Understanding carbon trading mechanisms & regulatory frameworks

Fundamentals of Carbon Trading Platforms & Mechanisms

Agreed targets set out in the Paris Agreement include governments committing to reach net zero by 2050. To achieve this aim, various carbon reduction initiatives have been launched, one of which is carbon trading. 

But how are carbon markets created? When market-based instruments are introduced, carbon markets begin to emerge. Essentially, prices are applied to carbon emissions and traded via trading platforms, meaning that trading units of offset carbon emissions can mitigate carbon emissions.

How Carbon Trading Mechanisms Work

Carbon trading mechanisms serve two goals: a) reducing carbon emissions in line with government or self-applied targets, b) financial gain. One business (the seller) may be actively reducing carbon emissions as part of their general business operations and trades units of offset carbon emissions to another business (the buyer).

Different Types of Carbon Trading Systems & Regulatory Systems

While both modes aim to achieve similar goals, two main types of trading systems currently exist: the Emissions Trading System (ETS) and carbon offset schemes.

Emissions Trading Scheme (ETS)

Created predominantly for heavy energy producers such as aviation or heavy industry, the European Union Emissions Trading System (EU ETS) dictates that high producers must pay for carbon emissions via carbon allowances. If these companies emit more carbon than their allowance, they face a penalty. One allowance equals one tonne of CO2 emitted. 

Businesses can trade these allowances amongst themselves within the carbon trading system, dictating the overall value of carbon emission units traded. Businesses that actively reduce carbon emissions through normal business operations can sell left over allowances to businesses who are due to exceed their allowances, avoiding fines. This model is called the cap and trade model. 

Carbon Offsetting 

This carbon reduction trading system allows over-producers of carbon to invest in or buy offset units of carbon from under-producing businesses to voluntarily reduce their carbon footprint. Targets are usually self-imposed and might be set as part of an environmental, societal and governance (ESG) campaign. For more information on ESG values and their role in carbon markets and sustainability, visit The Role of Carbon Markets in Environmental Sustainability section, which is next up in this feature. 

Compliance markets 

The compliance market applies to the ETS trading system (see above) which is in line with mandatory carbon emission reduction targets set by the government. This type of market or regulatory system is a legal compliance target which results in penalties if not met:

• Regulated carbon allowance schemes often feature 

• Industries such as aviation an heavy industry are often the key players in the compliance market 

• Businesses can opt to buy carbon allowances from other companies or reduce their overall carbon emissions 

Voluntary markets

In contrast to government-led regulatory systems are voluntary markets. Carbon offsetting and voluntary markets go hand-in-hand: businesses buying offset carbon are usually entering the voluntary market to hit internal sustainability targets, whereas the sellers of offset carbon are operating for financial gain:

• Often used to demonstrate a business’s dedication to sustainability targets, sometimes as part of a EVP (employee value proposition)

• Voluntary markets operate outside of government control or regulation 

• Investing in carbon offsetting is voluntary, so if targets aren’t hit external penalties are not applied

The Role of Carbon Markets in Environmental Sustainability

Carbon partner schemes, for example, allow businesses looking to reduce their overall carbon emissions to invest in various projects that help shrink carbon footprints while aligning with company values. The role of carbon markets in environmental sustainability includes:

To improve brand image  

Many businesses now include a sustainability charter or benchmarking report to inform investors or stakeholders in their businesses the actions they’re taking to reduce carbon emissions. They may be able to offer a better EVP to potential employees or they may be a more attractive supplier to potential investors if they possess a smaller carbon footprint - this is called carbon conscious investing. 

To encourage biodiversity 

Carbon partner schemes link up sustainable projects requiring finance to businesses looking to reduce their overall carbon emissions by purchasing units of offset carbon. These can be forestry- or wetland-led initiatives based locally, or rainforest initiatives based in developing countries. 

To give back to local communities  

Much like the biodiversity projects mentioned above, carbon partner schemes can also partner businesses wanting to purchase offset carbon with community-led projects which count towards lowering carbon emissions. These types of investments also generate local sustainability-led jobs, imparting sustainability education to a local community as well as financial support. 

To avoid fines or penalties  

Often, companies required to adhere to carbon emission levels take part in carbon trading to reduce or avoid carbon emission-related fines from the government, while at the same time investing in or techniques to prevent their carbon emissions from the beginning - for example investing in green energy production for their day to day business operations. 

The Future of Carbon Trading Mechanisms

Carbon trading has already seen an exponential growth rate since its inception, with the price of offset carbon skyrocketing in value. As low carbon targets approach, it’s only natural that more businesses will want to enter the carbon trading marketing in order to avoid penalties for carbon emissions, pushing the cost of offset carbon up further. A sector of the industry is already purchasing offset carbon to sell on the future carbon trading market as they anticipate similar levels of price increases to continue. On the flip-side, as businesses do more to reduce their carbon footprint, become carbon neutral and invest in green energy, it’s likely more sellers of offset carbon will enter the carbon trading market.