Carbon Market

The Kyoto Protocol

The 1997 Kyoto Protocol, a milestone in global efforts to protect the environment and achieve sustainable development, marked the first time that governments accepted legally-binding constraints on their greenhouse gas emissions. The Protocol also broke new ground with its innovative “cooperative mechanisms” aimed at cutting the cost of curbing these emissions. As it does not matter to the climate where emission reductions are achieved, sound economics argues for achieving them where they are least costly. The Protocol therefore includes three market-based ‘flexible mechanisms’ aimed at achieving cost-effective reductions — International Emissions Trading (IET), Joint Implementation (JI), and the CDM

IET

In broad terms, an emission trading system will see caps for emissions set for each installation. Any installation can keep within its cap either by reducing its emissions at that site or by paying for the right to emit an equal amount of pollutant at a third-party’s site. If the latter option is taken, that third party will need to keep its emissions below its cap to the extent that it has traded away its allowances. The third party then has an incentive to continue cutting its emissions below its cap. A trade will take place when it is cheaper for the third party to eliminate its emissions than for the initial installation to reduce its emissions; overall though costs will have been saved while delivering the same level of emission abatement.

Under the Kyoto Protocol, an emission trading scheme is established for industrialised countries, whereby a country that has exceeded its target can sell the excess to any country that finds it difficult or more expensive to meet its target. This should lower the costs of compliance, enabling deeper cuts in emissions to be pursued.

CDM

The CDM, contained in Article 12 of the Kyoto Protocol, allows governments or private entities in industrialized countries to implement emission reduction projects in developing countries and receive credit in the form of "certified emission reductions," or CERs, which they may count against their national reduction targets. Once registered these CERs or 'carbon credits' have a tradable value and can be bought or sold.

The value of CDM

The basic principle of the CDM is simple: developed countries can invest in low-cost abatement opportunities in developing countries and receive credit for the resulting emissions reductions, thus reducing the cutbacks needed within their borders. While the CDM lowers the cost of compliance with the Protocol for developed countries, developing countries will benefit as well, not just from the increased investment flows, but also from the requirement that these investments advance sustainable development goals. The CDM encourages developing countries to participate by promising that development priorities and initiatives will be addressed as part of the package. This recognizes that only through long-term development will all countries be able to play a role in protecting the climate. From the developing country perspective, the CDM can:

Attract capital for projects that assist in the shift to a more prosperous but less carbon-intensive economy;
Encourage and permit the active participation of both private and public sectors;
Provide a tool of technology transfer, if investment is channeled into projects that replace old and inefficient fossil fuel technology, or create new industries in environmentally sustainable technologies; and,
Help define investment priorities in projects that meet sustainable development goals.

Specifically, the CDM can contribute to a developing country’s sustainable development objectives through:

Transfer of technology and financial resources;
Sustainable ways of energy production;
Increasing energy efficiency & conservation;
Poverty alleviation through income and employment generation; and
Local environmental side benefits

Joint implementation (JI)

Joint implementation projects are the same as CDM project but are located in Annex 1 (industrialized countries) – they aim to reduce emissions below the level that might otherwise have occurred. Typically this involves industrialised countries working together to reduce emissions. Like CDMs but in Annex I countries, these authorised projects create emission reductions (known as Emission Reduction Units) that will be tradeable in the global emission trading scheme envisaged under the Kyoto Protocol.

GHGs mix uniformly in the earth’s atmosphere. Unlike sulphur dioxide or low-level ozone, carbon dioxide and other GHGs have the same impact on climate everywhere in the world. It does not matter, therefore, where we begin to reduce net emissions. This fact provides the economic justification for international co-operation on climate change projects and project based emissions trading. International co-operation makes economic sense because emissions reduction in developing countries generally cost less than in industrialised countries. There is therefore a directed economic incentive for players to reduce emissions under the Clean Development Mechanism.

European Union Emissions Trading Scheme (EU ETS)

A unanimous decision of the EU’s Council of Environment Ministers on 9th December 2002, committed European Nations to their targets in terms of Kyoto. The emission targets have there fore been legislated and will be acted upon regardless of the progress of Kyoto and the actions of non EU countries. In terms of this decision, emission trading has become the central instrument for the EU to deliver its Kyoto commitment. Directive 581 (.Establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC.) sets out a framework for European emission trading in two phases ,one running from the start of 2005 to the end of 2007, and one covering the period 2008 to 2012.

Under the framework, each installation emitting above a minimum threshold in specified sectors is monitored for its carbon dioxide emissions. Each installation is allocated rights to emit carbon dioxide. If emissions exceed the allocated rights, the installation’s owner must either purchase rights to emit or pay a fine.

If emissions are below the allocated rights, the owner can sell the rights to emit.
Key features of the scheme under the EU Directive are as follows:

It covers only CO2 in the first phase, although it is contemplated that other GHGs could be included in later phases.
It is mandatory for qualifying installations, of which there are approaching 5,000 that, in aggregate, are estimated to emit 1,798m tonnes of CO2 or 44% of total EU CO2 emissions.
Allowances will be allocated for free in the first phase (2005-07), up to 10% of allowances can be auctioned in the second phase (2008-12).
The fine for non-compliance is set at €40/tonne of carbon dioxide per year in the first phase (2005-07). The Commission originally proposed €50/tonne, but ministers reduced this to €40/tonne, although in the second reading the European Parliament may increase it back to €50/tonne, rising to €100/tonne in the second phase (2008-12).

Specified sectors include:

Energy activities (including electricity generation)
Production and processing of ferrous metals
Minerals including cement, glass and ceramic industries
Pulp, paper or board production

Emissions are traded under the Emissions trading scheme of the EU (EU ETS), a formalized OTC market for emissions trading. Trading officially commenced in January 2005 although a ‘grey’ market for emissions trading under the ETS had been operating for some 18 months. The First Phase of the EU ETS was completed end 2007 and the Second Phase of the EU ETS corresponds with the Kyoto Period from 2008-2012.

The Linking Directive

In March 2003 , The EU’s Council of Environment Ministers, ratified what is known as the Linking Directive. The linking Directive creates fungibility between Carbon credits created under the Clean Development Mechanism and Joint Implementation and allowances traded in the EU ETS. This allows carbon credits to be offset against allowance shortfalls and transferred in the same manner that occurs under the EU ETS. For the purposes of meeting of obligations under the EU, one t/CO2 allowance equals t/CO2 carbon credit and ownership transferring of credits between country registry’s will occur on the same Technology platform (the UK Defra solution for most European countries) .

Market activity in the EU ETS

In 2007, US$50 billion (€37 billion), almost entirely in Phase II allowances and derivative contracts were traded over-the counter, bilaterally, and, increasingly on exchange platforms that publish transparent data about price formation in the markets.4 Energy utilities and industrial companies hedged their carbon exposure by buying the EUA and financial companies bought and sold the EUA for their clients (“flow trading”) and for their own account (“proprietary trading”) (Source World Bank 2008).

Project Market Activity

Project-based markets In 2007, buyers also continued to show a strong appetite for primary project-based emission reductions, reflected by continued growth in the project pipeline showing that 68 countries had identified and offered to reduce 2,500 million tonnes of carbon dioxide equivalent (MtCO2e) through over 3,000 projects. This potential supply received strong interest, mainly from private sector buyers and investors, who in 2007 transacted 634 MtCO2e from primary project-based transactions (up 8% from 2006) for a corresponding value of US$8.2 billion (€6.0 billion), up 34% from 2006 (World Bank 2008).