Climate Dictionary | Emissions Trading Schemes

Abstract:

An emissions trading scheme is the primary market-based approach for regulating greenhouse gas emissions in many countries, including Australia, Canada, China and Mexico.

Part of a government’s job is to decide how much of the economy’s carbon emissions it wants to avoid in order to fight climate change. It must put a cap on carbon emissions that economic production is not allowed to surpass. Preferably, the polluters (that’s the manufacturers, fossil fuel companies) should be the ones paying for the cost of climate mitigation.

Regulators could simply tell all the firms how much they are allowed to emit over the next ten years or so. But giving every firm the same allowance across the board is not cost efficient, because avoiding carbon emissions is much harder for some firms (such as steel producers) than others (such as tax consultants). Since governments cannot know each firm’s specific cost profile either, it can’t customise the allowances. Also, monitoring whether polluters actually abide by their assigned limits is extremely costly.

An emissions trading scheme cleverly solves this dilemma using the cap-and-trade mechanism. Instead of assigning each polluter a fixed quota and risking inefficiencies, the government issues a large number of tradable permits – each worth, say, a tonne of CO₂-equivalent (CO₂e) – that sum up to the cap. Firms that can cut greenhouse gas emissions relatively cheaply can then trade their surplus permits to those who find it harder – at a price that makes both better off.