How Carbon Trading Works



This is a great overview article if you want to learn more about carbon trading and how it works. As frequent readers know, I am not a big proponent of these schemes because I think they are ripe for abuse and many of the “improvements” are just part of the standard process for constant economic savings. Also, as fuel prices rise, improvements become much more necessary.

It does seem likely though that some type of system is going to be implemented in the US and in other countries. So we should all learn more about these systems, their weaknesses and their strengths.

The dramatic imagery of global warming frightens people. Melting glaciers, freak storms and stranded polar bears — the mascots of climate change — show how quickly and drastically greenhouse gas emissions (GHG) are changing our planet. Such graphic examples, combined with the rising price of energy, drive people to want to reduce consumption and lower their personal shares of global emissions.

Carbon trading, sometimes called emissions trading, is a market-based tool to limit GHG [greenhouse gases]. The carbon market trades emissions under cap-and-trade schemes or with credits that pay for or offset GHG reductions.

Cap-and-trade schemes are the most popular way to regulate carbon dioxide (CO2) and other emissions. The scheme’s governing body begins by setting a cap on allowable emissions. It then distributes or auctions off emissions allowances that total the cap. Member firms that do not have enough allowances to cover their emissions must either make reductions or buy another firm’s spare credits. Members with extra allowances can sell them or bank them for future use.

A successful cap-and-trade scheme relies on a strict but feasible cap that decreases emissions over time. If the cap is set too high, an excess of emissions will enter the atmosphere and the scheme will have no effect on the environment. A high cap can also drive down the value of allowances, causing losses in firms that have reduced their emissions and banked credits. If the cap is set too low, allowances are scarce and overpriced.

Credits are similar to carbon offsets except that they’re often used in conjunction with cap-and-trade schemes. Firms that wish to reduce below target may fund pre-approved emissions reduction projects at other sites or even in other countries.

The European Trading Scheme (ETS) is mandatory across the European Union (EU). The multi-sector cap and trade scheme includes about 12,000 factories and utilities in 25 countries. Each member state sets its own emissions cap, or national allocation plan, based on its Kyoto and national targets. Countries then distribute allowances totaling the cap to individual firms. Even though countries distribute their own allowances, the allowances themselves can be traded across the EU. Independent third parties verify all emissions and reductions.

There has been, however, some question as to whether the ETS has actually helped reduce emissions. Some people even call it a “permit to pollute” because the ETS allows member states to distribute allowances free of charge

Like other cap-and-trade programs, the Chicago Climate Exchange (CCX) sets a limit on total allowable emissions and issues allowances that equal the cap. Member firms then trade the allowances — carbon financial instruments (CFIs) — amongst themselves. Each CFI equals 100 metric tons of CO2 equivalent. Members that meet their targets can sell or bank their allowances. Firms can also generate CFIs, specifically exchange offsets, by funding approved GHG reduction projects outside of the pool. In 2006, CCX traded a total of 10.2 million tons of CO2 [Climate Exchange, Plc]. Because CCX is owned by an independent, publicly traded company, it’s free from the federal regulations that can bog down mandatory carbon trading schemes.

There is much more to read and learn on this article and I suggest that you click through to read more.

You can also read other articles on this site that cover carbon trading by clicking here.

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2 thoughts on “How Carbon Trading Works”

  1. Dr. J says:

    The WSJ has a great article on the flaws and problems with cap and trade Kyoto style here:

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