UN probes claims firms are faking carbon credits

PUBLISHED : Sunday, 10 October, 2010, 12:00am
UPDATED : Sunday, 10 October, 2010, 12:00am

In the smoggy suburbs of Zibo city in Shandong province, an ordinary-looking factory sits in an ordinary-looking chemical industrial park. But what's going on here is anything but ordinary.

Beside the Dongyue Group's factory line that churns out refrigerants is a plant that destroys a potent gas, which is a by-product of the manufacturing process. Destruction of this gas creates 'credits' that can be traded on a multibillion-dollar global market. Carbon-market watchers say the plant is an example of how a system aimed at reducing greenhouse gases - widely thought to contribute to global warming - has been gamed for profit by overproducing ozone-damaging gas to fake credits.

'The evidence is overwhelming that manufacturers are creating excess [industrial gas] simply to destroy it and earn carbon credits,' says Mark Roberts, senior counsel and policy adviser in Washington at the non-profit Environmental Investigation Agency. 'This is the biggest environmental scandal in history and makes an absolute mockery of international efforts to combat climate change.'

Hong Kong-listed Dongyue is one of 10 companies subject to a probe under the Clean Development Mechanism, a United Nations system that regulates the trading of certain carbon credits. The investigation was quietly launched in August after a German non-governmental organisation called CDM Watch blew the whistle on what it saw as an abuse of the global carbon-trading system. The UN has asked the companies to respond to questions this month. Seven of them are in China, two in South Korea and one in India.

All are suspected of producing excess amounts of HFC-23, a gas also known as fluoroform that is a by-product of a common refrigerant used in cooling systems called HCFC-22. Fluoroform is a super greenhouse gas many more times damaging to the environment than carbon dioxide - and worth many more times its value as a carbon credit on the world market.

'There have been a number of people and companies making inappropriate and huge profits out of the carbon-credit system in general,' says Philippe Delhaise, chief executive of Capital Information Services, which provides due diligence and risk assessment on emission-reduction projects. 'This is particularly true in India, and, to a lesser extent, in China - except in the specific case of the HFC-23 destruction, where China has the biggest volume.'

The global carbon-trading system was set up as part of the 1997 Kyoto Protocol, an international treaty on global warming. To try to reduce global greenhouse-gas emissions, a system was devised that allows companies that exceed their emission quotas to offset their excess by 'buying' credits from other emitters. These credits are bought and sold at spot prices, mostly on an exchange in Europe known as the European Union Greenhouse Gas Emission Trading System. Alternatively, polluters can negotiate multi-year bilateral agreements with individual emitters, typically in developing countries.

China and other developing countries were exempted from the emission limits; the US opposed that exemption and has never ratified the treaty. Consequently, under national commitments undertaken at Kyoto, polluters - mostly Europeans - are subject to annual pollution quotas. If they can't meet their targets or find it uneconomical, they can buy 'credits' to offset their excess emissions. The seller is often a company in China, currently the biggest emitter of greenhouse gases and supplier of some 60 per cent of so-called certified emission reductions credits, or CERs, which are tradeable.

The production of CERs is subject to approval of the government of the developing nation that gets the credit as well as the executive board of the UN's Clean Development Mechanism. For each tonne of carbon-dioxide reduction in a developing nation, one CER credit is generated.

Individual emitters and others - such as clean-energy project developers in developing countries - submit projects which, if approved, are monitored, verified and certified by independent evaluators like SGS Group Management.

The first project involving HFC-23 was approved by the UN in 2006 and a total of 19 projects have since been approved. According to an estimate by the UN system's secretariat, as far as 'global warming potential' is concerned, HFC-23 is so potent that it would take 11,700 tonnes of carbon dioxide released into the atmosphere to have the same effect as one tonne of the super gas. By comparison, it would take 1,810 tonnes of HCFC-22, the common refrigerant gas, to equal the environmental impact of a single tonne of its by-product, HFC-23.

CDM Watch, the German NGO, examined several years of data and concluded there was 'strong evidence' some companies have been abusing the system. While they don't appear to have broken any laws, the NGO believes the system needs overhauling to close loopholes.

In July, CDM Watch asked the UN to revise the methodology governing projects related to HFC-23. That led to the UN probe. The companies have been asked to provide detailed information on their output, sales and demand of HCFC-22 since 2000, whether there was excess inventory and whether such inventory was stored or destroyed. Any payments owed for credits have been halted.

