The European Union Emissions Trading System (EU ETS) is the cornerstone of the EU’s policy to combat climate change and the world’s first major carbon market. It operates on a “cap and trade” principle, which is designed to limit greenhouse gas emissions from key sectors of the economy, such as power generation, heavy industry, and aviation. Launched in 2005, the EU ETS is now in its fourth phase (2021–2030) and remains a crucial mechanism for meeting the EU’s climate goals, including its target to reduce net emissions by at least 55% by 2030 compared to 1990 levels and achieve climate neutrality by 2050.
The origins of the EU ETS can be traced back to the Kyoto Protocol, adopted in 1997, which committed industrialized nations to reduce greenhouse gas emissions. Recognizing the need for a robust mechanism to achieve these goals, the EU devised the ETS as a way to ensure cost-effective emission reductions.
In its first phase (2005–2007), the EU ETS was implemented on a trial basis, with free allocation of emission allowances to industries and a limited scope. This phase was important for establishing the market infrastructure but suffered from some flaws, including an over-allocation of permits that led to a collapse in carbon prices.
The second phase (2008–2012) coincided with the first commitment period of the Kyoto Protocol. The system was expanded to cover more sectors and gases, and more stringent emission reduction targets were set. However, the 2008 financial crisis led to a surplus of emission allowances, driving down prices and reducing the system’s effectiveness.
The third phase (2013–2020) introduced significant reforms to address these issues. It included a single EU-wide cap on emissions instead of national caps, and a shift from free allocation of allowances to auctioning as the default method for distributing allowances. These changes were designed to reduce the surplus of allowances and increase the cost of emitting carbon.
The EU ETS is based on the “cap and trade” principle. A cap is set on the total amount of greenhouse gases that can be emitted by the installations covered by the system. This cap is reduced over time, so that total emissions fall.
Within the cap, companies receive or buy emission allowances, which they can trade with one another as needed. At the end of each year, companies must surrender enough allowances to cover all their emissions, or they face hefty fines. If a company reduces its emissions, it can keep the spare allowances to cover future needs or sell them to another company that is short of allowances. This trading creates flexibility that ensures emissions are cut where it is most cost-effective.
The EU ETS covers emissions from approximately 10,000 installations in the power and heat generation, energy-intensive industrial sectors, and airlines operating between participating countries. It applies to emissions of carbon dioxide (CO2), nitrous oxide (N2O), and perfluorocarbons (PFCs). The system is designed to incentivize companies to innovate and adopt cleaner technologies by putting a price on carbon.
Phase 4 of the EU ETS, which runs from 2021 to 2030, introduced several important reforms to strengthen the system and ensure it remains effective in achieving the EU’s climate goals:
A declining cap: The overall cap on emissions is reduced annually by 2.2%, compared to 1.74% in the previous phase. This ensures a steady reduction in emissions over time.
Market Stability Reserve (MSR): Introduced in 2019, the MSR is designed to address the surplus of allowances that built up in earlier phases of the system. The MSR automatically adjusts the supply of allowances to ensure the market functions effectively. If the number of allowances in circulation exceeds a certain threshold, a portion of them is placed into the reserve, reducing the number of allowances available in the market and supporting the carbon price.
Free allocation: To address the risk of “carbon leakage”—where companies relocate to countries with laxer emission regulations—the EU ETS continues to provide free allowances to industries at risk of relocating. However, the number of free allowances is gradually being reduced, and the system is designed to incentivize industries to invest in low-carbon technologies.
Innovation and Modernization Funds: Phase 4 includes two important funding mechanisms to support innovation and the modernization of the energy sector. The Innovation Fund supports the deployment of innovative low-carbon technologies in industries covered by the ETS, while the Modernization Fund helps lower-income EU Member States modernize their energy systems and improve energy efficiency.
Aviation: The EU ETS also applies to the aviation sector, which has been included since 2012. However, only flights within the European Economic Area (EEA) are currently covered, while international aviation is regulated through the global Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA).
Maritime Sector: The maritime sector, which has been outside the scope of the EU ETS, is being gradually integrated into the system in recognition of its significant emissions. This inclusion is part of the EU’s broader efforts to ensure all sectors contribute to climate targets.
One of the EU ETS’s key contributions to climate policy is establishing a carbon price signal that drives investment in cleaner technologies. By putting a price on carbon, the system encourages companies to reduce their emissions where it is cheapest to do so. In recent years, the carbon price under the EU ETS has increased significantly, reaching record highs in 2021 and 2022. This price increase reflects the tightening cap on emissions and the reforms introduced to address the oversupply of allowances.
Higher carbon prices make it more expensive to pollute, incentivizing companies to adopt energy-efficient technologies, switch to cleaner fuels, and invest in renewable energy. For example, higher carbon prices have contributed to the decline of coal-fired power generation in Europe, as coal has become increasingly uncompetitive compared to lower-carbon alternatives such as natural gas and renewable energy.
Despite its successes, the EU ETS has faced several challenges and criticisms over the years. Some of the key issues include:
Over-allocation and low prices: In the early phases of the EU ETS, the over-allocation of allowances led to low carbon prices, which reduced the incentive for companies to invest in emission reductions. Reforms such as the Market Stability Reserve have helped address this issue, but concerns remain about ensuring a sufficiently high and stable carbon price.
Carbon leakage: The risk of carbon leakage remains a concern, particularly for energy-intensive industries. While free allocation of allowances has mitigated this risk, critics argue that it can weaken the system’s effectiveness by reducing the incentive for companies to cut emissions. The EU is exploring additional measures to address carbon leakage, such as the introduction of a carbon border adjustment mechanism (CBAM), which would impose a carbon price on imports from countries with less stringent climate policies.
Social impacts: The costs of carbon pricing can be passed on to consumers in the form of higher energy prices, raising concerns about the social impacts of the EU ETS, particularly for lower-income households. To address these concerns, revenues from the auctioning of allowances are often used by Member States to fund climate action, support vulnerable households, and promote energy efficiency measures.
Scope and coverage: While the EU ETS covers a significant portion of the EU’s emissions, some sectors, such as agriculture and most of the transport sector, remain outside the system’s scope. Expanding the coverage of the ETS to these sectors could help drive further emission reductions but also presents political and technical challenges.
International linkages: The EU ETS is a model for other carbon markets around the world, and there have been efforts to link it with other systems, such as Switzerland’s ETS. However, creating a globally integrated carbon market remains a complex challenge, particularly given the differing levels of ambition and regulatory frameworks in other regions.
The EU ETS will play a central role in achieving the EU’s climate targets, particularly its goal of reducing emissions by at least 55% by 2030 and becoming climate-neutral by 2050. The system will need to continue evolving to meet these ambitious goals. Key areas of focus include further tightening the cap on emissions, expanding the scope of the ETS to cover more sectors, and addressing the challenges of carbon leakage and social impacts.
The EU’s proposed European Green Deal, unveiled in 2019, includes several initiatives that will impact the future of the ETS. These include the introduction of a carbon border adjustment mechanism, the expansion of the ETS to new sectors, and a stronger focus on ensuring a just transition for regions and communities affected by the shift to a low-carbon economy.
The EU ETS has established itself as a key tool for reducing greenhouse gas emissions in Europe and driving the transition to a low-carbon economy. While it has faced challenges, including fluctuating carbon prices and concerns about carbon leakage, the system’s design and the reforms implemented over the years have strengthened its effectiveness. As the EU continues to pursue its climate goals, the ETS will remain a vital part of its strategy, helping to ensure that emissions are reduced in a cost-effective and market-driven way, while supporting innovation and investment in clean technologies.