May 07, 2025 11:02:06 am
Manhajul Islam, S. Ak - BATS Consulting
A carbon market is an emissions trading mechanism that allows companies or countries to buy and sell carbon credits – permits to emit a certain amount of emissions (1 credit = 1 ton of CO₂). For example, if a factory manages to reduce its emissions below a specified limit, its remaining quota can be sold as carbon credits; conversely, if it exceeds the limit, it must buy additional credits or be fined. The main goal is to encourage efficient reductions in greenhouse gas emissions. Carbon markets also involve green projects (such as reforestation or renewable energy) that generate emission credits, as well as the standards and legal mechanisms that govern them. In other words, carbon markets connect parties who need to buy emission permits with projects or entities that can provide credits for reducing emissions.
A picture of a factory chimney appearing above the clouds as an illustration of the problem of industrial emissions.
In practice, carbon markets are divided according to the location of operation (sub-national, national, regional), regulatory status (mandatory vs voluntary), and trading system (cap-and-trade vs baseline-and-credit). This classification helps understand how carbon reduction schemes are implemented at different levels of government and sectors. For example, the EU manages the largest regional carbon market system (EU ETS) that is binding across member states, while many countries (China, Korea, New Zealand, Indonesia) are building national cap-and-trade schemes. On the other hand, there are also voluntary carbon markets (not regulated by governments) such as the Verified Carbon Standard and the Gold Standard that rely more on carbon credit-based projects. Below we explain each category with concrete examples.
By Location
Sub-national (city/province level) Carbon Markets operate within a specific administrative region. Well-known examples are the California Cap-and-Trade Program in the United States and the Tokyo Cap-and-Trade Program in Japan. California launched its cap-and-trade system in 2013, covering about 76% of the state’s greenhouse gas emissions. Tokyo, which launched its first ETS in 2010, covers large buildings and industries within the Tokyo metropolitan area, targeting ~20% of the city’s emissions. Both are mandatory (companies within the scope of the regulation must participate) and set an emissions quota on the total emissions of the region. Sub-national markets also include multi-city or inter-province initiatives; for example, the Saitama (Japan) emissions trading program is interconnected with the Tokyo Cap-and-Trade. Sub-national markets are important because they allow cities/provinces to act first on emissions controls even when there is no national scheme.
Night view of Tokyo (illustration). Tokyo Cap-and-Trade is an example of a sub-national carbon market that began in 2010 and regulates emissions from large buildings in the municipality.
National Carbon Markets are managed by a country’s government. National schemes typically cover a wide range of sectors and are mandatory for certain companies to comply with. A prime example is the China National ETS, the world’s largest national carbon scheme that began operating in 2021. It initially focused on the electricity sector, covering >2,000 large-capacity power plants, and is estimated to account for around 40% of the nation’s total CO₂ emissions. The system applies output-based emissions quotas that are allocated free of charge based on actual production. Other examples include the Korea Emissions Trading Scheme (K-ETS), launched in 2015, covering >70% of South Korea’s GHG emissions; and the New Zealand ETS, which has been in operation since 2008 and currently covers around half of New Zealand’s emissions. Indonesia is also developing a national carbon market in the form of an Economic Value of Carbon (NEK) for the electricity sector. In the initial phase (2023–2024), the NEK targets the 99 largest coal-fired power plants (25 MW and above), which represent ~37% of national electricity generation capacity (67.6% of coal-fired power capacity). Overall, national markets are large in scale and often integrated with national emission reduction targets (NDCs).
Regional or Transnational Carbon Markets are jointly managed by several countries or states. An example is the EU Emissions Trading System (EU ETS), which brings together the 27 European Union countries (plus several other European countries) into one large carbon market. The EU ETS, launched in 2005, caps total emissions from the electricity generation, heavy industry, and aviation sectors within the EU; it is the world’s first and largest cap-and-trade carbon market. The EU ETS imposes centralized emissions quotas and allocations of tradeable permits between participants. Another regional example in the United States is the Regional Greenhouse Gas Initiative (RGGI), a carbon market collaboration between 11 Northeastern US states to cap CO₂ emissions from electric power generation. RGGI is considered the first regional cap-and-trade scheme in the US. Other regional schemes include the Western Climate Initiative between California and Quebec (Canada), and plans to strengthen regional carbon markets in Southeast Asia. In essence, regional carbon markets are cross-border and generally mandatory for entities in the member region.
