What is an emission trading system (ETS)?

An emission trading system (ETS) is a market-based approach designed to reduce greenhouse gas emissions by providing economic incentives for achieving emissions reductions. In this system, a limit or cap is set on the total amount of emissions that can be emitted by all participating entities, such as companies or countries. Each entity or participant is allocated a certain number of emissions allowances, which represent the right to emit a specific amount of greenhouse gases.

If a company reduces its emissions below its allocated allowances, it can sell its surplus allowances to other companies that may need them. This trade creates a financial incentive for companies to lower their emissions. The flexibility of buying and selling allowances encourages innovation and investment in cleaner technologies, ultimately driving down overall emissions in a cost-effective manner.

This market-driven mechanism contrasts with regulatory approaches that may rely solely on mandates or technological requirements without providing financial incentives for emission reductions. Thus, the correct answer highlights the framework of economic incentives in encouraging emissions reductions, making it the central concept for understanding how an ETS operates.