The EU Emissions Trading System (EU ETS) is a pivotal mechanism in the European Union’s strategy to reduce greenhouse gas (GHG) emissions and combat climate change. At its core, the system operates on a “cap and trade” principle, establishing a market-based approach to incentivize emission reductions. It sets an overall limit, or cap, on the total amount of certain greenhouse gases that can be emitted by covered sectors, including electricity and heat generation, industrial manufacturing, transportation (aviation since 2012, maritime as of 2024), and associated countries such as Iceland, Liechtenstein, Norway, and Northern Ireland (for electricity). Within this framework, companies are allocated or purchase allowances, each permitting the emission of one tonne of CO2 equivalent.
The cap on emissions is designed to decrease over time, ensuring progressive reductions. Notably, starting in 2024, the cap will decline more aggressively, with a reduction factor of 4.3% per year for the period 2024-2027 and increasing to 4.4% annually from 2028 onwards. Additionally, two significant “rebasing” cuts are planned to facilitate these reductions, amounting to 90 million allowances in 2024 and 27 million allowances in 2026. For 2024, the cap is set at 1,386,051,745 allowances, with the inclusion of the maritime sector reflected in this calculation.
The distribution of allowances is managed through a combination of auctions and free allocations. While most allowances are auctioned by Member States, certain sectors receive free allocations to mitigate the risk of “carbon leakage,” where industries might relocate to countries with less stringent emissions regulations. Specific reserves, such as the Innovation Fund, Modernisation Fund, Social Climate Fund, and a buffer for new entrants, aim to support innovation, modernization, and social equity. Aviation falls under a distinct cap system, with a gradual elimination of free allowances planned between 2024 and 2026. This comprehensive system represents a critical tool in the EU’s efforts to achieve its climate objectives while fostering a market-based approach to reducing GHG emissions.
To illustrate the functioning of a simplified EU Emissions Trading System (ETS), consider a system comprising just three countries—France, Germany, and Spain. This exercise demonstrates how the auction and rebasing processes operate within such a framework.
Initial Starting Scenario (2023)
At the outset, the system assigns a combined cap of 1,000 allowances to these three countries for distribution:
- Germany receives 400 allowances to auction.
- France receives 350 allowances to auction.
- Spain receives 250 allowances to auction.
Impact of Rebasing in 2024
With the 2024 rebasing measure introducing a reduction of 90 million allowances across the EU ETS, our simplified system applies a proportional 9% cut. Consequently, the new distribution of allowances after rebasing is as follows:
- Germany reduces its allowances to 364 (400 – 36).
- France reduces its allowances to 319 (350 – 31).
- Spain reduces its allowances to 227 (250 – 23).
- Total allowances decrease to 910, reflecting the planned reduction in emissions allowances.
The Auction Process
Taking Germany as an example, its 364 allowances for 2024 are divided into quarterly auctions:
- Each quarter, 91 allowances are made available for auction.
- Companies participate by submitting bids for the desired number of allowances at specified prices:
- PowerCo bids €30 per allowance for 40 allowances.
- SteelCorp bids €28 per allowance for 30 allowances.
- ChemicalInc bids €25 per allowance for 21 allowances.
The available allowances (91 each quarter) are allocated to the highest bidders until capacity is exhausted. Winning bidders are obligated to pay their bidding price per allowance they secure. This market-based mechanism allows the allocation price to reflect real-time demand for emissions rights.
Additional Reductions in 2026
By 2026, further rebasing introduces an additional reduction of 27 million allowances EU-wide, equivalent to 2.7% in this example:
- Germany reduces to 354 allowances (364 – 10).
- France reduces to 310 allowances (319 – 9).
- Spain reduces to 221 allowances (227 – 6).
- Total allowances decrease to 885, intensifying scarcity.
Implications of the System
This structured reduction of allowances drives several critical outcomes:
- Increasing Allowance Prices: Reduced supply elevates allowance prices, incentivizing companies to lower emissions.
- Encouraged Innovation: Companies are motivated to invest in low-carbon technologies to limit reliance on costly allowances.
- Predictability: A scheduled decline in allowances provides predictability for businesses to strategize long-term emission reductions.
By analogy, the system functions as a controlled game of musical chairs, wherein:
- The number of chairs (allowances) diminishes incrementally.
- Players (companies) must bid competitively to secure their right to emit CO₂.
- Those unable to secure enough chairs are compelled to adapt by reducing emissions or bearing higher costs to continue operations.
Criticisms of the EU Emissions Trading Scheme (ETS)
The Oversupply Problem
One of the most prominent criticisms of the EU ETS emerged during its second phase, particularly in the aftermath of the 2008 economic crisis. The market experienced a significant oversupply of European Union Allowances (EUAs), which led to two primary concerns.
First, the “free allocation problem” undermined the system’s purpose. Large industrial sectors, such as steel manufacturing, received an excessive number of free allowances. Instead of cutting emissions, many companies capitalized on the surplus by selling their unused allowances at a profit, eroding the incentive to invest in decarbonization.
