The Big Question: What is carbon trading, and will it help in the battle against climate change?

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Why are we asking this now?

Because the Government seems likely to embark upon the construction of a new series of coal-fired power stations, which emit more carbon dioxide than any other form of energy generation – yet ministers say that Britain's climate targets can still be met through carbon-trading and other policy measures.

What exactly is carbon-trading?

It is a way of offering a financial carrot to big polluting companies to get them to clean up their act, at the same time as threatening them with a financial stick. Heavy plants are allocated permits by the Government to emit a certain amount of carbon dioxide in the course of their operations, one permit being equivalent to a metric tonne of CO2.

Once they reach the end of their allocation, they have to buy more permits, which – in theory – ought to be very expensive. However, if they cut their emissions to below their limit, and have permits left over, they can sell those permits on the "carbon market" to other companies who may be emitting too much – and thus make a profit. So there is a distinct financial incentive to cut emissions, and at the same time a penalty for failing to do so.

What advantages are there to the system?

Its proponents say there are several, and not only the combination of carrot and stick. You could indeed have government regulations which put precise CO2 emissions limits on precise facilities – cement works X, or steel plant Y, say. But that is very much a commercial and industrial straitjacket. Emissions trading gives companies the flexibility to meet carbon reduction targets according to their own strategy, by reducing emissions on site, or by buying allowances from other companies who have excess allowances. At a given moment, one may be more practical to do than the other. Second, the idea is to ensure that reductions take place where the cost of reducing is lowest – so lowering the overall cost of tackling global warming.

And is this actually being done now?

Yes, it is being carried out in the Emissions Trading Scheme (ETS) of the European Union, the world's first, which was set up in 2005, and which takes in all the major industry of Europe, including Britain, which sees it as the cornerstone of its policy to fight climate change.

Has the scheme been a success?

Not in the first phase of the scheme, which ran from 2005 to the end of 2007. The problem was that the governments of the EU member states allocated too many permits to the 10,000-plus industrial plants involved – partly because they did not have an exact picture of how much CO2 they were all emitting.

When, in the course of administering the scheme, the precise figures did emerge, it became clear that too many permits had been given out, and demand for permits collapsed – and with it the price. The price of carbon in the market was about one Euro per tonne – and as even this price reflected the cost of the small residual amount of trading that was going on, a tonne of carbon was in effect worthless. You couldn't sell permits, and there was no need to buy them. So there was no more carrot to cut emissions, and no more stick.

So did that mean the end of the scheme?

By no means. In the second phase of the ETS, which began on 1 January this year, and runs until 31 December 2012, the allocation of permits has been tightened up considerably. That this has had an effect is evident at a glance if you look at the price of carbon. "People said that the market didn't work, but the subsequent lift in the price shows there has been a learning experience," says James Burnham of Climate Change Capital, an investment bank working with the low-carbon economy. The higher the price of carbon, of course, the better the scheme works – indeed, the price of carbon is one of the key mechanisms for tackling global warming, according to Sir Nicholas Stern, who published his celebrated report on the economic consequences of climate change 18 months ago. Sir Nicholas pointed out that none of the damage that would be done by global warming was reflected in the price of the fossil fuels whose burning was responsible for it – and thus climate change was "the greatest market failure in history." Is the current price of carbon high enough to do the job? It's too early to say.

How has the number of permits been worked out?

They have been allocated by individual EU member states, each of which produces a National Allocation Plan, broadly on the basis of Europe's legally-binding CO2 reduction target under the Kyoto Protocol, the international treaty on climate change whose current, initial phase also runs out on 31 December, 2012.

If the second phase of the ETS works as designed, it will account for about half the emissions cuts that Europe as a whole needs to make by the end of Kyoto period. The target for the EU taken together is to reach eight per cent below the level of EU emissions in 1990, and this has been divided up with different "burdens" for different countries. Britain's target is 12.5 per cent below 1990 levels – which we are on target to meet.

But doesn't Britain have much bigger reduction targets?

The world has moved on from Kyoto, signed in 1995, and yes, we now have much bigger targets in Britain and in Europe. The EU wants to cut CO2 by 20 per cent by 2020, and 30 per cent if other major industrial economies will join in. Britain's targets are even tighter – under the Climate Change Bill going through Parliament, the Government will be legally obliged to cut UK carbon emissions by at least 26 per cent by the period 2018-2022, and by 60 per cent by 2050. This latter figure may be tightened further to 80 per cent following recommendations from the new Committee on Climate Change, which began its work yesterday headed by Lord Turner – the former Adair Turner, chair of the CBI in the mid-90s – who is now Britain's "climate czar". Will emissions trading make these cuts possible? Almost certainly, not on its own – we will need new technology such as carbon capture and storage, a big increase in renewable energy, and much more energy efficiency. It will certainly not help either if the Government does embark on a new generation of coal-fired power stations. Asked about this yesterday, Lord Turner diplomatically declined to answer – which is doubtless one of the reasons the Government made him climate czar in the first place.

Is carbon trading the solution to meeting Britain's CO2 targets?

Yes...

*The EU's Emissions Trading Scheme focuses on the heavy industries that are the biggest carbon emitters
*The scheme will get gradually tighter, forcing emissions down still further in Britain and Europe
*It may well be expanded to take in other sectors such as aviation and shipping

No...

*It will not remotely be enough on its own – other technologies will be required, such as carbon capture and storage
*There is no guarantee that future tightenings of the ETS will be adequate to meet the new targets necessary to fight global warming
*It may well give some sectors, such as aviation, merely a licence to carry on emitting CO2 by buying permits from other industries

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