Between 2006 and 2012, the seven Chinese companies were allowed to generate 271 million CER credits. Based on estimates, those credits are worth at least US$1.76 billion and could be worth up to US$5.8 billion, based on the current spot market price of about Euro15.50 (HK$167).

The credits are effectively subsidies aimed at encouraging polluters in developing countries to pursue measures to curb their pollution by investing in, among other things, renewable energy projects.

'What we're seeing is worse than gaming the financial systems, in many instances. Plants are producing excess HFC-23 simply so that it can be destroyed for the massive profits in the CDM credits,' says Roberts of the Environmental Investigation Agency, which says 59 per cent of European companies' carbon-credit purchases last year stemmed from HFC-23-related projects. Many of the alleged benefits of the carbon-trading system, Roberts adds, 'are simply a charade that actually increases the problem of global warming'.

The incentive to abuse the system is compelling. CDM Watch estimates that the income generated from credits derived from destroying HFC-23 is 70 times more than the cost to incinerate it. The potential huge profit provides 'perverse incentives' for operators to 'artificially' increase the output of the common refrigerant gas HCFC-22, and hence more of its by-product, to claim 'fake' carbon credits, CDM Watch says.

The UN system stipulates a maximum ratio of HFC-23 to HCFC-22 for each project. CDM Watch said the amount of HFC-23 produced per unit of HCFC-22 should have fallen over the years because of technological improvements. But the fact they had not was too coincidental. It concluded that the UN-sanctioned system's shortcomings, coupled with abuses by project operators, means that some plants would likely have produced less of the gases had it not been for the carbon-credit programme.

In the case of Dongyue, the production of the colourless gas chloro-difluoro-methane, better known as HCFC-22, is the firm's main profit source. Dongyue has been listed on the Hong Kong stock exchange since 2007 and, according to company literature, has been hailed by the Chinese leadership as China's answer to DuPont of the US and German industrial giants BASF and Bayer.

Dongyue is China's biggest producer of hi-tech fluorine and silicon materials, which the country previously had to import, says Cui Tongzheng, a co-founder of the company and its chief financial officer. These high-value materials are used in strategically important industries such as automobiles, aviation, aerospace, military equipment and solar energy.

In the half-year ended June 30, the company posted a profit attributable to shareholders of 274 million yuan (HK$318 million) - quadruple the year-earlier period, on the back of stronger demand for its refrigerants.

Dongyue has been a major generator of carbon credits through HFC-23. Cui denies that his company has abused the carbon-credit system. But he says it's possible some of Dongyue's competitors have done so. He also says Western NGOs such as CDM Watch have exaggerated how much money companies can make from HFC-23. Still, Cui says that even after paying a special 65 per cent tax levied by the government for a fund to fight climate change, and accounting for other expenses, the company's profit margin on selling the credits is a hefty 70 per cent.

It's a cash cow for the government, too. Each year Dongyue reaps about 444 million yuan from sales of its carbon credits. That makes the annual tax take about 288 million yuan

Shanghai-listed Changshu 3F Zhonghao New Chemical Materials is among the Chinese firms being investigated. Spokesman Wang Ronggen says it is unreasonable to accuse the firms of overproducing the industrial gases since production volumes are well-regulated by the UN and subject to independent verification.

Switzerland's SGS has acted as the independent verifier for all seven Chinese companies. Michael Fahy, a senior vice-president of environmental services, declined to comment, citing client confidentiality.

The World Bank also has been caught up in the UN probe. In 2006, to improve liquidity in the carbon market and support fledgling projects, the bank led a syndicate of private and government entities that agreed to buy 129 million CERs generated from two HFC-23 projects in China. At that time, the credits were worth nearly Euro800 million.

In a statement on its website in August, the bank disputes the idea that companies have exploited the UN system by inflating the amount of greenhouse gases produced. Citing data from China's Ministry of Environmental Protection, it says demand for HCFC-22 is 'real' with 'little surplus' and analysis by CDM Watch was based on 'a narrow and simplistic approach'.

Cui says he isn't worried about a potential clampdown on HFC-23 projects - and Dongyue is ploughing ahead with other products, including developing a refrigerant that won't deplete the ozone layer.

In the trade

China is the biggest emitter of greenhouse gases and supplies this percentage of tradeable CER credits: 60%

Massive profits

Seven of the 10 firms being investigated are located in China

The 271 million CER credits they have generated since 2006 could be worth, in US dollars, up to: $5.8b