Definition
Cap and trade is a regulatory approach to controlling pollution that sets an overall ceiling — the cap — on how much a pollutant may be emitted, then divides that ceiling into permits. Firms must hold one permit for each unit they emit, and they may buy and sell permits among themselves.
By attaching a tradable price to pollution, the policy turns an unpriced externality into a market commodity. The cap guarantees the environmental outcome; the trading determines who pollutes and at what cost.
Why it matters
How it works
The regulator issues permits up to the cap, either auctioning them or distributing them free. Firms that can cut emissions cheaply do so and sell their spare permits; firms that face high abatement costs buy permits instead. The permit price emerges from this trading and equals the marginal cost of the last unit of reduction.
Lowering the cap over time tightens supply, raises the permit price, and drives further cuts. Cap and trade applies the logic of the Coase theorem at scale: by clearly defining and making tradable the right to pollute, it lets the market allocate that right efficiently.