Under a cap-and-trade system, such as an emissions trading scheme, if the total emission cap is reduced by regulatory decree, what happens in the permit market?

A cap-and-trade system places an overall limit or "cap" on the total amount of pollution that regulated firms are permitted to emit. Emission permits are then allocated or auctioned to firms, and firms can trade these permits. The total supply of permits is determined by the regulatory cap. Suppose the regulator reduces the total emissions cap. This reduces the number of permits available in the market. Therefore: Emission Cap ↓ → Supply of Permits ↓ With permit demand unchanged, the reduced supply of permits causes the equilibrium permit price to rise. Therefore: Permit Price ↑ A higher permit price makes pollution more expensive. Firms consequently undertake greater pollution abatement. Each firm compares the cost of reducing one additional unit of pollution with the price of purchasing an additional permit. In a cost-effective equilibrium: MAC₁ = MAC₂ = ... = Permit Price where MAC represents Marginal Abatement Cost. When the cap becomes more stringent, the permit price rises and firms undertake more abatement. Thus, marginal abatement costs across firms equalise at a higher level.