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A "cap and trade" system

The EU ETS works on the 'cap and trade' principle. A 'cap', or limit, is set on the total amount of certain greenhouse gases that can be emitted by the factories, power plants and other installations in the system. The cap is reduced over time so that total emissions fall. In 2020, emissions from sectors covered by the EU ETS will be 21% lower than in 2005.

Within the cap, companies receive or buy emission allowances which they can trade with one another as needed. They can also buy limited amounts of international credits from emission-saving projects around the world. The limit on the total number of allowances available ensures that they have a value.

After each year a company must surrender enough allowances to cover all its emissions, otherwise heavy fines are imposed. If a company reduces its emissions, it can keep the spare allowances to cover its future needs or else sell them to another company that is short of allowances. The flexibility that trading brings ensures that emissions are cut where it costs least to do so.

By putting a price on carbon and thereby giving a financial value to each tonne of emissions saved, the EU ETS has placed climate change on the agenda of company boards and their financial departments across Europe. A sufficiently high carbon price also promotes investment in clean, low-carbon technologies.

In allowing companies to buy international credits, the EU ETS also acts as a major driver of investment in clean technologies and low-carbon solutions, particularly in developing countries.

Third phase brings significant changes

Launched in 2005, the EU ETS is now in its third phase, running from 2013 to 2020. A major revision approved in 2009 in order to strengthen the system means the third phase is significantly different from phases one and two and is based on rules which are far more harmonised than before. The main changes are:

• A single, EU-wide cap on emissions applies in place of the previous system of 27 national caps;
• Auctioning, not free allocation, is now the default method for allocating allowances. In 2013 more than 40% of allowances will be auctioned, and this share will rise progressively each year;
• For those allowances still given away for free, harmonised allocation rules apply which are based on ambitious EU-wide benchmarks of emissions performance;
• Some more sectors and gases are included.

Almost half of EU emissions covered

While emissions trading has the potential to cover many economic sectors and greenhouse gases, the focus of the EU ETS is on emissions which can be measured, reported and verified with a high level of accuracy.

The system covers emissions of carbon dioxide (CO2) from power plants, a wide range of energy-intensive industry sectors and commercial airlines. Nitrous oxide emissions from the production of certain acids and emissions of perfluorocarbons from aluminium production are also included (see box).

Participation in the EU ETS is mandatory for companies operating in these sectors, but in some sectors only plants above a certain size are included. Governments can exclude certain small installations from the system if fiscal or other measures are in place that will cut their emissions by an equivalent amount.

For commercial airlines, the system covers CO2 emissions from flights within and between countries participating in the EU ETS (except Croatia, until 2014). International flights to and from non-ETS countries are also covered, but as a goodwill gesture the European Commission has proposed deferring the scheme's application to these for 2012 to allow time for agreement on a global framework for tackling aviation missions to be reached in autumn 2013.

Altogether the EU ETS covers around 45% of total greenhouse gas emissions from the 27 EU countries.

Making a difference

The EU ETS has put a price on carbon and shown that it is possible to trade in greenhouse gas emissions. Emissions from installations in the scheme are falling as intended.

The success of the EU ETS has inspired other countries and regions to launch cap and trade schemes of their own. The EU aims to link up the ETS with compatible systems around the world to form the backbone of an expanded international carbon market. The European Commission has agreed in principle to link the ETS with Australia’s system in stages from mid-2015.

Debate on structural reform

However, the ETS also faces a challenge in the form of a growing surplus of allowances, largely because of the economic crisis which has depressed emissions more than anticipated. In the short term this surplus risks undermining the orderly functioning of the carbon market; in the longer term it could affect the ability of the EU ETS to meet more demanding emission reduction targets cost-effectively.

The Commission has therefore taken the initiative to postpone (or 'back-load') the auctioning of some allowances as an immediate measure, while also launching a debate on structural measures which could provide a sustainable solution to the surplus in the longer term.