A last-minute decision to put Reduced Emissions from Deforestation and Degradation (REDD) on the roadmap for future climate change talks opens the door to innovative financing schemes to reduce deforestation. Such schemes have long been advocated by investment banks and traders – who are expected to play an ever larger role in framing future climate change mitigation mechanisms. The Ecosystem Marketplace takes a closer look. (First of two parts) When trader David Pearse says that buying emission reduction certificates should be more like buying bags of beans, environmentalist Richard Worthington cringes and forestry expert Anna Lehmann rolls her eyes. But his amoral market talk may be on the ascendant after this week's climate change talks in Bali. "Practically no one here today has any understanding of financial markets or instruments, and yet they've taken it on their hands to create the most important financial market on the planet," says Pearse, a geologist by training who, as a commodity trader, set up Deutsche Bank's carbon trading desk in 2000. Today he runs an ecosystem investment group called Osmia Partners and says the mechanisms designed to promote Reduced Emissions from Deforestation and Degradation (REDD) are riddled with bad finance, perverse incentives, and market distortions. It is a problem nearly everyone in Bali was increasingly willing to acknowledge as the weeks wore on, with scores of debates focusing on how to set national baselines to determine the extent to which different parties are rewarded for reducing deforestation. Until Friday, the only mechanisms officially on the table were those basing future targets on recent rates of deforestation and other socioeconomic factors rather than on carbon already in trees (For background on the debate over determining baselines and avoided deforestation, see: Carbon and Avoided Deforestation: The Road to Bali). Countries and regions that had already reduced deforestation were haggling to get credit for early action, while scientists were coming up with ever more complex "baselining" strategies designed to mitigate the distortions. On the final day of negotiations, however, a clause was inserted into the draft of the so-called "roadmap document" which is set to outline future debate on global carbon emissions reductions, making it clear that future negotiations can explore financing mechanisms based on carbon already in trees, even if those trees aren't in immediate danger of being chopped down.
The Perverse Incentive
Just as developed nations were given targets to reduce emissions based on past pollution in the first phase of the Kyoto Protocol, developing nations are now being asked to accept targets to reduce deforestation after 2012 based on the speed with which they're chopping down forests today. "That creates a perverse incentive whereby you reward the people who have been chopping down their forests and punishes the people who have been good stewards of the land," says Pearse. "If you don't compensate the largest owners of forest who haven't been cutting down their forests, their only incentive to participate is to start cutting them down." That perverse incentive hasn't been removed – it appears to be with us through 2012, and remains the favored mechanism for whatever follows the Kyoto Protocol. Pearse – and other bankers on the sidelines of this week's talks – says the only way to avoid the incentive is to abandon the entire notion of baselining, toss out the concept of additionality, and value the forests that exist now. "The UN," he says, "should limit its role to the high-level stuff like determining the caps on deforestation and industrial emissions, and then turn Goldman Sachs, Merrill Lynch, and Deutsche Bank loose on it. We'll have this whole thing fixed in a couple of years." It's an argument that echoes the "carbon stock" approach co-developed by Charlotte Streck, a former World Bank attorney who now heads up a group called Climate Focus. She's made waves over the past few years by saying we should toss the baseline-and-credit system and replace it with a cap-and-trade system that operates by giving carbon stock units (CSUs) to participating countries based on the amount of carbon in their forests during a base year. Countries could sell CSUs based on how much forest they put under protection. The new approaches that investment bankers like Pearse are feeding into the system go a step further: He advocates the promotion of sustainable land use schemes that earn money in the short-term by managing the land, with the carbon in the trees serving as an embedded option that can be cashed in years down the road. It's heady stuff – and was largely ignored in Bali until the last day of talks.
