The EU Emissions Trading System (EU ETS) is a cornerstone of the European Union’s policy to combat climate change and a key tool for reducing greenhouse gas emissions, cost-effectively.
Here’s a basic breakdown of what the EU ETS is all about:

Cap-and-trade Principle
The EU ETS is based on the ‘cap and trade’ principle, where a cap is set on the total amount of certain greenhouse gases that can be emitted by the installations covered by the system. The cap is reduced over time so that total emissions fall.

Allowances and Trading
Within the cap, companies receive or purchase emission allowances, which they can trade with one another as needed. Each allowance gives the holder the right to emit one tonne of CO2 or the equivalent amount of another greenhouse gas.

Coverage
The EU ETS covers more than 11,000 power stations and industrial plants in 31 countries, as well as airlines. These are the sectors that produce a significant amount of overall emissions, such as power generation, iron and steel production, cement manufacturing, and others, including shipping.

Reducing Emissions
Companies must have enough allowances to cover their emissions, otherwise heavy fines are imposed. If they reduce their emissions, they can keep the spare allowances to cover their future needs or they can sell them to another company that is short of allowances.

Phases
The EU ETS is in its fourth trading phase (2021-2030), which aims to reduce greenhouse gas emissions from these sectors by 43% compared to 2005 levels. It’s structured in distinct trading periods known as phases. The system has become progressively stricter, with more sectors and gases included, a steadily decreasing emissions cap, and a higher share of allowances being auctioned rather than allocated for free.

International Linkages
The EU ETS is designed to be compatible with other ETS systems globally. This is towards building a global network of ETS systems which could ensure the cost-effective reduction of emissions on a global scale.

Innovation and Modernization
The system also promotes the innovation and uptake of low-carbon technologies by investing in various funds, like the Innovation Fund and the Modernisation Fund, which support the transition to a low-carbon economy in the EU.

Despite its pioneering role however, the EU ETS has faced several challenges and criticisms over time.

1. Oversupply of Allowances: A significant problem for the EU ETS has been the surplus of emission allowances, which has sometimes led to a price too low to encourage the necessary investment in low-carbon technologies.

2. Economic Recession: The 2008 economic downturn saw a reduction in industrial activity, leading to reduced emissions. This made many allowances redundant, further depressing prices and undermining the incentive to invest in greener technologies.

3. Carbon Leakage: There is concern that the EU ETS could cause companies to relocate their production to countries with less stringent emissions constraints (carbon leakage), resulting in no net reduction in global emissions.

4. Market Fluctuations: The market-based approach subjects the EU ETS to the vagaries of market forces. Prices for emissions allowances can fluctuate widely, creating uncertainty for business planning and investment in low-carbon solutions.

5. Politically Driven Changes: Adjustments to the EU ETS often require political consensus among member states, which can be challenging to obtain. This can lead to compromises and adjustments that may dilute the effectiveness of the system.

6. Complexity and Administrative Burden: The system’s complexity can be a barrier to understanding and participation, especially for smaller firms. This adds to administrative costs and can detract from the primary goals of emissions reduction.

7. Interaction with Other Policies: The interplay between the EU ETS and other environmental policies, such as feed-in tariffs for renewables, can sometimes lead to overlapping regulations that reduce the overall efficiency of the market-based approach.

8. Enforcement Challenges: Ensuring compliance can be difficult, particularly given the international nature of the system and the need to monitor and verify emissions across a wide range of industries and countries.

9. Inequities and Fair Allocation: Allocating allowances can create inequities between sectors and companies, with some arguing that free allocations based on historical emissions give an unfair advantage to certain businesses.

Responses have been devised to address some of these challenges: the Market Stability Reserve (MSR) was introduced to reduce surplus allowances and stabilize the market; the EU is continually working to harmonize the system with global efforts; and measures such as benchmarking are used to allocate allowances more fairly.
These solutions continue to be refined as the EU ETS evolves in response to new challenges and the ongoing imperative of mitigating climate change.
Marex Media