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The climate convention and evolution of the market for forest-based carbon offsets

P. Moura-Costa

Pedro Moura-Costa is the Managing Director
of EcoSecurities Ltd., Oxford, United Kingdom,
a consulting firm specialized in the technical
and financial aspects of forestry. EcoSecurities
has been involved in the carbon sequestration
sector since 1992, and has been engaged in
a series of innovative environmental
finance initiatives.

Although the role of forests in mitigating climate change is still unclear, forestry-based emission reduction projects are nevertheless on the increase, representing a potential for considerable investment in the forest sector.

Since the establishment of the United Nations Framework Con-vention on Climate Change (UNFCCC) in 1992, policy developments associated with the role of forests in mitigating atmospheric levels of greenhouse gases have been both rapid and complex. The Kyoto Protocol, with its binding commitments to reduce greenhouse gas emissions, mentions afforestation, reforestation and deforestation, among others, as land use activities to be considered in efforts to achieve the framework's aims. Included in the Kyoto Protocol are three flexibility mechanisms designed to facilitate the realization of emission reduction targets. The exact definition of how forestry can be included under the protocol is not entirely clear and is open to different interpretations. This is particularly true for the eligibility of land use based activities under the Clean Development Mechanism.

Although UNFCCC has not yet come into force, projects based on the carbon sequestration services of forest plantations have already been developed in anticipation of future benefits

- FAO FORESTRY DEPARTMENT/FO-0405/C. PALMBERG-LERCHE

Despite these uncertainties, an increasing number of forestry-based emission reduction projects have been established in parallel with the ongoing policy developments. To date, more than 40 forestry projects have been established with the main objective of fixing carbon or preventing its release to the atmosphere. Although the market for forestry-based carbon offsets is still dependent on policy decisions, there is potential for considerable infusion of capital into the forest sector. For such investment, foresters need greater understanding of carbon markets and the mechanisms for credit transactions, and of how this new commodity will affect management practices.

This article reviews the evolution of the negotiation process and how it has affected the market for carbon offsets and greenhouse gas reductions. Some of the trends and facts discussed may change following the second part of the sixth Conference of the Parties to UNFCCC (COP-6), scheduled to take place in July 2001 shortly after the article went to press.

POLICY BACKGROUND

UNFCCC and the concept of Joint Implementation

In July 1992, representatives from 155 nations gathered in Rio de Janeiro, Brazil for the United Nations Conference on Environment and Development (UNCED). Recognition that climate change was a legitimate threat led to the signature of the United Nations Framework Convention on Climate Change (UNFCCC), which resulted in a voluntary commitment by industrialized countries (Annex I countries) to reduce their emissions to the 1990 levels by 2000. Imbedded in the agreement was the concept of Joint Implementation with other countries to reduce greenhouse gases. Investors financing Joint Implementation projects would be allowed to claim credits for the reduction of carbon emissions or for carbon sequestration. These credits should be equivalent to the carbon sequestration derived from the investment, and investors would be allowed to use the credits to lower greenhouse gas related liabilities (e.g. carbon taxes, emission caps) in their home countries. The rationale of Joint Implementation is that the marginal costs of emission reduction or carbon dioxide sequestration are generally lower in developing than developed countries.

The Activities Implemented Jointly Pilot Phase

Dissatisfaction among G77 countries over the concept of Joint Implementation led to the growth of opposition to this model. Concerns included a perception that this was a mechanism by which industrialized countries could avoid addressing the real issues of reducing emissions at the source. It was also felt that developing countries might hand over all their cheap offset opportunities to industrialized countries in this initial phase while they had no commitments to greenhouse gas reductions.

In the first COP to UNFCCC, held in 1994, this dissatisfaction was voiced as a formal refusal of Joint Implementation. Instead, a compromise was accepted to have a pilot phase during which projects would be called "Activities Implemented Jointly". During this pilot phase, Joint Implementation projects were conducted with the objective of establishing protocols and experiences, but without allowing actual transfer of carbon credits between developed and developing countries.

