A Guide to Clean Development Mechanism (CDM) Projects in China

The United Nations Framework Convention on Climate Change (UNFCCC) is the first international convention in history aiming to protect against global climate change caused by human activity. China approved the Kyoto Protocol at the World Summit on Sustainable Development in 2002, and with continuing efforts from signing countries of UNFCCC, the Kyoto Protocol was signed and came into force on February 16 2005.

The Kyoto Protocol set forth fundamental principles, providing an effective framework and a set of rules for international cooperation in combating climate change. The Kyoto Protocol prescribed three market-based mechanisms, known as the Kyoto flexible mechanisms: emissions trading (ET) between governments, clean development mechanism (CDM) and joint implementation (JI), allowing industrialized countries to meet their targets cost-effectively by trading emissions allowances with each other and gaining credits from emissions-curbing projects abroad. The rationale behind the mechanisms is that greenhouse gas emission is a global issue, and that the location where reductions are achieved is irrelevant. Under such mechanisms, reductions can be made where costs are the lowest.

Article 12 of the Kyoto Protocol establishes the CDM to foster sustainable development in developing countries, and to help developed countries meet their mandated greenhouse gas emissions-reductions targets cost-effectively. This is a market-based financial instrument through which developed-country entities may use the certified emissions reductions (CERs) accumulated through CDM projects to meet their national commitments under the protocol. Only countries that have ratified the protocol will receive CERs. Although the United Stated has yet to sign the Protocol, US companies can still take advantage of the system by undertaking CDM projects and selling CERs through foreign subsidiaries or by other avenues.

The CDM Executive Board (EB) has provided 15 ways in which a CDM project can qualify. All projects which can lead to GHG reductions (including CH4, N2O, HFC, PFC and/or SF6) including but not limited to renewable energy projects, such as wind, solar, geothermal, (clean) biomass and hydro energy; energy efficiency improvement, transportation improvement, projects concerning recovery and utilization of methane (such as from waste landfills or coal mines), as well as projects concerning switching from fossil fuel to less carbon-intensive sources. In addition to these qualified CDM projects, investing in new technological developments that result in fewer greenhouse gas emissions will also potentially qualify. If foreign investors structure projects to retain ownership of the CERs, they can opt to sell these credits on the international market to a company anticipating a regulated reduction in its own emissions. Thus the buyer can maintain previous emissions levels while the seller can generate an additional revenue stream over the lifetime of a CDM project.

The life cycle for CDM projects includes following stages:

Stage 1 – Project Idea Note (PIN). A CDM project activity usually starts with the elaboration of a PIN containing a description of the planned project.

Stage 2 – The design of a CDM project is described in a Project Design Document (PDD).

Stage 3 – A Designated Operational Entity (DOE) has to approve it.

Stage 4 – A registration request may be submitted to the CDM Executive Board. The DOE handles the request on behalf of the project developer and at the last stage, when CERs are officially issued, they will be deposited into one or more registry accounts as specified and communicated to the CDM Executive Board at registration. Having a registry account is a precondition for the sale, purchase, possession and termination of CERs. The functionality of the accounts depends on the provisions taken by the registry holder.

THE CDM MARKET IN CHINA

A report issued by the World Bank shows that China has the potential to take an 80% share of the carbon reduction market, and will supply 50% of all CERs to the international market, with a value of US$2 to 8 billion a year.

Based on the national Climate Change Program (CCP), China has set up several quantified targets to fulfill within a specified period. According to Part 3 of the CCP, China will reduce energy consumption per unit of gross domestic product (GDP) by 20% by the year 2010. It has reaffirmed China's commitment to increase the percentage of renewable sources in the country's energy mix to 10% by 2010, up from the present 7%. China also has pledged to increase forest coverage to 20% and expand the country's nature reserves to 16% of China's total territory. Hydro and nuclear power will also be increased, as well as wind, solar, geo-thermal and tidal energy.

According to the United Nations' CDM Executive Board (EB), as of October 18 2007, EB had issued 20 certified CERs for Chinese CDM projects. It is also estimated that the expected average annual CERs from registered projects by host countries will total 170,971,092 (1 CER is the equivalent of a metric ton of carbon dioxide), 44.93% of which will be shared by China.

THE CDM REGULATORY REGIME

In practice there are three levels of regulatory authority for CDM projects in China. The first one is the international level – the United Nations Framework Convention on Climate Change, Kyoto Protocol and Marrakech Accords and its amendments, which have all been signed and agreed upon by the Chinese government. The second level is national laws and rules regarding CDM projects in China, which include Measures for Operation and Management of Clean Development Mechanism Projects in China (CDM Measures), Promoting Clean Production Act of the PRC, Energy Conservation Act of the PRC and other generally applicable laws and regulations.

