Carbon trading simply explained

FAQs on climate, Kyoto and the EU ETS

What are the voluntary carbon market and VERs?

In the 'voluntary' carbon market, individuals and organisations can choose to trade in the reduction of greenhouse gas (GHG) emissions. Separate 'compliance' markets exist for trading emission reductions for those who must meet mandatory regulations to do so - for example, the EU ETS in the European Union and the Clean Development Mechanism (CDM) under the Kyoto Protocol.

Demand for voluntary emission reductions comes mainly from organisations that choose to offset the emissions associated with their activities. A rising number of companies, public authorities and NGOs are looking to take action on emissions - either to prepare for expected mandatory reduction regulations, for the marketing and promotional value to their business, or purely out of a desire to establish more sustainable practices in the face of global warming.

This voluntary action takes the form of either -

  • taking direct action to cut emissions - eg. energy efficiency measures or investing in cleaner technology
  • buying carbon credits in the voluntary market to offset emissions
  • joining a voluntary carbon trading scheme and trading emission reduction allowances, or buying carbon offset credits through the scheme.

Carbon offset credits are given in return for paying for emission reducing activities, often in the developing world where it is cheaper to do so. Afforestation and reforestation of cleared land, biofuel production, landfill methane capture, no-till farming, wind farms and other renewable energy generation ventures are all examples of activities that reduce emissions of greenhouse gases and can generate offset credits.

Offset credits, created for the voluntary market, are generally known as verified emission reductions (VERs). One tonne (metric ton) of emissions reduced creates one VER credit. There is no global standard as yet for VERs, which are issued by any number of project-verifying companies around the world to different standards.

The voluntary carbon market has grown from around four million tonnes of CO2 equivalent - traded in 2004 - to somewhere between 20-50 million tonnes in 2006, according to estimates by The Climate Group. In 2007, volume is expected to reach 100 million tonnes or more.

The appeal to suppliers of carbon offsets to the voluntary market is the quicker and cheaper process of project approval and verification, than that of the CDM. The downside is the lower prices of the resulting VERs compared to the CDM's CERs.

A major centre of activity in the voluntary market centres around the Chicago Climate Exchange (CCX) in the US, which has traded 11 million tonnes of emission reductions since start-up in 2003.

CCX members are, predominantly, North American companies and state and local government agencies, which have voluntarily agreed to reduce their GHG emissions by 4 per cent below the average of their 1998-2001 baseline by 2006 (Phase I) and by 6 per cent by 2010 (Phase 2). As well as the trading of allowances, the CCX had also facilitated the creation of 3.6 million tonnes of offset credits by the end of 2006.


How are EU emission allowances bought and sold?
Under the Emissions Trading Scheme, EU countries and their companies are allowed to sell the emission allowances (EUAs) allocated to them, or buy those of others. The trade is designed to give companies a cheaper alternative for meeting their emissions reduction obligations and reward those which exceed their targets.

Futures and forward contracts
Most of the trade in EUAs is 'over the counter' (OTC) in deals negotiated through brokers. However, there is also growing trade on various electronic energy exchanges - such as the ECX, EEX, Nord Pool and Powernext. Most of the EUA trade is in forward contracts and futures, where the price is agreed now, but allowances and payment don't change hands until a set date in the future.

In the EU carbon market, delivery of the major forward allowance contracts happens in December in the OTC and exchange markets. While there are no real restrictions on maturity dates, much of the OTC trade is in EUAs for delivery in December 2007 and 2008. Companies buy based on when they think they're going to need EUAs to meet targets. December is the main delivery date because emissions targets are based around calendar years. Companies must reconcile their books for actual emissions and allowances and demonstrate compliance with their target by March 31 of the following year.

There is also growing trade in the 'spot' market (buy now, exchange immediately) - but, there is less emphasis on spots than forwards. It is also more efficient if all the contracts can be settled and allowances exchanged on one day - rather than have exchange happening after every trade.

Dec 08 contract dominates
The December 2008 forward contract is where most of the trade currently is - that being the first year of the second-phase of the EU ETS market coinciding with the Kyoto commitment period. Emphasis has shifted away from the first-phase contracts up to 2007, in favour of 2008 and beyond. During 2006, demand fell away for first-phase EUAs after it was revealed there would be little or no shortage of allowances to meet what have turned out to be lax emissions quotas.

There is also trade in a March forward contract - the deadline month for compliance for the previous year (current year allowances can, at this stage, be used to comply for the previous year).

Energy price link
A fundamental influence on the price of EUAs is the cost of energy - particularly the price of electricity and the 'spread' between coal and gas prices. More demand for power, drives up the cost of electricity but also leads to more demand for EUAs to offset higher emissions from fossil fuels burnt to increase that power supply.

The bigger the coal-gas spread gets, the greater the cost to power utilities of converting from coal to gas. Such a switch is the easiest strategy currently available to energy companies for reducing greenhouse emissions - burning gas produces less than half the greenhouse emissions of burning coal.

Therefore, the greater the spread, the greater the cost and the less the attractiveness of switching. The less conversion, the more demand there is for EUAs as an alternative to meet emissions reduction targets.


What is the EU Emissions Trading Scheme?
In 2005, the European Union introduced a Europe-wide market in carbon dioxide emissions for major greenhouse gas emitting industries. This is the forerunner to a similar system that will operate under the Kyoto Protocol among its signatories from 2008. The EU ETS is designed to prepare European nations for Kyoto.

