Carbon trading is a market mechanism to reduce greenhouse gas emissions. The idea is to put a price on carbon so that activities that emit greenhouse gases become expensive.
The trading part allows businesses to buy and sell carbon credits on a market. This means companies can continue to produce greenhouse gases so long as they purchase enough credits to cover their emissions.
A market for credits also allows governments to ramp the price by controlling credit supply, thus speeding the transition away from activities that release greenhouse gases.
Here is more on the four key ideas that sit behind this market mechanism.
A price on carbon means there is a cost for carbon emissions to be paid by those who emit.
This cost can be imposed directly as a penalty in proportion to the amount of greenhouse gases they emit. Usually companies pass the cost on to consumers as higher prices for their goods and services.
In short, activities that release CO2 to the atmosphere incur a cost.
As a carbon price is imposed there is a cost to the activity that generates emissions. Emitters must either absorb the cost or pass it on their customers who then pay more, be it on the quarterly electricity bill or a fuel levy on flights.
The price on carbon needs to be sufficient to make some business activities uneconomic or at least encourage behaviours that lead to fewer emissions — installing motion sensors for lighting is a simple example.
Eventually the service or product becomes too expensive and customers move to cheaper alternatives.
Once a price is imposed on emissions alternative activities with lower emissions become more economic. For example, energy from wind, solar and geothermal and manufacturing methods with lower carbon intensity succeed because these do not pay a carbon price.
Combine these three ideas and you have the basics for a market that trades carbon allowing businesses to find the cheapest way to absorb a carbon price and so even out the cost through the economy.
The alternative to a market to price carbon is to impose a carbon tax. Never a popular option with voters and one that relies on governments to act reasonably in both how they impose that tax and what they do with the revenues.
Trading takes the pressure off governments to source and fund emission reduction because price pressures make activity change.
Emitters must purchase permits or credits on the market to balance (offset) the carbon dioxide equivalents that they directly or indirectly release to the atmosphere.
Once there is a market, buyers and sellers can haggle over price and volume.
Carbon trading becomes complex as the buyers, who recall are forced to buy credits to offset their reported emissions, look for the best price. Soon all sorts of financial mechanisms emerge to hedge against risk, minimise cost and broker a deal.
A secondary market in credit on-selling, bundling and derivatives emerges that outstrips in volume and value the market for primary credits.
Sellers are those who have generated carbon credits from emission reduction, abatement or sequestration projects that generate carbon offsets .
Or have been allocated credits.
In a free market, trades happen and supply and demand determine the price.
The carbon market is not a free market because the reason for carbon trading is to reduce greenhouse gas emissions. And for this to happen we need a fourth idea.
To ensure a price rise, the number of permits and credits allowed in the system is limited. There is a cap. Supply cannot meet demand and the price goes up. It is a cap-and-trade system.
Initially demand will continue to rise as emissions grow. Remember that emissions will happen just as a result of economic growth that is the foundation of the capitalist economic systemand a necessity when the human population is growing at 8,000 an hour.
A cap on credit supply can be achieved by limiting the issuance of both faux credits (emission allowances or permits) and real credits generated from mitigation, abatement and offset projects.
There is a balance to be had though.
There must be enough credits to meet demand as emitters are forced to pay, and the market must create opportunities for cost saving, but the price per credit also needs to rise.
If idea #2 is to work then the price for carbon needs to reach a level that makes it cheaper not to emit greenhouse gases by shifting to alternative energy sources and production processes. Otherwise the objective is not achieved.
It is usually a legal requirement that company boards act in the best interests of their shareholders. So directors should choose cheaper, or the most cost-effective options when faced with a carbon price high enough to make it too risky to pass the cost on to consumers. Make the price high enough and they will shift behaviour.
In the debates on trading schemes, including the proposed Australian Carbon Pollution Reduction Scheme, this primary objective is often lost.
The market approach is favoured by most western governments because it is familiar and the claims are it will have least impact on economies. It also reduces government requirements to deliver more direct climate change actions.
And best of all it is not a tax.
The World Bank reports that carbon trading was worth $141.9 billion in 2010.
The compliance market, the various cap and trade systems around the world where emitters are required to purchase carbon credits dominate trades.
Also $338 million of project based credits were traded in the voluntary market where purchasers of credits do so because they believe it is the right thing to offset their emissions by paying for an equivalent amount of greenhouse gas to be mitigated or sequestered.
Carbon trading is a clever set of ideas that harness market mechanisms that have been honed over generations in the capitalist economies. It will allow some financiers to make serious money, and it fits the risk adverse middle ground of today's politics.
And of the ideas work it will change our greenhouse gas emissions because, in time, it will become too expensive to emit greenhouse gases.
Unfortunately, no one is really sure if carbon trading will change them fast enough.