In Warsaw As In California, Forest Carbon Carrot Needs Compliance Stick

11 November 2013 | WARSAW | Farms and forests loom large as year-end climate talks kick off here today. Negotiators are expected to agree on methods for measuring existing rates of deforestation in developing countries, and that will set the stage for clarity on how hundreds of millions – and, eventually, billions – of dollars in performance-based funding will flow to halt deforestation and promote climate-smart agriculture under the United Nations Framework Convention on Climate Change (UNFCCC).

But while global talks have yet to agree on ground rules for how to handle carbon emissions from forestry, voluntary markets are already delivering hard results. Indeed, Ecosystem Marketplace’s most recent State of the Forest Carbon Markets report showed that voluntary carbon projects are supporting an area larger than all the forests of the Democratic Republic of Congo combined and are poised to keep 1.4 billion tons of carbon dioxide out of the atmosphere over the next five years.

There is, unfortunately, a catch – and it’s a big one. The 1.4 billion-ton reduction that private conservationists have undertaken will only come to fruition if developers can keep their projects going, and developers can only keep their projects going if investors step up to buy millions of tons of reductions. That translates into a multi-billion dollar cash infusion, up to ten times more than all the money that’s flowed into voluntary forestry projects to-date.

Project developers concede that a significant proportion of this demand will have to come from compliance markets like California’s and public-sector purchases from donor countries and UN agencies. With land-use front-and-center in Warsaw, common sense would dictate a simple solution: simply incorporate the existing projects into emerging frameworks. Politics, however, dictates otherwise.

“A lot of bilaterals and multilaterals on the donor side are uncomfortable with having a direct relationship with projects,” said Naomi Swickard, manager of Agriculture, Forestry, and Land Use at the Verified Carbon Standard, quoted in the State of the Forest Carbon Markets report.

“We need to define structures that can reward emissions reductions at different scales within that type of relationship,” she added.

Those structures have come to be known as “nesting” – a general term for the various ways that existing projects can somehow be woven into emerging national accounting programs.

The Nesting Option

Donor countries like Norway and UN agencies like the Forest Carbon Partnership Facility (FCPF) will be sending billions to developing-world countries over the next few years, but most of that money is targeted to “readiness” initiatives that build up carbon accounting. Performance-based funding is part of the equation as well, but that won’t start flowing until much later – and isn’t likely to end up in existing projects.

That’s partly because voluntary projects follow rigorous methodologies developed for very specific instances. They have reference levels based on local factors, and their start dates aren’t tied to national strategy. That makes it difficult for donors to actually purchase offsets outright.

What they can do, however, is support the creation of national accounting mechanisms that make it easier to calculate leakage (which is what happens when a project reduces deforestation in one region only to see it move someplace else) and that also creates a trusted regulatory framework within which existing projects can “nest”.

“Nesting can create new opportunities for projects to access different types of finance from different sources of demand,” said Swickard.

Regional Markets

Meanwhile, regional programs such as those in Australia and in California can promote the use of forest carbon offsets, which would drive the demand needed to prevent the programs already underway from backsliding. Buyers in both locations sought forest carbon offsets in 2012 in preparation for domestic compliance regulations, with these credits often receiving above-average pricing, according to the report.

While California’s compliance cap-and-trade market launched in January, regulatory delays in releasing the offset program guidelines meant that many potential forestry projects found themselves in a holding pattern, an impact that would have been more noticeable in the North American region had it not been for significant volumes traded in the Chicago Climate Exchange’s offset program, according to Ecosystem Marketplace Co-Director Molly Peters-Stanley. Meanwhile, the future of Australia’s carbon price is uncertain, with new leadership pledging to ax the country’s carbon tax.

The lack of a compliance market that fully embraces forestry projects remains the fundamental problem in raising capital for such projects, said Eric Bettleheim, CEO and Founder of Floresta Group, speaking to attendees of the 2013 State of report launch last week.

“We need a market with real demand, demand that is measurable, demand that is driven by large commercial players needing to comply,” he said. “This has eluded us again and again. It eluded us in the EU ETS. It eluded us most recently in Australia. It may even elude us in California, which I think would be a tragedy.”

