CERs ERUs and the expiry of the first commitment period - carry-over issues

Introduction

Due to increasing client concern with the implications of the expiry of the Kyoto first commitment period, we thought it would be useful to carry out research in relation to the following two questions:

• Firstly, the context for the following statement in Recital 29 of the revised European Union Emissions Trading Directive¹ (the Revised EU ETS Directive)
• “As Member States cannot carry over CERs and ERUs held by operators between commitments periods under international agreements (“banking” of CERs and ERUs) before 2015, and only if Member States choose to allow the banking of those CERs and ERUs within the context of limited rights to bank such credits, this certainty should be provided by requiring Member States to allow operators to exchange such CERs and ERUs issued in respect of emission reductions before 2012 for allowances valid from 2013 onwards.”; and
• Secondly, the practical implications for holding 2008-2012 CERs/ERUs within the EU ETS beyond the expiry of the first commitment period. 

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Key risks identified

Our analysis has identified two key risks:

• Firstly, there is a risk that the market value of CERs or ERUs held in operator or person holding accounts after 2012 will decrease, given the increasingly limited opportunities for their use; and
• Secondly, such CERs and ERUs may be cancelled in 2015, unless they are exchanged for Phase III EUAs by operators or carried over by the Member States to the next commitment period (the scope for such carry-over being limited).

Executive summary

1. The Kyoto Protocol specifies quantitative limits on the amount of Kyoto credits that Parties can carry over into the subsequent commitment period. These restrictions on the carry-over of various Kyoto units were introduced into the Marrakesh Accords to manage uncertainty over the real reductions these credits represented.
2. 2008-2012 CERs or ERUs that remain in person holding accounts within national registries within the EU past 31 December 2012 may continue to be transferred after that date. However, there is a risk that the market value of units held after this date will decrease, given the increasingly limited opportunities for use of these units as:

• the date for operator surrender of Phase II allowances and Kyoto units passes (30 April 2013);
• the date for limited operator exchange of unused 2008-2012 Kyoto units for EUAs passes (31 March 2015);
• the Kyoto Party true-up period comes to a close (in 2014/2015); and
• the Kyoto Party carry-over period for Kyoto units closes (2015).
• Any 2008-2012 units remaining in operator and person holding accounts when carry-over accounting has been completed will probably be cancelled under the Kyoto Protocol rules (unless subsequent Kyoto decisions alter existing rules). However, there is a possibility that EU Member States that have not used up their own Kyoto Party carry-over allowances for ERUs and CERs may allow account holders to benefit from access to this carry-over opportunity. This will depend on future decisions taken by individual Member States.

1. As a consequence of the above we are left, in effect, with two distinct asset classes. On the one hand, CERs and ERUs issued in respect of emissions reductions before 2012 (pre-2012 CERs and ERUs); and on the other, CERs and ERUs issued in respect of emissions reductions generated after 2012 (post-2012 CERs and, if Joint Implementation (JI) is extended, ERUs). The differing treatment of these two classes of asset under the present regulatory framework will, no doubt, impact upon their pricing within the market.

Issue 1 analysis: findings

There are two questions to be answered in relation to the previous citation from the Revised EU ETS Directive:

• Firstly, what is the basis for stating that banking of CERs cannot take place before 2015?
• Secondly, why is the right to bank credits said to be “limited”?

We have answered each question in turn below on the basis of the Kyoto Protocol Reference Manual on Accounting of Emissions and Assigned Amounts, November 2008 (the Accounting Manual) established pursuant to the Kyoto Protocol. We have not cross-referred the sections of the Accounting Manual to the relevant Conference of the Parties Serving as the Meeting of the Parties to the Kyoto Protocol (COP/MOP) decisions; however, the latter can be obtained via the Accounting Manual references cited in the footnotes of this note.

Banking of CERs between commitment periods under the Kyoto Protocol: not before 2015

Main principles

Banking, or carry-over, refers to the process by which a unit that was issued and valid for one commitment period becomes valid for transactions during the subsequent commitment period.

