Emissions Trading Scheme Explained: What It Is, How It Works and What It Means for Global Trade

Emissions trading scheme defined An emissions trading scheme (ETS) — also called a cap-and-trade system — is a market-based mechanism for reducing greenhouse gas emissions. A government or authority sets a limit (the cap) on total CO2 emissions from covered sectors. Companies receive or buy allowances to cover their emissions. Those that emit less can sell surplus allowances; those that emit more must buy extra. The EU Emissions Trading System (EU ETS) is the world’s largest carbon market, covering power, heavy industry, aviation, and maritime shipping.

Table of Contents

1. How a Cap-and-Trade System Works
2. The EU ETS: The World’s Largest Carbon Market
3. EU Allowances (EUAs): The Tradeable Instrument
4. Phase History and the EUA Price Collapse
5. Sectors Covered: Power, Industry, Aviation, Maritime
6. Maritime Shipping: ETS Inclusion from 2024
7. How Shipping Lines Are Passing ETS Costs to Freight Rates
8. The UK ETS: Post-Brexit Divergence
9. CBAM: The Carbon Border Adjustment Mechanism
10. Frequently Asked Questions
11. Key Takeaways

How a Cap-and-Trade System Works

An emissions trading scheme has three moving parts: a cap, allowances, and a trading market.

The cap is the total volume of CO2 (and other greenhouse gases) that all covered companies are permitted to emit in a given period. The government sets this cap and decreases it over time. Each year, the cap falls. This is what creates pressure to reduce emissions — there is a finite, shrinking pool of permissions to pollute.

Allowances (also called permits or credits) represent the right to emit one tonne of CO2 equivalent. Companies receive a certain number for free (the allocation) or buy them at government auctions. At the end of each compliance year, every company must surrender enough allowances to cover its actual emissions. If a company emitted 1,000 tonnes of CO2, it must hand in 1,000 allowances.

The trading market allows allowances to move between companies. A company that reduced emissions through efficiency improvements or clean energy investment will have surplus allowances it doesn’t need — it can sell them. A company that is struggling to reduce emissions can buy extra allowances to cover its actual output. The price of allowances — set by supply and demand in the market — provides a financial signal. When the price is high, companies have a stronger incentive to invest in emission reductions. When it is low, reducing emissions may not be cost-competitive with simply buying allowances.

The elegance of the system: the government doesn’t dictate how companies reduce emissions. Companies choose the cheapest available reduction options, and the market efficiently allocates abatement across the economy.

The EU ETS: The World’s Largest Carbon Market

The EU Emissions Trading System began operating in 2005 under EU Directive 2003/87/EC. It was the world’s first large-scale international carbon market and remains the largest.

The EU ETS covers approximately 10,000 installations across the EU plus Norway, Iceland, and Liechtenstein. These installations — power stations, steel plants, cement kilns, glass furnaces, paper mills, aluminium smelters, aviation operators, and (from 2024) shipping companies — collectively account for approximately 40% of the EU’s total greenhouse gas emissions.

The system works in phases:

Phase	Period	Key Features
Phase 1	2005-2007	Pilot phase. Over-allocation of free allowances. EUA price collapsed to near zero.
Phase 2	2008-2012	Aligned with Kyoto Protocol commitment period. Financial crisis cut industrial emissions, oversupply problem worsened.
Phase 3	2013-2020	Shift from free allocation to auctioning (80%+ of power sector allowances). EU-wide cap (not national).
Phase 4	2021-2030	Strengthened cap reduction trajectory (2.2% per year until 2024, then 4.3%/year from 2024 onward). Inclusion of maritime shipping.

The EU ETS cap reduction is the core mechanism driving long-term emission reductions. As the cap shrinks, the scarcity of allowances increases, supporting the EUA price.

EU Allowances (EUAs): The Tradeable Instrument

An EU Allowance (EUA) is the basic unit of the EU ETS: the right to emit one tonne of CO2 equivalent. EUAs are:

• Auctioned by EU member states on energy exchange platforms (primarily EEX in Leipzig and ICE Futures Europe in London)
• Traded on secondary markets through ICE Futures Europe (the primary futures market), EEX, and over-the-counter broker markets
• Surrendered annually by covered companies by April 30, covering the prior year’s emissions

The ICE EUA futures contract (ticker: C) is the most liquid carbon futures instrument in the world. It trades in lots of 1,000 EUAs (1,000 tonnes CO2) and has active contracts for spot settlement, December of the current year, and several forward years.

