Kyoto and Carbon Trading

The vast majority of the international scientific community is now united in accepting global warming as fact. Various human activities - notably the burning of fossil fuels - have led to excessive warming of the atmosphere by releasing into it large amounts of so-called greenhouse gases, the most important of which is CO₂. The build up of these gases causes the 'greenhouse effect' - through trapping heat in the atmosphere in much the same way as heat is trapped in a greenhouse.

The main source of these greenhouse-gas emissions is energy production. Burning coal, oil and natural gas accounts for roughly 80% of all greenhouse-gas emissions. What is less well known is that the second largest source of greenhouse-gas emissions is deforestation. When forests are cleared for agriculture or development, most of the carbon in the burned or decomposing trees escapes into the atmosphere as CO₂. It is estimated that 3-9 billion tonnes of CO₂ are released in this way every year. Reforestation, however, can have the opposite effect, because growing trees absorb CO₂.

Models predict that average global temperatures may rise by up to 5.8°C by 2100, with dramatic consequences. Melting ice-sheets and glaciers mean that the mean sea level is expected to rise by up to 88cm, causing low-lying areas to flood. Some scientists also attribute the increase in extreme weather conditions - storms, floods, droughts - to global warming.

The international community is confronting this situation through the United Nations Framework Convention on Climate Change, adopted in 1992, and which now includes 185 Members. The set of agreements that it brokered are known as the Kyoto Protocol.

The Kyoto Protocol

Key amongst the various achievements of the Kyoto Protocol was to establish a set of legally binding greenhouse-gas emission quotas that were accepted by most industrialised countries. The Kyoto Protocol requires member countries to reduce their collective emissions to 5.2% below their 1990 levels throughout the first commitment period of 2008 to 2012.

What did Kyoto Agree?

Crucially, Kyoto permitted the establishment of a market-based system for trading carbon allowances, or 'Certified Emission Reductions' (CERs). Carbon trading allows polluting companies to meet their targets by buying carbon emission allowances from other companies, which have not used up their allowance, or carbon credits generated by emissions-reducing projects. In particular, Kyoto agreed the following:

• Specified legally binding emissions targets for industrialised countries to reduce collective CO₂ emissions to 5.2% below 1990 levels throughout the commitment period 2008 to 2012
• Specified subsequent 5-year commitment periods for which further reductions will be agreed
• Defined an international market-based trading system whereby carbon emissions allowances and credits may be bought and sold
• Approved an accreditation system whereby carbon credits may be issued in non-industrialised countries under the Clean Development Mechanism (CDM) or in industrialised countries under the Joint Implementation Mechanism (JI)
• Designated CO₂ as the standard trading unit, assigning a 'global warming potential' to each of the five non-CO₂ greenhouse gases (methane, nitrous oxide, sulphur hexafluoride, hydrofluorocarbons and perfluorocarbons) measured in 'tonnes of CO₂ equivalent'
• Promotion of inter-governmental co-operation, improved energy efficiency, reform of energy and transport policies, renewable energy and managed carbon sinks such as forests and grazing lands

The Clean Development Mechanism

The aim of the Clean Development Mechanism is to help non-industialised countries to develop sustainably in a way that contributes to the goals established by the Climate Change Convention.

The CDM Executive Board is responsible for validating projects in developing countries that will result in the generation of CERs. These projects can involve private or public entities and must have measurable and long-term effects on the host country's net carbon balance.

Reforestation, Sustainability and Biodiversity

It is known that forests play an important role in the world's CO₂ balance. Forests contain vast quantities of carbon. Some forests act as sinks by absorbing CO₂ from the air, while others whose carbon flows are in balance act as reservoirs. Deforestation and changes in land-use currently make the world's forests a net source of CO₂. But when areas are reforested and managed sustainably, they can start to absorb significant amounts of CO₂ both in the trees and the soil.

Reforestation under the CDM

Reforestation and afforestation projects can both qualify under the CDM. However, projects must be in line with the host country's sustainable-development objectives and must also promote the preservation of biodiversity.

