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Climate change is one of the most salient issues in modern politics. The basic question is: how do countries and companies reduce the harm they are causing to the environment without significantly compromising their economies and financial prosperity?
One answer is carbon markets. The first carbon market was created by the EU in the early 2000s, and the basic premise is this: polluting industries sign up to a scheme in which the government sets a limit, or a cap, for the volume of greenhouse gases (GHG) they can emit. For every metric of carbon dioxide equivalent (CO2e) that a company emits, it needs to provide one ‘carbon credit’ to offset the pollution. These carbon credits, also called allowances, can be bought from the government and fortnightly auctions, traded on secondary markets (like a stock market), or be given for free if the government deems a company eligible. This type of system is called a cap-and-trade system.
If a company emits more than the government target, it needs to buy carbon credits either from the government or on the secondary market. However, if they reduce their emissions, companies can sell their credits to those who need it for a profit, thus incentivising companies to cut their pollution. The organisation in charge of this system is the UK Emission Trading Scheme (ETS) – Britain left the EU ETS following Brexit. The number of allowances in circulation is determined by the UK ETS Authority, and each year the total volume decreases, thus requiring companies to reduce emissions over the medium term. A layered system of government Regulators and accredited third party verifiers manage the market and enforce compliance to the ETS Regulations.
The UK ETS applies to Greenhouse Gas (GHG) emissions from power production, energy intensive industry, oil and gas, and CO2 emissions from aviation. A company or individual who has signed up to the scheme are called ‘operators’, and operators are separated into bands depending on the size and type of environmental impact they have.
China has also just launched a national carbon trading market. Instead of UK Allowances (UKA), carbon credits are referred to as Carbon Emissions Allowance (CEA). A notable difference between the UK and China is that the cap on government distributed credits is stricter in the UK than in China. Instead of stating a fixed number of CEAs to be distributed, less specific targets are made based on the pollution levels of previous years. However, as China’s new national ETS matures, the Chinese government may begin auctioning CEA, similar to how UKA are auctioned, which could lead to tighter distribution volumes.
For a more detailed breakdown of carbon markets and how the work, check out the video below
The two markets highlighted are called compliance markets – they are government regulated, and the companies who are included are legally bound to the commitments they make. There is, however, a second dimension to carbon trading: the voluntary market. This, in contrast to the UK's ETS, is unregulated. No overarching framework of standards and registration exists. Instead, individuals undergo projects that contribute to emission reduction – a common example would be the construction of a wind farm which provides renewable energy. In the UK, there are no government or accredited third-party organisations to verify the quality of carbon credits traded on the voluntary market, or the process which claims to have earnt them. Some ad-hoc standards have begun to emerge. However, these standards remain inconsistent with each other, and many companies opt, on the voluntary market, to only buy credits which originate from the compliance market. Critically, however, any allowances bought on the voluntary market cannot be used by companies to offset any legally binding GHG reduction targets, such as the ones in the ETS. This is why regulation is not essential – there are no legal stakes.
This is one of the major differences between the Chinese and British carbon trading systems. China relaunched its voluntary market, on which credits are referred to as CCER, this year after 7 years of stagnated growth. Importantly, CCER can be used by major companies (called ‘key emitters’) to offset their emissions in the Chinese compliance market (the ETS). The process for individuals and companies to sell CCER is therefore much more regulated, with government and third-party verifiers checking that the project in question merits a carbon allowance.
On the one hand, this incentivises carbon mitigation and sequestration projects amongst businesses in a way that the UK system does not. Since CCER can be used to fulfil ETS obligations, there is higher demand from key emitters for them, which in turn stimulates supply. The result is that China has a vibrant sector of GHG reducing projects which curb environmental damage and stoke economic growth. The danger could be that China’s system risks slower progress over the medium-term in actually reducing net carbon emissions. Unlike the UK, where the cap on the number of allowances which circulate in the compliance market is not concrete, a high supply of CCER and CEA will allow companies to continue off-setting their emissions cheaply and not actually reducing their emissions over the medium term. This concern is mitigated, however, by the fact that CCER can only form 5% of key emitters CEA commitments, meaning that potential for the supply of CCER to become inflated is limited. As stated earlier, the lack of a strict limit on CEA could be indicative of the Chinese ETS’ relative infancy, having only been unified from its parent regional pilot programs 3 years ago.
Carbon trading markets are therefore forming an important way in which major global economies are tackling climate change. Both the UK and Chinese governments have expressed willingness to open their respective ETS to international involvement, and cross-border cooperation in these markets could be the key to halting the rise in global CO2e emissions.
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