What mechanism does the EU Emission Trading System use to regulate emissions?

• A. A tax on emissions
• B. A grant program for green tech
• C. A cap-and-trade system with trading allowances
• D. A complete ban on fossil fuels

Answer: (C)

The mechanism being tested is a cap-and-trade system with trading allowances. It works by setting a cap that limits the total emissions from covered sectors. The system then issues a limited number of allowances equal to that cap, which firms must hold a matching amount of to cover their emissions. Firms can buy or sell these allowances, so if a company can reduce emissions cheaply, it can sell its excess allowances to another that faces higher costs to cut emissions. This creates a market price for emitting, driving reductions where they’re cheapest and ensuring overall emissions stay within the set cap. Over time, the cap is tightened, pushing total emissions downward.

This approach differs from a direct emissions tax, which would set a price per ton through a tax rate, or a grant program, which provides subsidies for green tech rather than regulating emissions. A complete ban on fossil fuels is not how the EU ETS operates.