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Lessons from Chinese wind CDM controversy

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First appeared in China Dialogue on Nov 6, 2010. (1), (2)

The United Nations’ decision to deny a clutch of Chinese wind farms Clean Development Mechanism status has exposed structural failures in this carbon-cutting device, argue He Gang and Richard Morse.

China’s wind-power has expanded rapidly in recent years, almost doubling in size every 12 months since 2005. According to the Global Wind Energy Council, China had wind-power capacity of 25.1 gigawatts by the end of 2009. The Clean Development Mechanism (CDM) – the world’s leading carbon market and an important tool for the promotion of carbon cuts, climate protection and sustainable development – has played an important role in this growth. As of the end of 2009, 32% of China’s wind-power capacity was registered as CDM projects, with accumulated carbon cuts by 2012 predicted to be 82.5 million tonnes.

As a result, China’s wind-power development has been held up as a model of successful CDM application, and these projects have become popular low-risk options in international carbon markets. But the CDM Executive Board’s (EB) recent refusal to grant CDM status to 14 wind-power projects in China has cast this success story into doubt.

The refusal was caused by a debate over “additionality”: whether or not offsets from Chinese wind represent “real” emissions reductions beyond what would have occurred in the absence of the project.

In mid-2009, the EB’s 47th and 48th meetings found and considered uncertainties over power tariffs in the Project Design Documents (PDDs) of Chinese wind-power projects, in some cases requesting clarification or corrections. At the board’s 49th meeting, which took place in the run up to the Copenhagen climate-change conference, it rejected applications from 10 Chinese projects, causing deep concern among developers, project owners and even buyers, sellers and intermediaries. In 2010, the EB’s 52nd meeting saw two projects registered after clarification, but another six rejected.

At the centre of the controversy is the Chinese power tariff for wind, the most important factor in determining additionality. As more Chinese wind-power projects have applied for CDM support and the EB has gained more data, the board has observed that, in some provinces, the tariff has been falling. Former head of the EB Lex de Jonge indicated in an interview with market analysis Point Carbon that the EB was not clear if the Chinese were reducing the tariff to obtain CDM subsidies or if there was some other cause, and that he had therefore asked the developers to provide further information.

The EB decision set off a chain reaction. The International Emissions Trading Association (IETA) issued three open letters stating that this would increase market uncertainty and hence affect investment; and that the EB should raise these issues with the Chinese government – which sets the tariffs – rather than the developers. The IETA also complained about a lack of transparency and fairness in the EB’s decision-making process. It said that uncertainty over rules would impact on investment and that the EB had not fairly applied its own policies to China’s domestic policy.

The Chinese stakeholders also objected strongly. Representatives of China's wind-power sector issued a statement describing the refusal as a “wrong signal that will seriously damage the enthusiasm and confidence of investors”. At Copenhagen, Chinese experts commented that “the EB is prejudiced against Chinese wind-power projects” and that the process that led to the refusals was opaque and unfair.

The issue is so important because it does not only affect Chinese wind farms. It could spread to other countries and project types, impacting on the overall credibility and stability of the CDM and international carbon markets. The crux of the debate – the difficulty of establishing additionality – may seriously wound the integrity of the CDM system itself if it is not examined and resolved.

CDM funding rules state that projects need to prove their additionality, a crucial CDM concept. The Kyoto Protocol establishes CDM as an emissions-reduction mechanism required to bring about “additional efforts to reduce emissions”. According to the Marrakesh Declaration, additionality exists when the emissions-reducing project can only take place with CDM funding. If the project would happen regardless, additionality cannot be demonstrated.

Defining additionality is easy, but proving it is not. Currently, the core of the EB’s “Tool for the demonstration and assessment of additionality” judges itaccording to free-market profit logic, assuming that investment will go to projects with the highest internal rate of return (IRR), for example. Developers therefore need to show that, under the baseline scenario, the project does not provide the best rate of return, but that the CDM funds will make it the most competitive.

This set of IRR tools is based on a market economy and effective application requires two major conditions. First, the baseline used for comparison must be representative of the actual scenario in the host nation and be credible, stable and verifiable. Second, the IRR must be the main factor in investor decision-making – in other words, there must be a functioning market. And so these tools fail when applied to the reforming, complex and emerging wind-power sector we find in China. Some divergence in application from design is no surprise. However, it is regrettable that, when the desired results are not achieved, the response has been to criticise those applying it, rather than examining and improving the design of the mechanism itself.

The EB’s additionality tool is a standardised process used to determine if a project does or does not possess additionality. First, alternative scenarios are identified. For example, if the proposed wind power project is not built, what realistic and credible alternatives are available that can provide comparable service? Would a coal-power plant be built? Would another renewable source of energy be utilised? Or would more power from the existing grid be used? Legally or technically unfeasible projects are then filtered out to produce a list of possible alternatives for the host nation.

