Background
Burning of fossil fuels is a major source
of industrial
greenhouse gas emissions, especially for
power, cement, steel, textile, fertilizer
and many other industries which rely on
fossil fuels (coal, electricity derived from
coal, natural gas and oil). The major
greenhouse gases emitted by these industries
are
carbon dioxide,
methane,
nitrous oxide,
hydrofluorocarbons (HFCs), etc, all of
which increase the atmosphere's ability to
trap infrared energy and thus affect the
climate.
The concept of carbon credits came into
existence as a result of increasing
awareness of the need for controlling
emissions. The IPCC (Intergovernmental Panel
on Climate Change) has observed[2]
that:
Policies that provide a real or
implicit price of carbon could create
incentives for producers and consumers
to significantly invest in low-GHG
products, technologies and processes.
Such policies could include economic
instruments, government funding and
regulation,
while noting that a tradable permit
system is one of the policy instruments that
has been shown to be environmentally
effective in the industrial sector, as long
as there are reasonable levels of
predictability over the initial allocation
mechanism and long-term price.
The mechanism was formalized in the
Kyoto Protocol, an international
agreement between more than 170 countries,
and the market mechanisms were agreed
through the subsequent
Marrakesh Accords. The mechanism adopted
was similar to the successful US
Acid Rain Program to reduce some
industrial pollutants.
Emission
allowances
The Protocol agreed 'caps' or quotas on
the maximum amount of Greenhouse gases for
developed and developing countries, listed
in its
Annex I
[3]. In
turn these countries set quotas on the
emissions of installations run by local
business and other organizations,
generically termed 'operators'. Countries
manage this through their own national
'registries', which are required to be
validated and monitored for compliance by
the
UNFCCC[4].
Each operator has an allowance of credits,
where each unit gives the owner the right to
emit one metric tonne of
carbon dioxide or other equivalent
greenhouse gas. Operators that have not
used up their quotas can sell their unused
allowances as carbon credits, while
businesses that are about to exceed their
quotas can buy the extra allowances as
credits, privately or on the open market. As
demand for energy grows over time, the total
emissions must still stay within the cap,
but it allows industry some flexibility and
predictability in its planning to
accommodate this.
By permitting allowances to be bought and
sold, an operator can seek out the most
cost-effective way of reducing its
emissions, either by investing in 'cleaner'
machinery and practices or by purchasing
emissions from another operator who already
has excess 'capacity'.
Since 2005, the Kyoto mechanism has been
adopted for CO2 trading by all
the countries within the
European Union under its
European Trading Scheme (EU ETS) with
the
European Commission as its validating
authority[5].
From 2008, EU participants must link with
the other developed countries who
ratified
Annex I of the protocol, and trade the
six most significant
anthropogenic greenhouse gases. In the
United States, which has not ratified
Kyoto, and
Australia, whose ratification came into
force in March 2008, similar schemes are
being considered.
Kyoto's
'Flexible mechanisms'
A credit can be an emissions allowance
which was originally allocated or auctioned
by the national administrators of a
cap-and-trade program, or it can be an
offset of emissions. Such offsetting and
mitigating activities can occur in any
developing country which has ratified the
Kyoto Protocol, and has a national agreement
in place to validate its
carbon project through one of the
UNFCCC's approved mechanisms. Once
approved, these units are termed
Certified Emission Reductions, or CERs.
The Protocol allows these projects to be
constructed and credited in advance of the
Kyoto trading period.
The Kyoto Protocol provides for three
mechanisms that enable countries or
operators in developed countries to acquire
greenhouse gas reduction credits[6]
- Under
Joint Implementation (JI) a
developed country with relatively high
costs of domestic greenhouse reduction
would set up a project in another
developed country.
- Under the
Clean Development Mechanism (CDM) a
developed country can 'sponsor' a
greenhouse gas reduction project in a
developing country where the cost of
greenhouse gas reduction project
activities is usually much lower, but
the atmospheric effect is globally
equivalent. The developed country would
be given credits for meeting its
emission reduction targets, while the
developing country would receive the
capital investment and
clean technology or beneficial
change in land use.
- Under International
Emissions Trading (IET) countries
can trade in the international carbon
credit market to cover their shortfall
in allowances. Countries with surplus
credits can sell them to countries with
capped emission commitments under the
Kyoto Protocol.
These
carbon projects can be created by a
national government or by an operator within
the country. In reality, most of the
transactions are not performed by national
governments directly, but by operators who
have been set quotas by their country.
