Special Reports
Kyoto Protocol Carbon Trading - The Basics

August 13, 2007

Part 1

I received a great response to my last post on carbon trading from Kristy, who

ďAs I was reading [your post], I was aware that I didnít really know what
carbon-trading was. I had an idea it was some way of rich nations giving money
to poor nations to buy their right to pollute the environment, but I hope itís
a whole lot more than that.Ē - Kristy

Great point, Kristy. But is it true? Is carbon trading really nothing more than
a way for developed countries to ease their collective conscience while
continuing to emit more and more greenhouse gases into the atmosphere? Rather
than preach to you about the values of carbon trading (because admittedly, I do
believe it to be good thing), I will try to explain the basics of carbon trading
and let you decide for yourself.

This post is the first in a four-part series on carbon trading. Part 1 covers
the idea behind cap-and-trade. Part 2 will describe how the Kyoto Protocol works
as a carbon trading system. Part 3 will describe voluntary carbon markets and
carbon offsetting. Finally, Part 4 will talk about the business of carbon
trading and emerging carbon markets.

As this is a complicated and often confusing subject, I am looking forward to
hearing comments and questions from the Celsias community. Please donít hesitate
to ask; there are no bad questions.


Carbon trading comes in two forms: mandated and voluntary. In a mandated carbon
trading scheme, often called cap-and-trade, countries or firms are forced to
reduce their GHG emissions to a certain level. In a voluntary carbon market,
countries, firms, or individuals offset their emissions without legal necessity.
The idea of cap-and-trade is based on the fact that greenhouse gas emissions are
a global problem , not a local one. Scientifically, it does not matter whether
our greenhouse gas emissions comes from New York or Jakarta. The effect on
global climate is the same. Therefore, cap-and-tradeís main goal is be to reduce
overall emissions with little regard for their origin.

There are three basic ways to reduce our GHG emissions. First, we can reduce our
use of carbon-emitting technologies and devices. For example, buying energy
efficient products reduces the need for utilities to burn fossil fuels to create
your electricity, and therefore reduces total world carbon emissions. Second, we
can improve the technologies we use by reducing the emissions they create.
Third, we can develop projects that actively reduce atmospheric GHG. These
projects are varied, from planting trees (PDF) to recovering methane from
landfills , but they all serve the ultimate purpose of capturing greenhouse
gases rather than letting them be released into the atmosphere.

Cap-and-trade schemes (PDF) are an attempt to incorporate all three of these
methods in the most economically efficient way. Under a cap-and-trade system, an
overall cap is set on total emissions. The goal of the system is to reduce
emissions below that level. Each participant in the cap-and-trade scheme either
buys or is given so-called ďallowances.Ē These are amounts (generally expressed
in metric tonnes CO2 equivalent) of greenhouse gases that they are allowed to
emit. The total number of allowances adds up to the cap.

Here is how carbon trading works at its most basic level: Imagine a world with
only two greenhouse gas emitters, Power Plant A and Power Plant B (these could
also be countries or industrial companies, but imagine power plants for now).
Plant A can easily reduce its own emissions to below the level of its allowances
through energy efficiency retrofits or other personal measures. Plant A
therefore has excess allowances. For Plant B, on the other hand, it would be
prohibitively expensive to reduce its personal emissions below its allowed
level. So instead, Plant B buys the extra allowances from Plant A. The total
level of emissions remains below the cap, and each participant reaps the
benefits of trading. The Kyoto Protocol, which I will discuss in more detail in
Part II of this series of posts, introduces another element. Under Kyoto, Plant
B has the option of financing a carbon reduction project (such as reforestation)
in a developing country instead of, or in addition, buying extra allowances from Plant A.

Did Plant B buy its way out of reducing its own emissions? Undoubtedly, yes.
However, the ultimate goal of reducing total emissions below a set level was
achieved. Ultimately, every country will need to improve its own practices, but
some can change more quickly and easily than others. This is the theory behind
cap-and-trade. Itís up to you to decide whether it is right or wrong.

Part 2

This is part two in a four-part series on the basics of carbon trading. Part one
described the basic idea behind cap-and-trade. This post gives an overview of
the Kyoto Protocol, the biggest, and most important, case study of an
international cap-and-trade scheme.

What is the Kyoto Protocol?

