Participants are companies who are required to report their activities, such as importing fuel or manufacturing steel, and the emissions associated with them.
Fuel importers don't actually burn the fuel themselves, but if they import it, someone will use it and we can accurately predict the emissions.
These companies must match each unit of emissions they report with an allowance they surrender to the government or they face serious penalties.
People who plant forests can report the carbon dioxide they take out of the air. They claim allowances and can sell them.
As demand for allowances increases relative to supply, the allowance price goes up, creating a stronger incentive to reduce emissions.
This creates a trading market for allowances that generates the price on emissions and ensures total emissions are no greater than total allowances.
Participants in the ETS can choose to reduce their own emissions and their allowance obligation but often it's their customers who have opportunities to reduce emissions: for example supermarkets with fleets of trucks and commercial building managers.
Participants increase the prices of products associated with a lot of emissions so they can pay for the allowances and when these products are more expensive their customers try to buy less.
We are all affected, a little.
At the moment, there is a glut of allowances relative to demand.
However allowances can be saved for the future, supply is uncertain going forward and the price is around NZ$7.50 per tonne of carbon dioxide equivalent.
This is on the low end for systems internationally.
The price in the California system is around US$13.00.
A high emissions price makes it more expensive to use coal relative to alternatives to generate electricity; it makes cement and steel slightly more expensive, and inefficient cement and steel production processes more expensive still; it makes planting forests a little more profitable; it makes petrol a little more expensive. It makes investments in wind power and energy efficiency more attractive.
With a low price, the ETS has little effect on our decisions.
When the price is higher, it will help us all make the changes we need to make toward a low-emission economy and society.
Putting a price on emissions changes how companies and households assess the benefits of investments that reduce emissions and encourages them to do more.
The Kyoto Protocol is like an international ETS controlled by the United Nations - each country that participated had allowances equal to their agreed emissions target.
Developing countries were able to claim allowances if they invested in projects and reduced emissions.
Governments didn't trade much directly.
Some, including New Zealand, let their companies use allowances from other countries in their ETS.
Q. Over recent years there's been much criticism around the value of global carbon markets and whether they are actually working. What have been their weaknesses - and what do you feel is needed to make them work?
A. Although there are many popular criticisms of ETS, its use as a policy instrument is rapidly expanding around the world.
There are 17 different ETS systems, including the whole of the EU.
Many more places are considering ETS - Egypt, Taiwan, Alberta and Ontario have all made announcements in the last few weeks.
There are, however, two issues troubling some carbon markets: poor design and lack of political will.
Emissions trading, for climate change mitigation, is a new policy tool and we are still learning how best to do it.
Parts of New Zealand's system work well.
Our strong, simple monitoring and inclusion of forestry are internationally path breaking.
New Zealand's key weakness of design was to have no limit on our use of international units.
That was not a problem while Kyoto was operating and expected to strengthen - globally supply was initially less than demand - but we had no mechanism to respond when there was a global glut of Kyoto units.
This issue has now been fixed and our ETS no longer accepts international units.
We can now benefit from others' experience and strengthen our ETS.
The other key issue is that an emissions trading system is as strong as the political will behind it.
Global climate change is the ultimate "commons" problem.
We all want it to be solved, but few want to take responsibility to do so.
New Zealand is not the only country struggling to create meaningful action.
Changing to a different policy instrument won't make this fundamental challenge go away.
Q. The New Zealand ETS remains our main climate policy tool. But what weaknesses and short-comings do you see with the ETS itself? Do you feel it has been more a victim of weak policy choices that have surrounded it?
A. New Zealand needs to work with other countries to find a credible way to help reduce emissions in emerging and developing economies, in exchange for allowances that we can use alongside domestic action to help meet our national emission reduction commitment.
Existing mechanisms for international emissions trading are not functioning well and Paris will not solve that.
Climate change is a global issue and New Zealand has a lot to offer outside the country.
When New Zealand works with developing countries to help reduce their emissions, we'll be able to measure what is produced as a result.
Depending on international rules, we can expect to count those reductions when we report to other countries on how we are doing with our national emission reduction commitment.