Second, the surplus of allowances collapsed prices to unsustainably low levels, often below €5 per tonne of CO₂. To illustrate the magnitude of the issue, between 2019 and 2020, the surplus grew to over 2 billion tonnes of CO₂ — exceeding the annual emissions of all capped installations combined. Allowance prices at this level were insufficient to drive meaningful changes in corporate behavior, weakening the ETS as an effective tool for climate action.
The Revenue Usage Problem
Another key criticism relates to how ETS revenues are allocated and utilized. A reliance on historical emissions for revenue distribution generates inequities. For instance, Germany benefits from a disproportionate share of ETS revenues due to its historical industrial emissions, despite its substantial decarbonization efforts since then. This system rewards historical pollution rather than incentivizing contemporary mitigation actions.
Additionally, while the EU directive advises member states to allocate at least 50% of ETS revenues to climate and energy-related initiatives, compliance is inconsistent. Some nations, such as France, allocate these funds for energy renovation projects, while others, like Belgium, use them to subsidize high-emitting industries without achieving significant emission reductions. Many states absorb the revenues into their general budget, bypassing their intended function of combating climate change.
The Free Allocation Issue
A contentious aspect of the ETS is the continued reliance on free allocation of allowances. Between 2021 and 2030, EU industries are projected to receive approximately 6.5 billion free allowances, collectively worth nearly €200 billion, assuming a CO₂ price of €30 per tonne. This generous allocation forfeits potential revenues that could otherwise finance climate action and instead shields industries from the cost of their emissions, diluting the “polluter pays” principle.
Proposed Solutions
To address these criticisms, organizations such as Carbon Market Watch have recommended various policy reforms, including:
- Eliminating Free Allocations: Mandating that all emitters pay for their allowances to ensure accountability.
- Accelerating Cap Reduction: Increasing the annual rate of allowance reduction to amplify scarcity and strengthen pricing signals.
- Expanding Sector Coverage: Incorporating the maritime sector into the system while avoiding overburdening households and smaller sectors.
- Restricting Industry Influence: Minimizing the role of corporate lobbying in shaping environmental policies, particularly in cases linked to mechanisms like the Energy Charter Treaty.
Recent Performance and Impact
Despite its criticisms, the EU ETS has demonstrated substantial effectiveness in recent years. Notably, between 2022 and 2023, emissions within the system saw a record reduction of 15.5%, driven in large part by the accelerated adoption of renewable energy sources. This significant decline highlights the potential of the ETS to promote meaningful shifts in industrial and energy practices when adequately enforced and structured. Such achievements underscore the capability of market-based mechanisms to drive progress toward ambitious climate goals.
Global Context
The EU ETS stands as the largest of the 36 operational carbon trading systems globally as of early 2024. Collectively, these systems account for coverage of approximately 18% of global greenhouse gas emissions. This global context positions the EU ETS not only as a pioneer but also as a valuable model for other regions seeking to implement similar carbon trading frameworks. The EU’s leadership in this field continues to inform the evolution of carbon markets worldwide, fostering a broader collaborative approach to combating climate change.
Financial Scale and Revenue Usage
The financial scale of the EU ETS has expanded significantly, with auction revenues reaching €38.8 billion in 2022—a substantial increase from €31.1 billion in 2021. Of these revenues, €29.7 billion was allocated directly to EU member states, enabling substantial national-level investments in energy transition and climate action initiatives. Germany alone benefited from €7.8 billion, while a portion of the revenue, managed through the EU Innovation Fund and Modernisation Fund, supports broader efforts to accelerate clean technology deployment and modernize energy systems across the continent.
The New ETS II System
A landmark development within the EU’s climate strategy is the introduction of the ETS II system, which will come into effect in 2027. Unlike the original ETS, this secondary system focuses specifically on fuel distributors in the transport and building sectors. ETS II aims for a 42% reduction in emissions relative to 2005 levels by 2030, with its most notable feature being the complete lack of free allowance allocations—all permits will be auctioned. Furthermore, a price stabilization mechanism will include a cap of €45 per allowance during its first three years, ensuring greater predictability in early market operations.
Price Evolution and Market Dynamics
The EU ETS market has experienced significant price fluctuations in recent years, reflecting dynamic changes in supply and demand. Allowance prices peaked at a record €100 in early 2023 before dropping to €60 by early 2024, influenced by several intersecting factors. A decrease in gas prices enabled less emissions-intensive power generation, reduced energy demand from industries amid an economic slowdown, and the frontloading (“borrowing” from future years) of allowances under the REPowerEU plan. However, such shifts are expected to be temporary, as future scarcity of allowances could drive prices upwards, potentially exceeding €130 per allowance by 2030, as forecasted by some analysts.
Future Challenges and Opportunities
While the system has achieved notable milestones, challenges remain, particularly as the cap is set to reach zero by 2039. This “zero-supply state” raises questions about the long-term functionality and sustainability of the market. Discussions around the establishment of an EU Carbon Central Bank to manage the transition highlight the necessity of strategic planning to maintain market stability. Simultaneously, industrial sectors must prepare for stringent 90% emissions reduction targets by 2040, requiring accelerated innovation and decarbonization efforts. However, these challenges present opportunities to further develop a resilient, visionary framework for the EU ETS, driving greater global alignment toward carbon neutrality.
