A system of tradable permits is frequently called a ‘cap and trade’ system, because it limits or caps the total permissible emissions, while at the same time allows a market to develop in permits. For illustrative purposes, consider the hypothetical two-firm sector we developed above, composed of firms A and B. Firm A has invested in clean technology, firm B has not. Thus it is less costly for B to reduce emissions than A if further reductions are required. Next suppose that each firm is allocated by the government a specific number of ‘GHG emission permits’; and that the total of such permits is less than the amount of emissions at present, and that each firm is emitting more than its permits allow. How can these firms achieve the target set for this sector of the economy?
The answer is that they should be able to engage in mutually beneficial trade: If firm B has a lower cost of reducing emissions than A, then it may be in A’s interest to pay B to reduce B’s emissions heavily. This would free up some of B’s emission permits. A in essence is thus buying B’s emission permits from B.
This solution may be efficient from a resource use perspective: having A reduce emissions might involve a heavy investment cost for A. But having B reduce emissions might involve a more modest cost – one that he can more than afford by selling his emission permits to A.
The largest system of tradable permits currently operates in the European Union. It covers more than 10,000 large energy-using installations. Trading began in 2005. A detailed description of its operation is contained in Wikipedia. California introduced a similar scheme in November 2012.
See: Wikipedia – European Union Emission Trading Scheme
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