Carbon emission trading, also known as a carbon market, emission trading scheme (ETS), or cap and trade, is a system designed to control the amount of carbon dioxide (CO₂) and other greenhouse gases (GHGs) released into the atmosphere. It is a type of carbon pricing that aims to reduce climate change by setting a limited number of permits for emissions. Many countries use this method to meet their goals under the Paris Agreement, with systems already in place in China, the European Union, and other nations.
Emissions trading sets a specific limit on the total amount of emissions allowed by all participating companies. This limit helps determine the cost of emissions. If a company produces more emissions than its allowed amount, it must buy extra permits from companies that have used less than their share. This process can make fossil fuels, which are major causes of climate change, less competitive. Instead, it may encourage investments in renewable energy sources, such as wind and solar power.
However, these systems are often not aligned with global carbon budgets needed to keep warming below 1.5°C or "well below" 2°C. If too many permits are available, their prices may be very low, which has little effect on reducing fossil fuel use. As of September 2021, the cost of permits varied widely, ranging from €7 per tonne of CO₂ in China’s system to €63 per tonne in the EU-ETS.
Other greenhouse gases can also be traded, but their prices are calculated based on how much heat they trap in the atmosphere compared to CO₂.
An international group is working to create a global carbon market, including a worldwide cap on emissions that gradually decreases over time. This effort, which began at COP30, could help reduce emissions seven times faster in all participating countries. It could also provide $200 billion each year for clean energy and social programs.
Purpose
The economic challenge of climate change is that the people or groups who release greenhouse gases (GHGs) do not pay for the costs their actions cause. These costs include harm to people’s health and safety, damage to nature, and the long-term cost of carbon pollution. This issue can be solved using a system called emissions trading.
An emissions trading system for GHGs works by giving rights to use the atmosphere, which is a resource that belongs to everyone. The atmosphere is a global public good, and GHG emissions affect the whole world. In the cap-and-trade version of emissions trading, a limit is set on how much of a resource can be used. This limit is divided into permits, which are given to companies or groups. Compliance is checked by comparing how much pollution is actually created with the number of permits used. The way the limit is set influences how well the system helps protect the environment and can lead to both good and bad environmental results.
Programs like the European Union Emissions Trading System (EU-ETS) work with the rules from the Kyoto Protocol by allowing companies to buy and sell permits. These programs help countries meet their emissions goals by letting a national or international group assign permits to companies based on clear rules. This process helps achieve environmental targets in the most cost-effective way.
History
Setting prices for carbon emissions across the entire economy is a key part of any plan to reduce pollution while keeping costs as low as possible.
Carbon emission trading started in 1992 during a meeting in Rio de Janeiro, where 160 countries agreed to the UN Framework Convention on Climate Change (UNFCCC). More details about how to carry out the plan were left to be decided later by the UN Conference of Parties (COP).
In 1997, the Kyoto Protocol became the first major agreement to reduce greenhouse gases. Thirty-eight developed countries agreed to set goals and deadlines for reducing emissions. However, strict limits on greenhouse gas growth could lead to high costs if countries rely only on their own efforts.
Carbon emissions trading grew quickly in 2021 with the start of China’s national carbon trading program. Rising prices for carbon permits in the European Union Emissions Trading System (EU ETS) have increased the cost of using coal for electricity.
A 2019 study by the American Council for an Energy Efficient Economy showed that efforts to set prices on greenhouse gas emissions are increasing in North America. In 2021, shipowners said they did not want to be included in the EU ETS.
The global carbon market has grown significantly in recent years. In 2023, the value of the global carbon market reached a record high of 881 billion euros (about $949 billion), which is a 2% increase from the year before. The EU ETS remains the largest carbon market by value, making up about 87% of the global market in 2023.
In terms of trading volume, about 12.5 billion metric tons of carbon dioxide (GtCO2) were traded globally in 2022. This was a drop of more than 20% compared to the previous year but still a 18.2% increase from 2019 levels. Europe led in trading volume, accounting for about 74% of all carbon dioxide traded worldwide in 2022.
Economic aspects and tools
Economists agree that reducing emissions effectively requires all polluters to pay the full cost of their actions on society. If regulations only target one industry or area, it can make global efforts to cut emissions less efficient. However, scientists do not agree on how to fairly share the costs and benefits of reducing climate change or adapting to its effects.
A carbon credit is a certificate that can be bought and sold. It represents the reduction of one metric ton of carbon dioxide or its equivalent in greenhouse gases. Carbon offsetting happens when a company uses these credits to balance out its own emissions, as required by reporting rules or goals. Carbon credit trading allows project developers to reduce emissions through approved projects, like planting trees or retiring old power plants, and sell credits to buyers who can claim they have offset their emissions. In some regulated markets, such as the European Union Emissions Trading Scheme, companies can use credits to meet legal requirements, though rules vary by program. Credits can also help achieve global goals to balance emissions. The buyer decides how to use or "retire" the credit.
