Human activity is in a large part responsible for causing irreparable climate changes that could create economic and social turmoil if appropriate measures aren’t taken to stop global temperature increases. CO2 emissions trading a system that is designed to give an economic incentive to cut down on greenhouse gas emission. It is often called carbon trading, since the primary greenhouse gas is carbon dioxide, CO2.

There are three main choices available to incentivise greenhouse gas emission reduction and, in turn, to slow the impact of climate change. The first is direct regulation in smokestack emissions. It’s a rigid process that does not allow for the capability of the polluter to economically efficiently reduce their emission of greenhouse gases. The other mechanism is carbon taxation. It’s a market-based approach, i.e. one that encourages financial incentive for emissions reductions, however it lacks both flexibility and a guaranteed reduction in emissions. The third option, which is arguably the best, is limit and trade. A cap is set on the system and it is controlled by only a certain, and decreasing the number of permits for pollution. The emitters who can cut their emissions at low cost do so and also sell permits to those who find it more costly to reduce emissions.

“Cap and trade” is the incentive to cut emissions even further for those who are capable and reduces the cost of compliance for the least capable. The efficient distribution, via emissions trading of finite capacity of the atmosphere to adsorb greenhouse gas pollution helps the entire economic system. While at the same time, the price encourages new ways to reduce carbon emissions and markets are able to clearly price the environmental benefits.

What is the carbon trading process?

Carbon trading involves the purchase and selling right to release a tonne of CO2 or the equivalent (CO2e). The right of emitting a ton CO2 is usually referred to as carbon credit or carbon allowance. For example in the EU Emissions Trading Scheme there is the EU Allowance (EUA) and in the California system, there’s the California Carbon Allowance (CCA). The allowances in each trading system can be bought and sold by anyone but ultimately they reach end-users when they need the allowances to cover their compliance with regulatory requirements.

Allowances could exist in paper form much like share certificates, however for efficiency, they’re only in digital format and are kept in electronic “registry” accounts similar to an online banking system. The accounts for registry within compliance systems are managed by the regulator of that system to maintain integrity.

Trading in carbon allowances is similar to the trading of all other kinds of commodities. Futures exchanges can be used to facilitate spot and later dated delivery, as well as options. The same trades can be conducted ‘over the over the counter’ (i.e. in a bilateral manner) between two counterparties who are willing and frequently comprise carbon brokers as introducers or as an intermediary counterparty.

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Who is able to trade carbon allowances?

Anyone can get involved in carbon trading, in Europe there are no limitations regarding who can manage a registration account. The principal groups that participate with carbon trading are usually;

1. Installations that are compliant (e.g steel, cement, paper, chemicals and aluminium factories that are located in areas that have implemented 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 as well as

5. Carbon brokers whether as introducers or intermediaries.

How often is carbon traded?

In the carbon markets that are most liquid, trading can be found throughout the day all year long. However, the majority of installations covered by carbon trading systems focus their activities around compliance deadlines. In the EU ETS compliance purchasing is focused on the three months preceding the compliance deadline on April 30th. This could result in price aberrations depending on the supply / demand balance at the time.

People with more exposure, such as the electricity utilities, are able to trade more often and make purchases larger amounts. There are many allowances given to companies for free in the beginning stages of compliance schemes but to give a price signal to everyone in the long run, the amount of allowances sold by government agencies grows. This causes a spread in the time of trades throughout the year, and is an inevitable progression to a mature market.

Where is carbon traded?

It will be contingent upon the scheme, as various marketplaces exist for various ETS all over the world, but in the EU ETS the majority of emissions trading is done on exchanges.

Good market liquidity is essential to allow a carbon market to be effective. Liquidity is created by having low or no barriers to entry into the market, a large number of regular market participants and low transaction costs. regularised contracts, clear pricing, and a lot of competition between 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 from trading based on exchanges where the rules and contracts are the identical for all, but about half of all EU ETS trades are traded bilaterally between two counterparties. Trading on exchanges can be expensive, especially for smaller market participants, due to the cost of membership, clearing and trading fees.