How Emissions Trading Schemes Work
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An emissions trading scheme sets an overall limit, or cap, on total emissions allowed across a sector or economy, then issues a matching number of permits that businesses can buy, sell or trade among themselves, creating a genuine financial cost for emitting and a financial reward for reducing emissions below what was permitted.
Businesses that can reduce emissions relatively cheaply have a clear incentive to do so and sell their surplus permits to others facing higher reduction costs, meaning the overall emissions target is met at the lowest total cost across the whole economy, at least in theory, since the market decides where cuts happen most efficiently.
Over time, the overall cap is typically lowered according to a predetermined schedule, gradually tightening the total emissions allowed and pushing the traded price of permits upward, which in turn strengthens the financial incentive for businesses to invest in genuinely lower emission technology and processes rather than simply continuing to buy permits.