The following report was prepared and published by our sister platform SPEEDA—November 2022.

2015’s Paris Agreement marked a turning point, spurring green initiatives around the globe towards achieving carbon neutrality. Some promote low-to-no carbon emitting alternatives, such as renewable energy and electric vehicles, while others target CO2 removal and storage with afforestation and carbon capture and storage (CCS) projects. The success of reaching net zero emissions hinges not only on such voluntary initiatives, but also non-voluntary ones. One such example is the emissions trading system (ETS), which operates on a national/regional level under a compliance-based approach.

Under an ETS, regulators take into account overall emission reduction targets, set emission caps for greenhouse gas (GHG) emissions accordingly, and allocate emissions allowances to companies and power and industrial plants operating in carbon-intensive industries. Each allowance represents a unit of emissions permitted under the cap, and these are first allocated via auctioning and free allocation. Companies under an ETS scheme are obligated to purchase additional allowances if their measured (or expected) emissions exceed their allocated allowances. These additional allowances can be purchased through carbon trade markets, offered by companies that hold allowances they do not need when their emissions fall below the cap.

However, regulation differences and the lack of ETS adoption by some countries and regions create a loophole termed as “carbon leakage”, which arises when companies shift carbon-intensive production to countries that have more lenient GHG regulations. Governments are thus looking into carbon border adjustment mechanisms (CBAMs) to curb such leakage by compensating for carbon costs incurred in less regulated countries.

Meanwhile, an ETS regulates companies and industrial facilities operating in primarily the aviation, power generation, and other energy-intensive industries in participating countries or regions. Within the EU, for example, foreign companies of applicable industries with factories in the region, as well as joint ventures or subsidiaries of foreign companies, are generally subject to the regulations of the EU ETS unless their CO2 emission volumes fall below the threshold. Companies outside the scope of an ETS may also eventually become subject to regulation under CBAMs.

This Trends report provides an overview of the climate change tools ETS and CBAM, and takes a closer look at the actual impact they have on business.