This type of carbon market is better known as an emission trading system. It allows companies or industrial installations to trade pollution permits called ‘emission allowances’, each of which typically represents a tonne of greenhouse gas (or CO2) emissions.

A limit is set on the overall quantity of allowances to be traded within that system, and this is known as the cap. Using the EU ETS as a real-world example, the ceiling falls year on year, meaning that fewer emissions allowances are allocated annually (either available for purchase or handed out for free). This declining cap encourages the covered sectors and companies to decarbonise. Free allowances or low carbon prices can hinder the market’s ability to deliver meaningful climate action.

It is up to the companies covered by an ETS to ensure they have secured enough allowances at least equal to their actual emissions. A company typically does this by buying allowances from other companies when it overemits or by selling surplus allowances it possesses when it underemits. Alternatively, most markets allow companies to hold on to surplus allowances for future use or sale.