The Kyoto Protocol

The Kyoto Protocol was conceived during COP-3 of UNFCCC in December 1997. The most important aspect of the Kyoto Protocol is the binding commitment by 39 developed countries and countries with economies in transition (the so-called Annex B countries, called Annex I countries in UNFCCC) to reduce their greenhouse gas emissions by an average of 5.2 percent of 1990 levels by the commitment period 2008 to 2012. The protocol also approved the use of three flexibility mechanisms for facilitating greenhouse gas emission reduction targets: quantified emission limitations and reduction obligations (QUELRO) trading, Joint Implementation and the Clean Development Mechanism.

Another important output of the agreement was the recognition of forestry activities or "sinks" as valid options for reducing the net concentration of atmospheric greenhouse gases. This is mentioned in Articles 3.3 and 3.4 of the protocol, which deal with "afforestation, reforestation and deforestation" and "additional human-induced activities related to ... land use change and forestry", respectively. It is clear in the Kyoto Protocol that UNFCCC Annex I countries are required to report on land use changes that have occurred since 1990, and are responsible for any changes in carbon stocks associated with these changes. It is less clear in the protocol which forestry activities can be conducted as part of Article 12, the Clean Development Mechanism (see following section).

The Kyoto Protocol was opened for ratification on 16 March 1998 and would become legally binding 90 days after the fifty-fifth government ratifies it, provided that those 55 countries account for at least 55 percent of developed countries' emissions in 1990. As of 25 June 2001, 84 parties had signed the Kyoto Protocol and 35 had ratified it. To date, the United States (the largest individual source of emissions) has not ratified it, and there has been some discussion about the possibility that the country may decline to join the Kyoto process entirely.

Project-based mechanisms: the Clean Development Mechanism and Joint Implementation

Two of the Kyoto Protocol's flexibility mechanisms are related to project-based activities: the Clean Development Mechanism and Joint Implementation. In short, the Clean Development Mechanism involves investment by developed countries in carbon offset projects in developing countries. As defined by the protocol, its purpose is twofold: first, to assist developing countries (non-Annex I Parties) in making progress towards sustainable development and contributing to UNFCCC's objectives; and second, to assist developed countries and countries with economies in transition (Annex I Parties) in achieving their emission reduction targets. Non-Annex I Parties are supposed to gain economic, developmental and environmental benefits from implemented projects that generate Certified Emission Reductions for export. An important facet of the Clean Development Mechanism is that these Certified Emission Reductions are supposed to be bankable from the inception of the Clean Development Mechanism, which was originally planned to start in 2000.


Forests and carbon sequestration: scientific concepts

Carbon sequestration through forestry is based on two premises. First, carbon dioxide is an atmospheric gas that circulates globally; consequently, efforts to remove greenhouse gases from the atmosphere will be equally effective whether they are based adjacent to the source or on the other side of the globe. Second, green plants take carbon dioxide gas out of the atmosphere in the process of photosynthesis and use it to make sugars and other organic compounds used for growth and metabolism. Long-lived woody plants store carbon in wood and other tissues until they die and decompose, at which time the carbon in their wood may be released to the atmosphere as carbon dioxide, carbon monoxide or methane, or it may be incorporated into the soil as organic matter.

Plant tissues vary in their carbon content. Stems and fruits have more carbon per gram dry weight than do leaves, but because plants generally have some carbon-rich tissues and some carbon-poor tissues, an average concentration of 45 to 50 percent carbon is generally accepted (Chan, 1982). Therefore, the amount of carbon stored in trees in a forest can be calculated if the amount of biomass or living plant tissue in the forest is known and a conversion factor to convert weight of biomass into weight of carbon is applied.

Carbon fixation through forestry is a function of biomass accumulation and storage. Therefore, any activity or management practice that changes the biomass in an area has an effect on its capacity to store or sequester carbon. A variety of forest management practices can be used to reduce the accumulation of greenhouse gases in the atmosphere through different approaches. One is to increase the amount or rate of accumulation of carbon, i.e. "sink" creation or enhancement. This mechanism is important for forest plantations. A second is to prevent or reduce the rate of release of carbon already fixed in an existing carbon "pool".

