The EU ETS (European Union Emissions Trading System) is the world's largest "cap and trade" market designed to reduce industrial greenhouse gas emissions across Europe. By putting a mandatory price on carbon, it financially incentivizes companies to decarbonize and provides a market-based mechanism to fight climate change.
The European Union Emissions Trading System (EU ETS) is the cornerstone of the EU's policy to combat climate change and its key tool for reducing emissions cost-effectively. Established in 2005, it operates as a market-based mechanism that covers over 10,000 installations in the power, manufacturing, and aviation sectors. These sectors are collectively responsible for around 40% of the EU's total greenhouse gas emissions. The system's primary goal is to help the European Union achieve its ambitious climate targets in a structured and economically efficient way.
The EU ETS works on the "cap and trade" principle, which creates a market for carbon allowances.
- The Cap: The EU sets a "cap," or a limit, on the total amount of greenhouse gases that can be emitted by all participating installations. This cap is reduced over time, ensuring that total emissions fall in line with the EU's climate objectives.
- The Allowances (EUAs): The cap is converted into tradable emission allowances, known as European Union Allowances (EUAs), where one allowance gives the holder the right to emit one tonne of CO₂ equivalent. A portion of these allowances is allocated for free to certain industries, while the rest are auctioned.
- The Trade: Companies that can reduce their emissions at a low cost can sell their excess allowances on the market. Conversely, companies facing higher abatement costs must purchase additional allowances to cover their emissions. This creates a clear financial incentive to invest in cleaner technologies.
- Compliance: Each year, all installations must surrender enough allowances to cover their total verified emissions. Companies that fail to do so face heavy fines, ensuring the system's integrity and effectiveness.
Concrete Example
Imagine two companies, "CleanPower" and "OldSteel," both operating under the EU ETS and each receiving 100,000 allowances for the year.
- CleanPower invests heavily in new technology and only emits 80,000 tonnes of CO₂. It now has a surplus of 20,000 EUAs. It can sell these allowances on the carbon market, generating revenue from its environmental performance.
- OldSteel uses older equipment and emits 110,000 tonnes of CO₂. It has a deficit of 10,000 allowances. To comply with the law, it must go to the market and purchase 10,000 EUAs, perhaps from companies like CleanPower. This represents a direct operational cost for polluting.
This market dynamic creates the carbon price and drives overall investment towards decarbonization across the economy.
Internal/External Links:
- Learn more about the asset traded within this system: [see our definition of European Union Allowances (EUA)].
- Official Information Source: European Commission, EU Emissions Trading System.