The Carbon Market

by Nick Brubaker

There is a lot of talk in the media and by politicians about climate change negotiations, cap-and-trade, and carbon markets. But what is a carbon market? How does it work?

Carbon tax versus cap-and-trade

There are two primary methods to achieve a reduction in the anthropogenic, or human caused, release of greenhouse gases (GHGs) that contribute to climate change: (1) a carbon tax, and (2) a cap-and-trade system.

A carbon tax is fairly straight forward. It places a price on carbon dioxide equivalent (CO2e)* and requires those causing emissions to pay per ton of CO2e released. If the price of carbon is set correctly, polluters have the incentive to reduce emissions and governments can use the tax revenues for climate change adaptation and mitigation activities.

In a carbon cap-and-trade system, polluters are provided with ‘pollution rights’ in the form of specified emission allowances (the cap) and if they exceed their cap they must purchase more allowances from companies that have excess credits (the trade). The idea is that the monetary incentives of selling pollution rights will spur innovation and lead to a reduction in emissions over time. In addition to trading pollution rights, entities that have emission reduction targets have the option of purchasing carbon credits from carbon offset projects that reduce emissions, transferring their reductions to places where cuts in C02 are easier or cheaper to achieve. (Note: the voluntary carbon market operates somewhat differently, relying on environmental philanthropy rather than a limit on pollution rights. More information on voluntary markets is included later in this post).

Appeal of Carbon Markets

Cap-and-trade is the most politically favorable option today, having operated in Europe (EU ETS) since 2005 and currently evidenced by U.S. House and Senate debates on climate change. GHG pollution and the resultant contribution to climate change is a truly global crisis; the release of 1 ton of CO2 in San Francisco has the same impact as 1 ton of CO2 emissions in Kathmandu. Therefore, an appealing aspect of cap-and-trade is that avoided emissions can come from anywhere in the world, where the reduction in emissions may be cheaper, more feasible, and/or aligned with sustainable development objectives. This last factor is critical and is the basis of the Clean Development Mechanism (CDM) of the Kyoto Protocol (Joint Implementation is another project type within the Kyoto Protocol that is not discussed in this post.)

CDM and ‘Additionality’

In a CDM project, a rich country signatory of the Kyoto Protocol invests in a carbon offset project in a poor country and receives Certified Emission Reduction (CER) credits, allowing rich countries to achieve emissions reduction targets while providing development assistance to poorer countries. A key provision of CDM is the proof of ‘additionality,’ in other words demonstrating that the emission reductions from the project would not have occurred without CDM financing. For example, if China is running a coal-fired electricity plant to power a town but, because of CDM financing from Germany, switches to a cleaner energy source (solar, wind, biomass, etc), CER’s will be granted to be used toward emission reduction targets in Germany.

In order for a carbon off-set project to qualify as a CDM project, it must be implemented using an approved project methodology.

Carbon Markets and Deforestation

Deforestation accounts for 20% of all GHG emissions and is therefore a primary focus of climate change mitigation efforts. Currently, however, only afforestation and reforestation projects can qualify as CDM projects, meaning financing is not available for avoided deforestation. This will (likely) change as negotiations continue for a global climate change agreement that will begin when the Kyoto Protocol expires in 2012. The next agreement is slated to include Reducing Emissions from Deforestation and Forest Degradation (REDD) projects. There are several hurdles to the success of REDD projects, including proving additionality, ensuring permanence (guaranteeing the forest will remain standing), and avoiding leakage (making sure the deforestation doesn’t just shift to a forest outside of the project area). Another major area of concern is the cultural, social, and economic impact to local populations that traditionally depend on the forests. To address this, a new REDD+ project paradigm includes sustainable forest management, biodiversity protection, and the enhancement of carbon stocks.

Voluntary Carbon Markets

In recent years there has been an enormous growth in the Voluntary Carbon Market sector. Unlike the binding commitments to emissions reduction under a treaty or regulated agreement, the voluntary market relies on financing through philanthropy from individuals, businesses, governments and NGOs. These are people and organizations who commit to reducing their carbon footprint because they believe it is the socially and environmentally responsible thing to do. You have likely encountered voluntary offsetting, for example when purchasing an airplane ticket you may be offered the opportunity to offset the carbon footprint of your flight by paying an additional fee.

Carbon project developers seek accreditation from a recognized verification body, after which they can receive Voluntary or Verified Emission Reduction (VERs) credits that can be sold on the market. Emission reduction buyers purchase VERs in whatever quantity is needed to ensure that their emissions related activities are paying for an equivalent level of emissions avoidance somewhere else.

The Verdict

So what is the verdict on Carbon Markets? The jury is still out. There is great potential for carbon markets, both regulated and voluntary, to effectively reduce GHG emissions to help mitigate the effects of anthropogenic contributions to climate change. However, there are also a great number of challenges – technological, methodological, economic, social, regulatory, etc.– that must be overcome before carbon markets can achieve the level of emissions reductions required to slow global warming.