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Emissions trading involves the reduction of greenhouse gases or other pollutants (nitrogen oxides, sulphur oxides, volatile organic compounds, and hydro chlorofluorocarbons) and the sale of a credit or permit to emit the same amount of such pollutant. If issued under a mandatory cap-and-trade system, these credits can used by another entity and applied against a regulatory requirement to limit emissions, acquired for investment and later traded, or retired (not used). In addition to government-mandated cap-and-trade regulation, a growing voluntary market for greenhouse gas emissions also exists, where companies voluntarily undertake to reduce emissions and create "credits" that they may sell to other companies or
individuals.
Trading emissions credits is intended to provide firms greater flexibility in meeting regulatory obligations to reduce emissions of pollutants at reduced cost. From a policy point of view, these programs are intended to achieve the desired level of emissions reduction at reduced cost to society because reductions can be achieved by firms that have the lowest marginal cost of abatement. For emitters that have a low marginal cost of reducing emissions, they provide an economic incentive to reduce emissions below the mandatory level than would otherwise occur under a traditional command-and-control regulatory regime, and to resell these credits to other emitters. For emitters with high abatement costs, purchasing emissions allowances provides a cost effective
alternative to reducing their own emissions.
Kyoto Protocol to the United Nations Framework Convention on Climate Change
Developed countries that ratified the Kyoto Protocol to the United Nations Framework Convention on Climate Change accepted binding commitments to reduce their emissions of greenhouse gases during the 2008 to 2012 period by an aggregate 5% below 1990 emissions. Each country that accepted an emissions limit then imposes emissions limits for its own industries under their respective national laws. In addition to reducing one's own emissions, the Kyoto Protocol provides three flexible mechanisms for countries and their industries to meet their emissions reductions obligations: emissions trading, Clean Development Mechanism (CDM), and Joint Implementation (JI).
Under the Kyoto Protocol emissions trading arrangements, developed countries subject to emissions limits are obligated to set a maximum amount of emissions per compliance period, and then allocate emissions allowances (known as assigned allowed units or “AAUs”) to regulated emitters within their territory for each compliance period. At the end of a compliance period, each emitter must surrender AAUs equal to their emissions. If an emitter’s total emissions during a period exceed their allowances, the emitter must purchase additional AAUs and may be subject to a penalty. If its total emissions are lower, the emitter may sell excess AAUs at a price determined by the market.
The CDM and JI provide additional means to meet emissions targets under the Kyoto Protocol. Under the CDM, project sponsors earn tradable certified emissions reductions certificates (CERs) by developing projects that reduce greenhouse gas emissions in non-industrialized Kyoto Protocol countries. JI projects, in contrast, are undertaken in industrialized Kyoto Protocol countries, for which emissions reductions units (ERUs) are issued for verified emissions reductions. In addition to CDM and JI, removal units (RMUs) are issued to countries participating in the development of domestic sinks, such as forests and land use practices.
AAUs, CERs, ERUs and RMUs entitle the holder to emit one tonne of carbon dioxide equivalent and are fungible with each other for meeting emissions limits, subject to different restrictions on banking emissions allowances. Because CDM CERs are fungible with AAUs, ERUs and RMUs, these credits are substitutes for each other and are priced in relation to each other.
The CDM has been particularly successful in catalyzing investment towards renewable or emissions reductions projects in developing countries. CDM has resulted in investment in over 2000 qualified projects in developing countries, and mobilized commitments of $26.4 billion for projects that entered the CDM pipeline in 2006, over $24 billion of which was for renewable and energy efficiency projects, all of them in developing countries. A total of $7 billion was invested in CDM projects registered in 2006, of which approximately $5.7 billion was for renewable energy and energy efficiency projects. Joint Implementation projects, which allows investment in other industrialized countries, is expected to produce large investment flows in renewable energy projects in
Eastern Europe and the countries of the former Soviet Union, where mitigation costs are much lower. JI projects entering the pipeline in 2006 attracted investment of over $6 billion (UNFCCC (2007), Investment and Financial Flows to Address Climate Change. Bonn, Germany: United National Framework Convention on Climate Change Secretariat).
