I was asked to explain something about carbon trading by Vivek sometime back. Here I take a shot at it.
Emissions trading is an administrative approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. The development of a carbon project that provides a reduction in Greenhouse Gas emissions is a way by which participating entities may generate tradeable carbon credits. Say a company in
A central authority (in our case CDM India, an authority under the Ministry of Environment and Forests) sets a limit or cap on the amount of a pollutant that can be emitted in a country. Companies or other groups that emit the pollutant are given credits (CERs – Certified Emission Reductions) or allowances which represent the right to emit a specific amount. The total amount of credits cannot exceed the cap, limiting total emissions to that level. Companies that pollute beyond their allowances must buy credits from those who pollute less than their allowances or face heavy penalties. This transfer is referred to as a trade. In effect, the buyer is being fined for polluting, while the seller is being rewarded for having reduced emissions. Thus companies that can easily reduce emissions will do so and those for which it is harder will buy credits which reduce greenhouse gasses at the lowest possible cost to society. Countries which have companies having higher credits will enable them to sell the credits in the international market.
There are a number of international markets -- most notably the EU, with its European Union Greenhouse Gas Emission Trading Scheme (EU ETS) that began its operations on 1 January 2005. Companies which accumulate CERs sell them there in this market to interested buyers. The international market for CERs has crossed the $30 bn mark in 2006, largely driven by the trading of EUA (European Union Allowances). EUA are the equivalent of CERs (Certified Emission Reductions).