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Why does carbon trading exist?

Human activities are in major part responsible for causing irreparable climate change that could result in economic and social disruption if actions aren’t taken to stop global temperature increases. CO2 emissions trading a method that is designed to give an economic incentive to decrease the emission of greenhouse gases. It is often called carbon trading as the main greenhouse gas that is a greenhouse gas is carbon dioxide, CO2.

There are three major options that can be used to encourage greenhouse gas emission reduction and thereby limit climate change. The primary one is the direct control on smokestack pollution. It is a rigid mechanism that fails to reflect the capacity of polluters to economically efficiently reduce their emission of greenhouse gases. The second mechanism is carbon taxation. It’s a market based mechanism, i.e. one that financially incentivises emissions reductions, but that lacks either flexibility or a guaranteed emissions reduction. The third, and perhaps the most efficient one is cap and trade. A cap is set on the system that is managed through the limitation of a declining amount of pollution permits. The emitters who can cut their emissions at low cost do so and sell any spare permits to those who find it more expensive to cut emissions.

“Cap and trade” provides a profit incentive to cut emissions further for the most able and a reduced cost of compliance for those less able. The effective distribution, through Carbon trading limited capacity of the earth to absorb greenhouse gases is beneficial to the entire economy. However, pricing encourages the development of new methods to reduce carbon emissions as well as markets that transparently estimate the environmental benefits.

How does carbon trading function?

Carbon trading is the purchasing and selling right to emit a tonne CO2 or its equivalent (CO2e). The right to emit a tonne CO2 is typically referred to as carbon ‘credit’ or carbon allowance. For example in the EU Emissions Trading Scheme there is the EU Allowance (EUA) and in the California scheme, there’s the California Carbon Allowance (CCA). The allowances offered by any trading system may be bought and sold by anyone but ultimately they reach end-users who require these allowances in order to cover their regulatory compliance obligations.

Allowances are available in paper format, much like share certificates, however for efficiency, they’re only in digital format and are kept in electronic “registry” accounts as they are in an internet banking system. Registry accounts within compliance systems are managed by the regulator of that system to ensure the integrity of the.

Trading in carbon allowances is similar to the trading of every other kind of commodity. Futures exchanges can be used to enable spot and longer-dated deliveries as well as options. These same transactions are possible ‘over the counter’ (i.e. bilaterally) between two willing counterparties and typically involve carbon brokers acting as introducers, or as intermediary counterparties.

Who can exchange carbon allowances?

Anyone can get involved in carbon trading, in Europe there aren’t any restrictions at all on who can use a registry account. However the main groups involved in carbon trading typically;

1. Compliance installations (e.g cement, steel, paper, chemicals and aluminium plants in countries that have implemented cap and trade systems),

2. trading firms such as hedge funds,

3. electricity gas, electricity and other utility companies,

4. a small number of banks as well as

5. Carbon broker, whether as introducers or intermediaries.

When is carbon traded?

In the most liquid carbon markets trading occurs all day long and all year. However, the majority of installations that are covered by carbon trading systems have their activities close to compliance deadlines. The EU ETS compliance purchasing is focused on the three months prior to the compliance deadline of April 30th. This may cause price fluctuations depending on the supply /demand balance at the time.

The ones with greater exposure for electric utilities, make trades more regularly and purchase larger amounts. Many allowances are given out to companies for free in the beginning of compliance schemes but to provide an effective price signal to everyone and over time, the percentage of allowances auctioned by government agencies grows. This tends to spread the timing of trades out throughout the year. It is a natural progression to a mature market.

Where is carbon traded?

It will be contingent upon the scheme since various market places exist for different ETS around the world but within the EU ETS the majority of trading in emissions is done on exchanges.

Good market liquidity is essential to allow a carbon credit marketplace to be effective. Liquidity can be created through having no/low barriers to entry into the market and a high number of regular market participants and low transaction costs. regularised contracts, clear pricing, and competition between buyers and sellers. The development of liquidity naturally happens when there is a balanced mix of compliance installations; investors, speculators and brokers. The most rapid growth of liquidity comes from trading based on exchanges where the rules and contracts are same for everyone but around half of all EU ETS trades have been executed bilaterally between two counterparties. Exchange trading can be costly, especially for smaller market participants because of membership, clearing and transaction fees.