European Union Emissions Trading Scheme
The largest regulated market for greenhouse gas emissions is the European Union's Emissions Trading Scheme (EU ETS), which features a cap-and-trade regime for carbon dioxide emissions covering approximately 12,000 emitting facilities throughout the European Union. The regulation is intended to comply with the European Union's obligation under the Kyoto Protocol.
The EU ETS supports both a spot market and futures market for European Union Allowances (EUAs), which are the European Union equivalent of AAUs. The trading system operated in a trial phase from January 1, 2005 to December 31, 2007 among European Union member states. From 2008, the EU ETS commenced its first mandatory phase in compliance with the Kyoto Protocol. The EU plans for it to be accessible to all Kyoto Protocol countries. Currently, only carbon dioxide emissions are traded from large point sources in energy generation and energy-intensive industry, such as oil refineries, cement, iron and steel production.
Under the EU ETS, emitters can meet their obligations to cap emissions by reducing their own emissions, purchasing EUAs from other emitters who have reduced their emissions and have excess emissions allowances that they wish to sell, or purchase CDM or JI project-based emissions credits.
Emissions Trading Agreements
Emissions Reductions Purchase Agreements (ERPAs) for CDM and JI Projects
Emissions Reduction Purchase Agreements or ERPAs are agreements for the sale and purchae of AAUs, EUAs, CERs under the CDM, ERUs under the JI or voluntary emissions credits. ERPAs come in two basic types: for credits to be created (a project-based ERPA) and for credits that already exist . For project-based ERPAs, the seller is typically the developer of a CDM or JI project and the buyer may be a company or country that needs the CERs or ERUs for legal compliance purposes pursuant to their emissions limits under the Kyoto Protocol (in the case of countries) or national law (in the case of emitters located in countries that have ratified the Kyoto Protocol). For ERPAs concerning credits that already exist, there is a growing secondary market for trades in AAUs,
EUAs, CERs or ERUs.
ERPAs contain a number of standard terms relating to the creation, ownership and transfer of the emissions credits. ERPAs for CDM and JI credits also allocate risks associated with a project not receiving approval for registration by the CDM Executive Board or by the JI Supervisory Committee, a change in the methodology governing the project (which increases costs and potentially affects the number of credits generated by the project), allocates who pays for project costs associated with the generation of the credits, and who serves as the focal point for communication with the CDM Executive Board or JISC (which is important where multiple parties are involved).
Voluntary Carbon Markets
ERPAs have also been developed that are designed for voluntary carbon markets. Voluntary carbon markets are smaller, but are growing rapidly, especially in the United States.
Emissions reductions credits in voluntary markets are commonly called "Verified Emissions Reductions" credits or "VERs". An ERPA for VERs are based on similar principles to those for CDM CERs and JI ERUs, however, unlike Kyoto Protocol emissions credits which are based on compliance with the CDM or JI regime, the standards applied in voluntary carbon markets transactions are specified by the parties to the contract because these transactions not regulated by the United Nations or by national governments.
Legal Documentation Online Forum
SAMPLE DOCUMENTS
IETA Emissions Reduction Purchase Agreement (version 3)
IETA Emissions Trading Master Agreement for EU Scheme (version 3)
IETA Options Annex in respect of the Emissions Trading Master Agreement for EU Scheme (version 2)
IETA Emissions Trading Master Agreement for EU Scheme with Schedules and Options
IETA Emissions Allowance Single Trade Agreement for EU Scheme (version 4)
IETA Code of Terms (version 1)
International Swaps and Derivatives Association Emissions Trading Documents
European Federation of Energy Traders Standard Documentation
ACX-Change/Climex CDM Certified Emissions Reduction Purchase Agreement
CERSPA Certified Emissions Reductions Sale & Purchase Agreement
OTHER RESOURCES
International Emissions Trading Association
Environmental Markets Association
World Bank Carbon Finance Unit
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