How Does Emission Trading Work?

As the world deals with the growing challenge of climate change, innovative and effective strategies are essential for reducing greenhouse gas emissions and mitigating their impact on the planet. Among these strategies, emissions trading schemes (ETS) have emerged as a leading approach, offering both environmental responsibility and economic efficiency. 

By turning emissions into a tradable commodity, ETS not only incentivizes companies to innovate and reduce their carbon footprint but also plays a pivotal role in shaping a sustainable future. This market-based mechanism is helping nations and businesses to balance economic growth with environmental stewardship.

👉 In this article, we explore how emissions trading schemes work, their benefits, and challenges.

Emissions trading

Emissions trading, commonly referred to as a cap-and-trade system, is a market-based approach to tackling emissions by providing economic incentives for achieving reductions in the emissions of pollutants. Emissions trading schemes (ETS) involve setting a limit or cap on the amount of a certain pollutant that can be emitted. This cap is typically lower than the total amount that would be emitted under 'business as usual' scenarios, thereby ensuring a net reduction in emissions.

What’s the history of emissions trading?

The concept of emissions trading emerged during the late 20th century through a series of economic studies. The idea was first proposed by economists as a more efficient and cost-effective alternative to traditional ‘command-and-control’ regulation. The concept became a reality during the 1990s with the introduction of the U.S. Clean Air Act Amendments of 1990, and emissions trading emerged as a practical tool for reducing pollution. This act introduced a sulfur dioxide (SO2) trading system to tackle acid rain, marking the first large-scale emission trading scheme.

Cap and trade  

The basic principles of an emissions trading system are straightforward yet effective. The government - or a regulatory authority - begins by setting a cap on the total amount of a particular pollutant that can be emitted. This cap is then translated into emission allowances, with each allowance representing a right to emit a certain amount of the pollutant. These allowances can be allocated or auctioned to organizations that emit the pollutant.

Once the allowances are distributed, companies can trade them amongst themselves. A company that manages to reduce its emissions can sell its excess allowances to another that is struggling to reduce its emissions. This trading mechanism creates a financial incentive for companies to innovate and reduce their emissions: the less they emit, the more allowances they can sell, resulting in economic gain.

The effectiveness of the cap-and-trade system lies in its flexibility. Instead of prescribing a specific technology or method for reducing emissions, it allows companies to choose the most cost-effective way to meet their targets. This not only ensures environmental goals are met but also encourages innovation and efficiency. As the cap is gradually lowered over time, the overall level of emissions falls, leading to a cleaner environment.

The emissions trading system operates through a well-structured process involving the allocation of allowances, the trading of these allowances, and rigorous monitoring for compliance. Let’s take a closer look at how each aspect functions within the framework of emissions trading:

Allocation of allowances

The first step in emissions trading is the allocation of emission allowances by the governing authority. These allowances represent the right to emit a specific amount of pollutants and their total number is strictly controlled to ensure it remains under the predetermined cap. There are two primary methods for allocating these allowances: free allocation and auctioning.

• Free allocation: Companies receive allowances based on historical emissions or other criteria. This method is often used to reduce economic shock for industries that are heavy polluters and to ease the transition into the cap-and-trade system.
• Auctioning: In this method, companies bid for allowances in an auction. Auctioning is increasingly preferred because it reduces the risk of over-allocation, can generate government revenue, and ensures a fair and transparent distribution process.

Trading process

Once allowances are allocated, a market for trading them is established. Companies that reduce their emissions below their allowance can sell their excess allowances to other companies that are exceeding their emissions cap. This creates a financial incentive for companies to innovate and invest in cleaner technologies, as reducing emissions becomes an economic advantage.

The trading can occur in secondary markets, similar to stock exchanges, where allowances are bought and sold. The price of allowances is determined by market forces - ie. supply and demand. If the demand for allowances exceeds the supply, the price increases, incentivizing companies to cut emissions further.

Monitoring compliance

Ensuring compliance is an important part of the emissions trading system. Companies are required to monitor and report their emissions, and at the end of each compliance period, they must surrender allowances equal to their emissions. Failure to comply usually results in substantial penalties, which will normally be higher than the cost of complying.

The role of government and regulatory authorities

Government and regulatory authorities play an important role in setting the cap, allocating allowances, overseeing the trading process, and ensuring compliance. They are responsible for creating and maintaining a transparent, efficient, and fair market for emissions trading.

Emissions trading schemes (ETS) have been adopted in various forms around the world, tailored to meet the specific environmental and economic needs of a particular region. Alongside the European Union Emissions Trading System (EU ETS), several other systems have gained prominence. Let’s take a closer look at these trading schemes: 

The European Union Emissions Trading Scheme (EU ETS)

Perhaps the most prominent example of a successful emissions trading system is the European Union Emissions Trading System (EU ETS) which was launched in 2005. It is the largest international system for trading greenhouse gas emission allowances and covers more than 10,000 power stations and industrial plants across the EU. 

