Market-based mechanisms for mitigating climate change are surging in popularity and growth. And it’s hardly surprising; profiting financially from being more environmentally friendly is a win-win scenario. But let’s not forget, it’s complicated. Good thing we’re here to provide some basic know-how about carbon markets and emissions trading!
Carbon Markets—what’s the deal?
The central aim of carbon markets is to limit the amount of greenhouse gas (GHG) emissions through a cap-and-trade mechanism. As ‘cap-and-trade’ implies, there are two key elements of a carbon market: 1) limiting GHG emissions by placing a cap on overall emissions and 2) implementing an emissions trading system (ETS).
Carbon Markets: Cap
In order to limit GHG emissions, a regulator places a cap (such as the government) on overall emissions. The regulator establishes which GHGs to include, the minimum size for the emitters (such as companies), and which time span the cap should cover.
Once the cap is established, tradeable emissions permits/units/allowances/credits (they can go by many names, but we’ll stick with permits for this post) are allocated to the emitters, either free or sold (commonly by auction).
Each carbon permit represents one tonne of GHG emissions. Putting a price on emissions ties in with the polluter pays principle, which maintains that the polluter should pay for the environmental cost of their actions.
Carbon Markets: Trading
But what if a company wants to emit more than its share of permits? This brings us to the second key part of a carbon market: the trading system/scheme. Companies that have emitted less than their share of permits can sell their excess allowances to companies that want to emit more.
In order words, high-emitters can purchase allowances from low-emitters, meaning that they can keep up their production while the overall emissions remain within the cap’s limitation. Through this cap-and-trade mechanism, there’s profit to be gained from reducing emissions, while it’s more expensive to keep up high emissions.
Too Technical? Here’s an example
Say that the government implements a carbon market for the national steel industry. It defines which GHGs to include and which steelworks it should cover and settles on a cap for the overall emissions of one million tonnes GHG emissions per year.
This means that all steelworks included in the carbon market cannot emit more than one million tonnes GHGs a year combined. These one million tonnes are then divided into carbon allowances that the steelworks are either freely allocated or must bid for in an auction.
At the end of the year, the steelworks must have carbon allowances corresponding to their GHG emissions. However, steelwork A realizes that they will need more carbon allowances for their emissions to correspond towards the end of the year.
Meanwhile, steelwork B has managed to reduce emissions significantly during the year and has many allowances left. So, steelwork B can sell their excess allowances to steelwork A, increasing their profit, while steelwork A can keep up production and remain within the cap.
Carbon Market: Challenges
As you might have realized by now, the actual impact of a carbon market largely depends on the cap. You must carefully weigh environmental targets against what’s financially possible since you don’t want to risk stifling the economy with high emissions reductions that cause a severe loss in production.
An ambitious cap can make a huge difference in mitigating climate change by decreasing emissions, while a generous cap won’t have much of an impact at all.
If the cap needs to be low for the carbon market to be effective, the price of the carbon permits needs to be high, or it won’t make sense financially for companies to decarbonize. If the carbon permits are too cheap, companies would have more to profit from just purchasing more credits in order to keep up production. And the pricing of carbon in different markets varies greatly.
In 2017 one tonne of carbon dioxide was priced at less than $1 in Mexico and Poland, to $126 in Sweden. Generally, though, the price tends to be less than $10 per tonne. And this doesn’t seem to be good enough. Research indicates that to stay within the Paris Agreement’s target of 2°C (3.6°F) warming, carbon prices need to be somewhere between $50 and $100 per tonne within the next decade.
Another critical aspect of carbon markets is who it regulates. In theory, including a broad range of companies in an emissions trading scheme would allow it to have a larger impact. However, it also makes it more difficult to monitor and measure emissions.
Credible information regarding emissions is of key importance and monitoring companies in order to ensure that they comply with the regulations ensures the effectiveness of the carbon market.
Enough about the market
The first major carbon market was the EU ETS, established in 2005. Today, there are 24 ETSs across five continents, producing close to 54% of the global GDP. And more are on the way. In 2021, China launched the world’s largest carbon market, which regulates over 2 200 companies from the country’s power sector and covers around 40% of national GHG emissions.
Carbon markets are on the rise and are constantly evolving, with no one-size-fits-all solution. They span from cities to countries and even supranational entities such as the EU. And who knows, in the not-so-distant future, a carbon market could regulate your profession, hometown, or country. And wouldn’t that be great?
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