Carbon credit

Carbon credit

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A carbon credit is a generic term for any tradable certificate or permit representing the right to emit one tonne
Tonne
The tonne, known as the metric ton in the US , often put pleonastically as "metric tonne" to avoid confusion with ton, is a metric system unit of mass equal to 1000 kilograms. The tonne is not an International System of Units unit, but is accepted for use with the SI...

 of carbon dioxide or the mass of another greenhouse gas
Greenhouse gas
A greenhouse gas is a gas in an atmosphere that absorbs and emits radiation within the thermal infrared range. This process is the fundamental cause of the greenhouse effect. The primary greenhouse gases in the Earth's atmosphere are water vapor, carbon dioxide, methane, nitrous oxide, and ozone...

 with a carbon dioxide equivalent
Carbon dioxide equivalent
Carbon dioxide equivalent and Equivalent carbon dioxide are two related but distinct measures for describing how much global warming a given type and amount of greenhouse gas may cause, using the functionally equivalent amount or concentration of carbon dioxide as the reference.- Global warming...

 (tCO2e) equivalent to one tonne of carbon dioxide.

Carbon credits and carbon markets are a component of national and international attempts to mitigate the growth in concentrations of greenhouse gas
Greenhouse gas
A greenhouse gas is a gas in an atmosphere that absorbs and emits radiation within the thermal infrared range. This process is the fundamental cause of the greenhouse effect. The primary greenhouse gases in the Earth's atmosphere are water vapor, carbon dioxide, methane, nitrous oxide, and ozone...

es (GHGs). One carbon credit is equal to one metric tonne of carbon dioxide, or in some markets, carbon dioxide equivalent gases. Carbon trading is an application of an emissions trading
Emissions trading
Emissions trading is a market-based approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants....

 approach. Greenhouse gas emissions are capped and then markets are used to allocate the emissions among the group of regulated sources.

The goal is to allow market mechanisms to drive industrial and commercial processes in the direction of low emissions or less carbon intensive approaches than those used when there is no cost to emitting carbon dioxide
Carbon dioxide
Carbon dioxide is a naturally occurring chemical compound composed of two oxygen atoms covalently bonded to a single carbon atom...

 and other GHGs into the atmosphere. Since GHG mitigation projects generate credits, this approach can be used to finance carbon reduction schemes
Carbon project
A carbon project refers to a business initiative that receives funding because of the cut the emission of greenhouse gases that will result...

 between trading partners and around the world.

There are also many companies that sell carbon credits to commercial and individual customers who are interested in lowering their carbon footprint
Carbon footprint
A carbon footprint has historically been defined as "the total set of greenhouse gas emissions caused by an organization, event, product or person.". However, calculating a carbon footprint which conforms to this definition is often impracticable due to the large amount of data required, which is...

 on a voluntary basis. These carbon offset
Carbon offset
A carbon offset is a reduction in emissions of carbon dioxide or greenhouse gases made in order to compensate for or to offset an emission made elsewhere....

ters purchase the credits from an investment fund or a carbon development company that has aggregated the credits from individual projects. Buyers and sellers can also use an exchange platform to trade, such as the Carbon Trade Exchange, which is like a stock exchange for carbon credits. 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
Carbon project
A carbon project refers to a business initiative that receives funding because of the cut the emission of greenhouse gases that will result...

. This is reflected in their price; voluntary units typically have less value than the units sold through the rigorously validated Clean Development Mechanism
Clean Development Mechanism
The Clean Development Mechanism is one of the "flexibility" mechanisms defined in the Kyoto Protocol . It is defined in Article 12 of the Protocol, and is intended to meet two objectives: to assist parties not included in Annex I in achieving sustainable development and in contributing to the...

.

Definitions


The Collins English Dictionary defines a carbon credit as “a certificate showing that a government or company has paid to have a certain amount of carbon dioxide removed from the environment”.

The Environment Protection Authority of Victoria defines a carbon credit as a “generic term to assign a value to a reduction or offset of greenhouse gas emissions.. usually equivalent to one tonne of carbon dioxide equivalent (CO2-e).