By Regulation
A Mandatory Carbon Market is a scheme set by a government and must be met by certain entities. Participants are required to reduce emissions to a limit set by regulation. Examples include the EU ETS, RGGI, California Cap-and-Trade, Tokyo Cap-and-Trade, and China National ETS. In addition, international mechanisms under UN rules also include mandatory markets: The Clean Development Mechanism (CDM) regulated by the Kyoto Protocol is a mandatory carbon market for developed countries (Annex I) that buys credits from projects in developing countries. The characteristics of a mandatory market are the existence of a collective emission ceiling (cap) and legal enforcement; for example, companies that exceed their quota are subject to administrative sanctions or fines. In Indonesia, DNPI cites the CDM and the European Unions ETS scheme as the most active mandatory carbon programs. Mandatory carbon markets operate according to national or regional emission reduction targets, so that trading volumes in these markets can be planned for the long term.
A Voluntary Carbon Market operates outside of government regulation. In this market, companies or individuals voluntarily buy carbon credits to offset their carbon footprint. Credits in the voluntary market come from mitigation projects (renewable energy, reforestation, energy efficiency, etc.) that are verified by a specific body. Activities in the voluntary carbon market are not legally binding, but are driven by a company’s social responsibility or green image. Leading examples of voluntary market certifications are the Verified Carbon Standard (VCS) and the Gold Standard. The VCS, now managed by the Verra organization, has registered thousands of projects across a range of sectors and issued over 1.3 billion carbon credits. The Gold Standard was originally created for CDM projects but now also certifies voluntary projects, emphasizing additional sustainability benefits. These voluntary schemes are flexible and project-based; for example, small forestry cooperatives (Plan Vivo), local renewable energy projects, or green manufacturing. Although voluntary, these markets are important for directing private investment to climate mitigation. Governments often use voluntary markets to help meet emissions targets, but are officially outside of legal obligations.
By Trading System
A Cap-and-Trade system sets a total emissions limit and allows the trading of emissions permits between participants. The government or authority sets a cap (maximum emission volume) and then distributes quotas (allowances) to companies. If a company manages to reduce its emissions more than the target, the remaining allowances can be sold; conversely, if it exceeds the limit, the company must buy additional allowances. This system encourages companies to pursue cost-efficient emission reductions. Examples of cap-and-trade applications include the EU ETS, California Cap-and-Trade, Tokyo Cap-and-Trade, and RGGI. In the example of the EU ETS, since 2005 the European Union has reduced the total quota each scheme period, accelerating collective emission reductions. Cap-and-trade schemes are also proposed for national markets such as Indonesia: Indonesias NEK plans to eventually become a hybrid of "cap-and-trade plus carbon tax". In essence, a cap-and-trade market is a structured mandatory market, with strict monitoring, reporting, and auditing institutions, making it a key instrument of climate policy in many regions.
An example is the skyline of a large Asian city; many national carbon markets (such as China and Korea) focus on large cities and industries.
Baseline-and-Credit (Carbon Credit or Offsetting) systems are based on establishing a baseline (an expected value of emissions) and recognizing credits for emissions reductions above that baseline. There is no cap, but rather an entity or project receives credits if it successfully reduces emissions above the baseline. This scheme is often applied to mitigation projects or international mechanisms. A classic example is the Clean Development Mechanism (CDM) under Kyoto: projects in developing countries that reduce emissions relative to a defined baseline receive Certified Emission Reductions (CERs) to trade. In voluntary markets, standards such as the VCS and Gold Standard use a baseline approach: mitigation projects are verified and generate carbon credits that private companies can buy. In the context of domestic policy, Canada’s Output-Based Pricing System (OBPS) is an example of a credit-based system that operates in parallel with a carbon tax. The OBPS sets a standard for emissions intensity (per output) for intensive industries, and then issues credits if actual emissions fall below the standard. Thus, baseline-and-credit systems are more commonly found in certain projects/industries and often serve the purpose of “buying abatement” rather than limiting total emissions.
