1.1 Carbon credits are a key component of national and international attempts to mitigate the growth in concentrations of Greenhouse Gases (GHGs). Carbon trading is an application of an emissions trading (Emissions trading is an administrative approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants approach) & Greenhouse gas emissions are capped and then markets are used to allocate the emissions among the group of regulated sources. The idea is to allow market mechanisms to drive industrial and commercial processes in the direction of low-emissions or less "carbon intensive" approaches than are used when there is no cost to emitting CO2 and other GHGs into the atmosphere. Since GHG mitigations projects generate credits, this approach can be used to finance carbon reduction schemes between trading partners and around the world.

There are also many companies that sell carbon credits to commercial and individual customers who are interested in lowering their carbon footprint on a voluntary basis. These carbon offsetters purchase the credits from an investment fund or a carbon development company that has aggregated the credits from individual projects. The quality of the credits is based in part on the validation process and sophistication of the fund or development company that acted as the sponsor to the carbon project. This is reflected in their price; voluntary units typically have less value than the units sold through the rigorously-validated Clean Development Mechanism.

1.2 Clean Development Mechanism (CDM) is an arrangement under the Kyoto Protocol allowing industrialized countries with a greenhouse gas reduction commitment (called Annex B countries) to invest in projects that reduce emissions in developing countries as an alternative to more expensive emission reductions in their own countries. A crucial feature of an approved CDM carbon project is that it has established that the planned reductions would not occur without the additional incentive provided by emission reductions credits, a concept known as "additionality".

The CDM allows net global greenhouse gas emissions to be reduced at a much lower global cost by financing emissions reduction projects in developing countries where costs are lower than in industrialized countries. However, in recent years, criticism against the mechanism has increased.

Burning of fossil fuels is a major source of industrial greenhouse gas emissions, especially for power, cement, steel, textile, fertilizer and many other industries which rely on fossil fuels (coal, electricity derived from coal, natural gas and oil). The major greenhouse gases emitted by these industries are carbon dioxide, methane, nitrous oxide, hydro fluorocarbons (HFCs), etc, all of which increase the atmosphere's ability to trap infrared energy and thus affect the climate.
The concept of carbon credits came into existence as a result of increasing awareness of the need for controlling emissions.
The mechanism was formalized in the Kyoto Protocol, an international agreement between more than 170 countries, and the market mechanisms were agreed through the subsequent Marrakesh Accords. The mechanism adopted was similar to the successful US Acid Rain Program to reduce some industrial pollutants

The Protocol agreed 'caps' or quotas on the maximum amount of Greenhouse gases for developed and developing countries, listed in its Annex I. In turn these countries set quotas on the emissions of installations run by local business and other organizations, generically termed 'operators'. Countries manage this through their own national 'registries', which are required to be validated and monitored. Each operator has an allowance of credits, where each unit gives the owner the right to emit one metric tonne of carbon dioxide or other equivalent greenhouse gas. Operators that have not used up their quotas can sell their unused allowances as carbon credits, while businesses that are about to exceed their quotas can buy the extra allowances as credits, privately or on the open market. As demand for energy grows over time, the total emissions must still stay within the cap, but it allows industry some flexibility and predictability in its planning to accommodate this.

By permitting allowances to be bought and sold, an operator can seek out the most cost-effective way of reducing its emissions, either by investing in 'cleaner' machinery and practices or by purchasing emissions from another operator who already has excess 'capacity'.

Since 2005, the Kyoto mechanism has been adopted for CO2 trading by all the countries within the European Union under its European Trading Scheme (EU ETS) with the European Commission as its validating authority. From 2008, EU participants must link with the other developed countries that ratified Annex I of the protocol, and trade the six most significant anthropogenic greenhouse gases. In the United States, which has not ratified Kyoto, and Australia, whose ratification came into force in March 2008, similar schemes are being considered.

The Kyoto Protocol to the United Nations Framework Convention on Climate Change (UNFCCC) was adopted by more than 150 countries at the third session of the Conference of the Parties to the UNFCCC in Kyoto, Japan, on 11 December 1997. It is an international treaty containing binding constraints on greenhouse gas emissions and, mechanisms aimed at cutting the cost of reducing emissions and establish global markets for greenhouse gas (GHG) emission permits. Under the Kyoto Protocol, industrialized countries and countries with economies in transition will reduce their combined GHG emissions by at least five per cent below their 1990 levels by the first commitment 2008 to 2012. The most important GHG is carbon dioxide (CO2) whose emissions are mainly related to combustion of fossil fuels.

The developed countries commit themselves to reducing their collective emissions of six key greenhouse gases by at least 5%. This group target will be achieved through cuts of 8% by Switzerland, most Central and East European states, and the European Union (the EU will meet its target by distributing different rates among its member states); 7% by the US; and 6% by Canada, Hungary, Japan, and Poland. Russia, New Zealand, and Ukraine are to stabilize their emissions, while Norway may increase emissions by up to 1%, Australia by up to 8%, and Iceland 10%. The six gases are to be combined in a "basket", with reductions in individual gases translated into "CO2 equivalents" that are then added up to produce a single figure.

