Emissions Trading

Non-Technical Option | Generic Example
Climate & Air | Energy

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Emissions trading is a market based instrument. Emissions trading schemes can take one of two forms:  cap-and-trade, whereby the total volume of allowances permitted per unit of time is specified, and allowances are allocated such that the total does not exceed the cap; and baseline-and-credit, a rate based scheme whereby participants earn credits when they reduce their emissions below a defined baseline. Emissions trading offers polluters flexibility in complying with emission reduction requirements. The flexibility comes from the fact that emitters can buy and sell allowances or credits with other participants, thereby enabling progress to be made towards compliance within the broader market area. This facilitates the reduction of emissions in a more cost-effective manner. In addition to promoting static efficiency (cost minimisation), emissions trading provides participants with incentives to engage in R&D to innovate business/production practices (dynamic efficiency). There has been considerable experience with emissions trading in the United States, most notably with the SO2 trading programme. It is only relatively recently that the concept of emissions trading has gained prominence in the European environmental policy arena as part of the European emissions trading scheme.


Emissions trading schemes generally can take one of two forms - ‘cap-and-trade’ and ‘baseline-and-credit’. With a cap-and-trade scheme the regulatory authority determine a socially acceptable level of emissions that represents an absolute emissions cap. The cap is subsequently divided into a number of permits/allowances, each of which authorises the holder to emit a predetermined quantity of emissions, and which is allocated amongst those firms participating in the scheme. The quantity of allowances that a firm is allocated represents their emissions target. Allowance allocation centres on a choice between auctioning or free allocation using some form of free allocation metric (historical emissions, projected emissions, benchmarking, constant or updated metrics).

With a baseline-and-credit scheme the regulatory authority does not determine an explicit cap on emissions. Under such a scheme participating firms are permitted to emit a certain baseline level of emissions, with baselines normally defined in terms of historical emissions or some sort of performance standard that specifies a permitted ratio of emissions to output. The baseline establishes a standard against which emissions credits are generated. Participating firms generate emissions reduction credits by emitting less than their baseline emissions.

Irrespective of which form a trading scheme takes, the mechanics of their functioning are identical. For those firms operating in a cap-and-trade scheme they must ensure that at the end of a designated time period (normally a year) they have a sufficient quantity of allowances to cover their emissions. Baseline-and-credit firms need to ensure that their emitted emissions over the course of designated time period are consistent with their baseline level of emissions. ETS participants need to ensure that their annual emissions are monitored and verified by monitoring and reporting agencies approved by the respective competent authority.

In order for an emission trading scheme to operate effectively it is necessary for the scheme to have built in penalties that will discourage non-compliance with the scheme. Failure by ETS participants to surrender sufficient allowances or credits to a regulatory authority usually results in the imposition of a financial penalty. It is important to note that payment of the excess emissions penalty does not automatically release an ETS participant from the obligation to surrender an amount of allowances/credits equal to those excess emissions when surrendering allowances in the following period.

The major difference between cap-and-trade and baseline-and-credit trading schemes are that cap-and-trade guarantees that a specific emissions target will be met whereas baseline-and-credit does not. In addition, the process of determining the baseline can be complex and time consuming to both design and administer. For these reasons the majority of trading schemes tend to be of the cap-and-trade variety. However, industry generally favour baseline-and-credit schemes, because if they meet the standard they can expand indefinitely without having to buy allowances. 


The implementation of an ETS will impact on three different areas:

  • Environment
  • Society
  • ETS participants


The successful introduction of an ETS should generate a positive environmental impact as it directly targets emission reduction. In determining the allowance budget for a cap-and-trade scheme or the emissions baseline for a baseline-and-credit scheme an environmental regulator will set the allowance budget or emissions baseline such that it is below existing or historical emissions levels thereby achieving an emissions reduction.


From a social perspective an ETS generates both positive and negative impacts. Society in general benefits from the environmental improvement associated with the emissions reductions generated by an ETS. The implementation of an ETS is likely to lead to an increase in the price of consumer products as a result of ETS participants “passing through” allocation costs to consumers. However, where allowances are auctioned there exists an opportunity for governments/regulators to recycle some of the revenue generated from the auction back to consumers in order to partially offset the increase in price of consumers goods. Furthermore, the creation of a new environmental market (e.g. carbon) generates opportunities for R&D and employment.

ETS Participants

Industry will often face new costs when seeking to equate their emissions with a target emission level. While compliance with a regulatory imposed emissions target is unavoidable the attraction of emissions trading is that it offers firms flexibility in complying with an emissions target and provides them with an opportunity to do so in a least cost manner.

The flexibility is derived from the fact that firms can buy and sell allowances or emissions credits and that firms have different marginal emissions abatement costs. The ability to trade enables firms for whom it is very expensive to abate to buy allowances or credits from those with relatively low abatement costs. An incentive exists for those firms with low abatement costs to undertake additional abatement since surplus allowances and credits can be sold for profit. This flexibility allows all firms to minimise their overall abatement costs.

Economists highlight that in addition to being statically efficient (cost-effective) ETS provide firms with a dynamic efficiency incentive. The price signal that emerges from an ETS provides incentives for firms to invest in R&D and develop and adopt cheaper and more efficient pollution control technologies as such investments will lead to the reduction of abatement costs over time and the generation of additional allowances to sell. In addition, other firms will be interested in adopting this innovation if it costs less than the value of the allowance generated by its implementation.

Costs & Benefits

  • Societal costs – direct administrative costs
    • consumer product price increase


  • ETS Participant costs – emission reduction costs
    • allowance purchase costs
    • allowance market activity costs
    • monitoring, reporting and verification costs


  • Benefits should accrue where the emission caps defined by the policy process are respected

Evidence & Reference

The international emissions trading association : www.ieta.org


Video explaining the operation of the US SO2 and NOx trading programme


European Commission video explaining the EU ETS system

Modelling this Measure

Modelling the effects/impacts of an ETS presents a significant challenge since an ETS falls within the remit of a non-technical measure and a far reaching one at that. Within a given modelling framework the effects/impacts of an ETS can be captured through their impact on a number of key modelling parameters:

  • Activities­– the degree to which an ETS reduces energy consumption across the economy
  • Technology Change– the degree to which an ETS induces technology change – notably greater use of energy efficient technologies and abatement techniques –across specific economic subsectors
  • Costs– the financial costs associated with initial ETS operationalisation along with current and future operational costs
  • Benefits– with an ETS leading to a reduction in energy consumption there will be an associated change in emission levels and the benefit of which are felt through impacts on health, acidification and eutrophication levels
  • Utility– the degree to which an ETS impacts on a households financial well-being.

Site Entry Created by Policy Measures Admin on May 09, 2010
Edited by J A Kelly

Reference This Source

Policymeasures.com (2019). Emissions Trading. Available:
www.policymeasures.com/measures/detail/emissions-trading Last accessed: 19th February 2019

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