A cap-and-trade system is a market-based mechanism that uses market principles to achieve emissions reduction. A core component of a greenhouse gas cap-and-trade program is that an emitter must turn in one “allowance” for every metric ton of carbon dioxide equivalent (CO2e) that they emit.

The government(s) running the cap-and-trade program sets an absolute limit, or cap, on the amount of greenhouse gas emissions, and issues a limited number of allowances which total the cap and represent the right to emit a specific amount.  These allowances are tradable and fungible across emitters and jurisdictions. In this way, individual emitters do not have a limit on emissions, but the system as a whole has restricted supply of allowances to cover emissions. These allowances can be distributed by auction, free allocation, or a combination of the two.  The government specifies which entities or facilities must surrender allowances to cover their emissions at the end of a pre-determined period of time, which is called the “compliance period.”

Emitters have the choice to reduce emissions, and can transfer, or trade, allowances, to emitters who need more their emission allowances.  These decisions depend upon the cost to reduce emissions and other factors.  The price of allowances efficiently informs consumption and investment decisions.  For some participants, implementing new, low-emitting technologies may be relatively inexpensive. Those participants will buy fewer allowances or sell surplus allowances to participants that face higher emission control costs. A participant will choose to buy more allowances when the cost of an allowance is lower than the cost of reducing its emissions. By giving participants a financial incentive to control emissions and the flexibility to determine how and when emissions will be reduced, the capped level of emissions is achieved in a manner that minimizes the cost of emissions reductions. 

Role of the Market

The role of the market is to aggregate and communicate information. Information about price, trade volume, and current bids and offers help market participants and observers minimize trade cost and uncertainty about market activity. The use of a market minimizes the aggregate cost of reducing greenhouse gas emissions for the emitters included in the program.

Benefits 

Cap-and-trade programs may also cost governments less to implement than command-and control programs in which governments specify various performance, operational, or emission requirements based upon technology. The state or province needs only (1) to ensure that covered sources accurately report their emissions and, at the end of each compliance period, surrender a number of allowances equal to their emissions; and (2) to provide some market oversight to ensure fair competition.

When designed properly, cap-and-trade programs can be particularly useful in the effort to address climate change and can aid more traditional policies in achieving emissions reductions. Greenhouse gas emissions come from many different kinds of sources with widely varying options for achieving emission reductions, affording numerous opportunities for mutually advantageous trading. Also, the location of a given emissions reduction does not matter with respect to climate change. A GHG cap-and-trade program is environmentally effective because a ton of carbon dioxide (CO2) or other greenhouse gas emitted from one source has the same global warming effect as a ton emitted from any other.

Emissions trading programs have been successfully implemented in the United States and other countries to control other types of emissions, such as acid rain pollutants like sulfur dioxide (SO2), in an environmentally sound, cost-effective manner. Estimated savings for Phases I and II of the Acid Rain Program were more than $1 billion in 1995 dollars. The cost savings estimated in comparison to command-and-control approaches were estimated to be about 44-55 percent of the total compliance costs.