Designed to fail? The concepts, practices and controversies behind carbon trading

by Climate Finance and Markets on .


Carbon trading has become the central pillar of international efforts to halt climate change. It is a term that most people will recognise, but far fewer will have a good understanding of what it means and how it is supposed to work. Fewer still will feel confident to judge whether it is a success or not.

Carbon trading – the model

Put simply, carbon trading is the process of buying and selling permissions to pollute. In current schemes, these permissions take two forms: permits and credits. We will address each of these in turn.

The model used in all current carbon trading schemes is called ‘cap and trade’. In a ‘cap and trade’ scheme, a government or intergovernmental body sets an overall legal limit on emissions (the cap) over a specific period of time, and grants a fixed number of permits to those releasing the emissions. A polluter must hold enough permits to cover the emissions it releases.

Each permit in the existing carbon trading schemes is considered equivalent to one tonne of carbon dioxide equivalent (CO2e). In the theoretical model, (but rarely in practice) permits are to be sold – usually by auction – so that from the outset, polluters are forced to put a price on their emissions, and are incentivised to reduce to a bare minimum the permits they seek.

If one polluter does not use all its permits, it can trade them with another that has already used up all its permits and needs more to continue emitting beyond its legal limit. The theory holds that polluters are punished because they have to pay for more permits, and those who invest in more efficient energy consumption are rewarded financially, because they can sell their spare permits. The economy at large benefits because the energy savings are not made industry-by-industry, but where they cost least. The environment benefits because the overall level of emissions is reduced.

In any discussion of carbon trading, it is important to remember that it is only the cap that leads to emission reductions. The trading and associated offsetting only exist to make compliance with the cap less costly (often only in the short-term) for those participating.

The two key carbon trading schemes in operation to date are the Kyoto Protocol and the European Union Emission Trading Scheme (EU ETS). The Kyoto Protocol sets emission caps for each of the industrialised countries, covering six greenhouse gases, but did not set limits for developing countries with the argument that the main responsi- bility for initial reductions lies with the historically large polluters – the industrialised countries. Under the EU ETS, each EU Member State passes on a portion of the permits granted under the Kyoto Protocol to its major polluting industries. Other, smaller regional trading schemes are in existence, or proposed.

Setting the Cap

Under the Kyoto Protocol, a cap was set at 95 per cent of industrialised countries’ 1990 carbon emission levels. There was intense lobbying by countries to maximise their allowances and some countries received allowances greater than their actual use, because historically their emissions had been higher, or because they argued they were less industrialised than others or that capping their industries at current levels gave them an unfair disadvantage.

Pricing the permits

‘Cap and trade’ theory usually assumes that permits will be auctioned: that industries will bid for the permission to pollute, and that the price of each tonne of CO2e will therefore be set by demand. However, in practice, all existing ‘cap and trade’ schemes have initially distributed permits free of charge, on a company-by-company (or, in the case of the Kyoto Protocol, country-by-country) basis, based on what they claim to be their existing levels of pollution. This policy is known as grandfathering.

Monitoring and enforcement

Once a cap is set and permits have been allocated, emissions must be measured to ensure the cap is being complied with. Financial and other penalties exist for enterprises or countries that exceed their limits.

Emissions can be measured directly (as they are released), or measured by proxy (using conversion factors rather than direct measurement). While technology exists for direct measurement of some greenhouse gases, it is considered too expensive for widespread application, and so all current carbon trading schemes rely on measuring CO2 emissions by proxy. In the case of calculation by proxy, only approximations are produced, with errors far greater than with direct measurement.

What are offset credits?

Every current and planned carbon ‘cap and trade’ scheme involves offset credits in one form or another. Credits are a supplementary source of permissions to pollute that can be bought in from countries or industries outside the cap, usually in the developing world. Their purchase allows the emitter to exceed the emissions cap by paying someone else somewhere else to reduce their emissions instead. It is important to remember: offsets do not reduce emissions, they merely replace them.

