Carbon Trading: An Analysis

Greenhouse gas emissions are changing our climate and its dire effects are being felt worldwide, demanding unconventional solutions to protect the environment for future generations. In 1997, the creation of a new commodity gained international acceptance under the Kyoto Protocol to the United Nations Framework Convention on Climate Change. An emissions trading regime was established where greenhouse gases, primary carbon, could be traded within a market, like any other commodity. Carbon trading has since gained popularity as an effective weapon to slow climate change.

This article seeks to examine the concept of carbon trading and its formulation in the Kyoto Protocol, 1997. It would provide an overview of the three-carbon trading mechanisms established under the Protocol and its implementation on an international, regional, and national level. Finally, the article would highlight some concerns surrounding carbon trading.

Introduction

The rising concentration of Green House Gases (GHGs) in the Earth’s atmosphere has continued to exacerbate the effects of global warming and climate change, demanding the development of new strategies and measures to save this planet before it’s too late. The creation of carbon markets and tradeable carbon units is a novel addition in our battle against the climate crisis.

The concept of carbon trade originated with the Kyoto Protocol,1997 which called for a uniform and international standard on reducing GHG emissions. It specifically aimed to reduce emissions by 5% below the 1990 levels between 2008 and 2012 (the first commitment period). Since it does not matter where GHGs are released because it will soon spread around the Earth uniformly, the States realized that if they come together and agree to limit their total emissions to a certain amount, it will not matter who or how much each nation emits, as long as together they don’t emit more than what they committed. Further, it would be more feasible to reduce emissions where it is least costly to do so. This logic forms the underlying principle of emissions trading.

The major focus has been to reduce carbon emission since Carbon dioxide is the most prominent GHG. To this end, nations have established carbon markets where carbon emissions can be traded among entities.

The Concept of Carbon Trading  

Carbon trading is a form of emissions trading that specifically targets carbon dioxide. It is a market-oriented approach, offering financial incentives to industries in return for reducing emissions. This form of trading is also referred to as ‘cap-and-trade’ because an upper limit is set on the amount of carbon a given entity is allowed to release into the atmosphere, but which allows rights to emit beyond that limit to be bought from other entities that have cut emissions below the allowance limit.

For example, Entity A and Entity B have both been allocated carbon units i.e., the permissible limit, by their authorities. Entity A manages to reduce its emissions by implementing environmentally-friendly measures such that it has carbon units or carbon credits to spare. On the other hand, Entity B is struggling to reduce its emissions and would therefore need a permit to emit carbon beyond the permissible limit. Carbon trading allows Entity A to sell its spare carbon units Entity B, creating a system where the buyer would have to pay to pollute and the overall effect would still be reduced emissions.

Carbon is therefore traded like a commodity within carbon markets, in which the price of tradeable carbon units would depend on the number of units in circulation. Since the price of the carbon units would vary according to the demand and supply, the emissions trading system is designed to gradually reduce the permissible limit of emissions, making it more expensive to purchase carbon units. Over time, therefore, entities will employ more cost-effective measures to meet their emission obligations by investing in cleaner technology rather than buying expensive allowances to pollute.

Carbon trading occurs in two types of markets; compliance and voluntary markets. The compliance market is used by companies and governments that by law have to account for their GHG emissions and are regulated by mandatory national, regional, or international carbon reduction regimes.[1] Carbon trading on voluntary markets is voluntary.

International Carbon Trading Under the Kyoto Protocol

The Kyoto Protocol forms the backbone of most compliance markets. Each Annex I[2] Party has a binding commitment to limit or reduce GHG emissions and innovative mechanisms have been established for Parties to facilitate compliance with this commitment.[3] Under Article 3 paragraph 1, each Annex I Party has to ensure that its total GHGs emissions do not exceed the allowable level i.e., the Party’s assigned amount outlined in Annex B. The allowed emissions are divided into Assigned Amount Units (AAUs), each AAU equal to 1 metric tonne of CO2-equivalent emissions.

In addition to national measures for meeting commitments, the Kyoto Protocol laid down three implementation mechanisms for carbon trading; the Joint Implementation, Clean Development Mechanism, and International Emission Trading.

• Joint Implementation

Article 6 establishes the Joint Implementation (JI) mechanism which allows a country with an emission reduction commitment under the Kyoto Protocol (Annex B Party) to earn emission reduction units (ERUs) from an emission-reduction or emission removal project in another Annex B Party. This mechanism only applies to Annex B Parties, allowing for carbon trading only between such developed nations.

• Clean Development Mechanism

Under the Clean Development Mechanism (CDM), defined in Article 12, Annex I Parties may earn Certified Emission Reductions (CERs) by investing in emission-reduction projects in Non- Annex I Parties (comprising developing countries), to meet their reduction commitments under Article 3.

By allowing Annex I Parties to invest in such projects, they can offset their increased emissions by reducing emissions elsewhere in the world, and earn carbon credits this way. Therefore, the CDM resembles the JI mechanism defined in Article 6, except that it provides for the earning of credits by an Annex I Party with clean projects in a Non-Annex I Party. The CDM essentially targets Non-Annex I developing countries because of cheaper costs.

