key term - Cap-and-trade system

Definition

A cap-and-trade system is an environmental policy tool that limits total greenhouse gas emissions while allowing companies to buy and sell permits to emit a certain amount of pollutants. This market-based approach encourages companies to reduce emissions and invest in cleaner technologies, balancing economic growth with environmental protection. By establishing a cap on total emissions and allowing trading, this system creates financial incentives for reducing pollution more efficiently.

5 Must Know Facts For Your Next Test

1. Cap-and-trade systems set a specific limit on total emissions (the 'cap'), which decreases over time, promoting overall reductions in pollution.
2. Companies that reduce their emissions below their allotted cap can sell excess permits to other firms, incentivizing innovation and efficiency.
3. The flexibility of buying and selling emission permits allows businesses to determine the most cost-effective way to reduce their emissions.
4. Cap-and-trade programs can lead to significant reductions in greenhouse gases if designed effectively, potentially achieving targets at lower costs compared to traditional regulatory approaches.
5. Many countries and regions have implemented cap-and-trade systems, including the European Union Emissions Trading System (EU ETS), which is one of the largest and most established markets.

Review Questions

• How does a cap-and-trade system create incentives for companies to reduce their emissions?
  • A cap-and-trade system provides financial incentives by allowing companies that lower their emissions below the established cap to sell their excess emission permits to other companies. This market mechanism encourages firms to innovate and find more efficient ways to reduce pollution since they can profit from selling surplus permits. Additionally, as the overall cap decreases over time, the value of permits increases, motivating companies to continuously seek lower emissions.
• Discuss the advantages and disadvantages of implementing a cap-and-trade system compared to a carbon tax.
  • Cap-and-trade systems can achieve emission reduction targets more flexibly since companies can trade permits based on their unique circumstances. This can lead to cost savings by allowing reductions where they are cheapest. However, cap-and-trade may also create price volatility in the permit market and could be more complex to administer than a straightforward carbon tax. A carbon tax provides certainty in costs but lacks the same flexible mechanisms for achieving emissions reductions.
• Evaluate the effectiveness of existing cap-and-trade systems worldwide in achieving environmental goals and what improvements could enhance their impact.
  • Existing cap-and-trade systems have shown mixed results in meeting environmental goals. For example, while the EU ETS has successfully reduced emissions, it has faced criticism for price fluctuations and oversupply of permits. To enhance their effectiveness, improvements could include tightening caps more aggressively, implementing price floors for permits to stabilize markets, and ensuring that offsets used in trading represent real and additional emission reductions. By making these adjustments, cap-and-trade systems could more reliably drive down overall greenhouse gas emissions.

Related terms

Emission Permits: Certificates that allow the holder to emit a certain amount of pollutants; these can be bought and sold in a cap-and-trade system.

Externalities:

Costs or benefits that affect third parties who did not choose to incur those costs or benefits; cap-and-trade aims to internalize the external costs of pollution.

Carbon Tax: A tax imposed on companies based on their carbon emissions, serving as an alternative method for regulating greenhouse gas outputs.