For development to be sustainable in the long term, it must take place within a framework that does not focus solely on short-term financial returns, but also addresses wider economic, social and environmental issues.

For a reforestation project to qualify under the CDM it would typically be required to address issues such as the following:

• the re-establishment of natural biodiversity, so as to provide an environment where the natural flora and fauna of the region can thrive. This requires that over much of the area to be reforested, a range of indigenous trees and other plants must be established and grown in such a way that they would provide the natural habitat, cover and corridors that would promote the re-establishment of the indigenous fauna within the area;
• the provision of wood-fuel and construction timber to support the needs of the indigenous peoples of the area, thus reducing pressures on deforestation and timber collection and to contribute to meeting the country's internal and export needs. This may require that in any reforestation scheme, a certain area of commercial woodlots is set aside in which non-indigenous, fast-growing trees may be planted, managed and harvested in a sustainable manner;
• the ongoing management and protection of the reforested area, to prevent its subsequent deforestation or destruction;
• the creation of local sustainable industry such as agriculture and eco-tourism;
• the selection of areas for reforestation in line with the country's development and environmental protection plans.

In recent years large-scale reforestation projects have often attracted criticism, because they have not taken into account the wider sustainable-development and biodiversity requirements of the areas concerned. For example, in Brazil, there has been criticism of projects that have focused on planting monocultures of eucalyptus, which while providing timber and fuel, have done little to help support the country's natural biodiversity.

Evidence for the Value of Reforestation

While it has been accepted that reforestation will qualify under the CDM for carbon credits, no reforestation projects have been certified by October 2005.

By the summer of 2005, eleven reforestation and afforestation baseline and monitoring methodologies had been submitted to the CDM Executive Board. Of these, five had been rejected, four were to be assessed and two were returned to their proponents for further clarification. In consequence, there is still uncertainty around the methodologies that should be used for calculating and validating the carbon sequestration achieved by such projects, thus necessitating further research.

The type of trees grown and the planting density used heavily influence net carbon sequestration. The Intergovernmental Panel on Climate Change estimates sequestration rates for commercial plantations of 240 to 360 tonnes of CO₂ per acre over a project life. In tropical areas such as Brazil, various studies indicate 440-530 tonnes of CO₂ per acre may be sequestered.

The crediting period for a project is the period in which it is allowed to qualify for CERs under the CDM. Developers of reforestation projects may choose to apply for a crediting period of 30 years, or for a crediting period of 20 years with the option to renew twice, giving a maximum total crediting period of 60 years.

CERs generated by reforestation projects will be ‘long term’ CERs (lCERs), which are a variant of the 'normal' CERs that will be generated by other projects. Whereas a normal CER is valid for compliance under the Kyoto Protocol in perpetuity, lCERs expire at the end of the last crediting period and must be replaced. For example, if a project has a total crediting period of 60 years, then all lCERs from that project will expire at the end of the 60 years, irrespective of when they were generated.

An lCER may have less value than a CER, first because it expires, and second because it is not currently accepted under the EU Emissions Trading Scheme (although this is scheduled for review in 2006). It is widely accepted that predicting the exact value of an lCER is difficult. However, it is estimated that an lCER generated by a project with a 60-year lifetime would have a value equivalent to around 70% of that of a ‘normal’ CER generated by a project in the same time frame1.

Carbon Trading

The trading of CO₂ and other greenhouse-gas emissions has existed for several years. The greenhouse-gas emissions market is developing rapidly and analysts forecast that by 2010 the overall market could be worth upwards of US$10 billion a year.

The largest market by far is the the EU Emissions Trading Scheme (EU ETS) which opened in January 2005.

The EU ETS covers 11,500 industrial installations across sectors that include oil refining, power generation, pulp and paper manufacturing and cement production. All European Union companies in certain energy-intensive sectors must monitor and comply with allocated emission quotas.

Each EU country is given a national allocation of CO₂ emissions and that country then allocates emission allowances to companies in the relevant industry sectors. The companies must annually surrender sufficient emissions allowances and carbon credits to equate to the amount of CO₂ units that they have emitted in that year. Any shortfall can be covered by purchases of emissions allowances or credits on the open market. If the companies don't submit sufficient emission allowances or credits they will be fined (at a rate of €40 per tonne, rising to €100 per tonne in 2008).

