Carbon Markets and the Kyoto Protocol

I read a few articles about the proposed cap-and-trade system in the U.S. and thought it'd be a good opportunity to read up on the Kyoto Protocol.

According to a press release from the United Nations Environment Programme (from Wikipedia):

The Kyoto Protocol is an agreement under which industrialized countries will reduce their collective emissions of greenhouse gases by 5.2% compared to the year 1990 (but note that, compared to the emissions levels that would be expected by 2010 without the Protocol, this limitation represents a 29% cut). The goal is to lower overall emissions of six greenhouse gases - carbon dioxide, methane, nitrous oxide, sulfur hexafluoride, hydrofluorocarbons, and perfluorocarbons - averaged over the period of 2008-2012. National limitations range from 8% reductions for the European Union and some others to 7% for the US, 6% for Japan, 0% for Russia, and permitted increases of 8% for Australia and 10% for Iceland.

An additional summary from Wikipedia on the status of the agreement and how many nations have ratified it:

As of June 2008, 182 parties have ratified the protocol. Of these, 36 developed cg countries (plus the EU as a party in its own right) are required to reduce greenhouse gas emissions to the levels specified for each of them in the treaty (representing over 61.6% of emissions from Annex I countries), with three more countries intending to participate. One hundred thirty-seven (137) developing countries have ratified the protocol, including Brazil, China and India, but have no obligation beyond monitoring and reporting emissions. The United States has not ratified the treaty.

The basic reason that the US has still not ratified the agreement is that lawmakers believe the agreement is unfair. China, who now produces more greenhouse gas emissions than the US does, is still treated as a "developing country", as are India and Brazil, which means they are not obligated to reduce their emissions at all. That definitely puts the US at an economic disadvantage.

The result of the Kyoto Protocol has really been mixed. The only countries that are really on-target to meet their Kyoto obligations are ex-Soviet bloc countries whose economies have significantly shrunk in recent years. They will meet their obligations not through cleaner production, but from decreased production. And in Europe, emissions have actually increased.

Part of the reason for that was the system the EU put into place to regulate the emissions. In 2005, the EU established the Emissions Trading Scheme (ETS) to serve as a market for buying and selling emissions credits. There were multiple problems with the way the system was setup. An excerpt from a WSJ article (U.S. Aims to Skirt Flaws In Europe's Carbon Limits) explains some of the issues:

The failure of Europe's system to shrink emissions is due primarily to one policy blunder: Governments handed out too many carbon permits. When regulators were designing the system, they based the caps on emissions estimates provided by countries, which got estimates from companies. In 2006, the first year actual national-emissions data became available, it turned out that many factories had been given far too many permits.

That meant that companies had no incentive to revamp their factories or install lower-emissions technology. "The allocation process was tremendously flawed," says Sen. Bob Corker (R., Tenn.) who met with EU officials during a trip last year.

A second issue with the EU scheme was that the permits were distributed free to companies initially. The unusual result was that utilities and energy companies started raising rates even though they didn't incur any new costs yet.

The proposed US based cap-and-trade system aims to learn from such mistakes:

In Europe, power companies received most of their carbon permits free in the start-up phase, but some raised rates all the same, arguing emissions policies had raised their costs of production. In Germany, heavy-industrial companies saw their electricity costs jump, while major power producers' profits soared.

Instead of giving away all the permits, the Lieberman-Warner bill proposes to auction a quarter of the permits in 2012 when the program starts. Over time, the share auctioned off would rise, until some 70% are auctioned off by 2031. Making companies pay for permits rewards companies with cleaner operations and ensures that the cheapest, most efficient technologies are adopted first.

The result of legislation like this is that new markets similar to the ETS will emerge in the US. One such market is the Green Exchange (run by the NY Mercantile Exchange). How big can these markets get? From a Forbes article from back in February (Selling the Blue Sky), here's an estimate of what was exchanged last year:

There's more where that came from: The equivalent of some 3 billion metric tons of carbon emissions, valued at $79 billion, changed hands last year, says New Carbon Finance, a U.K. research firm.

That's a big market. It will be interesting to see how these commodities are packaged up, though, as there are complexities in how the carbon credits are recognized from country to country. Another excerpt from the Forbes article talking about Evolution Markets, an early mover in the carbon exchange market:

[Evolution] is working on projects like these: helping a European wind-turbine manufacturer expand; converting Indian coal plants to natural gas. Evolution gets a fee (and credits of its own) for bringing in private investors. It is tricky: Each country has a say about which credits are acceptable. European Union nations accept industrial projects like those Ertel is arranging in India but reject reforestation credits, for instance.

I'm still unclear on exactly how the Clean Development Mechanism (CDM) and Joint Implementation (JI) projects work. Apparently, the idea is that you can create additional carbon credits by executing emissions reductions projects in developing nations. I'll have to investigate that another time.