The Shape of Carbon Markets Today

In the last few years, carbon markets moved from the realm of economic theory into that of practical reality—due in no small measure to the Kyoto Protocol to the U.N. Framework Convention on Climate Change. Under this accord, 38 industrial countries agreed to cut their greenhouse gas emissions to, on average, 5.2 percent below 1990 levels between 2008 and 2012. This commitment became legally binding on participating countries in early 2005, after the protocol had been ratified by the required number of countries. By October 2007, the protocol had been ratified by 174 countries and the European Union (EU).3

The emissions reductions required under the protocol are just a small fraction of what scientists now believe will be needed to limit global average temperature increases to 2 degrees Celsius and to avoid crossing potentially catastrophic thresholds in Earth's climate system. (See Chapter 6.) Still, the reductions made under Kyoto represent a critical first step.4

The inspiration for today's rapidly growing carbon markets comes from a successful U.S. experiment with trading sulfur dioxide and nitrogen oxide credits. This market was created in the early 1990s primarily to address the problem of acid rain. As a result of this experience, the U.S. government successfully pushed for the inclusion of similar provisions in the Kyoto Protocol, overcoming initial skepticism from other countries. Ironically, the U.S. government has so far refused to ratify the protocol that contains the very provisions it championed, while the EU has created the most ambitious trading system to date.5 The protocol created three innovative market-based instruments to encourage its cost-effective implementation: • The Clean Development Mechanism

(CDM) allows countries with emissions reduction commitments under Kyoto to reduce their burden by investing in emissions reductions in developing countries that are party to the protocol but not held under it to any specific reductions.

• Joint Implementation (JI) allows countries to meet their reduction targets by investing in projects that reduce emissions in other countries bound by Kyoto targets, usually those in Eastern Europe and the former Soviet Union.

• Emissions trading allows parties with emission targets to trade portions of their national emission allocations among them-selves.6

So far, most of the credits generated under the terms of the Kyoto Protocol have involved the CDM, although some projects under Joint Implementation have also begun. Trading of emissions allocations between countries has not yet started, but it could begin as early as 2008—the first year of the Kyoto Protocol's initial commitment period.7

Carbon trading in all of the major markets reached an estimated total value of $30.1 billion in 2006, almost triple the amount traded in 2005. The EU Emissions Trading Scheme (EU-ETS) accounted for more than 80 percent of the total value of carbon credits traded in 2006, with credits related to the Clean Development Mechanism coming in a distant second. (See Table 7-1.)8

Within the broad category of carbon credits, there are two distinct segments: allowances and project-based transactions. Allowances are allotted through a government cap-and-trade system or by a financial institution with a binding emissions reduction schedule, such as the Chicago Climate Exchange (CCX). Global trade of allowances has increased rapidly, from 328 million tons of CO2 equivalent in 2005 to 1,131 million tons in 2006. The value associated with these trades rose

SPECIAL SECTION: PAYING FOR NATURE'S SERVICES Improving Carbon Markets

Table 7-1. Carbon Transactions, Selected Markets, 2005 and 2006

2005 2006

Table 7-1. Carbon Transactions, Selected Markets, 2005 and 2006

2005 2006

Market

Volume

Value

Volume

Value

(mill. tons of

(million

(mill. tons of

(million

CO2 equiv.)

dollars)

CO2 equiv.)

dollars)

EU Emissions Trading Scheme

321

7,908

1,101

24,357

New South Wales

6

59

20

225

Chicago Climate Exchange

1

3

10

38

Primary Clean Development

Mechanism*

351

2,638

475

4,257

Joint Implementation

11

68

16

141

Other compliance

20

187

17

79

Other voluntary markets

6

n/a

13

55

Total

716

10,863+

1,652

30,153

* Primary sales of credits generated through the CDM are distinguished from the secondary market, which exists when these credits are resold through a market mechanism such as the EU-ETS. t Excludes over-the-counter voluntary market. Source: See endnote 8.

* Primary sales of credits generated through the CDM are distinguished from the secondary market, which exists when these credits are resold through a market mechanism such as the EU-ETS. t Excludes over-the-counter voluntary market. Source: See endnote 8.

from just under $8 billion in 2005 to $24.6 billion just one year later.9

Project-based transactions are associated with specific carbon reduction projects. Companies and governments can acquire credits from international emissions reduction projects and count the reductions toward their national caps using the Clean Development Mechanism or Joint Implementation. And individuals, businesses, universities, municipalities, or organizations can seek to reduce their own "carbon footprints" by voluntarily investing in specific emissions reduction projects.

In sum, carbon trading can be described as either allowance-based (under a cap-and-trade scheme) or project-based, and it can be part of a compliance market (such as the EU-ETS) or a voluntary transaction.

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