Why was ETS created?
Emitting carbon dioxide generates negative externalities; meaning it is a cost that is not accounted for in the final price of goods and services. We are all familiar with the social costs of high GHG emissions, for they are the buzzwords of our century: climate change, global warming, air pollution, environmental degradation and so forth. ETS puts a price on such emissions with the aim of incentivising economic actors to reduce their carbon footprint and divert their investments towards low-carbon technologies. It can therefore be defined as a market-based carbon pricing mechanism consisting of a cap-and-trade system aimed at lowering emissions..
Two main kinds of carbon pricing currently exist:
- A carbon tax sets a specific price for emissions, leaving the quantity of CO2 up to the free choice of economic actors. In essence, the more one pollutes the more one will need to pay.
- An emission trading system, on the contrary, establishes a cap to the allowed amount (i.e. the quantity) of emissions and lets the market decide how much these emissions will cost.
The revenue generated from both approaches is then re-directed to support countries’ climate policies and incentivise innovation in low carbon technologies. While a tax on carbon can be a good option to raise money for climate mitigation, it might not guarantee the actual reduction in emissions needed to keep global temperatures at bay. ETS, on the other hand has proved to be a more efficient option to reduce actual emissions under the right market circumstances.
We will therefore focus on ETS for the rest of this article.
How does ETS work?
A region, country or group of countries agree on a cap to the amount of CO2 allowed to be emitted in a certain time frame. The emissions generated by an industrial activity falling within the scope of the system will have to be matched with a corresponding number of carbon certificates. In the EU, for instance, one allowance equals one ton of CO2 equivalent.
Emitting actors can buy, receive and trade allowances to cover their full emissions. Some sectors are also granted a defined number of free allowances to keep their operations competitive vis-a-vis external competitors with less stringent climate legislation. In the EU, these sectors include chemicals, aluminium, cement and steel.
What happens if a company does not comply?
Failing to cover excess emissions with allowances results in getting fined. In the EU fines are 100 euro per excess ton. This is a clear incentive for companies to lower their emissions, switch to low-carbon alternatives whenever possible and increase their energy efficiency.
How are ETS revenues used?
The EU Member States must use all of the revenues generated by this cap-and-trade system for climate-related purposes. The wide amount of revenues are re-directed to Member States’ budgets. Two special funds were also created to support the energy transition through innovation and modernisation of energy-intensive industries as well as the power sector. In particular:
- The Innovation Fund:
Established to finance innovative low-carbon solutions trying to scale to become market competitive, such as energy storage and carbon capture, but also generation technologies and manufacturing. - The Modernisation Fund:
Designed specifically to help the 10 lower-income EU Member States to meet energy targets, modernising and improving the efficiency of their energy systems. It therefore supports their power sectors’ transition away from fossil fuel-based generation towards renewable and clean energy sources. Since the 2023 revision Portugal, Greece and Slovenia have been added to the club.
As time goes by, temperatures rise, and climate targets come into force, the number of allowances will keep decreasing to incentivise companies to decarbonise. Such reduction is determined by something called a linear reduction factor (LRF).
Zooming in: what is the linear reduction factor?
Every year, the annual rate by which the cap on greenhouse gas emissions declines is defined by the linear reduction factor (LRF). This basically represents the effort that needs to be taken to get from point A (high level of emissions) to point B (the expected climate neutrality). It can be defined for certain periods and adjusted upwards or downwards to increase or reduce the pressure depending on the needs.
For instance, in the EU, the ETS cap is expected to reduce emissions from the covered sectors by 62% by 2030 compared to 2005 levels. In view of this target, which was also amended to correspond to the 55% emissions reduction target across the economy, the LRF has been adjusted during the 2023 revision. It has been raised from 2.2% to 4.3% from 2024-2027 and to 4.4% from 2028-2030. This is what happened with the latest reform of the EU ETS which we will detail later.
We have explained how the system works, but who runs it?
Who are the actors involved in ETS?
