The European Emissions Trading Scheme

Operating principles and evolution

The European Union Emissions Trading Scheme (EU ETS, see glossary) was created in 2005 to impose an emissions cap on the European Union's high emitting sectors. It is now in its fourth phase of operation (2021-2030).

Regulated entities must measure and verify their emissions each year and then surrender as many allowances (1 allowance = 1 ton of CO2 ) as their verified emissions from the previous year. They can buy them at auction or from other participants, and some receive allowances for free. The number of allowances put on the market corresponds to the cap that will allow the climate objectives to be met.

Since 2013, the scope of the EU ETS has been expanded by including new sectors and greenhouse gases. It now covers more than 11,000 industrial installations and power plants in the EU and the countries of the European Economic Area (Norway, Liechtenstein and Iceland) as well as flights within this area, which represents about 35% of the GHG emissions of this area. Since 2020, a link between the EU-ETS and the Swiss carbon market has been in operation, with mutual recognition of allowances.

The reform of the EU ETS, foreseen in the " Fit for 55" package, in addition to the accelerated reduction of the cap from -43% to -61% in 2030, plans to extend the scope of the EU ETS to the maritime sector and to progressively reduce the free allocation to sectors subject to the border carbon adjustment mechanism (BCA). It also plans to create a new emissions trading scheme specific to the building and transport sectors.

GHG emissions from stationary installations covered by the EU ETS by sector (2015-2021)

Note: "Other" includes glass, lime, paper, ceramics and non-ferrous metal production.
Source: I4CE, based on data from the European Environment Agency, 2022

Cap and Allocation of Allowances

In the first two phases of the EU ETS (the pilot phase in 2005-2007, and a second phase in 2008-2012 that coincided with the first commitment period of the Kyoto Protocol), the emissions cap was established in a decentralized, bottom-up manner. Each Member State established a National Allocation Plan (NAP) to distribute allowances among covered installations, and the sum of the NAPs formed the overall cap.

Phase 3, starting in 2013, established a cap at the European level. This cap decreased linearly by a factor of 1.74% each year to reach an annual reduction of about 38 million tons of CO2 eq. For Phase 4, starting in 2021, this factor increased to 2.2%, i.e. an annual reduction of 48 million tons of CO2 eq.

The revision of the EU ETS market in the European legislative package "Fit for 55" foresees an accelerated annual decrease of the emissions cap with a 4.2% decrease per year and a "rebasing" (strong decrease over one year) of 117 million tons CO2 eq in 2024.

Less and less free allowances

The majority of allowances were allocated free of charge in phases 1 and 2. These free allocations have progressively decreased in phase 3 and will become more and more binding in phase 4:

• Power plants have not received free allowances since 2013; only three Central and Eastern European countries continue to receive a Phase 4 exemption.
• Industrial sectors identified by the European Commission as being at risk of carbon leakage continue to receive free allowances. The allocation of these allowances will continue in Phase 4, but the allocation parameters will be more restrictive. The "Fit for 55" package provides for a gradual phase-out of these allowances for the sectors covered by the CBAM (see glossary).

Free allocations are established in relation to carbon intensity benchmarks established by product or by energy consumption.

The remaining allowances are sold at auction. Auction revenues are managed by the states, which are obliged to use at least half of them for climate and energy.

Quota exchanges

Allowances are tradable: an installation that reduces its emissions can, for example, resell its unused allowances. An installation can also buy allowances to cover its emissions several years in advance.

Trades between allowance suppliers and applicants are made either over the counter, i.e. through bilateral contracts between manufacturers, or on marketplaces, electronic portals that make public the prices and quantities traded.

Historical allowance prices

The 2008-2017 period was characterized by a low allowance price, due in particular to the economic crisis of 2008 and the increase in the supply of allowances, leading to a situation of oversupply ( "surplus of allowances"). Reforms undertaken to support the price signal have allowed this price to recover since 2017 (backloading, market stability reserve, see glossary). The allowance price has reached a significant level since 2021, exceeding €90/t CO2 eq in the first half of 2022, due in particular to the announcement of the revision of the EU ETS by the European Commission in the " Fit for 55" package and the energy crisis that the European Union has been experiencing since late 2021.

CO₂ allowance price

Sources: Sandbag Carbon price viewer, 2022; Ember Carbon price viewer, 2022

Implementation of a carbon border adjustment mechanism (CBAM)

The objective of the CBAM is to prevent carbon leakage, i.e. the displacement of emissions to non-European countries as a result of the implementation of climate policies. The pilot sectors for this mechanism in the Commission's proposal are steel, cement, aluminum, fertilizers and electricity.

In this "mirror" system of the ETS, importers of the products concerned must measure the emissions associated with the products and pay a carbon cost equivalent to that paid by European producers. This system will take into account the carbon prices paid in third countries, and can thus also encourage the European Union's partner countries to put in place carbon pricing policies.

This mechanism should begin in full in 2026 after a test phase in 2023-2025 and be accompanied by the gradual end of free allowances for the sectors covered by this mechanism.

Adaptation to climate change in Europe

In 2009, the publication of the White paper Adapting to climate change: towards a European framework for action provided the basis for the European strategy on adaptation to climate change published in 2013, which encourages Member States to publish their own national climate change adaptation strategy with an implementation plan.

In 2016, the Commission launched an evaluation process of the implementation of its adaptation strategy. This showed that the strategy had generally met its objectives, but that Europe remained highly vulnerable to the consequences of climate change.

In February 2021, the new European Union strategy for adaptation to climate change was published with the ambition to "build a resilient Europe" along 4 axes:

• smarter adaptation: improving knowledge and managing uncertainty;
• more systemic adaptation: support policy development at all levels and in all sectors;
• faster adaptation: accelerate adaptation in all areas;
• intensify international action for climate change resilience.

European countries that have adopted a national climate change adaptation plan

Source: Climate Adapt