Cap-and-trade

Also called: Emissions trading system, ETS, Emissions trading, Tradable pollution permits · Topic: Environment and Sustainable Development · NCERT: Beyond NCERT

Meaning

Cap-and-trade (also called an emissions trading system, or ETS) is a system in which the government sets a limit, called a cap, on the total pollution allowed. It then issues that many allowances (permits to pollute) and lets firms buy and sell them. Because of this trading, the cap is met at the lowest total cost.

• 1 allowance = the right to emit 1 tonne of CO₂e. CO₂e means carbon dioxide equivalent: other greenhouse gases are converted into the amount of CO₂ that would cause the same warming.
• It matters because it fixes the quantity of emissions. The total is certain. The market then decides the price of pollution.

Explanation

Why pollution needs a price

• Pollution is a negative externality. An externality is a cost that falls on people outside a deal. Here the polluter does not pay for the harm it causes to others.
• A coal plant's power price covers fuel, labour and capital.
• It does not cover the harm from its smoke to lungs, farms and the climate.

• So the power looks cheaper than it really is, and society makes too much of it.

• Marginal social cost (MSC) = marginal private cost (MPC) + marginal external cost (MEC)

• MPC is the firm's own cost of making one more unit.

• MEC is the harm to others from that one extra unit.

• Internalisation means making the polluter carry the full social cost. Cap-and-trade (tradable permits) is one of three ways to do this. The other two are a Pigouvian tax and Coasean bargaining.

How it works

• Step 1: Set the cap. The regulator fixes total emissions. It issues exactly that many allowances.
• Step 2: Firms compare costs. Each firm looks at its marginal abatement cost, which is the cost of cutting one more tonne.
• Firms that can cut cheaply cut more than they need to, then sell their spare allowances.

• Firms that find cutting expensive buy allowances instead.

• Step 3: The market sets a price. Trading produces a permit price. Each firm cuts emissions until its cost of cutting one more tonne equals that price.

• Result: the cuts happen where they are cheapest, and the total never goes above the cap.
• It needs strong support systems:
• good monitoring of each firm's emissions
• a registry that records who holds which allowances

Worked example

• Firm A can cut CO₂ for ₹500 per tonne. Firm B can cut CO₂ for ₹3,000 per tonne. The cap requires a total cut of 100 tonnes.
• Without trading, each firm cuts 50 tonnes:

• (50 × 500) + (50 × 3,000) = ₹25,000 + ₹1,50,000 = ₹1,75,000

• With trading, A cuts all 100 tonnes for ₹50,000 and sells 50 permits to B.

• The permit price will settle somewhere between ₹500 and ₹3,000.

• Both firms gain from the deal.

• Society saves ₹1,25,000 and still meets the same cap.

What makes the permit price rise or fall

• Tighter cap → fewer allowances → higher price. Firms then have a stronger reason to cut emissions.
• Cheaper clean technology → lower abatement costs → lower price.
• Higher output or demand → more firms need allowances → higher price.
• Main weakness: the price is uncertain, so firms cannot easily plan their investments. With a carbon tax, the price is fixed but the amount of emission cuts is uncertain.

In India

• India has no economy-wide absolute cap yet. It has moved towards a carbon market in steps.
• Step 1: PAT scheme (Perform, Achieve and Trade), 2012
• Energy-intensive plants get energy-saving targets.

• Plants that beat their target earn ESCerts (Energy Saving Certificates). Plants that miss it buy them.

• Step 2: RECs (Renewable Energy Certificates)

• These are tradable proof that renewable power was produced.

• Discoms (power distribution companies) buy them to meet their renewable purchase obligations.

• Step 3: Energy Conservation (Amendment) Act, 2022

• This gave the government the legal power to set up a carbon credit trading scheme.

• Step 4: Carbon Credit Trading Scheme (CCTS), June 2023

• It created the Indian Carbon Market (ICM) and a National Steering Committee for the Indian Carbon Market (NSCICM) [2].
• It prices greenhouse gas emissions through tradable Carbon Credit Certificates (CCCs) [2].

• Who does what:

  • BEE (Bureau of Energy Efficiency) is the administrator.
  • Grid-India is the registry. It records who holds which credits.
  • CERC (Central Electricity Regulatory Commission) regulates trading.

