What is emissions trading and how does it work?

Emissions trading, also known as ‘cap and trade’, is a market-based approach to address climate change.

The 'Cap'

The basic principle involves setting a limit on the total quantity of GHG emissions allowed to be released over a given period of time (the “cap”). Each participant in the scheme receives an individual cap or allowance. Emission permits or allowances are issued to help cover these caps.

And the 'Trade'

The trading part establishes a market for these permits by allowing organisations to buy and sell depending on whether they have a shortfall or surplus in allowances. (E.g. a participant who emits less than their allowance can sell the unused balance to another participant who has exceeded their allowance). Emissions trading encourages companies to continually reduce emissions – the more permits they don’t use, the more money they can make from selling that excess.

Offsetting

Most emissions trading schemes also allow participants to purchase carbon credits from GHG emission reduction projects in developing countries. One credit equals one tonne of emissions saved. As long as these credits are certified to the correct level then they can count towards the emitter’s target back home. However, to ensure that emitters are making a significant contribution to controlling their own emissions, and are not just buying their way out of their obligations, offset usage in trading schemes is usually limited to a proportion of the overall emissions target.