EU Emissions Trading System (EU ETS)
Operational since 2005, the European Union Emissions Trading System (EU ETS) is the oldest system in force. It is a cornerstone instrument of the EU’s policy framework to combat climate change and reduce GHG emissions cost-effectively. The system covers some 10,000 stationary installations, in the energy and industry sectors, and airlines operating in the EU. This represents around 38% of the EU’s total emissions. In 2021, the EU ETS entered its fourth trading phase (2021-2030).
The legal framework of the EU ETS is established in Directive 2003/87/EC. Its latest revision, for Phase 4, had been completed in 2018. However, in light of the “European Green Deal”, in 2021 the European Commission proposed reforms to the EU ETS to align the system with the updated 2030 climate target of at least 55% net emission reductions compared to 1990 levels.
In December, the European Parliament and the Council of the EU reached a provisional agreement on the reform of the EU ETS as part of the negotiating process to deliver on the European Green Deal. The agreement, among other things, includes:
- Increasing the level of emission reductions to be achieved by the EU ETS sectors by 2030 to 62% below 2005 levels;
- Raising the linear reduction factor to 4.3% for the period 2024-2027 and to 4.4% for the period 2028-2030;
- Rebasing the cap in two steps: in 2024 by 90 million allowances and in 2026 by 27 million;
- Updating parameters of the Market Stability Reserve, including a cancellation threshold of 400 million allowances and an extension of the intake rate of 24% until 2030;
- Increasing the sizes of the Innovation and Modernisation Funds;
- Gradually phasing out free allocation in the aviation sector by 2026;
- Gradually phasing out free allocation over 2026-2034 in the industries covered by the new carbon border adjustment mechanism;
- Including emissions from the maritime sector in the EU ETS from 2024;
- Establishing a separate emissions trading system, ETS 2, for fuels used in buildings, road transport and industry (see “ETS 2” factsheet).
In December, the European Parliament and the Council of the EU also reached a provisional agreement to apply ICAO’s Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) to international flights from 2022 to 2027. The intra EU-scope of the EU ETS is maintained.
In March, the European Securities and Market Authority published a report on the integrity of the EU carbon market. The report found no evidence of excessive price speculation, concluding that the price signal was mainly driven by market fundamentals.
Emissions & Targets
BY 2030: At least 55% below 1990 GHG levels
BY 2050: Climate neutrality
EUR 78.91(USD 83.10) (average 2022 auction price; updated prices available here)
EUR 80.82 (USD 85.11) (average secondary market price 2022)
Size & Phases
PHASE ONE: 3 years (2005-2007)
PHASE TWO: 5 years (2008-2012)
PHASE THREE: 8 years (2013-2020)
PHASE FOUR: 10 years (2021-2030)
PHASE ONE (2005-2007) and PHASE TWO (2008-2012): The cap was established bottom-up, based on the aggregation of the national allocation plans of each Member State. Phase 1 started with a cap of 2,096 MtCO2e in 2005; Phase 2 started with a cap of 2,049 MtCO2e in 2008.
PHASE THREE (2013-2020):
Stationary installations: A single EU-wide cap set at 2,084 MtCO2e in 2013, reduced annually by a linear reduction factor of 1.74% (of 2008-2012 baseline emissions). This translated into a year-on-year reduction of the cap by some 38 million allowances and resulted in a cap of 1,816 MtCO2e in 2020.
Aviation: Included in the EU ETS in 2012 under a separate cap. The cap for aviation was initially set at 221 million allowances (95% of 2004-2006 emissions) to reflect the coverage of all flights taking off or landing in an EEA state. However, following the “stop the clock” temporary suspension of the regulation, the system’s scope was limited to flights within the EEA and the number of aviation allowances put into circulation in 2013-2016 was reduced to 38 million allowances annually until 2016. This scope reduction was subsequently prolonged until 2023 to support the development of a global measure for aviation emissions under ICAO.
PHASE FOUR (2021-2030):
Stationary installations: A single EU-wide cap of 1,572 MtCO2e in 2021, subject to a linear reduction factor of 2.2% per year (of 2008-2012 baseline emissions). This translates into a year-on-year reduction of the cap by some 43 million allowances. The linear reduction factor does not have a sunset clause and the cap will continue to decline beyond 2030.
