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The issue of carbon emission reduction credits has come up a couple times recently on Newsvine, so I thought I would provide an explanation of how these systems work, along with some of their benefits and drawbacks.
First, an introduction. "Cap and Trade" systems are already in-place. The US utilizes a cap and trade system to control emissions of SO2, thereby controlling acid rain. This has been one of the more successful cap and trade systems to date. Others include the European Union's Emission Trading Scheme, and, at least in-essence, the CO2 restrictions of the Kyoto Protocol.
What a cap and trade system does is limit the total amount of a pollutant that is emitted over a geographic area, be it a state, a continent, or the entire world. Once that limit is put into place, the regulating authority grants the "right to pollute" up to a certain level through the issuance of permits. How these permits are distributed can vary. Sometimes permits are auctioned, other times they are given to existing entities.
Once the permits have been allotted, entities are given permission to trade these permits among themselves. Permits are bought and sold, and in the end the same emission level is achieved, with only the source of the emission changing. In some cap and trade schemes, each time a permit is traded, it becomes less effective. In such a case, a permit that allowed one polluter to emit 1 ton of a pollutant only allows the person who bought the permit from the original permitee 0.9 tons of the pollutant. In this case, the "cap" in the cap and trade system slowly decreases as the total permissible emissions drops as the permits are traded.
The greatest benefit of a cap and trade system is efficiency. If there is a goal to reduce emissions of a given pollutant by 20%, one could simply require all sources to reduce their emissions by 20%, or you could set a cap equal to 80% of the current total emissions, and then allow trading. Where a "command and control" approach (requiring across-the-board reductions) does remove some ambiguity, it is inherently inefficient. By permitting groups to trade their emission allowances, you ensure that the reduction is done in the most economically efficient means possible. This is because at any time the value of a permit to emit "X" amount of pollutant exceeds the cost of reducing your emissions by "X", you can sell your rights to emit "X", reduce your emissions, and then take the difference as a profit.
Such a method ensures that the easiest methods of control are those which are done first because cheaper reductions can always under-bid more expensive reductions, thereby resulting in the greatest total reduction in pollution per dollar spent.
Unfortunately, there can be a cost for this efficiency. Without any boundaries to this trading, one entity could purchase a disproportionate amount of pollution rights and create an excessive impact on their surroundings. For this reason, cap and trade systems tend to work best with pollutants whose effects are seen on a wider scale, where the impacts are spread throughout the system instead of a local area.
Carbon reduction credits are quite similar to this kind of system, but without the cap (at least here in the US). In such a system, those who wish to reduce emissions, but are unwilling to pay the high costs for doing so themselves, purchase reductions from others who can do so more cheaply. In the end, the emissions are still reduced, just from another source.
So there you go, a brief introduction to the economics of "Cap and Trade" systems.
