The carbon market emerged after 30 major nations voluntarily adopted greenhouse gas emission reduction schedules at a UNFCCC (United Nations Conference on Climate Change) conference in Kyoto, Japan, in December 1997. It involves national and international transfer of greenhouse gas emissions among players in different industries and by so doing reduce the damage GHG is causing to the environment.
The Kyoto Protocol is the foundation document for greenhouse gas reduction. The Kyoto Protocol allows the member States who have signed the agreement to change the level of their allowed emissions over the commitment period, by trading units with other Parties. This trading is carried out through the so-called Kyoto mechanisms which include: (a) Emissions trading; (b) Joint implementation (JI) and (c) Clean development mechanism (CDM).
The successful development of an emissions trading depends on the liquidity of the market. An international emissions trading regime requires not only a broad range of sectors but also sufficient volume to ensure an adequate diversity of contracts. The market has been described by the European Commission as "thin" and by the International Emissions Trading Association (IETA) as "fragmented". This is because public bodies set the agenda through schemes such as the The European Union Emission Trading Scheme (EU ETS) which establishes emissions allowances and also selects reductions target areas. There are advantages and disadvantages in this set up. One disadvantage is that policy failures can have a severe impact on the market. In the first year of the ETS, 362 million tonnes of CO2 were traded on the market for a sum of 7.2 billion euros.
The price of allowances increased more or less steadily reaching a peak in April 2006 of ca. 30 euros per tonne CO2. However, prices came crashing down in May 2006 to under 10 euros/ton when it became clear that many countries had given their industries such generous emission caps that there was no need for them to reduce emissions. Many observers have urged for urged for stricter caps in the second phase (2008-2012).
Carbon Exchanges offer three types of emissions derivatives instruments:
• Forwards: the purchase of emission allowances to be supplied in the future at a fixed price currently the most common type of market traded allowance
• Options: a guarantee of the right to purchase or sell allowances at a fixed price within a defined period of time
• Swaps: the exchange of payment obligations so that different allowance currencies can be exchanged
For example, an older power plant is upgraded to a clean new one. The new plant produces less emissions for the same kWh generated, and the difference in emissions can be turned into emission reduction credits. GHG is therefore a tradable commodities from which dervatives can been developed. These instruments include: Carbon Credits from equipment upgrades.
In this example, an older power plant is upgraded to a clean new one. The new plant produces less emissions for the same kWh generated, and the difference in emissions can be turned into emission reduction credits.
• Carbon Credits from sequestration activities Here, carbon credits represent the amount of carbon stored in a tree. It is measured in metric tons. Carbon dioxide (CO2) is absorbed (sequestered) by the tree from the air during photosynthesis. The carbon, or C part, is used by the tree as a building block in it's cellular structure. The oxygen, or O2 part, is respired as a waste product.
• Carbon Credits from clean energy In this case and as an example, an individual has a solar electric panel on his roof or a wind turbine on his property. The energy produced by this equipment is energy that didn’t have to come from the local utility. If electricity was generated by burning coal generates this equipment would save that amount of coal gas emission from entering the atmosphere. Reductions of greenhouse gas emissions (GHGs) can be quantified in terms of carbon credits accruing to a project, if these carbon credits have to be verified and certified by approved agencies in countries that has acceded to the Kyoto Protocol.