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Kyoto Protocol Mechanisms

The Kyoto Protocol, finally agreed in 1997, set up trading mechanisms for carbon emission permits and binding CO₂e emission reduction goals for the period 2008-12, under the auspices of the UNFCCC. The protocol was supposed to provide incentives to promote greenhouse gas emission reduction in both industrialised and developing countries. It divides the world into three groups:

• "Annex-I" countries (26 countries): the set of "developed" countries, notably not including the USA, which agreed to binding reduction goals, which were unfortunately different for each country and subject to political horse-trading
• Other Kyoto signatories (163 countries): mostly "developing" countries, but including China and India
• Other countries which have not ratified the Kyoto Protocol.

A key phrase in the UNFCCC treaty was "common but differentiated responsibility". This phrase is supposed to capture the fact that the industrialised countries undoubtedly bear more responsibility for the current state of CO₂e in the atmosphere than the developing world. This also takes account of the fact that the developing world has to be able to progress economically as well. Unfortunately, the wording only led to an unproductive polarisation into countries with targets and countries without.

In the meanwhile, Canada has left the Kyoto scheme. Some say this is because of difficulties meeting the agreed Kyoto targets, which Canada had already given up trying to meet back in 2007 (when the current Conservative government came to power). Another reason is the Canadian tar sands — the vast deposits of bitumen in the west of the country that promise to sustain Canada's status as an oil producer for decades to come, and enable oil exports to an "oil-hungry" US. Extracting something useable from tar sands takes substantially more energy than extracting "conventional" oil and leads to substantial CO₂e emissions.

The Flexible mechanisms

There are three main trading mechanisms each having a specific permit unit covering the emission of 1 t CO₂e:

• The International Emissions Trading (IET) scheme (Assigned Amount Units, AAU)

This is a cap-and-trade mechanism which links actual emissions to the agreed mandatory emission caps and is supposed to allow trading to reduce the gap

• The Clean Development Mechanism (CDM) scheme (Certified Emission Reduction, CER)

This mechanism allows units to be credited to Annex-I countries for certifiable emission reduction in non Annex-I countries

• The Joint Implementation (JI) scheme (Emission Reduction Unit, ERU)

This mechanism is similar to the CDM, but covers projects between Annex-I countries

The so-called Marrakesh Accords (2001) extended the set of schemes to include CO₂e "sinks" for specific land-use and forestry programs (and introduced another unit, the Removal Unit, RMU).

The European Union also established its own internal market for carbon permits, the EU Emission Trading Ssystem (EU ETS), with its own unit, the European Allocation Unit, EUA. The EU ETS has the advantage that it is not time limited and continues after 2012, whereas the Kyoto mechanisms have an unclear future from 2013 onwards, because no agreement was reached in Copenhagen in 2009.

Are the flexible mechanisms an efficient means towards reducing man-made climate impact?

We have achieved an awful lot with these mechanisms, in that they have proved the value of a carbon emission based market on a global scale and have taught us some lessons about what does and does not work. They also start the process of making climate risks a more mainstream part of business planning. This is, however, perversely where things start to break down. The lack of certainty post 2012 (at least for Kyoto based projects) takes away a major part of the business case for forward looking projects. Since many of the infrastructural projects have very long timescales, the stability of policy that is needed is simply not there at present. The EU is leading the way (thank goodness) - let's hope that the EUR crisis doesn't make other political agendas more interesting.

As for "efficiency", the mechanisms are only feasible for very large projects, where the serious levels of bureaucracy, time lag and process are not too significant a part of the overall budget. They are not at all efficient for smaller projects, and are skewed towards a particular subset of the business community which can or wants to participate. It is laudable that we have created such a comprehensive set of mechanisms for checking that the numbers of units counted are actually real, but we miss the bigger picture: to cut emissions we all need to emit less, which means we have to focus the entire economy on the problem and not just a specialist subset.

Another difficulty with the mechanisms is that they are not truly global: each country has its own interpretation, each country has its own loopholes, each country has its own different target, and it is bewildering to the outsider to understand whether a true cut in emissions results. It is unclear to the layman why it should be correct that CO₂e emitted in Europe is counted differently from CO₂e emitted by companies in China which make goods sold in Europe. Likewise, the anomaly of international transport emissions (in particular air transport) needs to be addressed. There seems not to be any link to the current level of CO₂e in the atmosphere, nor to the trend in that level. Likewise, although temperature change seems to be the key risk, we are not really targeting it.

On top of this, the plethora of allocation units leads to a serious fragmentation of the nascent carbon market. In addition, the Kyoto rules explicitly forbid the use of the carbon markets as a form of development aid, and the CDM and JI are based on the questionable concept of "additionality", which means that it is necessary to prove a reduction between "business as usual" and the (reduced) result after a given project has been carried out. The link to actual levels of emissions and their reduction is tenuous.

