Cap and Trade – Definition

Cite this article as:"Cap and Trade – Definition," in The Business Professor, updated March 7, 2019, last accessed October 21, 2020,


Cap and Trade or Emissions Trading Definition

Emissions trading is also known as “allowance trading,” or “cap and trade” refer to the approach that is used to reduce pollution and has been confirmed to protect the environment and human health successfully.

An emission trading system (SCE) refers to an instrument of the market the developed to minimize the emission of greenhouse gas (GHG). This model is based on the principle of “cap and trade”. The government played an important role in this model by setting the maximum cap or limit on the amount of emission of sectors in the economy. For the companies to operate in the economy, they must have permits that allow the emit gas to the environment. These permits can be received or bought by trading with other companies. Currently, the four continents have 17 emission trading systems. Besides, the current major world economic country such as China seeks to adopt a national system.

A Little More on What is Cap and Trade

The government plays an important role in determining the limit of emission allowed in the SCE – that is the “cap” dimension of the “cap and trade.” This cap must be determined in advance to allowed the traders to comply with the regulations for the specified periods. The government`s provision conforms with the objective of reduction of emissions from the jurisdiction.  This informs the market in the long-run and allows the investors to plan and make their investments in the consequence.

Emission Permits

The government distributes tradable permits of the caps set to the companies immediately they are set. One permit allows the company the emit one ton of GHG emissions. The granting of the permit depends on the government whereby the government can decide to give the permits free or auction them to the traders. The method of permit allocation affects the management of the company`s emission.

Who is Affected by Cap and Trade?

The government decides the sectors the economy and which GHG to be regulated under the system. Hypothetically, an SCE that has wide coverage of gases and sectors will be more effective. Nonetheless, in reality, the use of such a system makes it difficult to monitor or measure the amount of emission in some sectors. The current system includes even the electricity sector. One of the most common gases covered under GHG is Carbon dioxide (CO 2). Other gases covered under the model include nitrous oxide (N 2 O), methane (CH 4), and other gases fluorinated (SF 6, HFC s and PFC s)

Managing Company Emissions

The regulation provides that every company must present their emission report to the government and other related authorities at the end of every year. Achieving this requires companies to choose or more of the options below:

Reduce the emissions – this can be achieved when the company improve the efficiency in their production or resort to using energy that produces less carbon.

Use compensation credits (‘Offset credits’) – International and national Trading systems permit companies to cover some of their emission by using project credit from the reduction authorities or sectors that are not regulated by SCE. Some of the effective credits come from projects that use renewable energy.

Building additional periods – this applies to the companies that have surplus permits and reduced their emission.

The effectiveness of Cap and Trade Regulation

The companies must monitor and report their emission to the authority to help in ensuring effective conservation by SCE. The reports must be verified and certified by an independent authority to ensure accuracy. Sanctions should also be imposed to ensure business compliance. The authority should also monitor the permits transactions between SCE participants. The permits must have the elements of registry security to minimize the risk of fraud and manipulation.

