The primary way to mitigate human-induced climate change is to reduce and prevent emissions of greenhouse gases such as carbon (Intergovernmental Panel on Climate Change, 2014). The Kyoto Protocol was the first instrument to develop market-based mechanisms for reducing greenhouse gas emissions. In doing so, the Kyoto Protocol recognised emissions trading as a viable mechanism for reducing greenhouse gas emissions and mitigating the effects of climate change. Nevertheless, international progress on addressing climate change almost halted following the decision by the US to not ratify the Kyoto Protocol and was further frustrated when the 2009 negotiations in Copenhagen collapsed.
The Kyoto Protocol’s development of market-based mechanisms, coupled with the slow progress of international climate negotiations, contributed to the development of various regional, national and sub-national polities emissions trading schemes. For instance, California, Shanghai, New Zealand, Quebec, Kazakstan, the European Union (EU), Switzerland, Tokyo and Republic of Korea all have varying ETSs. In fact, an estimated half of the population of developed states live in a country or area with an ETS (Garnut Review 2011, 58).
Emissions trading is a market-based mechanism to reduce emissions of pollutants-particularly carbon and other greenhouse gases. There are two ways in which emission trading schemes are designed and regulated by the government or a private actor, but in practice these schemes may take elements of both models.
The first and most commonly employed emissions trading scheme is the cap-and-trade system. This model creates what is considered to be a compliance or regulatory market because it relies on public administration. Furthermore, participation in the market is generally for regulatory compliance purposes. In a cap-and-trade ETS, regulators:
A participant in a cap-and-trade emissions trading scheme is incentivised to reduce its emissions. Each time an entity uses an emission entitlement on its own emissions, it misses the opportunity to sell the entitlement. If a party exceeds its allocated emission entitlements, they must purchase more allowances from other parties. If they does not purchase more entitlements, it will exceed the cap and incur penalties. Meanwhile, a participant that can reduce its emissions at a lower cost than the cost of buying allowances will be incentivised to do so by being able to profit from on-selling its unused allowances to those parties concerned about exceeding the cap.
The second type of emissions trading scheme is referred to as a baseline-and-credit system. Unlike the cap-and-trade model, emission entitlements traded under this model are unlimited and no target cap or limit on emissions has been established. Instead, emission entitlements are generated by offset projects such as constructing energy-efficient buildings. Participation in baseline-and-credit schemes tend to be voluntary, but the model is also employed by regulators so participation can be mandatory depending on the context. Where a baseline-and-credit scheme is mandatory, a regulator could be able to penalise an actor for exceeding the baseline or require that they purchase allowances. Where the scheme is voluntary, any entity can formulate an offset project and participate in the emissions market.
Typically under a baseline-and credit scheme, an emitting party reduces their emissions below an established baseline, commonly by conducting offset projects, receives tradeable emission entitlements. The emission reductions or removals that result from a project will follow a specific, scientific verification process created under the particular emissions trading scheme. Those administering a baseline-and-credit scheme have to set a baseline to measure emission reductions or sequestration against. Emission entitlements will be granted to the person who has reduce their emission below the set baseline, and the amount of entitlements conferred represent the volume of emission reductions.
As emissions trading schemes develop and become inter-linked, clear distinctions between models and modes of participation (i.e. voluntary or mandatory) are being blurred.