Cap and Trade Definition (2023)

What Is Cap and Trade?

Cap and trade is a common term for a government regulatory program designed to limit, or cap, the total level of emissions of certain chemicals, particularly carbon dioxide, as a result of industrial activity.

Proponents of cap and trade argue that it is a palatable alternative to acarbon tax. Both measures are attempts to reduce environmental damage without causing undue economic hardship to the industry.

Key Takeaways

  • Cap-and-trade energy programs are intended to gradually reduce pollution by giving companies an incentive to invest in clean alternatives.
  • The government issues a set amount of permits to companies that comprise a cap on allowed carbon dioxide emissions.
  • Companies that surpass the cap are taxed, while companies that cut their emissions may sell or trade unused credits.
  • The total limit (or cap) on pollution credits declines over time, giving corporations an incentive to find cheaper alternatives.
  • Critics say that caps could be set too high and give companies an excuse to avoid investing in cleaner alternatives for too long.

Understanding Cap and Trade

A cap and trade program can work in a number of ways, but here are the basics. The government sets the limit, or "cap" on emissions permitted across a given industry. It issues a limited number of annual permits that allow companies to emit a certain amount of carbon dioxide and related pollutants that drive global warming. Other pollutants that contribute to smog can also be capped.

The total amount of the cap is split into allowances. Each allowance permits a company to emit one ton of emissions. The government distributes the allowances to the companies, either for free or through an auction.

But the government lowers the number of permits each year, thereby lowering the total emissions cap. That makes the permits more expensive. Over time, companies have an incentive to reduce their emissions more efficiently and invest in clean technology as it becomes cheaper than buying permits.

Companies are taxed if they produce a higher level of emissions than their permits allow. They may even be penalized for a violation. On the other hand, companies that reduce their emissions can sell allowances ("trade" them) to other companies that pollute more. They can also bank them for future use.

Advantages and Disadvantages of Cap and Trade


The cap and trade system is sometimes described as a market system. That is, it creates an exchange value for emissions. Since companies that have emissions credits can sell them for extra profit, this creates a new economic resource for industries.

Its proponents argue that a cap and trade program offers an incentive for companies to invest in cleaner technologies in order to avoid buying permits that will increase in cost every year. It also motivates companies to fund research into alternative energy resources.

This process may lead to faster cuts in pollution, since companies that cut their emission levels faster are somehow rewarded as can then sell their allowance to other companies.

(Video) Carbon pricing: how does a cap-and-trade system work?

Because the government can decide to auction emissions credits to the highest bidder, cap and trade is also a revenue source for the government, since it has the power to auction emissions credits to the highest bidder. This new revenue can cover infrastructure needs, social programs, be invested in cleaner technologies, or it can even be a way to solve a budget deficit at the state or national level.

As a free trade system, cap and trade gives consumers more choices as well. Consumers can choose not to purchase from companies that are out of compliance, and do business with those that are trying to reduce their pollution levels.

Finally, the cap and trade system also has benefits for the taxpayers. The government sells emission credits to businesses that need them. The income generated helps to supplement the resources that taxpayers are providing the government.


Opponents of cap and trade argue that it could lead to an overproduction of pollutants up to the maximum levels set by the government each year, since allowable levels may be set too generously, actually slowing the move to cleaner energy.

Also, emissions credits (and even penalties and fines for exceeding the cap limit) are usually cheaper than converting to cleaner technologies and resources. This is the case, for example, for industries that use fossil fuels. This means that cap and trade is not a real incentive for those industries to change their practices.

It's also argued that the "trade" mechanism is not always followed. Some credits are sold at auctions to the highest bidder, or even given away. This means it costs a company nothing to increase its emissions.

Most industries don’t have devices that help monitor and determine their amount of emissions. This makes it relatively easy for businesses to cheat on their emissions reports. For the cap trade system to be effective, monitoring systems must be implemented so that enforcement can take place.

Since renewable energy resources are still relatively new, they are also expensive. Products sold by companies that conform to the cap rules tend to be more costly to produce, affecting what consumers pay for them.

Finally, each country has different standards and maximum caps for emissions. Some may be very lenient and permit higher levels of pollution, while others may be very strict. Unless a global cap and trade system is established, it won't be effective globally and there may be little impact on the number of emissions spilled out into the atmosphere every year.


(Video) Compliance carbon markets: Definition, Trading systems (Cap and Trade, Baseline and Credit), Size

  • Income source for companies

  • Promotes cleaner technologies

  • Leads to faster cuts in pollution

  • Source of revenue for the government

  • Suplements taxpayers resources

  • Gives consumers the power to decide


  • Allowed emissions levels are set too high

  • Credits and penalties and are cheaper than converting to cleaner technologies

  • Some credits are given away

  • Companies can cheat the system

  • It increases the prices for goods and services

    (Video) Environmental Economics - Cap and Trade

  • There is no global consistency in the system

Sources: Brandon Gaille,

Challenges for Cap and Trade

One challenge in establishing a cap and trade policy is the ability of governments to impose the correct cap on the producers of emissions. A cap that is too high may lead to even higher emissions, while a cap that is too low would be seen as a burden on the industry and a cost that would be passed on to consumers.

