How the Chicago Climate Exchange Works

It's no secret the world is addicted to oil. People have been using oil for more than 5,000 to 6,000 years, and today, fossil fuels provide 85 percent of the energy in America alone [source: California Energy Commission and The Heritage Foundation]. Generating energy from fossil fuels has a downside -- greenhouse-gas emissions byproducts. Greenhouse gases (GHGs) are considered to be partly responsible for global warming, and international efforts are under way to reduce the emission of six offenders: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulphur hexafluoride. Under the Kyoto Protocol treaty, a legally binding agreement drafted in 1997 and enacted in 2005, 37 industrialized countries, as well as the European Union pledged to reduce total emissions by an average of 5 percent below their 1990 levels between 2008 and 2012.

How are counties reaching these goals? They have two choices. Invest in ways to reduce pollution levels or invest in others' capacity to cut their pollution, a cap and trade system that puts a price on emissions.

Cap and trade works basically like this: Countries (as well as companies or individuals) are given an allowance of how much GHG they may emit, known as the cap. Let's say Country A easily reduced its emissions and emitted 10 percent fewer GHGs than its cap permitted. Country B, though, didn't meet its cap. Country A can sell the unused 10 percent of its allowance to Country B and help Country B offset its emission excess -- the trade.

In 2000, economist Dr. Richard Sandor began studying whether a cap and trade system could be applied to U.S. companies and the way they reduce their GHG emissions. He believed the country was ready for a private carbon trading market, even if it didn't back an international treaty like Kyoto. Carbon trading is like selling company shares on the stock market except it's not shares of a company, it's shares of pollution. As it turns out, his brainchild was a hot idea. Sandor founded the Chicago Climate Exchange (CCX), and in 2003, 13 charter members began trading GHG allowances for the six named GHGs. Today, the CCX has roughly 300 multinational members [source: Chicago Climate Exchange].

The CCX was the first in the world when it launched, but affiliated exchanges have since opened around the world, including the European Climate Exchange (ECX), Chicago Climate Futures Exchange (CCFE), Montréal Climate Exchange (MCeX) and Tianjin Climate Exchange. The CCX is still the only carbon trading market in America.

How are emissions traded, and who trades them? Let's find out.

Membership of the Chicago Climate Exchange

The member base in the CCX is broken down into categories:

Members
Associate members
Participant members (offset providers and aggregators and liquidity providers)
Exchange participants

Members are those who directly generate and emit greenhouse gases through activities such as energy production, manufacturing and travel. Associate members don't generate their own direct GHG emissions but instead agree to offset 100 percent of indirect emissions, including electricity (and other energy) use and business travel.

Offset providers and aggregators and liquidity providers are participant members. Offset providers own projects that offset GHG emissions by storing, eliminating or reducing those emissions. Qualifying projects generate exchange offsets that can be traded (we'll find out more about these later). Offset aggregators administratively manage offset projects for the providers.

Liquidity providers and exchange participants are a little bit different. Liquidity providers aren't in it to comply with emission reduction, they're market makers -- professional traders, hedge-fund groups and proprietary-trading groups -- companies or individuals who want to trade on the CCX market. Exchange participants are companies or individuals without a GHG emissions reduction commitment of their own, such as the U.S. House of Representatives and the Clean Air Conservancy. Exchange participants buy carbon financial instruments (the CCX's measure of emissions) with the sole purpose of retiring the contracts.

With so many types of members, the CCX is made up of a diverse set of players, from Amtrak and Ford Motor Company, to waste-management facilities and even a brewing company. About 25 percent of members are from U.S. power utilities, 17 percent are part of the Dow Jones Industrials and 11 percent represent Fortune 100 companies. It's not just industry, though. Eight universities, eight U.S. cities, three counties and two states have also joined the CCX [source: Chicago Climate Exchange].

Joining is voluntary and self-regulating and comes with attractive benefits. Many U.S. companies see government emissions regulations in the future and want to get on the path to compliance before legislation is enacted. Many also need to comply with Kyoto Protocol regulations if they do business in countries committed to that treaty. Others see it as a good way to make extra money. If making the minimum reduction is easy for a company, it can profit from selling credits on the exchange. It's not all about profit and regulation, though. Reducing emissions is good for the planet and good public relations.

To join the CCX cap and trade system, each GHG-emitting member pays an entry fee and is given a yearly emission allowance based on their emission baseline and the CCX emission reduction schedule. This is their exchange allowance. Annual membership costs and compliance are also determined by the emission baseline and audits conducted by third-party verifiers. Once committed, the contract is legally binding.

The emission reduction schedule is two-phased. A member's emission baseline is calculated from average of annual emissions, worldwide, during a specific period of time. For Phase I (the first four years of the CCX -- 2003 to 2006) baselines were determined by 1998 through 2001 annual emission levels; during this phase, members reduced their carbon dioxide (or other GHG) emissions by a minimum of 1 percent annually. Phase I members committed to reducing total emissions to 4 percent below their established baseline.

