Emissions Trading System

An emissions trading system is a market-based instrument that limits or benchmarks greenhouse gas emissions and permits regulated entities to trade emission units. By making tradable emission units scarce and valuable, it rewards firms that cut emissions and raises the cost of continued high emissions.

How the trading mechanism works

Under cap-and-trade, the regulator limits total covered emissions and issues allowances within that limit. Under baseline-and-credit, firms emitting below a prescribed performance baseline earn credits, while firms exceeding it must acquire credits or take other permitted compliance action.

• Reliable measurement, reporting and verification determines each installation's emissions and compliance obligation.
• A firm that reduces emissions cheaply can sell surplus units; a high-cost firm may buy units and surrender them for compliance.
• The regulator progressively tightening the cap or baseline can increase the pressure for further reductions.

How market incentives arise

Trading creates a carbon price, making emissions a financial cost rather than a free by-product. Each firm compares this price with the cost of reducing an additional unit of emissions.

• Firms abate when doing so costs less than purchasing an emission unit.
• Firms with lower marginal abatement costs undertake more reductions and profit by selling surplus units.
• Even freely allocated allowances carry an opportunity cost, because using them for compliance means foregoing their sale.
• The expectation of future compliance costs encourages energy efficiency, fuel switching and investment in lower-emission technologies.
• Trading directs reductions towards firms that can achieve them most cheaply, lowering the overall cost of meeting the environmental target.

Conditions for effectiveness

The incentive depends on a stringent cap or baseline, credible enforcement and a sufficiently scarce supply of units. Over-allocation can depress prices and weaken emission reductions.

• Robust MRV systems are necessary to ensure that traded reductions are genuine and not counted more than once.
• Price volatility can weaken long-term investment signals unless market design provides adequate stability.
• Carbon leakage may occur if production shifts to jurisdictions with weaker emission constraints.