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What is, "Cap and Trade?"

Updated on December 3, 2013

Capping Credits

This rather ingenious system has already been used in the U.S. to reduce Nitrogen Oxides, the pollutant that results in acid rain. Within this system corporations are allowed to emit a certain limit of pollutants into the environment and only that amount essentially, "capping," their emissions. With the ever increasingly dire conditions concerning global warming, Carbon Dioxide, the gas most responsible for ozone erosion has been subject to this limit among European nations as a result of the European Union Emissions Trading Scheme. A consortium of European nations have issued credits to the corporations operating within their borders which entitle these corporations to emit only a set amount of Carbon Dioxide.

Trading Credits

By assigning these credits a monetary value, corporations that will easily be able to limit their emissions can sell their excess credits to other corporations that cannot. This creates a financial incentive to reduce Carbon Dioxide and likewise a financial penalty for corporations that must buy credits because they have exceeded their cap. This selling and buying of credits creates a para-economy that is contingent on amounts of corporate pollution. It creates an incentive for corporations to find better, less environmentally detrimental ways to produce their goods.

Pollution is one of many, "externalities." These are corporate activities that have an affect on other entities and yet are outside of the fiscal market. The Cap and Trade system brings the external activity of polluting into the sphere of financial gain and loss.

This Cap is a binding agreement and is usually put on a set schedule to be reduce in time with fewer credits being issued. On top of this these credits can be purchased by environmental groups thus decreasing supply and increasing demand along with the value of the credits. This makes polluting an increasingly expensive cost of doing business. The hope is that this will provide an incentive for companies to innovate more environmentally friendly ways to do business. Often a company can also donate it's excess credits to a non-profit organization for tax breaks.

Is Cap and Trade an Effective Solution to Pollution Emissions

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Market-Based Instruments

This grand design is considered a, "market-based instrument." These are considered more fair and less stringent than,"command and control instruments," which often don't discriminate among types of business, geographic locations, and other such factors.

That being said, for the system to work a government regulatory agency must set and enforce the cap with fines that exceed the cost of credits for companies that surpass emissions levels without buying enough extra credits. With this prohibition in place a company will have to consider the least costly way to proceed and innovate greener substitutes for their current manufacturing procedures.

One Carbon credit allows for one metric ton of carbon emission. The credits become an international commodity through the cap and trade system and their trading is monitored by the United Nations Framework Convention on Climate Change or the European Union.

Computer models testing the efficacy of this strategy were showing promise as early as 1967 by the U.S.'s EPA. it has been predicted by economist that with six exchanges currently trading in carbon credits that Carbon could come to be the world's most valuable commodity.

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