Emissions trading, or cap and trade, is a market-based approach to controlling pollution by providing economic incentives for achieving reductions in the emissions of pollutants. Polluters are required to hold permits in new trading equal to their emissions. In theory, polluters who can reduce emissions most cheaply will do so, achieving the emission reduction at the lowest cost to society. Cap and trade is meant to provide the private sector with the flexibility required to reduce emissions while stimulating technological innovation and economic growth.
There are active trading programs in several air pollutants. For greenhouse gases, which cause climate change, permit units are often called carbon credits. A coal power plant in Germany. Due to emissions trading, coal may become a less competitive fuel than other options.
Pollution is the prime example of a market externality. Emissions trading is a market-based approach to address pollution. The overall goal of an emissions trading plan is to minimize the cost of meeting a set emissions target. The baseline is determined by reference to the participant’s historical emissions.
In some schemes, participants can bank allowances to use in future periods. In some schemes, a proportion of all traded permits must be retired periodically, causing a net reduction in emissions over time. According to the Environmental Defense Fund, cap-and-trade is the most environmentally and economically sensible approach to controlling greenhouse gas emissions, the primary cause of global warming, because it sets a limit on emissions, and the trading encourages companies to innovate in order to emit less. Economy-wide pricing of carbon is the centre piece of any policy designed to reduce emissions at the lowest possible costs.
Some economists have urged the use of market-based instruments such as emissions trading to address environmental problems instead of prescriptive “command-and-control” regulation. After an emissions limit has been set by a government political process, individual companies are free to choose how or whether to reduce their emissions. Failure to report emissions and surrender emission permits is often punishable by a further government regulatory mechanism, such as a fine that increases costs of production. Under an emissions trading system, each regulated polluter has flexibility to use the most cost-effective combination of buying or selling emission permits, reducing its emissions by installing cleaner technology, or reducing its emissions by reducing production. The most cost-effective strategy depends on the polluter’s marginal abatement cost and the market price of permits. Kyoto Protocol by allowing private trading of permits. Trading exchanges have been established to provide a spot market in permits, as well as futures and options market to help discover a market price and maintain liquidity.
An emission license directly confers a right to emit pollutants up to a certain rate. In contrast, a pollution license for a given location confers the right to emit pollutants at a rate which will cause no more than a specified increase at the pollution-level. For concreteness, consider the following model. The pollution is a linear combination of the emissions. Therefore, a polluter that affects water quality at a number of points has to hold a portfolio of licenses covering all relevant monitoring-points. In the above example, if country 2 wants to emit a unit of pollutant, it should purchase two permits: one for location 2 and one for location 3.
Montgomery shows that, while both markets lead to efficient license allocation, the market in pollution-licenses is more widely applicable than the market in emission-licenses. Proof of Principle: First developments towards trading of emission certificates based on the “offset-mechanism” taken up in Clean Air Act in 1977. A company could get allowance from the Act on a greater amount of emission when it paid another company to reduce the same pollutant. Prototype: Launching of a first “cap-and-trade” system as part of the US Acid Rain Program in Title IV of the 1990 Clean Air Act, officially announced as a paradigm shift in environmental policy, as prepared by “Project 88”, a network-building effort to bring together environmental and industrial interests in the US. In the United States, the “acid rain”-related emission trading system was principally conceived by C. 1995, and according to Smithsonian magazine, those acid rain emissions dropped 3 million tons that year. One important economic reality recognised by many of the countries that signed the Kyoto Protocol is that, if countries have to solely rely on their own domestic measures, the resulting inflexible limitations on GHG growth could entail very large costs, perhaps running into many trillions of dollars globally.