Carbon Trading: The Challenges and Risks John Drexhage Director, Climate Change and Energy International Institute for Sustainable Development Agriculture and Carbon Management Workshop February 11, 2003 Winnipeg, Manitoba

Overview Key Characteristics of a Carbon Market Unique Challenges Strategies for Risk Minimization Influence of the International Negotiations

Characteristics of Carbon Credits Credits or Offsets can come from: –Reductions –Removals (sequestration of carbon) Should be in compliance with the Kyoto Protocol -- e.g.: − Based on net atmospheric reductions − Additional − Address leakage

The Carbon Market System The structure of a carbon market system for Canada is currently being developed. Assume that it will be based on: 1. Compliance with the rules and mechanisms of the Kyoto Protocol 2. An open market in which the agricultural sector does not have emission reduction targets 3. Technically credible, quantified credits verified by a third party.

What are the Risks? Those common to any new commodity –Price risk –Barriers to entry –General performance risk Unique challenges –Measurement –Permanence

Challenges of Carbon Markets Measurement: Additionality – emission reduction or removal must be in addition to what would have occurred in a business-as-usual scenario. Permanence – as stored carbon may be released in the future, how do you ensure that carbon credits reflect real emission reductions? − Baselines − Verification − Monitoring − Compliance

Absence of Market Structure Key questions to be addressed include: –Definition of an Emission Reduction Direct reductions Indirect reductions –Ownership What if the land manager is different from the land owner? Is soil a public good or a private good?

Timeliness of Credits Bankability –The ability of credit generators to bank credits for use in future years. Credit for Early Action –Will credit be given for actions that reduced or removed emissions prior to the establishment of regulations? Unlikely. Future Liability –What happens if an emissions cap is put on the agricultural sector?

Risk Minimization May be achieved through: Use of premium credits –Real, verified and additional Partial Sale of Credits –Maintain your own bank Government Purchase

Potential Marketing Systems Use of an Aggregator –Collective marketing of credits –E.g.: Pacific Northwest Direct Seed Association Leasing Carbon Removals –Lease credits to the buyer for a set period of time –May renew contract at end of period Options Contracts –Pay for the option of buying or selling credits in the future

Canada’s System The market system put in place by Canada is likely to be influence by decisions made in relation to the use of sinks within the Clean Development Mechanism (CDM) Two main options: –Temporary credits –Insurance

Temporary Credits Proposed by Columbia (2000) and the EU (2002) The EU Approach: Issue a temporary credit when have verified a carbon stock increase of 1 t of CO 2 Temporary credit expires at the end of five years or the Commitment Period, which ever is earlier The temporary credit may be retired by (e.g.) Canada to meet its Kyoto Protocol target In the next Commitment Period Canada would compensate for the temporary credit through the purchase of another credit When the credit expires, the original seller can re-verify and have a new temporary credit issued (again for a maximum of five years)

Insurance Provide insurance against the risk of carbon credits losing their value due to the loss of the sink. Proposed by Canada (2002) –Sellers can purchase insurance for replacement of the sink or the credits –Seller can self-insure by keeping credits in reserve. Uncertainty regarding insurance industry’s interest in this approach

Conclusions There are a number of uncertainties and risk associated with the carbon market at present. –These will be reduced as a credible marketing system is put in place Need a carbon marketing system that: –Is based on real, verifiable credits –Ensures that risk is not borne exclusively by the seller, but is also attractive to buyers