Emissions trading, also called cap-and-trade, is a policy tool that is being used by various governments to control emissions of air pollutants and greenhouse gases. It works on the "cap-and-trade" principle where a cap or limit is placed on the total amount of a certain type of emissions—like carbon dioxide emissions—that can be emitted by covered entities. The "trade" part of it means that companies or governments can buy and sell pollution permits or allowances.

How does Emissions Trading Work?

Under an emissions trading system, a government or regulatory agency sets an overall emissions cap and distributes allowances—each representing an authorization to emit a specific amount of a pollutant like carbon dioxide—to companies or facilities covered under the program. If a company emits less than their allowances, they can sell the extra allowances. Alternatively, a company that needs to emit more than their allowances can purchase additional allowances from others in the marketplace. This establishes a market price for emissions permits or allowances. Setting a cap ensures that environmental goals to reduce emissions are achieved and companies have flexibility to meet their emissions targets in the most cost-effective way possible through trading.

Global Emissions Trading Schemes

The largest and most comprehensive emissions trading system is the European Union Emissions Trading System (EU ETS), which is a carbon market operating in 31 countries across Europe. It covers around 45% of total EU greenhouse gas emissions from more than 11,000 power stations and industrial plants as well as airlines flying between EEA countries.

Other regional Emissions Trading schemes include the Regional Greenhouse Gas Initiative in the northeastern US, the California Cap-and-Trade Program, the Québec Cap-and-Trade System, and emissions trading pilots in China. At the international level, the Kyoto Protocol established a global cap-and-trade system called the Clean Development Mechanism for developed countries to purchase certified emission reductions from emission-saving projects in developing countries.

Benefits of Emissions Trading

Proponents argue that emissions trading systems provide significant benefits compared to traditional command-and-control regulation. It offers companies flexibility to reduce pollution in a cost-effective manner by choosing the lowest-cost abatement options, thereby reducing overall compliance costs. This flexibility stimulates innovation in low-carbon technologies as businesses look for new ways to lower emissions.

It also establishes a financial incentive for early actors who invested in clean technologies as they can benefit from selling excess allowances. Overall emissions caps are achieved with certainty while allowing market forces to determine the most efficient allocation of permits. Transparency and liquidity are increased through trading of allowances on centralized exchanges. Monitoring and reporting requirements under emissions trading programs improve data availability on emissions sources.

Challenges of Emissions Trading Systems

However, emissions trading schemes are not without challenges. Setting an appropriate emissions cap that drives meaningful abatement without being too lax or stringent is difficult. Allocation of free allowances can distort markets and raise concerns about unfair distribution of windfall profits. Monitoring and verifying reported emissions adds administrative costs. Price volatility in allowance markets can deter long-term investment planning by covered entities. Market power concentration and manipulation are potential issues in smaller cap-and-trade systems. International linking of disparate schemes also introduces complexities. Concerns over carbon leakage as emissions relocate to uncovered sectors must be addressed.

While early experiences from existing carbon markets demonstrate that emissions trading can work efficiently at scale, continual improvements are needed to enhance environmental integrity, mitigate market risks, and ensure a just transition to low-carbon economies. Strong complementary policies are also important to achieve deeper decarbonization over time. As climate change becomes an increasingly urgent global challenge, emissions trading will likely play a growing role in facilitating cost-effective emissions reductions worldwide. With further refinement, it holds potential as a key policy instrument for economies to achieve net-zero emissions targets by mid-century.

Emissions trading is an effective and flexible market-based approach that can help combat climate change by reducing greenhouse gas emissions from industrial operations and power generation. With proper design and oversight, it can incentivize low-carbon innovation while providing covered entities options to comply with emission limits at lowest cost. While continuing to evolve and address challenges, well-designed emissions trading systems have emerged as important tools for transitioning to more sustainable energy and industrial systems worldwide.

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