The EU Emissions Trading System (EU ETS) is a cornerstone of the EU’s policy to tackle climate change by reducing GHG emissions in a cost-effective and economically efficient way in the industry and aviation sectors. It contributes to the EU’s climate neutrality objective and applies the ‘polluter pays principle’, which means that those who emit the most should pay the most.
It “seeks to promote investments in emission reductions by making energy-intensive business as usual expensive” and “offers a great opportunity for the EU to shift funding from polluting activities to climate action, innovation and energy sector modernisation.”[2]
Essentially, the EU has given CO2 a price by creating the ETS, whereby incentives are created to reduce emissions. The ETS has already achieved a reduction of emissions of 47%, between 2005 and 2023. The reform in 2023 announced a more ambitious reduction of 62% by 2030, “this would bring the cap to zero by 2039” for the industries it covers.[3]
How does the ETS work
To make the use of fossil fuels more expensive and incentivise renewable and clean energy, “companies must buy or receive allowances corresponding to their CO2 emissions”. Following a ‘cap-and-trade’ approach, “the EU sets a cap on how much CO2 can be emitted”. This cap decreases each year. For every tonne of CO2 that companies emit in one year, they need to have a European Emission Allowance (EUA). Companies need to buy these EUA’s and can trade them between each other and after every year, “the companies surrender enough allowances to cover their full emissions”.
If companies emit more CO2 than they have bought emission allowances for, they face a fine. This fine is €100 per excess tonne CO2. This also incentivises companies to mitigate their emissions “by investing in energy efficiency as they can sell excess allowances.”
The ETS creates revenue every year, this goes “mainly to member states’ budgets, or flow into the EU-wide Innovation Fund and the Modernisation Fund.”[4]
ETS reform of 2023
At the end of 2022 the Commission agreed to reform the ETS system to broaden the scope to the transport sector and heating fuels. The key changes cover the following aspects: A new reduction target, as already mentioned above, the ETS should reduce 62% of emissions by 2030; Member states need to spend all of their ETS revenues on climate-related activities; Emissions from shipping will be included into the scope of ETS; There will be a phase out of the free emission allowances for products, “from 2026, free allocation should be conditional on investments in techniques to increase energy efficiency and reduce emissions”; The ETS will be applicable for intra-European flights, the EU “agreed to phase-out free allocation to aircraft operators and to move to full auctioning of allowances by 2026 to create a stronger price signal”; The market stability reserve will be reformed, this mechanism “removes allowances from the market or distributes them by adjusting the auction volumes in subsequent years”.[5]
The new ETS scheme
Since the EU ETS was longtime seen as a toothless mechanism for climate action because of the low prices for CO2 allowances, a new ETS scheme will be put into place. The ETS II will have a broader scope, it will cover the transport, building, and additional industrial sectors.
What changes with ETS II?
This new scheme will be ready in 2027 and will work separately from the original ETS up until the early 2030s when a merge should be happening. ETS II will also use the ‘cap-and-trade’ system like ETS I, but it will additionally cover upstream emissions as well, this means it is also applicable to distributors that supply fuels. “Those suppliers must “surrender allowances for their verified emissions corresponding to the quantities of fuels they have released for consumption”.”[6] ETS II “includes a price stability mechanism” which means that additional allowances can be released if the price of an allowance in ETS II rises above €45 during the first three years.
Similar to ETS I, Member States should spend their revenues on climate action and social measures. Part of these “revenues will be used for EU Social Climate Fund to support vulnerable households and micro-enterprises”.
Auctioning
In the ETS II, allowances will only be placed on the market through auctioning rather than allocation. This means that “the allowances in ETS II will not be fungible with allowances traded in the existing ETS” and there will be no more free allocation of allowances. This is because “auctioning is the most transparent method for allocating emission allowances and puts into practice the ‘polluter-pays-principle’”. “Businesses covered by EU ETS have to buy an increasing proportion of allowances through auctions.” Auctioning will take place in accordance with the Auctioning Regulation and the ETS Directive. It will also be used for allowances that were “made available to the Innovation Fund and the Modernisation Fund”.[7]
Furthermore, Member States need to use at least 50% “of auctioning revenues or the equivalent in financial value for climate and energy-related purposes.” Additionally, Member States are required to report annually in “the Carbon Market Report” regarding “the amounts and use of the revenues generated“. The auctioning is done on auctioning platforms.[8]
Annual compliance cycle
For the ETS to operate effectively, “the monitoring and reporting of GHG emissions must be robust, transparent, consistent and accurate”.[9] This is why the ETS compliance cycle, was created, which consists of “the annual procedure of monitoring, reporting and verification (MRV)”.[10]
For ETS II, the regulated entities must “hold a GHG emissions permit by 1 January 2025”, together with an approved plan “for the monitoring and reporting of their annual emissions.” These entities need to submit an emission report every year and from 2026, this data will need to be verified by an accredited verifier. The Commission has set out the rules in two regulations, the Monitoring and Reporting Regulation (MRR) and Accreditation and Verification Regulation (AVR), which will be adopted this year. For further guidance the Commission has also provided guidance documents on its website.
[1] Art.1 Directive (EU) 2023/959 of the European Parliament and the Council of 10 May 2023 amending Directive 2003/87/EC establishing a system for greenhouse gas emission allowance trading within the Union and Decision (EU) 2015/1814 concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading system (ETS); LIFE ETX (2021) EU ETS 101 – A beginner’s guide to the EU’s Emissions Trading System, 6.
[2] LIFE ETX (2021) EU ETS 101 – A beginner’s guide to the EU’s Emissions Trading System, 4.
[3] https://www.cleanenergywire.org/factsheets/understanding-european-unions-emissions-trading-system.
[4] https://www.cleanenergywire.org/factsheets/understanding-european-unions-emissions-trading-system.
[5] https://www.cleanenergywire.org/factsheets/understanding-european-unions-emissions-trading-system.
[6] https://www.cleanenergywire.org/factsheets/understanding-european-unions-emissions-trading-system.
[7] https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets/auctioning_en.
[8] https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets/auctioning_en.
[9] https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets/monitoring-reporting-and-verification-eu-ets-emissions_en.
[10] https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets/ets2-buildings-road-transport-and-additional-sectors_en.