The EU ETS works on the 'cap and trade' principle. A cap is set on the total amount of certain greenhouse gases that can be emitted by the operators covered by the system. The cap is reduced over time so that total emissions fall.

Within the cap, operators buy or receive emissions allowances, which they can trade with one another as needed. The limit on the total number of allowances available ensures that they have a value. The price signal incentivises emission reductions and promotes investment in innovative, low-carbon technologies, whilst trading brings flexibility that ensures emissions are cut where it costs least to do so.

After each year, an operator must surrender enough allowances to cover fully its emissions, otherwise heavy fines are imposed. If an installation reduces its emissions, it can keep the spare allowances to cover its future needs or else sell them to another operator that is short of allowances.

Revenues from the sale of allowances in the EU ETS mostly feed into Member States’ budgets. Allowances are also auctioned to supply the funds supporting innovation in low-carbon technologies and the energy transition n: the Innovation Fund and the Modernisation Fund.

The EU ETS covers the following sectors and gases, focusing on emissions that can be measured, reported and verified with a high level of accuracy:

• carbon dioxide (CO₂) from
  • electricity and heat generation,
  • energy-intensive industry sectors, including oil refineries, steel works, and production of iron, aluminium, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids and bulk organic chemicals,
  • aviation within the European Economic Area;
• nitrous oxide (N₂O) from production of nitric, adipic and glyoxylic acids and glyoxal;
• perfluorocarbons (PFCs) from the production of aluminium.

Participation in the EU ETS is mandatory for companies in these sectors, but:

• in some sectors, only operators above a certain size are included,
• certain small installations can be excluded if governments put in place fiscal or other measures that will cut their emissions by an equivalent amount,
• in the aviation sector, until at least 31 December 2023 the EU ETS will apply only to flights between airports located in the European Economic Area. As of 1 January 2019, aircraft operators are required to monitor and report their emissions also for the European Economic Area.

The legislative framework of the EU ETS is spelled out in the ETS Directive.

The system operates in trading phases. Now into its fourth trading phase (2021-2030), the ETS framework has undergone several revisions to maintain the system’s alignment with the overarching EU climate policy objectives.

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

On 14 July 2021, the European Commission proposed to strengthen the EU ETS, extend emissions trading to new sectors and set up a new Social Climate Fund to address the impacts of carbon pricing on vulnerable groups.

The European Parliament and the Council of the EU considered the proposal and reached a provisional agreement on the revision in December 2022.

The EU ETS has proven to be an effective tool in helping drive emissions reductions cost-effectively. Installations covered by the ETS reduced emissions by about 35% between 2005 and 2021 (comparing ETS emissions from stationary installations in 2021, without the UK, only electricity generators in Northern Ireland, to an adjusted value of 2005 emissions observing the same scope).

The introduction of the Market Stability Reserve in 2019 has resulted in higher and more robust carbon prices, which helped ensure a year-on-year reduction in emissions from ETS installations of 9% in 2019, with a 14.9% reduction in electricity and heat production and a 1.9% reduction in industry.

Under the European Climate Law, EU Member States will work collectively to become climate neutral by 2050. As a first milestone, the EU is aiming to reduce net emissions by at least 55% by 2030 compared to 1990. The EU ETS will contribute to delivering this target.

Set up in 2005, the EU ETS is the world's first international emissions trading system. It has since continued to inspire the development of emissions trading in other countries and regions.

The EU supports these efforts through knowledge exchange and capacity building activities. The EU also considers opportunities to link the EU ETS with other compatible systems.

In 2017, the EU and Switzerland signed an agreement to link their emissions trading systems. The agreement entered into force on 1 January 2020, and the link became operational in September that year.