CARBON TRADING

JAIPURIA INSTITUTE OF MANAGEMENT, LUCKNOW

Prepared For:
Prof. MRIDULA GOEL
Faculty, JIM-Lucknow

Prepared By:
PRATEEK SRIVASTAVA(CFT07-104)

07 December 2007
CARBON TRADING
INTRODUCTION
The dramatic imagery of global warming frightens people. Melting glaciers, freak storms and
stranded polar bears -- the mascots of climate change -- show how quickly and drastically
greenhouse gas emissions (GHG) are changing our planet. Such graphic examples, combined
with the rising price of energy, drive people to want to reduce consumption and lower their
personal shares of global emissions. But behind the emotional front of climate change lies a
developing framework of economic solutions to the problem. Two major market-based options
exist, and politicians around the world have largely settled on carbon trading over its rival,
carbon tax, as the chosen method to regulate GHG emissions.

EMISSION OF GREENHOUSE GASES

Carbon trading, sometimes called emissions trading, is a market-based tool to limit GHG. The
carbon market trades emissions under cap-and-trade schemes or with credits that pay for or
offset GHG reductions.
Cap-and-trade schemes are the most popular way to regulate carbon dioxide (CO2) and other
emissions. The scheme's governing body begins by setting a cap on allowable emissions. It then
distributes or auctions off emissions allowances that total the cap. Member firms that do not
have enough allowances to cover their emissions must either make reductions or buy another
firm's spare credits. Members with extra allowances can sell them or bank them for future use.
Cap-and-trade schemes can be either mandatory or voluntary.
A successful cap-and-trade scheme relies on a strict but feasible cap that decreases emissions
over time. If the cap is set too high, an excess of emissions will enter the atmosphere and the
scheme will have no effect on the environment. A high cap can also drive down the value of
allowances, causing losses in firms that have reduced their emissions and banked credits. If the
cap is set too low, allowances are scarce and overpriced. Some cap and trade schemes have
safety valves to keep the value of allowances within a certain range. If the price of allowances
gets too high, the scheme's governing body will release additional credits to stabilize the price.
The price of allowances is usually a function of supply and demand

Burning of fossil fuels is a major source of industrial greenhouse gas emissions, especially for
power, cement, steel, textile, and fertilizer industries. The major greenhouse gases emitted by
these industries are carbon dioxide, methane, nitrous oxide, hydro fluorocarbons (HFCs), etc,
which all increase the atmosphere's ability to trap infrared energy and thus affect the climate.
The concept of carbon credits came into existence as a result of increasing awareness of the
need for controlling emissions. It was formalized in the Kyoto Protocol, an international
agreement between 169 countries.
Kyoto Protocol: The Kyoto Protocol is a protocol to the international Framework Convention
on Climate Change with the objective of reducing Greenhouse gases that cause climate change.
As stated in the treaty itself, the objective of the Kyoto Protocol is to achieve "stabilization of
greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous
anthropogenic interference with the climate system. “Among various experts, scientists and
critics there is some debate about the usefulness of the protocol, and there have been cost-
benefit studies performed on its usefulness.

CLIMATE AND EMISSIONS TRADING

It was at the 1997 Kyoto Earth Summit that dozens of industrialized countries committed
themselves to significantly reducing their emissions of gases that affects climate change,
particularly carbon dioxide. To achieve this goal, they agreed to put in place several measures,
among them an international emissions trading system. Many experts believe that this trading
system, first implemented in the European Union in 2005, will be one of the most efficient
instruments to Promote international climate change protection. But how does it work? What
are the opportunities, challenges and risks of this market-based approach?

5 FACTS ABOUT CLIMATE AND EMISIONS TRADING

• The trade system involves the exchange of emissions certificates (one certificate covers one
ton of CO2). Trading can take place at national or international level, or between companies.

• Companies receive a certain number of free certificates from their governments. When a
company reduces its emissions, it can sell its excess certificates for profit to other companies. In
contrast, a company faces penalty if it does not acquire enough certificates.
• International emissions trading as agreed in the Kyoto Protocol officially begins in 2008, but
various regional and national trading initiatives have already begun. The largest and most
comprehensive of these initiatives was started by the EU in 2005.

