Human activity is in large part responsible for creating potentially irreparable climate changes that could lead to social and economic chaos if no steps are taken to stop global temperature rises. The carbon emission trading system is a method designed to provide an economic incentive to decrease greenhouse gas emission. It is often known as carbon trading as the main greenhouse gas used is carbon dioxide, also known as CO2.
There are three primary options for incentives to encourage greenhouse gas emission reduction and, consequently, limit warming of the climate. The first is direct regulation on smokestack pollution. It is a rigid system which does not take into account the ability of the polluter to economically effectively reduce emission of greenhouse gases. Another mechanism is carbon taxation. It’s a market-based method, i.e. one that encourages financial incentive for emissions reductions, but does not have both flexibility and emissions reduction. The third option, and possibly the most beneficial option is the cap and trade. A limit is set for the system to be controlled with a limited, and declining, number of pollution permits. The emitters who can cut their emissions costs to reduce emissions can do so and also sell permits to companies that consider it more costly to reduce emissions.
‘Cap and trade’ creates the incentive to cut emissions further for the most competent and also a lower cost for compliance for those who are least able. The efficient distribution, via emissions trading of finite capacity of the earth to adsorb greenhouse gas pollution is beneficial to the entire economy. While at the same time, a price stimulates innovative methods to reduce carbon emissions and markets that transparently estimate the price of emission reductions.
What is the carbon trading process?
To trade carbon credits is the purchasing or selling the rights to emit a tonne of CO2 or the equivalent (CO2e). The ability for a person to release a Tonne CO2 is typically referred to as a carbon ‘credit’ or carbon ‘allowance’. For instance, in the EU Emissions Trading Scheme there is the EU Allowance (EUA) and in the California scheme, there’s the California Carbon Allowance (CCA). The allowances offered by each trading system can be bought and sold by anyone but they ultimately end up with the users when they require them to cover their regulatory compliance obligations.
Allowances are available in paper forms similar to shares, but for efficiency they exist purely in digital format and are held in’registry’ accounts that are electronic which are similar to an internet banking system. The accounts of the registry in compliance systems are administered by the regulatory body of the system in order to safeguard the integrity.
Carbon allowances’ trading is exactly like trading the other commodities. Futures exchanges can be used to facilitate spot and longer dated deliveries, and also options. Similar trades can be conducted ‘over the counter’ (i.e. in a bilateral manner) between two counterparties who are willing and typically comprise carbon brokers as introducers, or as intermediary counterparties.
Who can trade carbon allowances?
Anyone can get involved in carbon trading. In Europe there aren’t any restrictions at all on who can manage a registration account. However the main groups involved with carbon trading are usually;
1. Conformity installations (e.g steel, cement papers, chemicals, steel, etc.) and aluminium factories located in jurisdictions with cap and trade systems),
2. trading firms such as hedge funds,
3. electricity or gas as well as other utility companies,
4. A small amount of banks, and
5. carbon brokering, whether as intermediaries or introducers.
When is carbon traded?
In the most liquid carbon markets trading can be found throughout the day and all year. However, many of the installations included in carbon trading systems concentrate their activities around compliance deadlines. In the EU ETS compliance purchases are concentrated in the 3 months prior to the compliance deadline on April 30th. This may cause price variations based on the supply / demand balance at the moment.
Those with larger exposure like electricity utilities, trade more regularly and purchase in larger quantities. Many allowances are given out to businesses for free during the beginning of compliance schemes but to provide an effective price signal for everyone in the long run, the amount of allowances sold by government agencies is increasing. This tends to spread the dates of trades across the year, which is a natural step in a market that is maturing.
Where is carbon traded?
It’s dependent on the scheme, as various market spaces exist for each ETS all over the world, but within the EU ETS most emissions trading occurs through exchanges.
A good liquidity in the market is crucial to allow a carbon market functioning effectively. Liquidity comes from having no/low barriers to market entry, a large amount of market participants who are regular with low transaction costs, standardised contracts, transparent pricing and competition between many purchasers and sellers. The development of liquidity naturally happens when there is a healthy mixture of compliance-related installations, investors, speculators, and brokers. It is much more easily developed through exchange-based trading, where the regulations and contracts are the same for everyone but around half of all EU ETS trades have been conducted bilaterally between two counterparties. Exchange trading can be expensive, especially for smaller market participants, due to registration, clearing, and trading fees.