Explaining the EU Emissions Trading System

Set up in 2005, with the aim of reducing greenhouse gas emissions, the EU Emissions Trading System (EU ETS) is the world's first international emissions trading scheme. The bloc's flagship scheme works on the basis of a 'cap and trade' model: the overall number of allowances (EUAs) issued is capped but these can be freely traded among participants. Each EUA represents one tonne of carbon dioxide equivalent (CO2e).

The EU ETS has been implemented through a series of phases, which have each been increasingly ambitious. The current phase, Phase IV (2021-2030), aims to help the EU reach its goal of reducing greenhouse gas (GHG) emissions by at least 55% by 2030.  

The scope

Participation in the EU ETS is mandatory in respect of certain gases and activities, including the following:

The mechanism

By 31 March each year, operators must submit an emissions report to the competent authority (covering the period 1 January to 31 December of the preceding year) which has been reported on and verified in accordance with Commission Implementing Regulation (EU) 2018/2066 (the Monitoring and Reporting Regulation) and Commission Implementing Regulation (EU) 2018/2067 (the Accreditation and Verification Regulation).

By 30 April, following verification, operators must surrender a number of EUAs equivalent to the total emissions emitted during that year. However, operators are not required to surrender allowances in respect of emissions that are:

• transferred out of the installation for capture and geological storage; or
• considered to have been captured and utilised in such a way that they have become permanently chemically bound in a product, preventing them from entering the atmosphere under normal use, including any normal activity occurring after the end of the product's life.

Emissions can be calculated or measured using standardised or accepted methods and supported by a corresponding calculation of emissions.

Operators of industrial installations and aircraft are required to have an approved plan for monitoring and reporting annual emissions.

EUAs are allocated freely in certain circumstances (see below) or purchased, either in an EUA auction or on a secondary market.

Free allocation

The free allocation mechanism was introduced to mitigate the risk of carbon leakage, where high-carbon production shifts to jurisdictions with laxer regulations, moving rather than cutting emissions. Sectors at high risk of carbon leakage receive allowances equivalent to 100% of their benchmark allocation for free. Sectors that are less exposed may obtain a maximum of up to 30% of the benchmark for free, but this will be phased out by 2030. Certain higher risk sector (eg, iron, steel, cement, aluminium and fertilisers) will also experience a phase-out of free allocation. However, due to the greater exposure to carbon leakage risk, this will happen more gradually (from 2026 to 2034), as the EU Carbon Border Adjustment Mechanism (EU CBAM) phases in. 

The benchmarks are calculated based on the performance of the most efficient 10% of installations in the relevant sector, meaning that only the most efficient installations obtain sufficient free allowances to offset all their emissions (thereby creating an incentive for installations to become more efficient).

Cap

To reduce emissions over time, the number of EUAs issued each year is capped, and this reduces annually by a linear reduction factor, which is set for each phase. For Phase IV, the cap will be reduced annually as follows:

• 2024 – 2027: 4.3%; and
• 2028 – 2030: 4.4%.

Market stability mechanisms

In an effort to stabilise the EUA market and reduce volatility, the Market Stability Reserve (the MSR) was introduced into the EU ETS in 2009. Whether or not the MSR is used, and if so how, is dependent on the total number of EUAs in circulation (the TNAC):

• if the TNAC exceeds certain thresholds, the number of EUAs auctioned is reduced;
• if the TNAC remains below certain thresholds, EUAs are released from the MSR and added to the number of EUAs to be auctioned; and
• EUAs may also be released from the MSR if certain price triggers are met.

The penalties

If an operator, aircraft operator or shipping company fails to surrender enough allowances in respect of their emissions, they will be liable to:

• a penalty of €100 per tCO2e (increased annually in line with the EU consumer price index (HICP)) emitted for which the operator or aircraft operator has not surrendered allowances; and
• surrender the amount of allowances in respect of those excess emissions.

Member States shall establish rules on penalties applicable to infringements of the provisions in the EU ETS Directive and shall take all measures necessary to ensure that rules are implemented.