Real-world Examples of Carbon Markets in Different Countries
A few concrete examples help to understand the variety of carbon markets:
EU ETS (Regional, Mandatory, Cap-and-Trade): Started in 2005, the world’s largest carbon market. The EU ETS brings together 27 EU countries and partners. Each industrial/generation plant within the mandatory coverage has an annual quota; more/less can be bought/sold as needed.
California Cap-and-Trade (Sub-national, Mandatory, Cap-and-Trade): Launched in 2013, covers electricity, transportation, industry, buildings, and most state emissions (~76%). The process involves auctioning and distributing permits, with proceeds going to green projects. California is even connected to Québec’s cap-and-trade system in Canada.
Tokyo Cap-and-Trade (Sub-national, Mandatory, Cap-and-Trade): The first city-level Kyoto scheme, active since 2010. Focuses on large buildings and facilities. Under this scheme, Tokyo buildings must monitor their historical emissions (baseline) and ensure gradual reductions over time.
China National ETS (National, Mandatory, Intensity-based Cap-and-Trade): Starting in 2021 and covering the electricity sector, this is the largest program by volume (approximately 40% of national emissions). Permit allocation is based on energy intensity; is being expanded to other industries (cement, steel) by 2024.
Indonesia NEK/ETS (National, Mandatory, Intensity-based Cap-and-Trade): Starting in 2023 for large coal-fired power plants. In the first phase, 99 PLN-connected coal-fired power plants (≥25 MW) will have their emissions reduced based on intensity targets. The government is also strengthening this scheme with the launch of a carbon exchange (IDXCarbon) in 2023.
RGGI (Regional US, Mandatory, Cap-and-Trade): A collaboration of 11 eastern US states, started in 2009. RGGI caps electricity sector CO₂ emissions with a joint quota auction mechanism.
VCS (Voluntary Carbon Standard): The most widely used global voluntary scheme. Focuses on certifying mitigation projects (forests, energy, etc.) to generate carbon credits that are traded voluntarily.
Gold Standard: A voluntary standard that emphasizes sustainability benefits. Established in 2003 for CDM projects and now serves the global voluntary market.
CDM (International Mandatory Market, Baseline-and-Credit): Under the Kyoto Protocol, the CDM allows developed countries to buy CERs from emission reduction projects in developing countries. Although its main period has ended, the CDM was once one of the largest channels for carbon trading (known as the Clean Development Mechanism).
South Korea ETS (National, Mandatory, Cap-and-Trade): Launched in 2015, covers energy, industry, buildings, transportation, waste, and public sectors, covers >70% of national emissions.
New Zealand ETS (National, Mandatory, Cap-and-Trade): Running since 2008, unique design as it includes forestry (both carbon source and sink). Covers CO₂, CH₄, N₂O, etc. Currently about half of the country’s emissions are covered.
Canada OBPS (National Canada, Mandatory/Performance-Based): Not a hard cap, but an intensity-based system for heavy industry. High-emitting companies must meet emissions standards per unit of output. If they exceed them, they are compensated through carbon payments; if they fall short, they receive credits that can be sold. OBPS complements Canada’s national carbon pricing system and avoids negative impacts on industry competitiveness.
Thus, carbon markets come in many forms. From binding mandatory markets (such as EU ETS, RGGI, NEK Indonesia) to voluntary project-based markets (VCS, Gold Standard), as well as cap-and-trade and baseline credit trading systems. These variations allow each country or region to adapt carbon schemes to its economic conditions, policies and climate goals, while learning from international success stories.