Economics Dictionary of Arguments

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Narassimhan I 968
Emissions Trading/Emissions Trading System/ETS/Carbon Pricing Mechanisms/Narassimhan: Carbon pricing mechanisms fall into three main categories: cap-and-trade (i.e. emissions trading systems (ETS)), carbon taxation or hybrid mechanisms that combine elements of both. >Emissions Trading/Fankhauser.
An ETS establishes a cap either on total emissions or on emissions intensity, as measured by emissions per unit of gross domestic product (GDP). An ETS may include emissions from all GHGs [greenhouse gases] or just some, such as CO2. Governments then provide allowances in the primary market, typically for free or through an auction, equal to the level of the cap (Aldy & Stavins, 2012)(2) (Cf. >Cap-and-Trade Systems/Aldy/Stavins).
A hybrid approach of partial auctioning and free allocation of some emission allowances is common in ETS markets. Firms may then trade allowances during a specified compliance period, after which they are surrendered to the government. Firms with lower abatement costs are expected to sell their allowances to firms with higher abatement costs in the secondary market, and overall, emissions reductions are theoretically achieved at least cost.
Key design considerations for an ETS include determining which GHGs and which sectors will be regulated under the cap; at what point of regulation emissions will be regulated (upstream or downstream); the stringency of the cap (or the total allowable emissions); costs of abatement, compliance and ETS administration; method of allowance allocation and distribution; monitoring, reporting and verification (MRV) of emissions and allowances; and impacts on international competitiveness (PMR and ICAP, 2016(3); Schmalensee & Stavins, 2017)(4). Additional considerations include policies that provide system flexibility such as banking credits for future compliance and borrowing credits from future compliance periods, creation of an allowance reserve to stabilize secondary market prices and ensure liquidity, creation of new trading registries to monitor and track carbon allowance markets, accounting for carbon offsets, international linkage, revenue management and stakeholder engagement (PMR and ICAP, 2016(3); Schmalensee & Stavins, 2017)(4).


1. World Bank. (2016). State and trends of carbon pricing 2016. Washington, DC: Author.
2. Aldy, J. E., & Stavins, R. N. (2012). The promise and problems of pricing carbon: Theory and experience. The Journal of Environment & Development, 21(2), 152–180.
3. PMR & ICAP. (2016). Emissions trading in practice: A handbook on design and implementation. Washington, DC: Partnership on Market Readiness (PMR), International Carbon Action Partnership (ICAP), and World Bank.
4. Schmalensee, R., & Stavins, R. N. (2017). The design of environmental markets: What have we learned from experience with cap and trade? Oxford Review of Economic Policy, 33(4), 572–588.


Easwaran Narassimhan, Kelly S. Gallagher, Stefan Koester & Julio Rivera Alejo, 2018: “Carbon pricing in practice: a review of existing emissions trading systems”. In: CLIMATE POLICY, Vol. 18/8, pp. 967–991.


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Narassimhan I
Easwaran Narassimhan
Carbon pricing in practice: a review of existing emissions trading systems 2018


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