Day of the Banker
"The painful lessons learned through the CDM process could have been avoided if the financial community had been more proactive in engaging in the policy debates at an early stage," says Abyd Karmali, the former United Nations Environmental Program climate change boss who now runs Merrill Lynch's global carbon operations. "That has been a key trend over the past six to 12 months: that more and more investment banks have realized that the markets and the incentives of carbon finance are heavily policy-driven, and that's why there's been a scaling up of interest from the banks." Banks, he says, see the world a lot differently than do most scientists and others involved in these markets to date – but so do many of the old pros who have been in the carbon markets for years. "The additionality concept is a curse on making a rational investment response through the flexible mechanisms of whatever follows the Kyoto protocol," says James Cameron, Vice Chairman of Climate Change Capital. "Now, with the additionality concept being extended into what could or would or should be done with forests, we're finding that strange partners have caused layers of complexity to get in the way of doing simple things that are right." Like advocates of the favored REDD regime, bankers say you need to account for emissions at both a national level and on a project-by-project basis to make sure that deforestation halted in one part of a country isn't deforestation begun in another. Their methods, however, allow the market to create a de facto baseline by trading forest-backed derivative instruments similar to bonds which can be redeemed at the end of 30 years for avoided deforestation credits. The value of the bonds would rise and fall with the market's perception of the degree to which countries are reducing deforestation. The value of credits from projects inside the country, if issued at all (in Pearse's scheme they're not), could then be indexed to the bonds – so that project developers have an incentive to make sure that the entire country is running a clean ship. The risk is then shifted to the investment banks that buy the bonds (with independent auditors acting as honest brokers) and it is up to them to determine which methodologies will pan out over the coming decades. "It's like buying a bag of beans," says Pearse. "If a trader thinks he's getting a deal on a cheap bag of beans, and then finds that half are rotten – then he takes the loss" and next time does more due diligence. "We're saying that banks should be allowed to determine what bags of beans they buy, and they should suffer the consequences if they buy the wrong ones," he adds, "while the UN is telling us not just what is an acceptable quality of bean, but which bags we're allowed to buy and which not – with the result that a lot of good bags of beans may never get picked up." He concedes the scheme might make it rough for governments that have been deforesting to sell bonds at a worthwhile price, but says that's not necessarily a bad thing. "In the early days, governments that had a history of deforestation would see the value of their bonds drop, because the market would need to be convinced they were serious," says Pearse. "But the market could very quickly drive up the price of those bonds if they see a change in practice." He adds that by removing the additionality requirement, you'd direct attention away from forests for their own sake to forests as a result of healthy land stewardship. "We used to talk about Land Use, Land Use Change, and Forestry – LULUCF," says Pearse. "There's an awful lot of letters there, and everyone here in Bali is clustered around the F, but what causes the pressure on the F? Land use, and land use change. Pressure on land and land use. Demand for food, demand for fuel, etc. If a country correctly manages its LULUC, it relieves pressure on its F, as opposed to putting a baseline of barbed wire around its forests and a machine gun posted on every corner." Kevin Conrad, Papua New Guinea's Environmental Ambassador and a participant in the roadmap talks, agrees. "We will see the development of new mechanisms that encourage early action, and that also promote efficient land use," he says. "That's a key issue, because in Papua New Guinea, the leading driver of deforestation isn't logging, but shifting agriculture."
All Those Opposed
At this point, the anti-baseline bandwagon has plenty of empty seats. One of those taking a pass is Anna Lehmann, a forestry project leader with of German carbon shop 3C. "This stuff sounds great in theory, but once you get on the ground, you realize how complex everything is," she says. "I'm all for market solutions, but we're also trying to promote sustainable land use planning at the national level, and that means capacity building, which is why it makes sense to 'reward' the biggest offenders – if you want to phrase it that way – because they are the ones most in need. I really don't see any way around baselines." For now, she's clearly in the majority – but projects are already underway that promote sustainable land use with the aim of cashing in on forest credits and other ecosystem service payments down the road – additional or not. For instance, the Brazilian state of Amazonas (which has been a self-driven success story in the fight to reverse deforestation) has already decoupled any future biodiversity benefits generated by its forest canopy from its carbon credits – with the state keeping the biodiversity rights, and the federal government getting the carbon. And many of Pearse's arguments flow from a project he's involved with in the Indonesian state of Aceh. In the coming weeks, we'll examine both of these in more detail. Steve Zwick is a regular contributor to the Ecosystem Marketplace. He may be reached at steve.zwick at gmail.com. First published: December 14, 2007 Please see our Reprint Guidelines for details on republishing our articles.