The Basics of Carbon Trading, “'Cap and Trade'”
Any attempt to meaningfully reduce greenhouse gas emissions is faced with the challenge of coordinating the introduction of sustainable practices across many different sectors of society.
'Cap and Trade' is one type of scheme that attempts to take on this challenge. The “cap” refers to an absolute limit placed on the emissions, or activities that cause them, over a given time period within a jurisdiction.
The aim of the cap is to gradually reduce the emission produced by a given sector over time. Emissions allowances, representing portions of the total cap, are distributed between actors wishing to engage in activities that create emissions; any actor exceeding the level of emissions determined by the allowances it holds faces penalties incentivising them to limit emissions within these bounds.
Some actors engage in the trade of allowances to address mismatches between those permitted to create emissions and those who want to engage in activities that create them. Trading creates a carbon market that allows emissions reductions to be achieved in the most efficient way possible. Organisations wishing to create additional emissions may buy up unused allowances from others that have been able to reduce their emissions. This ability to profit from the sale of unused allowances provides an incentive to reduce emissions. Additionally, carbon credits are created by emission reduction activities outside of the system. These credits may be purchased by organisations within the system allowing them to offset emissions that exceed their allowance.
Summary of “Cap and Trade”
A “cap” is set on the total carbon emissions for the period within the jurisdiction.
Organisations are allocated the rights to a certain fraction of these emissions in the form of allowances.
Organisations that exceed their allowance are reprimanded through fines and other sanctions.
An organisation can increase its right to emissions either by purchasing allowances from others, or the right to take credit for the reductions in carbon emissions of others in the form of carbon credits.
The market creates a price for carbon which should incentivise actors to reduce their emissions to avoid the cost associated with emissions.
Complexities of 'Cap and Trade' systems
There are various ways in which the allocation of emissions allowances can take place. The particular method employed can have a great effect on the dynamics of the system and its efficacy in producing emissions reductions. One possibility is that organisations must bid for the rights to create emissions at auction, creating an incentive to emit less in order to avoid having to pay for it. Alternatively, it can be done through ‘grandfathering’, where companies/ organisations are assigned an emissions limit based on their past activities and then have this limit progressively reduced each year.
Carbon credits represent the right to take credit for reductions in carbon emissions, or the removal of carbon from the atmosphere. An organisation that exceeds the level of emissions provided for by allowances can compensate by purchasing carbon credits created through the activities of others. Such activities undergo a certification process to show the extent of emissions reductions they have achieved compared to if there had been no intervention. Credits are sometimes sold before this process has been finalised leading to the buyer taking on the risk that the project will not be fully certified.
The trade of carbon products has led to the establishment of a secondary market of derivative products such as securities, swaps, and options.
An awareness of these complexities is important to understanding the large scale dynamics of the carbon trading system. Variations in these details in practical situations can greatly swing the effectiveness of a ‘'Cap and Trade'’ system in achieving real world emissions reductions.
UK legislation on Carbon trading.
Part three of the Climate Change Act (2008) allows the government to establish trading schemes that either limit activities that produce greenhouse gasses (GHGs), or encourage activities that lead to their reduced emission or removal from the atmosphere.
Such schemes apply to activities carried out in the UK, regardless of if the emissions themselves actually occur in the UK.
The CCC must be consulted before establishing such a scheme, as must stakeholders likely to be affected by the regulations.
Allowances representing the right to carry out a specified amount of activities in a trading period may be allocated between participants in the scheme
Each participant must acquire enough allowances to match their activities in a trading period. Allowances can be carried over between trading periods. Exceeding the allowance can be compensated for by acquiring credits. These credits represent reduction in GHG emissions or removal of GHG from the atmosphere. Exceeding allowances may be met with fines and penalty payments.
Allowances and credits can be traded.
Anyone wishing to carry our polluting activities that are regulated by a trading scheme must carry a permit.
Allowances can be traded between trading schemes, both within the UK and the EU. (it’s not yet clear how this will be affected by Brexit)
Violation of the trading scheme terms is punishable through fines and imprisonment . The regulator has the power to create offences with respect to the trading schemes and to punish transgressions accordingly.
I know this is meant to be a summary but theres a lot of points - can we maybe whittle it down further?
Problems with 'Cap and Trade'
The UK legislation on ‘'Cap and Trade'’ creates the framework from which emissions trading programs may be generated. The extent to which a given trading scheme is successful in supporting the decarbonisation of the economy will depend on the details of the scheme, rather than the underlying legislation. However, trading schemes that have been instigated around the world have often developed similar shortcomings, if these are not avoided they will be unable to support timely decarbonisation.
