Components of Cap-and-Trade Markets

• Permits: All such markets have permits that each represent a measurement (usually 1 ton) of the pollutant. In a cap and trade scheme, the government sets a target level of pollution that  it wants to accomplish within a certain time frame. The agency then sets a cap that is equal to or less than the target level of pollution. Then it allocates the permits to the polluting units. It does this either grandfathering them in based upon previous emissions, or it makes the firms buy the permits in a market, usually an auction. The agency can also use some mix of these two allocation methods as well. 
• Use of Permits: Firms can use permits to cover their emissions, up to their allocated amount of pollutants. After that, they must buy additional permits from another willing firm or wait for another annual auction. This selling firm must have excess permits that they didn’t need for their own emissions. Besides making a profit on a transaction, the firm with extra permits can also bank the permits to either use for future emissions or sell to other firms/units.
• Inter-and Intra-firm Permit Trading: In addition, these markets operate most efficiently when permits are allowed to be traded between firms and also between emitting units within a firm. It also helps if firms are allowed to substitute into the market low-abatement cost units that wouldn't usually be covered under the regulation. These low-cost abated pollutions would be allowed to cover or serve as credit for the emissions of high abatement-cost units. That way, they can reduce overall company emissions at least cost to the firm. 

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