As of 2021, emissions from UK installations, previously covered by the EU ETS, are no longer considered in the cap. Pursuant to the Protocol on Ireland/Northern Ireland of the EU-UK Withdrawal Agreement and the Trade and Cooperation Agreement between the EU and the UK, the cap in Phase 4 accounts only for electricity generators in Northern Ireland.
Aviation: The cap for 2021 was 28.3 million allowances, after being adjusted following the UK’s departure from the EU. As of Phase 4, the cap for aviation is subject to the linear reduction factor of 2.2% per year.
PHASE ONE (2005-2007): Power stations and other combustion installations with >20 MW thermal rated input (except hazardous or municipal waste installations), industry (various thresholds) including oil refineries, coke ovens, and iron and steel plants, as well as production of cement, glass, lime, bricks, ceramics, pulp, paper, and cardboard.
PHASE TWO (2008-2012): Several countries included NOx emissions from the production of nitric acid. The EU ETS also expanded to include Iceland, Liechtenstein and Norway.
Aviation: Emissions from international aviation were included in the EU ETS in 2012 (>10,000 tCO2/year for commercial aviation; >1,000 tCO2/year for non-commercial aviation since 2013). In November 2012, the EU temporarily limited the scope of the EU ETS to flights within the EEA only. Exemptions for operators with low emissions were also introduced.
PHASE THREE (2013-2020): Carbon capture and storage installations, production of petrochemicals, ammonia, nonferrous and ferrous metals, gypsum, aluminum, as well as nitric, adipic, and glyoxylic acid (various thresholds) were added to the system’s scope.
Aviation: In 2017, the reduced scope of the EU ETS for aviation was prolonged until 2023 to support the development of a global measure for aviation emissions under ICAO. In line with the Agreement between the EU and Switzerland on the linking of their emissions trading systems, the EU ETS covers emissions from flights departing from the EEA to Switzerland as of 2020.
PHASE FOUR (2021-2030): Phase 3 coverage continues.
Aviation: In line with the Trade and Cooperation Agreement between the EU and the UK, the EU ETS applies to emissions from flights departing from the EEA to the UK as of 2021.
8,757 stationary installations
371 aircraft operators
Allowance Allocation & Revenue
PHASE ONE (2005-2007): Allocation based on Member States’ national allocation plans. Allocation through grandparenting. Some Member States used auctioning and some used benchmark-based allocation.
PHASE TWO (2008-2012): Like in Phase 1, with ~90% of allowances allocated for free. Some benchmark-based free allocation and auctioning in eight Member States (Germany, United Kingdom, the Netherlands, Austria, Ireland, Hungary, Czechia and Lithuania), amounting to ~3% of the total allowance allocation.
PHASE THREE (2013-2020): 57% of allowances auctioned and the remainder allocated for free based on benchmarks.
88% of allowances were distributed to Member States based on verified 2005 or average 2005-2007 emissions; 10% were allocated to 16 lower-income Member States under the solidarity provision; and the remaining 2% were distributed among Member States that had reduced their emissions by at least 20% compared to the applicable base year under the Kyoto Protocol.
Power Sector: 100% auctioning, with an optional derogation for ten lower-income Member States to grant free allowances to energy installations to support sectoral modernization and diversification.
At the end of Phase 3, eligible Member States could decide to continue using the derogation in Phase 4 (2021-2030), monetize remaining allowances or transfer them to the newly created Modernisation Fund.
Industry: Free allocation based on benchmarks. Benchmarks were calculated using 2007-2008 activity levels and set at the average of the 10% most efficient installations in the (sub-)sector.
Sectors deemed at risk of carbon leakage received free allocation at 100% of the relevant benchmark. Sub-sectors deemed not at risk of carbon leakage had free allocation reduced gradually from 80% of the respective benchmark in 2013 to 30% by 2020.
As the demand for free allowances exceeded the supply, the free allocation volume of each installation was subject to a uniform cross-sectoral correction factor — which was revised in 2017.
The carbon leakage risk was assessed against the following criteria of emissions intensity and trade exposure:
- direct and indirect cost increase >30%; or
- non-EU trade intensity >30%; or
- direct and indirect cost increase >5% and trade intensity >10%.
