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How does the European Emissions Trading System actually work?

A precision landing for climate efforts: the European Emissions Trading System has a reputation for reliable results when it comes to reducing emissions in the long term. Find out here why it acts both as an incentive and as an insurance guarantee.

This is what it's all about: harmful greenhouse gas emissions are to be cut to protect the climate – at the lowest possible costs for the economy.

It is the central instrument of European climate policy and aims for nothing less than the reduction of GHG emissions that is urgently needed for climate change mitigation. In 2003, the European Emissions Trading System (ETS) was established by the European Parliament and the Council of the European Union; on 1 January 2005, the Emissions Trading Directive went into force. As of 2019, 31 European countries were participating in the scheme with about 11,000 high-emission installations from electricity production and carbon-intensive industries. And this has paid off: since 2005, emissions generated within the world's largest emissions trading system have decreased by nearly 30%, surpassing the EU's target of 21%. But how exactly does the ETS work and how can it be steered?

This is how the ETS works in practice

Anyone who operates a high-emission installation registered in the ETS is required to possess an allowance for each tonne of CO₂ that is emitted. Some operators obtain a certain annual amount of allowances free of charge so that their international competitiveness is not put at risk. Apart from this, however, operators have to buy their emission allowances, either at auctions or from other market participants. Thus, each tonne of carbon that is saved (or 1 EUA) is given a direct monetary value that is determined by means of supply and demand. Every year by the end of April, operators have to take stock of their emissions record. If the number of allowances does not equal the actual amount of CO₂ that has been emitted, a fine of €100 is payable for each excess EUA. The disclosed figures are also used to forecast emissions for the next year.

Allowances from the digital drawer

Operators use a kind of digital drawer to store the CO₂ allowances they have been assigned. This is because trade in emission allowances takes places exclusively in electronic form. It is conducted via trading exchanges – in a way similar to the electricity market – but also outside of them. Business dealings of the latter kind most often take place on a long-term and direct basis and are also known as 'over-the-counter' trading. The most important trading places for CO₂ allowances are the ECX (European Climate Exchange) in London, the EEX in Leipzig and the EXAA in Vienna. Every day at 11 a.m., the EEX publishes its EEX Carbon Index, the market price for short-term trading (spot market price) relative to the development of the carbon price in Europe.

'Cap and trade' – the most effective concept for handling the long-term challenge of climate change

The emissions trading system is based on a principle known as 'cap and trade'. A cap is set on the total amount of greenhouse gas emissions that installations subject to the ETS are allowed to generate. Member states allocate a certain amount of emission allowances to the installations – some of them free of charge, some via auctions. The allowances can be freely traded in the market, which leads to the creation of a price for GHG emissions. Consequently, trading provides the necessary flexibility to ensure emission reductions take place where this causes the lowest costs. Moreover, the carbon price and the symbolic effect of the cap both help to promote investment in clean, low-carbon technologies. Among the large number of approaches to emission reduction that have been devised, 'cap and trade' stands out as the most effective and reliable instrument. The ETS therefore creates an incentive to cut down on emissions. But it also acts as an insurance guarantee that ensures emission targets will be met even if other measures across the sectors covered by the ETS – such as the expansion of renewable energy or the closure of coal-fired power plants – prove insufficient. The latter measures are primarily relevant in terms of the impact they have on the price of emission allowances. That is why low prices for allowances do not necessarily mean that the goals set for the emissions trading system are not ambitious enough. They may also be the result of other measures leading to lower emissions and thus decreasing the overall demand for emission allowances.

Stability reserve against price volatility

In 2015, a market stability reserve was introduced in order to enhance the flexibility of the EU ETS with regard to strong fluctuations in demand and prices. The reserve is to gradually remove surplus allowances from the market. A surplus of allowances can build up if the need for allowances decreases significantly in times of economic downturn. In such an event, the market stability reserve ensures that the unutilised allowances cannot be saved for a later point in time when they would unnecessarily cause higher emissions.

Not all emissions are covered by the ETS

The participating sectors are, however, collectively responsible for about 50% of carbon emissions generated in Europe. These sectors include, for example, fossil-based energy generation facilities with a capacity of 20 MW or more; the coal industry with its refineries, coking and cracking plants; the metals industry with its iron, steel and aluminium works; the cement and lime industry as well as the production of plaster and mineral fibre; the glass, ceramics, and brick and tile industry; the paper and cellulose sector; the chemical industry; the production of technical gases (such as nitrous oxide and hydrofluorocarbons); and, since 2012, the European aviation sector.

The ETS has proven its efficiency throughout the past fifteen years. Therefore, current debate is focusing on the medium-term possibility of extending the EU ETS to the heat and transport sectors, and possibly to agriculture and land use as well. In addition, the possibility of integrating 'negative' emissions is being considered. This could provide a further financial incentive for those companies that manage to remove CO₂ from the atmosphere in a way that is reliable, permanent, sustainable and measurable.

National emissions trading system established as part of Germany's climate package

In autumn 2019, the Federal Government decided to establish a national emissions trading system as part of its climate package. This national scheme is independent of the European Emissions Trading System. It principally applies to the transport and buildings sectors, which are not covered by the EU ETS. From 2021, the fuel trade will thus be required to buy emission allowances for its products. In the medium to long term, it is conceivable that both systems will be linked by means of a common cap.