Emissions trading is an approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. It sets a limit on the amount of a pollutant that can be emitted. Companies or other groups are issued emission permits and are required to hold an equivalent number of credits which represent the right to emit a specific amount. The total amount of allowances and credits cannot exceed the cap, limiting total emissions to that level. Companies that need to increase their emissions must buy credits from those who pollute less. The transfer of allowances is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions by more than was needed.
Carbon trading is a better approach than a direct carbon tax or direct regulation.
The cap is usually lowered over time - aiming towards a national emissions reduction target. In other systems a portion of all traded credits must be retired, causing a net reduction in emissions each time a trade occurs. In many cap and trade systems, organizations which do not pollute may also participate, thus environmental groups can purchase and retire allowances or credits and hence drive up the price of the remainder according to the law of demand. Corporations can also prematurely retire allowances by donating them to a nonprofit entity and then be eligible for a tax deduction.
Because emissions trading use markets to determine how to deal with the problem of pollution, it is often touted as an example of effective free market environmentalism
The textbook emissions trading program can be called a "cap & trade" approach in which an aggregate cap on all sources is established and these sources are then allowed to trade amongst themselves to determine which sources actually emit the total pollution load. An alternative approach with important differences is a baseline & credit program. In a baseline and credit program a set of polluters that are not under an aggregate cap can create credits by reducing their emissions below a baseline level of emissions. These credits can be purchased by polluters that do have a regulatory limit.
It's possible for a country to reduce emissions using a Command-Control approach, such as regulation, direct and indirect taxes. But that approach is more costly for some countries than for others.
Emissions trading refer to a system for in which parties can buy and sell their carbon credits. It has been established in Europe and North America.