The Investopedia Inc investment dictionary defines a carbon credit as a “permit that allows the holder to emit one ton of carbon dioxide”..which “can be traded in the international market at their current market price”.

Background


Burning of fossil fuels is a major source of industrial greenhouse gas
Greenhouse gas
A greenhouse gas is a gas in an atmosphere that absorbs and emits radiation within the thermal infrared range. This process is the fundamental cause of the greenhouse effect. The primary greenhouse gases in the Earth's atmosphere are water vapor, carbon dioxide, methane, nitrous oxide, and ozone...

 emissions, especially for power, cement, steel, textile, fertilizer and many other industries which rely on fossil fuels (coal, electricity derived from coal, natural gas and oil). The major greenhouse gases emitted by these industries are carbon dioxide
Carbon dioxide
Carbon dioxide is a naturally occurring chemical compound composed of two oxygen atoms covalently bonded to a single carbon atom...

, methane
Methane
Methane is a chemical compound with the chemical formula . It is the simplest alkane, the principal component of natural gas, and probably the most abundant organic compound on earth. The relative abundance of methane makes it an attractive fuel...

, nitrous oxide
Nitrous oxide
Nitrous oxide, commonly known as laughing gas or sweet air, is a chemical compound with the formula . It is an oxide of nitrogen. At room temperature, it is a colorless non-flammable gas, with a slightly sweet odor and taste. It is used in surgery and dentistry for its anesthetic and analgesic...

, hydrofluorocarbons (HFCs), etc., all of which increase the atmosphere's ability to trap infrared energy and thus affect the climate
Climate change
Climate change is a significant and lasting change in the statistical distribution of weather patterns over periods ranging from decades to millions of years. It may be a change in average weather conditions or the distribution of events around that average...

.

The concept of carbon credits came into existence as a result of increasing awareness of the need for controlling emissions. The IPCC (Intergovernmental Panel on Climate Change) has observed
that:
Policies that provide a real or implicit price of carbon could create incentives for producers and consumers to significantly invest in low-GHG products, technologies and processes. Such policies could include economic instruments, government funding and regulation,

while noting that a tradable permit system is one of the policy instruments that has been shown to be environmentally effective in the industrial sector, as long as there are reasonable levels of predictability over the initial allocation mechanism and long-term price.

The mechanism was formalized in the Kyoto Protocol
Kyoto Protocol
The Kyoto Protocol is a protocol to the United Nations Framework Convention on Climate Change , aimed at fighting global warming...

, an international agreement between more than 170 countries, and the market mechanisms were agreed through the subsequent Marrakesh Accords.
The mechanism adopted was similar to the successful US Acid Rain Program
Acid Rain Program
The Acid Rain Program is a market-based initiative taken by the United States Environmental Protection Agency in an effort to reduce overall atmospheric levels of sulfur dioxide and nitrogen oxides, which cause acid rain...

 to reduce some industrial pollutants.

Emission allowances


Under the Kyoto Protocol
Kyoto Protocol
The Kyoto Protocol is a protocol to the United Nations Framework Convention on Climate Change , aimed at fighting global warming...

, the 'caps' or quotas for Greenhouse gases for the developed Annex 1 countries are known as Assigned Amounts and are listed in Annex B. The quantity of the initial assigned amount is denominated in individual units, called Assigned amount units
Assigned amount units
An Assigned Amount Unit is a tradable 'Kyoto unit' or 'carbon credit' representing an allowance to emit greenhouse gases comprising one metric tonne of carbon dioxide equivalents calculated using their Global Warming Potential....

 (AAUs), each of which represents an allowance to emit one metric tonne of carbon dioxide equivalent, and these are entered into the country's national registry.

In turn, these countries set quotas on the emissions of installations run by local business and other organizations, generically termed 'operators'. Countries manage this through their national registries, which are required to be validated and monitored for compliance by the UNFCCC. Each operator has an allowance of credits, where each unit gives the owner the right to emit one metric tonne of carbon dioxide
Carbon dioxide
Carbon dioxide is a naturally occurring chemical compound composed of two oxygen atoms covalently bonded to a single carbon atom...

 or other equivalent greenhouse gas
Greenhouse gas
A greenhouse gas is a gas in an atmosphere that absorbs and emits radiation within the thermal infrared range. This process is the fundamental cause of the greenhouse effect. The primary greenhouse gases in the Earth's atmosphere are water vapor, carbon dioxide, methane, nitrous oxide, and ozone...

