The Carbon Markets

As we draw ever closer to phasing out the Millennium Development Goals and replace them with Sustainable Development Goals in the Post 2015 Development period, there is little doubt that climate change will not be one of the main cross cutting themes. Here in Africa, climate change is a fairly new agenda and countries are facing a severe inadequacy of technical expertise and know how to initiate and scale up climate change governance interventions. Also, almost every other organization is coming up with various ways of “re-branding” its activities to fit into the “building resilience” realm – whose indicators are yet to be determined – in anticipation of funding for climate change governance strategies. 

It is also generally accepted that the level of funding needed to tackle the climate crisis is astronomical. For instance the most recent cost estimate for cutting deforestation in half ranges from USD 12 million to USD 35 billion per year (www.ucsusa.org/redd). Still, this figure is much more than is currently spent on protecting forests in the developing world and the question therefore is, where will the additional funding come from? Well, two main sources have been proposed: public funding and market finance. Public funding can come from several sources: dedicated funding that is additional to traditional overseas development assistance, the allocation of a portion of the revenue from cap-and-trade systems and/or through taxes and levies. Public funding can also come from international sources, or it can be raised internally within a country. 

Carbon finance on the other hand will come from carbon markets which are based on the premise that certain companies will be able to reduce their greenhouse gas emissions at a lower cost than others. If those companies are able to sell excess emissions reductions to other companies, the overall cost of compliance with the system will be lowered. Let’s see through an example of how a carbon market works. For this example, we have two companies representing the industrial sector as a whole, and we have a policy goal of reducing emissions by 2000 tons each.

Power Pro Ltd. uses old, inefficient power sources. It can make some easy updates to reduce its greenhouse gas emissions at a cost of USD 2 per ton. Power Pro is watching the carbon market, which is currently trading carbon credits at USD 4 per ton. At that price, Power Pro realizes it can reduce more emissions than required and sell its extra reductions at a profit. Power Pro therefore reduces 1000 tons more than required. At a cost of USD 2 per ton, reducing 1000 extra tons costs the company USD 2000. Credits are currently trading at USD 4 per ton so Power Pro should have no problem selling the extra 1000 tons at a profit in the carbon markets.    

For the second company, Newfangled Power, it is more costly to reduce emissions. It costs them USD 6 per ton to reduce emissions. For Newfangled Power to meet its requirement and reduce its emissions by 2000 tons, it would cost USD 12000. At that price, Newfangled Power realizes that buying credits from the carbon market would be cheaper than reducing their emissions because carbon credits are selling for USD 4 per ton. Buying 2000 tons of credits would cost them USD 8000.

Power Pro therefore reduced its emissions by 3000 tons, 1000 more than their goal. The cost to reduce those extra tons was USD 2000. They put their extra tons on the market at a price of USD 4000. Newfangled Power would like to buy credits to meet its goal of 2000 tons of reductions. Due to government rules, they can omly buy 50% of their necessary reductions on the market (and have to reduce the other 50% on their own). Therefore, they reduce 1000 tons of emissions themselves at a cost of USD 6000. They buy the other necessary 1000 tons at aprice of USD 4000. This transaction resulted in a USD 2000 profit for Power Pro and a USD 2000 savings for Newfangled Power, and 4000 tons of emissions were reduced, meeting everyone’s goals. Through the carbon markets, society achieves the needed emissions reductions at a lower overall cost. 

How governments administer carbon markets

Carbon markets result from policies that create “cap-and-trade” systems. A cap-and-trade system example follows. The first part of the system is the cap. Governments place a limit, or a cap, on the total amount of greenhouse gases that can be emitted each year. The amount of greenhouse gas emissions allowed generally declines in each subsequent year. Governments then print allowances allowances in the amount of the cap each year. Each allowance allows a company to emit one ton carbon dioxide equivalent (co_2e) that year. They then generally give some allowances to companies for free as a cost saving measure. Finally, the rest of the allowances are auctioned off. The revenue generated from the auction of allowances can be used to fund other efforts to mitigate or adapt to climate change.

Then there is the trading part of the system. This part operates just like the carbon market described in the previous example. Companies choose the most cost-effective way to meet their emission reduction requirements. Generally, they will reduce their emissions upto the point where it becomes more cost-effective to buy allowances from others rather than make further reductions. They then buy allowances from another company that was able to reduce their emissions below their requirement. The price of allowances is determined by the supply and demand in the market. 

It is important to note that in many cases, some sectors such forestry are not usually included in the emissions cap. This means that any reductions in emissions from such sectors are treated like an offset. An offset is a certified emission reduction that takes place outside of the regulated sector(s), for instance capture and combustion of methane from landfills, and agricultural manure management. Activities that measurably reduce emissions from any sector not covered by the cap could be eligible to sell offset credits. Firm regulated by a cap-and-trade system are sometimes allowed to submit offsets to cover their emissions in lieu of the allowances that make up the cap.

 

*A major proportion of this post is taken from the Nature Conservancy’s Reducing Emission from Deforestation and Forest Degradation and Enhancing Forest Carbon Stocks Course*