adoption of the new technology? How many tons of emissions reductions might be generated?

Ownership   Who will own the resulting emissions reductions? Who owns the project facilities? Who actually controls and operates the project? Who owns the equipment, if any, being installed to facilitate the emissions reductions of the project facility?

Liabilities   If the facility already exists and is being acquired, or has previously been acquired, were all assets and liabilities acquired? Were any arrangements entered into regarding emissions reductions?

Constraints   Do any other commercial arrangements exist that may affect the ability to generate and transact emission reductions?

Answering these and other questions will help ensure that emissions reductions are real and that future ownership of emissions reductions will not be in doubt. Contractual language must be straightforward and clear, and this may require providing a primer on the basics of climate change to the Chinese party and undertaking careful subsequent negotiations.

Wilder does not advise US companies to commence CDM projects except through their foreign subsidiaries or as "unilateral CDM" projects. He notes that because the United States is not a party, US entities will not even be permitted to register their projects under national registries. He adds, "We're seeing a lot of competition between Australian, US, UK, and other EU companies to get new investments in China, particularly in renewable energy projects—the hope is that many of these will become CDM projects."

—Tauna Szymanski

Why Undertake Early CDM Projects?

Gain experience for anticipated future regulation of greenhouse gases

Generate additional revenue

Improve public and community relations

Insure against future regulation

Hedge against potential shareholder liability suits

Establish market dominance

Obtain low-cost abatement projects, or "low hanging fruit"

Develop relationships in host countries

Help guide and advise governments on future regulation

Contribute to public health and environmental improvements

—Tauna Szymanski

Tauna Szymanski will receive her JD degree from Stanford Law School in May 2003 and is the editor-in-chief of the Stanford Environmental Law Journal. She previously served as a US China government relations consultant. Szymanski spent the last two summers working in Baker & McKenzie's Global Climate and China Practice groups in Chicago and Hong Kong and would like to acknowledge the assistance and support of her former colleagues in the research and preparation of this article.

The China Business Review, Volume 29, Number 6, November-December 2002

Last Updated: 31-Oct-2002