This is an economic model used to reduce carbon emissions.
A government sets a “cap” on the total amount of emissions to be allowed, and they sell “permits” or “certificates” or “credits” which allow organizations to emit a certain amount against that cap. The goal is to slowly reduce the cap every year.
For example, if a government deems that only 10,000 tons of carbon can be emitted by organizations under their authority, they might sell 10,000 credits at an annual auction. If your company emitted 100 tons of carbon a year, you would need to buy 100 of these at auction. If you emitted more than 100 tons of carbon, you would be subject to a severe penalty or tax.
The “trade” part is because a secondary market exists for the credits. If you purchased 100 credits, but only emitted 80 tons of carbon, then you still have 20 credits, which you can sell.
Another organization might realize they’re going to go over what they purchased for, so they’ll buy your extra credits at whatever price you agree on (in reality, the sale is rarely private – there are public markets and exchanges for the credits).
In some auctions, you don’t even have to be a carbon emitter to buy credits. Anyone can buy them as an investment. You might buy some credits, use none of them, and bet the market for them will increase so you can sell them to needy emitters before the next auction.
This secondary market sets a market price for emissions, essentially. Emitters are incentivized to reduce emissions, so they have to spend less, and the value of the credits will adjust based on economic conditions. If you produce less, you either buy less, or sell the leftover. If you change your business model to become cleaner, you also save money. If everyone emits more, then everyone needs more credits, so the price goes up.
Governments might also issue credits as incentives for certain business practices. For example, Tesla gets free credits because they only manufacture electric vehicles (they get these mostly from the State of California). They make hundreds of millions of dollars every year by selling those certificates on the secondary market. And this revenue is not tied to any expense – it’s essentially pure profit.
A large cap-and-trade pact is the Regional Greenhouse Gas Initiative which involves 10 northeastern states. It was established in 2009.
California has its own market, managed by the California Air Resources Board.
A cap-and-trade law from the 1990s (pushed by George Bush Sr.) that targeted sulfur dioxide emissions is often cited as ending the threat of acid rain.
There are those that believe cap-and-trade is just another form of taxation, albeit one that can be shared. The auction of credits required emitters to purchase credits, and that money goes to the government. The difference between this and a tax, is that the “tax” burden can be passed around to other companies.
Additionally, the establishment of a “cap” at all is essentially the government setting a limit on energy and rationing it.