The emerging carbon market encompasses both project-based emission reduction transactions—where a buyer purchases emission reductions (ERS) from a project which reduces greenhouse gases (GHG) emissions compared with what would have happened otherwise—and emissions trading of GHG emission allowances, where allowances are allocated under existing or upcoming cap-and-trade regimes.

Several governments, firms and individuals have started to take steps to reduce their greenhouse gases (GHG) emissions either voluntarily, or, increasingly, because of current or expected regulations. Since GHGs mix uniformly in the atmosphere, from an environmental standpoint it is equivalent to reduce emissions anywhere in the world regardless of political jurisdiction. Most of the regulations containing GHG emissions and most of the voluntary actions take advantage of this substitutability and allow for the purchase of emission credits both within and outside of the regulated area, thereby laying the ground for the so-called “carbon market.”

Two Types of Carbon Transactions
We define carbon transactions as contracts whereby one party pays another party in exchange for a given quantity of GHG emissions “credits” that the buyer can use to meet its objectives vis-à-vis climate mitigation.

Carbon transactions can be grouped in two main categories:

• Trades of emission allowances, such as, for example, Assigned Amount Units (AAUs) under the Kyoto Protocol, or allowances under the EU Trading Scheme (EUAs). These allowances are created and allocated by a regulator, usually under a cap-and-trade regime.
  
  
• Project-based transactions, that is, transactions in which the buyer participates in the financing of a project which reduces GHG emissions compared with what would have happened otherwise, and get “emission credits” in return. Unlike allowance trading, project-based transactions can occur even in the absence of a regulatory regime: an agreement between a buyer and a seller is sufficient.

Segments of the Carbon Market
Buyers mostly engage in carbon transactions because of regulatory pressure (present or anticipated). These regulations, at an international, or national or sub-national level, define various segments of the carbon market.

The most prominent of these regulations is the Kyoto Protocol (1997), which calls for industrialized countries and economies in transition—the so-called Annex B countries—not to exceed certain GHG emission targets during the period 2008-2012, which is also known as the first commitment period. In addition to domestic policies and measures, Annex B Parties can purchase Assigned Amount Units (AAUs), and implement emissions-reducing projects within Annex B (Joint Implementation or JI), and in non-Annex B countries (Clean Development Mechanism or CDM).

The EU Emissions Trading Scheme is a similar structure for large-scale point sources within the European Union: those entities are allocated European Emissions Allowances (EUAs) by EU member governments, which they can trade on a euro-wide market. A linking directive governs the relationships between the EU-ETS and the Kyoto Protocol. It allows entities under the EU-ETS to use emission reduction credits from JI or CDM projects against their targets under the EU-ETS under certain conditions.

In addition to responding to mandatory regulations, some firms are engaged voluntarily in the carbon market, either because they have adopted a voluntary emissions target, or for other strategic reasons. Their participation often takes the form of project-based transactions. However, the Chicago Climate Exchange (CCX) is prominent exception to this rule in that it is a private and voluntary market for emission allowances between firms.

Volumes exchanged are all expressed in metric tones of carbon dioxide equivalent (tCO2e) using the conversion factors of the UNFCCC. Volumes exchanged are also sorted in vintages up to 2012, and in vintages post-2012. This is because 2012 is the end of the first commitment period of the Kyoto Protocol and a milestone in most regimes. When the exact pre vs. post 2012 distribution was not available, we have assumed an even annual accrual of emission reductions (ERs).

The EU Trading Scheme
The so-called EU Trading Directive (European Directive 2003/87/EC) will create in January 2005 the single largest market for GHG emissions allowances (EUAs) for the period 2005-2007 to large fixed sources of CO2. (A second phase will cover 2008 to 2012.) More than 12,000 fixed sources, representing about 45 percent of the EU25 total CO2 emissions will be covered. In addition, a linking directive, approved April 20, 2004 by the European Parliament, will govern the relationships between the European Trading Scheme (ETS) and the Kyoto Protocol. The linking Directive allows for the import of ERUs and CERs into the ETS under certain conditions.

The Chicago Climate Exchange
The Chicago Climate Exchange (CCX) is a pilot GHG cap-and-trade system in which a group of North American companies have voluntarily agreed to limit their GHG emissions during 2003-2006. These companies can comply through internal reductions, purchase of allowances from other companies facing emission limitations, or purchase of credits from ER projects that meet specific criteria.

Regulatory Drivers
The linking directive adopted by the European Parliament April 20, 2004, clarifies the relationships between the EU-ETS and the Kyoto Protocol. Notably, entities under the ETS are allowed to use CERs for compliance purposes starting in 2005, and ERUs starting in 2008, albeit with certain restrictions. (AAUs, on the other hand, are excluded.) The Directive also addresses double-counting issues, and explicitly states that the acquis communcautaire—the existing body of EU legislation that accession countries must translate in their national laws—should be taken into account when setting baselines for JI projects.

* Excerpts taken from “The State of Trends of the Carbon Markets”