Posted by: PARTHA DAS SHARMA | November 11, 2009

Carbon trading is market based tool to limit GHG emissions

Carbon trading is market based tool to limit GHG emissions – effective for management of Carbon footprint

1. Introduction –

Carbon emissions into the earth’s atmosphere have resulted in drastic climatic changes. In 1997, in Kyoto, developed Industrialised countries pledged to reduce the production of greenhouse gases which contribute to Global warming by a minimum of 5% by 2012, compared to a 1990 baseline. The Greenhouse Gases which include Carbon di-oxide (CO), Methane (CH4) and also other oxides on account of incomplete combustion substantially disturb the balance of the heat in the earth’s atmosphere leading to warming of the atmospheric temperature which is called as Global Warming and is considered a major threat to life on earth.

Carbon trading is the idea is to develop a mechanism to allow market to drive industrial and commercial processes in the direction of low emissions. Working in that direction, Governments of various countries are trying to come up with, a trading mechanism where companies gain a monetary benefit out of polluting the air less. Kyoto protocol’s goal is exactly that. The idea is to divide the whole world into two, one who can afford making changes to their existing infrastructure and the ones who cannot. As everybody is polluting, be it a developed country or a developing country, the financial aspect has to be kept in mind. All developed countries will have to cut down their emissions by some x percentage or else they pay heavy fines. Now, one way of measuring how much they are polluting the air less, is by clean each tonne reduction of CO2 a unit and a company must own those amounts of units at the end of every period.

Carbon trading, sometimes called emissions trading, is a market-based tool to limit Greenhouse gas (GHG). Emissions trading aims at efficient investments in emission reduction. In other words, carbon credits are a key component of national and international emissions trading schemes that have been implemented to mitigate global warming. They provide a way to reduce greenhouse effect emissions on an industrial scale by capping total annual emissions and letting the market assign a monetary value to any shortfall through trading. The carbon market trades emissions under cap-and-trade schemes or with credits that pay for or offset GHG reductions.

2. Mechanism of Emission Trading System and functionalities –

In its simplest form, a “cap and trade” program has two main components. An emissions trading scheme (ETS) attempts to put a price on the emissions of a targeted gas, so as

to make firms internalize environmental resources in their business decisions. A cap is set for aggregate emissions in the system. Allowances are then issued that allow their holders to emit a certain quantity of the targeted gas. The sum of all allowances issued is equal to the overall cap. Firms are then allowed to trade these allowances. If it is cheaper to reduce emissions than buy an allowance, then a firm will become a net seller; conversely, if it is cheaper for a firm to buy allowances than reduce its emissions, then it becomes a net buyer.

As mentioned above, the first component is a ceiling or “cap” established on aggregate air emissions, which typically declines over time. This declining or “phasing-in” of the cap sets a maximum limit on emissions and imposes a legal obligation that ensures the specific longer-term environmental goals are met. By phasing in the cap over multiple periods, companies regulated by the program can begin investing in compliance while reduction requirements are less aggressive, and then accelerate their strategies as the cap is ratcheted down over time. Emitters within economic sectors covered by the program are responsible for reducing their emissions to comply with typically annual emission targets.

Without the legal certainty of future emission levels afforded by the hard “cap” the environmental objectives of the program may not be achieved. In contrast, programs that use emissions fees or taxes (e.g. a carbon tax) impose no legal obligation on the number of tons that can be emitted and thus provide no assurance that specific emissions targets would be achieved.

The second component in a cap and trade program is a market-based emissions trading system. An emissions trading system, which has become synonymous with the “trade” component in a cap and trade program, is created and regulated by government and provides for the use of emissions permits or “allowances” as a form of compliance with the stated emissions caps. Each allowance is the equivalent of one ton of emissions. Companies whose emissions are greater than their allocation or share of the cap are able to purchase allowances to meet their reduction goals. Companies that reduce their emissions more than required by their allocation are able to sell the excess allowances in the open market or to other companies interested in purchasing them. The tradable permit market that ensues from this structure provides clear price signals regarding the value of emissions reductions and allows rational economic decision making and risk management techniques to govern capped sources’ emissions management and control decisions.