“Until we have a compliance market, we’re going to continue to struggle to find a financing model which is robust and consistent,” Bettleheim added.

Following California’s Lead

California’s program currently allows improved forest management, avoided conversion and urban forestry offsets and the regulations have placeholder language that would allow international forestry offsets to become eligible. But California legislators could renew a push to prevent the state program from becoming the first compliance market to welcome REDD offsets, particularly amid vocal opposition to REDD by certain environmental and indigenous groups.

Bettleheim implored stakeholders to pressure key decision makers in California to ensure that the market works. “The real problem with carbon markets is that because it’s a legal regime, it attracts political interference,” he said. “That repeated interference causes enormous stress, particularly on an early-stage market.”

The US state, as well as other second-generation markets developing in China, Japan and South Korea, have learned from the mistakes of the EU ETS and are better designed than the programs put forth by the first movers in the carbon markets.

“My fear is that if California doesn’t work, nobody is going to follow,” Bettleheim said. “That the first generation of markets wasn’t properly designed is hardly surprising. Hopefully one of (the second-generation markets) will actually take forest credits as part of the system. I think the nearest and most impressive political and most important globally is California. Where California goes, the rest of the states go. Where (the United) States goes, a lot of the rest of the world will go.”

California has a memorandum of understanding with the Mexican state of Chiapas and the Brazilian state of Acre, with Acre seen to be further along in the quest to become the first jurisdiction-scale program to deliver REDD compliance offsets based on its use of the Verified Carbon Standard’s (VCS) jurisdictional nested REDD guidance. Between 60-95 MtCO2e of VCS REDD credits are rumored to be coming from Acre soon.

“It’s a big number,” said Alfred Evans, CEO, investor Climate Change Capital. “However, the government there is pretty sophisticated. They know what happens when you flood a market. I don’t think you’ll see millions and millions of tons suddenly transacted.”

Evans objected to the notion that the carbon markets have collapsed, citing the implementation or efforts to implement carbon markets in California, China and Rio de Janeiro and continued trading in the EU ETS, albeit at much lower prices than in previous years. Even the Australian carbon pricing program, now under threat from newly elected lawmakers, may shift from a tax to a market-based mechanism, he said. Policymakers continually return to markets as a potential tool to mitigate GHG emissions in their geographies, Evan said.

“Carbon markets have not gone away. In fact, they have proliferated,” he said. “The EU ETS hasn’t collapsed as of the last time I checked since we trade it every day. What has happened is the price has come down. But that tells us the market is working. It’s sending a signal that reflects supply and demand. It’s telling us that the design of the market might need to be addressed. It is a carbon market and it is highly relevant. And if you look around the world, it is one of many.”

Drawing in the Private Sector

Recent funds that have closed are not raising money from private equity investors, some of whom have either been burned by or lost confidence in the carbon markets, Bettleheim said. “Private investors are not here and the few that are there are very anxious and they don’t bet on carbon,” he said. “They want to know there is a hard asset that they actually can take away when the whole thing goes bust. They want downside protection.”

The problem for financing forestry projects is that these investors are stewards of private capital and they have to protect their returns, Evans said. His firm is in relatively advanced discussions around some forestry projects with other revenue streams such as agroforestry, tropical hardwoods and Forest Stewardship Council-certified wood, with carbon seen more as peripheral revenue stream rather than guaranteeing a good return on investment.

“Impact investors want a financial return and the carbon market won’t give them that,” he said.

This has led to an increasing focus on measuring and quantifying the non-carbon benefits and impacts of forestry projects, the report found. In 2012, the Climate, Community & Biodiversity Standards (CCB Standards) and the VCS introduced a joint project approval and offset issuance process, with the CCB Standards supplying the criteria for evaluating land-based projects’ community and biodiversity co-benefits.

“It’s really difficult to monetize the different impacts that forestry projects have, but for a lot of projects it’s very important to address these different impacts besides carbon,” said Kars Riemer, Consultant for NGO Face the Future.

Steve Zwick is Managing Editor of Ecosystem Marketplace. He can be reached at [email protected]