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 ‘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.

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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.

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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.

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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.

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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.

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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.