Carbon trading (or emission trading) is an administrative approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. It is sometimes called cap and trade.
A central authority (usually a government or international body) sets a limit or cap on the amount of a pollutant that can be emitted. Companies or other groups are issued emission permits and are required to hold an equivalent number of allowances (or credits) which represent the right to emit a specific amount. The total amount of allowances and credits cannot exceed the cap, limiting total emissions to that level. Companies that need to increase their emissions must buy credits from those who pollute less. The transfer of allowances is referred to as a trade.
In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions by more than was needed. Thus, in theory, those that can easily reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest possible cost to society. There are active trading programs for several pollutants. For greenhouse gases the largest is the European Union Emission Trading Scheme.In the United States there is a national market to reduce acid rain and several regional markets in nitrous oxide. Markets for other pollutants tend to be smaller and more localized.
CARBON CREDITS
The concept of carbon credits came into existence as a result of increasing awareness of the need for pollution control. It was formalized in the Kyoto Protocol, an international agreement between 169 countries. Carbon credits are certificates awarded to countries that are successful in reducing emissions of greenhouse gas.
Carbon credits are a tradable permit scheme. They provide a way to reduce greenhouse gas emissions by giving them a monetary value.
International treaties such as the Kyoto Protocol set quotas on the amount of greenhouse gases countries can produce.
Countries, in turn, set quotas on the emissions of businesses. Businesses that are over their quotas must buy carbon credits for their excess emissions, while businesses that are below their quotas can sell their remaining credits.
By allowing credits to be bought and sold, a business for which reducing its emissions would be expensive or prohibitive can pay another business to make the reduction for it. This minimizes the quota's impact on the business, while still reaching the quota.
Carbon Credits And Emissions
Carbon credits create a market for reducing greenhouse emissions by giving a monetary value to the cost of polluting the air. This means that carbon becomes a cost of business and is seen like other inputs such as raw materials or labor.
By way of example, assume a factory produces 100,000 tonnes of greenhouse emissions in a year. The government then enacts a law that limits the maximum emissions a business can have. So the factory is given a quota of say 80,000 tonnes. The factory either reduces its emissions to 80,000 tonnes or is required to purchase carbon credits to offset the excess.
A business would buy the carbon credits on an open market from organisations that have been approved as being able to sell legitimate carbon credits. One seller might be a company that will plant so many trees for every carbon credit you buy from them. So, for this factory it might pollute a tonne, but is essentially now paying another group to go out and plant trees, which will, say, draw a tonne of carbon dioxide from the atmosphere. As emission levels are predicted to keep rising over time, it is envisioned that the number of companies wanting to buy more credits will increase, which will push the market price up and encourage more groups to undertake environmentally friendly activities that create for them carbon credits to sell. Another model is that companies that use below their quota can sell their excess as 'carbon credits.'
The Kyoto Protocol provides for three mechanisms that enable developed countries with quantified emission limitation and reduction commitments to acquire greenhouse gas reduction credits. These mechanisms are Joint Implementation (JI), Clean Development Mechanism(CDM) and International Emission Trading(IET) .
Under JI, a developed country with relatively high costs of domestic greenhouse reduction would set up a project in another developed country that has a relatively low cost.
Under CDM, a developed country can take up a greenhouse gas reduction project activity in a developing country where the cost of greenhouse gas reduction project activities is usually much lower. The developed country would be given credits for meeting its emission reduction targets, while the developing country would receive the capital and clean technology to implement the project.
Under IET, countries can trade in the international carbon credit market.
Need of this Hour
Carbon trading can significantly reduce overall compliance costs for the specific pollutants covered by the trading program if the emissions reductions that take place are the most cost-effective ones. The trading market functions like any other commodity market, with trade brokers, outside investors interested in the future potential of innovators and established rules of acceptable activity. According to analysts from the International Energy Agency, the use of economic instruments such as domestic and international emissions trading could reduce the costs of complying with emissions targets by up to 50 per cent.
Emissions trading can also encourage innovation in the reduction of greenhouse gas emissions. Competition among emitters for the lowest-cost emissions can stimulate innovation and development of the least costly measures and techniques of emissions reduction. For example, a company can eliminate or significantly reduce its emissions by developing renewable technologies to replace traditional fossil-fuel-fired electricity generation.
When a new technology is introduced or an activity is undertaken that reduces emissions, an "offset" is created. The company can then take credit for that offset and sell it in the emissions market. The mass planting of trees, which act as "carbon sinks" because they absorb greenhouse gas emissions, is an example of an offset that could be used for a credit.
The concept of carbon credits came into existence as a result of increasing awareness of the need for pollution control. It was formalized in the Kyoto Protocol, an international agreement between 169 countries. Carbon credits are certificates awarded to countries that are successful in reducing emissions of greenhouse gas.
Carbon credits create a market for reducing greenhouse emissions by giving a monetary value to the cost of polluting the air. This means that carbon becomes a cost of business and is seen like other inputs such as raw materials or labor. 
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