The EU Emissions Trading System (ETS)

The EU Emissions Trading System (ETS) is one of the key policy tools used by the European Union to combat climate change. It’s the world’s largest carbon trading market and operates on the principle of cap and trade.

The EU sets a cap on the total amount of greenhouse gases that can be emitted by certain sectors, such as power generation, industry, and aviation. This cap is gradually reduced over time to achieve emission reduction targets.

Under the cap, companies are allocated or can purchase emission allowances, each representing the right to emit one tonne of CO2 or its equivalent. Initially, these allowances are often given to companies for free, but gradually more of them are auctioned.

Companies that emit more than their allocated allowances must buy additional allowances on the carbon market. Those that emit less can sell their excess allowances. This creates a financial incentive for companies to reduce their emissions: those that invest in cleaner technologies and practices can sell their surplus allowances for profit, while those that continue to emit large amounts of CO2 face increased costs.

Companies are required to surrender enough allowances at the end of each compliance period to cover their actual emissions. Failure to do so results in fines and other penalties.

The EU ETS aims to provide a cost-effective way for the EU to meet its emission reduction targets under the Kyoto Protocol and subsequent agreements. It also encourages innovation in low-carbon technologies and helps to create a market for carbon credits, which can be traded internationally.

The EU ETS has faced criticism for various reasons, including concerns about the initial allocation of free allowances to certain industries, the volatility of carbon prices, and the potential for carbon leakage (where industries relocate to countries with less stringent emission regulations). Nonetheless, it remains a central pillar of EU climate policy and has been instrumental in driving down emissions in covered sectors.