The European Union Emission Trading System (ETS) Explainer

Table of Contents

What is the EU ETS?

The European Union Emissions Trading System (EU ETS) is Europe’s primary regulatory instrument for reducing greenhouse gas (GHG) emissions. It works by setting a declining limit on the aggregate emissions it covers and by allocating an equivalent amount of tradable pollution permits to the regulated entities. These permits are called European Union Allowances (EUAs).

The EU carbon market was adopted in 2003 through Directive 2003/87/EC and entered into force in 2005. Since its first compliance phase (2005-2008), this system has been subject to several reforms, which have gradually expanded its scope, strengthened the incentives for emissions reductions, and reinforced the market’s responsiveness to shocks. The EU ETS has also served as a blueprint for similar systems in other jurisdictions.

It is estimated that, since its launch, the EU ETS has helped drive down emissions from electricity and heat generation and industrial production by 34,6%. Most of this reduction has taken place in the power sector.

What is the scope of the EU ETS?

The EU ETS covers the 27 EU Member States, plus Iceland, Liechtenstein, and Norway, as well as power plants in Northern Ireland. The UK used to participate in the EU ETS, but after Brexit it introduced its own national ETS. As of 1 January 2020, the EU ETS has been linked with the Swiss ETS. This means that allowances that are issued in one system can be surrendered for compliance in the other one, and vice versa.

The EU ETS covers electricity and heat generation, energy-intensive heavy industries, and aviation. In 2024, emissions from maritime transport will also be phased into the scheme. In addition, from 2027, a separate ‘ETS 2’ will be established to cover fuels for road transport, buildings, and additional sectors.

As with many other ETSs, the regulatory scope of the EU ETS is focused on emitting installations (i.e., regulated entities) rather than individual companies. In 2021, the EU ETS covered 8,757 electricity and heat plants and manufacturing installations, as well as 371 aircraft operators flying between European Economic Area (EEA) airports, and from the EEA to Switzerland and the UK. The above represent around 36% of all EU emissions.

In order to keep administrative costs manageable, the EU ETS only covers entities above a certain size. For most stationary installations, this threshold is 20 MW of total rated thermal input.

What are the main features of the EU ETS?

The EU ETS operates as a government-regulated market that requires entities to surrender an amount of allowances corresponding to their reported emissions. If they fail to do so, they face heavy penalties: a €100 fine (inflation-adjustable) for each ton of emissions without allowance, plus an obligation to surrender the outstanding allowances.

By gradually reducing the total number of emission allowances available (the ‘cap’), the EU ETS effectively establishes an absolute GHG emissions limit for the economic activities it regulates. By permitting regulated entities to engage in the trading among themselves, the emissions reduction target can be met at a lower cost. Companies reduce emissions in situations where it is cheaper for them to do so than to buy emission allowances. We explain this further in section 6 below.

At the beginning of its third compliance period (2013-2020), the EU carbon market experienced an unusual situation where there was very little demand for carbon allowances. This was influenced by a combination of factors, including an economic slowdown following the 2008 financial crisis and a strong push towards renewable energy sources, which reduced the need for these allowances. As a result, allowance prices dropped significantly. This decline in prices raised concerns among policymakers and stakeholders. They worried that the current mismatch between the supply and demand for allowances, if not addressed, could diminish the incentives for investments in low-carbon technologies and undermine the EU ETS’s ability to achieve its environmental goals. While there were already some mechanisms in place within the EU ETS to handle unexpected shifts in allowance demand, such as banking provisions, the situation sparked a need for further consideration.

How does the EU ETS differ from a voluntary carbon market?

Unlike the EU ETS, voluntary carbon markets are not legally mandated and are driven by voluntary sustainability goals and corporate social responsibility. Participants in these markets voluntarily purchase carbon offsets to compensate for their emissions, often supporting emission reduction projects that wouldn’t have occurred without these market incentives.

How was the supply and demand imbalance corrected?

As a short-term remedy, the EU Commission decided to postpone the auction of 900 million allowances from 2014-2016 to 2019-2020. As a long-term solution, in 2015, the EU legislature implemented the so-called Market Stability Reserve (MSR)This mechanism operates as a supply control system for the EU carbon market, based on predefined thresholds in relation to the total number of allowances in circulation.

When there is an excess of carbon allowances in circulation that could potentially lead to a significant drop in prices, some of these allowances are taken out of the market and subsequently invalidated. On the other hand, allowances are released back into the market if the total number of allowances in circulation falls below a certain value. On 1 January 2023, more than 2,5 billion allowances in the MSR were invalidated.

How are EU allowances allocated?

These allowances can be obtained through various means, including free allocation based on historical emissions or benchmarking, as well as through auctions and trading.

Initially, when the EU ETS was established, allowances were often allocated to installations based on their historical emissions. In other words, they received allowances for free based on the amount of GHGs they had previously emitted. Currently, a share of allowances is still allocated for free based on product benchmarks, but most allowances are auctioned. Auctions take place daily at the European Energy Exchange (EEX). The EU allowances are classified as financial instruments under the Markets in Financial Instruments Directive (MiFID), which means that their trading on the EU carbon market is subject to the same regulatory regime as EU financial markets.

Allowances can also be traded in the secondary market at any time, either directly between buyers and sellers, or indirectly through intermediaries. In the spot market, the allowances are immediately delivered from the seller to the buyer, like in a physical transaction. EU allowances can also be traded as derivatives, namely options and futures. Most of the trading takes place through these contracts (90% of volumes), which represent contractual rights (options) or obligations (futures) to buy or sell allowances at a predetermined price on a future date. This derivative market offers market participants risk-management tools, as we explain in section 7 below.

What are the compliance options for a regulated entity?

