“Cap and trade” emissions trading systems allow environmental damage to be reflected in market prices. By capping emissions, they guarantee that the desired level of emission reduction is achieved; and by allowing trading, they give business the flexibility to find the cheapest solutions, while rewarding investment in low-carbon technologies and innovation.

Cap and trade systems work by setting a cap on total carbon dioxide emissions from the plants or countries covered. Emissions allowances are then created and form a common trading currency, with one allowance giving its owner the legal right to emit 1 ton of carbon dioxide. When the actual emissions of companies or countries are below the legal cap, they can sell their permits to actors with emissions above the cap — thus enabling them to profit from their carbon savings.

Cap and trade systems are already in place in the European Union, Norway, New Zealand, Switzerland and a number of north-eastern states of the United States. They are also being developed and implemented in Australia, China, India and the Republic of Korea, as well as in California and some Canadian provinces, and debated in Japan and elsewhere.

Where emissions allowances are allocated through auctioning, as occurs partially in the European Union emissions trading scheme and the Regional Greenhouse Gas Initiative system in the north-eastern United States, they provide an important source of revenue which can be used to fund climate action or other public goods.

The European Union emissions trading system is the largest cap and trade system, launched in 2005, covering carbon dioxide emissions from around 11,500 installations across Europe and around 40 per cent of European Union greenhouse gas emissions. The European Union-wide cap for 2008-2012 amounts to 2.081 billion allowances per year. Use of offset credits from outside the European Union (including from the Clean Development Mechanism and other sources) is allowed, subject to quantitative and qualitative limits, making the European Union emissions trading system the main driver of the international carbon market and providing a clear incentive for action.

India is working on an emissions trading scheme for key local pollutants in three large states as a new approach to environmental regulation in the country. A pilot project has been launched in three states.

In addition, India has already launched an ambitious “Perform, Achieve and Trade” mechanism, which is intended to encourage 700 of the country’s most energy-intensive units to become more energy- efficient and in the process help reduce India’s greenhouse gas emissions by 25 million tons of carbon dioxide equivalent per year by 2014/15. About 700 of the most energy-intensive industrial units and power stations in India would be mandated to reduce their energy consumption by a specified percentage. The percentage reduction for a facility would depend on its current level of efficiency: the most efficient facility in a sector would have a lower percentage reduction requirement, while less efficient facilities would face larger percentage reduction requirements.

Australia recently introduced a carbon pricing mechanism as a key part of a plan for a clean energy future to underpin future national prosperity. Social equity is a key element of the scheme, which provides support to low-income households to assist with the impact of the carbon price.

In China, pilot projects on emissions trading have been launched in five cities and two provinces with the aim of gradually putting a regional carbon emissions trading system in place by 2015.