Under cap and trade schemes, governments or intergovernmental bodies set an overall legal limit on emissions in a certain time period (‘a cap’) and then grant industries a certain number of licenses to pollute (carbon permits or ‘emissions allowances’). Companies that do not meet their cap can buy permits from others that have a surplus (‘a trade’). The idea is that a scarcity of permits to pollute should encourage their price to rise, and that the resulting additional cost to industry and power producers should then encourage them to pollute less.
In practice, the European Union Emissions Trading System (the largest cap and trade market) and similar schemes have failed to limit emissions, with an over-supply of permits collapsing the carbon price. Critics argue that these failings signal more fundamental flaws in a market where the scope and supply of permits are decided by governments in accordance with corporate interests.