Trading Carbon

Is the carbon emission market actually decreasing emissions? How are Europe, China, and the US leveraging the cap and trade system?

By Greg Pustorino

Cap and trade has grown in popularity in the past two decades as an effective method to help countries around the world lower their emissions, while still allowing for growth in their domestic economy. The basic premise of this program is for a country to set a cap on the total amount of greenhouse gases they can emit in one year. This cap is then reduced every year, resulting in a drop in total emissions. Under the cap, companies are either allocated or sold allowances to emit, which they can sell to other companies in carbon emission markets. Scarcity of the emission allowances drives their prices up and incentivizes the development of technologies that emit less. Moreover, trading of emissions credits, or allowances, ensures that carbon emissions are cut in the most economical way possible, with the cheapest reductions being exploited first. Under such a system, countries that emit more greenhouse gases than they have permits for are heavily fined.

The first cap and trade system was implemented by the European Union to help meet the reduced emissions targets they pledged in the 1997 Kyoto Protocol. The EU emissions trading system, EU ETS, was established in 2005 and it remains the world’s largest carbon market with a value of nearly $200 billion. However, in the last decade China, the largest emitter of greenhouse gasses (28% of global emissions), initiated a pilot program in several of its most polluted cities including Beijing and Shanghai, and is in the process of adopting a nationwide emission trading system. Alternatively, the United States, the second largest greenhouse gas emitter (15% of global emissions), currently has no comprehensive carbon emission trading system. Bills that put forth a cap and trade system for carbon emission in the US failed to be approved by Congress in 2009 and again in 2016, leaving the US with fragmented emissions markets.

The European cap and trade model has been very effective and comprises four phases, with the transition to phase four currently in motion. The first phase was a pilot phase, starting in 2005, which set out to determine what the price of carbon emission credits would be, and how high the cap should be set. This included giving out carbon emissions allowances freely to power-generating and energy-intensive industries and penalizing companies that failed to comply with a €40 fee per ton of carbon emitted. Phase two of the cap and trade system went into effect in 2008 and set stricter protocols. A higher fee of €100 was enforced on noncompliance, the aviation sector was included as a monitored industry, 10% of emission credits were to be auctioned off to companies instead of freely allocated to them, and EU companies were allowed to purchase emission credits from foreign markets.

Phases three and four strengthened the earlier phases by increasing the greenhouse gasses that are monitored and the number of industries that are held to the emission cap. All emission allowances are to be sold via auction instead of free allocation in these phases. Also, phase four is to bring a greater reduction in the yearly emission cap, namely a 2.2% decrease each year. The EU ETS also introduced policies to keep the price of carbon emissions high and protect against an accumulation of credits that can accompany economic downturns like the current Covid crisis.

China’s National Carbon Trading Scheme is not purely cap and trade, as there is no established maximum set to emissions. Instead, the Chinese government has pledged to reduce carbon emission intensity per unit of GDP by around 65% by 2030. Under this scheme, the government allocated emission allowances to companies that incentivises those companies to decrease emissions per unit of output instead of total emissions. This approach helps to make firms more economically well off and efficient; however, it leaves room for total emissions to rise. If total production rises more than the rate of increased emission efficiency, then that company will emit more carbon than before the allowances were distributed.

Under the current proposal from the Chinese government, China will allocate nearly twice the amount of emission allowances than the EU ETS. Furthermore, the data from the pilot cities has shown that the price per ton to emit carbon is around $5 in China. Compared to the $23 per ton in the EU ETS, the problem of carbon leakage arises, which is when companies decide to move production to countries with lower emission prices or, if possible, purchase allowances from countries with lower emission credit prices. The Chinese ETS also enforces regular monitoring, reporting, and validation of emissions tracking, and penalizes offenders with a reduction of allowances or an increase in allowance price. The last feature that sets the Chinese ETS apart from its EU counterpart is that allowances are freely distributed to small private firms to promote growth and auctioned off to government owned producers.

The EU has surpassed its target for emissions reductions and seen a 21% decrease in emissions since 2005. By 2030, projections show emissions from industries covered by the EU ETS will decrease by 43% compared to 2005. This is in stark contrast to the US system which is made up of two disjointed initiatives and no country wide emission markets. The two initiatives are headed by the state of California and a coalition of Northeastern states, including NY, called the RGGI. California was able to implement a emissions trading program in 2012 and successfully decreased greenhouse gas emissions while growing their economy. RGGI sets an emission cap each year for its member states, and the region has seen carbon dioxide emissions fall since 2009. □

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