Overview

The European Union Emissions Trading System (EU ETS) is the world’s largest carbon market and a key policy instrument of the European Union to reduce greenhouse gas emissions in a cost-effective and market-based manner. It operates on the cap-and-trade principle, putting a price on carbon emissions.

Launched in 2005, the EU ETS is central to the EU’s climate strategy and its goal of achieving climate neutrality by 2050.

What is Cap-and-Trade?

Under the cap-and-trade system:

• A cap is set on the total amount of greenhouse gases that can be emitted by covered sectors.
• Emission allowances are issued, each permitting the emission of one tonne of CO₂ equivalent.
• Companies must hold allowances equal to their emissions.
• Allowances can be traded, allowing reductions where they are cheapest.

The cap is reduced annually, ensuring a gradual decline in total emissions.

Sectors Covered

The EU ETS covers around 40% of the EU’s total emissions, including:

• Power generation and heat production
• Energy-intensive industries such as steel, cement, chemicals, aluminium
• Aviation within the European Economic Area
• Maritime transport (added in later phases)

Greenhouse Gases Covered

• Carbon dioxide (CO₂)
• Nitrous oxide (N₂O) from specific industrial processes
• Perfluorocarbons (PFCs) from aluminium production

Allocation of Allowances

Auctioning
Most allowances are auctioned, especially in the power sector, ensuring transparency and revenue generation.

Free Allocation
Some allowances are given free to industries exposed to carbon leakage, where firms might shift production to countries with weaker climate rules.

Phases of EU ETS

• Phase I (2005–2007): Pilot phase with limited scope
• Phase II (2008–2012): Linked to Kyoto Protocol commitments
• Phase III (2013–2020): Single EU-wide cap, more auctioning
• Phase IV (2021–2030): Aligned with EU’s higher climate ambition and Green Deal

Market Stability Mechanism

The Market Stability Reserve (MSR) was introduced to:

• Address surplus allowances
• Stabilise carbon prices
• Improve the long-term functioning of the market

Excess allowances are absorbed into the reserve, while shortages can be corrected.

Achievements

• Emissions from covered sectors have fallen by over 40% since 2005
• Carbon pricing has encouraged cleaner technologies
• Generated significant public revenue, reinvested in climate and energy projects

Limitations and Criticism

• Carbon price volatility in earlier phases
• Free allocation reduced incentives for some industries
• Limited coverage of all sectors and gases
• Concerns about competitiveness and carbon leakage

Significance

The EU ETS is a benchmark for carbon markets worldwide, influencing climate policies in other regions and shaping global discussions on carbon pricing, emissions trading, and climate governance.

It demonstrates how market mechanisms can be integrated with environmental regulation to achieve large-scale emissions reduction.