Carbon trading simply explained

How does carbon trading work? Does it really help tackle climate change? Is it all just smoke and mirrors? Is the Kyoto Protocol doing any good?


As the evidence for global warming mounts, scientists tell us more of the drastic climatic changes we can expect.

With heightening pressure for economic measures to rein in greenhouse emissions, questions such as these are, increasingly, being asked.

The short answer is that carbon trading - under the Kyoto Protocol and in voluntary markets - is starting to work to reduce emissions. However, there are certainly some problems and inefficiencies that have hampered efforts to bed-down schemes in the early years.

Let's start with the basics of how greenhouse-gas emissions markets - or carbon trading - is designed to work.

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 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.

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 you 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. However, how the target is met, varies with flexibility given to emitters to ease the overall burden on industry and the economy.

To make it even more flexible, most emissions trading schemes also offer trade in a second type of 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. However, the use of offsets is usually limited to a small proportion - often 5 to 10 per cent - 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, over coming decades, the world can stabilise the concentration of greenhouse gases in the atmosphere and limit global warming at levels that will not cause catastrophic climate change.
Of course, it relies on a number of things 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 that the resulting emission savings are only counted once.

So that's the theory - now for the practical.

Some opponents of carbon markets say that 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. However, an objective analysis would show that, despite these glitches, there is evidence that carbon markets can and are working.

With the commitment period of the Kyoto Protocol (2008-2012) yet to begin, there are, as yet, only two significant legally-binding carbon markets in full operation - the EU's ETS and Kyoto's main offsets scheme, the Clean Development Mechanism (CDM). However, already, 770 million tonnes of emission reductions are underway under the CDM. Between 1.5 and 2 billion tonnes of emission savings are expected to be delivered - in all - by the end of the Kyoto commitment period in 2012 - all monitored and verified according to strict rules laid down by the UN.

The EU Emissions Trading Scheme is, as yet, the only major scheme of its type in operation although many are being planned in US states, Canada, Japan, Australia and New Zealand. The EU ETS has almost competed its trial phase ahead of the Kyoto period. This trial phase has not led to cuts in emissions because allocations to factories were not tight enough.

Allocations, now being made for the next phase - the crucial Kyoto phase, indicate that European industry will cut its emissions by 9 per cent, compared to thefigure that industry would have emitted under their original plans.

In May 2007, a group of environmental economists published an independent study of the EU ETS in the Review of Environmental Economics and Policy.

In that study, they concluded that the scheme was reducing emissions and was 'by far the most significant accomplishment in climate policy to date' worldwide.

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 have taken money for credits they have generated from projects where the emission reductions are dubious.

Regulation will grow in the voluntary market and, indeed, there are already reputable international accreditation schemes which voluntary buyers of offset credits should look out for. The Swiss-based Gold Standard and Voluntary Carbon Standard - backed by a large group of international aid and environmental organisations - is perhaps the best and provides third party verification of emission reduction claims from projects. The Chicago Climate Exchange ensures verification of offsets traded through it, while more accreditation schemes are popping up around the world.

Further information


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