• Some 12,000 installations across Europe with a combined trading volume of 1.2 billion tons of
CO2 are involved in the EU scheme. Many represent heavy polluting industries, such as energy
production and building material manufacturing.

• The use of these market mechanisms ensures that reductions in emissions are made where the
costs of reduction are lowest.

Carbon Credits
Carbon credits are a key component of national and international emissions trading schemes.
They provide a way to reduce greenhouse effect emissions on an industrial scale by capping
total annual emissions and letting the market assign a monetary value to any shortfall through
trading. Credits can be exchanged between businesses or bought and sold in international
markets at the prevailing market price. Credits can be used to finance carbon reduction schemes
between trading partners and around the world.
There are also many companies that sell carbon credits to commercial and individual customers
who are interested in lowering their carbon footprint on a voluntary basis. These carbons off
setters purchase the credits from an investment fund or a carbon development company that has
aggregated the credits from individual projects. The quality of the credits is based in part on the
validation process and sophistication of the fund or development company that acted as the
sponsor to the carbon project. This is reflected in their price; voluntary units typically have less
value than the units sold through the rigorously-validated Clean Development Mechanism

Emissions trading involve the exchange of emissions certificates. Operators of large energy
production plants or energy-intensive industrial companies are assigned a predetermined
number of emissions certificates by their governments. These initial certificates are free, and
authorize the companies to emit a specific amount of CO2. If a company exceeds its allowance,
it must buy in additional certificates.When a company reduces its emissions, it can sell its
excess certificates for profit. Companies face penalties when they do not acquire enough
certificates to balance out the CO2 they have emitted. In addition to the emissions certificates
allocated by the state, companies can also make use of other “flexible mechanisms.” If they
invest in emissions reduction projects in other countries, for example, they receive additional
emissions allowances, which are the equivalent of emissions certificates.These can also be
traded. The use of these market mechanisms ensures that the reductions in emissions are made
where the costs of reduction are lowest. Thus, for all companies involved, emissions trading
makes both ecological and economic sense.
Market-Based Approach

Thus companies must decide whether it is financially viable to buy in additional certificates or
whether it would not be more cost-effective, particularly in the long term, to modernize their
installations by incorporating technology designed to reduce emissions, and then to sell their
excess certificates. Emissions trading are therefore an instrument that creates incentives for
environmentally friendly investment and continued development of renewable energies, and is
intended to achieve climate protection at the lowest possible cost. Rather than relying on the
state to impose inflexible regulation and prohibitions, emissions trading allows companies to
pursue state-imposed targets however they see fit. “How trading functions is then dependent on
market participants and liquidity,” says Armin Sandhoevel, coordinator of Allianz’s Climate
Core Group. If emissions trading proves to be effective, other industries are expected
to be incorporated into the scheme from 2008. “So, in terms of risk management, companies
should ensure that they are well prepared for emissions trading,” warns Sandhoevel. “I really
would advise against adopting a ‘wait-and-see’ attitude.“ The future of emissions trading
Although there is broad agreement that emissions trading can help slow climate change, the
long-term future of the concept is still uncertain.
Establishing a viable, long-term climate policy that reaches beyond 2012 (the post-Kyoto
phase) and includes nations outside of the EU is critical. Only through long-term, global
emissions trading schemes can Europe avoid the competitive disadvantage of having higher
emissions costs than other economic areas. Therefore, international negotiations that include
nations outside of the EU are important. Industrial countries are currently drafting their
contributions to Article 3.9 of the Kyoto Protocol, which will determine the shape of
international climate change regulation process after the 1997 Protocol expires. roadmap for
the next steps is to be drawn up at the International Climate Conference in Nairobi in mid-
November 2006.

