Mandatory & Voluntary Offset Markets
Carbon markets exist both under compliance schemes and as voluntary programs. Compliance markets are created and regulated by mandatory national, regional or international carbon reduction regimes.This page gives a short introduction to both markets and their programs.
Emissions Trading Under the Kyoto Protocol
The Kyoto Protocol to the United Nations Framework Convention on Climate Change (UNFCCC) established a cap-and-trade system that imposes national caps on the greenhouse gas emissions of developed countries that have ratified the Protocol (called Annex B countries). Each participating country is assigned an emissions target and the corresponding number of allowances – called Assigned Amount Units, or AAUs. On average, this cap requires participating countries to reduce their emissions 5.2% below their 1990 baseline between 2008 and 2012. Countries must meet their targets within a designated period of time by:
- reducing their own emissions; and/or
- trading emissions allowances with countries that have a surplus of allowances; and/or
- meeting their targets by purchasing carbon credits.
This ensures that the overall costs of reducing emissions are kept as low as possible. To further increase cost-effectiveness of emissions reductions, the Kyoto Protocol also established so-called Flexible Mechanisms: the Clean Development Mechanism (CDM) and Joint Implementation (JI).
European Union Emissions Trading Scheme
The Kyoto Protocol enables a group of several Annex I countries to join together and form a so-called ‘bubble’ that is given an overall emissions cap and is treated as a single entity for compliance purposes. The 15 original member states of the EU formed such a ‘bubble’ and created the EU Emissions Trading Scheme (EU-ETS). The EU-ETS is a facility-based cap-and-trade system which came into force in 2005. Under this cap-and-trade scheme, emissions are capped and allowances may be traded among countries. The EU-ETS is the largest mandatory cap-and-trade scheme to date. Learn more about the EU-ETS.
There are currently several cap-and-trade compliance schemes that operate or are planned to operate independently of the Kyoto Protocol. All of these also incorporate an offset component to their program. Three such examples include:
The CDM allows Annex I countries to partly meet their Kyoto targets by financing carbon emission reductions projects in developing countries. Such projects are arguably more cost effective than projects implemented in richer nations because developing countries have on average lower energy efficiencies, lower labor costs, weaker regulatory requirements, and less advanced technologies. The CDM is also meant to deliver sustainable development benefits to the host country. CDM projects generate emissions credits called Certified Emissions Reductions or CERs – one CER is equal to one tonne of carbon dioxide equivalent – which are then bought and traded. Learn more about the CDM.
Joint Implementation works similarly to CDM, with the exception that the host country is not a developing nation but another Annex I country. The tradable units from JI projects are called Emissions Reductions Units (ERUs). It is not strictly a baseline-and-credit system since it also has aspects of a cap-and-trade system, and, notably, both participants have an overall reduction target. Learn more about JI.
The EU-ETS Linking Directive
The EU Linking Directive, which was passed in 2004, allows operators in phase 2 of the ETS to use a limited amount of credits from JI and the CDM to meet their targets in place of emission cuts within the EU. Learn more about the EU-ETS.
The voluntary carbon markets function outside of the compliance market. They enable businesses, governments, NGOs, and individuals to offset their emissions by purchasing offsets that were created either through the CDM or in the voluntary market . The latter are called VERs (Verified or Voluntary Emissions Reductions). Compared to the compliance market, trading volumes in the voluntary market are much smaller because demand is created only by voluntary buyers (corporations, institutions and individuals) to buy offsets whereas in a compliance market, demand is created by a regulatory instrument. Because there is lower demand and because VERs cannot be used in compliance markets, VERs tend to be cheaper than those credits sold in the compliance market (e.g. CERs).
Unlike under CDM, there are no established rules and regulations for the voluntary carbon
market. On the positive side, voluntary markets can serve as a testing field for new procedures,
methodologies and technologies that may later be included in regulatory schemes. Voluntary
markets allow for experimentation and innovation because projects can be implemented with fewer
transaction costs than CDM or other compliance market projects. Voluntary markets also serve a niche for micro projects that are too small to warrant the administrative burden of CDM or for
projects currently not covered under compliance schemes. On the negative side, the lack of quality
control has led to the production of some low quality VERs, such as those generated from projects
that appear likely to have happened anyway.