Carbon Trading: How it Works and Why it Fails

by Oscar Reyes, Tamra Gilbertson

This article is from issue 45 of the journal Soundings and is exclusively available online at NLP.

Emissions trading is the EU’s flagship measure for tackling climate change, and it is failing badly. While in theory it provides a cheap and efficient means to limit greenhouse gas reductions within an ever-tightening cap, in practice it has rewarded major polluters with windfall profits, whilst undermining efforts to reduce pollution and achieve a more equitable and sustainable economy. This article briefly examines the theory of carbon trading, then looks at the empirical record of the EU Emissions Trading System and the UN Clean Development Mechanism - the world’s largest carbon trading schemes. It then briefly surveys the many alternative and equitable ways to tackle climate change.

Proponents of carbon trading argue that it offers a way for companies to `internalise’ the economic costs of climate change. It enables them to put a price on climate change impacts, which traditional economists would describe as an `externality’ - something that remains off the balance sheet and is therefore not taken into account when decisions are made. Putting a price on carbon is seen as allowing this `externality’ to be included in a company’s balance sheet. This is achieved either through taxation or trading (though the latter is claimed to be more flexible and corporate-friendly). The hidden hand of the market then guides finance towards the cheapest options for tackling climate change.

But there are some fundamental problems with this conception. Firstly, the claim that markets offer the cheapest solutions for tackling climate change begs the question: cheapest for whom and over what timescale? In fact carbon markets have tended to pursue short-term `fixes’, whilst displacing the responsibility for tackling climate change onto the global South. In this respect, such markets are promoting climate injustice.

Secondly, the adoption of carbon pricing through carbon trading entails a reframing of the climate change debate. It presumes that global warming can be addressed by the relatively simple translation of `unpriced’ pollution into a tradable, ownable commodity. This reduces the politics of climate change to a simple economic calculation about how to incentivise shifts in private sector investment. In so doing, it closes down the space for asking the very questions that are crucial if we are to make the structural changes that might tackle climate change: what changes do we need for escaping from our dependence on fossil fuels? What `development paradigms’ are being pursued? What environmental regulations are appropriate and just? What public investment programmes are needed, and how can community control of these finances be ensured? Is constant economic growth compatible with greenhouse gas emissions reductions?

More generally - and partly because of this reframing - the idea that the trading of `carbon’ as a commodity will address climate change implies that there is no need to ask key questions about where and when changes should be made. Even if the theory worked out as planned - which is far from the case - it would end up chasing the cheapest short-term cuts, incentivising quick fixes to patch up outmoded power stations and factories, rather than pursuing more fundamental changes. Moreover, what is cheap in the short term does not translate to an environmentally effective or socially just solution over the long term.

Cap and trade

There are two main forms that carbon trading takes: `cap and trade’ and offsetting. Under cap and trade schemes, governments or intergovernmental bodies set an overall legal limit on emissions in a certain time period (`a cap’) and then grant industries a certain number of licenses to pollute (`carbon permits’ or `emissions allowances’). Companies that do not meet their cap can buy permits from others that have a surplus (`a trade’). The idea is that a scarcity of permits to pollute should encourage their price to rise; and the resulting additional cost to industry and power producers should then encourage them to pollute less. The empirical evidence, however, suggests that the incentives created by the scheme work very differently - awarding profits to polluters and encouraging continued investment in fossil fuel-based technologies, while disadvantaging industry that is focused on transition away from fossil fuels. This is not an arbitrary product of misapplied rules; it is a product of the way these markets reinforce existing power relations, thereby contributing to unjust economic decision-making.

The world’s largest cap and trade scheme is the European Union Emissions Trading Scheme (EU ETS). It has created a trade in European Union Allowances (EUAs), which are allocated according to National Allocation Plans, which are in turn subject to European Commission approval. The EU ETS covers approximately 11,500 power stations, factories and refineries in 30 countries - the 27 EU member states, plus Norway, Iceland and Lichtenstein. These account for almost half of the EU’s CO2 emissions, and include most of the largest single, static emissions sources, including power and heat generation, oil refineries, iron and steel, pulp and paper, cement, lime and glass production.

