While reading about the Singapore government's Climate Change Strategy I wasn't too clear on how carbon trading works but this Shell advertisement actually does quite a good job of explaining it.

Encouraging businesses to clean up

Most people agree we need to reduce the level of carbon dioxide emissions into the atmosphere. It is a global problem which needs global solutions. One way is to use the power of the world’s markets to provide businesses with a strong incentive to clean up.

Carbon Trading is a new market and owes its origins to the worldwide agreement to reduce greenhouse gas emissions signed in Kyoto in 1997. Under the Kyoto Protocol, European countries agreed to reduce the emission of six greenhouse gases by 8% below 1990 levels by 2012. It was left up to the individual signatory countries to find ways of achieving this.

How can the UK, and the other 25 member states of the EU, reach their targets? A major part of the EU’s response has been to launch the EU Emissions Trading Scheme at the start of 2005. This trading system puts in place laws obliging thousands of EU companies to hold one allowance for every ton* of CO2 emissions they release each year.

The total volume of CO2 that can be emitted to the atmosphere from the companies that are covered has been capped and reduced below “business-as-usual” levels. But this is a trading system that offers carrots to those companies that reduce emissions below as well as sticks to any company that might fail to do its bit.

How Carbon Trading works

At the start of each year companies receive an allocation of allowances to emit a certain quantity of CO2. For example a company might receive 1 million allowances for 2005. If that company expects to emit more than this allowance then it must choose whether it’s financially better to make the necessary emission reductions or whether it’s more cost effective to buy allowances in the market from other companies. Either way the company has to meet its legal obligation to hold a volume of allowances equal to its actual emissions at the end of the year.

The carrot appears with the market price of these allowances. For example, if the allowances trade at €24 (the price in September 2005) then a company can look at its activities to see if it can take action to reduce emissions at a cost of less than €24 per ton* of CO2. Companies may find new technologies or better working practices that can all reduce emissions more cheaply than buying allowances.

So let’s assume that the company makes the decision to invest in an emissions abatement project since it figures it can do so at a cost of only €15 per ton* of CO2. In this case the company can quickly see a pretty big carrot! If it reduces its emissions below its actual allocation level, it will have surplus allowances, which it can then sell in the market. And if the company is making these reductions for €15 and selling the surplus allowances for €24, that’s a €9 per ton* CO2 incentive for cleaning up.

In this way the market establishes a cost on emissions and a very clear incentive for reducing them!

* Based on UK(long) tons (one ton = 2240 pounds)

Note: US(short) ton = 2000 pounds