Emissions trading is a market-based instrument towards reducing greenhouse gas (GHG) emissions outlined within the Kyoto Protocol. Through emissions trading, an Annex I Party may transfer Kyoto Protocol units to or acquired from another Annex I Party. Specific eligibility requirements must be met for an Annex I Party to participate in emissions trading.
In an emissions trading scheme an allowable overall level of pollution is established and allocated among firms in the form of permits. Firms that keep their emission levels below their allotted level may sell their surplus permits to other firms or use them to offset excess emissions in other parts of their operations. Article 17 of the Kyoto Protocol states that countries are allowed to trade with their ‘allowances’, i.e. if a country does not emit its assigned amount of emissions, it can trade them with a country, which has too high emissions. Thus “carbon” has become a new commodity traded in “carbon markets”.
This mechanism is seen by many as a good alternative to traditional command and control policies due to its flexibility . Emissions trading is considered effective because it is economically efficient, is specifically designed to deliver an environmental objective, and delivers a clear price signal.