Worldwide: Carbon The Commodity

Originally published August 2007

A guide to the basic principles of international emissions trading.

The international framework consists of two principal legislative measures:

• the United Nations Framework Convention on Climate Change (the "Convention"); and
• the Kyoto Protocol (the "Protocol").

The Convention marked the first consensus that climate change needed to be addressed by co-ordinated international action, but the treaty was absent any hard targets to reduce emissions.

The Protocol, established under the Convention, fills this gap by setting legally binding targets for industrialised countries to reduce their greenhouse gas ("GHG") emissions. Industrialised countries must achieve these targets over the "First Commitment Period" which runs from 2008 to 2012. The US and Australia have refused to ratify the Protocol and therefore do not fall within the ambit of the international framework. It should also be noted that developing countries do not have specific targets under the Protocol for reducing their emissions.

The Protocol contains a number of market or "flexible mechanisms" to enable Parties to achieve their targets in the most cost effective manner. These include the Clean Development Mechanism; Joint Implementation and International Emissions Trading.

The Protocol will expire in 2012. Even if all its targets are met, the impact on global GHGs or the climate system will be negligible. A new international agreement is required for the post 2012 period and its success in mitigating the effects of climate change will largely be determined by its scope and the inclusion of the major emitters such as the US, China and India.

The Convention was agreed at the Earth Summit in Rio de Janeiro in 1992. It establishes a flexible and general framework for intergovernmental efforts to address climate change. Importantly the Convention acknowledges that anthropogenic GHG emissions may affect the global climate system’s stability.

The basic objective of the Convention (and hence the Protocol) is not to reverse the concentration of atmospheric GHGs, but rather to stabilise them at a level that would prevent "dangerous anthropogenic interference with the climate system".

The Convention has achieved near universal acceptance: 190 countries have ratified the treaty, including all major developed and developing countries and this includes the United States. Nations that did not sign the treaty may accede at any time.

The Convention requires signatories to, amongst other things:

• gather and share information on GHG emissions, national policies and best practices;
• launch national strategies for addressing GHG emissions and adapting to expected impacts, including the provision of financial and technological support to developing countries; and
• cooperate in preparing for adaptation to the impacts of climate change.

The signatories recognised that climate change was at that point primarily attributable to industrialisation by the developed world (listed in Annex I to the Convention and known as "Annex I" Countries). Developing countries argued and continue to argue that their industrialisation should not be sacrificed to address a problem caused by others. It was also recognised that even within the broad categories of developed and developing countries there were varying degrees of responsibility for climate change. For these reasons "common but differentiated responsibilities" were developed.

The Protocol was adopted under the Convention in 1997 to provide specific GHG emissions targets for developed countries. There was a long period of uncertainty after the adoption of the Protocol as each signatory went through the ratification process. The Protocol finally came into force on 16 February 2005 when it was ratified by Russia. As at March 2007, 169 countries had ratified it with the US and Australia the most notable dissenters.

The Protocol establishes a "cap and trade" system for the 38 countries listed in Annex B to the Protocol (an almost identical list to the one in Annex I). The targets are legally binding and must be achieved during the five years of the Kyoto’s First Commitment Period (2008-2012). If achieved, these targets will reduce developed countries’ total GHG emissions by up to 5.2 per cent below 1990 levels.

The Conference of the Parties ("COP") is an association of all signatories to the Convention, and meets annually. The "Marrakech Accords" were agreed at the 2001 COP meeting, and comprise the detailed set of international rules for implementing the Protocol. They also establish a ‘common currency’ for the international framework, based on one tonne of CO2 equivalent, in the form of interchangeable (fungible) units or "Kyoto Units". The first meeting of the parties ("MOP") to the Protocol occurred in Montreal in 2005 and is known as COP/MOP1. The Marrakech Accords were adopted and became law at this meeting.

The flexible or market mechanisms are designed to enable the countries listed in Annex B to meet their emission reduction targets in the most costeffective manner, and to encourage sustainable development in the developing world.