In the first phase of the scheme, from 2005 to 2008, however, far too many emissions permits were handed out to these industries - largely as a result of intensive corporate lobbying. When the first emissions data was released in April 2006, it showed that 4 per cent more permits were handed out than the actual level of emissions within the EU. In other words, the `cap’ did not cap anything. Nor was it just the first year of the scheme that was over-allocated. By the end of phase 1, emitters had been given permits to emit 130 million tonnes more CO2 than they actually did, a surplus of 2.1 per cent. As a result the price of carbon permits collapsed and never recovered. From a peak of around 30, the price slid below 10 in April 2006, and below 1 in the spring of 2007.

A further major criticism levelled at the first phase of the EU ETS is that it generated huge `windfall profits’ for power producers, helping them to make large unearned financial gains as a result of flaws in the rules rather than any proactive measures taken to reduce emissions through structural changes. An inquiry by the UK Parliament’s Environmental Audit Committee found that `it is widely accepted that UK power generators are likely to make substantial windfall profits from the EU ETS amounting to £500 million a year or more’. At first glance, this seems contradictory. How can polluters profit when the value of the credits in the scheme fell to almost nothing? The answer lies in the way energy companies account for the costs of the EU ETS. The costs that are indirectly passed on to consumers through an increase in wholesale energy prices do not reflect what carbon credits actually cost, but rather what the companies assume they may cost. This leaves considerable scope for over-estimates. First, by assuming a larger than necessary need to buy permits or credits; second, by assuming that there will be a high carbon price; and third, by assuming the costs of replacing EU Allowances, irrespective of their actual use of offset credits, which in any case have consistently commanded lower prices. When these assumptions have turned out to be over-generous, the surplus is more often pocketed as profit than returned.

The same problems of over-allocated permits and windfall profits for polluters are occurring in the second phase of the EU scheme, which runs from 2008 to 2012. Research by market analysts Point Carbon, for example, has calculated that the likely windfall profits made by power companies in phase 2 could be between 23 billion and 71 billion (and between 6 and 15 billion for UK power producers alone). Given that the majority of permits are still allocated for free, the EU ETS is effectively providing a subsidy stream for highly polluting industry. The example of ArcelorMittal, the world’s largest steelmaker and the holder of the greatest surplus of EU ETS permits, is instructive. It has routinely been awarded a surplus of permits of around 25 to 35 per cent above its actual level of emissions, and this has allowed the company to gain a subsidy of up to 2 billion since 2005. A recent Carbon Rich List survey, meanwhile, concluded that the 10 industries (mostly steel and cement companies) with the largest surplus of permits stand to gain over 3.5 billion in subsidies between 2008 and 2012.

Although the EU’s figures for 2008 show an overall reduction in emissions of around 50 million tonnes, these figures were inflated by over 80 million tonnes of credits from carbon offsets, mainly through the Clean Development Mechanism, which gives credits for schemes for `emissions-saving projects’  in the global South (for more on this see below). In other words, more than the entire claimed `reduction’ was generated by projects outside of Europe. As the UK’s National Audit Office found: `The maximum level of allowable emissions within the EU is higher than the cap once offset credits are taken into account’.

With a further surplus of permits, another price collapse in the EU ETS followed, from a peak of 31/tonne in the summer of 2008 to 8 in February 2009. The figure has since hovered between this level and 16 (to May 2010). Allocations for the second phase of the scheme were made on the assumption that European economies would keep growing. But the recession has reduced output and power consumption, leaving companies with a surplus of permits. Since these were mainly given out for free, the net effect is directly opposite to the scheme’s theoretical intention: polluting industries are offered a lifeline in the form of the option of cashing in their unwanted permits, while the supposed `price signal’ that is meant to change their polluting ways has been neutered.

This is already storing up problems for the third phase of the EU ETS. The main reason that the price of EUA permits in phase 2 has not collapsed to zero is that it is now possible to `bank’ them - in other words, to hold onto them for use in the third phase of the scheme, which will run from 2013 to 2020.

The World Bank estimates a surplus of 970 Mt CO2e (million tonnes) by the end of phase 2. This would account for almost 40 per cent of the `reduction’ that the EU claims will be required of power companies and industries covered by the ETS in phase 3 of the scheme. And this figure might yet be higher if companies decide to purchase a significant number of offset credits and `bank’ these too. Legally, the total could rise to 1.6 billion tonnes CO2e. In addition, companies will be allowed to purchase an additional 50 per cent of their `reductions’ in the form of offsets. Furthermore, this overall figure masks the fact that new ETS rules will allow power producers in the UK and Germany (currently the largest buyers of emissions permits), as well as companies operating in Spain and Italy (which allowed vast quantities of offsets in phase 2), to buy far more than 50 per cent of their `reductions’ in the form of offsets. The net result of this could be that the EU ETS will require very few domestic emissions reductions before 2020, and quite possibly none at all.

