Climate Trading

Climate change has been heralded as the most serious environmental problem facing humankind, deserving urgent action to curb emissions of the greenhouse gases causing the problem. The scientific community is in general agreement that greenhouse gases are accumulating in the atmosphere, that temperatures are rising and it is most likely due to human activity. The Intergovernmental Panel on Climate Change (IPCC) (see Section 1.2.1) in its third assessment report (2001) suggested that there is new and stronger evidence that most of the warming observed over the last 50 years is attributable to human activities. But many uncertainties still exist about the causes and effects of climate change. They are acknowledged by the scientific community and used by sceptics to argue for a greater understanding of the science before concrete action is taken. One Uncertainty is the extent to which changes in temperature might be due to the natural variability of the climate system. A second is the ability of models to simulate the natural variability of the climate system over long time scales (decades and centuries). A third uncertainty exist over how accurate a picture we have of the global mean temperatures for the past millennium since it is reconstructed using proxy information.

Much of the current development in climate change policies is a result of the adoption of the Convention and the Kyoto Protocol, including its mechanisms for emissions trading and project-based cooperation. While the Protocol is only a small step towards correcting a potentially dramatic environmental problem, the adoption of the Protocol was a major political breakthrough.

Cost considerations have been one of the key concerns for Annex I Parties when considering taking on reduction and limitation targets under the Kyoto Protocol. Incorporating an international emissions trading system into the Protocol was one of the key requirements for several countries within the climate negotiations. Without it, the adoption of an agreement with legally binding reduction and limitation targets probably would not have been possible. Or, at a minimum, the levels of the reduction and limitation targets would have been much lower. Although the targets seem relatively low, they are in fact significant when seen against the back drop of the amount of reductions an individual country will have to reduce. Some countries will have to reduce current emissions by up to 20 per cent to reach their target.

Since the 1990s, many Annex I countries have implemented some type of climate change policy or instituted other policies that affect greenhouse gas emissions (see Table 4.1). These policies range from direct regulation (for instance, landfill gas capture, labelling requirements and support for renewable energy) to voluntary agreements with industry. Very few Annex I countries managed to meet the Convention aim of reducing their individual emissions to 1990 levels by 2000. The Convention aim was reached overall but this was due to a steep decline in greenhouse gas emissions in countries with economies in transition (emissions in other Annex I countries rose by some 6 per cent). And within these countries a very limited number of industry undertook unilateral voluntary reduction programmes since there was insufficient incentive to justify adding on costs to production.

In recent years emissions trading schemes that aim to reduce greenhouse gases, has been the principal focus of government, industry and nongovernmental organizations. A great deal of emphasis has been placed on what the schemes should look like but less on what companies must do in order to participate in a trading scheme. Since the EU Directive on emissions trading was adopted, greater emphasis has been placed on the methods and tools that will be needed in order for companies to succeed in a carbon constrained economy. Thus far, industry’s main focus has been on limiting any potential negative impact of an emissions trading scheme (i.e. by either challenging the allocation process, attempting to limit the industry effect by a potential scheme or by attempting to influence the stringency of a cap). Developing strategies for coping with limitation on emissions has been a secondary concern.

Joint Implementation (JI) and the Clean Development Mechanism (CDM) have been looked upon with a great deal of interest and speculation since the adoption of the Kyoto Protocol. Prior to the adoption of the Marrakech Accords potential CDM and JI projects were in development, but the risks associated with those projects were very high — in part because rules governing the projects were not yet defined. It has also been difficult to assess the level of risk associated with investing in a project since it has been unclear how these two Kyoto Protocol mechanisms would interact with domestic emissions trading schemes. The Protocol provides for projects starting in the year 2000 to be eligible for both mechanisms, and the Marrakech Accords provided for the prompt start of the CDM. The CDM is up and running and there are governing bodies that can improve the rules as the system evolves. The rules for JI projects, however, are incomplete and the governing bodies will not be established until after the Protocol enters into force.

Once a company has assessed its carbon liability and determined whether (and how) it will participate in emissions trading, it will have to decide which segment of the carbon market to enter. The carbon market is in its formative stage and is segmented by type of commodity and buyer motivation. In addition it is not likely to be fully liquid or integrated for some time. Although companies and countries have a great deal of experience in trading, market development is a process. The US SO₂ market, for example, took up to six years before it reached maturity. Given that trading infrastructure exists and trades have occurred since as early as 1996, it may not take as long for the greenhouse gas market to mature.⁷⁹

Introduction of policies to reduce greenhouse gas emissions will impose costs, but emissions trading should help reduce the overall cost of compliance, especially compared to a direct regulatory approach. Emissions trading will enable companies (at the domestic level) and countries (at the international level) with high marginal costs to purchase reductions from companies and countries with lower marginal abatement costs. Even with emissions trading, however, costs will be incurred and impacts felt. Impacts will include a change in the generation mix and the price of electricity, but the extent of the impact is dependent on many other factors, including the composition of a country’s power generators, the primary fuel used, the cost of the primary fuel used, and domestic energy policies. The extent to which these impacts can be predicted, or felt during the trading periods, depends in part on the uncertainties surrounding the process of implementing an emissions trading scheme.