An Emissions Trading Scheme (ETS) is a market-based policy that puts a price on carbon by setting a firm limit, or "cap," on greenhouse gas emissions. This system creates a financial incentive for companies to reduce their pollution, as they can trade emission allowances with one another.
An Emissions Trading Scheme, commonly known as a “cap-and-trade” system, is a regulatory tool designed to reduce greenhouse gas (GHG) emissions in a cost-effective manner. Its primary importance lies in translating environmental goals into a clear economic signal. By creating a market for the right to emit, an ETS makes polluting more expensive, thereby encouraging industrial sectors like power generation, manufacturing, and aviation to invest in cleaner technologies and more efficient processes.
How It Works
The mechanism operates on the “polluter pays” principle and can be broken down into three core components:
- Cap: A government or regulatory body sets a mandatory, economy-wide limit on the total volume of specific greenhouse gases that can be emitted by covered entities over a set period. This cap is designed to decrease progressively over time to ensure that overall emissions fall in line with climate targets.
- Trade: The total cap is divided into tradable emission allowances (often called carbon permits), where one allowance typically represents the right to emit one tonne of carbon dioxide equivalent (CO₂e). These allowances are either allocated for free or auctioned by the government to the companies under the scheme. Companies that can reduce their emissions at a low cost can sell their surplus allowances to firms for whom reducing emissions is more expensive. This trading activity creates a carbon market.
- Reduce: Because the total number of allowances is capped and shrinks over time, they become scarcer. This scarcity, combined with market demand, establishes a carbon price. A rising carbon price provides a powerful and continuous incentive for companies to innovate and decarbonize their operations to avoid the increasing cost of purchasing allowances. This market dynamic ensures that emission reductions happen where they are most economically efficient.
Concrete Examples
- The European Union Emissions Trading System (EU ETS): Launched in 2005, the EU ETS is the world’s first and largest international carbon market. It regulates thousands of installations in the power and manufacturing sectors, as well as aviation within Europe. The financial instruments used in this market are called European Union Allowances (EUAs). Learn more about investing in EUAs.
- The United Kingdom Emissions Trading Scheme (UK ETS): Established in 2021 after Brexit, the UK ETS operates as a standalone system but is closely modelled on the EU ETS. It covers similar sectors and serves as the UK’s primary tool for pricing carbon and driving industrial decarbonization. Allowances in this market are known as United Kingdom Allowances (UKAs).
For more official details on the largest scheme, you can consult the European Commission’s page on the EU ETS.