What is the EU ETS?

The EU ETS works on the ‘cap and trade’ principle. A cap is a limit set on the total amount of greenhouse gases that can be emitted by the installations and aircraft operators covered by the system. The cap is reduced annually in line with the EU’s climate target, ensuring that emissions decrease overtime. Since 2005, the EU ETS has helped bring down emissions from power and industry plants by 37%.

The cap is expressed in emission allowances, where one allowance gives the right to emit one tonne of CO₂eq (carbon dioxide equivalent). For each year, companies must surrender enough allowances to fully account for their emissions, otherwise heavy fines are imposed.

Within the cap, companies primarily buy allowances on the EU carbon market, but they also receive some allowances for free. Companies can also trade allowances with each other as needed. If an installation or operator reduce their emissions, they can either keep the spare allowances to use in the future or sell them.

The declining cap offers companies certainty about the scarcity of allowances long term and ensures that allowances have market value. Allowance price serves as an incentive for companies to reduce emissions how and where it costs least to do so. It also determines the revenues that the EU ETS generates from the sale of allowances. Since 2013, the EU ETS has generated over EUR 152 billion in revenues.  

The revenues from the EU ETS feed mostly into national budgets. Member States use these revenues to support investments in renewable energy, energy efficiency improvements and low-carbon technologies that help reduce emissions further. The sale of allowances also supplies the EU ETS funds for low-carbon innovation and energy transition,  the Innovation Fund and the Modernisation Fund.

Launched in 2005, the EU ETS operates in trading phases. The system is now in its fourth trading phase (2021-2030). Its legislative framework is spelled out in the ETS Directive. Over the years, it has undergone several revisions aligning the system with the overarching EU climate targets.

The ETS Directive for phase 4 was first revised in 2018 in line with the EU's 2030 climate and energy framework. In view of the European Green Deal and EU’s more ambitious climate targets, however, another revision of the Directive for phase 4 was launched in 2021.

On 14 July 2021, the European Commission presented ‘Fit for 55’ - a package of proposals to reform EU climate and energy policy, including the EU ETS. The European Parliament and Member States in the Council of the EU adopted the ETS-related proposals by June 2023. They are now law.

Under the European Climate Law, EU Member States will become climate neutral by 2050. As a first milestone, they aim to reduce net emissions by at least 55% by 2030 compared to 1990. The EU ETS is critical to achieving this in a cost-efficient manner and the 2023 revision aligns the system with this ambition.

The following reforms of the ‘Fit for 55’ package concern the ETS Directive or related legislation:

1. Reform increasing the ambition of the EU ETS – adopted on 10 May 2023.
2. Reform strengthening the Market Stability Reserve – adopted on 19 April 2023.
3. Reform of the EU ETS concerning aviation – adopted on 18 January and 10 May 2023.
4. Reform of the rules of the monitoring, reporting and verification of emissions from maritime transport – adopted on 16 May 2023.
5. Reform establishing the Social Climate Fund to complement the new emissions trading system for buildings, road transport and small emitting industry– adopted on 10 May 2023.
6. Reform establishing a Carbon Border Adjustment Mechanism – adopted on 10 May 2023.

The cap on emissions is tightened to reduce emissions covered by the EU ETS by 62% by 2030, compared to 2005 levels. Through the revision, the following elements were introduced:

• Expansion of the scope of the EU ETS to cover maritime transport
• ETS 2: new emissions trading system for buildings, road transport and additional sectors
• Creation of the Social Climate Fund, mobilising EUR 86.7 billion from 2026 to 2032 to support vulnerable groups in our societies
• Increased resources for the Innovation Fund and the Modernisation Fund
• Adaptation of free allocation rules, including a phase-out of free allocation in the aviation sector and certain industrial sectors

You can find more information about the EU ETS functioning year to year, including on emission reductions and auction revenues, in the Commission’s annual Carbon Market Report in the Documentation section below.