The EU ETS (European Union Emissions Trading System) is the world’s first and largest carbon market, designed to reduce greenhouse gas (GHG) emissions cost-effectively across key sectors of the European economy. Introduced in 2005, the EU ETS is a cornerstone of the EU’s climate policy and a central tool for achieving its climate neutrality goal by 2050.
By putting a price on carbon, the system creates a financial incentive for companies to reduce their emissions, invest in cleaner technologies, and innovate in low-carbon processes.
How does the EU ETS work?
The EU ETS operates on a “cap-and-trade” principle:
- Cap: A limit (or cap) is set on the total amount of GHG emissions that can be released by companies covered under the system. This cap is reduced annually in line with the EU’s climate targets.
- Allowances: Within the cap, companies receive or purchase emission allowances—each representing the right to emit one tonne of CO₂-equivalent (tCO₂e).
- Trading: Companies can buy and sell allowances on the carbon market. Those that reduce emissions below their allocation can sell surplus allowances, while those exceeding their limits must buy additional ones or face penalties.
The system encourages emissions reductions where they are most cost-effective and allows for market-based flexibility in compliance.
Scope and coverage
As of Phase IV (2021–2030), the EU ETS covers:
- Power and heat generation
- Energy-intensive industries such as steel, cement, chemicals, glass, and refining
- Commercial aviation (intra-EEA flights)
- Maritime transport (phased in starting from 2024)
The system applies across all EU Member States, plus Iceland, Liechtenstein, and Norway, under the European Economic Area (EEA) agreement.
From 2027, the EU will also introduce a separate ETS for buildings and road transport (ETS2).
Key mechanisms and developments
- Auctioning: The majority of allowances are now sold through public auctions. Some sectors still receive free allocations to avoid carbon leakage.
- Market Stability Reserve (MSR): Introduced to address surplus allowances and stabilize the market by adjusting supply based on demand.
- Linear Reduction Factor (LRF): The cap is reduced annually at an increasing rate to ensure alignment with the EU’s Fit for 55 and Green Deal targets.
- Carbon Border Adjustment Mechanism (CBAM): From 2026, the EU will apply a carbon price to certain imports (e.g., steel, cement) to prevent carbon leakage and level the playing field with EU industries subject to the ETS.
Role in decarbonization
The EU ETS has proven effective in reducing emissions in covered sectors. Between 2005 and 2020, emissions from power and industry fell by approximately 43%. The system:
- Promotes low-carbon investment in renewable energy, efficiency, and cleaner production processes.
- Drives innovation in hard-to-abate sectors like steel and cement.
- Generates revenue for Member States, which must spend at least 50% of auction proceeds on climate-related projects.
With new rules in place, including the extension to maritime transport and a faster reduction in the emissions cap, the ETS is expected to play a leading role in delivering the EU’s 2030 and 2050 climate goals.
