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Introduction to the EU’s Emissions Trading System

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19 October 2022

The EU Emissions Trading System (the EU ETS) is one of the key pillars of the EU’s policy to combat climate change and to reduce greenhouse gas emissions from regulated sectors.

It was launched in 20051 as the world’s first international emissions trading system and the EU’s flagship initiative to reach the climate targets set under the 1997 Kyoto Protocol. It covers about 40% of the EU's greenhouse gas emissions and limits emissions from approximately 10,000 installations in the power, manufacturing, oil refinery and commercial aviation sectors in the EU/EEA countries2.

The main features of the EU ETS are:

  • an EU-wide emissions cap, subject to both permanent and ad-hoc reductions, applying to the total amount of greenhouse gas emissions3 that can be emitted by in-scope operations4
  • the trading of EU emission allowances (EUAs).

The emission cap sets a ceiling on the maximum amount of emissions for a pre-defined period or phase. In-scope operators must submit EUAs for each tonne of carbon dioxide equivalent that they emit annually.

EUAs only exist in virtual form and are held on accounts in a single EU-wide registry. They qualify as financial instruments under the EU’s regulations of financial markets. To the extent they are not allocated for free, EUAs are introduced to the market by the EU Member States via auctions (primary auctions) at the European Energy Exchange (EEX). Secondary trade in EUAs includes over-the-counter transactions5 and trading on exchanges. Primary and secondary trade is not only open for in-scope operators, but other actors, such as investment firms and credit institutions, may also participate.

The four EU ETS phases

Since its launch in 2005, the EU ETS has been subject to considerable changes and developments. The first phase was a pilot phase and was followed by a second, third and fourth phase, each of which was a response to lessons learnt from the preceding phase. The current fourth phase runs from 2021 to 2030. 

  • The first phase of the EU ETS (2005-2007) was a pilot phase to test the system and to establish the infrastructure to monitor, report and verify emissions from the relevant industries. Almost all EUAs were allocated for free. As reliable data on emissions was unavailable at the time, phase one caps were set on the basis of estimates. However, this resulted in the over-allocation of EUAs, and a price drop to zero.
  • During the second phase of the EU ETS (2008-2012), EU Member States (and the three EFTA states Iceland, Norway and Liechtenstein, which joined the EU ETS) had to meet concrete emission reduction targets. Free allocation still played a significant role, with only around 10% of EUAs being put on the market via auctions. A surplus of credits, in combination with the 2008 economic crisis, led to a very low carbon price throughout the second phase. Aviation emissions from flights within the EEA were brought in scope of the EU ETS in 2012.
  • The EU ETS Directive was substantially revised for the third phase (2013-2020)6, to address a number of inherent weaknesses of the EU ETS system. Although a number of EUAs were still allocated for free, auctioning was set as the default mechanism instead of this free allocation. However, in order to prevent businesses in certain sectors and sub-sectors from transferring their production to other countries with less stringent emission constraints (so-called carbon leakage), the revised EU ETS Directive provided for the free allocation of 100% of allowances to businesses exposed to a significant risk of carbon leakage7. The third phase started with a significant surplus of EUA, which the European Commission addressed by delaying the auctioning of a considerable number of EUAs (so-called back-loading8).
  • The EU ETS current fourth phase started on 1 January 2021 (2021-2030), with a cap aligned to the EU’s (previous) 2030 target of reducing greenhouse gas emissions by 40% compared to 1990 levels9.

The road ahead

In July 2021, the European Commission adopted the long-awaited “Fit for 55” package, a number of legislative proposals to achieve the EU Green Deal’s ambition to reach the target of at least a 55% net reduction in greenhouse gas emissions by 203010, and to achieve climate neutrality by 2050. As a part of this package, the European Commission proposed a revision of the EU ETS in the current fourth trading period. The legislative process is still ongoing.

The relevant EU institutions (being the European Commission, the European Parliament and the Council of the EU) are discussing in particular the following changes to the EU ETS:  

A reduced cap

The more ambitious greenhouse gas emissions reduction goal obviously goes hand in hand with a decrease of the overall cap. However, the exact cap and the way on how to achieve such decrease are still subject to discussion among the relevant EU institutions.

An end to free allocation for sectors covered by the CBAM

Certain sectors may no longer benefit from free allocation in the medium term, as they might be captured by another system addressing carbon leakage: the Carbon Border Adjustment Mechanism (the CBAM). The CBAM intends to equalise the price of carbon between products manufactured within the EU and imported products. As such, it aims at ensuring that the EU’s climate goals are not undermined by the relocation of production sites to countries with less ambitious carbon reduction policies.

