Cap-and-Trade

Definition

Cap-and-trade is a market-based approach to controlling pollution by providing economic incentives for achieving reductions in the emissions of pollutants. It sets a limit or 'cap' on the amount of a pollutant that can be emitted, and allows those industries or entities that emit the pollutant to trade emission allowances or credits with one another.

5 Must Know Facts For Your Next Test

1. Cap-and-trade systems set an overall limit or 'cap' on the amount of a specific pollutant that can be emitted, and then distribute or sell a corresponding number of emissions allowances or permits.
2. Entities that emit the pollutant, such as power plants or manufacturing facilities, must hold a permit for each unit of pollution they emit, and can buy, sell, or trade these permits on a market.
3. The cap is gradually reduced over time, incentivizing entities to find ways to reduce their emissions and either sell their excess permits or avoid having to purchase additional ones.
4. Cap-and-trade systems provide flexibility for firms to determine the most cost-effective way to meet their emissions reduction targets, whether through investing in cleaner technologies or trading permits.
5. The success of cap-and-trade programs depends on the stringency of the emissions cap, the availability of cost-effective abatement options, and the liquidity and efficiency of the permit trading market.

Review Questions

• Explain how a cap-and-trade system works to address pollution and environmental issues.
  • In a cap-and-trade system, the government sets a limit or 'cap' on the total amount of a specific pollutant that can be emitted. It then distributes or sells a corresponding number of emissions allowances or permits to the entities that emit the pollutant, such as power plants or manufacturing facilities. These entities must hold a permit for each unit of pollution they emit, and can buy, sell, or trade these permits on a market. The cap is gradually reduced over time, incentivizing entities to find ways to reduce their emissions and either sell their excess permits or avoid having to purchase additional ones. This provides flexibility for firms to determine the most cost-effective way to meet their emissions reduction targets, whether through investing in cleaner technologies or trading permits.
• Analyze how a cap-and-trade system can be considered a market-oriented environmental tool, as discussed in the context of Topic 12.3.
  • A cap-and-trade system is a market-oriented environmental tool because it uses economic incentives to achieve environmental goals. By creating a market for the trading of pollution permits or credits, it allows entities to determine the most cost-effective way to reduce their emissions, whether through investing in cleaner technologies or purchasing additional permits from others. This flexibility and the ability to trade permits creates a financial incentive for entities to find ways to reduce their emissions, as they can then sell their excess permits for a profit. The market-based approach of cap-and-trade systems is seen as a more efficient and cost-effective way to achieve environmental goals compared to traditional command-and-control regulations.
• Evaluate the potential benefits and costs of implementing a cap-and-trade system in the context of U.S. environmental laws, as discussed in Topic 12.4.
  • The potential benefits of implementing a cap-and-trade system in the U.S. include the ability to achieve emissions reduction targets in a more cost-effective manner, as firms can determine the most efficient way to meet their obligations. This flexibility can lead to innovation and the development of new clean technologies. Additionally, the market-based approach can generate revenue for the government through the sale of emissions allowances, which can be used to fund further environmental initiatives. However, the costs of implementing a cap-and-trade system can include the administrative burden of monitoring and enforcing the program, as well as the potential for market distortions and unintended consequences if the system is not designed and implemented properly. There are also concerns about the equity and fairness of the distribution of emissions allowances and the potential impact on certain industries or communities. Ultimately, the benefits and costs of a cap-and-trade system in the U.S. would depend on the specific design and implementation of the program.

Related terms

Emissions Trading: A cap-and-trade system that creates a market for the trading of pollution permits or credits, allowing entities to buy and sell the right to emit a certain amount of a pollutant.

Pollution Permit: A certificate or allowance that grants the holder the right to emit a specified amount of a pollutant, which can be traded in a cap-and-trade system.

Marginal Abatement Cost:

The additional cost incurred by a firm to reduce one additional unit of pollution or emissions, which determines the firm's willingness to buy or sell pollution permits in a cap-and-trade system.