How cap and trade works

Some of the best environmental policies harness the power of economics to achieve important goals.

Cap and trade is one example. It’s a system designed to reduce pollution in our atmosphere, including pollution that contributes to climate change:

• The cap is a limit on pollution. Usually, the cap gets stricter over time, with less and less pollution allowed.
   
• The trade part is a market where companies can buy and sell “allowances” that let them emit only a certain amount of pollution. With supply and demand setting the price for allowances, trading gives companies a strong incentive to save money by cutting emissions in the most cost-effective ways.

Many cap and trade programs also benefit communities in another way: Often, governments distribute allowances via auctions, raising revenues that can be invested in projects that reduce pollution, improve public health, strengthen the economy and more.

This form of cap and trade is sometimes called “cap and invest.”

Caps limit harmful pollution 

The government sets the cap across a given industry or set of industries. The government also decides the penalties for violations.

Pollution related to climate change is a common target of such caps. For example, in carbon markets that use cap and trade, the cap is an annual limit on emissions of greenhouse gases, such as carbon dioxide, that cause the planet to heat up, fueling climate change.

Other kinds of pollution can also be capped.

Learn about the pollution that’s causing climate change

Companies have incentives to cut pollution

The total amount of emissions allowed under the cap is split into permits called allowances, each permitting a company to emit a set amount of pollution, often 1 metric ton. (You’d have to drive a gasoline-powered vehicle about 2,500 miles, roughly the distance between New York City and Las Vegas, to emit that much CO2.)

The government distributes allowances to companies periodically, either for free or through an auction.

The cap — and the number of allowances distributed — typically declines over time. This provides a growing incentive for industry and businesses to reduce their emissions more efficiently, while keeping production costs down.

Trading can lead to cuts in pollution sooner

Companies that cut their pollution faster can sometimes “bank” unused allowances for future use, or sell them to companies that take longer to reduce their emissions.

For example, a power company that can close an aging coal plant and replace it with lower-cost renewable energy might do so and sell its unused emissions allowances. A steel plant that needs more time to make improvements might buy those allowances while it invests in cleaner ways to operate.

This market — the “trade” part of cap and trade — gives companies flexibility. It increases the pool of available capital to make reductions, encourages companies to cut pollution faster and rewards innovation. But no matter how much trade occurs, the cap is never exceeded.

In a well-designed cap-and-trade system, cutting pollution is good for business and can give companies a competitive edge.

Learn about the pollution that’s causing climate change

Cap and trade is lowering emissions globally

Ever wonder why you don’t hear about acid rain anymore? Thank cap and trade, which slashed levels of sulfur dioxide to solve the problem — at a fraction of the projected cost.

Today, governments are using this market-based approach to pursue goals for reducing greenhouse gas emissions.

The European Union’s Emissions Trading System uses cap and trade, for example, as do carbon markets in some U.S. states and Canadian provinces. 

We know that cap and trade works. In the U.S., California’s policies around climate change have led to a steady decline of the state’s carbon dioxide pollution while the state’s economy has thrived. The centerpiece is a cap and trade program that EDF helped design and implement.

Cap and trade is investing in communities

Many cap and trade programs, including California’s, are known as cap and invest programs, where auctions for emissions allowances raise funds for projects benefiting communities.

California’s program has invested billions of dollars in such projects in addition to helping the state reach its 2020 target for reducing emissions four years ahead of schedule.

Washington State has a cap and invest program, too, and revenue from that program has funded projects like energy bill rebates and home energy efficiency upgrades for low-income residents, clearing of brush to prevent wildfires, new electric ferries, expanded bike lanes around schools, and solar panels and battery storage for libraries, churches and schools.

Looking ahead, Washington State is taking steps to join California and the Canadian province of Quebec in a unified carbon market — a step toward cutting pollution even more efficiently and at a lower cost.