Carbon markets could play a crucial role in delivering promises made at the Paris climate conference.

The idea behind carbon markets is simple. A government issues a limited number of permits, which companies can then trade in return for the right to emit a certain amount of the pollutant. As companies scramble to obtain these permits in the carbon market, the price adjusts. High demand for permits will drive up price, and vice versa. Carbon is measured by the tonne emitted and, crucially, all companies within a particular country face the same price.

Carbon markets are already in use in Europe, Korea, seven Chinese provinces and cities, and several US states among other places. More are in the pipeline with China, the world’s largest emitter, planning to start a national market in 2017.

Yet most existing markets operate independently of each other. European permits cannot be used in the US, and Korean companies cannot trade emissions with firms in China. This is a missed opportunity. If companies in different markets were able to trade, they could make savings every time the price of permits varied across markets.

Enter carbon dating

This sort of linkage between markets has quietly been receiving increased attention. Prior to the UN summit in Paris last December, the G7 group of countries launched the Carbon Market Platform. The Paris Agreement itself contains important provisions for the use of linked markets.

We recently analysed the potential cost savings when previously isolated markets are linked. Our study examined how four key factors determine whether linking carbon markets, what we call carbon dating, is worth it.

So, what does make a good carbon date?

Opposites attract

Carbon markets will experience ups and downs due to booms and recessions, say, or weather fluctuations that affect demand for permits.

We found that opposites attract. A country prefers the demand in its partner’s market to be more variable (it changes over time) and inversely related to its own (my demand is up when yours is down). This makes the gains from trading larger.

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