How Cap and Trade Works

Posted: 30-Jan-2009; Updated: 28-May-2009

Cap and trade is the most environmentally and economically sensible approach to controlling greenhouse gas emissions, the primary driver of global warming. It's the policy solution rooted in the four principles of effective climate policy.

The "cap" sets a nationwide limit on emissions, which is lowered over time to reduce the amount of pollutants released into the atmosphere. The "trade" creates a market for carbon allowances, helping companies innovate in order meet, or come in under, their allocated limit. The less they emit, the less they pay, so it is in their economic incentive to pollute less.

The cap: The only certain way to limit pollution

A cap sets a maximum allowable level of pollution nationwide and penalizes companies that exceed their emission allowance. No other system can guarantee to lower emissions.

The cap is a limit on the amount of pollution that can be released nationally, measured in billions of tons of carbon dioxide (or equivalent) per year. It is set based on science.
It covers all major sources of pollution. The cap should limit emissions economy-wide, covering electric power generation, natural gas, transportation, and large manufacturers -- adding up to around 85 percent of total emissions.
Emitters can release only limited pollution. Permits or "allowances" are distributed or auctioned to polluting entities: one allowance per ton of carbon dioxide, or CO₂ equivalent heat-trapping gases. The total amount of allowances will be equal to the cap. A company or utility may only emit as much carbon as it has allowances for.
Industry can plan ahead. Each year, the cap is ratcheted down on a gradual and predictable schedule. Companies can plan well in advance to be allowed fewer and fewer permits – less global warming pollution – each year.

Trading: Leads to investment and innovation

Some companies will find it easy to reduce their pollution to match their number of permits; others may find it more difficult. Trading lets companies buy and sell allowances, leading to more cost-effective pollution cuts, and incentive to invest in cleaner technology.

Unlike with some pollutants, all CO₂ goes into the upper atmosphere and has a global — not local — effect. So it doesn't matter whether the factory making the emission cuts is in Boston, Baton Rouge, or Berlin, it reduces global emissions.

Companies can turn pollution cuts into revenue. If a company is able to cut its pollution easily and cheaply, it can end up with extra allowances. It can then sell its extra allowances to other companies. This provides a powerful incentive for creativity, energy conservation and investment -- companies can turn pollution cuts into dollars.
The option to buy allowances gives companies flexibility. On the other hand, some companies might have trouble reducing their emissions, or want to make longer-term investments instead of quick changes. Trading allowances gives these companies another option for how to meet each year's cap.
The same amount of pollution cuts are achieved. While companies may exchange allowances with each other, the total number of allowances remains the same. Nationally, the hard limit on pollution is still met every year.

Learn more about this concept from Cap and Trade 101 [PDF].

Americans Tired of Volatile Gas Prices Explain Cap and Trade

Last fall, Environmental Defense Action Fund held an online video competition challenging Americans to explain how a carbon cap would end our addiction to oil.

See how our top 5 finalists (Scott from Iowa, Susan from California, Leah from Chicago, Devon from Nashville, and John from Miami) explain a carbon cap in their own words.

Example of results: Cutting acid rain, cheaply

Cap and trade succeeded in rapidly reducing acid rain-causing pollution in the United States. As part of the Clean Air Act Amendments of 1990, Congress and President George H.W. Bush introduced a cap and trade proposal to reduce sulfur dioxide (SO2), the major precursor of acid rain.

The program has yielded a compliance rate of over 99 percent, as well as impressive environmental and economic results.
The long-term reduction targets were achieved three years ahead of schedule.
These targets were achieved at a fraction of the predicted cost. On the eve of legislation, the EPA estimated that the program would cost $6 billion annually once it was fully implemented (in 2000 dollars). The Office of Management and Budget has estimated actual costs to be $1.1 to $1.8 billion -- less than 30 percent of the forecast.

See more details of this cap and trade success story and discover the practical lessons learned from the EU's carbon market [PDF].