YPS - Review

Emission Trading Scheme: A Market-Based Solution to Climate Change

Sunmin Kwon

October 7th, 2024

As the world grapples with the escalating impacts of climate change, governments and industries are seeking innovative solutions to curb greenhouse gas emissions. One of the most effective and widely adopted mechanisms is the Emission Trading Scheme (ETS), often referred to as a cap-and-trade system. This market-based approach aims to reduce emissions by providing flexibility and economic incentives for companies to transition towards greener operations. At its core, an ETS sets a cap on the total amount of certain greenhouse gases (GHGs) that can be emitted by industries, power plants, and other polluters. Companies are allocated or purchase emission allowances, each representing the right to emit one ton of carbon dioxide or its equivalent. The total number of allowances is strictly limited, ensuring that the emissions cap is not exceeded.

Businesses which emit less than their allotted allowances can sell their excess permits on the carbon market. Meanwhile, companies which exceed their limit must purchase additional allowances from those with surplus. This creates a financial incentive for firms to reduce their emissions: the less they emit, the more they can profit from selling unused allowances. One of the most prominent examples of an ETS is the European Union Emissions Trading System (EU ETS), which was launched in 2005. Covering over 11,000 power stations and industrial plants across the EU, it remains the largest carbon market in the world. The EU ETS operates in phases, with the most recent phase aiming to reduce emissions by 55% below 1990 levels by 2030. 

The system has had tangible results. Between 2005 and 2020, emissions from sectors covered by the EU ETS fell by nearly 43%, a clear indicator that market-based incentives can effectively drive decarbonization efforts. Additionally, the carbon price under the EU ETS reached record highs in 2021, exceeding €60 per ton of carbon dioxide, pushing companies to invest in cleaner technologies. Several other countries and regions have adopted similar schemes, including China, which launched the world’s largest ETS in 2021. Covering over 4 billion tons of carbon dioxide annually, China’s system focuses initially on the power sector but is expected to expand into other industries in the coming years. Other countries, such as Canada, New Zealand, and South Korea, also operate successful ETS models. While each ETS is designed to suit specific national or regional goals, they all share a common feature: incentivizing emissions reductions in a cost-effective manner. Some systems, such as California’s Cap-and-Trade Program, also link with other regional markets, creating a larger, more efficient trading network.

Despite the success of ETS in reducing emissions, the system is not without its challenges. Critics argue that the initial allocation of allowances is sometimes too generous, particularly when industries receive free permits. This can weaken the incentive to cut emissions and lead to an oversupply of permits, which drives down carbon prices and reduces the effectiveness of the system. Additionally, carbon leakage remains a concern. If carbon prices rise too high in one region, industries may relocate their production to countries with weaker environmental regulations, undermining the global emissions reduction effort. To address these issues, policymakers are introducing reforms to tighten emissions caps and ensure the price of carbon remains high enough to drive meaningful change. In the EU, the European Green Deal includes plans to reform the ETS further, aiming for a 61% reduction in emissions by 2030 compared to 2005 levels. In addition, the Carbon Border Adjustment Mechanism (CBAM), proposed by the EU, would impose carbon tariffs on imported goods, reducing the risk of carbon leakage.

With climate change continuing to pose an existential threat, emission trading schemes remain a vital tool in the global effort to curb emissions. By combining environmental responsibility with economic incentives, ETS offers a flexible, market-based solution to one of the world’s most pressing problems.