This paper provides an assessment of the potential for smallholder agroforestry projects to be competitive in markets for carbon emission reduction credits, and explores the ways in which smallholder participation in such markets may be facilitated. The paper begins with an overview of the issue of global warming and the role of carbon sinks in mitigating climate change. Then an economic model of the carbon emission reduction (CER) market is presented, which includes the impact of transactions costs. An in-depth survey of the economic literature on transactions costs and their implications in the design of markets for CER follows. An assessment of the emission abatement and transaction costs likely to be associated with smallholder agroforestry projects is presented, based on case study information from Latin America and Indonesia. The paper concludes with policy recommendations on how to design carbon sequestration projects to benefit smallholders and suggests institutional reforms that will be necessary for reducing the transactions costs associated with smallholder participation in the market. The paper also includes a detailed annex with information on carbon sequestration projects involving smallholders that are already under implementation.