Guide to Emissions Trading

Emissions trading is a market-driven approach, enabled by legislation/regulation, to address environmental issues such as climate change. The Canadian greenhouse gas (GHG) emissions trading system provides economic incentives for reducing emissions at the least total cost.

Emissions trading originated in the United States (U.S.) to address acid rain caused by sulfur dioxide (SO₂) emissions. The Acid Rain Program, implemented through new federal legislation under the Clean Air Act, set a cap/maximum amount of allowed emissions from electric power plants across the country. The success of the program speaks for itself with 2002 SO₂ emissions recorded at 41 per cent lower than those in 1980 (prior to program). With human health benefits valued at $70 billion annually, the program’s social and environmental benefits clearly exceeded costs by more than 40 to 1. In fact, the cost of meeting the emissions cap was also a quarter of original government estimates and, as a result, the program has encouraged governments to use the emissions trading model to address other pollution types (i.e. GHGs).

While the Acid Rain Program addressed pollutants with relatively localized impacts, GHG emissions are global pollutants. This means a tonne of emissions from Canada, the U.S., Africa or China have exactly the same impact on the environment, in terms of contributing to climate change. Thus, the geographic location of a GHG emission reduction does not matter with respect to the atmosphere. With disparate costs to reduce emissions in different sectors and countries, emissions trading provides a strong economic signal to cost effectively achieve emission reduction targets.

An emissions trading system allows society to address three key policy objectives. First, a government authority sets a target level on the specific pollutant or gas. This sets the jurisdiction’s optimal scale of emissions based on environmental considerations.

Second, the government authority must set out how the target level will be implemented. One way the government could distribute permits to companies is based on their past emission levels (known as grandfathering). These permits could also be auctioned/sold to companies. Another approach is the baseline system, using a forecast of a company’s future emission levels to determine their targets. These allocation strategies address the question of equity because the cost of meeting the emission reduction is determined by how the target level is implemented.

The third policy objective is met when private decision-makers face a common price signal and have an incentive to minimize their own costs. In this scenario, an emissions trading market that creates a price for each unit of emissions can be established. As with all other markets, the price is created through the interaction of supply and demand. The emissions target creates demand for emission reductions. Supply is created based on the distribution of permits or the use of a baseline system. This establishes who has to make reductions and by how much. Groups that exceed the limit may buy emission reduction units to meet compliance. In a cap and trade system the unit is a permit or an allowance. In a baseline system, these units are called credits. Organizations use the price of units traded to measure the value of making internal emission reductions and/or trading permits or credits.

When a government or a company has an emission reduction target, it may only have a certain number of projects or opportunities for reducing emissions within its own operations. These projects or opportunities may also be relatively expensive compared to potential reduction opportunities for another company, sector or even another country. Emissions trading creates a way for organizations to meet their reduction targets at a lower cost by essentially paying others to undertake emission reduction projects. While this may seem like the system allows polluters to simply pay to continue polluting, as long as GHG emissions are being reduced by someone, anywhere in the world, climate change is being addressed. An emissions trading market can be an effective component in the fight against climate change.

The GHG market, particularly in Canada, is still in its infancy. With rules slowly emerging around the offset system and demand being created by regulated and potentially regulated entities a Canadian emissions trading market now has the means to develop.

While GHG emissions trades have already occurred in Canada, these transactions are low in number. They generally comprise bilateral agreements for forward or option streams of emission reductions. Early, higher risk transactions were done in hopes the contracted emission reductions would one day meet the criteria of an anticipated offset system. This transaction process, where buyers and sellers agree to terms, negotiate contracts and deliver offset credits, continues.