Basics:

Emissions trading schemes allow the world to achieve a specific outcome (in this case, reduced greenhouse gas emissions) at the lowest possible cost.  Because of the different Marginal Abatement Costs (MAC) for taking action in different countries (e.g. China might need to spend only $2 to reduce a ton of CO₂, whereas, say, Sweden or the USA might need to spend more to abate the same amount of CO₂), trading schemes provide for the transference of resources from rich areas to poorer ones to accomplish a goal important to both.  

Though some trading schemes are voluntary (see Chicago Climate Exchange below), in most cases a central authority (usually a government or international body) sets a limit or cap on the amount of a pollutant that can be emitted. Companies or other groups are issued emission permits and are required to hold an equivalent number of allowances (or credits) which represent the right to emit a specific amount. The total amount of allowances and credits cannot exceed the cap, limiting total emissions to that level. Companies that need to increase their emissions must buy credits from those who pollute less. The transfer of allowances is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions by more than was needed. Thus, in theory, those that can easily reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest possible cost to society.

Size:

• According to the World Bank's Carbon Finance Unit, 374 million metric tonnes of carbon dioxide equivalent (tCO₂e) were exchanged through projects in 2005, a 240% increase relative to 2004 (110 mtCO₂e)¹ which was itself a 41% increase relative to 2003 (78 mtCO₂e).²

• The carbon market grew in value to an estimated US$30 billion in 2006 (€23 billion), three times greater than the previous year.³

² http://carbonfinance.org/docs/CarbonMarketStudy2005.pdf

³ http://carbonfinance.org/docs/Carbon_Trends_2007-_FINAL_-_May_2.pdf

The European Union Emission Trading Scheme (or EU ETS) is the largest multi-national, greenhouse gas emissions trading scheme in the world and was created in conjunction with the Kyoto Protocol. It is currently the world's only mandatory carbon trading program.  Under the EU ETS, large emitters of carbon dioxide within the EU must monitor and annually report their CO2 emissions, and they are obliged every year to surrender (give back) an amount of emission allowances to the government that is equivalent to their CO2 emissions in that year. The installations may get the allowances for free from the government, or may purchase them from others (installations, traders, the government.) If an installation has received more free allowances than it needs, it may sell them to anybody.

In January 2008, the European Commission proposed a number of changes to the scheme, including centralized allocation (no more national allocation plans), a turn to auctioning a greater share (60+ %) of permits rather than allocating freely, and inclusion of the greenhouse gases nitrous oxide and perfluorocarbons. Also, the proposed caps foresee in an overall reduction of greenhouse gases for the sector of 21% in 2020 compared to 2005 emissions.¹

¹ http://en.wikipedia.org/wiki/Emissions_trading

Green tags or Renewable Energy Certificates are transferable rights for renewable energy within some American states. A renewable energy provider gets issued one green tag for each 1,000 KWh of energy it produces. The energy is sold into the electrical grid, and the certificates can be sold on the open market for additional profit. They are purchased by firms or individuals in order to identify a portion of their energy with renewable sources and are voluntary.

They are typically used like an offsetting scheme or to show corporate responsibility, although their issuance is unregulated, with no national registry to ensure there is no double-counting. However, it is one way that an organization could purchase its energy from a local provider who uses a fossil fuels, but back it with a certificate that supports a specific wind or hydro power project.

While traditional carbon emissions trading programs promote low-carbon technologies by increasing the cost of emitting carbon, RECs can incentivize carbon-neutral renewable energy by providing a production subsidy to electricity generated from renewable sources.¹

¹ http://en.wikipedia.org/wiki/Renewable_Energy_Certificates

Chicago Climate Exchange (CCX) is North America’s only voluntary, legally binding greenhouse gas (GHG) reduction and trading system for emission sources and offset projects in North America and Brazil.  CCX employs independent verification, includes six greenhouse gases, and has been trading greenhouse gas emission allowances since 2003. The companies joining the exchange commit to reducing their aggregate emissions by 6% by 2010. To date the exchange has more than 350 members ranging from corporations like Ford, DuPont, and Motorola, to state and municipalities such as Oakland and Chicago, to educational institutions such as University of California, San Diego, Tufts University, Michigan State University and University of Minnesota, to farmers and their organizations, such as the National Farmers Union and the Iowa Farm Bureau.¹

¹ http://en.wikipedia.org/wiki/Chicago_Climate_Exchange

Business Model:

In the case of the EU Emissions Trading Scheme and the Chicago Climate Exchange, the negative externality of a company’s activities becomes monetized and traded on an open market.  In the case of US Renewable Energy Certificates, the negative externality becomes monetized in a way, but it is the benefit of not creating them that gets traded.  The value of the allowances or renewable energy certificates comes from either a government cap on emissions or the reputational (or perhaps psychological) benefit of being environmentally friendly.

Assumptions:

1. The impact of the given activity (emissions) is the same in all locations.  In fact, the policy framework has to be different for regional pollutants because their impact varies by location (and thus it cannot be addressed with equal success in any area).  This is known as the “Hot Spot” problem.
2. Money used to buy credits goes towards reducing carbon output.  But sometimes companies already have low emissions and do not need to reduce them to profit from the sale of credits.  And since developing countries don't have any caps on emissions, companies can take the handsome payments they receive from carbon cuts and use the money to build new fossil-fuel and coal factories.¹
3. The emissions reduction targets are scientifically credible, sufficient, and challenging, and companies have maximum flexibility to achieve them.  The key elements for well-functioning carbon markets include: competitive energy markets; common, fungible units of measure; standardized reporting protocols of emissions data; and transferability of assets across boundaries.²  A mistake may also be made by giving away emission credits rather than auctioning them because they are then undervalued.

² http://carbonfinance.org/docs/Carbon_Trends_2007-_FINAL_-_May_2.pdf

• Risk sharing at the micro level balanced against risk management at macro level
• Emissions trading offers a potential model for how costs can be reduced while at the same time sharing risk (and risk prevention costs) among regions with different income and resources
• Potential  of new alliances to create risk pooling or collective purchasing/action
• Emissions trading unites companies, institutions, and governments from all different industries and parts of the world because they have a common goal.
• Healthcare defined as a public good leading to new social contracts
• Government can play a huge roll in making individual players value emissions allowances.  The public’s desire for “green” companies also creates this value.