Carbon emission trading systems: a review of systems across the globe and a close look at China’s national approach

A carbon emission trading system (ETS) is a market-based policy instrument to combat climate change. It internalizes the societal cost of carbon dioxide (CO2) emissions and thereby creates incentives for emission reductions through changes in production methods and levels of production as well as investments in low-carbon technologies. ETSs are an important and much-employed alternative to emissions taxes (such as a carbon tax) as an instrument for bringing about reductions in CO2 emissions. Under an emissions tax, the government sets the price of a unit of emissions – this is the tax rate – and the quantity of emissions is determined by the market, that is, by firms’ and consumers’ responses to the tax. In contrast, under an ETS, the government influences emissions through its decisions affecting the number of emissions allowances to be allocated to firms; the price of emissions is determined by the market, not directly by the government. A key feature of an ETS is the provision for allowance trading. If the market price of emissions allowances is below a firm’s marginal cost of reducing its emissions, a competitive firm will have an incentive to purchase additional allowances and thereby avoid some of the cost of reducing its emissions. The reverse is the case for a firm for which the market price of allowances is above its marginal cost of abatement. In the presence of allowance trading, the firm’s ultimate (end-of-period) allocation of allowances, plus (minus) any allowances it purchases (sells) on the trading market, must be at least enough to justify its emissions during the period. The price of allowances is an equilibrium outcome of the allowance supply and demand. Allowance trading helps reduce the economy-wide costs of achieving emissions reductions by bringing about more abatement by the facilities that can do so at lower cost.