• Compliance mechanism (the legally binding part)

• Obligated entities must meet GHG Emission Intensity (GEI) targets. These are measured in tonnes of CO₂e per tonne of product, not as an absolute cap [2][3].
• Entities that do better than their target earn CCCs and sell them. Entities that miss their target buy them [2].
• The first targets covered 7 sectors moved over from PAT: aluminium, cement, chlor-alkali, petrochemicals, petroleum refineries, pulp and paper, and textiles [2].

• GEI targets were later notified for 208 more carbon-intensive industrial units [1].

• Offset mechanism (the voluntary part): entities that are not obligated can register projects on their own and earn credits.

• Worked example: intensity target
• A cement plant's target is 0.60 t CO₂e per tonne of cement. It produces 10 lakh tonnes.
• Allowed emissions = 0.60 × 10 lakh = 6 lakh t CO₂e.
• Its actual intensity is 0.57, so it emits 5.7 lakh tonnes.
• It earns 30,000 CCCs that it can sell.
• If output grows, total emissions can still rise. This fits India's NDC (its national climate pledge), which is framed as an emissions-intensity-of-GDP target.

Don't confuse with

• Carbon tax: a carbon tax fixes the price per tonne, so the amount of emission cuts is uncertain. Cap-and-trade fixes the quantity, so the price is uncertain. Examples: Sweden (tax); EU ETS 2005 and China's national ETS 2021 (cap-and-trade).
• Intensity-based trading (India's CCTS): a true cap limits total emissions. CCTS limits emissions per unit of output, so total emissions can still rise.
• Carbon offset / voluntary carbon market: in cap-and-trade, firms are required by law to hand in allowances. In a voluntary market, buyers offset emissions by choice, for example firms with net-zero pledges.
• Green Credit: it rewards actions such as tree planting or water conservation. It is not a certified tonne of CO₂e, so it is not a carbon credit.

Prelims Hooks

• Cap-and-trade fixes the quantity (the cap). The permit price is left to the market. A carbon tax does the opposite.
• 1 allowance = the right to emit 1 tonne of CO₂e. 1 CCC = 1 tonne of CO₂e.
• The EU ETS started in 2005. China's national ETS started in 2021.
• Worldwide there are 80 carbon pricing instruments: 43 carbon taxes and 37 ETSs. Together they cover about 28% of global GHG emissions (2025) [4].
• CCTS (2023) was notified under the Energy Conservation (Amendment) Act, 2022.
• BEE is the administrator.
• Grid-India is the registry.

• CERC regulates trading.

• Trap: CCTS targets are GEI (intensity) targets, not absolute caps. The first 7 sectors came over from PAT [2].

Mains Points

• Tax vs trade for India
• A carbon tax gives certain revenue and is simple to run. That suits a country with limited monitoring capacity.
• An intensity-based ETS (CCTS) protects growth, because output can still rise, and it rewards efficient plants.

• The trade-off: intensity targets do not guarantee that absolute emissions will fall.

• Integrity and MRV

• Trading works only if every tonne is real. That depends on:
  • additionality: the cut would not have happened without the credit money
  • permanence: the carbon stays locked away
  • no leakage: emissions do not simply move somewhere else
  • no double counting: the same tonne is not claimed twice

• India needs strong MRV (Monitoring, Reporting and Verification), especially for its offset mechanism.

• CBAM link (GS-II/III)

• The EU's CBAM (Carbon Border Adjustment Mechanism) makes importers pay the same carbon price that EU producers pay under the EU ETS.
  • It covers steel, aluminium, cement, fertilisers, electricity and hydrogen.
  • Reporting began in October 2023. Payment starts in 2026.
• India calls CBAM unilateral and against CBDR (Common But Differentiated Responsibilities).
• A working domestic carbon price under CCTS can help Indian exporters ask for a deduction, because carbon already paid at home can reduce the CBAM charge.

Related concepts

• Internalisation of externalities
• Carbon pricing
• Green tax
• Social cost of carbon
• Internal carbon price
• Fossil fuel subsidies
• Carbon market
• Compliance carbon market
• Voluntary carbon market
• Carbon credit

Read more

• Pricing pollution: carbon taxes, cap-and-trade and carbon markets