What Is Emission trading?
Emission trading is a market-based mechanism designed to reduce pollution, specifically greenhouse gas emissions, by providing economic incentives for companies to decrease their environmental impact. As a core instrument within environmental policy and a form of financial regulation, it operates under the "cap and trade" principle. In an emission trading system, a governing body sets a limit, or "cap," on the total amount of specific pollutants that can be emitted by a group of facilities or industries. This cap is typically reduced over time, ensuring a gradual decrease in overall emissions. Companies are issued or can purchase allowances, each representing the right to emit one unit of the pollutant (e.g., one metric ton of carbon dioxide equivalent). Firms that reduce their emissions below their allocated allowances can sell their surplus carbon credits to other companies that find it more costly to reduce their own emissions. This creates a financial market for emission allowances, where the price is determined by supply and demand, incentivizing innovation and investment in cleaner technologies.
History and Origin
The concept of emission trading emerged from the idea of using market forces to address environmental challenges, rather than solely relying on command-and-control regulations. Its theoretical roots can be traced to economist Ronald Coase's work on property rights and externalities. The first major international implementation of an emission trading system was established under the Kyoto Protocol, an international treaty adopted in 1997 aimed at combating climate change. The Protocol, which entered into force in 2005, introduced flexible mechanisms, including international emissions trading, allowing industrialized countries to meet their emission reduction targets.6 This landmark agreement laid the groundwork for regional and national emission trading schemes around the world, adapting the "cap and trade" framework to suit specific economic and environmental contexts.
Key Takeaways
- Emission trading is a market-based mechanism designed to reduce greenhouse gas emissions by setting a limit on total emissions and allowing companies to trade emission allowances.
- It creates a financial incentive for companies to reduce their pollution, as they can sell surplus allowances if they emit less than their cap.
- The system operates on the "cap and trade" principle, where a declining cap ensures overall emission reductions over time.
- Major emission trading systems exist globally, including in the European Union and parts of the United States.
- The price of emission allowances is determined by market forces, reflecting the cost of pollution.
Interpreting Emission trading
Interpreting an emission trading system involves understanding how the "cap and trade" mechanism influences corporate behavior and broader economic activity. The effectiveness of an emission trading scheme is often judged by its ability to drive down the cost of emission reductions across various sectors, promoting market efficiency. When the price of an allowance is sufficiently high, it signals to polluters that emitting greenhouse gas has a tangible cost, thereby encouraging investments in abatement technologies or shifts to cleaner operations. Conversely, a very low price might indicate that the cap is not stringent enough or that the supply of allowances exceeds demand, potentially undermining the system's environmental goals. Participants in these markets, from industrial facilities to financial traders, continually assess the allowance price and its trajectory, making strategic decisions about their production methods, energy sources, and allowance portfolios. The success of emission trading is therefore linked to its capacity to create a robust and predictable carbon price signal.
Hypothetical Example
Consider "GreenCo," a manufacturing firm operating within a hypothetical emission trading system. The regulatory authority sets an annual cap on carbon dioxide emissions for all covered entities, with each allowance representing one metric ton of CO2. For the current compliance period, GreenCo is allocated 100,000 allowances.
In year one, GreenCo's operations emit 95,000 metric tons of CO2. Since they emitted less than their allocated allowances, they have a surplus of 5,000 allowances. Meanwhile, "PolluteCorp," another entity in the same system, emitted 105,000 metric tons but was only allocated 100,000 allowances. PolluteCorp needs to acquire 5,000 additional allowances to meet its compliance obligation.
GreenCo can sell its 5,000 surplus allowances to PolluteCorp on the open market. If the market price for an allowance is $30, GreenCo earns $150,000 from the sale. This revenue provides a direct economic incentive for GreenCo to continue investing in emission reduction technologies. For PolluteCorp, purchasing allowances is a cost, motivating them to explore ways to reduce their emissions in future periods to avoid these expenses.
