What is Carbon Emissions Trading?

Carbon emissions trading, also referred to as cap and trade, is an environmental policy device that puts an economic cost on carbon emissions. A government sets a price for carbon dioxide emissions and companies then have to pay for the amount of carbon they produce, creating an economic incentive not to pollute. In a cap and trade system, governments also set up a cap, or a limit, on how much carbon each company can emit. Companies may then reduce their emissions to operate beneath the cap, or they can operate above the cap and buy emissions rights from another company. Cap and trade is the traditional model for carbon emissions trading, but an alternative model, called baseline and credit, also exists.

Carbon dioxide (CO₂) emissions occur when carbon dioxide is released into the atmosphere, either naturally or through human activities such as burning fossil fuels. The Earth has natural processes that remove carbon from the atmosphere, so that natural carbon emissions, like animal and plant respiration, make no net change in the carbon concentration in the atmosphere. Human-related carbon emissions, however, have upset this balance so that the CO₂ concentration in the atmosphere has risen greatly since the Industrial Revolution in the 1700s. This creates a problem because carbon dioxide is a greenhouse gas, a gas that traps heat as it travels away from Earth toward space. If there is too much CO₂ in the atmosphere, too much heat will be trapped on Earth, creating a warming effect that may have life-threatening impacts.

The United States National Air Pollution Control Administration came up with carbon emissions trading in the late 1960s and began incorporating components of emissions trading into U.S. environmental policy in the 1977 Clean Air Act. The cap and trade system continued to evolve in the United States’ Acid Rain Program and was eventually implemented in the European Union. Coverage of carbon emissions trading programs has expanded to include many sources of emissions and sectors of business and government.

The principle components involved in a cap and trade scheme are caps, coverage, and monitoring. An international, federal, or local governing body sets up the cap, a fixed amount of carbon that a source is allowed to emit. The government then decides on coverage, or the sectors and sources of carbon that must comply with this limit. To ensure compliance with this cap, systems must also exist to monitor sources, checking and verifying each source’s reporting of carbon output. Sources, however, may go beyond their allowances, or over the cap, if they have traded with another source.

Imagine there are two companies, company X and company Y, which must comply with the same emissions cap and carbon prices. Both companies must pay five dollars per unit of carbon output and may only emit up to ten units per month. Company X only emits eight units of carbon per month, giving it two extra credits, and company Y regularly emits twelve, meaning it produces two units more than its allowed. Company X can save, or bank, its two unused credits in case it goes over its allowance in the future, or it can sell its credits to a company that emits more carbon, like Company Y. Company Y can either buy these credits or it can reduce its carbon output by two units to comply with the cap.

Emission trading ensures that the collective carbon output is at or below the cap, even when an individual company releases more than its allowance of carbon. Alternatively, a baseline and credit carbon emissions trading program does not put a cap on carbon emissions. Instead, sources gain credits by reducing carbon output to below a determined baseline level. These credits can then be bought by companies operating under a cap and trade program, so there is still an economic incentive to reduce carbon output and an emphasis on collective emission reductions. Critics complain, however, that carbon emissions trading redirects motives away from conservation and toward profit drive and that it narrows the scope of climate change efforts.