Each country’s emissions target must be achieved by the period 2008-2012. It will be calculated as an average over the five years. "Demonstrable progress" towards meeting the target must be made by 2005. Cuts in the three most important gases – carbon dioxide (CO2), methane (CH4), and nitrous oxide (N20) - will be measured against a base year of 1990 (with exceptions for some countries with economies in transition).
Cuts in three long-lived industrial gases – hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulphur hexafluoride (SF6) - can be measured against either a 1990 or 1995 baseline. (A major group of industrial gases, chlorofluorocarbons, or CFCs, are dealt with under the 1987 Montreal Protocol on Substances that Deplete the Ozone Layer.)

Actual emission reductions will be much larger than 5%. Compared with emissions levels projected for the year 2000, the richest industrialized countries (OECD members) will need to reduce their collective output by about 10%. This is because many of these countries will not succeed in meeting their earlier non-binding aim of returning emissions to 1990 levels by the year 2000; their emissions have in fact risen since 1990. While the countries with economies in transition have experienced falling emissions since 1990, this trend is now reversing.

Therefore, for the developed countries as a whole, the 5% Protocol target represents an actual cut of around 20% when compared with the emissions levels that are projected for 2010 if no emissions-control measures are adopted.

Countries have a certain degree of flexibility in how they make and measure their emissions reductions. In particular, an international "emissions trading" regime is established allowing industrialized countries to buy and sell emissions credits amongst themselves. They will also be able to acquire "emission reduction units" by financing certain kinds of projects in other developed countries through a mechanism known as Joint Implementation. In addition, a "Clean Development Mechanism" for promoting sustainable development enables industrialized countries to finance emissions-reduction projects in developing countries and receive credit for doing so.

The Protocol shall enter into force on the ninetieth day after the date on which not less than 55 Parties to the Convention, incorporating Annex I Parties which accounted in total for at least 55 % of the total carbon dioxide emissions for 1990 from that group, have deposited their instruments of ratification, acceptance, approval or accession.
The Kyoto protocol and the states that ratified the protocol could be found at the following.

4.1 The Kyoto Mechanisms encompass the following three instruments:

1. Joint Implementation (JI, Article 6 Kyoto Protocol) projects in other Annex B countries that lead to Emission Reduction Units (ERUs),

2. Projects in countries without emission targets Clean Development Mechanism (CDM), Article 12 Kyoto Protocol) that lead to Certified Emission reductions (CERs), and

3. International Emission Trading (IET, Article 17 Kyoto Protocol) of Assigned Amount Units (AAUs) among Annex B countries.

The concepts of JI and CDM refer to project based co-operations between two countries, where GHG emission reductions take place in the country with lower marginal abatement costs. In other words, a country that has adopted a quantified GHG emission reduction or limitation commitment under the Kyoto Protocol can fulfils parts of this commitment on the territory of another country where the costs are lower. The CDM envisages a project co-operation between industrialized countries with commitments (Annex I countries) and developing countries (non-Annex I countries), which have exempted from quantified commitments under the Protocol (JI refers to a project-based co-operation between two industrialized countries).

The main benefits that can be expected from the project-based Kyoto mechanisms are, on the one hand, that they potentially reduce industrialized countries’ costs of meeting the Kyoto Protocol targets, whereas, on the other hand, they are to support the host countries objectives regarding sustainable development.

With the help of CDM, countries which have set themselves an emission reduction target under the Kyoto Protocol (Annex I countries) can contribute to the financing of projects in developing countries (non-Annex I countries) which do not have a reduction target. Contributing to the sustainable development of the host country, the project should reduce the emission of greenhouse gases. The achieved emission reductions can be used by the Annex I country in order to meet its reduction target.

Carbon credits have become entrenched in the broader climate change debate; however, fundamental scientific and methodological problems persist. While these remain unresolved, they have the potential to seriously undermine the financial and environmental value of any carbon credits scheme. The danger is that reducing emissions at source and re-capturing carbon through sequestration are being treated by government and industry as equivalent policy options. ET should not be a mechanism that facilitates the transfer of fossilized carbon locked away for millions of years over to short-term biotic sinks. For this reason, the issue of carbon sinks is currently undermining the integrity of carbon credits and the creation of a carbon trading market.

Carbon credits are now a key component of national and international emissions trading schemes. They provide a way to reduce greenhouse effect emissions on an industrial scale by capping total annual emissions and letting the market assign a monetary value to any shortfall through trading. Credits can be exchanged between businesses or bought and sold in international markets at the prevailing market price. Credits can be used to finance carbon reduction schemes between trading partners and around the world.

There are also many companies that sell carbon credits to commercial and individual customers who are interested in lowering their carbon footprint on a voluntary basis. These carbon off-setters purchase the credits from an investment fund or a carbon development company that has aggregated the credits from individual projects. The quality of the credits is based in part on the validation process and sophistication of the fund or development company that acted as the sponsor to the carbon project.

Carbon credits create a market for reducing greenhouse emissions by giving a monetary value to the cost of polluting the air. Emissions become an internal cost of doing business and are visible on the balance sheet alongside raw materials and other liabilities or assets. The ultimate objective of regulating pollution through MBIs is improved environmental quality.

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