How Emission Trading Works to Reduce GHG Emissions

Emission trading has emerged as one of the most effective market-based tools for tackling climate change. Rather than dictating specific technologies or mandating how individual facilities must cut pollution, emission trading harnesses market forces to find the least expensive ways to reduce greenhouse gas (GHG) emissions. This approach has proven successful across multiple continents, and today, jurisdictions representing 58% of global GDP use some form of emission trading system.

Understanding cap and trade programs 🔗

Cap and trade is a market-oriented approach to controlling pollution that sets a firm limit on total emissions while providing economic incentives for reduction. The system works through two interconnected components: a regulatory cap and a market-based trading mechanism.

The cap: setting the emissions ceiling 🔗

The “cap” establishes the maximum allowable emissions from a group of sources-whether power plants, factories, or entire industrial sectors. Government authorities issue emission allowances, with each allowance authorizing the holder to emit one tonne of CO2 equivalent. Companies must obtain and surrender enough allowances to cover their annual emissions. Critically, this cap decreases over time in line with climate targets, ensuring that overall emissions decline steadily.

The trade: creating a carbon market 🔗

The “trade” component creates a functioning market where companies buy and sell these allowances based on supply and demand. Companies that cut pollution faster can sell their spare allowances to companies that pollute more, or save them for future use. This flexibility is what makes cap and trade economically efficient-it allows emission reductions to occur wherever they cost the least.

Companies face a choice: invest in cleaner technologies to reduce emissions, or purchase allowances from others who have already made cuts. Those who can reduce emissions cheaply will do so and sell their surplus permits at a profit. Those facing higher reduction costs can buy permits instead of investing in expensive upgrades. The result is that the same environmental outcome-meeting the cap-is achieved at lower overall cost than if every company were required to make identical cuts.

Proven track record 🔗

Cap and trade has a history of delivering results. The approach first gained prominence in the United States during the 1990s when it was used to tackle acid rain. That program slashed sulfur dioxide emissions at a fraction of the projected cost. Building on this success, emission trading has expanded to address climate change. The EU Emissions Trading System, launched in 2005, has helped reduce emissions from European power and industry plants by approximately 47% compared to 2005 levels.

Carbon markets: scaling up emission trading 🔗

Carbon markets have grown significantly as countries seek cost-effective ways to meet their Paris Agreement commitments. These markets create a price signal for carbon, incentivizing businesses to factor environmental costs into their investment decisions.

The emergence of major carbon markets 🔗

Carbon pricing now covers 28% of global emissions and generated over US$100 billion in 2024. The landscape includes both compliance markets, where participation is mandatory, and voluntary markets where companies purchase credits to meet self-imposed climate goals.

The EU ETS remains the world’s most established carbon market, operating in all EU countries plus Iceland, Liechtenstein, and Norway. It covers emissions from electricity generation, manufacturing, and aviation. The system has been reformed multiple times to increase ambition-the cap is now set to bring emissions down by 62% by 2030 compared to 2005 levels.

China’s national emission trading system, significantly expanded in 2024, is now the largest in the world by emissions volume. It covers about one-seventh of global emissions from fossil fuel combustion, primarily from the power sector. Unlike the EU system, China uses intensity-based benchmarks that link allowances to output levels rather than imposing an absolute cap.

The need for broader participation 🔗

Currently, 36 emission trading systems are in place worldwide, with another 22 under development or consideration. Emerging economies are increasingly turning to emission trading, including Argentina, Brazil, India, Turkey, and Vietnam. This expansion is essential because achieving deep emission reductions requires broad participation-the more sources covered, the greater the opportunities to find low-cost reductions.

Canada’s Global Carbon Pricing Challenge calls on all countries to adopt carbon pricing as a central climate strategy, with a collective goal of covering 60% of global emissions by 2030. Broader coverage not only increases environmental effectiveness but also reduces the risk of carbon leakage, where emissions simply shift to regions without carbon constraints.

Marginal abatement cost: the economics of emission trading 🔗

Understanding marginal abatement cost (MAC) is fundamental to grasping why emission trading works so effectively. MAC refers to the cost of reducing one additional unit of greenhouse gas emissions-typically measured in dollars per tonne of CO2.

What MAC tells us 🔗

Marginal abatement cost measures the expense of reducing pollution past a certain point. Different companies and sectors face vastly different costs for cutting emissions. A power plant might switch from coal to natural gas relatively cheaply, while a cement manufacturer might face enormous costs for the same percentage reduction. These differences are what make trading valuable.

Marginal abatement cost curves (MACCs) plot the cost-effectiveness of various emission reduction measures against the quantity of emissions reduced. This visualization helps policymakers and businesses identify which actions deliver the most reduction for the least expense. Some measures-like improving energy efficiency in buildings-may actually save money while cutting emissions. Others, like carbon capture technology, remain expensive.

How MAC drives trading 🔗

In a cap-and-trade system, the allowance price should reflect the marginal cost of abatement for participants. If a company can reduce emissions for less than the current allowance price, it makes economic sense to invest in those reductions and sell the spare permits. If reduction costs exceed the allowance price, purchasing permits is the smarter choice.

