All 182 countries that have so far ratified the Kyoto Protocol (as of August 2008) may participate in this market. This includes all developed countries except for the United States.

Market Features and Rules

In 1997, more than 160 nations met in Kyoto, Japan to negotiate binding limitations on greenhouse gases (GHG) for the developed nations, in accordance with the objectives of the United Nations Framework Convention on Climate Change (UNFCCC) signed five years earlier. The outcome of the meeting was the Kyoto Protocol, in which the industrialized countries and economies in transition—the so-called Annex 1 countries—agreed to cut their overall GHG emissions during the first commitment period (2008-2012) by about 5% relative to the levels emitted in 1990 (the baseline year). National targets range from 8% reductions for the European Union and some others, 6% for Japan and Canada, 0% for Russia, and permitted increases of 8% for Australia and 10% for Iceland.

The six greenhouse gases (GHGs) included in the targets are carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride.

The Kyoto Protocol entered into force (i.e., became legally binding) on February 16, 2005, after signatories representing at least 55 countries and 55% of the world's total GHG emissions had ratified the agreement. The Kyoto Protocol's first commitment period runs from 2008 through 2012, and whether the signatories will meet the 5% global reduction target remains uncertain.

Countries can achieve their Kyoto targets by reducing GHG emissions in their own country; implementing projects to reduce emissions in other countries; or trading, whereby countries that have satisfied their Kyoto obligations can sell their excess carbon allowances to countries finding it more expensive to meet their targets.

Two separate "flexibility mechanisms" cover emissions-reducing projects under the Kyoto Protocol. The first is the Clean Development Mechanism (CDM), under which Annex 1 countries can earn emissions credits for certain types of projects initiated after the year 2000 in developing (Annex 2) countries. CDM projects earn credits called Certified Emissions Reductions, or CERs. The second is Joint Implementation (JI), which covers GHG emissions reduction projects that are implemented jointly between two or more developed (Annex 1) countries. JI projects generate credits called Emission Reduction Units, or ERUs.

Carbon Forestry Rules

Projects involving the establishment of carbon "sinks," or natural reservoirs for carbon dioxide such as trees, soil, and the ocean, are eligible for generating credits under the CDM or JI. However, such activities are limited to afforestation and reforestation on land that was not forested in 1990, per the terms of the "Land Use, Land Use Change and Forestry (LULUCF)" rubric of the Kyoto Protocol,

The use of LULUCF offsets is capped at 1% of base year emissions, meaning that for most countries these activities can account for, at most, about 1/5 of their required reductions (since Kyoto mandates a ~5% overall reduction in emissions). It should be noted that most projects (whether LULUCF or otherwise) will have to be initiated by 2006 if they are to earn credits for use within the Kyoto Protocol's first compliance period (2008-2012), given the lead time of 3-8 years before an average project begins to actually yield credits.

Sink projects can only earn credits for the net amount of carbon they sequester through afforestation or reforestation activities as compared to the baseline scenario (i.e., conditions that would have been present had the CDM project not taken place). This rule ensures that projects only generate CDM credits for the carbon benefits that are truly "additional." The ability to prove additionality is a key tenet required of project developers in order for their projects to receive approval from the CDM Executive Board.

The Kyoto Protocol addresses the impermanent nature of sinks through the issuance of two kinds of CDM carbon credits – temporary certified emissions reductions (tCERs) and long-term certified emission reductions (tCERs). Projects can choose to issue either tCERs, which must be reissued every five years, or lCERs, which have a 20-year life-span but which must be re-verified at five-year intervals to ensure the carbon stored by the project has not been released. Countries may only use TCERs to defer their emission reduction obligations, since eventually they must be replaced by credits from "permanent" reductions, such as those from energy efficiency, renewable energy, or fuel switching projects. It should be noted that the liability for re-emissions rests with the buyer (unless certain side contracts are done on a private basis).

