A carbon emission market is a platform for the trading of permit and allowances to emit carbon dioxide (CO2) and other greenhouse gases that contribute to global warming. The unit is calculated in tonnes of carbon dioxide equivalent (CO2e). The market for carbon emissions is a market-based instrument that has risen out of the need for a solution to the planets environmental issues.

This mechanism, also termed "cap-and-trade", has been created with the intention to act on climate change and is aiming to stabilize atmospheric concentrations of greenhouse gases. The principle is to establish a market for trading greenhouse gas emissions, which makes it possible to cut emissions where it is most efficient, by enabling the trade of carbon credits.

Through this system the private sector is stimulated to reduce emissions, and has the choice of internal reductions or external sourcing. The trade of the carbon credits from abatement projects and allowances given by regulators in mandatory schemes is the mechanism that allows transactions.

Carbon trading is seen to be the most effective mechanism to curb emissions of greenhouse gases, without compromising economic growth, by integrating a global scheme that offers flexibility into the economic system.

How Carbon Emissions Trading Works?

There are many different forms of trading that have evolved over the past years. However, the basic principle is simple: to provide market participants with the possibility to determine the most economic way to reduce emissions, from sources on a global level.

The buyers (governments, companies, organisations and individuals) engage in carbon emission transactions either because of a regulated constraint in the right to emit GHG or in the voluntary attempt to offset own GHG emissions.

In the first case, a current or anticipated carbon emission constraint arises due to regulations (mandatory carbon emission schemes) at international, national or sub-national levels - a so-called carbon emissions trading scheme. Emissions trading schemes are a combination of regulation and market mechanisms. The regulatory authority defines the group of emitters that are falling under the scheme, usually heavy industries and power utilities.

The target level of greenhouse gas emissions is ideally below current emissions levels, respectively below the level under an anticipated business as usual (BAU) scenario for the future, and is thus limiting the total amount of emissions and stimulating abatement.

The scheme 's regulator defines which carbon transactions are accepted and allocates only sufficient emissions allowances to participants to meet the target level, and then allow to trade in emission permits. Practically, there are two types: allowances - rights to emit Greenhouse Gases allocated to scheme participants by regulators (auctioned or for free), and so called Carbon Credits, which are emission reductions that an emitter has achieved in excess of any required reductions. The excess amount is the credit and can be sold on the open market. In addition market participants may buy carbon credits even if they do not fall under the scheme.

A company that has achieved internal emissions reductions below its allocation of emission rights can sell these excess allowances to another market participant. Companies will evaluate whether internal emissions reductions is a more effective way then to acquire allowances or carbon credits. Thus, a carbon emission-trading scheme encourages emission reductions in the most economic way, as low cost opportunities for abatement will be sought first. At the same time, the carbon credits allow for a truly global market to develop.

Why does a price on GHG pollution make sense?

To summarise, carbon trading puts a price on emitting carbon and makes the right to emit tradeable.

Without a price signal, there is no incentive for polluters to cut emissions (although internal reduction measures often pay back in an acceptable period and deliver value). Without pricing that reflects the true environmental and health costs of greenhouse pollution, the economy has proven to choose cheap and dirty production and energy generation methods and would continue to do so, as the short term cost is more attractive then the long term benefit.

The underlying problem is that environmental pollution is damaging a common good over the short-term benefit of a single entity. In a market economy putting a fair price on the damage done to the common environment is the only viable solution.

Is carbon emissions trading effective?

Yes, an accurately designed carbon credit has a positive effect on the environment and is not simply a license to pollute. Emissions' trading has proved to be very effective in reducing emissions of sulphur dioxide (SO2) and nitrogen oxides (NO2) in the US, under the Acid Rain Program implemented in the 1980.

However, the challenge is bigger in the context of carbon emissions trading, as Global Warming is not a local, but global issue and involves every nation on the planet. The struggle over the Kyoto Protocol demonstrates this complexity.

In theory, carbon emissions should be monitored and levels enforced and the size of the cap reduced in steps every few years, thus ensuring that the value of permits, and hence their price, gradually increase until cleaner alternatives become cost-effective.

Experts recommend that initially at least 25% of the emissions permits should be auctioned, and this fraction should be increased in steps each time the cap is reduced. This will allow cleaner energy industries to enter the market and compete and have an edge over more established industries players who are not only do not make use of clean-energy but are also still major polluters.

Overall, carbon emissions trading gives participants some certainty about the quantity of emissions, as defined by the regulator, but uncertainty about the future price of permits and credits and are administratively complex. The key for effective schemes is the size of the cap on GHG emissions and the method of allocating the allowances.