Emissions Trading in Practice: The EU ETS

How the European Union's carbon market works, what went wrong in its early years, and how it has reduced emissions.

Economists have long recommended putting a price on carbon. The largest real-world example of a carbon market is the European Union Emissions Trading System, or EU ETS, launched in 2005.

How it works

The EU ETS is a cap-and-trade system:

A cap sets the total amount of greenhouse gases that covered sectors, including power plants, heavy industry and airlines within Europe, can emit.
The cap is divided into allowances, each permitting one tonne of carbon dioxide.
Companies must hold enough allowances to cover their emissions each year.
Companies can buy and sell allowances. Those that cut emissions cheaply can sell spare allowances; those that find cutting costly can buy more.
The cap falls over time, reducing total emissions.

Early problems

In its early years, the system faced problems:

Too many allowances: the cap was set too high, and many allowances were given away free.
Price collapse: after the 2008 financial crisis reduced industrial output, demand for allowances fell. Prices dropped to very low levels, giving little incentive to cut emissions.

Reforms

The EU introduced reforms, including a Market Stability Reserve from 2019, which removes surplus allowances from the market. Prices rose substantially, at times above 80 euros per tonne in recent years.

Results

Emissions from sectors covered by the EU ETS have fallen substantially since 2005, by around half by 2023 according to the European Commission. Research suggests the system contributed to these cuts, particularly by making coal power less competitive than gas and renewables.

The coal plant's choice

A power company can run an old coal plant or a newer gas plant. When carbon allowances cost 5 euros per tonne, coal is cheaper. When they cost 80 euros, the extra carbon cost makes coal more expensive than gas. The company switches to gas and renewables, cutting emissions. The carbon price changed the economics of the decision.

Carbon leakage and the border tax

A concern is carbon leakage: companies moving production to countries without carbon prices. The EU is introducing a Carbon Border Adjustment Mechanism, charging importers of goods like steel, cement and aluminium for their carbon content, with a transitional phase from 2023 and full charges from 2026. India and other exporters have raised concerns about its effects on their trade.

Thinking carbon markets let companies pollute freely

Companies can buy allowances, but the total is capped and falling. Trading ensures emissions are cut where it is cheapest, while the cap guarantees the overall reduction.

Key takeaways

The EU ETS, launched in 2005, is the largest cap-and-trade carbon market.
Early oversupply and low prices weakened it, prompting reforms.
Emissions in covered sectors have fallen by around half since 2005.
The EU's Carbon Border Adjustment Mechanism aims to prevent carbon leakage.