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How Does Carbon Cap and Trade Work? A Comprehensive Guide

Carbon Markets: Rules

A carbon cap-and-trade system such as the EU ETS puts a price on carbon emissions through the dynamics of free financial markets.

How Does Carbon Cap and Trade Work? A Comprehensive Guide

Cap and trade systems like the European Emissions Trading Scheme (EU ETS) are designed to decrease carbon emissions by integrating policy tools with free market dynamics. Within the EU ETS, there is a primary market where regulators issue EUAs through auctions (or give some away for free). Upon release, the secondary market for carbon allowances establishes a carbon price by bringing together the forces of demand and supply. This is an effective approach in combating climate change as it has a market-driven approach - regulators are not the ones setting the price for carbon. Hence, the mechanism incentivizes businesses to adopt cleaner practices and invest in sustainable technologies.

  • Understanding the Basics of Carbon Cap and Trade
  • The EU carbon cap and trade flows: the primary market 
  • The EU carbon cap and trade flows: the secondary market 
  • Why participate in the EU ETS market?

Understanding the Basics of Carbon Cap and Trade

Introduction to Carbon Cap and Trade

Definition and purpose of a cap and trade system

Cap and trade is a market-based approach to fight against climate change. It involves setting a limit or "cap" on the total amount of carbon emissions allowed to be released in an economy within a specific time frame. Then, carbon allowances (or permits) are issued in an amount equivalent to the cap. Each allowance represents the right to emit one tonne of CO2. 

As the cap reduces, so does the supply of allowances. Therefore, their unit cost increases. 

Participants to the cap and trade system such as companies or industries can buy and sell these permits. There is a primary and a secondary market, as we’ll discuss below. This creates a financial incentive for businesses to reduce their emissions - they are encouraged to invest in decarbonization technologies as they are facing increasing costs of carbon.

The global cap and trade systems

In Europe, the cap and trade system is called the European Union Emissions Trading Scheme (EU ETS). Following its effectiveness in fighting climate change, 39 other national jurisdictions have implemented or are scheduled to implement a cap and trade system of their own. Collectively, they cover 23% of global emissions or 11,7 Gigatons of CO2.

The Key Elements of a Carbon Cap and Trade system

Climate objectives

The initial phase of implementing a cap and trade system involves establishing a climate objective (often a limit on the global rise in temperatures). For example, the temperature goal associated with the European Green Deal is to limit global warming to well below 2 degrees Celsius above pre-industrial levels and pursue efforts to limit the temperature increase to 1.5 degrees Celsius. Then, as seen above, governments set a maximum amount of carbon emissions that can be released to allow the economy to reach those climate objectives. It issues a corresponding amount of carbon permits, translating into a decreasing “carbon budget” until 2050 - by then, the European economy will become carbon neutral.

Trading emission allowances

After being issued by the government, the carbon allowances become tradable assets. The purpose of a cap and trade system is to let the market dynamics determine prices. Regulators use cap and trade systems to pursue climate objectives, yet they are not the ones who set the price. It is the meeting of market supply and demand that does so.

The EU carbon cap and trade flows: the primary market

The EU ETS primary market: auction issuance 

The carbon permits within the EU ETS framework are called European Union Allowances (EUAs). EUAs are either auctioned to market participants or given away for free. This is what we call the primary market. The European Energy Exchange (EEX) in Germany is the common auction platform for the issuance of allowances across 25 EU Member States (Germany and Poland have chosen not to participate in the common auctioning platform). The auctions are organized on a daily basis from 9am to 11am and the results are published on EEX’s website.

What are the EU ETS auction volumes?

Approximately 3 million EUAs will be auctioned per session in 2024 (677 274 000 in total for the year). As a reminder, this year’s cap is 1 386 051 745 meaning that 49% of allowances will be auctioned, the rest being given away for free. The EU ETS is in the process of reducing the volumes of carbon allowances given away for free - those will be phased out for most industries by 2030.

Who can participate in the EU ETS auctions? What does the process look like?

