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Emissions trading scheme

What Is an Emissions Trading Scheme?

An emissions trading scheme (ETS) is a market-based mechanism designed to reduce pollution by providing economic incentives for achieving reductions in the emissions of pollutants. It falls under the broader umbrella of environmental finance, a field that integrates financial principles to address environmental challenges. At its core, an ETS operates on a "cap-and-trade" principle. A governing body sets a limit, or "cap," on the total amount of specific pollutants that can be emitted by industries or sectors covered by the scheme. This cap is typically reduced over time to encourage progressively lower emissions. Within this cap, pollution permits, often called carbon credits or allowances, are created and distributed to participating entities. These allowances represent the right to emit a certain amount of a greenhouse gas (GHG), such as carbon dioxide.

History and Origin

The concept of emissions trading gained prominence as a tool for environmental regulation in the late 20th century, particularly after the adoption of international agreements aimed at combating climate change. Its roots can be traced to the idea of using market forces to achieve environmental goals, rather than relying solely on command-and-control regulations. The Kyoto Protocol, adopted in 1997, provided an international framework that allowed for emissions trading among signatory countries, laying crucial groundwork for national and regional schemes.9, 10

One of the most significant and pioneering examples is the European Union Emissions Trading System (EU ETS). Launched in 2005, the EU ETS was the world's first large-scale cap and trade system for greenhouse gas emissions.8 Its establishment marked a major step in the EU's environmental policy, designed to meet its emissions reduction targets. The system initially covered emissions from power stations and energy-intensive industrial installations across EU member states.7 Over time, the EU ETS has undergone several phases of development, with adjustments made to the cap, scope, and allocation methods of allowances to enhance its effectiveness.6

Key Takeaways

  • An emissions trading scheme (ETS) sets a total limit (cap) on emissions and allows entities to trade permits (allowances) to emit.
  • The primary goal is to reduce overall pollution in a cost-effective manner, driven by market mechanisms.
  • Entities that reduce emissions below their allocated allowances can sell surplus allowances, creating an economic incentive for abatement.
  • Conversely, entities that exceed their allowances must purchase additional permits, creating a cost for polluting.
  • The system facilitates price discovery for emissions, guiding investment towards cleaner technologies and practices.

Interpreting the Emissions Trading Scheme

An emissions trading scheme effectively puts a price on pollution, transforming environmental externalities into a tradable commodity. The interpretation of an ETS revolves around the allowance price, which is determined by the forces of supply and demand within the market. When allowances are scarce or demand for them is high (e.g., during periods of economic growth leading to increased industrial output), their price tends to rise. A higher allowance price provides a stronger incentive for companies to invest in emission reduction technologies, improve energy efficiency, or switch to cleaner fuels, as it becomes more expensive to pollute.

Conversely, an oversupply of allowances or reduced demand (e.g., during economic downturns or due to successful abatement efforts) can lead to lower allowance prices. While lower prices reduce the immediate cost burden on businesses, they can also diminish the incentive to invest in long-term emission reductions. Regulators often adjust the cap over time to ensure the market remains effective in driving down overall emissions, aiming for a balance that promotes innovation without unduly hindering economic activity.

Hypothetical Example

Consider a hypothetical country, "Greenland," that implements an emissions trading scheme for its manufacturing sector. Greenland's environmental agency sets an annual cap of 10 million tons of carbon dioxide equivalent (CO2e) for all participating factories. The agency distributes 10 million allowances, with each allowance permitting the emission of one ton of CO2e.

Factory A, a modern facility, has implemented several measures to reduce its carbon footprint. In a given year, Factory A is allocated 100,000 allowances but only emits 80,000 tons of CO2e. This leaves Factory A with 20,000 surplus allowances.

Factory B, an older facility, struggles to meet its emissions target. It is allocated 100,000 allowances but emits 120,000 tons of CO2e. Factory B now needs to acquire an additional 20,000 allowances to comply with the scheme.

Factory A can sell its 20,000 surplus allowances to Factory B on the emissions market. If the market price for an allowance is $50, Factory A earns $1,000,000 ($50 x 20,000) by selling its excess, providing a direct financial instrument benefit for its eco-friendly efforts. Factory B pays $1,000,000 to cover its excess emissions, making it more expensive for them to pollute and encouraging future investment in abatement technologies, such as upgrading to use renewable energy.

Practical Applications

Emissions trading schemes are primarily applied as a regulatory tool within environmental governance, particularly for addressing climate change and air pollution. They are central to the strategy of many governments and regional blocs to meet their emission reduction commitments.

