by Alison Wise, National Renewable Energy Lab

May 20, 2008

Q: There is so much talk today about carbon legislation that I'd like to ask a really basic question. How do carbon markets work? And how do they help foster the development of renewable energy? -- Danny B., Whitehouse Station, NJ
A:

Despite the name, carbon markets do not trade existing carbon. They trade the reduction of carbon emissions into the atmosphere. So, like other emissions trading schemes, such as the sulfur dioxide "market" that helped to reduce the acid rain problem here in the U.S. over the last twenty years, carbon markets would theoretically mitigate carbon emissions as part of the effort to address climate change. Of course, there are problems other than climate change that come about with a carbon intensive economy. Fluctuating fossil fuel prices, dependence on politically unstable regions for the energy that fuels our economy, pollution issues such as the Exxon Valdez spill, as well as increasing concern about the theoretical phenomenon of "peak oil" all are weaknesses of a carbon intensive energy system.

Ultimately, however, carbon markets today are principally based within the context of greenhouse gas (GHG) reduction and the growing public concern about our warming planet and the catastrophe this could pose. The idea is straightforward at first glance, but becomes fairly complex rather quickly in terms of actual measured emission reduction as well as "unintended consequences."

Carbon Market Definition

Carbon markets can be either voluntary or mandatory. In a voluntary carbon market, an entity (company, individual, or another "emitter") volunteers to offset its carbon emissions by purchasing carbon allowances from a third party, who then takes this money and uses it towards a project that will reduce carbon in the atmosphere. These projects include planting trees (natural carbon sequestration) or investment in renewable energy generation (the additional renewable capacity reduces fossil fuel use from a traditional carbon-emitting energy source).

Compliance carbon markets function under a regulated limit to carbon emissions (a "cap" on emissions), where permits or "allowances" are given or auctioned to carbon emitters who then have to figure out how to conduct their business within this set limit. This creates a market for these allowances, where lower emitting entities can trade their extra allowances to those who need the additional capacity, hence the term "cap-and-trade" carbon markets.

The European Example

To understand a bit more about how these carbon markets work (or how they sometimes don't work), let's take a look across the Atlantic. The EU Emissions Trading Scheme (EU ETS) is the first international initiative to attempt to tackle this type of GHG market. It is a compliance market, functioning as a cap-and-trade and a credit-and-trade system under mandates set by the Kyoto Protocol. Article 17 of this accord sets up an ETS, where Annex I countries can exchange emission permits between them or trade emissions reductions from the investment projects made abroad under what are called the Kyoto mechanisms (Clean Development Mechanisms (CDM's) if they take place in countries with no carbon limit, Joint Implementation (JI's) if they take place in countries with a carbon limit). The EU ETS represents about 65% of the total volume of carbon traded worldwide representing $19 billion in 2006 according to The Climate Group, an international NGO (non-governmental organization) that tracks growing carbon markets.

Potential Market Pitfalls

There have been two prominent snafus in the roll-out of the EU ETS. The first concerns the creation of the allowance market itself. Evidently, the initial dispersal of allowances "over-allocated" them. In other words, the emissions cap as it was set did not match up with the number of allowances that were allocated to emitters. So, the market had the wrong signals and it took some time for the price to adjust.

The second issue, and potentially a more entrenched one, surrounds the CDM's and accountability. Emitters in the developed countries of the EU will often seek the lowest-cost way to satisfy their emissions reductions, often in the form of a CDM in a developing country. Within this decision are some potential problems: Is the project an additional reduction effort, or would the project have taken place anyway in a BAU (business as usual) situation (otherwise known as "additionality")? Can the project's emissions reductions be verified? Does the project create fewer GHG emissions, but produce other environmental and/or social problems? All of these concerns are creating increasing criticism of the EU ETS as it is currently run and have led to the United Nations raising the bar on approving these CDMs. This creates additional investment risks associated with the market, as projects that are slated to commence to fulfill reductions may be unable to pass muster.

Accountability and Oversight

There is also an issue surrounding the appropriate enforcement and oversight mechanism and/or institution for verifying emissions reductions and trading. This applies not only to verification of emissions reductions claims, but also oversight to make sure that "double-counting" of reductions doesn't occur. That is, when multiple stakeholders take credit for distinct emission reductions that should only be attributed to one emitter.

