The allowances to pollute issued to developed countries are listed in Annex B of the Kyoto Protocol and average 5.2 percent below countries' 1990 levels. Annex B countries have each been issued with assigned amounts which together equal the total amount of CO2e emissions agreed for 2008-2012. For example Great Britain and Northern Ireland agreed to cut their CO2e emissions by 8 percent. Their assigned amount for the first commitment period is therefore five times 92 percent of their 1990 emissions. A country can express all or part of its assigned amount in terms of tradable assigned amount units (AAUs).
While it may be equitable for industrialized nations to bear similar burdens in terms of a cap, the fact is that the costs of compliance will vary between countries. This cost disparity, together with the ability to trade, engenders a market for AAUs; the buyers of AAUs, which are in tonnes of CO2e, reduce their costs of compliance, and the sellers make deeper cuts but at a cost lower than the market price for AAUs. The overall amount of allowances remains the same, but trade allows the achievement of the target at least cost. The tighter the cap, the higher the price per tonne of CO2e in the market because of the increased demand for allowances by high-cost emitters.
Figure 1.1 illustrates trade in AAUs in a two-country model. The system accommodates trading of AAUs government to government, government to authorized trader, and vice versa, and authorized trader to authorized trader. Forward contracts and call options on AAUs can be sold, and any entity authorized by an eligible Annex I party can buy. The first trade in AAUs was brokered in 2002 between an Eastern European government (the seller) and a Japanese corporation (the buyer) (Evolution Markets, 2002).
The previous section suggested that the marginal social cost (MSC) of a tonne of CO2e should equal its price. While it was shown that there are very wide variations in estimates of the MSC, the price in the market can nevertheless be monitored under the cap and trade system adopted globally to see how the trading price of allowances compares with MSC estimates. If the price of carbon in the market is well below the MSC then there are benefits in tightening the cap and raising the price. On the other hand if the MSC is well above estimates of MSC there are benefits in loosening the cap and lowering the price.
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