Carbon offsets

Carbon offsets are based on `emissions-saving projects’ that are created to `compensate’ for continued pollution in industrialised countries in the North. They usually run in parallel with `cap and trade’ schemes and generate `credits’ that allow companies to pollute above the set limits. At present, the EU ETS is the major driver of demand for offset projects, under the UN’s Clean Development Mechanism, which is the world’s largest offsetting scheme; it had almost 1,800 registered projects in September 2009, and more than 2,600 further projects awaiting approval. Based on current prices, the credits generated by approved schemes will be worth around US$35 billion by 2012.

Although offsets are often presented as emissions reductions, the effect of these projects is to move the responsibility for reducing emissions from one location to another, normally from countries in the North to countries in the South. This frequently results in increased emissions, whilst also exacerbating social and environmental conflicts. Offsets are allowing companies and countries to buy their way out of responsibility for cutting their own emissions with reductions elsewhere that are often more theoretical than actual. Currently offsets are undertaken both through inter-governmental schemes and through voluntary programmes.

As the Clean Development Mechanism grows, as well as a plethora of renewable energy schemes it is increasingly funding new fossil fuel power generation projects - and even renewable energy projects cannot automatically be assumed to be clean or sustainable. Hydroelectricity, biomass projects and even wind farms, which are rapidly becoming important sources of CDM credits, generate significant side-effects that could have greater climate change impacts than if they had never happened. More importantly, such large-scale projects export a `development’ paradigm that is insensitive to the needs and cultures of local communities, including their territories, health, land use and water requirements.

One underlying problem is that emissions savings are defined in terms of a flawed `additionality’ concept. A baseline assumption is made about what the future would have held without the project; the CDM is assumed to have altered the future; and credits are awarded as a result. Credits from such a scheme are in principle unregulable, since they are calculated relative to a claim about what would otherwise have happened in the future. The future is impossible to predict, yet the CDM accords it a false certainty, and even goes so far as to quantify an exact number of emissions to be `saved’.

In addition, the counterfactual `baseline’ is measured against the purported emissions savings of a carbon offset project, and these are calculated over one hundred years. For example, a wind farm in India may claim to be generating carbon credits because it is saving on the burning of fossil fuels. However, as Kevin Anderson of the Tyndall Centre for Climate Change Research explains:

... those wind turbines will give access to electricity that gives access to a television that gives access to adverts that sell small scooters and then some entrepreneur sets up a small petrol depot for the small scooters and another entrepreneur buys some wagons instead of using oxen and the whole thing builds up over the next 20 or 30 years ... The additionality test would be, if you can imagine Marconi and the Wright brothers getting together to discuss where they will be in 2009, when easyJet and the internet will be facilitating each other through internet booking. That is the level of ... certainty you would have to have over that period. You cannot have that. Society is inherently complex.

A second assumption underpinning carbon offsets is that the cheapest reductions should be made first - with a market-based approach assumed to be the best means of achieving this goal. Yet what is good for the market is not necessarily good for the environment. The evidence of how the CDM and voluntary offsets schemes have performed to date shows this to be deeply flawed as a means to tackle climate change or stimulate `greener’ development paths.

Most CDM offset credits, called Certified Emissions Reductions (CERs), are generated by projects that contribute nothing to a transition to a non-fossil dependent society. As of September 2009, three-quarters of the offset credits issued were the result of large firms making minor technical adjustments at a few industrial installations to eliminate hydrofluorocarbons (HFCs) and nitrous oxide (N2O).[1] This picture is unlikely to change dramatically by the time the Kyoto Protocol’s first commitment period expires. By the end of 2012, HFC and N2O credits are still expected to account for the largest shares of the CDM (16.8 per cent and 8.9 per cent respectively), followed by hydro-electricity projects (16.7 per cent). HFC-23 projects have generated massive profits for a handful of companies producing refrigerant gases, and for others that use it as a primary feedstock for the production of polytetrafluoroethylene (PTFE), commonly referred to as Teflon. In fact, the sale of carbon credits from these activities rapidly became far more valuable to the companies producing them than the refrigerants and coatings that had led to its creation in the first place. But what was cheap and profitable for the companies cashing in on such projects has turned out for others to be an extraordinarily expensive subsidy to a highly polluting industry with a long record of blighting the lives of local citizens and the environment surrounding their factories. The largest direct buyers of CDM credits are all from the financial sector, with the main demand coming from the power sector in the EU, where a series of new coal-fired power plants is under consideration.

