Carbon trading 101

Human activities are in major part responsible for the occurrence of potentially irreparable climate changes that could cause economic and social turmoil if appropriate measures aren’t taken to stop global temperature rises. Trading in carbon emissions is a method that is designed to give an incentive for the economy to reduce the emission of greenhouse gases. It is commonly called carbon trading since the most prevalent greenhouse gas that is a greenhouse gas is CO2 (carbon dioxide).

There are three options that can be used to encourage emissions reductions from greenhouse gases and, consequently, limit the effects of climate change. The primary one is the direct control for smokestack emission. This is a strict mechanism that fails to consider the capacity of polluters to economically effectively reduce carbon dioxide emissions. The other mechanism is carbon taxation, which is a market-based system, i.e. one that rewards emissions with financial incentives reductions, however it lacks the flexibility of a guarantee for reduction in emissions. The third option, and possibly most effective option is the trading and cap. The cap is imposed on the system and it is controlled by the limitation of a declining amount of pollution permits. The emitters who can cut their emissions costs to reduce emissions can do so and then sell the permits to those who find it more costly to reduce emissions.

“Cap and Trade” creates an incentive for profit to reduce emissions even further for those who are capable and reduces the cost for compliance for those less able. The effective distribution, through trade in carbon, for the comparatively small capacity of the earth to absorb greenhouse gas emissions is beneficial to the entire economy. In the same way, the price encourages new ways to cut carbon emissions, and markets that transparently estimate the costs of reducing emissions.

What is the trade carbon credits process?

Carbon trading involves the purchase or selling the rights to emit a tonne CO2 or its equivalent (CO2e). The ability for a person to release a Tonne of CO2 is usually called carbon credit or carbon allowance. For instance, in the EU Emissions Trading Scheme there is the EU Allowance (EUA) and in the California system, there is California Carbon Allowance (CCA). California Carbon Allowance (CCA). The allowances in any trading system may be purchased and sold by anyone but they ultimately end up with the users when they require the allowances to cover their compliance with regulatory requirements.

Allowances can be found in paper forms similar to shares, but to maximize efficiency, they are in digital format and are stored in a registry account that is electronic similar to an online banking system. The accounts of the registry in compliance systems are managed by the governing body of that system to ensure integrity.

Carbon allowances’ trading is similar to the trading of every other kind of commodity. Futures exchanges are used to facilitate spot and later dated delivery, as well as options. These same transactions can be conducted ‘over the over the counter’ (i.e. in a bilateral manner) between two counterparties who are willing and typically include carbon broker acting as introductionrs, or as intermediary counterparties.

Who is able to trade carbon allowances?

Anyone can participate in carbon trading. In Europe there are no limitations whatsoever on who is able to manage a registration account. The main players in carbon trading typically;

1. Compliance installations (e.g cement, steel papers, paper, chemical and aluminium factories located in countries that have implemented cap and trade programs),

2. Trading firms, such as hedge funds,

3. electricity gas, electricity and other utility companies,

4. A small amount of banks as well as

5. Carbon brokers whether as intermediaries or introducers.

What is the time when carbon is traded?

In the carbon markets that are most liquid, trading is carried out throughout the day throughout the year. However, many of the installations that are covered by carbon trading systems focus their activities around deadlines for compliance. The EU ETS compliance buying is focused on the three months preceding the compliance deadline of April 30th. This could cause price fluctuations based on the demand / supply balance at the moment.

The ones with greater exposure for electric utilities, tend to trade more frequently and buy larger amounts of. A lot of allowances are offered to industries for free in the beginning stages of compliance programs, but in order to give a price signal to all as time passes, the percentage of allowances that are auctioned by government agencies grows. This is a way of spreading the time of trades throughout the year, and is a natural development to a mature market.

Where can carbon be traded?

It is contingent on the scheme since different marketplaces exist for various ETS across the globe, however within the EU ETS the majority of emissions trading is conducted through exchanges.

A good liquidity in the market is crucial for a carbon market functioning effectively. Liquidity is generated by having low or no barriers to entry into the market and a high amount of market participants who are regular with low transaction costs, regularised contracts, clear pricing, and competition between consumers and buyers. Liquidity naturally occurs when there is a balanced mixture of compliance-related installations, investors, speculators and brokers. Liquidity is more likely to develop through exchange-based trading, where the regulations and contracts are the identical for all, but about 50% of EU ETS transactions have been conducted bilaterally between two counterparties. Exchange trading can be expensive particularly for small market participants, because of the cost of membership, clearing and trading charges.