The European Emissions Trading Scheme (EU ETS) combats climate change through a steadily decreasing cap on carbon allowances, incentivizing emission reductions. The cap's annual reduction rate has accelerated over time, with further increases planned, leading to scarcer allowances and potentially higher carbon prices, promoting responsible investing and accelerating the transition to green finance and a green portfolio. This mechanism supports the EU's climate goals by encouraging ethical investments and the adoption of sustainable finance practices.
The greatest strength of the European Emissions Trading Scheme (EU ETS) is its steadily and gradually decreasing cap. As European climate ambition grows, the cap tightens faster, boosting the cap-and-trade scheme’s effectiveness in decarbonizing the economy.
Early years: cap based on emission expectations and verified emissions
In the first phase of the EU ETS (2005-2008), the cap on allowances was determined by individual countries' expectations of their carbon emissions. This period saw generous allocations that led to an oversupply of allowances, which in turn kept prices low and failed to provide a strong incentive for emission reductions.
Learning from this, the second phase (2008-2012) adjusted the cap based on verified emissions data from the first phase. This method aimed to align the volumes of allowances issued more closely with actual emissions levels. Despite these adjustments, the market remained oversupplied, which was further exacerbated by the global financial crisis and low levels of industrial activity.
Introduction of a predetermined cap and linear reduction
In response to the initial phases’ market imbalance, an important overhaul was implemented in 2013. This reform introduced a predetermined annual reduction rate for the cap (1.74% initially), making the EU ETS supply side more predictable and controlled. Every year, the volumes of carbon allowances issued would be reduced by this predetermined amount.
As part of the reform, international carbon credits from voluntary markets— allowed for EU ETS compliance in earlier phases—were phased out. This shift gave EU regulators an even greater control over the supply of EUAs.
Accelerated reduction post-2020
The linear reduction factor was increased to 2.2% per year after 2020 under the Fit for 55 legislative package to boost the system’s ambition and align the EU ETS with the EU’s stronger climate targets. This change prompted a positive market reaction with rising carbon prices as traders anticipated the quicker tightening of supply.
Current and future reduction rates
Currently, the cap reduction rate stands at 4.3%, and it is set to increase to 4.4% after 2028. This increased pace of reduction means that no new EUAs will be issued after 2039. Post-2039, the trading of carbon allowances will only involve quotas issued in previous years, which can considerably tighten the market and make prices rise further.
To achieve the EU’s ambitious climate goals, EUAs become scarcer, the EU ETS tightens, resulting in higher carbon prices and greater incentives for emission reductions.
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