The Kyoto Protocol's five-year compliance period begins in 2008. Industrialized nations around the world have pledged to cut carbon emissions, but the job seems to get harder, not easier. Can market mechanisms make the crucial difference?

The next 12 months will see the start of the serious business of the Kyoto Protocol.
Any party failing to reach its emissions cap has to make up the difference between its actual emissions and the cap during a second, post-2012 commitment period, plus an additional 30%.

Until now, the main focus of emissions trading has been to put in place the final pieces of the protocolthe institutions that will allow international emissions trading to actually work over the next five years -- and for governments and companies to get a taste of how emissions trading is meant to work.

But on January 1, the "compliance period" of Kyoto began, when Annex B Partiesmember countries that have accepted mandatory limits on emissions have to account for their greenhouse gas emissions, and ensure they have enough allowances or credits to cover every last metric ton of carbon dioxide, methane, nitrogen oxides or fluorocarbons that their industries covered by the protocol emit.

Annex B groups the 27 members of the EU, plus Switzerland, Norway, Iceland, Japan, Canada, New Zealand, Russia and Ukraine.

The penalties for non-compliance are pretty tough: any party failing to reach its emissions cap has to make up the difference between its actual emissions and the cap during a second, post-2012 commitment period, plus an additional 30%.

The problem is that there isn't a second commitment period yet. And diplomats negotiating whatever post-2012 framework does come along may well decide to draw a discreet veil over previous non-compliance in exchange for support for a new agreement.

There is one kicker, however: the United Nations Framework Convention on Climate Change can suspend the eligibility of a non-compliant signatory to make transfers under emissions trading. And while that may not sound tough, a suspension could really hurt the emissions trading business in 2008-12.

Just imagine that Germany finds itself in non-compliance in 2009 and is suspended from emissions trading in 2011. That would mean that German private sector activity under the EU Emissions Trading Scheme would grind to a halt. Millions of credits from clean technology projects in China would be stranded, since their German investors wouldn't be allowed to take delivery of credits until the suspension was lifted. German companies would likely line up to sue their government. They've already challenged their political leaders in court over the allocation of emissions allowances.

For this reason, European governments in particular are taking emissions trading very seriouslyany slip-ups will cost them and their private sectors a lot of money. Other Annex B countries have yet to set up emissions trading regimes that are anywhere near as strict as Europe's.

Created: January 2, 2008