An emission trading scheme typically works in this way:

  1. The government sets emission reduction targets in line with their protocol and other commitments.
  2. Businesses in sectors covered by the emissions trading scheme, whose greenhouse gas emissions are above
    a threshold, report those emissions to the government.
  3. The government uses its own short-term and long-term emission reduction targets, and emissions data from
    business, to allocate free emission permits and / or auction emission permits to businesses whose greenhouse gas emissions are above a threshold (known as scheme participants). Emission permits represent a right for the holder of the permit to emit a specified amount of greenhouse gas emissions during a specified period of time. The limit or cap on the number of permits allocated creates the scarcity needed for a trading market to emerge.
  4. If a scheme participant’s net emissions (gross emissions less activity that reduces emissions, such as the purchase of approved carbon offsets) at the end of a year is likely to be less than that allowed by the permits they hold, the participant can sell their excess permits to other scheme participants, or bank them for future use.

If the net emissions are likely to be more than the emission permits allow, a participant can: attempt to purchase approved carbon offsets; and / or reduce their emissions, for example by deploying more energy efficient technology; and / or attempt to purchase unused emission permits from other scheme participants.

If the participant is still unable to reduce their net emissions to equal the emissions allowed by the permits they hold, then the participant will have to pay an emissions fee to the government.

Example

Companies A and B both emit 100,000 tonnes of CO2 per year. The government allocates companies A and B emission permits that allow them to emit 95,000 tonnes a year each. Both companies must find ways of reducing their CO2 emissions by 5000 tonnes to meet the permit allocations.

Each permit represents a right to emit one tonne of CO2. The market price for each permit is $10.00. Company A calculates that if it invests in more efficient means of production the cost of reducing its emissions is only $5.00 per tonne, which will reduce its emissions by 10,000 tonnes. As reducing emissions is $5.00 per tonne cheaper than purchasing emissions permits from other scheme participants, company A decides to invest in improving its efficiency and reduce its emissions to 100,000 tonnes. This leaves company A with 5000 excess emission permits for the year that it can either sell to other scheme participants or bank for future use.

Company B is in a different situation as it has already done a lot to reduce its emissions by investing in low emissions technology. It has worked out that the cost to further reduce its emission is $15.00 per tonne. As the cost of reducing its emissions to 95,000 tonnes is greater than the cost of buying 5,000 emission permits, company B decides to purchase 5,000 permits from another scheme participant, so that it holds sufficient permits to cover its emissions for the year (100,000 tonnes).

Company A sells its 5,000 excess permits to company B for at the market price of $10.00 per tonne. For company A, it has spent $50,000 to reduce 10,000 tonnes of emissions and has made a gain of $50,000 on the sale of 5,000 excess permits to company B. Company B has saved $25,000 on what it would have had to otherwise spend, but for the emissions trading scheme.

The total emissions from company A and company B has reduced from 200,000 tonnes of CO2 to 190,000 tonnes.

From the CPA Australia publication EMISSIONS TRADING AND THER RELATED POLICY INITIATIVES