Carbon allowances or units totalling up to this maximum are then allocated or auctioned to companies in high-emission sectors, such as power generation, oil and gas refining, steel making, and chemical manufacturing. Each allowance permits the emission of one tonne of CO2. Inclusion of these high emitters in the cap-and-trade scheme is mandatory and regulated.
The allowances are tradable commodities. They can be bought and sold in the secondary markets, where banks and trading companies provide liquidity. This sets the market price for carbon.
If a company generates emissions over what it has been allowed, it needs to buy more carbon units from the market, thus incurring a cost. But if the company generates less than its allowance, it can sell any excess units in the market to a company that hasn’t successfully reduced emissions. Alternatively, it can hold its unused allowances for future use.
The price of carbon is determined by supply and demand. Supply of units is set by regulators to decrease annually, leaving the price of carbon to rise or fall depending on whether firms produce emissions above or below their allowances.
Prices for carbon emissions differ across all the various cap-and-trade programmes worldwide. The price of carbon emissions within the European plan reached €65 per metric tonne in September 2021. By contrast, the price of a similar amount within the California/Quebec cap-and-trade programme was less than $28 at the same time. The difference occurs because each programme covers different industries and is designed to meet different carbon emission reduction goals, etc.
RBC Capital Markets expects carbon prices will rise over time, pointing out that as the cap declines, the market supply of allowances should get tighter. The International Monetary Fund is of the opinion that prices must rise significantly to stimulate alternative or low-emission options. It estimates that at global level, a price of $75 per tonne or more is needed by 2030 to restrict global warming to below the Paris Agreement’s well below 2°C (3.6°F) threshold.
Proponents of cap and trade point out that it gives companies flexibility by allowing them to hold allowances into future compliance periods. As a result, reducing carbon emissions can become a multi-year decision. Cap and trade also tends to be viewed more positively by consumers/voters than carbon taxes.
Some countries with high carbon prices are considering putting a charge on the carbon content of imports from regions without similar schemes. To this end, the EU in particular is pondering a carbon border adjustment mechanism.
Carbon taxes are another way of implementing a fee on CO2 emissions. Governments set a price per tonne of carbon emissions high enough to provide an incentive to switch to clean energy technology such as wind, solar, or other non-carbon-emitting power sources. Moreover, the tax usually goes up over time. In Canada, the carbon tax is set at CA$40 per tonne of CO2 equivalent for 2021. The government recently updated its federal carbon pricing benchmark, setting a minimum carbon price of CA$65 per tonne in 2023, rising to CA$170 per tonne by 2030.
A carbon tax differs from a cap-and-trade scheme in that a tax provides a high level of certainty about future prices—as those are set by the government in advance—but not about emissions. Cap and trade, by contrast, provides visibility about future emissions—as decreasing limits are set—though the price is left to market forces.
Taxes can be more equitable to the extent that they can be applied to all CO2 emitters, either industrials or individuals, through a fuel tax as opposed to cap and trade, which assigns a cost only to industrial CO2 emitters.
Unsurprisingly, taxes are not popular with the electorate. President Joe Biden’s proposal of a carbon tax was vehemently opposed, causing him to opt for a payment scheme for emission reductions. In the UK, fuel taxes have not been changed since 2011. Furthermore, taxes can be watered down, making them a less-effective tool. In 1992, a carbon tax was discussed by the Clinton administration but was watered down to a negligible tax on gasoline.
Cap and trade and carbon taxes need not be mutually exclusive. RBC Capital Markets, LLC director of Commodity Markets Anthony D’Agostino points out that Canada, for instance, has both mandatory policy instruments in place: British Columbia imposes a carbon tax, Quebec and Ontario have cap-and-trade programmes, while Alberta has implemented a hybrid system that combines a tax with a cap for large industrial emitters.