The role of carbon markets in preventing dangerous climate change - Environmental Audit Committee Contents

2  Background

What is emissions trading?

8. There are two main types of emissions trading systems: cap and trade schemes, and offset schemes. In a cap and trade scheme, an overall cap on emissions is divided up into individual emissions permits (EU ETS permits represent one tonne of CO2). These permits are then acquired by—and traded between—participants, who use them up in line with the emissions arising from their activities. A participant who runs out of permits must either buy some from other participants with a surplus to sell, or cease emitting. The three main benefits of a cap and trade scheme are intended to be:

  • a cap imposing an absolute limit on the amounts that participating organisations can emit;
  • the limited number of permits within this cap giving them scarcity value, and hence putting a price on carbon (this is meant to encourage participants to reduce their emissions, either by adopting more efficient operations or by investing in low-carbon technology); and
  • the ability of organisations to trade permits allowing emissions reductions to take place in the most cost-effective manner.

9. The most prominent international example of a cap and trade scheme is the EU ETS. The Government explained how it is meant to work:

    The overall number of allowances allocated should be set below industry's normal emissions levels; each company with a shortfall must either reduce its own carbon emissions or buy allowances from other companies. This enables companies who can easily lower their carbon emissions to make large cuts in emissions and sell their allowances to those who find it harder to do so. The benefit of creating such a market is that it allows emissions reductions to occur where it is most cost effective.[12]

In the EU ETS, if participants do not have enough allowances (or project credits) to match their emissions they must pay a fine.

10. In offset schemes, where there is no overall cap on emissions, participants receive offset credits (again, each representing a quantity of emissions) in return for making investments that should reduce emissions (for instance, in the construction of hydroelectric dams). Offsets can then be sold to individuals, businesses or governments to mitigate their own greenhouse gas emissions voluntarily. For example, a company might choose to buy offsets to cover emissions associated with its business travel. We examined the voluntary offset market in 2007[13] and we do not cover it further in this report. Offsets can also be bought in order to meet a formal obligation to reduce emissions. For example, a government in a developed country might buy offsets from a project in a developing country in order to meet its Kyoto Protocol targets. Often offset credits do not represent an absolute reduction in emissions, but rather a reduction below the level of previously projected emissions growth under 'business-as-usual'.

11. In practice, offset schemes work together with cap and trade schemes. Offset credits are bought by businesses that are subject to a cap, to use them as additional permits to emit. Under the current design of the EU ETS, for instance, over the period 2008-2020, up to 1.6 billion offset credits, mainly from the Clean Development Mechanism (paragraph 39), can be used by European installations as additional emissions permits.[14] There is a dual rationale commonly given for this relationship between offset and cap and trade schemes: first, it can be cheaper for businesses in the developed world to pay for others in developing economies to make part of their required emissions cuts; second, this provides flows of funding for climate change mitigation and adaptation into the developing world.[15]

The Government's twin policy aims

12. The Government has made clear that emissions trading is one of the most important aspects of its climate change strategy. In November 2007, in his first major speech on the environment as Prime Minister, the Rt Hon Gordon Brown MP said: "A global carbon market is at the heart of our approach, […] harnessing the power of the market to set the global price for carbon, rewarding the most efficient and innovative action to tackle climate change".[16] In June 2009, the then Minister of State at the Department of Energy and Climate Change (DECC), the Rt Hon Mike O'Brien QC MP, told us that the key aim of emissions trading was to set a cap to ensure emissions were reduced and to get those emissions reductions at the least cost.[17] He also spelt out a related but subsidiary aim of creating "a carbon price [that] will help assist certain technologies and make them much more viable".[18]

13. In this report we examine how successful the EU ETS has been in meeting these twin objectives (in Parts 3 and 4), and how emission trading systems might be joined together to extend their coverage (Part 5).

12   Department of Trade and Industry, The Energy Challenge, Cm 6887, July 2006, p 28 Back

13   Sixth Report of Session 2006-07, The Voluntary Carbon Offset Market, HC 331 Back

14   National Audit Office, European Union Emissions Trading Scheme, Fig 23, p 59 Back

15   DECC, The Road to Copenhagen, Cm 7659, p43 Back

16 Back

17   Q 217 Back

18   Ibid. Back

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