EU ETS: An Introduction

by Reinout Debergh

The EU Emissions Trading System (ETS) is the cornerstone of EU climate policy and was established in 2005 as the world’s first international emission trading system [1]. 

Scope 

Its geographical scope includes the EU plus Iceland, Liechtenstein and Norway and it applies to the following greenhouse gases: carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulphur hexafluoride (SF6) [1].

The EU ETS covers over 11,000 installations: power plants and industrial plants (oil refineries, steelworks and production of iron, aluminium, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids, and bulk organic chemicals) [2, 3]. Small installations can be excluded under certain conditions [4]. The ETS also covers flights within the European Economic Area. It covers 45% of EU emissions and 5% of global emissions, though this share will diminish when coal is phased out [2]. The new ETS proposal under the ‘fit for 55’ package suggests an expansion of its scope to include the maritime sector, buildings, and transport. The latter two will be in a separate system from the other sectors [5].

Characteristics of a cap and trade system

A cap and trade system such as the EU ETS involves the trading of emission permits (or European Union Allowances (EAUs)) [6, 7]. It has the following characteristics [6]. 

First, a cap on the total amount of emissions allowed is defined [6]. For 2021, the cap in the EU ETS is set to 1,571,583,007 allowances or 1.57 GtCO2 equivalent [8, 9]. The cap declines every year with a certain percentage which is called the linear reduction factor (LRF). It was 1.74% until 2020 and increased to 2.2% from 2021 onwards [10]. The new ETS proposal, following the EU’s increased 2030 target, suggests an increase of the LRF to 4.2% from 2024 combined with a one-off reduction of 117 million allowances. This would result in an emission reduction of 61% by 2030 relative to 2005 [11]. This represents a significant increase compared to 43% under current parameters [12]. 

Secondly, emissions are monitored and penalties are given if they exceed the amount of surrendered allowances [6]. Installations have to report their emissions annually and the rules regarding monitoring, reporting, and verification (MRV) are set in EU regulations [13]. The penalty equals 100€ per excess tonne of CO2eq adjusted for inflation since 2013. Installations still have to surrender allowances for the excess CO2 [9]. 

Thirdly, there is an initial distribution of allowances [6]. 57% of the allowances are auctioned by member states of which 90%  are distributed among member states based on past ETS emissions from 2005 or the 2005-2007 average, whichever one is higher [14, 15]. The other 10% are allocated to poorer member states [15]. The rest of the allowances (43% of the total allowed emissions) are given for free to certain installations to mitigate the risk of carbon leakage. The new proposal suggests a phase-out of free allocation for sectors covered by the Carbon Border Adjustment Mechanism (to be introduced) [5]. Member states have to use at least 50% of their revenue from the auctioned EUAs for climate action and the new proposal suggests an increase to 100% [5, 14]. Some allowances are also used to finance the Innovation Fund, Modernisation Fund and Social Climate Fund to advance climate action across Europe [5, 16]. The new proposal suggests an increase of these funds [5]. 

Performance of the EU ETS

While emissions from the power sector have decreased significantly since 2013, those from industry have remained stable for most of the time and aviation emissions have even increased [17,18].

On 16/09/2021, the EU ETS carbon price was 59.31€ per tCO2eq [19]. It has significantly increased since 2018 due to a combination of factors such as increased credibility, the anticipation of scarcity, and a strengthening of the Market Stability Reserve (MSR) [20].

It is clear that the ETS is a large and complex system and it has had several issues [21]. Recent reforms have improved it, but further work remains to make it truly effective. 

