Introduction to the EU’s Emissions Trading System

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.

After tough negotiations among the relevant EU institutions, the revision was adopted in April 2023 and two Directives amending the EU ETS Directive, namely Directive (EU) 2023/958 and Directive (EU) 2023/959, entered into force on 5 June 2023. Member States must transpose these Directives into their national legislations. The relevant dates vary among the individual provisions of the Directives, from end of 2023 to end of 2025. The revised EU ETS Directive provides, in particular, for the following changes:

A reduced cap

The more ambitious greenhouse gas emissions reduction goal obviously goes hand in hand with a decrease of the overall cap. The revised EU ETS Directive provides for a one-off reduction of the EU-wide quantity of allowances by 90 million in 2024 and by 27 million in 2026 respectively and on an annual reduction of the overall cap by 4.3% from 2024 to 27 and by 4.4% from 2028 to 2030.

An end to free allocation for sectors covered by the CBAM

Certain sectors will in the longer term not benefit from free allocation anymore, as they will be captured by another system addressing carbon leakage: the Carbon Border Adjustment Mechanism (the CBAM). The CBAM, regulated by a separate EU Regulation¹¹, 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.

The CBAM will apply to products from a number of sectors and subsectors, including iron and steel, cement, aluminium, fertilisers, electricity and hydrogen. For those sectors or subsectors, free allocation will gradually be phased-out between 2026 and 2034. In parallel, the CBAM will be gradually phased in. During this period, the CBAM will apply only to the share of emissions that is not covered by free allowances under the EU ETS anymore.  

The Commission will need to regularly assess the impact of the CBAM on the export of products manufactured in the EU to non-EU countries, as the phase-out of free allocation might increase carbon leakage.

Measures to incentivise decarbonisation

One of the EU’s aims pursued by the revised 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, e.g., technologies where carbon dioxide is used as a feedstock in the manufacture of products. To incentivise CCU technologies, operators do 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 to come in relation to the aviation sector. This includes in particular a gradual phase-out of free allocation to aircraft operators by 2026, however with the possibility to receive free allocation for the use of sustainable aviation fuels until end of 2030. The EU ETS revision further implements the Carbon Offset and Reduction Scheme for International Aviation (CORSIA) for extra-European flights. While, in a first step, the EU ETS will continue to apply (only) to flights within the EU/EEA and departing flights to Switzerland and the United Kingdom, this may change following an assessment the Commission must carry out in 2026. In this context, the Commission needs to verify whether the implementation of CORSIA by aircraft operators is sufficient to reduce aviation emissions in light of the goal of the Paris Agreement. If it turns out that CORSIA is not sufficient in this respect, the Commission is obliged to prepare a legislative proposal, with the aim to extend the scope of the EU ETS to all flights departing from the EEA

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

Maritime transport

The EU ETS will be extended to maritime transport. The revised EU ETS Directive foresees a gradual introduction of obligations for shipping companies to surrender allowances: 40% for verified emissions from 2024, 70% for 2025 and 100% for 2026.

Buildings and road transport

A separate new ETS II for the combustion of fuel in a number of sectors, including road transport, buildings, energy, manufacturing and construction, will be established by 2027. The actors directly subject to the system will be the distributors of combustion fuels used in those sectors. The ETS II could however be postponed until 2028 if energy prices are exceptionally high. Furthermore, a new price stability mechanism will be set-up to address excessive prices. The mechanism applies in a number of scenarios. For instance, if the price of an allowance in the ETS II rises above 45 EUR for two consecutive months, 20 million additional allowances will be released. The revised Directive obliges the actors participating in the scheme to report the share of costs related to the surrender of allowances they pass on to consumers. If the Commission becomes aware of improper practices in this context, it may propose legislation addressing those practices.

Dealing with excessive price fluctuations

While the European Parliament had tried to limit access to the EU ETS to in-scope operators and intermediaries acting on their behalf in the course of the legislative procedure, it could not push this proposal through. The background of the Parliament’s request was to fight excessive EUA price fluctuations which it apparently attributed to speculative behaviour in trading with EUAs. The relevant EU institutions agreed on a different mechanism to address excessive price fluctuations: Where, for more than six consecutive months, the average allowance price is more than 2.4 times the average price of allowances during the two preceding years, 75 million of allowances will be automatically released to the market. This leads to a lower threshold for market intervention in case of excessive prices than under the current regime. Further, the EU carbon market will become subject to stricter regulatory surveillance and transparency requirements.

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.}

_{11 Regulation (EU) 2023/956 establishing a carbon border adjustment mechanism.}