The escalating impact of climate change has compelled governments to enact market-based mechanisms aimed at reducing emissions. One such mechanism is the carbon economy, which encompasses emissions trading. Introduced for the first time in 1997 at the UNFCC meeting in Kyoto, carbon trading has been implemented by numerous countries, either through governmental initiatives or business-driven efforts. This article provides a comprehensive overview of the global carbon trading environment.
A. This is Our Why
On November 7, 2023, our team (Aileshians) conducted internal carbon economy workshops. During these workshops, Aileshians gained a comprehensive understanding of carbon economics, with a particular focus on carbon trading. The workshops effectively stimulated meaningful discussions among the Aileshians regarding Ailesh’s position in the carbon economy.
In consideration of the articles in the Ailesh Carbon Economy Series and in keeping with our commitment to community engagement, the successes of these seminars have inspired us.This initiative aims to share our knowledge and expertise with a wider audience, enhancing their understanding of carbon economics, including its definition, the origins of carbon economy initiatives, and its regulatory framework in Indonesia.
The Carbon Economy Series articles will be published in two parts. The first installment provides a global overview of carbon trading, while the second part delves into its policy and practical applications in Indonesia.
B. Emissions Trading: The History
The escalating concentrations of greenhouse gases in the Earth’s atmosphere have resulted in a significant rise in global temperatures, triggering a cascade of adverse consequences. These include extreme weather events, rising sea levels, an increased frequency of droughts, and ocean acidification. The environmental anomalies in question have significant economic consequences, including damage to infrastructure, disruptions in the distribution of products and services, and scarcity of resources.
In economic theory, these uncompensated environmental costs are termed negative externalities. Negative externalities arise when an individual or entity engages in an activity that imposes costs on others without bearing those costs themselves [7].
Figure 1: Detrimental Effect of Climate Change [7]
In 1997, in Kyoto, the United Nations Framework Convention on Climate Change (UNFCCC) convened an international conference in response to the effects of climate change. The introduction of market-based mechanisms stems from the recognition of a pervasive issue in climate change, namely, the existence of “free riders.” In cases where a nation persistently generates excessive emissions, the adverse climate effects are felt globally. Conversely, if climate mitigation efforts are undertaken in one nation, the positive impacts are felt worldwide, even by countries that neglect their emissions responsibly. Consequently, unilateral decarbonization efforts would be deemed inequitable. The market-based mechanisms introduced in the Kyoto Protocol permit nations to collaboratively strive towards achieving the shared objective of mitigating the impact of the climate crisis.
The Kyoto Protocol marked the inaugural introduction of emissions trading, or carbon trading [14]. This introduction occurred concurrently with two other market-based mechanisms: the Clean Development Mechanism (CDM) and Joint Implementation (JI). A concise description of these three mechanisms follows.
International emissions trading allows countries to trade their emission quotas. First, each respective country can set its emission limits for each sector or subsector. These limits will become a benchmark for how intensely one country produces emissions. For example, if one country has exceeded its emission limits, then it must “buy” the allowance from countries that haven’t exceeded their limits. Typically, the countries that buy the emission allowance are developed countries (due to their high energy demand), while developing countries (due to their lower energy demand) sell their emission allowance [15].
The Clean Development Mechanism allows developed countries to invest in emission reduction projects in developing countries.CER (Certified Emission Reductions) units may then be generated from the emission reduction initiatives; developed nations may purchase these units, while developing nations may sell them, to “reduce” their emissions. Developed countries are classified under Annex I and II of the Kyoto Protocol, and the annex countries are developing countries [17].
Joint Implementation allows developed countries (Annex I and Annex II) to collaborate to initiate emission mitigation measures. Similar to CDM, JI also produces CER, which can be used to offset emissions in its respective countries [16].
Figure 2. Annex and Non-Annex Countries
C. Mandatory Emissions Trading and Voluntary Carbon Offsetting
When discussing emissions trading, two prevailing mechanisms are currently recognized. These are obligatory emissions trading and voluntary emissions trading, commonly referred to as carbon offset. The definitions of mandatory and non-mandatory emissions trading are as follows:
Carbon trading/emissions (mandatory) trading involves creating a system where an emission limit is set for specific sectors, in which: if they emit more than the limits, they must buy an emission allowance (otherwise they would pay fines or taxes); or, for entities that emit lower emissions compared to the limit, they can sell the gap between the limits and their emissions to other entities. Carbon trading and emissions trading are done mandatorily for sectors selected by the government.
Carbon/Emission Offsetting (Voluntary)
Not all countries have simultaneously established emission limit requirements and emissions trading obligations. Thus, entities engaged in emission-intensive processes or activities may voluntarily purchase carbon units from carbon offset projects to ‘mitigate’ their emissions.
