But Kyoto also allows companies to purchase “offsets”: credits from emissions-reducing projects in developing countries. Such projects, which currently account for as much as a third of total tradable credits, are overseen not by the EU but by the United Nations. In this way, more than 300 million credits—each representing the equivalent of one metric ton of carbon dioxide—have been generated. Carbon offsets—authorized through the United Nations Clean Development Mechanism (CDM)—are unlike any securities ever created: because such gases emerge not just from factories and automobiles but from felled trees, animal and agricultural waste, and innumerable other sources from every corner of the earth, the supply of promises to reduce greenhouse-gas emissions is potentially infinite.

Furthermore, unlike traditional commodities, which at some point during the course of their market exchange must be delivered to someone in physical form, the carbon market is based on the lack of delivery of an invisible substance to no one.

If cap-and-trade in the United States were to become reality along the lines of proposals now before Congress, up to 2 billion of the new credits would be drawn from carbon offsets, potentially increasing the worldwide supply of such credits by a factor of seven. This article discusses the process by which the UN approves carbon offsets and the flaws associated with this process.

THE APPROVAL PROCESS

The approval process for carbon offsets has two goals. One is to operate successfully as a market, with a steady supply of carbon offsets and varying prices to ensure that profits can be made. The other goal, of course, is the system’s ultimate purpose: to reduce greenhouse-gas emissions by channeling funds into cleaner technologies.

The UN has certified twenty-six firms worldwide as Designated Operational Entities (DOEs) to “validate” the promises of emissions reducers and then to “verify,” often years later, that those reductions actually occurred. SGS is one of two companies that dominate the carbon-validation business. The other is Det Norske Veritas (DNV), a Norwegian firm whose primary business is shipping inspection. Other major players include the accounting firm Deloitte Touche Tohmatsu, the transportation-safety firm Lloyd’s Register, and TUV SUD, a German industrial-testing company.

The UN approval of carbon offsets is basically a five-step process:

• After investors identify a prospective project, they hire a DOE to assess the reduction of emissions.

• The DOE then puts together a report that includes estimates of both existing greenhouse-gas release rates and the potential for reduction given different technological approaches.

• That report is then submitted to the UN Executive Board, which audits it before passing judgment.

• Once approved, the project is considered “validated” and the prospective credits can be placed on the market as a sort of futures contract: the credits can be bought and sold, but buyers who need credits to meet their caps do not actually receive them yet. Delivery happens months or even years later, after a DOE is brought in again to “verify” that the promised emissions reductions have occurred.

• Upon verification, the credits are called Certified Emission Reductions (CERs) and can be used by purchasers against their caps.

Validation and Verification
Validation requires additionality. To be credible as offsets, the emissions reduced, avoided, or sequestered must be additional to business-as-usual (i.e., what would have happened anyway). This concept is often called “additionality.” Additionality is proof that the renewable-energy project would not happen without the capital generated by selling carbon credits. In order to prove that an emissions reduction would not have happened otherwise, project developers try to demonstrate that a comparable, less emissions-intensive technology is not commonly used in the industry for which it is being considered, and also that the switch is not legally required—if everyone’s doing it, why should a company get extra money as a reward? Moreover, developers must show that the project would make no economic sense without CDM funds and that documentation exists to demonstrate that these factors were considered by the company’s board of directors in their decision to pursue CDM financing. Additionality is generally considered to be the most significant factor that determines the integrity of the offset.

Verification of the emission reduction or carbon sequestration is critical in efforts to mitigate climate change. One question is who will be responsible for verifying changes in carbon, which raises questions about the role of a regulatory agency for accrediting claimed changes in carbon levels from an activity. Existing programs typically recommend or require that the carbon offset be verified by an independent entity. Independent verification may be an auditing function, to assure the reality and accuracy of the carbon offset for markets (buyers and sellers), regulations (emitters and regulators), and reports (emitters and reporting organizations). One source has prescribed several qualities for independent verification: an “independent, qualified, third-party verifier” using “approved methodologies and regulations” and “whose compensation is not in any way dependent on the outcomes of their decisions” and who follows set procedures to avoid conflicts of interest.

