Understanding Cap and Trade: How Emissions Trading Protects the Climate
A comprehensive guide to how cap-and-trade systems function, impact greenhouse gas emissions, and shape climate policy worldwide.
What Is Cap and Trade?
Cap and trade is a market-based policy tool designed to reduce greenhouse gas (GHG) emissions by setting an upper limit—or cap—on total emissions and allowing regulated entities to buy and sell emission permits within that cap.
This system is widely recognized as a cost-effective and flexible approach to tackling climate change, providing economic incentives for industries to lower their emissions.
How Does Cap and Trade Work?
The core mechanism of a cap-and-trade program involves several key steps:
- Setting a cap: The governing body sets a firm upper limit on total emissions (usually measured in tons of CO2 or CO2-equivalents) that participating sectors or regions can emit over a given period.
- Issuing allowances: Emission permits (allowances) are distributed or auctioned. Each permit typically grants the right to emit one ton of greenhouse gases.
- Trading: Entities that reduce their emissions below their allowance can sell excess permits to others who exceed their limits, thus creating a carbon market.
- Enforcing compliance: At the end of each compliance period, regulated entities must surrender allowances equivalent to their verified emissions. Penalties apply for non-compliance.
This market system encourages the most cost-effective emission reductions across the economy. Companies that can lower emissions cheaply do so and sell their extra permits, while others buy permits when it is more expensive to cut their own emissions.
Cap-and-Trade vs. Carbon Tax
| Aspect | Cap and Trade | Carbon Tax |
|---|---|---|
| Emission Certainty | Yes (fixed total emissions) | No (uncertain, depends on economic response) |
| Price Certainty | No (allowance price can fluctuate) | Yes (fixed tax rate per ton) |
| Market Mechanism | Yes (trading allowances) | No (no trading, just a tax per unit emitted) |
| Flexibility for Companies | High | Moderate |
Key Components of Cap and Trade
- The Cap: Defines the total allowable emissions. This limit usually decreases each year, ensuring emissions decline over time.
- Allowances: Tradable permits representing the right to emit a specific amount (typically one metric tone) of greenhouse gases.
- Trading Market: Entities may buy or sell extra allowances as needed, promoting cost-effective emission reductions across the system.
- Compliance Period: At the end of each period, each emitter must surrender enough allowances to cover its actual emissions.
- Regulated Sectors: Usually includes major emitters like power plants, heavy industry, and refineries. Most programs start with carbon dioxide but can also include methane, nitrous oxide, and synthetic gases.
How Are Allowances Distributed?
Allowances can be allocated for free (often based on past emissions, output, or efficiency benchmarks) or auctioned to the highest bidder. The choice affects program revenue and distributional impacts:
- Free allocation: Often used to ease the transition for energy-intensive industries or protect against economic shocks.
- Auctioning: Generates significant revenue, which can fund renewable energy, climate initiatives, or help offset costs to consumers.
Examples of Cap-and-Trade Programs Worldwide
European Union Emissions Trading System (EU ETS)
The EU ETS is the world’s largest and most established cap-and-trade program, covering over 10,000 power plants and industrial facilities across 27 EU countries. It sets a declining cap and allows the trading of allowances across participating nations.
What others are reading
California Cap-and-Trade Program
California’s market covers about 85% of the state’s total greenhouse gas emissions, with a cap that declines every year. About 450 businesses must comply; the program uses auction revenue for further climate action and aims for steady, legally binding emissions reductions.
Regional Greenhouse Gas Initiative (RGGI)
RGGI is a cooperative effort among several Northeastern and Mid-Atlantic U.S. states focused on reducing carbon dioxide emissions from power plants. Proceeds from allowance auctions are invested in energy efficiency, renewable energy, and consumer benefit programs.
Other Notable Systems
- Canada’s federal backstop program and provincial systems (Quebec and Ontario).
- China’s national Emissions Trading System—now the world’s largest in terms of covered emissions.
- South Korea’s national ETS.
- Programs in New Zealand, Switzerland, and other nations.
Benefits of Cap and Trade
- Certainty of Emissions Reductions: The cap ensures emissions do not exceed predetermined targets, providing a clear path to climate goals.
- Market Efficiency: By allowing trading, the system finds the lowest-cost emissions reductions first, saving money compared to command-and-control regulation.
- Encourages Innovation: Companies have financial motivation to develop cost-effective technologies and processes, driving progress in clean energy and efficiency.
- Revenue Generation: Auctioning allowances provides funds that governments can reinvest in climate action, new technology, or economic transition efforts.
