Carbon trading, also known as emissions trading or cap-and-trade, is a market-based mechanism designed to reduce greenhouse gas emissions by creating a financial incentive for companies to limit their emissions. The basic premise of carbon trading is to establish a cap on total emissions and allocate or sell emission allowances to regulated entities. Companies that emit less than their allocated allowances can sell their excess allowances to those that exceed their allocated limits, creating a market for trading emissions permits.
Here’s how carbon trading market mechanisms typically work:
- Cap setting: A regulatory authority, such as a government or international organization, sets a cap on total allowable emissions within a specific jurisdiction or sector. The cap is typically based on scientific assessments of emissions reduction targets needed to mitigate climate change and achieve environmental objectives.
- Allocation of allowances: Emission allowances are distributed among regulated entities, such as power plants, factories, and other industrial facilities, either for free or through auctioning. Each allowance represents the right to emit one unit of greenhouse gas, usually measured in metric tons of carbon dioxide equivalent (CO2e).
- Compliance obligations: Regulated entities are required to hold a sufficient number of allowances to cover their actual emissions during a compliance period, which is typically one year. Entities that emit more than their allocated allowances must either purchase additional allowances on the carbon market or face penalties for non-compliance.
- Emissions trading: A secondary market for trading emission allowances is established, where regulated entities can buy and sell allowances among themselves or from other market participants. Trading can occur through exchanges, brokers, or over-the-counter transactions.
- Market dynamics: The price of emission allowances is determined by supply and demand dynamics in the carbon market. Factors that influence allowance prices include the stringency of the emissions cap, the availability of low-cost emission reduction options, economic conditions, technological advancements, and regulatory developments.
- Flexibility and cost-effectiveness: Carbon trading provides flexibility for regulated entities to choose the most cost-effective means of reducing emissions. Companies with low-cost abatement options can sell excess allowances to those facing higher abatement costs, enabling emissions reductions to be achieved at the lowest possible cost to society.
- Monitoring, reporting, and verification (MRV): Robust MRV systems are essential for ensuring the integrity and transparency of carbon trading markets. Regulated entities are required to accurately monitor and report their emissions, and emissions data are subject to independent verification to prevent fraud and ensure compliance with regulatory requirements.
Carbon trading market mechanisms have been implemented at various scales, from regional and national cap-and-trade programs to international carbon markets under the United Nations Framework Convention on Climate Change (UNFCCC), such as the Clean Development Mechanism (CDM) and the Paris Agreement’s Article 6. These mechanisms aim to harness market forces to drive emissions reductions, stimulate investment in low-carbon technologies, and support global efforts to combat climate change.