Emissions trading, sometimes referred to as “cap and trade” or “allowance trading,” is an approach to reducing pollution that has been used successfully to protect human health and the environment. Emissions trading programs have two key components: a limit (or cap) on pollution, and tradable allowances equal to the limit that authorize allowance holders to emit a specific quantity (e.g., one ton) of the pollutant. This limit ensures that the environmental goal is met and the tradable allowances provide flexibility for individual emissions sources to set their own compliance path. Because allowances can be bought and sold in an allowance market, these programs are often referred to as “market-based.”
Firms that expect not to have enough permits must either cut back on their emissions or buy permits from another firm. For a given permit price, some firms will find it easier, or cheaper, to reduce emissions than others and will sell permits. If there are too many such firms in the market, the price of permits, the total number of which is set in advance by the cap, will decline, inducing some firms to reduce their emissions reduction efforts. Only when the price of permits is just right will the number of permits offered for sale by firms that can reduce emissions at low cost be equal to the number of permits demanded by firms for which emissions reductions are costly. This process of trading ensures there is a unique price for all firms coordinating their activities and drives down emissions to the level allowed under the cap cost-effectively.
Of course, there is no reason to expect that a permit price that clears the market at a point in time will continue to do so in the future. As economic conditions and emitting firms’ circumstances change, permit prices will fluctuate, becoming more expensive when demand is high relative to supply (for example when the economy is growing robustly) and cheaper when demand is lower (for example when ample renewable electricity reduces the requirement for thermal generation firms).