There is also an overall lack of reliable data on emissions. The estimates for past and current emissions, as well as predictions for future emissions, vary widely among industries. A cap and trade system may be useless until accurate information on emissions is available, which involves a costly process and can take years to complete.

Apart from the lack of reliable emission data, there are also many methodological challenges when it comes to applying an effective cap and trade system: the difficulty to achieve an international consensus on emissions and caps since each country has different priorities, or the high transaction and administrative costs involved, among others.

Finally, predicting the long-term effects and benefits of cape and trade initiatives is also a great challenge.

Although cap and trade systems reduce emissions and can lead to faster cuts in pollution, they also tend to increase the price of oil, coal, and natural gas in an effort to force companies to switch to alternative forms of energy. These initiatives are expensive and impact negatively the economy.

Cap and Trade Examples

In 2005, the European Union (EU) created the world's first international cap and trade program with the goal of reducing carbon emissions. In 2019, the EU estimated that there would be a 21% reduction in emissions from sectors covered by the system by 2020.

During the administration of U.S. President Barack Obama, a clean energy bill that included a cap and trade program was introduced in Congress. It was eventually approved by the House of Representatives but never even got to a vote in the Senate.

The state of California introduced its own cap-and-trade program in 2013. The program was initially limited to fewer than 400 businesses, including power plants, large industrial plants, and fuel distributors. Its goal of reducing greenhouse gas emissions to 1990 levels by 2020 was successfully met in 2016.

Mexico is running a pilot cap-and-trade program that the country began in January 2020. This is the first emissions trading pilot program in Latin America, and it aims to move to full operations in 2018. The country committed to a 22% reduction in greenhouse gasses by 2030.

(Video) How does the emission trading scheme work?

Does Cap and Trade Really Work?

The effectiveness of cap and trade is constantly under debate. Cap and trade aims to reduce carbon emissions by putting a price on them, thus mitigating climate change. Those well-designed cap and trade initiatives have proven to be not only environmentally effective, but also cost-effective, since those companies that bank the excess allowances (or amount of the cap) can reduce significantly their costs.

In California, for example, the program met some initial benchmarks and inspired many other similar initiatives across the world. But some claim that the biggest oil and gas companies in the state have actually polluted more since the program started. Experts are increasingly worried that the cap and trade initiative is in reality allowing California’s biggest polluters to conduct business as usual and even increase their emissions.

An analysis conducted by ProPublica showed that carbon emissions from California’s oil and gas industry actually rose 3.5% since cap and trade began, and that emissions from vehicles, which burn the fuels processed in refineries, are also rising.

Carbon Tax vs. Cap and Trade

A carbon tax directly establishes a price on greenhouse gas emissions—so companies are charged a dollar amount for every ton of emissions they produce—whereas a cap and trade program issues a set number of emissions “allowances” each year. These allowances can be auctioned to the highest bidder as well as traded on secondary markets, creating a carbon price.

If well designed, either a carbon tax or a cap and trade program can be key elements for the U.S. in its effort to reduce greenhouse gas emissions.

Is Cap and Trade Used?

Yes. Today, cap and trade is used or being developed worldwide.

For example, European countries have been implementing a cap and trade program
since 2005, the Chinese government is working toward a national cap program and currently, several Chinese cities and provinces have had carbon caps
since 2013. Eleven states in the U.S. participate in the Regional Greenhouse Gas Initiative (RGGI), a cap-and-trade program established in 2009.

Is Cap and Trade Bad?

Although cap and trade aims to reduce emissions and pollution, it has some drawbacks affecting the economy. When implemented it leads to an increase in the cost of energy.

Is Cap and Trade Successful?

The proponents of cap and trade argue that well-designed cap and trade systems have proven to be environmentally effective and cost-effective. When a company has effective emissions monitoring systems and complies with regulations, a cap trade initiative can be beneficial not only for the environment for also for the economy, since banking the excess allowances can reduce significantly a company's costs.

(Video) Carbon Tax vs Cap & Trade

How Did Cap and Trade Work in California?

Californiabegan operating a cap-and-trade program in 2013, and as of 2022, it is one of the largest emissions trading systems in the world. The ambitious program aimed to reduce greenhouse gas emissions to 1990 levels by 2020 (a goal that was met in 2016), and now aims to reduce the emissions by 40% below 1990 levels by 2030, and 80% below 1990 levels by 2050. California also has additional goals of achieving 100% carbon-free electricity by 2045 and economy-wide carbon neutrality by 2045.


