A tradable permit system is a tool that allows the market to direct (typically) environmental efforts where a market does not naturally exist.  The tradable permit system can be thought of as a three-step process to reduce pollution emissions.

First, scientists provide information and recommendations concerning the physical impacts of a pollutant and the environment’s capacity to absorb it.  For example, if current emissions of 1,200,000 tonnes of carbon equivalents are found to be harmful to the environment, the scientific community can recommend limiting emissions to 1,000,000 tonnes (please note, these numbers are for the purpose of illustration only and do not represent scientific findings).

Second, the government (or governments) decides on what limits will be placed on emission of the pollutant.  The governing body will then issue permits to emit the pollutant in units that sum to the limit*.  For example, given the recommendations from the scientific community, the government could implement a cap of 1,000,000 tonnes of CO₂ emissions.  The government then issues 1,000,000 permits to emit 1 tonne of CO₂.  Any firm that subsequently emits CO₂, or equivalents, must legally hold permits for all of their emissions.

Third, the permits are either auctioned to the highest bidder or given to existing polluters in number proportionate to their baseline emissions (grand-fathering).  Once the permits are issued, the owners of the permits are free to buy or sell to anybody who wants to participate in the market (usually other polluters, but could potentially be advocacy groups).

Many people complain that a cap and trade program gives polluters the right to buy or sell pollution.  However, the cap and trade program represents an improvement over the status quo.  In the world of carbon pollution, the polluters had an unrestricted right to pollute prior to the cap and trade program.  Once the cap and trade system is in place, those polluters will have new costs associated with emitting carbon.  And, there will be assurances, through the “cap”, that total emissions from all sources will not exceed an internationally agreed upon limit.

Unlike a regulatory standard (legal limit per user), a tradable permit system offers flexibility to the polluters on how to accomplish the environmental goal.  If one polluter can overachieve at low cost, there is an incentive for them to do so – selling their rights to a polluter that cannot meet their objectives cheaply.  This can lead to the development of innovative solutions (that may spillover to other stakeholders) and minimizes the costs to society of complying with the limits (Tietenberg 2003).