The European Union Emissions Trading System (EU ETS) stands as a cornerstone of EU climate policy, playing a crucial role in the fight against global warming. As the world's first and largest carbon market, it has an influence on how industries across Europe manage their greenhouse gas emissions. Launched in 2005, the EU ETS was designed to reduce industrial greenhouse gas emissions through a cap-and-trade system.
At its core, carbon trading revolves around the concept of putting a price on carbon. By assigning a financial cost to the emission of greenhouse gases (GHGs), carbon trading creates an economic incentive for companies to reduce their emissions. There are two main types of carbon pricing mechanisms: carbon taxes and emissions trading systems (ETS).
Under an ETS, companies can buy, sell or trade these permits. If a company reduces its emissions, it can sell its excess permits to other firms that are struggling to meet their caps. This market-based approach allows emissions reductions to happen where they are most cost-effective, fostering innovation in low-carbon technologies.
The EU ETS operates on a 'cap and trade' principle. It sets a limit on the total greenhouse gas emissions allowed within the system, which decreases annually. Companies must acquire carbon allowances, either through auctions or free allocation, to cover their emissions. Each allowance represents the right to emit one tonne of CO2 equivalent. The system creates a market for these allowances, encouraging companies to reduce emissions cost-effectively. The cap is reduced yearly, with the reduction factor increasing to 4.3% per year from 2024 to 2027 and 4.4% from 2028 onwards. This approach aims to bring emissions down by 62% by 2030 compared to 2005 levels.
If a company emits more than its allocated allowances, it must buy additional allowances on the market or face heavy fines. Conversely, if it reduces its emissions, it can sell surplus allowances. The price of carbon is determined by market supply and demand, and this price fluctuation encourages industries to adopt cleaner technologies when it becomes economically favourable.
Sectors Covered by the EU ETS
The EU Emissions Trading System applies to over 11,000 power plants, industrial facilities and airlines operating between EU countries, Iceland, Liechtenstein and Norway. The system applies to around 10,000 installations in the energy sector and manufacturing industry, as well as aircraft operators flying within the EU and departing to Switzerland and the UK. From 2024, the EU ETS has been extended to include emissions from maritime transport. The system primarily targets carbon dioxide (CO2) emissions, but also covers methane (CH4) and nitrous oxide (N2O) in certain sectors. The sectors covered include:
Power generation and industrial plants (like steel, cement and chemicals), which are responsible for a significant portion of Europe’s emissions.
Aviation: Flights between airports within the European Economic Area (EEA) have been part of the EU ETS since 2012.
Maritime transport: Starting in 2024, large ships engaged in cargo or passenger transport in the EU will be required to acquire emission allowances, with offshore vessels joining in 2027.
These sectors collectively account for nearly 45% of the EU’s total emissions. Sectors like road transport and buildings are not directly covered by the ETS, but they are set to be targeted under a new Social Climate Fund and emissions trading scheme starting in 2027.
The Evolution of the EU ETS
The EU Emissions Trading System has undergone significant changes since its inception in 2005. Initially, it was a pilot phase to establish a carbon price and develop infrastructure for monitoring emissions.
Phase I (2005-2007): The pilot phase, where emissions allowances were allocated for free, and the system's foundations were laid.
Phase II (2008-2012): The system expanded to include more industries and set the stage for international cooperation under the Kyoto Protocol.
Phase III (2013-2020): Marked significant reform, including the auctioning of allowances rather than free allocation and the creation of the Market Stability Reserve (MSR) to address the surplus of allowances.
Phase IV (2021-2030): Current phase, with a tighter cap on emissions and an emphasis on innovation and carbon removal.
Impact of the EU ETS
The EU Emissions Trading System has had a significant influence on reducing greenhouse gas emissions. Between 2005 and 2023, emissions from covered sectors decreased by approximately 47%. The system's impact has been particularly notable in recent years, with a record reduction of 15.5% in 2023 compared to 2022 levels, largely due to increased renewable energy adoption. However, challenges remain. Current projections indicate that ETS emissions are expected to decrease by 41% to 48% by 2030, and 55% to 62% by 2040, relative to 2005 levels. To achieve more ambitious targets, the EU has proposed revisions to strengthen the system and expand its scope.
Additionally, carbon leakage (where industries relocate to countries with less stringent regulations) is a major concern. To combat this, the EU has introduced free allowances and is exploring a Carbon Border Adjustment Mechanism (CBAM) to impose taxes on imported goods based on their carbon footprint. To learn more about how your organisation can navigate CBAM, click here.
The Bottom Line
The EU Emissions Trading System has proven effective in the fight against climate change. Its cap-and-trade mechanism has had a significant impact on reducing greenhouse gas emissions across various sectors in Europe. Looking ahead, the EU ETS faces both challenges and opportunities. While current projections show continued progress, there's more to be done to meet ambitious climate targets. The proposed revisions and expansions of the system aim to address these challenges head-on. As it evolves, the EU ETS will continue to shape Europe’s path to climate neutrality, setting a precedent for global carbon markets.