Several other notable cost containment mechanisms help to create an even more cost-effective emissions trading system. First is the concept of “banking” emissions allowances. Banking allows companies that are regulated by the program to carry forward unused allowances from previous compliance years and use them to meet future years’ compliance goals. Banking has proven to be an important mechanism in reducing compliance costs because it provides companies with the flexibility of making additional emissions reductions earlier than required in order to avoid some future required reductions when the costs of compliance are much higher.

“Borrowing”, another cost containment mechanism, allows companies to borrow allowances from future compliance periods and submit them for current-year compliance periods. Borrowing was first introduced in the European Union’s Emission Trading System as a means to both reduce compliance costs and dampen allowance price volatility. The creation of a “strategic reserve” of allowances is another cost-containment mechanism by which allowance price volatility and compliance costs can be mitigated. The concept of a strategic reserve has been incorporated into several recent U.S. climate bills. The reserve would help stabilize market prices by injecting additional allowances into the market when market prices reached the reserve’s minimum auction price.

Another important mechanism of an emissions trading system, particularly with regard to greenhouse gases emissions, is the concept of an “offset”. Offsets represent actual, verified emission reductions made by greenhouse gas emitting sectors that cannot practicably be included under the cap. Examples include the U.S. agricultural and forestry sectors and certain sectors within developing countries. By utilizing market incentives, qualifying projects are able to reduce their overall emissions at a relatively low cost. Offsets are important because companies regulated by an emissions cap are able to purchase offset credits and use them towards their own compliance goals, generally at a cost lower than either purchasing allowances or pursuing more costly internal abatement options. Most economists and analysts expect that offsets will be a low-cost way for companies to meet their compliance goals by allowing them to access equivalent lower cost reductions outside of the cap, while achieving the same aggregate reduction of emissions. Offsets are a viable part of greenhouse gas emission programs since the effects of GHG emissions are the same wherever they are emitted in the world, unlike the case for the local or regional pollutants such as SO2 and NOx. Offsets also provide a valuable temporal bridge, allowing early emissions reductions objectives to be met at reasonable cost while new clean energy technologies are developed and available for commercial-scale deployment.

International offsets are also particularly important because of their relatively low cost and, critically, their role in providing incentives for the sustainability of tropical rain forests and the promotion of low-emitting technology in developing countries.

3. Discussion on cost effectiveness and environmental benefits of Cap-and-trade system –

* The U.S. Acid Rain Program is the most mature example of how a cap and trade system works to both reduce the cost of compliance and also meet and even exceed environmental targets.

* The European Union Emission Trading Scheme is the cornerstone of the EU’s successful effort to meet its emissions reduction obligation under the Kyoto Protocol. While the ETS cap nominally covers only approximately 40% of the emissions from the EU, the EU carbon market, particularly the flexibility provided by the use of offsets through the Clean Development Mechanism, has allowed the EU member-states to use international offsets to achieve reductions from sectors not covered by the trading program.

4. Summary of mechanism of Carbon Cap-and-Trading and related aspects –

Cap-and-trade schemes are the most popular way to regulate carbon dioxide (CO2) and other emissions. The scheme’s governing body begins by setting a cap on allowable emissions. It then distributes or auctions off emissions allowances that total the cap. Member firms that do not have enough allowances to cover their emissions must either make reductions or buy another firm’s spare credits. Members with extra allowances can sell them or bank them for future use. Cap-and-trade schemes can be either mandatory or voluntary.

A successful cap-and-trade scheme relies on a strict but feasible cap that decreases emissions over time. If the cap is set too high, an excess of emissions will enter the atmosphere and the scheme will have no effect on the environment. A high cap can also drive down the value of allowances, causing losses in firms that have reduced their emissions and banked credits.

If the cap is set too low, allowances are scarce and overpriced. Some cap and trade schemes have safety valves to keep the value of allowances within a certain range. If the price of allowances gets too high, the scheme’s governing body will release additional credits to stabilize the price. The price of allowances is usually a function of supply and demand.

Credits are similar to carbon offsets except that they’re often used in conjun­ction with cap-and-trade schemes. Firms that wish to reduce below target may fund pre-approved emissions reduction projects at other sites or even in other countries.

5. Working of Carbon Credits –

As stated above, carbon credits are reductions of emissions of greenhouse gases caused by a project or a Product utilized by anybody which directly or indirectly reduces or eliminates green house gases. Currently this reduction is measured in terms of CO2 reduced. Thus ‘One carbon credit’ is equivalent to ‘One ton’ reduction of CO2.

