What We Do

Kyoto Protocol

The Market

Much of the current legal framework relating to climate change can be traced to the United Nations Conference on Environment and Development that was held in Rio de Janeiro in 1992. This resulted in international agreement to the United Nations Framework Convention on Climate Change (UNFCCC). Many countries agreed that climate change was a problem and that action should be taken to reduce emissions of greenhouse gases in order to stabilise the climate and reduce adverse impacts on our planet. The convention came into effect in 1994.

In 1997, the signatories to the UNFCCC adopted a binding protocol at their meeting in Kyoto, which stated that developed countries should commit to reducing their greenhouse gas emissions to an average of 5.2 % below 1990 levels during the period 2008 to 2012.

At a meeting in Marrakech, Morocco in October-November 2001, negotiators completed the work of finalising most of the operational details and setting the stage for nations to ratify the Protocol. The completed package of decisions are known as the Marrakech Accords.

On July 2nd 2003, the European Union reached agreement on the EU Emissions Trading Directive, which set out to implement a trading scheme throughout Europe. Later that month the draft EU Linking Directive was published allowing emissions credits arising from the flexible mechanisms of the Kyoto Protocol to be allowed into the EU Emissions Trading Scheme (EUETS) with effect from 2005 for Certified Emissions Reductions and 2008 for Emissions Reductions Units (ERUs).

The Kyoto Protocol, which came into force on February 16th 2005, specifies a number of ways by which emissions reductions targets may be achieved, including emissions trading and what are known as 'flexible mechanisms'. The latter include initiatives which allow targets in the developed world to be met by undertaking emissions reduction projects in the developing world (Clean Development Mechanisms) and investment in projects by one developed country that reduces Greenhouse Gas emissions (GHGs) in another developed country (Joint Implementation).

A number of other signatories to the Kyoto Protocol are currently preparing to implement similar emissions trading schemes, for example the governments of Canada and Japan.

Emissions Trading

Trading in emissions is not a new idea. In the United States the Acid Rain Program was established by the 1990 Clean Air Act, which initially targeted sulphur dioxide. A decreasing cap was set on total SO² emissions for each of the following several years, aiming to reduce overall emissions to 50% of 1980 levels.

The largest GHG emissions trading scheme currently in operation is the EUETS, which was launched on 1st January 2005. In its first year, 362 million tonnes of CO² were traded on the market for a sum of €7.2 billion.

In the first phase (2005-2007), the EU ETS includes some 12,000 installations, representing approximately 45% of EU CO² emissions, covering energy activities (combustion installations with a rated thermal input exceeding 20 MW, mineral oil refineries, coke ovens), production and processing of ferrous metals, mineral industry (cement clinker, glass and ceramic bricks) and pulp, paper and board activities. Those sites that are covered by the scheme are required to have a permit to emit greenhouse gases and to comply with other requirements to monitor and report on their emissions.

The second phase (2008-2012) is to cover not only CO², but all greenhouse gases and at this point CDM and JI credits are expected to be introduced. The European Commission is also considering including aviation in the scheme, a move that is considered important due to the large and rapidly growing emissions from this sector.

It is likely that after 2012 the EUETS will include all greenhouse gases from all sectors, including the transport sector. The large number of individual users in this area means added complexity, but could be implemented either as a cap-and-trade system for fuel suppliers or a baseline-and-credit system for car manufacturers.

The EUETS is a 'cap-and-trade' arrangement which requires each participating country (ie all EU states) to propose a National Allocation Plan (NAP) showing the allocation of greenhouse gas emissions for power plants and other large emitters ('installations'). Each of these allowances represents one unit (tonne) of carbon dioxide emitted, or commonly 1 tonne CO², and is called an EU Allowance (EUA). The sum of individual allocations is equal to the desired level of emissions at the end of each phase of the scheme and will be lower than the total emissions at the start of the phase or allocation period.