Emission
markets
For trading purposes, one allowance or
CER is considered equivalent to one metric
tonne of CO2 emissions. These
allowances can be sold privately or in the
international market at the prevailing
market price. These trade and
settle internationally and hence allow
allowances to be transferred between
countries. Each international transfer is
validated by the
UNFCCC. Each transfer of ownership
within the European Union is additionally
validated by the European Commission.
Climate exchanges have been established
to provide a
spot market in allowances, as well as
futures and
options
market to help discover a market price
and maintain
liquidity. Carbon prices are normally
quoted in
Euros per tonne of carbon dioxide or its
equivalent (CO2e). Other
greenhouse gasses can also be traded, but
are quoted as standard multiples of carbon
dioxide with respect to their
global warming potential. These features
reduce the quota's financial impact on
business, while ensuring that the quotas are
met at a national and international level.
Currently there are five exchanges
trading in carbon allowances: the
Chicago Climate Exchange,
European Climate Exchange,
Nord Pool,
PowerNext and the European Energy
Exchange. Recently, NordPool listed a
contract to trade offsets generated by a CDM
carbon project called Certified Emission
Reductions (CERs). Many companies now engage
in emissions abatement, offsetting, and
sequestration programs to generate credits
that can be sold on one of the exchanges. At
least two
private electronic markets have been
established in 2008:
CantorCO2e[7]
and
Preserval Marketplace[8].
Managing emissions is one of the
fastest-growing segments in financial
services in the
City of London with a market now worth
about €30 billion, but which could grow to
€1 trillion within a decade.[citation
needed] Louis Redshaw, head of
environmental markets at
Barclays Capital predicts that "Carbon
will be the world's biggest commodity
market, and it could become the world's
biggest market overall."
[9]
Setting a
market price for carbon
Unchecked, energy use and hence emission
levels are predicted to keep rising over
time. Thus the number of companies needing
to buy credits will increase, and the rules
of
supply and demand will
push up the market price, encouraging
more groups to undertake environmentally
friendly activities that create carbon
credits to sell.
An individual allowance, such as a Kyoto
Assigned Amount Unit (AAU) or its
near-equivalent European Union Allowance (EUA),
may have a different market value to an
offset such as a CER. This is due to the
lack of a developed secondary market for
CERs, a lack of homogeneity between projects
which causes difficulty in pricing, as well
as questions due to the principle of
supplementarity and its lifetime.
Additionally, offsets generated by a
carbon project under the Clean
Development Mechanism are potentially
limited in value because operators in the EU
ETS are restricted as to what percentage of
their allowance can be met through these
flexible mechanisms.
Yale University economics professor
William Nordhaus argues that the price of
carbon needs to be high enough to motivate
the changes in behavior and changes in
economic production systems necessary to
effectively limit emissions of
greenhouse gases.
Raising the price of carbon will
achieve four goals. First, it will
provide signals to consumers about what
goods and services are high-carbon ones
and should therefore be used more
sparingly. Second, it will provide
signals to producers about which inputs
use more carbon (such as coal and oil)
and which use less or none (such as
natural gas or nuclear power), thereby
inducing firms to substitute low-carbon
inputs. Third, it will give market
incentives for inventors and innovators
to develop and introduce low-carbon
products and processes that can replace
the current generation of technologies.
Fourth, and most important, a high
carbon price will economize on the
information that is required to do all
three of these tasks. Through the market
mechanism, a high carbon price will
raise the price of products according to
their carbon content. Ethical consumers
today, hoping to minimize their “carbon
footprint,” have little chance of making
an accurate calculation of the relative
carbon use in, say, driving 250 miles as
compared with flying 250 miles. A
harmonized carbon tax would raise the
price of a good proportionately to
exactly the amount of CO2
that is emitted in all the stages of
production that are involved in
producing that good. If 0.01 of a ton of
carbon emissions results from the wheat
growing and the milling and the trucking
and the baking of a loaf of bread, then
a tax of $30 per ton carbon will raise
the price of bread by $0.30. The “carbon
footprint” is automatically calculated
by the price system. Consumers would
still not know how much of the price is
due to carbon emissions, but they could
make their decisions confident that they
are paying for the social cost of their
carbon footprint.
Nordhaus has suggested, based on the
social cost of carbon emissions, that an
optimal price of carbon is around $30(US)
per ton and will need to increase with
inflation.
The social cost of carbon is the
additional damage caused by an
additional ton of carbon emissions. ...
The optimal carbon price, or optimal
carbon tax, is the market price (or
carbon tax) on carbon emissions that
balances the incremental costs of
reducing carbon emissions with the
incremental benefits of reducing climate
damages. ... [I]f a country wished to
impose a carbon tax of $30 per ton of
carbon, this would involve a tax on
gasoline of about 9 cents per gallon.