Carry-over cannot be performed until after the true-up period (see below), or until compliance assessment for all Parties has been completed. For a carry-over transaction to occur, a Party must have discharged all mandatory transactions for the previous commitment period², namely:

• The Party must have retired sufficient units to cover its total Annex A emissions, and must not have been found to be in non-compliance with its Article 3, paragraph 1, commitment.
• The Party must have replaced all Temporary Certified Emissions Reductions (tCERs³) and Long-term Certified Emissions Reductions (lCERs⁴) that expired during the previous commitment period, and all lCERs that were subject to replacement for reversal of storage or non certification in that commitment period.
• The Party must have undertaken any transactions necessary to reflect a correction applied by the Compliance Committee, including any outstanding retirement.

The Kyoto Protocol specifies quantitative limits on the amount of Kyoto credits that Parties can carry over into the subsequent commitment period. These restrictions on the carry-over of various Kyoto units were introduced into the Marrakesh Accords to manage uncertainty over the real reductions these credits represented, as well as concerns over the potentially large number of credits that might be generated through the mechanisms - with consequent potential to undermine Kyoto targets and provide disincentives to domestic reductions.⁵

The true-up period

The annual report containing the inventory for the last year of the first commitment period (2012) will be submitted by each Party to the Kyoto Protocol in 2014. After completion of the review and compliance procedures for that year, each Party’s total Annex A emissions for the commitment period will be recorded in the Compilation and Accounting Database (CAD), as will the Party’s final accounting quantities for land-use, land-use change and forestry (LULUCF) activities.

Once the submission and review of the final annual report have been completed, the “additional period for fulfilment of commitments” will begin. This 100-day period, known as the true-up period, is intended to provide Parties with the opportunity to undertake and finalise the transactions necessary to achieve compliance with the Article 3, paragraph 1, commitment (i.e., the emissions reduction commitment). The accounting period for the end of the commitment period begins with the start of the true-up period.⁶

Before the end of the true-up period, and during the true-up period, eligible Kyoto Parties may continue to transfer and acquire Kyoto units, including CERs and ERUs.⁷ It is possible that the CDM Executive Board may continue to issue CERs during the true-up period that relate to emission reductions made during the first commitment period; however, it is also possible that guidance from the Meeting of the Parties to the Kyoto Protocol (CMP) will determine an earlier point from which CERs for emission reductions in the first commitment period are no longer to be issued.⁸

The true-up period report

The true-up period report, due at the end of the “additional period for fulfilment of commitments” (true-up period), is intended to enable the determination of the Party’s compliance with its Article 3, paragraph 1 obligations. The CMP “may clarify the due date for this report”.⁹ It is anticipated that the true-up period report for the first commitment period will be due at some time in 2015.

The report must contain all the information that is normally reported annually on assigned amount, but it must cover both the current calendar year and the true-up period. In addition, the report must include a list, by serial number, of the units that the Party has retired.

Review of the true-up period report

The true-up period report will be reviewed by an Expert Review Team (ERT) which will compare the resulting quantity of units in the Party’s retirement account to the Party’s total Annex A emissions for the commitment period. The review report of the ERT for the true-up period will include an assessment of whether the Party’s total Annex A emissions for the commitment period are less than or equal to the quantity of units retired by the Party (including any deduction for outstanding corrections or replacements).¹⁰

The ERT will also review the quantity of units that the Party has indicated that it wishes to carry over to ensure that the Party has no outstanding correction, and that the units requested meet the rules for carry-over.¹¹

Banking - conclusions

The carry-over of units can only happen once the true-up period report (expected to be submitted by Parties no earlier than 2015) has been reviewed by the ERT, which will also review the quantity of units the relevant Party has indicated it wishes to carry over. Hence carry-over of units cannot happen prior to 2015. 

