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The Carbon Allowance Tale - Part 2: Adjustments towards a free market

Carbon Markets: Rules

New mechanisms helped the EU ETS become a more sophisticated scheme, driven by demand and supply.

The Carbon Allowance Tale - Part 2: Adjustments towards a free market
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The European Union Emissions Trading System (EU ETS) is the backbone of the EU energy policy. Its main objective is to reduce greenhouse emissions. Enshrined in EU law is the target to decrease carbon releases by at least 55% by 2030 from the observed 1990 levels. The legal framework is called “Fit for 55”. 

The scheme is unique in that it represents a blend of regulatory decisions with a free-market approach. It has started as a controlled policytool that initially appeared ineffective in reaching the fundamental sustainability objectives. Legislative amendments and the gradual opening to financial markets has created the mature scheme that the EU ETS is today. 

Adjusting supply for better results 

As seen in “The theory of EUAs Part1: An inefficient policy making tool?”, oversupply was dominating the market until 2019. This phenomenon was keeping the asset prices low during the initial stages of the scheme. Regulators had created a mechanism generating inadequate prices that would have never helped the EU reach its environmental ambitions: it is progressively higher prices that keep incentivizing industrial companies to invest in decarbonation solutions. Such low prices had no incentivizing effect. Adjusting how the cap is decided was not enough to make the EU ETS an efficient policytool. Authorities needed to tackle other aspects of the supply side of compliance carbon markets. 

First, they deemed it essential to make EUAs fungible in time. Thus they introduced the possibility to “bank” allowances. Phase I (2005-2007) was the designed period for a trial, it is thought of as an experimental phase. There was a prohibition of retention of any unused allowances for future compliance needs. One could not purchase an EUA in Phase I and use it during Phase II (2008 - 2012). Conversely, the Phase II regulations permitted the carry-over and subsequent utilization of EUAs in the post-2012 ETS. In other words, industrials would be able to keep their permits issued in a certain year for following years compliance needs. One tonne of CO2 emission could be matched by a permit issued in a previous year. EUAs therefore became an interchangeable-over-time asset. The rigidity of the market supply thus decreased. Any unpredicted event or macroeconomic shock could be smoothened by the carried-over-time allowances. 

Other tools were also implemented to address the observed supply side market inefficiencies. One of the most important EU ETS adjustment mechanisms is the Market Stability Reserve (MSR), introduced in 2015, fully in operation from 2019. It initially shifted the supply curve of EUAs to take into account the existing surplus. In 2018, it was further reformed to impact the supply dynamically based on the Total Number of Allowances in Circulation, or TNAC. The TNAC basically corresponds to the amount of permits issued that have not been used by companies: 

  • If the EU commission “prints” 1.5 billion EUAs this year (the supply); 
  • But the economy only produces 1 billion tonnes of CO2 (therefore only “burning” 1 billion EUAs -the demand); 
  • There will be 0.5 billion EUAs remaining. Those can be sold, bought, and used by the carbon market players in the subsequent years. Those allowances are “in circulation” in the upcoming years, as they have not been “surrendered” to match emissions. 

The MSR aims to control the quantity of EUAs in circulation - in an ideal world, regulators would be very precise and accurate when setting the maximal amount of emissions that the economy could produce in a certain year. Otherwise, as described above, oversupply can push the prices dangerously low. Authorities need to be able to predict how many allowances need to be issued for the market to be healthy. For that reason, the MSR was introduced in order to control, a posteriori of the allowance issuance, the excess number of permits created. The rule set was that if the total number of allowances in circulation exceeds 833 million, the MSR removes 24% of the excess amount. There can also be shortages of allowances issued. It can also be dangerous if there are not enough EUAs in circulation. This could jeopardize liquidity - if the quantities are not sufficient so that every order to buy or sell can be satisfied in a timely manner, investors could get scared. They could try to exit the market permanently. Hence the MSR also has a mechanism saying that if the number of allowances in circulation is below 400m, 100 million are introduced to the market. 

