Cap-and-Trade Isn’t Broken—But We Keep Breaking It: Why market-based climate solutions fail—and what we’ve learned from those that work

For decades, policymakers have looked to cap-and-trade systems as a market-friendly way to curb pollution. The idea is elegant: set a limit (or “cap”) on total emissions and let companies buy and sell permits to pollute within that cap. The firms that can reduce emissions cheaply do so—and sell their extra allowances to those that cannot. In theory, everyone wins: the environment improves, and the economy adapts efficiently.

In practice, it has not always worked out that way.

Cap-and-trade has delivered real gains in some contexts, but many programs stumbled—not because markets cannot work, but because the policy architecture that governs those markets was flawed or distorted. Markets fail when rules are poorly designed, incentives are misaligned, or political compromises dilute accountability. Misunderstanding this leads to misplaced blame on market mechanisms rather than on the interventions that render them ineffective.

Yet when properly designed, cap-and-trade systems remain one of the most efficient tools available to reduce emissions, incentivize innovation, and transition toward a low-carbon economy. The challenge is understanding what makes these systems succeed—and what causes them to fall short.

This article traces the timeline of key cap-and-trade programs, highlights critical lessons from both successes and failures, and distills six essential ingredients for designing effective, equitable, and enduring carbon markets.

About the author:  Jeff Hulett leads Personal Finance Reimagined, a decision-making and financial education platform. He teaches personal finance at James Madison University and provides personal finance seminars. Check out his book -- Making Choices, Making Money: Your Guide to Making Confident Financial Decisions.

Jeff is a career banker, data scientist, behavioral economist, and choice architect. Jeff has held banking and consulting leadership roles at Wells Fargo, Citibank, KPMG, and IBM.

What Is Cap-and-Trade?

Cap-and-trade is a form of environmental regulation that limits the total amount of a pollutant—typically carbon dioxide (CO₂) or sulfur dioxide (SO₂)—that can be emitted in a region. The government issues a fixed number of emissions permits, each representing the right to emit a set quantity of pollution. Companies can trade these permits, creating a market.

This mechanism puts a price on pollution, internalizing a negative externality that would otherwise go unaccounted for. If designed well, it provides clear price signals to drive investment in clean energy, innovation, and emissions reductions—at the lowest societal cost.

A Timeline of Major Cap-and-Trade Programs

Next are four of the most influential programs and their turning points:

• 1995 – U.S. Acid Rain Program: Established under the 1990 Clean Air Act Amendments, this program successfully reduced SO₂ emissions from power plants using a cap-and-trade model. It is widely regarded as the first and most effective deployment of the concept.

• 2005 – European Union Emissions Trading System (EU ETS): Launched as the world’s largest carbon market, the EU ETS initially faltered due to over-allocation of permits. Major reforms, especially after 2017, transformed it into a more credible and functional system.

• 2009 – Regional Greenhouse Gas Initiative (RGGI): A cooperative effort among Northeastern U.S. states, RGGI targets CO₂ emissions from the power sector and reinvests revenue in energy efficiency and public health.

• 2013 – California Cap-and-Trade: California implemented a comprehensive cap-and-trade program, later linking with Quebec’s system. The state embedded environmental justice goals and price floors into the program’s design.

These programs demonstrate how cap-and-trade can evolve through trial, error, and reform. Below, we examine what went wrong—and what has been learned.

 The Missteps: Why Cap-and-Trade Often Falls Short

Cap-and-trade is not inherently flawed, but it is vulnerable to poor execution. Five key missteps have repeatedly undermined performance:

1. Over-Allocation of Permits

Political resistance to strong caps often leads governments to issue too many free permits in the early phases of implementation. This dilutes the scarcity that drives price discovery and emissions reductions.

• Example: The EU ETS Phase I (2005–2007) saw member states grant more permits than actual emissions. The market price of carbon collapsed to nearly zero, eliminating the incentive to reduce emissions and shaking public trust.

