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The EU ETS: Simple Concepts of Emissions Trading Schemes

Carbon Markets: Definitions

The EU ETS is a market-based instrument imposing a price on carbon emissions. It functioning through a "cap and trade" approach to drive emissions reduction.

The EU ETS: Simple Concepts of Emissions Trading Schemes

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

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.

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.

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.

A graph showing the emissions trends by sector (heat, paper, minerals, metals, petro, chemicals).

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.

A graph showing the increasing EU ETS reduction factor.

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 CO2.

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.

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.

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