The Future of Cap-and-Trade Markets Following the ICJ Advisory Opinion on Climate Obligations

By: John (Jack) W. Finn

In July 2025, the International Court of Justice (“ICJ”) delivered a landmark advisory opinion on the Obligations of States in respect to Climate Change. The Court affirmed that States have obligations under international law to protect the climate system from anthropogenic greenhouse-gas (“GHG”) emissions, to regulate activities under their jurisdiction—including those of private actors—and that a breach may constitute an internationally wrongful act, with possible reparations.

For practitioners of climate policy, particularly those focused on emissions-trading systems (“ETS”) or cap-and-trade mechanisms, this ruling carries profound implications. It repositions market-based mechanisms like cap-and-trade from options among many tools that must align with—and help fulfill—States’ newly clarified obligations. 

Overview of Cap-and-Trade Systems 

Cap-and-trade (or emissions-trading) systems function by having the government establishing a “cap” on total emissions from covered sources, allocating or auctioning allowances consistent with that cap, and allowing entities to trade those allowances. Entities whose emissions are lower may sell excess allowances, while those whose emissions are higher may buy them, creating a market-based price signal for carbon. 

Key design features include: the level and rate of decline of the cap over time; allocation method (free vs. auction); monitoring, reporting, and verification (“MRV”) of emissions; allowance banking or borrowing; and complementary policies. Several jurisdictions have long experience with these systems, including the EU Emissions Trading System (“EU ETS”) and the California Cap-and-Trade Program (U.S.). These models offer practical data and key lessons to learn from.

Cap-and-Trade has been heralded for combining economy-wide emission limits with cost-effectiveness and flexibility. However, the legal framing of such systems has traditionally regarded them as domestic policy choices rather than instruments tied to international obligations.  

Linking Cap-and-Trade to the ICJ Opinion 

The ICJ Opinion firmly established that States’ obligations are not merely aspirational. These obligations derive from (a) treaty law (such as the United Nations Framework Convention on Climate Change (UNFCCC) and the Paris Agreement), (b) other branches of international law (international human rights law, the law of the sea, and customary international law), and (c) due diligence obligations to regulate private actors under their jurisdiction. 

 Among the key clarifications: 

• Even if States are not a party to specific climate treaties, they remain bound via customary international law to protect the climate system. States must cooperate to reach concreate emission-reduction targets and take measures consistent with the scientific consensus (e.g., limiting warming to 1.5 °C). 
• A failure to take appropriate regulatory or legislative measures—including those related to production, consumption, and subsidies of fossil fuels—may amount to a wrongful act attributable to the State. 
• The obligations extend to regulating private-sector entities under a State’s jurisdiction. 

What this means for cap-and-trade is that market-based mechanisms must be designed and operated in a way that demonstrably contributes to the fulfillment of these obligations. If a State relies on a cap-and-trade system, that system must be configured so that the cap aligns with the State’s overall obligation, the trading regime does not undermine achievement of the objective, and the regulatory oversight ensures that private actors’ emissions are adequately controlled. 

Design Implications 

1. Ambition of the Cap 

Considering the ICJ advisory opinion, the cap cannot be arbitrary or loosely tied to business as usual. It must be compatible with limiting warming to 1.5 °C and consistent with the State’s national circumstances and contribution to cumulative emissions. Therefore, when designing a cap-and-trade system, setting the cap becomes an exercise in fulfilling an international legal duty, not simply a policy objective. 

2. Regulation of Private Actors 

One of the Court’s novel points is the obligation of States to regulate private-sector behavior under their jurisdiction. In a cap-and-trade system, this suggests that the allowance market must be accompanied by robust MRV frameworks, compliance enforcement, and accurate accounting of offsets and banking. If private actors evade obligations such that the aggregate cap target is undercut, the State risks failure of its due-diligence obligations. 

3. Complementarity and Integrity 

Cap-and-trade cannot exist in isolation from other policies. The ICJ emphasized that emission-reduction obligations derive from a spectrum of legal sources, including human-rights and environmental treaties; thus, a cap-and-trade system must maintain environmental integrity (e.g., avoiding vagueness, double-counting, or loopholes). For example, linking with other markets should occur only when those systems have compatible standards of integrity. 

