What is the carbon market? How does it work?

The Carbon Market resulted from the creation of the United Nations Framework Convention on Climate Change (UNFCCC) during the ECO-92 in Rio de Janeiro.

In 1997, in one of the most important meetings in Kyoto, Japan, it was decided that signatory countries should make stricter commitments to reduce greenhouse gas emissions, resulting in what become known as the Kyoto Protocol.

For this Protocol to come into force, 55% of countries, accounting for 55% of global greenhouse gas emissions should sign it. That only happened after Russia ratified it in November 2004.

Thus, the central objective of the Kyoto Protocol is that countries limit or reduce their emissions of greenhouse gases. This is why the reduction of emissions became economically valuable.

By convention, one ton of carbon dioxide (CO2) corresponds to one carbon credit. This credit can be traded in the international market. Reducing the emission of other gases, which also causes the greenhouse effect, can also be converted into carbon credits using the equivalent carbon concept.

To assist countries in meeting their emission targets and to encourage the private sector and developing countries to contribute to emission reduction efforts, Protocol negotiators have included three market mechanisms in addition to national actions or individual reduction efforts:

Emissions trading:

Countries in Annex I [1] that have not reached the emission limits (allowable but not used emissions) can sell that excess to other Annex I nations that are emitting gases above the thresholds.

One of the leading brokerages to trade emissions is the European Climate Exchange.

Joint implementation:

According to this mechanism, countries in Annex I join efforts to achieve their goals. Thus, if one country is not able to reduce its emissions sufficiently, but the other one is, they can sign an agreement of mutual help.

The joint implementation mechanism allows a flexible and cost-effective way for a country to achieve its reduction targets while the host country benefits from foreign investment and technology transfer.

This type of project should reduce emissions by source, or increase removals by sinks, in addition to what would occur if nothing were done.

Clean Development Mechanism (CDM):

This mechanism allows for emission reduction projects in developing countries that do not have emission reduction targets under the Kyoto Protocol. These projects can be converted into Certified Emission Reductions (CERs), which represent one ton of CO2 equivalent, which can be negotiated with countries that have emission reduction targets under the Kyoto Protocol.

CDM projects can be implemented in the energy, transportation and forestry sectors.

This mechanism encourages sustainable development and reduction of emissions by giving industrialized countries flexibility to meet their reduction targets while stimulating technology transfer and the involvement of society in developing countries.

Projects must be eligible, according to a rigorous public registry system, which has been developed to ensure that the projects are real, verifiable, reportable and incremental to what would occur without the project.

To be considered eligible, projects must first be approved by the Designated National Entity of each country (DNA). In Brazil, it is the Interministerial de Mudança Global do Clima [Interministerial Commission on Global Climate Change], comprised of representatives of eleven ministries.

This mechanism has been operating since 2006 and already registered more than 1,000 projects, representing more than 2.7 billion tons of CO2 equivalent.

The Kyoto Protocol, therefore, represents the “regulated market”, also called compliance, where countries have mandatory reduction targets to be met.

There is, in turn, a voluntary market, where companies, NGOs, institutions, governments, or even citizens take the initiative to reduce emissions voluntarily. Carbon credits (Verified Emission Reductions – VERs) can be generated anywhere in the world and are audited by an independent entity of the United Nations system.

Some voluntary markets features are:

  • Credits do not count as reduction of country goals;
  • The operation is less bureaucratic;
  • Projects with structures not recognized by the regulated market, such as REDD, can be accepted;

The main voluntary market is the Chicago Climate Exchange, in the USA.

In addition to these two types of market, another way to finance projects to reduce emissions or carbon sequestration are the voluntary funds. Their main characteristics are:

  • They are not part of the market mechanism (they do not generate carbon credits);
  • The donation amount cannot be deducted from the reduction target of donor countries;
  • Projects with structures not recognized by the regulated market, such as REDD, can be accepted;

The primary funds are the World Bank’s Forest Carbon Partnership Facility and the Brazilian government’s Amazon Fund.

Content by Ricardo Rettmann.

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[1] Annex I is the list of 40 countries and the European Community, listed in the Climate Convention, which have made commitments to reduce greenhouse gas (GHG) emissions. They are the countries of the Organisation for Economic Co-operation and Development (OECD). Non-Annex I countries (developing countries) are those that have not committed themselves to mandatory emission reduction targets, although some countries adopt voluntary actions to that end.

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