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What Is Carbon Trading?

Human activity is in a large part responsible for causing irreversible climate change that will cause economic and social upheaval if measures are not taken to limit global temperature rises. Carbon emissions trading is a system designed to provide an incentive for the economy to reduce greenhouse gas emissions. It is often described as carbon trading as the main greenhouse gas that is a greenhouse gas is carbon dioxide, also known as CO2.

There are three main choices available to incentivise greenhouse gas emission reduction and, in turn, to slow climate change. The primary one is the direct regulation of smokestack emissions. It’s a rigid process that doesn’t reflect the capacity of the polluter to efficiently reduce their carbon dioxide emissions. The second mechanism is carbon taxation, a market based mechanism, i.e. one that rewards emissions with financial incentives reductions, however it lacks the flexibility of a guarantee for emission reduction. The third option, which is arguably the most efficient one is cap and trade. A cap is set on the system that is managed with only a certain, and decreasing the number of permits for pollution. The emitters who can cut their emissions at low cost do so and then sell the permits to those who find it more expensive to cut emissions.

“Cap and Trade” creates an incentive for profit to reduce emissions further for those most capable and reduces the cost of compliance for the least capable. The effective distribution, through trade in carbon, for the very limited capacity of the atmosphere to absorb greenhouse gas pollution is beneficial to the entire economy. At the same time pricing encourages the development of new methods to cut carbon emissions, and markets allow for transparent pricing of the cost of emissions reductions.

How does carbon trading work?

Carbon trading involves the purchase and selling right to emit a tonne of CO2 or a similar amount (CO2e). The right to emit a tonne CO2 is usually described as a carbon ‘credit’ or carbon allowance. For instance, in the EU Emissions Trading Scheme there is the EU Allowance (EUA) and in the California scheme, there’s the California Carbon Allowance (CCA). The allowances of the various trading systems can be bought and sold by any person, however they will ultimately be distributed to the consumers when they require them to cover their regulatory compliance obligations.

Allowances may be in paper format, much like share certificates, however to maximize efficiency, they are in digital form and are stored in electronic ‘registry’ accounts which are similar to an internet banking system. The accounts of the registry in compliance systems are managed by the regulator of that system to ensure the integrity of the.

Carbon allowances’ trading similar to the trading of all other kinds of commodities. Futures exchanges can be used to facilitate spot and longer dated deliveries plus options. The same type of trade can take place ‘over the carbon credit exchange‘ (i.e. in a bilateral manner) between two counterparties who are willing and typically include carbon broker acting as introductionrs, or as intermediary counterparties.

Who can exchange carbon allowances?

Anyone can take part with carbon trading. In Europe there are no limitations whatsoever on who is able to manage a registration account. The main players with carbon trading are usually;

1. compliance installations (e.g steel, cement paper, chemicals, and aluminium factories that are located in jurisdictions with cap and trade schemes),

2. Trading firms, such as hedge funds,

3. electricity, gas and other utilities companies,

4. There are a few banks and

5. carbon brokers, whether as introducers or as intermediaries.

When can carbon be traded?

In the most liquid carbon markets trading can be found all day long all year long. However, the majority of installations which are covered by carbon trading systems have their activities close to compliance deadlines. For instance, in the EU ETS compliance purchase, the purchasing process is focused on the three months prior to the 30th April compliance deadline. This could result in price aberrations depending on the demand / supply balance at the time.

People with more exposure to electric utilities, tend to trade more frequently and buy in larger quantities. The majority of allowances are distributed to industries for free in the beginning stages of compliance plans, however in order to send a clear price signal to everyone in the long run, the amount of allowances auctioned by the government rises. This tends to spread the dates of trades throughout the year. It is a natural progression for markets that are maturing.

Where can carbon be traded?

It’s dependent on the scheme as different market spaces exist for each ETS around the world. However, in the EU ETS the majority of trading in emissions occurs through exchanges.

A good liquidity in the market is crucial if a carbon market is efficient. Liquidity is created by having no or low barriers to entry into the market and a high amount of market participants who are regular with low transaction costs, regularised contracts, clear pricing, and a lot of competition between purchasers and sellers. Liquidity naturally occurs when there is a healthy mix of compliance facilities; speculators, investors and carbon brokers. Liquidity is more likely to develop through exchange-based trading, where the rules and contracts are the same for everyone but around half of all EU ETS trades have been transacted bilaterally between two different counterparties. Exchange trading can be expensive particularly for smaller market participants, because of fees for membership, clearing and trading costs.