Depending on the region subject to the ETS, different actors come into the picture. By and large, however, any emission trading system features:
Public institutions: the State, the European Commission and the Market surveillance authority
The State oversees auctioning the agreed amount of emissions allowances every year. It also monitors compliance and ensures reporting of the interested companies. The Commissions monitors States’ compliance, while the Market Surveillance Authority (ESMA) is in charge of overseeing the transactions to ensure there is no manipulation of the market.
Non-financial entities
These are compliance parties who are naturally on the ‘demand’ side of the carbon market. They buy European emissions allowances (EUA) futures and use long-term contracts to hedge their carbon price exposure and manage the price risk of the emission allowances they must purchase to fulfil their compliance obligation. For this, they need companies willing to conclude such contracts with them, thereby taking the ‘supply’ side of the transaction.
Financial institutions
They participate in the market as intermediaries by buying and selling allowances on a continuous basis, thus acting as ‘client facilitators’ and ‘market makers’. This is particularly important in the carbon market, where there is only one supplier of emission allowances (governments). Financial institutions provide an integral service to compliance entities, providing market liquidity and price visibility. They also allow companies to hedge against future price fluctuations and better allocate their working capital by delaying payments for future usage.
This diverse ecosystem of participants ensures that the EU carbon market is resilient, less costly to access, and better equipped to provide hedging and risk-management solutions to companies. It is seen as a global benchmark for carbon trading and a success that other regions are seeking to follow.
Which countries have an emission trading system?
Governments worldwide are increasingly adopting emissions trading systems as a key element of their climate change policies, with significant progress being made in emerging economies.
The International Carbon Action Partnership (ICAP) counts around 36 emission trading systems in place today, with an additional 22 systems under development or consideration. Revenues generated under ETS break record every year, earning more than USD 74 billion in 2023. Some of the best-known examples are in the US state of California, South Korea and China.
But the leader in ETS remains the European Union.
EU is the leader on ETS
The EU ETS is the oldest and by far the largest trading system in the world. Since 2013, the EU ETS has raised over €175 billion according to the estimates of the European Commission. The bulk of this figure has been generated when the market has tightened. In 2022 alone, the EU raised a total of €38 billion euros in auction revenue, growing from €14 billion in 2019 – shows Eurelectric’s Power Barometer 2024.
Such increase followed a significant evolution of EU allowances prices, which went from an annual average of €24.73 per Mt of CO2eq in 2019 to € 83.6 per Mt of CO2eq in 2023.
Positively, the latest ETS review has set an obligation on Member States to use revenues to drive investment in renewable energy, energy efficiency improvements, and other technologies that help companies lower their carbon costs. In addition, a share of this revenues is dedicated to the Innovation Fund, expected to raise over €57 billion between 2021 and 2030, and the Modernisation Fund, projected to gather and invest €69.5 billion by 2030. While these amounts seem high, they represent only a fraction of the total investment need which the European Commission estimated to be around €1.5 trillion euros, from 2031 to 2050, in its Impact Assessment on the 2040 target.
What are the benefits of an emission trading system for the power sector?
Utilities typically consider the cost of allowances in an emissions trading system as a marginal cost when making operational decisions and as a factor in investment evaluations. For consumers, the implementation of a carbon price leads to higher costs for carbon-intensive goods. This creates a clear incentive to shift towards low-carbon alternatives or changes in consumption patterns. For instance, since the introduction of ETS 1, the power sector has been progressively switching from carbon-intensive sources of generation to more efficient and low carbon technologies. Similarly, technologies have evolved in steelmaking to replace fossil-based blast furnaces with more efficient electric arc furnaces.
In addition, the latest ETS review has introduced a new emissions trading system, called ETS 2 or BRT, covering fuels released from consumption in buildings, road transport and other sectors, to drive emissions reductions in these areas too. Here, household consumers can choose to opt for an electric heat pump instead of gas boilers for heating, or buying an electric vehicle as opposed to a fossil-fuel-based internal combustion engine for driving.
This system is particularly efficient as it relies on market dynamics and price incentives. With clear carbon pricing, investing in coal becomes less attractive than emission-free and allowance-free renewables. High-emitting fossil fuel power plants are ranked last in the energy-price-setting merit order and their operating hours are reduced in an economic dispatch model.