In theory, the value of carbon per ton should be the same as the value of natural disaster losses caused by the emission of one ton of carbon, or the Social Cost of Carbon (SCC) However, in trading carbon emissions, the price per tonne of carbon is determined by the carbon market price; therefore, prices fluctuate according to supply and demand.
D. Mandatory and Voluntary Carbon Market
Carbon trading occurs within the carbon market. Due to distinct trading mechanisms between mandatory and voluntary carbon units, the markets where mandatory and voluntary carbon units are sold also differ. Mandatory emissions trading takes place in the compliance market, whereas carbon offsetting projects are traded in the voluntary market.
Compliance Market (Mandatory)
A compliance carbon market, also known as a regulated carbon market, is a market where participants are legally required to comply with emissions reduction obligations or targets set by government regulations or policies. It operates under a regulatory framework and aims to ensure compliance with emissions reduction requirements. Below are several examples of voluntary markets.
In the US, emission trading programs exist at both federal and state levels. The Regional Greenhouse Gas Initiative (RGGI) aims to cap and reduce carbon dioxide (CO2) emissions from the power sector, with power plants required to hold allowances equivalent to their CO2 emissions, tradable through auctions [10].
The EU has been at the forefront of establishing and expanding emission trading systems. The European Union Emissions Trading System (EU ETS), launched in 2005, was the first and remains the largest international carbon market. It covers various sectors, including power generation, manufacturing, and aviation, and has influenced the development of emission trading in other regions [3]
Introduced the emissions trading scheme in 2008. The New Zealand Emissions Trading Scheme (NZ ETS) initially focused on greenhouse gas emissions from the energy, industry, and forestry sectors and has since been expanded to include additional sectors [9]
Figure 3. Examples of Compliance Market in Several Countries [3] [9] [10]
Voluntary Market (Voluntary)
It is a market where individuals, organizations, and companies can voluntarily purchase and trade carbon offsets or credits (also called carbon credits) to mitigate their greenhouse gas emissions. Unlike compliance carbon markets, participation in the voluntary carbon market is not driven by legal or regulatory obligations but rather by voluntary commitments. Different from the compliance market (entities that feel like they emit more can buy reduction certificates). The crucial difference is that the government does not regulate and supervise the voluntary market. Despite being unregulated by the government, credits are typically generated by projects that have been verified and certified by recognized standards and methodologies, such as the Verified Carbon Standard (VCS) and Gold Standard [4].
Private companies play a significant role in the voluntary carbon market by voluntarily participating in carbon offsetting and emissions reduction initiatives. Many companies have committed to achieving the net zero emissions or carbon neutrality target voluntarily, without being required by regulation. However, their activities still depend on CO2-producing fossil fuels, so companies often buy carbon offset certificates from projects that eliminate their carbon emissions from a voluntary carbon market.
Below are examples of companies that buy carbon offset or credit certificates
Figure 4. Examples of Companies Which Ventures into Voluntary Carbon Market [2, 12, 13]
E. Source of Offset Project Certificates and How to List it In Voluntary Market)
Thus, maybe we ask, How can one obtain carbon offset or carbon credit certificates? The way to obtain it is by funding or developing a carbon emission reduction project or project that increases nature’s carbon stock. Currently, four areas of the project qualify to be used to produce offset project certificates. That includes
Technology-based: funding or developing projects that avoid or eliminate carbon emissions based on technological innovation. Examples of such are the development of clean energy projects and clean transportation
REDD+: Pendanaan atau pengembangan proyek, atau mengembangkan proyek REDD+ kependekan dari (Reducing Emissions from Deforestation and Forest Degradation). Funding for these projects includes forest replanting and reduced logging.
Community-Based Projects: Funding or development of projects that reduce emissions and promote sustainable development in small communities For example, solar home systems or clean cooking projects in rural areas
Nature-based: funding or development of projects that can naturally sequester carbon dioxide in soil, plants, or water. Examples of such are regenerative farming or mangrove planting.
To list out the projects in the voluntary carbon market, the project developer first has to verify and quantify the emission abatement potential of the project through a certification body. The certification body typically uses the Gold Standard or Verified Carbon Standard, both of which have been approved by the U.N. Second, brokers, traders, retailers, and exchangers act as a means through which projects will meet their potential buyers. In this case, they will gather multiple projects into a package in which buyers can easily purchase the units of offsets. Lastly, the buyer finishes the purchase of the units of the offset from brokers, traders, retailers, or exchanges and proceeds with the transfer of carbon units. The process of such is summarized in Figure 5.