The damage that CDM continues to do on the ground should not be underestimated. On 6 January 2010, the Clean Development Mechanism registered its 2000th carbon offset project. Yet by far the largest share of credits in 2009 came from spurious industrial gas reductions (of HFC-23 and N2O), while four of the five largest projects registered in 2009 will subsidise the fossil fuel industry: coal and natural gas in China, and gas flaring in Nigeria. Hydroelectric dams, mostly under construction irrespective of CDM finance, remain a major source of activity too; CDM credits are frequently sought as an additional subsidy stream.

Can carbon trading be fixed?

One of the most common responses to the clear evidence that carbon trading is not working is to suggest fixes that would `improve’ the workings of the system: changing rules on the `banking’ of permits; introducing price floors and ceilings to control volatility; expanding global carbon markets to `increase liquidity’; and so on.

What these proposals have in common is an implicit assumption that carbon trading fails because the rules have been designed inadequately or have been badly applied. Although instances of such failings certainly exist, they bring us no closer to understanding why the system has misfired so spectacularly. They don’t, for example, answer the question of why so many corporations and states pushed for the inclusion of large volumes of offsets in carbon trade markets. Our argument is that this push has to do with a complex interaction of state and corporate power: those with the loudest voices push for offsetting as a means to escape their responsibility to change industrial and power production practices. In the case of the EU ETS, public decision-making on carbon trading is driven by concerns about business `competitiveness’ rather than for the environment. In the case of the CDM, offsetting is embedded in a development paradigm that disregards existing sustainable practices and community needs. Powerful economic and elite interests are at stake here, which are unlikely to be shifted by academic exercises in how to `perfect’ carbon markets - as though they existed in a power vacuum.

Ultimately, carbon trading is a means of pre-empting and delaying the structural changes necessary to address climate change. Instead of re-examining the fundamentals of an economic and political system that has led to climate change, carbon trading adjusts the problem of climate change to fit these structures. This wholesale re-definition can be found at every stage of the process - from cap-setting to trading, offsetting and speculation.

Carbon trading requires that action on climate change is translated into measurable units representing `emissions reductions’, but cap-setting imagines far greater certainty than climate science is able to deliver. It translates a series of complex and overlapping developments across a broad sweep of economic sectors - from power generation to manufacturing and agriculture - into a single linear path, to which a number is accorded by policy-makers for the purposes of comparison. And it also deflects questions about the underlying economic model, which is premised upon the cheap exploitation of fossil fuels to bankroll continued GDP growth. The trade in pollution permits aims to find the cheapest solutions for polluting industries, on the assumption that it does not matter where and how `reductions’ are made. The uncertainties about the long-term climatic effects of the adoption of different industrial and agricultural processes are overlooked, in order to ensure that a single commodity can be constructed and exchanged.

Trading also displaces measures to tackle climate change from one place to another through the practice of offsetting. Despite the well-documented problems with offsetting, most of the proposals on the table in UN climate negotiations actually advocate its expansion. Proposed changes such as `sectoral crediting’, the inclusion of new sectors in the Clean Development Mechanism, and the generation of carbon credits associated with Nationally Appropriate Mitigation Actions, would primarily serve to increase the volume of carbon trading. Such proposals are not being driven by considerations of environmental integrity, but by financial interests. The drive to expand carbon markets is being accompanied by the development of more complex carbon products, deploying a variety of derivative and hedge fund techniques. These are structures similar to those that contributed to the financial crisis. Like many derivatives, the new carbon commodities are difficult or impossible to value accurately, and may well lead to a new `bubble’ whose bursting would have disastrous results. Even without the usual complexities introduced by derivatives, securitisation and the like, carbon traders do not know what they are selling; paper `reductions’ may bear little specifiable relation to the changes in industrial practice or energy production that are needed for meaningful climate action. With rampant financial innovation added to the mix, speculation increasingly becomes an end in itself.

In short, the whole approach distracts from effective solutions - trapping us within a framework that sees the climate problem in primarily financial terms.

