Carbon trading: how does it work and why has it taken off?

The price of carbon has soared this year as carbon trading schemes begin to take off and new ones are implemented. But what is carbon trading, and is balancing business interests with the world’s goal to stop global warming really the best approach?

Joshua Warner @JoshWarner_IG
Analyst, London

Publication date : 2018-09-18T17:42:21+0100

Source: Bloomberg

The price of carbon has soared this year as carbon trading schemes begin to take off and new ones ‘The struggle against poverty in the world and the challenge of cutting wealthy country emissions all has a single, very simple solution. Here it is: put a price on a carbon,’ – Former US vice president and environmentalist Al Gore.

Climate change has never been higher on the agenda and yet the world is still struggling to find the best way to tackle it, creating what has so far been a national approach to a global issue, with most offering businesses the capitalist carrot rather than shaking a stick.

Despite how environmentally conscious we all claim to be, there is one common theme among the growing list of environmental policies that have been introduced to encourage both consumers and businesses to clean up their act. Most governments have realised the power of pricing and chosen to incentivise businesses to help change consumer behaviour. Consumers have seen their wallets hit by everything from taxes on plastic bags or coffee cups to congestion charges and vehicle excise duty, while businesses have been swayed by a combination of taxes and subsiding clean and renewable alternatives. The results are quite clear: we are much more willing to save the planet because we don’t want to spend more.

With that in mind, many have turned to carbon trading, effectively turning carbon dioxide and other pollutant gases into a commodity that is traded much like oil or foreign exchange. Carbon trading has had a difficult start in creating a market for something that has no intrinsic value, and it has so far failed to definitively prove itself as the best way to reduce the world’s carbon emissions. But acceptance is growing and the attitude toward carbon trading is improving.

Governments raised $33 billion worth of revenue last year from carbon trading and taxation, compared to just $22 billion in 2016, and the value of global carbon pricing initiatives rocketed to $82 billion from just $52 billion according to the World Bank. There may be agreement on putting a price on carbon, but how to do it - through trading, taxation or regulation - is still being debated.

So what is carbon trading, how does it work and is it the answer to the global climate change crisis?

What is carbon trading?

Carbon trading is a market-based system that aims to reduce the amount of greenhouse gases emitted by businesses, especially those burning fossil fuels. It creates supply and demand for carbon and places a price on emissions, providing permanent incentives for companies to lower their contribution to global warming and to invent and adopt new clean technologies.

How does carbon trading work?

There are currently 45 national and 25 sub-national carbon pricing initiatives globally, with sizes varying from ones that cover the entire European Union (EU) to those covering individual states in the likes of the US. Each carbon trading scheme sees the government or authority in charge determine how much carbon can be emitted by businesses – mostly power generators, airlines and industrial firms like manufacturers – each year. It breaks down carbon into ‘allowances’ or ‘certificates’ which quantify carbon. One tonne of CO2 (or equivalent) equals one allowance or certificate.

One positive change that carbon trading has already introduced is improved monitoring and reporting of emissions from the world’s biggest industries. Carbon trading would be meaningless without understanding the amount of pollution being caused or knowing how many certificates are needed. Tracking carbon emissions is now a mandatory feature in annual reports of big oil companies and other fossil fuel firms, for example.

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The authority in charge either auctions off or gives away the certificates, giving businesses the opportunity to buy the certificates they think they need to cover their emissions. However the idea is to promote scarcity, and significantly these certificates can be traded between businesses, allowing those that need more certificates to buy them and those with too many to sell them. That is the backbone of the entire market. With the allowance being reduced each year and the threat of fines for firms that emit more than they have certification for, companies are encouraged to lower their emissions through new technology and adopting alternatives or face paying the hefty price of additional certificates or worse, fines.

Like consumers, companies need the same push into greener pastures by using the threat of the price, and company boards are increasingly paying attention to their environmental decisions as a result of carbon being turned into a tradeable asset, giving them reasons beyond just ethics to reduce their contribution to climate change.

Cap and trade carbon trading: how does it work?

The foundations of carbon trading are based upon a system known as ‘cap and trade’. Broken down, this involves capping the amount of greenhouse gases that can be emitted which, due to limited supply, carry a value, and allowing them to be traded between companies to create a market for those that need more carbon certificates and others that have too many.

