Carbon Trading Explained

Burning fossil fuels like coal, oil or natural gas generates carbon dioxide emissions, and contributes to climate change.

In order to reduce emissions, The European Union has decided to turn greenhouse emissions into tradable assets, called carbon credits.

In the carbon credit market, a firm will now think twice before emitting carbon dioxide. If it is cheaper to avoid a ton of emissions and sell an allowance then the firm will do that. However, the firm may choose to emit more and just buy an allowance if that increases profit.

In order to make this happen, the EU has set a cap on the total emissions for each type of gas. For each year, this total emissions ceiling is reduced.

So say in 2020, the emissions ceiling is 100 units and it falls to 90 units in 2021. If a company emits 80 units in 2020, it will have 10 units left over (an allowance) which it can sell or bank for future use. On the other hand, if the company emitted 95 units in 2020, it would need to purchase 5 carbon credits in 2021 (at whatever the market price was at that time).

The logic behind carbon trading is that companies will be motivated to reduce their emissions because they can make money by selling their allowances, and they will be penalised financially if they exceed their emissions cap and need to purchase credits.

In order for the carbon trading system to work, there needs to be a way to measure and verify emissions. This is done through a process called "auditing." Emissions data is collected from companies and then checked by an independent third party to make sure it is accurate.

Carbon trading occurs within carbon markets, some categorical examples of which you can find below: 

• International carbon markets: These are voluntary market-based mechanisms for reducing greenhouse gas emissions. The largest is the Kyoto Protocol's Clean Development Mechanism (CDM).
• American carbon markets: The Regional Greenhouse Gas Initiative (RGGI) is a cooperative effort among nine northeastern and mid-Atlantic states to cap and reduce CO2 emissions from the power sector.
• African carbon markets: The Southern African Development Community (SADC) has a number of initiatives underway to develop a regional carbon market. One is the SADC Carbon Offset Facility, which aims to help countries in the region offset their emissions.

The international carbon market is the largest, but all of these markets are still in their early stages and there is a lot of uncertainty about how they will develop.