How buying carbon credits can reduce emissions

Carbon credits create a market for reducing greenhouse emissions by giving a monetary value
to the cost of polluting the air. Emissions become an internal cost of doing business and are
visible on the balance sheet alongside raw materials and other liabilities or assets.
By way of example, consider a business that owns a factory putting out 100,000 tonnes of
greenhouse gas emissions in a year. Its government then enacts a law that limits the emissions
that the business can produce. So the factory is given a quota of say 80,000 tonnes per year. The
factory either reduces its emissions to 80,000 tonnes or is required to purchase carbon credits to
offset the excess.
After costing up alternatives the business may decide that it is uneconomical or infeasible to
invest in new machinery. Instead may choose to buy carbon credits on the open market from
organizations that have been approved as being able to sell legitimate carbon credits.

• One seller might be a company that will offset emissions by planting a number of trees
for every carbon credit you buy from them under an approved CDM project. So
although the factory continues to emit gases, it would pay another group to go out and
plant trees which will draw back 20,000 tonnes of carbon dioxide from the atmosphere
each year.

• Another seller may have already invested in new low-emission machinery and have a
surplus of allowances as a result. The factory could make up for its emissions by buying
20,000 tonnes of allowances from them. The cost of the seller's new machinery would
be subsidized by the sale of allowances. Both the buyer and the seller would submit
accounts for their emissions to prove that their allowances were met correctly.
Climate Change: Why India Must Act

A new treaty with binding CO2 emissions cuts for the world’s major polluters - USA, China,
and India. While both India and China were under considerable pressure to accept such targets,
they resisted, promising only to “cooperate”.

India’s position on climate change is simple:

1. Climate change has been caused by the developed world, which must bear the costs of
abatement and mitigation.

2. India is not a significant greenhouse gas (GHG) emitter, and

3. It will not accept binding emission cuts, without compensation, as that would conflict
with the overarching goals of economic growth.

This position may be good for international negotiations. But as a policy, it is ethically
indefensible, logically and economically inconsistent, and worse - a wasted opportunity.

Ethically Indefensible: The Futility of Taking the High Road

India’s primary logic is based on ethical reasoning. While India is the fifth largest CO2 emitter,
on a per-capita basis its emissions remain very low. Since the developing world did not cause
the problem it should not pay the price of repairing it, nor suffer its consequences. Prime
Minister Manmohan Singh called this the “principle of common but differentiated
responsibility,” on the eve of the G8 Summit.

Yet, this ignores reality. It is today accepted that despite our best efforts global warming will
occur and its costs borne mostly by the poor. According to a report by Lehman Brothers cold
countries such as Russia will actually benefit (receiving a GDP boost of 0.5%), while the
regions to suffer the most will be India, Africa, and Europe (see graph). Critically, the poor
regions - including India - will also lack resources to help their populations adapt to changes, or
insure their consequences.

Given this reality, sitting on a pedestal and crying foul about who is responsible for climate
change will not help. The Indian government’s primary responsibility is not to apportion blame
for the world’s ills. It is to take action to protect its population against those ills.

Economically Inconsistent: Industrial vs. Agricultural Growth

The other argument is economic - mitigation is costly and threatens India’s economic growth. If
India is to act, it should be compensated for lost GDP growth.

Again, a desirable goal, but one that also ignores reality. First, the West is unlikely to
compensate India if it does not agree to be part of an international mitigation effort. Second, by
not acting India endangers the very growth it wishes to protect.
As numerous studies have concluded, climate change will significantly impact weather patterns
across the world. In India, it also threatens Himalayan glaciers that supply much of India’s
freshwater supplies (the Gangotri glacier has been retreating since measurements began in
1842, but its rate of retreat has almost doubled from around 62 feet per year between 1935 and
1971). The likely long-term impacts are increased droughts and cyclones, higher temperatures,
and scarcity of freshwater supplies.

These changes threaten India’s growth in the very important agricultural sector. For instance,
the World Bank estimates (original article at FT.com) that climate change could cause crop
yields to fall by 30% by mid-century. Contrast this with the government’s own target of raising
agricultural growth from 2% to a trend average of 4% in the eleventh five-year plan, and the
inconsistency becomes obvious. While the manufacturing and service sectors may indeed grow,
it is hard to understand how that will compensate the 70% of India’s population living in rural
areas, much of it dependent on the monsoons.