FLAWS IN THE UN APPROVAL PROCESS FOR CARBON OFFSETS

Lack of Additionality
A recent study of approximately a hundred offset projects by the journal Climate Policy found that just 60 percent of projects actually provided evidence that the CDM funding made a difference, and that 40 percent of companies would likely have reduced emissions anyway. A project developer tells a story about how his or her project is “additional.” A DOE checks the story. DOEs are relied on for their judgment. Unfortunately, it’s often a very selective judgment.

Inaccurate Measurement of Emissions Reductions
Study after study has demonstrated that CDMs have not delivered the promised amount of emissions reductions. According to a report by the UN’s Intergovernmental Panel on Climate Change, the margin of error in measuring emissions by DOEs can be as high as:

• 10% for the cement and fertilizer industries;
• 60% for the oil, gas, and coal industries; and
• 100% for some agricultural processes.

It is generally much simpler to measure and quantify an emission reduction from a direct source than from an offset project. Regulated sources determine their compliance by comparing actual GHG emissions data against their allowed emissions. In contrast, project developers determine offset emission data by comparing the expected reduced, avoided, or sequestered GHG emissions against a projected, business-as-usual scenario (sometimes referred to as a counter-factual scenario). To accomplish this task, offset project managers must establish an emissions baseline: an estimate of the “business-as-usual” scenario or the emissions that would have occurred without the project.

Conflict of Interest
A conflict of interest exists between DOEs and offset project developers similar to the conflict of interest that existed between the bankers and the credit ratings agencies when it came to credit derivatives during the recent Wall Street financial crisis.

Investors generally relied on a simplistic ratings scale (Triple-A, B, C) from the credit ratings agencies (Moody’s, Standard & Poor’s, and Fitch) to guide them through the strange new world of subprime mortgage-backed credit derivatives. While in the corporate bond world, the credit ratings agencies rated the bonds of thousands of companies and were not dependent on any one company for fees, subprime mortgage-backed credit derivatives were being produced by a small number of banks. These banks routinely threatened to boycott the credit ratings agencies if they failed to provide the desired AAA-ratings, thereby jeopardizing the sizable fees the credit ratings agencies earned from the banks for their services. Similarly, far from being independent third-party auditors, the DOEs get paid by the very offset project developers whose projects they are being asked to validate and/or verify. There is a serious potential for conflicts of interest in the area of onsite measurement of carbon emission reductions for CDM projects. It is not uncommon for validators and verifiers to cross over to the far more lucrative business of developing carbon projects themselves or for large third party project developers—and then requesting audits from their former colleagues. Interestingly, SGS and DNV have been responsible for nearly two thirds of the emissions reductions now being utilized by industries in the developed world.

Inadequate Oversight of DOEs
The only mechanism the UN has for evaluating its DOEs is the evidence the DOEs themselves create and present: the validation reports they write and the data they gather onsite. When the UN does spot checks of DNV and SGS, it performs them in the offices of the validators, not in the field. The increasingly complex and far-flung projects, with developers dredging up thousands of claimed reductions in remote areas all around the world, already far outstrip the UN’s ability to police them adequately.

Lack of Retroactive Removal

An even greater problem for the UN is the lack of retroactive removal—an issue that goes to the heart of cap-and-trade, which relies on a direct correlation between dollars spent and emissions reductions obtained. Every ton of offsets verified by a DOE can thereafter be used to compensate for excessive emissions by companies in Europe, Japan, Australia, and New Zealand. The UN Executive Board has no power to order the removal of credits from the market, even in the event of misconduct by a validator or verifier.

The two central questions are: (a) Who is liable if credits are found to have been contrived?; and (b) Could emissions credits based on faulty assumptions or inadequate review be revoked? These issues highlight the challenges of turning carbon into a commodity, with the undertaking’s simultaneous goals of imposing financial penalties on polluters, luring more investors into the market, and channeling money toward renewable energy technologies that would reduce emissions.

