The Kyoto Protocol

In December 1997, representatives from both the developed and the developing world met in Kyoto to negotiate their participation in a multilateral treaty that would seek to reduce global emissions. The treaty was underwritten by governments and is governed by global legislation enacted under the UN's shield. Under Kyoto's main principle, governments are separated into developed countries, referred to as Annex 1 countries (which have accepted greenhouse gas emissions reduction obligations); and developing countries, referred to as Non-Annex 1 countries (which, although they do not have legally binding greenhouse gas caps, must submit and monitor their annual greenhouse gas inventory).

The Kyoto Protocol came into force in February 2005. As of January 2007, 166 countries and other governmental entities had ratified the Accord. Notable exceptions include the United States and Australia, although they are signatories. Ratifying countries have committed to reduce, by 2008-12, their emissions by 5.2% below their 1990 levels. The Protocol provides three mechanisms:

  •     Emissions trading among Annex 1 countries;
  •     Joint Implementations (lls), which allow Annex 1 nations to obtain emission credits (Emission Reduction Units ¬ERUs) for projects that reduce emissions in other Annex 1 countries; and
  •     Clean Development Mechanisms (CDMs) whereby Annex 1 countries can obtain permits (Certified Emission Reduction units - CERs) for projects that reduce emissions in non-Annex 1 countries.

The European Union Emissions Trading Scheme (EU ETS)

The EU ETS is considered the paradigm of environmental markets. Above all, it represents the European Union's commitment to spearhead efforts to combat climate change, both by setting an example, and by fulfilling its pledge to reduce its emissions by 8% from 1990 levels by 2012. The EU ETS came into effect in January 2005, prior to the ratification of the Kyoto Protocol, and is the largest multi-country, multi-sector, greenhouse gas emissions trading scheme.

In the first phase (2005-07), the EU ETS includes some 12,000 installations, representing approximately 45% of total EU CO2 emissions. The sectors included in this phase are: power generation; ferrous metals production and processing; chemical processes: minerals; and pulp, paper and board. The European Commission has announced its intention to include aviation in the EU ETS in the second phase (2008-12), given the large and rapidly growing emissions of the sector. The proposed directive will cover emissions from flights within the EU from 2011, and all flights to and from EU airports from 2012.

The principal objective of the EU ETS is to internalize the external cost of carbon, i.e. institutionalize the 'polluter pays' principle and use market forces to encourage innovation and carbon reduction initiatives. However, critics remain skeptical whether the resulting carbon price will prove sufficient to drive or induce the requisite innovation for the EU to reach its Kyoto emissions reduction targets.

Through the Linking Directive, the EU allows both the corporate and the private sector to participate in the wider Kyoto scheme by allowing the trading of government permits, namely CERs. The number of such permits that a corporate is allocated to use for compliance purposes is capped and regulated at the national level (and are part of the National Allocation Plan (NAP) proposals), following strict EC guidelines.

" NAPs are a direct function of each country's progress vis-a-vis its own Kyoto targets and the EC's directives. In the first phase, several countries allocated themselves annual allowances covering 12% more CO2 than they actually produced in 2005, which led to a near-collapse of the market in April 2005 (from €30 a tonne to €14). But Phase II NAPs, the first of which were announced in November 2006, sent, in the words of the EU Environment Commissioner, Stavros Dimas, " ... a strong signal that Europe is fully committed to achieving the Kyoto target and making the EU emission trading scheme a success". The result seems likely to be an average cut of nearly 7% below the 2005 emissions level. In addition, the Commission has indicated that it will limit the proportion of allowances that can be offset by external credits, namely CERs and ERUs.

Going global

Greenhouse gases, unlike aerosols, diffuse quickly through Earth's atmosphere, so that reducing greenhouse gas emissions is equally effective regardless of where the reduction is effected. Kyoto recognizes this through its flexible mechanism tools, which allow countries to use externally gained credits to offset domestic emissions. Similarly, as mentioned above, the EU extended this principle to the corporate sector, allowing companies to use those external credits for their compliance needs. However, trading between countries is limited. Each nation is charged with its own responsibility to retain its emissions within its pre-agreed cap, both by trading offsetting credits and through domestic abatement actions.

Japan recently stressed the importance that it attaches to a balance being struck between the use of external credits and domestic abatement action.
Clean Development Mechanisms

Emissions Trading Schemes, and the CDM mechanism, are effective tools in helping countries achieve reductions in the most cost-effective way, on a global scale. At the same time, as emphasized, for example, by Cooper (2006), such schemes carry with them an inherent risk of corruption because of the potential scale of transfers between countries. This specific system is run by the United Nations Framework Convention for Climate Change (UNFCCC) and is a project-based reduction mechanism, designed in particular to minimize corruption risk. The procedures involved, from the early stages of the project to actual issuance of those credits by the UN, tend to be complicated and lengthy. Specifically, in the CDM world, CERs may be produced only from UN-registered projects that have been verified by independent Designated Operating Entities (DOEs) approved by the UN. Issuance of CERs is then undertaken only by the Executive Board of the UNFCCC, and is irrevocable. This process requires considerable due-diligence, throughout the project's life (5-7 years, on average).

Currently China is the biggest 'host' country for CDMs (44% of the global total). India has the largest number of registered projects, but they are on average smaller (50,000 credits per annum per project). To date, the great majority of issued CERs have come from large-scale HFC23 (Hydro-fluorocarbon 23) projects, which have the potential to generate hundreds of millions of credits. Those credits will be key for future Kyoto negotiations.

The demand for CERs comes either from the private sector, mainly to meet corporate compliance obligations, or from the public sector, in the form of governmental purchasing schemes. So far, the biggest buyers in the governmental compliance market have been Japan (through its global corporations) and some EU countries, whereas Canada recently revised downward its procurement plan.

Overall, however, most of the European Union's activity is still originated by private-sector initiatives, targeting mainly the EU compliance market. The public sector seems to be lagging, perhaps with the most notable exception being the government of the Netherlands, which has committed to many external projects - 23 JIs and 4 CDMs - for a total contracted volume of 18m tonnes of CO2.

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