How do cap-and-trade systems work to reduce greenhouse gas emissions?

Cap-and-trade systems reduce greenhouse gas emissions by setting a limit, or 'cap,' on the total amount of emissions allowed from a group of sources and then creating a market where entities can trade allowances to emit. In a cap-and-trade system, a regulatory authority, typically a government, sets an overall limit on the total amount of greenhouse gases that can be emitted by a group of regulated entities, such as power plants, industrial facilities, or even countries. This cap is usually set lower than the current level of emissions, requiring entities to reduce their emissions. The regulatory authority then issues allowances to each regulated entity, authorizing them to emit a certain amount of greenhouse gases. The total number of allowances issued is equal to the cap. Entities that can reduce their emissions at a low cost can do so and then sell their excess allowances to other entities that face higher costs of reducing emissions. This creates a market for allowances, where the price of allowances is determined by supply and demand. Entities that can reduce their emissions cheaply have an incentive to do so and sell their allowances, while entities that face higher costs of reducing emissions have an incentive to purchase allowances. Over time, the regulatory authority can lower the cap, reducing the total amount of emissions allowed and driving further emissions reductions. Cap-and-trade systems provide flexibility for regulated entities to reduce emissions in the most cost-effective manner, while ensuring that the overall emissions reduction target is met. They also incentivize innovation and the development of new technologies to reduce emissions.