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Cap and Trade


Cap and Trade is an environmental policy approach aimed at controlling pollution by setting a limit (cap) on the total emissions allowed by companies in a specific industry or sector. Companies are issued emission permits, and they can buy, sell or trade these permits as needed, granting them flexibility in their emission levels. This approach creates an economic incentive for companies to find innovative ways of reducing emissions, as companies with lower emissions can sell their extra permits to those that exceed the cap.


The phonetic pronunciation of “Cap and Trade” is /kæp ənd treɪd/.

Key Takeaways

  1. Cap and Trade is an environmental policy designed to limit and reduce greenhouse gas emissions by establishing a market-based system.
  2. Under Cap and Trade, governments set an overall limit or cap on emissions and distribute allowances to covered industries. Companies can buy, sell, and trade these allowances depending on their emissions levels, incentivizing them to develop cleaner technologies.
  3. Cap and Trade has been implemented in various countries and regions to tackle climate change, with the European Union’s Emissions Trading System (EU ETS) being the largest and most notable example.


Cap and Trade is an important term in business and finance because it serves as a market-based approach to controlling pollution and emissions, which is essential for addressing environmental challenges such as climate change and air quality issues. This system sets a limit or “cap” on the total amount of emissions allowed and permits companies to buy and sell “allowances” to emit these pollutants. By limiting the overall emissions and attaching a cost to pollution, Cap and Trade encourages businesses to innovate, become more energy efficient, and invest in cleaner technologies, while also allowing for flexibility in meeting environmental regulations. This system helps drive economic growth and environmental sustainability by rewarding companies that reduce their emissions, ultimately promoting responsible environmental practices and encouraging a greener economy.


Cap and Trade is an environmental policy instrument that aims to effectively reduce greenhouse gas emissions and air pollution by assigning a market price to these emissions. The primary purpose of this mechanism is to benefit the environment by encouraging industries to adopt cleaner technologies and decrease pollution through the application of a market-based approach. This system consists of setting an overall emissions cap, allocating or auctioning allowances to entities representing the predetermined emission limits, and providing the flexibility to trade these allowances. In essence, companies that reduce their emissions below their capped limit can sell their surplus allowances to other companies that are struggling with their emissions quota, thus providing incentives for adopting greener practices.

Cap and Trade system also facilitates competition among industries to reduce emissions efficiently, as companies that are successful in lowering their greenhouse gas output economically benefit by selling their excess allowances. Moreover, the limits imposed on emissions can be further tightened over time, propelling continuous improvements in pollution management. The market-based nature of the Cap and Trade system ensures that regulatory authorities do not impose a specific technology or method on the businesses; instead, the businesses can determine the most cost-effective measure to limit their emissions according to the monetary value of the allowances. This flexibility and adaptability enhance the overall efficacy and popularity of Cap and Trade in mitigating environmental concerns, while supporting businesses to grow sustainibly.


1. European Union Emissions Trading System (EU ETS): Established in 2005, the EU ETS is the world’s largest cap and trade system, aiming to reduce greenhouse gas emissions across the European Union. The system covers around 45% of the EU’s total greenhouse gas emissions and includes more than 11,000 power stations and industrial plants across the 27 EU member states as well as the United Kingdom, Norway, Liechtenstein, and Iceland.

2. California’s Cap-and-Trade Program: Launched in 2013, California’s Cap-and-Trade Program is a key component of the state’s Global Warming Solutions Act (AB 32) aimed at reducing greenhouse gas emissions. The program covers major sectors of the California economy, including electricity providers, industrial facilities, and fuel distributors. It sets a statewide limit on greenhouse gas emissions, allowing businesses to buy and sell emissions allowances to maintain flexibility in their compliance options.

3. Regional Greenhouse Gas Initiative (RGGI): The RGGI is a cooperative effort among nine Northeastern and Mid-Atlantic states in the United States, including Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, and Vermont. The cap and trade program was initiated in 2009 with a focus on reducing carbon dioxide emissions from power plants in the participating states. It sets a regional cap on CO2 emissions and allows businesses to trade emissions allowances, using the proceeds from allowance auctions to invest in energy efficiency, renewable energy, and other consumer benefit programs.

Frequently Asked Questions(FAQ)

What is Cap and Trade?

Cap and Trade is an environmental policy tool that sets a limit or cap on the total amount of emissions that industries and businesses can produce. Those entities are then able to buy, sell, or trade emission allowances based on their individual needs, creating a market for pollution reduction.

How does Cap and Trade work?

Under a Cap and Trade system, the government sets an upper limit on the total greenhouse gas emissions allowed for specific industries or sectors. To comply with the cap, companies either have to reduce their emissions or purchase additional allowances from entities emitting lower than their allowance.

What is the purpose of Cap and Trade?

The main goal of Cap and Trade is to reduce emissions while promoting economic efficiency. By setting a cap and allowing businesses to buy, sell, or trade allowances, companies have an incentive to reduce their emissions and can do so in the most cost-effective way.

Is Cap and Trade effective in reducing emissions?

Yes, Cap and Trade has proven to be effective in reducing emissions in several regions around the world, notably the European Union, California, and New England. It provides a flexible and market-based approach that encourages businesses to innovate and invest in cleaner technologies.

What are the financial implications of Cap and Trade for businesses?

Businesses that can lower their emissions below the cap can sell their surplus allowances, generating revenue. However, companies that exceed the cap need to invest in clean technologies to meet the regulations and/or purchase extra allowances to cover their emissions, which can entail additional costs.

Can Cap and Trade lead to higher prices for consumers?

In some cases, businesses might pass on the costs of emission allowances to consumers as higher prices for goods and services. However, the competitive nature of a market-driven policy might also encourage businesses to innovate and adapt, ultimately minimizing the impact on consumer prices.

What is the role of offsets in Cap and Trade?

Offsets are emission reduction projects undertaken by entities outside of the Cap and Trade system, such as reforestation, renewable energy, or methane capture ventures. Companies within the Cap and Trade system can purchase offsets to help meet their emission reduction targets, while also encouraging environmentally beneficial projects in other sectors.

Related Finance Terms

  • Emissions Trading System (ETS)
  • Carbon Credits
  • Allowance Auctions
  • Carbon Offset Projects
  • Greenhouse Gas Inventory

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