What Is an Emissions Trading System?
An emissions trading system (ETS) is a market-based environmental policy tool designed to reduce specific pollutants, most commonly greenhouse gases, by placing a limit, or "cap," on the total amount that can be emitted. As a core component of market-based environmental policies, an ETS operates on the principle of "cap-and-trade," where a governing body sets an aggregate limit on emissions for regulated entities. This limit decreases over time, ensuring a targeted reduction in pollution. Within this cap, permits, often referred to as allowances or carbon credits, are issued, each representing the right to emit one unit of the pollutant (e.g., one metric ton of carbon dioxide equivalent). These allowances can be bought, sold, or traded among entities, creating a market mechanism that incentivizes pollution reduction.
History and Origin
The concept of emissions trading emerged from economic theory advocating for market-based solutions to address environmental externalities. The idea gained prominence in the late 20th century as policymakers sought more flexible and cost-effective alternatives to traditional "command-and-control" environmental regulation. The first major international emissions trading system for greenhouse gases, the European Union Emissions Trading System (EU ETS), was established in 2005. Its origins can be traced back to discussions following the 1997 Kyoto Protocol, which set legally binding emissions reduction targets for industrialized countries. The EU ETS was a pioneering effort to create a continent-wide carbon market, initially covering CO2 emissions from power and heat generation and energy-intensive industrial sectors.16,15,14,13 This system became a cornerstone of the EU's climate policy, designed to achieve ambitious climate change mitigation goals.12
Key Takeaways
- An emissions trading system (ETS) sets a total limit (cap) on specific pollutants, which declines over time.
- It operates as a "cap-and-trade" system, where permits (allowances) to emit are tradable among regulated entities.
- The market for allowances creates economic incentives for businesses to reduce emissions where it is most cost-effective.
- Entities that reduce emissions below their allocated allowances can sell their surplus, while those needing more can purchase them.
- The EU ETS, launched in 2005, was the world's first major international emissions trading system.11
Interpreting the Emissions Trading System
An emissions trading system aims to achieve environmental targets, such as reducing overall greenhouse gas emissions, with greater market efficiency than traditional regulatory approaches. The system provides a price signal for carbon, reflecting the cost of emitting pollutants. Businesses constantly evaluate the cost of reducing their own emissions versus purchasing allowances from the market. If a company can reduce emissions for less than the market price of an allowance, it has an incentive to do so and sell its excess allowances. Conversely, if abatement costs are high, it may find it more economical to buy allowances. This flexibility helps ensure that emission reductions occur where they are least expensive, leading to overall lower compliance costs for the economy.
Hypothetical Example
Imagine a country establishes an emissions trading system to reduce carbon dioxide emissions from its industrial sector. The government sets an initial cap of 100 million metric tons of CO2 for all covered facilities. It then distributes 100 million allowances, with one allowance permitting the emission of one metric ton of CO2.
Company A is allocated 10,000 allowances but, through investments in renewable energy and process improvements, manages to reduce its emissions to 8,000 metric tons. It now has 2,000 surplus allowances. Company B, facing higher costs for emission reductions, emits 12,000 metric tons but was only allocated 10,000 allowances.
Under the emissions trading system, Company A can sell its 2,000 surplus allowances to Company B. This transaction benefits both companies: Company A profits from its emission reductions, and Company B meets its compliance obligations without incurring prohibitively high internal abatement costs. The overall cap of 100 million metric tons is still met, demonstrating how the market facilitates efficient pollution control.
Practical Applications
Emissions trading systems are widely applied as a key instrument in environmental and climate policy frameworks globally. They are predominantly used to manage greenhouse gas emissions, forming the backbone of carbon pricing initiatives in various jurisdictions. Beyond the EU ETS, other notable examples include California's Cap-and-Trade Program in the United States, which covers approximately 80% of the state's greenhouse gas emissions from major sources.10,9 This program is managed by the California Air Resources Board and is a central element of California's strategy to meet ambitious climate targets.8,7 Such systems provide a clear price signal for emitting fossil fuels and other pollutants, encouraging businesses to invest in cleaner technologies and practices. They also appear in other contexts, such as regional efforts to control sulfur dioxide or nitrogen oxide emissions, demonstrating their versatility as a tool for pollution reduction across various sectors and pollutants.
Limitations and Criticisms
While emissions trading systems offer a flexible and cost-effective approach to environmental protection, they are not without limitations and criticisms. One significant challenge relates to price volatility. Unlike a carbon tax, which offers price certainty, the price of allowances in an ETS fluctuates based on supply and demand dynamics within the market. This can lead to periods of low allowance prices that may not provide sufficient incentive for long-term investments in emission reduction technologies, or excessively high prices that could disproportionately impact certain industries.6 Critics also point to the complexity of initial allowance allocation, the potential for market manipulation, and the risk of "carbon leakage"—where industries relocate to regions with less stringent environmental regulations to avoid compliance costs. Furthermore, the effectiveness of an emissions trading system heavily depends on the stringency of its cap and the robustness of its monitoring, reporting, and verification mechanisms. Some argue that political influence can lead to an over-allocation of allowances, undermining the system's environmental integrity, as was observed in the early phases of the EU ETS.,
5## Emissions Trading System vs. Carbon Tax
An emissions trading system (ETS) and a carbon tax are both market-based approaches to carbon pricing, aiming to reduce greenhouse gas emissions by making pollution more expensive. The fundamental difference lies in what each instrument primarily controls: an ETS directly sets the total quantity of emissions allowed (the cap), with the price of emissions determined by the market, whereas a carbon tax sets a fixed price on emissions, with the quantity of emissions determined by how emitters respond to that price. A4n ETS provides certainty over the environmental outcome (the amount of emissions reduced), but the price can be volatile. Conversely, a carbon tax provides price certainty but offers less assurance about the exact quantity of emissions that will be reduced., 3T2he choice between an emissions trading system and a carbon tax often depends on policy priorities—whether certainty in emission reductions or price stability is deemed more crucial.
FAQs
What is the primary goal of an emissions trading system?
The primary goal of an emissions trading system is to reduce the total amount of specific pollutants, such as greenhouse gases, emitted into the atmosphere by setting a firm limit (cap) on overall emissions and allowing market forces to determine the most cost-effective way to achieve that reduction.
How do companies comply with an ETS?
Companies comply with an ETS by ensuring they hold enough allowances to cover their actual emissions for a given period. They can achieve this by reducing their own emissions, purchasing additional allowances from other entities in the market, or a combination of both.
Can an emissions trading system generate revenue?
Yes, an emissions trading system can generate revenue, especially if allowances are auctioned rather than freely allocated. The revenue collected from the sale of allowances can be used by governments for various purposes, such as investing in clean technologies, funding other environmental programs, or providing tax relief or rebates.
##1# What are "allowances" in an ETS?
In an ETS, "allowances" (also known as emission permits or carbon credits) are tradable units that represent the right to emit a specific quantity of a pollutant, typically one metric ton of carbon dioxide equivalent. These allowances are the currency of the trading system, allowing companies to buy and sell the right to pollute.
Is an emissions trading system a form of tax?
While both an emissions trading system and a carbon tax put a price on carbon, an ETS is not a direct tax. Instead of a fixed tax rate, an ETS creates a market where the price of emitting pollutants is determined by the supply and demand for emission allowances.