A Cap is the total, legally binding limit on the amount of greenhouse gases that can be emitted by entities covered under an emissions trading system (ETS). By creating a finite supply of emission allowances, the cap is the mechanism that establishes scarcity, drives the carbon price, and guarantees that overall emission reduction targets are met.
The Cap is the cornerstone of any "cap-and-trade" system, representing the environmental guarantee of the policy. It is a mandatory ceiling on the total volume of greenhouse gas (GHG) emissions allowed from a specific group of installations—such as power plants, industrial factories, and airlines—over a set period. This mechanism is crucial for governments to achieve their climate targets, like those under the Paris Agreement, by ensuring that emissions decrease in a predictable and enforceable way.
The primary function of the cap is to create scarcity in the market. This scarcity gives a direct monetary value to the right to emit, creating a powerful economic incentive for companies to decarbonize their operations.
How the Emissions Cap Works
The implementation of an emissions cap follows several key steps that form the foundation of a carbon market:
- 1. Setting the Limit: A regulatory body, such as the European Commission for the EU ETS, sets a total emissions cap based on scientific data and long-term climate policy goals (e.g., reaching net-zero by 2050). Crucially, this cap is designed to decline year after year.
- 2. Creating Allowances: The total cap is divided into tradable permits known as carbon allowances (like EUAs or UKAs). Each allowance typically gives the holder the right to emit one tonne of carbon dioxide equivalent (tCO₂e). The total number of allowances issued into the market is equal to the cap.
- 3. Allocation: These allowances are distributed to the covered entities, either through free allocation or, increasingly, through government auctions. Companies that can reduce their emissions at a low cost can sell their surplus allowances.
- 4. Enforcing Compliance: At the end of each compliance period (usually a year), each company must surrender enough allowances to cover its total verified emissions. Companies that fail to do so face heavy financial penalties, creating a strong driver for compliance and for trading on the carbon market.
The annual reduction of the cap is what ensures progressive decarbonization. As the supply of allowances shrinks, their price is expected to rise, making it more economically rational for companies to invest in cleaner technologies rather than purchasing expensive permits.
Concrete Examples
- The EU Emissions Trading System (EU ETS): As the world's first and largest carbon market, the EU ETS has a cap covering over 10,000 installations across the energy, industry, and aviation sectors. This cap is being reduced at an accelerated rate under the "Fit for 55" package to align with the EU's goal of a 55% emissions reduction by 2030.
- The UK Emissions Trading System (UK ETS): Established after Brexit, the UK ETS operates on the same principles. It has its own independent cap, which is also set on a declining trajectory to help the UK meet its legally binding carbon budgets and its 2050 net-zero target [Learn more about the UK Emissions Trading System (UK ETS)].
For more official details on how the cap is structured, you can consult the European Commission's official page on the EU ETS.