“Limited rights” to carry-over units

Request to carry over units

Under the Kyoto Protocol, if a Party has Assigned Amount units (AAUs), ERUs or CERs remaining in its registry after it has retired sufficient units to cover its Annex A emissions, it may request that these units be carried over to the subsequent commitment period. The Party must include a list of these units, by serial number, in its true-up period report. The ERT will review such a request (see above).¹²

Limitations on carry-over

The type and quantity of units for which carry-over is requested must comply with the rules and limitations for carry-over:

• AAUs can be carried over without limitation;
• CERs and ERUs from emission reduction projects may each be carried over up to a quantity equal to 2.5 per cent of the Party’s initial assigned amount (the total combined carry-over may not exceed 5 per cent of the initial assigned amount); and
• Removal units (RMUs), tCERs, lCERs and ERUs from LULUCF projects may not be carried over.¹³

The mechanics of carry-over

Following the review and compliance procedures for the true-up period by the ERT, the total quantity of units available and eligible for carry-over for each Party will be recorded in the CAD and provided to the International Transaction Log (ITL).

Upon receipt of this data, the ITL will send a notification to each registry, indicating the total number of units that the registry may carry over. The registry must then initiate carry-over transactions, subject to the carry-over limitations referred to above and up to the total number given in the notification, referencing the notification ID. The units remain in the same account and the serial numbers remain unchanged, except for the applicable commitment period identifier. The Data Exchange Standards (DES) state that such transactions must be completed within 30 days from the date of the notification. Any units remaining in holding accounts (i.e., those that are not carried over) must be transferred to the mandatory cancellation account.¹⁴

Cancellation of units not carried over

The Kyoto Protocol Accounting Manual provides as follows:

“7.3.5. Mandatory cancellation

Cancellation into a mandatory cancellation account is necessary to clear units from holding accounts in national registries when they have been made permanently invalid for the purposes of compliance. Circumstances under which units maybe made invalid in this manner are:

• ICERs issued for a CDM project for which a certification report is not submitted in the appropriate timeframe;
  
• Units from a commitment period which remain in holding accounts after the carry-over of units from that commitment period have been completed".¹⁵

The above interpretation would require the cancellation of CERs and ERUs that remain in operator accounts and person holding accounts in national registries after the Member State has decided how it will manage (distribute) the 2.5 per cent carry-over of CERs and 2.5 per cent carry-over of ERUs permitted under decision 13/CMP.1.

Carry over - conclusion

Only AAUs, CERs and ERUs can be carried over between commitment periods, and, in the case of CERs/ERUs, a Party may only carry over CERs up to 2.5 per cent of its initial assigned amount and ERUs up to a maximum of 2.5 per cent of its initial assigned amount.

Issue 2 analysis: findings

The second issue we examined is what physically happens to 2008-2012 CERs/ERUs within the EU ETS upon the expiry of the first commitment period (31 December 2012)?

EU ETS consistency with Kyoto limits on use of CERs and ERUs

The EU has addressed the Kyoto Protocol’s carry-over limits and supplementarity requirements within the EU ETS in two ways: by requesting that Member States indicate in their national allocation plans the extent to which they will allow their operators to rely on Kyoto credits, and by keeping track of overall holdings of Kyoto credits within the EU ETS through the linked registry system.

Under Article 30(3) of the EU ETS Directive¹⁶, each EU Member State was required to “publish in its national allocation plan its own intended use of ERUs and CERs and the percentage of the allocation to each installation up to which operators are allowed to use ERU s and CER s in the Community scheme for that period. The total use of ERUs and CERs shall be consistent with the relevant supplementarity obligations under the Kyoto Protocol and the UNFCCC and the decisions adopted thereunder”. Although there has been no express quantification of what constitutes supplementary use of the mechanisms, domestic action must be a “significant element” of the effort made by each Annex I Party.¹⁷

Article 19 of the EU ETS Directive required the adoption of regulations for a standardised system of registries, to ensure, among other things, “that there are no transfers incompatible with obligations resulting from the Kyoto Protocol”. The "Linking Directive" amended Article 19(3) to include provisions concerning the use and identification of CERs and ERUs in the Community scheme and provisions on the monitoring use of these units.

