Carbon Credits and Offsets

Principle source: House of Commons Select Committee on Environmental Audit, Sixth report published 3rd July 2007. Section on 'Understanding the compliance and voluntary carbon markets'.

The compliance carbon market

In 1997, the United Nations Framework Convention on Climate Change (UNFCC) adopted the Kyoto Protocol. This established legally binding targets for reductions in greenhouse gas emissions on those countries which have ratified the Protocol: predominantly the 'developed' countries, with the notable exception of USA. These countries are known as Annex I countries in the Protocol. To enable compliance, the Protocol established 'Flexible Mechanisms' to allow these countries to meet their targets by trading 'emission reduction units' (or 'carbon credits'). The compliance market is the product of these Flexible Mechanisms established by the Protocol. 'Non-Annex I' countries (the less economically developed nations signatory to the Protocol) are currently not subject to greenhouse gas reduction obligations. Transfers and acquisitions of these units are tracked and recorded through the registry systems under the Kyoto Protocol. These include a national registry to be established and maintained by each regulated country.

Water vapour and ozone are also potent greenhouse gases.

Whilst the greenhouse effect is natural, mainly due to water vapour, it is thought that it is being enhanced by human activity increasing the concentration of these gases in the atmosphere. Carbon dioxide from burning fossil fuels is thought to be responsible for about 60% of the enhanced greenhouse effect.

The unit for measuring emissions of the gases is tCO₂e or tonne of carbon dioxide equivalent. This allows us to take account of the differing degrees of 'Global Warming Potential' (GWP) of the different gases. So for carbon dioxide an emission of 1 tonne is equal to 1 tCO₂e. And for methane an emission of 1 tonne is equal to 23 tCO₂e. The multiple is the GWP, as estimated by the Intergovernmental Panel on Climate Change (IPCC).

An emission reduction unit or carbon credit is 1 tCO₂e.

Reducing Emissions from Deforestation and Degradation (REDD) is now being developed at the UN for forest protection.

Emissions Trading

The Kyoto emissions trading scheme is a cap-and-trade scheme, where parties are given an emissions allowance (or quota) based on an emissions reduction target. In order to create scarcity, a limited number of allowances are issued equal to the 'global' target for a particular period. Allowances are measured in Assigned Amount Units (AAUs) which are equivalent to one tonne of carbon dioxide.

At the end of a period each party must hold the equivalent number of AAUs equal to the amount of greenhouse gas it emitted. This allows parties to decide whether to reduce their emissions internally, or whether to buy credits from other parties, who may have been able to make an emission reduction more cheaply. Similarly, parties which have reduced their emissions below their target will be able to sell any surplus allowances they hold to other parties who cannot, or who do not want to meet their targets internally.

Parties can also meet their targets by buying or generating credits from the other mechanisms. The practice of investing in emission reduction projects in place of making internal reductions is known as 'offsetting'. In general, 'carbon offsets' are sold to individuals and organisations who are not subject to compulsory quotas, through the voluntary market.

The rationale behind emissions trading is cost-effectiveness: in theory, parties will choose the most cost-effective way to either make or buy their emission reductions.

Clean Development Mechanism

The Clean Development Mechanism (CDM) allows Annex I countries to meet their emissions reduction targets by generating credits from projects to reduce emissions in developing countries. This allows for the reduction to be made at a lower cost than may otherwise be possible domestically. The projects generate emissions credits called Certified Emissions Reductions (CERs) which can be bought and traded. One CER is equal to one tonne of carbon dioxide equivalent.

In order to be recognised in the CDM, projects have to demonstrate that they create savings which are additional to anything that might have happened anyway - a concept known as 'additionality'. Additionality is proved by using the CDM toolkit, which provides stringent criteria for a project to meet and provides a methodology for calculating baseline emissions which give a business-as-usual (BAU) scenario against which the project is compared. The amount of credits that a project is entitled to is the difference between the project emissions and the baseline emissions. The methodology enables project developers to show that the emission reductions would not have happened but for the project. There are currently approximately 60 different methodologies to cover a range of different project types. An authorised third party called the Designated Operational Entity (DOE) is responsible for the verification and certification of the project. Verification involves on-site inspection and review. The certification procedure provides written assurance that the project has achieved the claimed emissions reductions.

A CDM 'Gold Standard' has been developed by a group of NGOs led by WWF-UK. This is built on the foundations of CDM standards and methodologies, but also incorporates guidelines to demonstrate a project's sustainable development achievements. Projects are restricted to renewable energy and end-use energy efficiency projects and are also assessed via a scoring system on their environmental, social and economic impacts on sustainable development. Although this standard is not intended exclusively for CDM projects, the use of CDM standards (which are costly to meet) as a foundation means that few projects outside of the compliance market are attracted to it.

