One of the less discussed and least used features of the Kyoto Protocol is the tradability of the Assigned Amount Unit or AAU. This is the instrument that national governments use for compliance and it functions in pretty much the same way as allowances do in a cap-and-trade system. If a Kyoto signatory country emitted 500 million tonnes CO2e in 1990 and agreed to a 10% reduction, then the UNFCCC would grant that country 5*(500-50)=2250 million AAUs for the period 2008-2012. The country can of course emit whatever it wants, so long as it can surrender sufficient AAUs or related units such as CERs from the CDM. The AAU is backed by a certain set of definitions that establish the measurement and reporting protocols for the emissions they represent.

One option open to a country is to buy from or sell AAUs to another country, depending on its overall position, i.e. in surplus or deficit. But the AAU can also transfer through other means. The EU-ETS is underpinned by the AAU, such that if an EU allowance was bought by a participant in a linked ETS, say the upcoming Australian system, then an AAU would quietly make its way from the EU account to the Australian one on the International Transaction Log (ITL) to keep everyone whole at the international level. Of course there is only one AAU backed ETS today and nobody is linked to it, so none of this has actually happened yet, but the principal is important to the long term goal of building a global carbon market.

Bangkok talks

I am in Bangkok this week at another round of UNFCCC talks in the lead-up to Copenhagen and one issue that has suddenly leapt out of the dark is the often ignored AAU. The US delegation has made the point that as they are not a signatory to the Kyoto Protocol and don’t intend to be, the AAU will not feature in the US view of a future agreement. By contrast, the Kyoto signatories whose (future) emissions trading systems are built around the AAU see this as the undermining of their hopes for a growing market. Other nations simply saw it as a brazen US attempt to tear up the Kyoto Protocol and said so in no uncertain terms – so the negotiations go on!

Despite this, the US delegation made it clear that they see linking to the EU-ETS (and others) as an important goal for the future. I for one can’t see this happening whilst the AAU is still part of the system, or at least part of some of the system. The problem is that there are a finite number of AAUs that represent the cap on those countries with targets on the basis of a certain measurement protocol. Typically, a national emissions trading system (cap-and-trade) is a cascade down into the economy of the AAU, but with a name change and revised legal definition on the way such that trading rules can be crafted for particular national circumstances. Nevertheless, there remains a one-to-one alignment between the two. When two trading systems are linked the AAUs move back and forth as described above. But if a US system were to link, trade between the two would be very limited. Certainly EU allowances could flow to the USA as this would be the same as retiring AAUs from that part of the system and just lowering the defined cap. But US allowances couldn’t flow back as this would bring unknown allowances into the system, raising the cap by the same amount. The exception would be if the US registry had a bank of AAUs from previous trades from the EU or if both recognised the same project mechanism and the US had a bank of these instead – but once the bank ran out that would be it, no more trade.

There are probably constructions around this, such as special recognition of US allowances (given that their cap is known and presumably agreed), but perversely the US is then effectively recognising AAUs within its system, which it didn’t want to do at the outset. The systems would also have to adopt the same definitions throughout, such that allowance arbitrage did not take place, which means that any change in the US system (and vice versa) at any point in time would have to be internationally ratified, which isn’t that different to recognising AAUs in the first place. The sensible thing to do is to back all the national targets with a single underpinning currency but this looks impossible from the discourse in Bangkok – for the US it would mean recognising some aspect of the Kyoto Protocol, which it just can’t do or for the Kyoto countries it would mean dismantling the Protocol, which is a non-starter for most participants.

A further casualty of an AAU free agreement could be a cap-and-trade approach for sectors such as shipping and aviation. The approaches described in my previous posting both rely on a carbon currency exisiting in the international agreement. The units are used as the basic building block of the shipping approach.

So, is the notion of a future global carbon market under threat? Perhaps not, but it will be quite a bit more difficult getting there given the current sentiment. The irony of the situation is that apparently some time back in 1997 it was the US delegation that invented the AAU in the first place!!!