I recently did a radio interview in which the journalist asked a lot of really basic questions about how a market for carbon might operate. It made me realise that many people have little idea about this extremely topical question, so here is a brief primer.

There are many details that could vary, but this description provides an outline of a standard cap and trade system, which seems to be what policy makers are thinking about.

To start with, “carbon market” is a misnomer. Assuming that a market is created, it will not actually be a market for carbon dioxide. It will be a market for permits that allow the holder to emit carbon dioxide. That might sound backwards, but it does make sense.

This sort of market has several components:

1. The government sets a quantitative limit on emissions (e.g. of carbon dioxide equivalents), at some reduced level.

2. The government creates permits that allow people to emit no more than that level of carbon dioxide, and distributes them somehow (e.g. by giving or selling them to current emitters).

3. The government enforces compliance. If anyone emits more carbon dioxide than the amount for which they have permits, then they are penalised. The level of penalty, and the probability of detection, have to be high enough to encourage high levels of compliance.

4. The government sets up and manages a system that allows people to buy and sell permits from each other.

The first three components are the elements that control the degree of reduction in carbon dioxide emissions. Without the fourth element, the system would be similar to a simple regulatory approach that required people to cut back their emissions.

The fourth component means that the cost of reducing emissions is substantially reduced. It means that reductions in emissions are redistributed such that we achieve the reductions at least overall cost. People or businesses who have the least to lose by reducing emissions are the ones who actually make the reductions.

An example

Suppose ABC Electricity Company does not own any permits, but wishes to emit 10,000 tonnes of carbon dioxide in the process of generating and selling electricity. Suppose that, if it was prevented from making these emissions (i.e. if it was prevented from producing and selling electricity), it would miss out on profits of $2,000,000.

XYZ Mining Company owns 10,000 tonnes worth of emission permits. It could either use the permits and continue mining, with a profit of $500,000, or it could sell the permits to someone else.

If ABC Electricity bought the emission permits from XYZ Mining for, say, $1,000,000, both businesses would be better off than the status quo. The profit for ABC would rise from zero (with no permits) to $1,000,000 ($2,000,000 minus $1,000,000 to buy the permits). The profit for XYZ would increase from $500,000 (if the permits are used to continue mining) to $1,000,000 (if the permits are sold).

As a result of the trade, the total cost of reducing emissions would fall from $2,000,000 (from preventing the operation of ABC) to $500,000 (from curtailing mining by XYZ).

In reality there would be lots of buyers and sellers in the market, and the actual price would depend on the overall balance of supply and demand among them all, but the example illustrates the basic logic of the approach.

The permits have value in this system (i.e. buyers are willing to pay good money for them) because they allow the holder to avoid an even greater cost involved in reducing their carbon emissions. Not everyone can avoid this cost, only those people who value the permits highly enough to be willing to buy them (or, if they already own them, to be willing to forego the income from selling them).

A fifth component is the possibility for people to sequester carbon dioxide, such as in a tree plantation. These people would be issued with new emissions permits to match the level of sequestration, and they could sell these permits on the market. The existence of the market would encourage this option if the cost of sequestration is lower than the cost of just cutting back on emissions. This is, therefore, another way of reducing the overall cost of reducing emissions.

Yet another pathway to reduced costs is through innovation. If an existing emitter is able to use a new technology or management system that reduces emissions for a given level of production, they don’t need so many emissions permits any more, and can sell some. In this way a market creates ongoing incentives for innovative ways to cut emissions. There would be no such incentive in a simple regulatory approach.

On another issue, I’ve heard someone say that the price of carbon permits would reflect the benefits of avoiding climate change. This is unlikely to be correct. It would actually reflect the marginal cost of reducing carbon emissions. The price would be higher if the permits were scarcer, requiring more expensive abatement measures to be implemented. If the number of permits was just right, then the price would match the resulting climate-change benefits, but given the massive imponderables and uncertainties in the system, this could only occur by luck.

David Pannell, The University of Western Australia