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Fact sheet - Cap and Trade: A Primer

Archived Backgrounder

Fact sheet - Cap and Trade: A Primer

The Cap

Cap and trade is a form of market regulation applied to greenhouse gas (GHG) emissions. It requires industry to reduce GHG emissions but provides financial incentives to help with the cost of doing so.

A regulation establishes a "cap" or limit on GHG emissions for the territory - in our case, Ontario.  The cap determines the maximum amount of GHG that can be emitted, which is then transcribed into number of allowances.  The government distributes these allowances to companies (emitters).  Companies must match their emissions to their allowances.  Over time, the overall cap is lowered leading to reductions in GHGs.

This process occurs in every jurisdiction that employs a cap-and-trade system.  The European Union is already using cap and trade, the United States is committed to this approach and developing economies (e.g., China and India) are interested.  


The Trade

A company that is part of a capped sector must report its total emissions according to prescribed methods.  If the company's actual emissions are equal to the number of its allowances, then the emitter is compliant and needs to do nothing.

If the actual emissions are less than the allocated allowances, then the company has unused allowances or a surplus that it can sell or save for use later.  Creating and selling surplus allowances can subsidize the cost of "going green".

If the actual emissions are greater than the allowances allocated, then the company must purchase allowances (from other companies) or offsets (see below).  Otherwise, the company faces penalties imposed by the regulator.

Surplus allowances are traded and are priced according to the laws of supply and demand.  As government gradually lowers the cap on emissions, fewer allowances are distributed.  This creates a demand for allowances which increases their value or price.  Over time, industries that use older, carbon-intensive technology will find it more economical to upgrade to new low-carbon technology in order to decrease their need for allowances.
 
The Cost

Cap and trade does not give polluters a free ride.  It does give financial incentives to companies to reduce emissions below their cap.  In this way companies find that it is in their best interest to reduce emissions and convert to a lower emissions approach (i.e.,. become greener).

It works like this:

Companies are allocated allowances, either for free or by auction or a combination.  They must match their emissions to these allowances.  They can invest in technology to reduce emissions and their need for allowances, buy unused allowances from other companies, or purchase offsets.  They may even combine all three methods.  Any choice they make, they pay.

In some cases, a complete technological overhaul will be required to reduce greenhouse gases.  The technology costs can be high.  

Some companies will phase in new technology over time to keep the costs manageable.  Others may find it more economical to purchase allowances or offsets until they make the necessary technology changes.  But, eventually, as allowances or offsets become scarce and more expensive, companies will find it cheaper to purchase low-carbon technology.


The Need

This need for new, better technology is one force powering an emerging green economy. Not only will cap and trade reduce GHG emissions but it will encourage longer term investment in new technology.  This will create new businesses and related jobs.


Other elements

Offsets

Cap-and-trade systems also create an economic incentive for "carbon offsets", which can be used to achieve compliance in the carbon trading system.

Offsets are projects that reduce or remove GHG undertaken by non-regulated industries.  It could be a tree-planting project (trees naturally capture carbon dioxide), or other activity that reduces greenhouse gases.

Offsets can be sold so that emitters can meet their compliance obligations.  Offset projects are usually undertaken by groups, companies, environment associations, etc.  To be eligible as an offset, projects have to meet criteria specified by the regulatory authority.

Offsets in Farm Country

Farmers and other rural landowners can develop offset projects by changing some of their practices - such as changing the way they till their land. (Tillage/ploughing opens up the topsoil, which then releases carbon dioxide, a GHG.)  Another offset project could be about on-farm management of manure.
 
Offsets in the North

Ontario is working with its partners in forestry to develop, implement and verify a number of carbon offset measures.  Tree planting is one project type as trees act as "sinks" to absorb carbon.

Background Information

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