How do carbon markets work?

Companies are driven by money So putting a price on carbon emissions. . .

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should encourage businesses to stop polluting, right? That’s exactly what carbon markets were designed to do. .

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. reduce emissions by charging polluters. .

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. but so far they haven’t achieved that aim Here’s why: Towards the end of the 1980s America had a problem For years, its power stations. .

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. had been emitting large amounts of sulphur dioxide. .

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. which was falling back to Earth as acid rain. .

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. causing harm to plants, aquatic animals and infrastructure But there was no incentive for the power plants. .

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. to stop emitting sulphur dioxide Weather warnings, an acid-rain alert is in effect So in 1990 the American government launched an experiment… . .

. passing a law to force polluters. .

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. to pay for their emissions, by establishing a new kind of market. .

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. governed by a system called “cap-and-trade” Eight years later, acid-rain levels over large regions. .

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. in eastern America had fallen by 20% And a new way of cutting emissions was born In 1997 the international climate-change treaty. .

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. known as the Kyoto protocol. .

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. suggested applying the concept of cap-and-trade to carbon In the years that followed different countries and regions. .

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. set up their own carbon markets Many of these used cap and trade And this is how it works A government sets a cap on the amount of CO2. .

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. that can be emitted by an industry It splits the cap into permits. .

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. and either gives or sells these permits to firms If a company doesn’t use up all of its allowance. .

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. it can sell what it doesn’t need If it needs more permits, it can buy them from those with spares Each year the cap gets stricter. .

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. and the shrinking pool of permits gets more expensive The genius of cap-and-trade systems when they’re done properly. .

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. is that they both use a stick and a carrot That gives them an incentive to innovate, to get cleaner and cleaner. .

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. it provides that carrot for innovation. .

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. and that trading mechanism. .

. The magic of the market unleashes those animal spirits. .

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. in favour of decarbonisation While regulation can introduce a new industry standard. .

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. it doesn’t give firms an incentive to cut emissions below a certain level But a carbon market creates a race in which companies. .

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. are motivated to cut emissions as fast as they can The more they cut emissions, the fewer permits they have to buy. .

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. and the more excess they have to sell So in theory in a cap-and-trade market. .

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. carbon-dioxide emissions should fall. .

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. but in reality, they’ve continued to rise Because incentives work only if they’re big enough Carbon markets are great in theory, but in practice. .

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. we run into a problem Carbon prices have been far too low to motivate change. .

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. that’s needed to decarbonise the world economy According to Joseph Stiglitz and Nicholas Stern, two economists. .

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. in order to meet the Paris Agreement goal of limiting global warming. .

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. to two degrees above pre-industrial levels. .

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. the price of carbon worldwide. .

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. needs to be between $50-100 per tonne by 2030 However, the majority of carbon prices still remain far below that figure What’s more, even if carbon is priced appropriately. .

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. the fines for exceeding permitted levels. .

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. are sometimes ineffectively low In the EU, a fine can be as low as €100 per excess tonne Considering that’s not that much more than the price of a permit. .

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. it’s hardly a deterrent And that’s if firms even get caught Now in theory, regulators enforce carbon prices and permits. .

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. but in practice, it can be very challenging There’s measurement problems. .

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. direct emissions versus indirect emissions There’s questions of cheating, for example. .

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. you find in most markets around the world. .

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. enforcement is lax and punishment is not great And even if some markets adopt effective deterrents. .

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. the ones next door may not If you look globally. .

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. you have a mind-boggling variety of rules, systems. .

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. enforcement mechanisms And so if you’re a company that’s based in multiple countries. .

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. divisions of your company making the same product in the same way. .

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. will face a mind-boggling patchwork of rules, regulations that differ Worse than that, you have leakage, among these markets as well The direct result of this patchwork of systems. .

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. is known as “carbon leakage” A business or an industry relocates from an area. .

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. with high environmental regulations. .

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. to somewhere where the rules are more relaxed Which means it can avoid having to pay for its carbon emissions But these problems have solutions The role of regulation is important because absent regulation. .

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. nobody would pay for carbon emissions or pay a penalty for emitting carbon So almost by definition, government has to create the market. .

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. set the rules, enforce penalties, set a carbon cap. .

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. for example, the maximum amount a company or industry can emit If governments limited the number of permits, it would drive their price up Setting a minimum price that rises over time. .

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. would mean the price would never fall too low. .

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. and governments could enforce more stringent deterrents. .

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. for potential rule-breakers Getting serious about regulating carbon markets. .

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. really involves regulators making it clear to industry. .

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. that they will not tolerate cheating They will not tolerate leakage or obfuscation. .

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. and ultimately that they will hold corporate executives to account. .

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. for their carbon emissions I think we’re getting there, particularly in the European Union. .

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. we’re seeing much more seriousness. .

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. that this is not a frivolous greenwashing exercise. .

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. nudge, nudge, wink, wink, but rather that this is as serious as safety. .

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. or other regulations. This is not yet the case in many other parts of the world It would help if the world had more integrated carbon markets.

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. . but as that’s unlikely to happen in the short term.

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. . one solution to help prevent carbon leakage is a border tax The EU has recently proposed to tax the carbon emitted.

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. . in goods produced outside its carbon market Importers would have to pay the same amount.

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. . as if the goods had been made in the EU Meaning it wouldn’t be any cheaper.

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. . to source goods from a region with less regulation If we’re going to get serious about dealing with climate change.

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. . within the next few years, we must.

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. . achieve something like a global carbon price.

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. . and some form of harmonisation amongst economies Now we’re getting to something like momentum in this direction The big kahuna is China because it’s such an industrial powerhouse.

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. . it’s so carbon intensive If it doesn’t get serious and work with other economies.

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. . to harmonise carbon pricing and carbon-trading systems.

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. . then most of the world’s efforts will probably be undermined.

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. . by the fact that countries like China.

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. . are producing heavily carbon-intensive goods And we’ll see multinationals shifting production.

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. . to those places even more than they have in the past As climate change has moved up the political agenda.

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. . governments are starting to improve how their carbon markets work Since 2019, the EU has been taking steps.

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. . to reduce the number of permits it hands out Partly as a result, carbon prices in the EU.

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. . are now hitting record highs of over €60 per tonne Carbon prices in other markets are also rising.

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. . as regulators look at ways to make them more effective If it seems that money can be made.

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. . other countries might create their own markets We have seen just in the last 12 to 18 months.

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. . a dramatic take-off in carbon markets This is a really exciting time for people.

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. . who believe that there is a good marriage.

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. . between public policy and regulators and markets and innovators If prices stay high enough… .

. . helped by commitments from governments and regulators… .

. . then greener industrial processes would become more attractive And carbon markets could start to achieve their original goal .

. . of helping to decarbonise the world I’m Vijay Vaitheeswaran.

. . The Economist’s global energy and climate innovation editor To keep up to date with all of our climate-change coverage.

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