Set up in 2005 by the European Union to limit its greenhouse gases emissions and reach its reduction target of -55% by 2030 (vs1990), the European Emissions Trading System (EU ETS) is a cornerstone of the European strategy to limit climate change.
How it works?
It is a ‘cap and trade’ system:
-the ETS sets a ‘cap’ on the total amount of greenhouse gases that specific industries and power plants can emit. This cap represents emissions allowances that companies either receive for free or buy (more details below). This cap is gradually lowered over time to ensure that emissions are reduced in line with the EU’s climate goals.
-Companies that emit less than their allocated amount of greenhouse gases can sell their unused allowances to companies that need more budgets to cover their emissions; they ‘trade’ their emissions allowances. This creates a market for greenhouse gas emissions, incentivizing companies to reduce their emissions to avoid buying allowances.
In other terms, it is a ‘polluter pays’ principle: the more virtuous you are, the more you can resell your unused allowances; the more you pollute, the more you pay.
Who is targeted by the EU ETS?
Companies in the following sectors must participate in the system
- Energy: electricity and heat generation,
- Heavy industry: Oil refineries, steel, iron, aluminum, metals, cement, line glass ceramics, pulp, paper, cardboard, acids and chemicals production
- Aviation (for intra-European flights)
- And more recently, maritime
Each year, companies must report their emissions. If the emissions are higher than the ‘cap’ set up for the specific industry, or in other terms, if the company has not enough allowances, it must pay a fee.
How to get emission allowances?
The cap is divided into pollution permits known as EU Allowances (EUAs). One EUA represents 1 ton of CO2 equivalent emissions. Companies can:
- Receive them for free: sectors deemed to be at risk of carbon leakage (specifically the aviation sector) and electricity production in some lower-income member states receive free allocations.
- Buy them at auction: auctions are organized by the European Energy Exchange (EEX). The profit generated is going directly to the EU’s 27 member states.
- Buy them on the open/secondary market: there are several trading platforms where ETS operators can trade allowances between each other. Transfers of EUAs can also be included in other contracts (for example for the purchase of heat or electricity).
In the first period of the setup of the EU-ETS, most of the EUAs were given for free. The impact on the allowances prices and the lack of impactful results pushed the EU to reform the system.
Evolution of the EU-ETS
To be in line with its ambitious targets in terms of climate mitigation, the cap will be lowered for specific sectors and free allowances will be increasingly stopped by 2034. Free allocations can also be cut by 20 percent if companies do not introduce decarbonization measures demanded by energy audits. Furthermore, the scope of the Eu-ETS will be expanded. For example, methane emissions not initially accounted for will be included, as well as a new system will be set up for the transport and building sector.
ETS and the CBAM
To avoid that the EU's efforts to reduce greenhouse gas emissions are neutralized by an increase in emissions outside its borders resulting from a relocation of production to third countries, the carbon border adjustment mechanism (CBAM) has been put introduced. From 2026, EU importers will have to purchase certificates equivalent to the EU carbon price. The CBAM will initially be applied to specific sectors such as cement, iron and steel, aluminum, fertilizers, electricity...