Carbon Trade: Definition, Purpose, and How Carbon Trading Works

What Is Carbon Trade?

Carbon trade is the buying and selling of credits that permit a company or other entity to emit a certain amount of carbon dioxide or other greenhouse gases. The carbon credits and the carbon trade are authorized by governments with the goal of gradually reducing overall carbon emissions and mitigating their contribution to climate change.

Carbon trading is also referred to as carbon emissions trading.

Understanding Carbon Trade

Carbon trading is based on the cap and trade regulations that successfully reduced sulfur pollution during the 1990s. This regulation introduced market-based incentives to reduce pollution: rather than mandating specific measures, the policy rewarded companies that cut their emissions and imposed financial costs on those that could not.

The idea of applying a cap-and-trade solution to carbon emissions originated with the Kyoto Protocol, a United Nations treaty to mitigate climate change that took effect in 2005. At the time, the measure devised was intended to reduce overall carbon dioxide emissions to roughly 5% below 1990 levels by 2012. The Kyoto Protocol achieved mixed results, and an extension to its terms has not yet been ratified.

The notion is to incentivize each nation to cut back on its carbon emissions in order to have leftover permits to sell. The bigger, wealthier nations effectively subsidize the efforts of poorer, higher-polluting nations by buying their credits. But over time, those wealthier nations are incentivized to reduce their emissions so that they don't need to buy as many credits on the market.

When countries use fossil fuels and produce carbon dioxide, they do not pay for the implications of burning those fossil fuels directly. There are some costs that they incur, like the price of the fuel itself, but there are other costs not included in the price of the fuel. These are known as externalities. In the case of fossil fuel usage, these externalities are often negative externalities, meaning that the consumption of the product has negative effects on third parties.

Advantages and Disadvantages of Carbon Trading

Proponents of the carbon trade argue that it is a cost-effective partial solution to the problem of climate change and that it incentivizes the adoption of innovative technologies.

However, carbon emissions trading has been widely and increasingly criticized. It is sometimes seen as a distraction and a half-measure to solve the large and pressing issue of global warming.

Despite this criticism, carbon trading remains a central concept in many proposals to mitigate or reduce climate change and global warming.

Regional Carbon Trading Markets

While there is no global marketplace for carbon trading, several regional jurisdictions have created their own markets for the exchange of carbon credits. The state of California operates its own cap-and-trade program. Several other U.S. states and Canadian provinces got together to create the Western Climate Initiative.

In July 2021, China started a long-awaited national emissions-trading program. The program will initially involve 2,225 companies in the power sector and is designed to help the country reach its goal of achieving carbon neutrality by 2060. It will be the world's largest carbon market.

That made the European Union Emissions Trading System the world's largest carbon trade market. The EU's trading market is still considered the benchmark for carbon trading.

Carbon Trading Agreement Post Glasgow COP26

After much deliberation, rules for a global carbon market were established at the Glasgow COP26 climate change conference in November 2021, enacting a globally unified approach first laid out at the 2015 Paris Climate Agreement. The agreed-upon framework, known as Article 6, will comprise a centralized system and a separate bilateral system. The centralized system is for the public and private sectors, while the bilateral system is designed for countries to trade carbon offset credits, helping them meet their emission targets.

Under the new agreement, those who create carbon credits will deposit 5% of proceeds generated into a fund to help developing countries tackle climate change. Also, 2% of credits will be canceled to ensure an overall reduction in emissions. The new rules allow participants to use previous credits created between 2013 and 2020, prompting fears that they could potentially saturate the market and put downward pressure on prices.

Proponents of the framework say that it creates financial incentives for countries and companies to create emission-reducing technology and initiatives, such as mechanical carbon capture systems and forest planting—all of which will help reduce carbon levels in the atmosphere.