Many people consider a cap and trade system to be the most palatable option when it comes to reducing pollution and greenhouse gas emissions. Major economies such as the United States, European Union, Canada, Australia, and Japan have all implemented cap and trade on some level.

What a cap and trade system is

Cap and trade, or emissions trading, is a policy tool that provides economic incentives for meeting emission targets. Typically, cap and trade system follows this general format:

  • The regulating authority (eg. city/state/federal government) sets an aggregate emission cap per year which can decrease over time.
  • The regulated parties (eg. power plants, oil producers, or even individual households) have to obtain allowances for emissions they generate in a particular year.
  • Emission allowances, adding up to the total cap, are allocated to each party. This allocation could be based on historical emissions and/or via an auction.
  • Parties can trade allowances. An effective “carbon tax” then emerges as the market price at which these carbon allowances trade.

Downsides to a cap and trade system

The main concerns surrounding cap and trade programs come from the uncertainty of policy implementation. Some examples of contentious points with existing programs are:

  • Major polluters getting free emission permits in order to “grandfather in” their existing emissions. These free permits may give the organizations unfair advantages over the competition.
  • Regulators run the risk of issuing too many emission credits. This would result in low prices on GHG emissions over the limit, and may reduce the incentive for companies to cut back on their emissions.
  • Local cap and trade regulations may put domestic companies at a disadvantage if their international competitors are not subject to the same regulations.

Despite some downsides, cap and trade programs are an important policy tool to help reduce both pollution and greenhouse gas emissions.