The commodification of natural resources has long-centred on the value derived from the tangible hydrocarbon, metal or rock – the item that will be processed and sold for profit. Many industrial players have found ways in which they can recycle or reuse their by-products, such as the production of hydrogen in the refining process or sourcing Uranium in the extraction of Gold. Yet, a commodity is merely an asset than can be traded and as the world rethinks our impact on the planet, the commodification of pollution has become a tangible asset to buy, sell or trade greenhouse gas (GHG) emissions – a policy instrument widely called an Emissions Trading Scheme (ETS).

These ETS policies vary between markets and countries; however, the idea remains largely the same from place-to-place. An ETS provides a framework for jurisdictions to allocate a defined quota per tonne of GHG emissions and divide these between sectors of the economy. In doing so, the allowances given or sold to emission-intensive companies are utilised over the contract length to mitigate their carbon impact. If a company has a surplus of these ‘allowances’ these may be sold or traded; if a company uses their quota limit, they must stop production (or face penalties) or purchase allowances from other entities.

A brief by the Organisation for Economic Co-Operation and Development (OECD) outlines the differences among the two main systems, a “Cap-and-trade system” and a “baseline-and-credit system”:

“In a cap-and-trade system, an upper limit on emissions is fixed, and emission permits are either auctioned out or distributed for free according specific criteria. Under a baseline-and-credit system, there is no fixed limit on emissions, but polluters that reduce their emissions more than they otherwise are obliged to can earn ‘credits’ that they sell to others who need them in order to comply with regulations they are subject to.”

These allowances are typically distributed via auctions or a direct allocation.  A preference has arisen for the open auctioneering of allowances as it limits the capacity for corporate lobbying and preferential treatment – while an auction also facilitates the development of a market price.

Benefits and Utility

The utility of and need for Emissions Trading Schemes has become pronounced in recent years as the global clarion call to achieve net-zero reached new horizons. The Paris Climate Agreement set out a legally binding framework in which a global, concerted effort could effectively combat climate change – the main goal being to limit global atmospheric heating to 1.5 degrees Celsius.

By developing a market in which emissions are measured and charged for, governments can track and limit their impact on the atmosphere against the measures outlined in the PCA. In turn, this develops a platform (or platforms) through which practical and consistent reductions in emissions are dictated by market forces and trade, more so than regulation – often a sticking point in global agreements.

Limitations

Of course when developing the concept of an ETS across regions and economies, there are challenges that arise in moulding the policy mechanism in-line with economic or political objectives. Yet the prevailing schemes set up across the world, in vastly differing contexts, suggest that emissions trading schemes are flexible in their design.

The first issue is how to define the cost of carbon and why straight carbon tax is not sufficient in encouraging action.

A set-price ‘carbon tax’ creates an interesting dilemma wherein polluters are paying for the emissions, yet in a manner that provides little incentive or room to make effective reductions in their processes. In a “baseline-and-credit” scheme the emitter may simply accept their emissions, as long as they can afford them. If the cost of emissions reductions is higher than the profit derived from their carbon-intensive product, the incentive is to continue production.

On the other hand, a “cap-and-trade system” develops a market price through the distribution of allowances that are purchased for use or if unused, sold on a secondary market. The capacity for companies to trade these allowances provide incentives to lower their emissions, for the lowest cost, in order to sell their surplus quota – providing an additional income stream.

Additionally, an ETS differs from a carbon tax in that it sets a clear ceiling on emissions, rather than taxing each tonne of emissions an entity creates. Without a limit on emissions, a profitable but carbon-intensive entity may accept the tax and pass on the financial burden to their consumer. However, an ETS ensures that a carbon-intensive company can only produce a set level of emissions before having to purchase allowances from a competitor or facing strict penalties for failing to comply. The consequence is a global, diverse range of actions taken to combat emissions – it places the onus on the emitter to change and develops a new market of economic activity.

Secondly, the broader effects of an ETS are less pronounced but similarly as significant – the creation of environmental and social co-benefits that passively work to improve the world we all live in. Resources are used more efficiently and sparingly; fewer emissions ensure cleaner air and waterways; greater energy security which in turn creates geopolitical stability; and the cost of technologies lowered to be inclusive for less wealthy, underdeveloped nations to make the shift.

Thirdly, there is the concern of ‘carbon leakage’ – essentially, the shifting of emissions from a ‘home’ country to the third-world where regulations are not as concerned with the climate. To mitigate this states will provide an expanded number of free allowances to competitive industries that may leave. As ETS become more pervasive, these incidences will diminish but it presents a concern for countries who wish to make greater GHG reductions against countries who seek greater economic growth, no matter the cost.

Practically, how are these implemented at scale and what are tangible affects can we appreciate in the present to encourage the promotion of Emissions Trading Schemes? The Energy Council has highlighted a selection of the most prominent Emissions Trading Schemes:

Emissions Trading Schemes around the world

European Union

Since 2005, the European Union has pioneered the ‘cap-and-trade’ ETS, limiting the emissions of 11,000 heavy-emitting industries and airlines across the region and regulating over 40% of the continent’s emissions. The September 2020 revised ‘impact-assessed plan’ sought to maximise on the Covid oil and gas slump to push for greater reductions in emissions, pushing the reduction target to 55% by 2030.