Joint Implementation

Joint Implementation (JI) allows Annex I countries to meet their emission reduction targets through projects in other Annex I countries. These projects generate tradable credits which are called Emission Reduction Units (ERUs). As under the CDM, projects must demonstrate additionality and go through a similar verification and certification process. At the moment, the Government does not approve any JI projects in the UK, but it does allow companies to participate in JI projects abroad.

Land use, land-use change and forestry

Parties can generate credits through land use, land-use change and forestry (LULUCF) activities, which generate 'Removal Units' (RMUs).

Regional mechanisms

In addition to these, several nations and groups of nations have developed their own trading mechanisms to help them meet their targets. The European Union Emissions Trading Scheme (EU ETS) began in January 2005 and is the largest emissions trading scheme covering 12,000 installations in 25 countries. Emissions are regulated by governments allocating credits to companies, which represent their emissions allowance. The trading units in this scheme are called EU Allowances (EUAs). Parties in this scheme can buy and sell EUAs, or they can purchase CERs or ERUs, within certain limits.

In the first round (or trading period) of ETS (2005-2007) too many credits were allocated by governments, with some companies successfully negotiating 110% of their emissions requirements. Obviously, there has been little incentive to reduce emissions or buy credits in this period. And the large surplus has meant that the price for credits bottomed out and effectively collapsed. In May 2006 prices fell from €30 per tonne to €10 when the surplus became evident. In March 2007 they sold for €0.88 per tonne, and by July 2007 they had hit zero.

The failure of ETS to generate any reductions in greenhouse gas emissions has attracted criticism of the market approach to reducing emissions, as opposed to direct regulation by government. However, there may be no inherent reason why it shouldn't be successful, if managed correctly in the light of experience.

The details for the second round (2008-2012) are being finalised at the EU, and it appears that the issue of over-allocating credits has been addressed. Further business sectors, including aviation, will be added to the scheme. On 3rd July 2007, EUAs for 2008 were trading at €21.45 a tonne.

Voluntary carbon market

The voluntary carbon market (VCM) has developed independently of government targets and policies and is a place where anybody, from businesses and other organisations to individuals, can participate in offsetting their emissions. Carbon credits are generated in the voluntary market, but unlike the compliance market where credits are tradeable under the Kyoto flexible mechanisms, credits in the voluntary market are generally not tradeable between schemes.

People invest in emissions reductions or offsets for a variety of reasons, usually associated with wanting to reduce their 'carbon footprint'or to become 'carbon neutral'. Some credits in this market are verified according to certain standards, others do not meet any identifiable verification standards.

Customers in the voluntary market are able to purchase credits either from the compliance market or from the voluntary market. It is not always very clear to consumers which type of credit they are buying. In the voluntary market there are no overarching or compulsory standards or methodologies for creating credits. There are however, a number of voluntary standards emerging in an attempt to bring greater robustness and harmonisation to the voluntary offset marketplace.

Voluntary market standards

The Voluntary Gold Standard (VGS)

Launched by WWF-UK in May 2006, the Voluntary Gold Standard is a simplified version of the CDM Gold Standard. The standard applies only to voluntary emissions reductions and generates a unit called 'Voluntary Emissions Reduction' (VER). The VGS is only available for energy projects in developing countries. Whilst it uses the basic methodologies of the CDM Gold Standard, it is intended to make them easier to apply to the smaller project types more generally found in the voluntary market.

The Voluntary Carbon Standard (VCS)

The Voluntary Carbon Standard has been developed by The Climate Group and the International Emissions Trading Association (IETA). The VCS generates a unit called Voluntary Carbon Unit (VCU). The VCS aims to ensure that all voluntary emission reductions projects that want to trade in VCUs are independently verified to meet specific criteria and that these will represent "real, quantifiable, additional and permanent project-based emission reductions". The VCS will provide protocols and criteria to certification entities and project developers on the specifications for creating, verifying, and registering VCUs. The VCS has created a registry managed by the Bank of New York which is used to register, transfer and retire VCUs from the market.

Other developed standards

The Climate, Community and Biodiversity Standards (CCB) developed by the Climate, Community and Biodiversity Alliance, are for "land-based projects that can simultaneously deliver compelling climate, biodiversity and community benefits." There are three levels of CCB validation: approved, silver and gold. There are 23 possible standards to meet of which 15 are compulsory for 'approved' validation with the remaining eight being optional, to give either silver or gold validation. An independent third party evaluates whether the project merits approval, and if so, at what level. The standard uses the methodologies of the Intergovernmental Panel on Climate Change Good Practice Guidance (IPCC GPG) but can also use approved CDM methodologies for calculating carbon reductions.

Similarly the Plan Vivo System provides a standard for "managing the supply of verifiable emission reductions from rural communities in a way that promotes sustainable livelihoods." The Plan Vivo System is managed by BioClimate Research and Development which is a not-for-profit organization and is responsible for development and maintenance of the Plan Vivo system. Projects are usually monitored using local experts and credits are registered on a database.

