Greetings! In our last post, we have shown the growth dynamics of CO2 emissions and their impact on the environment and outlined the essential methods to decarbonize the industrial (most polluting) sectors.

The carbon market consists of Regulated (Compliance) and Voluntary Markets. Today, we are going to talk about the Regulated Market. This market includes three methods: Carbon Tax, Emission Trading System, and Carbon Border Tax. So how do these systems operate?

The Three Methods of the Regulated Carbon Market:

1. Carbon Tax

Carbon Tax is a domestic tax levied by a country on its CO2 emitters on the carbon content of fuels, usually in the transport and energy sectors. Governments of each country set the price that issuers must pay for each ton of greenhouse gas emissions.

The companies are obliged to pay a certain amount for every ton of carbon emissions associated with their business. In addition, companies must share their environmental report with authorities of the operational regions, and at the end of the fiscal year, companies pay the authorized governmental bodies.

2. Emission Trading Systems

Emission Trading Systems are created and, thus, operate according to mandatory international and regional regulations to reduce carbon emissions. Examples of the developed mechanisms are European Union Emission Trading System (EU ETS) and California Carbon Market.

These carbon allowances are traded and treated as a commodity. The allowances of emission issued by the state can be further traded on such exchanges as the European Energy Exchange & European Climate Exchange. They are issued on an annual basis with a fixed emission reduction rate.

For example, government issues 1,000 carbon credits (1 credit = 1 ton of CO2 (or any other gas equivalent)) to Company X. These credits can offset the current emissions or be sold on the earlier-mentioned stock exchanges if the company successfully reduces its carbon footprint and does not use up the state allowance. Each year, the number of issued credits is reduced to motivate businesses to limit their carbon footprint further and continuously work on reducing carbon emissions.

3. Carbon Border Tax

Carbon Border Tax is tax on the carbon footprint associated with imported goods, which has high carbon intensity and a direct environmental impact (risk).

The most recent example is CBAM mechanism in the EU that will begin to operate from October 2023 onwards. Initially, a simplified CBAM would apply with importers obliged to collect and report carbon data. Then, from 2026 onwards, the full CBAM will kick in, and the levy – linked to the EU’s carbon market price – will be payable.