Investment analysis is then used to compare the IRR of the project and its alternatives to decide if CDM funding support is required to attract investors.Investment analysis consists of simple cost analysis; investment-comparison analysis and benchmark analysis. This produces feasible alternative projects, which are used as a baseline. For wind-power projects, the aim of investment analysis is to eliminate situations where the project would be implemented without CDM.

But problems arise when this tool is applied in China, which is also the source of the current controversy. Our observation and analysis of the 143 wind-power PDDs registered by the EB up to the end of 2009 shows that almost none of these projects were compared with coal power, as government policy restricts construction of coal-fired power stations of less than 135 megawatts. It seems counter-intuitive that, in a market that is 80% coal-fired, wind power is not compared to coal.

There may be several reasons for this. First, it may be difficult to obtain and calculate IRR data for coal-generated power, due to the scattered and complex nature of the coal market, generating technology and power-plant types. Second, even if IRR data was obtained, the sector is led by state-owned enterprises and not governed by profit – its goal is maintaining low electricity costs to ensure economic growth, social stability and energy security.

IRR may therefore be extremely low and, where coal costs are high, may even be negative. If this is used as a baseline, some government-subsidised wind-power projects may look like more profitable investments, and are unlikely to pass additionality tests. The use of an electricity market which may have a negative IRR as baseline is clearly unreasonable. The current tools do not reflect or meet the demands of China’s complex coal-led power sector and electricity market.

That leaves baseline analysis. Most of these PDDs use as an industry baseline the 8% level set in 2002 in the “Temporary Method for Economic Evaluation of New Electricity Projects”. This has not changed in the five years since China’s first CDM wind-power project was built in 2006, presenting obvious flaws. There are no details of how this baseline was arrived at and, even if we assume it was a realistic figure at the time, the electricity market has in the last five years seen a series of reforms, including coal-market reform and restructuring of the electricity sector.

With China maintaining annual economic growth of over 8%, it is hard to accept that profits from an investment project would remain unchanged for so long. So why do the PDDs still use it? Primarily it is a case of learning from others – since other projects have used this baseline and passed, why not re-use it? Secondly, with no better data around, it seems safer to use publicly available and reasonably authoritative figures.

These are flaws in implementing “additionality”. A more serious issue lies within the nature of additionality itself, which we call the “offsetter’s paradox”. CDM is an international offsetting mechanism that helps developed nations to reduce emissions at low cost while developing nations obtain the funds to develop low-carbon technology. But what looks like a win-win situation has a deep underlying problem: perverse incentives. In order to promote low-carbon technology such as renewable energy, developing nations need to apply stimulus policies such as special tariffs and renewable-energy quotas. But this makes proof of additionality harder and reduces the chances of CDM assistance. So what will be chosen – strong domestic policy, or the CDM? This puts certain countries in a quandary and fails to meet the international community’s aim of encouraging certain domestic policies.

To relieve this difficulty by reducing reliance on domestic policy, the EB introduced the E+/E- rule, which stipulates that regulatory changes at a national level should not be incorporated into baseline calculations if the regulation favours a less or a more emissions-intensive technology over the other. For example, any renewable-energy project that reduces emissions can be considered as possessing additionality. It is worth wondering why, in the controversy over China’s CDM wind-power projects, the EB has not been able to apply the E+/E- policy. Clearly, additionality is not an easy job.

Is the Chinese government manipulating power tariffs in order to obtain CDM funding? This is hard to answer. The west will start from simple economic principles and find that the Chinese government has an incentive to do so and that incentives predict behaviour. This is, of course, correct, and the Chinese government has admitted that “CDM has played a major role in overcoming funding and technology obstacles for wind-power firms and, without CDM, China’s wind-power sector would not have developed this quickly.” 

But the incentive and the act are two entirely different things. The government has repeatedly stated that it has set prices for wind power by relying on the objective laws of development of the sector and the grid’s ability to adapt and that CDM factors have not been taken into consideration.

According to the 2007 “China Wind Power Report” by the Chinese Renewable Energy Industries Association, the Global Wind Energy Council and Greenpeace, the sector has gone through four key stages. The period from 1986 to 1993 saw initial demonstrations, with tariffs equal to that of coal power (under 0.3 yuan per kilowatt hour) and projects mostly relying on international aid. Then, 1994 to 2003 saw commercialisation, with tariffs being set between 0.38 yuan (US$0.06) and 1.2 yuan (US$0.18) per kilowatt hour in contracts between wind-power plants and the grid operators on the basis of cost plus reasonable profit.

From 2003 to 2009, there was scaling and localisation: a combination of pricing via tenders and approval, with sustained increases in tendered prices. And October 2009 saw the start of compulsory purchase of power at four levels (0.51 yuan; 0.54 yuan; 0.58 yuan; and 0.61 yuan per kilowatt hour).

