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THIS WEEK'S MARKET REPORT

GLOBE-Net Special Feature

A Primer on Climate Change and Carbon Trading

What are carbon credits and how do they work?

A 'carbon credit', sometimes referred to as an offset, is a permit to emit a specified amount of greenhouse gases, usually expressed in metric tonnes of carbon dioxide equivalent (CO2e). 'Carbon credits' are named after the most prominent greenhouse gas, carbon dioxide, but can represent other warming gases.

Carbon dioxide equivalent (CO2e) is a metric used to compare the global warming potential of various greenhouse gases. For example, the contribution of methane to global warming is rated as 21 over 100 years. This means that an emission of one metric tonne of methane is equal to emissions of 21 tonnes of carbon dioxide.

Credits can be allocated by a government as part of a plan that sets a limit on the total amount of CO2 that may be emitted in that jurisdiction, in what generally referred to as a cap-and-trade system. Companies may be awarded a number of permits, and must emit only as much GHG for which they have permits. Carbon credits can be earned through projects that reduce emissions, or by companies that cut their own emissions and thereby free up credits they possess for trading. Carbon markets exist wherein which companies may purchase and sell credits.

The World Bank has reported that worldwide trading of carbon credits was valued at $21.5 billion during the first nine months of 2006, more than double the value for all of 2005. The market suffers from volatility and will require some reforms, but is showing promise of achieving its goal of using financial incentives to curb emissions, says the bank.

As noted, the 'Cap-and-Trade' approach uses free market principles to achieve a reduction in emissions of a particular greenhouse gas. A government or regulatory body sets a limit on the total amount of emissions that are allowed, and issues or auctions permits (carbon credits) for that amount. Companies or organizations covered by the cap must only emit according to the permits they possess.

If companies exceed their allowable limits of emissions, they must obtain credits from other companies that have surplus credits, or by investing in projects that offset their emissions (Offset Projects). Thus, emissions are 'capped', and emitters can 'trade' credits until their emissions match the amount of permits they possess.

Although it can be argued that purchasing carbon offsets amounts to "buying one's way out," it is clear that companies can never eliminate 100% of their emissions. Purchasing carbon credits offer the opportunity for companies to better manage their climate impact.

Also, creating an emissions inventory, which is a necessary first step in determining how many offsets need to be purchased, is an important first step for many companies that can lead to emission reductions later.

Currently, the European Union possesses the only legally mandated carbon trading system, the EU Emissions Trading Scheme, which works as a cap-and-trade system. Other jurisdictions have made legislation in preparation for future carbon trading markets, including California and a group of seven Northeast U.S. states. Other carbon trading that does not take place under Kyoto Protocol mechanisms is based on voluntary schemes. These markets are discussed in the section "Where are other carbon trading markets located?"

Offset Project is a term describing a venture that reduces greenhouse gas emissions, such as a renewable energy development or energy efficiency upgrade. An example would be a wind power installation in an area that received most of its electricity from coal; total emissions would be reduced because less coal would need to be consumed. A wind farm in an area that uses hydroelectricity would not 'offset' any emissions.

For many companies, an Offset Project is one that is undertaken outside normal operations. For example, a company that owned a natural gas plant could invest in the development of a methane capture project at a landfill. While the natural gas plant would continue to produce carbon dioxide, the company would 'offset' those emissions by capturing methane at the landfill.

In this case, investors would hope to earn carbon credits that can then be applied against their own emissions to help them meet their targets.

Another way that the natural gas plant operator could meet their emissions targets would be to invest in pollution control technology. While this could result in the same net reduction in emissions, the company would not earn carbon credits. However, the upgrade could allow the company to sell some credits it owns under a cap-and-trade scheme, as its emissions would be lower than previously.

Carbon sequestration is another way of reducing emissions. It occurs when carbon dioxide in the atmosphere is trapped in a sink. A Sink is any natural reservoir that stores carbon. The most commonly thought-of sinks are forests and vegetation. The world's oceans are also large sinks. This concept is applied in the Kyoto Protocol, as the creation of sinks can help countries earn carbon offsets through sequestration.

The Kyoto Protocol allows for carbon credits to be earned for sequestration projects, such as the planting of trees. For example, forestry companies that replant deforested areas could potentially earn offset credits, as forests absorb carbon dioxide as they grow. A key issue in this area is that the projects must represent an actual reduction of emissions compared to 'business as usual'.

Many developing nations want the opportunity to earn credits by preventing deforestation. Brazil has proposed the creation of a fund that nations could tap into if they reduced deforestation to below 1990 levels, and this topic has been up for debate by the UNFCCC in the past year.