Trading system where a government sets a cap on the total allowable CO2 emissions and allows businesses to trade emission allowances, encouraging emissions reductions.
There are multiple ways to price carbon emissions. One of them is to let the market define a price for each marginal ton by fixing the total number of tons that can be emitted during a period. This market-based approach is often referred to as a “cap and trade” system, or an “emissions trading scheme”.
Governments introduce a maximal amount of emissions that can be produced over a certain period of time and by a certain number of industries. We can think about it as a “carbon budget”. For instance, in one year, the economy can be allowed to produce 2 billion tons of carbon. They issue permits, or allowances, corresponding to the CO2 levels decided.. One such allowance represents 1 ton of carbon. In this example, the government would issue 2 billion permits.
Companies generate CO2 when conducting their activity. For each ton of carbon that they emit, they need to possess one carbon allowance. At the end of the year, they need to “burn” or surrender such allowances. The amount of allowances surrendered should correspond to the amount of CO2 produced by their activity.
Governments either give those permits for free or make companies pay for them. There are penalties for actors who pollute more than what they can match with carbon allowances.
Companies can trade the carbon allowances. If they consider that they are not able to purchase enough permits from the authorities, they can do so from other companies. Vice-versa, should they own too many allowances, they are allowed to sell them in the market.
Governments do not impose a price on carbon allowances. Companies can decide themselves on the reasonable price they exchange their allowances for. This mechanism follows the logic of a free market.
Companies are offered flexibility. They always have the choice between purchasing allowances at the market price or investing to reduce their emissions, as long as the “overall carbon budget” is respected. In return, the market price is the most efficient price point at which industries reduce their emissions in line with the political decarbonation objectives.
