Carbon finance is a mechanism whereby parties hope to simultaneously reduce the total amount of greenhouse gases in the atmosphere, promote clean development in the Global South, and accomplish both in an efficient, market fashion.

Climate Change & Global Warming

Global warming is caused by increased concentration of greenhouse gases (GHGs) in the Earth’s atmosphere. These GHGs trap the heat from the sun – heat that then does not radiate heat back into space -- resulting in “warming” of the Earth’s atmosphere, also known as the greenhouse effect[[#_ftn1|[1]]]. “Climate Change” and “Global Warming” are terms that tend to be used referring to buildup of GHGs in the atmosphere. Experts believe the emission of man-made carbon dioxide – mainly from the extraction and burning of fossil fuels (oil, gas, coal, etc.) on an increasingly large scale to produce energy but also from other industries such as cement, lime, glass, metal extraction, pulp and paper – is the greatest contributor to the current global warming phenomenon.

As a result of man-made GHG increases the Earth’s surface temperature is expected to rise between 3 and 7 degrees Fahrenheit (0 F) by 2100, which is expected to cause a rise in sea levels as polar caps melt, subsequent submersion of coastal areas, increased rain resulting in flooding in some areas. Temperature changes may also provoke shifts in ocean currents, wind and rainfall that cause drought or desertification in other regions. All of these climatic changes will have consequences to arable lands, potable and agricultural water resources, the spread of diseases, and other impacts that will change human life, especially in developing countries.

Climate change is an increasingly critical issue. A European Commission working paper recently estimated that a worldwide cumulative damage totaling $74 trillion could be incurred if nothing is done to prevent climate change. Because GHG emissions are a global issue a unit of emission reductions in developing countries counts just the same as a unit of emissions reductions in industrialized countries. Through a notion of “trading” credits for saved emissions between countries (and industries) the possibility of international monetization of carbon benefits has emerged.

Carbon Monetization: a local opportunity

There are a variety of reasons to incorporate basic carbon benefit information in an energy enterprise proposal. Some of these reasons are current and clear – applying for CDM, VCS or Gold Standard approvals (described below), facilitating the sale of carbon benefits, seeking grants or loans from entities such as the Global Environment Facility, demonstrating a significant triple-bottom-line impact to a social investor. Other reasons are still to be determined, such as the value of a metric tonne of carbon dioxide equivalent after 2012 (also referred to as “post-Kyoto”).

Carbon benefits occur when a sustainable resource displaces an unsustainable one or a quantity of carbon is kept in place rather than being released, for example, through such adaptation techniques as “no-till” farming. If cow manure or poultry litter can be used to produce fuel that can be substituted for unsustainably cut fuel wood, every kilogram of firewood not burned could result in 1.5 kg of carbon dioxide equivalent avoided. Avoiding this unsustainable burning of fuel wood reduces the amount of carbon dioxide released into the atmosphere. Processes have been established to quantify such benefits, which can be sold to others who may have a need to demonstrate improvements in their impact on global climate. For example, an electricity utility in Japan may acquire credits produced by a small hydroelectricity project in Honduras; the benefit may help the utility meet its commitment to reducing carbon dioxide while helping the project in Honduras become financially viable.

[1] Another cause of global warming occurs when the ozone layer that surrounds the Earth and serves to deflect the heat from the sun becomes thin or depleted, in large part due to the emission of chlorofluorocarbons (CFCs) from industrial chemicals. The subsequent rise in the earth’s temperature is, in this case, caused by two different mechanisms: one by virtue of the fact that CFCs are greenhouse gases and the other by ozone depletion

The following is adapted from E+Carbon:

"A Carbon Finance Industry Brief for Energy Entrepreneurs"

The principles behind emissions trading are simple, but the process can be somewhat complicated. Under a basic emissions trading framework, polluters are issued permits corresponding with a reduced annual greenhouse gas emissions limit. If they emit less than this limit, they can sell their unused permits for additional income. On the other hand, if they find it too costly to reduce their emissions, emitters can purchase additional permits on an open market from other firms with a surplus. The price of these permits changes according to supply and demand.

Emissions trading systems usually include an “offset” component, which enables polluters to purchase permits from cleaner projects operating outside of their home trading system. The emissions saved from these cleaner projects offset emissions from polluters under the regulated emissions trading system. The chart to the right displays this relationship. Providing polluters with access to these offsets is the basic premise on which the global carbon finance industry is based.

In recent years, environmentally conscious companies and individuals who are not mandated to limit greenhouse gas emissions have begun voluntarily offsetting their emissions. A small but growing sub-sector within the carbon finance industry provides these environmentally conscious companies and individuals with access to voluntary offsets. Consequently, today we observe two carbon finance market categories: the compliance markets and the voluntary markets.