. Operators that have not used up their quotas can sell their unused allowances as carbon credits, while businesses that are about to exceed their quotas can buy the extra allowances as credits, privately or on the open market.
As demand for energy grows over time, the total emissions must still stay within the cap, but it allows industry some flexibility and predictability in its planning to accommodate this.

By permitting allowances to be bought and sold, an operator can seek out the most cost-effective way of reducing its emissions, either by investing in 'cleaner' machinery and practices or by purchasing emissions from another operator who already has excess 'capacity'.

Since 2005, the Kyoto mechanism has been adopted for CO2 trading by all the countries within the European Union
European Union
The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...

 under its European Trading Scheme
European Union Emission Trading Scheme
The European Union Emissions Trading Scheme also known as the European Union Emissions Trading System, was the first large emissions trading scheme in the world. It was launched in 2005 to combat climate change and is a major pillar of EU climate policy...

 (EU ETS) with the European Commission
European Commission
The European Commission is the executive body of the European Union. The body is responsible for proposing legislation, implementing decisions, upholding the Union's treaties and the general day-to-day running of the Union....

 as its validating authority. From 2008, EU participants must link with the other developed countries who ratified
Ratification
Ratification is a principal's approval of an act of its agent where the agent lacked authority to legally bind the principal. The term applies to private contract law, international treaties, and constitutionals in federations such as the United States and Canada.- Private law :In contract law, the...

 Annex I of the protocol, and trade the six most significant anthropogenic greenhouse gases. In the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...

, which has not ratified Kyoto, and Australia
Australia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...

, whose ratification came into force in March 2008, similar schemes are being considered.

Kyoto's 'Flexible mechanisms'


A tradable credit can be an emissions allowance or an assigned amount unit
Assigned amount units
An Assigned Amount Unit is a tradable 'Kyoto unit' or 'carbon credit' representing an allowance to emit greenhouse gases comprising one metric tonne of carbon dioxide equivalents calculated using their Global Warming Potential....

 which was originally allocated or auctioned by the national administrators of a Kyoto-compliant cap-and-trade scheme, or it can be an offset
Carbon offset
A carbon offset is a reduction in emissions of carbon dioxide or greenhouse gases made in order to compensate for or to offset an emission made elsewhere....

 of emissions. Such offsetting and mitigating activities can occur in any developing country which has ratified the Kyoto Protocol, and has a national agreement in place to validate its carbon project
Carbon project
A carbon project refers to a business initiative that receives funding because of the cut the emission of greenhouse gases that will result...

 through one of the UNFCCC's approved mechanisms. Once approved, these units are termed Certified Emission Reduction
Certified Emission Reduction
Certified Emission Reductions are a type of emissions unit issued by the Clean Development Mechanism Executive Board for emission reductions achieved by CDM projects and verified by a DOE under the rules of the Kyoto Protocol...

s, or CERs. The Protocol allows these projects to be constructed and credited in advance of the Kyoto trading period.

The Kyoto Protocol provides for three mechanisms that enable countries or operators in developed countries to acquire greenhouse gas reduction credits
  • Under Joint Implementation
    Joint Implementation
    Joint implementation is one of three flexibility mechanisms set forth in the Kyoto Protocol to help countries with binding greenhouse gas emissions targets meet their obligations. JI is set forth in Article 6 of the Kyoto Protocol...

     (JI) a developed country with relatively high costs of domestic greenhouse reduction would set up a project in another developed country.
  • Under the Clean Development Mechanism
    Clean Development Mechanism
    The Clean Development Mechanism is one of the "flexibility" mechanisms defined in the Kyoto Protocol . It is defined in Article 12 of the Protocol, and is intended to meet two objectives: to assist parties not included in Annex I in achieving sustainable development and in contributing to the...