The EU ETS is in it’s third phase; replacing national caps with an EU-wide cap, utilising auctions to dispense of allowances, a broader industrial application and development of an innovation fund from the sale of allowances.

With Phase 4 expected to begin in 2021, the EU will further their commitments to the ETS by establishing a market stabilization reserve that would reduce risks to the carbon market price, and seeking annual emissions reductions of 2.2%. As of January 2021, the EU ETS had reached a record high price of €33.11 per tonne of GHG emissions.

North America

The United States has no national ETS, as energy policy and supply is predominantly a decision of state legislatures and an attempt by former President Obama failed to secure a national GHG ETS failed to pass into law. Due to the failure of the federal government to establish a level of emissions restrictions, the onus fell to many state legislatures to develop their own policies.

The most prominent scheme is the Regional Greenhouse Gas Initiative (RGGI), a collective agreement among 12 of the most north eastern states to reduce their GHG impact and to develop a ‘cap-and-trade’ ETS that allows for the development of a carbon market. Each state develops their own budget and regulatory guidelines, which are combined to establish the regional cap of allowances that are placed at auction each quarter.

The ETS has had succeeded in both driving down the emissions of the targeted sectors by 40% while economic growth has risen 8%, and in doing so, developing a functional market price. Although the ETS at $7.41 per short ton of GHG emissions remains significantly lower than the EU ETS, the euro-price for carbon was at a similar level only two years ago. This does not factor in the imbalance in the comparison between the world’s strongest trading bloc and a group of twelve like-minded states. The potential for growth has been established.

California is the only other state to have implemented an independent ETS, promisingly however five more states in deeper Republican territories have ETS legislation under consideration.

South of the border, Mexico has introduced an ETS pilot policy in place from January 2020 to test the efficacy of the scheme – however, any economic impact to entities is on-hold over the pilot period.

North of the border, Canada has two provincial schemes, one each in Nova Scotia and in Québec that have grown their carbon markets to between $15-16 per tonne of CO2e. Signalling promise for a broader regional integration with the RGGI.

East Asia

While the Asia Pacific region trails behind the global West in progressive climate policy action, several countries have taken up a form of an ETS – most promisingly these include the chief regional emitters in China, Japan and South Korea. The necessity of these states in reducing their significant industrial emissions can not be understated, and their action toward emissions reductions is increasingly positive.

South Korea has arguably the most successful ETS in the region, and the second largest after the EU ETS. Developed in 2015, the project covers around 70% of emissions from the country’s 610 largest polluters. Now in it’s third-phase, Korea has continually raised the targets of their emissions reductions, expanded the auctioneering of allowances and opened the market to allow for limited international allowances. As a result South Korea has achieved the world’s second highest carbon price at $25.59 per tonne/CO2e.

China has a two-tiered system that covers a National ETS, while also developing more localised city-wide ETS across their major industrial hubs. The National ETS is a five-year pilot scheme covering 30% of national emissions, instituted to develop effective market infrastructures and to simulate the trading of carbon.

Simultaneously, there are ETS policies in force across eight of China’s major city jurisdictions that cover at least 40% of industrial emissions, with a carbon price typically between $2-4 per tonne CO2e. Beijing bucks the trend attaining a carbon price of $11.37 per t/CO2e, the success being a driving factor in a cross-regional trading with the city’s provincial neighbours.

Japan’s ETS covers the cities of Tokyo and Saitama, which requires entities to reduce their GHG emissions by up to 27% before 2024. A report released by the Tokyo Metropolitan Government indicated that 79% of entities had surpassed their targets between 2015 – 2019.

Rest of the World

Throughout the globe, the schemes are becoming an attractive outlet for nations to manage and monetise their carbon markets; 11 other countries (and 5 US states) have legislation under consideration and 4 countries (3 US States) are actively developing legislation.

As ETS become more established and the schemes begin to entrench a fair market price for carbon across different trading platforms, it is likely they will become pervasive throughout most nations. Poorer nations are often dependent on these progressive measures to be trialed where the economic impact can be mitigated more effectively. However, it is necessary there is an inclusive global program to promote ETS’s in order to avoid the shifting of carbon-intensive assets to poorer nations via the carbon leakage.

 

It is the view of The Energy Council that the implementation of Emissions Trading Schemes will encourage and facilitate the commercial argument for cleaner industry. The demands of investors now rely on the guidance of ESG principles to dictate their commitment to pollution-heavy industries, in turn, this influences the direction of the business to actively reduce their impact to secure new funding. By making the necessary reductions, each entity may then utilise their success to sell their leftover allowances.

The commercialization of emissions and the development of international carbon markets is one of the most effective policy mechanisms that will directly reduce GHG impact, while also benefitting the local economy via the incorporation of a new trading platform.