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The Kyoto Protocol is an international treaty subsidiary to the United Nations Framework Convention on Climate Change (UNFCCC/1992). Negotiations for the Kyoto Protocol were initiated at the first Conference of the Parties (COP 1) of the UNFCCC in Berlin in 1995, in recognition that the voluntary measures included in the UNFCCC were ineffective. The major feature of the Kyoto Protocol is that it sets 'quantified emission limitation or reduction obligations' (QUELROs) - binding targets - for 38 industrialised countries and the European Community (Annex B countries) for reducing greenhouse gas (GHG) emissions by an aggregate 5.2 per cent against 1990 levels over the five-year period 2008-2012, the so-called 'first commitment period'.
The Protocol was agreed in December 1997 at the third Conference of the Parties (COP3) in Kyoto, Japan. After COP 7 in Marrakech in late 2001, the Protocol was considered ready for ratification, and over the course of the next three years sufficient countries ratified the agreement in order for it to enter into force on 16 February 2005. Industrialised countries that ratify the Protocol commit to reducing their emissions of carbon dioxide and a basket of five other GHGs according to the schedule of emissions targets laid out in Annex B to the Protocol.
The Parties to the UNFCCC agreed that the effort to combat climate change should be governed by a number of principles, including the principle of 'common but differentiated responsibilities', in recognition that:
As a result of this, most provisions of the Kyoto Protocol apply to developed countries, listed in Annex I to the UNFCCC. China, India and other developing countries have not been given any emission reduction commitments, in recognition of the principles of common but differentiated responsibilities and equity enumerated above. However, it was agreed that developing countries share the common responsibility of all countries in reducing emissions.
The overall objective of the international climate regime, articulated in Article 2 of the UNFCCC, is to achieve 'stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic (human) interference with the climate system'.
The goal of the Kyoto Protocol is to reduce overall emissions of six GHGs - carbon dioxide, methane, nitrous oxide, sulphur hexafluoride, hydrofluorocarbons, and perfluorocarbons - by an aggregate 5.2 per cent over the period of 2008-2012, the first commitment period, which would then be followed by additional commitment periods with increasingly stringent emissions reduction obligations.
National emissions reductions obligations range from 8 per cent for the European Union and some others to 7 per cent for the US, 6 per cent for Japan, 0 per cent for Russia, and permitted increases of 8 per cent for Australia and 10 per cent for Iceland. Emission figures exclude international aviation and shipping.
One of the most heavily contested issues in the Kyoto Protocol negotiations was the legally binding nature of the emissions reductions, and the compliance regime. As the detailed architecture of the Protocol emerged in the period from 1997-2001, it became clear that for carbon markets to function effectively, the private sector needed to be able to 'bank' on the efficacy of the regime and the legality of the carbon credits.
What was agreed in the end was a compliance mechanism which held national governments accountable for their emissions reductions obligations, imposing a penalty of 30 per cent on countries for failing to meet their obligations by the end of the first commitment period (2012). Their obligation in the second commitment period, in addition to what was negotiated, would be increased by 1.3 tonnes for each tonne of shortfall in meeting their first commitment period obligation. Furthermore, if they were judged by the Protocol's Compliance Committee to be out compliance, then their right to use the flexible mechanisms would be suspended until they were brought back into compliance. Thus far, these legal arrangements have been sufficient to allow the functioning of the carbon markets, although the true test is yet to come.
As of May 2008, 182 parties have ratified the protocol. Out of these, 38 developed countries (plus the EU as a party in its own right) are required to reduce GHG emissions to the levels specified for each of them in the treaty. The protocol has bee ratified by 145 developing countries, including Brazil, China and India. Their obligations focus on monitoring and reporting emissions, which also enable them to participate in the Clean Development Mechanism (CDM). To date, the US and Kazakhstan are the only signatory nations of the UNFCCC not to have ratified the protocol.