Ways forward

In seeking ways forward, we need to look again at the nature of the question being addressed. Tackling climate change requires, first and foremost, a rapid phasing out of fossil fuel use. No single alternative will suffice to achieve this. But carbon markets do not address this problem: they simply foster a trade in claimed `emissions reductions’ that are cheap according to current economic assumptions. Furthermore, reducing emissions in the short term by a small amount can be done without starting any of the structural changes needed in the long term. Current practices in a whole host of sectors, from manufacturing to industrial agriculture, need to be reviewed and reassessed. There is no evidence that a complex social and economic problem of this scale can be effectively tackled by indirect economic `incentives’ of the sort offered by carbon trading.

This is not simply a question of money. The knowledge systems that are currently being applied to address climate change tend to reproduce the ingrained privilege of the wealthy minority that caused the problem. Recognising and learning from existing climate solutions, by contrast, requires an approach of a multitude of locally adapted technologies and practices that do not neatly fit with the grand schemes promoted by current economic elites.

In planning a transition away from fossil fuels, and the unsustainable industrial and agricultural practices that they enable, there is a broad range of approaches that holds far more promise than carbon markets. In the EU this would include measures to shift subsidies away from fossil fuels; a reassessment of energ demand and efficiency, including demand-side management measures; and the expansion of various forms of conventional regulation, including the adoption of non-tradable output limits on greenhouse gas emissions.

Structural transformations typically required public investment, since the research and development costs associated with large-scale transformative technologies tend to require a greater investment risk than private capital is willing to bear. However, `public investment’ itself is not a sufficient remedy, especially within the current institutional framework, where public ownership generally takes the form of preferred-bid contracting with private entities, and control remains unaccountable and within private hands. More broadly, the nature of existing public institutions needs to be re-examined, particularly in the energy sector, where within the EU privatisation has led to a consolidation, with control now in the hands of a small number of private and public companies - such as EDF, owned by the French state, and Vattenfall, owned by the Swedish government. These state companies are structured as commercial enterprises, and offer little scope for public influence in favour of a sustainable and just energy production model. For such reasons, any increase in public finances to change the energy system should be accompanied by democratising the governance of the expenditure.

On a global scale, meanwhile, EU countries and corporations - which have done most to contribute to accelerating climate change - have huge responsibilities for the restitution and repayment of a `climate debt’. This implies not merely a commitment to public finance for community-controlled projects in the global South, but adjustments in trade rules to favour the patent-free exchange of intellectual property rights to low carbon technologies; and a more robust framework of international corporate law to tackle the impunity of large corporations in respect of human rights abuses and environmental degradation. The perverse incentives created by carbon markets and biofuel targets - as well as the expectation of a new marked-based approach to Reducing Emissions from Deforestation and Degradation - are contributing to massive land grabs, in forested areas in particular; whereas a just and sustainable approach would start with securing land tenure for Indigenous Peoples and forest-dependent communities, and promoting sustainable local farming and people’s food sovereignty over and above the interests of industrialised agriculture. Ultimately, there are no short cuts that bypass the difficult work of political organising and alliance-building. There are no techno-fixes to the historical and international policies that have created climate change; debates are needed on colonialism, racism, gender, women’s rights, exploitation, land grabs, agriculture and the democratic control of technology. Carbon trading will never have the capacity to address these critical issues: the struggle against climate change has to be part of the larger fight for a more just, democratic and equal world.

This article is a summary and update of material published in Carbon Trading: how it works and why it fails (Dag Hammarskjöld Foundation 2009), which can be downloaded for free from: <./p>

Thanks to Larry Lohmann and the Durban Group for Climate Justice, whose Carbon Trading: a critical conversation on climate change, privatization and power, was the source and inspiration for this work.

Tamra Gilbertson is a researcher with Carbon Trade Watch. She is a co-founder of the Durban Group for Climate Justice. Oscar Reyes is a researcher with Carbon Trade Watch and environment editor of Red Pepper magazine. They are co-authors of Carbon Trading: how it works and why it fails (Dag Hammarskjöld Foundation, 2009).


1. According to Risoe data, 56 per cent of the emissions reductions arise from HFC-23 projects, with a further 20 per cent from N20 projects. HFC-23s are a powerful greenhouse gas produced as a byproduct in refrigerant production.


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First published: 18 December, 2010

Category: Corporate power, Environment

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