Similarly, the tax on coal-generated
electricity would be about 1 cent per
kWh, or 10 percent of the current retail
price. At current levels of carbon
emissions in the United States, a tax of
$30 per ton of carbon would generate $50
billion of revenue per year.
William Nordhaus, 2008. A Question of
Balance - Weighing the Options on Global
Warming Policies, Yale University Press.
How buying
carbon credits can reduce emissions
Carbon credits create a market for
reducing greenhouse emissions by giving a
monetary value to the cost of polluting the
air. Emissions become an internal cost
ofdoing business and are visible on the
balance sheet alongside raw materials and
other liabilities or assets.
By way of example, consider a business
that owns a factory putting out 100,000
tonnes of greenhouse gas emissions in a
year. Its government is an Annex I country
that enacts a law to limit the emissions
that the business can produce. So the
factory is given a quota of say 80,000
tonnes per year. The factory either reduces
its emissions to 80,000 tonnes or is
required to purchase carbon credits to
offset the excess. After costing up
alternatives the business may decide that it
is uneconomical or infeasible to invest in
new machinery for that year. Instead it may
choose to buy carbon credits on the open
market from organizations that have been
approved as being able to sell legitimate
carbon credits.
We should consider the impact of
manufacturing alternative energy sources.
For example, the energy consumed and the
Carbon emitted in the manufacture and
transportation of a large wind turbine would
prohibit a credit being issued for a
predetermined period of time.
- One seller might be a company that
will offer to
offset emissions through a project
in the developing world, such as
recovering methane from a swine farm to
feed a power station that previously
would use fossil fuel. So although the
factory continues to emit gases, it
would pay another group to reduce the
equivalent of 20,000 tonnes of carbon
dioxide emissions from the atmosphere
for that year.
- Another seller may have already
invested in new low-emission machinery
and have a surplus of allowances as a
result. The factory could make up for
its emissions by buying 20,000 tonnes of
allowances from them. The cost of the
seller's new machinery would be
subsidized by the sale of allowances.
Both the buyer and the seller would
submit accounts for their emissions to
prove that their allowances were met
correctly.
Credits versus
taxes
Carbon credits and carbon taxes each have
their advantages. Credits were chosen by the
signatories to the Kyoto Protocol as an
alternative to
Carbon taxes. A criticism of tax-raising
schemes is that they are frequently not
hypothecated, and so some or all of the
taxation raised by a government may be
applied inefficiently or not used to benefit
the environment.
By treating emissions as a market
commodity it becomes easier for business to
understand and manage their activities,
while economists and traders can attempt to
predict future pricing using well understood
market theories. Thus the main advantages of
a tradable carbon credit over a carbon tax
are:
- the price is more likely to be
perceived as fair by those paying it.
Investors in credits have more control
over their own costs.
- the flexible mechanisms of the Kyoto
Protocol ensure that all investment goes
into genuine sustainable carbon
reduction schemes, through its
internationally-agreed validation
process.
- if correctly implemented a target
level of emission reductions is achieved
with certainty, while under a tax the
actual emissions would vary over time.
- it provides a framework for
rewarding people or companies who plant
trees or otherwise sequester carbon.
The advantages of a carbon tax are:
- possibly less complex, expensive,
and time-consuming to implement. This
advantage is especially great when
applied to markets like gasoline or home
heating oil.
- perhaps some reduced risk of certain
types of cheating, though under both
credits and taxes, emissions must be
verified.
- reduced incentives for companies to
delay efficiency improvements prior to
the establisment of the baseline if
credits are distributed in proportion to
past emissions.
- when credits are grandfathered, this
puts new or growing companies at a
disadvantage relative to more
established companies.
- It is clear what effect the policy
has on the price of energy.[10]
Creating Real
Carbon Credits
The principle of
Supplementarity within the Kyoto
Protocol means that internal abatement of
emissions should take precedence before a
country buys in carbon credits. However it
also established the
Clean Development Mechanism as a
Flexible Mechanism by which capped entities
could develop real, measurable, permanent
emissions reductions voluntarily in sectors
outside the cap. Many criticisms of carbon
credits stem from the fact that establishing
that an emission of CO2-equivalent
greenhouse gas has truly been reduced
involves a complex process. This process has
evolved as the concept of a
carbon project has been refined over the
past 10 years.
The first step in determining whether or
not a
carbon project has legitimately led to
the reduction of real, measurable, permanent
emissions is understanding the CDM
methodology process. This is the process by
which project sponsors submit, through a
Designated Operational Entity (DOE), their
concepts for emissions reduction creation.
