Over the past decade, many countries have taken up the fight against global warming by crafting policies to curb greenhouse-gas emissions. Some have slapped taxes on emissions of carbon dioxide, the main global-warming gas. Others have chosen a system that establishes an overall limit on carbon-dioxide emissions and then allows companies to buy and sell the right to pollute within that limit.

The European Union was the first to try the latter approach, known as a cap-and-trade system or emissions trading. The U.S. has debated adopting such a system, but in June the Senate voted overwhelmingly against it, worried that it would saddle consumers with higher energy prices and hurt the economy. The U.S. is likely to reconsider the idea at some point, however, since both presidential candidates support cap-and-trade.

Emissions Trading

PODCAST: The Journal's Leila Abboud describes how the cap-and-trade system works and whether it has reduced greenhouse-gas emissions.

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So how exactly does a cap-and-trade system work? How effective has this approach been in reducing greenhouse-gas emissions? How will the costs affect consumers and companies? Here are some answers to those and other questions about this policy option.

What's the thinking behind cap-and-trade?

A cap-and-trade system uses financial incentives to encourage companies to reduce the amount of carbon dioxide they emit. A regulatory body sets an overall limit, or cap, on annual carbon-dioxide emissions and then assigns shares of that total to major polluters. If a company wants to emit more than its individual cap allows, it must buy emission permits from a business that is emitting less than its allotment.

Over time the pollution caps are ratcheted down, making it more costly to keep polluting, and achieving the desired reductions in greenhouse-gas emissions.

The idea is that this system will cut pollution more effectively and at a lower overall cost than other regulatory approaches. For instance, cap-and-trade provides more certainty on emissions levels than a carbon tax because it sets firm limits on pollutants. Cap-and-trade is also thought to be more cost-effective than other policies because it allows each company to decide how to reduce its emissions, and companies presumably will choose the cheapest way to achieve their goals. By contrast, measures imposed by the government, like a requirement to adopt a certain cleaner technology, might not be the most cost-effective method for every company.

Who participates under the EU setup?

The EU system covers six industrial sectors: pulp and paper makers, concrete, glass and steel producers, electric utilities and oil refineries. The system, which has been in place since 2005, covers about 11,500 industrial facilities, accounting for about half of Europe's total greenhouse-gas emissions. Emissions from cars, planes and buildings aren't covered by the rules.

How is the system set up?

Here's how it works in Europe: The European Union Commission on the Environment sets overall limits for carbon-dioxide emissions in each of the EU's 27 member states. Each country then submits an allocation plan to the commission, spelling out what share of the country's allotment will go to each participating factory. Emissions permits are distributed based on those allocations, with each permit giving the holder the right to emit one kilogram of carbon dioxide. For example, a large iron and steel works in Scunthorpe, England, owned by Tata Steel Group's Corus unit, will be allocated 8.3 million permits each year from 2008 through 2012.

Allocations are based in part on the emissions expected at each plant, but policy makers also consider the impact on each business of the cost of cutting emissions. By giving more permits to companies that they think would be crippled by added costs, they can protect jobs. The allocation of permits is often the subject of intense lobbying by industries.

So far most of the permits distributed by governments have been given away free, but that is changing. Governments across Europe are moving toward auctioning at least a portion of the permits to raise the cost of polluting. The U.K. will auction off 7% of its permits for the 2008-2012 period, and the EU Commission has floated the idea that all permits to the power sector should be auctioned after 2013.

Each December, companies are required to turn in to national authorities one permit for each kilogram of carbon dioxide they emit into the air, based on calculations that include measuring the amount of fuel they burn or electricity they consume. These figures are audited annually by independent firms to ensure their accuracy. Companies that have exceeded their emissions allocation need to buy additional permits to turn in to the authorities.

So how would a company go about buying those additional permits?

A company that needs permits can buy them directly from a company that has some to spare. But most permits are bought and sold on electronic exchanges.