However, by far the greatest criticism of the Kyoto mechanisms is that they are not currently working. The level of CO₂e rises unabated. A sign that the carbon market is not yet working correctly is the low value of an emission permit. At current rates (2010), a CER is valued at around €15, which is certainly not enough to cause real change!

Is the EU-ETS a strong and reliable enough instrument to incentivise companies to reduce their emissions?

The EU-ETS is there and functioning to a degree now that the initial over-allocation of units has been corrected, and it goes past 2012! One can criticise the fact that less than half the EU emissions are covered, and that the treatment of the non EU emissions is not so clear, but it is a good start. It is also a multi-lateral system. The way that permits are allocated needs some attention in my view, and it would be good to try to factor in adaptation costs into the unit price. Certainly, the EU-ETS has incentivised companies to take action, but the price per unit seems low to the layman, and it is too easy to game the system when creating units.

What can be done?

A simpler model is needed

We need to get to a simpler model that is not too politically manipulable, so that there is sufficient certainty for a global market to develop:

• a single global emission permit pool linked to the current level of CO₂e and its trend
• an allocation of emission permits based on a mix of GDP and population, with a penalty element for countries missing their target in a given year, and also linked to the average temperature level (which has regional differences, affecting adaptation costs)
• collection of permits as near as possible to the points of primary emission: this focuses on the main polluting industries, and mostly those which are currently measured in the Kyoto systems - the rules for the number of units should be fixed as far as possible globally for a particular technical process type by independent scientific groups (and probably will need to be spot checked by independent agents)
• freely exchangeable permits, like a normal instrument of exchange, with no "distortional" taxes (such as tariffs that protect a local market) - just like in other trade treaties
• one central market for exchanging units between participating countries, establishing a global price for the units, which would be paid by polluters not having sufficient units - a cap and trade market
• expiry of permits after a certain period to prevent hoarding, or an equivalent mechanism such as negative interest on holdings.

Other aspects

• supposing that there is a central bank for permits, it could sell new permits to participating countries at a premium each year and use the proceeds to fund adaptation projects, or to help in disasters caused by climate change as a last resort re-insurer
• a mechanism is needed for charging non participating countries for embedded emissions in their exports, and for compensating them for embedded emissions in imports from participating countries (which have already been counted)
• a solution is needed for how to charge for airline and similar "international" emissions not tied to a particular country
• the mechanisms must be treated like the EU's acquis communautaire - that is, if a country participates in the scheme, it follows identical global rules (and can participate multi-laterally in adjusting them)
• "sinks" are problematic, because they are hard to measure and justify - however, the destruction of mature trees (such as in the rainforests) needs to be counteracted, so perhaps there could be a credit for woodland, on the condition that it is sufficiently mature that carbon is truly bound - perhaps this can be assessed by means of a satellite survey.

Although the model should be neutral in economic terms, there will be winners and losers. What is very important is that it is conceived so that no big bureaucracy is needed to vet projects: they should take place based on the "normal" economic mechanisms that projects follow, except that they factor in the price of the emission permits.

The scheme must provide the right market environment and enough longer term certainty. The primary issue would then be the political process around emission allocation, which is the right place for the debate.

Link permits to actual emissions

The idea is to link permits directly to emissions and control the total number of permits in circulation, thereby creating a form of "money". As long as this "money" is credible and suitably backed by policing, then it can be used as a normal financial instrument. A project to generate electricity, for example, would have a component of its costs over its lifetime expressed in this "money", which itself has a market price. The control of the units would be carried out by the normal auditors of the books and records of the companies involved.

There is a group of countries where this "money" can be used, and where the rules giving it its value are clear and uniform (including policing etc.). The "money" needs to be set up such that there is an economic interest for countries to become participating countries: if your country is outside the group, then its exports to the group will be penalised for their emissions, by being charged in terms of this "money". Only the countries inside the group can get credits in this "money", though. Those outside have to buy it on the open market.

It should be possible to start with a smallish set of countries and other countries will (want to) join when they are ready/willing: getting the economics right, so that the economic incentives drive things in the right direction needs a multi-disciplinary team to set the key basic concepts well from the start.

Setting the emission permit pool's overall volume and the allocation rules are a political issue (just like the targets under Kyoto). The difference is that one overall emission target would apply for all across the whole system, with one agreed split between GDP and population overall. Also, if possible, the amount of "money" in circulation should be tied to a physically measurable number, like the level of CO₂e in the atmosphere. The scheme needs a global central bank which follows these rules to allocate units to national central banks, a bit like the ECB in the EU. The rules for removing the "money" from circulation need to be the same for all countries and obviously need to be policed. Likewise, the penalties for "overspending", and a negative interest rate on holdings (set to discourage hoarding) need to be defined globally. All loans of this money must be backed 1:1 -- it should not be permitted to go "short" -- the only place where this money can be created is in the central bank. Detailed allocation within countries could still remain a local matter.

