Some Basics of the Trade in Carbon Offsets

The term ‘carbon trading’ is a short-hand way of embracing all aspects of the merchandising – selling and buying – of a right to release greenhouse gases (GHGs) into the atmosphere, in the absence of which entitlement the emission would be illegal or, if not, would expose the emitter to criticism in some way. The word ‘carbon’ is used as a proxy for all the anthropogenic – created by us humans – gases which contribute to the ‘greenhouse effect’, otherwise known as global warming. The principal contributor is carbon dioxide (CO2) – hence the generic use of ‘carbon’ – but the other main offenders are methane, nitrous oxide and the fluorocarbons. This is not factually accurate. These gases are not only produced by humans, simply their dangerously high levels are the result of human activity. Carbon is also not used as a proxy for all greenhouse gases. For the practicality of measurement and the facilitation of carbon offsets as fungible units, other greenhouse gases are calculated by their carbon equivalent. Ie if the effects of GHG A are twice as harmful in terms of their contribution to global warming as carbon dioxide, one carbon offset unit will be required to offset half a ton of emissions.

In concept, carbon trading is based on the fundamental notion that when it comes to global warming, Mother Earth is indifferent to where GHGs are generated. You are mixing up carbon trading with carbon offsetting. Carbon trading is the ‘trade’ of the fungible units of the carbon offsetting system. CO2 emitted in, say, the United States contributes to the greenhouse effect worldwide. And by the same token, the planet doesn’t care where GHG emissions are mitigated – either by their prevention or, in the case of CO2, by its absorption in a ‘sink’, that is, a forest. To the extent that the emission of a GHG is mitigated in, say, China, that mitigation will be global in its effect.

From these basic premises comes the idea that someone – a large manufacturing enterprise, say – generating GHGs in one part of the world and either under a legal obligation or having the desire in any event to mitigate its pollution may partly achieve its objective by investing in some form of mitigation elsewhere. The corporation will still be emitting in its particular part of the planet but it will be contributing to a reduction in emissions in another part.

This is known as ‘offsetting’ and is the basis for carbon trading. Ok, here my previous criticism is somehow nullified but I would still quality the earlier definition of trading more clearly than being ‘based-on’ followed by the description of offsetting. It is an intrinsic consequence of the fact that offsetting was created as a commodity-based system. But what is it exactly that is traded? In essence, we are talking about a quantity, measured in metric tonnes, of either CO2 itself or a quantity of its equivalent in another GHG, and referred to so many mtCO2e.

The origins of this trade in carbon offsets can be traced back to the Kyoto Protocol to the 1992 United Nations Framework Convention on Climate Change, the first international recognition that we are contributing to climate change and need to do something about it. The protocol was drawn up in 1997 but did not become effective until the requisite number of signatories was reached in 2005, with Russia’s accession. The Kyoto Protocol gave express blessing to the notion that countries which committed to specific reductions in GHG emissions, relative to a baseline year, could offset part of that obligation by investing in mitigation projects in other countries. This entitlement was, needless to say, passed on by committed countries to their resident corporations which had to contribute to the national reduction commitment.

The mechanism was carbon trading. In simple terms, a market is created where a quantity of carbon offsets – also known as carbon credits – is offered for sale in so many mtCO2e and referable to a specific project which has been approved by some mechanism as a genuine contribution to GHG mitigation. The buyers in that market will typically be enterprises with an obligation to reduce their own emissions but, as explained above, entitled to some extent to do that by purchasing offsets. But the international carbon market has other participants on both the buying and selling side. Other buyers will be enterprises not subject to compulsory compliance but buying forward in anticipation of future participation or purchasing carbon offsets voluntarily to mitigate global warming as part of a ‘corporate social responsibility’ (CSR) policy. There will be not-for-profit organisations also using carbon trading as a way to stimulate ‘green’ projects in selected parts of the world. And on both selling and buying sides there are a mix of strategic and speculative investors in carbon credits, being parties which treat them as any other tradable commodity and aim to extract leverage – and ultimately profit – from movement in the market price.

To this point, there is no such thing as a ‘world market’ for carbon trading. The Kyoto Protocol itself stimulated the development of a host of carbon exchanges in different countries and underpinned the European Union’s Emissions Trading Scheme (the EU ETS) launched in 2005, which remains the world’s largest compliance (as opposed to voluntary) trading mechanism. But trading as an economic activity was and is not limited to participants in the Kyoto Protocol. Notably the United States, which refused to join Kyoto at the outset, was home to the first formal carbon exchange – the now-defunct Chicago Climate Exchange – and this year will see a major new compliance-based trading regime launched in the state of California.

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