Compliance Markets

The Kyoto Protocol, a global treaty on climate change, was initiated in 1997 in Kyoto, Japan and became legally binding after Russia approved the treaty in 2004.
  • The treaty became legally enforceable on February 16, 2005.
  • It binds 35 industrialized countries to reduce their greenhouse gas emissions by levels that vary by nation according to their current emissions levels, forest stocks and other variables.
  • The aggregate emissions cuts will result in 5% reduction among these nations by 2012.
  • A total of 168 nations are signed onto the treaty, which is only binding for those industrialized countries listed in “Annex I”.[1]

The Clean Development Mechanism (CDM), a part of the Kyoto Protocol, allows countries to trade carbon permits corresponding with projects that decrease greenhouse gas emissions. The CDM allows developed nations to offset some of their emissions by purchasing certified emissions reductions (CERs) from projects in developing nations, where emissions abatement is sometimes cheaper. The CDM therefore offers participating nations flexible incentives to reduce emissions. While developing nations are not currently required to participate in the Kyoto Protocol, they can take part voluntarily under the CDM. [2]

Small projects are expensive under CDM

Overhead costs of small-scale CDM projects tend to be high. Since there is no emissions cap in developing countries, the project owner must prove that emissions reductions will occur from a planned clean energy project. This results in costly consulting fees needed to generate and certify emissions reductions permits through the CDM.[3] Lawmakers have simplified small-scale project procedures in an effort to make small projects more cost competitive, but these efforts have been inadequate to incorporate the smaller projects.
  • Studies suggest that under the CDM’s simplified project approval procedures, projects that abate less than 10,000 tons of CO2 equivalent per year are not economically viable.
  • Another matrix suggests that projects are only viable if transaction costs constitute less than 10% of total revenues from CER sales.[4]
  • Since projects have to abate less than 15,000 tons per year to qualify for the CDM’s simplified procedures, the current policy only allows projects abating between 10,000 and 15,000 tons per year, and in those circumstances, profit margins are narrow. In reality, the lower limit for which CDM projects no longer make financial sense varies between sectors, technology types and methodologies, and there is no set rule for a threshold below which it no longer makes financial sense to develop through the CDM.

Since Kyoto went into effect, trading volumes have increased significantly. Moreover, most CDM transactions have been limited to several nations and industrial sectors and the majority of CDM transactions involve projects in the chemical industry, while renewable energy accounts for only 13% of total CDM projects.

The price for Emissions Reduction Units (ERUs) in Europe has fluctuated dramatically since Kyoto went into force in 2005, from a low of around $1/ton to a high of over $40/ton. ERUs are the internal European emissions permits to which CERs are converted after the CDM approval process. The price for ERUs and CERs are correlated and very close, but not exactly the same due to regulatory risk under the CDM.

Voluntary Markets

Verified emissions reductions (VERs) are greenhouse gas emissions offsets that allow individuals and companies to neutralize their climate change contribution from electricity consumption or daily activities such as car or air travel. From the project owner perspective, voluntary markets offer a way for smaller projects to benefit from carbon finance since overhead costs tend to be lower and verification is faster than in compliance markets.

The voluntary carbon markets are an unregulated industry in which no universal standards exist. Buyers and sellers have recognized the need for standards, however, and a host of standards have emerged that help to promote healthy markets and convince potential buyers that VERs represent real emissions reductions. Well known standards include the Voluntary Gold Standard and the Voluntary Carbon Standard.

In spite of these standards, the voluntary carbon markets are young and undeveloped, making it challenging for market participants to determine critical details necessary to make informed decisions. Estimates of sale price vary significantly.
  • VERs have been sold in retail markets for as little as $1/ton to as much as $40/ton.
  • Corporate markets, where buyers are purchasing larger volumes, range from about $1/ton to $15/ton. [5]
  • A study performed by EcoSystem Marketplace and New Carbon Finance recently concluded that average sale price for VERs was $3.88 in 2006 . [6]

As in the compliance markets, it is important to consider contract terms in the context of VER prices since they can play a larger role in determining a project owner’s total revenues than the final sale price. While complete information on contract terms within the voluntary markets does not exist, several general patterns are clear.

  • Some carbon developers do not charge up front verification fees from project owners. This is often not the case under the CDM.
  • Carbon developers in voluntary markets are willing to consider forward contracts to fund future construction. This practice also occurs under the CDM, but is less common.
  • VER pricing structures and terms vary significantly.

Examining contracts in the compliance markets can act as a good benchmark with which to evaluate voluntary contracts since voluntary contracts are often based on trends and procedures established in the compliance markets.

[1] United Nations Framework Convention on Climate Change.
The negotiation of the Kyoto Protocol and its rulebook., accessed on April 3, 2007.
[2] The Kyoto Protocol to the United Nations Framework Convention on Climate Change. United Nations, Conference of Parties, 1998.
[3] Krupp, Fred. Grab the Green Brass Ring. Business Week, February 5, 2007.
[4] Realizing the Potential of Small-Scale CDM Projects in India. IT Power, November, 2004.
[5] The World Bank. State and Trends of the Carbon Markets 2007. Washington D.C., May, 2007. Can be downloaded at
[6] State of the Carbon Markets 2007: Picking Up Steam. EcoSystem Marketplace and New Carbon Finance. July, 2007.

