Assuming that companies A and B both emit 100.000 tonnes of CO2 per year. The government gives each of them 95.000 emission allowances. One allowance represents the right to emit 1 tonne of CO2. So, neither company is fully covered for its emissions.
At the end of each year, the companies have to surrender a number of allowances corresponding to their emissions during the year, whatever the emissions of the individual company are. Companies A and B both have to cover 5.000 tonnes of CO2, and they have two ways of doing this.
- They can either reduce their emissions by 5.000 tonnes,
- They can purchase 5.000 allowances in the market.
In order to decide which option to pursue, they will compare the costs of reducing their emissions by 5.000 tonnes with the market price for allowances. For the sake of the example, lets say that the allowance market price is 10 per tonne of CO2.
Company As reduction costs are 5 (i.e. lower than the market price). Company A will reduce its emissions, because it is cheaper than buying allowances. Company A may even reduce its emissions by more than 5.000 tonnes, say 10.000 tonnes.
Company A spends 50.000 on reducing 10.000 tonnes at a cost of 5 per tonne and receives 50.000 from selling 5.000 tonnes at a price of 10. So Company A fully offsets its emission reduction costs by selling allowances, whereas without the Emissions Trading Scheme it would have had a net cost of 25.000 to bear.
For Company B, the situation may be the opposite: its reduction costs are 15 (i.e. higher than the market price) so it will prefer to buy allowances instead of reducing emissions.
Company B spends 50.000 on buying 5.000 tonnes at a price of 10. In the absence of the flexibility provided by the Emissions Trading Scheme, company B would have had to spend 75.000.
Since only a company that has low reduction costs and therefore has chosen to reduce its emissions, like Company A, is able to sell, the allowances that Company B buys represent a reduction of emissions, even if Company B did not itself reduce emissions.
This is important to remember. This ensures that the cheapest reductions are made first. Since the scheme is EU-wide, companies will seek out the cheapest reductions in the whole of the EU and ensure that they are made first. It is this flexibility in the system which makes emissions trading the most cost-effective manner of achieving a given environmental target. The overall cost to industry would have been higher if Company B had been forced to reduce emissions at its own plant at a higher cost.