Guide: What is the European Emissions Trading Scheme (EU ETS)?

08 July 2021

Established in 2005 as the world's first international emissions trading scheme, the European Emissions Trading Scheme (EU ETS) remains a complex topic within the energy sector.

Since it was introduced, the scheme has undergone several changes. Divided into distinct trading periods, known as phases, it’s now in its fourth phase.

To keep our energy customers informed and up to date, we'll take a closer look at the EU ETS in more detail. In this extensive guide, we'll delve into what the EU ETS is, its origins, how it works and how it differs from the UK ETS.   

What is the European Emissions Trading Scheme?

The EU ETS operates on what's known as a "cap and trade" system, whereby a cap on emissions is set and companies who are part of the scheme buy (at auction) and then trade emissions allowances within the cap. Companies are required to measure and report their carbon emissions, handing in one allowance for every tonne of CO2 they emit.

As the first and largest emissions trading system aimed at reducing greenhouse gas emissions, the EU ETS covers over 11,000 power stations and industrial plants in 31 countries, whose carbon emissions make up almost 50% of Europe's total.

The EU ETS plays a large role in the European Union's efforts to meet emissions reduction targets, both now and in the future. The use of trading helps fight against climate change in a cost-effective and economically efficient way.

What is the EU ETS

What is the UK Emissions Trading Scheme?

After leaving the EU ETS at the end of the Brexit Transition Scheme, the UK has implemented its own emission trading scheme (UK ETS) to replace it.

Like the EU ETS, the UK ETS is also a cap and trade emissions system, so its design and aims are fairly similar. However, it differs in having a 5% reduction in the emissions cap (notional cap) that would have been set under the EU ETS rules for Phase IV. Additionally, it also aims to align with the UK 2050 net zero target by 2024 at the latest.

The UK Government indicated in the past the possibility to link the UK ETS to another international emission trading Scheme, most likely the EU ETS. However, no decision on a potential linkage has been made yet.

The UK TS covers about 1,000 installations and the first phase of the scheme is set to run from 2021 to 2025.

How did the European Emissions Trading Scheme originate?

The EU ETS has its roots in the Kyoto Protocol. Agreed in 1997, this set legally binding greenhouse gas reduction targets (or caps) for 37 industrialised countries for the first commitment period 2008-2012. The influence of caps and phased periods can be felt in the EU ETS' employment of similar features.

The signing of the Kyoto Protocol led to the need for policy instruments in order to meet its commitments. In March 2000, the European Commission presented a green paper on "Greenhouse gas emissions trading within the European Union", containing initial ideas as to the EU ETS' design.

The foundational basis of the green paper led to a series of stakeholder discussions that would shape the EU ETS in its first phases. From here, the EU ETS Directive was adopted in 2003, followed by the formal introduction of the EU ETS two years later.

The first phase

Seen as the pilot phase of the EU ETS, the first phase ran from 2005 to 2007.

This initial phase was used to test price formation in the carbon market and to establish the necessary infrastructure for monitoring, reporting and verifying emissions. Since there was no reliable emission data available at the time, the cap was based largely on estimates.

The primary goal of the first phase was to ensure the EU ETS functioned effectively ahead of 2008, allowing EU Member States to meet their commitments under the Kyoto Protocol. The EU ETS' Linking Directive also allowed businesses to use certain emission reduction units generated under the Kyoto Protocol to meet their EU ETS obligations.

First phase EU ETS

The second phase

The second phase of the EU ETS ran from 2008 to 2012, within the same timeframe as the Kyoto Protocol's first commitment period.

From 2008, businesses could use emission reduction units generated under joint implementation (JI) and clean development mechanism (CDM) to fulfil their EU ETS obligations. As a result, this made the EU ETS the largest source of demand for joint implementation and clean development mechanism emission reduction units.

Towards the end of phase 2, the scope of the EU ETS was expanded to include aviation from 2012.

The third phase

The third phase of the scheme ran from 2013 to 2020.

Building on what was learnt from the previous two phases, the third phase focused more on improving the harmonisation of the scheme across the EU. Additionally, several other changes were also implemented, including:

  • The setting of an overall EU cap, with allowances allocated to EU members
  • Tighter limits on the use of offsets
  • Limiting banking of allowances between phases 2 and 3
  • A move from allowances to auctioning
  • The inclusion of more sectors and gases

How does the European Emissions Trading Scheme operate? 

Companies are either rewarded or penalised for their ability to keep their level of actual emissions within the anticipated level. This is done either through the revenue from sales of spare allowances or by the cost of purchasing additional allowances.

As mentioned earlier, emitting firms must obtain and surrender a permit for each unit of their emissions. Those firms expecting not to have enough permits must cut back on their emissions or purchase them from the market.

Additionally, if a company fails to surrender the annual permits before the April 30th deadline, it can be hit with heavy fines. This acts as a further incentive for companies to reduce emissions.

How does the EU ETS work?

Depending on the price of the permit, some companies will find it easier, or cheaper, to reduce emissions than others, and will sell permits as a result. If there are too many firms in the market eager to sell, then the price of permits (which the cap sets the total number of in advance) will decline. This causes some firms to reduce their emission reduction efforts.

When the price of permits is just right, the number of permits offered for sale by firms that can reduce emissions at low cost is equal to the number of permits demanded by firms for which emissions reductions are costly.

Trading in this way ensures there is a unique price for all firms coordinating their activities. This reduces emissions to the level allowed under the cap.

However, a permit price that clears the market at one point in time won't necessarily continue to do so in the future. When economic conditions and company circumstances change, permit prices fluctuate too.

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They can become more expensive when demand is higher than supply), before becoming cheaper when demand is lower. There are other factors considered as key price determinants like, regulatory changes, market fundamentals, macroeconomic factors, and the price of other energy commodities - essentially, coal and gas prices which influence the fuel switching profitability of power generation (coal generation emits twice as much CO2 than gas generation).

What are the benefits of the European Emissions Trading Scheme? 

The EU deemed the "cap and trade" approach to be the best means of meeting greenhouse gas emissions reduction targets at the lowest cost to both participants and the economy.

In comparison, a traditional command-and-control approach might mandate a standard limit per installation, but it provides little flexibility for companies as to where or how emissions reductions take place.

Measuring emissions

The current approach is, therefore, more preferable for the following reasons:

  • Greater certainty on quantity: Greenhouse gas emissions trading can directly limit greenhouse gas emissions by setting a system cap designed to ensure compliance with the relevant commitment. There is certainty about the maximum quantity of greenhouse gas emissions for the period where system caps are set. This helps support the EU's international objectives and obligations as well as it’s carbon reduction targets.

  • Cost-effectiveness: The flexibility of trading means that all companies involved in the scheme will face the same carbon price, ensuring that emissions are cut where it costs the least to do so.

  • Revenue generation: If greenhouse gas emissions are auctioned, it allows governments to generate a source of revenue, at least 50% of which should be used to fund measures to tackle climate change in the EU or other Member States.

  • Minimising risk to Member State budgets: The EU ETS provides certainty to emissions reduction from installations that are responsible for around 50% of EU emissions. As a result, this reduces the risk that Member States will need to purchase additional international units to meet their international commitments under the Kyoto Protocol.

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