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Carbon trading

What Is Carbon Trading?

Carbon trading, a central component of environmental finance, is a market-based mechanism designed to reduce emissions of greenhouse gases, particularly carbon dioxide. It operates under the principle of putting a price on carbon pollution, thereby creating an economic incentive for companies and countries to decrease their carbon footprint. The most common form of carbon trading is a cap-and-trade system, where a governing body sets a limit, or "cap," on the total amount of specific emissions allowed over a period. This cap is then divided into tradable permits, known as allowances or carbon credits, which can be bought and sold among regulated entities.

History and Origin

The concept of carbon trading emerged from international efforts to address climate change. Its formal introduction on a global scale can be traced to the 1997 Kyoto Protocol, an international agreement under the United Nations Framework Convention on Climate Change. The Protocol established three "flexible mechanisms," including international emissions trading, which allowed countries with surplus emission units to sell them to countries exceeding their targets. This mechanism aimed to help countries meet their national targets more flexibly and cost-effectively.34,33,32,

Following the Kyoto Protocol, regional and national carbon trading schemes began to develop. A significant milestone was the launch of the European Union Emissions Trading System (EU ETS) in 2005.31, The EU ETS became the world's first major international emissions trading systems, covering a significant portion of the EU's greenhouse gas emissions from power generation, energy-intensive industries, and aviation.30 Its creation provided a blueprint for other jurisdictions considering similar market-based approaches to emissions reduction.

Key Takeaways

  • Carbon trading is a market-based approach designed to reduce greenhouse gas emissions by creating a financial incentive for emission reductions.
  • It typically involves a "cap-and-trade" system where a limit is set on total emissions, and tradable permits (allowances or carbon credits) are distributed.
  • The system aims to achieve emission reduction targets efficiently by allowing entities to buy or sell allowances based on their abatement costs.
  • Major carbon markets, such as the EU ETS and California's program, have demonstrated the viability and effectiveness of carbon trading in certain contexts.
  • Despite its potential, carbon trading faces criticisms related to price volatility, allocation fairness, and concerns about "greenwashing."

Interpreting the Carbon Trading

In a carbon trading system, the interpretation of the market price of an allowance reflects the perceived cost of emitting one unit of carbon dioxide equivalent. A higher price indicates a greater financial incentive for entities to reduce their emissions, as it becomes more expensive to pollute. Conversely, a lower price might suggest an oversupply of allowances or a lack of stringent caps, reducing the incentive for decarbonization efforts.

For regulated entities, interpreting the carbon price involves a cost-benefit analysis. If the cost of reducing emissions internally (e.g., by investing in cleaner technology or improving energy efficiency) is less than the market price of buying an allowance, the entity has a clear incentive to reduce its emissions. If internal reduction costs are higher, it becomes more economical to purchase allowances from the market. This dynamic encourages emission reductions where they are most cost-effective across the economy. The total number of allowances issued also serves as a direct indicator of the maximum allowed emissions, ensuring that environmental targets are met if the system is well-designed.

Hypothetical Example

Consider a hypothetical country, "Ecotopia," that implements a cap-and-trade system for its industrial sector to reduce carbon emissions. The government sets a cap of 1,000,000 tons of CO2 equivalent for the year and distributes 1,000,000 allowances, each representing one ton of CO2.

Two companies, "GreenTech Manufacturing" and "OldCo Industries," are part of this system. Each initially receives 100,000 allowances.

  • GreenTech Manufacturing has invested heavily in renewable energy and efficient processes. By the end of the year, it only emits 80,000 tons of CO2. It now has 20,000 surplus allowances.
  • OldCo Industries, with older equipment, emits 120,000 tons of CO2. It needs 20,000 additional allowances to cover its emissions beyond its initial allocation.

Instead of paying a penalty for exceeding the cap, OldCo can purchase allowances from GreenTech. If the market price for an allowance is $50, OldCo buys 20,000 allowances from GreenTech for $1,000,000. GreenTech profits from its emission reductions by selling its excess, while OldCo meets its compliance obligation. This carbon trading scenario illustrates how the system provides flexibility and incentivizes emission reductions.

