Carbon markets allow firms or countries to trade emissions reductions allowing emissions targets to be met at least cost.  They comprise two main types of schemes: cap and trade schemes (such as the EU ETS) and schemes which generate offset credits (such as the Clean Development Mechanism).

Cap and trade schemes

• Set a limit on total emissions from the scheme.
• The total allowed emissions is divided up into tradable ‘allowances’, each equivalent to a tonne of CO₂.
  Allowances are given or sold to participants in the scheme.
•  Participants must have enough allowances to cover all their emissions.
• Where participants have more emissions than allowances, they must either cut emissions or purchase allowances. Alternatively, participants with a sufficient number of allowances may cut emissions and sell allowances.
• In deciding whether to cut emissions participants compare associated costs with the allowance price.
   The price at which allowances can be purchased is determined by the overall emissions limit – the tighter the limit, the higher the price.
• The methodology for initial allocation of allowances does not affect their price.
• The EU has created its own cap and trade scheme called the EU Emissions Trading Scheme (EU ETS). This covers energy intensive sectors (e.g. power generation, iron and steel, cement, etc.) which together account for around half of EU CO₂ emissions.

Offset credit schemes

• Offset credits are generated from projects which save carbon, for example, installation of emissions reduction technology in an industrial plant.
• The number of credits granted is equal to the emissions reduction.
• Credits can then be sold to Governments to help meet emissions reduction targets, to participants in cap and trade schemes, or can be used to help companies or individuals offset the carbon they produce in their activities.
• The price of credits reflects the emissions reduction cost.
• The best known offset credit scheme is the Clean Development Mechanism (CDM), which grants credits to projects in developing countries.