The Evolution of the Carbon Markets: Is There Room for Russia?

As the negative effects of rising temperatures intensify, and efforts to reduce greenhouse gas emissions are making little headway, global concern about climate change is growing.

The climate issue is the most global of all problems facing humankind, and the only way to counter it is for all the leading states to work together. A specific feature of climate change is that the temperature rises no matter where on the planet the emissions occur. It is the volume of emissions that is important. Therefore, from the point of view of the global good, it would be logical to reduce emissions where it is cheaper to do so. This goal is subordinated to the workings of the emission offset system, or the carbon markets. The idea behind this system is for issuers to offset their obligations by paying for the efforts of another issuer for whom reducing emissions is easier.

In Russia, the carbon markets are not seen as a potential source of economic gain, which is a mistake. The high rates of energy and carbon intensity in manufacturing, the initial low level of development of renewable energy sources and the large volumes of energy losses as a result of the outdated infrastructure all make Russia a country with significant potential for low-cost emission reduction. One sector in particular that holds great potential for reductions is forestry, where there are plenty of opportunities for increasing forest cover and reforestation. If it is cheaper to reduce emissions in Russia than in most other countries, then this means that it could benefit from participating in international market mechanisms. This has already happened in the framework of the Kyoto Protocol, with Russian companies receiving an additional $600 million thanks to the country’s participation in Joint Implementation projects. And they could have earned more, up to $6 billion according to some estimates, had the scheme for registering and selecting Kyoto projects been created earlier and organized in a more effective manner.

The Kyoto project mechanism are no longer available to Russia, but the development of the voluntary carbon offset markets also provides considerable opportunities to capitalize on the huge potential of cheap emission reduction in the country. Many commercial banks and investment, trust and pension funds believe that investing into green projects is now a top priority. The same applies to international organizations, and not only to the World Bank Group or the European Bank for Reconstruction and Development, which Russia has a difficult time receiving money from due to the confrontation with the West, but also to the BRICS New Development Bank, the Asian Infrastructure Investment Bank, the Silk Road Fund, the Eurasian Development Bank, etc. Reducing the carbon footprint, cutting emissions dramatically or even shifting to full carbon neutrality over the next several decades gradually appear on the agenda of many large companies. In many cases, they find it difficult (at least to begin with) to achieve these goals by their own efforts, so they prefer to compensate for their carbon footprint by financing low-carbon projects outside. There are many such projects in Russia, and if it succeeds in presenting them to the world, these projects can become a big source of investment – and in some cases technologies – into the Russian economy.

Finally, it is difficult to attract financing for low-carbon projects to a country that not only does not have its own carbon regulation but even considers the development of “green technologies” among the “challenges and threats to economic security” at the level of an official document. The regulation can be developed, and its main contours have already been outlined. An even more difficult task, however, and one that is at the same time more important, is to change the narrative – to stop treating the green agenda as a whim or a threat to the development of the economy and start seeing it as an opportunity.

As the negative effects of rising temperatures intensify, and efforts to reduce greenhouse gas emissions are making little headway, global concern about climate change is growing.

The climate issue is the most global of all problems facing humankind, and the only way to counter it is for all the leading states to work together. A specific feature of climate change is that the temperature rises no matter where on the planet the emissions occur. It is the volume of emissions that is important. Therefore, from the point of view of the global good, it would be logical to reduce emissions where it is cheaper to do so. This goal is subordinated to the workings of the emission reduction system, or of the carbon markets. The idea behind this system is for issuers to offset their obligations by paying for the efforts of another issuer for whom reducing emissions is easier. In other words, the carbon markets help reduce emissions in the most affordable ways and in companies where it is cheaper to do so.

The key drawback of today’s international climate regulation system is that the main sources of financing low-carbon projects are geographically separated from the most effective projects to reduce emissions. That is, financing mainly comes from the West, and partially from Japan and China, while the most promising projects are primarily located in developing countries, where there is greater potential to reduce greenhouse gas emissions relatively cheaply. The carbon markets play a particularly important role in bridging this gap.

