In the late 1980s, the United States faced a significant environmental challenge. Power plants nationwide released vast amounts of sulfur dioxide, which led to acid rain that harmed plants, aquatic life, and infrastructure. However, there was no incentive for these power plants to reduce their emissions.
In response, the American government took a ground-breaking approach in 1990, passing legislation to create a “cap-and-trade” market that required polluters to pay for their emissions. Within eight years, acid rain levels in large regions of eastern America had decreased by 20%, marking the birth of a novel method for cutting emissions. The Kyoto Protocol, an international climate change treaty established in 1997, proposed applying the cap-and-trade concept to carbon emissions.
Over time, various countries and regions established their carbon markets, with many employing the cap-and-trade system. In this model, a government sets a cap on the industry’s CO2 emissions and divides the cap into permits, which are either distributed or sold to companies. Firms that don’t use their entire allowance can sell the excess, while those needing additional permits can purchase them.
As the cap becomes stricter annually, the limited pool of permits increases in value.
When implemented effectively, cap-and-trade systems provide both a stick and a carrot, incentivizing innovation and promoting cleaner practices. By leveraging market forces, these systems encourage companies to race to reduce their emissions. The more they cut, the fewer permits they need to purchase and the more they have to sell.
In theory, cap-and-trade markets should lower carbon dioxide emissions; however, emissions have continued to rise because the incentives often need to be increased.
While carbon markets hold great potential, their effectiveness in reducing emissions has been limited. The primary issue lies in inadequate carbon pricing, which fails to spur the necessary changes to decarbonize the global economy. According to economists, to achieve the Paris Agreement’s goal of limiting global warming to two degrees above pre-industrial levels, the price of carbon must reach $80-100 per tonne by 2030. Yet, most carbon prices remain far below that threshold.
Additionally, the penalties for exceeding permitted emission levels are frequently too low to serve as a deterrent. In the European Union, for example, fines can be as low as a permit’s price. Moreover, these penalties only apply if companies exceed their limits. Consequently, carbon markets must address these issues to drive emissions reduction and support global decarbonization efforts effectively.
Loopholes and Challenges in Carbon Markets
In theory, regulators should enforce carbon prices and permits effectively. However, this can be a daunting task in practice due to measurement issues, differentiating between direct and indirect emissions, and cheating. Enforcement is often lax in many markets worldwide, and penalties need to be increased. Furthermore, even if some markets implement effective deterrents, neighboring markets may not. This inconsistency results in a complex array of rules, systems, and enforcement mechanisms across the globe. Companies operating in multiple countries face an intricate patchwork of regulations, leading to “carbon leakage”—the relocation of businesses or industries from areas with stringent environmental regulations to regions with more lenient rules to avoid paying for carbon emissions. Despite these challenges, solutions exist.
Solutions to Strengthen Carbon Markets
The role of regulation is crucial in creating and maintaining carbon markets, setting rules, enforcing penalties, and establishing emission caps. By limiting the number of permits, governments could drive up their prices. Setting a minimum price that increases over time would ensure that the price never falls too low, and governments could impose more stringent deterrents for potential rule-breakers.
Regulators must communicate to the market that any misconduct, leakage, and obfuscation will not be tolerated and could hold corporate executives accountable for their carbon emissions. While the European Union has demonstrated increased commitment to carbon market regulation, many other regions lag. An integrated global carbon market would be ideal, but short-term solutions include implementing border taxes on carbon emitted in goods produced outside regulated carbon markets. The EU has proposed taxing importers the same amount if the goods were produced within its market, preventing cost advantages from sourcing goods in regions with weaker regulations.
Achieving a global carbon price and harmonization among economies is vital for addressing climate change effectively. Momentum in this direction is growing, but the cooperation of major industrial powerhouses like China is crucial. If China does not work with other economies to harmonize carbon pricing and trading systems, global efforts may be undermined by the production of carbon-intensive goods and multinational companies shifting production to less-regulated locations.
Fortunately, as climate change becomes a higher priority on political agendas, governments are improving carbon market regulations. Since 2019, the EU has reduced the number of permits issued, resulting in record-high carbon prices of over €60 per tonne. Carbon prices in other markets also increase as regulators explore ways to enhance effectiveness. If prices remain high, supported by government and regulatory commitments, greener industrial processes will become more appealing, and carbon markets can finally achieve their original objective of decarbonizing the world.