International talks are intensifying over what policy should follow the Kyoto Protocol, a treaty set to expire in 2012 that established binding reductions of greenhouse gas emissions for thirty-six countries. The Obama administration and Democratic lawmakers hope to put into law legislation that would establish emissions targets for U.S. industries. In June of 2009, the U.S. House passed a bill that would establish a U.S. carbon market, and legislation is pending in the Senate. Problems with some current trading markets offer lessons for crafting new cap-and-trade policies.

The Kyoto Protocol established a market-based mechanism to allow developed countries with binding emissions targets to reduce greenhouse gases such as carbon dioxide, methane, carbon tetrafluoride, trifluoromethane, and nitrous oxide. Under the cap-and-trade system, industries would be allocated allowances limiting them to a certain amount of greenhouse gas emissions each year. Most trading schemes use one ton carbon-dioxide units for sale, or convert non-CO₂ gases into CO₂-equivalent units for the purposes of trading. Industries are also allowed to purchase credits that offset their carbon output above those caps. The goal of the cap is to prevent increases in net emissions. Some facilities may find it more economical to reduce their emissions and then sell their surplus emission allowances as credits, while others may find it cheaper to buy credits to offset their emissions rather than make direct reductions. Greenhouse gas emission credits can be purchased or sold from either a carbon market or a project certified by the United Nations.

Cap-and-trade systems have been utilized in the past to successfully reduce other types of emissions. The cap-and-trade system instituted under the 1990 Clean Air Act amendments in the United States is credited with achieving significant reductions in acid-rain-causing sulfur-dioxide emissions by power plants.

• Clean Development Mechanism. Kyoto's "Clean Development Mechanism" (CDM) is intended to provide a way for developing countries to reduce their emissions without emissions caps. Nations with Kyoto targets are allowed to purchase emissions-offset credits generated from carbon abatement projects in the developing world. Projects must be registered with the UN's CDM board, which certifies the amount of emissions reductions that occur as a result of the project. Those "certified emissions reductions" (CERs) can then be sold to a nation or party with binding emissions caps. At the end of 2008, there were about 4,200 projects in the pipeline (PDF) that were expected to yield reductions of 2.9 billion metric tons of carbon dioxide by 2012.
• Joint Implementation. Another Kyoto mechanism nearly identical to CDM is joint implementation. However, instead of the project taking place in a developing nation, it is created in an industrialized nation. By 2008, there were 167 such projects (PDF) in the pipeline that could offset approximately 300 million equivalent tons of carbon dioxide by 2012. According to the UN Framework Convention on Climate Change (UNFCCC), Russia dominates this market with more than 65 percent of the estimated annual emissions reductions for Kyoto's enforcement period (2008-2012).
• European Union (EU) Trading System. The EU trading scheme, also allowed by Kyoto, is the largest of its kind in the world. Started in 2005, it covers more than 11,500 facilities across the bloc's twenty-seven member nations, 40 percent of overall emissions. Facilities include coke ovens, coal plants, cement factories, and iron works. Trading began in 2005 and so far covers only carbon dioxide.
• New South Wales. Australia's New South Wales Greenhouse Gas Abatement Scheme is a state-level market that began in 2003. The state capped its overall emissions at a little over seven metric tons of carbon-dioxide-equivalent emissions annually in greenhouse gas. In 2007, all except for one (PDF) of the forty participants fully met their abatement obligations under the program and the other seven were allowed to carry forward their shortfalls into 2008.
• Regional Greenhouse Gas Initiative (RGGI). The first mandatory carbon cap-and-trade program in the United States involves ten Northeastern and Mid-Atlantic states, and aims to reduce carbon dioxide emissions below 2009 levels by 10 percent by 2018. The initiative covers about 225 facilities in the power sector, and is the first mandatory carbon trading program to auction nearly all of its allowances. The compliance period began in January 2009, and there were two pre-compliance auctions in 2008 distributing about 85 percent of allowances. Participants can use offset projects for up to a little over 3 percent of their compliance obligations.
• Voluntary Cap-and-Trade. The United States, which has not ratified the Kyoto Protocol, has a growing voluntary cap-and-trade market. The Chicago Climate Exchange, which began trading in 2003, is currently the only global trading exchange for all greenhouse gases. Emitters that join the exchange, including companies, utilities, and public-sector entities, enter into legally binding contracts to reduce their emissions at least 6 percent below an emissions baseline-based on the entity's average annual emissions between 1998 and 2001 by 2010. Those exceeding their reduction commitment may sell their surplus emission allowances; those failing to make their reduction commitment must buy allowances to comply. Emissions offsets can also be generated through exchange-certified projects located throughout the world. With more than 400 members the exchange includes emitting entities, liquidity providers, and offset providers. The exchange also handles CERs and carbon futures contracts.

According to the World Bank's May 2009 report (PDF) on trading systems, a total of more than $64 billion in allowances was traded in 2007, and trading more than doubled in 2008 to over $126 billion. Of the 2008 total, nearly $92 billion was traded on the EU market, about $7 billion was for UN projects, $183 million was on the New South Wales exchange, $309 million was on the Chicago Climate Exchange, and another $246 million on the new RGGI exchange. In the previous year's report, the bank notes that 2007 also saw the emergence of other voluntary programs such as the California Climate Action Registry, and "secondary markets." The 2008 bank report calls secondary markets an innovation in response to procedural CDM certification delays. In secondary markets, aggregators sell guaranteed CER contracts that are secured through a slice of their overall carbon portfolios. Secondary CDM allowance trading surpassed sales of primary CDM credits. In 2008, secondary CDM credits totaled $26 billion--more than quadrupling from 2007, while primary CDM credits total nearly $6.5 billion, a slight drop from the previous year.

