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How does “cap and trade” work?

Cap and trade is a market-based mechanism to solving problems of pollution in energy creation. Cap and trade is a less expensive form of mitigating pollution and more effective form of doing so, according to the EPA.

A regulating agency, such as EPA, puts a “cap,” or a maximum level, on the amount of total pollution to be emitted. The level of the cap is gradually lowered over time in order to reduce the total amount of emissions. The “cap” is divided into equal amounts that are called allowances.  Companies that receive or purchase allowances are allowed to pollute equivalent to the number of allowances they possess. If at the end of the year, a company has excess allowances, it is eligible to “trade” (sell) an allowance to another company. If the company has polluted more than its allowance, it can purchase additional allowances from another company. If there are no permits available for “trading,” the company will be monetarily penalized at an amount that is greater than the cost of a permit.

Cap and trade  limits the level of greenhouse gases in the atmosphere while providing fiscal incentives for companies to lower their emissions.