Carbon Trading

Carbon Trading

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks about Carbon Trading.


Carbon trading is a market-based system focused on alleviating greenhouse gases, particularly carbon dioxide which is emitted by burning fossil fuels. Carbon trading is essentially the purchasing and selling of credits that allows a country, company, or entity to emit a specific quantity of carbon dioxide. The credits are authorized by governments with the aim to gradually reduce the overall carbon emission and alleviate its contribution to climate changes.

China, in July 2021, started a national emission-trading program. The program currently involves 2,225 companies in the power sector. The program is designed to aid the country reach its goal of achieving carbon neutrality by 2060. This program will overtake the European Union Emissions Trading System to become the world’s largest carbon trade market.

How does Carbon Trade work?

The carbon trade commenced with the Kyoto Protocol. It was a United Nations treaty set in 2005 with the aim to alleviate the global carbon emission and mitigate climate change.

The carbon trade works in the following way. Each country is allocated with a certain number of permits to emit carbon dioxide. For instance, if a country does not utilize all of its permits, it can sell the unused permits to another country. However, a slightly small number of new permits is allocated to each country every year.

The main agenda is to motivate each country to cut back on its carbon emission as an incentive to sell its new permits. The bigger and wealthier nations used to buy the credit from the poor and higher polluting countries. But over time, those wealthier countries reduced their emissions. As a result, those nations don’t need to buy as many on the market now.

The Cap-and-Trade System

The cap-and-trade system is a variation on carbon trade, in which, the trade is conducted between companies and is authorized and regulated by the government. Each firm is given a maximum carbon pollution allowance and unutilized allowances can be sold to the other firms. The main aim is to ensure that companies as a whole do not exceed the baseline level of pollution, which is reduced annually.

In the U.S. and Canada, a group of states and provinces got together to start the Western Climate initiative while the state of California has its own cap-and-trade program.

Countries don’t pay for the harsh effects of burning the fossil fuels and producing carbon dioxide, they incur some costs such as the price of the fuel. While the price of the fossil fuel is a cost itself, there are other costs as well, which are known as externalities. Externalities are the cost or benefits received by the society at large who may or may not consume products that cause such externalities. Even though externalities can be positive in nature, they are usually negative which means that consumption causes adverse effects on third party. For example, using fossil fuel as a source of energy causes environmental harm and global warming which are negative externalities experienced by the almost everyone despite people who might not indulge in fossil fuel consumptions.

Does carbon trading work to reduce emission?

Carbon trading is extensively criticized, especially because of the carbon dioxide emissions in industrialized countries is not declining at the necessary rate to avert the catastrophic climate change.

Many scientists believe that the best way is to shift to a low carbon energy, transport, agriculture, and industrial world now. They believe that we don’t have time to wait on the high price on carbon, thus, we need to directly regulate the use of the fossil fuel. There has been no evidence to prove that carbon trading has provided us with any form of monetary gain. However, the concept of pollution trading keeps appearing in proposals to reduce the environmental harm, despite the flaws.

Advantages of Carbon Trading

The argument is that companies have a choice to use the most cost-effective method of meeting the requirements. For instance, these firms have incentives to reduce the carbon emissions and develop better technology to promote that. However, it is said to believe that if the price of permits is low, these companies might decide to buy more.

The main idea behind carbon trading is to gradually reduce the number of permits given every year by the government. Thus, forcing the companies to find more ways to reduce carbon emissions.

Disadvantages of Carbon Trading

  • Deciding the number of permits to allow is a complex task. For instance, in the initial period of 2005 – 2007, when the EU introduced the system of carbon trading, the price of the carbon permits came down to zero as the EU misinterpreted the number of permits.
  • It is very difficult to measure the carbon emissions of a company. Hence, making it a complicated system as well as difficult in measuring the constant transaction costs involved in the buying and selling of permits.
  • If carbon trading is effective in one country but not being followed in the other countries, it may cause a production shift to the others, known as the Free rider problem. Excess carbon emissions are a global issue and requires a global solution. Thus, countries don’t want to start carbon trading due to the fear of other countries free riding on their efforts.
  • Carbon tax might be a much simpler and easier to administer. Carbon trading might have greater impact on the low-income areas who have opportunities to change their lifestyle.

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About the author

The article was written in October 2021 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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