Cost intensity was determined by the formula: [Carbon price × (direct emissions × auctioning factor + electricity consumption × electricity emission factor)]/ gross value added
Trade intensity was determined by the formula: (imports + exports)/(imports + production)
Aviation: 15% of allowances were auctioned and 82% were allocated to aircraft operators for free. The remaining 3% constituted a special reserve for new entrants and fast-growing airlines. Due to the temporary derogation limiting the scope of the EU ETS for aviation to intra-EEA flights, free allocation was adjusted accordingly.
New Entrants’ Reserve (NER): 5% of the cap for Phase 3 was set aside to assist new installations or to cover installations whose capacity significantly increased since their free allocation had been determined. 300 million allowances from the reserve were allocated to the NER300, a large-scale funding program for innovative low-carbon energy demonstration projects.
PHASE FOUR (2021-2030):
Power Sector: 100% auctioning, with an optional derogation for lower-income Member States to grant free allocation to energy installations to support sectoral modernization and diversification. Three out of ten eligible Member States decided to continue using the derogation in Phase 4.
Industry: Benchmark values are updated twice in Phase 4 to reflect technological progress in different sectors. The first set of benchmark values applies to the period 2021-2025; the second set will cover 2026-2030. The European Commission calculates updated benchmark values based on data submitted by Member States (a list of incumbent installations and associated emissions). The first updated set of benchmarks was published in March 2021.*
Benchmarks are determined by the average emissions intensity of the 10% most efficient installations within a (sub-)sector, based on 2016-2017 activity data. The values are adjusted for technological progress on a yearly basis. An annual reduction rate (0.2% to 1.6%) is determined for each benchmark. For the steel sector, which faces high abatement costs and leakage risks, the 0.2% annual benchmark reduction applies.
As of Phase 4, the volume of free allocation is adjusted when changes in industrial production occur. The threshold for adjustments is set at 15% increasing or decreasing production.
Carbon leakage rules: The third carbon leakage list, adopted in February 2019, applies for 2021-2030. The list includes a reduced number of sectors classified at risk of carbon leakage. Free allocation for other sectors will be discontinued by 2030 (except for district heating).
As an additional safeguard, the Phase 4 cap includes a buffer of more than 450 million allowances, initially earmarked for auctioning, which can be made available if the initial free allocation volume is fully absorbed (thereby avoiding the need to apply the cross-sectoral correction factor).
Carbon leakage is assessed against a composite indicator of trade intensity and emissions intensity, according to the following criteria:
Trade intensity x emissions intensity > 0.2
Trade intensity x emissions intensity > 0.15 but < 0.2; qualitative assessment will follow based on abatement potential, market characteristics, and profit margins.
Emissions intensity is determined by:
[direct emissions + (electricity consumption x electricity emission factor)]/ gross value added
Trade exposure is determined by:
(imports + exports)/(imports + production)
The uniform cross-sectoral correction factor for the adjustment of free allocation is 1 for 2021-2025.
Free allocation of allowances will be phased out from 2026 to 2034, together with the phase-in of EU CBAM obligations for third-country imports in covered sectors (initially iron and steel, cement, aluminum, fertilizers, electricity, and hydrogen).
Aviation: Same breakdown as in Phase 3. Free allocation will be phased out gradually with planned free allocation reduced to 75% in 2024, 50% in 2025 and 0% from 2026 onward.
Auctioning: 57% of allowances are auctioned. Out of these, 90% are distributed to Member States based on their share of verified emissions, with 10% distributed among the lower-income Member States under the solidarity provision. Auctions are cancelled if the highest bid is significantly below the prevailing secondary market price, to avoid market distortion. If an auction is cancelled, its volume is distributed over the subsequent four auctions scheduled at the same trading platform.
New Entrants’ Reserve: The initial volume of the NER at the start of Phase 4 amounted to 331.3 million allowances. This included unallocated allowances from Phase 3 and 200 million allowances from the Market Stability Reserve.
*Revised benchmark values for free allocation of emission allowances for the period from 2021 to 2025.
EUR 139.5 billion* (USD 158.4 billion) since 2013
EUR 38.8 billion** (USD 40.8 billion) in 2022
* Includes revenue from Iceland, Liechtenstein and Norway, and the UK, as well as of the Innovation and Modernisation Funds funded from the EU ETS.
