Understanding Cap and Trade

Climate change and other environmental concerns are constantly in the news. With the recent passing of a climate change bill (American Clean Energy and Security Act of 2009) by the U.S. House of Representatives, interest is growing in concepts such as carbon offsets and cap and trade. The trouble is, confusion remains about what exactly carbon offsets are and how carbon markets work. This article provides some insight as to what carbon offsets might mean.

A Little Explanation
Carbon is carbon dioxide (CO2), the leading greenhouse gas (GHG). GHGs are harmful emissions from homes, businesses, and vehicles that scientists believe contribute to global warming. A carbon offset is the act of avoiding or reducing GHG emissions in one place in order to offset GHG emissions occurring elsewhere. The carbon offset then becomes a tradable financial instrument, in which the off-setter can sell the emissions reductions to another party who is interested in reducing their carbon footprint. An offset provider is the owner or controller of an emissions reduction or sequestration project. Offset aggregators are organizations that act as administrative and trade representatives for multiple offset projects.

Mandatory Emissions Trading Systems
Carbon credits first appeared as financial instruments that were key components of national and international mandatory emissions trading systems implemented to limit pollution. Emissions trading is a market-based approach to pollution control which uses economic incentives to achieve emissions reductions. Emissions trading programs are often called cap and trade.

An emissions trading program first sets a cap, or maximum limit, on emissions. Facilities covered by the program, receive authorizations to emit in the form of emissions allowances, with the total amount of allowances limited by the cap. In a typical program, each facility designs its own compliance strategy to meet the overall reduction requirement, including the sale or purchase of allowances. Since carbon (carbon dioxide) is the best-known GHG, emissions trading schemes became known as carbon markets, and the commodities exchanged there as carbon credits.

The largest and most visible emissions trading scheme is organized under the Kyoto Protocol—an international treaty, signed in 1997, whereby participating nations have agreed to limit GHG emissions by established targets. These targets are divided into assigned amount units (AAU) and allotted to the various countries. Emissions trading allows countries with unused AAUs to sell them to countries that are exceeding their emissions levels.

The American Clean Energy and Security Act of 2009 would establish a cap and trade system, designed to reduce GHG emissions. Facilities emitting an excessive amount of GHGs would receive emission allowances annually based on their tonnage limit for that year. Covered facilities would be able to offset part of their emissions through EPA-approved offset credits. Offset credits could be traded, sold, and banked for further use—subject to certain restrictions. Note that this bill has not become law and similar legislation is currently under consideration by the U.S. Senate. The details of the cap and trade program are likely to change if and when the bill becomes law.

Voluntary Carbon Markets
A growing number of voluntary trading schemes are available where interested parties can buy and sell emissions reductions. Under a voluntary program, an organization that wishes to reduce its carbon footprint can purchase offsets from a third party that will use the money to offset emissions, through projects such as planting trees. Credits can also be obtained from environmental investment funds or carbon development companies that have aggregated offsets from various projects.

The Chicago Climate Exchange (CCX) is an example of a voluntary U.S. carbon trading market that has specific criteria and certification procedures. Your power supplier, Associated Electric Cooperative, Inc. has participated voluntarily in the CCX since it was formed. In the CCX, members agree to reduce GHG emissions by an established amount over a specified period. The CCX registers Offset Projects as tradable commodities known as Carbon Financial Instruments. Eligible projects sequester, destroy, or reduce GHG emissions. Renewable energy, energy efficiency, and fuel switching are examples of typical project types.

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