The existing financial system is used to do all the accounting and price setting. The investment flows will definitely take place if there is a "market", and that will happen if the rules are sufficiently simple and stable. For this reason, a single rule set is preferable that is defined by all participants multi-laterally, which can be a controllable political process. As long as the system is suitably long-term, then the financial sector will develop all sorts of fancy instruments and derivatives where they make economic sense.

Rather than keep negotiating detailed targets, country by country, and year by year, in the way Kyoto did, the idea is to define the rules for pricing emissions, and let the markets determine the outcome, choosing the best technologies along the way.

Further reading

The book "Kyoto 2" by Oliver Tickell, ISBN 1-84813-025-2, presents many of these ideas convincingly and in considerable detail. The main difference is that Tickell stops short of the idea of using a currency as the vehicle for emission permit accounting.

See also the website Kyoto2 .

Making it more concrete: World Carbon Currency — WOC

The Basic Idea

The World Carbon Currency is new type of global commodity money: an extension of the cap & trade idea. The basic idea is that 1 unit of this money (WOC 1) has to be spent whenever 1 kg CO₂e is emitted at source. The reason for choosing this size of unit is to make it more relevant to individual people: an average European currently needs between WOC 7000 and 9000 per annum, whereas the goal is more like WOC 2000!

By controlling the amount of this money that is in circulation, the level of emission can be influenced. By charging a negative rate of interest on WOC holdings, the World Carbon Central Bank — WCCB encourages circulation of the currency and discourages hoarding. Also, it must be forbidden for commercial banks to issue WOCs that they do not have (unlike with normal currency). Apart from these basic rules, the WOC currency can be traded like any other currency and will float to find its own value, driven by supply and demand.

The set of countries that have the legislation and facilities in place to collect and distribute WOCs form the World Carbon System — WCS. Countries outside the WCS have to pay a levy in WOCs to compensate for the embedded CO₂e emissions in their exports to the WCS. Similar arrangements apply for air and sea travel and cargo emissions to and from WCS countries.

The various carbon units currently in circulation within the Kyoto flexible mechanisms and the EU ETS can be converted into WOCs. Although one EUA (for example) is a permit to emit one tonne of CO₂e, and so is notionally worth WOC 1000, it is likely that the market rate will be lower than WOC 1000 because of the lower liquidity of the Kyoto and EU ETS units.

The WOC is intended to be demand deposit money that can only be held on bank accounts: modern charge, credit and debit cards should be able to handle such a new electronic currency, even as a dual currency, without much adjustment being necessary. It would also be possible to use mobile phone based charging mechanisms, as is common in parts of the Third World. The complication of having notes and coin is avoided.

WOCs are withdrawn from circulation as near as possible to points of primary CO₂e emission, by collecting them from primary emitters, like electricity companies. How many WOCs have to be paid to the WCCB depends on the nature of the emission and its level. The rules are determined by independent scientists and are applied in an identical way by all countries in the WCS. Initially, the same industries covered by Kyoto and the European Carbon Trading Scheme (including international airline and sea travel) are covered so as to take advantage of existing auditing and measurement mechanisms. Over time, other emission points can be included. Governments (and voters) in countries in the WCS would need to agree to police these mechanisms.

Consuming WOCs

For example, if you want to pay petrol for your car, or oil for your heating, or an air trip to Guadeloupe, you would notionally have to pay the required number of WOCs, or their current market value in home currency.

The idea of collecting the WOCs as near to the primary emission point as possible is to keep the number of players that have to collect WOCs at a reasonable level. This also means that the cost of policing can be kept to a managable level, and the number of objective measures needed (eg, how many WOCs is 1 kWh of this particular electricity type worth) not too onerous. If the policing is adequate and importantly the WCCB's monetary policy is sufficiently restrictive, then WOCs will attract a reasonably high market value in developed countries (after all, people want to drive their cars and fly to Guadeloupe).

Creating WOCs

A key issue is how to allocate WOCs. Suppose that a simple country-based scheme can be found based on current emission levels, and population and GDP (perhaps 50:50), with a penalty scheme for countries not collecting sufficient WOCs to "pay" for their actual emissions (measurement of overall emissions will need an independent watchdog). If this is set up right, there is an incentive for WOCs to flow from developing to developed countries which would have part of the effect we want to achieve. It could become an "aid" reserve currency, also used for paying for adaptation projects.

The private person will get involved in this scheme, since he will need WOCs to do those nasty polluting things that he really wants to do. Either individuals would have to buy WOCs (effectively from less polluting countries and individuals) or they would have to be allocated in some equitable way, perhaps through taxes. This is a social issue that politics would have to solve, maybe differently in different countries.

