As the world continues to mitigate the impact of climate change, businesses realize that reducing greenhouse gas (“GHG”) emissions isn’t just an environmental responsibility—it’s also a strategic financial opportunity. By adopting cleaner technologies and more sustainable practices, companies can cut costs, avoid regulatory penalties, and even generate new revenue through carbon markets.
Two mechanisms are driving this shift: cap-and-trade programs and carbon taxes. These carbon pricing tools don’t just penalize pollution but also reward innovation, efficiency, and emissions reduction.
What is “CAP”, and who sets it?
A cap on carbon emissions is a fixed allowance that limits companies’ GHG emissions. It pertains to the emissions allowed in an Emission Trading System (“ETS”). This is typically set by the government and shrinks over time, forcing a gradual decrease in overall emissions.
Once the cap is set, the government then distributes or auctions tradeable allowances. Often, one unit of allowance is equivalent to one ton of the corresponding emission. The government also decides which GHGs should be prioritized, and which industry sectors will be included in the system.
The government and the system primarily cover industries like power generation, transportation, and energy-intensive sectors (e.g., oil refineries, steelworks, metal production). These industries were prioritized due to their significant greenhouse gas emissions.
Cap-And-Trade vs Carbon Tax
Cap-and-trade and carbon taxes are tools used to combat climate change by reducing GHG emissions, but they take different approaches.
Under a cap-and-trade program, the Companies whose emissions are below their set allowance have the option to sell their unused portion to those companies whose emissions exceeded their initial set allowance. The price for trading off their allowance is dictated based on the supply and demand of the market. Allowing the sale of excess allowances creates a financial reward for companies that reduce their emissions—providing a strong incentive to invest in cleaner technologies, energy efficiency, and sustainable practices. This system encourages the internalization of environmental costs into business operations, making carbon emissions a financial consideration in strategic planning.
In contrast, a carbon tax directly sets a price on emissions. The government establishes a fixed cost per ton of CO2 or other GHGs emitted. Companies then pay this tax directly, increasing the cost of polluting activities. The revenue generated from carbon taxes is allocated to support a range of environmental and energy initiatives. Countries such as the UK, US, Argentina, and Japan have adopted carbon taxes to reduce carbon emissions.
While a carbon tax sets the price of CO2 emissions and helps the market determine the amount of reduced emissions, a cap-and-trade system sets the quantity of emissions allowed and enables the market to trade based on these allowances. The key difference here is certainty versus flexibility.
Global Cap-And-Trade Programs
Cap-and-trade programs are gaining traction worldwide as a tool to combat climate change. Pioneered in Europe in 2005, these programs are now being implemented or developed in various regions.
The European Union (“EU”) boasts the world’s largest multi-sector cap-and-trade program, encompassing over 11,000 power plants and industrial facilities across member states.
China, a major player in the global emissions landscape, has established its own cap-and-trade program focused on the power sector. This program allows the cap to adjust based on actual electricity consumption during a compliance period.
South Korea stands out as the first Asian nation to implement a mandatory, nationwide cap-and-trade program.
The North American Landscape
The United States showcases a patchwork approach. The Regional Greenhouse Gas Initiative (“RGGI”) brings together eleven states in a collaborative effort to reduce emissions. California also has a regional Cap-and-Trade Program, which covers 400 facilities and emissions from the power, industrial, transport, and buildings sectors. Additionally, Washington state has enacted its own cap-and-invest legislation.
Looking Ahead: New Programs on the Horizon
Several countries plan to launch cap-and-trade programs in the coming years.
Within the United States, New York is developing an economy‑wide cap‑and‑invest program authorized by its 2019 Climate Leadership and Community Protection Act. After delays, draft greenhouse gas reporting regulations were released in early 2025, with full implementation still pending and subject to legal scrutiny.
Canada is also preparing the first federal cap‑and‑trade system for its oil and gas sector. Draft regulations published in late 2024 propose a cap reducing emissions by ~35–38% below 2019 levels by 2030–2032, with compliance periods beginning in 2030.
A pilot ETS launched in Mexico in 2020 has advanced toward full implementation. Though initially expected in 2024, progress is ongoing, with national rollout anticipated in 2025.
How is this relevant to you?
Cap-and-trade programs have significant financial implications, including recognition of distributed allowance, potential earnings from unused allowance, and potential cost from excess emissions. Participating companies are also subject to specific reporting requirements to ensure transparency and accountability. These reports fall into four main categories:
- Emission Allowance Transaction Reports detail all activities involving emission allowances, including purchases, sales, and transfers. Regulators use this data to track the movement and consumption of allowances within the system.
- Compliance Reports summarize and compare a participant’s emissions against their allocated allowances. At the end of a trading period (typically a year), each covered entity must submit enough allowances to fulfill their compliance obligations.
- Verification Reports prepared by independent third parties provide assurance that the reported data is accurate and complies with all regulatory requirements, ensuring the integrity of the ETS. Additionally, allowance transactions among participants are tracked through a central registry within the ETS.
- Financial Statement Disclosures shall reflect the impact of the GHG emission reduction programs on the company’s financial health.
Consequences
Failing to comply with the reporting requirements of a cap-and-trade program can lead to significant consequences for businesses. The severity of these penalties varies depending on the specific program and jurisdiction. In addition to regulatory sanctions, companies risk reputational damage that can affect stakeholder trust.
One of the most immediate risks is the imposition of monetary fines. For instance, California’s Cap-and-Trade Program can penalize non-compliant entities up to $25,000 per day per violation, in addition to requiring companies to make up for any allowance shortfall. The EU ETS provides a well-known example of this, where companies that fail to surrender enough allowances face a dual penalty: a €100 fine per ton of excess emissions and the obligation to submit the missing allowances the following year. Similarly, states participating in the RGGI may impose daily penalties and mandate corrective measures, depending on each state’s regulations.
Beyond fines, persistent non-compliance may result in the suspension or revocation of emission permits, effectively halting operations until the issue is rectified.
How can Scrubbed help?
Navigating the compliance implications of cap-and-trade programs requires a sound understanding of both emissions accounting and the relevant sustainability and financial reporting standards. Scrubbed brings sustainability and technical accounting expertise to help businesses comply with evolving requirements and manage the operational impact of participation in emissions trading schemes.
Our ESG team assists companies in interpreting and applying existing standards when recognizing, measuring, and disclosing emission allowances. In addition, we help organizations implement processes for accurate GHG emissions tracking, assess financial reporting obligations, and evaluate risks arising from allowance shortfalls or compliance gaps.
Disclaimer
The information contained herein is general and is not intended to address the circumstances of any particular individual or entity. It is not intended to be relied upon as accounting, tax, or other professional services. Please refer to your advisors for specific advice. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.
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**Special thanks to Lord Gen Rilloraza for his valuable contribution to this article.
