EU ETS Explained: How the Emissions Trading System Works

EU ETS defined The EU Emissions Trading System (EU ETS) is the world’s largest carbon market, operating since 2005. It is a cap-and-trade system that sets a total limit (cap) on CO2 and other greenhouse gas emissions from approximately 10,000 power stations, industrial plants, aviation operators, and (from 2024) shipping companies in the EU and EEA. Companies buy or receive EU Allowances (EUAs), each representing the right to emit one tonne of CO2. They surrender allowances to cover their actual annual emissions, trading any surplus or deficit on the open market.

Table of Contents

1. The Cap-and-Trade Mechanism in Detail
2. Phases of the EU ETS: 2005 to 2030
3. EU Allowances (EUAs): Price History and Trading Mechanics
4. Why EUA Prices Crashed — and What Fixed Them
5. Sectors Covered in EU ETS (Phase 4)
6. Maritime Shipping in the EU ETS from 2024
7. EU ETS 2: Road Transport and Buildings from 2027
8. CBAM: The Carbon Border Adjustment Mechanism
9. How Companies Comply: Registration, Monitoring, and Surrender
10. Frequently Asked Questions
11. Key Takeaways

The Cap-and-Trade Mechanism in Detail

Cap-and-trade is straightforward in concept but has important details in practice.

The cap is the total volume of greenhouse gases — measured in tonnes of CO2 equivalent (tCO2e) — that all companies covered by the EU ETS are permitted to emit collectively in a given year. The EU sets this cap, and it decreases each year. This annual reduction is what creates long-term pressure to reduce emissions.

Allocation is how companies receive allowances at the start of each year. There are two methods:

1. Free allocation: Some allowances are given to companies at no cost, based on benchmarks comparing their emissions to the most efficient installations in their sector. Free allocation is designed to protect internationally exposed industries from carbon leakage — the risk that production moves to non-EU countries to avoid carbon costs. The volume of free allocation is being gradually phased down.

1. Auctioning: Allowances not allocated for free are auctioned to companies. The power sector (electricity generators) receives almost no free allocation and must buy nearly all its allowances at auction. Revenue from these auctions goes to EU member states, many of which direct it to clean energy investment.

Compliance cycle: Every covered installation operates under an annual cycle:

• Monitor and report emissions throughout the year (via verified monitoring plans)
• By April 30 each year: surrender EUAs equal to actual prior-year emissions
• Any surplus allowances can be banked for future years or sold on the market
• Any shortfall requires purchasing additional EUAs (plus a penalty for non-compliance)

The compliance obligation is at the installation level, not company level. A steelmaker with three furnaces in two countries has three separate installation accounts, each with its own monitoring plan and surrender obligation.

Phases of the EU ETS: 2005 to 2030

The EU ETS has operated in four distinct phases, each with different rules and outcomes.

Phase 1 (2005-2007) — The Pilot Phase

The EU ETS launched on January 1, 2005. Phase 1 was explicitly called a “learning by doing” phase. The cap was set based on member state estimates of emissions — estimates that turned out to be too generous. Free allocation was nearly 100% of expected emissions.

When actual 2005 emissions data was released in May 2006, it became clear the market was significantly over-allocated. EUA prices fell from around €30/tonne to below €1/tonne. The Phase 1 allowances could not be banked into Phase 2, so any surplus became worthless at the end of 2007. The system delivered essentially no emissions reduction in Phase 1.

Phase 2 (2008-2012) — Kyoto Commitment Period

Phase 2 ran alongside the Kyoto Protocol commitment period. Banking was allowed — Phase 2 allowances could be carried forward into Phase 3. The cap was tighter than Phase 1. Aviation was added for intra-EU flights.

The 2008-2009 global financial crisis massively reduced industrial output and emissions, creating an enormous structural surplus of allowances. Companies that had invested in emissions reductions sold their surplus; companies that hadn’t didn’t need to buy. EUA prices fell from around €20 to below €5/tonne. The carbon price signal was too weak to drive significant investment decisions.

Phase 3 (2013-2020) — Major Reform

Phase 3 introduced fundamental structural changes:

• Single EU-wide cap (replacing national caps — member states lost their ability to set their own allocation levels)
• Power sector moved to near-full auctioning of allowances
• Annual linear reduction factor of 1.74% applied to the cap
• International aviation excluded from EU ETS for non-EU flights (following ICAO dispute)

Despite these reforms, the structural surplus from Phase 2 persisted into Phase 3. EUA prices remained depressed at €5-10/tonne until 2018.

Phase 4 (2021-2030) — Current Phase

Phase 4 is the most ambitious yet:

• Annual reduction factor increased to 4.3% per year from 2024 (up from 2.2% in 2021-2023), following the “Fit for 55” legislative package targeting 55% emission reductions by 2030
• Maritime shipping included from 2024
• Free allocation to industry being phased down in parallel with CBAM rollout
• EU ETS 2 established for road transport and buildings (separate market, launching 2027)

EU Allowances (EUAs): Price History and Trading Mechanics

EU Allowances (EUAs) are standardised, electronically registered instruments. Each EUA represents the right to emit one tonne of CO2 equivalent.

