Cap and Trade Explained: All You Need to Know

Cap and Trade Explained: All You Need to Know

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Grace Smoot

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Cap and trade is one mechanism that allows us to put a price on carbon emissions. And it can be an effective way to mitigate climate change and ensure a sustainable planet for future generations. So, we had to ask: What is cap and trade really, and how could it help us mitigate climate change?

Cap and trade puts a cap on carbon emissions (that is decreased over time) and allows entities to then trade carbon credits according to their usage. Cap and trade uses financial incentives to mitigate climate change but is limited by discrepancies in standards and caps.

Keep reading to find out all about what cap and trade is, the impact you can have with it both individually and globally, its benefits and drawbacks, and why it may not be the most effective way to mitigate climate change.

The Big Picture of Cap and Trade

Carbon emissions already have a price tag attached to them, but it is our environment that pays the price, not the emitters. Carbon pricing seeks to resolve this issue and make emitters pay for their carbon emissions. 

One form of carbon pricing is cap and trade. Cap and trade sets an upper limit on the amount of emissions entities are allowed to emit. 

Cap and Trade: a system for controlling carbon emissions and other forms of pollution by setting a limit on the amount any business or organization may produce while allowing them to buy extra capacity from other organizations which have not used their full limit”

Cambridge Dictionary

Cap and trade utilizes tradable allowances called carbon credits, which are certificates or permits that give companies, industries, or countries the right to emit 1 tonne (1,000kg) of CO2 or the equivalent amount of a different greenhouse gas (GHG). Each entity operating under a cap-and-trade program is issued a certain number of carbon credits each year for use on the cap-and-trade market. 

Cap-and-trade markets became established after the Kyoto Protocol, an international treaty, set a maximum amount of GHG emissions that could be released into the atmosphere, both globally and nationally. In this market, unused carbon credits can be sold to entities that have exceeded the cap.

Globally, the four largest cap and trade systems currently in operation are:

  1. The European Union emissions trading scheme (EU ETS): The world’s first and largest trading system in operation which was established in 2005. 11,000 installations and a few hundred aircraft operators in Europe are required to participate in the scheme. It has reduced emissions from power generation and energy-intensive industries by roughly 43% since its inception
  1. The National Emissions Trading Scheme (China): Established in 2021 after nearly a decade of planning, China’s trading system will be the largest in the world once it is implemented fully. It targets the power sector, specifically the 2,200 entities accounting for nearly 40% of China’s annual carbon emissions. China’s goal is to be carbon neutral by 2060.
  1. Korea Emissions Trading Scheme (K-ETS): Established in 2015, the K-ETS became East Asia’s first, nationwide mandatory trading scheme that covers 684 of the country’s largest GHG emitters that account for over 70% of national GHG emissions. Their goal is to achieve carbon neutrality by 2050.
  1. California’s Cap and Trade Program: First implemented in 2013, this US-based trading system targets the roughly 450 businesses that comprise the electric power plant, industrial power plant, and fuel distribution sectors. California’s GHG emissions decreased by 5.3% from 2013 to 2017 due in part to this program, and their goal is to reduce GHG emissions to 80% below 1990 levels by 2050. 
What cap and trade isCap and trade is a mechanism to control carbon emissions that sets an upper limit on total emissions, allowing entities to trade carbon credits according to their usage.
How cap and trade worksCarbon credits cap how much CO2 an entity can emit. This cap on emissions can be gradually reduced over time, leading to less and less overall emissions.
The impact of cap and trade on your own emissionsCap and trade does not directly reduce your carbon footprint. 
The impact of cap and trade on global emissionsCap and trade mitigates the problem, but it does not work at the core issue of reducing overall CO2 emissions.
The overall effectiveness of cap and trade on reducing carbon emissionsImproper reporting and discrepancies in maximum GHG levels between countries limits cap and trade effectiveness on a global scale. 
The main benefits of cap and tradeCap and trade aids in climate change mitigation, improves air quality, protects ecosystems, incentivizes the switch to green energy, and promotes energy independence.
The main drawbacks of cap and tradeCap and trade faces improper reporting, discrepancies in caps, and price volatility.

How Does Cap and Trade Work

Cap and trade works by setting a cap on allowable carbon emissions and decreasing that cap gradually over time. It is one way to mitigate the adverse effects of carbon emissions that occur after they enter our atmosphere.

How Does Cap and Trade Reduce Carbon Emissions

The goal of cap and trade is to reduce carbon emissions to mitigate climate change.

