Emission Trading Scheme

An Emission Trading Scheme (ETS) is one of the three main ways (alongside Carbon Taxes and CC) through which a government can regulate the carbon emissions of an economy. Like a carbon tax, an ETS is a market-based solution, meaning it does not set an upper limit on the pollution caused by any individual company but instead tries to provide a financial incentive for companies to pollute less.

An Emission Trading Scheme is set up by handing out pollution permits to companies and by creating a market on which these permits can be traded freely. The allocation of such permits respects differences in sectors across an economy and thus does not “punish” polluting sectors like heavy industries. Generally, when an ETS is first established, any individual company is allowed to pollute as much as it did in the past without incurring an additional cost. If a company chooses to pollute less than in previous years and has permits left over, it can sell them to other companies that can use these permits to emit more CO2 in that given year. Over time, the government will decrease the number of permits in the market, which will lead create a shortage of supply and drive up the prices of pollution permits, which in turn will create an incentive for companies to decrease their pollution levels through innovation or avoidance. In general, ETS’s can be used for different types of emission and pollution; it’s most common use case, however, is an intended reduction of greenhouse gases like CO2.

ETS’s are also called Cap and Trade (CAT) because, just like within a command and control system, the government can choose a limit of the total emissions caused within an economy, i.e., the total number of permits in the ETS. Through the set cap, a government can very effectively control the total amount of emissions caused within an economy, allowing it to plan to reach its long term emission goals (e.g., to comply with the Paris Agreement)

At the same time, implementing an ETS is a market-based solution, letting individual companies freely decide on their emission levels without incurring the high costs of a carbon tax. As a result, ETS’s are generally favored by both consumers and companies, as in the short run, they do not increase consumer prices.

The biggest downside of an ETS is that it implies far higher monitoring costs than a carbon tax or a CC system. Thus, ETS’s are mostly employed on a national or supranational level, making use of economies of scale.

The largest trading scheme implemented thus far is the European Union ETS (EU ETS), which governs about half of the CO2 emissions caused by all EU and EEA member states. While it often got criticized for giving out too many permits and contracting the market too slowly to have a significant effect, a recent study shows that indeed the EU ETS managed to reduce emissions effectively and save more than 1 billion tons of CO2 between 2008 and 2016 .

Further reading:
A recent article on the effectiveness of the EU ETS

(Definitions and content draw heavily on ECON204 thaught by Prof. Neumeyer at the London School of Economics and the corresponding textbook Environmental Economics: An Introduction by Field and Field)