CARBON TRADING TO REDUCE CLIMATE CHANGE

Carbon trading (or emissions trading) is a consequence of the Kyoto Protocol. The idea is that countries that create more greenhouse gases than allowed can purchase credits from countries whose emissions are much lower.

The Kyoto Protocol is a ‘cap and trade’ system that imposes national caps on the emissions of developed countries. On average, this cap requires countries to reduce their emissions 5.2% below their 1990 baseline over the 2008 to 2012 period. Although these caps are national-level commitments, in practice most countries will devolve their emissions targets to individual industrial entities, such as a power plant or paper factory. This is the case today in the EU, and other countries may follow suit in time.

This means that the ultimate buyers of Credits are often individual companies that expect their emissions to exceed their quota (their Assigned Amount Units, Allowances for short). Typically, they will purchase credits directly from another party with excess allowances, from a broker, from a JI/CDM developer, or on an exchange.

National governments, some of whom may not have devolved responsibility for meeting Kyoto targets to industry, and that have a net deficit of Allowances, will buy credits for their own account, mainly from JI/CDM developers. These deals are occasionally done directly through a national fund or agency, as in the case of the Dutch government’s ERUPT program, or via collective funds such as the World Bank’s Prototype Carbon Fund (PCF). The PCF, for example, represents a consortium of six governments and 17 major utility and energy companies on whose behalf it purchases Credits.

Trading carbon credits

Since Carbon Credits are tradeable instruments with a transparent price, financial investors have started buying them for pure trading purposes. This market is expected to grow substantially, with banks, brokers, funds, arbitrageurs and private traders eventually participating. Emissions Trading PLC, for example, was floated on the London Stock Exchange’s AiM market in 2005 with the specific remit of investing in emissions instruments.

Although Kyoto created a framework and a set of rules for a global carbon market, there are in practice several distinct schemes or markets in operation today, with varying degrees of linkages among them.

Kyoto enables a group of several Annex I countries to join together to create a so-called ‘bubble’, or a cluster of countries that is given an overall emissions cap and is treated as a single entity for compliance purposes. The EU elected to be treated as such a group, and created the EU Emissions Trading Scheme (ETS) as a market-within-a-market. The ETS’s currency is an EUA (EU Allowance). The scheme went into operation on 1 January 2005, although a forward market has existed since 2003.

The UK established its own learning-by-doing voluntary scheme, the UK ETS, which runs from 2002 through 2006. This market will exist alongside the EU’s scheme, and participants in the UK scheme have the option of applying to opt out of the first phase of the EU ETS, which lasts through 2007.

Canada and Japan will establish their own internal markets in 2008, and it is very likely that they will link directly into the EU ETS. Canada’s scheme will probably include a trading system for large point sources of emissions and for the purchase of large amounts of outside credits. The Japanese plan will probably not include mandatory targets for companies, but will also rely on large-scale purchases of external credits.

Next to the EU ETS, the most important sources of credits are the Clean Development Mechanism (CDM) and the Joint Implementation (JI) mechanism. The CDM allows the creation of new Carbon Credits by developing emission reduction projects in Non-Annex I countries, while JI allows project-specific credits to be converted from existing credits in Annex I countries. CDM projects produce Certified Emission Reductions (CERs), and JI projects produce Emission Reduction Units (ERUs). CERs are valid for meeting EU ETS obligations as of now, and ERUs will become similarly valid from 2008 (although individual countries may choose to limit the number and source of CER/JIs they will allow for compliance purposes starting from 2008). CERs/ERUs are overwhelmingly bought from project developers by funds or individual entities, rather than being exchange-traded like EUAs.

Since the creation of these instruments is subject to a lengthy process of registration and certification by the UN, and the projects themselves require several years to develop, this market is at this point almost completely a forward market where purchases are made at a deep discount to their equivalent currency, the EUA, and are almost always subject to certification and delivery (although up-front payments are sometimes made). According to IETA, the market value of CDM/JI credits transacted in 2004 was EUR 245m; it is estimated that more than EUR 620m worth of credits were transacted in 2005.

Non-Kyoto markets

Several non-Kyoto carbon markets are already in existence as well, and these are likely to grow in importance and numbers in the coming years. These include the New South Wales Greenhouse Gas Abatement Scheme, the Regional Greenhouse Gas Initiative (RGGI) in the United States, the Chicago Climate Exchange, the State of California’s recent initiative to reduce emissions, the commitment of 131 US mayors to adopt Kyoto targets for their cities, and the State of Oregon’s emissions abatement program.

Taken together, these initiatives point to a series of linked markets, rather than a single carbon market. The common theme across most of them is the adoption of market-based mechanisms centered on Carbon Credits that represent a reduction of CO2 emissions. The fact that most of these initiatives have similar approaches to certifying their credits makes it conceivable that Carbon Credits in one market may in the long run be tradeable in most other schemes. This would broaden the current carbon market far more than the current focus on the CDM/JI and EU ETS domains. An obvious precondition, however, is a realignment of penalties and fines to similar levels, since these create an effective ceiling for each market.

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