Munden Project report on REDD and Forest Carbon: “Forest carbon trading is unworkable as currently constructed”

In the Road Runner cartoons, the coyote chases the road runner off the cliff and keeps going until he looks down. Once he realises what’s happened, he falls. Proponents of trading the carbon stored in forests are currently running coyote fashion as fast as they can towards the edge of the cliff.

A new report from the Munden Project suggests they should stop and take a look where they are heading.

The report can be downloaded here: “REDD and Forest Carbon: Market-Based Critique and Recommendations” (pdf file 993 KB). (The Munden Project is financed by Ford Foundation.) This report is particularly interesting because it is written from the perspective of the market. REDD-Monitor looks forward to a discussion about the problems highlighted in the Munden Report – in particular from proponents of a forest carbon commodity-based model for financing REDD.

The report does not question whether large sums of money are needed to preserve forests. Neither does it question whether carbon markets are the right way to raise this money. (Incidentally, neither does UN-REDD, which explains on its website that “[T]he final phase of REDD involves developed countries paying developing countries carbon offsets for their standing forests.”)

Instead, the report asks whether carbon markets will achieve what REDD sets out to do. UN-REDD explains the goals of REDD as follows:

REDD is a cutting-edge forestry initiative that aims at tipping the economic balance in favour of sustainable management of forests so that their formidable economic, environmental and social goods and services benefit countries, communities, biodiversity and forest users while also contributing to important reductions in greenhouse gas emissions.

The Munden Project report summarises the role of carbon trading in REDD with this equation:

So, will this meet REDD’s expected outcomes? “In a word,” states the Munden Project, “the answer is ‘no’, for four reasons:”

• Poor Transaction Structure. Transactions in REDD are structured as over-the-counter (OTC) arrangements, a fact that impedes REDD’s developmental goals and leads to a serious misallocation of resources.

• Commodities and Monopsony Power. Commodities markets are already unfavorable to producers and privilege intermediaries, largely because of the inherent nature of commodities themselves. Moreover, REDD’s global reach and scale suggest that intermediaries will obtain monopsony positions relative to projects. Both would imply that forest carbon will work against, not for, REDD’s stated development objectives.

• Poorly Defined Assets. From a trading point of view, the process [by] which forest creates carbon is ill defined to the point of being unacceptably risky. It contains a vague, poorly defined and scientifically unreliable process for creating forest carbon.

• Unsolvable Clearing Problems. As a consequence, pushing these commodities through the derivatives trading framework will prove impossible. This will either cause the trading system to not be created in the first place, or (as seems more likely) will result in the creation of a substandard, risky and ultimately destructive forest carbon market.

The report consists of three parts. The first part, “OTC and Commodities,” deals with the first two points, which are problems for the producers of the REDD commodity: forest carbon. The second part, “Assets and Clearing,” deals with the problems for the markets and traders of forest carbon. The third part, “Conclusions and Recommendations” summarises the problems and suggests some ways forward.

The report details how forest carbon will be traded. While many of those involved in REDD focus on forests, looked at from the market perspective, that is the smallest part of an inverted pyramid:

To anyone who is not an economist (and perhaps even to some economists) this inverted pyramid looks inherently unstable, but the Munden Project is not concerned about this market structure except to ask whether the structure is appropriate for REDD:

We believe that it is not only unsuitable operationally – in that it implies significantly higher costs for projects – but furthermore, that is highly likely to work at cross purposes with REDD’s stated objectives.

The Munden Project notes that there is a huge asymmetry of information between those selling carbon credits (who may only do so once) and those buying them (traders who deal in such trades regularly): “Derivatives contracts are complex legal documents and firms with more experience are also more skillful in structuring them to their advantage.” This is a major disadvantage for REDD projects, “who are forced to either muddle through these issues or engage expensive outside help.”

In an interview in 2007, economist Joseph Stiglitz, who was a joint-winner of the 2001 Nobel Prize in Economics for his work on asymmetric markets, explained that,

The theories that I (and others) helped develop explained why unfettered markets often not only do not lead to social justice, but do not even produce efficient outcomes.