2. Weak or Unstable Price Signals

At the heart of any effective cap-and-trade system is a price signal—the market-determined cost of emitting one ton of pollution. In economic theory, prices do far more than facilitate transactions; they act as information carriers, aggregating the complex web of trade-offs made by consumers, producers, regulators, and innovators. This insight, championed by economists like Friedrich Hayek, underscores that prices are not just numbers—they are dynamic signals of scarcity, demand, innovation potential, and opportunity cost.

A strong and stable carbon price is essential because it tells firms and investors the true cost of polluting and the real value of clean alternatives. When the price of emissions is credible and predictable, companies can justify long-term investments in clean technologies, infrastructure upgrades, and supply chain transformation. It creates certainty and urgency, both of which are critical for innovation and emissions reductions.

However, when carbon prices are weak, volatile, or distorted, they fail to signal the need for change. Firms may continue business as usual, choosing cheaper but dirtier energy sources because the market gives them no reason not to. Worse, volatility in permit prices can paralyze decision-making, as companies hedge against uncertainty instead of investing in progress.

• Example: In the aftermath of the 2008 financial crisis, emissions across Europe fell as industrial activity slowed. But because the EU Emissions Trading System had no effective mechanism to adjust permit supply, the market was flooded with unused allowances. As a result, the price of carbon plunged—at one point dropping below €5 per ton. This price was too low to incentivize meaningful emissions reductions, and investments in clean technology stalled. Without a reliable price signal, the system became a formality rather than a driver of change.

• Lesson: To maintain the integrity of cap-and-trade systems, policymakers must ensure price stability mechanisms are in place. Tools like price floors set a minimum cost for pollution, ensuring the carbon market continues to shape behavior even during economic downturns. Auction-based allocation reduces the distortion caused by free permits and reflects real market demand. Market Stability Reserves (MSRs)—as adopted by the EU ETS in 2017—allow regulators to remove surplus permits during periods of low demand, maintaining price integrity and restoring confidence in the system.

In sum, a cap without a coherent price signal is like a compass with a broken needle. Cap-and-trade systems only work when the price of pollution consistently and transparently reflects its social cost—and when that price is allowed to guide the millions of decentralized decisions made by firms, innovators, and consumers across the economy.

The Struggle of Goodhart’s Law

British economist Charles Goodhart famously observed: “When a measure becomes a target, it ceases to be a good measure.” In the context of cap-and-trade, this is more than a theoretical warning—it reflects a real risk to the credibility of emissions monitoring and pricing systems. When permit prices or emissions levels become the primary targets for political or regulatory performance, actors may manipulate inputs—such as banking allowances, lobbying for looser caps, or engineering short-term reductions—at the expense of long-term outcomes. This undermines the quality of the price signal and the informational value of the metric itself. Effective program design must guard against this by building in feedback loops, independent oversight, and adaptive mechanisms that preserve the price signal as a reflection of actual environmental and economic trade-offs—not just a policy scoreboard.

3. Complexity and Administrative Burden

Cap-and-trade systems hinge on the credibility of their enforcement. To work as intended, they require robust monitoring, reporting, and verification (MRV) frameworks that track emissions, validate compliance, and ensure environmental integrity. But as Thomas Sowell emphasizes in Knowledge and Decisions, monitoring is not free—it incurs administrative, technological, and political costs. The key, Sowell argues, is that the cost of oversight must be justified by the value of the trade-offs it secures.

In the case of cap-and-trade, the benefits of market flexibility and cost-efficiency are only realized when participants trust that everyone is playing by the same rules. That means the system must be both rigorous and accessible. However, many programs—especially early on—struggled to strike this balance.

• Larger emitters often have the legal, financial, and technical resources to navigate complex reporting protocols and secure favorable treatment.

• Smaller businesses, municipalities, and frontline communities may lack the same access or expertise. As a result, they are frequently underrepresented in program benefits or burdened by compliance challenges.

Excessive complexity can lead to regulatory bottlenecks, reduced participation, and diminished environmental impact. Worse, when compliance costs outweigh perceived benefits, public support erodes—undermining the long-term stability of the system.

