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Emissions trading
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Thick smoke billows from an industrial smokestack, spreading across the sky and blending with clouds. Side-by-side diagrams compare command-and-control and cap-and-trade approaches to pollution control. The left shows both Plant A and Plant B each reducing emissions by 50 tons, resulting in higher total costs. The right shows cap-and-trade, where Plant A reduces emissions by 75 tons and Plant B by 25 tons, with Plant B paying Plant A for extra reductions, leading to lower overall costs. Emission levels, reduction amounts, and costs are labeled for both methods.
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Thick smoke billows from an industrial smokestack, spreading across the sky and blending with clouds.
Emissions from industrial smokestacks.

Emissions trading

pollution control
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Emissions trading, an environmental policy that seeks to reduce air pollution efficiently by putting a limit on emissions, giving polluters a certain number of allowances consistent with those limits, and then permitting the polluters to buy and sell the allowances. The trading of a finite number of allowances results in a market price being put on emissions, which enables polluters to work out the most cost-effective means of reaching the required reduction. Emissions trading has been used with notable success to reduce emissions that cause acid rain, and it is currently being used in various attempts around the world to control emissions of greenhouse gases.

Emissions trading in principle

Side-by-side diagrams compare command-and-control and cap-and-trade approaches to pollution control. The left shows both Plant A and Plant B each reducing emissions by 50 tons, resulting in higher total costs. The right shows cap-and-trade, where Plant A reduces emissions by 75 tons and Plant B by 25 tons, with Plant B paying Plant A for extra reductions, leading to lower overall costs. Emission levels, reduction amounts, and costs are labeled for both methods.
emissions tradingHow emissions trading worksAssume two emitting plants, A and B. Each plant emits 100 tons of pollutants (for a total emission of 200 tons), and the requirement is that these emissions be cut in half, for an overall reduction of 100 tons.(Left) In a traditional command-and-control system, each plant might be required to reduce by 50 percent, or 50 tons, to meet the overall reduction of 100 tons. Plant A might be able to reduce at only $100 a ton, for a total expenditure of $5,000. Plant B might have to spend $200 a ton, for a total of $10,000. The cost for both plants to reach the overall reduction of 100 tons would therefore be $15,000.(Right) In a cap-and-trade system, each plant might be given allowances for only half its previous emissions. Plant A, where reduction costs only $100 a ton, might be able to reduce emissions to as little as 25 tons, leaving it with unused allowances for 25 tons of pollutants that it is not emitting. Plant B, where reduction costs $200 a ton, might find it less costly to reduce to only 75 tons and then buy Plant A's unused allowances, effectively paying Plant A to make the 25 tons of reductions that Plant B cannot afford. The overall reduction of 100 tons would still be reached but at a lower overall cost ($12,500) than under the command-and-control system.

An idealized trading scheme might work in the following manner: A regulating authority might assign polluters a certain number of allowances defining the amount of pollutants they are permitted to emit that year. The total number of allowances would represent a certain reduction over the year before, and they would probably be scheduled to go down each subsequent year in order to reach the long-term reduction targets. One group of polluters might be able to take action during the year at relatively little cost that would actually reduce their emissions well below their allowances. In that case, they would face the prospect of finishing the year with unused allowances. A second group of polluters, meanwhile, might find it very expensive to reach their own reduction goals. In order to avoid this cost but also to avoid being fined by the regulating authority for exceeding their allowances, the second group of polluters might be willing to buy unused allowances from the first group—in effect, paying the first group to undertake the extra reductions that are too expensive for the second group. The two would then negotiate a price for the allowances, and the agreed-upon reductions would be undertaken.

The regulating authority would not be concerned with who owned the unused allowances, so long as the total emissions were reduced. Over time, as emissions limits were progressively lowered, the allowances would become fewer in number and fetch a higher price on the market. At some point even the most severe polluter might find it cheaper to invest in pollution reduction than to purchase expensive allowances, though this would not necessarily be the case; some polluters might continue to emit above their allowed levels indefinitely, so long as other polluters were still able to sell them unused allowances at an affordable price. Polluters would continue to invest in emissions-reduction schemes or in emissions trading, depending on which was less expensive at any given time, until the overall reduction target was met.

Acid rain and greenhouse gases

The economic principles behind trading in emissions were explained by American economist Thomas Crocker in his 1966 essay “The Structuring of Atmospheric Pollution Control Systems” and by Canadian economist John H. Dales in his landmark book Pollution, Property, and Prices: An Essay in Policy-Making and Economics (1968). Emissions trading received its first large-scale practical application in the Acid Rain Program run by the U.S. Environmental Protection Agency in the 1990s. In 1990, amendments to the U.S. Clean Air Act of 1970 called for a halving of emissions of sulfur dioxide (SO2) within two decades, along with a parallel ambitious reduction in emissions of nitrogen oxides. Emissions of SO2, mainly by electric power plants, were eventually to be “capped” at 8.95 million tons per year in the continental United States—as opposed to the approximately 17 million tons emitted in 1980. Beginning in 1995, a growing number of power plants (eventually reaching more than 1,000) were brought into the program. Each plant was given a number of annual emission allowances consistent with the nationwide cap, and each plant’s management was left to its own devices either to align its actual emissions with its allowances or to buy allowances from plants that had reduced their emissions below their yearly allowances. By 2010, power plants included in the Acid Rain Program were emitting about five million tons of SO2 per year—well below the program’s cap—and North America’s acid rain problem was universally considered to have been brought under control. Industry and government officials agreed that the reductions were accomplished more efficiently under the cap-and-trade program than they would have been under a more traditional “command-and-control” system of regulations that would have specified how, when, and by how much at each plant emissions were to be reduced.

The world’s first multilateral trading scheme for greenhouse gas emissions was the European Union Emissions Trading Scheme (EU ETS), established in 2005 in response to goals set by the Kyoto Protocol of 1997. The EU ETS is a cap-and-trade system similar in theory to the U.S. Acid Rain Program but vastly more complicated in practice, covering more than 10,000 large installations, from power plants to iron and steel mills as well as all of transport, including flights of non-EU airlines that arrive and depart from EU airports. Among other ambitious goals, the EU ETS aims to reduce the EU’s emissions of greenhouse gases (particularly carbon dioxide) to 20 percent below 1990 levels by the year 2020.

Other so-called carbon-trading schemes exist outside the EU, though none is as ambitious or as complex. Some are limited to individual regions (e.g., Alberta, California), some are undertaken by a collection of regional governments (e.g., the Regional Greenhouse Gas Initiative in the northeastern United States), and some are organized countrywide (e.g., New Zealand, Australia).

Some proponents of emissions trading argue that no system will be truly effective at reducing greenhouse gases until it is joined by all the world’s major emitters, including not just the EU but also the United States, China, and India. The linking of emissions-trading schemes around the world under the umbrella of internationally agreed-upon reduction targets, so their argument goes, would create a global price on carbon, and a globally accepted price on carbon would in turn eventually result in an efficient reduction of greenhouse gases. Some other analysts, however, argue that no emissions-trading scheme could efficiently reduce greenhouse gases, especially on a global scale. First, they argue, the damage caused to the global environment by each incremental emission of CO2 is very small and perhaps unknowable, making it very hard to put an accurate price on emissions. Second, a global cap-and-trade system would be very difficult to administer and almost impossible to enforce. Political opponents of emissions trading add the argument that any cap-and-trade arrangement would be an unnecessary and burdensome tax on economic activity.

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This article was most recently revised and updated by Robert Curley.