Can emissions trading systems drive the transition to clean energy?

Some had suspected it for years. Others were finally convinced when India announced in 2023 the creation of a carbon credit trading scheme (CCTS). In the “Olympics” of major climate policy instruments, emissions trading systems (ETSs) (such as the CCTS) are increasingly gaining prominence. 

Whether they will be true winners remains to be seen. But, for now, more and more policymakers are placing their bets on them. With 36 jurisdictions already using them, and over 20 more in development or under consideration, ETSs are truly on the rise. 

In an ETS, a central authority sets a limited “cap” of emissions permits over a set time, which polluters can trade, creating a market-driven carbon price. Most ETSs cover the power and industry sectors and are thus cornerstones of the energy transition. As of 2024, 18% of global greenhouse gas (GHG) emissions are addressed by ETSs, a share expected to increase further.

Putting so much emphasis on ETSs might, however, seem like a risky bet considering that their history has been far from glorious. Their introduction took a long time, and even when implemented, some ETSs struggled for years to be taken seriously and start driving investments in clean technologies. Yet, the EU ETS appears to have become a frontrunner after its early years of limping and has revived hope in the instrument’s efficacy.

Emissions trading systems existed long before climate policy

With climate action often taking center stage, it’s easy to lose sight of other crucial sustainability efforts. We may also forget that some prominent climate policies originated from earlier environmental instruments. For instance, the first ETS was not the EU ETS but one addressing nitrogen oxides (NO_x) and sulfur dioxide (SO₂) emissions under the Acid Rain Program (ARP) in the US, established in 1990.

Although the ARP also faced challenges, it is ultimately considered a successfully implemented ETS, having significantly reduced SO₂ and NO_x emissions from coal power plants and helped mitigate acid rain.

So, why does the road to effective GHG ETSs seem rockier than that of their predecessors?

GHG ETSs face bigger challenges

There are fundamental differences between the ETSs under the ARP and GHG ETSs, which make the latter particularly challenging. Obstacles arise at every stage: securing support for establishment, achieving operational status in the initial years, and maintaining functionality over time.

The most significant difference between the ARP and GHG ETSs lies in the scale of the intended impacts. While the ARP aimed to reduce SO₂ emissions mainly through technological adjustments in coal power plants, achieving net-zero GHG emissions requires an overhaul of the entire energy system, involving new technologies, infrastructure, and fuels. 

To continue our Olympic analogy, in the ARP we gave our team new shoes. In the GHG ETS we need to replace the whole team. And their stadium, shoes, and coach. 

This monumental transformation also means larger investments. To illustrate, SO₂ certificates (at 150 USD per tonne of SO₂) increased coal power costs by around 0.1 cents per kilowatt-hour. CO₂ certificates, meanwhile (at 80 USD per tonne of CO₂), increase coal power costs by roughly 8 cents per kilowatt-hour.

These larger investments and energy price effects likely mean stronger pushback against GHG ETSs. It’s further amplified by the fact that all climate policies face acceptance hurdles due to the global nature and long timeframe of climate change.

History has shown that GHG ETSs often faced difficulties in their early years. For example, the EU ETS struggled with a large surplus of allowances. Similarly, low credibility is believed to have played a significant role in depressing certificate prices.

More fundamentally, the necessity of a complete system overhaul presents a specific challenge to GHG ETSs. In the early ETSs, from around 2005 to 2015, most alternatives to fossil technologies were expensive and immature. To incentivize the decades-long investments into research and development needed to bring these technologies to market readiness, the ETS would have required much higher prices than were realized, along with strong trust that prices would remain high over decades. Hence, additional policies, such as feed-in tariffs, subsidies, and infrastructure provision, were necessary to support nascent technologies in becoming competitive.

Today, many clean technologies are market-ready, enabling the ETS to focus solely on its specialty of pricing externalities and not having to additionally shoulder the burden of driving innovation. Does this mean that GHG ETSs can now serve as the primary driver of the transition to clean energy? What will be required so that ETSs deliver their promises?

Critical factors for GHG ETSs to deliver

In the best-case scenario, ETSs incentivize companies to reduce emissions in a phased, cost-effective manner that balances immediate and future expenses. This helps avoid sudden investments or delayed actions that could lead to environmental and financial risks. In the worst-case scenario, when prices are too low, ETSs can act as a delay mechanism for climate action. 

So, how can we ensure we achieve the best-case outcome?

High credibility

Let’s begin with perhaps the most central point: ETSs are politically created markets that only function when participants trust in their long-term existence and stringency. To maintain this trust, ETSs must be credible, requiring policymakers to consistently commit to the cap and establish clear rules for an ETS’s final years. 

For years, the EU ETS struggled due to a lack of trust among participants. It was only after the EU demonstrated substantial commitment through major reforms that confidence grew, leading to a surge in activity and prices.

Stable price expectations

Participants also need stable and sufficiently high price expectations to commit to large investments. This can be achieved through explicit measures, such as a price floor – or implicitly, by resisting backlash during price increases. For example, when EU carbon prices rose during the energy crisis, backlash risk was high. However, the EU held firm, with Frans Timmermans, Vice President of the European Commission, stating that carbon prices should be even higher.

Global coverage and social justice

Finally, for a higher success rate of ETSs, it is important to avoid carbon leakage. This is essential not only to reduce the risk of industry delocalization (industry relocating away from regions with stricter environmental controls) but also to tackle the global nature of climate change. Additionally, to address potential social inequalities exacerbated by the policy, it is crucial to be transparent and incorporate compensation mechanisms that support disadvantaged households and regions when managing the revenues.

To summarize, one could simply say: the stronger we believe in ETSs and the more ETSs exist globally, the better their overall performance – and a place in the winning team will be waiting.

ETSs (and other competitors) can bring gold

If the points mentioned above are addressed, ETSs can become fundamental drivers of the transition to clean energy. Nevertheless, cap and trade mechanisms may face market failures, which is why additional policy instruments have been – and likely will continue to be – beneficial in addition to ETSs. 

For regions still deciding on the right policy instruments, it should be noted that carbon taxes are not necessarily less efficient than ETSs. While they bring larger uncertainty on the resulting emissions reductions, they offer the benefit of establishing clear price expectations. And who knows? In the end, it might also be the hybrid approach – a price-collared ETS, potentially combining the advantages of both strategies – that makes the race. Ultimately, the choice is ours to make.