Projects that reduce emissions must follow rules set by crediting programs, including approved methods for different types of projects. For example, tree planting or closing coal plants may have specific guidelines. If a project meets all requirements, it can earn credits. Each program has its own label for credits, like CERs or VERs.
Many types of projects exist with approved methods for reducing emissions. The Clean Development Mechanism (CDM) was the first major program to create carbon credits and has a list of approved methods. However, each program has its own rules, so a method approved by one program may not work for another. Carbon credits are a way to set prices on emissions, similar to carbon taxes or border adjustments. While credits can be used in different markets, some programs only accept certain types of credits based on factors like when they were created or where the project took place.
A country’s carbon trading system can only control emissions within its borders. If emissions are not regulated in other areas, some emissions may move there, reducing the effectiveness of the system. However, this "leakage" can sometimes help, like when regulations in one area lead to better technology that reduces emissions elsewhere.
As of 2021, about 22% of global emissions are covered by carbon taxes or trading systems. Companies in industries that use a lot of energy may feel these systems make them less competitive if other countries have weaker rules. This can lead to carbon leakage, where companies move production to areas with less regulation. To stop this, governments need to create fair global rules and offer incentives to keep companies from moving to less regulated areas.
One way to address leakage is to give free emission permits to industries that face strong competition from other countries. However, some experts argue that selling permits through auctions is more transparent and fair. Another approach is to set higher prices on imported goods from countries with weaker environmental rules, called border adjustments. This can help reduce emissions but may also be used to protect local industries unfairly. The European Union’s Carbon Border Adjustment Mechanism (CBAM) will apply to six sectors starting in 2026.
A study on the CBAM found that it might increase costs for European companies, especially those relying on suppliers from outside the EU. Companies with lower profits or more non-EU suppliers saw bigger drops in stock prices. This suggests some companies may struggle with higher costs due to their reliance on outside suppliers or limited ability to pass costs to other countries.
Carbon trading can help achieve climate justice by moving money from wealthier, high-emission countries to poorer countries with lower emissions, supporting climate action. However, cap-and-trade systems may not always benefit low-income communities, as they often live near polluters and may not receive the same benefits from reduced emissions. Companies may also increase emissions of other pollutants not covered by the system, harming these communities more.
The Paris Agreement created a legal basis for a global carbon market, which could help fight climate change. In 2024, progress was made at the Bonn meeting, where new tools and oversight groups were established. The European Union Emissions Trading System can connect with other systems, like Switzerland’s, and China’s system is also developing.
Allocation of permits
Tradable emissions permits can be given to companies in an Emissions Trading System (ETS) in two main ways: by giving permits for free to existing companies or by selling them through an auction. When permits are given for free, the government does not receive any money from carbon emissions. When permits are sold through an auction, the government receives the full value of the permits, on average. In both cases, permits are equally limited in number and have the same value to companies, so the price of permits will be the same in either method.
Companies that receive permits for free may see their profits increase because they do not have to pay for the permits. However, if they must pay for permits, their profits will decrease. If the cost of carbon emissions equals the true cost of carbon to society, the long-term decrease in profits will reflect the cost of reducing emissions. If companies are not prepared for this cost, they may face a one-time loss due to new regulations, not just the cost of carbon itself. However, if companies are given enough time to adjust or if the carbon price increases gradually, this one-time loss will be smaller.
When permits are given based on a company’s past emissions, this method is called "grandfathering." Grandfathering can create unfair advantages, such as a company receiving fewer permits in the future if it reduces emissions significantly. Another way to use grandfathering is to base permits on a company’s current production of goods, not past emissions. In this method, the government sets a standard level of emissions for each type of good and gives permits based on how much of that good a company produces. However, giving permits based on production can indirectly support companies that produce more.
The Garnaut Climate Change Review noted that grandfathered permits are not free. Since permits are limited in number, they have value, and the company that receives them gains that value. The cost of this value is passed on to others in the economy, usually to consumers who cannot pass on costs. The cost of a grandfathered permit can be seen as the value lost by not selling the permit at its full price. As a result, companies that receive free permits may raise prices for customers because emissions now have a cost. This encourages companies that pollute to reduce emissions. However, if a company produces the same amount of goods as before without changing its methods, the value of the free permits becomes unexpected profit. This is less likely if the permit system reduces production or forces companies to spend money to become more efficient.
