Question

Describe the scheme whereby a nation's allocation of carbon dioxide emission could be traded on a market. Describe two schemes by which initial allocations could be made.

Short answer

Carbon trading allows markets to buy and sell emission allowances; initial allocations can be made via grandfathering or auctioning.

Step-by-step solution

Understanding the Concept of Carbon Trading

Carbon trading is a market-based system where countries or entities that produce carbon dioxide emissions can buy or sell emission allowances. These allowances represent the right to emit a certain amount of CO2 and create an economic incentive to reduce emissions.

Description of Cap-and-Trade Program

In a cap-and-trade system, the government sets a cap on the total level of carbon emissions. Companies are issued emission permits and can trade them with each other. If they emit less than their allocation, they can sell the extra permits; if they emit more, they must buy additional permits.

Defining Initial Allocation Scheme: Grandfathering

Grandfathering is a method where initial emissions allowances are distributed based on past emissions levels. This method rewards historical emitters, giving them allowances proportional to their previous emission levels, often criticized for not incentivizing reduction.

Defining Initial Allocation Scheme: Auctioning

In an auctioning scheme, emissions allowances are sold to the highest bidder. This method encourages companies to reduce emissions as they have to pay for allowances, distributing the cost fairly across industries based on their financial capabilities rather than past emissions.

Comparison and Summary of Initial Allocation Schemes

The grandfathering method can be advantageous to existing businesses but does not necessarily encourage emission reductions. Auctioning promotes emission reduction by creating a cost for emissions and redistributes financial resources in a market-driven way.

Key concepts

Cap-and-Trade System

Imagine a large balloon that can only hold so much air. The cap-and-trade system is somewhat similar, but it is about limiting carbon dioxide emissions instead of air in a balloon. The government sets a 'cap' or maximum limit on emissions that an industry or a region can produce.
Once this cap is set, emission allowances are distributed, either freely or through a sale, and companies can trade these allowances. If a company manages to emit less than their cap, it can sell the leftover allowances to another company. Alternatively, if a company is over its allowance, it can purchase extra permits from the market.
This system creates a financial incentive for businesses to reduce emissions. It allows for flexibility since companies can choose the most cost-effective way to manage their emissions.

Emission Allowances

Emission allowances are like tickets or permits to emit a specific amount of carbon dioxide. Think of them as coupons you use when shopping, but in this case, they 'pay for' each ton of CO2 emitted. These allowances are crucial in regulating and controlling emissions under the cap-and-trade system.
The total number of allowances is predetermined by the cap, ensuring that the overall emission levels remain within set limits. Companies that emit less can retain their allowances for future needs or sell them to others.
Allowances can initially be allocated in different ways, such as through grandfathering or auctioning, which we will explore further.

Grandfathering

Grandfathering is like giving out free meal vouchers based on last month's dining history. In terms of emissions, this method allocates allowances based on a company's historical emissions.
Companies that have polluted more in the past receive more allowances. This can be seen as fair to established companies as it accounts for their existing operations and infrastructure.
However, a downside is that it doesn't motivate companies to change their current behavior or reduce emissions, since they are receiving allowances based on how much they've already polluted.

Auctioning

Auctioning flips the script by selling emission allowances to the highest bidders. This method is like an art auction, where the price of a painting is determined by how much buyers are willing to pay.
This approach ensures that there’s an inherent cost to emissions that companies must consider in their operations. As they have to purchase allowances, they are encouraged to invest in cleaner technologies to minimize costs.
Auctioning also promotes fairness, as companies pay based on their financial capability rather than their past emission levels.

Emission Reduction Incentives

Incentives are like a nudge in the right direction, encouraging companies to act responsibly. Within the cap-and-trade system, various incentives promote emission reduction.
The market-driven nature of emissions trading encourages lower emissions, as companies that emit less can sell their excess allowances. This becomes profitable if the market price for emissions is high.
Moreover, as the cap lowers over time, it forces companies to innovate and reduce emissions to avoid rising costs associated with purchasing additional permits.