National Governing Authorities and their Roles

The National CDM Project Board (the Board) is established under the National Coordination Committee on Climate Change (the Committee), and a national CDM project management authority is established under the Board. China's National Development and Reform Commission (NDRC) and Ministry of Science and Technology (MOST) serve as co-chairs, and the Ministry of Foreign Affairs (MOFA) serves as vice chair of the Board, which also consists of the State Environmental Protection Administration, China Meteorological Administration, Ministry of Finance and Ministry of Agriculture.

The Board is in charge of reviewing CDM project activities, participants' eligibility, PDD, CER Prices and issues related to funding, technology transfer and sustainable development effects of the project, reporting to the Committee the status of a CDM project, potential problems and making recommendations.

The NDRC is China's Designated National Authority (DNA) for CDM projects, which means that it is responsible for scrutinizing project applications and making approvals on behalf of the Chinese Government. The securitization conducted by the NDRC will focus on the eligibility of the project participants and the trading price of CERs.

Key legal issues involved in CDM projects

CDM participant eligibility – It is defined in the Measures that Chinese funded or “Chinese-held enterprises within the territory of China are eligible to conduct CDM projects with foreign partners.”This definition has raised questions of whether foreign-invested enterprises (FIEs) are eligible, and whether Hong Kong and Macao Companies are considered as domestic companies investors. Consultation with NDRC officials confirms that FIEs controlled by foreign investors are not eligible as CDM participants unless the Chinese partners are the controlling shareholders of the project company. Authorities have also confirmed on several occasions that Hong Kong and Macao companies will be treated as foreign investors for CDM projects.

“Chinese-held” – This refers to 51% control or more of the equity by a Chinese party regardless of the party's nature, collective, private or state-owned, which means foreign investors can only hold no more than 49% shares of the CDM project company in China.

Legal ownership of CERs – In practice, the seller and buyer usually agreed through contract that the ownership of CERs will be transferred to buyers once registered with EB. However, the Measures say that “CERs produced from a particular CDM project are owned by the Chinese project owner.”

CER pricing – The CER price depends on a number of factors, such as the legal jurisdiction of where the credits are to be sold, the buyers' willingness to pay, and risk sharing structures in the contracts, including regulatory risk (such as eligibility of the project, verification and certification, issuance of CERs) project performance, and delivery risk. Under the Measures, the national CDM Board will review the CER price, which is not international practice. The authority has confirmed that there is no fixed base price, and that the price review will be based on the international CER market and whether it is favorable to the Chinese project owner. However, the Chinese government's intention to protect its own interests and to avoid malicious competition has reduced international buyers' interest in CERs, and in reality, no buyer will be willing to pay the full price at the onset of the CDM project, so as to protect themselves from price fluctuation.

Revenue sharing – The Measures have explicitly stated that proceeds from CER sales are owned jointly by the Chinese Government and project owners. The Chinese government's rationale is that the resources of emission reductions are owned by the Chinese government. The project owners are therefore not allowed to enter into any agreement to own a portion of CERs or share the proceeds from the sales of CERs.

Tax and cost – Under the CDM Measures, the Chinese government is entitled to:

• 65% of the sale price of CERs from hydro fluorocarbon and per fluorocarbon projects;
• 30% of the sale price of CERs from nitrous oxide projects; 
• 2% of the sale price of CERs from new and renewable energy projects, or projects to recover and utilize coal bed methane.

Such taxes would be in line with the government's goals of sustainability and generating social benefits – carbon credits that are easy to produce and have no other economic or productive output would be given higher taxes, whereas those with independent revenue streams, such as a wind farm that produces electricity for a nearby city, would be taxed at a lower rate. These are factors that the CDM project owner should take into consideration when assessing the viability of a project in the future. In addition, the proceeds from CER sales are also subject to Chinese tax.

CONCLUSION

Recently, climate change has become a hot topic both for developed and developing countries. The Chinese government has been under international pressure to deal with climate change, and is eager to attract more investors with advanced technology to improve their overall environmental situation. As a sign that investment in this area is welcome, an official from the NDRC has said that China will not impose a CER tax in the near future, considering that such taxes may hinder the financial viability of CDM projects and diminishing investors' interest. In the meantime, President Bush's denunciation of Kyoto has not chilled the booming market for global investors and international companies looking for green business opportunities in China.