(aka Carbon Credits or Transferable Emissions Permits)
The goal of a “Cap and Trade” system is to limit greenhouse gas (GHG) emissions in an efficient and market-based way by putting a price on climate altering pollution. In general, this system sets an upper cap on GHG emissions below a level that is scientifically considered to be dangerous. Industries then buy, or are given, credits from the government where each credit represents a fraction of the total acceptable emissions over the year (ex. 1 credit = 1 ton of emissions).
You’re probably thinking: well surely not all emissions are the same, wouldn’t 1 ton of methane contribute differently than 1 ton of carbon dioxide to climate change? You would be right! The way to solve this problem is to convert all greenhouse gas emissions (ex. methane, N02, etc.) into the equivalent quantity of carbon dioxide (aka carbon emissions). This allows different GHGs to be expressed in a common unit (carbon dioxide) and makes pricing all GHGs much easier.
Reducing emissions comes at a cost and these costs are not the same for all industries or individual companies. This means that some companies can reduce emissions at a cheaper rate and more effectively than others. A company that cannot reduce their emissions easily could, in this system, buy emission credits from a company who has reduced emissions below the mandated level and has credits to spare. This would effectively achieve the same result as a caped system with no trade (aka a carbon tax) but much more efficiently. By allowing companies that are of high value to society to continue operations and emitting, these companies can continue to add a net benefit to the world. On the other hand, companies who are more efficient with their operations with regards to GHGs, will have more money and a competitive advantage in the market.
As society gets closer to the dangerous emission limit established by science and government, less carbon credits are made available. This incentivizes industries and organizations to gradually find solutions or innovations around emitting GHGs. As the supply of credits declines and the price of carbon increases, dirty technology becomes unprofitable, and companies who don’t emit thrive.
Cap and trade is not without its challenges (a topic for a future post), but it does present a way to use our powerful market system to put a price on emissions, stimulate innovation, and prepare for a low carbon future.
Comment below with any questions about the post or specific topics of interest for future discussions