However, a significant proportion of certificates are still being given away for free as governments carefully balance environmental policy with that of business, wary of placing too big a burden on some of their biggest industries that have to compete globally, sometimes against foreign rivals that don’t have to worry about paying for their pollution.

With governments in charge of the amount of certificates they issue but little control over the policies in other countries, these certificates share some characteristics with foreign exchange, with free allowances representing a monetary tool to help control the price of carbon certificates when there are too many in the market, or not enough.

The advantages and disadvantages of cap and trade and carbon trading

‘If someone wants to do a carbon fee and someone else wants a cap on emissions…we don’t start labelling each other as more or less progressive,’ – US senator Brian Schatz.

Schatz, alongside senator Sheldon Whitehouse, have based their vote on environmental issues and are against the cap and trade system, favouring taxation measures, but ultimately unhappy with both methods. While Schatz has called for the US to move beyond ‘the traditional constituency of climate activists and environmental groups that back either a cap and trade approach or a carbon tax’, Whitehouse has held a firmer view against providing profit opportunities from climate change, previously stating that the cap and trade approach ‘is tainted by all the Wall Street market failures that we’ve had to live through’.

Like all policies, it comes down to balancing the positives with the negatives and the benefits with the drawbacks – and carbon trading is no different. By allowing companies to trade carbon it gives them more options for how they want to behave environmentally, giving them the choice between becoming more environmentally friendly or stumping up more cash and representing more of a nudge than the push that taxation offers. A benefit shared by both is the improved monitoring and reporting of carbon emissions, although there is still a long way to go in improving this.

A robust carbon price supports the investment in new, cleaner technologies which in turn helps accelerate the world to its emission goals. This will be additionally aided as carbon trading schemes start to merge, with better benefits the wider the net is cast.

On the downside, some argue that carbon trading has commoditised climate change and placed the fate of the planet in the hands of bankers and traders, ultimately slowing down progress and hampering efforts to tackle global warming. In addition to taxation the third considered method actively used is simple strict regulation, or the stick: telling companies what they can and can’t emit without the use of incentive or threat, although this has little benefits for either the government (billions of income) nor businesses (which are forced to change with no incentive). However, that would be the only current method that doesn’t monetise pollution and give companies the option to pollute if they’re willing to pay the price.

Creating a financial market is a much more popular policy among businesses than new taxations or strict legislation, and the control over allowances can help governments deliver numerous environmental targets. Carbon trading has so far been too politicised, with countries trying to reduce emissions without hurting their economies or their ability to compete on the international stage. This highlights the need for wider collaboration between countries and the ineffectiveness of national or regional approaches.

Carbon trading: the tool of the Kyoto Protocol and Paris Climate Deal

Forming a worldwide strategy on how to take on climate change has been slow in the making, but more progress has been made in the past two decades than ever before. The first ‘global’ agreement was signed by 37 nations (the Kyoto Protocol of 1997), and more recently there was the Paris Climate Deal signed by 195 countries in 2015 that will come into effect in 2020, with 88 countries already working toward the agreed targets.

Following Kyoto, the first international agreement to impose legally binding targets to reduce emissions, countries had to look for a way of facilitating their plans: a tool to tackle climate change. The concept of carbon trading had been considered as a solution during talks in Kyoto, and was an American proposal using the cap and trade system that would let the market sort out climate change. But following the entry of a Republican administration in 2000, former US President George Bush’s White House didn’t sanction the Kyoto Protocol, having got others like the EU on board.

Europe’s Emission Trading System: the first and largest carbon trading system

Europe has been the pioneer of carbon trading and, after a dogged and lonely decade, things are starting to look up. Launched in 2005, the European Emission Trading System was the first of its kind. It is the largest carbon trading system in the world, accounting for about three-quarters of global trading volumes in certificates, although that has fallen from 82% in 2010 as more countries adopt their own systems.

Although the US had indicated that it was going to introduce a carbon trading system, despite abandoning the Kyoto Protocol, Europe’s leap into the dark was a lonely one and it has had to learn many of the lessons that others can now avoid.

