Emissions

Fundamentals

Framework

The international community began the long process towards building effective measures to tackle greenhouse gases (GHG) emissions in response to the increasing assertions that global warming is happening due to man-made emissions and the uncertainty over its likely consequences. That process began in Rio de Janeiro in 1992, when 160 countries agreed the United Nations Framework Convention on Climate Change (UNFCCC) . The UNFCCC is a framework, whereby the necessary detail are left to be settled by the annual Conference of Parties (CoP) .

In 1997 the Kyoto protocol was signed and ratified since by most countries, with noticeable exception of the United States and Canada (which renounced in 2011). It came into force in 2005. Under the protocol, nearly 40 countries (so-called 'Annex 1' countries) commit themselves to a reduction of greenhouse gases, relative to their emission level in a base year (usually 1990), on aggregate, by increasing reduction targets averaged over the subsequent commitment periods (Phase 1 to 4, corresponding respectively to years 2005-2007, 2008-2012, 2013-2020, 2021-2030). The EU which ratified the protocol as a single body, committing an overall 8% reduction in Kyoto 1, 20% in Kyoto 2.

The Marrakesh Accords reached during the CoP7 in 2001, defined the international trading mechanisms and registries needed to support trading between countries (sources can buy or sell allowances on the open market, and because the total number of allowances is limited by the cap, emission reductions are assured). Each country has designated a national authority to manage its GHG inventory (emission sources and removal sinks) and fulfill its Kyoto obligations.

In December 2015, to close the CoP21, the Paris Agreement was reached, which is the first-ever universal, legally binding global climate change agreement. By 2020, countries submit their plans for climate action known as Nationally Determined Contributions (NDC). Those are reconsidered on a 5-year cycle of increasingly ambitious climate action carried out by countries.

Cap and Trade

The Kyoto protocol foresees four 'flexible mechanisms', allowing to monetize excess allowances or reduction credits, thereby creating the carbon market:

• Emissions trading scheme (ETS)
  Initial emission permits (allowances) are assigned over a given period at the level of the reduction target of each country, calculated as:
  

  \( \textsf{Emission level in base year} \times \frac{(100 - \textsf{Reduction percentage})}{100} \times \textsf{Number of years in the commitment period} \)

  
  Those Assigned Amount Units (AAU) are expressed in tons of CO₂ equivalent. Each country allocates or auctions those Emission Allowances (EA) further to the industries within its borders, up to the level of the overall limit. It is a public authority which sets a maximum threshold GHG emissions over a period of compliance (usually one year), creating a primary market. Operators exceeding their reduction target can sell their excess allowance units (emission credits) to participants falling short. Credits are exchanged between the obliged entities on so-called secondary markets (marketplaces, direct exchanges, via intermediaries or over the counter). This 'cap and trade' scheme thus creates an economic incentive for achieving emission reductions, which is effective as long as the reduction effort proves less costly than having to buy extra allowances to cover the assigned emission permit. Authorities determine the amount of pollution, the market determines the price.
  The emission threshold is normally revised downwards over time and the scope of economic actors , entities and installations submitted to pollution control gradually enlarged. It mechanically increases the price of emitted CO₂ which spurs further innovation in order to emit less.


• Clean development mechanism (CDM)
  Clean Development Mechanism allows a country or company with an emission reduction commitment to implement an emission reduction project in developing countries, and thus earn saleable Certified Emission Reduction (CER) credits. Those are issued only once the emission reductions from the project have been independantly verified (so-called certain CER). Purpose is to stimulate sustainable development and adding flexibility in how to achieve emission reduction.


• Joint implementation (JI)
  Joint Implementation allows a country or company with binding emission reduction targets to earn Emission Reduction Units (ERU) from an emission reduction project in another country, as an alternative to achieve it domestically. The host country, which itself has emission reduction requirements, benefits from foreign investment and technology transfer while offering the investor more flexibility in meeting its emission reduction obligations, often at a lower cost. The mechanism do not add to the overall supply of units (ton of CO₂ equivalent), because the host country's AAU are just swapped into ERU.


• Removal units (RMU)
  A Removal Unit (RMU) is a carbon credit granted for carbon absorption by a carbon sink in land use, land use change and forestry (LULUCF), such as reforestation. They are issued in the national registry of the host country.

