Revision sheet: Introduction to Carbon Pricing and Emissions Trading

📋 Course Outline

1. Carbon taxation
2. Emission trading systems
3. Cap-and-trade mechanics
4. Price signals and market design
5. Major emissions trading programs

📖 1. Carbon taxation

🔑 Key Concepts & Definitions

• Carbon tax rate : A carbon tax rate is the fixed government price set per ton of emitted greenhouse gas.
• Explicit price for GHGs : An explicit price for GHGs is a direct per-ton charge that turns emissions into a measurable cost.
• Pass-through to consumers : Pass-through to consumers is the extent to which firms transfer carbon costs to end-product prices.

📝 Essential Points

• A carbon tax is a fixed per-ton payment imposed on entities that emit carbon under government rules.
• Effectiveness depends on the tax rate, demand elasticity for affected products, and how much costs firms can pass to consumers.
• A carbon tax provides predictability because the emission price is set directly rather than emerging from trading.

💡 Memory Hook

Tax = fixed fee per ton, so emissions become a known bill.

📖 2. Emission trading systems

🔑 Key Concepts & Definitions

• Emission trading system (ETS) : An emission trading system is a compliance market created under law that reduces emissions using tradable allowances.
• Jurisdictional cap : A jurisdictional cap is a legal limit on total allowable GHG emissions from covered installations in a jurisdiction.
• Emission allowances : Emission allowances are permits issued to share the total capped emissions volume.

📝 Essential Points

• An ETS aims to reduce ongoing GHG emissions by setting a jurisdictional limit and creating matching allowance supply.
• Allowances are typically denominated as shares, most often 1 metric ton of CO2 equivalent each.
• Covered entities must buy enough allowances for verified annual emissions and surrender them to the regulator for compliance.
• Allowances can be sold by the regulator at auction, set price, or allocated free of charge to covered installations.

💡 Memory Hook

Cap sets the ceiling; trade supplies the price; surrender proves compliance.

📖 3. Cap-and-trade mechanics

🔑 Key Concepts & Definitions

• Periodic declining cap : A periodic declining cap is an annually set volumetric limit that shrinks over time to force emission reductions.
• Compliance market price signal : A compliance market price signal is the allowance price that influences decisions on abatement and investment.
• Internalized carbon cost : An internalized carbon cost is the carbon price embedded in covered entities’ production costs.

📝 Essential Points

• The cap is typically measured annually in tons of CO2 equivalent and declines by reducing the number of permits each year.
• Scarce permits raise allowance costs, which can exceed abatement investment costs and reduce permit demand.
• Trading enables a forward curve via derivatives contracts, providing price signals for future years.
• If markets are not legally linked, permits issued in one ETS are not fungible in another ETS unless a political linking decision is made.

💡 Memory Hook

Declining cap → permit scarcity → higher price → firms shift to lower-carbon options.

📖 4. Price signals and market design

🔑 Key Concepts & Definitions

• Forward curve : A forward curve is a forward-looking set of carbon prices generated through derivatives contracts in cap-and-trade markets.
• Derivatives contracts : Derivatives contracts are agreements used in ETSs to create tradable expectations of future allowance prices.
• Lowest-cost abatement opportunities : Lowest-cost abatement opportunities are reductions that become more accessible when more emitters trade in a larger market.

📝 Essential Points

• A well-designed cap-and-trade system uses allowance prices to drive investment toward low-carbon alternatives to legacy technologies.
• Scarcity and declining supply can raise carbon prices enough to change firms’ production and reduction choices.
• Linking ETS markets can create economies of scale and lets entities exploit lowest-cost abatement across a larger pool.

💡 Memory Hook

Link markets → bigger pool → cheaper reductions available → better allocation of effort.

📖 5. Major emissions trading programs

🔑 Key Concepts & Definitions

• EU ETS : EU ETS is the European Union’s emissions trading system program listed among major active programs.
• California Cap-and-Trade Program : The California Cap-and-Trade Program is a listed major cap-and-trade emissions program in California.
• China National ETS : China National ETS is the listed national emissions trading system program operating in China.
• Swiss ETS : Swiss ETS is the listed Swiss emissions trading system program that was developed independently before linking with the EU.

⚠️ Common Pitfalls & Confusions

1. Confusing carbon taxation with an ETS: a tax fixes a per-ton price, while an ETS typically forms a price through allowance trading.
2. Thinking ETS permits are automatically usable everywhere: permits are not fungible across markets unless markets are linked by political decision.
3. Assuming the cap declines for both systems in the same way: carbon taxation uses a fixed price, while cap-and-trade uses a periodic declining permit supply.
4. Mixing up compliance steps: covered entities surrender allowances matched to verified annual emissions to the regulator for compliance.
5. Assuming the allowance price always equals abatement cost: it rises with permit scarcity and can pass abatement costs, changing permit demand.

✅ Exam Checklist

1. Define carbon taxation and state what governments set and who must pay.
2. Explain what determines carbon tax effectiveness: rate, demand elasticity, and cost pass-through.
3. Define an ETS as a legal compliance market and state its overarching emissions-reduction goal.
4. Describe how ETS design uses a jurisdictional cap and allowances to control total emissions.
5. State what allowances represent and the typical unit described (1 metric ton of CO2 equivalent).
6. List compliance duties in an ETS, including acquiring allowances and surrendering them for verified annual emissions.
7. Identify allowance allocation/sale methods: auction, set price, or free allocation.
8. Explain the cap-and-trade mechanism of a periodic declining cap implemented by reducing permit supply.
9. Connect permit scarcity to higher allowance costs and reduced permit demand via abatement investment comparison.
10. Describe how trading and derivatives can create a forward curve for many years ahead.
11. State the rule about linking ETS markets: no fungibility without legal agreements or a political linking decision.
12. Explain why linking markets can provide economies of scale and broader lowest-cost abatement access.
13. Recall the major programs named in the source across regions (EU ETS, RGGI, California, Western Climate Initiative, Swiss ETS, New Zealand ETS, South Korea K-ETS, China National ETS, Kazakhstan KAZ ETS, Tokyo Cap-and-Trade Program).