With climate change a growing threat, economists came up with the idea of trading the right to pollute, creating a financial incentive to curb emissions.

Mostly, policymakers have three options to reduce greenhouse gas emissions:

To set a specific limit that a company cannot exceed. To introduce a carbon tax where the company pays for the amount of CO2 they produce. Businesses that can reduce emissions will invest in cleaner options as long as it is cheaper than paying the tax. To implement an emission trading scheme — to create a carbon market. In this scenario, companies buy and sell the ‘right to pollute’ from each other.

At the beginning of a trading phase, emission permits are either allocated to businesses for free or have to be bought at auction. The number of available permits decreases over time, putting pressure on the participating companies to invest in cleaner production options and reduce their CO2 outputs. In the long run, this fuels innovation and drives down the price of new technologies. The idea is to pay for emission reductions elsewhere rather than invest in the country of operation.

Who is participating?

Today, more than 40 countries and 25 subnational governments have implemented a price on carbon.

The European Union’s scheme remains the most significant initiative to date. China has been running eight pilots and is creating a national trading system which is set to become the largest in the world.

But governments aren’t the only proponents of carbon markets. More than one thousand businesses and investors have called for a comprehensive price on carbon. Seventy-nine top executives went on to join the World Economic Forum’s CEO climate leaders, and the Carbon Pricing Leadership Coalition continues to mobilize business support.

Internal carbon pricing has equally been gaining momentum; over 1200 companies already account for the climate risks their business is exposed to. This helps companies plan ahead and weigh the financial risks of future investments. Our steel producer might be operating in several countries and needs to budget the cost of doing business as more regulators implement carbon prices.