4. Transparency, Accountability, and Legal Consequences 

Given that the ICJ advisory opinion links failure to act with wrongful acts, States now face heightened legal risk if their systems are weak, misdesigned, or fail to deliver. Reparation, non-repetition, and restitution are legal consequences. Thus, designers of cap-and-trade systems must build institutional frameworks that can demonstrate compliance, including periodic shrinkage of the cap, public disclosure of performance, and mechanisms to correct underperformance. 

5. Equity and Historical Responsibility 

The Court noted the relevance of States’ contributions to cumulative emissions and the needs of vulnerable developing countries. While cap-and-trade tends to emphasize cost efficiency, the legal context now adds an equity dimension: how free allocations are handled, how auction revenues are spent (e.g., facilitating adaptation, loss and damage), and how burdens are shared. Although economic design is essential, legal fairness must also be built in.  

Why Cap-and-Trade is a Strategic Tool for Fulfilling Legal Obligations 

While the legal framing raises the bar for design and implementation, cap-and-trade retains considerable value: 

• It sets a firm emissions limit consistent with legal obligations, rather than relying purely on voluntary or national-pledge targets. 
• It provides flexibility and cost-effectiveness for emitters, encouraging innovation and lower-cost abatement, thus helping to meet obligations efficiently. 
• It creates a transparent price signal, enabling governments to align policy, investments, and regulatory oversight with legal standards. 
• When well-designed, it can generate revenue through auctions that States can use to support adaptation, low-carbon transitions, and vulnerable populations—aligning with the broader obligations under international law. 

Challenges and Risks 

Despite its potential, a cap-and-trade system must be carefully managed to avoid shortcomings that could compromise a State’s legal obligations: 

• If the cap is too weak, emissions may remain too high, undermining the obligation to protect the climate system. 
• Loopholes (e.g., excessive free allocations, weak offset rules, or banking that delays real reductions) risk eroding environmental integrity. 
• If monitoring and enforcement are weak, private actors may evade obligations, and the system may fail to deliver, raising risks under the ICJ framework. 
• If the system ignores issues of fairness, burden-sharing, or historical responsibility, it may fall short of the duty to cooperate and act with due diligence, as emphasized by the Court. 
• Linking with other systems without equivalent safeguards may import weaknesses and undermine a State’s legal position. 

Moving Forward 

To operationalize the ICJ ruling via cap-and-trade, States should consider the following action points: 

• Align the cap trajectory with scientifically based pathways and ensure periodic review and increasing ambition. 
• Ensure robustness of MRV and compliance regimes: regular independent audits, public reporting, credible enforcement penalties, and avoidance of creative accounting. 
• Embed equity in design: allocate auction revenues or allowances to support vulnerable communities, adaptation, loss and damage, and capacity building. 
• Integrate and cross-check with legal obligations: ensure market design is coherent with treaty-based, human-rights, and customary obligations, and periodically evaluate legal risks. 
• Design a phase-out of fossil fuel subsidies and other support for high-emitting activities, aligning with the Court’s emphasis on States’ duty to regulate fossil fuel consumption and production. 
• Demonstrate transparency and accountability, ensuring that the system helps a State show it is upholding its international obligations and potentially reducing future litigation risk. 

Conclusion 

The ICJ’s advisory opinion on the obligations of States in respect to climate change marks a turning point: climate-change mitigation is no longer solely a matter of policy choice but squarely a matter of legal obligation. For cap-and-trade systems, this means the stakes are higher: markets must deliver real-world reductions, be legally defensible, and serve both market efficiency and equity. Well-designed cap-and-trade systems offer one of the most powerful tools for States to meet their international responsibilities, but poorly designed markets may expose States to legal risk and undermine the obligation to protect present and future generations. 

As the world prepares for COP30 and international forums increasingly call for accountability, the connection between market mechanisms and international law will only deepen. Policymakers, regulators, and markets must now work together under this new legal paradigm to ensure that cap-and-trade systems make not only economic sense, but also legal and moral sense. 

This article was written by PECC's Energy and Climate Law Scholar Jack Finn, a law student at Elisabeth Haub School of Law at Pace University. It was originally published on November 10, 2025, in Volume 1, Issue 2 of the R.E.A.C.T. by PECC Newsletter.

Editors: Mercè Martí I Exposito, Frances Gothard, Carington Lowe