A carbon cap and trade system is a form of taxation on CO2 emissions. It works in the following manner:
- Regulators set an aggregate emissions cap per year which can decrease over time.
- Regulated parties have to obtain allowances for emissions they generate in a particular year.
- Emission allowances, adding up to the total cap, are allocated to each party. This allocation could be based on historical emissions and/or via an auction.
- Parties can trade allowances. An effective “carbon tax” then emerges as the market price at which these carbon allowances trade.
The goal of the system is to put an economic value to carbon emissions so that it influences business decisions.