Phase II extends of the reduction schedule and covers the subsequent years up to 2010. For members who participated in Phase I, emission reduction requirements rose by 2 percent, to a total of 6 percent. The baseline for new members joining Phase II is established by total emissions during the year 2000, and the reduction target is a minimum of 6 percent below that baseline. Phase III? We'll have to wait and see.

Trading in the Chicago Climate Exchange

Greenhouse-gas emissions are released into the atmosphere, so you may be wondering how something in the air can be bought and sold. What's actually traded on the CCX market is something called the carbon financial instrument (CFI).

A CCX member who has hit or surpassed its target emission reduction goals has an emission credit. These credits, the difference between the actual GHG emission levels and the allowed GHG emission levels, are represented by the CFIs. One CFI contract is made up of exchange allowances and exchange offsets and represents 100 metric tons (110 tons) of carbon dioxide equivalent (CO₂e), the international measure of greenhouse-gas emissions. CFI contracts can be saved or sold to members who exceeded their reduction goal to help with their compliance. But sold at what cost? That's the beauty of the system -- the market demand sets the price of CFI contracts. The more members who want to buy credits, the more in demand they are, which causes prices to rise accordingly.

Trading isn't conducted through brokers, but is instead done anonymously (to other users) on the CCX electronic trading platform, an Internet-based trading floor that is linked with the CCX registry. This comprehensive system is available to the CCX member base and offers administrative and reporting tools, as well as a tracking system for members to manage their emission inventory (the gases they're emitting), portfolio of CFI holdings, bids (orders) and statements, emission allowances and offsets.

CFIs are issued by the year in which the emission reduction was realized: 2003 Vintage CFI, 2005 Vintage CFI, etc. A CFI can be used in the same calendar year as its vintage, or a member can save it for use in upcoming years.

Transactions made in the CCX electronic trading platform are done based on live market quotes posted by members and may be settled one of two ways -- trades that are exchange cleared or trades that are bilaterally cleared. Exchange cleared trades are those cleared and settled through the CCX; the cash settlements in bilaterally cleared trades are handled by the members themselves. All trade settlements are made in U.S. dollar amounts.

All members with exchange allowances and exchange offsets are monitored continuously and report their emissions each year via procedures set up by the CCX and by the World Resources Institute/World Business Council for Sustainable Development initiative. Another layer of monitoring happens through the Financial Industry Regulatory Authority (FINRA), a nongovernmental regulator for all securities firms doing business in the United States. In addition to the CCX, FINRA works with NASDAQ, the American Stock Exchange and the International Securities Exchange. FINRA also verifies offset projects proposed and registered by members and offset providers and aggregators.

Chicago Climate Exchange Projects

Members with emission reduction goals aren't the only ones trading on the CCX, nor are exchange allowances the only type of trades. All members also have the opportunity to buy exchange offsets from offset providers and offset aggregators, as well as members with a qualifying project proposal. Offset providers could be farmers, waste management operators, renewable energy suppliers or any other company or individual proposing a GHG emission-reducing project. Offset aggregators manage multiple projects, all emitting less than 10,000 metric tons (110 tons) of CO₂e annually.

Offset projects are evaluated and approved by CCX staff based on standardized CCX rules, and CFI contracts are issued once the project's viability has been reviewed by a third-party independent verifier. Project types include methane capture and combustion for agricultural, coal mine and landfill methane; agricultural soil carbon management, improved rangeland soil management; forestry; renewable energy (wind and solar power) and ozone depleting substance destruction. Additional project types that are reviewed and approved on a case-by-case basis include energy-efficiency and fuel-switching projects, as well as clean development mechanism (CDM)-eligible projects that allow industrialized countries to invest in emission-reducing projects in developing countries rather than in their own.

Just as members voluntarily agree to join the exchange and reduce their GHG output, eligible offset projects must be voluntary (not required by law). A forestry GHG offset project may, for example, include maintaining or increasing a forest area through reforestation. To kick things off, the project initiator would submit a proposal to the CCX committee on offsets for review and approval. Upon that approval, the project owner would then have the project independently verified by a CCX-endorsed third party.

Projects, just like allowances, are also subject to third-party verification to determine three things:

That the project is eligible
That the equipment generating the GHG displacement credit is owned by the offset provider (giving the provider the right to propose the project)
That the project is performing effectively.

The CCX provides a list of third-party verifiers to its members. Once verified, reports are reviewed for accuracy by FINRA. Only then may they be set up as tradable CFI contracts in the CCX registry.

There's no limit to the number of projects an offset provider or aggregator can register and receive CFI contracts for trading on the CCX electronic trading platform. To mitigate duplicating sold credits, each project is assigned a unique identification number in the CCX system. According to the CCX, offsets aren't yet as popular a trade as are emission allowance credits: one offset is used for every 50 times a buyer needs a credit to comply with its emission schedule [source: World Business Council for Sustainable Development].

Though government regulations have yet to be defined, the global carbon trading market is expanding rapidly each year and is predicted to reach $200 billion by 2010 [source: Kennedy]. Is it effective environmentally? We'll see.

To learn more about the CCX and carbon trading, look over the links on the next page.