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Carbon trading is part of a carbon pricing mechanism to reduce greenhouse gas emissions by industry.

Each year, the government decides on the total amount of greenhouse gases it will allow industries to emit from all activities. Each business that is a major source of greenhouse gas emissions is allowed to buy (or is granted free) an annual quota of permits to produce greenhouse gases, so that all such permits equal the national target for the year. If the business modifies its processes such as to reduce its greenhouse emissions, it can sell its unwanted permits to the highest bidder. If another business wants to expand and exceed the limit imposed by its own quota, it can buy permits from another business. Thus, there is an incentive for a business to reduce its emissions so that it can sell its permits at a profit, and so that it does not have to pay an increasingly high price for permits on the secondary market.

By this means, the government can control, then reduce, the total greenhouse gases produced in the state or nation. It can gradually reduce this limit in line with the long-term national target.

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