The Environment Consultant

The EU Emissions Trading System (EU ETS) is the cornerstone of the European Union’s climate policy and remains the world’s largest and most established carbon market.

Operational since 2005, the EU ETS functions on a “cap-and-trade” principle, setting a declining limit on greenhouse gas emissions from high-emitting sectors while allowing market mechanisms to drive cost-effective reductions. As the EU scales up its climate ambition under the Green Deal and Climate Law, the ETS has undergone significant reforms, positioning it as a powerful tool for decarbonisation.

How the EU ETS works

The EU ETS covers around 40% of the EU’s total greenhouse gas emissions, including sectors such as power and heat generation, heavy industry (steel, cement, chemicals), and intra-EU aviation. Under the system:

• A cap is set on the total amount of greenhouse gases that can be emitted by covered installations.
• Emission allowances are either allocated for free (mainly to protect industry from carbon leakage) or auctioned.
• Companies must surrender allowances equivalent to their actual emissions each year, or face heavy penalties.
• Surplus allowances can be traded, creating financial incentives for companies to reduce emissions where it’s cheapest to do so.

Over time, the cap is reduced, tightening the supply of allowances and raising the carbon price – currently a key driver of industrial decarbonisation in Europe.

Key Features

The EU ETS has been significantly strengthened in recent years to align with more ambitious climate targets, particularly under the “Fit for 55” package and the EU Climate Law. Key updates include:

• A faster annual cap reduction rate (Linear Reduction Factor), increasing from 2.2% to 4.3% in 2024 and 4.4% from 2028 onwards.
• Phase-out of free allowances for some sectors, especially with the introduction of the Carbon Border Adjustment Mechanism (CBAM), which aims to prevent carbon leakage while preserving competitiveness.
• Inclusion of maritime transport emissions from 2024, extending the ETS to a new sector for the first time in over a decade.
• A separate ETS for buildings and road transport (ETS2), launching in 2027, to address emissions from sectors not currently covered.
• A Social Climate Fund, financed by ETS revenues, designed to support vulnerable households and small businesses during the transition.

These reforms are intended to not only reinforce the environmental integrity of the system but also ensure fairness and political acceptability as the EU moves toward net-zero.

Science and Carbon Markets

The EU ETS offers a rich case study in policy design, emissions accounting, and market-based governance. Its performance hinges on robust monitoring, reporting, and verification (MRV) systems, ensuring that emissions data are accurate and transparent. Research into carbon pricing effectiveness, market dynamics, and distributional impacts continues to shape how the system evolves.

Moreover, the ETS has important implications for carbon removal technologies, the role of carbon sinks, and the integration of negative emissions into regulatory frameworks. These are key areas for scientific input in the coming decade.

A Global Benchmark for Carbon Pricing

The EU ETS has significantly influenced domestic emissions trajectories and inspired similar systems worldwide. As carbon markets expand globally, the EU’s experience offers critical insights into the design of effective, transparent, and adaptive emissions trading mechanisms.

In a policy landscape often constrained by short-termism, the EU ETS demonstrates how long-term, science-based frameworks can align economic and environmental goals, turning climate ambition into real-world emissions reductions.