What is carbon trading?

Reducing greenhouse gas
emissions, like carbon dioxide,

is a crucial component in the
fight against climate change.

One way governments are trying to reduce their
emissions is through carbon trading, a market-based

system that aims to provide the economic
incentives for countries and businesses

to reduce their
environmental footprint.

Almost every activity from travel to farming
and even watching this video leads to the

emission of gases such as carbon dioxide,
contributing to the greenhouse effect

responsible for
climate change.

Unlike voluntary offsets, where consumers
can choose to pay a company to balance out

their carbon footprint, such as funding reforestation
projects which absorb CO2, carbon trading

is a legally binding scheme that caps total
emissions and allows organizations to trade

their allocation, hence
the term “cap and trade.”

All “cap-and-trade” systems have emissions
limits calculated by governments and policymakers,

which are compatible with their target of
limiting environmental damage.

Carbon allowances, or units, totalling up to
this maximum are then allocated to companies

and can be traded
on a market.

Each year, organizations with a large carbon
footprint are allocated an allowance proportionate

to their historical emissions, which can then
be bought and sold on a secondary market.

If, for example, a company knows they have
gone over their allowance, then they will

need to buy more carbon
units from their carbon market.

But if they implemented measures to reduce
their emissions, they can sell any excess

units on
the market.

A credit, which can start from $12 or run
as high as $125, allows for the emission of

pollutants equivalent to
one ton of carbon dioxide.

The price of carbon is determined
by supply and demand.

Supply of units is capped at a level deemed
acceptable and their cost will rise and fall

depending on whether firms
find alternatives to polluting.

By assigning a price to damaging activity,
the system provides a financial incentive

for firms to reduce emissions, whilst lowering
the overall cost of these reductions as the

cheapest improvements
are made first.

Although carbon trading seems great in theory,
it hasn’t been easy to put into practice.

The first international carbon
market was set up under the

UN’s 1997 Kyoto Protocol
on Climate Change.

However, following widespread reports of corruption
and abuse of the system, the market collapsed.

A report in 2015 found that an estimated 80%
of sustainable projects under the trading

scheme were questionable, enabling emissions
to increase by roughly 600 million metric tons.

Since then, there hasn’t been a
consensus on the best way to implement

a cap-and-trade
scheme globally.

However, there are a number of emission
trading markets around the world

at both national
and regional levels.

The oldest active carbon market is the European
Union’s Emission Trading System, which

launched in 2005, while other schemes are
operating in Canada, Japan, New Zealand, South

Korea, Switzerland and the United States.
At the start of 2021, China launched the world’s

largest carbon market for
its thermal power industry.

The sector accounts for 40% of China’s emissions,
equivalent to double the emissions covered

by the EU’s
carbon market.

As governments tightened environmental standards,
the total value of global carbon markets grew

34% in 2019,
reaching €194 billion.

It’s the third consecutive year of record
growth and values these emissions nearly five

times their
worth in 2017.

And the number of cap-and-trade markets is
likely to increase as many countries, cities

and companies worldwide try to meet their
ambitious pledge of net-zero carbon emissions

by 2050 — a target set
by the United Nations.

Cap-and-trade systems have been successful
in tackling environmental problems in the

past, including one covering sulphur dioxide
emissions, which helped reduce acid rain in

the U.S. Compared to direct regulations or
taxes, carbon trading doesn’t require as

much government intervention in the economy,
leaving businesses to find their solutions.

And as long as the cost of emitting greenhouse
gases is high enough to encourage these alternatives,

many environmentalists believe it could be
a relatively straightforward and efficient

method to drive
decarbonization.

However, an oversupply of carbon allowances
during the 2008 financial crisis saw the price

of polluting fall in the EU’s trading
system, reducing the incentive

for businesses to
change their behaviour.

In response, the EU created the ‘market
stability reserve,’ or MSR, a decade later,

which gives the European Commission the ability
to tighten or loosen the supply of carbon units.

As a result, their price tripled
from 8 euros per tonne of CO2

to around 25 euros per
tonne of CO2 over a year.

In turn, the energy sector moved output away
from coal power stations to cleaner, natural

gas powered-electricity production
that produces less CO2.

In 2019, emissions fell by 8.7%,
the largest decline since 2009.

The EU’s carbon market has also caught the
eye of hedge funds and traders.

Whereas OPEC controls a third of the global
oil supply, the EU regulates all carbon allowances

within its emission
trading system.

And with the EU’s long-term aim of gradually
increasing the price of carbon units, these

are seen as a popular
long-term investment.

While the COVID-19 pandemic led to a glut
of carbon allowances as activity across the

economy fell, prices are now back
up above pre-COVID levels.

However, there are concerns that heavy emitters
may find loopholes in carbon trading systems.

Unlike the earlier Kyoto Protocol agreement,
the 2015 Paris Climate Agreement commits all

signatories, not just the most developed economies,
to impose carbon emission targets.

If implemented successfully, analysts believe
that international emissions trading could

cut global emissions by
around 60% to 80% by 2035.

Critics of carbon trading worry that countries
facing economic difficulties might be tempted

to cheat, either by making their
overall emissions cap too generous,

or using accounting tricks
to overstate reductions.

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