Emissions Trading
What is Emissions Trading?
Emissions trading, under a cap and trade policy, is an approach to controlling large amounts of emissions from a group of emitters. Emissions trading uses market forces to allow emitters to reduce emissions at costs that are lowest for each emitter’s individual circumstance.
In a cap-and-trade system, the government sets the total amount of a pollutant that can be put into the environment by an entire industry or class of emitters. The government establishes emission allowances, which can be bought and sold among companies in the industry. The only requirements are that emitters completely and accurately measure and report all emissions and then turn in the same number of allowances as emissions at the end of the compliance period.
For example:
Companies A and B both emit 100,000 tonnes of CO2 per year. In their national allocation plans their governments give each of them emission allowances for 95,000 tonnes, leaving them to find ways to cover the shortfall of 5,000 allowances. This gives them 3 choices:
- Reduce their emissions by 5,000 tonnes
- Purchase 5,000 allowances in the market
- Take a position somewhere in between.
Before deciding which option to pursue they compare the costs of each. In this example, the market price of an allowance at that moment is € 10 per tonne of CO2e.
Company A calculates that cutting its emissions will cost € 5 per tonne, and so decides to do this because it is cheaper than buying the necessary allowances. Company A even decides to take the opportunity to reduce its emissions not by 5,000 tonnes but by 10,000, to ensure that it will have no difficulty holding within its emission limit for the next few years.
Company B is in a different situation. Its reduction costs are € 15 per tonne, i.e. higher than the market price, so it decides to buy allowances instead of reducing emissions.
Company A spends € 50,000 on cutting its emissions by 10,000 tonnes at a cost of € 5 per tonne, but then receives € 50,000 from selling the 5,000 allowances it no longer needs at the market price of € 10 each. This means it fully offsets its emission reduction costs by selling allowances, whereas without the Emissions Trading Scheme it would have had a net cost of € 25,000 to bear (assuming that it cut emissions by only the 5,000 tonnes necessary).
Company B spends € 50,000 on buying 5,000 allowances at a price of € 10 each. In the absence of the flexibility provided by the ETS, it would have had to cut its emissions by 5,000 tonnes at a cost of € 75,000.
In this example, emissions trading brings a total cost-saving of € 50,000 for the companies involved. Since Company A chose to cut its emissions (because this was the cheaper option in its case), the allowances that Company B purchased represent a real reduction in emissions, even though Company B did not reduce its own emissions.