Carbon markets' policies and regulations are in continuous change, making them extremely complex systems (UNFCCC, 2014; Technology Executive Committee, 2011). There are two approaches towards carbon markets: allowance and project-based systems.
Project-based systems have acted through the Kyoto Protocol Flexibility Mechanisms and the voluntary carbon market, whereby GHG emission abatement or sequestration projects are developed, receiving carbon offsets (credits) for what would have occurred under “business as usual.” The two most prominent project-based mechanisms are the CDM, which generates Certified Emission Reduction credits (CERs) within developing countries (non-Annex countries of the Kyoto Protocol); and Joint Implementation, which generates Emission Reductions Units (Ockwell et al., 2008). Climate change and carbon market finance under the UNFCCC can help to make lower‑carbon pathways more attractive by reducing the risks for investors, offering lines of otherwise unavailable credit and funding projects that are additional (Newell and Bulkeley, 2017).
Allowance-based systems work where greenhouse gas (GHG) emissions are regulated under a cap that determines how many carbon allowances each entity, region, or country is allowed to emit. Those governed by the scheme are generally allowed to trade their allowances, to let them meet the cap in the most efficient way possible.
How does it work?
A government sets a cap on the amount of CO2 that can be emitted by an entity, it splits the cap into permits and either gives or sells these permits to firms. If a company doesn't use up all of it's allowance it can sell what it doesn't need. If it needs more permits it can buy them from those with spares. The cap and trade system is effective because it gives companies an incentive to innovate to get cleaner in favour of decarbonisation.
Solving the problem
Then, why are emissions still going up?. The main reason that is preventing the carbon market to succed is the low price of carbon, which is too low to incentivise companies and motivate change. If governments limit the number of permits, it would drive their price up. Another issue is that the fines for exceeding permitting levels of emissions are many times ineffectively low. For this, carbon markets need better regulation. Governments have to create the market, set the rules, enforce penalties, set a carbon cap and improve accountability.
The European Union is already working on setting a tax for imported goods to prevent carbon leakage, meaning that it wouldn't be any cheaper to import goods from a country that does not regulate carbon emissions.