Cap and Trade is a regulatory mechanism tied to reducing emissions by power plants or other industries. It is designed for flexibility in allowing the marketplace to determine the most efficient ways of meeting an emissions cap set by the regulator.
Under Cap and Trade:
the regulatory agency starts with a historical amount of emissions in a specific geographical area
the regulator then sets an allowable emissions cap based on the historic emissions
typically, the cap is reduced over time to result in lower and lower emissions as the program is implemented over multiple years
Using the mandated cap to determine the amount of allowances, the regulator allocates allowances to emit regulated substances to various market participants who own power plants. These may be allocated for free, or they may be auctioned. At the end of a compliance period, power plant owners must submit a number of allowances equal to the amount of emissions they have put into the air during the period. Failure to do so results in significant fines or other penalties.
To facilitate efficient solutions, market participants are permitted to trade allowances. Thus, participants that can cost-effectively reduce emissions can then sell unutilized allowances to other parties who have a higher cost of reducing emissions. This means that the market should be able to find the least-cost way of reducing emissions to a specific cap. This methodology has been used since 1995 for SO2 and more recently for NOx in certain regions of the U.S. In general, it has proved successful in reducing emissions at a low cost. Cap and Trade systems for greenhouse gases (GHG) have been implemented in various regions in recent years including various northeast U.S. states, California, Quebec, many countries in Europe, and more recently in China.