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Monday, October 22, 2007

NYSE EURONEXT (NYX): Carbon CO2 Trading Platform. What Is Carbon Emissions Trading?

Emissions trading (or cap and trade) is an administrative approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants.

In such a plan, a central authority (usually a government agency) sets a limit or cap on the amount of a pollutant that can be emitted. Companies or other groups that emit are required to hold an equivalent number of credits or allowances which represent the right to emit a specific amount. The total amount of credits cannot exceed the cap, limiting total emissions to that level. Companies that need to increase their emissions must buy credits from those who pollute less. The transfer of allowances is referred to as a trade. In effect, the buyer is being fined for polluting, while the seller is being rewarded for having reduced emissions. Thus, in theory, those that can easily reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest possible cost to society.

There are active trading programs in several pollutants. For greenhouse gases the largest is the European Union Emission Trading Scheme. In the United States there is a national market to reduce acid rain and several regional markets in nitrous oxide.[3] Markets for other pollutants tend to be smaller and more localized.

Trading is often seen as politically viable because the initial allocation of allowances is often allocated based on a 'grandfathering' provision in which polluters receive rights in proportion to their historical emissions. Critics of emissions trading point to problems of monitoring, enforcement, and problems with the initial allocation.


The overall goal of an emissions trading plan is to reduce emission. The cap is usually lowered over time - aiming towards a national emissions reduction target. In other systems a portion of all traded credits must be retired, causing a net reduction in emissions each time a trade occurs. In many cap and trade systems, organizations which do not pollute may also buy credits. Environmental groups that purchase and retire pollution credits reduce emissions and raise the price of the remaining credits according to the law of demand. Corporations can also retire pollution credits by donating them to a nonprofit and then be eligible for a tax deduction. Allowances are accounted for in the balance sheet of the company as intangible assets, as recommended by the IAS 37 issued by IASB.

Because emissions trading uses markets to determine how to deal with the problem of pollution, it is often touted as an example of effective free market environmentalism. While the cap is usually set by a political process, individual companies are free to choose how or if they will reduce their emissions. In theory, firms will choose the least-cost way to comply with the pollution regulation, creating incentives that reduce the cost of achieving a pollution reduction goal.

Flexible mechanisms such as Clean Development Mechanism (CDM) and Joint Implementation (JI) are the methods by which the UNFCCC's Kyoto Protocol enables participants to comply with emissions objectives via the development or investment in a carbon project.

Emissions trading principles are based on proposals by the Technocracy movement of the 1930's. Technocracy proposed a system of Energy Accounting, or emissions trading, to promote balanced and harmonious development throughout the world.

Cap & trade versus baseline & credit

The textbook emissions trading program can be called a "cap & trade" approach in which an aggregate cap on all sources is established and these sources are then allowed to trade amongst themselves to determine which sources actually emit the total pollution load. An alternative approach with important differences is a baseline & credit program [5] In a baseline and credit program a set of polluters that are not under an aggregate cap can create credits by reducing their emissions below a baseline level of emissions. These credits can be purchased by polluters that are under a regulatory limit. Many of the criticisms of trading in general are targeted at baseline & credit programs rather than cap & trade type programs.

Prices versus quantities and the 'safety valve'

There has been longstanding debate on the relative merits of price versus quantity instruments to achieve emission reductions. An emission cap and permit trading system is a quantity instrument because it fixes the overall emission level (quantity) and allows the price to vary. In contrast, emission taxes are a price instrument because the price is fixed and the emission level is allowed to vary according to economic activity. One problem with the cap and trade system is that it creates uncertainty in the cost of compliance for firms as the price of a permit is not known in advance. On the other hand, a major drawback of emission taxes is that the environmental outcome (the amount of emissions) is not guaranteed. Hence the debate in academic circles.

Some economists have argued that an emission tax is the best choice of instrument for greenhouse gas abatement. The best choice depends on the sensitivity of the costs of emission reduction, compared to the sensitivity of the benefits (i.e., climate damages avoided by a reduction) when the level of emission control is varied. Because there is high uncertainty in the compliance costs of firms, some argue that the optimum choice is the price mechanism. The prices vs. quantities debate was first described in a paper by Martin Weitzman in 1974[6].

However, some scientists have warned of a threshold in atmospheric concentrations of carbon dioxide, beyond which a run-away warming effect could take place, with a large possibility of causing irreversible damages. If this is a conceivable risk then a quantity instrument could be a better choice because the quantity of emissions may be capped with a higher degree of certainty. However, this may not be true if this risk exists but cannot be attached to a known level of GHG concentration or a known emission pathway (see, for example, Certainty vs. Ambition)[7]

A third option, known as a ‘safety valve’ is a hybrid of the price and quantity instruments. The system is essentially an emission cap and tradeable permit system, but the maximum permit price is capped. Emitters have the choice of either obtaining permits in the marketplace or purchasing them from the government at a specified ‘trigger price’ (which could be adjusted over time). The system is sometimes recommended as a way of overcoming the fundamental disadvantages of both systems by allowing the flexibility to adjust the system as new information comes to light. It can be shown that by setting the trigger price high enough or the number of permits low enough, the safety valve can be used to mimic either a pure quantity or pure price mechanism. [8].

