Emissions trading is an administrative approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants.
 

In such a plan, a central authority (usually a government agency) sets a limit or cap on the amount of a pollutant that can be emitted. Companies or other groups that emit the pollutant are given credits or allowances which represent the right to emit a specific amount. The total amount of credits cannot exceed the cap, limiting total emissions to that level. Companies that pollute beyond their allowances must buy credits from those who pollute less than their allowances or face heavy penalties. This transfer is referred to as a trade. In effect, the buyer is being fined for polluting, while the seller is being rewarded for having reduced emissions. Thus companies that can easily reduce emissions will do so and those for which it is harder will buy credits which reduces greenhouse gases at the lowest possible cost to society.

There are currently several trading systems in place with the largest being the European Union's. The carbon market makes up the bulk of these and is growing in popularity. Many businesses have welcomed emissions trading as the best way to mitigate climate change. Enforcement of the caps is a problem, but unlike traditional regulation, emissions trading markets can be easier to enforce because the government overseeing the market does not need to regulate specific practices of each pollution source. However, monitoring (or estimating) and verifying of actual emissions is still required, which can be costly. Critics doubt whether these trading schemes can work as there may be too many credits given by the government, such as in the first phase of the European Union's scheme. Once a large surplus was discovered the price for credits bottomed out and effectively collapsed, with no noticeable reduction of emissions.

Overview

The overall goal of an emissions trading plan is to reduce emissions of the greenhouse gases that cause climate change.

The cap 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 buy credits.

Environmental groups that purchase and retire pollution credits reduce emissions and raise the price of the remaining credits according to the law of demand.

Corporations can also retire pollution credits by donating them to a nonprofit and then be eligible for a tax deduction.

Allowances are accounted for in the balance sheet of the company as intangible assets, as recommended by the IAS 37 issued by IASB.

Because emissions trading uses markets to determine how to deal with the problem of pollution, it is often touted as an example of effective free market environmentalism. While the cap is usually set by a political process, individual companies are free to choose how or if they will reduce their emissions. In theory, firms will choose the least-cost way to comply with the pollution regulation, creating incentives that reduce the cost of achieving a pollution reduction goal.

Flexible mechanisms such as Clean Development Mechanism (CDM) and Joint Implementation (JI) are the methods by which the UNFCCC's Kyoto Protocol enables participants to comply with emissions objectives via the development or investment in a carbon project.

The carbon market

Carbon emissions trading is emissions trading specifically for carbon dioxide (calculated in tonnes of carbon dioxide equivalent or tCO₂e) and currently makes up the bulk of emissions trading.

It is one of the ways countries can meet their obligations under the Kyoto Protocol to reduce carbon emissions and thereby mitigate global warming.

Enforcement

Another critical part of the bargain is enforcement. Without effective enforcement, the licenses have no value. Two basic schemes exist:

In one, the regulators measure facilities, and fine or sanction those that lack the licenses for their emissions. This scheme is quite expensive to enforce, and the burden falls on the agency, which then may need to collect special taxes. Another risk is that facilities may find it far less expensive to corrupt the inspectors than purchase emissions licenses. The net effect of a poorly financed or corrupt regulatory agency is a discount on emission licenses, and greater pollution.

In another, a third party agency certified or licensed by the government, verifies that polluting facilities have licenses equal or greater than their emissions. Inspection of the certificates is performed in some automated fashion by the regulators, perhaps over the Internet, or as part of tax collection. The regulators then audit licensed facilities chosen at random to verify that certifying agencies are acting correctly. This scheme is far less expensive, placing the cost of most regulation on the private sector. The transparency of this process helps act as a safeguard against corruption.

Resources:

Point Carbon - independent carbon market analysis provider

International Emissions Trading Association

Carbon Trading White Paper

The New Carbon Cycle

carbon footprint

CO₂ Allowance & Electricity Price Interaction  2007

Linking GHG Emission Trading Systems and Markets  2006

The Developing CDM Market: May 2006 Update  2006