Emissions trading schemes: Meaning, Criticisms & Real-World Uses

What Is Emissions Trading Schemes?

Emissions trading schemes (ETS) are market-based environmental policy instruments designed to reduce greenhouse gas (GHG) emissions. Falling under the broader category of environmental finance, these schemes establish a total limit, or "cap," on the amount of specific pollutants that can be emitted by a group of regulated entities, such as industrial facilities or power plants. Within this cap, participants are allocated or can purchase allowances, each typically representing the right to emit one tonne of carbon dioxide equivalent (CO2e). Entities that reduce their emissions below their allocated allowances can sell their surplus allowances to those that find it more costly to reduce emissions, thereby creating a carbon market and providing economic incentives for emission reductions. Emissions trading schemes aim to achieve emission reduction targets efficiently by allowing the market to discover the most cost-effective ways to cut pollution.

History and Origin

The concept of emissions trading schemes gained significant international traction with the adoption of the Kyoto Protocol in 1997. As an international treaty extending the 1992 United Nations Framework Convention on Climate Change (UNFCCC), the Kyoto Protocol introduced three market-based mechanisms to help industrialized countries meet their greenhouse gas reduction targets, one of which was international emissions trading. This mechanism allowed countries with surplus "assigned amount units" (AAUs), representing permitted emissions not used, to sell them to countries exceeding their targets. This development essentially created a new commodity: emission reductions or removals.²⁰,¹⁹,¹⁸ The protocol provided a framework for countries to achieve their emission reduction targets flexibly, including through the trading of emission units.

The European Union Emissions Trading System (EU ETS), launched in 2005, became the world's first major international emissions trading scheme, covering a significant portion of the EU's greenhouse gas emissions.,¹⁷,¹⁶ This system, based on the "cap and trade" principle, served as a pioneering model for regional and national emissions trading schemes globally.

Key Takeaways

Emissions trading schemes (ETS) set a total cap on pollutant emissions and allow companies to trade emission allowances, fostering cost-effective reductions.
They create a market for pollution rights, where the price of allowances fluctuates based on supply and demand and the stringency of the cap.
ETS are a key component of climate policy, aiming to drive down greenhouse gas (GHG) emissions.
Many schemes also allow the use of offsets from projects outside the capped sectors, providing additional flexibility for compliance.
Successful implementation requires robust monitoring, reporting, and verification to ensure the integrity and effectiveness of the system.

Interpreting Emissions Trading Schemes

Emissions trading schemes are interpreted as a flexible and economically efficient way to achieve environmental goals. By putting a price on carbon, these schemes incentivize companies to reduce their carbon footprint. The price of an allowance in an ETS signals the cost of emitting one unit of a pollutant. A higher allowance price indicates either a stricter cap on emissions or strong demand for allowances, pushing companies to invest in cleaner technologies and operational efficiencies to avoid purchasing costly permits. Conversely, a lower price might suggest an oversupply of allowances or less stringent targets. The market price for carbon credits serves as a continuous feedback loop, reflecting the collective effort and cost of decarbonization within the regulated sectors. Effective compliance and rigorous enforcement are crucial for the integrity and real-world impact of emissions trading schemes.

Hypothetical Example

Consider a hypothetical emissions trading scheme implemented in "Industrialand," a country aiming to reduce its total annual CO2 emissions from major industries by 10% over five years. The government sets an initial cap of 100 million tonnes of CO2 per year and distributes 90 million allowances to participating companies, while auctioning the remaining 10 million. Each allowance grants the right to emit one tonne of CO2.

Company A, a large steel manufacturer, is allocated 5 million allowances. After implementing energy efficiency measures, it manages to reduce its emissions to 4.5 million tonnes. Company B, a cement producer, has difficulty reducing its emissions due to high costs and emits 5.2 million tonnes, exceeding its 5 million allowance allocation.

At the end of the year, Company A has a surplus of 0.5 million allowances. Company B needs to acquire 0.2 million additional allowances to cover its emissions. Company A can sell its surplus allowances to Company B on the carbon market. If the market price for an allowance is $30, Company A earns $15 million (0.5 million allowances * $30), rewarding its emission reduction efforts. Company B pays $6 million (0.2 million allowances * $30) to meet its compliance obligation. This interaction ensures the overall emissions target is met while allowing companies to find the most cost-effective path to compliance, influencing their future investment decisions in emission reduction technologies.

