Cap and Trade

A cap and trade market is pretty simple to understand, at least in theory. A regulatory body places a limit (cap) on the amount of carbon allowed to be emitted, then allocates Permits/Allowances to the participants (emitters) of the scheme. The Permits/Allowances are of a uniform size (one ton of carbon in the EU ETS for instance) and basically represent the right to emit carbons. The participants are then allowed to buy/sell permits if desired/needed.

For example, a participant that emits less than its allowance could sell some of its extra allocation (in the form of permits/allowances) to a participant that plans to emit more than their allowance and wants to stay in compliance. A penalty is usually assessed to those participants that are not compliant.

The trading market determines the price of a carbon allowance based on good old fashioned supply and demand. Although, the regulatory agency could still have some impact on the carbon price since it can modify the supply side of the equation.

Although cap-and-trade schemes typically follow the steps above, each cap-and-trade market is different and has its own unique characteristics, which makes it more difficult to generalize when speaking about cap and trade markets.

Rather than listing all the differences, I thought it would be easier to list the major characteristics that cap and trade schemes have in common from a regulatory and participants’ standpoint.

Regulation

First and foremost, a governing body must be in place to develop a framework before actual carbon trading can begin. The major issues that must be addressed are:

  • The cap size of allowable emissions
  • Whether the allowances are freely allocated or are auctioned off
  • The allocation of the allowances to the emitters
  • Rules for the purchase of offsets and trading of allowances

Market Participant’s Business Decision

From the emitters’ perspective, analysis must be done to determine the most efficient course of action that would make the participant compliant under its cap. The participant will decide whether it is more efficient to purchase allowances and/or offsets given the current (and future) market price, or to invest the capital necessary to reduce the emissions itself. The participant primarily has these options available:

  • Pay/invest to generate offset credits through a third party project
  • Purchase either and emission allowance or offset in the spot market, or a derivative contract based on the underlying allowance/offset that would give the participant the desired exposure to the emission
  • Implement its own internal strategy to reduce its emissions

It is also worth noting that some argue a direct tax on carbon emissions would be a more transparent and efficient way to regulate carbon emissions. However, I will not get into the arguments for/against a carbon tax since the four major US carbon markets are/will be cap and trade, and any future national scheme will likely be cap and trade as well.