Under the EU ETS, a regulated entity has essentially two options to comply:

  1. The first option is to buy enough allowances to match their emissions. This option is economically rational as long as the cost of reducing an additional unit of emissions is higher than the EU carbon (allowance) price. Keep in mind that ‘carbon price’ and ‘carbon cost’ are not interchangeable, as we explained here.
  2. The second option is to reduce or eliminate the emissions that are subject to the EU carbon price. In the early stages of the system, when the majority of allowances were allocated for free, entities could realize an economic benefit by reducing their emissions and then selling the excess allowances to parties that exceeded their initial allocation. As a growing proportion of allowances are now auctioned rather than allocated for free, companies benefit from avoiding the costs associated with purchasing additional allowances.

By combining the two options above, entities might find a middle ground, cost-effectively reducing a portion of their emissions. For instance, adopting more efficient materials or transitioning to low-carbon fuels could be economically justified beyond a certain carbon price threshold. Yet, for the same price threshold, other more expensive measures like retrofitting an existing installation to install Carbon Capture Storage and Utilization (CCSU) technologies might not be justified. It is also worth noting that these mitigation actions won’t be executed overnight. To make these decarbonization investment decisions, companies need long-term visibility and legal certainty.

How do companies hedge their carbon pricing risk exposure?

Companies can mitigate their exposure to the risk of carbon pricing by banking allowances. Companies can purchase allowances when prices are relatively low or when they anticipate future price increases. This could be the case when policy reforms are expected to be adopted that will result in a tighter supply of allowances. By holding these allowances for future compliance periods, companies can protect themselves from potential price surges and maintain more predictable compliance costs.

Companies can also mitigate the risk associated with volatile carbon prices by using derivatives (options and futures). These financial instruments enable companies to lock in prices for carbon allowances for future transactions, which can enhance predictability for their compliance obligations and investment strategies. As previously explained, futures contracts oblige the holder to buy or sell allowances at a predetermined price on a future date, while options give the holder the right, but not the obligation to do so.

Who are the main players in the EU carbon market?

The primary players in the EU carbon market are the operators of the regulated installations, who are the ones bearing the obligation to surrender sufficient allowances to cover their facilities’ annual emissions. An operator under the EU ETS is defined as ‘any person who operates or controls an installation or, where this is provided for in national legislation, to whom decisive economic power over the technical functioning of the installation has been delegated’.

Investment funds and other types of financial entities also participate in the EU carbon market. Their market share in 2021 was below 8%. On the one hand, financial trading performs key functions, by enhancing market liquidity and facilitating trade of allowances among compliance entities at lower costs. On the other hand, financial trading could lead to the risk of excessive speculation, potentially leading to destabilizing effects for the market. 

In 2022, the European Securities and Markets Authority (ESMA) was asked by the Commission to analyze the behavior of financial institutions in the carbon market and whether high carbon prices were due to speculative behavior from financial market participants. ESMA’s findings suggested that ‘the observed evolution of carbon prices and volatility seem to have followed market fundamentals’.

How are emissions monitored, reported, and verified?

Emissions under the EU ETS are monitored at the installation level. What matters is direct emissions (Scope 1). All covered entities must submit a monitoring plan, which must be approved by the competent authority, and report their emissions on an annual basis. Emissions reports must be verified by independent accredited verifiers.

The specific rules for monitoring, reporting and verification are outlined in the Monitoring and Reporting Regulation (MRR) and in the Accreditation and Verification Regulation (AVR).

The MRR offers entities the flexibility to choose between (combinations of) different monitoring methodologies. The largest emissions sources are subject to additional monitoring safeguards and reporting requirements in comparison to smaller emitters. Independent verifiers must fulfill certain competence criteria and be accredited by a National Accreditation Body. Each verification report requires on-site inspections, accompanied by strategic and risk analyses, while it is subject to additional independent review.

What is today’s status of the EU ETS?

The EU ETS is currently in its fourth compliance phase (2021-2030). The cap has been decreasing each year at a rate of 2.2%. In July 2021, the EU Commission presented a new package of reforms to reach the goal of reducing net emissions by at least 55% in 2030 compared to 1990 levels.

As part of this package, reforms were also proposed and adopted for the EU ETS, with an increased goal to reduce emissions of EU ETS sectors by 62% by 2030 compared to 2005 levels. Based on the latest reforms, the reduction rate of the cap will be increased to 4,3% from 2024 to 2027, and to 4,4% from 2028.

Additional reforms include tighter free allocation rules for both stationary installations and aviation, the expansion of the system to the maritime sector, and the implementation of the new EU carbon market (ETS 2) for road transport and buildings, as mentioned above.

How are the revenues of the EU ETS invested?

The auctioning of allowances generates significant revenues. Between 2013 and 2021, the EU Member States collected over EUR 100 billion from these auctions. Member States are obliged to annually report information on their use of EU ETS revenues (article 19 of Regulation (EU) 2018/1999).

In 2021 alone, total auctioning revenues amounted to EUR 31 billion. The Member States invested most of their EU ETS revenues, specifically EUR 19.4 billion, in climate and energy projects, focusing on renewable energy and transport.

The European Commission has proposed that 30% of all EU ETS revenues and a share of the revenues from the sale of certificates of the carbon border adjustment mechanism (CBAM) go to the EU (as EU ‘own resources’). Based on these proposals, the EU ETS is projected to generate about EUR 7 billion annual revenue for the EU budget from 2024, which will reach €19 billion per year from 2028, when the new ETS for road vehicles and buildings will also be implemented. In addition, the EU annual revenues generated from CBAM are estimated to reach EUR 1.5 billion as of 2028. The approval of these proposals will require a unanimous agreement by the 27 EU Member States at the Council of the EU.

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