Practical Applications

Emissions trading schemes are a cornerstone of modern climate change mitigation strategies, found in various forms across the globe. They are primarily used to:

Reduce Industrial Emissions: Large industrial emitters, such as power plants, manufacturing facilities, and aviation, are often included in these schemes. The European Union Emissions Trading System (EU ETS) is a prominent example, covering over 11,000 installations across electricity generation, energy-intensive industries, and aviation within the EU, Iceland, Liechtenstein, and Norway.¹⁵,¹⁴
Drive Innovation and Investment: By creating a financial cost for emissions, ETS encourage companies to invest in cleaner technologies, renewable energy sources, and energy efficiency improvements to reduce their allowance needs.
Generate Revenue: Many ETS involve the auctioning of allowances, generating revenue for governments. This revenue can then be reinvested into further climate action, green infrastructure, or to mitigate the impact of carbon pricing on vulnerable populations.
Facilitate International Cooperation: The concept originated from international agreements like the Kyoto Protocol, and various schemes, such as the California Cap-and-Trade Program, have linked with those of other jurisdictions, like Quebec, to create larger, more liquid markets.¹³,¹² California's Cap-and-Trade Program is a key element of the state's strategy to reduce greenhouse gas emissions, applying to approximately 85% of its GHG emissions.¹¹,¹⁰ This program, implemented under the authority of the California Air Resources Board (CARB), complements other efforts to cost-effectively meet the state's ambitious emission reduction goals.⁹,⁸

These schemes serve as a vital regulatory framework within the broader scope of market-based mechanisms for environmental protection.

Limitations and Criticisms

Despite their widespread adoption, emissions trading schemes face several limitations and criticisms. One primary concern is the potential for price volatility in the carbon market. If allowance prices are too low, they may not provide a sufficient incentive for significant emission reductions or investment in clean technologies. Conversely, excessively high prices could lead to economic strain for industries.

Another significant criticism revolves around carbon leakage, where industries might relocate to regions with less stringent emission regulations to avoid compliance costs, potentially negating the environmental benefits. To counter this, some schemes include provisions like free allocation of allowances to certain sectors or border adjustment mechanisms.

There are also concerns about "greenwashing" and the integrity of carbon credits, particularly those generated through offsets from projects outside the direct cap. Critics argue that some offset projects may not represent genuine, additional emission reductions, leading to companies claiming "carbon neutrality" without sufficient efforts to reduce their own direct emissions. Regulatory bodies, such as the U.S. Commodity Futures Trading Commission (CFTC), have initiated investigations into false claims and misconduct in voluntary carbon markets, highlighting the need for enhanced oversight and standardization.⁷,⁶,⁵ This scrutiny is aimed at addressing instances where companies might rely too heavily on low-quality offsets rather than prioritizing actual emission reductions from their operations.⁴,³ Such practices can undermine public trust and the overall effectiveness of emissions trading schemes.²

Emissions Trading Schemes vs. Carbon Tax

Emissions trading schemes and a carbon tax are both market-based approaches to reducing greenhouse gas emissions, but they differ fundamentally in how they achieve this.

An emissions trading scheme, often referred to as a "cap and trade" system, sets a quantitative limit (the "cap") on the total amount of emissions allowed. The market then determines the price of carbon through the trading of allowances under this cap. This approach provides certainty regarding the maximum level of emissions, as the cap is a hard limit. However, the price of carbon (and thus the cost to businesses) can fluctuate based on market dynamics.

In contrast, a carbon tax sets a direct price on carbon emissions (e.g., $X per tonne of CO2). This approach provides certainty regarding the cost of emissions for businesses, allowing them to plan more predictably. However, the resulting level of emission reduction is not guaranteed; it depends on how industries respond to the fixed price signal. If the tax is too low, it might not incentivize significant changes, whereas a higher tax could lead to more substantial reductions.

While emissions trading schemes fix the quantity of emissions and let the price vary, a carbon tax fixes the price and lets the quantity of emissions vary. Both aim to internalize the external cost of pollution, but their mechanisms for achieving this differ.

FAQs

What is the primary goal of emissions trading schemes?

The primary goal of emissions trading schemes is to reduce overall pollutant emissions, particularly greenhouse gases, in a cost-effective manner by using market forces. They create a financial incentive for companies to lower their environmental impact.

How do allowances work in an emissions trading scheme?

Allowances are permits that grant the holder the right to emit a specific amount of a pollutant, usually one tonne of carbon dioxide equivalent. Companies either receive these allowances for free or purchase them. If a company emits less than its allocated allowances, it can sell the surplus. If it emits more, it must buy additional allowances to cover its excess emissions.

What is "cap and trade"?

"Cap and trade" is the most common form of an emissions trading scheme. A "cap" is the total limit set on emissions from covered entities. "Trade" refers to the ability of companies to buy and sell emission allowances within that cap, allowing for flexible and efficient emission reductions across the economy.

Are emissions trading schemes effective?

Many studies suggest that emissions trading schemes can be effective in reducing greenhouse gas emissions and encouraging investment in cleaner technologies. For example, the EU ETS has helped bring down emissions from European power and industry plants significantly compared to 2005 levels.¹ However, their effectiveness can depend on factors like the stringency of the cap, the price of allowances, and the presence of strong monitoring and enforcement mechanisms.

What is the difference between an allowance and a carbon credit?

In the context of an emissions trading scheme, an allowance is typically a permit issued by the regulating authority that allows the emission of a specific amount of a pollutant within the capped system. A carbon credit, often an offset, usually represents a verified reduction or removal of greenhouse gases from the atmosphere achieved by a project outside the direct scope of the ETS. While both can be traded in the broader carbon market, allowances are typically tied to the "cap" within a specific scheme, whereas credits often come from voluntary projects or separate mechanisms.