How carbon markets work.

Emission permit trading systems are also simply called carbon markets. They're also called cap and trade systems because the overall amount of permits is capped. But what are carbon markets? What are the mechanics of carbon markets? Who is trading them? Where are they traded? And what is actually being traded? What is changing hands? They exist in many parts of the world, and it is a tool for policymakers to reach their climate ambitions. This is how they work. Firstly, governments set a predefined emissions reduction target based on international agreements. Every year, there will be an overall cap, which is lowered for each subsequent year. Each year, this overall amount given by the cap is divided and shared between the different market players in the form of tradable allowances. So a certain amount of emissions allowances is allocated to so-called compliance entities, such as power plants or industrials, and increasingly also to sectors such as shipping and aviation. Each such allowance represents the right for an entity such as an industrial plant to emit one ton of carbon dioxide or carbon dioxide equivalent. Those allowances are registered in a central registry and can be traded.

At the end of each year, the companies captured by the system must demonstrate a balance in their allowances and emissions. Every year, these entities have to submit enough allowances to cover the previous year's emissions. The entities that know that they will be short of allowances will need to buy more of them on the market. Those with surplus can sell that surplus or save them for use in future years. The precise timing and deadlines will depend on each market. Other notable features that may exist include the possibility to save unused allowances for future years, the use of regular auctions of allowances to supplement the free distribution of a portion of them, and a system of fines for those who fail to obtain sufficient allowances. The key feature that is common to the systems around the world is that the overall supply is restricted. It is determined by the predefined cap. The level of demand driven by many factors then determines the price. While a number of regions operate their own carbon markets independent of each other, the future is likely to see them linked. In general, the system of allowances covers thousands of companies and most emissions in each market where they're used. Currently, 17% of global greenhouse gas emissions are covered by an emissions trading scheme. With the China national scheme and the EU scheme being the largest. These cover roughly 40% of greenhouse gas emissions in these regions.