Definition
Pollution permits, also called tradable emission allowances, are a market-based tool for controlling pollution. A government sets an overall cap on the total amount of a pollutant that may be released, then issues permits adding up to that cap.
Firms must hold permits to cover their emissions, and they may buy and sell permits among themselves. This combination of a fixed cap and a tradable right is the heart of a cap-and-trade system.
Why it matters
How it works
The cap forces total emissions down to the target level. Trading then sorts out who reduces pollution. A firm that can cut emissions cheaply will do so and sell its unused permits; a firm facing high abatement costs will buy permits instead.
Because permits flow to where they are most valuable, the cheapest reductions happen first, and the cap is met at the lowest total cost. Over time the government can tighten the cap, raising the permit price and pushing emissions lower.