Over the past three years carbon trading has emerged as one of the most important weapons in the fight against climate change, with politicians and business leaders of all stripes singing its praises.

The principle behind the idea is simple: make firms pay for their carbon emissions and they will, for the first time ever, have a financial incentive to cut carbon emissions.

But how do the various carbon trading schemes that have emerged work and how are they having an impact on UK firms? BusinessGreen.com offers a quick guide to the three most significant schemes to affect UK businesses: The EU emissions trading scheme, the UK's carbon reduction commitment and the UN's clean development mechanism.

EU Emissions Trading Scheme

The EU Emissions Trading Scheme (ETS) is the first international trading scheme, and is widely regarded as crucial to help tackle climate change, both by providing a financial mechanism to help reduce Europe's emissions and a basis for an eventual global scheme.

It is designed to set a cap on emissions and allow businesses to buy or sell from each other the right to emit the gases that cause global warning. Firms exceeding their emissions cap have to buy extra credits to cover the excess, providing an incentive for them to come in under the capped level, while those that do not use up all their allowances can sell them, providing the least-polluting firms in the scheme with an extra revenue stream and an incentive to deliver deeper cuts.

The first phase of the scheme ran from the beginning of 2005 to the end of 2007. It was widely considered a failure because over-allocation of free allowances led to a huge price crash in 2006. It also emerged that some companies had made millions from the scheme by selling off the credits that they were freely allocated while delivering minimal cuts in emissions.

The second phase of the scheme launched at the start of this year. It will run until 2012 and more controlled allocation of allowances has led to a more stable price so far of between €20 (£16) and €30 (£24) per tonne.

From 2013, the third phase will begin. The proposals for the third phase are under review by EU member states, but they are expected to result in a significant reduction in the amount firms can pollute, an extension of the scheme to include more industries including aviation, and a huge increase in the proportion of credits that are auctioned to firms as opposed to allocated for free.

This is when the scheme will start to have a real effect, according to Sir Nicholas Stern, the economist behind the influential Stern report on the economic case for curbing emissions.

"Emissions trading is a powerful way of establishing co-operation across borders," he said recently. "The Emissions Trading Scheme is leading the way. Beyond 2012 there is an opportunity for it to be ambitious, long term, and open to trade with other countries and regions."

So what does the EU ETS mean for your business?

For businesses that are already involved in the scheme, much will stay the same in phase III.

The EU ETS is aimed at the 10,000 or so energy companies and heavy polluters across Europe that produce 50 per cent of the continent's emissions.

However some businesses not involved in phase II may be included in phase III under draft proposals, most notably airlines, although the aviation industry is heavily contesting this idea. It is also proposed that maritime emissions may be included, as well as companies that produce metals and alloys, aluminium, gypsum and various chemicals not included in phase II.

A significant change in phase III will see about three quarters of emissions allowances auctioned, rather than the 10 per cent allowed in phase II – meaning significantly higher costs for those businesses involved.

The EU ETS in the UK is policed by the Environment Agency, which will contact businesses likely to be involved directly. It issues permits which require a business to monitor and report emissions in accordance with the European Commission's guidelines.

Each year emissions data must be verified, and the equivalent number of allowances surrendered. All transactions and surrendering of allowances take place on a national registry.

Carbon Reduction Commitment

Those less carbon-intensive UK businesses that think that carbon trading is the sole preserve of the large polluters included in the ETS could be in for a nasty surprise with the introduction from 2010 of a smaller scale cap-and-trade scheme known as the Carbon Reduction Commitment (CRC).

If your company has at least one meter settled on the half-hourly energy market and its total half-hourly metered electricity use is greater than 6,000 megawatt-hours (MWh), it will be obligatory to be involved.

If it is unclear whether this includes your firm or not, a more general guideline is that those businesses which spend more than £500,000 a year on electricity are likely to be covered by the CRC. Schools, hospitals and other public sector bodies will also be included in the scheme.

"This scheme puts a limit on the level of emissions for an entire organisation, excluding transport," explains Thomas Counsell, strategy associate with the Carbon Trust. "Organisations will be able to buy emissions permits from auctions, on a secondary market or out of the EU ETS."

Participants will also be required to submit annual data statements via an online registry to the Environment Agency, which will also audit the scheme.

The aim is for a lighter touch than the EU ETS, relying on self-certi fication of emissions – with intermittent checks – rather than the third-party verification required at the higher level.

Clean Development Mechanism

But what about those smaller firms that are not covered by either the ETS or CDM?

Currently, they are under no obligation to take part in carbon trading schemes, but they can still choose to buy in carbon credits to offset their emissions, either from offset providers operating in the so-called voluntary market or through the UN's Clean Development Mechanism.

The CDM allows companies to fund projects that help to reduce emissions in countries without a Kyoto target. It works by issuing these projects with Certified Emissions Reductions certificates for every tonne of carbon they stop from being emitted into the atmosphere, which they can sell to western governments and companies.

Similarly, smaller companies can also buy ETS credits, a move that in theory creates a shortage of credits and helps drive up the price of carbon for polluters, providing them with a clear incentive to cut emissions.

These links between the different schemes are designed to help establish greater liquidity in the market and lay the groundwork for a genuinely global scheme. At which point we can only hope the carbon market will get a whole lot simpler.