What is meaning of cap and trade? ›

In a cap-and-trade system, the government sets an emissions cap and issues a quantity of emission allowances consistent with that cap. Emitters must hold allowances for every ton of greenhouse gas they emit. Companies may buy and sell allowances, and this market establishes an emissions price.

Are cap and trade systems effective? ›

Well-designed cap-and-trade systems have proven to be environmentally effective and cost-effective. Successful cap-and-trade systems have had accurate emissions monitoring, significant violation penalties, and high compliance.

What is the main goal of a cap and trade system? ›

What is Cap and Trade? The goal: To steadily reduce carbon dioxide and other greenhouse gas emissions economy-wide in a cost-effective manner. The cap: Each large-scale emitter, or company, will have a limit on the amount of greenhouse gas that it can emit.

Who created cap and trade? ›

Thomas Crocker, the man that invented cap and trade, says the United States shouldn't use cap and trade to reduce carbon emissions.

What is the full meaning of cap? ›

abbreviation (1) Definition of cap (Entry 5 of 6) 1 capacity. 2 capital. 3 capitalize; capitalized.

Why does cap-and-trade fail? ›

Why did cap and trade die? The short answer is that it was done in by the weak economy, the Wall Street meltdown, determined industry opposition and its own complexity. The idea began as a middle-of-the-road Republican plan to unleash the market to reduce power plant pollution and spur innovation.

Does cap-and-trade rely on property rights? ›

Cap-and-trade is based on this property rights approach, as Coase himself has noted. By setting up a trading system, it lowers the costs of transactions, which can occur at a commodities exchange. Under the cap, allowable emissions are allocated to industry as tradable property.

When was cap-and-trade most successful? ›

(Schmalensee and Stavins, p. 106-07; 114.) In Europe, the peak of cap-and-trade came 10 years ago. The European Union adopted the Emissions Trading System (ETS) in 2003, as a cost-effective way to achieve the commitments it had made under the Kyoto Protocol on Global Climate Change.

Which countries use cap-and-trade? ›

Countries or regions that have already passed cap-and-trade: This includes the European Union, Australia, New Zealand, South Korea, California, and Quebec. They've all set hard limits on a significant portion of their carbon emissions. (Different countries have different targets and exemptions for various sectors.)

What statement about cap-and-trade systems is true? ›

What statement about Cap-and-trade systems is true? It issues permits that allow companies to emit a percentage of the overall amount of a given pollutant.

How many states have cap-and-trade? ›

The 10 states in the greenhouse initiative were the first to get a carbon cap-and-trade program running. Their goal—and that of cap-and-trade programs in general—is to reduce carbon dioxide emissions from power plants, which generate more than one-quarter of the region's greenhouse gases.

When was CAP first used? ›

A cap is a flat headgear, usually with a visor. Caps have crowns that fit very close to the head. They made their first appearance as early as 3200 BC.

Is cap-and-trade a tax? ›

A carbon tax and cap-and-trade are opposite sides of the same coin. A carbon tax sets the price of carbon dioxide emissions and allows the market to determine the quantity of emission reductions. Cap-and-trade sets the quantity of emissions reductions and lets the market determine the price.

What is the new definition of cap? ›

The Common Alerting Protocol (CAP), a digital format for exchanging emergency alerts, allows a consistent alert message to be disseminated simultaneously over multiple communications pathways.

What are examples of caps? ›

The definition of a cap is a covering. An example of cap is a baseball hat. An example of cap is a soda bottle top.

Where is the term cap from? ›

This meaning of cap dates back to the early 1900s. History lesson: In the 1940s, according to Green's Dictionary of Slang, to cap is evidenced as slang meaning “to surpass,” connected to the ritualized insults of capping (1960s). These terms appear to be rooted in the sense of cap as “top” or “upper limit.”

What is the main criticism of the cap-and-trade program? ›

Critics of cap-and-trade point to problems that actual cap-and-trade programs like the European Union Emissions Trading Schedule and the Regional Greenhouse Gas Initiative have confronted, such as weak emissions caps, volatility in emissions allowance prices, and overly generous allocations of emissions allowances to ...

Where does the money from cap-and-trade go? ›

California's Cap and Trade program collects revenues to offset greenhouse gas emissions. MTC helps the Bay Area submit projects that will strongly compete for these dollars. The Cap and Trade program reduces pollution by imposing limits on emissions.

Which is a potential problem with the cap-and-trade program? ›

what is a potential disadvantage of cap-and-trade programs? suppressing competition among similar firms; Because larger firms can hoard permits, they can prevent smaller ones from entering the market.

