What is a cap-and-trade system?

‍Quick Answer: A cap-and-trade system is a market-based policy mechanism that sets a fixed limit (the cap) on the total greenhouse gas emissions allowed across a group of companies or industries, then lets those companies buy and sell emissions allowances between themselves (the trade). It creates a financial incentive to reduce emissions: companies that cut their output below their allowance can sell the surplus, while those that exceed it must buy more. Cap-and-trade systems are a form of carbon pricing used by governments to reduce emissions at the lowest possible cost to the economy.

How a cap-and-trade system works

A cap-and-trade system has two distinct parts that work together.

A regulatory authority sets the cap as the total volume of greenhouse gas emissions permitted within a defined geography or sector. Regulators typically measure this cap in tonnes of CO2 equivalent (tCO2e), and it decreases over time, so the overall emissions ceiling gets lower year on year.

The trade is what happens next. Regulators distribute or auction a fixed number of emissions allowances, each representing the right to emit one tonne of CO2e. Companies that emit less than their allocation can sell their surplus allowances on a carbon market. Companies that emit more must buy additional allowances to cover the difference, or face penalties.

Supply and demand set the price of allowances. When the cap tightens, allowances become scarcer and more expensive, which increases the financial pressure on high-emitting companies to reduce their output.

What is a cap-and-trade system in practice?

The most widely studied example is the European Union Emissions Trading System (EU ETS), launched in 2005. It covers power generation, heavy industry, and aviation across EU member states, and is the largest carbon market in the world by trading volume.

California's cap-and-trade programme, administered by the California Air Resources Board, is another significant example. Research published in Energy Policy (Lessmann and Kramer, 2024) found that California's programme reduced CO2 emissions in the power sector by 48% compared to a synthetic counterfactual, driven largely by a shift from natural gas to renewables. Results in the industrial sector were more mixed, highlighting that cap-and-trade works differently across sectors depending on the complementary policies in place.

The Regional Greenhouse Gas Initiative (RGGI), a collaboration between eastern and Mid-Atlantic US states, operates a similar compliance market focused on the power sector.

These are all compliance markets: regulated entities must participate, and the carbon credits traded within them are standardised and government-issued.

Cap-and-trade vs. carbon tax: what is the difference?

Both are forms of carbon pricing, but they work differently.

A carbon tax sets a fixed price per tonne of emissions. Companies know exactly what they will pay, but the total volume of emissions is not guaranteed to fall by a specific amount.

A cap-and-trade system sets a fixed volume of permitted emissions. The environmental outcome (the cap) is certain, but the price of allowances fluctuates with market conditions.

In practice, many jurisdictions use both mechanisms together, or introduce price floors and ceilings within cap-and-trade systems to reduce price volatility. The World Bank's Carbon Pricing Dashboard tracks over 70 carbon pricing instruments currently in operation globally, covering roughly 23% of global greenhouse gas emissions (World Bank, 2024).

Cap-and-trade vs. voluntary carbon markets

Cap-and-trade systems are compliance markets. The law requires companies operating within the regulated sectors and geography to participate.

Voluntary carbon markets operate separately. In these markets, companies buy carbon credits or offsets to meet self-imposed sustainability commitments, not legal obligations. Projects such as reforestation or renewable energy development generate the credits traded in voluntary markets; government regulators do not issue them.

The distinction matters for credibility. Compliance market allowances are standardised, government-backed, and subject to strict verification. Voluntary market credits vary considerably in quality, and the sector has faced scrutiny over the integrity of some offset projects.

Some companies participate in both: meeting compliance obligations through their national ETS while also purchasing voluntary offsets to address emissions not covered by the cap.

Why does a cap-and-trade system matter for carbon accounting?

For companies operating within a cap-and-trade jurisdiction, the system has direct implications for how they measure and report their emissions.

Accurate carbon accounting is a prerequisite for compliance. A company needs to know its actual emissions across all relevant scopes before it can determine whether it holds enough allowances, whether it has a surplus to sell, or whether it needs to purchase more. Errors in measurement translate directly into financial risk: buying unnecessary allowances wastes money, while under-reporting emissions can result in regulatory penalties.

This is where the quality of a company's underlying emissions data becomes commercially significant, not just a reporting exercise. Businesses using Seedling can produce a GHG Protocol-aligned footprint covering Scopes 1, 2, and 3, giving them the accurate baseline they need to understand their position within a compliance market and to track progress against reduction targets year on year.

As cap-and-trade systems expand in scope and the cap tightens, the cost of holding insufficient allowances will increase. Companies that invest in accurate measurement now are better placed to manage that exposure and to identify where genuine emissions reductions are achievable, rather than relying on purchased allowances indefinitely.