Types 

of 

Trading

The United States has pioneered the use of emissions

trading for more than 25 years. Emissions trading can

take different forms and can be used in different sectors

to meet regulatory requirements. There are three general

types of emissions trading programs: cap and trade

programs, project-based or credit programs, and ratebased or averaging programs.

Cap and Trade Programs

In a cap and trade program, sources are allocated a fixed

number of allowances. Each allowance represents an

authorization to emit a specific quantity of a pollutant

(e.g., one ton). The number of allowances is capped in

order to reduce emissions to the desired level, and sources

are required to meet stringent, comprehensive emission

monitoring requirements. At the end of the compliance

period, emission sources must hold sufficient allowances

to cover their emissions during the period. Sources that

do not have a sufficient number of allowances to cover

emissions must purchase

allowances from sources that

have excess allowances from

reducing emissions.

Cap and trade programs 

have been applied to large

electric power and industrial

emissions sources. These

programs do not require caseby-case review of allowance

trades because of the certainty

provided by the emissions cap,

the fixed number of allowances

available, and the stringent

monitoring and tracking of all

emissions. Examples of cap

and trade programs include:

the Acid Rain SO2 Program;

the Ozone Transport Commission NOx Budget Trading

Program and the NOx SIP call; as well as proposed

legislation and regulations for additional emission

reductions in the power sector.

Project-based, Credit or 

Offset Programs

In a project-based program, also referred to as a credit

or offset program, sources earn credit for projects that

reduce emissions more than is required by a pre-existing

conventional regulation or other benchmark. These

credits can then be traded to other facilities where 

they can be used for compliance with a conventional

regulatory requirement. The decision to generate these

credits is usually voluntary; however, credits must be

certified through some sort of administrative process. 

Credit programs impart flexibility to existing programs,

but do not require reductions (except to the extent

some percentage of credits generated may be retired for

environmental benefit). In the past, the need to determine

whether these types of credits represent real emission

reductions has sometimes been time-consuming, costly

and uncertain. However, credit programs may include a

larger variety of sectors and

source types than do the

other types of trading

programs. Examples of

these types of programs

include offset requirements

for new sources in areas

that do not meet National

Ambient Air Quality

Standards and open

market trading programs

in some states.

All three types of emission trading

programs are meant to work in

conjunction with existing 

regulations. Any emission trading

program should be designed and

undertaken to complement basic

safeguards for public health and the

environment under the Clean Air

Act and other environmental laws.

Three Forms of Trading Compared 

Cap and Trade

Project-based Trading

Rate-based Trading

Low

High

Low to Medium

Administrative &

Transaction Costs

Yes

Yes

Yes

Cost

Minimization

Potential to Limit 

Total Emissions

High

Low to Medium

Medium

Source: “Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control,” June 2003 EPA 430-B-03-002
Rate-based or Averaging Programs

In rate-based or averaging programs, the regulatory authority sets a

constant or declining emission rate performance standard (e.g. tons

of emissions per megawatt hour). Emission sources with average

emission rates below the performance standard earn credits that they

can sell to other emission sources. Sources with emission rates above

the standard must obtain credits to cover the excess. Rate-based

programs can lower emissions, but emissions can subsequently grow

if activity grows. The successful program to phase-out lead in

gasoline in the early 1980s used this type of trading mechanism to

provide flexibility and cost-savings to oil refineries before the final

ban was implemented. These programs are most easily applied in a

specific sector where facilities have similar emissions characteristics

(such as refineries, mobile sources, and power plants).

Comparing Emission Trading Programs

For all types of emissions trading, the basic concept is similar:

trading provides companies with the incentive to develop cost

effective emission reduction strategies. Companies may elect to

control emissions more than required and sell surplus allowances or

credits to other facilities that may face more expensive options to

reduce emissions. All three types of trading can include provisions

to allow companies to save extra allowances or credits for use in

future years (banking). 

Each of the three forms of emission trading is appropriate in certain

situations. When achieving and maintaining an absolute emission

goal is important, a cap and trade program provides more certainty

about total emissions from a defined set of sources. Administrative

and transaction costs for cap and trade programs often are lower

than for project-based trading. Project-based trading is burdened by

higher uncertainty and risk and the need for extensive regulating

authority involvement due to the need to assess individual projects.

Offset trading programs have historically evolved from introducing

limited flexibility in traditional command-and-control programs.

Because offset programs usually do not require net emission reductions,

they are not effective as stand-alone programs. However, a welldesigned program may complement a command-and-control

program that establishes emission or concentration limits. It also may

complement a cap and trade program in sectors for which accurate

emission measurement of regulated sources or activities may not be

developed as well.

Rate-based trading can be an effective way to promote efficiency if

circumstances do not require an absolute cap on emissions. The

administrative and transaction costs for rate-based trading programs

are likely to be similar to those for cap and trade. All three types of

emission trading programs are meant to work in conjunction with

existing regulations. Any emission trading program should be

designed and undertaken to complement basic safeguards for public

health and the environment under the Clean Air Act and other

environmental laws.

Initial 

Emissions

Allowable 

limit (cap)

Trade

Trade

Regulated Non-Regulated

Performance

Standard

Emissions

Rate

Emissions

Rate

Tons/kwh

Time

Trade

For all types of emissions

trading, the basic concept is

similar: trading provides

companies with the flexibility to

develop cost effective emission

reduction strategies.

Source: “Tools of the Trade: A Guide to Designing and 

Operating a Cap and Trade Program for Pollution Control,” 

June 2003 EPA 430-B-03-002

Cap and Trade

Project-based

Rate-based