     (CDM) a developed country can 'sponsor' a greenhouse gas reduction project in a developing country where the cost of greenhouse gas reduction project activities is usually much lower, but the atmospheric effect is globally equivalent. The developed country would be given credits for meeting its emission reduction targets, while the developing country would receive the capital investment and clean technology
    Clean technology
    Clean technology includes recycling, renewable energy , information technology, green transportation, electric motors, green chemistry, lighting, Greywater, and many other appliances that are now more energy efficient. It is a means to create electricity and fuels, with a smaller environmental...

     or beneficial change in land use
    Land Use, Land-Use Change and Forestry
    Land use, land-use change and forestry is defined by the United Nations Climate Change Secretariat as "A greenhouse gas inventory sector that covers emissions and removals of greenhouse gases resulting from direct human-induced land use, land-use change and forestry activities."LULUCF has impacts...

    .
  • Under International Emissions Trading
    Emissions trading
    Emissions trading is a market-based approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants....

     (IET) countries can trade in the international carbon credit market to cover their shortfall in Assigned amount units
    Assigned amount units
    An Assigned Amount Unit is a tradable 'Kyoto unit' or 'carbon credit' representing an allowance to emit greenhouse gases comprising one metric tonne of carbon dioxide equivalents calculated using their Global Warming Potential....

    . Countries with surplus units can sell them to countries that are exceeding their emission targets under Annex B of the Kyoto Protocol.


These carbon project
Carbon project
A carbon project refers to a business initiative that receives funding because of the cut the emission of greenhouse gases that will result...

s can be created by a national government or by an operator within the country.
In reality, most of the transactions are not performed by national governments directly, but by operators who have been set quotas by their country.

Emission markets


For trading purposes, one allowance or CER is considered equivalent to one metric ton of CO2 emissions. These allowances can be sold privately or in the international market at the prevailing market price. These trade and settle
Settlement (finance)
Settlement of securities is a business process whereby securities or interests in securities are delivered, usually against payment of money, to fulfill contractual obligations, such as those arising under securities trades....

 internationally and hence allow allowances to be transferred between countries. Each international transfer is validated by the UNFCCC. Each transfer of ownership within the European Union is additionally validated by the European Commission.

Climate exchanges have been established to provide a spot market
Spot market
The spot market or cash market is a public financial market, in which financial instruments or commodities are traded for immediate delivery. It contrasts with a futures market in which delivery is due at a later date...

 in allowances, as well as futures and options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...

 market
Futures exchange
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of...

 to help discover a market price and maintain liquidity
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...

. Carbon prices are normally quoted in Euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...

s per tonne of carbon dioxide or its equivalent (CO2e). Other greenhouse gasses can also be traded, but are quoted as standard multiples of carbon dioxide with respect to their global warming potential
Global warming potential
Global-warming potential is a relative measure of how much heat a greenhouse gas traps in the atmosphere. It compares the amount of heat trapped by a certain mass of the gas in question to the amount of heat trapped by a similar mass of carbon dioxide. A GWP is calculated over a specific time...

. These features reduce the quota's financial impact on business, while ensuring that the quotas are met at a national and international level.

Currently there are six exchanges trading in carbon allowances: the Chicago Climate Exchange
Chicago Climate Exchange
The now defunct Chicago Climate Exchange was North America’s only voluntary, legally binding greenhouse gas reduction and trading system for emission sources and offset projects in North America and Brazil....

, European Climate Exchange
European Climate Exchange
The European Climate Exchange manages the product development and marketing for ECX Carbon Financial Instruments , listed and admitted for trading on the ICE Futures Europe electronic platform. It is no longer a subsidiary of the Chicago Climate Exchange but rather a sister company...

, NASDAQ OMX Commodities Europe, PowerNext
Powernext
Powernext is a regulated investment firm based in Paris and operating under the multilateral trading facility status. Powernext designs and operates electronic trading platforms for spot and derivatives markets in the European energy sector...

