The permits can also be bought and sold by emitters who need them – governments create a market for these pollution permits.
This is “cap and trade”.
So, both the level of the target (the cap) and the remaining permits to pollute place a price on emitting carbon. Emitters have an incentive to cut their emissions, because they will have to buy fewer permits and may be able to sell any spare.
In a perfect market, all this should minimize the cost of emissions reductions. But in practice, as the world has recently discovered in the financial crisis, markets are far from perfect.
The price of carbon, like anything else, can rise and fall dramatically. Such fluctuations can seriously undermine the long-term investment decisions needed to find solutions to climate change.
Markets also suffer from herd instincts among investors. All the money rushes to one technology or country. For example, all the money could go into, say, wind power, starving solar and other renewables. Such outcomes might obey the short-term imperatives of the market, but they would fail to deliver the low-carbon economy the world needs.
The bottom line is that the market must be structured and managed in a way that delivers what the world requires.
For WWF, carbon markets are no silver bullet. If conducted properly they have their place. However, recent experiences with the European Emissions Trading Scheme resulted in strong over-allocation of pollution permits and too many offsets which all brought the carbon price down and in turn stifled low-carbon investment.
WWF strongly recommends supplementing emissions trading with Emissions Performance Standards, such as those enacted in California, where no coal-fired power stations may be built without carbon capture and storage in place.
In addition, the transport, construction and forestry sectors, amongst others, are likely to benefit much more from specific legislation on legally binding standards than from being put under a cap-and-trade regime.