cap and trade | Wex | US Law | LII / Legal Information Institute

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class="container-fluid"> <div class="row"> <div title="Definitions Frame"></div> <div id="extracted-content"> <div id="main-content"> <h1 class="title" id="page-title">cap and trade</h1>  <h2 class="element-invisible">Primary tabs</h2> <div id="content1"> <article about="/wex/cap_and_trade" class="node-16492 node node-wex-cck en view-mode-full clearfix" typeof="sioc:Item foaf:Document"> <header> <span class="rdf-meta element-hidden" content="cap and trade" property="dc:title"></span> </header> <div class="field field-name-body field-type-text-with-summary field-label-hidden"> <div class="field-items"> <div class="field-item even" property="content:encoded"><p dir="ltr"><span id="docs-internal-guid-16451919-7fff-a9e3-dc36-eac7905f3c71">Cap-and-trade is a system that limits </span><a href="https://www.edf.org/climate/how-cap-and-trade-works">aggregate emissions</a> from a group of emitters by setting a “cap” on maximum emissions. It is characterized as a <a href="https://www.usaid.gov/work-usaid/private-sector-engagement/market-based-approaches">market-based policy</a> to reduce overall emissions of pollutants and encourage business investment in fossil fuel alternatives and energy efficiency.</p> <p dir="ltr"><span id="docs-internal-guid-16451919-7fff-a9e3-dc36-eac7905f3c71df47a538-9083-11ef-b8c7-e9213680cfdc">In a </span><a href="https://www.epa.gov/emissions-trading-resources/what-emissions-trading">typical program</a>, the government first creates a “cap” on the total amount of pollutants emitters may release. By setting a <a href="https://www.americanprogress.org/issues/green/news/2008/01/16/3816/cap-and-trade-101/">maximum limit on emissions</a>, the government then grants the right to emit pollutants through emissions allowances. An emissions allowance is a <a href="https://www.law.cornell.edu/wex/license">license</a> to emit pollutants; the total number of allowances is limited by the cap. Because allowances are tradeable, bankable, and <a href="https://education.nationalgeographic.org/resource/scarcity">scarce</a>, they become a <a href="https://www.greenbiz.com/article/why-cap-and-trade-still-main-way-price-emissions">price signal</a> for the cost of emitting when companies <a href="https://www.epa.gov/emissions-trading-resources/what-emissions-trading">buy and sell</a> allowances.</p> <p dir="ltr"><span id="docs-internal-guid-16451919-7fff-a9e3-dc36-eac7905f3c71df47a539-9083-11ef-b8c7-e9213680cfdc">Emitters are </span><a href="https://www.edf.org/climate/how-cap-and-trade-works">empowered</a> to use their allowances in several ways. For instance, emitters are encouraged to design compliance programs to meet the emission reduction requirements. A compliance program typically includes the implementation of pollution controls and measures to increase energy efficiency. In addition, an emitter “<a href="https://www.edf.org/climate/how-cap-and-trade-works">bank</a>” their allowance by choosing to hold the allowance for future use.</p> <p dir="ltr"><span id="docs-internal-guid-16451919-7fff-a9e3-dc36-eac7905f3c71df47a53a-9083-11ef-b8c7-e9213680cfdc">Alternatively, an emitter may </span><a href="https://www.edf.org/climate/how-cap-and-trade-works">sell</a> their allowance to other emitters, who pay value for the right to emit. When a price for emissions is set by a market, some emitters may choose to emit less than the amount authorized by their allowance. In that situation, emitters can “<a href="https://www.edf.org/climate/how-cap-and-trade-works">trade</a>” their excess allowances by selling them in a <a href="https://parlinfo.aph.gov.au/parlInfo/download/library/prspub/2501441/upload_binary/2501441.pdf">secondary market</a>. The <a href="https://www.law.cornell.edu/wex/market_definition">market</a> for allowances is a hallmark of cap-and-trade: it permits the overall distribution of emissions reduction efforts to accord with market forces. In a cap-and-trade program, no single firm has a maximum limit of emissions. Rather, the cap controls the aggregate emissions freeing emitters to buy and sell allowance based on supply and demand.</p> <p dir="ltr"><span id="docs-internal-guid-16451919-7fff-a9e3-dc36-eac7905f3c71df47a53b-9083-11ef-b8c7-e9213680cfdc">An emitter covered by the cap-and-trade program </span><a href="https://www.edf.org/climate/how-cap-and-trade-works">must conform their emissions</a> to the amount permitted by the allowance. Emitters are generally under an <a href="https://ww3.arb.ca.gov/regact/2010/capandtrade10/capv2appd.pdf">obligation</a> to completely and accurately measure and report their emissions. Otherwise, the purpose of the program–to cap emissions–is defeated.