Emission Trading Schemes Market Overview

Emission trading schemes – Emission trading schemes allow companies to buy and sell allowances to meet regulatory emission reduction targets.

An Emission Trading Scheme (ETS), often referred to as a cap-and-trade system, is a mandatory, market-based approach to environmental regulation. Its core qualitative function is to control the total amount of a specific pollutant—in this case, greenhouse gases—that can be emitted by a set group of industries or sectors.

The process begins with the Cap: a government or regulatory authority sets an overall limit on emissions for all participating entities. This cap is a political decision that defines the maximum environmental outcome. The cap is then divided into tradable permits called Allowances, where one allowance typically grants the right to emit one ton of CO 
2
​
  equivalent. The crucial feature is that the cap is designed to decrease over time, ensuring a predictable path toward overall emission reduction across the regulated economy.

The Trading component introduces flexibility. Allowances are allocated to covered entities, either through free distribution (grandfathering) or auctioning. At the end of a compliance period, each regulated entity must surrender enough allowances to cover their total emissions. Companies that successfully reduce their emissions below their allowance allocation can sell their surplus allowances on the market. Conversely, companies facing higher costs to abate their pollution must purchase additional allowances. This trading mechanism creates an economic incentive to reduce emissions—it rewards efficient abatement with revenue from credit sales and penalizes inefficient, high-emission activities with the cost of purchasing credits. The ETS is designed to achieve a set environmental target (the cap) at the lowest overall economic cost, allowing the market, rather than a central planner, to discover the most cost-effective places for abatement.

Emission Trading Schemes FAQs
Q: What is the main purpose of an ETS in qualitative terms?
A: The main purpose is to ensure that a defined, predetermined level of total emission reduction (the cap) is achieved across a regulated sector in the most economically efficient way possible.

Q: What qualitative effect does the 'trading' aspect have on a regulated company's behavior?
A: It creates a continuous economic incentive: companies are rewarded for reducing their emissions below their allocation (by selling surplus allowances) and penalized for exceeding their allocation (by having to purchase more allowances).

Q: How is the overall environmental goal of an ETS guaranteed?
A: The environmental outcome is guaranteed by the cap itself, which is a binding regulatory limit on the total volume of allowed emissions for all covered entities collectively.

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