The European Emission Trading System is therefore the inspiration for carbon trading systems around the world. It now covers all 28 EU member states plus Norway, Liechtenstein and Switzerland. It currently covers roughly half of all the carbon emissions to come out of the EU, and the goal is to slash the amount emitted by businesses subject to carbon trading by 43% in 2030, relative to 2005 when the system was first introduced.

The system is also the most collaborative approach to carbon trading yet, with few other networks having managed to break free of international borders. European countries are obliged to spend at least half of all the money it raises through the Emission Trading System, and all of that raised from the heavily polluting aviation industry, on countering climate change.

Europe is currently in the middle of what is a long process to fully establishing a carbon trading market that can flourish, but one that is starting to yield benefits.

European carbon trading: ‘learning by doing’

With no dataset to work with and no infrastructure in place, Europe spent the first three years building the Emission Trading System under a pilot phase, establishing all of the major components: the price of carbon, the capped allowance limit and setting up the monitoring and compliance processes. The EU was following a ‘learning by doing’ principle between 2005 and 2007, preparing for the second phase that ran from 2008 to 2012, coinciding with the first commitment period of the Kyoto Protocol.

Several major changes were made in phase two, including the cap, the amount of free allowances given out and a higher penalty for companies emitting more than they were certified for.

The power industry was the first sector to be targeted by carbon pricing initiatives and they have had to buy all their certificates since 2013, although eight countries have been given more time and are operating under less burdensome parameters until the next phase starts in 2020. Industrials have been the second most targeted, but three out of every ten certificates issued to manufacturers will still be free by 2020. The aviation sector, having only been added by the EU at the start of phase two, is still receiving major support, with more than eight out of every ten certificates being issued to the industry for free and only applicable to intra-EU flights from one EU country to another.

Carbon trading: why has the price of carbon increased?

Carbon prices have experienced something of a revival, and this has been driven by two major drivers: the hard work completed by Europe during its first two phases are starting to bear fruit and other major players are starting to introduce their own carbon trading system in what looks to be the first glimpse of a truly international system.

With a lot to figure out and no benchmark to work towards, the European carbon trading market collapsed within its first two years. Due to the lack of emissions data Europe’s estimates about where to set the cap and how many allowances to auction off or give away were wrong. Allowances outstripped emissions, meaning that there was a massive surplus of certificates in the market which led to the carbon price crashing to $0 in 2007.

The start of phase two in 2008 had better foundations. It had now set up the infrastructure to collect the data it needed to make accurate estimates to set the cap and decide how many allowances would be issued. The amount of certificates it issued was slashed following the previous glut (although no certificates from phase one could be moved to the second), but timing was not on its side. The amount of businesses that collapsed or fell on hard times following the 2008 financial crash meant all the estimates that formed the basis of the cap were null and void, and Europe found itself in the same position as before. Allowances far exceeded emissions and this was reflected in the price of carbon throughout phase two.

It has taken over a decade but Europe seems to have started figuring it all out. The success of the Paris Climate Deal cemented the market in 2015, with Europe and others using carbon trading as a key mechanism to achieve their legally binding goals. Europe finds itself with a growing amount of new friends in the carbon trading market, with China’s tentative launch of its own system being the biggest boost yet. Europe had said from day one that it hoped to link its Emission Trading System with those set up by other countries but after its appalling start, many countries, including the US, decided to hold off.

But China, a string of states in the US and other nations like South Korea and Canada have now implemented carbon trading mechanisms – and Europe has already completed its first link with Switzerland.

One other important change to the European Emission Trading System in 2013 has played a major role in reviving the price of carbon and helping it find longer-term support. Beforehand, each country was able to set their own allowance cap, and the rules governing carbon trading across Europe were too varied. Now the laws are much more harmonised and the cap is decided in Brussels, removing some of the political power to prevent governments from using carbon certificates as a tool for foreign policy.

Carbon trading: what is the price of carbon?

Carbon prices remained well below their recommended levels during the first two phases of the EU Emissions Trading System, but the improving outlook and adoption of carbon trading has seen the price skyrocket since the start of 2018. Below, you can see the impact on the futures market.

Carbon Emissions chart

Find out the live carbon emissions futures price here

What is the outlook for European carbon trading?