Alternative legislation

Authorities foresee other control mechanisms to enforce virtuous behavior, by either punishing pollution through taxes, or promoting emission sinks through subsidies. Those set a unit price for pollution or pollution remedy however without defining quantity targets. It is less flexible and responsive than a cap and trade mechanism, but can be applied to correct competition distortion, arising from the fact that countries impose uneven emission reduction targets to their industries.

Voluntary market

Many entities, public or private, take voluntary action, combining the measurement and abatement of emissions with the finance of emission reductions and removals in locations under our outside their direct control and which are additional to regulatory requirements. Those are verified and registered under respected third-party standards and protocols so that claims of neutrality are backed with publicly accessible information that underpins the quality and integrity of voluntary action. Offset credits are only issued for GHG emissions that have already been prevented from entering or removed from the atmosphere and have been accurately quantified and verified.

Companies choose to include offsets in their environmental and sustainability plans because beyond the financial incentive, it engages them towards local communities or targeted customer groups, it builds awareness of and trust in their comittment to fight climate change beyond their stict legal obligations.

Drivers

Climate change, global warming and emissions reduction are complex processes and set new paradigms for institutions, business and households. It requires different mindsets and innovation in many business processes. New bodies and working groups popped up to cope with those challenges and define the framework for this market to operate :

Carbon markets framework setters

Acronym	Organization	Description
ICAO	International Civil Aviation Organization	A UN agency setting policies for civil aviation. It defined the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) . Among others, it lists the carbon offset registries eligible for CORSIA accredition, which became a de facto benchmark for approval by financial institutions.
ICAP	International Carbon Action Partnership	To give confidence, improve transparency and enhace price discovery, it is important to guarantee stable legal frameworks and create instruments which are comparable and fungible. ICAP investigates and coordinates various proposals for linking these systems across markets.
ICROA	International Carbon Reduction & Offset Alliance	A non-profit membership organization (part of IETA) to promote, develop, apply and advance best practices in voluntary climate action.
IETA	International Emissions Trading Association	Founded by international companies and business associations, to achieve climate objectives defined by the Kyoto Protocol in an economical meaningful way. It is an international, multi-sectoral, purely business group devoted to pricing and trading greenhouse gas reductions. It promotes GHG reduction policy developments towards its members and acts as a forum for policy dialogue, assessing potential market impacts in the ongoing process of devicing new regulations. As they brand themselves: "to address climate challenges with market solutions".
PMR	Partnership for Market Readiness	A task force of the World Bank which sponsors the setup of reliable emission reduction programs and associated Carbon Pricing Instruments (CPI).
REDD+	Reducing Emissions from Deforestation and Forest Degradation	The scientific community estimates that deforestation and forest degradation account for around 11 percent of CO2 emissions. With the REDD+ prgram, the UN-FAO supports developing countries in preservation and sustainable management of forests.

Products

Greenhouse gases

A greenhouse gas absorbs and emits radiation within the thermal infrared range. Solar radiation, at the frequencies of visible light, largely passes through the atmosphere to warm the planetary surface, which then emits this energy at the lower frequencies of infrared thermal radiation. Infrared radiation is absorbed by greenhouse gases, which in turn re-radiate much of the energy to the surface and lower atmosphere. This reduces airflow and isolates warm air inside the structure so that heat is not lost by convection, causing an elevation of the average surface temperature, known as greenhouse effect. Without this effect, life on earth would barely be possible, however burning of fossil fuels and clearing of forests, have intensified the natural greenhouse effect, causing global warming .

Water vapor accounts for the largest percentage, but human activity does not significantly affect water vapor concentrations. Carbon dioxide on the contrary accounts for about 72% of anthropogenic GHG emissions, primarily from combustion of fossil fuels. Hence greenhouse gas is often scaled in carbon dioxide equivalent (CDE, CO₂e) , a quantity that describes, for a given mixture and amount of GHG, the amount of CO2 that would have the same global warming potential (GWP) , when measured over a specified timescale (generally 100 years).

The primary GHG in the earth's atmosphere are:

Greenhouse gases

Gas	Formula	Contribution to GHG effect (pct)
Water vapour	HO2	36 - 70
Carbon dioxide	CO2	9 - 26
Methane	CH4	4 - 9
Nitrous oxide	N2O	5 - 8
Ozone	O3	3 - 7

Traded products

One emission unit is equivalent to one metric ton of carbon dioxide emitted or its equivalent (CO₂e). Other greenhouse gases can also be traded, but are quoted as standard multiples of carbon dioxide with respect to their global warming potential.