Practical Applications
Emission trading systems are a cornerstone of many jurisdictions' efforts to mitigate climate change and achieve emission reduction targets. One of the most prominent examples is the European Union Emissions Trading System (EU ETS). Established in 2005, it is the world's first and largest international carbon market, covering power generation, energy-intensive industries, and aviation within the EU, Iceland, Liechtenstein, and Norway.5 It has been instrumental in driving down emissions from covered sectors within the EU by approximately 47% compared to 2005 levels.4
Another significant application is the California Cap-and-Trade Program, implemented by the California Air Resources Board (CARB). Launched in 2013, this program is one of the largest multi-sectoral emissions trading systems globally, covering about 85% of California's greenhouse gas emissions.3 It complements other state policies, such as renewable energy mandates, to achieve ambitious climate goals. These systems demonstrate how emissions trading can be applied at regional and sub-national levels to create market-based solutions for environmental regulation and to foster investment in cleaner technologies like renewable energy.
Limitations and Criticisms
Despite their widespread adoption, emission trading systems face several limitations and criticisms. A primary concern is that the effectiveness of emission trading hinges on the "cap" being set at an appropriately stringent level to genuinely drive down emissions. If the cap is too high or if too many free allowances are distributed, the price of allowances may remain low, reducing the economic incentive for significant emission reductions.2 This can lead to a less impactful outcome than intended.
Another criticism relates to market volatility. The price of allowances can fluctuate significantly due to changes in economic conditions, policy updates, or even speculative trading, which can create uncertainty for businesses trying to plan long-term investments in decarbonization. Critics also point to the potential for "carbon leakage," where industries might relocate to regions with less stringent emission regulations to avoid compliance costs, potentially shifting emissions rather than reducing them globally. Furthermore, some argue that relying on market mechanisms for essential environmental protection commoditizes the right to pollute and may not adequately address environmental justice concerns in vulnerable communities. The International Monetary Fund (IMF) has noted that while carbon pricing, including through emissions trading, is essential for accelerating decarbonization, its implementation can be politically challenging and may not generate sufficient revenue for global green transition without complementary measures.1
Emission trading vs. Carbon tax
Emission trading and a carbon tax are both market-based mechanisms aimed at reducing greenhouse gas emissions, but they achieve this through different approaches to pricing and quantity control. The core distinction lies in what is fixed and what fluctuates.
In an emission trading system (cap and trade), the total quantity of emissions (the "cap") is fixed by the regulator, and the price of allowances is determined by the market through supply and demand. This provides certainty over the total amount of emissions, as the cap directly limits the quantity. However, the exact cost of emissions for businesses can vary based on market fluctuations.
Conversely, a carbon tax fixes the price of carbon emissions (e.g., $50 per metric ton of CO2), and the market then determines the resulting quantity of emissions. Companies know precisely how much they will pay for each unit of greenhouse gas they emit, which offers cost certainty. However, the total emission reduction achieved is not guaranteed and depends on how responsive companies are to the tax. While both mechanisms internalize the cost of pollution, emission trading directly controls the environmental outcome by setting a hard limit, whereas a carbon tax controls the economic incentive by setting a fixed price.
FAQs
What is the primary goal of emission trading?
The primary goal of emission trading is to reduce the overall amount of specific pollutants, like greenhouse gases, released into the atmosphere by setting a limit on total emissions and creating a market for the right to pollute. This incentivizes companies to find cost-effective ways to reduce their emissions.
How do companies obtain emission allowances?
Companies typically obtain emission allowances through a mix of free allocation by the regulator and purchasing them in auctions or on secondary markets. The mix often depends on the specific design of the cap and trade system and the sector involved.
What happens if a company emits more than its allowances?
If a company emits more pollutants than the allowances it holds, it must acquire additional allowances from the market to cover its excess emissions. Failure to do so typically results in significant fines and penalties imposed by the regulatory authority.
Is emission trading effective in reducing emissions?
Emission trading has proven effective in many jurisdictions, such as the European Union and California, in reducing greenhouse gas emissions within covered sectors. Its effectiveness largely depends on the stringency of the emissions cap, the stability of the market for allowances, and the robustness of enforcement.
How does emission trading contribute to economic development?
Emission trading can contribute to economic development by encouraging investment in cleaner technologies and renewable energy sources. The revenues generated from auctioning allowances can also be used by governments to fund green initiatives, support innovation, or provide transitional assistance to affected industries and communities.