Carbon trading is a system of limiting carbon emission through granting firms permits to emit a certain amount of carbon dioxide.
The amount of permits is decided by the government, and then permits are given to firms depending on various criteria (such as how much output a firm produces)
With the permits, a firm can then buy and sell these permits in an open market. For example, if a firm wanted to emit more pollution, it could buy more permits. If it reduced its pollution emissions, it could sell its surplus permits on the market.
Benefits of Carbon Trading
- The argument is that firms are free to choose the most cost-effective way of meeting permit requirement. For example, they have an incentive to develop better technology which limits carbon emissions. However, if the price of permits is low, they may decide to buy more.
- Gradual reductions in Permits. The idea of carbon trading is for governments to gradually reduce the number of available permits from year to year. Therefore, firms need to increasingly find more ways to reduce carbon emissions.
Arguments Against Carbon Trading
- Complex. It can become complicated deciding how many permits to allow. For example when the EU introduced a system of carbon trading, in the initial period of 2005-07 the price of carbon permits were driven down to zero because the EU misjudged the number of permits. However, any scheme will take a while to be effective.
- The difficulty of measuring how much a firm is actually polluting.
- Transaction costs involved in buying and selling permits.
- Free Rider Problem. The problem of excess carbon emissions is a global problem. Therefore, there needs to be a global solution. If carbon trading is introduced in one country but not others, it may cause production to shift to countries without the scheme. Often countries don’t start carbon trading precisely for the fear other countries will be free-riding on their efforts.
- Carbon Tax may be more simple, transparent and easy to administer.
- Carbon Trading may have a greater impact on those with low incomes and poor areas who have less flexibility to change their lifestyles.
Alternatives to Carbon trading
A tax on carbon has the same effect of reducing the quantity and raises revenue for the government.
Carbon trading starts with pollution permits.