The cost of reducing emissions varies considerably between regions. The mechanisms enable Annex B countries to purchase GHG emission reductions from elsewhere (including other Annex B countries), where they may be achieved more cheaply, and to offset them against that Party’s emissions. The advantage to project host countries is increased investment and technology transfer. There are three primary mechanisms:

• the Clean Development Mechanism ("CDM"), established under Article 12 of the Protocol;
• the Joint Implementation ("JI") mechanism, established under Article 6 of the Protocol; and
• international emissions trading ("IET"), established under Article 17 of the Kyoto Protocol.

In addition to making use of these market mechanisms, Parties have agreed to take domestic action to reduce emissions as a "significant element" of that Party’s efforts to meet its emissions reduction target (the principle of supplementarity). In this way the Protocol ensures that it does not bestow a "right, title or entitlement" on Annex I Parties to pollute (i.e. emit GHGs).

The authors of the Protocol envisaged that the private sector would have a role to play in the mechanisms, but they could not have imagined the full extent to which the private sector has driven forward the opportunities presented by the mechanisms.

The basic model for the CDM is that an Annex B Party (and/or entities authorised by such Party) finances or implements an emission reduction project in a developing country that is a Party. The mechanism is achieved by the United Nations issuing carbon credits (known as "Certified Emission Reductions" or "CERs") equal to the actual emission reductions achieved by the project, to the relevant Annex B Party financier. The Annex B Party financier can then either use the CERs to discharge any compliance obligation it may have or sell them on to a third party who does. The CDM has evolved slightly from this basic model to allow developing countries and entities authorised by them to carry out unilateral projects without an identified Annex B Party participant. The idea is that the CERs will be delivered to the non-Annex B Party with a view to that Party selling them in the market once they have been received. Participation in the CDM is voluntary, and both the host and the Annex B Party involved must approve the relevant project through that Party’s designated national authority. The CDM is supervised at an international level by the CDM Executive Board which itself operates under the authority of the COP/MOP. For a project to be eligible as a CDM project, it is required to go through a rigorous approval and assessment process administered by the CDM Executive Board.

In order to get the approval of the host and Annex B Party the legal entities carrying out the project ("Project Participants") must submit a project design document ("PDD") to an accredited third-party ("Designated Operational Entity" or "DOE") for validation. Validation is the process by which the DOE assesses the project against the criteria specified in the Marrakesh Accords for a valid CDM project. The main criteria are that:

• the participation requirements (as discussed above) have been satisfied;
• comments by local stakeholders have been considered and reported to the DOE;
• environmental impacts of the project activity have been properly assessed;
• the project reduces emissions below those that would have otherwise occurred (the principle of additionality); and
• the baseline and monitoring methodologies are compliant with the stipulated requirements of the Protocol and the Marrakech Accords.

If validation is successful the CDM Executive Board will register the project after a six week period during which the validated project is publicised and third parties are given the opportunity to object to registration. The overwhelming majority of projects that achieve validation will also be registered. However, where an objection is lodged the project will go through a further review process before either being rejected or, where the concerns can be addressed, registered.

Once the project is registered the Project Participants can implement the project and start generating emission reductions. In order for the reductions they make to be recognised, they must implement the approved monitoring plan and have them verified and certified as CERs by a DOE (except for small scale CDM projects this must be a different operational entity from the one that validates the project).

CERs will be issued to the Project Participants by the CDM Executive Board based on the operational entity’s verification and certification reports and in accordance with the instructions of what is called the ‘focal point’, who is nominated by the Project Participants as being able to direct the issuance of CERs. Once verification is complete the verification report is submitted to the CDM Executive Board and CERs are issued after six weeks provided there are no objections.

Examples of current CDM projects include: generation of electricity from landfill gas, hydroelectric projects and the collection and incineration of hydrofluorocarbon (HFC) emissions from chemical facilities. European Member States of the European Union are prevented from using CERs from nuclear activities (Parties are generally discouraged from using such CERs) and from hydroelectric projects exceeding 20 megawatts that do not meet certain sustainability criteria.

