Emissions Trading: How does it work?
Emissions trading offers a market-based approach to achieve environmental policy goals by providing financial incentives to reduce emissions and other pollutants.
The central emissions trading mechanism is known as cap-and-trade. Under such a program, a government or other authority establishes a total limit – known as the cap – on the targeted pollutant based on a prior emissions year. Emitters are given an emissions target, generally on an annual basis, which they are required to meet. Using both carrots and sticks, cap-and-trade typically includes a penalty structure in the event of non-compliance.
Emitters that need allowances can make up for the shortfall by buying permits from other allowance holders who have a surplus. However, the total cap on how much can be emitted annually stays constant, ensuring that while some emitters may increase emissions, society benefits through an annual reduction in the overall level of emissions covered by the program.
In addition to domestic reductions, an emissions trading program may also permit the use of so-called offset permits. The Clean Development Mechanism (CDM) is currently the largest offset market and encourages the transfer of clean energy technologies by implementing emissions reduction projects in developing countries. At the same time it allows the developed world to finance the required emissions reductions at a lower cost as it is generally cheaper to abate greenhouse gas emissions in the developing world.