EUA price history:

Period	EUA Price Range	Key Driver
Phase 1 (2005-07)	€0-30/tonne, crash to ~€0	Over-allocation; no banking between phases
Phase 2 (2008-12)	€5-30/tonne, crash to ~€3-5	Over-allocation, financial crisis reducing emissions
Phase 3 start (2013)	~€5-8/tonne	Structural oversupply still dominant
2018-2019 recovery	€15-25/tonne	Market Stability Reserve (MSR) implementation announced
2021 surge	€30-55/tonne	Post-COVID demand recovery, tighter caps, energy transition awareness
2022-2023 peak	€80-100/tonne	Energy crisis, gas-to-coal switching in power sector
2024 range	€50-75/tonne	Correction after peak; policy uncertainty about Phase 4

The most critical structural reform was the introduction of the Market Stability Reserve (MSR) in 2019. The MSR automatically removes surplus allowances from circulation when the total number outstanding exceeds a threshold, and releases them back when the surplus falls below a lower threshold. This mechanism prevents the oversupply that collapsed Phase 1 and Phase 2 prices.

Phase History and the EUA Price Collapse

Understanding why Phase 1 and Phase 2 prices crashed is important for assessing how credible the current system is.

Phase 1 (2005-2007): The EU allocated free allowances based on estimates of industrial emissions — but these estimates were too generous. When actual 2005 emissions data was released in May 2006, it became clear the market was over-allocated. EUA prices fell from around €30/tonne to below €1/tonne almost overnight. Because allowances couldn’t be “banked” into Phase 2, the surplus became worthless at Phase 1 end.

Phase 2 (2008-2012): Banking was allowed, but the financial crisis of 2008-2009 collapsed industrial output and emissions, creating a massive additional surplus of unused allowances. EUA prices fell from €15-20/tonne in 2008 to €3-5/tonne by 2012. The EU was criticised for designing a system with no mechanism to manage this structural surplus.

Post-Phase 3 reforms: The EU introduced the Market Stability Reserve in 2019. It also “back-loaded” allowances (delaying their release) to address immediate oversupply. These reforms, combined with the actual tightening of the cap from Phase 4 onward, are what drove the price recovery to €80-100/tonne in 2022-2023.

The lessons: a cap-and-trade system only works if the cap is actually binding (tight enough that companies need to buy allowances) and if there is a mechanism to absorb structural surplus. The EU ETS had neither in its early years, and prices reflected that failure.

Sectors Covered: Power, Industry, Aviation, Maritime

Power and heat generation: The largest sector covered. Power stations and industrial combustion plants above 20 MW thermal capacity. The power sector was the primary target of Phase 3 because it had the most cost-effective decarbonisation options (switching from coal to gas to renewables).

Heavy industry: Steel, cement, aluminium, glass, ceramics, paper, refining. These sectors receive some free allocation based on benchmarks (the most efficient installations in each sector), but allocation is phased down over time toward full auctioning.

Aviation: Aviation within the European Economic Area (EEA) has been covered since Phase 3. International flights (outside the EEA) were initially excluded; the extension of coverage to international aviation remains contested under ICAO negotiations.

Maritime shipping (from 2024): The most significant recent expansion. From January 2024, shipping companies must surrender EUAs for CO2 emissions from voyages:

• 100% for voyages between EU ports
• 50% for voyages between an EU port and a non-EU port
• Coverage: vessels above 5,000 gross tonnes

The inclusion is being phased in: 40% of emissions must be covered in 2024, 70% in 2025, and 100% from 2026.

Maritime Shipping: ETS Inclusion from 2024

The extension of the EU ETS to maritime shipping is the most consequential regulatory change for the shipping industry since the introduction of sulphur limits (IMO 2020).

How it works: The shipping company responsible for a vessel (typically the shipowner or the company named as responsible in the ship’s safety management system) must register in the EU MRV (Monitoring, Reporting, Verification) system and surrender EUAs for their CO2 emissions on covered voyages.

The compliance party is the Document of Compliance holder (the company with overall responsibility for the vessel’s operation, usually the commercial manager). This is important for contracts of affreightment and charterparty negotiations — the party surrendering allowances needs to recover that cost from whoever is operating or chartering the vessel.