**Includes revenue from Iceland, Liechtenstein and Norway, and Northern Ireland, as well as of the Innovation and Modernisation Funds funded from the EU ETS.
In the EU ETS, the main share of revenues from auctioning allowances accrues to Member States’ budgets. At least 50% of these revenues should be used for climate- and energy-related purposes.
Member States report annually to the Commission on how they spent their auction revenues. On average, Member States spent ~76% of their revenues in 2021 on domestic and international climate- and energy-related purposes.
A share of allowances is auctioned to supply the Innovation and Modernisation Funds – two funds established for Phase 4 (2021-2030) to support decarbonization in the EU ETS sectors.
Innovation Fund: Supports the commercial demonstration of innovative low-carbon technologies and industrial solutions to decarbonize Europe’s energy-intensive industries, as well as the development of renewable energy, energy storage, and carbon capture use and storage.
The fund is monetized through auctioning 450 million allowances and the remaining budget from the NER300, a funding program from Phase 3 (2013-2020). It is expected to have a funding capacity of EUR 33.8 billion (USD 35.6 billion) until 2030.
Since 2020, four calls for projects (two for large-scale and two for small-scale ones) have been completed, awarding over EUR 3.1 billion (USD 3.3 billion) in development grants to around 70 projects. A third call for large-scale projects launched in November 2022.
Modernisation Fund: Supports investments in ten lower-income Member States (Bulgaria, Croatia, Czechia, Estonia, Hungary, Latvia, Lithuania, Poland, Romania and Slovakia) aimed at modernizing energy systems, improving energy efficiency, and supporting a socially just transition to climate neutrality. It is one of the solidarity mechanisms of the EU ETS, which addresses Member States’ different starting points.
The fund is capitalized through auctioning 2% of the cap for Phase 4 (2021-2030) and transfers of allowances from other EU ETS solidarity mechanisms. By 2030, it is expected to have raised around EUR 48.2 billion (USD 50.7 billion).
Flexibility & Linking
Unlimited banking has been allowed since 2008. Borrowing is not allowed. However, implicit borrowing within trading periods is allowed, i.e., the use of allowances allocated in the current year for compliance in the previous year.
PHASE ONE (2005-2007): Unlimited use of Clean Development Mechanism (CDM) credits and Joint Implementation (JI) credits allowed. In practice, no credits were used in Phase 1.
PHASE TWO (2008-2012):
QUALITATIVE LIMITS: Most categories of CDM/JI credits were allowed, except for LULUCF and nuclear power. Strict requirements applied for large hydro projects exceeding 20 MW.
QUANTITATIVE LIMITS: In Phase 2, operators were allowed to use JI and CDM credits up to a certain percentage limit determined in the respective country’s National Allocation Plan. Unused entitlements were transferred to Phase 3 (2013-2020).
PHASE THREE (2013-2020):
QUALITATIVE LIMITS: Newly generated international credits (post-2012) had to originate from projects in least developed countries. Credits from CDM and JI projects from other countries were eligible only if registered and implemented before the end of 2012. Projects from industrial gas credits (projects involving the destruction of HFC-23 and N2O) were excluded regardless of the host country. Credits issued for emission reductions that occurred in the first commitment period of the Kyoto Protocol were no longer accepted after March 2015.
QUANTITATIVE LIMITS: The total use of credits for Phase 2 and Phase 3 was capped at 50% of the overall reduction under the EU ETS in that period (~1.6 Gt CO2e).
PHASE FOUR (2021-2030): The use of offsets is not allowed.
As of 2020, the EU ETS and the Swiss ETS are linked. This means that allowances issued in one system can be surrendered for emissions generated in either of the two systems. The Linking Agreement between the EU and Switzerland sets out the conditions and requirements under which the two systems are linked. A direct link was created between the registries of both systems. It allows regulated entities to transfer allowances from an account in one system to an account in the other system. The transfers are planned, generally taking place twice a month.
One calendar year: operators must submit an emission report by the end of March for the preceding calendar year.
REPORTING FREQUENCY: Annual self-reporting based on harmonized electronic templates prepared by the European Commission.
VERIFICATION: Verification by independent accredited verifiers is required before the end of March of the following year. Once verified, operators must surrender the equivalent number of allowances by the end of April.
