Carbon Emissions Trading

Carbon Emissions Trading: A short history

Carbon credit is the vernacular term commonly used to refer to carbon emission offset units. As a commodity market, carbon emissions trading came into being in the wake of the Kyoto Protocol of 1997. The legally binding agreement sought a united international strategy to combatting global warming. 191 signatory nations have committed to reducing overall global emission levels to 5.2% below 1990 levels by 2020.

The mechanism agreed upon as the most effective way to deliver this target of quantitative and measurable reductions in emission levels was a greenhouse gas cap-and-trade system. The fungible unit of measurement within this system is a carbon credit. The five major greenhouse gases are broken down to the equivalent denominator of one ton of carbon, represented as a carbon credit.

Although all of the Kyoto signatories have agreed to implement national strategies to reduce emission levels, the industrialised nations have binding agreements on reduction quotas. This recognises the fact that global warming has largely been caused by their industrial processes over the past 150 years.

Industrialised nations have accepted a gradually lowering ceiling on their emission levels, denoted by an allocation of carbon credits. These carbon credits are then allocated to polluting industry in a given country. They must offset each equivalent ton of carbon emissions above their allocated 'pollution' quota with one carbon credit. Should they manage to bring emission levels below their capped level, usually through investment in technology which captures emissions, they may sell their surplus to companies who exceed their quota via the established carbon emissions trading mechanisms. Hence the reference to 'cap and trade', carbon schemes.

The Structures of Carbon Emissions Trading within the Kyoto Agreement

Two carbon emissions trading flexibility mechanisms, the Clean Development Mechanism CDM) and the Joint Implementation Mechanism (JI), were introduced to the system to ensure its viability. These mechanisms are project based and largely similar, the main difference being that JI mechanism projects are located in industrialised nations with an emissions cap and CDM projects in developing economies. These projects are of varying natures with the common factor that they can be shown to quantitatively reduce overall emission levels of greenhouse gases.

Projects are verified as achieving quantitative reduction of greenhouse gas emissions and must show that they would not be viable other than as part of an emissions reduction program ie. would not have existed otherwise. They are allocated carbon credits, the fungible units of carbon emissions trading, relative to the tons of equivalent carbon emissions they have prevented. These carbon credits can then be sold to polluting industry up to a certain percentage above their quota if they exceed it, by way of offsetting their additional emissions with the prevented emissions resulting from the project.

The sale of these carbon credits largely funds emissions reduction projects in developing countries including them in the Kyoto apparatus and paving the way for eventual full implementation of cap-and-trade carbons emission trading globally. It also facilitates a more financially attractive means of offsetting emissions in industrialised economies.

The Voluntary Carbon Emissions Trading Market

As well as the obligatory compliance carbon market, there is also a voluntary carbon emissions trading market for carbon credits. Projects which produce carbon credits for the voluntary market have a similar nature to those within the JI and CDM flexibility mechanisms. Ratification of the project as reducing emissions and verification of the carbon credits produced is carried out by third-party standards rather than the UN established national bodies. Also, social, ecological and sustainable development criteria are also often evaluated as well as emissions reduction qualities.

Those participation in carbon emissions trading of voluntary carbon credits are predominantly corporations who wish to offset their emissions as part of their CSR policy, without being obliged to do so as part of the compliance system. Prominent examples include Google, General Motors and UPS who spend millions annually on voluntary carbon credits.

Other companies buy voluntary carbon credits in order to offer their clients to opportunity to offset the carbon footprint of services used by paying a small supplement towards carbon credits. Easyjet provide this option for all flights booked.

Since its inception is 2005 in its modern format, the carbon emissions trading market has grown quickly and in 2010 had a total value of $124 billion. Quite an impressive statistic for such a young commodity market.

Investing in Carbon Emissions Trading

The major financial institutions such as investment banks now generally have specialised departments for carbon emissions trading, as do energy trading companies. Private investors looking for attractive sustainable investments are also now entering this booming new commodities market. Investing at project level in the voluntary carbon credits market is of particular interest to private investors due to relatively low entry level investments, ease and the fact that many investment vehicles connected to carbon credits are SIPP compatible.

2010 saw the voluntary carbon emissions trading market reach a record high of 131 Mt CO2 worth of carbon credits traded, recovering from the recession and surpassing 2008's previous record high.

The Future of Carbon Emissions Trading

Carbon offsetting through carbon credits is becoming a fact of life in both industry, business and our day-to-day lives. So much so that predictions have been made that the carbon market could become the world's largest commodity market in coming years. Such claims may be fanciful, at least based on current value levels, but carbon credits and the carbon market appear to be here to stay. Year on year new sub-national, national and regional cap-and-trade compliance markets enter into force and more companies voluntarily offset their emissions as the public demand environmental responsibility.

Given the rate of growth that the market has shown, investing in carbon credits is likely to continue to attract more and more investors looking for a sustainable investment that makes financial sense.