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How Carbon Trading Works

Mandatory Carbon Trading
U.N. Secretary-General Kofi Annan marking the Kyoto Protocol's entry into force in February 2005.
U.N. Secretary-General Kofi Annan marking the Kyoto Protocol's entry into force in February 2005.
AP Photo/Itsuo Inouye

The Kyoto Protocol, an international treaty on climate change that came into force in 2005, dominates the mandatory carbon market. It serves as both a model and a warning for every emerging carbon program.

In the early 1990s, nearly every member state of the United Nations resolved to confront global warming and manage its consequences. Although the resulting United Nations Framework Convention on Climate Change (UNFCCC) international treaty recognized a unified resolve to slow global warming, it set only loose goals for lowering emissions. In 1997, the Kyoto amendment strengthened the convention.

Under the Protocol, members of the convention with industrialized or transitional economies (Annex I members) receive specific reduction targets. Member states with developing economies are not expected to meet emissions targets -- ­an exception that has caused controversy because some nations like China and ­India produce enormous levels of GHG. The Protocol commits Annex I members to cut their emissions 5 percent below 1990 levels between 2008 and 2012. But because the Protocol does not manage the way in which members reduce their emissions, several mechanisms have arisen. The largest and most famous is the European Trading Scheme (ETS), still in its two-year trial phase.

The ETS is mandatory across the European Union (EU). The multisector cap and trade scheme includes about 12,000 factories and utilities in 25 countries [source: Europa]. Each member state sets its own emissions cap, or national allocation plan, based on its Kyoto and national targets. Countries then distribute allowances totaling the cap to individual firms. Even though countries distribute their own allowances, the allowances themselves can be traded across the EU. Independent third parties verify all emissions and reductions.

There has been, however, some question as to whether the ETS has actually helped reduce emissions. Some people even call it a "permit to pollute" because the ETS allows member states to distribute allowances free of charge [source: ­BBC News]. The ETS also excludes transport, homes and public sector emissions from regulation. And as with all cap-and-trade schemes, governments can essentially exempt influential industries by flooding them with free allowances.

The ETS allows its members to earn credits by funding projects through two other Kyoto mechanisms: the Clean Development Mechanism (CDM) and Joint Implementation (JI). CDM allows Annex I industrialized countries to pay for emissions reduction projects in poorer countries that do not have emissions targets. By funding projects, Annex I countries earn certified emissions reduction (CER) credits to add to their own allowances. JI allows Annex I parties to fund projects in other Annex I countries.

The Kyoto Protocol expires in 2012. Lawmakers around the world are rushing to analyze its achievements and shortcomings and negotiate a successor. The United States, Kyoto's most famous holdout, lacks any national mandatory carbon legislation but, ironically, has a booming voluntary carbon market. In the next section we'll learn about the Chicago Climate Exchange.