Q&A: The Carbon Trade

Fossil fuel burning is the main source of emissions

With climate change now an increasingly important concern for policy-makers, carbon trading is riding high on the agenda. BBC News examines current approaches to the issue.

What is the idea behind carbon trading?

Carbon trading is a market mechanism intended to tackle global warming. Though it dates back to 1989 it only took off as a market after the Kyoto Protocol was signed.

Under the Kyoto treaty - which came into force in February 2005 - industrialised countries must reduce total greenhouse gas emissions by an average 5.2% compared with 1990 levels between 2008-2012.

The most important greenhouse gas contributing to global warming is carbon dioxide, which is mainly emitted by burning fossil fuels. Under Kyoto, each participating government has its own national target for reducing carbon dioxide emissions.

Other reduction initiatives - not part of Kyoto - include company-based schemes, which also have specific targets.

The key idea behind carbon trading is that, from the planet's point of view, where carbon dioxide comes from is far less important than total amounts.

So, rather than rigidly forcing the reduction of emissions country-by-country, (or company-by-company), the market creates a choice: either spend the money to cover the costs of cutting pollution (emissions), or else continue polluting (emitting), and pay someone else to cut their pollution.

In theory this enables emissions to be cut with the minimum price tag.

Is carbon trading new?

The Kyoto protocol is the first scheme that includes global trading in greenhouse gases, but the idea of trading pollutants was first tried in the 1970s when the US decided to trade sulphur dioxide and nitrous oxide to tackle acid rain.

Neither is the idea of trading allowances for ecological protection new.

The European Union, under its Common Agricultural Policy, has for some time had schemes for trading national or local quotas, in dairy production or fishery catches.

How big is the market today?

Exact figures are hard to come by because the market is still fairly new, since data is not easily available and since several different schemes exist, not all directly comparable.

The World Bank, one of the main players in carbon financing, estimates the value of carbon traded in 2005 to be about $10bn.

Financing carbon deals is big money

The Bank believes the carbon market has the potential to bring more than $25bn (£14bn) in new financing for sustainable development to the poorest countries and the developing world.

Trading firms, brokers and banks are among those expected to make money through commissions for organising carbon deals.

The Bank's own carbon finance fund has more than doubled from $415m in 2004 to $915m last year.

How is carbon traded?

There are two main ways to exchange carbon.

The first is what is called a cap-and-trade scheme whereby emissions are limited and can then be traded. Under Kyoto developed countries can trade between each other.

The European Trading Scheme (ETS) is a cap-and-trade scheme and the largest companies-based scheme around.

It is mandatory and includes 12,000 sites across the 25 European Union member states.

It came into force in 2005 and covers heavy industry and power generation, including non-European companies.

There are also voluntary cap-and-trade schemes.

The Chicago Climate Exchange (CCX) is such a scheme.

Interest in carbon trading at regional level is increasing in America, even though the US government has decided not to ratify Kyoto.

The UK also has its own voluntary scheme, for which companies cut their emissions in return for incentive payments.

The second main way of trading carbon is through credits from projects that compensate for or "offset" emissions.

The Kyoto protocol's Clean Development Mechanism (CDM), for example, allows developed countries to gain emissions credits for financing projects based in developing countries.

A Kyoto mechanism called Joint Implementation (JI), also involves project-based schemes whereby one country can receive emissions credits for financing projects that reduce emissions in another developed country.

Compliance is critical.

Under their Kyoto obligations, industrialised countries have 100 days after final annual assessments to pay for any shortfall - by buying credits or more allowances via emissions trading.

Failure to do so leads to further penalties.

In voluntary schemes, by contrast, this is not the case.

It sounds attractive - does it work as a way of dealing with climate change?

Trading, whether between companies or countries, only works if emissions are reduced enough to contain global warming. Creating a market does not, by itself, reduce emissions.

Moreover, the benefits could be severely limited if trading is not comprehensive.

As important as what or who is included is what is not included.

Carbon dioxide represents only part - albeit a crucial part; more than 70% - of all greenhouse gases.

Furthermore, the US, the world's largest CO2 polluter, excluded itself by choosing not to ratify Kyoto.

And while the US is the biggest emitter today, China, which is projected to exceed the US in emissions by mid century, has no obligation to reduce emissions.

Most sectors are not obliged to cut emissions

Even within trading schemes such as the ETS, whole sectors' emissions are excluded, such as transport, homes and the public sector.

Aviation is the fastest-growing source of CO2 emissions, and some experts have calculated that if it were included, the UK's entire allowance would soon be used up.

Critics say trading carbon condones the idea of "business as usual" and fails to emphasise the need to invest in renewable energies and move away from fossil fuels.

Trading, while it may acknowledge the threat posed by global warming, does not address the seriousness and scale of the problem, argue environmentalists.

For trading to work it would have to become much broader - perhaps even embracing personal carbon allowances for individuals, some say.

More and more scientists are saying that the carbon dioxide ceilings under the treaty are too high - perhaps far too high - to help avert serious climate change.