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About Carbon Markets

The Kyoto Protocol, an agreement made under the United Nations Framework Convention on Climate Change (UNFCCC), has been ratified by more than 150 countries. Countries from Annex 1 of the UNFCCC that have ratified the Kyoto Protocol commit to reduce their emissions of carbon dioxide and five other greenhouse gases (GHGs), or engage in emissions trading to acquire carbon credits.

Carbon markets are a key element of the Kyoto Protocol. The reduction targets established in the Kyoto Protocol can be met by reducing domestic GHG emissions, or by utilising three “flexible” mechanisms allowed under the Kyoto Protocol: Emissions Trading, Joint Implementation (JI) and the Clean Development Mechanism (CDM).

These flexible mechanisms have created markets for trading emissions which many governments and companies worldwide are using to manage carbon risk. The new mechanisms also provide opportunities for developing countries to attract significant inward investment for emission-reducing projects.

In addition, the European Union has established the Emissions Trading Scheme (EU ETS) as a means of meeting their Kyoto targets. The EU ETS allocates emissions allowances to large private sector GHG emitters and allows them to trade them as a way of enabling emissions to be reduced at least cost.

Other voluntary and mandatory markets for emissions reductions are also starting to emerge elsewhere, including at the state level in the United States.

Uncertainty remains about the precise long-term nature of carbon trading. Over the next few years, governments will enter into difficult, complex and, at times, contentious negotiations on the future actions needed to reduce greenhouse gas emissions and to adapt to a changed and changing climate. In our opinion, emissions trading will form an important cornerstone of future action on climate change. Trading provides for many benefits and will be at the heart of least-cost economic solutions to reducing greenhouse gas emissions. In addition, leadership will not only come from governments determined to lay a strong foundation for action but also from enlightened corporations and those feeling the weight of consumer concerns. Many corporations are already taking actions on a voluntary basis.

The markets for emission reductions under the flexible mechanisms and the EU ETS have increased from small and hesitant trades to a growing market, projected to possibly exceed $10 billion in the CDM alone. In a follow up commitment period to the Kyoto Protocol, projections place a market size at over $100 billion. But despite the growth of these markets and their increasing liquidity, this is an immature market subject to high degrees of uncertainty and substantial risk. In particular, institutional and regulatory uncertainty at the international, regional and national level creates significant risk both for individual projects and for the operation of the market as a whole.

To profit from these uncertainties while mitigating risk is the major challenge for all players trading in the carbon market. Improving access to information about these risks is the critical factor that will enable the carbon market to mature.