How does carbon trading work?

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How did we end up turning carbon into a commodity? The world trades everything from sugar cane to luxury cars, as well as intangible goods like intellectual property and patents. With climate change a growing threat, economists came up with the idea of trading the right to pollute, creating a financial incentive to curb emissions. Essentially, policy makers have three options to reduce greenhouse gas emissions. The first is to set a specific limit that a company cannot exceed.

The second option is to introduce a carbon tax where the company pays for the amount of CO2 they produce. Businesses that can reduce emissions will invest in cleaner options as long as it is cheaper than paying the tax. The third option is to implement an emission trading scheme — to create a carbon market. Pretty much everything we buy has a carbon footprint. It took about a tonne of steel to build it. Producing a tonne of steel emits two tonnes of carbon dioxide. The number of permits in the market is capped; the total amount corresponds to a reduction target.

At the beginning of a trading phase, emission permits are either allocated to businesses for free or have to be bought at auction. The number of available permits decreases over time, putting pressure on the participating companies to invest in cleaner production options and reduce their CO2 outputs. In the long run, this fuels innovation and drives down the price of new technologies. Carbon pricing can be combined with offset credits.

The idea is to pay for emission reductions elsewhere rather than invest in the country of operation. A European steel producer might already have the most efficient technology available and choose to invest in a clean development project in India instead. The same funds will likely help to avoid a larger amount of carbon in emerging or developing markets where emission reduction costs are lower.

In reality, we see a combination of all these measures across different jurisdictions and types of greenhouse gases. Besides limiting or pricing emissions, there are positive incentives that reduce the cost of clean tech options. These include tax breaks, cutting tariffs for green products or renewable energy subsidies. These funds can be used to reinvest in green development projects. In other cases the revenues are used to decrease the overall tax burden.

Today, more than 40 countries and 25 subnational governments have implemented a price on carbon. China has been running eight pilots and is creating a national trading system which is set to become the largest in the world. More than one thousand businesses and investors have called for comprehensive price on carbon. Internal carbon pricing has equally been gaining momentum; over companies already account for the climate risks their business is exposed to.

This helps companies plan ahead and weigh the financial risks of future investments. Our steel producer might be operating in several countries and needs to budget the cost of doing business as more regulators implement carbon prices. This trend was reinforced by the recommendations of the Task Force on Climate-related Financial Disclosures — a G20 initiative currently chaired by Michael R. With a number of milestones coming up, the end of the Kyoto protocol in will be the most significant moment.

After this point the Paris Agreement will govern international carbon pricing schemes. The details of the mechanism are still being negotiated; the main difference being that both developed and developing nations have set reduction targets. The Kyoto Protocol allowed for emission offsets in developing countries, whereas Paris creates an opportunity to extend the reach and deepen the integration of carbon markets.

Linking various trading schemes into an international carbon market will stabilize prices and offer more cost-effective emission reduction options. Permit prices need to be substantial to make it financially attractive for the steel producer to invest in cleaner technologies.

Carbon markets have seen relatively low prices for a number of years. In earlier schemes, difficulty in assessing emission baselines and the free allocation of carbon permits led to an oversupply in the market. This can be remedied by tightening caps in line with current climate targets and auctioning all available permits. International aviation and shipping have traditionally not been included in trading schemes.

However inthe International Civil Aviation moved to create a market based mechanism to reduce greenhouse gas emissions which is to become operational in Increasing the regional and sectoral reach of international trading systems will go a long way to remedy carbon leakage and drive up prices.

Broader criticisms of carbon trading include concerns that it has proven ineffective - some offset schemes even counterproductive - and it disproportionately affects lower income classes. The views expressed in this article are those of the author alone and not the World Economic Forum. We are using cookies to give you the best experience on our site. By continuing to use our site, you are agreeing to our use of cookies. Carbon trading emerged as an incentive to curb emissions.

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