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
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
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
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
What is the EU Emissions Trading
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
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
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
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
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
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
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.