In the United States, third party NGO's have stepped in within voluntary markets to fulfill this function, but their role is questioned by corporate watchdog groups who suspect that being reliant on corporate funding for their existence compromises their objectivity. There has been some talk about establishing a "self regulatory organization" like the Securities and Exchange Commission (SEC) to regulate a compliance carbon market here in the U.S. should national cap-and-trade legislation pass. Some sort of independent global stakeholder may need to be created to fill this role internationally (the definition of independent to be determined). Whatever the solution, it cannot be overstated that the success of the carbon market will be based on the trust between its participants.

Carbon Markets in the U.S.

Which brings us back to the United States, where, by all accounts, there appears to be some sort of national carbon legislation on the horizon and where several regional initiatives are already in place. For a complete overview of all the legislation that's currently on the table, the Pew Center on Global Climate Change provides a spreadsheet that outlines all of the particulars.

Ultimately, for a carbon market to have traction it needs to be fungible; it needs to be able to act like financial markets that can navigate internationally. But in the meantime, we have a growing voluntary market and several regional compliance markets already underway. The Chicago Climate Exchange is the largest voluntary carbon trading system in the U.S., trading $36.5 million worth of offsets in 2006 (some of this may represent renewable energy investments). And the U.S. is home to the largest provider of carbon offsets by volume; the Climate Trust had reduced carbon emissions by four million metric tons by the end of 2005.

In California, AB 32 has been signed into law mandating greenhouse gas reduction of 25 percent by 2020 and 80 percent by 2050. The California Air Resources Board is the entity responsible for enforcing this cap, and for making plans and rules that will implement the goal. It is expected to introduce a cap-and-trade system to achieve these reductions.

The Regional Greenhouse Gas Initiative (RGGI-pronounced "Reggie") is a regional cap-and-trade system for participating Northeast states that has just experienced its first trades. An option trade between EcoSys Capital Adviser and energy trader Vitol was the inaugural transaction on February 14th, 2008. The next trade was a forward trade placing a price for allowances at $7 a ton, putting an annual value for the RGGI market at $1.3 billion. These regional and voluntary markets are testing grounds for future carbon market growth.

Carbon and Renewables

The broader question of how carbon market development relates to renewable energy development is a bit tricky. Right now, it is safe to say that any price tag associated with carbon could be good for renewables in the long run as carbon intensive energy generation becomes more expensive, making renewable energy generation more cost competitive in comparison. And within voluntary markets, sometimes renewable energy projects are created to represent an emissions offset so one could argue this builds the renewable market directly.

But there is some tension in the ultimate design within carbon pricing. The question becomes, are we designing a system that rewards least-cost carbon mitigation that may continue our reliance on carbon intensive fuels by focusing on cleaner emissions and projects that don't necessarily displace carbon intensive fuel dependence? Or are we designing a system that rewards emissions reductions through efficiency measures and innovation in terms of both carbon mitigation and renewable energy development?

Interestingly, if we focus solely on carbon sequestration and other technologies that create cleaner carbon emissions, these applications could potentially compete with renewables within a trading framework that ideally would reward all solutions to climate issues.

If, for example, Renewable Energy Credits (RECs) are not bundled with Certified Emission Reductions (CERs) then there is a potential for emissions reductions to be sourced solely from carbon mitigation and not renewable projects (based largely on current costs). Basically, renewable energy projects impact overall carbon emissions. As emissions are reduced as these renewables come online, the carbon quota should decrease to reflect this in order to maintain the right price signals in the market and to ensure that renewables are associated with emissions reductions. This market performance is facilitated by linking RECs and CERs.

This is one example of the way in which carbon and renewables impact each other, which brings us to the observation that it is important for renewable energy proponents to follow carbon issues. We should keep close watch on the technology that is being developed that would mitigate carbon problems through sequestration and emissions reductions as a potential market competitor. But perhaps more importantly, we need to be well informed about policy that addresses carbon to look for a framework for synergy between these technologies and renewables.
 

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