Member State responsibility

Member States are ultimately responsible for compliance with Kyoto obligations:

“Any Member State that authorises private or public entities to participate in project activities remains responsible for the fulfilment of its obligations under the UNFCCC and the Kyoto Protocol and should therefore ensure that such participation is consistent with the relevant guidelines, modalities and procedures adopted pursuant to the UNFCCC or Kyoto Protocol”.18

Article 11(a) of the EU ETS Directive, inserted by “Linking Directive”, provides that

“…during each period referred to in Article 11(2) [2008-2012], Member States may allow operators to use CERs and ERUs from project activities in the Community scheme up to a percentage of the allocation of allowances to each installation, to be specified by each Member State in its national allocation plan for that period. This shall take place through the issue and immediate surrender of one allowance by the Member State in exchange for one CER or ERU held by the operator in the national registry of its Member State“.

Member States were required to specify in their NAPs the maximum amount of CERs and ERUs which may be used by operators, consistent with Member State's supplementarity obligations under the Kyoto Protocol and decisions adopted under the Kyoto Protocol. The Registry Regulations¹⁹ assist in enforcing these restrictions:

“The registry administrator shall only accept requests to surrender CERs and ERUs up to the percentage of allocation to each installation provided by Member State legislation. The CITL shall reject any request to surrender CERs and ERUs that would surpass the maximum allowed amount of CERs and ERUs to be surrendered in the Member State”.²⁰

Under Article 12(4) of the Registry Regulations, Member States can require applicants for person holding accounts to agree to comply with reasonable terms and conditions (addressing issues set out in Annex V to the Registry Regulations) before creating or giving access to accounts. Annex V includes as one issue the relationship between account holders and registry administrators. Member States have included in these terms and conditions notice to account holders that trading may be restricted based on UNFCCC requirements (such as the Member State’s need to maintain a compliance period reserve, or with respect to restrictions on Kyoto units).²¹

CER/ERU holdings within the EU ETS post-2012

The Revised EU ETS Directive provides at Article 11(a)(2):

“To the extent that the levels of CER and ERU use, allowed to operators or aircraft operators by Member States for the period 2008 to 2012, have not been used up or an entitlement to use credits is granted under paragraph 8, operators may request the competent authority, to issue allowances to them valid from 2013 onwards in exchange for CERs and ERUs issued in respect of emission reductions up until 2012 from project types which were eligible for use in the Community scheme during the period 2008 to 2012. Until 31 March 2015, the competent authority shall make such an exchange on request”.

This provision is somewhat ambiguous, in that it is not clear whether “the levels of CER and ERU use allowed” refers to the limit applicable to each operator, or the level of use allowed to operators as a group within a Member State. There appears to be no similar provision in the Directive for person account holders.

The question that remains is what happens to CERs and ERUs that remain in Member State's registries after 31 December 2012? The answer appears to depend upon how the particular EU Member State chooses to manage its 2.5 per cent carry-over allowance for CERs and 2.5 per cent carry-over allowance for ERUs:

• CERs and ERUs that have not been surrendered by operators by 30 April 2013 will remain in operator accounts. Under Article 11(a)(2) of the Revised EU ETS Directive, if operators did not surrender CERs or ERUs up to the permitted ceiling within their Member States in Phase II, they may exchange additional Kyoto units they hold up to that ceiling for Phase III EUAs until 31 March 2015.²²
• CERs and ERUs that have not been transferred out of person holding accounts by 30 April 2013 can remain in person holding accounts. There appears to be no provision similar to Article 11(a)(2) for person holding account holders that guarantees exchange.
• CERs and ERUs in Party accounts can remain through the true-up period under the Kyoto Protocol.
• Holders of CERs and ERUs in accounts past the date of surrender (30 April 2013) may be able to sell them on to a government or to another Member State for banking.
• However, at the conclusion of the true-up period, and the unit carry-over process, any “invalid units” remaining from the first phase under the Kyoto Protocol will be cancelled from national registries. “Invalid units” include CERs and ERUs remaining in these accounts that are not carried over within the carry-over allowance given to a Member State.

