Emissions Trading

What is emissions trading?

Emissions trading is essentially a market-based cap-and-trade system where a cap on the limit of emissions is set and emitters buy the right to emit in the form of permits where each permit is usually equal to one tonne of CO2 equivalent. The overall cap and with it the overall number of tradable permits decreases every year by a fixed percentage to gradually drive up the cost of fossil fuels and incentivise emitters to utilise cleaner technology to emit less. Allowing permits to be traded allows flexibility in terms of how and where pollution is reduced and allows the market to put a price on pollution; the price per permit is the cost of emitting one tonne of CO2-eq. 

The figure below depicts the working principle. Companies with high abatement costs deem it more economical to purchase permits from companies - typically those with low abatement costs - than to actually procure new machines.

Principle of cap and trade

Who is subject to an emissions trading system?

That answer can vary from ETS to ETS depending on the dynamics of the economy that is being covered under the ETS. The EU or California sees most of its greenhouse gas emissions stem from the fossil fuel industry whereas, in New Zealand, nearly half of its greenhouse gas emissions stem from the sectors of agriculture, land use and land use change. So for the EU, it would make sense to subject the users or producers of fossil fuels to the ETS whereas in New Zealand it might be well worth it to cover the agricultural sector along with the users or producers of fossil fuels.

Do ETSs work?

For instance, the world’s largest ETS, the EU ETS which has been in force since 2005 is set to achieve an emission reduction of 21% in 2020 compared to 2005 levels and 43% in 2030 in the sectors covered. The California Cap and Trade program, in existence since 2013, is expected to achieve emission reduction of 16% from regulated sectors between 2013 and 2020 and an additional 40% by 2030. There are currently several national and state ETSs in operation around the world with several more under consideration. The map below shows the current state of emissions trading around the world.

World ETS map

With reference to the above figure, areas in green are those where functioning ETS’s are already in place, areas in dull green are those where ETS’s are scheduled to be implemented and regions in grey are those where the implementation of an ETS is being considered.

What are the drawbacks of the cap and trade?

As with any system, cap and trade has its share of drawbacks. Similar to what happened in the EU ETS, setting too high an emission cap will lead to very low permit prices. To combat this, permits can temporarily be withheld from circulation in a process that is known as backloading. Another issue with cap and trade is the price uncertainty. Since the market determines the price through supply and demand, it is impossible to know how low or high the price of permits might go. To resolve this, a price floor and a price ceiling can be set to bring in some degree of predictability.

Conclusion

Emissions trading is an economic instrument to reduce carbon emissions by compelling the primary emitters of greenhouse gases to purchase permits for every tonne of CO2-eq emitted. It allows flexibility as to who reduces emissions and how emissions are reduced. The decreasing number of permits on a yearly basis decreases the supply and drives up the demand, thereby also driving up the price of carbon permits, which in turn favours the usage of clean technology. National governments have found success with ETS and several new ETSs are set to come into force in the coming years.