In addition to the companies that must abide by emissions caps, banks, hedge funds and other investors can trade carbon permits just as they would any other financial instrument. Most of the big international banks -- including Barclays PLC, Merrill Lynch & Co., Citigroup Inc. and Allianz SE's Dresdner Kleinwort unit -- have set up emissions-trading operations. They advise clients on when to buy and sell permits, publish research on the permit market and manage their own portfolios of permit investments. The market is expanding rapidly: According to the World Bank, some $50 billion of carbon permits changed hands in 2007, more than twice the amount traded in 2006.

Just as a company's share price changes constantly, so does the price of a carbon-emissions permit. Several factors can influence the demand for permits and therefore their prices, including energy prices, extreme weather and economic growth. For example, if the price of natural gas increases sharply, some utilities might turn to more coal to produce electricity, increasing their carbon-dioxide emissions, meaning they'll need more permits to offset the added pollution. Or if a recession hits Europe and construction slows, steel factories would reduce production, emitting less pollution, meaning they'll need fewer permits at the end of the year.

Complying with emissions caps hasn't proved too costly for companies yet, but as caps are lowered, obeying the rules will require real changes or extra costs for companies. Companies will have to decide what they prefer: to pay for extra permits or pay to revamp their operations to pollute less.

How effective has this system been?

Carbon-dioxide emissions have actually risen in the EU since the cap-and-trade system was instituted in 2005 -- by 1.1% in the first year and 0.8% in the second year, according to the European Commission.

Policy makers and environmental experts agree that the early years of the system were hobbled by one major mistake: European governments, worried about hurting their economies and big employers, set the initial emissions cap too high. That left room for emissions to grow under the cap and gave companies no real incentive to revamp their factories. European regulators have already moved to address the problem: Fewer permits will be issued during the program's second phase, from 2008 to 2012. In the end, the effectiveness of any cap-and-trade system depends on political will.

Doesn't a cap-and-trade system just make everything more expensive?

By requiring companies to reduce carbon-dioxide emissions, caps raise the cost of generating electricity for power utilities and make it more expensive for manufacturers to produce goods. It's inevitable that some of these extra costs would be passed on to consumers in the form of higher prices.

But in the real world, it's difficult to discern the exact impact of carbon caps on consumer prices. Prices for electricity and gasoline depend on a range of factors such as regulation, tax levels and general market demand; figuring out how much a carbon cap added to the price tag is tricky. And prices for consumer goods also depend on a myriad of factors, with the carbon cap accounting for only a sliver of any change.

There haven't been any major studies of how Europe's prices for energy and consumer goods have been affected, if at all, since its system started in 2005.

A study by the Congressional Budget Office estimated that middle-income U.S. households would see annual cost increases totaling 2.8% of their income under a cap-and-trade system designed to cut emissions by 15% from 1998 levels. Poorer people would be harder hit, with higher prices eating up 3.3% of their income, while richer people would see prices increase by only 1.7% of their income.

What are some of the objections to a cap-and-trade system?

Some economists think that taxing carbon-dioxide emissions is preferable to emissions trading because it's a much simpler way to change the behavior of companies. Proponents of a carbon tax argue that it does the same thing as emissions trading -- provide a financial incentive to reduce pollution -- without the extra expense and hassle of setting up a whole new market. They argue that a tax allows for less political gaming and lobbying by affected industries. Proponents of carbon taxes include former U.S. Treasury Secretary Lawrence Summers and economist Joseph Stiglitz. But few policy makers expect such a tax to be politically palatable in the U.S.

Some environmentalists oppose cap-and-trade as too kind to polluting industries. But most major green groups, including the World Wildlife Fund and the Sierra Club, have embraced the approach as the best compromise: feasible politically and good for the planet.

—Ms. Abboud is a staff reporter for The Wall Street Journal in Paris.

Write to Leila Abboud at leila.abboud@wsj.com