The Kyoto Protocol is an international agreement that arose from the United
Nations Framework Convention on Climate Change (UNFCCC). Negotiations for the
treaty ended in December 1997 in Kyoto, Japan. Currently, the Kyoto Protocol has
172 signatories (PDF) which include all developed nations except the United
States and Australia. The overall objective of the treaty is to reduce
Greenhouse Gas emissions in developed countries 5.2% relative to 1990 levels by
2012. However, individual countries have different goals, ranging from an 8%
decrease in emissions in the European Union to a 10% increase in Iceland. These
goals are designed to be implemented through a major multinational cap-and-trade
scheme that includes all signatory nations.

How does it work?

There are four mechanisms through which the Kyoto Protocol attempts to meet these goals:

1) International Emissions Trading

This system allows countries that cannot meet their own emissions goals to
purchase additional credits (called Assigned Amount Units or AAUs) from other
countries that have been able to exceed their own goals. Systems have emerged
among countries to facilitate this type of trading, the largest of which is the
European Emissions Trading System (EU ETS). The EU ETS began on January 1,
2005 and has a two-phased system. The first phase, which ends December 31, 2007,
has come under fire for providing too many credits to its members. As a
result, prices for credits have been exceedingly low and the targeted emissions
reductions have not been reached. Phase two will run from 2008-2012 with new
allocations of credits and more stringent caps on emissions. For more
information on current carbon prices under EU ETS as well as the latest news on
carbon markets, I highly recommend Point Carbon .

2) Domestic Emissions Trading

A number of countries have either implemented or considered introducing
their own regional cap-and-trade schemes. These systems allow states, regions,
or businesses within a country to trade emissions credits with each other in
order to achieve the country-wide emissions goal. A major problem with these
schemes is that they often introduce their own units for carbon credits, with
their own elements and requirements. As such, there is often little coherence
between international trading schemes and domestic trading schemes. There needs
to be a single standard and unit for carbon credits. A global market would allow
for more gains from trade and would lead to better success for the Kyoto Protocol.

3) Clean Development Mechanism (CDM)

As I explained in Part one of this post series, the goal of a cap-and-trade
scheme is to reduce global emissions with little regard for their origin. Based
on this concept, the Kyoto Protocol allows developed countries to offset their
excess emissions by reducing emissions in developing countries, where such
projects may be more cost-effective (read: inexpensive). Rather than, or in
addition to, trading credits with other developed nations, some countries elect
to finance emission reduction projects in developing countries through the CDM.
Projects in the CDM must go through a complicated and relatively expensive
approval process before being accepted as a qualified emissions reduction
projects. There are currently 55 countries participating in the CDM with
hundreds of project types.

4) Joint Implementation (JI)

The Joint Implementation mechanism is often grouped with CDM because it is a
very similar system. The major difference is that the countries in which
projects can be built under the JI are primarily in the Eastern Bloc . This is
separate from the CDM because these countries are generally considered
developed, but fit within their own category.

Has it been successful?

There is a lot of debate over the effectiveness thus far of the Kyoto Protocol.
Detractors have a number of complaints. Their strongest complaint, in my
opinion, is that the EU ETS handed out far too many allowances (called EU
Allocations or EUAs), and in doing so flooded the market with credits and
drastically reduced the need to reduce emissions. In addition, critics note
that Kyoto extends only through 2012, not nearly long enough to achieve the
sustained reductions necessary for mitigating the climate change crisis.
Finally, it is widely believed that many countries will not meet their stated
emissions targets by the end of the 2008-2012 cycle. Most proponents of Kyoto
acknowledge these flaws, but view the Protocol as a stepping stone to a
better, more effective international cap-and-trade scheme.

Personally, I am inclined to believe that despite Kyoto's (significant) flaws,
it is a major step in the right direction. It is important to keep in mind that
the Kyoto Protocol introduced by far the largest cap-and-trade scheme ever, and
we are still in the very beginning stages of its implementation. I am hopeful
that it will extend beyond 2012, and as regulators, countries, and industry
alike become comfortable under the system, carbon prices will stabilize and
significant emissions reductions will take place. However, without the United
States as a signatory and with significant barriers to other countries'
emissions reductions, we should not rely on the Kyoto Protocol as a panacea to
climate change.

But I want to hear your opinions. Based on what you know about the Kyoto
Protocol, what do you think? Is it worth pursuing as a long-term strategy, or
should it be scrapped as a failed policy after 2012?


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