Overview of the carbon market

Carbon dioxide (CO2) is a key component of greenhouse gas (GHG) emissions and scientific research has proved that due to a steady rise in GHG emissions, global temperature has continued to increase. The ‘Paris Agreement’, a legally binding international treaty formed on 12 December 2015 (set into motion on 4 November 2016) at the UN Climate Change Conference (COP21) in Paris, to tackle climate change and its effects, set long-term goals in an effort to – • guide all nations to substantially reduce global greenhouse gas emissions to limit the global temperature increase in this century to 2 degrees Celsius while pursuing efforts to limit the increase even further to 1. 5 degrees; • review countries’ commitments every five years, i. e. , member countries would return in five years to either make a new round of or update, their climate commitments known as nationally determined contributions (NDCs); • provide financial, technical and capacity-building support to developing countries to mitigate climate change, strengthen resilience and enhance abilities to adapt to climate impacts. At present, 194 parties (193 nations & the European Union) have their signatories on the Agreement. It is also worth noting that the Paris Agreement marks the start of a shift towards net-zero, as it calls for GHG emissions to be reduced by 45% by 2030 and net-zero to be achieved by 2050. Rules for a global carbon market were established at the Glasgow COP26 climate change conference in November 2021, enacting the agreement first laid out at the 2015 Paris Climate Agreement. Carbon markets are essentially trading systems aimed at fighting climate change, in which ‘carbon credits’ or ‘carbon offsets’ are purchased/sold (1 tradable carbon credit is equal to 1 tonne of CO2). Carbon credits, also referred as carbon allowances, are essentially permits which allow a business/company to emit CO2. For example, if a company buys a carbon credit (typically from the Government) they acquire the permission to generate 1 tonne of CO2 or an equivalent of any other greenhouse gas in the form of emissions. Conversely, when a company successfully removes 1 tonne of CO2 from the atmosphere, they generate a carbon offset. This offset can further be bought by other companies so that they can reduce their own carbon footprint. Carbon revenue in the case of carbon credits flow from companies/businesses to governments/regulators and in the case of carbon offsets, between companies. Even though the terms – carbon credit and carbon offset are often used interchangeably, they cater to different carbon markets. Adopted at the third Conference of the Parties (COP) to the UNFCCC held in Kyoto, Japan, in December 1997, the Kyoto Protocol committed industrialized country signatories (so-called “Annex I” countries) to collectively reduce their GHG emissions by at least 5. 2 percent below 1990 levels on average over 2008–2012. Annex I countries could fulfil their commitments through domestic actions or the use of three flexibility mechanisms - International Emissions Trading (IET), Clean Development Mechanism (CDM) and Joint Implementation (JI). The amendment adopted in Doha, Qatar, in December 2012 provided a basis for the three Kyoto mechanisms to continue for 2013–2020. The IET, JI and CDM were of significant relevance in the creation of cross-boundary carbon markets. Note: Annex I and Annex B Countries/Parties are the signatory nations to the Kyoto Protocol that are subject to caps on their emissions of GHGs and committed to reduction targets–countries with developed economies. Annex I refer to the countries identified for reduction in the United Nations Framework Convention on Climate Change (UNFCCC) while the Annex B is an adjusted list of the countries identified under the more recent Kyoto Protocol. Annex B countries have their reduction targets formally stated. i. The International Emissions Trading Mechanism, stated in Article 17 of the Kyoto Protocol, grants countries with spare emission units (units that are permitted but not used) the right to sell the excess units to countries that need to reach their emissions target. Parties committed to the protocol have targets of allowed emissions/assigned amounts, which are divided into assigned amount units (AAUs) each equal to one tonne of CO2. The other units which may be transferred under the scheme, each, may be in the form of: • A Removal Unit (RMU) issued by an Annex I Party on the basis of land use, land-use change and forestry (LULUCF) activities; • An Emission Reduction Unit (ERU) generated by a joint implementation project under Article 6 of the Protocol. • A Certified Emission Reduction (CER) generated from a clean development mechanism project activity under Article 12 of the Protocol. ii. The Clean Development Mechanism (CDM), outlined in Article 12 of the Protocol, permits a developed country with an emission-reduction or emission-limitation commitment under the Protocol to implement an emission-reduction project in developing countries. These projects are worth viable certified emission reduction (CER) credits, each equivalent to 1 tonne of CO2, which can ultimately be considered as taking a step towards meeting the Kyoto target. The final approval for emission-reduction projects is given by the Designated National Authorities after a thorough and public registration and issuance process. CDM is supervised by the Clean Development Mechanism Executive Board, which is subject to any and all inquiry by the countries that consented to signing the Kyoto Protocol. iii. The Joint Implementation (JI) Mechanism, defined in Article 6 of the Protocol, grants a developed country with an emission-reduction or emission-limitation commitment under the Protocol the liberty to earn emission reduction units (ERUs) from an emission-reduction or emission removal project in another Annex B Party, each equivalent to 1 tonne of CO2. This can be considered as taking a step towards meeting the Kyoto target as well. JI therefore offers countries a highly adaptable and cost-effective means of fulfilling a part of their Kyoto commitments. Registry systems track and record transactions by Parties under the three Kyoto Protocol mechanisms. The UN Climate Change Secretariat keeps an international transaction log to verify that transactions align with the rules of the Protocol. In addition to this, reporting is done by Parties by submission of annual emission inventories and national reports under the Protocol at routine intervals and a compliance system confirms if Parties are meeting their commitments and helps them to meet their commitments if they have any complications in doing so. Furthermore, the Adaptation Fund was established under the Protocol to finance adaptation projects and programmes in developing countries that are Parties to the Kyoto Protocol. In the first commitment period, the Fund was financed mainly with a share of proceeds from CDM project activities. In Doha, in 2012, it was decided that for the second commitment period, international emissions trading and joint implementation would also provide the Adaptation Fund with a 2% share of proceeds.