The best climate policy — environmentally and economically — limits emissions and puts a price on them. Cap and trade is one way to do both. A cap-and-trade scheme obligates polluters to pay for their emissions and creates certainty over the total quantity of the emission reductions that will be achieved.
At its core, a cap-and-trade or emissions-trading scheme operates as a market instrument to regulate greenhouse gas emissions. By imposing a cap on the total allowable emissions, this policy mandates that polluters pay for each tonne of emitted carbon dioxide or its equivalent. The scheme incentivizes emission reduction, creating a market where entities trade emission allowances. As a consequence of its construction, the policy rewards those who reduce their emissions. One tonne of carbon dioxide equivalent is a measure for the quantity of another greenhouse gas that gives the same amount of global warming based on the conversion factors adopted by the United Nations Framework Convention on Climate Change.
Entities within the scheme are allocated emission allowances, representing permissible greenhouse gas emissions over a specific period. Tradable in the carbon market, these allowances enable emitters exceeding their limit to purchase from those operating below it. The market-driven price of emission allowances ensures both certainty in emission reduction quantity and promotes cost-effective strategies for adhering to the assigned cap. Different caps, such as "absolute" and "relative," dictate the stringency of emission restrictions. "Baseline and credit" schemes assign entities target emission pathways, rewarding credits for emission reductions below the baseline and imposing the purchase of credits for excess emissions.
To mitigate costs, offsets—credits generated from emission reduction projects outside the cap's coverage—are employed. However, the use of offsets raises concerns about potential delays in transitioning to low-carbon energy systems. Cap-and-trade schemes can adopt "upstream" or "downstream" designs, each with unique implications. "Upstream" systems apply to fuel suppliers, offering simplicity and cost-effectiveness, while "downstream" approaches cover direct emitters, providing immediate price signals for behavioral change among consumers.
The coverage of cap-and-trade schemes varies, ranging from sector-wide to economy-wide approaches. Pilot schemes and modeling help determine optimal measuring methodologies, sectors, and entities for coverage. Gradual expansion or linkage with other schemes allows for flexibility in adapting to changing circumstances.
Trading platforms such as the European Climate Exchange and the Chicago Exchange facilitate the exchange of carbon credits. Essential infrastructure, including registries, verifiers, exchanges, and financial institutions, must be in place before trading commences.
Designing the cap-and-trade scheme as a generator-based “upstream” system, which applies to fuel suppliers, such as oil refiners and gas processors, assures a simple and less costly implementation because it involves relatively few participants and readily available data coverage. A “downstream” approach is a load-based system that covers the direct emitters of greenhouse gases and offers a more immediate price signal to stimulate behavioural change of consumers, which provides more emissions reduction options and has been more widely used to date. The coverage varies from system to system and can range from sector-wide to economy-wide approaches. In many cap-and-trade schemes, the coverage usually includes the electricity, energy and industry sectors. It is determined by the availability of information on emissions and the respective measurement methods and systems in place. Pilot schemes and modelling exercises are used to determine the best measuring methodologies. Through them, the greenhouse gases, sectors and entities (including the scale) that will be covered in the cap-and-trade scheme can be determined, based on eco-efficiency criteria. The coverage must also be evaluated by the government, the participating entities and the public. To ease their introduction, cap-and-trade schemes can start with a narrow coverage and then gradually expand to include additional sectors or entities that will be subjected under the scheme at a later stage or it can be linked to other cap-and-trade schemes or regions, for example via the offset mechanisms.
Carbon credits are exchanged on trading platforms, such as the European Climate Exchange in London, the European Energy Exchange in Leipzig, the Nord Pool in Oslo, the Bluenext in Paris and the Chicago Exchange in Chicago. The credits can be traded over the counter through brokers (banks or members of the exchange), among operators of businesses and through futures and spot markets. Voluntary credits, which can be used as offsets, are sold in dedicated trading platforms. Basic infrastructure needs to be in place before the trading begins: registries to collect data on emissions; accredited verifiers; exchanges and over-the-counter systems to enable trading; financial institutions; human resources, including information providers and analysts; and project developers.
trading programs, regulating nearly 11% of global emissions. An additional three programs are poised to commence, including an anticipated extensive cap-and-trade initiative in China. The preeminent European Union Emissions Trading System, inaugurated in 2005, encompasses 11,000 power plants, industrial sites, and inter-EU airline flights, constituting the largest extant cap-and-trade program. A critical reflection on the effectiveness of these systems underscores the notable achievements, such as the EU program yielding a 4% reduction in emissions. Despite commendable strides, concerns persist regarding low prices, volatility, and the imperative need for more robust pricing mechanisms to attain net-zero emissions by 2050.
Strict monitoring and enforcement is critical for ensuring the credibility of the scheme. Data collection and analysis is a vital element to kick off a cap-and-trade scheme, especially for setting the appropriate emissions cap. A registry must be set up to track and verify emission reductions from the participating entities. Verification of data is carried out by a third-party audit or through self-reporting with auditing. Many developing countries, however, may lack the capacity to collect and analyse the data necessary to operate this kind of emissions registry. In this case, technical assistance from experienced industrialized countries can be effective in designing and employing cap-and-trade schemes. Some countries can build on existing systems and capacities at the national level; for example, existing data collection and monitoring infrastructure for conducting greenhouse gas inventories (which respond to the reporting requirement of the climate change National Communications under the United Nations Framework Convention on Climate Change) can be used to measure emissions and emission reductions and assure compliance with the cap-and-trade scheme.
The trajectory toward a sustainable future mandates perpetual growth in well-crafted initiatives, stringent pricing mechanisms, and heightened prices to decisively confront the existential climate dilemma
Adapted from Low Carbon Green Growth Roadmap for Asia and the Pacific, United Nations Economic and Social Commission for Asia and the Pacific,
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