If over time, the total number of WOCs in circulation is continuously reduced, then economic theory indicates that their value would increase. The "power of the market" could be harnessed to drive things in a positive direction, and at least in the West, individuals would still retain a degree of personal choice. For example, if I choose to use public transport and local holidays, or am a poor person (low number of WOCs needed), then I can sell my excess WOCs to others who want/need to drive cars and fly to Guadeloupe).

This whole scheme needs a lot of political will and leadership to get started, but might really be a credible alternative to the use of force/threat of war, and requires less administration than today's Kyoto mechanisms. Because the "market" is involved, it could be an attractive system for conservative and liberal politicians, and socialists will like the reallocation aspect. Also, because it would be a world currency, it would bind rich and poor in a new way, encouraging the pursuit of a common goal of emission reduction.

The private sector would get involved in maximising "profits" in WOCs, just like with any other currency. "Micro" accounting for carbon emissions will take place only where the cost of doing this is justifiable: otherwise, the WOCs can just be treated as an expense in a different currency.

Bootstrapping the World Carbon System: Start with one country

Starting the WCS within one country gives that country the opportunity to shape the overall rules and to take a key role in the development of the WCS. The WCCB would naturally be based in the initial host country, and this could conceivably be undertaken by the local Central Bank.

Inside the country

The necessary legislation needs to set up to enable a new currency to be used in parallel with the existing home currency. Primary Emitters of CO₂e are taxed for their emissions in WOCs — the WOCs are returned to the Central Bank (WCCB) and removed from circulation. A registered emitter receives the Central Bank WOC "buy" price in local currency. If a given emitter does not have sufficient WOCs, he will have to buy them on the open market, or at a premium from the Central Bank. As far as possible, 1 WOC is always removed from circulation for the emission of 1 kg of CO₂e: this means that individual emission types will have different, but (scientifically) fixed WOC values. For example, 1 kWh of electricity produced from a particular type of coal will cost more WOCs than 1 kWh of electricity produced from biogas, because of the difference in embedded CO₂e emission levels.

Individuals and companies are allocated newly created WOCs, as a part of annual tax return processing: these WOCs are notionally bought from the Central Bank. The WOCs can be paid into any normal bank account. Holdings of WOCs attract negative interest from the Central Bank, thereby discouraging hoarding. It is not permitted to "go short" in WOCs: loans must be fully covered and cannot be lost through default/bankruptcy. For this reason, a full deposit guarantee on WOC deposits must be provided by banks, fully covered (at all times) by deposits held with the Central Bank.

Key parameters used by the Central Bank to control WOC liquidity are: the level of WOC "money" in circulation, the interest charged on deposits, and the backstop buy and sell prices in local currency. The Central Bank liquidity and monetary targets should be set based on the measured level of CO₂e and its trend. The Central Bank can (within limits) create additional WOCs within its circulation targets, should demand outstrip supply, but these WOCs would be charged at a substantial premium.

Crossing borders: import/export and customs

Implied primary CO₂e emissions in imported and exported items are charged in WOCs by the Customs Authorities. If the WOCs have already been collected within the country, then they are not collected again (this must be certifiable). If there is insufficient information about the level of embedded emissions, then a default (higher) level of WOCs is charged. For companies involved in import/export, a WOC account can be held with the Customs Authorities. Just as with other WOC accounts, the account may not go below zero, and any credit can be sold on the open market. If WOCs have to be bought from the Central Bank, they will be charged for at a premium. Airline travel and freight are also included, and charged based on distance and transportation type: here the EU has new rules which could provide a basis.

In order to keep the level of bureaucracy to a minimum, individuals should be allowed to import and export small quantities of items without having to account for them. This would most likely have to apply, for example, to the petrol contained in vehicle tanks. Within the country, WOCs will have been charged directly or indirectly for the implied CO₂e emissions. Outside the country, a litre of petrol can be bought without this having been taken into account. It is probably too expensive to monitor petrol imports and exports contained in private motor vehicles.

Industries covered

The initial list of primary CO₂e emitters are in energy, mineral exploitation, pharmaceuticals, farming, waste disposal (tbc).

Go viral

Because WOCs can be treated like any other foreign currency, any individuals and companies can hold and transact in them (whether inside or outside the initial country). In addition, the banking industry would certainly be interested in offering WOC-based financial products. The Central Bank itself can use typical financial products such as repos and bonds to manage its own liquidity.

Since countries outside the system do not have direct access to WOC liquidity, this should be an incentive to join the system, expecially if the WOC itself is managed by the initial Central Bank so that it can be an attractive "reserve currency". This means that the Central Bank must have WOC price stability as a key target.

External links

• Personal carbon trading (Wikipedia)

• Personal Carbon Trading of the UK Sustainable Development Commission

• Guardian article from 2002