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Cap-and-trade is a system that limits aggregate emissions from a group of emitters by setting a “cap” on maximum emissions. It is characterized as a market-based policy to reduce overall emissions of pollutants and encourage business investment in fossil fuel alternatives and energy efficiency.

In a typical program, the government first creates a “cap” on the total amount of pollutants emitters may release. By setting a maximum limit on emissions, the government then grants the right to emit pollutants through emissions allowances. An emissions allowance is a license to emit pollutants; the total number of allowances is limited by the cap. Because allowances are tradeable, bankable, and scarce, they become a price signal for the cost of emitting when companies buy and sell allowances.

Emitters are empowered to use their allowances in several ways. For instance, emitters are encouraged to design compliance programs to meet the emission reduction requirements. A compliance program typically includes the implementation of pollution controls and measures to increase energy efficiency. In addition, an emitter “bank” their allowance by choosing to hold the allowance for future use.

Alternatively, an emitter may sell their allowance to other emitters, who pay value for the right to emit. When a price for emissions is set by a market, some emitters may choose to emit less than the amount authorized by their allowance. In that situation, emitters can “trade” their excess allowances by selling them in a secondary market. The market for allowances is a hallmark of cap-and-trade: it permits the overall distribution of emissions reduction efforts to accord with market forces. In a cap-and-trade program, no single firm has a maximum limit of emissions. Rather, the cap controls the aggregate emissions freeing emitters to buy and sell allowance based on supply and demand.

An emitter covered by the cap-and-trade program must conform their emissions to the amount permitted by the allowance. Emitters are generally under an obligation to completely and accurately measure and report their emissions. Otherwise, the purpose of the program–to cap emissions–is defeated.

In theory, the cap-and-trade program makes it economically rational for emitters to reduce their emissions. The benefit to low-emitters is twofold because (1) they generate greater value in their allowance by lowering their emissions and (2) generate greater value in the secondary market by the option of selling a larger allowance. In this way, a cap-and-trade program encourages business behavior through market signals (i.e., cost of emitting compared with the cost of emitting less) and not through “command and control” regulation.

The United States created its first cap-and-trade program in Title IV of the Clean Air Act Amendments of 1990 to regulate sulfur dioxide emissions through allowances. In 2005, the EPA released another cap-and-trade program through its Clean Air Interstate Rule (CAIR), which covers sulfur dioxide and nitrogen oxides. And California was the first state to issue its program with the RECLAIM Program in the South Coast Air Quality Management District.

However, the policy is controversial and has sprung numerous lawsuits in the United States. Many of the lawsuits have successfully repealed cap-and-trade laws. For instance, in North Carolina v. EPA  (2008), the D.C. Circuit struck down the EPA’s 2005 cap-and-trade program for being "arbitrary and capricious," "not otherwise in accordance with the law," and "fundamentally flawed." On the state level, California’s cap-and-trade system for carbon emissions was challenged on the basis that it improperly created a tax due to the extensive amount of revenue raised from the auction of allowances. The state appellate court found the program valid since, inter alia, the auction system was not a tax because purchasing emissions allowances is a voluntary business decision, and the allowances are valuable and tradable commodities.

Internationally, cap-and-trade has played a role in reducing emissions. Under the Kyoto Protocol, a number of United Nations member countries established a cap-and-trade program to reduce greenhouse gas emissions. The Montreal Protocol successfully implemented a cap-and-trade program to reduce ozone-depleting substances. Europe achieved greenhouse gas reductions under its cap-and-trade program. Since the European Union's Emissions Trading System capped emissions from stationary structures in 2005, emissions reduced by 29% in 2018 since the program started.

[Last updated in May of 2020 by the Wex Definitions Team]