Key applications include:

  • Carbon Markets: The most prominent application is in carbon markets, where the pollutants traded are greenhouse gases. The EU Emissions Trading System (EU ETS) is the largest and oldest example, covering emissions from power generation, heavy industry, and aviation within participating European countries.4, 5 Other significant carbon ETSs include those in California and Quebec (linked), the Regional Greenhouse Gas Initiative (RGGI) in the northeastern United States, and systems in China, South Korea, and New Zealand.
  • Compliance Mechanisms: Companies operating in sectors covered by an ETS must participate in the compliance market. They are legally obligated to hold enough allowances to cover their emissions, or face significant penalties. This creates a direct incentive for industrial entities to monitor and reduce their environmental impact.
  • Encouraging Green Investment: The pricing signal from an ETS encourages the flow of investment capital into cleaner production methods, energy efficiency improvements, and the development of low-carbon technologies. When the cost of emitting increases, the financial viability of green alternatives improves.
  • Interoperability and Linkage: Some ETSs are linked, allowing allowances to be traded between different jurisdictions. This expands the market, potentially leading to greater liquidity and more cost-effective emissions reductions across a broader area. The EU ETS, for example, is linked with the Swiss ETS.3

The EU ETS has proven to be a significant policy instrument for reducing greenhouse gas emissions.2

Limitations and Criticisms

While emissions trading schemes are widely adopted, they face several limitations and criticisms:

  • Price Volatility: The market price of allowances can be highly volatile, influenced by economic conditions, policy changes, and speculative trading. High volatility can create regulatory risk and uncertainty for businesses, making long-term investment decisions in abatement technologies more challenging. For instance, the EU carbon market experienced significant uncertainty following landmark policy deals. [Reuters]
  • Over-allocation: In some early phases of ETSs, notably the EU ETS's first phase (2005-2007), an initial over-allocation of allowances led to a surplus and a collapse in prices.1 This reduced the effectiveness of the scheme as an incentive for emissions reduction. While adjustments have been made to address this, careful calibration of the cap is crucial for the scheme's efficacy.
  • Distributional Impacts: The initial allocation of allowances, whether through free allocation (grandfathering) or auctioning, can have significant distributional impacts on industries and consumers. Concerns have been raised about potential competitive disadvantages for certain sectors or regions, and the possibility of "carbon leakage" where emissions-intensive industries relocate to jurisdictions with less stringent environmental regulations.
  • Market Manipulation and Speculation: Like any commodity market, emissions markets can be subject to speculation and potential manipulation, which could distort price signals and undermine environmental goals.
  • Effectiveness and Additionality: Critics sometimes question whether an ETS truly leads to "additional" emissions reductions beyond what would have occurred naturally or through other policies. There are debates over the ideal stringency of the cap and the overall impact compared to other policy instruments. Some analysis suggests that challenges like oversupply in the early phases of the EU ETS limited its effectiveness in promoting behavioral change. [IMF]

Emissions trading scheme vs. Carbon tax

An emissions trading scheme and a carbon tax are both market-based mechanisms aimed at reducing greenhouse gas emissions, but they differ fundamentally in how they achieve this.

FeatureEmissions Trading Scheme (ETS)Carbon Tax
Price vs. QuantitySets a quantity limit (cap) on emissions, price variesSets a price on emissions, quantity varies
PredictabilityEmission reductions are predictable; cost is variableCost of emissions is predictable; reductions are variable
Market CreationCreates a new market for tradable emission allowancesApplies a direct tax per unit of emission
Revenue UseRevenue from allowance sales (auctioning) can be used for various purposes or returned to taxpayersRevenue directly collected as tax, can be hypothecated or used for general revenue
ComplexityCan be more complex to design, implement, and adjust (e.g., managing allowance supply)Simpler to implement, but setting the "right" tax level can be challenging

The primary distinction lies in whether the policy directly controls the quantity of emissions or the price of emissions. An ETS provides certainty on the amount of pollution reduction but allows the cost to fluctuate with market dynamics. A carbon tax provides certainty on the cost of emissions for businesses but the resulting level of emission reduction is not guaranteed and depends on how responsive polluters are to the tax. Both systems aim to internalize the external cost of pollution, making polluting activities more expensive and incentivizing cleaner alternatives.

FAQs

What is the main goal of an emissions trading scheme?

The main goal of an emissions trading scheme is to reduce the overall amount of specific pollutants, like greenhouse gases, released into the atmosphere by putting a limit on total emissions and creating a market for the right to pollute. This incentivizes companies to find the most cost-effective ways to reduce their own emissions.

How do companies participate in an ETS?

Companies covered by an ETS receive or purchase emission allowances. They must surrender enough allowances to cover their actual emissions for a given period. If a company emits less than its allocated allowances, it can sell the surplus. If it emits more, it must buy additional allowances from other companies or through auctions to meet its compliance obligation. This trading mechanism drives the overall economic incentive to reduce a company's carbon footprint.

Are emissions trading schemes effective?

The effectiveness of an emissions trading scheme depends on its design, particularly the stringency of the emissions cap. When the cap is set sufficiently low and progressively reduced, and the market is well-regulated, an ETS can be a powerful tool for achieving significant and cost-effective emissions reductions. The EU ETS, despite initial challenges, has been credited with driving substantial cuts in emissions in participating sectors.

How is the price of an emissions allowance determined?

The price of an emissions allowance is determined by the forces of supply and demand in the market created by the scheme. The supply is set by the total cap on emissions and the allocation of allowances. Demand is driven by the emissions levels of participating companies and their need to acquire allowances for compliance. External factors like economic growth, energy prices, and the availability of abatement technologies also influence allowance prices.