New tree planting in afforestation, reforestation, forest rehabilitation or agroforestry schemes results in carbon fixation during tree growth, i.e. the creation of new carbon sinks. In the context of the Kyoto Protocol, these activities conform to the concept of Article 3.3 (see text). Although carbon sequestration is often discussed in the context of the establishment of new forests, carbon fixation can also be achieved by improving the growth rates of existing forests. This can be achieved through silvicultural treatments such as thinning, liberation treatments, weeding or fertilization. Since substantial amounts of carbon are stored in soils, management practices that promote an increase in soil organic matter can also have a positive effect. These activities fit into the spirit of Article 3.4 of the Kyoto Protocol.

In terms of carbon storage, not all forests are equal. Generally, longer-lived trees with high-density wood store more carbon per volume than short-lived, low-density, fast-growing trees. However, this does not mean that carbon offsets that involve big, slow-growing trees are necessarily better than those involving plantations of fast-growing trees or vice versa, since sequestration is a function of growth rates and storage over time (Moura-Costa, 1996a, 1996b).


Other features of the Clean Development Mechanism include the following.

Given that the structure, organizational framework and modus operandi of the Clean Development Mechanism are not yet defined, its starting date is uncertain. It also depends, of course, on the survival of the Kyoto Protocol.

Joint Implementation, on the other hand, is a parallel mechanism based on projects involving Annex I Parties only. Article 6 of the protocol defines Joint Implementation as the creation, acquisition and transfer between Annex I Parties of Emission Reduction Units that result from projects aimed at reducing emissions at source or enhancing greenhouse gas removals by sinks. As stated in the Kyoto Protocol, credits from Joint Implementation will only start accruing from the beginning of the first commitment period, 2008 to 2012.

Are land use activities eligible under the Clean Development Mechanism?

Although Article 3.3 of the Kyoto Protocol specifically mentions the role of afforestation, reforestation and deforestation (although not forest conservation) for reaching the targets agreed by Annex B countries, Article 12 on the Clean Development Mechanism refers only to "emission reductions" with no mention of any specifically eligible activities. The vagueness of the protocol in this regard has allowed a disturbingly broad scope for interpretation, and totally opposite views have been put forward.

Countries that want forestry included have argued that Article 12 implicitly refers to the activities listed in the main body of the Kyoto Protocol text (Articles 3.3 and 3.4), while those that do not want forestry included argue that only fossil fuel based emission reduction activities should be allowed. Even among those promoting the inclusion of forestry activities, a further point of contention is the types of forestry activity that should be considered. Some countries propose only those activities listed in Article 3.3 (afforestation, reforestation and deforestation), while others promote a much wider range of land use activities as in the spirit of Article 3.4 ("other activities").

Contention over the inclusion of forestry in the Clean Development Mechanism led delegates at the COP-4 meeting in Buenos Aires, Argentina in November 1998 to defer any decision until COP-6. This was a central issue during COP-6 and led to the breaking of the talks in November 2000. The issue will need to be revisited during the next rounds of the negotiation process.

In 1998, the UNFCCC Subsidiary Body for Scientific and Technological Advice commissioned a special report on land use, land use change and forestry, which was prepared by an international collaborative research network of forest scientists under the auspices of the Intergovernmental Panel on Climate Change (IPCC). The objective was to provide policy-makers with the necessary information to enable the implementation of the forestry aspects of the Kyoto Protocol, by reviewing the requirements and outcomes of different policy options. Chapter 5 of the special report deals with forestry projects, and it is generally positive about the potential and feasibility of using this greenhouse gas mitigation option (IPCC, 2000).

MARKET EVOLUTION

During the almost ten years since UNCED, forestry-based carbon offsets have evolved from a theoretical idea to a market mechanism for accomplishing global environmental objectives. To date, more than 40 forestry projects have been established with the main objective of fixing carbon or preventing its release to the atmosphere (Moura-Costa and Stuart, 1998) (Figure).