Figure 4. Mechanisms of Voluntary Carbon Market [4]
F. Examples of Offset Projects Located in Indonesia that are Sold in Voluntary Market
Indonesia currently has two projects that are listed on the voluntary carbon market. Both projects are classified as REDD+ projects, which focus on forest conservation. The details of both projects are as follows:
The Sumatra Merang Peatland Project (SMPP) aims to protect and restore 22,922 ha of a peatland ecosystem located in the Musi Banyuasin district in South Sumatra province. The restoration project is led by “Forest Carbon,” a Singaporean restoration developer company, by implementing ecosystem and habitat restoration activities while establishing sustainable avenues for economic success amongst the local communities. It is noted that the project carbon credit is verified by the VERRA and sold with a cumulative amount that reaches 3 229 923 metric tons of CO2, with notable buyers such as LOREAL and other multiple buyers. [5,6]
Borneo Forest Protection, Katingan Mentaya Project, is another forest restoration project. The project is led by PT. Rimba Makmur Utama, an Indonesian-based restoration developer company, to help with the conservation of peat forest in Central Kalimantan. With a total area of 160.000 ha, the project’s carbon credit is verified by VCS (Verified Carbon Standard), with annual sales that reach 7.5 million metric tons of CO2, with notable buyers such as Shell, Volkswagen, and BNP Paribas. Furthermore, the project also states its alignment with 3 SDG points, namely point 13 about handling climate change, 15 about protecting land ecosystems, and 17 about establishing partnerships to achieve the goals. [8,11]
Having described the global overview of carbon trading, starting from the history of the initiation of emissions trading together with two other market-based mechanisms in the Kyoto UNFCC summit, the distinction between voluntary emissions offsetting and mandatory emissions trading, as well as the markets where these emissions are traded, the Ailesh Carbon Economy Series Article Part 2 will delve into the intricacies of carbon trading practices in Indonesia. This exploration will encompass the regulatory framework governing emissions trading, the sectors where carbon values are assessable, the cap-and-trade mechanism, and IDX Carbon, Indonesia’s first verified emissions trading platform. However, for the sake of reader comprehension and to facilitate the digestion and reflection of the broad overview information on carbon trading, Part 2 will be released approximately one week after the publication of this series. Thus, see you in the next part.
References :
Asian Development Bank. 2011. Clean Development Mechanism Overview. https://www.adb.org/sites/default/files/publication/29055/cdm-brief-01-overview.pdf
Clifford, C. 2023. How Apple Made its First Carbon Neutral Products. CNBC News. https://www.cnbc.com/2023/10/06/how-apple-made-its-first-carbon-neutral-product-apple-watch.html#:~:text=In%20order%20to%20call%20its,footprint%20of%20making%20a%20watch.
European Commision. EU Emissions Trading System (EU ETS). https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets_en
Favasuli, S. Sebastian, V. Voluntary Carbon Markets : How They Work, How They’re Priced and Who’s Involved. :https://www.spglobal.com/commodityinsights/en/market-insights/blogs/energy-transition/061021-voluntary-carbon-markets-pricing-participants-trading-corsia-credits
Forest Carbon. 2023. Sumatera Merang Peatlands Project. https://forestcarbon.com/projects/
International Database on REDD+ Projects and Programmes. 2022. Project : Sumatera Merang Peatland Project (SMPP). https://www.reddprojectsdatabase.org/view/project.php?id=648
2021. Summary for Policymakers. In: Climate Change 2021: The Physical Science Basis. Contribution of Working Group I to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [Masson-Delmotte, V., P. Zhai, A. Pirani, S.L. Connors, C. Péan, S. Berger, N. Caud, Y. Chen, L. Goldfarb, M.I. Gomis, M. Huang, K. Leitzell, E. Lonnoy, J.B.R. Matthews, T.K. Maycock, T. Waterfield, O. Yelekçi, R. Yu, and B. Zhou (eds.)].
Katingan Mentaya Project. 2023, Katingan Mentaya Project Overview. https://id.katinganmentaya.com/
New Zealand Ministry for The Environment. 2023. New Zealand Emissions Trading Scheme. https://environment.govt.nz/what-government-is-doing/areas-of-work/climate-change/ets/ .
Regional Greenhouse Gas Initiatives. 2023. Elements of RGGI. https://www.rggi.org/program-overview-and-design/elements
Laman Web Rimba Makmur Utama. 2023. https://rimbamakmurutama.com/
2022. Nature Based Solutions. https://www.shell.com/energy-and-innovation/new-energies/nature-based-solutions.html
The Walt Disney Company. Year of Published N/A. “Striking a Balance, How We’ve Grown our Business While Reducing our Net Impact on The Environment. https://thewaltdisneycompany.com/app/uploads/Striking-a-Balance-1.pdf
2023. Apa itu Protokol Kyoto. https://unfccc.int/kyoto_protocol
2023. Emissions Trading. https://unfccc.int/process/the-kyoto-protocol/mechanisms/emissions-trading
2023. Joint Implementation. https://unfccc.int/process/the-kyoto-protocol/mechanisms/joint-implementation
2023. The Clean Development Mechanism. https://unfccc.int/process-and-meetings/the-kyoto-protocol/mechanisms-under-the-kyoto-protocol/the-clean-development-mechanism
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