The earth’s climate is the ultimate example of a global commons—a shared resource vital to survival for all the earth’s inhabitants. Human actions that degrade it therefore present a set of notoriously difficult environmental problems.

Because the problems are urgent, reducing human greenhouse-gas emissions will require creativity and widespread action. We will need to change the way we do business: how we generate energy, propel our vehicles, and clean up our countless other greenhouse-gas-intensive activities.

But climate change also presents us with an unusual opportunity: since all that ultimately matters is the concentration of greenhouse gases in the whole atmosphere, it doesn’t matter where on the globe those emissions occur. So reductions in emissions anywhere are good for people everywhere. Enter the possibility of carbon finance, a key element of the Kyoto Protocol.

The Kyoto Protocol is an important stimulant of change, and carbon finance is its most powerful tool. The Kyoto Protocol sets clear limits on the amount of greenhouse gas a country can emit. However, instead of simply forcing nations to meet inflexible emission targets, carbon finance establishes the necessary market structures to trade the right to emit a unit of greenhouse gas as a commodity: countries can exceed their cap by purchasing permits from other countries, under rules described below.

This “cap-and-trade” system encourages innovative nations to conserve more than is strictly prescribed, since every unit conserved now has value for nations that are slower to adapt. Experts expect that almost half of the emissions reductions mandated under the Kyoto Protocol will be achieved through trading. Already, carbon trading is a multi-billion-dollar business. With the Kyoto Protocol having come into force in February 2005 and the European Commission having put in place an EU-wide trading scheme in January 2005, the market for emission reductions has rapidly expanded, with the sale of emissions reductions from developing countries reaching over $22 billion in the first nine months of 2006.

How far we as a global community want to limit emissions is determined by the cap, but our ability to meet those limits will in large part be determined by the ability to trade under the cap. In the abstract, the core ideas behind carbon finance are as simple as supply and demand, but the mechanistic reality of these increasingly important trading schemes hinges on a few particular details.

On February 16, 2005, the Kyoto Protocol came into force: its purpose is to reduce the amount of greenhouse gas emitted in the course of human economic activity. Developed nations and economies in transition, referred to as “Annex 1” nations, are required to adhere to an annual limit on the total amount of greenhouse-gas emissions. These nations must reduce their emissions to an average of five percent below their 1990 levels by 2012. Developing nations that are signatories to the Kyoto Protocol (Non–Annex 1) do not have a cap, but they must produce an annual emissions inventory.

Annex 1 countries may attain their emissions reductions through three means. First, they may make direct reductions in emissions within their borders. Second, under “Joint Implementation,” they may purchase surplus reductions from another Annex 1 nation that reduced its emissions below its set cap. The surplus reductions are then available as tradable emission credits on a market exchange. Finally, under the “Clean Development Mechanism” (CDM), they may purchase reduced emissions from a Non–Annex 1 nation.

The CDM enables us to take advantage of opportunities for low-cost abatement in developing nations (when compared to the cost in richer countries) and gains from trade on both sides. Non–Annex 1 nations, though they are not yet subject to caps on their own emissions, can agree to sell any emissions reductions to an Annex 1 country. These reductions are achieved through substituting high-carbon-emission projects (the baseline) with more environmentally friendly projects. The crucial stipulation in the CDM is that the greener projects would not have been possible without the purchase of the certified emissions credits (proof must be supplied). In other words, if a hydroelectric power plant was already planned before applying for CDM involvement, no emissions reductions would be granted from not building a hypothetical coal power plant. A third-party auditor verifies the emissions reductions. The non–Annex 1 nation then notes its reduction in its annual, audited emissions inventory and the Annex 1 nation augments its Kyoto emissions allotment by the amount of Certified Emission Reductions it purchased.

For these complex trading schemes to work efficiently, the market requires experienced facilitators to broker the trades and rigorously analyze potential emission-reduction strategies. One pioneering international broker is the Carbon Finance Unit at the World Bank. As an organization whose mission is poverty alleviation and sustainable development, the World Bank is committed as a leader in combating climate change. Climate change has the potential to devastate the poorest nations and undermine economic-development gains. Carbon-finance operations in the World Bank have grown from $180 million in the original Prototype Carbon Fund (fully capitalized in 2000) to activities that now involve capital of over $1.9 billion. Nine carbon funds and facilities created by 13 governments and 73 private companies are involved.

World Bank staff identify projects based on their emissions-reductions potential. For example, if a coal-fired power plant is on the books to be built next year, World Bank staff would flag it as a possible project. If the energy could be generated through wind farms instead, less carbon would go into the atmosphere. But a wind farm will undoubtedly be more expensive, and the technology might be unproved in that nation. To alter the business-as-usual baseline, the World Bank brings in financing and technical support, originating from buyers seeking to purchase reduction credits.

Annex 1 nations and companies who expect to exceed their carbon allotments contact the Carbon Finance Unit. Brokered by this unit, the buyer signs an emissions-reduction purchase agreement with the entity that agreed to implement the more environmentally friendly technology. Sometimes this is a nation, but often it is a private partner. This agreement stipulates the conditions: how many tons of carbon emissions are expected to be avoided, how much the buyer will pay, what the monitoring arrangements are, and so forth. In this way, capital from Annex 1 parties is invested in clean-energy technology, sustainable agriculture, and forestry in return for income in the developing nation from sales of greenhouse-gas emissions reductions.

Importantly, by limiting its financial commitment to a quarter of the purchase agreement, the World Bank leverages financing from private investors and banks who otherwise might shy away from carbon-finance projects due to the risk. The primary focus of the World Bank’s work in carbon finance in the period between 1997 and 2005 has been to create demand by building confidence in the market. In this period, carbon finance in the World Bank expanded from a prototype engagement in an emerging trade of emission reductions to an increasingly mainstream World Bank activity that directly supports the sustainable-development goals.

The World Bank’s carbon funds strive for technological and regional diversity; its project pipeline includes 190 projects with an estimated carbon-asset value of more than 2.2 billion tons carbon equivalent as of August 31, 2006. Fifty-seven projects have active, signed emission-reductions purchase agreements totaling $1.2 billion. The technological diversity includes a major emission-reduction contract with China for HFC-23 destruction, landfill gas recovery in Mexico, energy efficiency, renewable energy development (such as wind, hydro, geothermal, sugar cane and other biomass, and biogas generation), and reforestation. In terms of geographic distribution of the portfolio, East Asia, particularly China, accounts for about three fourths of the total value of the carbon finance, but numerous projects are scattered around Latin America and the Caribbean region, Eastern Europe and Central Asia, as well as Africa.

Both inside and outside the World Bank there is recognition that carbon finance can be a powerful new tool for financing sustainable development and an important asset to help reduce greenhouse-gas emissions. Successful projects range from the expected renewable-energy development such as wind farms to less obvious capture of methane emissions from landfills or energy-efficiency schemes in water-supply networks. Carbon financing is attainable for many levels of projects—from individual energy generators interested in new technology to municipalities trying to improve solid waste management to nations implementing energy-efficiency policies. The possibilities are promising and expanding. Already, developing nations are successfully participating in the emerging carbon market, achieving both developmental and environmental goals.