The EU ETS: simple concepts of emissions trading schemes

EU ETS stands for European Union Emission Trading Scheme. Put in place following the Kyoto Protocol, it is a European policy which puts a price on the carbon emissions of industrial polluters. It is the backbone of Europe’s climate and energy policy and the world’s largest carbon market, covering a growing number of industrial facilities and sectors.  Under the scheme, each ton of CO2 must be matched to an allowance. We call them EUAs, or European Union Allowances. Today, the system covers around 45% of the EU emissions. 

How does the EU ETS work ? At the end of each year, industrial polluters have the obligation to surrender a number of allowances, or EUAs, equivalent to their emissions of that year. They obtain EUAs on a dedicated market. The EU does not set a fixed price for EUAs; instead, it establishes a cap on the total amount of allowances that are issued each year and lets companies trade their allowances freely. The total number of allowances issued by the EU on the market is equivalent to that year’s emissions cap. When the EU ETS price increases, companies are incentivized to decarbonize their processes rather than purchasing allowances.

- What is an ETS
- Main characteristics of the EU ETS
- The Objectives of EU carbon allowances
- EU carbon pricing results in decarbonization

- EU ETS Phase 4 (2021-2030): A Necessary Acceleration

- The Arrival of ETS 2 in 2027: Heating and Road Transport

- Future Plans for the European Carbon Market

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What is an ETS

ETS: a price for carbon

An emissions trading system (ETS) is a market-based mechanism for reducing greenhouse gas emissions by associating a cost to each ton emitted. It is also called a “cap and trade” system. It works by setting a cap on the total amount of emissions that can be released by a group of polluters, such as power plants or factories. Polluters can receive, bid for,, and trade emission allowances, which are permits to emit a certain amount of greenhouse gasses. At the end of the year, they have the obligation to surrender a number of allowances equivalent to their emissions.

ETS: the Cap

The cap is the sum of all emission allowances issued in a given. One allowance covers the emission of one tonne of CO2eq (carbon dioxide equivalent). The cap is gradually reduced, creating a supply pressure which pushes prices upwards. Every year, compliance with the system by covered industries is verified. This ensures that every tonne of CO2 emitted by industries subjected to the EU ETS is covered by an allowance. Violating this directive is subject to substantial fines. The compliance rate is close to 98%.

ETS trade

Trade is an essential mechanism of this system. A polluter can end up producing less greenhouse gas than the amount equivalent to their allowances held at the end of the year. In this scenario, they can sell their excess of allowances. In contrast, an industrial can buy more carbon allowances in the market before the time to surrender them comes. As industrials buy and sell allowances in the market, a price is formed.

The size of the EU ETS

The largest ETS in the world is in the European Union, where EU Allowances have a trading volume of over 800 billion euros per year. Study of the historical price data of EUA proves the effectiveness of this system. Higher Prices mean less pollution. Over the past 15 years, emissions reduced by 40% while prices were multiplied by 10.

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Main characteristics of the EU ETS

Launched in 2005, the EU ETS has evolved over multiple phases. The system is now in its fourth phase (2021-2030). Its legislative framework is spelled out in the EU ETS Directive.

• One EUA = 1 tonne of CO₂
• The EU ETS covers 29 states: Every country in the European Union, Norway and Iceland

• Over 11 000 industrial sites are covered by EU ETS: they cover sectors like electricity and heat generation, oil refineries, ceramics, glass, cement and lime,, steel metals and aluminum, petrochemicals, paper, and other energy intensive industries . Collectively, they are responsible for 45% of european union emissions amounting 1 284 million tCO2 in 2022
• Flights within the European Union of any airlines are also in the scope of the EU ETS, emitting 48.7 million tonnes of CO2 in 2022.
• Since 2024, maritime transport is also covered by the market.

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The Objectives of EU carbon allowances

Decreasing emissions with EUAs

The EU ETS is the heart of the European Union policy to reduce CO₂ emissions. Europe aims at reducing its greenhouse gas emissions by 50% in 2030  compared to 1990 levels. To do so, one of the biggest leverages of the European Union is its cap and trade system.

The EU ETS impact on emission reduction is proven by several institutional studies.
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The EUAs mechanisms - the annual cap

The EU ETS cap is the annual “carbon budget”. It is the maximum amount of carbon that the European industry can emit over the year in question. To meet its 2030 objectives, the EU lowers the cap every year. In total between 2005 and 2026, the EU will have reduced the cap by 63%.

Sectors covered by the EU ETS

Over time, EU EST has also expanded to a wide range of sectors: heavy industries, power plants, aviation, maritime and road shipping. Until 2023, the commission was decreasing the annual EUA supply at a rate of 2.2% per year. From 2024 on, this rate has increased to 4.3%. 