Figure 1 shows the CDM Cycle in outline.

Figure 1 – CDM Project Cycle

The costs of putting a project through the process outlined above can be significant. It was recognised that for certain small projects the level of scrutiny was disproportionate to the number of CERs likely to be generated by the project. A fast track procedure has been developed for these projects that reduces some of the administration. Projects that qualify are:

• renewable energy projects with a maximum output capacity equivalent of up to 14 megawatts;
• energy efficiency improvement projects which reduce energy consumption on the supply and/or demand side by up to the equivalent of 15 gigawatt hours per use; or
• other project activities that both reduce anthropogenic emissions by sources and directly emit less than 15 kilotonnes of carbon dioxide equivalent annually.

Such projects have simplified monitoring plans, baseline methodologies and a reduced project design document. They may also be bundled together to reduce overheads.

Similarly to the CDM, the JI mechanism enables Annex B governments (or entities authorised by such governments) to benefit from projects located elsewhere which achieve emission reductions. The main difference is that the projects must occur in industrialised nations that have emissions reduction targets under the Protocol (activity has primarily been in those economies in transition located in the former Soviet Union and Eastern Europe).

The mechanism enables any Annex I country to transfer to or acquire from another Annex I country, emission rights ("Emission Reduction Units" or "ERUs") equal to the emission reductions achieved by the project.

For a project to qualify as a JI project, the Protocol requires that there is specific investment in that project. In addition, both Parties (the transferor and the transferee of the ERUs) must approve the project and any emissions reductions achieved must be ‘additional’ to those that would otherwise have occurred.

There are two tracks for getting approval for a JI project. If the industrialised host country has met all of the eligibility criteria (discussed below) under the Protocol then the simplified Track 1 will apply and the host nation can independently approve JI projects and issue ERUs accordingly. Track 2 requires the involvement of the JI Supervisory Committee (equivalent to the CDM Executive Board) and requires an equivalent level of scrutiny.

Emissions monitoring and any claimed emissions reductions are required to be verified by an independent third party approved by the JI Supervisory Committee.

The JI mechanism will lead to ERUs being issued to project developers from the start of the First Commitment Period in 2008.

Article 17 of the Protocol provides a framework for Assigned Amount Units ("AAUs"), CERs, ERUs and removal units ("RMUs") to be transferred between registries located in Annex I Parties. Only Annex I Parties with emission limitation and reduction commitments under the Protocol may participate in IET.

The mechanism enables an Annex I Party to acquire units from other Annex B Parties and use them towards meeting that Party’s own emissions reduction target under the Protocol. An Annex B Party may only choose to transfer units when such Party does not require them for compliance with its own emission targets.

Transfers and acquisitions of these units are to be tracked and recorded through the computerised system of registries established under the Protocol known as the International Transaction Log ("ITL"). It is anticipated that the ITL will be put into operation in late 2007. However, there have been multiple delays to its deployment that make any deadline uncertain. Each Annex B Party must establish and maintain a national registry (which is linked to the ITL). National registries will be used to monitor the relevant Annex I Party’s compliance with its emissions targets by comparing the Parties’ actual GHG emissions with its holdings of ERUs, CERs, AAUs and RMUs in the national registry.

Businesses and other legal entities may participate in IET if authorised by an Annex I Party. An account in the name of the participant will be created in the relevant national registry for this purpose.

Various national and regional GHG emissions trading schemes have been established or are being investigated. All international transfers which occur under such domestic or regional trading schemes (such as the EU Emissions Trading Scheme ("EU ETS") fit under the umbrella of the Kyoto’s IET scheme. In this regard under national and regional level schemes, governments set emissions reduction targets to be achieved by participating installations or entities. Holding ERUs, CERs, AAUs and RMUs established under the Protocol can sometimes be used towards compliance with these obligations. Thus where transfers are made from one Annex I Party to another, either under linked domestic trading schemes or under a regional trading scheme, these need to be accounted for under the accounting rules of the Protocol. For the EU ETS this will be done automatically.

