Trading Mechanics
From cap-setting to compliance: understanding market operations
Your Progress
Section 2 of 5Cap-and-Trade: The Core Mechanism
Most compliance markets use cap-and-trade. Understanding the mechanics is key to seeing how markets drive emissions down.
🏭 Cap-and-Trade Simulator
Your Company Profile:
Strategy Options:
Economic Logic: Credits ($40) are cheaper than your abatement cost ($50)—buy credits in the market!
How Trading Works:
Step 1: Cap Set
Government sets emissions cap and allocates allowances
You have 80 allowances but emit 100 tonnes
Key Market Design Elements
🎯 Setting the Cap
- •Absolute cap: Total emissions limit (e.g., 100 Mt CO₂/year)
- •Declining trajectory: Cap reduces over time (e.g., 2% annually)
- •Science-based: Aligned with climate targets and carbon budgets
📋 Allowance Allocation
- •Auction: Government sells allowances to highest bidders (most efficient)
- •Free allocation: Grandfathering based on historical emissions or benchmarks
- •Hybrid: Mix of auction and free (common for competitiveness concerns)
💱 Trading & Compliance
- •Secondary trading: Entities buy/sell allowances at market prices
- •Banking: Save unused allowances for future periods
- •Surrender requirement: Must submit credits equal to verified emissions
🛡️ Price Stabilization
- •Price floor: Minimum auction price prevents collapse (e.g., RGGI $3)
- •Price ceiling/reserve: Release extra allowances if price spikes
- •Market Stability Reserve (MSR): EU ETS adjusts supply dynamically
💡 The Economic Elegance of Cap-and-Trade
Cap-and-trade achieves environmental certainty (the cap) and economic efficiency (lowest-cost reductions found through trading) simultaneously. Unlike carbon taxes (price certainty, quantity uncertainty), cap-and-trade guarantees emissions outcome.
Coase Theorem in action: When property rights are clear (allowances) and transaction costs low, trading reaches efficient allocation regardless of initial distribution.