There are plenty of reasons to suggest that the cost of allowances will only rise and trickle through to the secondary marketplace. The addition of the aviation sector has offered the most buoyancy. Whilst the sector has been gently eased in and is currently given the vast majority of the allowances it needs to keep operating, this will change when Europe enters its fourth phase in 2020.

Chief executive of the International Emissions Trading Association previously told the Guardian that the addition of the aviation sector to carbon trading from 2020 could ‘more than double the amount of carbon subject to market pricing’. While the inclusion of the high-polluting industry will be taken into account, the idea is that there will already be less supply by the start of the next decade, and the aviation sector, plus industrials that will receive less of their allowances for free mean demand will only heighten. More businesses and a smaller cap means growing demand and shrinking supply, and points toward higher trading volumes between companies and intermediaries as competition for allowances increases.

Europe revised its plans for the fourth upcoming phase earlier this year. Of all the allowances that have and are to be issued under the EU Emission Trading System over 2013-2020, 57% will be auctioned off, with the remainder being dished out for free. This ratio will remain the same over 2020-2030, but Europe will accelerate the reduction in the overall cap from a 1.74% annual reduction in phase three to 2.2% in phase four.

It also plans to reinforce the Market Stability Reserve that was introduced in 2015 to help prevent another supply glut, providing further support to prices over the long term.

How could Brexit impact carbon trading in the UK and EU?

Interestingly, the UK actually introduced its own unilateral emission trading system as far back as 2002, with the voluntary scheme operating until it eventually transferred to the EU Emissions Trading System. The UK has been seen as an outperformer in the European carbon market. Having been the first state to hold an auction in phase two, the UK saw a much higher uptake of allowances, selling around 10% compared to the paltry EU average of just 3%.

The move to the EU system was mandatory but, even more interestingly, the UK was one of just three countries that used an opt-out clause at the start of phase three which allowed them to set up its own national platform for carbon allowances to be traded, rather than use the centralised European one. Germany and Poland were the other two that took their platforms in-house.

Although the term Brexit had not even been invented yet, the UK’s decision to manage more of its carbon trading could prove beneficial in the coming years, although the UK-EU relationship is as unclear as it is for everything else, and it has its sticking points too.

Minister of Energy and Clean Growth Claire Perry revealed earlier this year that the UK would remain part of the EU Emission Trading System until at least 2020, when the opportunity for a natural break occurs with the start of the next phase. But for Brexiteers this is another example of too little action too late, as this means remaining under the thumb of the European Court of Justice (ECJ) after formally leaving the EU in March 2019, because it oversees the European carbon market.

The picture beyond 2020 is unclear, and it is not known whether the UK will (or wants to) stay part of the EU Emission Trading System for the long haul, but Perry has said that her vision does revolve around carbon pricing either way. But this is just one of thousands of sectors and agreements that need to be made, and without a deal the warnings of shock and disruption will come true. Currently with no trading deal in place, those allowances acquired in the UK under European law could become void and European and British businesses wouldn’t be able to trade their certificates in each other’s borders. The UK has already had to bring forward its auctions and compliance deadlines for 2018 as a result, and Europe has made those issued in the UK distinguishable from other EU allowances so they can be identified and dealt with after Brexit occurs.

Put simply, the effect of Brexit on carbon trading is not likely to be felt until the start of 2020, but there is plenty of opportunity for problems to arise beforehand amid the current uncertainty over future UK-EU relations.

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Carbon trading in the US: a state by state affair

‘The home is the planet. Unless you’re a Martian, you know, we’re sharing the planet and the emissions don’t stop and the CO2 doesn’t stop with the border of France, Spain, or between Canada and the US,’ – Secretary General of the Organisation of Economic Co-operation and Development (OECD) Jose Angel Gurria.

Having failed to agree on a national system decided at the federal level on numerous occasions, and to ratify the Kyoto Protocol, the US attitude to carbon trading has been mixed and this has created a very ineffective approach that sees states deciding how best to tackle climate change. Considering US President Donald Trump’s lax attitude toward global warming and pledges such as to ‘end the war on coal’, the fact that his more willing predecessors failed (both Barack Obama and John McCain supported a US-wide system in the 2008 election, but Obama’s attempt after his victory was rejected by Republicans) provides little hope for environmentalists, but the financial aspect could play to Trump’s passion for business.

