What Is Cap and Trade? Policy, Examples, and Effectiveness

Cap and trade is an emissions reduction tool in which governments or other authoritative bodies limit how much greenhouse gas (GHG) corporations can emit and allow them to purchase more emissions from corporations that haven't reached their limit. The goal is to control corporate emissions through policy while creating a market (hence the "trade" in cap and trade).

It's meant to be a cost-effective way to reduce emissions globally by gradually lowering the caps. As the demand for emissions—including carbon dioxide and other, related pollutants—rises, so will their price. Ideally, corporations will reduce their emissions to save money.

Cap and trade is one of several emissions reduction strategies and has met criticism from environmentalists and economists. Learn more about the policy, its effectiveness, and pros and cons.

Policy Background

Most sources point to Thomas Crocker as the mastermind behind the cap-and-trade system. As the story goes, Crocker was studying economics at the University of Wisconsin in the 1960s when he developed a possible solution to the budding climate crisis: Cap emissions of pollutants and make firms trade with one another to procure more.

It wasn't until 2005 that any government rolled out an official cap-and-trade system (that government happened to be the European Union). The EU called it the Emissions Trading Scheme (ETS)—enforced throughout all 27 EU countries plus Iceland, Liechtenstein, and Norway—and it continues to be the largest example of international cap-and-trade policy today.

As his idea came to life, cap-and-trade founding father Crocker, now a professor at the University of Wyoming, told the Wall Street Journal he preferred the idea of a carbon tax over the cap-and-trade system he devised, saying "I'm skeptical that cap-and-trade is the most effective way to go about regulating carbon."

Today, 47 national and 36 sub-national jurisdictions have implemented some sort of price on carbon globally, be it through a carbon tax or cap and trade.

How It Works

In the EU's Emissions Trading Scheme, as a prominent example, all firms are given a cap of EU emissions allowances, or EUAs, each equal to one metric ton of CO2 or CO2 equivalent. Allowances—in some cases called carbon credits—can be obtained through free allocation, granted in proportion to a firm's individual emissions output, or through auctioning, now the default means of procurement.

To accurately track emissions, each firm submits EUAs through a Union Registry account at the end of the year. With a Union Registry account, firms can also buy and sell EUAs directly amongst each other or purchase additional EUAs from a Member State. The EU says, "auction revenues from the existing ETS go mainly to Member States' budgets and are predominantly to tackle climate change."

In 2022, EUA prices fluctuated from about €58 (March) to €100 (August) per metric ton of CO2-equivalent.

Examples of Cap and Trade in Action

In 2019, the EU estimated a 21% emissions reduction (from 2005 levels) from sectors covered by the system. Since introduced in 2005, emissions in the EU have been cut by about 43%.

Several nations, states, and cities outside the EU have implemented cap-and-trade systems. New Zealand, Kazakhstan, Tokyo, Korea, the Russian island of Sakhalin, the UK, Canada, and several states across the United States West Coast and Northeast are among them. According to The World Bank's Carbon Pricing Dashboard, more than 80 national and sub-national initiatives are already in place and cover an amount of CO2-equivalent equal to 23% of global GHG emissions.

Cap-and-trade plans are now underway in Nigeria, Turkey, Pakistan, and Southeast Asia, among other countries, and are being piloted in Mexico.

China

After several years of piloting cap and trade in seven different localities, China—the world's largest GHG emitter—rolled out the largest single-nation emissions trading scheme in 2021. Studies showed that even with low carbon prices and little trading, China's regional ETS pilots led to a 16.7% reduction in firm emissions and a 9.7% reduction in emission intensity.

The country's ambitious cap-and-trade scheme has been slow to start and not without flaws—several power plants were found to have falsified their emissions reports by millions of allowances during the first year. But on the scheme's first anniversary, nearly 200 million metric tons of allowances had been traded, worth more than $1 billion. China's ETS will be key to reaching its peak emissions target by 2030 and achieving carbon neutrality by 2060.

The U.S.

Meanwhile, stateside, the Regional Greenhouse Gas Initiative (RGGI) has slowly gained traction since 2009. It started with nine states: the six states that comprise New England —plus Delaware, Maryland, and New York. The RGGI has since spread to New Jersey, Pennsylvania, and Virginia.

Within the regional framework of RGGI, states set caps on the CO2 (no other GHGs) emitted by fossil fuel-fired power plants. A 10-year review of RGGI revealed that, due to cap and trade, carbon emissions from participating power plants had fallen by 47%, and RGGI states' GDPs had increased by the same amount since generating a total of $3.2 billion from allowance auctions. As a result, electricity prices fell by almost 6% in RGGI states while they actually rose by almost 9% in the rest of the country.

While the RGGI expands across the Northeast and Mid-Atlantic, West Coast states have been developing and fine-tuning their cap-and-trade systems. Although California's program predates the RGGI by a few years, its first allowance auction wasn't until 2012. In 2016, it reached its target of achieving 1990 levels of GHG emissions four years ahead of schedule. With the scheme, the state aims to achieve carbon neutrality by 2045.

Oregon runs a similar program, and on October 1, 2022, Washington finalized plans to launch its own ETS on January 1, 2023.

Pros

Cap and trade is one of the most sound and widely used emissions reduction tools worldwide. Here are the top benefits:

1. The market provides a reward (cash) for firms to cut their emissions quickly.
2. Auctioning allowances increases government revenues, which can be used to support other environmental initiatives.
3. The cap can be reduced gradually to reduce total emissions.
4. Cap and trade can be used to reduce all greenhouse gases, not just carbon.
5. It can be used with a carbon tax (Example: In Alberta, Canada, cap and trade is used among the largest emitters while smaller firms pay a carbon tax).

Cons

Cap-and-trade systems also receive their share of criticism from both environmentalists and economists. Here are the top drawbacks:

1. Cap and trade allows companies to emit as much GHG as they wish because they can procure more from the market.
2. Critics say cap and trade isn't as stringent as a carbon tax, which charges corporations for every ton of emissions produced.
3. Governments may set caps too high, so corporations don't have an incentive to reduce their emissions.
4. Self-reporting emissions means firms can cheat (and have cheated) the system.
5. Charging firms for their emissions in any capacity (cap and trade, carbon tax, or otherwise) can drive up the price of energy and energy-intensive goods for consumers. (the opposite has also occurred, as with RGGI states in the U.S.)

Outlook of Cap-and-Trade Programs

Today, locales with the tightest regulations on GHG emissions have implemented or plan to implement a hybrid policy using parts of cap and trade and a carbon tax together to drive emissions down quickly and effectively. Mexico, Canada, New Zealand, and individual countries throughout the EU are examples.

On the World Bank Carbon Pricing Dashboard, cap and trade and hybrid systems remain more popular than carbon tax used alone. Still, locales have reservations about adopting emissions trading schemes because they can cause energy prices to spike, among other reasons. In the U.S., a cap-and-trade program was proposed via the American Power Act of 2009. The act was approved by the House of Representatives but never brought to the Senate floor.

More recently, the U.S. government considered a carbon tax as part of the Build Back Better Act, again passed by the House and halted in the Senate. The carbon tax was later dropped as Build Back Better became the Inflation Reduction Act, signed into law in August 2022.

In the meantime, California legislatures validated critics' concerns that its emissions trading scheme isn't working well enough for the state to meet 2030 targets. Currently, government officials are reevaluating the program and possibly considering a hybrid system, as are others. As of 2022, the U.S. still has not established a national carbon price.