Emission trading systems set a cap on greenhouse gas emissions
Emission trading systems (ETS), also referred to as cap-and-trade systems, set a cap on greenhouse gas (GHG) emissions that declines annually to achieve the climate goals of its jurisdiction or members. Carbon allowances equal to the emissions cap are then either freely allocated or auctioned to emitting entities who may then trade these allowances between them. The supply and demand for these allowances establishes a market price.
Allowance trading is a key benefit of ETS as it incentivizes least-cost abatement, as firms with a low abatement cost will abate and sell their allowances to firms with a higher abatement cost (as shown in the diagram below). An ETS also often allows firms to “bank” allowances and hold them for use in future compliance years. Emitters with an insufficient amount of allowances required for their industry at the end of the reporting period incur penalties.
Global compliance carbon markets grew by 21% in 2020 to reach US$261 billion in value, according to Refinitiv, which was over a fivefold increase in three years. According to the World Bank, there are 29 ETSs operating worldwide in April 2021. These ETSs collectively cover 9 gigatons of carbon dioxide equivalent (Gt CO2e), representing 16% of global GHG emissions.
Many companies will purchase carbon credits in the compliance markets for long-term price appreciation with selective trading when specific events or supply/demand imbalances create opportunities. These companies will principally focus on compliances credits from three ETSs: the European Union emission trading system (EU ETS) and North America’s two main carbon markets, the California-Québec linkage under the Western Climate Initiative (WCI) and the Regional Greenhouse Gas Initiative (RGGI) in the US Northeast.
EU ETS: The EU emission trading system (EU ETS) is the largest carbon pricing system in the world by value (the recently launched ETS in China is the largest by volume of emissions), covering around 40% of Europe’s GHG emissions and approximately 4% of global GHG emissions. The scheme covers emissions from various heavy emitting industries such as power, oil reﬁneries, steel, mining & materials, paper & packaging, chemicals and aviation. The EU ETS was established in 2005 and is now in its fourth phase, which started in January 2021. The EU ETS represents the central pillar of the EU climate change policy and its principals are modified periodically to achieve climate policy goals. The European Commission recently raised the GHG reduction target to 55% below 1990 levels by 2030, up from 40%, to achieve the objectives of the European Green Deal.
WCI: California and Québec each independently established cap-and-trade systems using the framework developed by the Western Climate Initiative (WCI). Their first compliance periods started on January 1, 2013 and their systems were linked one year later, creating the first international cap-and-trade system consisting of sub-national jurisdictions. The California cap-and-trade system (CaT) is enforced by the California Air Resources Board (ARB). The program applies to power generators, industrial plants and fuel distributors and covers approximately 80% of the state’s total GHG emissions. The Québec cap-and-trade system covers fossil fuel combustion and industrial emissions in power, buildings, transport and industry, and covers approximately 82% of the province’s total GHG emissions. Both systems have an auction reserve price that increases by 5% plus inflation each year.
RGGI: The Regional Greenhouse Gas Initiative (RGGI) was the first market-based carbon pricing initiative in the United States. It is a cooperative effort among the states of Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, Vermont and Virginia to cap and reduce CO2 emissions from the power sector. Pennsylvania is considering an ETS and linking to RGGI.