Carbon Credit

Background

Carbon credits are a valuable commodity in voluntary or mandatory carbon markets. The laws and regulations of a mandatory market set forth how these credits are defined, measured, verified, registered, traded, and retired, and how the entities involved are supervised and audited.  In the voluntary market, carbon credits are produced outside of a legal framework and are guided by a number of different voluntary standards.

The carbon markets were developed based largely on the success of the United States Acid Rain Program, which was mandated by the 1990 Clean Air Act.  Title IV of the Clean Air Act requires large reductions in SO2 emissions, and established a market-based cap and trade program for SO2 emissions from electric generating units (EGUs).¹  Under the Acid Rain Program, facilities are issued allowances, or authorizations to emit specific amounts of SO2 during a set time period.  Facilities can then buy, sell and trade those allowances to help them meet their emission limits. The Acid Rain Program achieved its emission reduction goals three years ahead of its 2010 statutory deadline², and at one-quarter of the cost of EPA’s original estimate.³ 

The Kyoto Protocol picked up on the concept of emissions trading to reduce green house gas emissions.   Parties with commitments under the Protocol (Annex B Parties) have accepted targets for limiting or reducing emissions, which are referred to as “assigned amounts.” These assigned amounts are divided into “assigned amount units” (AAUs), which is the same as an allowance.  The Protocol allows countries with emission below their assigned amount to sell AAUs to countries that are over their targets.⁴

The Kyoto Protocol introduced the concept of using carbon credits as a way to help countries meet emissions targets. In addition to allowing countries with commitments to buy and sell AAUs, the Kyoto Protocol also established the Clean Development Mechanism (CDM) and the Joint Implementation (JI) process, both of which allow countries to use "carbon credits" or "voluntary offsets" generated from GHG reduction projects in other countries  to count toward their emission targets. Under CDM, developed countries with Kyoto emission reduction commitments (Annex B) are allowed to invest in projects that reduce GHG emissions in developing countries and have those reductions count toward their Kyoto targets.  CDM-approved emission-reduction projects earn certified emission reduction (CER) credits, which are equivalent to one metric ton of CO2. CERs can be then bought, sold, and traded by industrialized countries to meet a part of their emission reduction targets under the Kyoto Protocol.⁵ JI allows Annex B countries to earn emission reduction units (ERUs) from an emission-reduction or emission removal project in another Annex B Party, each equivalent to one ton of CO2, which can be counted towards meeting its Kyoto targets and can also be bought, sold, and traded.⁶

Credits in the Carbon Market

Although the term carbon credit is used -- often colloquially -- to represent both an allowance or permit giving an entity the right to emit a certain quality of GHG, as well as a specific reduction or offset, an allowance is usually used to mean a legal authorization to emit a specific amount of a pollution.  For example, a steel producer  in a mandatory market may have a legally binding emission quota of 10 metric tons of CO2, which could be referred to 10 allowances. If this same producer expects to produce 11 metric tons of CO2, the producer might be required to buy one metric ton of CO2 from another entity that has reduced their emissions at least one metric ton below their quota. This producer may also be allowed, depending on the rules of the market, to buy one carbon credit as an offset from an entity that does not have a mandatory quota, but which has chosen to voluntarily reduce their emissions by one metric ton.

Carbon credits have been part of the mandatory and voluntary carbon markets that have developed rapidly in the last decade.  Members of the European Union Emissions Trading Scheme (EU-ETS), which was launched in 2005, are permitted to buy and sell CERs and ERUs to help meet their emissions targets.⁵ The Chicago Climate Exchange (CCX), a membership-based exchange that facilitates the trading of credits and the buying of offsets among members on a voluntary basis, was launched in 2003.⁶   The Regional Greenhouse Gas Initiative (RGGI) in the Northeastern United States, which covers the power sector, began auctioning allowances in September 2008 and allows the purchase of offsets in limited circumstances.⁸

In addition to a mandatory market, a strong over-the-counter (OTC) voluntary offset market has grown along side these more formal markets. In the over-the-counter voluntary market, entities or people choose to, but are not required to, offset their emissions from a particular activity or event by buying carbon credits, which are usually referred to as voluntary emission reductions (VERs). For example, if a person wants to offset their green house gas emissions resulting from a airplane flight, that person can find a carbon offset provider or retailer, usually on the internet, who will calculate that persons emissions from the flight and sell that persons offsets or credits that represent green house gas emissions reductions equal to the emissions caused by that persons activity. Today, over 170 organizations worldwide sell carbon offsets¹⁰, or VERs. Compared to the compliance market, however, the size of the voluntary market is small, about 2.2% in terms of volume of transactions of the compliance market in 2007.¹¹ 

Footnotes

¹: EPA, Title IV - Acid Deposition Control, 19 Dec 08 (last updated).  Accessed April 8, 2009.

²: http://www.epa.gov/AIRMARKETS/progress/arp07.html

³: http://www.epa.gov/airmarkets/cap-trade/docs/ctresults.pdf

⁴: http://unfccc.int/kyoto_protocol/mechanisms/emissions_trading/items/2731.php

⁵: http://cdm.unfccc.int/index.html,

⁶: http://ji.unfccc.int/index.html

⁷: http://ec.europa.eu/environment/climat/emission/index_en.htm

⁸: http://www.chicagoclimatex.com

⁹: http://www.rggi.org

¹⁰: Ends, The Ends Guide to Carbon Offsets, 2008

¹¹: Katherine Hamilton, Milo Sjardin, Thomas Marcello, Gordon Xu, Forging a Frontier: State of the Voluntary Carbon Markets 2008, Ecosystem Marketplace, New Carbon Finance, May 2008, page 6.