How will cap-and-trade affect me? ›

Newcomers will face a competitive disadvantage before they even open their doors; having not obtained free allowances from the government, their costs will be greater than those of their competitors. Simply put, cap and trade raises barriers to entry in a most un-market-like fashion.

How does cap-and-trade help the environment? ›

Emissions trading, also known as 'cap and trade', is a cost-effective way of reducing greenhouse gas emissions. To incentivise firms to reduce their emissions, a government sets a cap on the maximum level of emissions and creates permits, or allowances, for each unit of emissions allowed under the cap.

Is cap-and-trade a federal law? ›

The United States created its first cap-and-trade program in Title IV of the Clean Air Act Amendments of 1990 to regulate sulfur dioxide emissions through allowances. In 2005, the EPA released another cap-and-trade program through its Clean Air Interstate Rule (CAIR), which covers sulfur dioxide and nitrogen oxides.

Why cap-and-trade is better than carbon tax? ›

While a carbon tax sets the price of CO2 emissions and allows the market to determine the amount of reduced emissions, a cap-and-trade system sets the quantity of emissions allowed, which can then be used to estimate the decline in the rise of global temperatures.

Does cap-and-trade increase prices? ›

A cap-and-trade system would raise the prices of goods and services whose production and use involve the emission of greenhouse gases. But it would also generate revenues to offset the effects of these cost increases.

How does cap-and-trade affect supply and demand? ›

In essence, cap and trade uses the law of supply and demand by shrinking the supply of allowances to increase their value to encourage firms to make an internal economic decision as to the best approach to reduce emissions including increasing the efficiency of combustion.

What is the goal of cap-and-trade energy policy quizlet? ›

A cap-and-trade program is an emissions-control policy and market incentive that limits an industry's emission allowance and allows it to purchase emission from other lower-emitting industries.

What happens in a cap-and-trade program quizlet? ›

under a cap-and-trade system, the government determines an acceptable level of pollution and then issues permits to pollute. a company receives credit for amounts it does not emit and can then sell this credit to other companies.

What will the cap-and-trade incentives be used for? ›

Under this system the market determines the price of quotas. In this way, the emission cap ensures that total pollution goes down and companies are given an economic incentive to find better ways to reduce harmful greenhouse gas emissions and support clean energy.

Who does cap-and-trade benefit? ›

Cap and trade reduces emissions, such as those from power plants, by setting a limit on pollution and creating a market. The best climate policy — environmentally and economically — limits emissions and puts a price on them. Cap and trade is one way to do both.

How does cap-and-trade affect consumers? ›

As a free trade system, cap and trade gives consumers more choices as well. Consumers can choose not to purchase from companies that are out of compliance, and do business with those that are trying to reduce their pollution levels.

Is cap-and-trade command and control? ›

Cap and trade systems and command and control regulation both involve the limiting of emissions in polluting sectors of the economy. However, cap-and-trade provides economic incentives for private sector actors to engage in mitigation, thereby making it the most efficient method of achieving an environmental target.

How does cap-and-trade work in addressing climate change? ›

Emissions trading, also known as 'cap and trade', is a cost-effective way of reducing greenhouse gas emissions. To incentivise firms to reduce their emissions, a government sets a cap on the maximum level of emissions and creates permits, or allowances, for each unit of emissions allowed under the cap.

Does cap-and-trade raise prices? ›

Impact of economic conditions.

In times of economic expansion, the opposite would be true – under cap and trade, allowance prices would rise based on market forces, but taxes would remain the same unless adjusted through government action.


1. How do carbon markets work?
(The Economist)
2. Understanding Cap and Trade and a Price Collar
3. Optimal Pollution Abatement, Pigovian Taxes, and Cap and Trade
(Todd R. Yarbrough, Ph.D.)
4. What is carbon trading? | CNBC International
(CNBC International)
5. What are Trailing Stops and How to Trade with Them
(Trading 212)
6. Trading Pollution: How Pollution Permits Paradoxically Reduce Emissions
(Marginal Revolution University)
Top Articles
Latest Posts
Article information

Author: Nicola Considine CPA

Last Updated: 11/16/2022

Views: 6021

Rating: 4.9 / 5 (69 voted)

Reviews: 92% of readers found this page helpful

Author information

Name: Nicola Considine CPA

Birthday: 1993-02-26

Address: 3809 Clinton Inlet, East Aleisha, UT 46318-2392

Phone: +2681424145499

Job: Government Technician

Hobby: Calligraphy, Lego building, Worldbuilding, Shooting, Bird watching, Shopping, Cooking

Introduction: My name is Nicola Considine CPA, I am a determined, witty, powerful, brainy, open, smiling, proud person who loves writing and wants to share my knowledge and understanding with you.