What is an Allowance?
Carbon allowances are issued by governments under emissions cap-and-trade regulatory programs. Each allowance (or emissions permit) typically allows its owner to emit one tonne of a pollutant such as CO2e.
Under a cap-and-trade system (also called emission trading systems (ETSs)), the supply of GHG allowances is limited by the mandated ‘cap’. Allowances can be allocated freely by the governing program, be purchased when auctions are held, or be purchased from other entities that have excess.
Location
The location of the emission sources covered by a cap-and-trade program depends on its scope set out in regulation or legislation. There are programs in the European Union, United States (California, Washington, and RGGI), Canada (Alberta and Quebec), China, Korea, New Zealand, and many others (visit the ICAP ETS Map for listing of cap-n-trade programs globally).
The EU Emissions Trading System (EU-ETS) is the largest cap-and-trade program covering about 45% of the EU’s GHG emissions (as of 2024).
In the United States, there are three ETSs as of 2024:
- The Regional Greenhouse Gas Initiative (RGGI) began in 2009. RGGI is the first mandatory GHG cap-and-trade system in the United States. It includes eleven Northeastern and Mid-Atlantic states. Each state establishes its own cap and trade program that sets limits on in-state CO2 emissions from electric power plants. These programs link to a multi-state allowance market.
- The cap-and-trade program established by California’s Global Warming Solutions Act AB32 started in 2013 (CA ETS). It covers 85% of California’s GHG emissions, including the transportation sector. The California and Quebec cap-and-trade programs are linked.
- The Washington State Cap and Invest program started in 2023 following passage of the Climate Commitment Act (CCA).
Cost and Management Burden
Cost per tonne of CO2e (2024 data):
- RGGI: US$16-21
- California: US$35-43
- EU ETS: around €50-80
Most RGGI member states allow non-capped voluntary buyers to purchase and cancel RGGI allowances. The purchase of CA, WA, or EU-ETS allowances is also possible. The purchase of such allowances to make a voluntary emission reduction claim would not require a major management burden, and ongoing-management costs would be minimal. Numerous environmental commodity brokers exist that can facilitate the purchasing and retirement of allowances.
You can find updated allowance price information and more details on program price floors and other aspects of these and other cap-and-trade programs here.
Environmental Integrity
Buying and retiring allowances from a cap-and-trade system offers an alternative to carbon credits for claiming emission reductions. This approach has the potential to avoid credit quality issues, such as non-additionality. The purchase and voluntary retirement of allowances reduce the availability of allowances in a cap-and-trade system, effectively “tightening the cap” and, in principle, reducing emissions that can be produced by sources covered under the cap (e.g., power plants, large industry, and fuel suppliers). By this logic, purchasing and retiring allowances compels cap-covered sources to achieve additional emission reductions. However, a concern with this approach is that cap-and-trade programs can have oversupplied allowance markets, or that additional allowances can be released from reserve accounts should prices rise too high.
Retiring allowances in an oversupplied market has a negligible effect. Retiring allowances will only result in additional emission reductions to the extent that allowance markets are not over-supplied. Oversupply can build up if the emissions cap is unambitious (i.e., higher than the projected business-as-usual (BAU) emissions). In such a case, a cap-and-trade policy in a country or region actually has no significant effect on emissions from covered sources. There will be too many allowances issued by the governing regulatory authority and result in an accumulation of surplus allowances in the market. More allowances mean covered sources can emit as much as they choose.
Oversupply of allowances can also be created if the covered entities engage in more mitigation activities than required by the cap. If a cap is ambitious, over-achievement will be transient and will not lead to a build-up of surplus allowances.
In a cap-and-trade system with a long-term oversupply problem, retiring surplus allowances is one option to remove the built-up surplus but this action will not cause emission reductions. Retiring allowances from an oversupplied market may lead to additional emission reductions later in time, assuming the oversupply was temporary and that there is a scarcity of allowances in the future. However, such emission reductions would be subject to uncertainty, as reductions would depend on the continuation of the ETS and increased stringency in the ETS’s cap.
Historically, many cap-and-trade systems have been oversupplied with allowances. Many have also incorporated minimum price floors for new emission allowances sold at auction. One clear signal that a market is oversupplied is that auction prices are at or near the program’s price floor. Some ETSs also have a price ceiling, at which additional allowances are released to supply the market if auction prices reach the ceiling. Retiring allowances from a market that is trading at its ceiling will also not lead to additional emission reductions.
- The EU-ETS was oversupplied for many years, but changes to the program were instituted to neutralize that surplus (e.g., Market Stability Provisions 2019). Prices reflect these EU-ETS oversupply adjustments improving the efficacy of the program to reduce emissions. The oversupply problems with the EU ETS appear to have been resolved.
- The CA-ETS has a price ceiling and price floor. Allowances are currently trading well above the price floor, indicating that there is a scarcity of allowances.
- RGGI was severely oversupplied in the past because of a switch to natural gas from coal by many utilities and a weak economy over the baseline setting period. RGGI has a low price floor and allowance prices have traded at or slightly above this floor, indicating that there is no scarcity of allowances.
- The WA ETS only began allowance auctions in 2023. After an initial period of high prices, auction prices in 2024 have been near the price floor due to some uncertainty in the program’s political future.
Potential Risks
Concerns related to the environmental integrity of allowances due to oversupply present a significant risk – if used as an instrument to make voluntary emission reduction claims. Buyers should not make such claims based on the voluntary retirement of allowances from oversupplied cap-and-trade programs.
Social and Environmental Co-benefits
Unlike carbon credits, the purchase of allowances would not allow the purchaser to select activities with sustainable development benefits.
Outlook and Considerations
Buying and Retiring allowances from a cap-and-trade system offers an alternative to carbon credits but environmental integrity can only be ensured if allowances come from a system that is not oversupplied over the long-term.
The retirement of EU-ETS and CA allowances has become a viable option as the EU-ETS no longer appears oversupplied. RGGI is clearly oversupplied and should not be considered for voluntary allowance retirement. More time is needed to understand the future of the WA ETS. Other ETSs globally require evaluation of their supply of allowances before relying upon them as an alternative to carbon credits. Any buyer considering this option should follow developments in the selected system to track prices, allowance supply, and changes to programmatic rules that may effect the environmental integrity of using ETS allowances to make voluntary emission reduction claims.
[1] The terms retiring and canceling may be used interchangeably in some contexts. In some systems canceling refers to deleting the units without using them for compliance or claiming them toward a voluntary emission reduction goal while retiring implies the use of the allowances or credits toward regulatory compliance or voluntary goals (see glossary).