Grandfathering can also slow the development of cleaner technologies. The Garnaut Report noted that any method of giving permits for free has problems, such as high complexity, high costs, and unfair decisions based on arbitrary standards. These issues can lead to unproductive behavior, like companies trying to influence government decisions to gain benefits.
At the same time, giving permits can help protect companies that face competition from other countries. This happens when companies in one country compete with companies not subject to the same rules. This idea has been used in the EU ETS, where industries facing international competition are given permits for free.
The International Air Transport Association, which represents 93% of international air travel, argues that emissions limits should be based on industry averages, not past emissions of individual companies. They say this would unfairly punish airlines that already reduced emissions, while using industry averages could reward more efficient operations.
Hepburn et al. note that businesses often oppose selling permits through auctions, but economists generally support this method. Selling permits through auctions gives the government money that can be used to fund clean energy projects and reduce taxes that harm the economy. Auctions can be more efficient and fair than giving permits for free. Garnaut noted that fully auctioning permits increases transparency, reduces costs, and gives governments control over the money earned from permits. Auctions also allow for more flexibility in how costs are shared, encourage innovation, reduce political arguments over money, and lower the need for harmful taxes. Using money from permit sales can also help reduce the overall cost of a cap-and-trade system.
The unfair advantages of grandfathering can be reduced by using auctions.
Regulatory agencies risk giving too many permits, which can lower the price of permits and reduce the incentive for companies to cut emissions. On the other hand, giving too few permits can make permit prices too high. Some argue for a hybrid system with both a minimum and maximum price for permits. However, setting a maximum price removes the guarantee of a specific limit on total emissions.
Criticisms
Emissions trading has faced criticism for several reasons. Some people believe that climate change needs stronger actions than pollution trading systems, and that major changes are needed to cut fossil fuel use. At the same time, carbon credits have been criticized for allowing large companies to pollute while harming local communities. Carbon trading has also been described as a form of colonialism, where wealthy countries keep their high levels of consumption while receiving credit for carbon savings in projects that are not efficient.
Groups like the Corner House say that the market often chooses the easiest way to save carbon in the short term, which may not help reduce climate change. In September 2010, the group FERN released a report titled "Trading Carbon: How it works and why it is controversial," which includes many arguments against carbon trading. Carbon Trade Watch says carbon trading has had a "disastrous track record." The EU ETS program was criticized for not working well, and the CDM system was accused of supporting projects that were not helpful for the environment or fair to people.
Some groups say that countries can claim emission reductions that did not actually happen because of extra carbon allowances. For example, Russia had extra allowances after its economy declined following the end of the Soviet Union. Other countries could buy these allowances from Russia, but this would not have reduced emissions. As of 2010, Kyoto Protocol countries had not decided to stop buying these surplus allowances.
The complexity of cap and trade systems worldwide has caused confusion in countries like Australia, Canada, China, the EU, India, Japan, New Zealand, and the US. Because of this, some organizations have had little motivation to make changes or follow rules, leading to ongoing disagreements among groups for over 20 years.
Alternative ideas to avoid problems with cap-and-trade systems include Cap and Share, which was considered by the Irish Parliament in 2008, and Sky Trust schemes.
Carbon emission trading without rules for exports can hurt the global competitiveness of products that use a lot of carbon.
Some critics in the EU said the EU ETS contributed to the 2021 global energy crisis. In August 2022, Polish Prime Minister Mateusz Morawiecki asked for a temporary pause in the EU ETS to lower electricity prices, saying the cost of carbon permits was too high and hurting families.
The Financial Times wrote that cap-and-trade systems create confusion and allow unproven manipulation. Emissions trading has also been criticized for possibly creating a new market for trading environmental risks through financial tools.
Annie Leonard’s 2009 documentary, The Story of Cap and Trade, said carbon trading gives major polluters free permits, allows unfair advantages, and distracts from finding other solutions.
In China, some companies created artificial greenhouse gases only to earn carbon credits, which were later sold to companies in the US and Europe. Similar actions happened in India.
Some carbon and government trading systems have been changed in ways that may allow money laundering to occur.
Examples by country
In 2003, the New South Wales (NSW) state government created the New South Wales Greenhouse Gas Abatement Scheme to reduce emissions. This required electricity generators and large consumers to buy NSW Greenhouse Abatement Certificates (NGACs). The scheme helped fund free energy-efficient compact fluorescent lightbulbs and other energy-saving measures. However, the Centre for Energy and Environmental Markets (CEEM) at the University of New South Wales (UNSW) criticized the scheme for not effectively reducing emissions, being unclear, and failing to verify if emission reductions were truly additional.