Practical Applications

Carbon trading schemes are actively employed worldwide as a policy tool within environmental finance to mitigate climate change. They are primarily found in:

  • National and Regional Compliance markets: Governments establish mandatory systems, such as the European Union Emissions Trading System (EU ETS) which covers emissions from power and industrial plants across member states.29 Another prominent example is California's Cap-and-Trade Program, launched in 2012, which applies to approximately 80% of the state's greenhouse gas emissions.28,27,26 The Regional Greenhouse Gas Initiative (RGGI) in the northeastern and Mid-Atlantic United States is a similar program focused on the power sector.25,,24,23,22
  • Voluntary Carbon Markets: Beyond mandatory schemes, companies or individuals can voluntarily purchase carbon credits to offset their emissions, often as part of corporate social responsibility initiatives or "net-zero" targets. These credits typically come from projects that reduce or remove greenhouse gases from the atmosphere, such as reforestation or renewable energy development.21,20
  • Investment and Financial Products: Carbon allowances and credits are treated as a financial instrument and can be traded on exchanges, leading to the development of derivative products like futures and options. This allows market participants to manage price risk and gain exposure to carbon markets. The total revenue generated from carbon pricing instruments globally, including both carbon taxes and emissions trading systems, reached a record $104 billion in 2023, according to the World Bank.19,18

Limitations and Criticisms

While carbon trading is promoted as an efficient market-based mechanism for reducing emissions, it faces several limitations and criticisms:

  • Price Volatility and Low Prices: Carbon prices can be highly volatile, which can undermine the long-term investment signals needed for decarbonization. Critics also argue that prices have often been too low to drive significant behavioral change or incentivize costly abatement measures.17,16 Oversupply of allowances, sometimes due to economic downturns or initial over-allocation, can depress prices.15,14
  • Carbon Leakage: A concern is "carbon leakage," where industries might relocate production to regions with less stringent or no carbon regulations, shifting emissions rather than reducing them globally.13,12,11 Policies like the EU's Carbon Border Adjustment Mechanism (CBAM) are being developed to address this risk.10
  • Additionality and Quality of Offsets: In voluntary markets, and sometimes in compliance markets through offset programs, there are debates about the "additionality" of carbon credits. This refers to whether the emission reductions would have occurred even without the carbon finance. If a project would have happened anyway, the credit does not represent a true additional reduction.9,8 This can lead to concerns about "greenwashing," where companies claim emission reductions that aren't genuinely achieved.7,6
  • Fairness and Distributional Impacts: The initial allocation of allowances can raise questions of fairness. If allowances are given away for free, it can lead to windfall profits for polluting industries. The costs of carbon pricing can also disproportionately affect lower-income households if not mitigated by revenue recycling mechanisms.5,4 As highlighted by Global Witness, lack of robust quality controls and oversight in some voluntary carbon markets can allow companies to overstate climate actions.3

Carbon Trading vs. Carbon Tax

Carbon trading and carbon tax are both forms of carbon pricing, aiming to reduce greenhouse gases by attaching a cost to carbon emissions. However, their mechanisms differ significantly.

Carbon trading, typically implemented through a cap-and-trade system, directly limits the total amount of emissions allowed. The governing body sets a quantitative cap, and the market determines the price of carbon through the buying and selling of allowances. This provides certainty over emission reduction outcomes, as the total quantity of emissions is capped. However, the price of carbon can fluctuate based on market supply and demand dynamics, which may introduce price volatility.

In contrast, a carbon tax sets a direct price on carbon emissions, typically as a fixed fee per ton of CO2 emitted. The government determines the price, and regulated entities can emit as much as they are willing to pay for. This approach provides price certainty for businesses, allowing them to better plan for carbon costs. However, the exact emission reduction achieved is less certain, as it depends on how industries respond to the tax. While a carbon tax offers clear pricing, carbon trading offers a clear quantity limit. The International Monetary Fund (IMF) has suggested that a significant carbon price, such as $75 per ton by 2030, is needed to effectively meet climate challenges, whether achieved through a carbon tax or an equivalent carbon trading price signal.2,1

FAQs

What is the primary goal of carbon trading?

The primary goal of carbon trading is to reduce the overall emissions of greenhouse gases into the atmosphere. It aims to achieve this reduction in the most economically efficient way by creating a market where the right to emit carbon can be bought and sold, incentivizing polluters to lower their emissions.

How does a cap-and-trade system work in carbon trading?

In a cap-and-trade system, a government or regulatory body sets a "cap" on the total amount of pollutants that can be emitted. This cap is then divided into tradable permits, or allowances, each representing the right to emit one unit of the pollutant. Companies that reduce their emissions below their allocated allowances can sell their surplus to companies that find it more costly to reduce emissions, creating a market for these permits.

Are all carbon trading schemes mandatory?

No, not all carbon trading schemes are mandatory. While many significant schemes, like the European Union's Emissions trading systems or California's program, are mandatory compliance markets set by governments, there are also voluntary carbon markets. In these voluntary markets, companies or individuals choose to purchase carbon credits to offset their emissions, often as part of sustainability goals or corporate responsibility initiatives.