Tradable pollution (or emission) permits are a free-market solution to the problems caused by negative externalities.

The difficulty is that companies that pollute create a cost to society but not a cost to themselves.  Because the company does not have an accurate view of its costs of production, it cannot set its production at the level that maximizes efficiency in the economy.

One method of stopping this economic problem is to impose emission (or pollution) taxes.  This would mean that companies have to pay a certain amount for the pollution they produce.  While this system would solve the externalities problem, it would make it difficult for the government to set absolute pollution limits if it felt the need to do so.

Tradable emission permits allow the government to give companies licenses to pollute at a certain level.  Companies can buy, sell, and trade these permits on the market.

It is in the interests of companies to pollute as little as possible.  If they pollute at a level higher than their permit allows, they have to buy permits from another company.  If they pollute less than they are allowed to, they can sell their permit.

Today, in the United States, the majority of laws concerning the environment set limits on how much a company can pollute, then give them a permit to pollute at that level.

One problem critics see with tradable pollution permits is that rather than attempt to reduce pollution, companies will simply bear the cost of polluting.  In the long run, some companies will pollute heavily, and other will not.  The end result will be that some areas of the world will become highly polluted and other areas will be relatively clean.

Other critics object to the government, as they see it, promoting pollution.  It is also difficult to measure exactly how much a company is polluting.  However, tradable pollution permits remain a reasonably affective way to deal with the problem created by externalities.