These caps mean that unless operators of installations are able to reduce their emissions to the capped level, they must buy from the open market to meet their allocations. Conversely, any surplus can be sold at the end of each year of the allocation period. The installations' performance against their allocation is independently verified based on numbers of allowances surrendered at the end of each reporting period and failure to surrender sufficient allowances results in fines of €40 per tonne, rising to €100/tonne in Phase 2. In addition to the fine the installation must still purchase and surrender the required shortfall of allowances.

The allocation of allowances has so far been the subject of a great deal of controversy within the European Union with the various member states adopting different approaches for the measurement and benchmarking of allocated emission targets. The allowances themselves are also currently given free to the operators of the installations by the member states, although a number of countries have indicated that they will in future be auctioning a percentage of the allocation for each site and this is likely to become the norm across the European Union.

The infrastructure for market trading in allowances is in place both at member state level as well as across the EU with the creation of an electronic registry (the ETL). This provides a platform for the emerging market to trade internationally and M&C Energy Group as a licensed trader now acts on behalf of buyers and sellers of EUAs to ensure the most favourable deal is achieved for its clients.

Emissions Reduction Projects

Under the Kyoto Protocol Non-Annex 1 countries who do not have emissions reduction targets imposed upon them may engage in projects to reduce greenhouse gas emissions which, when quantified and verified, can be sold in the form of Emissions Reductions to Annex 1 countries.

Clean Development Mechanisms encourage the transfer of clean energy technologies and the development of emissions reduction projects to ensure that economic growth in industrialising developing countries such as India and China is sustainable. Furthermore it also allows the developed world to take on the burden of emissions reductions at a lower cost as it is generally cheaper to reduce greenhouse gas emissions in the developing world.

The operation of CDMs is overseen by the CDM Executive Board in Bonn, Germany, and its functions include the approval of new baseline methodologies, which can be applied to qualifying projects, the accreditation of Designated Operational Entities (DOEs) who validate and verify projects, the registration of projects and the issuing of CERs. The CDM Executive Board is in turn accountable to the Conference of the Parties (COP), which meets annually and oversees climate change policy as set out in the United Nations Framework Convention on Climate Change (UNFCCC).  

Joint Implementation

The Kyoto Protocol also includes a flexible mechanism know as Joint Implementation (JI) which allows Annex 1 parties to the UNFCCC, and who therefore have specified emissions reduction targets that need to be met by 2012, to sell Emissions Reductions Units to other Annex 1 countries.

ERUs from JI projects are issued by the governments of the Annex 1 countries and each ERU is backed by an equivalent Assigned Amount Unit (AAU), the unit of compliance with targets under the Kyoto Protocol. The ERUs can be used for compliance either by Governments retiring them to help meet Kyoto targets, or by companies surrendering them to help meet their allocations under the EU Emissions Trading Scheme.

Those countries that are able to issue ERUs are divided under Kyoto rules into Track 1 and Track 2 based on whether the host country meets certain eligibility requirements. ERUs from Track 1 countries are overseen by that country, whereas Track 2 ERUs will be supervised by the international Supervisory Committee for JI.

While ERUs cannot be issued until 2008, there is an active forward market for them, particularly among European governments who have been purchasing ERUs from JI projects in Eastern Europe.

As a result of the contraction of the economies of a number of European countries since 1990, the baseline year against which emissions are measured, many states are likely to have surplus AAU's that they will be able to sell to other Annex 1 countries. As we move forward, the rapid industrialisation of Eastern European countries in particular will mean that these areas are likely to be the location for many JI projects in the future.

ERUs can be traded within the EU ETS by exchanging them on a one for one basis with European Union Allowances (EUAs), from 2008 subject to a number of criteria being met. ERUs generally trade at a discount to EUAs in the primary market owing to the additional project and regulatory risks. This makes them popular to some participants in the international emissions markets and both European and Japanese private sector entities have been joining governments as buyers in the market. There is unlikely to be a secondary market in ERUs until after 2008.