Carbon trading has become mumbo jumbo for the “cap-and-trade system for reducing greenhouse gas emissions.”

There are several concepts included here that we further explain.

First, “greenhouse gases” refers to several gases recognized by scientists as enhancing the greenhouse effect. The most important of these in terms of their global contribution to climate change are carbon dioxide and methane.

“Cap” means the quantitative limit of emissions that is imposed by a regulator on a region, a country, a set of sectors, or a group of installations. The cap is usually expressed in terms of a certain amount of greenhouse gas emissions permitted to be emitted in one year.

The cap is then broken down into allowances (also sometimes called permits) and then those allowances distributed to each of the entities that has the legal obligation to comply with the cap. Each allowance corresponds to one unit of emissions (e.g. one tonne of carbon dioxide equivalent).

The regulator’s objective is to set the cap so that there is a shortage of allowances relative to what the companies’ business-as-usual emissions will be.

It is this scarcity of allowances that sets the price of emissions in the marketplace and can allow a derivatives market (futures and options) to emerge. The economic benefit from carbon trading comes in the “trade” part.

At the end of the emission accounting period (usually year-end) each entity with a compliance obligation will need to hold allowances that are at least the same in number as its actual emissions for the period.

Entities now face a critical choice with every unit of emissions they produce. Should they purchase emissions allowances from other participants in the market or should they find ways to reduce emissions by implementing changes in their operations?

The virtues of the carbon trading approach are many. The principal one is that, when considering all of the participants’ overall costs of reducing emissions, economic theory and now business practice teaches us that a carbon trading approach is the least cost way of meeting the green objective.

Another key benefit of trading is each of the participants under a cap has complete flexibility in how they reduce emissions.

The price of carbon thus acts as both a motivator for action and a catalyst for technological innovation. Furthermore, it rewards companies who over-reduce their emissions since they can earn revenue from selling their allowances to those who find it less easy to reduce emissions.

Algae Biofuel projects may seek competitive advantages through Cap N Trade…. more to come.