Emissions trading uses a property rights approach to provide incentives for individuals to conserve their environment by clarifying their rights to and responsibilities for common property. The common property in question is the quality of the environment and, in this particular case, the quality of the atmosphere.
There are four main variations on emissions trading systems:
- a cap-and-trade system
- project based schemes, or
- hybrid schemes.
The cap and trade approach creates a system of tradeable permits allowing a set amount of emissions to be made. The number of tradeable permits is fixed, in effect limiting the amount of emissions that can be made in any one period. Tradeable permits are quotas, allowances or ceilings on pollution emission levels that, once allocated to the polluters, can be traded subject to a set of prescribed rules. The ownership of a tradeable permit allows a firm to pollute up to a certain limit. If the firm wishes to expand production, then they must either invest in pollution control equipment or purchase more permits. Firms which choose to emit less than their allowance may sell their surplus permit to other firms or use them to offset excess emissions in other parts of the plant. In this pollution control regime, firms with the lowest abatement costs have an incentive to control more emissions, and those with high abatement costs have an incentive to buy permits instead of investing in costly pollution control equipment. The market is left to determine the most efficient way to control pollution within a regulatory framework.
The European Union's Emission Trading System is the major example of a cap-and-trade system currently operating.
An alternative approach is a baseline-and-credit system. Under this approach participating emitters are allocated a certain amount of allowable emissions, called their baseline level of emissions. These emitters then must surrender enough emissions credits to account for their emissions above this baseline. Third parties create the credits through various projects and then sell these credits to the emitters, or other market participants. Ideally, as the emitter’s baseline is lowered the overall amount of emissions reduces.
The important difference with this approach is that emitters are not under a strict aggregate emissions cap. Rather, they are required to purchase offsetting emission credits. These credits are created by firms or development projects that either reduce the amount of overall emissions or destroy/absorb existing emissions.
The New South Wales Greenhouse Gas Reduction scheme is an example of this type of approach.
Project based markets
A feature of the Kyoto Protocol was the development of the so called ‘flexible’ mechanisms. These mechanisms are approaches designed to lower the overall cost of reducing, or offsetting, unwanted greenhouse gas emissions.
The two main flexible mechanisms are the, Clean Development Mechanism and Joint Implementation Projects. Generally, use of these mechanisms is only open to countries that have ratified the Kyoto Protocol. The emission reduction credits generated by these projects are used by individual countries to offset their emissions on a national scale.
The Clean Development Mechanism (CDM) is an arrangement under the Kyoto Protocol allowing industrialised countries with a greenhouse gas reduction commitment to invest in projects that reduce, or destroy emissions in developing countries, as an alternative to more expensive emission reductions in their own countries. An example would be investment in a project that, as a part of its activity, collects methane (where the methane is a by-product of another economic activity) and uses it to generate electricity. Currently, China hosts the greatest number of CDM projects.
A Joint Implementation Project (JI) is similar to CDM save that the investment is in another country that also has emission reduction obligations under the Kyoto Protocol. A JI project might involve, for example, replacing a coal-fired power plant with a more efficient combined heat and power plant. Most JI projects are expected to take place in so-called ‘economies in transition,’ noted in Annex B of the Kyoto Protocol. Currently Russia and Ukraine appear to host the greatest number of JI projects.
The emissions units generated by these projects can be used by Kyoto Protocol signatories to meet their emissions targets under this Protocol. Individual participants in specific emissions trading schemes (such as the NZ emissions trading scheme) may also use these units to meet their responsibilities under those schemes.
As the name suggests a hybrid emissions trading scheme is one that combines selected features of the above approaches. For example, an emissions trading scheme where the price of the emissions permit is subject to set limits combines the features of a carbon tax and a cap-and-trade scheme. A scheme that allows the unlimited use of Kyoto Protocol emissions credits combines the features of a cap-and-trade, and the project market, approach.
The final version of the now defunct Australian Carbon Pollution Reduction Scheme was, in effect a hybrid scheme, whose main structure was cap-and-trade, but with set limits on the price of an emissions permit in its initial years and unlimited acceptance of certain types of Kyoto Protocol emissions credits.