The CDM Executive Board, with the CDM
Methodology Panel and their expert advisors,
review each project and decide how and if
they do indeed result in reductions that are
additional[11]
Additionality
and Its Importance
It is also important for any carbon
credit (offset) to prove a concept called
additionality. Additionality is a term used
by Kyoto's Clean Development Mechanism to
describe the fact that a carbon dioxide
reduction project (carbon
project) would not have occurred had it
not been for concern for the mitigation of
climate change. More succinctly, a project
that has proven additionality is a
beyond-business-as-usual project.
It is generally agreed that voluntary
carbon offset projects must also prove
additionality in order to ensure the
legitimacy of the environmental stewardship
claims resulting from the retirement of the
carbon credit (offset). According the World
Resources Institute/World Business Council
for Sustainable Development (WRI/WBCSD) : "GHG
emission trading programs operate by capping
the emissions of a fixed number of
individual facilities or sources. Under
these programs, tradable 'offset credits'
are issued for project-based GHG reductions
that occur at sources not covered by the
program. Each offset credit allows
facilities whose emissions are capped to
emit more, in direct proportion to the GHG
reductions represented by the credit. The
idea is to achieve a zero net increase in
GHG emissions, because each tonne of
increased emissions is 'offset' by
project-based GHG reductions. The difficulty
is that many projects that reduce GHG
emissions (relative to historical levels)
would happen regardless of the existence of
a GHG program and without any concern for
climate change mitigation. If a project
'would have happened anyway,' then issuing
offset credits for its GHG reductions will
actually allow a positive net increase in
GHG emissions, undermining the emissions
target of the GHG program. Additionality is
thus critical to the success and integrity
of GHG programs that recognize project-based
GHG reductions."
Criticisms
Environmental restrictions and activities
have been imposed on businesses through
regulation. Many are uneasy with this
approach to managing emissions.
The Kyoto mechanism is the only
internationally-agreed mechanism for
regulating carbon credit activities, and,
crucially, includes checks for additionality
and overall effectiveness. Its supporting
organisation, the UNFCCC, is the only
organisation with a global mandate on the
overall effectiveness of emission control
systems, although enforcement of decisions
relies on national co-operation. The Kyoto
trading period only applies for five years
between 2008 and 2012. The first phase of
the EU ETS system started before then, and
is expected to continue in a third phase
afterwards, and may co-ordinate with
whatever is internationally-agreed at but
there is general uncertainty as to what will
be agreed in
Post-Kyoto Protocol negotiations on
greenhouse gas emissions. As business
investment often operates over decades, this
adds risk and uncertainty to their plans. As
several countries responsible for a large
proportion of global emissions (notably USA,
Australia, China) have avoided mandatory
caps, this also means that businesses in
capped countries may perceive themselves to
be working at a competitive disadvantage
against those in uncapped countries as they
are now paying for their carbon costs
directly.
A key concept behind the cap and trade
system is that national quotas should be
chosen to represent genuine and meaningful
reductions in national output of emissions.
Not only does this ensure that overall
emissions are reduced but also that the
costs of emissions trading are carried
fairly across all parties to the trading
system. However, governments of capped
countries may seek to unilaterally weaken
their commitments, as evidenced by the 2006
and 2007
National Allocation Plans for several
countries in the EU ETS, which were
submitted late and then were initially
rejected by the
European Commission for being too lax
[12].
A question has been raised over the
grandfathering of allowances. Countries
within the EU ETS have granted their
incumbent businesses most or all of their
allowances for free. This can sometimes be
perceived as a protectionist obstacle to new
entrants into their markets. There have also
been accusations of power generators getting
a 'windfall' profit by passing on these
emissions 'charges' to their customers[13].
As the EU ETS moves into its second phase
and joins up with Kyoto, it seems likely
that these problems will be reduced as more
allowances will be auctioned.
Establishing a meaningful offset project
is complex: voluntary offsetting activities
outside the CDM mechanism are effectively
unregulated and there have been
criticisms of offsetting in these
unregulated activities. This particularly
applies to some voluntary corporate schemes
in uncapped countries and for some personal
carbon offsetting schemes.
There have also been
concerns raised over the validation of CDM
credits. One concern has related to the
accurate assessment of additionality. Others
relate to the effort and time taken to get a
project approved. Questions may also be
raised about the validation of the
effectiveness of some projects; it appears
that many projects do not achieve the
expected benefit after they have been
audited, and the CDM board can only approve
a lower amount of CER credits. For example,
it may take longer to roll out a project
than originally planned, or an afforestation
project may be reduced by disease or fire.
For these reasons some countries place
additional restrictions on their local
implementations and will not allow credits
for some types of
carbon sink activity, such as forestry
or land use projects.
See also
References
External links