How do emissions trading systems work?

11 June, 2018

Emissions trading, also known as ‘cap and trade’, is a cost-effective way of reducing greenhouse gas emissions. To incentivise firms to reduce their emissions, a government sets a cap on the maximum level of emissions and creates permits, or allowances, for each unit of emissions allowed under the cap. Emitting firms must obtain and surrender a permit for each unit of their emissions. They can obtain permits from the government or through trading with other firms. The government may choose to give the permits away for free or to auction them.

Firms that expect not to have enough permits must either cut back on their emissions or buy permits from another firm. For a given permit price, some firms will find it easier, or cheaper, to reduce emissions than others and will sell permits. If there are too many such firms in the market, the price of permits, the total number of which is set in advance by the cap, will decline, inducing some firms to reduce their emissions reduction efforts. Only when the price of permits is just right will the number of permits offered for sale by firms that can reduce emissions at low cost be equal to the number of permits demanded by firms for which emissions reductions are costly. This process of trading ensures there is a unique price for all firms coordinating their activities and drives down emissions to the level allowed under the cap cost-effectively.

Of course, there is no reason to expect that a permit price that clears the market at a point in time will continue to do so in the future. As economic conditions and emitting firms’ circumstances change, permit prices will fluctuate, becoming more expensive when demand is high relative to supply (for example when the economy is growing robustly) and cheaper when demand is lower (for example when ample renewable electricity reduces the requirement for thermal generation firms).

The origins of cap-and-trade programmes to control pollution date back to the 1980s and 90s when they were successfully used in the United States to phase out lead in petrol and to reduce sulphur dioxide and nitrous oxide emissions to combat acid rain.

What role does emissions trading play in reducing climate change?

Emissions trading is widely considered a key part of efforts to reduce the manmade greenhouse gas emissions that are causing climate change. The setting of caps is informed by scientific evidence of the emissions cuts needed to limit climate change, including meeting the Paris Agreement target of keeping temperature rise well below 2°C this century. For example, the European Union describes its emissions trading system – the world’s largest – as ‘a cornerstone’ of its climate change policy. It attributes past success in reducing emissions to the system and predicts that in 2020 emissions from the sectors it covers will be 21% lower than in 2005. Research has also shown that the EU emissions trading system has helped to drive innovation in low-carbon technologies such as renewable power sources and energy efficiency, one of the original objectives of the system. Increased use of these technologies also helps to reduce greenhouse gas emissions.

Does emissions trading impact negatively on the economy?

One criticism is that participating firms could lose out to firms lying outside the scheme that are not subject to the regulations, whose costs are lower. However, research has found, in the case of the EU ETS at least, very little evidence for negative economic impacts.

Which countries have emissions trading systems?

As mentioned above, the European Union emissions trading system, or EU ETS, is currently the world’s largest system. It operates in all 28 EU countries plus Iceland, Liechtenstein and Norway, limiting emissions from more than 11,000 heavy users of energy including power stations and industrial plants, and airlines operating between the ETS member countries. In total, it covers around 45% of the EU’s greenhouse gas emissions. Under the third phase of the ETS, which runs from 2013–20, a single, centralised cap covering the whole EU was set. This cap will be reduced by at least 1.74% each year up to 2020, and by 2.2% a year from 2021 onwards under Phase 4 reforms, in order to achieve further emissions reductions, at an increased pace.

The World Bank’s State and Trends of Carbon Pricing (May 2018) reports that there are 51 implemented or scheduled carbon pricing initiatives worldwide. These include ETSs in Switzerland, South Korea, New Zealand and several US states and Canadian provinces, as well as national-level carbon taxes. The International Carbon Action Partnership (ICAP) estimates that emissions trading now covers 15% of global emissions.

China officially launched a major national emissions trading scheme in December 2017 after piloting seven schemes at local government level. It plans to introduce the national scheme first to the energy sector, with full implementation by 2020, to become the largest ETS in the world. The scheme has been lauded for its scale and ambition, which could mean that China’s emissions start to decrease before 2030.