For combating climate change, it does not matter where emissions are reduced, as it is the overall global reduction that counts. As a result, the Kyoto Protocol has taken a strong market approach, recognising that it may be more cost-effective for industrialised (Annex I) parties to reduce emissions in other countries, either also Annex I or developing countries. In order to achieve their targets set under the Kyoto Protocol, industrialised countries thus have the ability to apply three different mechanisms in which they can collaborate with other parties and thereby achieve an overall reduction in GHG emissions. These are:
1. Joint Implementation (JI);
2. The Clean Development Mechanism (CDM); and
3. Emissions Trading.
The Joint Implementation procedure is set out in Article 6 of the Kyoto Protocol. This stipulates that an Annex I country can invest in emissions reduction projects in any other Annex I country as an alternative to reducing emissions domestically. This allows countries to reduce emissions in the most economical way, and to apply the credit for those reductions towards their commitment goal. Most JI projects are expected to take place in so-called "transition economies," as specified in Annex B of the Kyoto Protocol, mainly Russia, Ukraine and Central and East Europe (CEE) countries. Most of the CEE countries have since joined the EU or are in the process of doing so, thereby reducing the number of JI projects as the projects in these countries were brought under the European Union Emissions Trading Scheme (EU ETS) and its rules to avoid double counting. The JI development in Russia and Ukraine was relatively slow due to delays in developing the nations' domestic JI rules and procedures, although activity is now picking up.
The credits for JI emission reductions are awarded in the form of 'emission reduction units' (ERUs), with one ERU representing a reduction of one tonne of CO2 equivalent. These ERUs come out of the host country's pool of assigned emissions credits, which ensures that the total amount of emissions credits among Annex I parties remains stable for the duration of the Kyoto Protocol's first commitment period.
ERUs will only be awarded for JI projects that produce emissions reductions that are 'additional to any that would otherwise occur' (the so-called 'additionality' requirement), which means that a project must prove that it would only be financially viable with the extra revenue of ERU credits. Moreover, Annex I parties may only rely on JI credits to meet their targets to the extent that they are 'supplemental to domestic actions'. The rationale behind these principles is to formally limit the use of the mechanism. However, since it is very hard to define which actions are 'supplemental' to what would have occurred domestically in any event, this clause is, sadly, largely meaningless in practice.
Clean Development Mechanism
The Kyoto Protocol's Article 12 established the Clean Development Mechanism, whereby Annex I parties have the option to generate or purchase emissions reduction credits from projects undertaken by them in non-Annex I countries. In exchange, developing countries will have access to resources and technology to assist in development of their economies in a sustainable manner.
The credits earned from CDM projects are known as 'certified emissions reductions' (CERs). Like JI projects, CDM projects must meet the requirement of 'additionality', which means that only projects producing emissions reductions that are additional to any that would have occurred in the absence of the project will qualify for CERs. The CDM is supervised by an Executive Board, which is also responsible for issuance of the CERs. Other requirements, including compliance with the project and development criteria, the validation and project registration process, the monitoring requirements, and the verification and certification requirements, are done externally by a third party.
A wide variety of projects have been launched under the CDM, including renewable energy projects such as wind and hydroelectric; energy efficiency projects; fuel switching; capping landfil gases; better management of methane from animal waste; the control of coal mine methane; and controlling emissions of certain industrial gases, including HFCs and N2O.
China has come to dominate the CDM market, and in 2007 expanded its market share of CDM transactions to 62 per cent. However, CDM projects have been registered in 45 countries and the UNFCCC points out that investment is now starting to flow into other parts of the world, such as Africa, Eastern Europe and Central Asia.
In 2007, the CDM accounted for transactions worth €12 billion (Point carbon, 2008), mainly from private sector entities in the EU, EU governments and Japan.
The average issuance time for CDM projects is currently about 1-2 years from the moment that they enter the 'CDM pipeline', which counted over 3,000 projects as of May 2008. Around 300 projects have received CERs to date, with over two-thirds of the issued CERs stemming from industrial gas projects, while energy efficiency and renewable energy projects seem to be taking longer to go through the approval process. However, there are now more than 100 approved methodologies and continuous improvement to the effective functioning of the Executive Board.
The rigorous CDM application procedure has been criticised for being too slow and cumbersome. The 'additionality' requirement has especially represented a stumbling block for some projects, since it is difficult to prove that a project would not be viable without the existence of CERs. The CDM also has the potential to create perverse incentives, i.e. discouraging the implementation of rigorous national policies for fear of making the additionality argument more difficult.
There are many improvements yet to be made, and the additionality principle will be one of the many issues surrounding the flexible mechanisms to be discussed during the negotiations leading to a post-2012 climate agreement. The CDM, as a project-based market mechanism, is by definition going to be fundamentally limited in both scope and geographic application. A variety of options for sectoral approaches are under consideration for moving away from a project based approach with its additionality requirements. In addition, it has become very clear in retrospect that the large industrial gas projects which still count for a large share of the CERs on the market during this first period should in reality be dealt with legislatively rather than through the CDM.