  • Cap and trade represents indirect emission reductions. Putting a cap on emissions and decreasing this cap over time reduces carbon emissions over time, preventing CO2 from entering the atmosphere.

When you hear the words “cap and trade”, think about the term “allowance”. Cap and trade uses carbon credits that represent the maximum amount of CO2 an entity is allowed to emit. This cap on CO2 emissions slowly decreases over time, forcing entities to emit less and less CO2 to stay within the boundaries of the cap. Companies with high levels of emissions can continue to operate, but only at an increased cost.

What Impact Does Cap and Trade Have on Your Own Carbon Emissions

One of the best ways we can aid in the fight against global climate change is to reduce our carbon footprint. And to do this we first have to reduce our own carbon emissions. 

  • Cap and trade does not directly reduce your carbon footprint. 

Carbon credits do not directly reduce your own carbon emissions. Setting a limit on allowable carbon emissions is an indirect method of emissions reduction because companies can continue to emit as long as they pay the price. 

What Impact Does Cap and Trade Have on Global Carbon Emissions

Every year we pump over 36 billion tons of CO2 into the atmosphere, fueling climate change. This causes temperature and sea-level rise, melting of sea ice, changing precipitation patterns, and ocean acidification. Cap and trade aims to reduce global emissions and mitigate these negative environmental effects.

  • Cap and trade indirectly works at the core issue of reducing overall CO2 emissions by providing companies a financial incentive to do so.

Carbon credits do not have a significant impact on global carbon emissions yet, although the potential is there with cap and trade to align the incentive for companies to reduce their CO2 emissions with their bottom line. In that way, the goal of carbon permits to reduce greenhouse emissions or support sustainable energy projects is aligned with companies’ economic goals to increase their profits.

The COVID-19 pandemic triggered the largest decrease in energy-related carbon emissions since World War II, a decrease of 2 billion tonnes. However, emissions rebounded quickly and rose by 6% in 2021 to 36.3 billion tonnes, their highest ever level. This indicates that the earth is still warming at an accelerated rate, and still not enough is being done to implement direct carbon reduction measures.

Illustration of annual CO2 emissions globally
Our World in Data: Annual total CO2 emissions

How Effective Is Cap and Trade in Reducing Carbon Emissions

Cap and trade can be effective at reducing carbon emissions if it is used correctly.

Carbon credits have faced criticism because most industries lack the technology that monitors and determines their amount of CO2 emissions. This makes it easier for companies to cheat on their emissions reports and say they are emitting less than they actually are. 

Also, different countries have different standards and caps for CO2 emissions. If the cap is set too high, then companies are not incentivized to reduce emissions. But set the cap too low, and companies will be overly burdened to reduce emissions. And the extra cost will be passed down to consumers as a result.

What Are the Main Benefits and Drawbacks of Cap and Trade

As with anything, cap and trade comes with benefits and drawbacks that must be understood before implementing the mechanism on a large scale. 

What Are the Main Benefits of Cap and Trade 

Cap and trade comes with environmental benefits in addition to limiting global carbon emissions resulting from fossil fuels (i.e., coal, oil, and natural gas). 

  • Aids in climate change mitigation: Cap and trade aims to reduce the amount of carbon emissions that enter our atmosphere. Levels of carbon in our atmosphere that cause climate change have increased as a result of human emissions since the beginning of the Industrial Revolution in 1750. The global average concentration of carbon dioxide (CO2) in the atmosphere today registers at over 400 parts per million. Carbon avoidance can help prevent these levels from increasing even more.
Illustration of atmospheric carbon dioxide levels over 800,000 years
National Oceanic and Atmospheric Administration: Carbon Dioxide Over 800,000 Years
  • Improves air quality: Degradation of air quality as a result of carbon emissions is a serious issue. In 2009, the US government declared CO2, CH4, N2O, hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulfur hexafluoride (SF6) threats to the public health and welfare of current and future generations. Reducing the amount of carbon entering our atmosphere would lead to improved public health in terms of asthma, respiratory allergies, airway diseases, and lung cancer
  • Incentivizes the switch to green energy: Cap and trade incentivizes companies to switch to greener energy sources including solar, wind, hydro, and geothermal energy which emit lower levels of climate-change inducing CO2, nitrogen oxides, sulfur dioxides, and mercury. This in turn promotes energy independence. Being able to produce your electricity without the aid of foreign countries is an important step in becoming more self-sufficient. 