Article 12(9) states that participation under the clean development mechanism may involve private and/or public entities, and is to be subject to whatever guidance may be provided by the executive board of the clean development mechanism. CDM projects are therefore regulated under the Kyoto Protocol and are supervised by the United Nations Framework Convention on Climate Change (UNFCCC) bodies.

From the example discussed earlier, Entity B can either buy carbon credits from Entity A, or it can offset its emissions by investing in carbon reduction measures in Entity C, a developing nation. Even though the latter has no obligations under the Kyoto Protocol, the UNFCC can still approve the carbon emission reductions and give Entity B CERs, under the CDM.

It has been reported that the CDM and other market mechanisms have supported the development and implementation of about 3,000 projects from India till December 2012, out of which about 40% have been registered with UNFCCC. These registered projects represent an investment of over INR 1.6 trillion and have generated over 170 million Certified Emission Reductions (CERs) that can be used by developed countries to meet their compliance requirements under the Kyoto Protocol.[4]

• International Emission Trading 

Article 17 of the Protocol states that:

“The Parties included in Annex B may participate in emissions trading to fulfill their commitments under Article 3”

Therefore, the AAUs of Annex I/Annex B Parties are tradeable where countries with emissions under their limits can sell their excess carbon units to other countries that need them to meet their emissions goals. While the JI and CDM represent offsetting mechanisms to reduce emissions, the Emissions Trading System treats carbon like any commodity within a market. The AAUs represent actual emission units, rather than offsets.

Implementation of Carbon Trading Mechanisms Under the Kyoto Protocol

Governments of the 38 Annex B Parties have put in place national registries, containing accounts within which units are held in the name of the government or in the name of legal entities authorized by the government to hold and trade units.[5] The national registries are connected to the International Trade Log (ITL) under the UNFCCC. The ITL ensures accurate accounting and verification of transactions proposed by registries to support the review and compliance process of the Kyoto Protocol.[6] All international trades are reported by the Parties to the UNFCCC secretariat or to a designated subsidiary body, who keeps accounts of international permit trade and calculates changes in the allowances of participating countries by adding up all notified trades by the end of each year.[7]

Regional and National Carbon Trading Systems

The mechanisms established under the Kyoto Protocol prompted the emergence of many national and regional compliance and voluntary markets in carbon. Many Annex B Parties have entered into arrangements with other countries or have set up their own domestic emissions trading system to achieve their compliance in the first and subsequent commitment periods.

The European Union

The European Union (EU) was at the forefront of the effort to fulfill its obligations under the Kyoto Protocol when it set up the first international emissions trading system. It launched the European Union Emissions Trading System (EU ETS) in 2005, which is based on the same mechanisms as Kyoto, operates in all EU countries plus Iceland, Liechtenstein and Norway, making it the largest carbon market in the world. It covers around 45% of the EU’s GHG emissions and aims to reduce emissions by 21% by 2020 and 43% by 2030 from its 2005 level.[8]

The United States

Despite not having ratified the Kyoto Protocol, the United States established the Regional Greenhouse Gas Initiative (RGGI), a mandatory carbon cap-and-trade program, in 2009. This trading system covers fossil-fuel-fired electric power generators with a capacity of 25 megawatts or greater in ten north-eastern and mid-Atlantic states. Over the period 2005-2013, RGGI states experienced a reduction of over 40% in power-sector Carbon dioxide emissions while the regional economy grew by 8%.[9] It further set an annual cap for the total carbon emissions which would decline at a rate of 2.5% per year from 2015 to 2020. Before the RGGI, the Chicago Climate Exchange was the first legally binding voluntary cap-and-trade system that was set up in 2003. It however shut down its emissions trading in 2010 due to, inter alia, lack of congressional support.

Other Annex I Parties that have set up similar national emissions trading systems include Australia and New Zealand.

India

India ratified the Kyoto Protocol in 2002. However, being a Non-Annex I developing country, it was not required to submit any binding reduction commitments. In 2009, India submitted a voluntarily pledge to reduce its emissions intensity per unit of GDP by 20-25% by 2020 relative to 2005 levels, and further set a new target in the year 2015 to reduce the same by 33-35% by 2030.[10]

India launched the Perform Achieve and Trade (PAT) initiative in 2008 which resembles the ETS. The first cycle of the PAT Scheme, from 2012-2015, reduced the energy consumption of more than 400 industries in the energy-intensive sectors by 5.3%, above the initial target of 4.1%,[11]  and has proven to be successful.

Carbon Trading – An Effective Solution to the Climate Crisis?

The Kyoto Protocol has been lauded for succeeding in committing most developed nations, save the United States, to binding targets for reducing their GHGs emissions, and advancing a new approach to the problem of climate change through the creation of carbon trading mechanisms. This, however, has not come without its challenges, and there are a host of issues regarding the very concept of carbon trading and the implementation of its mechanisms on an international level.

