In Spain when children do not behave, parents often say: "Si no te portas bien, Papa Noel te traera carbon", which would translate to: "If you don't behave, Santa Claus will bring you coal". So maybe carbon trading has always been part of us, at least for Spaniards…
Jokes aside, when we talk about carbon trading we are referring to the trade, in international or jurisdictional markets, of carbon emission permissions or carbon credits. Carbon emission permissions are traded in compliance markets ("cap and trade" schemes) and carbon credits are traded in voluntary carbon markets ("off-setting" schemes); with some exceptions where both assets can be traded in both market types. To better understand what is the difference between them, we need to dig deeper into the history of carbon trading. For reference, I use indistinctively green-house gas (GHG), carbon (CO2) and carbon equivalent (CO2eq); so you can assume they are all equivalent from here onwards.
The compliance markets
The inception of carbon trading is the Kyoto Protocol from 1997. In this international treaty, a set of Parties (i.e. countries) of the UNFCCC committed to reduce their green-house gas (GHG) emissions taking year 1990 as baseline. More concretely, the Annex I countries (i.e. developed countries) had to fix a maximum "cap" for their carbon emissions and implement initiatives to reduce them down to that "cap" against 1990 emissions level.
To achieve this, each country would distribute carbon emissions permits (i.e. the asset being traded) to economic agents (i.e. companies) as a share of the total cap (i.e. the total amount of permissions distributed would add up to the national "cap") and create the scheme for a carbon market for companies to trade these permissions among them. To understand this mechanism better, let's use an example. On one side, company A wants to pollute 1 tone of CO2eq (e.g. in order to produce its products) but it has only received permissions (share of the "cap") for 0.5 tones. This company A would then need to choose between investing in less polluting technologies, or buy in the carbon market additional emission permissions for 0.5 tones more. Let's assume company A decides to buy in the market. Given that compliance carbon markets are decentralized over-the-counter markets, company A would buy the permissions of a company B that has also received permissions for 0.5 tones, but that is not about to use them (e.g. because it has moved to renewable energy and does no longer pollute that much).
With this "cap and trade" scheme, 3 main objectives are achieved (assuming no market failures and the inclusion of all relevant polluters in the scheme - which is not the case in most of the existing compliance markets):
The total carbon emissions within a certain country / jurisdiction are fixed to a certain pre-established "cap"
Companies that need to pollute more (e.g. increase in the demand for iPhones) can access the carbon market and buy additional emissions permissions
Companies that invest in emissions reduction actions (e.g. moving to renewable energy) get additional funding from the sale of emission permissions sold in the market
Nowadays the most important compliance carbon markets are the European Union Emission Trading System (EU ETS), the Californian compliance market and the New Zealand Emissions Trading Scheme. Other, non-jurisdictional, compliance carbon schemes include the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) which aims to limit the global aviation emissions to the 2020 level.
There are thousands of caveats and nuances in the above, so please feel free to leave your questions and doubts in the comments section. I will be more than happy to further detail and answer them.
The voluntary markets
To be continued...