How does the EU ETS scheme work

The EU Emissions Trading System (EU-ETS) is a ‘cap and trade’ system that helps to combat climate change in a cost-effective and economically efficient manner. It is a major tool of the European Union in its efforts to meet emissions reductions targets now and into the future.

So, how does the EU-ETS work? The system places a cap on the total amount of greenhouse gas emissions that installations, such as power plants, factories, and airlines, can emit in a given period. Within this cap, these installations are allocated a certain number of allowances, each of which allows them to emit one tonne of carbon dioxide equivalent (CO2e). These allowances can be bought or sold between installations as needed.

At the end of each year, installations must surrender enough allowances to cover their actual emissions. If they do not surrender enough allowances, they face heavy fines. Conversely, if an installation reduces its emissions, it can keep the spare allowances to cover its future needs or sell them to another installation that is short of allowances.

During the initial phase, allowances were provided free of charge to installations, but gradually they were required to purchase a portion of their allowances through auctions. This gradual introduction of auctioning aimed to give installations enough time to adapt to the new system and also to reduce the risk of sudden spikes in allowance prices.

The overall working of the EU-ETS can be visualized in the following diagram:

The EU-ETS is divided into trading periods known as phases. The first phase, which ran from 2005-2007, was a trial phase to establish the infrastructure for monitoring, reporting, and verifying actual emissions from covered installations. The second phase, which ran from 2008-2012, included the aviation sector and allowed businesses to use credits from the Kyoto Protocol’s Clean Development Mechanism (CDM) and Joint Implementation (JI). In the third phase, which ran from 2013-2020, the overall cap was defined and allocated to member states. It also included a liner reduction at 1.74% annually on the overall emission allowance at the EU level and introduced the concept of auctioning and free reserve. Additionally, a carbon leakage safeguard was included to prevent production transfer to countries with laxer climate policies.

The EU-ETS has undergone several changes since its introduction in 2005, but it has remained a key policy tool in the EU’s efforts to reduce greenhouse gas emissions. It is a system that enables the least-cost measures to be taken up to reduce emissions while ensuring that the total emissions stay within the cap. With the EU’s ambitious climate targets for the coming years, the EU-ETS is likely to play an even more significant role in the fight against climate change.