In a cap-and-trade system, emitters face transition risk, to the extent that emission caps and permit prices are volatile. We show, theoretically, and empirically for the EU Emissions Trading System, that (i) emitters hedge with emission permits futures bought from financials, (ii) financial constraints limit hedging, in particular by limiting and delaying emitters' purchases of permits in the spot market, implying (iii) permit prices are below the prices of replicating derivatives portfolios. Moreover, we show theoretically that constrained Pareto optima are implemented in equilibrium with cap-and-trade systems, in which the variance of emission caps is set lower than in the unconstrained case.