Emissions trading is a market-based scheme to control emissions by providing economic incentives for companies to reduce their levels of green house gas emissions.

Emissions trading is a relatively new phenomenon yet there has been rapid growth in both volume and complexity. Under the trading system, companies are given credits or allowances which represent the right to emit a specific amount. The total amount of allowances distributed cannot exceed a cap, limiting total emissions to that level. Companies that emit beyond their allowances must buy allowances from those that emit less or face heavy penalties. The buyer pays for polluting, while the seller is rewarded for having reduced emissions. Companies that can easily reduce emissions will do so and those for which it is more expensive will buy credits.

The EU Emissions Trading Scheme (ETS) is one of the policies introduced across the EU to reduce emissions of carbon dioxide and other greenhouse gases in an effort to combat the serious threat of climate change. The first phase of the scheme ran from 2005 to 2007 and the second phase runs from 2008 to 2012 to coincide with the first Kyoto commitment period.

ETS works on a 'cap and trade' basis whereby all EU member states are required to set a limit or cap on the amount of a pollutant that can be emitted for all 'installations' covered by the scheme. Such installations include all fossil fuel power generation facilities and large industrial energy users, such as cement manufacture, paper and pulp manufacture and food processing. Ireland has just over 100 installations participating in the scheme out of an EU-wide total of more than 11,400.

Each installation is allocated allowances for the particular commitment period, with the number of allowances allocated to each installation for any given period being determined on the basis of a national allocation plan. The national allocation plan determines the total quality of carbon dioxide emissions that member states grant to companies located in that state, which can then be sold or bought by the companies themselves.

The idea is that member states limit carbon dioxide emissions from the energy and industrial sectors through the allocation of allowances, thereby creating scarcity, so that a functioning market can develop later and overall emissions are then reduced. Each year, the installations must return enough emissions allowances to the relevant regulator to cover their actual emissions, which in turn encourages emissions reduction.

The ETS is a cornerstone in the fight against climate change. It is the first international trading system for carbon dioxide emissions in the world. It is important to point out that ETS does not imply new environmental targets; rather it is intended to allow for more cost-effective compliance with existing targets under the Kyoto Protocol by allowing participating companies to buy or sell emission allowances.

The European Commission has not stipulated on what price allowances should be, rather the price is function of supply and demand. Companies with commitments may trade allowances directly with each other, or they may buy or sell via a broker, bank or other allowance market intermediary. A carbon trading market has now started to form. Market intermediaries quote prices for allowances offered or bid for. The European Commission will not intervene in the allowance market. Of course, if distortions occur, competition law would be applicable as with any other market.

Due to the risk that international competition could result in "carbon leakage" (the relocation of carbon intensive industry to less regulated jurisdictions) the European Commission intends to assess and determine the exposed sectors and such sectors will receive 100% of their allowances for free.

Provision is also made for an electronic registry system that keeps track of the ownership of emission allowances as they are exchanged within the market. In Ireland, the Environmental Protection Agency is responsible for establishing and maintaining a national emission trading registry.

Last December, the European Parliament voted in favour of the European Commission's proposed climate and energy package, which is intended to help Europe transform into a low-carbon economy and increase energy security. In line with the European Commission's proposals, agreement was reached on legally-binding targets so that by 2020 there would be a cut in greenhouse gas emissions by 20%, a 20% share for renewable energy would be established and energy efficiency would be improved by 20%. The package also contains a choice to go further and commit to a 30% cut in the event of a satisfactory international agreement being reached. Included in the package were significant changes to the existing ETS. The improvements mean that from 2013, an emissions cap will be set at EU level and cut each year to reach a 21% cut in 2020.

Therefore, under the ETS, from 2013 member states will no longer prepare a national allocation plan. In place of that there will be one EU-wide cap on emission allowances which will decrease along a linear trend line. The agreement will increase the level of auctioning in the system.

The new proposals entail a major change from the previous framework and will create significant and far-reaching challenges for government, industry and consumers.