For a practical example: a Panamax bulk carrier carrying Brazilian iron ore from Santos to Rotterdam (an EU/non-EU voyage) in 2025 emits approximately 3,500 tonnes of CO2 on that voyage. In 2025, 70% of those emissions (2,450 tonnes) must be covered by EUAs. At €60/tonne, that is €147,000 in ETS compliance cost for a single voyage.

Per TEU equivalent cost for container shipping on EU routes: estimates in 2024 ranged from $10-50 per TEU depending on route length, vessel efficiency, and EUA price.

How Shipping Lines Are Passing ETS Costs to Freight Rates

Shipping lines have moved quickly to recover EU ETS compliance costs from cargo customers.

ETS surcharges: Major container shipping lines introduced explicit EU ETS surcharges from early 2024. CMA CGM, Hapag-Lloyd, MSC, and Maersk all publish EU ETS surcharges — typically expressed per TEU for each voyage type (EU-EU, EU-non-EU inbound, EU-non-EU outbound).

Typical surcharge levels (2024): Approximately $10-50 per TEU for intra-European routes, and $20-80 per TEU for Asia-Europe routes with EU port calls, depending on route and EUA price at time of calculation.

These surcharges are indexed to EUA prices and updated periodically. When EUA prices move, surcharges adjust with a short lag.

For bulk carriers and tankers, EU ETS costs are typically negotiated in voyage charterparty agreements. Charter parties now routinely include provisions specifying which party is responsible for obtaining and surrendering EUAs, with reimbursement clauses where applicable.

For importers and supply chain managers: EU ETS costs are now a real, quantifiable component of shipping costs for cargo into, out of, or within the EU. They need to be built into landed cost calculations and budgets.

The UK ETS: Post-Brexit Divergence

When the UK left the EU in January 2021, it exited the EU ETS. From May 2021, the UK launched its own UK Emissions Trading System (UK ETS), which largely mirrors the EU ETS in structure.

Key similarities with EU ETS:

• Same cap-and-trade structure
• Same sectors covered (power, heavy industry, aviation within UK)
• UK ETS allowances (UKAs) priced separately but generally correlated with EUA prices

Key differences from EU ETS:

• UK ETS does not yet include maritime shipping (the EU ETS maritime inclusion does not extend to UK)
• UK ETS has a different (and generally more generous) initial cap trajectory
• UK ETS allowances (UKAs) trade on ICE Futures Europe separately from EUAs; prices have historically been lower than EUA prices
• UK ETS started with a price support mechanism (cost containment measures) that EU ETS lacks in the same form

In 2024, UK ETS allowance prices ranged from approximately £30-55/tonne CO2 — generally 10-20% below comparable EUA prices.

The practical implication for global commodity traders: a UK shipment or manufacturing step does not currently incur maritime ETS costs, but industrial emissions from UK plants do carry UK ETS costs. Supply chains that span both UK and EU face two separate carbon pricing regimes with different prices and slightly different rules.

CBAM: The Carbon Border Adjustment Mechanism

The Carbon Border Adjustment Mechanism (CBAM) — established by EU Regulation 2023/956 — is directly linked to the EU ETS and is designed to prevent carbon leakage.

Carbon leakage is the risk that European manufacturers facing EU ETS carbon costs will lose market share to imports from countries without equivalent carbon pricing — or that European production moves offshore to avoid the carbon cost, shifting emissions elsewhere while achieving no global reduction.

CBAM addresses this by placing a carbon cost on imports of specific carbon-intensive goods from non-EU countries.

Sectors covered initially:

• Iron and steel (including some downstream products)
• Aluminium
• Cement
• Fertilizers (ammonia, nitric acid, and derived products)
• Electricity
• Hydrogen

Timeline:

• October 2023 – December 2025: Transitional phase — EU importers of covered goods must report embedded carbon content but no payment is required.
• From January 2026: Full operation — importers must buy CBAM certificates at a price linked to the weekly average EU ETS auction price.

How CBAM works in practice: An EU importer of steel from India calculates the CO2 embedded in the steel production (in tonnes per tonne of steel). It subtracts any carbon price already paid in India under a domestic carbon scheme. It then purchases CBAM certificates for the remaining embedded emissions at the current EU ETS price.

For commodity importers and procurement teams: CBAM means that the effective carbon cost of importing steel, aluminium, fertilizers, and cement into the EU now includes EU ETS pricing — even if the producer is outside the EU. This changes the competitive landscape for materials procurement and is reshaping trade flows for affected commodities.