Critics have voiced their concerns about the uncertainty and lack of transparency surrounding the carbon markets, which produce highly abstract commodities and are dominated by speculators.[12] An article published by the Financial Times opined that “ carbon markets create a muddle“ and that they “leave much room for unverifiable manipulation”.[13]

Further, the effectiveness of the Kyoto Protocol mechanisms is undoubtedly contingent on a collective agreement reached by the Member States, establishing a global emissions market with uniform and accurate systems of measurement and monitoring. An enforcement or compliance procedure is indispensable to the success of this novel mechanism. Since the emissions trading proposal was adopted at the very end of the Kyoto negotiations, designing the relevant principles, modalities, rules, and guidelines governing emissions trading had been deferred to a subsequent conference.[14]

The Marrakesh Accords were the product of the 7^th Conference of the Parties (COP) of the UNFCC held in 2001, providing a set of monitoring and compliance procedures and setting out detailed rules for the implementation of the Kyoto Protocol. During the negotiations, while the EU had insisted on the compliance procedure being legally binding and adopted as an amendment to the Kyoto Protocol, other states such as Russia and Japan opposed this.[15] A decision on the legal nature of the compliance procedures and further work on the Kyoto Protocol mechanisms was postponed.

Following many unsuccessful negotiations, the Paris Agreement at the 21^st COP, adopted in 2016 by 175 countries, marked a milestone in global action against climate change but was a failure in the carbon trading front. The final section of the Paris Agreement which under Article 6, prescribes rules for an international carbon market regulated by the United Nations, remained unresolved. The 25^th COP held in Madrid in 2019 was expected to finalize rules for future carbon trading but ended with no agreement reached. Therefore, one of the principal reasons for the failure of carbon trading has been the absence of an effective implementation agreement.

Conclusion

A significant achievement of the Kyoto Protocol was its focus on the reduction of GHG emissions, and the development of new approaches in combating climate change. The carbon trading mechanisms established under Articles 6, 12, and 17 have inspired the creation of around 16 compliance carbon markets across the world. Several regional and national schemes, like the EU ETS, did gain ground and are commendable to a considerable extent.

However, the lack of political consensus and indecisiveness of the Member States highlights the major challenge to the implementation of an EMS at an international level between the states. The biggest barrier to materializing the carbon trading mechanisms has been the aloofness of and lack of action from the world’s largest polluters. The United States withdrew from the Kyoto Protocol in 2001 while China and India, being developing countries, were exempt from the application of the Protocol. Canada, which played an active role in the Kyoto negotiations, eventually withdrew from the Protocol in 2011. Therefore, numerous problems continue to exist in the carbon trading sphere and the need for a unified market covering a significant percentage of the total global emissions is essential.

FAQs

1. What is carbon trading and how does it work?
2. What were the carbon trading mechanisms established under the Kyoto Protocol, 1997?
3. How have countries implemented carbon trading?
4. What are some of the regional and national emissions trading systems that have been established?
5. What are some of the issues surrounding carbon trading?

References

• [1] Food and Agriculture Organization of the United Nations, Working Paper: Carbon Finance Possibilities for Agriculture, Forestry and Other Land Use Projects in a Smallholder Context (2010)
• [2] Annex I Parties include the industrialized countries that were members of the OECD (Organisation for Economic Co-operation and Development) in 1992, plus countries with economies in transition (the EIT Parties), including the Russian Federation, the Baltic States, and several Central and Eastern European States.
• [3] United Nations Framework Convention on Climate Change, Kyoto Protocol Reference Manual on Accounting of Emissions and Assigned Amount (2009)
• [4] GIZ, Carbon Market Roadmap for India – Looking Back on CDM and Looking Ahead, Deutsche Gesellschaft (2004)
• [5] Registry Systems under the Kyoto Protocol, United Nations Climate Change https://unfccc.int/process/the-kyoto-protocol/registry-systems
• [6] International Transaction Log, United Nations Climate Change https://unfccc.int/process/the-kyoto-protocol/registry-systems/international-transaction-log
• [7] Tietenberg, Grubb, International Rules for Greenhouse Gas Emissions Trading, United Nations Conference on Trade and Development, UNCTAD/GDS/GFSB/Misc.6  (June 1, 1999)
• [8] EU Emissions Trading System (EU ETS), Official Website of the European Union https://ec.europa.eu/clima/policies/ets_en
• [9] Investment of RGGI Proceeds Through 2013, RGGI, Inc. (2015) https://mde.maryland.gov/programs/Air/ClimateChange/MCCC/Publications/RGGIProceeds2013.pdf
• [10] Mitra, Chitkara & Ross, Working Paper: Pathways For Meeting India’s Climate Goals, World Resources Institute (2017) 
• [11] Recommendations of the Global Commission, Global Commission for Urgent Action on Energy Efficiency (2020)
• [12] Larry Lohmann, Uncertainty Markets and Carbon Markets: Variations on Polanyian Themes, 15 New Political Economy 2 (2010)
• [13] Carbon Markets Create a Muddle, Financial Times (United Kingdom) April 26, 2007
• [14] Supra note 8
• [15] Obergassel, Ott, Global Climate, 25 Yearbook of International Environmental Law 1 (2014)