The regulatory compliance market and the voluntary market are the two different forms of carbon markets. Companies and governments who are required by law to account for their GHG emissions use the compliance market. Mandatory national, regional, or global carbon reduction regimes govern it. Trading of carbon credits occurs voluntarily on the voluntary market. For the regulatory market, the Clean Development Mechanism (CDM), Joint Implementation (JI), and EU Trading System (ETS) are the three Kyoto Protocol measures that are most crucial. Some nations have other legally obligatory state and regional GHG reduction plans but have not formally ratified the Kyoto Protocol. Developing nations are taking part only in the CDM. This article concentrates on the compliance of carbon market.
Government policy is a major influence on compliance with carbon credit prices. Maximum emission caps also referred to as permits or credits, will be determined by government policy. The purchase or sale of carbon credits by carbon emitters depends on the emissions produced. If their emissions are below their cap, they sell the extra credits. If they go above their limit, they purchase to make up the difference.
There are now three main emissions trading systems operating globally. European Union’s Emissions Trading System (EU), The California Global Warming Solutions Act (USA), and The Chinese National Emission Trading System (China). Let’s start with the Emissions Trading System (ETS) of the European Union, accounted for 90% of the global compliance market.
The European Union’s Carbon Market (ETS)
A pillar of EU climate policy is frequently referred to as the EU Emissions Trading System (EU ETS). By putting a price on greenhouse gas (GHG) pollution from the power, industrial, and aviation sectors, seeks to lower emissions. Increasing the cost of energy-intensive business, as usual, it not only aims to encourage investment in emission reductions. Also presents the EU with a wonderful chance to redirect financing from polluting activities to climate action, innovation, and energy sector modernization.
Along with the 27 EU member states, Iceland, Norway, and Liechtenstein, it includes around 10,400 industrial and electricity installations, roughly 350 airlines. In addition a link to the Swiss ETS. The EU ETS objective, which calls for a 43 percent reduction in emissions from the industries it regulates by 2030 (relative to 2005), was already accomplished by 2020. In 2020 alone, emissions from EU ETS installations decreased by a staggering 11.4 percent . Compared to 2005, emissions from industry and power decreased by 41%.
However, conceals discrepancies in emission trends between sectors: emissions from the production of energy and heat have declined by over 45 percent since 2011. Industry emissions hardly changed between 2013 and 2019: a meager 1.3 percent. Other circumstances and laws, such as the COVID-19 epidemic, the Renewable Energy Directive, and the Energy Efficiency Directive, contributed to emission reductions under the EU ETS. A “cap and trade” system, the EU ETS. Indicates a general cap (or overall limit, or “cap”) on the total amount of greenhouse gas (GHG) emissions that equipment in the covered industries may emit cumulatively. The steady lowering of this cap enables the EU policymakers’ reduction goals for the EU ETS sectors to be met. The power industry, heavy industry, and aviation are the three main economic sectors in the EU ETS.
Six greenhouse gases are addressed by the ETS, though not in all sectors. For instance, CO2 from the production of electricity and heat, air travel, and many other energy-intensive industries are all included, but only perfluorocarbons (PFCs) from the manufacture of aluminum are as well. The cap is divided into EU Allowances, which are pollution permits (EUAs). One ton of CO2 equivalent emissions is equal to one EUA. The cap was around 1.57 billion EUAs in 2021. Installations subject to the EU ETS are required to surrender (sometimes referred to as hand over) an amount of EUAs each year equal to their emissions from the prior year. For instance, a facility that produced 1 million tonnes of CO2 in 2020 would have to transmit 1 million EUAs to the central registration of the European Commission in 2021.
But how can companies acquire these EUAs? Buy them at auction. The European Energy Exchange organizes auctions. The proceeds are distributed according to a predetermined division key among the 27 EU member states. Receive them for free. The aviation industry, as well as some lower-income member states’ power generation, receive free allocations in sectors that are thought to be in danger of carbon leakage. Purchase them on the open (or so-called secondary) market. ETS operators, as well as other parties like financial institutions, can trade permits on a number of trading platforms. Other contracts (such as those for the purchase of heat or electricity) may also contain transfers of EUAs.
Companies may trade and resell allowances, including those they have obtained for free, on the open market. The term “trade” in “cap and trade” alludes to this. For instance, if a company has been successful in reducing its emissions particularly quickly, it might sell its extra allowances to another company or bank them for use in the future.