</p> <p dir="ltr"><span id="docs-internal-guid-16451919-7fff-a9e3-dc36-eac7905f3c71df47a53c-9083-11ef-b8c7-e9213680cfdc">In theory, the cap-and-trade program makes it </span><a href="https://web.archive.org/web/20110501113141/http:/www.rff.org/documents/RFF-DP-01-58.pdf">economically rational</a> for emitters to reduce their emissions. The benefit to low-emitters is twofold because (1) they generate greater value in their allowance by lowering their emissions and (2) generate greater value in the secondary market by the option of selling a larger allowance. In this way, a cap-and-trade program encourages business behavior through market signals (i.e., cost of emitting compared with the cost of emitting less) and not through “<a href="https://www.khanacademy.org/economics-finance-domain/microeconomics/market-failure-and-the-role-of-government/environmental-regulation/a/command-and-control-regulation-cnx">command and control</a>” <a href="https://www.law.cornell.edu/wex/regulation">regulation</a>.</p> <p dir="ltr"><span id="docs-internal-guid-16451919-7fff-a9e3-dc36-eac7905f3c71df47a53d-9083-11ef-b8c7-e9213680cfdc">The United States created its first cap-and-trade program in </span><a href="https://www.epa.gov/clean-air-act-overview/1990-clean-air-act-amendment-summary-title-iv">Title IV of the Clean Air Act Amendments of 1990</a> to regulate sulfur dioxide emissions through allowances. In 2005, the EPA released another cap-and-trade program through its <a href="https://archive.epa.gov/airmarkets/programs/cair/web/html/index.html">Clean Air Interstate Rule (CAIR)</a>, which covers sulfur dioxide and <a href="https://en.wikipedia.org/wiki/NOx">nitrogen oxides</a>. And California was the first <a href="https://www.law.cornell.edu/wex/state">state</a> to issue its program with the <a href="https://www.enveraconsulting.com/aqmd-reclaim-program/">RECLAIM Program in the South Coast Air Quality Management District</a>.</p> <p dir="ltr"><span id="docs-internal-guid-16451919-7fff-a9e3-dc36-eac7905f3c71df47a53e-9083-11ef-b8c7-e9213680cfdc">However, the policy is controversial and has sprung numerous </span><a href="https://www.law.cornell.edu/wex/lawsuit">lawsuits</a> in the United States. Many of the lawsuits have successfully repealed cap-and-trade laws. For instance, in <a href="https://www.courtlistener.com/opinion/187215/north-carolina-v-epa/">North Carolina v. EPA</a> (2008), the D.C. Circuit struck down the EPA’s 2005 cap-and-trade program for being "arbitrary and <a href="https://www.law.cornell.edu/wex/capricious#:~:text=Capricious%20is%20defined%20as%20an,for%20the%20facts%20and%20circumstances.%22">capricious</a>," "not otherwise in accordance with the law," and "fundamentally flawed." On the state level, <a href="https://www.c2es.org/content/california-cap-and-trade/">California’s cap-and-trade system for carbon emissions</a> was <a href="https://www.leagle.com/decision/incaco20170406051">challenged</a> on the basis that it improperly created a <a href="https://www.law.cornell.edu/wex/tax">tax</a> due to the extensive amount of <a href="https://corporatefinanceinstitute.com/resources/knowledge/accounting/revenue/">revenue</a> raised from the <a href="https://ec.europa.eu/clima/policies/ets/auctioning_en">auction of allowances</a>. The <a href="https://www.leagle.com/decision/incaco20170406051">state appellate court</a> found the program valid since, inter alia, the <a href="https://ww2.arb.ca.gov/our-work/programs/cap-and-trade-program">auction system</a> was not a tax because purchasing emissions allowances is a voluntary business decision, and the allowances are valuable and tradable commodities.</p> <p dir="ltr"><span id="docs-internal-guid-16451919-7fff-a9e3-dc36-eac7905f3c71df47a53f-9083-11ef-b8c7-e9213680cfdc">Internationally, cap-and-trade has played a role in reducing emissions. Under the </span><a href="https://www.epa.ie/climate/thekyotoprotocol/">Kyoto Protocol</a>, a number of <a href="https://www.law.cornell.edu/wex/united_nations_general_assembly">United Nations</a> member countries established a cap-and-trade program to reduce greenhouse gas emissions. The <a href="https://www.c2es.org/content/the-montreal-protocol/">Montreal Protocol </a>successfully implemented <a href="https://academic.oup.com/reep/article/11/1/59/3066276#64197008">a cap-and-trade program</a> to reduce ozone-depleting substances. Europe achieved greenhouse gas <a href="https://ec.europa.eu/info/index_en">reductions</a> under <a href="https://ec.europa.eu/clima/policies/ets_en">its cap-and-trade program</a>. Since the <a href="https://ec.europa.eu/clima/policies/ets_en">European Union's Emissions Trading System</a> capped emissions from stationary structures in 2005, emissions <a href="https://www.edf.org/climate/how-cap-and-trade-works">reduced by 29% in 2018</a> since the program started.