So we can say that the Chinese government sets wind-power tariffs in accordance with its own needs – they are not set just for CDM. Figures back this up: In 2009, total investment in Chinese wind power was 130 billion yuan (US$19 billion). Meanwhile, the sector obtained CDM investment of 1 billion yuan (US$146 million). The addition of CDM funding is of course welcome, but it only puts a little extra in the pot and is clearly not enough to influence policy.

In addition, observation and analysis of PDDs for the 143 wind-power projects registered up to the end of 2009, show reported power tariffs ranged from 0.4 yuan (US$0.06) to 0.8 yuan (US$0.12) per kilowatt hour. This level was sustained, with no clear trend of falling prices. These are of course the estimated PDD prices and there will be slight discrepancies with the price approved by the National Development and Reform Commission(NDRC). But these are the prices used by the EB for IRR calculations and are representative of the overall situation. Of course, wind resources vary, policy environments are uneven and tariffs change across provinces and even projects. A look at electricity prices across different regions with wind-power projects shows how complex pricing is. But we failed to find any major trend of falling prices.

To sum up, there is no sound foundation for EB’s rejection of Chinese wind-power projects due to government control of power tariffs. Meanwhile, the unexpected results of the additionality tool when applied to the Chinese market show that there are flaws with its design – namely, that a tool based on market economics does not work in the context of the changing regulatory environment of China’s rapidly growing electricity sector. The EB should learn from this and work on reform of the mechanism itself.

Of course, there is also room for improvement in China: for example in transparency of policy and processes for setting power tariffs; the regular checking and updating of data; and increasing the feasibility ofmeasurement, reporting and verification (MRV). A well-functioning CDM mechanism is in line with China’s interests: providing credible pricing signals, creating a stable market and promoting faster growth of renewable-energy investment. The greatest losers from this controversy have been China’s wind-power firms, project developers and carbon-trading agencies.

CDM was a seed of great potential when it was first created. But it has grown into a hot potato. In many areas, it has played a positive role: helping to realise funding transfers for global emissions cuts, promoting some technology transfers, boosting development of clean energy and low-carbon technology in developing nations, strengthening capacity for emission reductions in poor countries and more. The main problem with CDM is the debate over additionality, which has spread from the destruction of greenhouse gas HFC23 to wind-power projects.

The system is also over-complex and burdened with lengthy processes, the EB’s capacity building has been inadequate and regional distribution of projects is uneven. The CDM’s contribution should not be ignored, but nor should its problems. The above analysis shows that work is needed in one of two directions: to find a way to account for complex domestic policies or to find a standard for evaluation which is agnostic towards domestic policy. And either choice presents challenges.

In the short term the most important task is to set realistic and credible baselines. For wind power in China, a method for comparison with an actual baseline may be required. For the Chinese market, this is generally held to be coal power. Given the effect of complex ongoing reform and the logic of state-owned enterprise behaviour, the independent power producer (IPP) model may be a feasible alternative for the current market. Although IPPs only account for about 10% of China’s power market, they can operate largely in accordance with market rules and better reflect a market scenario. Although tariffs for IPPs still require NDRC approval and there are issues with obtaining the data, it is a more credible approach.

At the same time, third party expert verification of baselines and increased transparency of government tariff-setting mechanisms will reduce risk for developers and consulting agencies, and also help to strengthen CDM credibility. This will not resolve the issues of perverse incentives and the “offsetter’s paradox”, but will, as much as possible, reduce the debate over additionality and regulatory risks.

But as long as additionality is the standard, it will be hard to separate activities from domestic emissions policy and avoid disputes. When the Chinese government starts large-scale subsidies, or policy requires certain emissions-reduction projects (such as power-saving bulbs or the Golden Sun project subsidising photovoltaic solar power) either the policy requirement will mean additionality tests are failed, or accounting analysis will fail as the funding is adequate. Additionality stipulations are still a challenge – and this is an issue that the EB and climate policymakers must face up to.

Global climate negotiations remain deadlocked and there is huge uncertainty over the CDM beyond 2012. But humanity’s efforts to meet the climate-change challenge will not end here. Without the CDM, we will have some other development mechanism – perhaps a policy tool such as a carbon tax or other policy instruments. The issues that have arisen during the application of CDM demonstrate the enormity of the climate-change challenge. But whatever tools are used, we need to understand their strengths and limitations, and the challenges that may arise during implementation, and then improve their design. CDM may only be one small part of the overall climate-change landscape, but countless individual projects combine to form international emissions-reduction efforts – a kind of creativity in the face of climate change. We hope that this will continue in spite of controversy.

He Gang and Richard Morse are research associates at Stanford University’s Program on Energy and Sustainable Development.

This is a summary of the full report, “Making offsets work in developing countries: lessons from Chinese wind controversy”, published by Stanford University Program on Energy and Sustainable Development.