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Cap and Trade

Michael Forlini | Aug 1, 2008

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Cap and Trade is a market-based policy tool designed to protect human health and the environment. This tool was designed to minimize pollution (such as air emissions) from sources. The first step in a cap and trade program is to set caps, or maximum limits, on the source releasing pollution. Authorizations for maximum limits are obtained from an overseeing government entity or overseeing organization (such as the Ozone Transport Commission).

Emissions allowances were first established for controlling air emissions. Each emission source had a capped emission amount (capped source), based on the amount of pollutants that the emitter is allowed to release into the atmosphere in a given year. During the year, each capped source is required to monitor its actual emissions and report annual or seasonal emissions amounts. At the year's end, if the actual emissions are equal to the number of allowances allocated, the capped emitter has achieved compliance and does not have to take further action.

However, if the actual emissions are greater than the number of allowances allocated, the capped emitter may consider buying allowances from another capped emitter that has excess allowances, in order to maintain compliance. Future pollution controls on air emissions should also be considered. If the actual emissions are less than the number of allowances, the capped emitter can sell its allowances to another capped emitter, which exceeded its allowances, or bank them to meet its own reduction commitments in future years. The program awards high environmental performance and requires restitution from performance that demonstrates higher emissions.

Strategies include the sale or purchase of allowances, installation of pollution controls, and the implementation of efficiency measures. In the SO2 Allowance Trading Program, EPA maintains an Allowance Management System (AMS) that records allowance transfers. Each affected utility source, corporation, group or individual holding allowance, has an account in the AMS. Parties must notify EPA to have transfers recorded in their AMS account, but it is not necessary to record all transfers with EPA until such time that the allowances are to be used to meet a source's SO2 emissions limitation requirement. Environmental groups have actively purchased allowances as a strategy to retire that allowance from ever being used as an emission source.

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