Now Carbon Credits can be obtained by undertaking new projects under Joint Implementation (JI) with funding agencies or through usage of Products or Projects under Clean Development Mechanism (CDM).  In JI, carbon credits are officially called Emission Reduction Units or ERUs. In the CDM, they are called Certified Emission Reductions or CERs.  CO2e  (Carbon dioxide equivalent)is the same as a carbon credit, ERU or CER.

Companies in countries buy the emission reduction achieved (carbon credits) that are realized through investment in JI or through CDMs and that otherwise would not have existed. Prices are realised by process of competitive bidding.

Carbon credits may be generated from Investments and Projects in renewable energy, energy efficiency, fuel switch and waste management projects.

5.1. CDM projects for Carbon credit purposes –

Some of the fields where Carbon Credits or CER can be generated through implementation of CDM Projects:

* Energy Supply:  Renewable energy (e.g. wind mills) – biomass (heat and/or power) and cogeneration.

* Fuel switch:  Switching the fuel for Boilers, Furnaces or Power Plants from Coal or Conventional fuel Oils to biomass or Eco-friendly fuels)

* Energy demand:   Replacement of existing electrical equipment with more efficient units and improvement of energy efficiency of existing production equipment.

* Transport:  Using more efficient engines for transport (e.g. replacing old diesel trains by modern diesel trains) or through transport model shift (e.g. from plane to train) and fuel switch (e.g. public transport buses fuelled by natural gas or Bio-fuels)

* Waste management:   Capture of landfill methane emissions & utilisation of waste and wastewater emissions.

* Domestic Utilities: Improving energy efficiency by replacing existing equipment  and installing  new efficient, new water pumps etc.

* Forestry:   Afforestation & Reforestation or Plantation of Eco-friendly plants.

* Carbon capture and storage (CCS): This Technology allow emissions of carbon dioxide to be ‘captured’ and ‘stored’ – preventing them from entering the atmosphere.

5.2. Benefits of Carbon Credits –

* Provide an additional source of revenue

* Improve the return on investments in Projects

* Boost the economic feasibility of projects

* Accelerate project implementation

* Contribution towards the fight against Global warming.

5.3. Buying carbon credits reduces emissions –

Carbon credits create a market for reducing greenhouse emissions by giving a monetary value to the cost of polluting the air. Emissions become an internal cost of doing business and are visible on the balance sheet alongside raw materials and other liabilities or assets.

By way of example, consider a business that owns a factory putting out 100,000 tonnes of greenhouse gas emissions in a year. Its government is an Annex I country that enacts a law to limit the emissions that the business can produce. So the factory is given a quota of say 80,000 tonnes per year. The factory either reduces its emissions to 80,000 tonnes or is required to purchase carbon credits to offset the excess.

After costing up alternatives the business may decide that it is uneconomical or infeasible to invest in new machinery for that year. Instead it may choose to buy carbon credits on the open market from organizations that have been approved as being able to sell legitimate carbon credits.

* One seller might be a company that will offer to offset emissions through a project in the developing world, such as recovering methane from a swine farm to feed a power station that previously would use fossil fuel. So although the factory continues to emit gases, it would pay another group to reduce the equivalent of 20,000 tonnes of carbon dioxide emissions from the atmosphere for that year.

* Another seller may have already invested in new low-emission machinery and have a surplus of allowances as a result. The factory could make up for its emissions by buying 20,000 tonnes of allowances from them. The cost of the seller’s new machinery would be subsidized by the sale of allowances. Both the buyer and the seller would submit accounts for their emissions to prove that their allowances were met correctly.

5.4. Procedure for Obtaining Carbon Credits –

Before you can sell carbon credits you first of all, look into areas where you can reduce emissions and be eco-friendly, then identify and plan a suitable CDM project and determine how much your project reduces emissions. Prior to this you define a baseline, which is a scenario in which you provide supporting evidence about what the emission of greenhouse gases would be until 2012 without your investment. You compare this baseline with the lower emission that will be achieved through your investment. The difference between them is the amount of saleable carbon credits.