</p> <p dir="ltr"><span id="docs-internal-guid-16451919-7fff-a9e3-dc36-eac7905f3c71df47a540-9083-11ef-b8c7-e9213680cfdc">[Last updated in July of 2022 by the</span><a href="https://www.law.cornell.edu/lii/about/lii_staff/wdt"> Wex Definitions Team</a>]</p> </div> </div> </div> <div class="field field-name-taxonomy-vocabulary-7 field-type-taxonomy-term-reference field-label-above"> <ul> <li class="field-label">wex <ul class="field-items"> <li class="field-item even"><a aria-label="category: wex: ACADEMIC TOPICS" datatype="" href="/wex/category/academic_topics" property="rdfs:label skos:prefLabel" typeof="skos:Concept">ACADEMIC TOPICS</a></li> <li class="field-item odd"><a aria-label="category: wex: law and economics" datatype="" href="/wex/category/law_and_economics" property="rdfs:label skos:prefLabel" typeof="skos:Concept">law and economics</a></li> <li class="field-item even"><a aria-label="category: wex: CIVICS" datatype="" href="/wex/category/civics" property="rdfs:label skos:prefLabel" typeof="skos:Concept">CIVICS</a></li> <li class="field-item odd"><a aria-label="category: wex: trade regulation" datatype="" href="/wex/category/trade_regulation" property="rdfs:label skos:prefLabel" typeof="skos:Concept">trade regulation</a></li> <li class="field-item even"><a aria-label="category: wex: government" datatype="" href="/wex/category/government" property="rdfs:label skos:prefLabel" typeof="skos:Concept">government</a></li> <li class="field-item odd"><a aria-label="category: wex: international law" datatype="" href="/wex/category/international_law" property="rdfs:label skos:prefLabel" typeof="skos:Concept">international law</a></li> <li class="field-item even"><a aria-label="category: wex: international trade" datatype="" href="/wex/category/international_trade" property="rdfs:label skos:prefLabel" typeof="skos:Concept">international trade</a></li> <li class="field-item odd"><a aria-label="category: wex: COMMERCE" datatype="" href="/wex/category/commerce" property="rdfs:label skos:prefLabel" typeof="skos:Concept">COMMERCE</a></li> <li class="field-item even"><a aria-label="category: wex: commercial activities" datatype="" href="/wex/category/commercial_activities" property="rdfs:label skos:prefLabel" typeof="skos:Concept">commercial activities</a></li> <li class="field-item odd"><a aria-label="category: wex: energy/utilities" datatype="" href="/wex/category/energy/utilities" property="rdfs:label skos:prefLabel" typeof="skos:Concept">energy/utilities</a></li> <li class="field-item even"><a aria-label="category: wex: environmental law" datatype="" href="/wex/category/environmental_law" property="rdfs:label skos:prefLabel" typeof="skos:Concept">environmental law</a></li> <li class="field-item odd"><a aria-label="category: wex: commercial transactions" datatype="" href="/wex/category/commercial_transactions" property="rdfs:label skos:prefLabel" typeof="skos:Concept">commercial transactions</a></li> <li class="field-item even"><a aria-label="category: wex: foreign perspective" datatype="" href="/wex/category/foreign_perspective" property="rdfs:label skos:prefLabel" typeof="skos:Concept">foreign perspective</a></li> <li class="field-item odd"><a aria-label="category: wex: wex articles" datatype="" href="/wex/category/wex_articles" property="rdfs:label skos:prefLabel" typeof="skos:Concept">wex articles</a></li> <li class="field-item even"><a aria-label="category: wex: wex definitions" datatype="" href="/wex/category/wex_definitions" property="rdfs:label skos:prefLabel" typeof="skos:Concept">wex definitions</a></li> </ul> </li> </ul> </div> </article> </div> </div> </div> </div> </div> </div> <div id="page-bottom" aria-hidden="true"> <div class="region region-bottom"> <div id="block-liidfp-2" class="block block-liidfp first last odd"> <div class="gfs"> <div id="div-gpt-ad-bottom" data-google-query-id="CNH77Z7C7d8CFURLAQodp9oMpg"> <script type="text/javascript"> googletag.cmd.push(function () { googletag.display('div-gpt-ad-bottom'); 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