Another intervention of note on the supply side of the market was the narrowing of eligible instruments to comply with the EU ETS standards. In Phases I and II, industries could use both EUAs or certified emission reductions (CERs) to fulfill the regulatory requirements. CERs are carbon credits (or emission units) used to offset carbon emissions. Every credit is used to compensate for one tonne of carbon produced. To simplify, there are projects that help reduce CO2 volumes. Their organizers create a certificate, accounting for the removal of one tonne of carbon. Anyone can then purchase this CER, considering to have offset the corresponding tonne of CO2. Before 2013, such contracts were compliant with the EU ETS. Basically, EUAs and CERs were interchangeable. However, regulators have judged this market design to be inefficient. The asset substitution was deemed not environmentally optimal. Compliance and voluntary markets needed to be separated in order to find a price economically able to reach the EU’s objectives. Hence, since the start of Phase III (2013 - 2020), CERs were no longer compliance units within the EU ETS. 

Making EUAs time fungible, inaugurating a post-issuance market stability mechanism, and removing voluntary credits from the EU ETS scene made some proof of economic efficiency. Nonetheless, intervening exclusively on the supply side of the market was not enough either. Policymakers needed to also re-think some of the demand-side aspects of the ETS in their quest for the price of carbon. 

Looking for support in the free market  

As previously seen, finding a fair price could not be done exclusively by regulatory actions affecting supply. Price levels are also sensible to demand-side fluctuations. In their quest for a fair price of carbon, European authorities have decided to make structural changes to modify this side of the market. Carbon allowances were first designed as a highly controlled policy making tool. However progressively, the apparent limits of the initial engineering pushed the hunt for a solution in the free-market. 

In the highly regulated introductory stage, the majority of EUAs were distributed at no cost. However, as there has been a shift towards a more free-market approach, the allocation of free permits has decreased. This proportion will slowly fade out - for most installations, free allocations will go to zero by 2030. Carbon market players will only be able to make their purchases through auctions or by buying them from other industries. Both of those efforts will involve pricing allowances. Consequently, this is supposed to further assist increasing market efficiency. (It is important to know that historically, allowances at no cost are given out to avoid making European companies relocate. If the carbon prices are too high, they may seek lower production mechanisms elsewhere. Hence, the Commission has decided to help industrials by providing one part of allowances for free. With the introduction of new mechanisms, those EUAs will be gradually phased out. )

More players and more volumes were needed to make the market increasingly sophisticated. The more actors express their vision of what the “just” price is, the easier it is to encounter it in practice. One important regulatory reform was the classification of emission allowances as financial instruments since 2018. EUAs became part of the Markets in Financial Instruments Directive (MiFID II). This categorization brought new players to the EUA markets. Before MiFID II, permits were only purchased by carbon emitters. They would purchase certificates and match them to their produced CO2 volumes. After the re-classification, the allowances could also be used for investment and speculation purposes. Non-compliance traders became part of the picture. We will go deeper into the free-market logic of the EU ETS in future publications. Yet, it is important to note that EU authorities are progressively relying more and more on the market-driven economy to find the just value for carbon. 

Towards an optimal price of carbon 

The measures described above have proven to be efficient as we seem to be getting closer to an efficient carbon price. The “trial-and-error” dynamic of the EU ETS market had brought too many allowances to the market in the initial stages of the scheme. The prices were artificially deflated but they ended up progressively grinding higher through the years. 


Until the beginning of 2019, the year of operational introduction of the MSR, the value of one EUA remained low, below €15, broadly. Pre-pandemic, the prices were around €25, and those fell to €16 again in March 2020, due to the general economic slowdown. Since then, a sustained upward trend has brought prices to the current levels of €80-85. By and large, we can say that the price has almost tripled in the last 3 years. 

In summary, the European carbon compliance market first experienced inefficiencies around its creation in 2005, following a “trial-and-error” approach. Regulators recognized the need to adapt and make necessary adjustments to the EUA supply. It was also deemed crucial to start to rely on the free-market in the quest for efficient price levels. Amendments were needed to bring the European Economy to a triumph in its environmental ambitions. Over time, these efforts bore fruit, leading to the development of a more mature market, showing environmental impact. The journey from the shaky start with inadequate prices to a more efficient market exemplifies the regulatory adaptability of the EU ETS. 


European Council of the European Union. (2023). Fit for 55: The EU plan for a green transition.

European Commissions. (2023). ETS Market Stability Reserve to reduce auction volume by over 272 million allowances between September 2023 and August 2024

Veyt. (2023). The hot air is gone: EU ETS has entered a new era

European Commission. (2023). Use of international credits.

Pellerin-Carlin, T., Vangenechten, D., Lamy, P., Pons, G. (2022). No more free lunch. Ending free allowances in the EU ETS to the benefit of innovations.

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