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Cap and Trade

How It Works.

  • Emission permits are sold or given way in an amount equal to the cap. 
  • Permits can be traded -- bought and sold by emitters or middlemen.
  • Because permits are scare their price is positive.
  • The permit price (and not the cap) limits the demand for permits and hence limits emissions.
  • The permit market adjust the price so that it is just high enough to enforce the cap.


  • Emission reduction decisions are made by those who know the cost (including inconvenience costs) best.
  • "Where flexibility:" Trade ensures that emissions are reduced where they are cheapest to reduce.
  • "When flexibility:" Trade is said to ensure that emissions are reduced when they are cheapest to reduce.
    • Because the market has very poor information about future costs, this works very poorly.
Deceptive Benefit Claims:
  • The first criterion of any environmental policy is: "can it meet its targets."
    • Only true when cost is no object -- when an infinite permit price is justified.
  • A cap provides certainty of meeting it's target. But only if
    • Offsets are not allowed.
    • There is no safety valve.
    • There is no possibility the law will be changed.

Emission-Cap Certainty?
First, environmental effectiveness: a tax does not guarantee achievement of an emissions target, but it does provide greater certainty regarding costs. This is a fundamental trade off. Taxes provide automatic temporal flexibility, which needs to be built into a cap-and-trade system through provision for banking, borrowing, and possibly a cost-containment mechanism. On the other hand, political economy forces strongly point to less severe targets if carbon taxes are used, rather than cap-and-trade — which is why environmental
NGOs are opposed to the tax approach. ...

But the key difference is that political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs — some low-cost emission reduction opportunities are left off the table. But political pressures on a cap-and-trade system lead to different allocations of allowances, which affect distribution but not environmental effectiveness and not cost-effectiveness.   —Stavins, "Cap-and-Trade or Carbon Tax," Environmental Law Institute, Jan/Feb 2008.

The first criterion any proposed climate policy must meet is environmental effectiveness: Can the proposed instrument achieve its intended targets?

A cap-and-trade system is the best approach in the short to medium term. Besides providing certainty about emissions levels,... 

a cap-and-trade system can achieve emission targets with high certainty because emission guarantees are built into the policy.

Overall, a cap-and-trade system provides certainty regarding emissions from the regulated sources as a group, because aggregate emissions from all regulated entities cannot exceed the total number of allowances.

—Stavins, "A U.S. Cap-and-Trade System to Address Global Climate Change," The Brookings Institution, 2007.