How does carbon trading work?

How did we end up turning carbon into a commodity? The world trades everything from sugar cane to luxury cars, as well as intangible goods like intellectual property and patents.

With climate change a growing threat, economists came up with the idea of trading the right to pollute, creating a financial incentive to curb emissions.

Essentially, policy makers have three options to reduce greenhouse gas emissions. The first is to set a specific limit that a company cannot exceed.

The second option is to introduce a carbon tax where the company pays for the amount of CO2 they produce. Businesses that can reduce emissions will invest in cleaner options as long as it is cheaper than paying the tax.

The third option is to implement an emission trading scheme – to create a carbon market. In this scenario, companies buy and sell the ‘right to pollute’ from each other.

Pretty much everything we buy has a carbon footprint. Consider a car. It took about a tonne of steel to build it. Producing a tonne of steel emits two tonnes of carbon dioxide. At current prices, this will cost a steel producer in the EU roughly $16. Other companies that can avoid CO2 emissions at little cost (below $16) will sell their rights to those companies that have higher emission reduction costs.

The number of permits in the market is capped; the total amount corresponds to a reduction target. At the beginning of a trading phase, emission permits are either allocated to businesses for free or have to be bought at auction. The number of available permits decreases over time, putting pressure on the participating companies to invest in cleaner production options and reduce their CO2 outputs. In the long run, this fuels innovation and drives down the price of new technologies.

Carbon pricing can be combined with offset credits. The idea is to pay for emission reductions elsewhere rather than invest in the country of operation. A European steel producer might already have the most efficient technology available and choose to invest in a clean development project in India instead. The same funds will likely help to avoid a larger amount of carbon in emerging or developing markets where emission reduction costs are lower.

In reality, we see a combination of all these measures across different jurisdictions and types of greenhouse gases. Besides limiting or pricing emissions, there are positive incentives that reduce the cost of clean tech options. These include tax breaks, cutting tariffs for green products or renewable energy subsidies.

Both tax and trading schemes generate revenues for governments - about $22 billion in 2016. These funds can be used to reinvest in green development projects. In other cases the revenues are used to decrease the overall tax burden.

Today, more than 40 countries and 25 subnational governments have implemented a price on carbon.

The European Union’s scheme remains the biggest initiative to date. China has been running eight pilots and is creating a national trading system which is set to become the largest in the world.

But governments aren’t the only proponents of carbon markets. More than one thousand businesses and investors have called for comprehensive price on carbon. 79 top executives went on to join the World Economic Forum’s CEO climate leaders and the Carbon Pricing Leadership Coalition continues to mobilize business support.

Internal carbon pricing has equally been gaining momentum; over 1200 companies already account for the climate risks their business is exposed to. This helps companies plan ahead and weigh the financial risks of future investments. Our steel producer might be operating in several countries and needs to budget the cost of doing business as more regulators implement carbon prices.

This trend was reinforced by the recommendations of the Task Force on Climate-related Financial Disclosures – a G20 initiative currently chaired by Michael R. Bloomberg.

With a number of milestones coming up, the end of the Kyoto protocol in 2020 will be the most significant moment. After this point the Paris Agreement will govern international carbon pricing schemes. The details of the mechanism are still being negotiated; the main difference being that both developed and developing nations have set reduction targets.

The Kyoto Protocol allowed for emission offsets in developing countries, whereas Paris creates an opportunity to extend the reach and deepen the integration of carbon markets.

Under current schemes, our car producer might choose a steel supplier that isn’t subject to a carbon tax. Linking various trading schemes into an international carbon market will stabilize prices and offer more cost-effective emission reduction options.

Permit prices need to be substantial to make it financially attractive for the steel producer to invest in cleaner technologies. Carbon markets have seen relatively low prices for a number of years. Earlier in 2017, prices for a tonne of carbon dioxide ranged from below $1 in Mexico and Poland to $126 in Sweden. Yet, in most places prices remain less than $10 a tonne.

An informal survey in Davos 2017 found that the vast majority of CEOs believe carbon prices need to rise to $20 to effectively shift investments and more than half called for prices above $40 by 2025. Academia agrees - Lord Nicholas Stern, Chair of the Grantham Research Institute, stated that "in order to stay within the 2 degree target, carbon prices need to reach between $50-100 over the next 15 years."

In earlier schemes, difficulty in assessing emission baselines and the free allocation of carbon permits led to an oversupply in the market. This can be remedied by tightening caps in line with current climate targets and auctioning all available permits.

International aviation and shipping have traditionally not been included in trading schemes. However in 2016, the International Civil Aviation moved to create a market based mechanism to reduce greenhouse gas emissions which is to become operational in 2020.

Increasing the regional and sectoral reach of international trading systems will go a long way to remedy carbon leakage and drive up prices.

Broader criticisms of carbon trading include concerns that it has proven ineffective - some offset schemes even counterproductive - and it disproportionately affects lower income classes.