The scheme is based on the allocation of greenhouse gas emission allowances - called EU Allowances (EUAs) - to specific industrial sectors, through national allocation plans (NAPs) with oversight by the European Commission (EC). These allowances can be traded. The first-phase of the EU ETS covers the period 2005-2007, while the second-phase coincides with the Kyoto Protocol's first commitment period - from 2008 to 2012.

The first phase of the EU ETS applies to 7,300 companies and 12,000 installations in heavy industrial sectors in the EU. These  include - energy utilities, oil refineries, iron and steel producers, the pulp and paper industry as well as producers of cement, glass, lime, brick and ceramics.


How does the EU Emissions Trading Scheme work?
The ETS imposes annual targets for carbon dioxide (CO2) emissions on each EU country - and then, in turn, each country allocates its national allowance across those companies whose factories and plants are the major emitters of carbon dioxide - power utilities, building products manufacturers and other heavy industrial enterprises.

Nearly 12,000 industrial installations across Europe have had annual carbon emission reduction targets set for them under National Allocation Plans for each EU country. The 7,300 companies that own the installations are allocated a number of allowances - called EUAs - matching their target.

Each EUA gives the owner the right to emit one tonne of carbon dioxide. Companies that don't use up all their allowances - i.e. emit less than they are entitled to - can sell them. Companies which exceed their emission target must offset the excess emissions by buying EUAs, or pay a fine of €40 a tonne.

To manage the trade in allowances and verify holdings, the ETS requires all 25 EU member states to create a national emissions allowance registry - holding accounts for all companies included the scheme.

A market now operates through brokers and on electronic exchanges where EUAs are traded on a daily basis. What is mainly being traded are EUA 'forward contracts' - i.e. EUAs for delivery at a future date. These future dates correspond to the end of the calendar years to which the allowances relate.


What are the greenhouse gases?
The three most important greenhouse gases are -

  • carbon dioxide (CO2) - the biggest contributor to global warming
  • methane (CH4) - eg. from decomposing landfill and flatulent cattle
  • nitrous oxide (N2O) - eg. from vehicle exhaust fumes.

There are also three other industrial gases that contribute to global warming -

  • hydrofluorocarbons (HFCs) - used for refrigeration
  • perfluorocarbons (PFCs) - produced in the making of semi-conductors
  • sulphur hexafluoride (SF6) - a by-product of aluminium manufacturing and the electronics industry.

Another major group of harmful industrial gases, chlorofluorocarbons - or CFCs - are also greenhouse gases, but are already being reduced under the 1987 Montreal Protocol on Substances that Deplete the Ozone Layer.


What is the Kyoto Protocol?
This agreement, which came into force in 2005, commits developed nations - collectively - to cut their greenhouse gas emissions to 5.2 per cent of 1990 levels by 2012. So far, 165 countries have ratified the agreement, including most of the world's developed nations.

The Kyoto Protocol was struck in 1997 in Kyoto, Japan, when member nations of the United Nations Framework Convention on Climate Change agreed that developed countries must reduce their emissions of six greenhouse gases to meet the overall target, with specific targets varying from country to country.

The Protocol came into force in February 2005 and includes 35 countries that account for 61.6 per cent of total world carbon dioxide emissions. The biggest greenhouse gas emitters overall - the United States and China - together with Australia, the biggest emitter per capita, have never ratified the treaty.


What is 'emissions trading'?
The emission of greenhouse gases is being subjected to allowance quotas. These rights to emit can be traded in a commercial market. In the EU from 2005, a trading system for emissions operates - the forerunner to a similar international system set to begin in 2008 under the Kyoto Protocol.

These systems allow countries and companies, who reduce emissions beyond their obligations, to sell their excess emission capacity to others who are unable to meet their own emission reduction targets.

A business or country is given a limit for the amount of greenhouse pollutant gases it can produce - called an 'allowance'. Should it exceed its quota, it must purchase another country's or company's unused allowance, or pay a fine.

There are two broad types of emissions trading schemes - cap and trade and baseline and credit.

'Credits' can also be traded - which are created when a project is undertaken elsewhere that reduces greenhouse gases.


What is the greenhouse effect?
The greenhouse effect refers to a rise in average global temperatures, caused by the activities of humans. These activities lead to higher concentrations of gases in the atmosphere that absorb the sun's energy, such as carbon dioxide.

The term comes from the glass structure used for the cultivation of plants, in which temperature and humidity can be raised above that of the surrounding environment.


What is the 'global warming potential' of the greenhouse gases?
Each of the six greenhouse gases has a vastly different potential to induce global warming. While carbon dioxide is, by far, the most abundant greenhouse gas, it is also the weakest in its ability to trap heat in the atmosphere.

To compare the 'global warming potential' of the greenhouse gases, each is given a GWP measure relative to that of carbon dioxide. The official estimates of GWPs from the Intergovernmental Panel on Climate Change in 2001 were -

  • Carbon dioxide lllllllllllll1
  • Methane lllllllllllllllllllllllll;23
  • Nitrous oxide lllllllllllllllll300
  • Hydrofluorocarbons ll.120-12,000
  • Perfluorocarbons lllllll.l5,700-11,900
  • Sulphur hexafluoride. 22,200.

For example, methane's global warming potential is 23 times greater than that of carbon dioxide, while sulphur hexafluoride is 22,200 times more potent.



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