Carbon credit explained

Alice is back answering your questions about the world of finance. This week she explains carbon credit

Dear Prateek,

It's always nice to see a student who's up with the times - you must have been reading The Gateway. Indeed, your question is one which is particularly relevant at this moment in time.

Unless you have been living in a cave for the last 50 years (which is highly unlikely given that I received your query via then you'll be aware of the issues surrounding climate change.

No doubt you will have read the article in our first issue of the term outlining the build up to the United Nations Climate Change Convention being held in Copenhagen next month. At the conference, representatives from 40 UN states will meet to finalise an attempt to agree a formal programme for reducing carbon emissions. This will replace the Kyoto Protocol of 1997, which has been in place since 2005.

One of Kyoto's main objectives was to establish a universal "cap-and-trade" system aimed at reducing emissions of harmful greenhouse gases, such as CO2. The protocol is generally agreed to have had limited success in making a serious dent in lowering output of greenhouse gasses. Not least, the convention is remembered for the fact that the world's largest CO2 emitter, the US, neglected to ratify the treaty despite having signed up to the agreement. Since Kyoto, global emissions have risen by 25%.

Anyway, to get back to your question, carbon credit is basically one of the key components, outlined at the first convention, and hopefully finalised at the second, for reducing the carbon emissions of individual nations.

In simple terms, if a company has one carbon credit it is entitled to emit one tonne of carbon. Under the agreement, each individual country is given a target for reducing the collective CO2 output of its industry and business and, based on this objective, is responsible for handing out credits to individual companies.

Each firm will receive a set quota of credits, depending on its size and the nature of its operation, which it is allowed to use up over the year. Going over this allowance will result in a harsh penalty. In theory, the system will force companies to regulate the volume of emissions they produce and the amount of energy they use.

With me so far?

Alternatively, companies likely to exceed their agreed stipulation are able to gain extra credits through a variety of means. One way they can do this is by earning carbon offset credits: the amount of CO2 they use is offset by investments in clean forms of energy production in developing countries. A firm can also earn carbon reduction credits, which are given to them in exchange for putting money back into methods of reducing carbon from the atmosphere, such as reforestation and creating technology for storing emissions.

In answer to your second question "how are credits traded?", a third way of gaining additional credits is by buying them from companies which have not used up their allocation, leaving a surplus which they are willing to trade in exchange for cash or other goods. In other words, companies can trade the right to pollute more with those who are willing to forego part of their allowance. This process is often known as cap-and-trade.

Since Kyoto, a number of markets have been established to facilitate this process, allowing firms to trade across different countries and continents. The largest of these is the European Climate Exchange which was created in 2005 under the European Union Emission Trading Scheme, or EU ETS for short. The exchange allows the 25 nations that signed up to the scheme to trade credits freely between themselves. It works on the premise that the sum of the total number of credits allocated is less than the amount of pollutants that would ordinarily be emitted if there were no cap in place. Some developed countries outside the EU, such as New Zealand and Australia, have their own exchanges.

The exchange works much like a conventional stock market. Companies registered with the market are able to trade credits with each other through a broker who will negotiate the price between the two parties as you would a conventional financial asset. Firms are also permitted to "bank" credits by saving part of their yearly allocation and then adding them to their allowance for the following year. By the same token, they are also able to "borrow" credits from another firm, going over their initial quota and then paying them back to the creditor the following year.

While this system represents the most regulated form of trading, companies are also permitted to trade directly with each other outside of the exchange, or even auction off credits to the highest bidder.

One important point to mention is that while 192 nations signed up to the emissions capping objectives agreed by the Kyoto Protocol, under the convention only a select group of developed states are required to lower their emissions through issuing allowances. This caveat acknowledges the right of developing countries to undergo industrialisation to prevent them from falling behind economically.

As such, another benefit of the cap-and-trade system is that developed states are encouraged to introduce clean energy technology to poorer countries in exchange for additional credits.

This all sounds like a great idea in theory, however the system has been heavily criticised. After all, if it had worked there would be scant need for a second Convention just four years after the original plans were put into effect.

One argument is that the current trading system encourages companies to sell carbon emissions allowances they would not normally use, meaning that wealthy companies that go over their allowance find it relatively easy and economical to pollute more if they choose to. In plain English, the net reduction in emissions would be lower if another system was used, for example a tax system, which acted as a better deterrent to firms looking to increase their allowances.

Another criticism is that the system currently in place is too hard to regulate. The lack of transparency surrounding the trading scheme allows companies to get away with going above their emissions quota without being caught.

Details... details. The main draw-back of the scheme is that the US has not yet signed up to it. Without the participation of the world's biggest polluter there is little hope of making a serious dent in global emissions. Here's hoping that Obama will able to put that right in Denmark next month.