A prominent example of an emission trading system is the SO2 trading system under the framework of the Acid Rain Program of the 1990 Clean Air Act in the USA. Under the program, which is essentially a cap-and-trade emissions trading system, SO2 emissions are expected to be reduced by 50% from 1980 to 2010.

Some experts argue that the "cap and trade" system of SO2 emissions reduction reduced the cost of controlling acid rain by as much as 80% versus source-by-source reduction.

In 1997, the State of Illinois adopted a trading program for volatile organic compounds in most of the Chicago area, called the Emissions Reduction Market System.[9] Beginning in 2000, over 100 major sources of pollution in 8 Illinois counties began trading pollution credits.

In 2003, New York State proposed and attained commitments from 9 Northeast states to form a cap and trade carbon dioxide emissions program designated the Regional Greenhouse Gas Initiative or RGGI. This program will officially launch on January 1, 2009, and by 2018 each state's carbon "budget" will be reduced 10% below 2009 allowances.

Also in 2003, corporations began voluntarily trading greenhouse gas emission allowances on the Chicago Climate Exchange.

In 2007, the California Legislature passed Ab-32, which was signed into law by Governor, Arnold Schwarzenegger. This bill is aimed at curbing Carbon emissions. Thus far flexible mechanisms in the form of project based offsets have been established for 5 main project types. A carbon project creates offsets by showing that it has reduced carbon dioxide and equivalent gases. The project types include; manure management, forestry, building energy, SF6, and landfill gas capture.

European Union

The European Union Emission Trading Scheme (or EU ETS) 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 25 (now 27) member states of the European Union participating in it.[11] 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.[12]

Whilst the first phase (2005 - 2007) has received much criticism due to oversupply of allowances and the distribution method of allowances (via grandfathering rather than auctioning), the European Commission have been tough on Member States' Plans for Phase II, dismissing many of them as being too loose again.[13] In addition, the first phase has established a strong carbon market. Compliance has also been high in 2006, increasing confidence in the scheme.


On the 4th of June, 2007, Prime Minister John Howard announced a new Australian Carbon Trading Scheme to be introduced by the year 2012 but has been accused by the opposition that it is "too little, too late." [14]

The New South Wales (NSW) state government has set up the NSW Greenhouse Gas Abatement Scheme to reduce emissions from the electricity sector by requiring electricity generators and large users to purchase NSW Greenhouse Abatement Certificates (NGACs) to offset a fraction of their GHG emissions. This has resulted in the rollout of free energy efficient compact fluorescent lightbulbs and other energy efficiency measures in NSW funded by the credits generated by these measures. The scheme set up by the NSW government has enabled the creation and trading of verifiable greenhouse abatement certificates. NGACs are generated and can be purchased from numerous companies.

Kyoto Protocol

The Kyoto Protocol is a 1997 international treaty that took effect in 2005 which currently bind ratifying nations to a similar system, with the UNFCCC setting caps for each nation. Under the treaty, nations that emit less than their quota of greenhouse gases will be able to sell emissions credits to polluting nations. (The United States and Australia are the only two wealthy nations that did not sign into this treaty)

The development of a carbon project that provides a reduction in Greenhouse Gas emissions is a way by which participating entities may generate tradeable carbon credits. Kyoto Protocol provides for this facet of its cap and trade program with the Clean Development Mechanism (CDM). The CDM, as well as Joint Implementation (JI) provide flexible mechanisms to aid regulated entities in their compliance with their caps.

Green tags

Green tags or Renewable Energy Certificates are transferable rights for renewable energy. A renewable energy provider is issued one green tag for each 1,000 KWh of energy it produces. The energy is sold into the electrical grid, and the green tag or REC can be sold on the open market for additional profit. The credits are purchased by firms or individuals who either want or are required to generate a portion of their energy from renewable sources.

The carbon market

This section deals with carbon emissions trading between nations. For carbon trading schemes for individuals, see Personal carbon trading.

Carbon emissions trading is emissions trading specifically for carbon dioxide (calculated in tonnes of carbon dioxide equivalent or tCO2e) and currently makes up the bulk of emissions trading. It is one of the ways countries can meet their obligations under the Kyoto Protocol to reduce carbon emissions and thereby mitigate global warming.

Market trend

Carbon emissions trading has been steadily increasing in recent years. According to the World Bank's Carbon Finance Unit, 374 million metric tonnes of carbon dioxide equivalent (tCO2e) were exchanged through projects in 2005, a 240% increase relative to 2004 (110 mtCO2e)which was itself a 41% increase relative to 2003 (78 mtCO2e)

Business reaction

With the creation of a market for trading carbon dioxide emissions within the Kyoto Protocol, the London financial markets has established itself as the center of the carbon market, a potentially highly lucrative business. The New York and Chicago stock markets would like a share (unlikely as long as the current US administration rejects Kyoto).

multinational corporations have come together in the G8 Climate Change Roundtable, a business group formed at the January 2005 World Economic Forum. The group includes Ford, Toyota, British Airways and BP. On 9 June 2005 the Group published a statement stating that there was a need to act on climate change and stressing the importance of market-based solutions. It called on governments to establish "clear, transparent, and consistent price signals" through "creation of a long-term policy framework" that would include all major producers of greenhouse gases.

