The global carbon market explained

In December 1997, the Kyoto Protocol capped emissions of a basket of six greenhouse gases in so called Annex I countries – industrialised countries and economies in transition – for its first commitment period, until 2012.

This was through the introduction of emission targets to be met through a combination of internal emission reduction measures and three so called flexible mechanisms, International Emissions Trading (IET), the Clean Development Mechanism (CDM) and Joint Implementation (JI).

The principle behind these economic policy instruments, known as the “equivalence” principle, states that, due to the uniform mix of the greenhouse gases in the atmosphere, from a strictly environmental standpoint it is irrelevant where exactly in the world emission reduction measures are implemented. This justifies the very existence of a global carbon market.

The commodity traded in this market, commonly referred to as a carbon unit, is measured in metric tonnes of CO₂ equivalent, to accommodate the existence of greenhouse gases other than CO₂. Carbon units are exchanged between market participants through carbon transactions, purchase contracts where one party, the buyer, pays another party, the seller, in exchange for a given amount of carbon units to be used towards its own mandatory obligations as well as voluntary targets vis-à-vis climate change mitigation.

Carbon transactions

There exist two conceptually different categories of carbon transactions. The first is that of allowance-based transactions, where the carbon units are allowances, or units of “right to pollute”, created and assigned through various systems, including free allocation and auctioning, by regulators under cap-and-trade regimes.

Noticeable examples of such regimes are, at country level, the Kyoto Protocol IET introduced above, which generates tradable carbon units known as Assigned Amount Units, and, at installation level, the European Union Emissions Trading Scheme (EU ETS), which deals in EU Allowances (EUAs).

The second includes project-based transactions, where the carbon units are carbon credits, also referred to as carbon offsets or emission credits. These are units of “carbon compensation”, generated by so called offset (or emission reduction) projects with the overriding aim of negating, or neutralising, a given amount of greenhouse gas emissions (in CO₂ equivalent) released in one place by avoiding the release of the same amount of emissions elsewhere or by absorbing the equivalent amount of CO₂ that would have otherwise remained in the atmosphere (in a process known as carbon sequestration).

The Kyoto Protocol CDM and JI schemes are examples of project-based mechanisms and the carbon units traded within those market segments are known as Certified Emission Reductions (CERs) and Emission Reduction Units (ERUs), respectively.

Cap-and-trade schemes, such as the emissions trading introduced by the Kyoto Protocol, allow for an additional and cost effective way for those purchasing tradable carbon allowances to meet their own legally binding emission reduction targets, alongside direct internal emission reduction measures.


Compliance schemes are currently aimed at those responsible for the greatest damages


Similarly, project-based transactions allow for the introduction and trade of new and possibly cheaper assets that can be used for compliance in addition to the initial supply of allowances. In particular, the JI and CDM mechanisms generate carbon credits through implementation of emission reduction projects within Annex I (developed) and non-Annex I (developing) countries, respectively.

An analogous market structure is observed in the EU carbon market segment, where the Linking Directive has established full equivalence of EUAs, CERs and ERUs as compliance units within the EU ETS regime, subject to certain rules, thereby governing the relationship between the EU ETS itself and the Kyoto Protocol.

Low hanging fruits

Major differences between the compliance and the voluntary carbon markets include the preferred type of emission credits being traded and the particular players active in the marketplace.

Research has shown that non-CO₂ greenhouse gas destruction projects represented the great majority of reductions traded in the compliance market in 2005 and Q1 2006. This is not surprising, as projects with emission reductions that can be generated quickly and at a cheaper price are developed first to meet Kyoto first commitment period requirements.

As far as market participants are concerned, compliance schemes are currently aimed, at company level, at the most “energy intensive” emitters, those responsible for the greatest damages.

The voluntary market, on the contrary, serves the purpose of businesses (typically brand and service companies, intermediary type organisations), government departments, NGOs and single individuals coming to terms with their carbon footprint and managing it through compensation, And at the same time signalling to others their sense of personal or corporate social responsibility.

It is informative, in this respect, to mention the recipients of the EU ETS, as specified in Annex I of European Directive 2003/87/EC. For the first phase of the EU ETS (2005 to 2007), installations covered by the scheme were those carrying out the following activities: energy activities (basically power generators and oil refineries), production and processing of ferrous metals (iron and steel), mineral industries (cement, glass and ceramic products) and pulp and paper industries. The only sectors likely to be included in the second phase of the EU ETS (2008 to 2012), due to their predicted growth, are aviation and maritime transport.

Beyond 2012

It is worth mentioning that some studies have already analysed the possibility of extending the ETS scheme to further sectors in a post-2012 regime. Potential candidates include the chemical sector (fertilisers and ammonia, petrochemicals and other chemicals), secondary manufacturing industries (food and drink), non-ferrous metals (primary aluminium), non-metallic minerals (gypsum and rock wool), fuel production (onshore and offshore oil and gas flaring) and waste incineration.

The efficacy of these policy instruments based on carbon trading in reducing emissions relies heavily on two distinct factors, depending on whether the scheme is project- or allowance-based.

For project-based mechanisms the additionality of the offset project and the adoption of rigorous monitoring, reporting and verification procedures for the generation of real and measurable emission reduction units are essential for the safeguard of the environmental integrity of the mechanism itself.

For cap-and-trade schemes, based on the initial allocation and subsequent trade of carbon allowances, the scarcity of emission allowances is vital to the scheme if the resulting carbon price is to stimulate genuine dynamic incentives.

The dramatic fall in the price of EUAs (and of carbon offsets) following the disclosure, in April 2006, of 2005 actual emission data was the consequence of realising an oversupply of allowances compared to what was required for compliance with the scheme across Europe.

This pointed to the importance of tougher emission caps for the second phase of the scheme, which is exactly what is being observed at the Commission level with several member state national allocation plans being rejected for not effectively using the scheme to bring industry emissions in line with what is needed to meet Kyoto targets.


Alberto Binello and Peter Pearson are researchers at Imperial College, London.