Zoom in: what is the merit order?
The merit order is the ranking of power plants according to their respective generation costs. It is established based on the variable costs of each power plant, calculated in €/ kwh. Renewables have the lowest variable costs, as sun and wind are for free, and they are not exposed to carbon prices. The merit order therefore ranks renewables first, followed by nuclear, gas, coal and oil fuel in that order.
For more information, check out our electricity markets page.
In practice , however, these investment signals are sometimes offset by fossil fuel subsidies, a lack of long-term clear policies on ETS or by volatile allowance prices within the system.
“Power markets are often fully or partially regulated, meaning producers can be constrained when it comes to decisions on investment or generation, and can face regulated wholesale and retail electric prices. If retail electricity prices are highly regulated, for example, the carbon price signal will not be visible to electricity consumers. This effect limits or removes the incentive for electricity consumers to save electricity or to choose low-carbon electricity suppliers. Similarly, in market structures where wholesale prices and dispatch decisions are regulated, a carbon price would have limited impact on shifting the merit order towards low-carbon power sources.” – warns the International Energy Agency.
An ETS success story: the power sector
2023 marked the highest annual emission reduction since ETS’ inception in 2005 – announces the European Commission. According to data provided by EU countries as of 2 April 2024, emissions decreased by 15.5% compared to 2022, putting ETS emissions approximately 47% below 2005 levels. This sets the EU ETS sectors on a good track to meet the 62% emission reduction target for 2030.
The primary factor behind the record decrease in EU ETS emissions has been the power sector’s notable progress in decarbonising. Thanks to much higher renewable energy production, emissions from electricity production dropped by an impressive 24% compared to 2022. This is largely due to wind and solar replacing coal and gas and to a lesser extent by the recovery of hydropower and nuclear generation aided by more favourable climate conditions.
Turning to energy intensives, emissions were lowered by 7% when compared to 2022 due to a combination of decreased output and efficiency gains, especially in the cement, iron and steel sectors. On the contrary, aviation emissions increased by around 10% from 2022, reflecting the industry’s continued recovery from the pandemic-related drop in traffic.
How has ETS evolved throughout the years?
Since its official launch in 2005, ETS sectors have reduced emissions by over 42%. Over time, more sectors were included under its remit and targets have become more stringent to better align with the EU climate ambition. We can recap the EU ETS journey with the following four key phases:
2005 – 2007
ETS officially began in the EU in 2005 but talks about emission trading systems actually date back to the1997 Kyoto Protocol . The protocol marks the first time, legally-binding emission reduction targets were fixed in thirty seven developed countries.
Following the Summit, the European Commission released in 2000 its Green Paper on greenhouse gas emissions trading within the European Union to discuss the design of the EU ETS with civil society, industry and policy makers. Negotiations led to the adoption of the EU ETS Directive in 2003 and the official launch of the European Emission Trading system in 2005.
Since then, the EU ETS witnessed highs and lows, but it remains one of the most effective policy tools for decarbonising Europe’s economy. It also became a reason of pride for the EU who was able to position itself as the international leader in climate action.
During the first 3-year pilot, most allowances were given for free and emission trading only involved the power sector and energy intensive industries. The penalty for non-compliance was only €40 per ton of CO2. This initial mechanism proved inefficient however, as it caused the price of allowance to reach zero in 2007. Thus, it needed to be improved.
2008-2012
In the second phase, free allowances were slightly reduced to 90%, the penalty for non compliances was raised to €100 per ton of CO2 and Iceland, Liechtenstein and Norway joined the EU ETS. The number of allowances in circulation was also lowered by 6.5% when compared to 2005.
The 2008 financial crisis had a profound impact on ETS as it depressed the demand for emission allowances. The supply, on the other hand, was further expanded through international carbon credits, thus generating an allowances surplus. With market dynamics, when a surplus occurs, the price drops. That’s exactly what happened in 2013 with the European emissions allowance prices collapsing from €30 in 2008 to €2.75 in April 2013. To address this oversupply, a market stability reserve (MSR) was created in January 2019.