, Commodity Exchange Bratislava and the European Energy Exchange
European Energy eXchange
European Energy Exchange AG, Germany's energy exchange, is the leading energy exchange in Central Europe.-Overview:The European Energy Exchange is located in Leipzig. Preceding companies were LPX Leipzig Power Exchange, located in Leipzig and European Energy Exchange, located in Frankfurt...

. NASDAQ OMX Commodities Europe listed a contract to trade offsets generated by a CDM carbon project
Carbon project
A carbon project refers to a business initiative that receives funding because of the cut the emission of greenhouse gases that will result...

 called Certified Emission Reductions (CERs). Many companies now engage in emissions abatement, offsetting, and sequestration programs to generate credits that can be sold on one of the exchanges. At least one private electronic market
Private electronic market
A private electronic market uses the Internet to connect a limited number or pre-qualified buyers or sellers in one market. PEMs are a hybrid between perfectly open markets A private electronic market (PEM) uses the Internet to connect a limited number or pre-qualified buyers or sellers in one...

 has been established in 2008: CantorCO2e. Carbon credits at Commodity Exchange Bratislava are traded at special platform - Carbon place.

Managing emissions is one of the fastest-growing segments in financial services in the City of London
City of London
The City of London is a small area within Greater London, England. It is the historic core of London around which the modern conurbation grew and has held city status since time immemorial. The City’s boundaries have remained almost unchanged since the Middle Ages, and it is now only a tiny part of...

 with a market estimated to be worth about €30 billion in 2007. Louis Redshaw, head of environmental markets at Barclays Capital
Barclays Capital
Barclays Capital is a global British investment bank. It is the investment banking division of Barclays plc which has a balance sheet of over £1.2 trillion . Barclays Capital provides financing and risk management services to large companies, institutions and government clients. It is a primary...

 predicts that "Carbon will be the world's biggest commodity market, and it could become the world's biggest market overall."

Setting a market price for carbon



Unchecked, energy use and hence emission levels are predicted to keep rising over time. Thus the number of companies needing to buy credits will increase, and the rules of supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

 will push up the market price
Elasticity (economics)
In economics, elasticity is the measurement of how changing one economic variable affects others. For example:* "If I lower the price of my product, how much more will I sell?"* "If I raise the price, how much less will I sell?"...

, encouraging more groups to undertake environmentally friendly activities that create carbon credits to sell.

An individual allowance, such as an Assigned amount unit
Assigned amount units
An Assigned Amount Unit is a tradable 'Kyoto unit' or 'carbon credit' representing an allowance to emit greenhouse gases comprising one metric tonne of carbon dioxide equivalents calculated using their Global Warming Potential....

 (AAU) or its near-equivalent European Union Allowance (EUA), may have a different market value to an offset such as a CER. This is due to the lack of a developed secondary market for CERs, a lack of homogeneity between projects which causes difficulty in pricing, as well as questions due to the principle of supplementarity
Supplementarity
"Supplementarity", also referred to as "the supplementary principle", is one of the main principles of the Kyoto Protocol. The concept is that internal abatement of emissions should take precedent before external participation in flexible mechanisms...

 and its lifetime. Additionally, offsets generated by a carbon project
Carbon project
A carbon project refers to a business initiative that receives funding because of the cut the emission of greenhouse gases that will result...

 under the Clean Development Mechanism are potentially limited in value because operators in the EU ETS are restricted as to what percentage of their allowance can be met through these flexible mechanisms.

Yale University economics professor William Nordhaus
William Nordhaus
William Dawbney "Bill" Nordhaus is the Sterling Professor of Economics at Yale University. Nordhaus lives in New Haven, Connecticut, with his wife Barbara.-Career:...

 argues that the price of carbon needs to be high enough to motivate the changes in behavior and changes in economic production systems necessary to effectively limit emissions of greenhouse gases.