Measures to incentivise decarbonisation

One of the EU’s aims pursued by the revision of the EU ETS Directive is to boost decarbonisation. In this context, for instance, operators may be encouraged to use carbon capture and utilisation (CCU) technologies. These are, for example, technologies where carbon dioxide is used as a feedstock in the manufacture of products. To incentivise CCU technologies, operators may under the revised EU ETS Directive not need to surrender allowances for greenhouse gas emissions that end up permanently chemically bound in a product.

Further emissions reductions in the aviation sector

Changes are also envisaged in relation to the aviation sector. This includes in particular a reduction of the total number of aviation allowances in the ETS on the longer term, a progressive reduction of free allocation to aircraft operators and the implementation of the Carbon Offset and Reduction Scheme for International Aviation (CORSIA) for extra-European flights.

An extension of the EU ETS to the maritime, buildings and road transport sectors

  • Maritime transport: It is planned to extend the EU ETS to maritime transport. The obligation to surrender allowances will be gradually phased-in over a couple of years, with details still being subject to discussion.
  • Buildings and road transport: A separate emissions trading system is envisaged for the buildings and road transport sectors. The actors directly subject to the system will be the distributors of combustion fuels used in the buildings and road transport sectors. Given the energy crisis triggered by the Ukraine conflict, details are still subject to discussion, including in particular to which extent combustibles for private households and private car drivers will be covered by this new emissions trading system.

Limitation of access to the EU ETS to in-scope operators and intermediaries acting on their behalf

A major change that was not part of the European Commission’s proposal, but which the European Parliament introduced in the course of the legislative procedure, is the limitation of access to the EU ETS to in-scope operators and intermediaries acting on their behalf. Other players, such as market makers, would appear to be excluded from the EU’s carbon market. It seems that the European Parliament seeks to fight excessive EUA price fluctuations with this measure, which it apparently attributes to speculative behaviour in trading with EUAs. It is not yet certain that the European Parliament’s position will become law, as the European Parliament is only one among three European institutions that are empowered to decide and agree revisions to the EU ETS Directive.

Lower thresholds for intervention in case of excessive price fluctuations

In the legislative process, the European Parliament and the Council of the EU have taken the position that huge amounts of allowances should be released to the market where, for more than six consecutive months, the average allowance price is more than twice (the European Parliament) respectively 2.5 times (the Council of the EU) the average price of allowances during the two preceding years. If this approach would become law, it would lead to a lower threshold for market intervention in case of excessive prices than under the current regime.

Footnotes

1. By virtue of Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC (the EU ETS Directive), as subsequently amended.

2. Sectors that fall outside the scope of the EU ETS Directive such as transport, buildings, agriculture, non-ETS industry and waste are subject to binding greenhouse gas emission targets under Regulation (EU) 2018/842 of the European Parliament and of the Council of 30 May 2018 on binding annual greenhouse gas emission reductions by Member States from 2021 to 2030 contributing to climate action to meet commitments under the Paris Agreement and amending Regulation (EU) No 525/2013 (the Effort Sharing Regulation).

3. These greenhouse gases currently include: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulphur hexafluoride.

4. In-scope operations are listed in Annex I of the EU ETS Directive, and include inter alia energy-intensive industry sectors such as manufacturing facilities and oil refineries, power stations and commercial aviation within the EEA. 

5. E.g., direct transactions between in-scope operators or transactions concluded through an intermediary, such as a bank.

6. By virtue of Directive 2009/29/EC of the European Parliament and of the Council of 23 April 2009 amending Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance trading scheme of the Community. 

7. By virtue of a Decision 2010/2 dated 24 December 2009 (as subsequently amended), the European Commission determined a list of sectors and subsectors which are deemed to be exposed to a significant risk of carbon leakage. This first carbon leakage list applied for the years 2013-2014 and was followed by the second carbon leakage list (introduced by Commission Decision 2014/746/EU dated 27 October 2014), which applied until 31 December 2020.  

8. Back-loading was a short-term measure introduced to address the growing surplus of EUAs; the auctioning of 900 million EUAs from 2014-2016 was postponed to 2019-2020. Later on, it was decided not to auction the back-loaded volumes, but to place them in the so-called Market Stability Reserve instead.  

9. By reducing emissions in the EU ETS Directive sectors by 43% compared to 2005 levels.  The Union-wide quantity of allowances (“cap”) for 2021 is set at 1,571,583,007 by virtue of Commission Decision C(2020) 7704 final dated 16 November 2020 on the Union-wide quantity of allowances to be issued under the EU Emission Trading System for 2021.  

10. Compared to 1990. 

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