Graph taken from the European Commission’s Development of EU ETS
Zooming in: what is the EU market stability reserve?
The Market Stability Reserve (MSR) is an add-on to the EU ETS. It was conceptualised as a safeguard mechanism to help ensure the supply and the demand of quotas align thus reducing surpluses or shortages. The MSR is the main mechanisms at play for market balancing and depends on a key indicator: the total number of allowances in circulation (TNAC). If the number of allowances exceeds a fixed upper threshold, the MSR adjusts the volumes downwards. On the contrary, should the volumes be below the lower threshold, the scheme reinjects permits from the reserve.
Every year 20% of allowances are moved to the MSR to grow reserves and stabilise the market. Such allowances do not remain in the MSR forever, as there is an allowance threshold of 400 million allowances above which allowances are released.
2013-2020
The third phase of the EU ETS brough several improvements. The cap began applying uniformly throughout the EU replacing previous national caps. Auctioning became the default method to sell allowances. In particular, 40% of allowances were auctioned in this time frame, requiring electricity producers to buy all their allowances except for some member states such as Poland, Bulgaria, Hungary, Lithuania and several others.
More sectors and gases were included under the ETS umbrella, but free allowances were mainly kept for the manufacturing and aviation sectors as well as for those sectors deemed to be at risk of carbon leakage. As a consequence, carbon prices were never uniformly applied.
Zooming in: What does carbon leakage mean?
Carbon leakage occurs when companies move their production to countries with more lenient climate regulations to avoid the costs associated with carbon pricing, leading to a potential increase in global emissions. This problem can be mitigated by reducing the carbon price for producers competing with foreign companies that have lower carbon costs, implementing trade policies that drive decarbonisation outside the EU, or introducing a carbon border adjustment mechanism (CBAM) for imports. We will discuss in another article, the EU’s CBAM, which was introduced in 2023.
2021 – 2030
As the fourth phase of the EU ETS began, around 57% of emissions allowances were auctioned and the amount and sectors eligible for free allowances were cut as agreed during the system’s 2018 reform. A new reform period began to align ETS with the new climate and energy targets put forward by the EU Green Deal and specifically by the Fit for 55 package and RePowerEU.
The reform, concluded in 2023, now targets a 62% ETS emission reduction by 2030 compared to 2005 levels with a linear reduction factor going from 2.2% to 4.3% for 2024-2027 and then to 4.4% from 2028. The system was also extended to new industries such as the maritime sector, road transportation, buildings, and could potentially be further expanded to cover all fossil fuel use.
The EU ETS II
To cover road transport and buildings’ emission, a new trading system was created, dubbed as ETS II, that will start functioning by 2027. ETS II will initially operate alongside the original system, with plans to merge the two in the early 2030s.
The emissions reduction trajectory and the linear reduction factor are set at 5.1% starting in 2024 and will increase to 5.38% from 2028. To ensure a smooth launch, an additional 30% will be frontloaded to the auction volume in the first year. Similar excessive price-safeguard mechanisms as in ETS1 exist, but in this case, they are price-based, as opposed to the ETS1 where they are volume-based.
Additional changes introduced as part of the reform concern the Innovation and Modernisation funds. In particular:
- The Innovation Fund will focus on decarbonising the maritime sector and sectors covered by the Carbon Border Adjustment Mechanism (CBAM). The number of allowances for financing the Innovation Fund will be increased from 450 million to 575 million allowances and frontloaded to ensure sufficient resources for innovation.
- The Modernisation Fund volumes will be increased by auctioning an additional 2.5% of the cap, and by including three more Member States (Greece, Portugal and Slovenia) to become eligible for funding. Generally, fossil-fuel-based energy generation will not qualify for funding, with transitional exemptions for natural gas projects under certain conditions.
