How Does Carbon Trading Work?

Ever ask yourself, "How does carbon trading work?" Also known as "emissions trading,"carbon trading has evolved from work done in the US in the mid-1990s to limit acid rain producing gases. Today, carbon trading has evolved into a market estimated at almost $100 billion dollars a year.

How Does Carbon Trading Work To Clean The Air

Carbon trading is designed to limit the emission of harmful gases into the atmosphere by industrial production. Carbon dioxide, methane and nitrous oxide are gases that have been identified as having long-term, harmful effects on the atmosphere. Giving companies a financial incentive to lower their emissions is seen as an efficient way to reduce pollution in a cost effective way. Here's how carbon trading works:

• Setting limits. The first step in establishing a carbon trading system is for the governing body to determine the amount of intended reduction. Typically, this reduction is expressed as a percentage of current production. If the goal were a 10% reduction, then each plant in a given industry would be charged with reducing emissions by that amount.
• Creating a market. Once the reduction goal (also called a limit or cap) is established, each source of emissions (factories, power plants, etc.) is given a permit allowing them to produce a specific amount of the gas in question. This limit is typically expressed in arbitrary units. These units are given monetary value, making them tradable and bankable.
• Rewarding efficiency. Given that each factory or plant operates under different conditions, some may not be able to operate under their new cap, while others might become more efficient and operate well under their cap. The more efficient factories are now able to sell or trade their excess units to factories that are less efficient. This system provides a direct financial incentive for factories to reduce emissions, while providing less efficient factories a way to stay in business-at an increased cost.
• A simple example. Consider three independent power plants called Alpha, Beta and Gamma. Each plant has a carbon cap of 10 units. Power plant Beta only produces 7 units of carbon, while Alpha produces 12 and Gamma produces 11. Beta may sell its 3 excess units to Alpha, Gamma or a third party. Alpha and Gamma will have to decide whether it makes more financial sense to purchase the units from Beta or reduce their own emissions.