Emissions Trading System (ETS)

An emissions trading system (ETS)—also known as a carbon market—is an economic mechanism that assigns a price to the emission of greenhouse gases (GHGs). By setting emission caps and issuing tradable allowances, it encourages companies to reduce their carbon footprint in a cost-effective manner.

Fundamentals of an Emissions Market

• Cap (limit): A maximum allowable volume of emissions is established for a given period.
• Allowance allocation: Companies receive or purchase emission permits, each representing one tonne of CO₂ equivalent (CO₂e).
• Trading: Firms emitting less than their quota can sell surplus allowances to others that exceed theirs.
• Progressive reduction: Over time, the total number of allowances decreases to promote ongoing decarbonization.

Objectives of the ETS

• Internalize costs: Assign a carbon price that reflects the true environmental and health costs of pollution.
• Encourage innovation: Stimulate investment in clean technologies and energy efficiency.
• Meet climate goals: Support global GHG reduction and progress toward carbon neutrality.

Examples of Emissions Trading Systems

• EU ETS: The first and largest carbon market, operating across the European Union.
• RGGI (Regional Greenhouse Gas Initiative): A cooperative carbon market in the northeastern United States.
• China’s ETS: The newest and largest emissions trading system in the world.

Benefits and Limitations

Benefits:

• Provides flexibility for companies to choose how to reduce emissions.
• Generates revenue that can be reinvested in green transition projects.
• Encourages international cooperation by allowing the linking of different ETS frameworks.

Limitations:

• Carbon price volatility can affect investment stability.
• Carbon leakage risks may arise if regulations differ significantly between regions.
• Excessive free allocation of allowances can weaken climate incentives.

Keys to Success

• Robust design: An ambitious cap and fair allocation process.
• Transparency and oversight: To prevent fraud and double counting.
• Progressive ambition: Gradual tightening of the cap over time.

An emissions trading system is a central tool in the fight against climate change. By putting a price on pollution, it drives efficiency and innovation, making it a powerful instrument for achieving global decarbonization.