Proprietary standards

Voluntary offset retailers have developed their own standards which create credits which use the generic term of Verified Emission Reductions (VERs). They share their acronym with Voluntary Emission Reductions and the two are often used interchangeably which can cause confusion as in one, the emissions reduction or saving has been verified, whereas in the other, this is not necessarily the case. The standards for these verified emissions reductions vary widely in many respects including how the project baselines are calculated, how additionality is tested and how verification is carried out. For some projects, this is not done at all, which reflects the cheaper cost of some of these credits in the voluntary market. It is up to the buyer of credits to determine what standards they want their credits to meet. Consequently these sorts of credits are neither comparable nor tradeable.

Proposed UK Government Code

In January 2007 the Department for Environment, Food and Rural Affairs (DEFRA), launched its consultation on establishing a voluntary code of best practice for the provision of carbon offsetting to UK customers. Its purpose in establishing the code is to "ensure consumer confidence in an emerging market and continued growth of that market through that confidence." The code will not create a new tradable unit in the voluntary offset market but will be applicable only to compliance market credits being traded in the voluntary market, principally CERs. The code will define standards for offset providers trading in these credits, who in return for meeting these standards will be awarded a quality mark. The code proposes standards for: ensuring accurate calculations of emissions to be offset; providing clear information for consumers about the mechanisms and projects supported; transparent pricing; and a timetable for cancelling or retiring credits.

Carbon offsets and carbon credits

Broadly speaking, a carbon credit is an emissions allowance awarded to companies by their government, based on national allowances awarded by the UN. A carbon offset is a credit gained by investing in a carbon reduction project elsewhere. Credits and offsets are theoretically interchangeable. In practice, an allowance, such as a European Union Allowance (EUA), generally has more value than an offset such as a CER. On 3rd July 2007, EUAs for 2008 were trading at €21.45 a tonne, 47% more than the price of €14.54 for 2008 CERs. An offset generated by a carbon project is limited in value by the fact that regulated businesses in the European Union Emission Trading Scheme (ETS) are limited as to what percentage of compliance can be accomplished via offsets. Companies can in theory cash in on this price differential by selling their EUAs and replacing with CERs up to the limit allowed.

Some carbon offset companies have been turning a good trade 'offsetting' their customers' carbon emissions by buying EUAs and 'retiring' them. The theory is that, by writing them off against emissions that will not now happen because the allowance has bewen retired, the equivalent amount of carbon dioxide has been prevented from being released into the atmosphere. However, with the over-allocation of EUAs, these credits have been reduced in value to zero. This provides good profit margins for the carbon offset company, but doesn't help the atmosphere, and could leave customers deceived.

At present, CERs generated from forestry are not eligible for trading within the EU ETS, although there is considerable political lobbying for such credits to be included.

Problems with offset projects

Forestry and land use projects have come under criticism, because of some early projects that were poorly designed, as well as various uncertainties due to the complexity of issues around these projects. Well designed projects can alleviate much of the uncertainty, particularly if attention is paid to security of land tenure and permanence of the land use change. Moreover, by selling only a proportion, say 80%, of the estimated carbon absorbed or saved, the uncertainties in actual carbon savings and their longevity can be balanced across a portfolio of projects. It is also apparent that other types of projects share similar problems.

Additionality:

It is sometimes difficult to ascertain whether forest protection is additional, in that the rate of deforestation that would have taken place without the carbon credits cannot be known. Estimates of projected deforestation based on past years can provide a baseline, but this rewards countries with a poor record in forest protection, and penalises those who have good forest protection policies in place. Therefore, if the carbon market is to recognise good practice, we are obliged to accept an element of additionality.

Most carbon offset money goes into projects to reduce energy consumption, or to produce renewable energy. In principle, none of these are free from an element of additionality. As energy reduction measures provide financial benefits to the energy consumer, it makes good business sense to introduce energy conservation measures, without the added bonus of carbon credits. In the long term, supply of oil and gas will reduce to a point where they will become prohibitively expensive to use, as the 'Peak Oil' makes very clear. It is therefore strategically as well as environmentally prudent to invest in non-fossil fuel energy supplies.

Other projects to directly reduce emissions of greenhouse gases from industry do not bear up well to scrutiny. The largest share of CDM credits (30 per cent) has been generated by the destruction of HFC-23. This potent greenhouse gas with a GWP of 12,000, is created by the manufacture of refrigerant gases. Emissions reductions of the gas generates 12,000 CER units for each tonne of HFC-23 'saved'. A study in the February 2007 article of Nature showed that the value of these credits at current carbon prices was €4.7 billion. Not only was this twice the value of the refrigerant gases themselves, but it was also estimated that the cost of implementing the necessary technology to capture and destroy the HFC-23 was less than €100 million. So something in the region of €4.6 billion was generated in profit for the owners of the plants and the project brokers. Meanwhile, pollution at a local level has dramatically increased, causing severe environmental and health effects.