An Emissions Trading Scheme (ETS) is a market-based, cost-effective approach to reducing greenhouse gas (GHG) emissions. Governments economically incentivise firms, corporations, and other entities to cut emissions by setting a limit on emissions and issuing permits within the limit that each allows for one tonne of GHG emissions. Permits must be obtained, either from the government or through trade with other firms, and surrendered per unit of emissions. The cap is lowered over time to ensure emissions fall. Firms, therefore, if insufficient in their quantity of permits, must either reduce emissions or purchase more permits – with a given permit price always equals to one tonne of CO2.
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Under an Emissions Trading Scheme, also known as ‘cap and trade’, what motivates companies and other entities to cut emissions is profit and its potential to rise or fall rather than tackling pollution with the traditional threat of penalties. The carbon market has thus formed as a result of carbon being traded just like any other commodity.
Emissions Trading Schemes globally by and large operate along similar straits, by utilising the cap and trade system. The sectors and extent of emissions covered however, are usually where systems differ.
How Is an Emissions Trading Scheme Effective?
- A hard limit and the market– according to its theorists, ETS works effectively not only because of the ‘hard’ limit it sets, but also because it lets the market decide how best to reduce emissions, at the lowest possible cost.
- A price on carbon– by nature of creating a market for GHG emissions, ETS sets a clear and agreed-upon price for carbon. Meaning much of the costs incurred by GHG emissions such as the detrimental impact to both public human health and wildlife extinction are taken into account when pricing other goods and services.
- Strict reduction quota– unlike other forms of carbon pricing (such as a carbon tax) that have been criticised for their lack of strict targets for emission reduction, ETS allots a stringent requirement for reduction via the setting of a maximum.
- Flexibility in a variety of contexts– ETS works well and can adapt to a range of different socioeconomic settings. Worldwide, 39 national and 23 sub-national jurisdictions have implemented or are planning to implement carbon pricing tools, including emissions trading systems and taxes.
How Is an Emissions Trading Scheme Ineffective?
- Lenient caps: many caps set by governments have been deemed too weak, and ineffective in curbing emissions at any meaningful rate.
- Purchases of “offsets”: carbon credits have been bought from countries not included in ETS and emission reduction programs in the developing world.
- Prone to lobbying: like any other legislation, cap and trade systems are susceptible to influence, and thus reduction targets are not often reached due to corporate and political interests.
Countries such as New Zealand, do not include the largest emitters of GHG (agriculture, for example), due to the vital role they play for the economy and the damage that limits on their activity would potentially cause.
4 Examples of Implemented and Operational Schemes
1. China
The China National ETS was launched in 2021 after three years of preparation, becoming the world’s largest ETS. The scheme covers more than 2,200 companies from the heating and power sectors, totalling 26,000 tonnes of CO2 (tCO2) per year. In total however, the CNETS will cover more than 4 billion tCO2, accounting for over 40% of national GHG emissions. A hard cap has not been set yet, as the scheme will operate as an intensity-based ETS where the cap is set in the future, based on actual production levels.
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2. Europe
The EU ETS, launched in 2005, is the second largest carbon market in the world. The scheme operates throughout all EU countries including Iceland, Lichtenstein, and Norway, and is linked to limiting emissions from 10,000 different installations in the power sector, combustion plants, oil refineries, and airlines. This totals about 40% of the EU’s GHG emissions (2 billion tonnes of CO2 per year) with the immediate target of a 55% net reduction in GHG emissions by 2030. GHGs covered include CO2, nitrous oxide, and perfluorocarbons, and from 2021 onwards, the scheme includes an annual hard cap of 1,572 Mt CO2-e (million tonnes of carbon dioxide equivalent). In November 2022, the bloc has agreed to add the maritime industry to its carbon market.
According to the EU, net GHG emissions had fallen by about 43% from 2005 until today, showing a marked decrease in emissions and the effectiveness of the EU ETS. Prior to the introduction of the Market Stability Reserve (MSR) mechanism in 2019 however, the EU ETS had been plagued by issues such as a surplus of permits and shocks to the price. But with the scheme now fortified by the MSR and newly emerging data, it appears to be looking promising as an effective tool in combating climate change in Europe.
3. South Korea
The K-ETS was launched in 2015 as East Asia’s first nationwide compulsory ETS, and is the world’s third largest carbon market. The scheme covers 685 of the largest emitters which account for ~73.5% of total GHG emissions, to reach their target of a 24.4% reduction by 2030 from 2017 emissions. All six GHGs are covered, in addition to indirect emissions from electricity use. The scheme includes an annual hard cap of 601 Mt CO2-e from 2020 onwards.
According to the latest data available, the years of 2015 to 2018 saw an increase of 4% in net GHG emissions (697 to 727.7 Mt CO2-e). South Korea’s economy is heavily dependent on the manufacturing sector for its success, so ETS only increases the conflict between emission reduction and economic prosperity. Climate Action Tracker predicts that without more stringent climate measures, Korea will be far from its target by 2030. Therefore, the K-ETS alone will not suffice in combating emissions, but will also need fortified policies surrounding the power and renewable sectors.
4. New Zealand
The NZ ETS was launched in 2008 and is linked to all sectors of New Zealand’s economy, limiting emissions in sectors including forestry, waste, synthetic gases, stationary energy, and industrial processes. This covers 50% of the GHG emissions in New Zealand, with the target of net zero emissions by 2050. GHGs covered include CO2, methane, nitrous oxide, and hydrofluorocarbons, and the scheme includes no hard cap.
According to the New Zealand government, net GHG emissions have increased by about 17% from 2008 to 2020 (from 47 to 55 Mt CO2-e), showing a moderate rise in emissions and perhaps the short term ineffectiveness of the NZ ETS. This could also be attributed to the lack of a hard cap. While projected data shows a peak in emissions by 2027 (65.7 Mt CO2-e) before decreasing to 23.8 Mt CO2-e by 2050, only time will be the best indicator in determining whether the NZ ETS is yielding effective results against climate change. Additionally– agriculture, the only major sector of the New Zealand economy not required to surrender emission permits, is in fact responsible for 48% of the total emissions— perhaps strongly affecting reduction goals. A pricing mechanism through the ‘He Waka Eke Noa’ program is currently being developed, slated to come into effect in 2025.
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