Carbon Trading

Carbon trading is an administrative approach to controlling greenhouse gas emissions. It aims to provide economic incentives to companies to reduce emissions. It is also referred to as emissions trading and cap-and-trade.

Carbon trading has received mixed responses from the public, as well as the policy community, and there is a certain degree of skepticism that an economic tool will be able to transform heavy polluters into environmental champions.

In practice, a central authority (usually a governmental body, but some voluntary schemes are managed by private entities) sets a limit or cap on the amount of greenhouse gas emissions (expressed as a carbon dioxide [CO2] equivalent) that can be emitted. Companies covered by a cap-and-trade carbon trading scheme are issued emission allowances and are required to hold an equivalent number of allowances (or credits) that represent the right to emit a specific amount of pollutant. In practice, the unit is one metric ton of CO2 equivalents in United Nations and European Union schemes, and one short ton in the U.S. scheme Regional Greenhouse Gas Initiative (RGGI).

The total amount of allowances and credits cannot exceed the cap, limiting total emissions to that level. Entities that emit more than their allocated total of allowances must buy allowances or credits from those who emit less than the amount they were allocated. In effect, the buyer is paying for emitting CO2, while the seller is being rewarded for having reduced emissions by more than was needed. Thus, in theory, companies that can reduce their emissions most affordably will do so, creating a virtuous dynamic where actors are rewarded for emission reductions.

In particular, five essential elements must be thoroughly defined in order for a carbon trading scheme to be environmentally, economically, and socially effective:

• Defining a scope (a cap and a commitment period)
• Allocating allowances
• Managing the price volatility
• Monitoring, reporting, and tracking allowances on a registry
• Reconciling emissions with allowances and setting penalties for noncompliance

[Page 60]The definition of the scope is based on several parameters, including geographical coverage, temporal range, and the gases covered. Demand for allowances will depend on the severity of the cap, but also on the level of actual emissions from companies included in the scheme. If the reduction target is small, demand for allowances will be weak. Similarly, if companies are able to significantly reduce their emissions, thus remaining within their cap, then demand for allowances will again be weak and prices will remain low to moderate. This can occur either because of the use of mitigation technologies, such as improving energy efficiency, or because of a fall in production during an economic downturn.

The commitment period is the time period for attaining emissions reductions. If the benefits of emissions trading are to be realized, the system must balance predictability in its shape and rules, and have the flexibility to take advantage of changing circumstances. A long commitment period, with banking and borrowing of emissions credits between periods, can provide greater certainty and reduce policy risk.

The creation of a new emission market requires property rights to be identified and allocated where there previously were none. There are two main allocation approaches: selling the rights to pollute, that is, allowances; or giving them away. Free allocation involves giving pollution rights away free of charge under some predefined rule. The most common method of allocation is “grandfathering,” where allowances are allocated on the basis of prior use. This allocation method is usually strongly advocated by polluters as it recognizes their implicit right to use the environment as they always have, albeit now under the constraint of a cap. In a free allocation process, the allocation is political and is, therefore, influenced by various forms of lobbying and can be very laborious. It also often results in overallocation.

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