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Carbon emissions trading is a type of policy that allows companies to buy or sell government-granted allotments of carbon dioxide output. The World Bank reports that 40 countries and 20 municipalities use either carbon taxes or carbon emissions trading. That covers 13 percent of annual global greenhouse gas emissions.

Carbon emissions trading really took off when the European Union instituted a cap and trade program in 2005. This set a cap on the total the amount of CO2 that heavy industries and utilities could emit.

The cap must be low enough to actually reduce the greenhouse gases that cause global warming. If the cap is too low, then it will make the cost of doing business too high and slow economic growth. If the cap is too high, then it won't impact the pace of global warming.

The market for carbon trading was $176 billion in 2011. It could exceed $1 trillion by 2020. At least 84 percent of this is the EU's Emission Trading Scheme. It caps emissions for any company doing business in the EU.

As part of the United Nations Framework Convention on Climate Change, all countries agreed to the Durban Platform in 2011. This said they would negotiate the details of a comprehensive global cap and trade program by 2015.

How Trading Works

The cap allows each company to emit a certain amount of CO2. The EU issues about 2 billion of these European Union Allowances each year. To comply with the EU mandate, companies may either:

  1. Take measures to emit only what they are allowed.
  2. Reduce their emissions below the allowed amount and sell or bank the surplus EUAs.
  3. Continue emitting above their allowance and buy EUAs in the marketplace to cover it.

Carbon Emission Reductions Credits

Certified Emission Reductions credits are also traded. These were created by the Kyoto Protocol. They are credits issued to projects in developing countries that reduce emissions.

There are also greenhouse gas emission credits, which cover more pollutants than just CO2. They can fulfill nation-specific caps in the United States, United Kingdom, Canada, New Zealand, and Japan.

Is Carbon Emissions a New Form of Currency?

This ability to buy and sell EUAs, CERs, and other units on a freely traded market has created a new form of "currency." Traders include not only the emitters themselves but also banks, hedge funds, and other investors. They provide liquidity and increase market efficiency. A unit of carbon trading equals the reduction of one metric ton of carbon dioxide or its equivalent in other greenhouse gasses.

The idea of a tradeable market based on something that is just a concept takes trading to a new level. Even if the value of a mortgage-backed security is far removed from its underlying asset, you can still trace it back to something tangible: a loan made by a bank to a person who owns a house. Increasingly abstract forms of currency are on the rise. The 2008 financial crisis was created by new types of derivatives. The value of these collateralized debt obligations and MBS expanded far beyond that of the hard assets upon which they were based.

Creation of new forms of currency is bound to continue.

In some ways, carbon trading is a new form of currency. The value of EUAs, CERs, and the like can only be traced back to a colorless, odorless gas. But the monetary value assigned to a unit of this gas is based on how much damage it can do the climate systems that affect all aspects of our lives. Like gold, but unlike a house, it doesn't really have a “useful” value other than what the market says it has. But the market didn’t assign that value arbitrarily. It was assigned to address a threat to stability and safety of life on Earth.