Limit and trade

What are caps and trades?

Cap-and-trade is a common term for government regulatory programs designed to cap or limit the overall level of emissions of certain chemicals, particularly carbon dioxide due to industrial activity.

Proponents of cap-and-trade see it as a palatable alternative to a carbon tax. Both measures are attempts to reduce environmental damage without causing undue economic hardship to the industry.

key takeaways

  • The cap-and-trade energy program aims to gradually reduce pollution by incentivizing companies to invest in clean alternative energy sources.
  • The government issues a certain number of licenses to companies, which include a cap on the amount of carbon dioxide they are allowed to emit.
  • Companies that exceed the cap will be taxed, while companies that reduce emissions can sell or trade unused credits.
  • The total limit (or cap) on pollution credits falls over time, incentivizing businesses to find cheaper alternatives.
  • Critics say the cap could be set too high, giving companies an excuse to avoid investing in cleaner alternatives for too long.

Understanding Limits and Transactions

Cap-and-trade schemes can work in a number of ways, but here are the basics. Governments set limits or “caps” on emissions that are allowed in specific industries. It issues a limited number of annual permits that allow companies to emit a certain amount of carbon dioxide and related pollutants that contribute to global warming. Other pollutants that cause smog can also be limited.

The total amount of the cap is divided into allowances. Each quota allows a company to emit one ton of emissions. The government distributes subsidies to companies for free or through auctions.

But the government reduces the number of permits every year, thereby lowering the total emissions cap. This makes licenses more expensive. Over time, companies have an incentive to reduce emissions more efficiently and invest in clean technology because it is cheaper than buying a permit.

If a company produces more emissions than its permit allows, it needs to be taxed. They may even be penalized for noncompliance. On the other hand, companies that reduce emissions can sell (“trade”) their allowances to other companies that pollute more. They can also bank them for future use.

Advantages and disadvantages of capping and trading


Cap and trade systems are sometimes described as market systems. That is, it creates exchange value for emissions. This creates new economic resources for industry as companies with emissions credits can sell them for additional profit.

Its proponents argue that the cap-and-trade program provides an incentive for companies to invest in clean technology to avoid buying licenses that add to the cost each year. It also incentivizes companies to fund alternative energy research.

This process could lead to faster reductions in pollution, as companies that lower their emissions levels faster are rewarded in some way because they can sell their emissions allowances to other companies.

Since the government can decide to auction emissions credits to the highest bidder, cap-and-trade is also a source of revenue for the government, as it has the power to auction emissions credits to the highest bidder. This new revenue could meet infrastructure needs, social programs, invest in clean technology, and even be a way to address budget deficits at the state or national level.

As a free trade system, cap and trade also provide consumers with more choices. Consumers can choose not to buy from non-compliant companies and do business with companies that try to reduce pollution levels.

Finally, cap-and-trade systems are also beneficial to taxpayers. The government sells emissions credits to businesses that need them. The revenue generated helps supplement the resources taxpayers provide to the government.


Opponents of cap-and-trade argue that it could lead to excess production of pollutants reaching the maximum levels the government sets each year, because allowable levels may be set too wide, effectively slowing the transition to clean energy.

Also, emissions credits (and even penalties and fines for exceeding caps) are often cheaper than switching to cleaner technologies and resources. This is the case, for example, in industries that use fossil fuels. This means that capping and trading is not the real incentive for these industries to change their practices.

It was also argued that the “trade” mechanism was not always followed. Some points are sold at auction to the highest bidder or even given away. That means the company doesn’t have to incur any cost to increase its emissions.

Most industries do not have equipment to help monitor and determine their emissions. This makes it relatively easy for companies to cheat on emissions reports. For a cap-and-trade system to be effective, a monitoring system must be implemented so that it can be enforced.

Since renewables are still relatively new, they are also expensive. Products sold by companies that comply with capping rules tend to be more expensive to produce, affecting what consumers pay for them.

Finally, each country has different emission standards and caps. Some may be very permissive, allowing higher levels of contamination, while others may be very strict. Unless a global cap-and-trade system is in place, it won’t be effective globally, and it will likely have little impact on the emissions that leak into the atmosphere each year.


  • Company’s source of income

  • Promote clean technology

  • lead to faster pollution reduction

  • source of government revenue

  • Supplementary taxpayer resources

  • Empower consumers to decide


  • The allowable emission level is set too high

  • Points and penalties, and cheaper than switching to cleaner technology

  • some credits are given away

  • Companies can cheat the system

  • it raises the price of goods and services

  • The system has no global consistency

source: Brandon Gale, Vitana Net

The challenge of capping and trading

A challenge in developing cap-and-trade policy is the ability of governments to impose the correct caps on emission producers. A cap that is too high can lead to higher emissions, while a cap that is too low is seen as a burden on the industry and a cost passed on to consumers.

