A number of emissions trading scheme/ systems (ETS) exist worldwide for several pollutants. Most schemes entail market mechanisms used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. These schemes or markets exist both under compliance schemes, such as the European Union ETS, the European Economic Area ETS, the Regional Greenhouse Gas Initiative (RGGI) in the USA, the Carbon Pollution Reduction Scheme (CPRS) in Australia, and under voluntary programs, such as the Chicago Climate Exchange (CCX). Unlike the compliance schemes, there are no established rules and regulations in the voluntary schemes.
Another essential distinction in emissions trading systems is the “cap and trade” (also known as “allowance-based”) approach or the “baseline and credit” (also known as “project-based”) approach. In a cap-and-trade approach, such as the EU ETS, an overall maximum limit (cap) is identified for reductions in emissions. Each player in a cap-and-trade mechanism –for example countries or industries- is given a particular number of allowances (rights) based on an emissions-reduction goal. In a cap-and-trade mechanism the maximum limit entails a certain number of allowances which is determined by legislation or government. This certain number leads to a scarcity of allowances and hence creates a demand for allowances. The goal of a cap-and-trade system is to internalize part of the emissions costs, and hence urges players to look for cost-effective means to reduce their emissions. The challenge in a cap-and-trade mechanism is to determine the appropriate level at which to set the maximum limit, which should be adequately strict to create the desired level while driving total costs down. In a cap-and-trade mechanism, a firm that has an allowance deficit can buy its allowances from the outside market or look for effective ways to reduce its emissions, or even borrow allowances from the following year if this is allowed (or use a combination of options). A firm that has additional allowances can sell them at the market or keep them for future use.
The emissions trading concept in a cap-and-trade mechanism is depicted in the following figure. Each company picks the most cost-effective ways to reduce pollution and remain in line with its allocated allowances.
The Emissions Trading Concept. [Eurelectric report on “The Impact of Emissions Trading on Electricity Prices”].
On the other hand, a baseline-and-credit mechanism, such as the Kyoto project-based mechanisms Clean Development Mechanism (CDM) and Joint Implementation (JI), does not involve a certain number of allowances, but more credits are generated with the implementation of a new project. These credits can be used by buyers to satisfy an emissions target, to compensate for an emitting activity or to be carbon neutral with zero emissions. In a baseline-and-credit mechanism, a carbon buyer can declare to compensate his emissions if the emissions reductions originate from a project that would not have happened. This concept is called “additionality”, and in the Kyoto Protocol it refers to the requirement that reductions in emissions are additional to any that would occur in the absence of the project activity. In a cap-and-trade mechanism it is the maximum limit (cap) and the rules that drive demand for allowances, and hence determine the level of emissions reduction. Therefore activities that are realized because of the maximum limit (cap) do not need to prove that they are additional.