Post-UNCED phase

The first forestry project designed with the primary purpose of sequestering carbon was developed in 1992 by the Face (Forests Absorbing Carbon-dioxide Emissions) Foundation, an organization created by the Dutch Electricity Board. The mandate of the Face Foundation was to promote the planting of enough forests to absorb an amount of carbon dioxide equivalent to the emissions of a medium-sized coal-fired power plant (400 megawatts) during its 40-year lifetime (Face Foundation, 1994; Dijk et al., 1994). Its first project was a 25 000 ha enrichment planting initiative in Malaysia (Moura-Costa et al., 1996). This was followed by four other projects involving the reforestation of degraded pasture land by small farmers in Ecuador (1992), rehabilitation of an acid-rain degraded park in the Czech Republic (1992), urban forestry in the Netherlands (1993) and rain forest rehabilitation in Uganda (1994).

Other forestry projects initiated in the first years following UNCED included (Putz and Pinard, 1993; Moura-Costa and Tay, 1996):

New carbon sequestration projects developed during five phases since 1989

All these projects were voluntary in nature. Projects were established in anticipation of expected changes in environmental legislation that would require polluters to reduce greenhouse gas emissions, and were created to capitalize on their public relations value. Given that CO2 emissions were not penalized (indeed, they are still not penalized) companies wanted to be sure that their investments would be recognized under future regulatory regimes. Regulatory institutions were not at first given the authority to accept or reject projects on the basis of emissions credit aspects; however, they could accept or reject projects for inclusion in a national registry system.

The model for the transactions carried out in the early years consisted of investor companies paying for the full costs of the carbon sequestration activities, in return for the promise of carbon credits generated as a result of these activities. The amount paid for carbon therefore almost invariably corresponded to marginal costs, accounted for through an open-book approach for the purposes of the competitive bidding process of project selection. The party responsible for project implementation in general received payment for all costs involved in developing the project and usually kept the rights for all forest products derived from the project.

Decline during the Activities Implemented Jointly Pilot Phase

With the establishment of the Activities Implemented Jointly Pilot Phase in 1994, the level of interest in carbon offset projects declined, because projects were conducted to establish protocols and experiences but carbon crediting between developed and developing countries was still not allowed. The pilot phase was meant to simulate the process of Joint Implementation, giving substantive information to help decision-makers formulate the final system for emissions transactions between countries and private entities. However, the absence of credit transfer substantially dulled the appetite for participation, especially in the private sector. Only three new tree planting projects were initiated in 1997: a 6 000 ha reforestation project with klinky (Araucaria hunsteinii) trees in Costa Rica; a 13 000 ha community forestry project in Mexico, financed by the International Automobile Association; and a community forestry project for fuelwood production in Burkina Faso, financed by the Government of Norway through the World Bank.

After Kyoto

After the Kyoto Protocol was conceived in December 1997, the establishment of binding commitments led to more demand for offsets. According to a study of the Massachusetts Institute of Technology (MIT) in the United States and the World Bank (Ellermann, Jacoby and Decaux, 1998), accomplishing emission reduction targets through greenhouse gas emissions trading would generate a demand for Emission Reduction Units in the order of US$20 billion a year. Endorsement of the emissions trading concept generated an immediate response in the still incipient carbon market. In the months following the Kyoto Protocol a variety of initiatives were announced. These included:

An important initiative launched after 1997 was the Costa Rican national programme, the first producer-led carbon offset initiative in the world and the first initiative to utilize independent certification and insurance. The programme attracted funding from the Government of Norway. In 1998, State Forests of New South Wales, a government organization in Australia, began to sell the carbon sequestration services of some of its plantations to Australian and Japanese power companies. Other forestry companies also realized that they could attract carbon funding to help finance their operations, as illustrated by prospectus-based forestry investment funds in Australia. Around the same time, the World Bank launched its Prototype Carbon Fund, with an initial capitalization of US$150 million, which has the intention to include some forestry projects (initially in Annex I countries with economies in transition).

