Governments cannot leave it to the companies to control their emissions as companies don’t have incentives to control their pollutants. Cap and trade is a regulatory system that is meant to reduce certain kinds of emissions and pollution and to provide companies with a profit incentive to reduce their pollution levels faster than their peers. The approach first sets an overall cap, or maximum amount of emissions per compliance period, for all sources under the program (across the industry). The cap is chosen in order to achieve a desired environmental effect. Authorizations to emit in the form of emission allowances are then allocated to affected sources, and the total number of allowances cannot exceed the cap.
How does it work?
- Producers need a permit for every unit of production
- Cap is equal to the total number of permits in the market
- Permits are tradable (market price)
- Leads to known quantity of pollution, unknown price
Cap and Trade has been very successful to reduce emissions overall at a regional and global level. While achieving significant reductions on a regional scale, cap and trade programs can deliver substantial air quality improvements. However, they may not be the solution to every problem. For example, eliminating localized concentrations of pollution is not their primary purpose. The cap and trade approach is best used when:
• the environmental and/or public health concern occurs over a relatively large area;
• a significant number of sources are responsible for the problem;
• the cost of controls varies from source to source; and
• emissions can be consistently and accurately measured.
A good cap and trade program has to include: an effective cap on emissions, accurate way of measuring the emissions without any ambiguity, and simplicity in operations. Markets function better and transaction costs are lower when rules are simple and easily understood by all participants, leading to effective implementation of such programs.