Frequently Asked Questions

What is the difference between an ETS and a carbon tax?

A carbon tax sets a fixed price per tonne of CO2 and lets emissions vary. An ETS sets a fixed quantity of allowable emissions (the cap) and lets the price vary. Under an ETS, the environmental outcome (total emissions reduction) is guaranteed by the cap; the cost is uncertain. Under a carbon tax, the cost is certain but the emission reduction is uncertain. Both are market-based approaches to reducing emissions.

What happens if a company doesn’t surrender enough EUAs?

A company that fails to surrender enough allowances by the April 30 deadline faces a penalty of €100 per tonne of CO2 shortfall (indexed to inflation in Phase 4), plus it must still surrender the missing allowances in the following year. This penalty is severe and has been consistently enforced.

Why did EU ETS prices crash in Phase 1 and Phase 2?

In Phase 1, the EU over-allocated free allowances based on estimates that were too generous. When real emissions data showed the market was over-supplied, prices fell to near zero. Banking allowances between Phase 1 and Phase 2 was not allowed, so the surplus became worthless. In Phase 2, the 2008-2009 financial crisis reduced industrial output and emissions dramatically, creating a structural surplus that kept prices depressed until the Market Stability Reserve was introduced.

How do shipping companies calculate their ETS liability?

Shipping companies report their CO2 emissions per voyage under the EU MRV (Monitoring, Reporting, Verification) system. For EU ETS compliance, covered emissions are calculated as: (fuel consumed on covered voyage in tonnes) × (CO2 emission factor for fuel type). The company then surrenders EUAs equal to the required percentage of those covered emissions (40% in 2024, 70% in 2025, 100% from 2026).

What does CBAM mean for a commodity importer?

If you import steel, aluminium, cement, fertilizers, or electricity into the EU, CBAM will require you to report embedded carbon content from October 2023, and purchase CBAM certificates from January 2026. The certificate price is linked to EU ETS prices. The practical effect: carbon-intensive materials produced in countries without carbon pricing will become more expensive to import into the EU, narrowing the cost advantage they currently enjoy over EU producers who pay EU ETS costs.

How does the UK ETS compare to the EU ETS in 2024?

Both are cap-and-trade schemes covering similar sectors. UK ETS allowances (UKAs) typically trade at £30-55/tonne CO2, roughly 10-20% below EU ETS prices. The UK ETS does not yet include maritime shipping. The two systems are not linked — a UK company cannot use UKAs to satisfy EU ETS obligations or vice versa. Post-Brexit, the UK has indicated interest in eventually linking the two schemes, but no timeline has been established.

Key Takeaways

• An ETS (cap-and-trade system) sets a total emissions limit, issues tradeable allowances, and requires companies to surrender one allowance per tonne of CO2 emitted.
• The EU ETS is the world’s largest carbon market, operating since 2005 and covering approximately 40% of EU greenhouse gas emissions from power, heavy industry, aviation, and (from 2024) maritime shipping.
• EU Allowances (EUAs) are traded on ICE Futures Europe; prices collapsed in Phase 1 and Phase 2 due to over-allocation, recovered after 2019 Market Stability Reserve reforms, and peaked near €100/tonne in 2022-2023.
• Maritime shipping inclusion phases in: 40% of emissions covered in 2024, 70% in 2025, 100% from 2026 — adding real, quantifiable per-voyage carbon costs for EU-touching voyages.
• Shipping lines have introduced EU ETS surcharges (typically $10-80 per TEU depending on route) to recover compliance costs from cargo customers.
• The UK ETS mirrors the EU ETS in structure but runs separately with lower prices (approximately £30-55/tonne); maritime shipping is not yet included in the UK scheme.
• CBAM (Carbon Border Adjustment Mechanism) extends EU ETS carbon costs to imports of steel, aluminium, cement, fertilizers, and hydrogen from non-EU countries, preventing carbon leakage; full operation begins January 2026.
• For supply chain professionals, EU ETS costs are now a real budget line for shipping and procurement teams working with EU-touching cargo or materials.

Related Reading

To deepen your understanding of the topics covered in this article, explore these related guides: the European programme that pioneered this policy approach, how carbon permit prices feed through to power generation costs and the new category of price exposure these schemes create for emitters.