Cap and trade limits pollution by setting a total ceiling on emissions and letting companies trade permits to emit. The government sets the cap. It issues or auctions permits equal to that cap. Companies that pollute less can sell unused permits. Companies that pollute more must buy them. The market decides who cuts and who pays.

The system has a track record. The US Acid Rain Program, launched in 1995, cut sulfur dioxide emissions sharply at lower cost than expected. The European Union Emissions Trading System covers thousands of installations and is the largest carbon market in the world. California and Quebec run a joint market. China launched a national system in 2021.

Critics point to problems. Caps can be set too loose. Permits can be given away instead of auctioned, creating windfall profits. Offsets allow companies to pay for reductions elsewhere rather than cutting their own. Design matters. A tight cap with auctioned permits and strict monitoring works. A loose cap with free permits does not.

Key design choices

• Level of the cap
• Auction vs. free allocation
• Use of offsets
• Price floor and ceiling
• Monitoring and enforcement