The EU ETS successfully demonstrates the effectiveness of emissions trading in reducing greenhouse gas emissions, having achieved significant reductions since its inception - the system is estimated to have reduced emissions in impacted sectors by around 35% between its inception in 2005 and 2021. 

The EU ETS functions by capping the total amount of certain greenhouse gases that can be emitted by installations covered by the system and allows trading among them. The cap is reduced over time so that total emissions fall. The EU ETS has helped drive investment in sustainable energy and technology solutions across Europe, highlighting how emissions trading can be used as a tool for achieving environmental objectives.

👉 Learn more about the EU ETS in our article. 

The US Regional Greenhouse Gas Initiative (RGGI) 

The Regional Greenhouse Gas Initiative (RGGI), is a cooperative effort among several U.S. states, including Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, and Vermont.

Launched in 2009, RGGI is the first mandatory market-based program in the United States to reduce greenhouse gas emissions. RGGI sets a cap on CO2 emissions from the power sector and allows electricity generators to trade emission allowances. The proceeds from these auctions are reinvested into energy efficiency and renewable energy programs, providing both environmental and economic benefits to participating states. 

The RGGI has been successful in reducing emissions while demonstrating that cap-and-trade schemes can complement a region's economic development goals. Participating states have seen fossil fuel emissions fall 90% faster than any other states in the country! 

The California Cap-and-Trade program

The California Cap-and-Trade Program, a part of the California Global Warming Solutions Act (AB 32), is another significant emissions trading scheme. Launched in 2012, it aims to reduce greenhouse gas emissions from major industries in California by setting a cap that decreases over time. This program includes a diverse range of entities, from power plants to industrial facilities, and even includes emissions from vehicle fuels. 

The California program is notable for its strict emission verification requirements and for linking with other carbon markets, such as the Quebec ETS in Canada, to broaden the environmental impact and market liquidity.

The UK Emissions Trading Scheme (UK ETS)

The United Kingdom has its own emissions trading scheme, known as the UK Emissions Trading Scheme (UK ETS). The UK ETS was established following the UK's exit from the European Union, which meant it also left the European Union Emissions Trading System (EU ETS).

The UK ETS was launched on January 1, 2021, and it mirrors many aspects of the EU ETS. It aims to reduce greenhouse gas emissions by setting a cap on the total amount of certain greenhouse gases that can be emitted by installations covered by the scheme. This cap will decrease over time, thereby reducing the total emissions.

The scheme covers energy-intensive industries, the power generation sector, and aviation. Like the EU ETS, the UK ETS operates on a "cap-and-trade" principle, where a limit is set on the total amount of certain greenhouse gases that can be emitted by the sectors covered by the system. Companies receive or buy emission allowances, which they can trade with one another. The system is designed to encourage cost-effective carbon reduction, incentivizing companies to innovate and invest in cleaner technologies.

👉 To understand more about the UK ETS head over to our article. 

Emissions trading schemes (ETS) offer several significant advantages, particularly in their cost-effectiveness, encouragement of innovation, and flexibility for businesses. These benefits have made ETS a preferred tool in environmental policy for addressing climate change and reducing greenhouse gas emissions.

Cost-effectiveness in achieving emissions reductions

One of the main advantages of emissions trading is its cost-effectiveness. By setting a cap on emissions and allowing the market to dictate the price of emission allowances, ETS creates an economic incentive for reducing emissions in the most cost-effective manner. 

Companies are motivated to find the least expensive way to comply with the emission limits, leading to cost savings compared to more traditional regulatory approaches. This market-based mechanism ensures that the environmental objectives are achieved at the lowest possible cost to the economy. Moreover, the revenue generated from the auctioning of allowances can be reinvested into environmental initiatives, further enhancing the scheme's cost-effectiveness.

Driving innovation and technological advancement

ETS also drives innovation and technological advancement. As businesses seek to reduce their emissions cost-effectively, there is a greater incentive to develop and adopt new technologies and practices that lower emissions. This innovation not only contributes to emission reductions but also often leads to improvements in operational efficiency and the development of new products and services. The competitive advantage gained from innovation can open up new markets and opportunities.

Flexibility for businesses and industries

Another advantage of emissions trading is the flexibility it offers businesses and industries in managing their emissions. Unlike rigid regulatory approaches, ETS provides companies with options - they can either invest in reducing their own emissions or purchase allowances from others who have a surplus. 

This flexibility allows businesses to choose the most cost-effective strategy for them, which can be particularly beneficial for industries facing technical or financial challenges in reducing emissions. The ability to trade emissions also helps in smoothing out any regional disparities in the cost of reducing emissions, as businesses operating in areas where reducing emissions is more expensive can purchase allowances from regions where it is cheaper.

