Carbon trading simply explained

How does carbon trading work? Does it really help tackle climate change? Isn’t it all just smoke and mirrors? Is the Kyoto Protocol doing any good?

These and similar questions are increasingly being asked as the evidence for global warming mounts, scientists tell us more of dramatic climatic impacts we can expect, and pressure for measures to rein in greenhouse gas emissions heightens. At the same time, there are warnings from industry over the costs in jobs, profits and consumer prices that will stem from mandatory carbon trading regulation.

The short answer is that the early experience of 'carbon trading', or 'emissions trading', shows it can be a valid tool for reducing greenhouse emissions on a wide scale. But that's not to say there aren't problems that are hampering efforts to implement schemes successfully.

Let’s start with the basics of how a greenhouse emissions market is designed to work.

Targets

The idea is that, first, governments set annual targets for the reduction of greenhouse gas emissions for industry, and perhaps agriculture, in their countries. These targets, or caps, limit overall emissions to a set level, measured in millions of tonnes.

Second, the overall target amount is divided up among all the major emitters in the economy so that each industry sector, and then each factory or plant within each sector, knows how many tonnes it can emit each year.

Emission permits, or allowances, are issued to cover these amounts. Each permit confers the right to emit one tonne of carbon dioxide, or the global warming equivalent of one tonne in other greenhouse gases, into the atmosphere. Then, a trading scheme is applied which establishes a market for these permits, allowing emitters and financial players to buy and sell them.

Trading

This is 'emissions trading' and gives emitters flexibility in how they meet their individual targets. Instead of having one rigid emissions limit to stick to, and a fine if they exceed it, emitters can choose to emit more than their target and buy the excess allowances of another emitter which does not need all its permits.

The system therefore also encourages companies to beat their targets and lower their emissions as much as possible – the more permits they don’t use, the more money they can make from selling that excess.

In this way, a market ensures that the overall national target for reducing emissions is met because there is only a finite and limited number of permits on issue. But how the target is met varies, with flexibility given to emitters to ease the overall burden on industry and the economy.

Offsets

To make it even more flexible, most emissions trading schemes also offer trade in a second type of carbon financial instrument; offsets, or carbon credits. As well as buying the excess permits of others, emitters can also pay someone else outside the scheme to cut their emissions instead. If it is cheaper to pay someone in China to plant a forest to absorb carbon dioxide, or a factory in India to install clean technology to cut its emissions of greenhouse gases, then doing so under an approved method will generate carbon credits. Again, one credit equals one tonne of emissions saved. These credits can then count towards the emitter’s target back home.

The use of offsets recognises that all emissions go into the one atmosphere, and that it is not as important where emissions are cut as that they are cut somewhere. But the use of offsets is controversial and must have limits. Offsets usage in trading schemes is usually limited to a proportion of the overall emissions target to ensure that emitters are making a significant contribution to controlling their own emissions and are not just buying their way out of their obligations.

This two-fold system of 'carbon trading' is seen by many as the most flexible and cost-effective way of lowering greenhouse emissions so that in coming decades the world can stabilise the concentration of greenhouse gases in the atmosphere and limit global warming at safe levels.

It relies, however, on a number of conditions for it to work:

• Accurate measurement of existing and future emissions at a local, national and eventually global level
• All nations, especially the industrialised countries which have long had high emissions, committing to emissions reduction targets
• Proper verification of carbon offset projects to ensure that emissions reductions have taken place, have done so directly because of an offset agreement and the resulting emission savings are only counted once

So that’s the theory, now for the practical.

Verdict

Some opponents of carbon markets say they just don’t work in practice. It’s true to say that there are flaws and teething problems in the way carbon markets are working in their early, formative years. But an objective analysis would show that despite these glitches there is evidence that carbon markets can, and are, working. Not yet delivering steep cuts in emissions, but changing the behaviour of emitters and motivating to plan ahead to control and reduce their emissions liabilities.

With the commitment period of the

Kyoto Protocol

(2008-2012) underway, there are as yet only two significant legally-binding carbon markets in full operation – the EU Emissions Trading Scheme (

EU ETS

) and Kyoto’s main international offsets scheme, the Clean Development Mechanism (

CDM

). But already hundreds of millions of tonnes in emission reductions are being delivered under CDM projects. Around 1.3 billion tonnes of emission savings are expected to be delivered in all by the end of the Kyoto commitment period in 2012, monitored and verified according to rules laid down by the UN.

The EU ETS is as yet the only major scheme of its type in operation although others are under consideration in the United States, Canada, Australia. New Zealand begins a transitionary phase of its ETS in 2010. The EU ETS has completed its trial phase and begun a second phase concurrent with the Kyoto commitment period. The trial phase did not led to cuts in emissions because emissions permit allocations to power genrators and factories were not tight enough.

The allocations made for the current phase, the crucial Kyoto phase, indicated that European industry would have to cut its emissions by almost 10 per cent compared to what it wanted to emit. But recession in Europe has lowered emissions anyway leading to the possibility of a permit surplus again. There is also significant debate over the appropriate levels at which to limit offsets in trading schemes. Some critics say they are too high in the EU ETS - that too much of the emissions cuts can come from buying offsets - and may also be set too high in the US and other emerging schemes.

In 2007, a group of environmental economists published an independent study of the EU ETS in the Review of Environmental Economics and Policy, concluding that the scheme was reducing emissions and was “by far the most significant accomplishment in climate policy to date” worldwide.

Voluntary

Voluntary markets, mainly dealing in offsets, are another story and have attracted criticism for the lack of verification of actual emission cuts. In some cases, these concerns are entirely valid. These markets cater for companies, organisations and individuals who decide of their own accord to offset their emissions. Because this is not part of a compulsory scheme imposed by government, there is generally no authority regulating standards for projects generating carbon offset credits. It is clear that in some cases firms offering carbon credits in recent years have taken money for credits where the emission reductions are dubious.

However, reputable international accreditation schemes backed by groups of international aid and environmental organisations have raised the raised the bar in the voluntary market since 2007. Voluntary buyers of offset credits should only consider credits from projects approved by one or more of

these carbon standards

, such as the Gold Standard and Voluntary Carbon Standard. They provide independent, third-party verification of emission reductions. Some also provide an assessment of the other environmental and social impacts of the offset activity. By 2008, 96 per cent of offset projects were registered with one or more of these independent standards, according to a report by Ecosystem Marketplace and New Carbon Finance.