Cap-and-Trade Could Be a Viable Solution to Climate Change

By Henry Li

London, United Kingdom

A simplified explanation of the cap-and-trade system developed by the European Union's Emission Trading System (ETS). (Investigate Europe)

Climate change is wreaking havoc on the planet. Thanks to humanity’s addiction to fossil fuels, the buildup of greenhouse gasses in the atmosphere has led to a warmer, more unpredictable climate. The severe and wide-ranging impacts include rising sea levels, habitat loss, and extreme droughts. It is therefore becoming increasingly clear that the world must be carbon-neutral by 2050 to avert this impending crisis, but who will shoulder the cost?

Creating a market for carbon credits could ensure that the most polluting firms are penalized the most, thus providing an incentive to cut emissions. In a ‘cap-and-trade’ system, the government sets a cap on the amount of greenhouse gasses each industry can emit and splits this amount into permits. The permits are either given or sold to businesses, mandating that they limit pollution to a certain level or face a fine. Moreover, the system turns carbon emissions into a commodity, creating a regulatory market where credits are bought and sold. If businesses exceed their annual allowance, they can buy more permits, and if they cut emissions sufficiently such that they have credits left over, they can also sell them to other firms. In addition to providing an economic incentive for decarbonization, carbon credit markets open up revenue streams for businesses: Tesla sold $518 million in carbon offsets to car manufacturers in the first quarter of 2021.

To investigate the effectiveness of the ‘cap-and-trade’ system, the EU set up its Emission Trading System (ETS) in 2005. The initiative covers 10,400 industrial installations across the 27 member states, focusing on energy production, heavy industry, and aviation. The first phase of the experiment, which lasted until 2007, involved handing out allowances for free. But this undermined the essential principle that polluters must pay for their emissions. Furthermore, the cap was too large, creating an oversupply of carbon credits which led to the price of permits dropping significantly.

Later phases of the EU ETS sought to solve these structural flaws. As well as reducing the cap and holding auctions for carbon credits, the EU introduced the Linear Reduction Factor (LRF). This value represents the fixed amount the cap decreases each year, standing at 2.2% as of 2021. The LRF serves two purposes. First, a constantly falling allowance means businesses pollute less each year, helping the EU reach net zero faster. Second, a lower cap results in fewer permits, increasing their price and further incentivizing decarbonization.

International offset credits also exacerbated the oversupply issue. An offset credit represents a ton of carbon dioxide removed from the atmosphere due to an emission-reducing project. This may include planting trees in the Amazon rainforest, investing in carbon capture technology, or building wind farms. But the use of these offset credits inflated the carbon permit market. The EU therefore ruled that firms had to exchange offset credits with a permit. It also set up the Market Stability Reserve to remove carbon credits from the market and maintain their high price. In terms of reducing pollution, the ETS has proved a success. Emissions in the EU fell by 8.7% in 2019 compared to the previous year, and the ETS has become a pioneer for the ‘cap-and-trade’ system, making up three-quarters of the international carbon market.

Critics point to three flaws in the ‘cap-and-trade’ system. First, fines for exceeding

permitted levels of pollution are too low. An EU penalty stands at $100 per excess tonne

emitted, which is barely a punishment considering that the price of carbon is $76 per tonne.

Second, a patchwork of global systems encourages businesses to relocate and avoid ‘cap-and-trade.’ This could undermine the carbon market and harm a country’s economy. Third, double counting damages the integrity of reporting emissions. Replacing a coal plant with a wind farm reduces pollution, freeing up carbon permits, and allows the government to take credit for the cut in emissions. But the company that owns the wind farm is likely to sell the leftover credits to another firm. This company will then count this purchase as a reduction in

pollution on their part too. Therefore, two businesses can claim credit for the same climate

action, which is highly problematic.

There are many ways to improve the ‘cap-and-trade’ system. Making fines harsher, building mechanisms to address oversupply, and auctioning permits instead of handing them out for free could help. Supporting independent agencies that verify emission data and creating rules

to prevent double counting would preserve the integrity of the carbon market. But discouraging firms wishing to avoid the ‘cap-and-trade’ system from relocating requires a broader set of measures. Working with other nations to make carbon markets more integrated could work. After all, if all countries had the same regulations, then relocation would be pointless. However, this is diplomatically challenging and would take decades to complete.

‘Cap-and-trade’ ensures that firms pay the price for their emissions, even with the system's

many flaws. Whilst some critics insist that this means that the carbon market is doomed to

fail, innovative solutions have brought about convincing results. Between September 2021

and August 2022, the EU’s Market Stability Reserve reduced oversupply by as much as 378

million permits, restoring confidence in the system. ‘Cap-and-trade’ is our best weapon in the

fight against climate change. What governments need to do now is to work together and pave

the way for a global carbon market.