References:

[1] EU Emissions Trading System (EU ETS), European Commission, https://ec.europa.eu/clima/policies/ets_en, accessed on 14/08/2021. 
[2] EU Emission Trading System (EU ETS), Florence School of Regulation, https://fsr.eui.eu/eu-emission-trading-system-eu-ets/, accessed on 14/08/2021.
[3] Appunn, K., Understanding the European Union’s Emissions Trading System (EU ETS), Clean Energy Wire, https://www.cleanenergywire.org/factsheets/understanding-european-unions-emissions-trading-system, accessed on 15/08/2021. 
[4] Exclusion of small installations and hospitals from the EU ETS, Glowacki Law Firm,  https://www.emissions-euets.com/carbon-market-glossary/952-small-installations-and-hospitals-exclusion, accessed on 15/08/2021.  
[5] DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Directive 2003/87/EC establishing a system for greenhouse gas emission allowance trading within the Union, Decision (EU) 2015/1814 concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading scheme and Regulation (EU) 2015/757, European Commission, https://ec.europa.eu/info/sites/default/files/revision-eu-ets_with-annex_en_0.pdf, accessed on 16/08/2021.
[6] Perman et al., 2003, Natural Resource and Environmental Economics, Pearson Education 3th edition, ISBN: 0-273-65559-0. 
[7] Merrill Brown, L., Hanafi, A., Petsonk, A., 2012, The EU Emissions Trading System Results and Lessons Learned, Environmental Defense Fund, https://www.edf.org/sites/default/files/EU_ETS_Lessons_Learned_Report_EDF.pdf. 
[8] COMMISSION DECISION of 16.11.2020 on the Union-wide quantity of allowances to be issued under the EU Emissions Trading System for  2021, 2020, European Commission,: https://ec.europa.eu/clima/sites/default/files/news/docs/c_2020_7704_en.pdf. 
[9] Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a system for greenhouse gas emission allowance trading within the Union, European Commission, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A02003L0087-20200101, accessed on 15/08/2021. 
[10] Start of phase 4 of the EU ETS in 2021: adoption of the cap and start of the auctions, European Commission, https://ec.europa.eu/clima/news/start-phase-4-eu-ets-2021-adoption-cap-and-start-auctions_en, accessed on 15/08/2021. 
[11] Evans, S., Gabbatiss, J., Q&A: How ‘Fit for 55’ reforms will help EU meet its climate goals, Carbon Brief, https://www.carbonbrief.org/qa-how-fit-for-55-reforms-will-help-eu-meet-its-climate-goals, accessed on 16/08/2021. 
[12] Revision for phase 4 (2021-2030), European Commission, https://ec.europa.eu/clima/policies/ets/revision_en, accessed on 15/08/2021.  
[13] Monitoring, reporting and verification of EU ETS emissions, European Commission, https://ec.europa.eu/clima/policies/ets/monitoring_en, accessed on 14/08/2021. 
[14] Auctioning, European Commission, https://ec.europa.eu/clima/policies/ets/auctioning_en, accessed on 15/08/2021. 
[15] COMMISSION DECISION (EU) 2020/2166 of 17 December 2020 on the determination of the Member States’ auction shares during the period 2021-2030 of the EU Emissions Trading System, European Commission, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32020D2166&from=EN, accessed on 14/08/2021. 
[16] Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL establishing a Social Climate Fund, European Commission, https://ec.europa.eu/info/sites/default/files/social-climate-fund_with-annex_en.pdf, accessed on 15/08/2021.
[17] Carbon Market Watch?s response to the public consultation on the EU Emissions Trading System (EU ETS) review, Carbon Market Watch, https://carbonmarketwatch.org/publications/carbon-market-watchs-response-to-the-public-consultation-on-the-eu-emissions-trading-system-eu-ets-review/, accessed on 02/09/2021.
[18] Marcu et al., 2021, 2021 State of the EU ETS Report, ERCST, https://ercst.org/2021-state-of-the-eu-ets-report/, accessed on 02/09/2021.
[19] Daily Carbon Prices, Ember, https://ember-climate.org/data/carbon-price-viewer/, accessed 19/08/2021. 
[20] Roig-Ramos, C., Booming Prices on the European Emission Trading System: From Market Oversupply to Carbon Bubble?, French Institute of International Relations, https://www.ifri.org/en/publications/editoriaux-de-lifri/edito-energie/booming-prices-european-emission-trading-system, accessed on 16/08/2021. [21] Willingham, M., How does European Carbon Trading Work? https://climatalk.org/2021/09/11/how-does-european-carbon-trading-work/