While Emissions Trading Schemes (ETS) are effective tools for managing greenhouse gas emissions, they are not without challenges. These challenges range from design and implementation complexities to broader economic and social considerations. Let’s take a closer look at the challenges arising from emissions trading schemes: 

Complexity in implementation and regulation

Designing and implementing an ETS can be complex. Establishing the right cap level, deciding the allocation method for allowances (auction vs. free allocation), and integrating the system with existing regulatory frameworks requires careful planning. Planning errors can lead to issues like over-allocation of allowances, which undermines the system's effectiveness. Additionally, robust monitoring, reporting, and verification systems are essential to ensure compliance and prevent fraud, adding layers of regulatory complexity.

Market volatility and price uncertainty

The market-based nature of ETS can lead to price volatility in emission allowances. Factors like economic downturns, changes in energy prices, or varying weather conditions can impact allowance prices. This uncertainty can be challenging for businesses planning long-term investments in emission-reduction technologies. Price floors and ceilings are sometimes introduced to mitigate this volatility, but they need to be carefully balanced to avoid undermining the market's integrity.

Carbon Leakage

Carbon leakage occurs when companies relocate production to countries with less strict emission constraints to avoid the higher costs associated with ETS. This displacement not only affects the local economy but also undermines the environmental benefit of the ETS. Addressing carbon leakage requires careful policy design, including measures like allocating free allowances to at-risk sectors or linking different ETSs globally.

💡 The EU ETS is taking significant steps to combat carbon leakage by introducing the Carbon Border Adjustment Mechanism (CBAM). CBAM aims to level the playing field for EU companies by imposing a carbon price on imports of certain goods from outside the EU. By adjusting the cost of imports based on their carbon content, CBAM effectively discourages companies from shifting their operations to regions with laxer emission standards. 👉 Learn more about CBAM on our blog. 

Distributional and social equity concerns

ETS can raise concerns about distributional equity, particularly if the costs of the scheme disproportionately impact lower-income households or communities. For example, if companies pass the costs of purchasing allowances onto consumers, this can lead to higher energy prices. It’s important that emissions trading schemes include mechanisms to mitigate these impacts, such as using revenue from allowance auctions to support vulnerable groups.

Global participation and consistency

The effectiveness of ETS is strengthened by participation. However, aligning different countries’ emissions trading schemes - each with unique economic and environmental contexts - presents a challenge. Global consistency in ETS policies can be hard to achieve, but it's essential for maximizing the environmental impact and minimizing market distortions.

Emissions Trading Schemes (ETS) have been gaining popularity globally as an effective tool for reducing greenhouse gas emissions and addressing climate change. These schemes play a critical role in the international effort to meet climate goals and are expected to evolve with technological advancements and increased integration with other environmental initiatives. 

Global overview of emissions trading schemes

The adoption of ETS around the world varies - some countries and regions have already implemented comprehensive systems while others are still in the early stages of development. The European Union Emissions Trading System (EU ETS) is the largest and most established, but other significant schemes include the Regional Greenhouse Gas Initiative (RGGI) in the United States, the California Cap-and-Trade program, China's national ETS, and the UK ETS post-Brexit. These systems demonstrate a growing recognition of the effectiveness of market-based approaches to reducing emissions.

Role in achieving global climate goals

Emissions trading schemes play an important role in achieving global climate goals. By putting a price on carbon emissions, these schemes align economic incentives with environmental objectives, driving down emissions where it is most cost-effective to do so. 

This market-based approach helps meet the targets set in international agreements like the Paris Agreement, which aims to limit global warming to well below 2 (and preferably to below 1.5 degrees Celsius) compared to pre-industrial levels.

Effective ETSs can also contribute significantly to the nationally determined contributions (NDCs) that countries submit under the Paris Agreement, outlining their efforts to reduce national emissions and adapt to the impacts of climate change.

Future trends

Looking to the future, several trends are likely to shape the evolution of ETS:

• Expansion and global linking - There's a trend towards the expansion of existing ETS and the establishment of new ones. Also, linking different national or regional ETS can create a more unified global carbon market, leading to more efficient emission reductions.
• Integration with other green initiatives - ETS is increasingly being integrated with other environmental and sustainability initiatives, such as renewable energy targets and energy efficiency programs. This holistic approach ensures a more comprehensive strategy towards achieving environmental goals.
• Technological advancements - Technologies like blockchain offer promising enhancements to ETS. Blockchain can provide a more transparent, secure, and efficient way to track emission allowances and transactions, thereby reducing the potential for fraud and increasing market integrity.
• Adaptation to economic changes - ETS will need to adapt to changes in the global economy, including shifts towards renewable energy sources and the potential impact of economic downturns on carbon markets.

At Greenly we can help you to assess your company’s carbon footprint, and then give you the tools you need to cut down on emissions. Why not request a free demo with one of our experts - no obligation or commitment required. 

If reading this article has inspired you to consider your company’s own carbon footprint, Greenly can help. Learn more about Greenly’s carbon management platform here.