Cap and trade can mitigate the effects of climate change, which has a positive cascade effect on public health and plant and animal diversity. In addition, it boosts the global economy and leads to innovative, more environmentally-friendly solutions in years to come.

What Are the Main Drawbacks of Cap and Trade 

The main drawbacks to cap and trade involve improper reporting, discrepancies in cap limits, and unpredictable pricing.

  • Improper reporting: Many industries lack the technology to monitor and determine exactly how much carbon they are emitting. This makes it easier for companies to cheat their emissions reports and say they are emitting less carbon than they actually are.
  • Discrepancies in standards and caps: Currently there is no universal cap for carbon emissions. Instead, different countries have different standards and caps. Setting the cap too low overly burdens companies to reduce their emissions, and the extra cost will be passed down to consumers. But setting the cap too high will not be a big enough incentive to reduce emissions.
  • Unpredictable price volatility:  With cap and trade, the price of carbon emissions is not predetermined. The trading system leaves the price up to the market to decide.

Why Is Cap and Trade Important to Fight Climate Change

As outlined in the 2015 Paris Climate Agreement, we must cut current greenhouse gas (GHG) emissions by 50% by 2030 and reach net zero by 2050. Cap and trade is important to meet these targets because it can reduce global carbon emissions, carbon that if emitted can remain in our atmosphere for tens of thousands of years.

However, cap and trade should not be viewed or used as a panacea for climate change. Relying on it solely is impractical because the immediate effect of reducing emissions under the cap-and-trade system is to benefit a company’s bottom line. 

In the long term, direct methods of carbon footprint reduction are much more effective. Reducing your household, travel, and lifestyle carbon footprint can go a long way in the fight against climate change!

What are Better Alternatives to Cap and Trade

If used correctly, cap and trade can provide environmental, economic, and social benefits that go beyond reducing carbon emissions. It has the potential to instigate meaningful environmental change and begin to reverse some of the effects of climate change. 

But in the long term, direct methods of carbon footprint reduction are much more effective. These reduction measures don’t have to involve drastic changes either. Actions that may seem small can have a big impact because those small changes add up! You can reduce your carbon footprint in three main areas of your life: household, travel, and lifestyle. 

Reduce your household footprint:

Reduce your travel footprint:

  • Walk or bike when possible: The most efficient ways of traveling are walking, bicycling, or taking the train. Using a bike instead of a car can reduce carbon emissions by 75%. These forms of transportation also provide lower levels of air pollution.

Reduce your lifestyle footprint:

  • Switch to Renewable Energy Sources: The six most common types of renewable energy are solar, wind, hydro, tidal, geothermal, and biomass energy. They are a substitute for fossil fuels that can reduce the effects of global warming by limiting global carbon emissions and other pollutants.
  • Recycle: Recycling uses less energy and deposits less waste in landfills. Less manufacturing and transportation energy costs means less carbon emissions generated. Less waste in landfills means less CH4 is generated.
  • Eat less meat and dairy: Meat and dairy account for 14.5% of global greenhouse gas emissions, with beef and lamb being the most carbon-intensive. Globally, we consume much more meat than is considered sustainable, and switching to a vegan or vegetarian diet could reduce emissions. 
  • Take shorter showers: Approximately 1.2 trillion gallons of water are used each year in the United States just for showering purposes, and showering takes up about 17% of residential water usage. The amount of water consumed and the energy cost of that consumption are directly related. The less water we use the less energy we use. And the less energy we use, the less of a negative impact we have on the environment.

Final Thoughts

Cap and trade is a form of carbon pricing that sets a cap (maximum limit) on carbon emissions with the goal of reducing global emissions by gradually lowering the cap over time. This does not work at the core issue of reducing global emissions, and improper reporting and price volatility can inhibit its success. But if implemented properly, cap and trade can aid in climate change mitigation, incentivize the switch to green energy, and promote energy independence.

Cap and trade is a good place to start if you want to get into the carbon-emission reduction game, but to be effective in the long term, we must not rely on it solely. Cutting emissions from the source is the best way to reduce our carbon footprint and provide the highest environmental benefits.

Stay impactful,

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Grace Smoot

Grace loves to research and write about all things related to climate action and sustainability. She holds a Bachelor’s degree in Environmental Biology and works as an Environmental Survey Technician. Outside of work, she loves to work out, play soccer, and take her dog for long walks.

Did you know that the internet is a huge polluter of the environment? But fortunately not this site. This site is powered by renewable energy and all hosting-related CO2 emissions are offset by three times as many renewable energy certificates. Find out all about it here.

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