Compromising efficacy for acceptability
The widespread adoption of 'Cap and Trade' in preference to alternative systems such as a carbon tax or direct regulation was largely motivated by the concerns about achieving sufficient buy-in from relevant stakeholders. Among these stakeholders are big players in the fossil fuel industry as well as the wider business and industrial sectors who have taken advantage of a status quo; a fossil fuel driven economy that thrives on overconsumption and lax environmental regulations. These companies use their considerable financial and lobbying power to resist changes to the conditions under which they have been able to thrive. Consequently, any mechanism for carbon reduction sensitive to the wishes of these stakeholders will not reduce emissions as effectively as it otherwise might. Additionally, any policy making process that is overly sensitive to societal opinion without making great efforts to investigate exactly how that opinion is structured runs the risk of falling foul to pluralistic ignorance. False pictures of public opinion on contentious issues, such as climate policy, are allowed to develop because those in opposition to the perceived consensus fear speaking out against it. Reticence inhibits the discovery that they are in fact part of a silent majority. If due care is not taken, then policies which pander to the perceived public/ stakeholder opinion that climate is not an important issue risk ignoring widely held yet less outspoken support for more drastic emissions reduction methods.
Insufficiently stringent emissions caps
It is the cap, and only the cap, that leads to reductions in emissions.
This makes the level at which it is set crucial to the effectiveness of the scheme in driving emissions reductions. There are two possible ways in which caps can be chosen.
Either, the current emissions levels are used as a starting point and then an appropriate yearly reduction is identified and imposed, or, starting from the ultimate emissions goal of net zero, emissions targets are assigned to each year working backwards towards the present day.
In theory, both systems are sufficient to achieve the ultimate goal. However, systems that use contemporary emissions levels as a starting point face several barriers to the timely realisation of decarbonisation. Firstly, using past emissions as a starting point for reductions legitimises those emissions, the levels of consumption that drive them, and the technologies involved in their production. This validation of the status quo increases the inertia that resists movement towards a more sustainable society.
Secondly, those organisations that emitted the most in the past are rewarded by being allowed to emit the most in the future and accrue the associated benefits, whilst those who have been more sustainable in the past are further restricted in their future activities. This creates a perverse incentive to be emitting as much as possible at the time the scheme is put in place to gain the maximum allowances which can be used to maintain emissions or sold on at a profit.
Thirdly, allowances may be assigned to organisations that would never have used them anyway, leading to ghost emissions reductions. For example, a company may have made energy efficiency savings independent of the 'Cap and Trade' scheme but assigned allowances based on its old inefficient practices. It is left with spare allowances that can be sold to other companies allowing them to create increased emissions. However, in the absence of the allowances the savings would still have been made without being compensated for by the increase in emissions from the organization that bought the allowances. A large contributing factor to these issues is that allowances are initially assigned to emitters free of charge, rather than being auctioned off. Auctioning would create a financial incentive to reduce emissions as soon as possible, rather than inflating and maintaining historical emissions.
THIS IS A MASSIVE PARAGRAPH CAN WE BREAK IT UP? Potentially using bullet points?>
Carbon trading does not always favour the best long term emissions reduction strategy
The trading of allowances and credits allows the market to find the most efficient way of achieving marginal emissions reductions.
At a glance this sounds great, but always choosing the least costly emissions reductions in the short term creates problems of its own. Firstly, maximising short term outcomes risks missing out on other possible emissions reductions pathways that would be more effective in the long term but require higher initial investment.
In the short run emissions reductions can be made more quickly and cheaply by working with with the exiting infrastructure. However, investment in new infrastructure and re-organisation may allow for increase emissions cuts in the long run, despite the short term costs being greater and emissions reductions slower to begin with.
Unregulated forces in the carbon market favour investment within the scope of the current infrastructure, further tightening the lock in of society to its current m.o. and increasing the cost of transition to sustainable technologies that will inevitably be required in the future. If decarbonisation is to be achieved in a timely and cost effective manner then the market must be regulated to prevent short term gains continuing to distract from long term goals.
Secondary markets create conflicts of interests that distract from decarbonisation goals
The buying and selling of carbon products has led to the development of a secondary market in derivatives. This market is much less focused on achieving reduction in GHG emissions, instead favouring those engaged in profiteering. This creates a conflict of interest as the goal of reducing emissions favours an accurate and stable price for carbon, yet profits can be maximised in a risky and volatile market. Additionally, all the time that people are able to make money off the market there is an incentive to keep the market in existence, whereas if full decarbonisation was achieved then there would be no need for the carbon market. These conflicts of interests will lead people to act in ways that don't favour decarbonisation of the economy, slowing progress towards its realisation.
Carbon trading rests on the flawed assumption that all units of carbon emissions are equal.
The cheapest emissions reductions can often be found in the Global South, incentivising countries and corporations of the Global North to buy the rights to emissions reductions here through carbon credits, rather than make reductions themselves. The offshoring of emissions reductions allows the fundamental problem of overconsumption in the North to continue unaddressed, postponing the required shifts in consumption behaviour to a later date.
