What is the EU ETS?

The EU ETS is based on a “cap and trade” principle. The cap refers to the limit set on the total amount of GHG that can be emitted by installations and operators covered under the scope of the system. This cap is reduced annually in line with the EU’s climate target, ensuring that overall EU emissions decrease over time. By 2023, the EU ETS has helped bring down emissions from European power and industry plants by approximately 47%, compared to 2005 levels.

The EU ETS cap is expressed in emission allowances with one allowance giving right to emit one tonne of CO₂ eq (i.e., carbon dioxide equivalent). Allowances are sold in auctions and may be traded. As the cap decreases, so does the supply of allowances to the EU carbon market.

Under the system, companies must monitor and report their emissions on a yearly basis and surrender enough allowances to fully account for their annual emissions. If these requirements are not met, heavy fines are imposed.

While allowances are predominantly sold in auctions, companies receive some allowances for free. Companies may also trade allowances among themselves as needed. If an installation or operator reduces emissions, the company can either sell the spare allowances and/or keep them to use in the future. All these operations are recorded in the Union Registry.

The price of allowances is determined by the EU carbon market, which is subject to a robust set of oversight rules. The declining EU ETS cap informs companies about the long-term scarcity of allowances on the market, while ensuring they have market value. The carbon price, in turn, provides an incentive for companies to reduce emissions cost-effectively. This price also determines the revenue generated from the sale of allowances. Since 2013, the EU ETS has raised over EUR 175 billion.

The EU ETS revenue primarily flows to national budgets and Member States must use it to support investments in renewable energy, energy efficiency improvements and low-carbon technologies that help reduce emissions and, with this, companies’ carbon costs. Furthermore, a share of the EU ETS revenue supports low-carbon innovation and the EU’s energy transition via 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).

The legislative framework of the EU ETS is spelled out in the ETS Directive. Over the years, the Directive has undergone several revisions to align the system with the overarching EU climate targets.

The ETS Directive for the fourth trading phase was first revised in 2018, in line with the EU’s 2030 climate and energy framework, established in 2014. With the launch of the European Green Deal and more ambitious climate targets under the European Climate Law, the Directive was revised further in 2023.

On 14 July 2021, the European Commission presented ‘Fit for 55’ – a set of proposals aimed at reforming EU climate and energy policy, including the EU ETS, to implement the Green Deal. The European Parliament and the Council of the EU approved all ETS-related proposals by June 2023. They are now law.

Under the ‘Fit for 55’ package, the following reforms concerned 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.

Under the European Climate Law, EU Member States committed to becoming climate-neutral by 2050. As a first milestone, the EU aims to reduce its net emissions by at least 55% by 2030, compared to 1990 levels. The EU ETS plays a crucial role in achieving this goal cost-effectively, and the 2023 revision of the ETS Directive aligned the system with this target.

Key changes agreed in the 2023 revision of the ETS Directive:

• The cap has been tightened to bring emissions down by 62% by 2030, compared to 2005 levels. This covers emissions from maritime transport, which have been included in the EU ETS from 2024.
• Free allocation of allowances to companies has been scaled down, in line with the tighter cap, and made conditional on the companies’ decarbonisation efforts. For the aviation sector, free allocation will be removed as of 2026.
• The Market Stability Reserve has been revised to foster balance in the reformed EU carbon market.
• More resources have been mobilised to support people and businesses in the green transition. Member States have committed to using all EU ETS revenues (or financial equivalent) towards climate action and a just, green transition. The Innovation Fund and Modernisation Fund budgets have been increased accordingly.
• A new emissions trading system, called ETS2, has been created to cover emissions from buildings, road transport and additional sectors. The new system will become operational in 2027 and complement other European Green Deal policies in these sectors.

The Social Climate Fund (SCF) has been created to address the social impact of carbon pricing in the sectors covered by ETS2, making sure vulnerable citizens are not left behind in the green transition. The SCF will mobilise EUR 86.7 billion from the ETS2 revenue in the 2026-2032 period.

For more information about the EU ETS and its annual performance, see the European Commission’s annual Carbon Market Report as well as other relevant documentation below.

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