Carbon Emissions Trading

Carbon Emissions trading is a market-based approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants.^[1] It is a form of carbon pricing.

A central authority (usually a governmental body) sets a limit or cap on the amount of a pollutant that can be emitted. The limit or cap is allocated or sold to firms in the form of emissions permits which represent the right to emit or discharge a specific volume of the specified pollutant. Firms are required to hold a number of permits (or carbon credits) equivalent to their emissions. The total number of permits cannot exceed the cap, limiting total emissions to that level. Firms that need to increase their emission permits must buy permits from those who require fewer permits. The transfer of permits is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions. Thus, in theory, those who can reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest cost to society.

There are active trading programs in several air pollutants. For greenhouse gases the largest is the European Union Emission Trading Scheme. In the United States there is a national market to reduce acid rain and several regional markets in nitrogen oxides. Markets for other pollutants tend to be smaller and more localized.

The overall goal of an emissions trading plan is to minimize the cost of meeting a set emissions target. The cap is an enforceable limit on emissions that is usually lowered over time — aiming towards a national emissions reduction target. In other systems a portion of all traded credits must be retired, causing a net reduction in emissions each time a trade occurs. In many cap-and-trade systems, organizations which do not pollute may also participate, thus environmental groups can purchase and retire allowances or credits and hence drive up the price of the remainder according to the law of demand. Corporations can also prematurely retire allowances by donating them to a nonprofit entity and then be eligible for a tax deduction.

By definition, an externality is an activity of one entity that affects the welfare of another entity in a way that is outside the market mechanism. Pollution is the prime example most economists think of when discussing externalities. There are many different ways to address these from a public economics perspective including emissions fees, cap-and-trade, and command-and-control regulation. Here we will discuss cap-and-trade as the chosen public response to externalities.

The economics literature provides the following definitions of cap and trade emissions trading schemes.

A cap-and-trade system constrains the aggregate emissions of regulated sources by creating a limited number of tradable emission allowances, which emission sources must secure and surrender in number equal to their emissions.

In an emissions trading or cap-and-trade scheme, a limit on access to a resource (the cap) is defined and then allocated among users in the form of permits. Compliance is established by comparing actual emissions with permits surrendered including any permits traded within the cap.