Understanding the EU Emissions Trading System (ETS)

We must reduce GHG emissions to net zero by 2050 to have a reasonable chance of limiting global warming to 1.5C. Human activities – mainly the burning of fossil fuels – are currently emitting far too much CO2 every year. One approach to reducing CO2 emissions is emissions trading – it is carrot-and-stick: emitters of CO2 are given a financial incentive to cut back, while the authorities set a limit on emissions that falls over time. It is good for all of us to better understand the ETS. This is a recent article on the Investor Corner website.


Climate action 101 – The EU Emissions Trading System

The EU Emissions Trading System – effectively a market in carbon dioxide – sets a price on a tonne of CO2. This GHG is pervasive: the manufacturing, agriculture, transport, waste, power generation and other sectors release the gas that traps heat from the sun and thus contributes to global warming.

Under the system, emitters receive a fixed number of allowances, i.e. permits to emit CO2. These act as currencies for the carbon market.

How does it work?

  • If a company does not have enough, it can either cut emissions or buy extra allowances
  • If it has a surplus, it can keep the allowances for next year or sell them.

The EU calls this the smart way forward and has branded it the cornerstone of its strategy to tackle climate change head-on.

The system – the world’s first, largest and longest running – has operated for more than a decade and covers almost half the EU’s emissions.

It is seen as a flexible, cost-effective and business friendly path to a lower carbon and greener future.

In more detail

The Emissions Trading System covers power stations, energy-intensive industries (e.g., oil refineries, steelworks, and producers of iron, aluminium, cement, paper, and glass) and airline flights within the EU and the European Economic Area – in total, more than 11 000 power plants and factories.[1] For companies in these sectors, participation is mandatory.

Geographically, it involves the 28 EU member states plus Iceland, Liechtenstein, and Norway. It covers around 45% of the EU’s greenhouse gas emissions.

Companies need to hold European Emission Allowances (EUAs) for every tonne of CO2 they emit within one calendar year. They are fined if they emit more CO2 than covered by their emission allowances.

Financially, a company is incentivised to cut emissions by investing in energy efficiency because if they reduce emissions beyond the level of their allowances they will hold excess allowances, which they can then sell.

Participation and gases covered

The system focuses on emissions from sectors and gases that can be measured, reported and verified accurately:

  • CO2 from power and heat generation, energy-intensive industries and commercial aviation
  • nitrous oxide (N2O) from production of nitric, adipic and glyoxylic acids[2] and glyoxal[3]
  • perfluorocarbons (PFCs) from aluminium production

Participation in the EU ETS is mandatory, but in some sectors, only plants above a certain size are included, certain small installations can be excluded if governments put in place measures that will cut their emissions by an equivalent amount, and in aviation, until 31 December 2023, the ETS applies only to flights between airports located in the EEA.

Where does emission trading fit in?

The EU is looking to tighten its emissions reduction target to at least 55% by 2030, the European Commission said recently, up from the current goal of 40% – both from 1990 levels. The increase is part of a green overhaul of the European economy, with pandemic-fighting economic rescue packages seen as an opportunity to speed up EU ambitions for a more sustainable economy. Ultimately, the objective is for Europe to achieve climate neutrality (a balance between emitting carbon and absorbing carbon from the atmosphere in carbon sinks) by 2050.

New Commission plans will call on European automakers to adopt tougher pollution standards, while energy will increasingly become cleaner. Buildings will need to become more energy-efficient and companies face stricter pollution caps in the EU carbon market.

The carbon market can have unexpected side effects. The pandemic-induced drop in air travel has meant that airlines bought fewer emission allowances, causing the price of EUAs to fall (see Exhibit 1). This has made carbon pollution cheaper in other sectors of the economy. Such a development, if it persisted, would do little for the decarbonisation effort, which is a declared EU priority.

In the longer run, however, the EU’s increased emissions reduction target and the (proposed) broadening of the ETS’s cover to include, for example, shipping, demand for EUA’s can be expected to rise, driving up carbon prices and enhancing the incentive for companies to cut back emissions.[4]

What is next?

For the next trading period, from 2021 to 2030, these changes are planned[5]:

  • Strengthening the EU ETS as a driver of investment by upping the pace of annual reductions in allowances to 2.2% as of 2021 and reinforcing the mechanism that reduces the surplus of emission allowances
  • Maintaining the free allocation of allowances to sectors whose international competitiveness could be threatened by carbon leakage[6], while ensuring that the rules for free allocation reflect technological progress
  • Helping industry and the power sector to meet the innovation and investment challenges of the low-carbon transition via several low-carbon funding mechanisms.

The adjustments are meant to ensure that the ETS contributes to the EU’s 2030 emission reduction targets. They are also part of the EU’s contribution to the Paris Agreement.


[1] Source: https://ec.europa.eu/clima/policies/ets_en

[2] .The main use for adipic acid is as a component of nylon-6/6. The US is a major producer accounting for about 40 % of world production. Nitric acid is used primarily to make synthetic commercial fertiliser. Source: https://www.ipcc-nggip.iges.or.jp/public/gp/bgp/3_2_Adipic_Acid_Nitric_Acid_Production.pdf Glyoxylic acid can be applied in the agro, pharma and fine chemical industries for water purificants and pesticides, an intermediate of varnish material and dyes, and the preservation of food, among other uses. Source: http://www.kat-chem.hu/en/prod-bulletins/glioxilsav

[3] Glyoxal is used in textile, paper, oil/gas, cosmetics and leather applications, disinfectants, and in special epoxy resins, among other uses. Source: http://www.intermediates.basf.com/chemicals/glyoxal/faq

[4] Also see EU carbon market shrugs off pandemic  by Mark Lewis; Financial Times 1 July 2020

[5] See https://ec.europa.eu/clima/policies/ets_en, EU ETS: ‘Key features of phase 4 (2021-2030)’

[6] Carbon leakage occurs when, because of climate-related costs, (energy-intensive) businesses transfer production to other countries with laxer emission constraints, raising their total emissions.

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8 thoughts on “Understanding the EU Emissions Trading System (ETS)

  1. Hi Rod,
    Good to publish this !….many people do not quite understand the mechanism, even though they should !
    I would suggest the same to explain “the voluntary market” for emissions reductions !

    1. Thanks Catalin
      I agree that many do not quite understand the mechanism. But it is becoming more important than ever. You make a good point about the voluntary market. We also need to know more about such as the Effort Sharing Regulation which covers the non-ETS sectors.

  2. From January the geographical spread of the EU ETS alters. The Swiss emissions trading system is effectively merging into the EU ETS. But simultaneously all UK based participants are set to quit the system. These have been responsible for around 11% of current allowances.

    Whilst a replacement system has been regularly promised for the past three years, as of now the U.K. government has yet to confirm precisely what it will be!

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