Emissions Trading

To move to a low-carbon future and successfully hold the increase in the global average temperature to well below two degrees above pre-industrial levels, action will be needed on multiple fronts, including: decarbonizing the production of electricity; massive electrification and, where this is not possible, switching to cleaner fuels; improving energy and resource efficiency, and reducing waste in all sectors; and preserving existing and increasing the number of natural carbon sinks in forests and other vegetation and soils.

This will require a shift in investment patterns and behaviors, and innovation in technologies, infrastructure, financing, and practice. Policies will be needed that achieve this change in ways that reflect local circumstances, create new economic opportunities, and support citizens’ wellbeing.

For many jurisdictions, GHG carbon pricing is emerging as a key driver of this transformation. By aligning profits with low-emissions investment and innovation, a uniform price on carbon can channel private capital flows, mobilize knowledge about mitigation within firms, and tap the creativity of entrepreneurs in developing low-carbon products and innovations, thereby driving progress toward reducing emissions. A price on carbon makes clean energy more profitable, allows energy efficiency to earn a greater return, makes low-carbon products more competitive, and values the carbon stored in forests.

A growing number of firms and investors are advocating carbon pricing policies from government, and applying an internal carbon price to guide investment in advance of government policy to that effect. Carbon pricing by itself cannot address all of the complex drivers of climate change; some combination of regulations, standards, incentives, educational programs, and other measures will also be required. However, as part of an integrated policy package, carbon pricing can harness markets to drive down emissions and help build the ambition needed to sustain a safer climate.

Under an Emissions Trading System (ETS), the relevant authority imposes a limit (cap) on the total emissions in one or more sectors of the economy, and issues a number of tradable allowances that does not exceed the level of the cap. Each allowance corresponds to one unit of emissions (typically one tonne).

The regulated participants in an ETS are required to surrender one allowance for every unit of emissions for which they are accountable. They may initially either receive freely or buy allowances from the government, and participants and others can also choose to trade allowances or bank them for future use. They may also be able to use eligible units from other sources, such as domestic offset credits (from sectors outside the cap), international offset mechanisms, or other ETSs.

The cap on allowances and the establishment of a market to trade them result in a price for allowances, creating an incentive to reduce emissions. A more stringent cap translates into lower allowance supply, so—all other things being equal—the allowance price will tend to be higher, creating a stronger incentive. The ability to trade on the market also results in price convergence and a uniform price signal, which in turn favors lower-emission goods and services. Setting the cap in advance provides a long-term market signal so participants can plan and invest accordingly.

Allowances can be allocated for free—based on some combination of past emissions, output and/or performance standards—or sold, typically at auction. The latter supports transparent price formation and generates revenue for the government, which can be used for a variety of purposes, among others, to fund climate action, support innovation, or help low-income households. Additional mechanisms can be used to support price predictability, cost containment, and effective market operation.

The environmental integrity of the system is ensured through requirements for emissions monitoring, reporting and verification (MRV) and the enforcement of penalties for noncompliance. This is facilitated by the use of registries into which allowances are issued with unique serial numbers and that enable allowances to be tracked as they are traded between different participants and canceled. Market oversight provisions safeguard the broader integrity of trading activity.

Different jurisdictions can choose to link their ETS directly or indirectly through mutual recognition of allowances or other units, such as offset credits. Linking broadens access to least-cost mitigation, attracts resources for further mitigation, supports market liquidity, and enables political cooperation on carbon pricing.

The scope of an ETS refers to the geographic area, sectors, emissions sources, and GHGs for which allowances will have to be surrendered, as well as which entities will have to surrender them. The ETS scope defines the boundaries of the policy. It therefore has implications for the number of regulated entities, the share of emissions facing a carbon price, and effort sharing between the covered and uncovered sectors to meet economy-wide emissions reduction targets.

There is a great diversity across existing ETSs in terms of scope, suggesting there is no single “right” approach. Almost all systems cover at least the power and industrial sectors. A phased approach can be useful to allow time to build the capacity to include smaller or more complex sectors. All systems cover carbon dioxide; many cover up to seven gases. While some jurisdictions have placed the point of regulation for emissions from fuel combustion upstream to reduce administrative costs (e.g., fuels in California, Québec, and New Zealand), others have opted for downstream options for alignment with existing regulatory or reporting systems (e.g., EU, California, and Québec for large point sources), or for hybrid options because energy prices are regulated and carbon price signals otherwise would not be passed through the supply chain (e.g., Korean ETS and pilot ETSs in China).

The ETS cap sets a limit on the number of allowances issued over a specified time period which then constrains the total amount of emissions produced by the regulated entities. All else equal, the lower the cap, the higher the carbon price will be and the stronger will be the incentive to reduce emissions. However, other design features, such as access to offsets, linking, and different cost-containment mechanisms, interact with the cap to determine the overall emissions constraint and the resulting carbon price.

In practice, setting the cap is a balancing act accounting for the relative values of emissions reductions, cost constraints, credibility, and fairness within the broader policy context.

An ETS can allow “offsets”—credits for emissions reductions in uncovered sources and sectors—to be used by covered entities to meet compliance obligations under the cap. Once accepted, offsets are treated as equivalent, for compliance purposes, to ETS allowances.

Opening up an ETS to offsets expands the amount of abatement options in the market, as it renders new regions, sectors, and activities eligible to sell emissions reductions (although this can be counter-balanced with a reduction in allowance supply to maintain the overall cap). These options may be available at lower cost than abatement opportunities under the cap; allowing the use of offsets for compliance can thus reduce entities’ costs of compliance, which can potentially enable greater mitigation ambition for an ETS. Allowing offsets often has economic, social, and environmental co-benefits and can also support low-carbon investment, learning, and engagement among uncovered sources.

Retired and delivered offsets provide tangible benefits for communities and the environment—all while meeting rigorous, third-party standards. Legislation, such as California’s AB32, require the Air Resources Board (ARB) to ensure all emission reductions recognized by the state as CCOs are real, permanent, quantifiable, verifiable and enforceable. Offsets are reviewed multiple times before being issued as validated carbon reductions. The cap and trade regulation crafted by ARB to meet the goals of AB32 recognized that offsets must be “additional” to meet these criteria. ARB’s approach to additionality was vetted in rulemaking, a process that included substantial stakeholder input from across the spectrum.

Offsets can come from a variety of sources: entities from uncovered sectors within the jurisdiction (e.g., depending on the system, transport, forestry, or agriculture); uncovered entities outside the jurisdiction’s borders; and early (pre-ETS) reductions. Allowing offsets can facilitate investment flows into other sectors where financial support is needed to stimulate low-carbon development and often yield additional co-benefits.

Offsets provide a powerful tool for containing cost, expanding mitigation incentives beyond the cap, and generating co-benefits.

Whereas the cap determines the emissions impact of an ETS, allowance allocation is an important determinant of its distributional impacts. It can also influence the efficiency of the system and therefore merits careful attention.

The government can distribute allowances through free allocation, auctioning, or some combination of the two, as well as award allowances for removals. Free allocation methods vary according to whether they are based on entities’ historical emissions—referred to as grandparenting—or based on an industry-specific benchmark; and depending on whether allocation changes when output changes. To differing degrees, these options can protect against leakage (the concern that carbon pricing causes geographic relocation of emissions rather than genuine emissions reductions) and can also help compensate for economic losses that compliance with the ETS might otherwise cause. Auctioning generates government revenue, which can pay for cuts in distortionary taxes, support spending on public programs (including other forms of climate action), or be returned to households directly.