Business in the UK have come out strongly in support of emissions trading as a key tool to mitigate climate change, supported by Green NGOs.


Another critical part of the bargain is enforcement. Without effective enforcement, the licenses have no value. Two basic schemes exist:

In one, the regulators measure facilities, and fine or sanction those that lack the licenses for their emissions. This scheme is quite expensive to enforce, and the burden falls on the agency, which then may need to collect special taxes. Another risk is that facilities may find it far less expensive to corrupt the inspectors than purchase emissions licenses. The net effect of a poorly financed or corrupt regulatory agency is a discount on emission licenses, and greater pollution.

In another, a third party agency certified or licensed by the government, verifies that polluting facilities have licenses equal or greater than their emissions. Inspection of the certificates is performed in some automated fashion by the regulators, perhaps over the Internet, or as part of tax collection. The regulators then audit licensed facilities chosen at random to verify that certifying agencies are acting correctly. This scheme is far less expensive, placing the cost of most regulation on the private sector. The transparency of this process helps act as a safeguard against corruption.


There are critics of the schemes, mainly environmental justice NGOs and movements who see carbon trading as a proliferation of the free market into public spaces and environmental policy-making.[21] They point to failures in accounting, dubious science and destructive impacts of projects upon local peoples and environments as reasons why trading pollution rights should be avoided.[22] Instead they advocate making reductions at the source of pollution and energy policies that are justice-based and community-driven.[23] Most of the criticisms have been focused on the carbon market created through investment in Kyoto Mechanisms. Criticism of 'cap and trade' emissions trading has generally been more limited to lack of credibility in the first phase of the EU ETS.

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. Likely this would occur over time through central regulation, though some environmental groups acted more immediately by buying credits and refusing to use or sell them. The National Allocation Plans by member governments of the European Union Emission Trading Scheme came under fire for this recently when some governments issued more carbon allowances than emissions during Phase I of the scheme. They have also been criticised for the widespread practice of grandfathering, where polluters are given carbon credits by governments, instead of being made to pay for them.[24] Nevertheless, the transfer of wealth from polluters to non-polluters provides incentives for polluting firms to change, especially if the market price for pollution credits is very high. Tight controls are necessary in order to establish a reverse commodity market like Green Tags as well. Regulatory agencies run the risk of issuing too many emission credits, diluting the effectiveness of regulation, and practically removing the cap. In this case instead of any net reduction in carbon dioxide emissions, beneficiaries of emissions trading simply do more of the polluting activity.

Many environmental activists and foundations consider Al Gore's strong advocation of carbon trading to be a denial of the imminence of climate change and a formalized failure of international policy to address the gravity of the carbon increase. 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.
A mistake may also be made by giving away emission credits rather than auctioning them. Emission credits are, in effect, money and therefore should be treated as such. The giving away of emission credits may also have the negative result of turning down investment dollars that might have been spent on sustainable technologies, if the government chooses to.

Economists also point out disadvantages of carbon trading schemes compared to emission taxes which they argue are a simple and economically efficient means of achieving the same objective. Possible problems with cap and trade systems include:

* Permit prices may be unstable and therefore unpredictable
* Cap and trade systems tend to pass the quota rent to business
* Cap and trade systems could become the basis for international trade in the quota rent resulting in very large transfers across frontiers
* Cap and trade systems are seen to generate more corruption than a tax system
* The administration and legal costs of cap and trade systems are higher than with a tax
* A cap and trade system is seen to be impractical at level of individual household emissions

The problem of unstable prices can be resolved, to some degree, by the creation of forward markets in caps. Nevertheless, it is easier to make a tax predictable than the price of a cap. The problem of passing quota rents to businesses is a political one, and can also be avoided by auctioning permits instead of giving them away, but government may be compelled to give them away in order to make the scheme politically acceptable.

The Financial Times wrote an article on cap and trade systems that argues that "Carbon markets create a muddle" and "...leave much room for unverifiable manipulation".

Despite the criticisms and disadvantages, emission cap and permit trading systems are seen to be more politically feasible than emission taxes and are being adopted in various jurisdictions around the world. One explanation for their attractiveness could be that the cost increases are not as directly apparent to consumers as they are with a tax. Indeed, some would argue that any policy that contains the word 'tax' is a political taboo.

There is a great deal of criticism of the use of carbon credits by regions affected by such schemes. The principal objection is that old growth forests (which have slow carbon absorption rates) are being cleared and replaced with fast-growing vegetation, to the detriment of the local communities.

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