Recognizing this, many successful cap-and-trade programs have adopted a test-and-learn approach. Rather than assume a perfect design upfront, regulators build in feedback loops that allow for iterative adjustments to improve efficiency and reduce unnecessary burdens. This adaptive governance model ensures that MRV protocols are right-sized—rigorous enough to maintain integrity, but not so onerous that they stifle participation or innovation.

Ultimately, the administrative burden of cap-and-trade is not a flaw—it is a design variable. When approached thoughtfully, monitoring becomes an investment, not a cost: one that secures trust, ensures fairness, and enables the market to deliver on its environmental promise.

4. Market Manipulation and Speculation

Like any market, carbon trading is subject to strategic behavior. Some entities bank allowances, speculate on future prices, or lobby for regulatory loopholes—undermining environmental goals.

• Speculative actors may buy up credits to resell later at higher prices or influence permit distribution.

• Without robust oversight, these dynamics can skew both fairness and effectiveness.

5. Equity Failures and Localized Harm

Perhaps the most serious critique of cap-and-trade is its potential to exacerbate environmental injustice. While total emissions may fall, pollution can concentrate in specific communities, especially near heavy industry.

• Example: In California, studies have shown that some low-income and minority communities experienced increased local pollution, even as the state’s overall emissions dropped.

• Solution: Include place-based safeguards, geographically targeted reinvestments, and air quality co-benefits to ensure pollution reductions are felt where they are needed most.

Lessons From Success: What Actually Works

Despite the challenges, several programs have thrived—offering a blueprint for future cap-and-trade systems. Here are six essential features that distinguish success from failure:

A. A Credible, Declining Cap

The most important design feature is a tightening cap over time. Emissions must be meaningfully constrained—and companies must believe the cap will not be politically reversed.

• Case: The U.S. Acid Rain Program set a clear path to SO₂ reductions and backed it with enforceable limits. Utilities responded with fuel switching and scrubber technology.

B. Strong Monitoring, Reporting, and Verification (MRV)

Data integrity is non-negotiable. Successful programs have real-time, third-party-verified emissions reporting and consistent enforcement.

• Case: The U.S. SO₂ market required utilities to install and maintain continuous emissions monitoring systems (CEMS).

C. Revenue Recycling and Co-Benefits

Auctioning permits generates revenue—which can be strategically reinvested in the public interest.

• Case 1: RGGI allocates over 50% of proceeds to energy efficiency programs, weatherization for low-income families, and health improvements.

• Case 2: California dedicates billions in cap-and-trade revenue to support transit, electric vehicle access, and climate resilience in disadvantaged communities.

These reinvestments increase public support and magnify impact beyond emissions reductions alone.

D. Price Stabilization Tools

Markets require guardrails. Tools like minimum price thresholds, circuit breakers, and stability reserves help maintain economic certainty.

• Case 1: The EU ETS’s 2017 introduction of a Market Stability Reserve curbed oversupply and restored confidence.

• Case 2: California includes a minimum auction price (floor) that rises annually, maintaining pressure on polluters.

E. Complementary Policies

Cap-and-trade cannot do it alone. It performs best when integrated into a broader policy ecosystem that includes:

• Emissions standards

• R&D subsidies

• Clean energy mandates

• Public transit investment

Successful programs layer incentives to ensure deep, cross-sector decarbonization.

F. Transparency and Legitimacy

Finally, cap-and-trade must be understandable, transparent, and inclusive. Programs that clearly communicate their goals and outcomes—especially to vulnerable communities—build trust and staying power.

The Future of Cap-and-Trade: Scaling What Works

As global climate urgency intensifies, cap-and-trade remains a core tool for many jurisdictions. The challenge is to scale what works while avoiding past mistakes.

New carbon markets in China, New Zealand, and parts of Latin America are taking shape. If these systems adopt the essentials—credible caps, stable price signals, equity integration, and administrative clarity—they can help deliver real decarbonization. Efforts to link markets internationally may further enhance efficiency, but only if transparency and enforcement remain strong.

