Reducing carbon emissions is often seen as incompatible with a free market incentivised by profit, and state intervention comes at the expense of growth. To counter this, carbon trading was developed back in 1995 to utilise market forces in a way that drives down emissions, whilst encouraging ingenuity and stimulating new green growth. With many countries including the UK struggling to tackle climate change at the rate required, can carbon trading effectively lower emissions and encourage sustainable growth simultaneously?

Carbon trading is often seen in “cap and trade” schemes where governments or intergovernmental organisations allocate permits for CO2 emissions and regulate markets which trade in the unused allowances. This allows companies or countries to sell the remainder of unfulfilled quotas to others who have exceeded theirs, thereby incentivising the reduction in emissions especially from those with the lowest marginal cost to do so. According to the World Bank, the market is valued at £164bn and covers around 17% of all emissions globally. The largest of these schemes is the EU Emissions Trading System (EU ETS) which allocates quotas to countries which they then either assign to companies, or in later stages, auction them. Regulators then reduce the size of quotas by around 2% a year to ensure CO2 production is constantly reduced.

There is no doubt the EU ETS has had a significant impact in reducing emissions of harmful gases. It has caused declines of 35% in covered sectors since 2005 and regulates many other toxic pollutants like perfluorocarbons from heavy industry. However, despite its effectiveness at driving down emissions, the scheme only covers 40% of all greenhouse gas sources, drastically limiting its overall impact. It is also vulnerable to shocks and initially suffered from a surplus of credits.

The Great Recession caused the carbon price in the EU ETS to collapse due to a surplus of allowances, meaning that the price signal to reduce emissions wasn’t strong enough. This led the power sector to increase the use of fossil fuels as there was no financial incentive to scale back. In reaction, the UK set up the Carbon Price Floor (CPF) to charge generators a minimum amount of £18.10 per ton of CO2 emissions. This was set to be raised to £30 in 2020 but was rejected and postponed. This specific tax does not explicitly limit carbon emissions but by making highly polluting power stations unviable, it motivates the switch to cleaner forms of generation. The CPF is widely accredited for the significant falls in coal powered electricity and whilst it has likely raised prices for consumers, it has also driven significant investment in renewable generation.

As an alternative to complex and often flawed carbon trading systems, a universal carbon price similar to the UK’s CPF has been proposed to reduce emissions worldwide. Many other countries, such as France and Australia have also introduced blanket carbon taxes on top of trading schemes; however, a unified system is yet to take hold. It would be a crude method of combatting rising emissions and require huge international cooperation, but would be a decisive step forward in meeting the Paris Climate Agreement’s target. Uniform pricing would also be crucial in preventing “pollution havens” where laxer regulation allows for large emissions. One study found that an appropriate carbon price would need to be $50 – $100 by 2030 to meet the goals of the Paris Agreement. This high price- especially for developing nations- and the practical difficulties of implementation make any effective universal carbon price a fanciful pipe dream.

In the recovery from Covid-19, with a new US president in office, the world must look forward to reduce emissions and tackle climate change. Carbon trading systems have their flaws, but represent a vital tool in driving down emissions in a sensitive and sustainable way. Other more basic methods like a blanket tax can shock the market and result in job losses and friction: creating resistance against climate policies is something that must be avoided at all costs.

This is where the main benefit of cap-and-trade systems lies.

They effect real, noticeable change, as shown by the EU ETS, but do so in a way that gives businesses time to adapt to the new regulations. This limits uncertainty and means that people support the scheme, allowing it to be effective. Carbon trading can, if managed effectively, lower emissions and redistribute cash to renewable investment whilst having the minimum disruptive and regressive impact. In reality, a combination of many policies across the world will be necessary to tackle emissions, but there is little doubt that carbon trading will have an important part to play.

“Photo” by Daria Shevtsova from Pexels is licensed under CC BY 2.0