A cap and trade system is a method of reducing overall carbon emissions by rewarding companies which are able to reduce their emissions, and penalizing those that are not, while reducing the emissions of industry as a whole. Emission offsetting may also be considered towards reduction levels.
The 'cap' component of the system is dictated by a regulating organization or government. It sets carbon emission limits for major emitting companies by allowing emissions permits. These permits dictate a set amount of carbon the company is allowed to emit. Companies which are able to reduce (or offset) their emissions are able to sell the remaining permits for a profit. Companies which are unable to keep their emissions within permitted levels must purchase additional permits, or face fines by the regulatory body. The exchange of permits between the emissions-reducing company and the over-emitting company comprises the 'trade' component of the system. One article suggests that the cost of permits might be approximately $10 - $15 per metric ton of carbon emitted. There are two main methods of distributing permits: free allocation or auctioning. Some systems may employ a mix of both methods. Free allocation allows some companies to receive an automatic profit (if their emissions are already low), but auctioning does not necessarily provide all companies with a fair opportunity.
By allowing excess allowances to be traded to companies producing excess emissions, the cap and trade system encourages companies to reduce their emissions, while balancing the emissions of the industry within the total capped amount. The total capped amount is reduced or offset annually, with the intent to meet a set future goal of reduced emissions. In addition, this system encourages the development of green technology which not only contributes to reducing climate change, but creates the potential for new jobs and businesses (like emissions management advice, or softwares).
Both pros and cons can be argued with respect to a cap and trade system. Some sources hold that emission targets can be met without actually reducing emissions. If the cost of purchasing additional permits is less than that of reducing emissions, companies may maintain the status quo at a slightly higher cost. If a company can make cheap changes to reduce or offset emissions, they may make a quick profit if allowances are allocated using the 'free allocation' method. However, if the cap is reduced over time, it does provide an absolute reduction in total carbon emissions, and as allocations become less available, companies will be motivated to look into different solutions.
The effectiveness of the program depends on the method of employment and the level of monitoring. It also depends on the ambitiousness of the cap limit, and the level of enforcement by regulating bodies. However, the implementation of emissions reducing programs such as the cap and trade system is a step in the right direction.
References:
http://www.americanprogress.org/issues/2008/01/capandtrade101.html
http://www.news.ontario.ca/ene/en/2009/12/reducing-greenhouse-gas-emissions.html
http://www.iea.org/papers/2007/ET_Trends&Prospects.pdf
http://www.dhf.uu.se/pdffiler/cc7/cc7_web.pdf
http://www.greenbiz.com/blog/2010/07/29/its-time-give-spreadsheets-tracking-carbon-emissions
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