European Emissions Trading System (EU ETS)

Last Updated:
February 14, 2024
European Emissions Trading System (EU ETS) explained
The transition to a low carbon economy is on every CEO's agenda nowadays. The impacts of climate change and responses to it will transform every business sector in the coming decades. Although Climate change will affect a majority of companies, all will be expected to contribute to its solution.
Nevertheless, it is challenging for most companies to devise and implement a credible decarbonisation strategy. The transition requires new ways of doing business, including new ways of displaying capabilities and resources and new ways of thinking. But despite the challenges, companies around the world are scaling up their decarbonisation commitments.
We can see this trend with the number of companies committing to reducing emissions. More than 2000 companies have confirmed emissions reduction targets under the Science Based Target initiative (SBTi). Additionally, more than 370 have committed to The Climate Pledge, pledging to achieve net zero emissions by mid-century or sooner.
For most companies and investors, carbon credits play a crucial role in their Net-Zero strategy. They allow companies to make earlier and more ambitious commitments. Credits allow companies to reduce their current emissions through offsets, while taking cost-effective steps to reduce future emissions through asset rotation and business model development. In the long term, credits can play an essential role in offsetting difficult-to-avoid emissions from products for which no low- or zero-emission options exist.
The growing interest in recent years is also reflected in the Voluntary Carbon Market (VCM), which organises the pledging and trading of carbon credits. In 2022, the demand for carbon credits is at its peak. Prices have increased by more than 140% since 2021 and forecasts assume that demand for credits will increase 15-fold by 2030, to $50 billion per year.
But the voluntary carbon market has a problem. It cannot cope with demand. Access, which plays a crucial role in the global effort to combat climate change, is often limited to large organisations and is characterised by opaque pricing and market inefficiencies. Furthermore, due to a lack of transparency and credibility, it has faced a number of problems in recent years.
This report examines the key role for on-chain carbon credits as part of net zero strategies and the VCM. It was prepared by senken to help business decision makers identify and understand the best use of credits for their business.

What is the EU ETS?

The EU ETS, or European Emissions Trading System is designed to reduce emissions in an economically efficient manner. The system operates on a "cap and trade" principle, where a cap, or limit, is set on the total amount of emissions that can be emitted by the covered sectors, and any emission allowances not used can be sold and/or traded.

How EU ETS works
In the context of the compliance carbon market, carbon credits represent emission allowances.

Sectors Included:

The EU ETS covers a range of sectors, including but not limited to:

  • Energy and heat generation
  • Energy-intensive industries like steel, cement, and chemicals
  • Aviation within the European Economic Area (EEA) and departing flights to specific destinations
  • Maritime transport, with different rules for emissions based on voyage origins and destinations
  • Production of specific gases like nitrous oxide and fluorocarbons

How It Works:

Here's a simplified explanation of how the ETS operates:

A more detailed overview can by found in the ETS Directive documentation.

  1. Emission Allowances: The EU sets an overall limit on greenhouse gas emissions for the covered sectors. This limit is divided into individual allowances, each allowing the holder to emit a specific amount of greenhouse gases.
  2. Allocation: Initially, these allowances are allocated to companies based on various factors, including historical emissions and sector-specific benchmarks. Companies can buy or sell these allowances as needed.
  3. Compliance: At the end of each compliance period (usually a year), companies must surrender enough allowances to cover their actual emissions. If they emit more than their allocated allowances, they need to buy additional allowances. If they emit less, they can sell their surplus allowances.

EU ETS Regulations

  • The cap on emissions covered by the EU ETS is set to decrease by 62% by 2030, based on 2005 emission levels.
  • The EU ETS launched in 2005 and operates in different trading phases. The system is currently in its fourth phase, running from 2021-2030. The legislative framework behind this can be found in the ETS Directive.
  • In order to keep the system in-line with the broader EU climate goals, the EU ETS legislation gets revised periodically, with the most recent major revision occurring in 2021 to align with the European Green Deal.
  • In 2021, the European Commission presented the Fit for 55 package, which is designed to reform EU policy surrounding climate and energy, including the EU ETS. The ETS-related proposals are now a part of EU climate regulation after being adopted by the European Parliament and Member States in the Council of the EU in June 2023.