Compliance Carbon Markets

Compliance carbon markets are regulated markets in which covered emitters must meet legally binding emissions obligations. Under cap-and-trade, a regulator limits total covered emissions and issues tradable allowances, each normally permitting the emission of one tonne of carbon dioxide equivalent (CO2e).

Setting the cap and distributing allowances

The regulator sets an emissions cap for specified sectors or installations over a compliance period. The supply of allowances is linked to this cap, creating scarcity and giving emissions a price.

• Allowances can be distributed through auctioning, free allocation, or a combination of both.
• A progressively declining cap reduces the emissions permitted within the system over time, aligning covered emissions with the reduction pathway.
• The cap applies to the covered system as a whole; trading allows individual emitters to follow different reduction paths.

How trading lowers the cost of compliance

Each emitter compares the allowance price with its marginal abatement cost, meaning the cost of reducing one additional tonne of emissions.

• An emitter can save money by reducing emissions when doing so costs less than buying the allowances needed to cover them.
• An emitter facing higher reduction costs can purchase allowances from others rather than undertake equally expensive reductions itself.
• Trading directs reductions towards lower-cost opportunities, helping meet the overall cap at a lower aggregate cost.
• Buying an allowance does not increase the system-wide cap; it transfers the right to emit within that cap.

Monitoring and enforcing compliance

A credible system requires monitoring, reporting and verification of emissions. At the compliance deadline, each covered entity must surrender allowances corresponding to its verified emissions.

• An allowance registry records ownership and transfers, helping prevent the same allowance from being used more than once.
• Penalties for non-compliance make meeting the obligation more credible than simply avoiding it.
• Where offsets are permitted, their quality and quantity limits matter because they allow external emission reductions to substitute for allowances.

What determines environmental effectiveness

A stringent cap and effective enforcement are essential: trading lowers compliance costs, but does not itself determine the ambition of the target.

• An oversupply of allowances can weaken prices and incentives to invest in cleaner technologies.
• Unlike a carbon tax, which sets an emissions price, cap-and-trade sets the permitted emissions quantity while allowing the market price to vary.