What it means
The Kyoto Protocol was agreed in Kyoto, Japan, in 1997 and came into force in 2005. It required participating developed countries to cut their greenhouse gas emissions, on average, to about 5% below 1990 levels over the period 2008 to 2012.
Countries then passed those limits down to industries through national rules and trading schemes. To help meet targets at lower cost, the agreement introduced market mechanisms.
Emissions trading let countries with spare allowances sell them to those that were over their limit. The Clean Development Mechanism allowed developed countries to earn credits by funding emission-reducing projects in developing countries, and Joint Implementation did the same between developed countries.
For companies, the practical effect was the creation of a price for carbon. A business that emits more than it is allowed must buy extra allowances or credits, which shows up as a real cost, while a business that emits less may be able to sell its surplus.
Finance teams therefore started to forecast carbon costs, account for allowances and consider emissions when appraising investments. The accounting is not always straightforward.
Allowances can be treated as intangible assets or inventory, and the obligation to surrender them can be a liability, depending on the reporting framework and the facts. Companies should follow their local standards and take advice from their auditors.
The original Kyoto commitments have since been followed by later agreements, but the carbon market ideas it introduced remain widely used. Many of today's emissions trading systems and voluntary carbon credit markets trace their roots to the principles set at Kyoto.
Critics pointed out that the original targets did not cover every large emitter, and some countries chose not to take on binding commitments. Supporters replied that the agreement still proved that international carbon pricing could work in practice.
For a manager, the useful lesson is that climate policy tends to arrive as a cost or a trading market, so it is worth watching early.
In practice
Real-world examples.
Example
A European steel producer finds that it has used more allowances than it received for the year. The treasury team buys the shortfall on the carbon market and includes the cost in its quarterly forecast.
Example
A utility company in an emerging economy builds a wind farm and sells the resulting emission credits to a buyer in a developed country. The credit income improves the project's expected return.
Example
A consumer goods group adds an internal carbon price of $30 per tonne when comparing investment proposals. A project that cuts emissions but costs slightly more upfront now wins, because the carbon saving is counted as a benefit.
Formula
Calculation
Emissions allowance = base emissions x (1 - required reduction %)
Cost of shortfall = (actual emissions - allowance) x price per tonne
Worked example (a Kyoto-style cap applied to one company): a factory had base emissions of 2,000,000 tonnes of carbon dioxide equivalent and must cut 5%. This year it emits 1,950,000 tonnes, and allowances cost $20 per tonne.
Step 1: Allowance = 2,000,000 x (1 - 0.05) = 2,000,000 x 0.95 = 1,900,000 tonnes.
Step 2: Shortfall = 1,950,000 - 1,900,000 = 50,000 tonnes.
Step 3: Cost = 50,000 x $20 = $1,000,000.
The factory must buy 50,000 tonnes of allowances at a cost of $1,000,000, or invest in cutting emissions further if that costs less than $20 per tonne.Case study
Seen in the real world.
Northgate Ceramics is a fictional manufacturer of tiles with two kilns that burn natural gas. When a national cap-and-trade scheme inspired by the Kyoto framework began, the finance director was asked to estimate the impact on the next five years of profit.
She found that the kilns would be about 8% over the company's free allowance, which meant buying credits every year. Replacing one kiln with a more efficient model would cost $3 million but would eliminate most of the shortfall.
In this illustrative story, the company compared the kiln cost against several years of avoided credit purchases and decided to upgrade. The decision turned an unwelcome regulation into a measurable investment case.
Watch out
Common mistakes.
- Believing the Kyoto Protocol set targets for every country, when its binding targets applied mainly to developed countries.
- Treating carbon credits as free, when they can be a significant and volatile cost for emitters.
- Assuming Kyoto is only about government policy, when its market mechanisms directly affect company budgets and investment decisions.
Questions
People also ask.
What is the Kyoto Protocol?
It is an international treaty adopted in 1997 that committed developed countries to reduce greenhouse gas emissions and introduced carbon trading mechanisms.
What is a carbon credit?
It is a tradable certificate that represents the reduction or removal of one tonne of carbon dioxide equivalent.
Does Kyoto affect businesses that are not large emitters?
It can, because suppliers, lenders and customers may pass on carbon costs or ask for emissions reporting.
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