Under the cap and trade system an environmental regulator establishes a "cap" that limits emissions from a selected group of polluters to a level lower than their current emissions. This cap is then divided up into individual permits - usually equal to one ton of a greenhouse gas - that represent the right to emit the specified amount.

Because the emissions cap restricts the amount of greenhouse gas that can be emitted into the atmosphere, these permits take on financial value. This way, the companies that are able to reduce emissions at a low cost can sell their extra permits to companies facing high costs, ensuring that emission reductions are achieved in a least cost manner.