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What is a Cap-and-Trade System?

A Carbon Cap-and-Trade system is a situation in which the government places a firm limit or cap on the whole level of carbon pollution from factories, and lowers that cap annually to attain a set pollution objective. As the cap/limit decreases every year, it lowers plant’s overall greenhouse gas emissions to the set limit as required by the law, and then compels polluters, which exceed their emissions allocation to purchase unused share from other firms. Therefore, it is the responsibility of the government to create as well as distribute the pollution quotas, in most cases through auction. Hence, this creates incentives for the companies to reduce the level of their emissions, and to be capable of selling instead of buying the pollution quotas. The market therefore is expected to set all the prices of the quotas under this system (Qiu, Qiao, & Pardalos, 2017). Thus, in this manner, the emission cap makes sure that the amount of pollution reduces, and the firms are provided with the economic incentive in order to find the alternative methods of reducing the harmful gases emitted from the greenhouses and support the use and production of the clean energy.

Cap-and-trade in action

The cap-and-trade method has been applied successfully in the United State to limit the emissions of nitrous oxide as well as sulphur dioxide, the two main ingredients accountable for the acid rain. Ever since 1980s, the system of cap-and-trade has been applied in the reduction of the acid rain formation, leading to the healthier environment. On the other hand, the European Union started applying the system of cap-and-trade in 2005 in order to limit the greenhouse gases that are emitted from approximately 10,000 large organizational emitters. Consequently, Tokyo which is perceived as a city with footprint of carbon larger than most manufacturing counties, established the system of cap-and-trade in 2010. Overall, the initiative used to the most energy as well as carbon intensive companies, and seeks to limit the emission to 25% level below 2000 by the year 2020.

Carbon tax or cap-and-trade

Over the years, there has been various discussions surrounding the issue of whether the carbon tax or rather the system of cap-and-trade is the most effective method of putting the price on the gas pollution emitted by greenhouse. This depends on how every system is formulated or designed. Moreover, the design is helpful in the determination of the environmental as well as economic effectiveness of the system. For instance, how effective is the use of incentives to limit the emission as well as for the companies to switch to the cleaner energy, to which extent does the emission department does the system apply, and how are the revenue collected from the firms used to sustain the cleaner energy? If all the systems are designed effectively, the two options, carbon tax and cap-and-trade system, are alike and can be applied in tandem. Rabe (2016) believes that the pricing should be used broadly in the most industrialized countries, and that it might be done through cap-and-trade system, carbon tax or a blend of the two systems. It is however important to note that the pricing on the carbon pollution gives an incentive for every person, ranging from the firms to the households, to be a part of the larger solution. Eventually, the vital factor in limiting the heat-trapping emissions is the strength in the financial signal. The stronger price of carbon will ensure to kick start growth in the renewable, clean energy as well as encourage the use of greener practices both in the firms and industries.

Pros and cons

Both the two systems of pricing, cap-and-trade as well as carbon taxes, can work effectively as long as they are properly designed to give a stringer financial signal in order to switch to the cleaner energy. Nevertheless, there are some differences which exist between the two systems. On one hand, cap-and-trade has one main environmental benefit over the carbon tax in that it gives a more certainty concerning the amount of the emissions limitations which will result, as well as the little certainty concerning the price of the emissions, that is stipulated by the emission trading market. On the other hand, the carbon tax gives the certainty concerning the price but provides little certainty concerning the total amount of the emissions limitations. Similarly, a carbon tax has an advantage over the cap-and-trade in that it is quicker as well as easier for the government implement it compared to the cap-and-trade system.

Further, a carbon tax tends to be very simple to apply, since it can depend on the existing structures of the administrative for taxing fuels hence can be effectively implemented within few months. Moreover, in theory, the same tactic applies to the system of cap-and-trade, however, in practice, they are much more complex (Rabe, 2016). The two systems require more time to develop the essential regulations, and they are deemed to be more prone to loopholes as well as lobbying. Further, the cap-and-trade also needs the establishment of the trading market of an emission. Besides, under the two systems, the price to pollute formulates the strength of the financial signal, and determines the exact level to which the green choices are encouraged.

