How does European Carbon Trading Work?

by Marion Willingham

‘Carbon trading’, ‘emissions trading’ or ‘carbon markets’ refer to an approach to reducing greenhouse gas emissions, which turns the right to emit greenhouse gases into a commodity with economic value. This approach is called a ‘cap and trade system’, in which a ‘cap’ or upper limit on greenhouse gas emissions is chosen, and then an accordant number of permits is distributed among emitters (any companies in the industries targeted by a system) [3]. Emitters can only emit the amount of CO2eq (CO2 or equivalent) specified by the number of permits they have, else they receive a financial penalty [3]. The cap is designed to limit emissions, whilst the ‘trade’ part of the mechanism is implemented for economic reasons [5].  

According to cap and trade theory, permits are initially auctioned off to emitters, which immediately assigns value to carbon emissions, encouraging emitters to buy the smallest number of permits they can, as this will cost them the least [5]. Allowing emitters to trade (buy and sell) their permits means that the emitters who can switch to renewables at the lowest cost will make a profit by selling their excess permits, meaning that the cheapest emissions reductions are made first [1]. This is why carbon trading is seen as a ‘flexible’, ‘cost-effective’ and ‘business-friendly’ approach to managing emissions (as opposed to carbon taxes or direct regulations) [1].  

The largest carbon trading system currently in operation is the EU Emissions Trading System (EU ETS) [2]. The EU ETS only applies to some sectors, which are responsible for around 40% of EU emissions [3]. Sectors may not fall under the scheme because it is too hard to track / estimate emissions accurately, or because they involve countries outside of the EU (international aviation, for example). In this system, permits are called allowances, or EUAs [3]. One EUA permits the emission of one tonne of CO2eq [3]. Emitters are referred to as installations [3]. The EU ETS works in trading phases, between which the system is adapted [3]. Phase 1 began in 2005 and ended in 2007, Phase 2 lasted until 2012, Phase 3 until 2020, and Phase 4 began in 2021 [4].

In Phase 1, unlike the theoretical cap and trade model, EU member states issued free allocations to installations, based on their emission history, rather than auctioning off EUAs [7]. Free allocations have been criticised for ‘rewarding polluters’, as the installations with the greatest historic emissions were granted the most EUAs, resulting in huge windfall profits [5]. Since then, in Phases 3 & 4, 57% of EUAs were auctioned rather than allocated [7]. It is difficult for the EU to commit to auctioning off all allowances as the EU ETS is not a global system, so risks carbon leakage. Carbon leakage refers to businesses moving their highly emitting practises abroad in order to avoid local regulations on emissions, preventing any emissions reductions [10]. By offering free allocations to installations in highly competitive sectors the aim is to encourage them to remain within the system and gradually reduce their emissions. 

Phase 1 suffered from over-allocation [7]. Too many EUAs were granted, so their price dropped to 0 €, meaning there was no financial incentive for an installation to reduce its emissions [6]. Despite a cap reduction in Phase 2, prices dropped again as offsets were integrated into the system [7]. ‘Offsets’ refer to various emissions trading mechanisms established under the Kyoto Protocol. These allow installations to gain allowances in return for emissions reductions outside of the EU, though they have been severely criticised [5]. A combination of the new offset credits in the system, and the reduced emitting practises after the 2008 financial crisis meant that EUAs were again too abundant and their price dropped to 7 € [7]. In Phase 3, two mechanisms called backloading and the Market Stability Reserve were introduced to remove excess allowances from the system, and to promote scarcity and increased prices [7]. The European Commission identified that their introduction led to higher and more robust carbon prices, and a year on year emissions reduction of 9% in 2019 [3]. 

The cap has also been reduced with every phase of the EU ETS, with the Phase 4 cap designed in line with the EU target of reducing emissions by 55% (as compared to 1990 levels) by 2030 [3]. It is designed to decrease by 2.2% every year [3]. Upon leaving the EU, the UK has established its own carbon trading system: the UK ETS, which is designed to function similarly to Phase 4 of the EU ETS, though the cap is lower [2]. The UK’s cap is described as ‘5% below the UK’s notional share of the EU ETS cap for Phase 4’, consistent with the UK’s generally more ambitious post-Brexit climate goals [2]. 

There is evidence that carbon trading can lead to emissions reductions, especially when problems such as over-allocation are tackled: The European Commission identifies that within phases 1-3, sectors covered by the EU ETS reduced their emissions by 35% [3]. However, the EU’s current emissions target and cap is not ambitious enough to meet the goals of the Paris Accord [8]. Following the EU ETS, carbon trading schemes are being implemented or considered around the world [9]. A global system of linked carbon trading schemes could allow for a strict global cap on emissions, and the prevention of carbon leakage. 

Marion Willingham is a linguistics undergraduate and student journalist at Gonville & Caius College, Cambridge. She is a researcher for the Global Student Policy Alliance’s Climate Policy Database and the publicist of the Cambridge Climate Society. She is interested in international climate policy and the ethics of achieving climate goals.

[1] EUClimateAction, The EU Emissions Trading System Explained,, accessed 10th August 2021.  
[2] Elena Ares,  The UK Emissions Trading Scheme, House of Commons Library,, accessed 10th August 2021.  
[3] European Commission, EU Emissions Trading System (EU ETS),, accessed 10th August 2021. 
[4] International Carbon Action Partnership, EU Emissions Trading System (EU ETS),, accessed 10th August 2021. 
[5] Austen Naughten, Designed to fail? The concepts, practices and controversies behind carbon trading, FERN,, accessed 10th August 2021. 
[6] European Commission, The EU Emissions Trading System (EU ETS),, accessed 10th August 2021. 
[7] Chandreyee Bagchi & Eike Karola Velten, The EU Emissions Trading System: An Introduction, Climate Policy Info Hub,, accessed 10th August 2021. 
[8] Climate Action Tracker, EU,, accessed 10th August 2021.
[9] Andreas Tuerk & Elizabeth Zelljadt, The Global Rise of Emissions Trading, Climate Policy Info Hub,, accessed 10th August 2021. [10] European Commission, Carbon Leakage,, accessed 9th September 2021.
Categories Business & Finance/Uncategorized

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