EU ETS’s trading component
The EU ETS’s trading component is the one that, in principle, should make decarbonization more affordable. Ensures that the cheapest emission reductions are implemented first. A carbon market, however, is insufficient to remove non-market constraints (such as a lack of funding for energy-saving investments). In addition can support the development of novel, ground-breaking clean technology.
The overall cap is enforced by limiting the supply of EUAs; each year, only that number of EUAs—the cap for that year—are made available through auctions and free allocations to enterprises. To ensure that GHG emissions from the involved industries also decline, the cap is decreased annually. The ETS companies are aware of this fact. They are aware that even if this was not the case in the initial years after the system was implemented, in theory, this indicates that EUAs will get more and more expensive with the time. In theory, businesses have a financial incentive to cut emissions. Getting a EUA now and in the future will cost money. Either these enterprises continue to pay for high emissions levels, or they make investments in projects and technologies to lower their emissions and the number of EUAs they require.
The California Carbon Market (Global Warming Solutions Act)
The Global Warming Solutions Act of 2006 (AB 32), a landmark piece of legislation that established a firm statewide cap on greenhouse gas emissions and reaffirmed California’s commitment to moving toward a sustainable, clean energy economy, served as an early test bed for EDF’s climate work. EDF was a cosponsor of this legislation
With the adoption of SB 32 in 2016, California enhanced and extended the cap on greenhouse gas emissions. The state increased its 2030 greenhouse gas emission reduction target to 40% below 1990 levels. The results of California’s implementation of its climate legislation are now being seen in impressive ways. After a decade of AB32 implementation, carbon pollution is dropping while California’s economy is expanding. The state is well on its way to achieving its renewable energy target thanks to creative developments in clean energy and energy efficiency.
More lately, the state is giving its proposed California Tropical Forest Standard significant thought as a way to use its cap-and-trade program to protect rainforests worldwide. The proposal lays out detailed specifications for extensive projects to cut emissions from tropical deforestation. They will be taken into account for crediting in future global compliance markets.
China’s Compliance Carbon Markets
The main goal of China’s ETS is to offer cost-effective, market-driven support for greenhouse gas (GHG) emission reduction objectives. They are essential to China’s ambition to peak its emissions by 2030 and become climate neutral by 2060. The system, which comes after a series of regional experiments launched in 2013, is intended to give businesses, investors, and other market participants incentives to support China’s transition to clean energy and decarbonization. In China’s ETS, there is currently no absolute cap. The main distinction between it and the EU ETS is that. Currently, China uses a bottom-up strategy in which all covered enterprises receive free allocation of their emission allowances. The allocation is based on a national benchmarking system. It calculates and compares the average carbon intensity of significant industries and products to that of individual emitters. Amounts equal to each emitter’s certified emissions will be allotted in terms of allowances.
China’s national strategy
This strategy means that China’s national ETS isn’t yet a cap-and-trade system. However, businesses that are successful in lowering the carbon intensity of their manufacturing can produce extra allowances to sell. The cost of the allotment is dynamic and changes every day. The Chinese ETS’s primary motivation to operate more efficient coal-fired facilities over less efficient ones. This is another significant point of differentiation. Except for generators whose entire fleet is inefficient and who are likely to lose money if they continue operating, the intensity-based allocation does not explicitly encourage the transfer from coal to renewables. Therefore, China’s ETS is likely to induce the closure of extremely inefficient coal plants sooner rather than later if they are already running at low rates of capacity. Inversely, as there would be less cross-subsidization, this should increase the profitability of the coal power sector as a whole.
Because an intensity-based cap merely rewards more efficient coal plants over less efficient ones, there is no incentive to convert from coal to renewable energy. Coal would still be used to produce the same amount of power overall as before the ETS, but because of the higher efficiency, there would be fewer emissions overall. In contrast, every ton of carbon that exceeds the cap will result in a financial penalty under an absolute cap. Companies have an incentive to switch their overall generation portfolio away from coal and towards renewables. If the price of carbon is anticipated to climb over time if they have renewable assets because they may sell those into the grid without affecting their ETS compliance obligation.
Written by our Energy Enthusiast
Pavlos has a Bachelor’s in International and European Studies from the Panteion University of Athens. He has worked successfully at a Law Firm in Kolonaki, Athens. Currently, he is working at a Solution Provider/System Integrator Company in Athens. Postgraduate student of the MSc in Energy: Strategy, Law, and Economics at the University of Piraeus in the faculty of International and European Studies. Speaks Greek, English, and German. He is keen on Middle East culture and history.