Offsetting is based on the assumption that it does not matter how or where emissions are reduced. Emissions can be reduced where costs are cheapest – generally the global South – while allowing emissions to continue in the capped country – generally the industrialised North – with least disruption to existing methods of production and at the lowest costs to those covered by the cap.

In short, companies and governments pay someone else to try to make reductions, somewhere else, because it’s cheaper (financially and / or politically) in the short-term than doing it themselves.

Advocates of the offset system point to the many world- wide carbon-reduction projects that are funded by the system; the savings to industry (and thus consumers and society at large); the flow of money from North to South; the export of new technologies to developing economies; and how innovation in low carbon technologies has been incentivised. FERN believes that these claimed benefits very rarely exist in reality, and are heavily outweighed by the significant, systemic failure of offsetting to reduce emissions at all, which we discuss in the last section of this paper.

The size of the offset credit markets

The offset credit market is split between the compliance market – serving end-users who have to comply with ‘cap and trade’ regulations, and the voluntary market, serving end users who have voluntarily chosen, for ethical or public relations reasons, to seek to offset their carbon footprint. The compliance market is subdivided into the Clean Development Mechanism (CDM), where projects take place in the developing world (in countries that don’t have a cap under the Kyoto Protocol), and the Joint Implementation (JI) market, which covers projects in the developed world (in countries that do have a cap under the Kyoto Protocol).

The offset credit approval process

Before a carbon offset project can sell its credits, it has to pass through a series of stages to establish how many offset credits it has earned. In the CDM market (the largest offset credit market) the process works like this:

  • The owner of the project produces a Project Design Document (PDD) to show how emissions will be reduced, and by how much. PDDs are highly technical documents and are usually sub-contracted to specialist project design consultants. The PDD includes a hypothetical baseline (how many emissions would have occurred if this project didn’t go ahead) and calculates the supposed carbon savings by comparing the hypothetical baseline emissions with the predicted emissions from the completed project;
  • Once the PDD is submitted, it goes through a complex and lengthy process of consultation, validation, approval, registration and verification involving several consultan- cies and auditing firms, before the credits are awarded;
  • The project sells these offset credits into the carbon market. In practice, the credits are often sold at a reduced price long in advance of project approval. The reduction in price reflects the risk that some or all of the project’s credits may not be awarded.

Similar processes are in place for projects in the JI and voluntary offset markets, though the voluntary market has less extensive processes and is widely regarded as less than transparent and has acquired the reputation of being the playground for ‘carbon cowboys’.

Many people still think of carbon trading as a simple process whereby offset providers with credits to sell, or companies with too many/few permits, trade with each other directly. However, the carbon market has deepened or matured (to use the language of traders) significantly over the years, adding a wide variety of buyers and sellers to the original market participants and introducing a broad range of increasingly complex financial products. The size of the carbon market is, to a large extent, now determined by the amount of trading (both for hedging and specula- tion) in these complex financial products, rather than by the simple transactions described above. Financial speculation – rather than the need to comply with emissions targets – has become the underlying driving force of the carbon market.

Why carbon trading does not work and cannot be made to work

Carbon trading has not had a smooth ride in its first decade. It has suffered from volatile carbon prices; systematic fraud; unreliable and unverifiable reporting and monitoring; profiteering; and most importantly, global greenhouse gas emissions have continued to rise.

Many carbon trading proponents argue that initial problems should be expected as the systems are complex and take in different greenhouse gases emitted from countless sources across a large number of different sectors of the economy. However, an increasing number of climate scientists and economists believe these are not hiccups that will be overcome in time, but fundamental flaws that make carbon trading not fit for purpose. It is FERN’s contention that carbon trading will not and cannot provide the systemic changes required to avert runaway climate change. The mechanism by which the cap was set is fatally flawed, the cap has been punctured by the introduction of carbon offsets, while the trading element is at best an irrelevance to climate change, at worst an impediment to restructuring energy infrastructure, and even an excuse for increased emissions. The only clear benefits have been to polluting industries and profiteering carbon traders .