References for Cap and Trade

Academic Research on Cap and Trade

  • Assessment of US GHG cap-and-trade proposals, Paltsev, S., Reilly, J. M., Jacoby, H. D., Gurgel, A. C., Metcalf, G. E., Sokolov, A. P., & Holak, J. F. (2008). Climate Policy, 8(4), 395-420. This topic presents the assessment of the GHG by the US Congress. The topic points out that the US Congress has made a significant attempt to reduce the emission of the gas to the environment. The Congress has proposed and passed regulations steered towards eradicating the emission.  In 2007 for example, the US Congress started considering a set of bills to implement a cap-and-trade system to minimize the emission of the nation’s greenhouse gas (GHG).
  • Combating global climate change: Why a carbon tax is a better response to global warming than cap and trade, Avi-Yonah, R. S., & Uhlmann, D. M. (2009). Stan. Envtl. LJ, 28, 3. This article presents various mechanisms that can be used by both the government and the companies to eradicate GHG emission. The author states that the global climate has greatly and thus the ways of combating the emission. The paper also discusses the measures that can be taken by the government such as carbon tax that can be used to minimize the emission by the companies.
  • Balancing cost and emissions certainty: An allowance reserve for cap-and-trade, Murray, B. C., Newell, R. G., & Pizer, W. A. (2009). Review of Environmental Economics and Policy, 3(1), 84-103. This paper discusses the price-based policies that the government can use to address the problem of climate change. The article presents a slight modification to the concept of a safety valve which is also referred to as the allowance reserve. The authors suggest that the concept may fill the gap that exists between the competing interests. This can also be used to improve the efficiency in the companies just like other price-based models.
  • Game-theoretic analysis for an emission-dependent supply chain in a ‘cap-and-trade’system, Du, S., Ma, F., Fu, Z., Zhu, L., & Zhang, J. (2015). Annals of Operations Research, 228(1), 135-149. The article discusses the implication of emission ‘cap-and-trade’ model known as emission-dependent supply chain that has emission-dependent firm and emission permit supplier. The discussion extends to the cap-and-trade system. The author suggests that emission permit has become one of the key production factors for emission-dependent firms. Thus, the introduction of market mechanism injects new life into environment protection
  • Combining rate-based and cap-and-trade emissions policies, Fischer, C. (2003). Climate Policy, 3(sup2), S89-S103. This paper focuses on the rate-base policies such as tradable performance standards, TPS. The paper discusses the role played by cap-and-trade (CAT) policies to fix total emissions. This paper further revealed that unconstrained trade between rate-based and cap-and-trade programs always raises combined emissions. However, this gives exemptions when product markets are related in particular ways.
  • A meaningful US cap-and-trade system to address climate change, Stavins, R. N. (2008). Harv. Envtl. L. Rev., 32, 293. In the recent periods, the has been a growing impetus for domestic climate and combining that presents a constructive reduction of Co2 emission and other gases. This article analyses and propose profound scientific, rational economic and feasible political policies for the united states to reduce its emission of GHG.
  • Multi-item production planning with carbon cap and trade mechanism, Zhang, B., & Xu, L. (2013). International Journal of Production Economics, 144(1), 118-127. This paper examines the problem of multi-item production planning with carbon cap and trade mechanism, whereby a company applies carbon emission quota and common capacity to produce many products to meet independent stochastic needs.  The study proposed the profit-maximization model t optimize the problem. The paper also analyzes and present solutions to the occupational complexity models.
  • The effect of allowance allocations on cap-and-trade system performance, Hahn, R. W., & Stavins, R. N. (2011). The Journal of Law and Economics, 54(S4), S267-S294. This article investigates the implications of allowance on the cap-and-trade system. The author examines the conditions under which the independence property is likely to hold—both in theory and in practice. call this the independence property.
  • To link or not to link: benefits and disadvantages of linking cap-and-trade systems, Flachsland, C., Marschinski, R., & Edenhofer, O. (2009). Climate Policy, 9(4), 358-372. This study explores the concepts of linking cap-and-trade systems. It also analyses the systematic of the political economic and regulatory implications of linking cap-and-trade systems. The study indicated that economic and political factors post a potential benefit along with many potentially negative side effects. Political benefits are resulting from the strengthened commitment to international climate rule and the abolition of competitiveness apprehensions among linking partners. On the other hand, regulatory drawbacks may come from the linked system’s irregularity with original domestic strategic aims and the partial de facto cession of flexible control over the national emissions trading system.
  • Emission-dependent supply chain and environment-policy-making in the ‘cap-and-trade’system, Du, S., Zhu, L., Liang, L., & Ma, F. (2013). Energy Policy, 57, 61-67. The paper explores the emission-dependent supply chain involving of one solitary emission-dependent producer and one solitary emission permit dealer in the ‘cap-and-trade’ system.  The article proved that the system-wide and the producer’s profits rise with the emission cap while the permit dealer’s decreases.
  • Impacts of alternative emissions allowance allocation methods under a federal cap-and-trade program, Goulder, L. H., Hafstead, M. A., & Dworsky, M. (2010). Journal of Environmental Economics and management, 60(3), 161-181. This paper studies the impacts of different allowance apportionment designs for business profits and GDP under a federal cap-and-trade program to minimize GHG. The study employed general equilibrium model of the US economy that has different treatment capital dynamics. The study reveals that effects on profits rely critically on the relative reliance on auctioning or free allocation of allowances


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