CONCLUSION

An offset-based cap-and-trade system would provide the necessary transfer of technology and know-how from developed nations to developing nations, channeling much needed resources to parts of the world that otherwise would be forgotten by major multinational corporations searching for emission credits. It should be remembered that carbon exists as a commodity only through the decisions of politicians and bureaucrats, who determine both the demand, by setting emissions limits, and the supply, by establishing criteria for offsets. However, the credibility of the UN approval process for these carbon offsets is in question. The central flaw is in the UN’s reliance on private companies to validate emission reductions. A possible solution may be a system wherein project developers would pay a fee to the UN, which in turn would assign validators to a project in a random selection process thereby providing some level of protection from evident conflicts of interest. In addition, independent, qualified, third-party verifiers (that did not validate the offset project in question) using approved methodologies and regulations and “whose compensation is not in any way dependent on the outcomes of their decisions” should be employed to verify the carbon offset project.

REFERENCES

• Harnessing Farms and Forests in the Low-Carbon Economy: How to Create, Measure, and Verify Greenhouse Gas Offsets, by Zack Willey and Bill Chameides, Nicholas Institute for Environmental Policy Solutions, 2007.

• How Credit Derivatives Brought the US Economy to the Brink of a Second Great Depression, by Brian J. Donovan (February 19, 2010)

• Intergovernmental Panel on Climate Change, Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report (2007)

• Is the CDM Fulfilling its Environmental and Sustainable Development Objectives? An Evaluation of the CDM and Options for Improvement, by Lambert Schneider, World Wildlife Fund, November 2007

• Offset Quality Initiative, Ensuring Offset Quality (July 2008), available at: http://www.pewclimate.org/

• RGGI, Regional Greenhouse Gas Initiative Model Rule, 1/5/07 Final

• Schapiro, Mark, “Conning the Climate: Inside the Carbon-Trading Shell Game,” Harper’s Magazine (February 2010)

• The Role of Offsets in Climate Change Legislation, by Brian J. Donovan (3 March 2010)

• United Nations Clean Development Mechanism

• United Nations Climate Change Conference Copenhagen 2009

• Why Carbon Emissions Should Not Have Been the Focus of the UN Climate Change Summit and Why the 15^th Conference of the Parties Should Have Focused on Technology Transfer, by Brian J. Donovan (20 December 2009)

About the Author

Brian J. Donovan is an engineer and attorney with more than thirty-four years of international business experience. Mr. Donovan is CEO of Renergie, Inc. (“Renergie”). Renergie was formed on March 22, 2006 for the initial purpose of raising capital to develop, construct, own and operate a decentralized network of ten modular-designed small advanced biofuel manufacturing facilities (“SABMFs”) in the parishes of the State of Louisiana which were devastated by hurricanes Katrina and Rita. Each SABMF has a production capacity of five million gallons per year of fuel-grade ethanol. Renergie’s unique “Field-to-Pump” strategy is to produce non-corn ethanol locally and directly market non-corn ethanol locally. “Field-to-Pump” maximizes rural development and job creation while minimizing feedstock supply risk, the burden on local water supplies, and the amount of energy necessary to process sugar into fuel ethanol. “Field-to-Pump” disrupts the status quo by allowing advanced biofuel producers to be drivers of transportation fuel prices rather than merely price takers in the market. Renergie is in the process of transferring its proven renewable energy technology worldwide by working closely with developing countries in Latin America, the Caribbean, Asia and Africa.

Mr. Donovan drafted the “Advanced Biofuel Industry Development Initiative” for the State of Louisiana. On 21 June 2008, Louisiana Governor Bobby Jindal signed into law the Advanced Biofuel Industry Development Initiative (“Act 382”). Act 382, the most comprehensive and far-reaching state legislation in the US enacted to develop a statewide advanced biofuel industry, is based upon Renergie’s “Field-to-Pump” strategy. On 24 February 2009, the US EPA granted Renergie a first-of-its-kind waiver for the purpose of testing hydrous E10, E20, E30 & E85 ethanol blends in non-flex-fuel vehicles and flex-fuel vehicles in Louisiana. On-site blending pumps, in lieu of splash blending, are used for this test.

Mr. Donovan, a member of The Florida Bar, The US District Court, Middle District of Florida and The United States Court of Appeals for the Eleventh Circuit, holds a J.D. from Syracuse University College of Law (where he was recipient of the “Global Law & Practice Award” as the outstanding graduate in the areas of International Law and International Business Law) and a B.S., with honors, in Marine/Mechanical and Nuclear Engineering from the United States Merchant Marine Academy.

Mr. Donovan does not represent, nor has he received any compensation from, any party in regard to climate change legislation.