To be eligible for CDM credit, projects must utilize rigorous baseline and monitoring methodologies that have been approved by the CDM Executive Board. Any project can submit a methodology for consideration or rely on relevant methodologies that have already been approved (see Related Links). Currently, eleven LULUCF methodologies have been approved by the UNFCCC, and all relate to afforestation or reforestation.

Small-scale forestry projects that are developed or implemented by low-income communities or individuals receive special treatment under the Kyoto Protocol. For example, simplified baselines and monitoring methodologies can be used, no adaptation tax is payable, and reduced registration and administration fees apply. To be eligible, projects must generate less than 8,000 tCO2-worth of carbon credits per year, which represents about 200 to 400 hectares for a typical forest project planting fast-growing species.

Market Participants

All developed countries and economies in transition, with the notable exception of the United States, have ratified the Kyoto Protocol. Each of these participating countries has or is in the process of establishing its own compliance mechanisms and trading schemes, such as the EU Emissions Trading Scheme (EU ETS), for meeting its Kyoto obligations cost-effectively. This has resulted in specific emissions caps being set for individual companies in the more carbon-intensive industries.

In addition, most of the world's developing countries have signed onto the Kyoto Protocol. These nations are, at this stage, mostly seeking to host CDM projects in order to capture the associated sustainable development benefits, such as technology transfer, funding for infrastructure development, and job creation.

Currently the largest investment pool focused on LULUCF projects is the World Bank's BioCarbon Fund, which invests in biosequestration projects around the globe. Investors include: Tokyo Electric Power Company, Okinawa Electric, and the nations of Canada, Italy, Luxemburg and Spain.

Market Activity: Value and Volume

According to the World Bank's State and Trends of the Carbon Market 2008 report, project-based transactions that generated Certified Emissions Reductions (CERs) and Emission Reduction Units (ERUs) experienced strong growth in 2007, accounting for 832 MtCO2e valued at $13.4 billion in 2007. This represents a 43% increase from the 578 MtCO2e transacted in CER and ERU contracts in 2006. The Primary CDM market transacted 551 MtCO2e valued at $7.4 billion in 2007. Some of these CDM credits were further sold into a burgeoning secondary market which traded 240 MtCO2e of secondary CDM credits, valued at $ 5.4 billion, in 2007. The CDM market as a whole accounted for 87% of volume and 91% of the value of the project-based offset market in 2007.

For Joint Implementation (JI) projects, a total of 41 MtCO2e valued at $499 million was transacted in 2007. Transactions in the JI market doubled, and values tripled between 2006 and 2007. Despite this noteworthy growth, the World Bank projects that potential CDM or JI credit sellers will increasingly look to the voluntary markets to sell their credits, as buyers in early 2008 "became more cautious in response to a combination of mounting delivery and issuance challenges, higher perceived credit risks amid the generally bearish sentiment in the financial markets."

Despite market volatility, prices remained potent. The average price of project-based CER was $13.60 per tCO2e for CERs (€9.90) in 2007. This represents a 24% increase from 2006 price levels. The average price for an ERU sold in 2007 was $12.20 per tCO2e (€8.90) in 2007, representing a 38% increase from 2006.

Forestry Credits Registered

In 2008, less than 1% of CDM credits were sourced via approved forestry or the broader Kyoto category defined as Land Use, Land Use Change and Forestry (LULUCF) methodologies, due to the complexities of permanence, leakage, measurement, and monitoring in forestry projects. However, an ever-growing number of sink projects is being developed with the intention of generating Kyoto-compliant credits. As of mid 2008, at least eleven projects were in the pipeline to become CDM forestry projects. Additionally, much talk at the Bali climate conference in December 2007 revolved around bringing avoided deforestation (also known as REDD, or Reduced Emissions from Deforestation and Degradation) activities into the scope of projects eligible to generate Kyoto credits soon. For now, the voluntary carbon markets are the home of avoided deforestation activities.