The EU Emissions Trading System
The EU ETS is the world's oldest and most developed carbon market. Launched in 2005, it has gone through multiple phases, survived crises, and evolved into a robust system covering about 40% of EU emissions. Its lessons have shaped carbon pricing worldwide.
EU ETS at a Glance
| Feature | Details |
|---|---|
| Launch | 2005 |
| Current phase | Phase 4 (2021-2030) |
| Coverage | Power, industry, aviation, soon maritime |
| Emissions covered | ~1.4 billion tons CO2e (~40% of EU total) |
| Number of installations | ~11,000 |
| 2024 price | ~€80-85/ton |
| 2023 auction revenue | ~€43 billion |
The Four Phases
Phase 1 (2005-2007): Pilot
The learning phase. Key features:
- Free allocation based on historical emissions
- Limited data on actual emissions
- Cap set too loose
- Prices collapsed to zero in 2007
Phase 2 (2008-2012): First commitment period
Aligned with Kyoto Protocol commitments:
- Tighter cap than Phase 1
- Aviation added (intra-EEA)
- Financial crisis crashed demand
- Massive surplus accumulated
- Prices fell from €30 to under €10
Phase 3 (2013-2020): Major reforms
Significant structural changes:
- EU-wide cap (no national allocation plans)
- Auctioning became default for power
- Benchmarks for free allocation
- Market Stability Reserve introduced
- Prices recovered toward end of phase
Phase 4 (2021-2030): High ambition
Aligned with 2030 and 2050 targets:
- 62% reduction by 2030 (from 2005)
- Linear reduction factor 4.2%/year
- Strengthened MSR with cancellation
- Maritime added (2024)
- ETS II for buildings and transport (2027)
The EU ETS demonstrates that carbon markets can recover from setbacks. The surplus crisis of 2008-2017 was addressed through the MSR, and prices have risen substantially. Persistence and willingness to reform matter.
Key Design Features
Scope and coverage:
- All power and heat installations above 20 MW
- Energy-intensive industry (cement, steel, chemicals, etc.)
- Intra-EEA aviation
- Maritime shipping (from 2024)
The cap:
- EU-wide cap declining linearly
- Currently at 4.2% annual reduction
- Aligned with 55% by 2030 target
Allocation:
- Power sector: 100% auctioning
- Industry: Free allocation based on benchmarks
- Leakage-exposed sectors: 100% of benchmark
- Non-exposed sectors: Declining free allocation
The Market Stability Reserve:
- Withdraws allowances when surplus is high
- Releases when surplus is low
- Cancels excess allowances permanently
The Market Stability Reserve, implemented in 2019, fundamentally changed the EU ETS:
Before MSR:
- 2+ billion surplus allowances
- Prices stuck at €5-8
- No effective scarcity
- Investment signals absent
After MSR:
- Surplus being drained
- Prices rose to €80+
- Effective scarcity restored
- Strong investment signals
The mechanism: When surplus exceeds 833 million allowances, 24% of the excess is withheld from auctions. When surplus falls below 400 million, allowances are released. Since 2023, allowances in the MSR exceeding the previous year's auction volume are cancelled permanently.
Impact: By 2024, over 2.5 billion allowances had been cancelled through the MSR, permanently reducing the cumulative cap.
Lesson: Quantity-based adjustment mechanisms can restore price signals without explicit price controls.
Price History
| Year | Average price (€/ton) |
|---|---|
| 2005 | €22 |
| 2007 | €1 (Phase 1 collapse) |
| 2008 | €22 |
| 2012 | €7 |
| 2017 | €5 |
| 2019 | €25 |
| 2021 | €55 |
| 2023 | €85 |
Recent Developments
ETS II (2027):
A separate ETS for buildings and road transport covering fuel suppliers upstream. Includes a price ceiling and social climate fund.
Maritime shipping:
Ships calling at EU ports must surrender allowances for their emissions, phased in from 2024.
CBAM:
The Carbon Border Adjustment Mechanism applies to imports of cement, steel, aluminum, fertilizers, electricity, and hydrogen, phased in from 2023.
Fit for 55:
The 2021 legislative package increased ambition to 55% reduction by 2030, accelerating the cap decline.
Revenue Use
EU ETS revenue goes to member states, with requirements on use:
- At least 50% must be used for climate purposes
- In practice, most countries exceed this
- Common uses: building renovation, renewable energy, efficiency programs
- Some revenue goes to the Innovation Fund and Modernisation Fund
Lessons from the EU ETS
1. Start and learn
Phase 1 had problems, but starting created momentum for improvement.
2. Crises can be addressed
The surplus crisis was severe but was ultimately resolved through the MSR.
3. Ambition can increase
From modest Phase 1 targets to 55% by 2030, ambition has ratcheted up over time.
4. Market mechanisms work
With proper design, trading produces price signals that drive investment.
5. Political sustainability
Despite challenges, the EU ETS has survived 20 years and multiple political changes.
The EU ETS is like a house that has been extensively renovated. The original structure (market-based trading) remains, but almost everything else has been upgraded. The current system is far more sophisticated than what launched in 2005.
Looking Ahead
China's national ETS, while newer, now covers more absolute emissions than any other system. The next lesson examines China's approach to carbon pricing.