Conclusion: Cap-and-Trade Is a Tool, Not a Guarantee

Cap-and-trade programs do not fail because markets are inherently flawed—they fail when policy decisions distort or undermine the core mechanisms that make markets work. A common misunderstanding is that market failures stem from internal limitations. In reality, markets tend to break down when external interventions—such as misallocated permits, overly generous exemptions, or regulatory uncertainty—suppress price signals, weaken accountability, or favor incumbents.

Markets are powerful precisely because they aggregate information and allocate resources efficiently. But they must be designed with integrity and governed with discipline. In the context of cap-and-trade, success depends not on ideology, but on institutional craftsmanship: credible emissions caps, resilient price signals, adaptive oversight, and transparent governance.

As the old adage reminds us, “you get what you pay for.” In cap-and-trade, the incentives embedded in permit allocation, pricing mechanisms, and oversight structures directly shape environmental outcomes. If policymakers underinvest in accountability or misalign incentives, the results will reflect those decisions. The key is not simply to create a market, but to design and fund it in a way that consistently drives long-term environmental and economic value.

We now benefit from decades of experience—from early missteps to modern refinements. The task is not to abandon cap-and-trade, nor to reinvent it, but to apply what we have learned. When implemented with care and courage, cap-and-trade remains one of our most effective tools for delivering a low-carbon, innovation-driven, and opportunity-rich future.

Resources for the Curious

1. Stavins, Robert N. “A U.S. Cap-and-Trade System to Address Global Climate Change.” The Hamilton Project, Brookings Institution, 2007. Outlines the economic rationale for cap-and-trade and provides design principles for an efficient U.S. emissions trading system.

2. Ellerman, A. Denny, et al. Pricing Carbon: The European Union Emissions Trading Scheme. Cambridge University Press, 2010. A comprehensive analysis of the EU ETS’s first two phases, highlighting key policy lessons from the world's largest carbon market.

3. Burtraw, Dallas, et al. “The Costs and Consequences of Clean Air Act Regulation of SO₂ from Power Plants.” Journal of Environmental Management, vol. 90, 2009, pp. 1075–1083. Assesses the cost-effectiveness and public health gains of the U.S. Acid Rain Program, the most successful cap-and-trade system to date.

4. Sowell, Thomas. Knowledge and Decisions. Basic Books, 1980. Explores how institutions and prices act as repositories of distributed knowledge, with insight into the cost and value of regulatory monitoring.

5. Greenstone, Michael, and Cass R. Sunstein. “Behavioral Public Choice: The Economics of Agency Regulation.” Harvard Law Review, vol. 127, no. 2, 2013. Examines how behavioral biases and administrative complexity affect environmental regulation outcomes, including carbon pricing.

6. Aldy, Joseph E., and Stavins, Robert N. “The Promise and Problems of Pricing Carbon: Theory and Experience.” Journal of Environment & Development, vol. 21, no. 2, 2012, pp. 152–180. Reviews global carbon pricing experiences, emphasizing lessons for cap design, price floors, and hybrid approaches.

7. Borenstein, Severin. “Fixing the Carbon Market.” Milken Institute Review, Fourth Quarter, 2016. Argues for reforms in cap-and-trade programs to ensure meaningful carbon prices and reduce political manipulation.

8. Rabe, Barry G. Can We Price Carbon? MIT Press, 2018. Analyzes the political durability of carbon pricing mechanisms in the U.S. and Canada, including lessons from RGGI and California.

9. Tietenberg, Tom H. “Tradable Permits in Principle and Practice.” Penn State Environmental Law Review, vol. 14, 2005, pp. 251–263. Provides a foundational look at the economic and legal structure of emissions trading and why permit markets succeed or fail.

10. California Air Resources Board. “Cap-and-Trade Program Annual Reports.” CARB.ca.gov, 2015–2023. Official documentation of California’s evolving program, including allowance prices, auction results, and reinvestment impacts.

11. Goodhart, Charles A.E. “Problems of Monetary Management: The U.K. Experience.” Papers in Monetary Economics, vol. 1, Reserve Bank of Australia, 1975. Introduces the principle now known as Goodhart’s Law, which warns that when a measure becomes a policy target, it tends to lose its effectiveness as a measure.