Intergovernmental Emission Offset System: From the Kyoto Protocol to the Paris Agreement

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The principle of trading emissions permits was put into practice before the climate agenda came to the fore. A sulphur dioxide trading system was up and running in the 1990s, for example, which helped combat the acid rain problem. The RECLAIM urban sulphur and nitrogen oxide emissions cap-and-trade program helped Los Angeles significantly reduce the smog that had previously been an integral part of the cityscape.

With regard to greenhouse gases, the first emissions trading mechanisms were introduced already at the global level. The 1997 Kyoto Protocol established quantitative goals for leading countries to reduce their emissions. So-called flexible mechanisms were introduced in order to facilitate the implementation of the relevant measures.

Three mechanisms were introduced. First was the direct trading of allowed emissions among the parties to the agreement (Emission Trading). Second were two project mechanisms: Joint Implementation (JI) and the Clean Development Mechanism (CDM). The mechanisms allowed companies in one country to implement projects related to emissions reductions in another and use the reductions as disbursement of their obligations. At the same time, the JI mechanism involved implementing these projects in developed countries and countries in emerging markets, while the CDM was intended for developing countries that had not assumed any quantitative obligations under the Kyoto Protocol.

Sadly, the mechanisms proved to be largely ineffective. Production in Eastern European countries fell dramatically following the collapse of their planned economy systems, which meant that they exceeded their obligations under the Kyoto Protocol and became holders of a large number of excess “quotas,” called “hot air.” As a result, the Czech Republic, Poland and Slovakia earned hundreds of millions of dollars. However, this did absolutely nothing in terms of combating climate change.

The project mechanisms became more widespread, but there were accusations that many projects financed by European companies as part of the CDM and JI did not meet the “complementarity” criterion, that is, the emission reductions attributed to them could have been achieved without raising funds under the Kyoto mechanisms. What is more, the CDM provoked the classic “cobra effect,” a term that references an incident during the British colonial administration in India in the late 19th century, when the authorities, worried about the increase in the number of poisonous cobras in the country, offered a bounty for every dead snake brought to them, resulting in enterprising natives starting to breed snakes in order to make some money [1]. Similarly, there were cases during the first period of the Kyoto Protocols (2008–2012) where enterprises in developing countries (particularly China) generated abnormally high emissions with the specific purpose of attracting investments to reduce them. The flexible mechanisms have lost much of their former demand in the second period of the Kyoto Protocols (2013–2020), as the conditions for implementing project activities have been tightened and a number of countries have refused to accept new quantitative obligations.

The 2015 Paris Agreement, which effectively replaced the Kyoto Protocol, is fundamentally different from it, including in terms of the functioning of the international carbon markets. The Paris Agreement has a “bottom-up” structure, whereby countries declare their own emission reduction targets based on their energy development plans, other carbon-intensive industries and the economy as a whole. These targets are not binding and are nothing more than guidelines for the countries that declare them.

In the absence of strict quantitative commitments to reduce emissions, the principle of how the cross-border emission offset systems work has also been transformed – it is now called the Sustainable Development Mechanism (SDM). The specific content of the SDM is still being agreed upon by the parties to the Paris Agreement and will only be finalized by the end of 2019 at the earliest. This notwithstanding, it is already clear that the SDM is unlikely to be particularly broad in its scope. It will cover voluntary projects. Some countries (for example, Japan) see participation in the reduction of emissions in other countries as a way to promote their green technologies. There are cases where the national regulatory system implies that companies can fulfil their obligations by reducing emissions abroad, and the Sustainable Development Mechanism standardizes this process. However, this can hardly be considered a key element of the new climate regime.