However, other actions, that might be equally effective, will have unmeasurable effects.
We can only provide plausible evidence of those effects.
More generally, policy instability is a key concern.
Prices are always unpredictable and market players are used to that, but policy instability creates unnecessary risk that tends to deter investment.
Various options, from bipartisan political agreements to innovative policies such as the Afforestation Grant Scheme - where effectively the government takes out the carbon price risk by buying allowances up front - can reduce policy instability and its effects.
Other countries have learned a lot about this - we can learn from them.
In addition, we need to clarify New Zealand's strategic climate change objectives in the longer term, and define the role of the ETS in meeting those objectives.
An ETS depends on a limit on emissions over time - at the moment it's not clear what that limit is.
The Intergovernmental Panel on Climate Change (IPCC - a group that involves most of the world's climate change experts) has emphasised that globally we need to transition toward zero net emissions (so any emissions of gases like carbon dioxide that stay in the atmosphere for a really long time are matched by trees or other ways of taking carbon dioxide out of the air); otherwise the climate will keep on warming.
The speed with which we get to net zero will determine whether temperature rises remain below 2C.
New Zealand will need to join the rest of the world in de-carbonising its economy over time.
That means the ETS limit has to go toward zero over time.
We don't need to decide now how soon we will get to zero but we need to provide investors with some indication of how scarce allowances will be in the coming years.
Q. The Government is launching a review of the ETS. In your mind, what should we be doing immediately to improve its effectiveness?
A. In my opinion, the ETS first needs to cap the number of allowances that can be issued in the near term with indicative caps out into the future (for 10 years or more).
This would help define supply and allow market participants to make meaningful predictions of future prices.
Once the caps are clear, the ETS should begin to auction those allowances on a predictable schedule and decide how best to use the revenue those auctions will generate.
New Zealand also needs to establish effective mechanisms to manage prices.
We should consider recent international experience and particularly the approach taken in California where prices have been quite stable.
Although our earlier experience with international units scarred many, we do need to work with one or more potential 'seller' countries to create a credible mechanism for international emissions trading.
This could be bilateral or in collaboration with other countries that want to buy allowances.
The key element, however, is to put in place processes to gain cross-party support for a rising price on emissions in the long term and greater policy stability on emissions trading across election cycles.
This would need to be accepted and even encouraged by business and the New Zealand public.
Q. Do you feel there is an over-reliance on carbon trading when it comes to setting climate policy and goals - and do you see other effective approaches to mitigation that we're not pursuing enough presently?
A. New Zealand has been very focused on emissions trading and it is only part of an effective climate policy.
We need to focus on what is required to reduce our long-lived (carbon dioxide and nitrous oxide) gases to net zero in the medium term and identify the multitude of actions we can take now that will make that both possible and welfare improving.
No one knows the "correct" path.
The future world will be different in ways we cannot imagine.
We need to try many different things such as accelerating the adoption of electric vehicles, encouraging even more renewable energy, or investigating carbon storage.
Then we need to reflect on our experience, keep important options open, be willing to fail - and admit it, continually seek new opportunities, and keep moving forward.
Q. Climate Change Issues Minister Tim Groser has pointed out that we and other developed nations are effectively wasting our time if developing nations aren't also committed to emissions mitigation and reduction. Do you agree?
A. Climate change is a cumulative problem and higher temperatures are increasingly damaging.
We cannot reach the two-degree goal without action by every type of country.
In the lead-up to the Paris conference, we have seen pledges submitted by most developing countries which show their commitment to reducing emissions as part of their pathway to sustainable development.
Of course developing countries need to act.
Most emissions occur in developing countries and emissions everywhere need to be reduced.
However, if we, and other developed countries act, developing countries are more likely to make serious commitments and achieve them.
Our global contribution can be greater than our national emission reduction target.
One of New Zealand's greatest potential contributions comes because we are in many ways similar to a developing country.
Our emissions profile and electricity sector are very similar to those in Latin America for example.