The cap is the wrong size

The cap is the only part of ‘cap and trade’ that actually reduces carbon emissions, so if it is not ambitious enough, runaway global climate change will not be averted. The logical starting point for setting the cap would therefore be to establish the rise in global temperature that can be tolerated without catastrophic results and the CO2e in the atmosphere that would limit temperature rises to that level. Annual permissible emission levels would then be set at a level that would achieve that target and inter- national negotiations would haggle over the distribution of these remaining permissible emissions permits. For political reasons however, the cap was set by identifying what was already being emitted in the countries that had contributed most to the problem, then allocating permits to these historically highest emitters for 95 per cent of that total. In other words, the setting of the cap was not connected to the primary objective, and was therefore too high.

The cap is leaky 1

As the cap does not cover all countries or industries, it is very simple to move rather than reduce emissions. Countries from the global North can give the false impres- sion that they have reduced emissions by continuing to consume as much or more than before but moving produc- tion to a country outside of the cap area, or importing additional offset credits from countries outside the cap.

The cap is leaky 2

In the vast majority of cases, emission monitoring is inadequate and untrustworthy. Real-time monitoring of emissions is costly and for many sources of greenhouse gases, no such technology yet exists. Almost all carbon emissions are calculated by proxy – meaning that margins of error dwarf the modest changes sought by the current cap. It is estimated that error rates are between 10 to 30 per cent and the high proportion of self-reporting, and low levels of independent verification, exacerbate this risk.

The cap is leaky 3

In addition to the systemic flaw that offsetting is not designed to reduce emissions, offset credits are based on the inherently unreliable notion of additionality. Additionality is the supposed net reduction/prevention of emissions delivered by the project, but additionality is never reliably calculated and can never be verified as it involves calculations based on a hypothetical volume of emissions. Carbon trading has rewarded polluters and penalised non-polluters. Polluters have benefited ever since carbon trading theory was first put into practice, beginning with the initial distribution of permits. If a country or industry was a heavy emitter before 1990, it was rewarded with free tradable carbon permits. Industries measured their own emissions and lobbied hard for the highest possible level of allow- ances. Over-allocation and business-as-usual practices were the inevitable result.

The market cannot find the right price for carbon

The primary goal of carbon trading theory was to attach a cost to pollution and so use market forces to discourage industry from polluting. In reality, the market has consist- ently failed to find the ‘right’ price for carbon.

To date the price of carbon has never been high enough to force the necessary carbon reduction measures,10 but even if it did, in the third phase of the EU ETS for example, ‘price triggers’ are in place to curb such market forces. If demand for permits were ever high enough to make prices spike, EU Member States have agreed to meet to find ways of bringing the price of carbon down again. So, there are structural checks in place to ensure supply and demand will not be allowed to price polluters out of the market.

Offset credits do little to help development in poor nations

One defence of the offset credit market is that through the CDM it channels funds and new technologies to the global South, allowing them to leap-frog into low-carbon industries. The reality is that a large percentage of energy projects that sell CDM offset credits would have existed regardless of the CDM, in particular wind and hydro projects. CDM projects tend to supplement, not supplant, old energy technologies. Indeed, in some cases such as a different type of coal power generation, known as super- critical coal technology, they even finance them. What is more, the projects that can make the maximum credits are most likely to get funded so that, for example, clean coal is promoted above solar power.

Offsetting does not recognise that not all carbon is equal

There is increasing interest in using forestry projects to offset the carbon dioxide produced by fossil fuels. At first glance, this seems logical: if trees absorb carbon dioxide, then we might plant (or protect) trees to absorb the emissions of industry. This does not however take into account that, for the climate, there is a huge difference between a tonne of CO2 remaining in the ground as oil or coal, or being trapped in growing trees. The release of each tonne of fossil CO2 permanently increases the overall burden of CO2 circulating among oceans, air, soil, rock and vegetation. Once it is released it will not move back into the fossil carbon pool for millennia. Carbon trapped in trees will remain there for, in climate terms, only a few short years – at most a few centuries. A CO2 molecule from a coal-fired power plant may be chemically the same as a CO2 molecule from a burning forest, but it is not climatically the same.

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