Emissions Trading System: A compliance carbon market that works on the ‘cap and trade’ principle.
A cap is set on the total amount of certain greenhouse gases that can be emitted by the industries covered by the system. The cap is reduced over time so that total emissions fall.
Within the cap, installations can find themselves in 2 scenarios:
• Shortfall: When their emissions are not covered by the permits received for free from the Authorities. In this case they must go to the market to buy more emission permits.
• Surplus: When their emissions are covered by the permits received for free from the Authorities. In this case they can sell the surplus to another installation that is short.
The limit on the total number of allowances available ensures that they have a value. At the end of the year, an installation must surrender enough allowances to cover fully its emissions, otherwise, heavy fines are imposed.
If an installation reduces its emissions, it can keep the spare allowances to cover its future needs or else sell them to another installation that is short of allowances.
Trading brings flexibility that ensures emissions are cut where it costs least to do so. A robust carbon price also promotes investment in innovative, low-carbon technologies.