Carbon credits are a tradable permit scheme. They provide a way to reduce greenhouse gas emissions by giving them a monetary value. A credit gives the owner the right to emit one tonne of carbon dioxide.
International treaties such as the Kyoto Protocol set quotas on the amount of greenhouse gases countries can produce. Countries, in turn, set quotas on the emissions of businesses. Businesses that are over their quotas must buy carbon credits for their excess emissions, while businesses that are below their quotas can sell their remaining credits. By allowing credits to be bought and sold, a business for which reducing its emissions would be expensive or prohibitive can pay another business to make the reduction for it. This minimizes the quota's impact on the business, while still reaching the quota.
Credits can be exchanged between businesses or bought and sold in international markets at the prevailing market price. There are currently two exchanges for carbon credits: the Chicago Climate Exchange and the European Climate Exchange.
In addition to the burning of fossil fuels, major industry sources of greenhouse gas emissions are cement, steel, textile, and fertilizer manufacturers. The main gases emitted by these industries are methane, nitrous oxide, hydroflurocarbons, etc, which increase the atmosphere's ability to trap infrared energy.
The concept of carbon credits came into existence as a result of increasing awareness of the need for pollution control. It was formalized in the Kyoto Protocol, an international agreement between 169 countries. Carbon credits are certificates awarded to countries that are successful in reducing emissions of greenhouse gases.
For trading purposes, one credit is considered equivalent to one tonne of CO2 emissions. Such a credit can be sold in the international market at the prevailing market price.
How buying carbon credits attempts to reduce emissions?
Carbon credits create a market for reducing greenhouse emissions by giving a monetary value to the cost of polluting the air. This means that carbon becomes a cost of business and is seen like other inputs such as raw materials or labor.
By way of example, assume a factory produces 100,000 tonnes of greenhouse emissions in a year. The government then enacts a law that limits the maximum emissions a business can have. So the factory is given a quota of say 80,000 tonnes. The factory either reduces its emissions to 80,000 tonnes or is required to purchase carbon credits to offset the excess.
A business would buy the carbon credits on an open market from organisations that have been approved as being able to sell legitimate carbon credits. One seller might be a company that will plant so many trees for every carbon credit you buy from them. So, for this factory it might pollute a tonne, but is essentially now paying another group to go out and plant trees, which will, say, draw a tonne of carbon dioxide from the atmosphere.
As emission levels are predicted to keep rising over time, it is envisioned that the number of companies wanting to buy more credits will increase, which will push the market price up and encourage more groups to undertake environmentally friendly activities that create for them carbon credits to sell. Another model is that companies that use below their quota can sell their excess as 'carbon credits.'
The possibilities are endless; hence making it an open market.
The Kyoto Protocol provides for three mechanisms that enable developed countries with quantified emission limitation and reduction commitments to acquire greenhouse gas reduction credits. These mechanisms are Joint Implementation (JI), Clean Development Mechanism and International Emission Trading.
Under JI, a developed country with relatively high costs of domestic greenhouse reduction would set up a project in another developed country that has a relatively low cost. Under CDM, a developed country can take up a greenhouse gas reduction project activity in a developing country where the cost of greenhouse gas reduction project activities is usually much lower. The developed country would be given credits for meeting its emission reduction targets, while the developing country would receive the capital and clean technology to implement the project. Under IET, countries can trade in the international carbon credit market.
There are currently several trading systems in place with the largest being the European Union's. The carbon market makes up the bulk of these and is growing in popularity. Many businesses have welcomed emissions trading as the best way to mitigate climate change. Enforcement of the caps is a problem, but unlike traditional regulation, emissions trading markets can be easier to enforce because the government overseeing the market does not need to regulate specific practices of each pollution source. However, monitoring (or estimating) and verifying of actual emissions is still required, which can be costly.
Critics doubt whether these trading schemes can work as there may be too many credits given by the government, such as in the first phase of the European Union's scheme. Once a large surplus was discovered the price for credits bottomed out and effectively collapsed, with no noticeable reduction of emissions.
Perhaps the most successful emission trading system to date is the SO2 trading system under the framework of the Acid Rain Program of the 1990 Clean Air Act in the United States. Under the program, which are essentially cap-and-trade emissions trading system, SO2 emissions are expected to be reduced by 50% from 1980 to 2010.
The European Union Emission Trading Scheme is the largest multi-national, greenhouse gas emissions trading scheme in the world and was created in conjunction with the Kyoto Protocol. It commenced operation in January 2005 with all 27-member states of the European Union participating in it. It contains the world's only mandatory carbon trading program. The program caps the amount of carbon dioxide that can be emitted from large installations, such as power plants and carbon intensive factories and covers almost half of the EU's Carbon Dioxide emissions.
Critics argue that emissions trading does little to solve pollution problems overall, as groups that do not pollute sell their conservation to the highest bidder. Overall reductions would need to come from a sufficient and challenging reduction of allowances available in the system.
Critics of carbon trading, such as Carbon Trade Watch argue that it places disproportionate emphasis on individual lifestyles and carbon footprints, distracting attention from the wider, systemic changes and collective political action that needs to be taken to tackle climate change.
Srinivasan Venkataraghavan is Chief Executive Officer, Altos Advisory Services