In the case of JI projects you can only sell the reduction achieved between 2008 and 2012 and not what you achieved in the previous years or years after.

5.5. Certification requirements under Carbon Credits –

A validation or certification organisation, acting as an independent third party, validates the baseline you have drawn up. This organisation must work according to the “Accreditation Guidelines on the Application of EN 45004 (ISO/IEC Guide 17020) for the Validation and Verification of JI projects” or according to the guidelines of the UNFCCC Executive Board Accreditation Panel for CDM projects.

The host country’s government must give approval for the transaction in carbon credits through a Letter of Approval. However, even if there is a MOU with the country in which you want to invest, you will have to obtain this letter from this country’s government yourself or through an Accreditated Agency.

The payback mechanism under the Kyoto Protocol is a system called carbon credits that are traded like stocks and bonds. The ones who are selling are companies that use clean technology and those doing the buying are the world’s polluters like the Industries, Power Plants, Aviation and the energy sector.

A company that wants to earn from reducing green house gas emissions can get itself certified from the Indian government and the UN body monitoring climate change.

Then it can sell the credit it earns from reducing emissions to another company that’s failed to achieve the Kyoto target or to a company that trades using the generated Carbon Credits. Thus the idea behind carbon trading is quite similar to the trading of securities or commodities in a marketplace. Carbon is given an economic value, allowing companies, agencies or governments to buy, sell, bank and trade Carbon Credits called Certified Emission Reductions or CERs.

6. Carbon credit and management of Carbon footprint –

Since GHG mitigation projects generate credits, this approach can be used to finance carbon reduction schemes between trading partners and around the world. There are many companies that sell carbon credits to commercial and individual customers who are interested in lowering their carbon footprint on a voluntary basis. These carbon offsetters purchase the credits from an investment fund or a carbon development company that has aggregated the credits from individual projects. The quality of the credits is based in part on the validation process and sophistication of the fund or development company that acted as the sponsor to the carbon project. This is reflected in their prices.

7. Conclusion –

Some of the world’s leading climate scientists are sceptic and opine that, we need to be far more active in cutting carbon emissions, urgently. Currently, atmospheric CO2 levels are at 383ppm and we need to go back to 350ppm if we want to keep our globe liveable. This implies a range of technologies that actively remove CO2 from the atmosphere, such as reforestation, carbon-negative bio-energy etc. They say, we must use biological means to tackle a crisis that could otherwise end in a catastrophe much earlier than expected. They even warned that, the world needs innovative, biological ways to reduce carbon dioxide as emissions trading by itself isn’t nearly enough to address the climate crisis. Global warming risks with a sudden climate shift triggered by events such as a rapid release of methane from melting permafrost would be havoc. If such an event happens, there is nothing man can do. This is why we need to act now. The potential costs of inaction are far too great.




* Economics of Greenhouse Gas Trading: Reaching Economic Goals Cost Effectively, International Emissions Trading Association (IETA),

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* Carbon Taxes vs Carbon Trading, PricewaterhouseCoopers – March 2009,

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* United States Environmental Protection Agency (1999), Progress Report on the EPA Acid Rain Program, 1999.

* Nielson, Leslie (2009), Emissions Trading: Has it worked, Parliament of Australia, Parliamentary Library

* European Environment Agency (2008), Climate for a transport change: Term 2007 indicators tracking transport and environment in the European Union

* Napolitano, Sam, Stevens, Gabrielle, Schreifels, Jeremy, Culligan, Kevin (2007), The NOx Budget Trading Program: A Collaborative, Innovative Approach to Solving a Regional Air Pollution Problem, The Electricity Journal, Volume 20, Issue 9, November 2007.

* Ellerman, Denny (2007), Are Cap-and-Trade Programs More Environmentally Effective than Conventional Regulation?, In Freeman, Jody and Charles D. Kostad (eds.), Moving to Markets in Environmental Regulation: Lessons from Twenty Years of Experience. New York: Oxford University Press, 2007

* Burtraw, D. (1998), Cost Savings, Market Performance, and Economic Benefits of the U.S. Acid Rain Program. Resources for the Future, April.

* IMF (2008), ‘Climate change and the global economy’, Chapter 4 in World Economic Outlook, April 2008.

* PricewaterhouseCoopers (2006), ‘Carbon Taxes: Background and Issues’.



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