Key Design Elements in a Carbon Cap-and-Trade

In the system of a Carbon Cap-and-Trade, the government is responsible for setting an emissions cap and gives the amount of emission allowances that is equal to that cap. Therefore, emitters are expected to hold allowances for each mass of greenhouse gases they emit. Firms may purchase and sell allowances; this market regulates the price for emissions price. Consequently, firms that have the ability to substantially reduce their emissions at a lesser cost can sell excess allowances for firms facing greater costs to buy. More importantly, beyond these fundamentals, policymakers should put into consideration array of design choices, which may influence the fee of compliance as well as the distribution of these charges in society.

Complementary policies are integral in Carbon Cap-and-Trade since they determine whether the cap and trade will become the main policy instrument for lowering emissions, or whether it needs other policies, which will also assist in achieving climate goal. The complementary policies influences the carbon cost as well as the pace of emissions drop (He, Zhang, Xu, & Bian, 2015). Notably, computer modeling plus other analytical methods may offer guidance to policymakers concerning the costs as well as results of various sets of climate acts.

Scope is another element of cap and trade system. It determines the kind of sources of emissions as well as the sort of greenhouse gases that will be enclosed by the cap. For instance, RGGI covers CO2 emissions from industries whereas California covers numerous greenhouse gases from factories, industrial facilities, transportation, as well as buildings. For easy administration, policies tend to comprise merely the major sources of greenhouse gases within the economy. Similarly, target as a tenet of cap and trade system determines the level of emissions decrease will be required, and by what time it will be achieved. For instance, the yearly budget allowance in California will be estimated to enable the state stay on the course of attaining its 2020 target to reduce emissions.

Allowance allocation as an element determines how allowances will be distributed. In this sense, governments may auction allowances and freely offer them away to the covered facilities. It is important to allocate certain allowances freely to prevent emissions. Moreover, auctioning generates income that may be used for preserving the environment. Cap and trade system may also be facilitated through banking/borrowing. It determines whether facilities can save additional allowances for use within later years or rather borrow allowances from an upcoming year. As a matter of fact, both banking and borrowing assist in avoiding cost spikes. Additionally, banking offers a financial incentive in order to keep lowering emissions beyond what is required. Nonetheless, borrowing may create supply limitations in future years.

On the other hand, compliance periods determines the duration in which the facilities are expected to surrender allowances annually. Indeed, a multi-year compliance duration may reduce cost volatility. Also, offsets establishes whether firms can use verified emissions discounts made outside the cap to comply. Indeed, offsets may help in lowering the overall prices of attaining the cap. For example, agricultural as well as forestry projects may often lower emissions at a reduced cost compared to industrial facilities. To remain effective, offset plans should undergo rigorous confirmation procedures to make sure that emissions are reduced, and only a single entity earns the acknowledgement for the offset. Lastly, market integrity as an element of cap and trade, determines how market manipulation will be avoided. A secure, safe and transparent registry may be used to track transactions, and stop theft and double counting of allowances. Additionally, most authorities choose independent specialists to review contract information and monitor for fraud.

How carbon pricing work

There are two major ways to put a cost on carbon: Under a cap-and-trade system, policies or rather regulations have the capacity to limit or cap carbon emissions from specific segments of the economy or even the entire economy, and give allowances, which permits emissions, to match the limit set. For instance, if the limit is 10,000 tons of carbon dioxide then there would be 10,000; one- ton grants that is awarded. A reduction in emissions limit would assist in reducing emissions over time. Therefore, every source of emissions is subject to the limit and is expected to hold allowances equivalent to their emissions. The operators of the power plant may obtain their allowances through an auction or allocation. Once these facilities have allowances, then they would be allowed to trade or rather sell allowances freely to other authorized market participants. Since the allowances are “capped” and thus valuable, the companies that are subjected to the cap will then try to lower their emissions to reduce certain allowances they need to buy.