The purpose is to make industries emit less CO2 by bringing up carbon prices. This is achieved through a gradual supply decrease.

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EU carbon pricing results in decarbonization

EU ETS: a regulated free market

Within a cap-and-trade system like the EU ETS, authorities cannot decide on what the price of carbon should be. The laws of demand and supply and the free market do so. The EU commission has the power to control supply - by reducing it every year, it brings tension to the market and makes prices go up.

How the EU ETS pushes industrial to decarbonize

Industrials are rational economic players - they want to minimize their costs while maximizing their returns. They will always choose the less expensive of two options: purchase allowances or decrease their emissions. . They are constantly weighing between what they need to pay for EUAs and how much it costs to decarbonize their activities. If EU ETS price is too high they’ll prefer to change their industrial processes to emit less CO_2.

EU ETS now open to individuals thanks to Homaio

Initially, the market was built only for industrial players. Progressively, this market opened to new actors, hedge funds, institutional investors, and other financial entities. Now, with Homaio, individual investors can also participate, marking a significant milestone in democratizing access to impact.

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EU ETS Phase 4 (2021-2030): A Necessary Acceleration

The EU Emissions Trading System entered its fourth phase in January 2021. This period is defined by significantly increased climate ambition to align with the "Fit for 55" plan, which aims for a 55% reduction in emissions by 2030.

The pillars of Phase 4 include:

• Strengthening the Linear Reduction Factor (LRF): The overall cap on emissions is now decreasing faster (4.2% per year compared to 2.2% previously) to create structural scarcity.
• The Market Stability Reserve (MSR): A mechanism that absorbs surplus allowances to support prices and ensure market resilience against economic shocks.
• The Phase-out of Free Allocations: For industrial sectors, protection against "carbon leakage" is transitioning toward the new Carbon Border Adjustment Mechanism (CBAM).

The Arrival of ETS 2 in 2027: Heating and Road Transport

This is the major shift of the decade. To achieve carbon neutrality, Europe is launching a separate, second market: ETS 2.

Starting in 2027, this new system will apply to fuel distributors for:

1. Road transport (gasoline, diesel).
2. Buildings (heating oil, gas).
3. Small industries not covered by ETS 1.

Why is this crucial for investors? ETS 2 will create massive new demand for carbon assets. While ETS 1 focuses on large industrial emitters, ETS 2 will directly impact downstream consumption, incentivizing a rapid transition to electric vehicles and heat pumps. A "Social Climate Fund" will be established alongside it to support the most vulnerable households.

Future Plans for the European Carbon Market

The EU ETS is not a static system. Several regulatory evolutions are already in motion or under discussion:

• Full integration of the maritime sector: Since 2024, commercial ships must progressively surrender allowances for their emissions.
• Elimination of free quotas for aviation: By 2026, the intra-European aviation sector will have to pay for 100% of its emissions.
• Linking with Carbon Dioxide Removal (CDR): Looking ahead, the EU is exploring how to integrate carbon removal technologies (Direct Air Capture, geological storage) into the ETS to offset residual emissions after 2050.

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FAQ: Everything You Need to Know About the Emissions Trading System

What is the difference between ETS 1 and ETS 2?ETS 1 targets large industrial sites, the power sector, and aviation. ETS 2, starting in 2027, will target fuel distributors for building heating and road transport.

What is the Linear Reduction Factor (LRF)?It is the annual rate at which the total number of allowances available on the market decreases. The higher the rate, the scarcer the supply, which mechanically drives the price per ton of CO2 upward to encourage decarbonization.

Why do carbon prices fluctuate?Prices depend on the balance between supply (fixed by the European Commission) and demand (which depends on industrial activity, natural gas prices, and weather conditions). Legislative reforms and investor speculation also play key roles.

How do companies obtain allowances?The majority of allowances are now sold through auctions. Some industries still receive free allocations to remain competitive against non-EU competition, but this share is decreasing every year.

Can individuals invest in the EU ETS?For a long time, this market was reserved for institutional players and industrials. Today, thanks to solutions like those offered by Homaio, it is possible to gain exposure to the performance of European carbon allowances through accessible financial instruments.

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Sources:

Dechezleprêtre, Nachtigall, Venmans. The joint impact of the European Union emissions trading system on carbon emissions and economic performance.

The EU law data base, 2003. Directive 2003/87/EC.

Ministère de la transition écologique et de la cohésion des territoires, 2023. Système d'Echange de Quotas d'Emission.