Raising the price of carbon will achieve four goals. First, it will provide signals to consumers about what goods and services are high-carbon ones and should therefore be used more sparingly. Second, it will provide signals to producers about which inputs use more carbon (such as coal and oil) and which use less or none (such as natural gas or nuclear power), thereby inducing firms to substitute low-carbon inputs. Third, it will give market incentives for inventors and
innovators to develop and introduce low-carbon products and processes that can replace the current generation of technologies. Fourth, and most important, a high carbon price will economize on the information that is required to do all three of these tasks. Through the market mechanism, a high carbon price will raise the price of products according to their carbon content. Ethical consumers today, hoping to minimize their “carbon footprint,” have little chance of making an accurate calculation of the relative carbon use in, say, driving 250 miles as compared with flying 250 miles. A harmonized carbon tax would raise the price of a good proportionately to exactly the amount of CO2 that is emitted in all the stages of production that are involved in producing that good. If 0.01 of a ton of carbon emissions results from the wheat growing and the milling and the trucking and the baking of a loaf of bread, then a tax of $30 per ton carbon will raise the price of bread by $0.30. The “carbon footprint” is automatically calculated by the price system. Consumers would still not know how much of the price is due to carbon emissions, but they could make their decisions confident that they are paying for the social cost of their carbon footprint.

Nordhaus has suggested, based on the social cost of carbon emissions, that an optimal price of carbon is around $30(US) per ton and will need to increase with inflation.

The social cost of carbon is the additional damage caused by an additional ton of carbon emissions. ... The optimal carbon price, or optimal carbon tax, is the market price (or carbon tax) on carbon emissions that balances the incremental costs of reducing carbon emissions with the incremental benefits of reducing climate damages. ... [I]f a country wished to impose a carbon tax of $30 per ton of carbon, this would involve a tax on gasoline of about 9 cents per gallon. Similarly, the tax on coal-generated electricity would be about 1 cent per kWh, or 10 percent of the current retail price. At current levels of carbon emissions in the United States, a tax of $30 per ton of carbon would generate $50 billion of revenue per year.

Carbon credits SPOT trading safety


Exchanges after reports of stolen carbon credits created safety messures to make the SPOT trading safe. Bluenext announced on 13.04.2011 Safe harbour initiative . Commodity Exchange Bratislava opened on March 11th, 2011 the Suspicious carbon credits registry . The SCC Registry is free to use to check the block serials safety. SCC Registry asks emitters to report the stolen credits as soon as possible.

How buying carbon credits can reduce 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
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...

 alongside raw materials and other liabilities or assets.

For 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.

We should consider the impact of manufacturing alternative energy sources. For example, the energy consumed and the Carbon emitted in the manufacture and transportation of a large wind turbine would prohibit a credit being issued for a predetermined period of time.
  • One seller might be a company that will offer to offset emissions
    Carbon offset
    A carbon offset is a reduction in emissions of carbon dioxide or greenhouse gases made in order to compensate for or to offset an emission made elsewhere....

     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.

Credits versus taxes


Carbon credits and carbon taxes each have their advantages and disadvantages. Credits were chosen by the signatories to the Kyoto Protocol as an alternative to Carbon tax
Carbon tax
A carbon tax is an environmental tax levied on the carbon content of fuels. It is a form of carbon pricing. Carbon is present in every hydrocarbon fuel and is released as carbon dioxide when they are burnt. In contrast, non-combustion energy sources—wind, sunlight, hydropower, and nuclear—do not...

es. A criticism of tax-raising schemes is that they are frequently not hypothecated
Hypothecation (taxation)
The hypothecation of a tax is the dedication of the revenue from a specific tax for a particular expenditure purpose. Hypothecation is the pledging of assets....

, and so some or all of the taxation raised by a government would be applied based on what the particular nation's government deems most fitting. However, some would argue that carbon trading is based around creating a lucrative artificial market, and, handled by free market enterprises as it is, carbon trading is not necessarily a focused or easily regulated solution.

By treating emissions as a market commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....

 some proponents insist it becomes easier for businesses to understand and manage their activities, while economists and traders can attempt to predict future pricing using market theories. Thus the main advantages of a tradeable carbon credit over a carbon tax are argued to be:
  • the price may be more likely to be perceived as fair by those paying it. Investors in credits may have more control over their own costs.
  • the flexible mechanisms of the Kyoto Protocol help to ensure that all investment goes into genuine sustainable carbon reduction schemes through an internationally agreed validation process.
  • some proponents state that if correctly implemented a target level of emission reductions may somehow be achieved with more certainty, while under a tax the actual emissions might vary over time.
  • it may provide a framework for rewarding people or companies who plant trees or otherwise meet standards exclusively recognized as "green."