The subsequent communication of the allowances between demand and supply in the marketplace determines the cost of an allowance, the carbon price.  What is more, with a carbon tax, policies or regulations are passed, which puts in place a fee on each ton of the emitted carbon from a segment or even the entire economy (Purohit, Shankar, Dey, & Choudhary, 2016). The firm owners are subject to a tax are expected to pay levies, which are equivalent to the tons of their total carbon emissions. Notably, those who can reduce carbon emissions cost-effectively would be able to cut their tax payments. Equally, those subject to the levy would be able to have an enticement to reduce their emissions, by moving to cleaner energy as well as using energy more proficiently. Resultantly, a rising carbon levy would assist in ensuring a reducing in emissions for certain period of time.

However, there is need to have hybrid programs, which limit carbon emissions. One of the hybrid approaches include adjusting the levy to make sure specific emission cut goals are attained. Another hybrid technique would be when an authority applies a carbon cap-and trade system for certain segments, and execute a carbon levy on others. Carbon pricing schemes may also work in a corresponding way with other energy efficiency strategies like renewable electricity as well as vehicle fuel budget rules. From an economic viewpoint, the carbon tax as well as a cap-and-trade systems operates in equivalent manner: one gives the cost of emissions that then controls the level of carbon emissions, while the other gives the level of carbon emissions that determines a cost for the emissions. The level of cap, and its rate of growth or decline over time pushes the level to which carbon emissions are cut. All these approaches have the capacity to deliver on the major objectives of a vigorous carbon pricing policy that is to assist reduce emissions economically in line with various energy goals.

Economic benefits of cap and trade

Carbon cap-and-trade policy with auctioned payments may generate substantial revenues. The application of these incomes has significant implications for the distributional fairness as well as economic growth. The potential application of carbon income include: offsetting the unequal influences of higher energy costs for a low-income households. It also helps in providing transition assistance to employees as well as communities, which depend on coals for a living (Purohit, Shankar, Dey, & Choudhary, 2016).

A good policy design needs addressing possible equity implications. Thus, these equity concerns comprise the regressive influence of potential energy cost upsurges on low-income families; the prospective for carbon tax policies to enable certain fossil fuel-fired factories or rather refineries to remain in operation. Notably, most industrialized nations have used carbon levies to depress fossil fuel emissions while promoting clean energy.


In summary, cap and trade is a technique that harnesses marketplace forces in order to reduce carbon emissions cost-effectively. Just like other market-based programs, it varies from “command-and-control” methods in which the government sets presentation standards, or even dictates technology selections for separate facilities. Cap and trade enables the marketplace to determine a cost on carbon; and that cost drives investment choices and encourages market innovation. Cap and trade varies from a levy in the sense that it offers a high level of inevitability about future carbon emissions, although not about the cost of those carbon emissions. A cap can be the desirable policy when an authority has a stated emissions target.


He, P., Zhang, W., Xu, X., & Bian, Y. (2015). Production lot-sizing and carbon emissions under cap-and-trade and carbon tax regulations. Journal of Cleaner Production103, 241-248.

Purohit, A. K., Shankar, R., Dey, P. K., & Choudhary, A. (2016). Non-stationary stochastic inventory lot-sizing with emission and service level constraints in a carbon cap-and-trade system. Journal of Cleaner Production113, 654-661.

Qiu, Y., Qiao, J., & Pardalos, P. M. (2017). A branch-and-price algorithm for production routing problems with carbon cap-and-trade. Omega68, 49-61.

Rabe, B. G. (2016). The Durability of Carbon Cap‐and‐Trade Policy. Governance29(1), 103-119.


A coal power plant

Cap-and-trade and carbon tax pricing programs can both help economies move away from carbon-intensive forms of energy.



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