Under the International Emissions Trading provisions, Annex I countries can trade so called 'Assigned Amount Units' (AAUs) among themselves, which are allocated to them at the beginning of each commitment period. The emissions trading scheme, which is established in Article 17 of the Kyoto Protocol, also foresees this to be 'supplemental to domestic actions' as a means of meeting the targets established for the Annex I parties. The total amount of allowable emissions for all Annex I countries (the 'cap') has been proposed under the Kyoto Protocol. The scheme then allocates an amount of these emissions as 'allowances' to each of the Annex I parties (the 'assigned amount'). The assigned amount for any Annex I country is based on its emissions reduction target specified under Annex B of the Kyoto Protocol. Those parties that reduce their emissions below the allowed level can then trade some part of their surplus allowances (or 'AAUs') to other Annex parties.
The 'transition economies', such as Russia, Ukraine and CEE countries, have a huge quantity of surplus AAUs in the first commitment period, which is largely as a result of the collapse of the Warsaw Pact economies in the early 1990s. As these surplus AAUs were not created from active emissions reductions, the EU and Japanese buyers have vowed not to purchase them from the region unless the AAU revenue is associated with some 'greening' activities. The problem is partly being solved through the introduction of a new mechanism called the Green Investment Scheme (GIS), in which the sales revenue from AAUs are channeled to projects with climate and/or environment benefits. The surplus AAUs are now beginning to enter the market, with some CEE countries taking a lead in establishing the scheme. Various estimates suggest the total amount of AAUs entering the market through the GIS could be very large - much larger than the World Bank estimate of demand of between 400 million and 2 billion AAUs in the market (WB, 2008). The exact figure of the supply is hard to predict, however, as the biggest reserve of surplus AAU is in Russia, whose participation in the GIS is not yet clear.
How the EU ETS works
In order to tackle climate change and help EU Member States achieve compliance with their commitments under the Kyoto Protocol, the EU decided to set up an Emissions Trading System (ETS). Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 established the EU ETS. On 1 January 2005 the EU Emissions Trading System commenced operation. The system is being implemented in two trading periods. The first trading period ran from 2005 to 2007. The second trading period is set in parallel to the first commitment period of the Kyoto Protocol: it began on 1 January 2008 and runs until the end of 2012. A third trading period is expected to start in 2013 and to be implemented along with a reviewed ETS Directive.
The EU ETS is the first and largest international trading system for CO2 emissions in the world (see 'Carbon as a Commodity'). Since January 2008 it applies not only to the 27 EU Member States but also the other three members of the European Economic Area - Norway, Iceland and Liechtenstein. It covers over 10,000 installations in the energy and industrial sectors which are responsible for about 50 per cent of EU's total CO2 emissions and about 40 per cent of its total greenhouse gas emissions. The emission sources regulated under the system include combustion plants for power generation (capacities greater than 20 MW), oil refineries, coke ovens, iron and steel plants, and factories making cement, glass, lime, bricks, ceramics, pulp and paper. Discussions are under way on legislation to bring the aviation sector into the system from 2011 or 2012 (EC, 2006b)
The EU ETS is an emission allowance cap and trade system, that is to say it caps the overall level of emissions allowed but, within that limit, allows participants in the system to buy and sell allowances as they need. One allowance gives the holder the right to emit one tonne of CO2.
Currently, for each trading period under the system, Member States draw up national allocation plans (NAPs) which determine their total level of ETS emissions and how many emission allowances each installation in their country receives. By allocating a limited number of allowances, below the current expected emissions level, Member States create scarcity in the market and generate a market value for the permits. A company that emits less than the level of their allowances can sell its surplus allowances. Those companies facing difficulties in keeping their emissions in line with their allowances have a choice between taking measures to reduce their own emissions or buying the extra allowances they need on the market.
The ETS Directive stipulates that at least 95 per cent of issued allowances should be given out for free by Member States for the period 2005-2007. For the second trading period (2008-2012), this value is 90 per cent. The remaining percentage can be charged for, for example in an auction. This process, referred to as 'allocation', has been carried out using what is known as a 'grandfathering' approach, which is based on historical data (emissions or production levels).
The scheme is linked to the Kyoto Protocol's flexible mechanisms through the Directive 2004/101/EC. According to the 'Linking Directive', in addition to domestic action, Member States may also purchase a certain amount of credits from Kyoto flexible mechanisms projects (CDM and JI) to cover their emissions in the same way as ETS allowances.
