Company A may be given an allowance of 5.5 million tonnes of CO₂ equivalent (M(t)CO_2e) but currently needs to produce 6.5 M(t)CO_2e. Conversely company B may have an allocation of 3.8 M(t)CO_2e but through altering their production plant can now manage with an allocation of 2.8 M(t)CO_2e Thus company A can attempt to buy the spare allocation from company B or company B can attempt to sell their spare allocation to company A. Now since this is financially attractive to company B but financially unattractive to company A it has a positive effect on the direction of future emissions, since company A will not want to incur these costs in the future whilst company A will want to gain from spare allocation.

In the above we assume company A can only buy from company B and that company B can only sell to company A. In reality of course there will be several companies in both situations which enables the price to reflect competition, supply and demand. In theory, company A would have a limit on how much it was prepared to buy allowances for e.g. it would probably need to be less than the cost of altering its plant to reduce the emissions to match its allowance. Company B may therefore aim to get quite close to this in what it asks company A. However company C may also have spare allowance and compete with company B for the trade. In other word, the whole mechanism of market trading has been re-created, but using carbon allowances.

Since the global aspiration is to reduce emissions, each year nation’s targets get more demanding and so too those of contributing individual companies e.g. BP, British Airways, UK Coal etc in the UK who remain driven to minimise outputs to match their allowance, and preferably to generate spare allowance capacity to sell. The mechanism leaves the final approach to the individual companies rather than simply dictating e.g. by law, what they should do. In this sense it is a free market economy which determines results.

Some critics cite the focus on carbon trading as a weakness in Stern’s Review as the focus is on carbon rather than all greenhouse gases. Nevertheless this system is now gaining in maturity in the UK having had a four year trial period (see DEFRA report link) and companies have found it useful in preparation for the European scheme which according to article 3 of the European directive deals with all six greenhouse gases as defined at Kyoto. At the global level attitudes have become much more positive too, including in the USA.

That the market is being used to create an instrument to effect global behaviour in an effort to counteract climate change is exciting and gives optimism. In theory it can even be attractive to developing nations. However, it is essential that some regulation is set e.g. expectations of levels for national allocations and that these are set correctly. It may also be necessary to cap the market or to underpin the trading prices – we cannot have the equivalent to a company going “bust”. These steps would not strictly conform with the principles of a free market economy