The EU Emissions Trading System

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While the Earth’s climate has been through many cycles of warming and cooling, the current rate of surface temperature rise is unprecedented. The overwhelming scientific consensus is that this warming is directly related to greenhouse gas emissions from human activity, and that if emissions are not reduced, and quickly, the ecological, social and economic consequences will be severe.

Over the past three decades, an international framework for the coordination of global action on climate change has evolved, starting in 1992 with the establishment of the United Nations Framework Convention on Climate Change (UNFCCC). The UNFCCC was set up to act as an international forum for developing measures to fight climate change, with the stated objective to:

Achieve […] stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system.

It was these early negotiations that led to the Kyoto Protocol in 1997, which set a target for the 37 industrialised countries of the UNFCCC to reduce their emissions by 5% below 1990 levels for the period 2008-2012, and established an ‘emissions trading’ mechanism. Under this mechanism, national emissions targets were split into individual units, each equal to one tonne of CO2. These emission units could be traded between countries. This enabled those countries which were overachieving on their emissions targets to sell their excess capacity to others that were falling short. It was this emissions trading mechanism that formed the conceptual basis for future carbon markets, including the EU Emissions Trading System (EU ETS).

What is the EU ETS?

The EU ETS is what is known as a ‘cap and trade’ scheme, a form of carbon pricing in which an overall emissions limit is set and divided up into units known as emissions allowances, each equivalent to one tonne of CO2. The cap is then lowered annually so that total emissions fall over time. These allowances are distributed to businesses and operations by free allocation or state-level auctions, and can be traded between participants across the EU. In this way, a market is created for allowances, with the limited number ensuring they have value. Cap and trade schemes differ from other carbon pricing strategies such as a carbon tax in that the limit on emissions is determined, but the price of emissions is not. Instead, the cost of emissions allowances is dictated by market forces – on the basis of supply and demand.

The EU ETS is mandatory for power, industrial and aviation sectors, covers around 45% of the EU’s greenhouse gas emissions and represents approximately 75% of international carbon trading. Under the scheme, participating businesses are required to obtain and surrender sufficient allowances to match their annual emissions, with heavy fines imposed for those who do not. This leaves participants with an incentive to either invest in low-carbon technologies, or accept the increased cost of emissions. However, as allowances can be traded, participants that achieve significant emissions reduction can sell their surplus allowances.

An Unstable Carbon Price

The EU ETS has been central to the EU’s action on climate change, and the commission estimates that by 2020 emissions covered by the scheme will be 21% lower than in 2005. This coordinates with the EU’s target of reducing overall emissions by 20% compared to 1990 levels in 2020. While this may seem to suggest that the EU ETS has been successfully driving down emissions, the reality is not so clear-cut. The 2008 financial crisis caused a significant drop in industrial output, and consequently greenhouse gas emissions. Furthermore, this sudden drop in emissions led to a monumental surplus of allowances, as allocations had been calculated based on historic levels of emissions that were no longer valid. By the end of 2012, this surplus had reached over 2 billion allowances, equivalent to over a year’s budget of allowances. As a result, the allowance price plummeted from over €30 in June 2008 to under €3 per tonne CO2 by April 2013. This is significant because if the cost of emissions is not high enough, participating businesses have a reduced incentive to invest in low-carbon alternatives.

This issue of the low allowance price was the reason for the UK Government’s implementation of the Carbon Price Support (CPS) in April 2013. The CPS applies to the UK power sector in addition to the EU ETS allowance price, and is currently set at £18 per tonne of CO2. This established what is known as the Carbon Price Floor (CPF), which describes the combined CPS and EU ETS allowance price. This was intended to create a minimum cost for emissions, and was established with the primary aim of reducing emissions in the UK power sector by driving out coal. In this objective it was arguably successful, with the share of coal in the power sector dropping from 41% in 2013 to 8% in 2017. This has produced a shift towards gas-powered electricity generation as it produces roughly half the CO2 emissions per unit of electricity relative to coal, leading to reduced overall emissions in the UK power sector.

EU ETS Reform

Recently, as part of a series of reforms to the EU ETS, the market stability reserve (MSR) was introduced. The MSR entered force in January 2019 and is intended to stabilise the allowance price by annually adding or removing allowances from circulation so that the number is maintained within a pre-defined range. It is hoped that these reforms will strengthen the EU ETS and create a high enough price on emissions to drive low-carbon investment by businesses. In addition, the rate of annual emissions cap reduction has also been revised. The overall cap will now reduce by 2.2% per year, up from 1.74% as was the case previously, and is intended to accelerate the pace of EU emissions reductions.

John Ferrier, Researcher (NERC PhD intern), Brexit, Environment and Rural Affairs