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An Introduction to Carbon Cap-and-Trade Systems Around the World

02/24/2015 01:39 pm ET | Updated Apr 26, 2015

Carbon markets are being established around the world, but how exactly do cap-and-trade systems work? By answering a few questions on cap-and-trade systems, this piece illustrates why and how such systems are being adopted in practice.

What is the point of a cap-and-trade system? Cap-and-trade systems are an approach to reducing greenhouse gas (GHG) emissions and combating climate change. Market mechanisms, which include both cap-and-trade systems and carbon tax, are preferred by many economists, policy makers, and environmentalists due to their ability to enhance efficiency and innovation. The alternative to market mechanisms is the more traditional command and control approach which includes ambient standards, source-specific emission limits, or technology requirements.

But what exactly is a cap & trade system? Industries covered by a cap-and-trade system have a limit or cap on the amount of carbon dioxide (CO2) or CO2 equivalent GHG they can pollute. Cap-and-trade systems usually start by covering big emitting industries such as power plants, but should eventually include the entire the economy, lowering the cap on pollution over time to continually reduce emissions. Companies that pollute more than their limit can buy carbon credits (aka permits or allowances) that each represent one metric ton of carbon dioxide. Companies will purchase these credits if it's cheaper to buy more credits than reduce their emissions. If companies emit less than their allowance, they can sell their credits to companies that wish to buy more. If it is more cost-effective for companies to reduce their emissions and then sell their allowances, they will do so. Thus, the carbon market is established and credits are auctioned off. One way or another, each year companies have to cover their emissions or a fine is imposed.

How prevalent is this approach? Carbon cap-and-trade systems have been adopted by 39 national and 23 sub-national jurisdictions across continents. The European Union Emissions Trading System (EU ETS) is the first and largest in the world, but has seen it's fair share of obstacles and has not been as effective at reducing emissions as many had hoped. Specifically, the price of carbon on the market has been low and when the price is low, there is less of an incentive to reduce emissions. Yet new carbon markets are emerging, others are maturing, and lessons are being learned. 2014 was a big year for carbon markets: Quebec and California linked their existing systems and a sixth province in China, the country that emits the most CO2 in the world, launched a cap-and-trade system. In the first few months of 2015 South Korea opened the world's second largest carbon market and plans are in the works for a system in Washington state.

What factors contribute to a successful system? As we have now had time to observe and learn from the various regional and national carbon markets around the world, common characteristics that contribute to the market's success are emerging. Here are some examples:

Putting an efficient amount of carbon permits on the market. It boils down to basic economics, but is key for cap-and-trade systems. Too many permits on the market will result in low permit prices. The EU ETS ran into this problem due to the decrease in energy demand during the economic crisis. The lack of demand for permits resulted in an oversupply of them, thus dropping the price of allowances. If not enough permits are available, the price will skyrocket.

Credits auctioned off rather than grandfathered in. When a system is beginning, there is strong pressure from industry for a certain number of permits to be allocated for free or 'grandfathered' in and we see the amount of allowances given away vary by industry. This may be politically necessary to get the system up and running, but as mentioned above, too many permits on the markets keeps the price of carbon low and reduces incentives to cut emissions.

A floor price or price that one ton of carbon cannot go below. Price floors, or a minimum price per metric ton of carbon, allows for emissions reductions even if the price of CO2 is lower than expected. This also provides certainty and confidence to the market by limiting the volatility of permit prices. The exact price of one ton per carbon will be established by the market and dependent on the amount of permits on the market, but a floor price should be implemented by the government to ensure that the price of carbon is high enough to be felt. The floor should increase annually.

Bring industries in over time. This approach is the norm and it works for political as well as economic reasons. By gradually introducing industries into the system, starting with the most polluting ones, people can get used to the system and any kinks can be worked out. For example, Quebec's cap-and-trade system covered industrial and electric sectors in its first phase from 2013-14, then expanded to fuel distributors in 2015.

Clearly defined and regulated offset market. A sometimes controversial aspect of cap-and-trade systems is the ability to 'offset' emissions or invest in projects outside the cap-and-trade program that reduce, rather than do so directly. Offsets usually take the form of forestry or livestock projects that limit deforestation and methane flaring. Although the offset aspect of the system can be cost-efficient, it is important that these offset projects are regulated, monitored and third-party verified.

New cap-and-trade systems are being implemented using the examples of existing markets and tweaking aspects that proved problematic. For example, in order to prevent a large and inadequate amount of allowances on the market (as was the EU ETS case), the Chinese province of Hubei is attempting to make adjustments in how many credits are allocated after they are auctioned off, after reported emission levels are available. Specifically, RTCC reports that with this approach "companies that emitted more than 120 percent of the level covered by the free permits could seek extra permits, while those which emitted less than 80 percent of their allocation may have permits withdrawn." Preventing this abundance of permits on the market can prevent a crash in carbon prices as well.

California also used the EU ETS's low permit prices as an example of what to avoid, when the state implemented a price floor. In California's first auction in 2012, the minimum allowable bid was set at $10, and will increase 5 percent annually, plus the rate of inflation. In the most recent auction in August 2014, the price floor was set at $11.34, and permits were sold at $11.50 ($11.34 for future permits).

What are done with the revenues from permit auctions? Many people question where the revenues that were generated from the selling of state-owned GHG emission permits go. Governments often allocate these revenues to projects that will further reduce GHG emissions. For example, California's 2014-2015 budget appropriated $850 million in auction revenue to various state programs, such as sustainable communities programs, clean transportation including funding a high-speed rail, energy efficiency, natural resources, and waste diversion. Governments in the Regional Greenhouse Gas Initiative (RGGI), which poses a cap on the power sector in northeastern U.S. states, allocated proceeds to energy efficiency retrofits in low-income apartments and other measures that reduce consumer energy costs.

The expanding carbon market is providing best practices for cap-and-trade systems around the world. A credible and functional carbon market is important in today's political context, as governments are still apprehensive in establishing strong climate policy to reduce greenhouse gas emissions. An expanding carbon market can encourage companies that are not yet a part of any cap-and-trade program to voluntarily set an internal price on carbon or to incorporate carbon prices into their management plans, as they anticipate the future market. And of course, reductions in GHGs help countries meet their reduction goals and sets path for addressing climate change internationally.