Popularly known as “Cap and Trade,” emissions trading is a method of using economic incentives to control pollution.
Greenhouse gas emissions are highly regulated around the world. A central government body usually decides on an allowable level of pollution. It then limits or caps the amount of pollution that can be emitted. This cap or quantity is allocated between firms in the form of permits. Each emission permit, called a carbon credit, represents a fixed amount of emissions that the firm can emit. Usually, one permit is considered equal to one metric ton of carbon dioxide (CO2) emissions. These permits are also known as Certified Emission Reduction (CER) units or Kyoto units.
Since the overall cap or limit of emissions is fixed, it gives rise to trading of the individual permits among firms. Firms that need to increase their volume of pollutants or emissions need to buy permits from firms that have reduced their emissions below their allotted levels.
Firms can sell these credits privately in one on one exchanges or on the international markets according to market prices. The units can be traded and settled internationally and thus, allowances can be transferred across borders.
There are various trading programs for different pollutants. The European Union Emission Trading Scheme (EU ETS) is the largest trading program for greenhouse gases. In the United States, the Environmental Protection Agency runs the Clean Air Markets which is a market-based program that regulates outdoor concentrations of fine particles, sulfur dioxide, nitrogen oxides and mercury.
Other pollutants also have different markets that are smaller and more localized.
The United Nations Framework Convention on Climate Change (UNFCCC) validates each international trade of emissions permits. Within the European Union, each transfer is further approved by the European Commission.