This dynamic means that emission reductions automatically flow to wherever they can be achieved most cheaply. Environmental Defense Fund research shows that at marginal costs up to $60 per tonne, clean technologies in electricity and transportation can reduce annual carbon emissions by roughly one gigatonne. As carbon prices rise, more expensive abatement options become economically viable.

Why MAC matters for policy 🔗

Policymakers use marginal abatement cost curves to analyze how much reduction an economy can achieve at different cost levels and where policy should be directed. Studies worldwide show that improving building energy efficiency and replacing fossil-fueled power plants with renewables typically offer the most cost-effective pathways for reducing emissions.

As reduction efforts progress, the cost of abating each additional tonne increases. Easy, low-cost measures get implemented first. Deeper cuts require more expensive technologies and fundamental process changes. This is why emission trading systems are designed to become more stringent over time-as prices gradually rise, additional abatement solutions become economically competitive.

Global impact of emission trading 🔗

Emission trading delivers benefits beyond environmental protection. When designed well, these systems foster international cooperation, reduce compliance costs, and stimulate innovation in clean technologies.

International cooperation through carbon markets 🔗

Article 6 of the Paris Agreement details how countries can cooperate to achieve their emission reduction targets. This framework allows nations to transfer carbon credits across borders, enabling emission reductions to occur wherever they are most cost-effective globally.

At COP29, governments adopted new international standards for carbon markets, establishing mechanisms for trading emission reduction credits among countries and creating a UN-managed crediting system open to both governments and private participants. These developments provide the foundation for a truly global carbon market.

The EU has been actively building cooperation with other jurisdictions. The EU ETS is already linked with Switzerland’s system, and the European Commission works with partners including China and Korea to support emission trading development worldwide.

Reducing compliance costs 🔗

Research shows that global use of carbon markets could lower costs by two-thirds compared to achieving the same reductions without international trading. This efficiency gain enables more ambitious targets-the same money buys more emission reductions when markets can operate across borders.

Global revenue from emission trading systems surpassed US$74 billion in 2023. These proceeds are typically channeled into further emission reduction initiatives, including low-carbon technology development, energy efficiency programs, and support for affected communities. Since 2013 alone, the EU ETS has raised over EUR 175 billion, funding renewable energy, efficiency improvements, and low-carbon innovation.

Driving innovation 🔗

A predictable carbon price sends a clear signal to innovators and investors: clean technologies will have growing value. Cap and trade lets the market determine a carbon price, and that price drives investment decisions and spurs market innovation.

When companies know that emission allowances will become scarcer and more expensive over time, they invest in developing solutions. The trading system increases the pool of available capital to make reductions and rewards companies that find innovative ways to cut pollution. This dynamic has helped accelerate the transition to renewable energy, improve industrial efficiency, and bring new clean technologies to market.

Carbon markets can unlock climate finance for developing countries and drive meaningful emission reductions while supporting broader economic development. The challenge now is to expand and link these markets to achieve the scale needed for deep decarbonization.

Looking forward 🔗

Emission trading has evolved from an experimental policy tool to a central pillar of climate strategy worldwide. A 2024 systematic review found that carbon pricing systems achieve average emission reductions of approximately 5-21% after implementation. As more countries adopt emission trading and international market connections deepen, the potential for cost-effective, ambitious climate action grows.

The success of emission trading depends on good design: caps must be stringent enough to drive meaningful reductions, monitoring must be rigorous, and market oversight must prevent manipulation. When these conditions are met, emission trading provides a powerful tool for reducing greenhouse gases while fostering innovation and economic efficiency.

What do you think? Can carbon markets successfully scale up to deliver the deep emission reductions needed by mid-century? And how should governments balance the efficiency benefits of international trading against concerns about ensuring local emission reductions?

References

1. https://icapcarbonaction.com/en/publications/emissions-trading-worldwide-2024-icap-status-report
2. https://www.epa.gov/emissions-trading/what-emissions-trading
3. https://climate.ec.europa.eu/eu-action/carbon-markets/eu-emissions-trading-system-eu-ets/about-eu-ets_en
4. https://www.edf.org/climate/how-cap-and-trade-works
5. https://climatepromise.undp.org/news-and-stories/what-are-carbon-markets-and-how-do-they-work
6. https://climate.ec.europa.eu/eu-action/carbon-markets/international-carbon-pricing-and-markets-diplomacy_en
7. https://en.wikipedia.org/wiki/Marginal_abatement_cost
8. https://www.homaio.com/post/what-is-the-marginal-abatement-cost-of-carbon-macc-curve
9. https://www.envcp.com/article/the_marginal_abatement_cost_of_carbon
10. https://www.edf.org/revamped-cost-curve-reaching-net-zero-emissions
11. https://www.iisd.org/articles/deep-dive/will-international-carbon-markets-finally-deliver
12. https://www.whitecase.com/insight-alert/cop-29-global-carbon-market-making
13. https://climate.ec.europa.eu/eu-action/carbon-markets/eu-emissions-trading-system-eu-ets/international-carbon-market_en
14. https://www.sciencedirect.com/science/article/pii/S0305750X2300075X
15. https://www.c2es.org/content/cap-and-trade-basics/
16. https://blogs.worldbank.org/en/climatechange/state-and-trends-of-carbon-pricing–international-carbon-markets
17. https://en.wikipedia.org/wiki/Carbon_emission_trading