The other day I wrote an article on how carbon taxes could be used as a way of addressing carbon emissions. Today I’m going to look at another widely accepted method; emissions trading, or the cap and trade system.

Instead of charging a fixed tax for each tonne of carbon dioxide emitted, the government sets a limit on annual emissions for the country (called the ‘cap’). These limits are then allocated to polluters, giving them a right to emit a certain amount of carbon dioxide for the year. Let’s imagine these allocations as certificates, each one allowing the owner to emit a tonne of carbon dioxide

If the polluter has the right number of certificates to cover the amount of carbon dioxide that he emits during the year, then life is simple. At the end of the year, he submits one certificate to the government for every tonne of carbon dioxide that he emitted.

However, if the polluter doesn’t have enough certificates to cover the amount of carbon dioxide that he emits, then he needs to buy more to ensure that he complies with government regulations.

But where can he buy them? We can’t create new ones, otherwise the number of certificates would be larger than the carbon dioxide we set earlier.

Fortunately, some polluters will have more certificates than they need, and they are free to sell them to the highest bidder (the ‘trade’ part of the system). It works on a very simple supply and demand principle If there are a lot of extra certificates available, then the price of these traded certificates is low. If there aren’t many available, then the price goes up. Each year, the number of certificates are reduced in line with emission targets. Polluters are faced with an ever decreasing supply of certificates, and thus an increasing price of buying the additional ones that they need to continue business as usual.

So how does this result in emissions being cut?

Well, there are many technologies or options available to industry to reduce emissions, from changing energy sources, to increasing efficiency, to capturing and storing the carbon dioxide. Right now, the cost of these carbon reduction technologies is prohibitively expensive, but as the cost of buying all of these additional certificates gets higher and higher, they begin become economically viable.

For example, a power generation company has a coal fired power plant. It’s always been cheap to run, because coal is cheap, and no-one has been charging them for the huge amount of carbon dioxide they emit every year. This is the ‘Business As Usual’ scenario shown in the chart below.

A cap and trade system is put in place, and in the first phase they are only allowed to emit 90% of the carbon dioxide they did in the previous year. It’s a small reduction, and they have two options; continue to operate as normal and and pay the small price associated with buying additional certificates (P1 – Purchase), or to reduce their emissions (P1 – Reduce). At their disposal is a technology known as carbon capture and storage, where the carbon dioxide is capture from the chimney and permanently stored underground. As you can see, at this stage, it is much cheaper for the power station owner to buy certificates, essentially paying someone else to reduce their emissions on his behalf.

Over the next few years, they receive fewer and fewer certificates until one year they are only allowed to emit 75% of the amount of carbon dioxide that they could in the first year. Again, the same two options are available (P2 – Purchase and P2 – Reduce), but the most preferable option has changed. This time, the additional cost of carbon capture and storage is much cheaper than having to buy the additional certificates. The main reason for this is that they have managed to reduce his emissions far below the amount that was required, meaning that they are now able to sell their excess certificates.

At a certain carbon dioxide certificate price, options like these make economic sense. For different technologies, and different industries, it happens at different certificate prices. The beauty of it is that in a highly efficient market such as Canada, the price of a certificate should be more or less equal to the cheapest way possible to meet the annual emission target. If someone can reduce their emissions for less, it is better to pay them to do it rather than waste money doing it yourself. We have incentivized the market to find the cheapest possible solution to climate change.

The overriding advantage of a cap and trade system is that, assuming there is a large enough penalty for breaking the rules, it guarantees emission reductions. The cost of buying an additional certificate will just keep rising until someone cuts their emissions. And since no-one has an unlimited supply of money to spend on certificates, at some point that becomes their only choice. It focuses directly on the problem by setting a maximum amount of carbon dioxide that we want to emit, as opposed to the indirect method of trying to specify an appropriate level of carbon tax to reduce emissions to the required level.

The downside is that it is a very complex system. Because of this it would take a number of years to implement. A large amount of administration would be needed to regulate the trading of these certificates, and because of the complexity associated with buying and selling certificates, it can really only be applied to large industrial emitters which make up only about 50% of Canada’s annual emissions. Also, due to the fact that cost of a certificate is not fixed, there is a certain element of uncertainty about what the price might be in 5 or 10 years time. For large industries, spending large amounts of money on projects that may well be operational for 25-50 years, this uncertainty can be a source of great frustration.

Emissions trading has been proven before, as it has been in use since 1990 in the United States in order to try and reduce sulphur dioxide emissions (responsible for acid raid) by 10 million tonnes from 1980 levels.. The most widely known example of a carbon dioxide cap and trade system is the European Union Emissions Trading Scheme. It has been running since 2005, and has had its fair share of teething problems. In the first phase, far too many certificates were handed out, meaning that virtually no-one needed to buy them, and those that did had an enormous number available to sell. The result was that the cost of a certificate dropped to about $0.01 per tonne of carbon dioxide. Lessons have been learned, and the second phase is proving to be much more successful, with the price currently trading at about $36 per tonne.