Carbon trading

Carbon trading is an innovative market-based solution to the problem of reducing greenhouse gas emissions3. Its main rationale is that, by attaching a price to carbon dioxide emissions, trading schemes will generate powerful economic incentives to cut emissions and channel investment efficiently.

Emissions trading works by setting limits on total allowable emissions that are then converted into tradable permits to be distributed amongst participants. For example, a company with commitments to reduce its emissions by 20% during a set 'commitment period' will be allocated permits equal to 80% of what it would have emitted given an agreed baseline emissions level. Participants have the option of trading a certain proportion of their allocation but must ensure that they hold enough permits to cover their emissions reduction target when the commitment period comes to an end. Those that find they can make reductions relatively cheaply have an incentive to reduce their emissions below their allocated level knowing that they can sell any excess permits to participants for whom direct reductions are too expensive. By these means, all participants will end up spending less than they would have done without the trading mechanism, helping to reduce emissions more quickly than would otherwise have been possible.

The United States successfully argued for including carbon trading as a central component of the Kyoto Protocol in 1997, citing the effectiveness of its own domestic sulphur dioxide trading scheme. International discussions subsequently provided the impetus for the European Union to develop the first international scheme. The European Trading Scheme commenced operation in 2005, covering some 11 500 industrial plants accounting for 45% of total EU carbon dioxide emissions. Since then a number of governments have announced plans for their own variants of carbon trading schemes including Australia, New Zealand, Canada and several states within the USA. Rules and procedures agreed under the Kyoto Protocol provide a framework through which future trading schemes might be linked.

Two factors are key to the success of any emissions trading scheme. First is the provision of accurate and verifiable information regarding actual emissions by different sectors and countries. Secondly, the method of allocation of permits must be transparent and fair to all participants; in practice this presents a large challenge. At the start of the European Trading Scheme, substantial over-allocations of permits occurred which led in 2006, to a collapse of the price of carbon. For the 2008-12 period, procedures have been tightened. One method of allocation, known as grandfathering, allocates permits in proportion to participant's current emission levels. This tends to favour the largest current emitters. Another, potentially fairer, method is to auction the permits using the auction proceeds, for instance, to assist reductions schemes that are of general value to the participants. Lessons learnt from the European Trading Scheme so far point strongly to future arrangements in which most of the permits are allocated by auction.

As an instrument of policy the market-based approach underlying emissions trading has been criticised for favouring emission reduction projects that promise low initial costs and rapid paybacks in the short term over more radical, systematic programmes that offer greater and cheaper reductions over a longer period of time.4 It has also been criticised for its inadequate recognition of human rights especially in developing countries. Emissions trading therefore, although an important instrument for the control of emissions, must be supported by other measures mentioned later in this chapter or in Chapter 11.

end of the first commitment period, 130% of the excess is deducted from their allowance in the second period.

The Kyoto Protocol is an important start to the mitigation of climate change through reductions in greenhouse gas emissions. With its complexity and its diversity of mechanisms for implementation, it also represents a considerable achievement in international negotiation and agreement. It will stem continuing growth of emissions from many industrialised countries and achieve a reduction overall compared with 1990 from those Annex I countries that participate. A Kyoto Protocol with successful achievements will be essential for movement to be made towards a truly global system (i.e. involving both developed and developing countries) with binding targets after 2012. The much more substantial longer-term reductions that are necessary for the decades following 2012 will be discussed later in the chapter.

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