The Protocol establishes eligibility criteria which Parties must satisfy before they can participate in the flexible mechanisms. They are broadly the same for the three mechanisms, however the criteria are most severe in relation to IET. In order to participate in the mechanisms a Party must:

• be a Party to the Protocol;
• have established its Assigned Amount (i.e. the size of its emissions cap);
• have in place a national system for the estimation of GHG emissions by sources;
• have in place a national registry; and
• have submitted annually the most recent required GHG inventory; and supplementary information on its Assigned Amount.

In order to address the concern that countries could "oversell" units and subsequently be unable to meet their own emission targets, each Party to the Protocol is required to hold a minimum level of ERUs, CERs, AAUs and RMUs (different types of Kyoto units) in its national registry at all times - known as the commitment period reserve ("CPR"). The total reserve which could contain any of these units is calculated as the lower of the following:

(1) 90 per cent of the country’s assigned amount as defined in articles 3.7 and 3.8 of the Protocol. This calculation is likely to be relevant to participating Annex B countries which prove, at the end of the commitment period, to be "net buyers" of units under the mechanisms; or

(2) the level of national emissions indicated in the country’s most recent emissions inventory (multiplied by 5 for the 5 years of commitment period). This calculation is likely to be relevant to Annex B countries which prove, at the end of the commitment period, to be "net sellers" of units under the mechanisms.

The transaction log will identify transfers that would cause the CPR to be violated and may then automatically not allow any further trades until the CPR has been restored. Trades are recorded on a first come first serve basis so factors such as who the parties are or the order in which the projects were registered, would have no relevance.

Any Annex I country which fails to meet its Kyoto obligation will be required to submit 1.3 emission allowances in a second commitment period for every tonne of GHG emissions they exceed their cap in the First Commitment Period.

A compliance committee was established at the Marrakech meeting, and has two branch committees: the facilitative branch and the enforcement branch. The facilitative branch provides advice to the Parties on implementation of, and compliance with, the Protocol. The enforcement branch determines noncompliance by a Party with its emission limitation or reduction commitment, reporting requirements or the Eligibility Requirements.

Figure 2 shows the Eligibility Process in outline.

The key issue dominating the climate change agenda is what will happen when the current targets agreed under Kyoto come to an end in 2012. There is still a wide spectrum of views on climate change, its likely impacts and whether we should do anything to try to prevent it or simply learn to adapt to its inevitable consequences. The Intergovernmental Panel on Climate Change most recent intervention into this debate was to state with at least 90% certainty that Climate Change is a manmade phenomenon. The recent Stern Report on the economics of climate change has pushed the prevention rather than adaptation agenda, which would suggest further targets. In addition the EU has made a significant announcement that it will unilaterally agree to a 20 per cent cut by 2020 and will agree a further 10 per cent if wider international consensus on targets can be reached.

At the recent G8 Summit in Heiligendamm the major greenhouse gas emitters agreed to seriously consider halving global emissions by 2050. Consensus was also reached on the continued use of the UN framework as the forum for moving toward a post-2012 global agreement including all major emitters. That process is set to commence in Bali, Indonesia in December 2007 with a view to achieving agreement by 2009 at the latest. Further action is to be based on the principle of "common but differentiated responsibilities" with technology transfer, energy efficiency and market mechanisms, including emissions trading systems and tax incentives, being the key to success.

In all, the momentum appears to be behind those advocating cuts in greenhouse gas emissions, with the principal barriers to agreement likely to be bringing China, India and the other most developed developing nations into an emissions constrained environment and persuading the US, domestically, that cap-and-trade is not anti-trade. The issue now really is not whether there will be future action, but what shape the framework will take.

© Linklaters. All Rights reserved 2007

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