• Emission allowance
  The primary market, where a national or international authority allocates permits to individual companies, with a view to meeting national and/or regional Kyoto targets. Permits can further be sold privately or in the international market. These trade and settle internationally, and hence allow permits to be transferred between countries. Each international transfer is validated by the UNFCCC. Each transfer of ownership within the European Union is additionally validated by the European Commission.
  Depending on the regulatory authority where those permits are registered, they will have different labels such as Emission Allowances, Carbon credits, Kyoto units, Assigned amount units (AAU), etc.


• Emission reduction
  The Emission Reduction Unit (ERU) from a Joint Implementation (JI), the Removal Units (RMU) resulting from a Land use, Land use change and Forestry (LULUCF) initiative and the Certified Emission Reduction Units (CER) oversighted by the Clean Development Mechanism (CDM), are all gained by proving measurable volumes of GHG reduction following implementation of an emission reduction project.


• Emission offset
  The Global Emission Offset (GEO) products are the CO₂e tonnages offset by voluntary projects, monitored by and registred in duly accredited registries.

Trading exchanges have been established to provide a spot market in permits, as well as futures and options market to help discover a market price and maintain liquidity. The exchanges trading in UNFCCC related carbon credits and their products are detailed further under Markets 🔎.

Geography

If global warming is a phenomenon affecting our entire planet, the remedies to it are organized locally. This market exist because a legal framework sets emission caps. Measuring emissions or how to reduce them is complex and registering all the required data obey strict rules and are submitted to controls to guarantee a transparent and fair level playing field. To root those initiatives and markets into its 'physical' reality, i.e. legally binding reduction targets, expressed on one hand as a right to emit pollutants over a given period, on the other hand as verified volume reduction through approved sinks, it is of utmost importance to register all executed transactions, as well as all measurements of emitted or reduced CO₂ equivalents. Each regulating authority should perform Measuring, Reporting and Verification (MRV) of the actual pollution levels, and enforce the allowances. There are concerns on the cost of MRV and enforcement, and the risk that facilities may lie about actual emissions. Linked to the difficulty of enforcing international rules against sovereign states, development of the carbon market is an ongoing process which requires negotiation and consensus-building.

Each country having comitted reductions (so called 'Annex 1' countries of the Kyoto protocol) maintains a registry of the Kyoto units and provides a mechanism for their transfer, domestically and internationally. National registries issue AAU, ERU and RMU, while the UNFCCC operated CDM registry issues CER. Once issued, units can be tranferred between accounts on the national registry, or transferred to accounts on a foreign registry (under verification of the UNFCCC). Each country or region then organizes its own Emission Trading Scheme (ETS). Each country submits on regular interval its GHG National Inventory Report (NIR ) to the UNFCCC.

For the voluntary market there are several Offset Project Registries (OPR). They have to guarantee transparency, mult-stakeholder participation, credibility and regulatory oversight to be accredited.

• The UNFCCC coordinates the efforts of the national registries of emissions data and provides now a rich and granular dataset on emissions per country .
• The International Carbon Action Partnership (ICAP) provides an insightful map on the multiple Emission Trading Schemes across the globe

Markets

Emissions is an emerging market, created by the 'cap and trade' mechanisms foreseen in the Kyoto protocol. By gradually reducing legally accepted emission levels and organizing a market for emission allowances and reduction credits, virtuous behaviours will be rewarded and polluters penalized.

Primary market

The primary market is the allocation of AAU, certification of ERU and RMU (all three issued by national registries), together with certification of CER (issued by the UN-CDM program). Monitored installations have to remit yearly as much allowance units as their measured emissions. Allowances are allocated for a trading period, which spans one to several years. Allowances and credits are increasingly auctioned rather than distributed freely. This supports prices of emission reduction products and improves market transparency. Good performers have the opportunity to sell their excess allowances, polluters have to buy extra allowances or credits.

Secondary market

This cap and trade mechanism creates a secondary 'carbon market' with various venues. They can be private whereby allowances are reassigned between sites within the same company, or traded bilaterally with another operator. They can be traded through brokers on the OTC market, or on Exchanges, where eligible carbon equivalent units are marketed as spot, future and option products.