The eligible participants for EU ETS auctions are compliance buyers (industrial entities), investment firms, and credit institutions. The European commission describes the auctions process as a single-round, sealed bid, uniform price auction. Every bidder specifies the number of allowances they would like to buy at what price. The bidding window is open for at least two hours. Then, the auction platform determines and publishes the auction clearing price at which demand for allowances equals the number of allowances offered for sale on that day. Successful bidders are the ones who have placed bids for allowances at or above this clearing price. All successful bidders pay the same price, regardless of what they had specified in their initial bids.

The EU ETS Auction Revenues

How are EU ETS auction revenues redistributed? 

The revenues from the common auctions in the EU ETS are centralized and then redistributed to member states. Every country receives a set percentage of revenues, a figure that is determined at the beginning of every year. 

A portion of the proceeds from the EU ETS auctions is directed towards the Innovation and Modernisation Funds. The EU Innovation Fund helps Member States finance climate initiatives aimed at implementing net-zero technologies. On the other hand, the EU Modernisation Fund supports the modernization of energy systems and enhances energy efficiency technologies in 13 lower-income EU Member States. The goal is to assist these countries in reaching their climate targets and aligning with the objectives outlined in the European Green Deal.

A graph showing the auctioning revenues and reported usage in 2022 of the revenues from the EU ETS auction

How are the EU ETS auction revenues used?

Between 2013 and 2022, EU countries have used 76% of the total revenue from the EU ETS auctions for sustainability-related projects. was dedicated to climate, renewable energy, and energy efficiency initiatives. Until now, it was a legal requirement for them to use at least 50% of auctioning revenues from EUAs for climate-related projects. However, a new directive from 2023 now requires Member States to dedicate all of their auctioning to climate- and energy-related purposes.

The EU carbon cap and trade flows: the secondary market

What is the EU ETS secondary market?

The secondary market within the EU ETS is when EUAs are sold and bought after their initial issuance or allocation. Here is an example of such a transaction: after purchasing EUAs from the auction hosted by EEX, a financial firm can sell its carbon allowances to another entity (a financial institution, a broker, a compliance entity…) at a different price than what they have initially paid during the auction.

Why is the EU ETS secondary market important?

Increased market diversity, volumes and liquidity

Since 2018 (and the MIFID 2 regulation), EUAs are considered as a financial asset. Before this, only compliance entities could participate in the markets. Following this change, there was an increased market activity both in terms of volumes and the nature of investors. The EU ETS market participants now have different objectives, profiles, and have different investing timelines.

A stable secondary EU ETS market 

In a market where all participants are the same, there can be significant detrimental price movements more easily. Drastic market drops can occur if everyone starts selling at the same time for example. So, increasing the diversity of the investor profiles and bringing more players to the EU ETS stage has stabilized the market and increased its liquidity. More people invest different amounts at different times.

Why participate in the EU ETS market?

EU ETS: invest to comply

Industrials in covered sectors by the EU ETS have a legal requirement to purchase carbon allowances. They must monitor their carbon emissions and ultimately surrender a respective amount of allowances at the end of every period.

EU ETS: Invest for impact

An individual investor can reduce the available carbon emissions budget to industrials by buying carbon allowances. By increasing demand, they also influence prices on the upside, making it more expensive for industries to pollute. CO2 emitters are then brought to invest in decarbonization technologies, faced with more and more significant costs of carbon.

EU ETS: Invest for financial results

Over the last 10 years, European Union Allowances (EUAs) were an asset with 32.4% annual growth rate. Even if the pace of the growth is likely to decrease, both academics and carbon expect analysts foresee carbon allowance prices on the rise: as seen in our latest price update, expert analysts expect on average a 12.9% growth in EU ETS by the end of 2024.

Sources

The World Bank, 2023. Carbon Pricing Dashboard

The European Commission, 2023. The European Green Deal

EEX, 2023. EU ETS Auctions

Journal officiel de l'Union européenne, 2023. Décision relative à la quantité de quotas à délivrer pour l’ensemble de l’Union pour 2024 dans le cadre du systèmed’échange de quotas d’émission de l’Union européenne

EEA, 2023. Use of auctioning revenues generated under the EU Emissions Trading System

European Commission, 2023. What is the Innovation Fund?

European Commission, 2023. Modernisation Fund

ESMA, 2022. Final report, Emission allowances and associated derivatives

ESMA, 2023. MiFID II

The European Parliament, 2022. The role of financialoperators in the ETS marketand the incidence of theiractivities in determining theallowances’ price

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