An emissions trading system (ETS) is a market-based mechanism that is applied to achieve emissions targets at least cost. By fixing a quantity of emissions (the cap), requiring that companies surrender one allowance for each unit of emissions generated and making the allowance tradable, a carbon market is created through which an allowance price emerges. For producers, the allowance price is treated as a marginal cost in operation decisions and is a commodity that needs to be reflected in investment appraisals. It encourages them to optimize their operations with a view on the system-wide emissions constraint, render their goods less emissions-intensive or to make low-carbon investments. For consumers, carbon-intensive goods become more expensive, encouraging a switch to low-carbon alternatives or to change consumption patterns (e.g., energy efficiency). The relative change in prices creates incentives to invest in low-carbon assets and to develop new products, processes and technologies that use carbon more efficiently. At the same time, high-carbon assets become less competitive, which could lead to an accelerated decommissioning of these assets.
When declining emission caps are set also for future periods, an ETS serves not only as an economic (carbon pricing) mechanism but also as an informational instrument; that there will be less scope for emissions-intensive activities in our future economies. This can provide visibility and accountability on the longer-term pathways for time horizons that potentially go beyond the periods that are most relevant for decision-making on long-lived assets. The long term signal will be strongest where the ETS is embedded within a credible, long-term policy architecture that reduces uncertainty for participants.