We can share our knowledge, and potentially create commercial opportunities at the same time. Some of New Zealand's dairy farmers, like Leite Verde, are already doing that.
New Zealanders are good at innovating in policy.
Our current ETS has several good, innovative features.
Our "upstream" approach to ETS - regulating fuel suppliers, rather than energy users - is now incorporated in the systems of California and Quebec.
We have the lowest level of free allocation of allowances in the world.
Unlike ETS in other countries which issue all or most allowances for free, in New Zealand most allowances are bought by companies, not given out for free.
The ones we do give out now are targeted to reduce emissions leakage (shifting production and hence emissions to unregulated countries) and improve the environmental effectiveness of our system.
We're also alone in the world including forestry in our ETS - both credits and liabilities.
New Zealand's efforts on reducing fossil fuel subsidies, our collaboration with other countries through the Global Research Alliance on Agricultural Greenhouse Gases (an international research consortium initiated by New Zealand) and our domestic research on agricultural emissions are also potentially very smart effective contributions to global mitigation.
It's hard to measure the effects, but they could be huge.
Q. Through what existing mechanisms does New Zealand support developing nations in mitigation, and how might the global climate fund being negotiated at Paris enhance such efforts?
A. I'm not a big believer in centralised global climate funds.
They have their place and all cooperative efforts should be supported.
I don't think any of us know the right way to do this and we should try out many approaches.
However, only a limited amount of financial flows can be managed by centralised mechanisms, and those mechanisms are likely to be bureaucratic and risk being politicised.
In 2015, the New Zealand government pledged NZ$3 million to the Green Climate Fund.
It is also providing financial support for developing country mitigation through other channels, with a strategic focus on the Pacific.
I think New Zealand should again lead through innovation by designing new mechanisms to provide resources (financial and other) to a small number of developing countries we work with closely.
One of the huge challenges in funding developing country mitigation is that it is hard to know if emissions actually fall as a result of your effort.
Larger-scale efforts in one country are more likely to lead to measurable effects than many small efforts.
Emissions are also often better measured at an official national scale.
If we work with a developing country that has taken on its own reduction target already, and we only pay for reductions beyond that target, we can be more confident that we made a difference.
Q. After Paris, are we likely to see the formation of new trading "clubs" of nations or regions based on preferences for trading with countries that have set good climate targets?
A. I think emissions trading "clubs" are already forming.
There is one operating between California and Quebec for example, that Ontario is planning to join shortly.
I don't think they will limit trade in products (for quite a long time at least) if that is what you mean.
They will limit which allowances can be used within the club.
These are very like currency unions - you don't let just anyone print your money.
New Zealand needs to be part of a club that involves countries that want to sell units (and countries in which we would be happy to fund emission reductions).
We could create a new one.
Maybe we could make one in the Pacific with the French.
It would be best for the world if many different clubs develop.
Each club can then try out different approaches.
This is more likely to identify good ways of linking countries (and trading among countries) and less likely to cause problems on a global scale if things don't go well
Later we could link up the clubs - or simply coordinate prices among them.
Q. Further, might we see countries with weak commitments becoming less attractive trading partners?
A. I'm not sure I understand this question. Trading what? We interpreted the previous one as emissions trading.
If you mean trading of other goods and services, it's probably too early and too speculative to say what will happen as some countries take strong action and others lag.
It's not yet clear who the leaders are and how increasingly informed and engaged consumers will respond.
We all need to do more.
Q. How vital do you feel this Paris conference is to securing meaningful and lasting emissions reduction commitments? And if it fails, would you expect the world to find another way?
A. Paris is another step along a long path. If the meeting there can create a common framework for action by both developed and developing countries, give stronger backing to the mitigation contributions that countries are planning to make, create stronger monitoring and reporting mechanisms so we can all see what each country is doing, and create a process to keep cooperation and mitigation ambition growing, it will be a success.
International agreements can be useful enablers of ambition and cooperation, but if countries want to do more, then international agreements needn't stand in their way.
If the Paris conference 'fails' to deliver a positive outcome, we will keep trying - the problem isn't going away.
The stakes of inaction are too high.