The report shows the EU system traded about 3.1 billion metric tons of carbon allowances in 2008 while UN projects accounted for about 463 million metric tons. New South Wales traded about 31 million tons and the Chicago Climate Exchange about 69 million tons.

The reviews of the Clean Development Mechanism have been mixed. The World Bank reports significant delays in certifying and rolling out projects. Meanwhile, some environmental advocates worry that the program is heavily skewed toward big countries and big projects rather than truly being a development mechanism for least developed countries. According to UNFCCC, the majority of projects in the pipeline focus on sustainable energy production, including biomass, wind power, and hydropower. The bulk of the projects continue to be located in relatively wealthy developing nations such as China and India. China alone accounts for more than half of the certified emissions reductions being generated by the CDM. Raymond J. Kopp, director of the climate and technology program at the environmental think tank Resources for the Future, asserts that smaller countries will only start to benefit from the CDM if the program is widened to include deforestation, not just reforestation as it does now. Carbon that escapes during deforestation accounts for 20 percent (FT) of the world's carbon dioxide emissions. The 2007 UN conference in Bali yielded an agreement to include deforestation in the next enforcement period.

Michael Wara, a research fellow at Stanford University's Program on Energy and Sustainable Development, says even though developing nations such as China and India are benefiting, the mechanism has not achieved its goals. He points to the billions spent to abate chemicals such as nitrous oxide and trifluoromethane, also known as HFC-23, instead of to construct large-scale power projects (PDF), which he argues would be a better development outcome and abate greenhouse gases over the long term. In an April 2008 report, Wara, writing with former CFR Adjunct Senior Fellow for Science and Technology David Victor, noted that "offsets can play a role in engaging developing countries, but only as one small element in a portfolio of strategies." They recommend the United States invest in a climate fund (PDF) to help finance changes in the policies of developing countries to encourage "near-term reductions," and pursue infrastructure deals "with key developing countries" to shift their development in ways that are both consistent with their own interests and result in large greenhouse gas emissions reductions.

The financial downturn at the end of 2008 also created problems for CDM trading. A drop in EU industrial activity lowered the demand for credits, and in some cases prompted companies to sell off credits for quick cash (ClimateWire). An April 2009 review of CDM by Nature Magazine says the monthly average for new project approvals between November 2008 and January 2009 dropped about 15 percent below the monthly average for 2008 overall, in part due to the financial crisis.

CFR Senior Fellow for Energy and the Environment Michael Levi points out there are two discussions going on right now on CDM: getting the existing procedures right and overhauling for the future. The EU, he says, is currently pushing for the mechanism to be refocused toward a tool for least developing countries and wants additional requirements placed on large developing countries before they can participate in new projects. Meanwhile, there's also debate about whether CDM should be used for projects such as carbon capture and sequestration (CCS) and energy efficiency, both of which are currently not eligible.

The first round of trading was intended (PDF) to work out kinks in the system and did not have goals for meeting Kyoto targets. Prices for credits started fairly high, but quickly devalued when it was learned that the European Union handed out too many emissions allowances. The surplus meant industries had little need to make emissions reductions or buy credits to meet their targets. Instead, emissions from large European polluters rose slightly from 2005 to 2006.

Some experts say despite flaws in the initial rollout, the EU trading system has broken new ground by creating an emissions-trading regime across multiple jurisdictions and has "provided new evidence on how different approaches to enforcement and monitoring, allocation, and even effort and stringency can be encompassed in a single trading program," said a February 2007 Resources for the Future discussion paper (PDF) on the EU trading scheme. Kopp notes that EU emissions futures trading--where people buy credit contracts set at a certain price for the future--is strong, which he says implies investor confidence in the stability of the market.

The second phase of trading began in mid-2008. According to analysis by New Carbon Finance, EU emissions decreased 3 percent in 2008 from 2007 levels because of emissions trading. However, criticism persists. "Four years later, it is becoming clear that system has so far produced little noticeable benefit to the climate--but generated a multibillion-dollar windfall for some of the continent's biggest polluters," reports this December 2008 New York Times article, pointing out that concerns over economic competiveness led the EU to continue to give away a bulk of the credits for free. The European Commission proposes that allowances be auctioned off in the third round of trading beginning in 2012.

In a March 2009 report, Climate Strategies, a Cambridge-based policy research firm, notes carbon markets are particularly vulnerable to the boom-bust patterns because they are not a "natural market, connecting supply of a 'natural' good to a private demand, but an instrument to achieve collective public goals." The report notes nascent carbon markets already include a high degree of political uncertainty that deters investment, uncertainty that is exacerbated when carbon prices fall-increasing the possibility that policy goals, such as providing stable resource flows to developing countries, will not adequately be delivered.

Lawmakers in the United States, debating federal global-warming regulations in spring 2009, were proposing auctioning initial allowances rather than giving them away as Europe has done. Proposals under consideration in the U.S. Congress would auction at least some of the allowances in the initial round of trading. However, U.S. lawmakers, like the EU, have been dogged with competiveness concerns and the possibility of increasing energy costs. May 2009 testimony from Douglas W. Elmendorf, director of the nonpartisan Congressional Budget Office, says policymakers could protect consumers and industry from some of the economic impacts of a U.S. cap-and-trade system, but not all. Meanwhile, environmentalists fear the proportion of allowances auctioned in the initial round will be small.