It is up to each Member State to decide how it uses its 2.5 per cent carry-over limitation on CERs. Thus, in terms of policy options, the Member State may keep the 2.5 per cent carry-over allowance for its own CERs, or it may choose to allow account holders to take advantage of the carry-over. If the carry-over is shared with account holders, this could be done in various ways, such as on a first-come-first-served basis, or on a pro-rata basis. If the carry-over is not shared, then CERs and ERUs remaining in holding accounts past the surrender date will diminish still further in value.

Demand for CERs/ERUs post-2012

By way of background, the Revised EU ETS Directive specifies that, in the period prior to the entry into force of an international agreement on climate change operators under the EU ETS will have from, 1 January 2013 to 31 March 2015, the right to exchange CERs or ERUs in respect of project activities for Phase III EUAs in the following cases:

(i) for emission reductions up until the end of 2012;
(ii) in respect of emissions reductions from 2013 onwards from projects registered before 2013; and
(iii) from new projects started from 2013 onwards in Least Developed Countries.

The key risk associated with the usage of CERs or ERUs in accordance with above mechanisms is the development and application of measures that may, from 1 January 2013, restrict the use of specific credits from project types.

Determining a view on the likelihood for qualitative restrictions being imposed on CERs in the EU post 2012 is therefore a question of the likelihood of a “successful” result being achieved in Copenhagen or soon thereafter. The trigger for the European Commission doing so will be the EU forming the view that the Copenhagen negotiations have not generated the framework for a sufficiently ambitious successor to the Kyoto Protocol. We believe that it is unlikely that the Commission would implement the above prior to Spring 2010.

If restrictions are contemplated by the European Commission, it is likely that the starting point will be those listed in Recital 29 of the Revised EU ETS Directive, namely that project activities generate “real, verifiable, additional and permanent emission reductions and have clear sustainable development benefits and no significant negative environmental or social impacts”. In the absence of further consideration by the Commission to date it is difficult to form a view on project activities that may be at risk. However, both at the EU and international level, it is clear that there is concern about HFC-23 destruction and, to a lesser extent, Nitrous Oxide destruction (which are also producers of significant volumes of CERs, an indirect consideration for the Community in the context of a post-2012 scenario where there are limited demand sources for CERs other than the EU ETS). On balance, we consider it possible but less likely that restrictions will be developed that have the effect of restricting eligible CERs to only those from renewable energy and energy efficiency.

In parallel with this process, it is likely that Community representatives would in accordance with the Revised EU ETS Directive commence negotiations on bilateral or multilateral agreements with developing countries in order to enable the Community to be in a position where credits from projects or other emission reduction activities in those countries may be used in the EU ETS (with particular focus on enabling countries hosting ERU generating projects being able to continue to generate credits capable for compliance use in the EU ETS). It is important to note that in the final negotiations of the text of the Revised EU ETS Directive, amendments were made to the text expand the scope of project types under such agreements from solely renewable energy or energy efficiency technologies to also encompass project types that were eligible for use in the EU ETS during the period 2008 to 2012.

Going forward, there are also risks associated with the conclusion of an international agreement. The Revised EU ETS Directive provides that only credits from third countries that have ratified such an agreement shall be accepted in the EU ETS from 1 January 2013. There is therefore a risk that a delay between reaching agreement and ratification by relevant host countries will have a consequent impact on usage of credits by operators.

