Over the last few decades, there has been growing concern about global warming and climate change caused by greenhouse gases (GHG) - emissions from human activities that involve fossil fuel combustion. In 1992, the United Nations Framework Convention on Climate Change (UNFCCC) adopted the Kyoto Protocol, signed by 84 countries, under which all the major industrialized nations must limit their GHG emissions and bring them back down to 1990 levels.

One approach to mitigating global warming is emissions trading - the trading of permits to emit carbon dioxide and other greenhouse gases, calculated in tons of carbon dioxide equivalent (tCO2e). Emissions trading has emerged over the last two decades as a preferred environmental policy tool. One key advantage to emissions trading is that it gives countries and firms flexibility in meeting their emissions targets, rather than imposing predetermined technologies or standards.

The European Union (EU), under the Kyoto Protocol, has committed to reducing its GHG emissions by 8 percent from 1990 levels between 2008 and 2012. The European Union’s Emissions Trading Scheme or EU-ETS was enacted in January 2005 as one of the policy measures to enable the EU to meet its Kyoto targets. EU-ETS is a landmark environmental policy, representing the world’s first large-scale GHG trading program, covering approximately 12,000 installations in 25 countries and six major industrial sectors.

The EU-ETS offers an opportunity for critical insights into the design and implementation of a market-based environmental program of significant size and complexity. The EU-ETS grants allowances to companies for their GHG emissions in accordance with their government’s environmental objectives. The program permits a company to emit more than its allowance of GHGs as long as it has reached an agreement to buy allowances from other companies that emit less than they are permitted to.

Within the EU, the supply of allowances is initially determined by individual member states, which develop National Allocation Plans showing the allowances they plan to allocate over a given period and the methods to be used for granting allowances to various facilities. The total quantity of allowances made available by each member state must correspond to the target assigned to it under the Kyoto Protocol. The member state must therefore ensure that the allowances it grants will enable it to reach its target. In 2005, the EU member states issued allowances for 2.2 billion tons of CO2.

These amounts make the European allowance the leading CO2 unit of value in the world, with a potential market of more than 50 billion Euros. Considering that the market is young and has encountered delays in getting up to speed, this trading volume is noteworthy and encouraging.

The rise in market prices for allowances reflects a growing recognition of the effect of carbon constraints on industries and of the European Commission’s authority to enforce these limits.

It is the ability of public authorities to enforce compliance with emissions reductions that creates scarcity of allowances on the nascent carbon market and determines their value. Despite the challenges and some flaws in the EU-ETS and regardless of developments in the European exchanges over the next few years, Europe is developing a real financial industry for carbon allowances that will ultimately have its own specialized professions and institutions.