Taking the many policy developments that unfolded in the past five years, how did the carbon price react? With highs and lows. Prices rose considerably, from €9.68 in 2018 to a record of €100 in early 2023. In 2024 however, the allowance price fell again to €60 due to, among other aspects, lower demand for certificates a fall in power demand due to industrial slowdown and higher energy efficiency and an oversupply of allowances triggered by the financing scheme of REPowerEU. Analysts however, forecast that the ETS price will rise again and possibly reach €130 by 2030, reports CLEW.
What’s the future of ETS?
As the reform stands today, the ETS cap will likely reach zero by 2039. New developments will take place once the EU decides on the 2040 climate targets, currently under discussion. The Commission has recommended a 90% emission reduction target by 2040. With a newly-elected legislative mandate, it will be up to the new Commission and Parliament to see whether this 90% target will see the light of day.
To see our reaction to the 2040 climate target, please read our press release “Eurelectric on EU 2040 targets: Yes, to power-driven decarbonisation – keep society on board”.
Moving forward, one key shift is clear: industrial decarbonisation will play a greater role in ETS. This reflects a more general focus of the new European Commission which stressed the importance of keeping a competitive industrial base in Europe while continuing the EU economy’s decarbonisation. In its 2024 ETS status report, ERCST noted that current trends suggest the industrial sectors covered by the EU ETS will face significant challenges in meeting a potential 2040.
What’s the power sector’s view on the 2023 ETS reform?
Eurelectric welcomes the ETS reform as a cornerstone of the EU’s policy to combat climate change. Therefore, to reach its decarbonisation objectives, the EU will need a liquid and resilient carbon market that encourages the power sector and industry to rapidly decarbonise.
Eurelectric also welcomes the expanded level of ambition and scope of emissions covered by the economy. Europe moved from having roughly 40% to 70% GHG emissions covered by the system with the inclusion of the maritime, heating and cooling sectors, as well as incinerators. This is a landmark in the ETS evolution, but upcoming developments should seek to ensure fair distribution of climate targets between ETS I, ETS II and non-traded sectors, as well as across Member States.
In our latest position paper, we look at the Future of EU ETS post-2030 through six lenses:
1. Ambition
It explores (1) the role of technological permanent removals and their potential integration into the EU ETS1, (2) the role of waste incinerators, (3) the geographical expansion – with the call for linking with the EU ETS by COP30, (4) international trading and the role of climate diplomacy.
2. Electrification
How can the EU ETS support electrification? How can the ETS II support the shift to energy efficient, electric technologies? What measures can tackle indirect emissions?
3. Carbon pricing
To incentivise a cost-effective decarbonisation, Europe must ensure a strong, market and volume-based EU ETS I, which delivers meaningful price signals that spur investment. For that, ETS predictability needs to be improved, via better explainability to make sense of price movements and enhanced credibility.
4. Stability and predictability
The MSR should improve its responsiveness to periods of high volatility to recalibrate imbalances through additional indicators, a more flexible and adaptable framework and by revising its timing for activation depending on market changes, including surplus or scarcity. To this end, article 29a of the ETS directive should be strengthened to ensure that the MSR can be effectively applied in view of the market evolution.
5. Market functioning
As the transition to net-zero advances, it’ important to keep an eye on new market behaviours and the availability of abatement technologies. In particular, the EU should consider how technological removals can help drive liquidity in the market, and how to enable linkage roadmaps to increase the appetite for linking ETS markets.
6. Revenues
The EU should prioritise meaningful decarbonisation projects going forward, and continue its support for the Modernisation Fund.
After years of structural problems, the ETS is finally enabling decarbonisation at the scale required to reach climate targets. Going forward, policy developments must maintain a strong market-based EU ETS. To do so, upcoming measures should seek to minimise market distortions, reduce short-term volatility and long-term uncertainty over price movements. Predictability is key for ensuring the necessary decarbonisation investments, and deliver cost-effective emissions reductions. That’s why at Eurelectric, we advocate for a meaningful, predictable long-term carbon price signals that should remain devoid of ad-hoc political interventions.
Disclaimer: This article is for informative purposes only and may not entirely reflect Eurelectric official positions. For formal positions, please consult our position papers here.