Perpetuating Inaction
There is one final reason for action - that inaction by India perpetuates inaction by others. The
US has long held that it will not accept emissions targets unless India and China follow suit.
India’s inaction is therefore doubly harmful, providing “a figleaf for US inaction”. Further, with
India - and China’s - absence from international climate change negotiations, the needs of
developing countries remain unaccounted for.

Given the inevitability of global warming, and given that India will bear a disproportionate cost
of that change, India’s policy objectives need to be reversed:

1. 1. To encourage all countries to act urgently to mitigate climate change, and

2. 2. To develop an international mechanism that allows poor countries to mitigate, adapt
to or insure against climate change, drawing resources from the developed world.

Turning Challenge into Opportunity

India’s lethargy to act has prevented both from happening. And in the process, the policymakers
are loosing a major socio-economic opportunity.

Climate change may be a threat, but it is also transforming industries and creating new ones. As
proof, consider the North American cleantech venture capital industry which grew by 78% in
2006 to $2.9billion (PE & VC funding grew 167%)! Over half of this goes into clean and
renewable energies, but that is not the only sector and the US not the only country benefiting.
Israel is the largest investor in the water segment of the cleantech industry. In great need,
venture capitalists have seen great opportunity. The PM can very well demand cheap access to
low-carbon technology, but he should be spending at least as much time encouraging R&D and
investment in those very technologies. If nothing else, he’d be hedging his bets.

Second, moving to a low-carbon economy can actually save money. The Economist, in its
special of June 2nd points out the cost of cutting carbon through various technologies (Irrational
incandescence - see chart below).
The odd thing is that simple things - better fuel-efficiency, insulation, water heating, CFLs -
actually save money. Admittedly, these are areas hard to get at for policymakers, since they
affect distributed stakeholders. Yet, India cannot hide behind protecting its GDP growth. If
anything, the government should accept binding cuts, then use that as an excuse to force its
industries and consumers to become more energy efficient.

Finally, India’s position is a wasted political opportunity to shape the international climate
change framework. By doing nothing, India can expect nothing in return. More and more, India
does not look like a leader, but a laggard - and a unhappy one at that. What the country needs is
to accept the need for binding cuts, specify a compensatory system that provides access to IPR
and funding, and then start negotiations in earnest. This is particularly important now, when the
world still wants our participation. Once the US and China (which published a policy paper
prior to the G8 summit) take a definitive lead on the issue, we will be left not with the
opportunity to shape an international framework, but with the responsibility to accept whatever
is decided on in our absence.

This post does not argue what India should ask for, or can reasonably expect. It simply makes
clear that there is an urgent need for India to act - in its own interest - to mitigate climate
change. There is also an social and economic opportunity in doing so, with the costs of inaction
likely to outweigh the costs of action. And finally, climate change presents a political
opportunity to shape - to India’s benefit - an international framework (as India is doing with the
Indo-US Nuclear Agreement).

Disadvantages of emissions trading

The greatest challenge in emissions trading is the politics in designing the scheme, the politics
in deciding who is allocated what, etc. Also, emissions trading cannot easily be applied to all
sectors,such as transport. Although air travel is easier because of the large volumes of emissions
from each airline, it is much more difficult with individual cars, which are a significant and
growing problem.

What we do have to acknowledge is that there is a cost of reducing greenhouse gas emissions
and that there are going to be costs for companies covered by the scheme as a whole. But it is
very important to understand that these costs are lower than they would be if we were still
trying to achieve the same environmental targets without an instrument like emissions trading.

The issue of currency is certainly a challenge. Whatever kind of program is developed, we

would want to make sure that the currency used could be tradable in the open market - so that
one ton of carbon in the United States is worth the same as a ton of carbon in Canada, or the
EU. This will help promote a better market for trading overall.