The advantages of a carbon tax are argued to be:
  • possibly less complex, expensive, and time-consuming to implement. This advantage is especially great when applied to markets like gasoline or home heating oil.
  • perhaps some reduced risk of certain types of cheating, though under both credits and taxes, emissions must be verified.
  • reduced incentives for companies to delay efficiency improvements prior to the establishment of the baseline if credits are distributed in proportion to past emissions.
  • when credits are grandfathered, this puts new or growing companies at a disadvantage relative to more established companies.
  • allows for more centralized handling of acquired gains
  • worth of carbon is stabilized by government regulation rather than market fluctuations. Poor market conditions and weak investor interest have a lessened impact on taxation as opposed to carbon trading.

Creating real carbon credits


The principle of Supplementarity
Supplementarity
"Supplementarity", also referred to as "the supplementary principle", is one of the main principles of the Kyoto Protocol. The concept is that internal abatement of emissions should take precedent before external participation in flexible mechanisms...

 within the Kyoto Protocol means that internal abatement of emissions should take precedence before a country buys in carbon credits. However it also established the Clean Development Mechanism
Clean Development Mechanism
The Clean Development Mechanism is one of the "flexibility" mechanisms defined in the Kyoto Protocol . It is defined in Article 12 of the Protocol, and is intended to meet two objectives: to assist parties not included in Annex I in achieving sustainable development and in contributing to the...

 as a Flexible Mechanism by which capped entities could develop real, measurable, permanent emissions reductions voluntarily in sectors outside the cap. Many criticisms of carbon credits stem from the fact that establishing that an emission of CO2-equivalent greenhouse gas has truly been reduced involves a complex process. This process has evolved as the concept of a carbon project
Carbon project
A carbon project refers to a business initiative that receives funding because of the cut the emission of greenhouse gases that will result...

 has been refined over the past 10 years.

The first step in determining whether or not a carbon project
Carbon project
A carbon project refers to a business initiative that receives funding because of the cut the emission of greenhouse gases that will result...

 has legitimately led to the reduction of real, measurable, permanent emissions is understanding the CDM methodology process. This is the process by which project sponsors submit, through a Designated Operational Entity (DOE), their concepts for emissions reduction creation. The CDM Executive Board, with the CDM Methodology Panel and their expert advisors, review each project and decide how and if they do indeed result in reductions that are additional

Additionality and its importance



It is also important for any carbon credit (offset) to prove a concept called additionality. The concept of additionality addresses the question of whether the project would have happened anyway, even in the absence of revenue from carbon credits. Only carbon credits from projects that are "additional to" the business-as-usual scenario represent a net environmental benefit. Carbon projects that yield strong financial returns even in the absence of revenue from carbon credits; or that are compelled by regulations; or that represent common practice in an industry are usually not considered additional, although a full determination of additionality requires specialist review.

It is generally agreed that voluntary carbon offset projects must also prove additionality in order to ensure the legitimacy of the environmental stewardship claims resulting from the retirement of the carbon credit (offset). According the World Resources Institute/World Business Council for Sustainable Development (WRI/WBCSD) : "GHG emission trading programs operate by capping the emissions of a fixed number of individual facilities or sources. Under these programs, tradable 'offset credits' are issued for project-based GHG reductions that occur at sources not covered by the program. Each offset credit allows facilities whose emissions are capped to emit more, in direct proportion to the GHG reductions represented by the credit. The idea is to achieve a zero net increase in GHG emissions, because each tonne of increased emissions is 'offset' by project-based GHG reductions. The difficulty is that many projects that reduce GHG emissions (relative to historical levels) would happen regardless of the existence of a GHG program and without any concern for climate change mitigation. If a project 'would have happened anyway,' then issuing offset credits for its GHG reductions will actually allow a positive net increase in GHG emissions, undermining the emissions target of the GHG program. Additionality is thus critical to the success and integrity of GHG programs that recognize project-based GHG reductions."