There is also a general lack of reliable emissions data. Estimates of past and current emissions, as well as projections of future emissions, vary by industry. Cap-and-trade systems can be useless until accurate information about emissions is available, which involves an expensive process and can take years to complete.

In addition to the lack of reliable emissions data, there are a number of methodological challenges in applying effective cap-and-trade regimes: difficulties in reaching an international consensus on emissions and caps due to the different priorities of each country, or high trading volumes and administrative costs involved.

Finally, predicting the long-term impact and benefits of Cape Town and trade initiatives is also a huge challenge.

While cap-and-trade systems can reduce emissions and reduce pollution faster, they also tend to raise the price of oil, coal and natural gas to force companies to switch to alternative forms of energy. These moves are costly and have a negative impact on the economy.

Examples of caps and transactions

In 2005, the European Union (EU) created the world’s first international cap-and-trade program aimed at reducing carbon emissions. In 2019, the European Union estimated that by 2020, emissions from the industries covered by the system would be reduced by 21%.

During the administration of US President Barack Obama, Congress introduced a clean energy bill that included a cap-and-trade program. It was eventually approved by the House, but never even voted in the Senate.

California introduced its own cap-and-trade program in 2013. The program was initially limited to fewer than 400 businesses, including power plants, large factories and fuel distributors. Its goal of reducing greenhouse gas emissions to 1990 levels by 2020 was successfully achieved in 2016.

Mexico is implementing a cap-and-trade pilot program, which began in January 2020. This is the first emissions trading pilot program in Latin America and is targeted to be fully operational in 2018. The country has pledged to reduce greenhouse gas emissions by 22% by 2030.

Do caps and deals really work?

The effectiveness of capping and trading has been debated. Cap-and-trade aims to mitigate climate change by reducing carbon emissions by putting a price on carbon emissions. Those well-designed cap-and-trade schemes have proven not only effective for the environment, but also cost-effective, as companies that bank excess quotas (or capped amounts) can reduce costs significantly.

In California, for example, the program met some initial benchmarks and inspired many other similar initiatives around the world. But some claim that the state’s largest oil and gas company has actually polluted more since the program started. Experts are increasingly concerned that the cap-and-trade program will actually allow California’s biggest polluters to do business as usual and even increase their emissions.

An analysis by ProPublica shows that carbon emissions from the California oil and gas industry have actually increased by 3.5 percent since cap-and-trade began, as have emissions from vehicles burning refinery-processed fuel.

Carbon Tax and Cap-and-Trade

Carbon taxes directly price greenhouse gas emissions — so companies pay a fee for every ton of emissions they generate — while cap-and-trade programs issue a certain number of emissions “allowances” each year. These allowances can be auctioned off to the highest bidder or traded on the secondary market, creating a carbon price.

If properly designed, either a carbon tax or a cap-and-trade program can be a key element of the U.S. effort to reduce greenhouse gas emissions.

Are caps and trades used?

Yes. Today, capping and trading are used or developed around the world.

For example, European countries have been implementing cap-and-trade schemes
Since 2005, the Chinese government has been working hard to develop a national carbon emission cap plan, and currently, many cities and provinces in China have established carbon emission caps
Since 2013. Eleven US states participate in the Regional Greenhouse Gas Initiative (RGGI), a cap-and-trade program established in 2009.

Are caps and deals bad?

Although cap-and-trade is designed to reduce emissions and pollution, it has some downsides that affect the economy.When implemented, it results in energy costs.

Are caps and deals a success?

Proponents of cap-and-trade argue that well-designed cap-and-trade systems have proven effective and cost-effective for the environment. When a company has an effective emissions monitoring system and is in compliance with regulations, a cap-and-trade program is not only good for the environment, but also for the economy, as banking excess allowances can significantly reduce the company’s costs.

How does cap-and-trade work in California?

California began its cap-and-trade program in 2013, and as of 2022, it has one of the largest emissions trading systems in the world. The ambitious plan aims to reduce greenhouse gas emissions to 1990 levels by 2020 (a target already achieved in 2016), and now aims to reduce emissions by 40% from 1990 levels by 2030 %, reducing emissions by 80% from 1990 levels by 2050. California has also set additional goals for 100 percent carbon-free electricity by 2045 and carbon neutrality for the entire economy by 2045.

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