The effect on the US carbon markets so far looks minimal. According to figures from Reuters carbon allowance, trading volumes in the US rose 5% year-on-year (YoY) in 2017. But the contribution from Europe was the main driver of support for the 22% overall lift in carbon prices last year, which would have helped attract new volumes as the market sees better money-making opportunities.

The current US set up is a state by state affair, allowing them to decide what, if any, policies they should adopt regarding carbon. The failure at the federal level has not stopped eager states from looking beyond their own (or even national) borders.

At the One Planet Summit in Paris late last year a landmark collaboration was unveiled across the Americas, with the carbon pricing in the Americas cooperative framework set to (eventually) link up carbon trading systems spanning Canada, Colombia, Chile, Mexico and interestingly the two US states of California and Washington. Both states are seen as environmentally friendly and their governors have clashed with Trump’s policies. Only this month California passed a law committing to only producing carbon-free electricity by 2045, flying in the face of the president’s wish to revive the US coal market. While it is easy to think that Trump simply shrugs off the disobedience of a few states, they are major ones – California would have the fifth largest economy in the world if it was an independent country. While borders have been broken down by Europe with a view of expanding the carbon market in the US further, it lies in the hands of individual states.

Carbon trading in China: the upcoming giant to overtake Europe

It is early days for China’s carbon market but the signs are promising. Europe may have the largest system by trading volumes but China’s equivalent is already the biggest by the amount of emissions it covers. That is promising considering China is by far the biggest polluter on the world stage, with its coal-powered manufacturing economy emitting more than the US and the EU combined since 2012, according to oil giant BP.

After much hesitation, China tentatively launched a pilot emission trading scheme in December 2017. This initially only covers the power generation sector, but over time it intends to span over a total of eight polluting industries. With major cities like Beijing often choked of clean air the country is increasingly turning green and China’s ambitious system - to cover about half of all the nation’s greenhouse gases – is a direct attack on its dirty coal industry, reinforcing the idea that China is stepping up to the front of the world stage as the US retreats behind the curtain.

Some governments in the developing world, such as China’s heavily polluting neighbour India, believe they should have the luxury of burning their dirty resources that their western counterparts enjoyed so they too can build their economies like they did, demonstrating the importance of the progress being seen in China. India is one of the most significant countries that have adopted a carbon tax over carbon pricing, with Argentina and South Africa being the latest nations to place a tax under consideration.

The future of carbon trading: positives begin to outweigh the negatives

‘You should be attack carbon emissions, period, and whether its cap and trade or carbon tax or whatever, that’s the realm we should be playing,’ – former US vice president Joe Biden.

The journey has been far from smooth but the benefits of carbon trading seem to be starting to outweigh the downfalls that have shrouded the market in doubt for well over a decade. As climate change moves up government agendas it will also become a higher priority for corporate boards. Although it looks highly likely that systems will break free from international borders the highly fragmented nature of the carbon market means global businesses that emit lots of pollution will have the task of navigating different regulatory environments, and more businesses will be affected as governments apply their carbon pricing strategies on new sectors.

The future of carbon trading as a way of tackling climate change lies in the hands of governments, which have a lot to consider. Businesses have already welcomed carbon trading in fear of the alternatives like a tax, but some argue that this system has weaponised climate change as a tool used by businesses to make money and by governments to compete economically with other countries, skewing the ultimate goal. Europe is evidence that its model reduces emissions of the sectors it covers, but about half of the region’s total greenhouse gases are not subject to the allowances and many other countries, even those introducing carbon trading systems labelled as green policies, continue to subsidise dirty fossil fuels. China subsidises more fossil fuels than anyone else, spending over $35 billion in 2016. Some argue the progress made in one country is negated by another, and estimates suggest 80-85% of global greenhouse gases are still not covered by any form of carbon legislation, highlighting the crucial need for a global carbon trading strategy for it to succeed.

That all screams of a strategy that works economically but is counterproductive on the environmental front, and gives those who doubt the ability of carbon trading to solve the world’s climate change problems a reason to shout.