It should also be noted that the usage provisions summarised at the start of this section are for the period prior to the entry into force of an international agreement on climate change. The mechanisms under the Revised EU ETS Directive for the further adjustment of the EU ETS Directive in this scenario contains positive language regarding the use of additional types of project credits or the use by operators of other mechanisms under the international agreement. However, there is no statement that such implementation will not undermine the rights of operators prior to the international agreement being reached.

Conclusion

2008-2012 CERs/ERUs that remain in operator or person holding accounts within the EU ETS may continue to be transferred after 31 December 2012. It is likely that there will continue to be some level of demand from operators for CERs/ERUs up until the deadline for the surrender of allowances within the EU ETS (30 April 2013), and a very limited demand from operators permitted to exchange 2008-2012 Kyoto units for EUAs up until 31 March 2015 because they have not used up the level of CERs/ERUs allowed to them by Member States for surrender under the EU ETS in Phase II. There may also be demand from Kyoto Parties (inside and outside the EU) for these CERs/ERUs up until the end of the Kyoto Protocol true-up period (2014/2015). Finally, there may be some limited demand from EU Member States that wish to use some of these units toward their allowed carry-over of CERs/ERUs under the Kyoto Protocol (sometime in 2015). However, despite the potential areas of demand described above, it is not unreasonable to assume that the increased restriction on CERs and ERUs in the post 2012 period will have an impact upon overall demand for them, particularly pre-2012 Kyoto units.

In addition, if pre-2012 Kyoto units remain in person holding accounts after the true-up period and carry-over process end, they will be cancelled from national registries in keeping with Kyoto Protocol limits on the carry-over of these units.

It is possible that individual EU Member States may wish to share any unused portion of their 2.5 per cent carry-over allowance for CERs and 2.5 per cent carry-over allowance for ERUs (relative to initial assigned amounts) with Kyoto unit holders within their registries (effectively allowing unit holders to exchange these Kyoto units for EUAs/AAUs in advance of their cancellation). However, this will be up to each Member State.

While it is also theoretically possible that individual EU Member States might act to control CERs and ERUs that remain in operator and person holding accounts into the true-up period (as it is left to Member States to establish terms and conditions for account holders), there is doubt as to whether Member States would take this approach as the response from holders of CERs and ERUs would be simply to transfer these units away from their national registry accounts to another registry without such a restriction before the effective date of any such action.

Footnotes

1. Directive 2009/29/EC. O.J. No L 140/63, 5.6.2009.
2. Section 7.6 of the Accounting Manual.
3. "Temporary CER" or "tCER" is a CER issued to project participants in an afforestation or reforestation project activity under the CDM which expires at the end of the commitment period following the one in which they are issued (5/CMP.1, Annex, paragraph 1(g)).
4. lCERs differ from tCERs (above) in that ICERs expire at the end of the crediting period for the project.
5. Yamin, F., Climate Change and Carbon Markets: A Handbook of Emission Reduction Mechanisms at 137 (2005).
6. Section 3.3. of the Accounting Manual.
7. Id.
8. Id.
9. Section 3.3.1. of the Accounting Manual.
10. Section 3.3.1.1. of the Accounting Manual.
11. Section 3.3.3. of the Accounting Manual.
12. Section 7.6 of the Accounting Manual
13. Id.
14. Id.
15. Citing decisions 5/CMP.1 para. 53 and Appendix D para 3 and decision 14/CMP.1, Annex, para. 36.
16. Directive 2003/87/EC, O. J. No L 275 , 25/10/2003, as amended by the "Linking Directive", 2004/101/EC, Directive 2008/101/EC and Regulation (EC) No 219/2009.
17. Decision 2/CMP.1, para. 1.
18. "Linking Directive", Preamble.
19. Commission Regulation (EC) No 2216/2004.
20. Registry Regulations, Article 53.
21. See http://emissionsregistry.environment-agency.gov.uk/ (UK Registry terms and conditions).
22. Revised EU ETS Directive, Article 11(a)(2).