- Flexibility for Emitters: Entities choose how they comply—by reducing their own emissions, buying allowances, or investing in offsets.
Challenges and Controversies
- Permit Allocation: The method of distributing allowances (free allocation vs. auction) can spark debate about fairness, effectiveness, and market impacts.
- Market Manipulation and Volatility: Prices for permits can be unpredictable, and poorly designed markets may be vulnerable to fraud or speculation if not adequately regulated.
- Carbon Leakage: Companies might relocate operations to countries with weaker climate policies, undermining climate progress.
- Environmental Justice: Some critics argue cap and trade does not directly address disproportionate pollution burdens on low-income or marginalized communities.
- Complexity: Cap-and-trade systems can be complex to design, monitor, and enforce compared to more straightforward policies like carbon taxes.
Cap and Trade vs. Carbon Offsets
Cap-and-trade systems may allow emitters to use offsets — verified emissions reductions achieved outside the cap’s coverage area (for example, through reforestation, methane capture, or clean energy investments). Limits are typically set to ensure that offsets do not undermine the overall integrity of the emissions cap.
Effectiveness and Impact
Cap-and-trade programs, where well designed and enforced, have demonstrated their potential to reduce emissions efficiently and cost-effectively. Real-world results include:
- EU ETS: A significant, steady decline in covered emissions since inception, though early overallocation and price volatility prompted reforms.
- California: Achieved targets ahead of schedule and generated billions in revenue for state climate efforts.
- RGGI: Substantial regional reductions in power sector carbon emissions, while supporting energy transition policies.
However, the design details—including ambition of the cap, allowance allocation, and compliance rules—are crucial. Programs with weak caps or excess allowances can see underwhelming emission cuts.
Cap-and-Trade in Practice: A Simple Example
Consider two companies within a sector subject to a cap-and-trade program:
- Company A finds it inexpensive to reduce emissions and lowers its emissions below its cap, ending up with unused permits.
- Company B faces high costs for emissions reductions and so chooses to purchase extra permits from Company A instead of making expensive operational changes.
This transaction ensures the same total emissions but at a lower cost to the entire economy. The carbon market matches the supply and demand for emissions reductions most efficiently.
Future Directions: Linking and Globalization
Interest is growing in linking different cap-and-trade programs to form larger, interconnected carbon markets. Benefits include higher market liquidity, broader coverage, and potential for greater emission reductions at lower overall cost. For example, California has linked its system with Quebec, and discussions about international linkages continue as part of UN climate negotiations.
Frequently Asked Questions (FAQs)
What is the difference between cap-and-trade and a carbon tax?
Cap-and-trade sets a limit on total emissions and allows trading of permits, guaranteeing specific emission reductions but leaving permit prices subject to market forces. A carbon tax imposes a fixed price per ton of emissions, which provides price certainty but does not guarantee a fixed level of emission reductions.
Why do some companies get free allowances?
Free allowances are often given to industries facing international competition or high compliance costs, to prevent economic disruption and carbon leakage (the relocation of industry to jurisdictions with laxer climate policies). However, the trend is toward increasing auctioning over time.
Can cap-and-trade address climate change on its own?
Cap-and-trade is a powerful tool but is most effective as part of a larger suite of climate policies, including regulations, incentives for renewables, and support for green innovation.
How does cap-and-trade help drive down emissions cost-effectively?
By setting a market price on carbon and enabling trading, the system ensures the cheapest emission reductions are made first, minimizing the overall cost of meeting climate goals.
Do cap-and-trade systems have social or environmental justice impacts?
Critics argue that trading can lead to pollution hotspots where companies buy allowances instead of reducing emissions locally. Well-designed programs aim to address this error by supplementing cap-and-trade with targeted policies in overburdened communities.
References
- https://www.youtube.com/watch?v=bxs6ZrxLvHg
- https://www.lse.ac.uk/granthaminstitute/explainers/how-do-emissions-trading-systems-work/
- https://unfccc.int/policy/cap-and-trade-programme
- https://www.law.berkeley.edu/wp-content/uploads/2019/12/Fact-Sheet-Cap-and-Trade.pdf
- https://www.c2es.org/content/cap-and-trade-basics/
- https://www.edf.org/climate/how-cap-and-trade-works
- https://ww2.arb.ca.gov/our-work/programs/cap-and-trade-program
- https://ww2.arb.ca.gov/our-work/programs/cap-and-trade-program/about
Similar Articles
Read full bio of medha deb
