What it means
The cap is the total quantity allowed across everyone covered by the scheme, usually expressed in tonnes of carbon dioxide equivalent per year. The regulator divides that total into allowances, each permitting one tonne, and distributes them by auction, free allocation or a mixture of the two.
At the end of each compliance period, every covered business must surrender allowances matching its actual emissions or pay a penalty. The trade half is what makes the system efficient.
Because allowances can be bought and sold, a company facing a $15 per tonne cost to cut emissions will do so and sell the allowances it no longer needs, while a company facing an $80 per tonne cost will buy allowances instead. The environmental outcome is identical, but the total cost to the economy is lower than if every business were ordered to cut by the same percentage.
For a finance team, the practical effect is that emissions become a balance sheet item and a budget line. Allowances are assets that can be held, traded or carried forward, and a shortfall is a liability that must be provided for.
Companies with heavy exposure hedge their allowance requirements years ahead, in much the same way they hedge fuel or currency. The design details determine whether the scheme actually bites.
Too many free allowances, or a cap set above business-as-usual emissions, produces a collapsed price and no incentive to change anything. Most schemes have therefore added mechanisms such as price floors, reserve pools and steadily tightening caps to keep the allowance price meaningful.
Cap and trade is frequently confused with a carbon tax, and the difference matters. A tax fixes the price and lets the quantity of emissions land where it may; cap and trade fixes the quantity and lets the price land where it may.
Businesses generally find a tax easier to budget for and regulators find a cap easier to hold to an environmental target.
In practice
Real-world examples
Example 1
A power generator switches two plants from coal to gas, cutting emissions by 400,000 tonnes a year. It surrenders far fewer allowances than it holds and sells the surplus 250,000 allowances at $31 each, adding $7.75 million to its results.
Example 2
An aluminium smelter cannot cut emissions without replacing its entire process. It buys allowances every year, treats the cost as part of production overheads and passes what it can into its selling price.
Example 3
A packaging group builds an internal carbon price of $40 a tonne into every capital approval, above the current market price of $28. Projects that look marginal today are approved on the expectation that the cap will tighten and allowance prices will rise.
Think of it
Imagine a housing estate with a strict rule limiting total water usage to one thousand litres a day. Every household gets an equal water voucher. If the Smith family installs water-saving taps and only uses six hundred litres, they can sell their four hundred spare litre vouchers to the Jones family next door, who have a massive swimming pool and need extra water.
Formula
Calculation
Allowance shortfall = Actual emissions - Allowances held
Compliance cost = Allowance shortfall x Allowance price
A cement plant emits 120,000 tonnes of carbon dioxide in a year. It received 90,000 free allowances under its allocation, and allowances trade at $28 each.
Shortfall = 120,000 - 90,000 = 30,000 tonnes.
Compliance cost = 30,000 x $28 = $840,000.
Now suppose the plant can install a heat recovery system that cuts 30,000 tonnes a year at an all-in cost of $22 per tonne avoided.
Cost of abatement = 30,000 x $22 = $660,000.
Saving versus buying allowances = $840,000 - $660,000 = $180,000 a year.
Because abating costs $22 a tonne and allowances cost $28 a tonne, the plant should invest rather than buy. If the allowance price fell to $18, the arithmetic would reverse and buying 30,000 allowances for $540,000 would be the cheaper route.Case study
Seen in the real world
Meridian Kiln Works is an invented ceramics manufacturer used purely as an illustrative example. When its region introduced a cap and trade scheme, Meridian emitted 200,000 tonnes a year and received 170,000 free allowances, leaving it to buy 30,000 a year at around $20, a manageable $600,000 charge.
The scheme was designed to cut free allocation by 8% a year while the cap itself tightened. Within four years Meridian's free allocation had fallen to roughly 122,000 allowances, and with emissions still near 200,000 tonnes the shortfall had grown to about 78,000 tonnes. Allowance prices had meanwhile risen to $34, turning a $600,000 line into a charge of about $2.65 million.
In this fictional scenario the finance director had already commissioned an abatement cost curve, ranking every possible reduction by cost per tonne. Kiln insulation and waste heat recovery could remove 60,000 tonnes at under $18 a tonne, so both were approved immediately, while an electric kiln conversion at $95 a tonne was deferred. Meridian also bought forward three years of its residual requirement to stop the budget moving with the market.
Watch out
Common mistakes
- Treating allowances as a compliance formality rather than a traded commodity. Their price moves with policy and energy markets, and an unhedged position can swing a profit forecast materially.
- Assuming free allocation continues indefinitely. Most schemes reduce free allowances on a published schedule, so the cost profile worsens even if emissions stay flat.
- Confusing cap and trade with voluntary carbon offsets. Compliance allowances are issued by a regulator under a legal cap, while most offsets are voluntary credits with no surrender obligation.
Questions
People also ask
What is the difference between cap and trade and a carbon tax?
Cap and trade fixes the quantity of emissions and lets the market set the price, whereas a tax fixes the price and lets the quantity settle wherever it settles.
Can a business bank unused allowances for later years?
In most schemes yes, and banking is one reason companies over-buy in cheap years to cover expected shortfalls in tighter ones.
How should allowances be recorded in the accounts?
Practice varies by framework, but the common approach is to carry purchased allowances as an intangible asset and recognise a liability as emissions occur.