Criticisms


The Kyoto mechanism is the only internationally agreed mechanism for regulating carbon credit activities, and, crucially, includes checks for additionality and overall effectiveness. Its supporting organisation, the UNFCCC, is the only organisation with a global mandate on the overall effectiveness of emission control systems, although enforcement of decisions relies on national co-operation. The Kyoto trading period only applies for five years between 2008 and 2012. The first phase of the EU ETS system started before then, and is expected to continue in a third phase afterwards, and may co-ordinate with whatever is internationally agreed at but there is general uncertainty as to what will be agreed in Post–Kyoto Protocol negotiations on greenhouse gas emissions. As business investment often operates over decades, this adds risk and uncertainty to their plans. As several countries responsible for a large proportion of global emissions (notably USA, Australia, China) have avoided mandatory caps, this also means that businesses in capped countries may perceive themselves to be working at a competitive disadvantage against those in uncapped countries as they are now paying for their carbon costs directly.

A key concept behind the cap and trade system is that national quotas should be chosen to represent genuine and meaningful reductions in national output of emissions. Not only does this ensure that overall emissions are reduced but also that the costs of emissions trading are carried fairly across all parties to the trading system. However, governments of capped countries may seek to unilaterally weaken their commitments, as evidenced by the 2006 and 2007 National Allocation Plans for several countries in the EU ETS, which were submitted late and then were initially rejected by the European Commission
European Commission
The European Commission is the executive body of the European Union. The body is responsible for proposing legislation, implementing decisions, upholding the Union's treaties and the general day-to-day running of the Union....

 for being too lax.

A question has been raised over the grandfathering of allowances. Countries within the EU ETS have granted their incumbent businesses most or all of their allowances for free. This can sometimes be perceived as a protectionist obstacle to new entrants into their markets. There have also been accusations of power generators getting a 'windfall' profit by passing on these emissions 'charges' to their customers. As the EU ETS moves into its second phase and joins up with Kyoto, it seems likely that these problems will be reduced as more allowances will be auctioned.

See also


  • Cap and trade
  • Carbon finance
    Carbon finance
    Carbon finance is a new branch of Environmental finance. Carbon finance explores the financial implications of living in a carbon-constrained world, a world in which emissions of carbon dioxide and other greenhouse gases carry a price....

  • Carbon leakage
    Carbon leakage
    Carbon leakage occurs when there is an increase in carbon dioxide emissions in one country as a result of an emissions reduction by a second country with a strict climate policy.Carbon leakage may occur for a number of reasons:...

  • Carbon offset
    Carbon offset
    A carbon offset is a reduction in emissions of carbon dioxide or greenhouse gases made in order to compensate for or to offset an emission made elsewhere....

  • Carbon project
    Carbon project
    A carbon project refers to a business initiative that receives funding because of the cut the emission of greenhouse gases that will result...

  • Carbon Trade Watch
    Carbon Trade Watch
    Carbon Trade Watch is an independent research collective working on climate change and climate policy from a justice-based perspective. It was formerly part of the Amsterdam-based Transnational Institute....

  • CDM Gold Standard
    CDM Gold Standard
    The Gold Standard is the world's only independent standard for creating high-quality emission reductions projects in the Clean Development Mechanism Joint Implementation and Voluntary Carbon Market. It was designed to ensure that carbon credits are not only real and verifiable but that they make...

  • Emissions trading
    Emissions trading
    Emissions trading is a market-based approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants....

  • Energy speculation
  • Kyoto Protocol emissions trading
  • Nutrient trading
  • Removal Units
    Removal Units
    A Removal Unit is a tradable carbon credit or 'Kyoto unit' representing an allowance to emit one metric tonne of greenhouse gases absorbed by a removal or Carbon sink activity in an Annex I country....

  • Emissions Reduction Currency System
    Emissions Reduction Currency System
    Emissions Reduction Currency Systems are schemes that provide a positive economic and or social reward for reductions in greenhouse gas emissions, either through distribution or redistribution of national currency or through the publishing of coupons, reward points, social currency, or...


External links