National and Regional Emission Trading Systems

Along with the development of intergovernmental regulation of greenhouse gas emissions over the past decade, the practice of using national and regional emissions trading systems (ETS) is expanding rapidly. At present, a total of 27 administrative entities (integration associations, countries and regions) use this instrument. Its main idea is to determine the maximum allowable amount of emissions in the economy, which is distributed (free of charge or through an auction) between issuers covered by the regulation. If the allowable emissions are exceeded, the companies are obliged to buy up the shortfall on the market, and if the permissible volume is not exceeded, they may sell the surplus. Thus, the emission ceiling set by the regulator and the abundance of transactions on the purchase and sale of emission permits are what form the market price for them.

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The most developed system is the European Union Emissions Trading System (EU ETS), which was launched in 2005 and now covers 11,000 companies in 31 countries. The EU ETS is the main instrument of the European policy for the transition to low-carbon development and combating climate change. During the second phase of its operation, which coincided with the first period of the Kyoto Protocol (2008–2010), the total reduction in emissions on account of the European carbon market (not accounting for other factors that affect emissions) amounted to 15 percent. The EU ETS has also become a model for the creation of similar systems in California, several Canadian provinces, New Zealand and other countries.

An emissions trading system launched in China in December 2017 has already become the largest platform of its kind in terms of coverage, and there are plans to expand it further. So far, the Chinese ETS only includes the electricity generation sector and regulates emissions of 1700 issuers (including combined heat and power plants), which account for approximately 30 percent of all the country’s emissions.

Many national emissions trading systems have channels of communication with the outside world. For example, the EU ETS was coordinated with the SDM and the JI, which allowed companies trading on the European carbon market to participate in projects outside the continent. However, until a more effective international system for offsetting reduction units is developed by 2020, the EU ETS will continue to significantly limit the offsetting of reduction units of third-party projects.

Precedents have appeared in recent years for combining national emissions trading systems. In 2012, the EU and Australia reached an agreement to combine their ETS starting in 2018. The emissions trading systems of California and Quebec merged in 2014 and were joined by Ontario in 2017. Nevertheless, while combining national systems is fraught with many difficulties associated with the uneven distribution of gains and a strong dependence on the political situation. Suffice it to say that the agreement between the European Union and Australia was canceled after the new government came to power in Australia, which replaced the cap-and-trade system with other regulatory instruments. And the province of Ontario, which joined the California–Quebec emissions trading system in 2017, left the system the following year after the very first elections that led to the victory of alternative political forces.

Voluntary Carbon and Green Bonds Markets

Carbon markets are also developing outside of government regulation. The role of voluntary emission reduction offsetting schemes based on investment projects is growing. Companies are eager to take part in these schemes, driven by the desire to reduce greenhouse gas emissions for reasons of corporate responsibility, as well as to reap the associated benefits, including obtaining long-term competitive advantages through the earlier development of advanced green technologies compared to their competitors. It is telling that leading corporations are increasingly introducing their own internal carbon prices independently of any government regulation. Many large companies, including the oil and gas giants ExxonMobil, Royal Dutch Shell, Equinor, ConocoPhillips, Total and others have already set prices for themselves. Internal carbon prices are used when making investment decisions: an estimated volume of emissions within the framework of a planned project, multiplied by the price, is included in the planned costs and, alongside the traditional financial indicators, affects the assessment of the project’s potential and, as a result, the decision on whether or not to launch the project in the first place.

Generally speaking, internal carbon pricing is, first of all, a way to manage the risks associated with regulating emissions at the international, national and industry level; second, it is a tool for these companies to position themselves in a world where increasing attention is being paid to green development issues.

The implementation of voluntary projects to reduce emissions is controlled by a set of international standards for the verification of reduction units (the Verified Carbon Standard, Gold Standard, etc.), which vary depending on the type and geography of the project activities, as well as on the methodology for counting the reductions. Projects cover various areas of activity, from agriculture to improving the energy efficiency of production and transitioning to clean energy sources. Forestry projects have been particularly common of late, having been launched in 83 countries, with the majority of those being in India, China, the United States, Turkey, and Brazil.

