Ticking Time Bomb

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International carbon trading stems from the Kyoto Protocol, which is part of the United Nations framework convention on climate change.

The objective of the Kyoto Protocol, and the countries which ratify it, is to reduce the greenhouse gases that attribute to global warming. While over 170 countries have ratified the protocol, only the European Union and 36 other developed nations are required to rigorously monitor and report on its greenhouse gas emissions levels as specifically outlined for each of them in the treaty.

Europe Currently Has The Word's Largest Carbon Trading Market

Consequently, the largest regional carbon trading scheme in operation is the European Union's Emissions Trading System (EU ETS).
The United States is the only major developed country that has not yet ratified the Protocol.

International carbon trading stems from the Kyoto Protocol, which is part of the United Nations framework convention on climate change.
The objective of the Kyoto Protocol, and the countries which ratify it, is to reduce the greenhouse gases that attribute to global warming. While over 170 countries have ratified the protocol, only the European Union and 36 other developed nations are required to rigorously monitor and report on its greenhouse gas emissions levels as specifically outlined for each of them in the treaty.

Europe Currently Has The Word's Largest Carbon Trading Market

Consequently, the largest regional carbon trading scheme in operation is the European Union's Emissions Trading System (EU ETS).
The United States is the only major developed country that has not yet ratified the Protocol. However, some States in the Midwestern US as well as on the Pacific coast are currently in advanced discussions to develop their own regional emissions trading schemes. This is in addition to the existing SO2 trading system developed under the framework of the Acid Rain Program in the 1990 Clean Air Act.

Cap and Trade Explained

The 'cap and trade' system, which is the most commonly known type of carbon trading, imposes ceilings on the emissions of such developed countries by an average of 5.2% below their 1990 levels, and to do so between 2008 and 2012.
While these caps are based on a national level, most countries allocate parts of their aggregate allowance to individual entities by way of credits/AAUs (Assigned Allocation Unit). Examples of such entities would be an auto manufacturer, a utility company, or a major airline company. Essentially, if any such entity intends to exceed their quota they could then purchase excess credits from another entity willing to sell its allowed credits via a broker/investment bank, a market exchange, or even directly with another entity.

How Carbon Markets Work

The intention of having carbon markets exist both regionally and globally under the Kyoto Protocol is to place a cost on carbon emissions. The market value is then determined by several key factors, including the weather, the demand for fuel worldwide, and the supply of available credits in the marketplace.
A basic example of why a company would choose to purchase credits in a given year rather than a voluntary reduction of emissions is because the cost of revamping and/or modifying equipment and operations may far outweigh the cost to purchase their additional required tonnage of emissions credit. Vice versa, a basic example of why a company would choose to sell its credits over a period of years may be to help finance an expansion of its operations in another market with more lax or lenient pollution policies.

Why Emission Credits Are A Valuable Asset.

Being assigned emission credits is the equivalent of being automatically allocated an asset; a very valuable asset, which entities are then able to trade and profit from.
As such, there has been considerable debate as to the motives and usefulness of the cap and trade system, whereby the supposed reduction of pollution (limiting the supply of an asset) becomes highly profitable due to increasing demand (industrial growth).
Further contributing to a potentially significant increase in value of carbon credits is that the emissions cap for all countries must be reduced further after 2012. Plus, public exchanges allow even non-polluting entities the ability to acquire carbon credits for speculative or even long-term investment purposes, which is also a contributing factor to its market price.

Trends In Carbon Price Movements

The most recent price of an EUA (European Union Allowance) as measured per tonne of CO2 is €19.85. In 2006, €18.1 billion was transacted through the EU ETS, a majority of the €22.5 billion which was transacted worldwide. This is a 150% increase from 2005.
Early year-end 2007 reports indicate an average increase of 50% in transactions over 2006 with continued double-digit increases projected in the years ahead.

Future Pricing

As the global carbon trading markets continue to grow, pricing will also be largely affected by the expected enhancements to environmental policies of the major participating nations in the Kyoto Protocol.

 
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