Current uncertainties

While the Kyoto Protocol has not yet been ratified by sufficient countries to come into force, initiatives for investment in forestry-based sequestration continue to be developed, with the aim of influencing the development of the policy process. Meanwhile, forestry has become one of the most controversial topics of the negotiations of the Kyoto Protocol. On one side, the United States and other countries of the Umbrella Group negotiating coalition (Australia, Canada, Iceland, Japan, New Zealand, Norway and the Russian Federation) have strongly supported the use of sinks as a greenhouse gas mitigation activity in the protocol. On the other side, the European bloc has strongly opposed the use of sinks, demanding a much stronger use of direct emission reductions at source as a means of meeting targets (although the Netherlands and Norway have had a more positive opinion of the use of sinks).

Although various reasons have been given for opposing the inclusion of sinks (scientific and environmental integrity, equity and moral issues, etc.), this standpoint is strongly linked to the awareness that excluding sinks from the Clean Development Mechanism would greatly increase the costs of greenhouse gas mitigation in the United States, providing a comparative advantage to European Union (EU) countries. The prospects of a negative impact on the United States economy led the newly elected President George W. Bush to deny his country's involvement in the current Kyoto process in March 2001.

The implications of this new United States position are important, given that the United States is the single largest greenhouse gas emitter in the world. While the EU has insisted on ratification of the protocol even in the absence of the United States, in practice this would greatly increase production costs within the EU, with serious implications for international trade. At the same time, a greenhouse gas mitigation strategy that excludes the United States would be at best limited in impact. Some commentators believe that the importance of having a global protocol may lead these parties to reconcile their positions in the search for a workable compromise based on the original tenets of the Kyoto Protocol, which would include the use of sinks (even if somewhat limited). Alternatively, it is unlikely that the United States would simply walk away from the process without providing an alternative. Some believe that an alternative would lead to an expansion of the United States' programme of greenhouse gas mitigation activities, initiated in 1993, which is strongly based on investment in mitigation projects in Latin American and other developing countries and on the use of sinks both in projects around the world and domestically.

In spite of these uncertainties, a great deal of new initiatives have been launched since President Bush's announcement. These include a purchase tender by the Netherlands Government (the Emission Reduction Units Purchase Tender), state-led project investment initiatives in the United States (e.g. the states of Washington and Massachussets) and private-sector-led calls for proposals in the United States. It is believed that recent United States initiatives are all intended to influence policy and to anticipate likely restrictions in greenhouse gas emissions within the United States.

WAYS FORWARD

To date, greenhouse gas mitigation funding covers a cumulative 4 million hectares of forests worldwide. According to IPCC (Brown et al., 1996), forestry has potential for offsetting approximately 15 percent of the world's greenhouse gas emissions, a partial solution to the overall problem. If the current investment trend continues, a huge infusion of new capital may be seen in the forest sector, which will have enormous implications for forestry, sustainability and conservation.

The potential size of the forestry-based offset market is still very dependent on policy decisions - on how offsets will be accounted for and which forestry activities will be accepted under the Clean Development Mechanism and Joint Implementation mechanisms. The IPCC special report (IPCC, 2000) will assist policy-makers in deciding on these issues. The report is generally positive about the feasibility of this greenhouse gas mitigation option. It has been estimated that forestry-based carbon offset projects, if unconstrained by policy regulations, could attract billions of dollars of carbon funding (IPCC, 2000; Ellerman, Jacoby and Decaux, 1998), which in turn could leverage much higher levels of investment in the forest sector as a whole.

In order for investment to be directed, however, markets have to be developed. Suppliers will have to learn about this new commodity or environmental service generated by their enterprises. A new production possibility now exists, involving a balancing of the value of traditional forest products and this new environmental value of carbon sequestration, and forest managers have to become aware of it in order to maximize forest output.

Investors will need to identify the full extent of their environmental liabilities and to utilize market mechanisms to lower them through the purchase of credits or options. This may lead to investment of greater capital in forestry activities worldwide, making it possible to meet some global environmental targets more cheaply. 

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