Under an Emissions Trading Scheme, a governmental or other regulating body sets a limit or ‘cap’ on the total amount of a particular pollutant that can be emitted. Emission allowances are then distributed or sold to firms in the regulated sector. Each allowance entitles its owner to emit one tonne of carbon dioxide, or the equivalent amount of another greenhouse gas.
Companies that emit less than their allocation of emissions can sell their surplus allowances. Conversely, firms that emit more than their allocation are required to buy additional allowances. Economically, it benefits firms to reduce their emissions, since they can then sell their excess allowances. This ultimately helps to ensure that emissions reductions happen where they are least costly, enabling overall reduction goals to be achieved in the most economical way.
ETS serves as a driving force for the ‘polluter pays’ principle, as those who pollute need to hold enough allowances to cover their emissions. This market model rewards firms that innovate and reduce their pollution and provides an ongoing incentive to continue to do so, as lower emissions mean fewer allowances need to be held or purchased.
Emissions Trading Schemes have become an integral part of global efforts to mitigate climate change, especially in reducing greenhouse gas emissions. The largest such scheme, the EU Emissions Trading Scheme, has been in operation since 2005 and has influenced the establishment of similar systems worldwide. Despite some critiques about their effectiveness and fairness, experience has shown that properly designed and well-managed ETSs can be an effective and efficient tool in reducing the greenhouse gas emissions that cause global warming.
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