Under the provisions of the EU ETS, CERs can be traded and used fully interchangeably with emissions allowances, hence the price of emissions allowances is a proxy for the likely value of CERs.

In the first eight months of trading, EU allowance prices rose from around €8 per tonne to a peak of €30 per tonne before settling back to around €22 per tonne by the end of August. Traded volumes averaged 8.5 million tonnes a month. The graph below illustrates the price of emissions traded under the EU ETS.

Outside the EU ETS there are a number of other carbon emission trading schemes, including programmes in countries that have not signed up to the Kyoto Protocol. For example, in both the US and Australia, certain individual state governments are introducing legislation that places binding constraints on greenhouse-gas emissions, despite the lack of action at a national level.

The EU Emissions Trading Scheme

CO2 and other greenhouse-gas emissions have been traded for several years but volumes have increased substantially as a result of the launch of the EU Emissions Trading Scheme (EU ETS) in 2005. PointCarbon, a leading commentator, estimates that transactions across all sectors of the global carbon market exceeded €22 billion in 2006 alone.

The largest sector of the market by far is the EU ETS which opened in January 2005 and covers all 25 EU member states.  Almost 65% of all carbon trading volumes worldwide fall within the EU ETS. The first phase of the Scheme runs from 2005 to the end of 2007. The second phase coincides with the first Kyoto commitment period, from 2008 to 2012. The EU ETS is being closely monitored by governments around the world as the leading example of an attempt to use market forces to tackle environmental problems.

The EU ETS covers 12,000 industrial installations in a range of energy-intensive sectors that include oil refining, power generation, pulp and paper manufacturing and cement production. Around 45% of all EU greenhouse emissions are covered by the Scheme.

All European Union companies in these sectors must monitor their emissions and ensure that they keep emissions within allocated quotas. Each EU country negotiates a National Allocation Plan of greenhouse-gas emissions and then allocates EU Emission Allowances to companies in the relevant industry sectors. A European Union Allowance (EUA) represents one tonne CO₂ equivalent (CO₂ e).  Companies must surrender sufficient allowances to equate to the number of units of CO₂e that they have emitted that year. Any shortfall can be covered by purchases of allowances on the open market. If a company doesn't submit sufficient allowances it will be fined at a rate of €40 per tonne (rising to €100 per tonne in 2008) and will also be required to meet the shortfall.

Under the provisions of the EU ETS carbon credits including Certified Emission Reductions (CERs), created from emission reduction projects in developing countries, can be traded and used fully interchangeably with EUAs. At present, CERs generated from forestry are not eligible for trading within the EU ETS, although there is considerable political lobbying for such credits to be included.

Trading in the EU ETS has grown strongly with Phase II EUAs (i.e. 2008 to 2012) trading at around €15 in early 2007. The market weathered a setback in April 2006, when the price of a EUA for delivery in the first phase of the Scheme (2005 to 2007) fell overnight from €31 to €9 and then slowly declined to less than €4 by early 2007. The collapse in price was precipitated by a succession of announcements from member countries stating that greenhouse-gas emissions were lower than projected leading to a surplus of EUAs for the first phase of the EU ETS.

The long-term outlook for emission allowance pricing ultimately depends on the commitment of governments to tackling climate change through market based mechanisms, such as the EU ETS. The tighter the national allocations of greenhouse gas emissions, the more upward pressure there is on prices. This is, of course, countered by the supply of allowances from companies that have achieved emission reductions and from qualifying projects that create carbon credits such as CERs.

EU ETS Price Trading History

Further Information

UN Climate Change Secretariat (UNFCCC):
www.unfccc.int

United Nations Department of Economic and Social Affairs (DESA):
www.un.org/esa/

United Nations Development Programme (UNDP):
www.undp.org

United Nations Environment Programme (UNEP):
www.unep.ch

World Meteorological Organisation (WMO):
www.wmo.ch