China's booming hydropower sector is facing mounting criticism for generating subprime carbon credits from projects that don't need extra earnings to succeed, raising the risk of tougher rules and putting billions of dollars of clean energy investments at risk.

To qualify for the U.N.'s Clean Development Mechanism, which allows developed countries to meet Kyoto Protocol obligations by investing in clean-energy projects in poorer nations, a project must demonstrate that it could not proceed without additional income from carbon credit sales.

But critics say Chinese hydropower projects -- which account for almost half of its estimated $14.6 billion CDM-related revenues in the pipeline -- don't need to sell these Certified Emission Reduction offsets (CERs) in order to make money, violating this fundamental tenet of additionality.

So there is a lot at stake, especially for developers and their foreign partners like Norway's DNV, Mitsui and Co. of Japan, the Italian utility Enel SpA, EDF of France and EcoSecurities of the U.K.

I'd be surprised if any of the Chinese hydros in the CDM project pipeline are actually additional, or needed CERs to be built, said Patrick McCully, executive director of International Rivers, a California-based environmental pressure group.

Green groups like Friends of the Earth have said that cheap hydropower projects in China and elsewhere -- which they have dubbed subprime carbon -- have helped create a glut that makes no meaningful contribution to the fight against climate change.

Others disagree, noting that China's electricity tariff regime means hydropower projects are paid less than coal power plants, making them that much harder to fund.

Hydro tariffs are lower than coal-fired power, so investing in hydro is less attractive than coal. It is easy to defend in terms of CDM, said Zhang Zhongxiang, a CDM expert with the East-West Center in Hawaii.

What's clear is that as global negotiations to find a broader global climate pact by December intensify, so too do the calls to redesign the U.N. carbon offset scheme, potentially leading to limits preventing China's hydropower plants from participating.

Underscoring the growing pressure to reform the CDM, the European Union's executive arm in January proposed crediting only those projects that deliver real additional reductions and go beyond low-cost options.

For a graphic showing China CDM projects and global hydro projects, click on

here

TOO LAX?

Much of the debate centers around the U.N.'s rules for vetting projects under the CDM, which many developers say are already very tough. They fear earnings could be hurt if rules are tightened and particular countries targeted.

Critics, however, argue that the U.N. is too lax in its reviews because it has an incentive to generate more credits.

Anders Brendstrup, managing director for China for Camco, one of the larger CDM project developers and advisers in China, says China is effectively being singled out for the successful way it has adapted to the CDM.

China will generate 58 percent of the 1.59 billion in CERs forecast by 2012, the United Nations Framework Convention on Climate Change predicts, which at current prices of 11.91 euros would be worth 11 billion euros ($14.6 billion).

They should be praised, not criticized, for this success, Brendstrup said.

While large hydropower projects like the one at the Three Gorges are profitable and backed by massive state support, small plants could struggle to make ends meet without the additional revenues generated by carbon trading.

Small hydro meets the principles of the CDM, a foreign CDM developer told Reuters. People tend to think of the Three Gorges, but small hydro is clean and safe.

He declined to be named because his company has been involved in several CDM hydro projects with local governments in China.

There is no internationally accepted definition for small hydro. The EU recognizes plants with capacities of no more than 10 megawatts, allowing a maximum of 50 MW for Chinese projects.

But last month, the Bingling hydroelectric facility on the upper reaches of China's Yellow River -- partnered by Enel -- became the biggest hydropower plant so far to make use of the mechanism, and will have a total capacity of 240 megawatts once it is completed later this year.

Lex de Jonge, chairman of the CDM's executive board, which decides which projects get to issue CERs, told Reuters that it doesn't matter what size the plant is, as long as it meets their additionality rules.

It will be a while before investors know the shape of a revised CDM. Delegates from nearly 200 nations gather in the Danish capital Copenhagen in December to try to agree on the shape of a post-2012 emissions trading system.

Many countries have voiced concerns about how the funding should be spent, Yang Ailun, China climate campaign manager with Greenpeace, said. It is clear that it won't be so easy for China to fund projects like hydropower.

($1=.7492 Euro)

(Reporting by Beijing newsroom; Editing by David Fogarty and Michael Urquhart)

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