Before the 2007 federal election, both the Howard Coalition government and the Rudd Labor opposition promised to create an emissions trading scheme (ETS). After Labor won the election, the Rudd government introduced the Carbon Pollution Reduction Scheme, which the Liberal Party supported at the time. Tony Abbott, a leader of the Liberal Party, opposed the ETS and instead supported a "simple tax" to reduce emissions. In December 2009, Abbott defeated Malcolm Turnbull in a leadership challenge, and the Liberal Party later opposed the ETS. This made it difficult for the Rudd government to pass the ETS bill, and it was eventually withdrawn.
Julia Gillard became Federal Prime Minister in June 2010 after defeating Rudd. She promised not to introduce a carbon tax but aimed to set a price on carbon for the 2010 election. In the first hung-parliament result in 70 years, the Gillard government needed support from crossbenchers, including the Greens. A requirement for Greens' support was a carbon price, which Gillard included in forming a minority government. The plan included a fixed carbon price that would later transition to a floating-price ETS. The fixed price was seen as a "carbon tax," and the opposition criticized the Clean Energy Bill introduced in 2011 as breaking an election promise.
The Clean Energy Bill passed the Lower House in October 2011 and the Upper House in November 2011. The Liberal Party vowed to repeal the bill if elected. This led to the passage of the Clean Energy Act, which allowed flexibility in its design and had uncertainty about its future.
The Liberal/National coalition government, elected in September 2013, promised to undo the climate legislation of the previous government. In July 2014, the carbon tax and the Emissions Trading Scheme (ETS) planned for 2015 were repealed.
The Canadian provinces of Quebec and Nova Scotia operate emissions trading schemes. Quebec connects its program with the U.S. state of California through the Western Climate Initiative.
China’s national carbon trading scheme is an intensity-based system for carbon dioxide emissions, starting in 2021. In 2010, the Chinese Ministry of Finance proposed a carbon tax to begin in 2012 or 2013, but it was never passed. Instead, in 2021, the government created an ETS where emitters can buy and sell emission credits.
China is the largest emitter of greenhouse gases (GHG), and many major cities had severe air pollution during the 2010s, with improvements in the 2020s. The scheme is managed by the Ministry of Ecology and Environment, which plans to limit emissions from six major industries. In 2021, the scheme began with power plants, covering 40% of China’s emissions (15% of global emissions). China gained experience from the United Nations Framework Convention on Climate Change (UNFCCC) and the Clean Development Mechanism (CDM).
China’s national ETS is the largest of its kind and helps meet its Nationally Determined Contribution (NDC) under the Paris Agreement. In July 2021, permits were given for free rather than auctioned, and the market price per tonne of CO₂e was about RMB 50, roughly half of the EU ETS and UK ETS but better than the U.S., which has no formal cap-and-trade program.
The ETS reduced carbon emissions by up to 18.2%, reduced inequality, and improved welfare. A third of health benefits from air pollution reduction were achieved through the ETS. In some cases, it reduced GDP and innovation. The system cut power sector emissions by 13% between 2013 and 2020. By 2027, the ETS is expected to expand to all major industrial emitters and establish an absolute cap.
The European Union Emissions Trading System (EU ETS) is a carbon emission trading scheme (cap-and-trade) that started in 2005 to lower greenhouse gas emissions in the EU. Cap-and-trade schemes limit emissions by requiring polluters to buy allowances to cover their emissions. Money from the system is used for environmental and social goals. As of 2026, the ETS covers about 40% of the EU’s greenhouse gas emissions. The cap will decrease gradually and reach zero by 2039. After 2039, no more allowances will be issued, and emissions will be banned.
Starting in 2027, a new EU ETS2 will cover road transport, buildings, and industrial installations not included in the original ETS. ETS2 will focus on fuel suppliers rather than consumers. Together, ETS and ETS2 will cover 75% of the EU’s greenhouse gas emissions.
Compared to 2005, the EU ETS’s 2020 caps aimed for a 21% reduction in greenhouse gases, achieved six years early by 2014. Between 2005 and 2025, emissions in ETS-covered sectors dropped by about 50%, while non-covered sectors dropped by 20%. A 2020 study found the ETS reduced CO₂ emissions by 11.5% in covered sectors despite low carbon prices. A 2024 study estimated a 7% reduction, and a 2023 study showed a 10% reduction between 2005 and 2012 with no negative effects on profits or employment. A 2024 study also found the ETS reduced air pollutants like sulfur dioxide, fine particulate matter, and nitrogen oxide, leading to health benefits. EU countries see the ETS as essential for meeting climate goals.
Trading in India’s mandatory energy efficiency trading scheme began in 2014 after a three-year rollout.