The EU ETS has so far failed to achieve some of its main objectives, notably encouraging investment in clean technologies and the use of CO2 emissions reduction certificates as a market signal to regulate greenhouse gas emissions (Carbon Trust, 2007; Open Europe, 2007). This is due to a combination of adverse incentives associated with the EU ETS design:
Political National Influence on the Allocation Process and Over-Allocation of Permits
As previously explained, in order to make sure that real trading emerges, Member States must make sure that the total amount of allowances issued to installations is less than the amount that would have been emitted under a business-as-usual scenario.
Under the current system, where a significant degree of freedom over the elaboration of the NAPs is retained by Member States, decisions concerning allocation hinge upon emission projections, national interests and business efforts to increase the number of allowances (del Río González, 2006; Kruger et al., 2007; Blanco and Rodrigues, 2008).
Actual verified emissions in 2005 showed allowances had exceeded emissions by about 80 million tonnes of CO2, equivalent to 4 per cent of the EU's intended maximum level (Ellmerman and Buchner, 2007). This happened because government allocation had been based on over-inflated projections of economic growth and participants had a strong incentive to overestimate their needs (ENDS Europe Report, 2007).
The publication of those figures provoked the collapse of the CO2 prices to less than €10/ tCO2 in spring 2006. By the end of 2006 and into early 2007 the price of allowances for the first phase of the EU ETS fell below €1/tCO2 (€0.08/tCO2 in September 2007) (www.pointcarbon.com). The over-allocation of permits and the consequent collapse of CO2 prices have hampered any initiative of clean technology investment, as it is clear that most companies regulated by the EU ETS didn't need to make any significant change to their production processes to meet the target they had been assigned (Blanco and Rodrigues, 2008).
Counterproductive Allocation Methods
The first phase of the EU ETS has shown that free allocation based on absolute historical emissions (grandfathering) causes serious distortions in competition by favouring de facto fossil-fuel generation (EWEA, 2007).
A controversial feature of the system has been the ability of the power sector to pass through the marginal cost of freely allocated emissions to the price of electricity and to make substantial profits. This happens because in competitive markets the power generation sector sets prices relative to marginal costs of production. These marginal costs include the opportunity costs of CO2 allowances, even if allowances are received for free. As a consequence, fossil fuels power producers receive a higher price for each kWh they produce, even if the costs for emitting CO2 only apply to a minor part of their merchandise. The effect is known as windfall profit.
In the first phase of the EU ETS, conventional power generators are believed to have made over €12.2 bn windfall profits in the UK alone (Platts, 2008). There have been similar arguments over ETS windfall profits in other European countries, such as Germany and Spain (Platts, 2008). Carbon market experts see the situation as likely to arise again in the second trading period. According to a recent Point Carbon study of the UK, Germany, Spain, Italy and Poland, power companies could reap profits in excess of €71 bn over the next four years (Point Carbon, 2008).
Furthermore, as the economist Neuhoff remarks, any free allocation acts as a subsidy to the most polluting companies which - in addition to not paying the environmental cost they entail - obtain substantial gains (Nuehoff et al., 2006). This is clearly in contradiction with the 'polluters pay principle' (established by Article 174 of the EC Treaty), which states that 'environmental damage should as a priority be rectified at source and that the polluter should pay'.
Grandfathering also penalises 'early action' and justifies 'non-action'. Since allowances are allocated as a function of emission levels, firms are clearly encouraged not to reduce their emissions as this would result in fewer allowances in future phases (Neuhoff et al., 2006).
Limited Scope of the ETS
About 55 per cent of the CO2 emitted in the EU comes from sectors outside the EU ETS. In the same way, other more powerful greenhouse gases, such as nitrous oxide, sulphur hexafluoride and methane are excluded. The experience from recent years illustrates that it is in some of the sectors that have been left outside the ETS - notably transport - that the highest CO2 emission growth rates have occurred (Eurostat, 2007).
As a preliminary step to design the third phase of the EU ETS (post-2012), the European Commission has embarked in a public consultation on what the new system should look like. The debate started in November 2006 with the publication of the Communication 'Building a global carbon market' (EC, 2006a). In the context of the European Climate Change Programme (ECCP), a Working Group on the review of the EU ETS was also set up to discuss the four categories of issues identified by the EC Communication (EC, 2006a):
As part of the Commission's climate change and energy package, and in the light of the European Council's 2020 commitments to reduce greenhouse gas emissions by 20 per cent compared to 1990 levels (30 per cent if other developed countries join the effort), a new proposal for reform of the EU ETS Directive was presented on 23 January 2008 (EC, 2008).
Although the proposal still needs to be approved by both the Council of the EU and the European Parliament, the main elements of the new system, which will enter into force in 2013 and run until 2020, seem to be the following:
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