EU Emission Trading System (ETS) Made Easy: Understanding The Basics

by Viola Baldeshi

To deliver on its emissions reduction goals, in 2005 the EU established the European Union Emission Trading System (EU ETS) with Directive 2003/87/EC. Based on similar principles to the international carbon credit market of the Kyoto Protocol, the system introduced a market mechanism as a climate mitigation policy [1]. Please also see our other article on EU ETS which frames the introduction in a different way.

Within the EU’s “Fit for 55” strategy, the ETS is foundational to achieve the target of reducing 55% of greenhouse gas (GHG) emissions by 2030 compared to 1990 levels [2]. 

Why is the EU ETS so important? 

Complemented by the Effort Sharing Regulation, the industries covered by the system account for 38% of the total emissions produced in the EU. In order to make the system more ambitious, the 25th of April 2023, the European Parliament and Council formally adopted the revision of the reduction targets from -43% to -62% [2]. This puts the EU ETS in a position to have a significant impact on the emission reduction goals of the EU and incentivize the development of low-carbon technologies. 

But how exactly can the EU ETS achieve such ambitious goals? 

The EU ETS is based on a “cap and trade” mechanism. This means that a maximum amount of GHG emissions – the cap – is set by the EU each year, and it is gradually reduced over time until, in principle, it reaches nil. The cap is distributed among operators in the different industries in the form of allowances, which are the right of an operator to emit within a set period of time a certain amount of GHG. 

The cap ensures that allowances do not lose their value and that emissions, as well as the number of available allowances, are progressively reduced [3]. The Market Stability Reserve (MSR) is the main instrument that addresses supply and demand imbalances in the EU ETS, with allowances being transferred to the reserve when the total number in circulation exceeds 833 million [4].   

These allowances are distributed or sold to the operators in the different industries on the basis of their past and projected emissions. If the actual emissions of the operator amount to less than the allowances purchased, the surplus allowances can be sold in the market, thus creating an incentive for businesses to pollute less. On the contrary, if the allowances are not sufficient to cover the emissions, fines are imposed [3].  

What are the industries covered and how are allowances allocated? 

The industries covered by the EU ETS are electricity and heat generation, energy-intensive industry sectors, aviation within the European Economic Area, and the maritime sector. With the last revision, by 2027 a separate ETS II will also account for the emission of buildings and transport [5]. 

The ETS was developed in four phases, starting from 2005 to the current fourth phase (2021-2030) [3]. Throughout the different phases there has been an important shift regarding the allocation of allowances, which is one of its most debated aspects. It started with a free allocation of allowances which is set to gradually transition towards an auction system. Free allocation – or the allocation of allowances free of charge – is set for certain industries which are deemed to be the most at risk of carbon leakage – that is when companies relocate to other countries with laxer emission constraints [5]. Instead, the auction system, regulated by the Auctioning Regulation, requires countries to auction their allowances on an auctioning platform, which is currently the European Energy Exchange. 

In the current phase, 57% of the allowances are being auctioned and among these, 90% is distributed to Member States on the basis of their verified emissions. [3] The rationale behind this is that the free allocation of allowances will be gradually phased out and instead replaced with the Carbon Border Adjustment Mechanism to ensure that an equal carbon price is paid between imports and exports [4]. Organisations like the WWF are deeply critical of the free allocation of allowances, maintaining that the polluter pays principle is hardly respected and leading to ineffective results [6]. 

Revenues from auctioning allowances feed into Member States’ budgets, which must spend at least 50% on climate and energy related purposes. A share of the revenues contribute to the Innovation fund, the Modernisation fund, and with ETS II also a newly established Social Climate fund [4].    

Talking impact: has the ETS been successful? 

According to a recent empirical study on emission data from France, the Netherlands, Norway and the UK, between 2005 and 2012 the EU ETS was associated with a ‘statistically significant reduction of carbon emission in the order of -10%’ [7].  Another study supports the claim at the sector level, finding that the EU ETS has contributed to a reduction of 3.8% of EU-wide emissions despite the low prices [8]. 

A more ambitious EU ETS working in synergy with other policies is key to achieve the emissions reduction goals set for 2030 [9]. Expanding the scope of the EU ETS and increasing its overall reduction goals are signals towards significant progress. 

References:
[1] European Commission, 2000, Green Paper on greenhouse gas emissions trading within the European Union. Com (2000) 87 Final. Brussels, Commission of the European Communities. https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52000DC0087&from=EN
[2] European Council, Infographic – Fit for 55: reform of the EU emissions trading system, https://www.consilium.europa.eu/en/infographics/fit-for-55-eu-emissions-trading-system/, accessed on June 13, 2023. 
[3] European Commission, EU Emissions Trading System (EU ETS), https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets_en, accessed on June 8, 2023.  
[4] International Carbon Action Partnership, 2022, EU Emissions Trading System (EU ETS), https://icapcarbonaction.com/system/files/ets_pdfs/icap-etsmap-factsheet-43.pdf
[5] Federal Ministry for Economic Affairs and Climate Action, 2023, New EU climate policy in place: political agreement in finalising the Fit for 55 climate package, https://www.bmwk.de/Redaktion/EN/Pressemitteilungen/2022/12/20221218-new-eu-climate-policy-in-place-political-agreement-in-finalising-the-fit-for-55-climate-package.html, accessed on June 14, 2023. 
[6] WWF, 2021, Fit for 2030: Making EU ETS Revenues Work for People and Climate, https://wwfeu.awsassets.panda.org/downloads/making_eu_ets_revenues_work_for_people_and_climate_summary_report_june_2021__2_.pdf
[7] Antoine Dechezleprêtre, Daniel Nachtigall, Frank Venmans, 2023, The joint impact of the European Union emissions trading system on carbon emissions and economic performance, Journal of Environmental Economics and Management 118, https://doi.org/10.1016/j.jeem.2022.102758. 
[8] Patrick Bayer, Michaël Aklin, 2020, The European Union Emissions Trading System reduced CO2 emissions despite low prices, PNAS 117 (16), https://doi.org/10.1073/pnas.1918128117
[9] Climate Action Tracker, EU, Policies & action, https://climateactiontracker.org/countries/eu/, accessed on June 13, 2023.