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There are a variety of policy tools to reduce the greenhouse gas emissions responsible for climate change. This installment of the Climate Change 101 series explains how a cap-and-trade program sets a clear limit on greenhouse gas emissions and minimizes the costs of achieving this target. By creating a market, and a price, for emission reductions, cap and trade offers an environmentally effective and economically efficient response to climate change.

This brief is part of a series called Climate Change 101: Understanding and Responding to Global Climate Change, published by the Pew Center on Global Climate Change and the Pew Center on the States.

What is “Cap and Trade”?
Policymakers have many options as they consider how to achieve greenhouse gas (GHG) reductions, but two approaches are most prominent: traditional command-and-control regulation, in which regulatory authorities direct how emissions limits will be achieved, and market-based approaches, which harness the forces of supply and demand to change behavior and achieve environmental goals. One proven market-based approach is cap and trade.

In a cap-and-trade program, the government determines which facilities or emissions are covered by the program and sets an overall emission target, or “cap,” for covered entities.
This cap is the sum of all allowed emissions from all included facilities.

Once the cap has been set and covered entities specified, tradable emissions allowances (rights to emit) are distributed (either auctioned, or freely allocated, or some combination of these). Each allowance authorizes the release of a specified amount of greenhouse gas emissions, generally one ton of carbon dioxide equivalent (CO2e).1 The total number of allowances is equivalent to the overall emissions cap (e.g., if a cap of one million tons of emissions is set, one million one-ton allowances will be issued). Covered entities must submit allowances equivalent to the level of emissions for which they are responsible at the end of each of the program’s compliance periods.

Alternatively, the government could establish a cap-and-trade system, setting an overall emissions cap of 600 tons and then issuing 600 emissions allowances. If allowances were evenly distributed, both emitters would have an incentive to trade because emissions reduction costs are higher for A than for B. Emitter B might cut emissions by 200 tons and sell its excess allowances to Emitter A for less than it would have cost Emitter A to make the reductions itself (for example, $2,500 for 100 allowances). In this scenario, the desired level of emissions is reached at a lower total cost of $4,500 and a lower cost per ton of $15. The total cost is lower, as is the cost for each regulated facility.
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Other sections:
Driving Innovation
Cap and Trade Market Design
Cost Containment Mechanisms
Allowance Distribution
Tax or Trade?
Greenhouse Gas Trading in Practice
The Benefits of Cap and Trade
Cap and Trade Key Terms Glossary

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The Pew Center on Global Climate Change is a non-profit, non-partisan, independent organization dedicated to providing credible information, straight answers, and innovative solutions in the effort to address global climate change.
http://www.pewclimate.org/docUploads/Cap&Trade.pdf