Placing the burden for emission reduction on the Global South is also fundamentally unfair. The disparity in standards of living between the Global North and South has been facilitated by the North emitting far more that its fair share of carbon. The trade of carbon credits between the Global North and South only serves to reinforce this imbalance. Although carbon credits may provide short term financial benefit to those in the south, they can also impede much needed development in the medium and long term, reinforcing the historical inequalities between the South and the North. Additionally, paying others to incur emissions reductions costs outsources the responsibility for dealing with them to those that did not produce them, and did not benefit from them. This violates a base principle that those responsible for emissions must take on the responsibility of dealing with them.
The carbon credit system rests on the assumption that any unit of GHG emissions has the same significance for the Climate Crisis. This is not the case. The climate system is incredibly complex containing many feedback, feedforwards, spatial, and interaction effects. These combine to create a dynamic system in which a given unit of carbon can have very different effects on the climate depending on the timing, location, and source of its emission. Current carbon credit schemes fail to take into account the different consequences of different types of emissions, allowing harmful emissions processes to be compensated for in the carbon accounts by emissions reductions practices that do not fully compensate for the climatic harm of the emissions.
Gaming the carbon credit system
The carbon credit system can be exploited by organisations for profit in ways that do not lead to reductions in overall emissions or have no positive effects in mitigating against the climate crisis. Credits are often assigned to projects that take place outside of the system directly regulated by the 'Cap and Trade' policy. They are given to projects which can prove to be reducing emissions or actively removing carbon from the atmosphere. However, because the focus is on gross rather than net reductions, some organisations have been seen to create extra emissions simply to remove them again and then sell these removal activities as carbon credits, despite such activity being of no benefit, or even detrimental, to the mitigation of the climate crisis.
Monitoring and enforcement
A 'Cap and Trade' system is heavily reliant on monitoring and enforcement to be effective. Emissions must be measured to ensure that the cap and allowances are being complied with. Despite the importance of monitoring, it is considered too expensive to measure emissions directly with proxy methods being used instead.
Using approximations when measuring carbon emissions creates the possibility of error, and more carbon being emitted than is measured. Consequently, emissions caps may be exceeded unknowingly with those responsible for the emissions not being held to account.
Measurements and approximations must also be carried out to quantify the effectiveness of emissions reductions schemes and the carbon credits that can be allocated to them. Error here can lead to polluters offsetting their emissions with credits that represent smaller reductions than they claim to, and consequently more carbon being emitted than is claimed.
Carbon pricing is not accurate, rarely tracking estimations of the true cost of emissions leading to the price being too low to disincentive emissions. Conversely, when the price is too high such that big polluters are priced out of the market, regulators have been seen to step in to cap the price. This is yet another example of an unwillingness to undergo the types of change that are required for the decarbonisation to be achieved in a timely manner.
This section is quite complicated and I think rather dense, is there any way we can make it simpler?
Despite its flaws, 'Cap and Trade' holds potential
“'Cap and Trade'” systems face several flaws as tools for bringing about the timely decarbonisation of the economy and the timely achievement of net zero emissions goals. The only mechanism they present for reducing emissions is the carbon cap itself, with the level at which it is set being a key determining factor of the efficacy in achieving emissions reductions.
Caps based on what are perceived to be achievable reductions based on historic emissions consistently fall short of creating an adequate emissions reductions schedule. Practices surrounding grandfathering of emissions allowances and exportation of the responsibility for emissions reductions via carbon credits exacerbate existing inequity and actively block progress towards sustainable development goals. Carbon markets provided incentives to pursue the most efficient emissions reductions in the short term, leading to those with higher start up costs but more efficacy in the long term being ignored. This myopia delays to the serious pursuit of the drastic societal change required to secure a better climate future.
Despite their shortcomings, even the present incarnations of 'Cap and Trade' systems have had some success in incentivising emission reductions. Further fine-tuning will allow these schemes to realise their full potential to contribute to the rapid realisation of a sustainable and decarbonised society. Carbon markets must be carefully regulated to ensure that all incentives are aligned towards the timely achievement of sustainability and development goals. Emissions allowances must be allocated via auctions to create a competitive carbon price. The use of funds raised through carbon markets should be regulated to ensure that a percentage is re-invested in further sustainability progress.
Carbon credits must be given diminishing value structures in order to prevent organisations meeting reductions quotas purely through the work of others. The non-equivalence of different carbon emissions must be appreciated and accounted for by the market. All this rests on robust mechanisms of carbon accounting, without which even the best structured and regulated market will be undermined by leakage of emissions that go un accounted for. By working hard to optimise the structure of ‘Cap and Trade’ systems in these and other way, they can be made central components of the journey towards a decarbonised and fair society.
Written by Louder than the Storm Political Lead, MacGregor Cox