FRAMEWORK: Since Phase 3, the MRV framework for the EU ETS has been further harmonized. Specific regulations apply for emissions monitoring and reporting, as well as for verification and accreditation of verifiers. A monitoring plan is required for every installation and aircraft operator (approved by a competent authority). MRV procedures were updated in 2020.
Regulated entities must pay an excess emissions penalty of EUR 100 (USD 105.30), adjusted for inflation, for each tonne of CO2 emitted for which no allowance has been surrendered, in addition to buying and surrendering the equivalent number of allowances. The name of the non-compliant operator is also made public. Member States may enforce different penalties for other forms of non-compliance.
MARKET PARTICIPATION: Compliance entities and non-compliance entities.
Primary: Uniform price auctions with single rounds and sealed bids, conducted daily by EEX. Germany has opted out of the common auctioning platform, instead running national auctions through the EEX. Poland has also opted out but continues to participate in the common auction platform at the EEX until further notice.
Secondary: Spot, futures, options, and forward contracts are traded on the secondary markets, both on exchange and over the counter. Besides the EEX, futures are traded on ICE, ENDEX and Nazdaq.
LEGAL STATUS OF ALLOWANCES:
Directive 2014/65/EU classifies EU ETS emission allowances as financial instruments. The associated derivatives can hence be traded on secondary markets.
BACKLOADING: As a short-term measure to address a growing surplus of allowances in the EU ETS, the auction of 900 million allowances was postponed from 2014-2016 to 2019-2020. The allowances were eventually placed in the Market Stability Reserve.
MARKET STABILITY RESERVE (MSR): The MSR was created in 2015 as a long-term measure to address a growing surplus of allowances in the EU ETS. It adjusts auction volumes according to pre-defined thresholds of the total number of allowances in circulation (TNAC), fostering balance in the EU carbon market and resilience to demand shocks. The reserve started operating in 2019.
Thresholds: The Commission publishes the TNAC communication in May each year.
- When the TNAC is above 833 million, 24% of its volume is withdrawn from future auctions and placed into the MSR over a period of 12 months.
- When the TNAC is less than 400 million allowances, 100 million allowances are released from the reserve and auctioned.
At the start of 2022, the MSR held 2,663 million allowances, with 348 million placed in the reserve between September 2022 and August 2023.
Swiss ETS allowance supply is not considered in the TNAC, and Swiss auction quotas are not affected by the MSR.
CANCELLATIONS: As of Phase 4, a Member State may cancel allowances from their auction share if they take additional policy measures that result in a closure of electricity generation capacity. The quantity of allowances cancelled shall not exceed the average verified emissions of the installation from five years preceding the closure.
European Commission: Authority responsible for establishing the regulatory framework of the EU ETS and implementing centralized administration of the system, e.g., the EU registry.
Competent authorities of all EU Member States as well as Iceland, Liechtenstein, and Norway: Implementing authorities, e.g., verifying compliance with MRV and surrender obligations.
The European Commission publishes annual reports on the functioning of the European carbon market (most recent being a 2022 report on market functioning in 2021).
The Directive 2003/87/EU stipulates that the system be kept under review in light of the implementation of the Paris Agreement and the development of carbon markets in other major economies. Two major EU ETS reviews — before Phase 3 and before Phase 4 — have been conducted to date. With the more ambitious 2030 emissions reduction target, the European Commission is currently implementing a third major revision of the EU ETS.
In March 2022, the European Securities and Markets Authority (ESMA) published a report on emission allowances and associated derivatives, which analyzed trading behaviour on the EU carbon market. ESMA concluded that the market was functioning well and that the carbon price signal was in line with market fundamentals.
Directive 2003/87/EC of the European Parliament and of the Council establishing a scheme for GHG emission allowance trading within the Community and amending Council Directive 96/61/EC.
Decision concerning the establishment and operation of a market stability reserve for the Union GHG emission trading scheme and amending Directive 2003/87/EC (6 October 2015).
Consolidated Auctioning Regulation (25 February 2014): Commission Regulation 2019/1868 amending Regulation (EU) No 1031/2010 in particular to determine the volumes of GHG emission allowances to be auctioned in 2013-2020 (26 February 2014).
All other legislation and documentation can be found here.