Carbon Trading

What is Carbon Trading?

Carbon trading, or more generically emissions trading, is the term applied to the trading of certificates representing various ways in which carbon-related emissions reduction targets might be met. Participants in carbon trading buy and sell contractual commitments or certificates that represent specified amounts of carbon-related emissions that either:

• are allowed to be emitted;
• comprise reductions in emissions (new technology, energy efficiency, renewable energy); or
• comprise offsets against emissions, such as carbon sequestration (capture of carbon in biomass).

People buy and sell such products because it is the most cost-effective way to achieve an overall reduction in the level of emissions, assuming that transaction costs involved in market participation are kept at reasonable levels. It is cost-effective because the entities that have achieved their own emission reduction target easily will be able to create emission reduction certificates "surplus" to their own requirements. These entities can sell those surpluses to other entities that would incur very high costs by seeking to achieve their emission reduction requirement within their own business. Similarly, sellers of carbon sequestration provide entities with another alternative, namely offsetting their emissions against carbon sequestered in biomass.

Emissions trading is one of the flexibility mechanisms allowed under the Kyoto Protocol to enable countries to meet their emissions reduction target. Countries/companies with high internal emission reduction costs would be expected to buy certificates from countries/companies with low internal emission reduction costs. The latter entities would also be expected to maximise their production of low cost emission reduction so as to maximise their ability to sell certificates to high cost entities. The overall outcome is that the emission reduction target is met, but at a much lower cost than would be incurred by requiring each entity to achieve the emission reduction target on their own.

How is carbon trading undertaken?

The simplest type of carbon trade involves an entity preparing a contract that describes and specifies the kind of activity they are undertaking to either reduce or offset emissions. The contract may or may not be independently verified, although doing so will increase buyer confidence and probably attract a higher price. This contractual commitment is then sold to another entity that wishes to make use of the specified amount of the reduction or offset.

Contractual commitments are usually traded "over the counter" (OTC), which means that the trade is usually a bilateral one between a willing buyer and a willing seller without the need for a market to exist. OTC trades are usually single trades where the terms are either partially or fully confidential. OTC markets are relatively simple and operate where there is limited "liquidity" (that is, not many trades are occurring) or where the product being traded is somewhat unique for each trade.

In contrast, a carbon trading market is more akin to a share market. Products traded on a market are generally more homogeneous; for example, all types of carbon sequestration that meet the rules defining the creation of a "carbon sequestration certificate" may be deemed to be identical in the market. This both increases the liquidity of the product and helps market participants understand and have more confidence in the product being traded. The existence of a set of enforced rules associated with the creation of both emission reduction and emission offset certificates also increases market confidence in the product.

What is necessary for a carbon trading market to commence?

There is no carbon/emissions trading market operating in Australia at present [May 2002]. The Australian Greenhouse Office has prepared several papers associated with the potential introduction of emissions trading in Australia (see www.greenhouse.gov.au).

An emissions trading market has commenced in the United Kingdom and is proposed or imminent for several European countries (see for example www.ieta.org). An emissions trading market is also under development in the United States (see www.chicagoclimatex.com).

A carbon trading market will commence only if it meets a perceived need. If a penalty is attached to failing to meet an emission reduction target, such as in the UK and potentially in the EU within a few years, a market will benefit participants by facilitating a least cost outcome. In the case of the US, a market may still be successful in an environment in which emission reduction is voluntary. This would occur where there are sufficient participants to enable a market to operate effectively, and where companies participate because they have made a corporate decision to reduce greenhouse gas emissions and want to understand to role that emissions trading will play in achieving that outcome.

A market requires a range of structures to be in place to reduce risk in the market and improve the confidence of market participants in the integrity of the market. Participants need confidence that the product is "real". This is usually achieved by setting in place a set of rules, overseen by an independent body with sufficient power to enforce the rules, about carbon accounting, independent verification and risk management that must be met by any entity seeking to sell carbon certificates on the market. In this way, the liability for establishing and managing the validity of what is being sold lies with the seller; the buyer does not taken on that liability. Participants need confidence that trades will be properly settled, such that buyers get their certificates and sellers get their money. Participants need confidence that ownership of certificates is well established and is tracked over time, and that certificates are retired/extinguished as they are used to meet emission reduction targets.

The most likely drivers to create a carbon trading market in Australia in the near future are:

• requirements proposed by the NSW Government for NSW electricity retailers (also being considered at national level), whereby mandatory per capita targets for emissions reduction are imposed together with a penalty for non-compliance (see Ministry for Energy and Utilities sequestration workbook);
• a push by major corporate companies to achieve voluntary emission reductions and to use a market to do so cost-effectively, notwithstanding the existence or otherwise of any national commitment to meeting emission reductions under the Kyoto Protocol or a similar policy.

For progress to date on carbon trading in NSW, see Carbon Trading Milestones.