The next problem that the Munden Project report notes is that “the commodity-based approach is at loggerheads with the development benefits REDD is expected to generate.” They use the example of milk as a commodity to show that if REDD follows the same commodity-based approach, the vast majority of the money invested would go on intermediaries and project costs. Governments would receive 5% and project returns (from which any payments to communities would come) would be 3%.

There is a high risk of REDD forest carbon forming a monopsony, or a market with many sellers but few buyers. The report explains that,

Logic dictates that the scale and resources required to source forest carbon credits will be so large that only a very few global intermediaries will be capable of providing it. Furthermore, these very same entities – or their parent companies – might also provide the connection between a project and the market.

The danger is that the buyers end up controlling the price – leaving sellers with no alternative but to accept the price offered. The Munden Project concludes that,

REDD is unlikely to generate expected impact at the producer level. That is, the bulk of benefits from forest carbon will not go to REDD projects, the communities that live within them or the countries where they are located, and those projects that are able to operate will come under intense pressure to cut costs due to monopsony buying power.

The report highlights a series of possible scenarios of “particular concern,” that might result from trading forest carbon under current circumstances:

• Scenario One. The commodity pricing structure does not create the benefit flows expected by governments, projects and communities, forcing them to abandon the concept. REDD – and more worryingly, the concept of engaging capital in the fight to protect forests – loses major credibility.

• Scenario Two. Vague, opaque standards for counting carbon lead to significant price shocks as carbon is revalued – or worse, a perpetual cycle of loosening standards as participants learn to game the system. Developing country governments see their economies become linked to the forest carbon market, and in the wake of these shocks, are forced to prop up or bail out those markets in order to preserve stability.

• Scenario Three. Bad incentives and conflicts of interest in verification and validation create a tragedy of the market’s commons, where carbon price is depressed as issuers overwhelm buying capacity. If linked with existing platforms like EU-ETS, this is a real problem.

• Scenario Four. The lack of clearing will cause deforestation by creating a bubble, in much the same way as subprime lending’s bubble caused bankruptcies. In this scenario, the popping of the bubble would cause damage to forest countries and communities, forcing them to generate cash flow to compensate by leveraging their most readily available and marketable asset: forest timber.

The Munden Project report takes an extremely critical view of trading forest carbon as a way of achieving REDD’s goals. However, the report does make four recommendations in an attempt to address these problems:

1. Invest in tenure
   Our first recommendation is the most straightforward. In many cases we analyzed, a very simple question – does the project have the right to do this on this land? – was impossible to answer. If there is any involvement from private capital sources, we cannot envision a scenario where the answer to that question is not important.

2. Change the definition of forest carbon
   If forest carbon proves to be such an attractive brand, we think the best bet is to move it – and move it dramatically – in the opposite direction from its current trend, away from microanalysis, and towards a broader, clearer definition.

   Agreement should be reached on a much more straightforward measurement of forest carbon, one that can be easily applied by projects with minimal – or ideally, no – reference to outside quantification experts.

3. Engage community-driven approaches, and do so more effectively
   Extensive evidence shows that giving communities greater rights to forests is effective from an environmental standpoint.

4. Generalize projects’ operational functions and use technology to enable them
   It makes little sense for REDD to develop into an approach that requires highly trained forestry experts to master accounting software and inflation projections. The key is to keep this dynamic sustainable.

   Given that REDD funding is currently driven by a small number of capital sources, we wonder if they might not be able to coalesce around a simple, web-based solution to this problem. Developing an application that project developers can use to cost out their projects, operate them and report results makes a lot of sense.

Numbers 1 and 3 of these recommendations are similar to demands that NGOs interested in the rights of indigenous peoples and local communities have been making for many years. The third recommendation suggests a process for developing REDD projects with local communities. Number 2 would reduce (or eliminate) the difficulties of measuring how much carbon is stored in forests and the soils beneath forests, which would surely be a huge relief to millions of forest dwelling communities around the tropics. (Although several hundred carbon measuring experts who would be put out of work might be considerably less happy with this suggestion.) And the fourth recommendation looks a little like a variation on the theme of a hammer seeing any problem as a nail – after all the Munden Project consists of builders of software systems. Nevertheless, the recommendations might provide a way of looking at REDD that highlights the fact that the REDD carbon trading coyote is currently running like crazy towards the edge of the cliff.