Illustrative Proposal

Carbon Monetization for Household Biogas

Note: The following is an example of the impact of carbon benefits on transactions and how to prepare such an estimate. It is not meant to illustrate formal CDM, VCS or Gold Standard calculations It is intended to illustrate the potential of carbon benefits from a financial and proposal impact perspective.

Household biogas – pro-forma analysis – analysis of impact on customer cost. Based on saving 4 tonnes CO2e per year (= 1.5 times the annual tonnes of unsustainably harvested fuel wood + 2.5 times the annual consumption of kerosene replaced by biogas cooking and lighting, net of any losses).

Household Biogas Digester example costing 25,000
Monthly cost calculation
Case 2
Base Case
CO2e per year

Contract crediting period

Price per tonne

€1 =
(Local currency units)

Price per tonne

Discount rate

Crediting percentage

Capital cost

CO2e credit

Without CO2e credit
Net cost to household

Down payment percentage

Down payment amount

Base finance amount

Number of years

Service charge (one year “flat”)

Finance amount, including service charge

Payment/month/base case

Total payments

Finance amount

Service charge

Down payment

Grand total

Carbon benefit

Links to case studies:

1. La Esperanza - (Hydro facility, Honduras) one of the first small scale projects registered under the CDM. More project information available at:

2. Biogas Sector Partnership - (Program, Nepal) Also registered as a CDM. More project information available at and

3. Toyola Energy Ltd. - (Cookstove company, Ghana) Received a $40,000 advance on future carbon revenues to be sold in the voluntary market.

Glossary of Terms

Addionality: Emission reductions over and above the general trend or "Business as usual" scenario ; The extent to which an activity (and associated outputs, outcomes and impacts) is larger in scale, at a higher quality, takes place quicker, takes place at a different location, or takes place at all as a result of intervention. Additionality measures the net result, taking account of deadweight, leakage, displacement, substitution and economic multipliers.[1]
CERs: Certified emissions reductions, tons of CO2e reductions that are produced for the compliance (CDM) market, and regulated according to CDM standards and procedures
CO2e: carbon benefits are quoted in tonnes (metric) of carbon dioxide equivalent.
Compliance markets: offsets sold in countries that need to comply with their commitment under the Kyoto Protocol
With approval through the UN’s Clean Development Mechanism’s Executive Board (CDM EB)

Designated National Authority: The DNA is the official body representing the national government which takes part in the arrangement of CDM projects.
Designated Operational Entity: A Designated Operational Entity is an independent body accredited by the CDM Executive Board (EB) that either validates a project proposal and recommends it for registration by the CDM EB, or verifies the monitoring data and recommends to the CDM EB the amount of carbon credits that should be issued.
Registration: Refers to the entry of a particular, approved project into a database, this helps prevent double counting. Once a project is registered, offsets can be sold.
Stakeholder Consultation: A step in the carbon monetization process involving organizing and reporting on a local meeting of different stakeholders in which the project is explained and discussed. In the Gold Standard process, for example, there is one stakeholder consultation in the design phase and another in the validation phase. The purposes of these are to solicit input and concerns from various stakeholders as well as assess whether those concerns have been properly handled.
Validation: Based on the Project Design Document (PDD), the Designated Operational Entity (DOE) will evaluate the proposed project, confirming:
1 – Parties are voluntarily participating
2 – Stakeholders have been invited to comment
3 – Project participants have submitted documentation on environmental impacts to the DOE
4 – The project will result in greenhouse gas reductions that are additional
5 – A methodology has been adopted in accordance with CDM rules
6 – Provisions for monitoring, verification and reporting are in accordance with CDM rules
7 – The project complies with all other CDM rules

Verification: Projects are monitored or verified after having been approved and registered. Periodic checks are made to make sure that real emissions reductions have taken place. Offsets are issued based on the verification reports.
VERs: Voluntary emissions reductions, tons of CO2e reductions that are traded the voluntary market; there are various types of procedures for producing VERs
Voluntary Markets: offsets sold to individuals and companies who want to offset their climate change impact voluntarily
With approval through voluntary standard, such as Gold Standard or Voluntary Carbon Standard

[1] Scottish Enterprise (2007) Scottish enterprise economic impact assessment, version 1.0

Sample Working Documents:

The following are sample emissions reduction purchase agreement templates produced by the World Bank. WB_CER_ERPA_07_07_06_model.doc & WB_VER_ERPA_4_18_06_model.DOC

The originals were downloaded here:
and here:

Thumbnail slides

(courtesy of E+Carbon)