The development of the green bonds market has led to the expansion of international low carbon projects. A green bond is a debt instrument, the issuer of which receives a fixed amount of funds from the investor and then directs it to projects reducing the negative impact on the environment. Green bonds are supported by a number of states and international organizations, and many institutional investors view these as an indispensable element of their investment portfolios. The importance of financial instruments of this type will only grow: their role is to link the financial resources of economic agents that are willing to invest in green development with low-carbon projects around the world. In this sense, they perform the same function as international project mechanisms, but with less red tape and greater transparency. A disadvantage is that, thus far, most green bonds have only been issued in developed countries. However, it is likely just a matter of time before they become widely distributed in the developing world too.

Opportunities for Russia

Climate agenda 2030
COP 21 Results. Countries' Commitments Overview

In Russia, the carbon markets are not seen as a potential source of economic gain, which is a mistake. The high rates of energy and carbon intensity in manufacturing, the initial low level of development of renewable energy sources and the large volumes of energy losses as a result of the outdated infrastructure all make Russia a country with significant potential for low-cost emission reduction. One sector in particular that holds great potential for reductions is forestry, where there are plenty of opportunities for increasing forest cover and reforestation. If it is cheaper to reduce emissions in Russia than in most other countries, then this means that it could benefit from participating in international market mechanisms. This has already happened in the framework of the Kyoto Protocol, with Russian companies receiving an additional $600 million thanks to the country’s participation in Joint Implementation projects. And they could have earned more, up to $6 billion according to some estimates, had the scheme for registering and selecting Kyoto projects been created earlier and organized in a more effective manner.

The Kyoto project mechanisms are no longer available to Russia, but the development of the voluntary carbon offset markets also provides considerable opportunities to capitalize on the huge potential of cheap emission reduction in the country. Many commercial banks and investment, trust and pension funds believe that investing into green projects is now a priority. The same applies to international organizations, and not only to the World Bank Group or the European Bank for Reconstruction and Development, which Russia has a difficult time receiving money from due to the confrontation with the West, but also to the BRICS New Development Bank, the Asian Infrastructure Investment Bank, the Silk Road Fund, the Eurasian Development Bank, etc. Reducing the carbon footprint, cutting emissions dramatically or even moving to full carbon neutrality over the next several decades gradually appear on the agenda of many large companies. In many cases, they find it difficult (at least to begin with) to achieve these goals by their own efforts, and they prefer to compensate for their carbon footprint by financing low-carbon projects outside. There are many such projects in Russia, and it succeeds in presenting them to the world, these projects can become a big source of investment – and in some cases technologies – into the Russian economy.

Much work needs to be done in this area, however. Unlike the Kyoto project mechanisms, it is of key importance to prove that the project meets the principle of complementarity. This can be done by verifying projects according to international standards, issuing green bonds in line with international principles, creating low-carbon project registers that will be recognized by the international community, etc. This kind of infrastructure is only at the initial stages of development in Russia, and it is up to the government to support and expand it.

Compliance with the principle of complementarity is particularly difficult for manufacturing and traditional power companies and is easiest to ensure in renewable energy sources development, waste management, and forestry. However, in Russia, there are significant regulatory, administrative and bureaucratic barriers in these areas that hinder foreign investors from entering the country. Whether or not these barriers will be overcome depends on the place that Russia occupies on the map of voluntary low-carbon projects.

Finally, it is difficult to attract financing for low-carbon projects to a country that not only does not have its own carbon regulation but even considers the development of “green technologies” among the “challenges and threats to economic security” at the level of an official document. The regulation can be developed, and its main contours have already been outlined. An even more difficult task, however, and one that is at the same time more important, is to change the narrative – to stop treating the green agenda as a whim or a threat to the development of the economy and start seeing it as an opportunity.

1. Siebert, Horst. The Cobra Effect. How to Avoid Misconceptions about Economic Policy. Moscow: Novoye Izdatelstvo, 2005.