EUAs are:

• Auctioned on EEX (European Energy Exchange, Leipzig) and ICE Futures Europe (London)
• Traded on ICE Futures Europe (primary futures market) and EEX derivatives platforms
• Held in accounts within the EU Transaction Log (EUTL) — the central registry that tracks all EUA holdings, transfers, and surrenders

The ICE EUA futures contract (ticker: C) is the most actively traded carbon futures instrument globally. It trades in lots of 1,000 EUAs. December settlement is the most liquid contract, as it allows companies to hedge their full-year compliance position.

EUA price history summary:

Year	EUA Price Range (€/tonne)	Key Event
2005-2006	€10-30, then crash	Phase 1 over-allocation revealed
2007	<€1	Phase 1 end: surplus goes to zero
2008-2012	€5-20, then €3-5	Financial crisis surplus
2013-2017	€3-10	Structural oversupply persists
2018-2019	€10-25	Market Stability Reserve anticipation
2020	€15-32	COVID dip, then recovery
2021	€25-55	Phase 4 optimism, tighter cap awareness
2022	€55-100	Energy crisis, coal switching in power
2023	€60-100	Sustained high prices
2024	€50-75	Correction, CBAM/ETS2 uncertainty

The EUA price matters directly for any business covered by the EU ETS because it represents the cost of each tonne of CO2 emitted. At €65/tonne, a steel plant emitting 500,000 tonnes/year faces an annual carbon cost of €32.5 million — a significant business cost that affects competitiveness and investment decisions.

Why EUA Prices Crashed — and What Fixed Them

The EU ETS price history looks alarming if you don’t understand the cause. Here is what happened and what changed.

The problem (Phase 1 and 2): The EU set the cap based on estimates of industrial emissions. Those estimates were too generous — they assumed higher emissions than actually occurred, particularly because the EU was simultaneously mandating renewable energy growth that was cutting power sector emissions. The 2008-2009 recession then dramatically reduced industrial output, creating an even larger surplus. Companies held millions of unused allowances.

The attempted fix (back-loading, 2014): The EU temporarily withdrew 900 million EUAs from auctions in 2014 and 2015, delaying their return to the market (they were eventually put back in 2019-2020). This provided only temporary relief.

The structural fix (Market Stability Reserve, 2019): The Market Stability Reserve (MSR) is an automatic mechanism that:

• Removes allowances from auctions when the total number of allowances in circulation exceeds 833 million
• Returns allowances to the market when the circulation falls below 400 million
• Since 2023, permanently cancels allowances placed in the MSR above a threshold (rather than re-releasing them)

The MSR announcement in 2018 immediately caused EUA prices to rise, because market participants could see that the structural oversupply would be corrected. When the MSR became operational in January 2019, prices rose further. The combination of the MSR, the tighter Phase 4 cap trajectory (4.3%/year reduction), and inclusion of new sectors (maritime) has changed the structural picture fundamentally.

The EU ETS is now a genuinely binding constraint on covered emissions — the cap is tight enough that companies must actually reduce emissions or buy allowances. This is what a functioning carbon market looks like.

Sectors Covered in EU ETS (Phase 4)

The EU ETS currently covers:

Power and heat generation: All combustion installations above 20 MW thermal capacity. This includes power stations, combined heat and power plants, and large industrial boilers. The power sector represents roughly 45% of EU ETS covered emissions.

Heavy industry: Iron and steel, aluminium (from smelting), cement, lime, glass, ceramics, paper and pulp, chemical production (nitric acid, adipic acid), oil refining. These sectors collectively represent roughly 35% of covered emissions.

Aviation: Commercial flights within and between EU/EEA member states and Switzerland. Aviation represents approximately 3-4% of covered emissions (only intra-EEA flights are included; intercontinental flights are excluded pending ICAO’s CORSIA implementation).

Maritime shipping (from 2024): Shipping companies operating vessels above 5,000 gross tonnes on voyages to, from, or between EU ports. Coverage is 100% for intra-EU voyages, 50% for voyages between EU and non-EU ports. This represents a significant new sector — maritime shipping accounts for approximately 3-4% of global CO2 emissions, and a large share of that relates to EU trade.

Not covered: Road transport, residential and commercial heating, agriculture, and forestry are NOT covered by EU ETS 1. These sectors are covered by the separate Effort Sharing Regulation (ESR) at the member state level, and from 2027, road transport and buildings will have their own EU ETS 2.

Maritime Shipping in the EU ETS from 2024

The inclusion of maritime shipping in the EU ETS was formalised by EU Directive 2023/957, amending the original EU ETS Directive.

How it works:

Shipping companies (defined as the Document of Compliance holder — typically the shipowner or commercial manager) must:

1. Monitor and report CO2 emissions from covered voyages under the EU MRV (Monitoring, Reporting, Verification) Regulation. Monitoring plans must be approved before operating.

1. Open an ETS account in the European Union Transaction Log (EUTL) or a member state registry.

1. Surrender EUAs annually by September 30 (one year after the standard industrial surrender deadline) covering:

• 40% of 2024 emissions
• 70% of 2025 emissions
• 100% of 2026 and subsequent emissions

Coverage of voyage types:

• Intra-EU voyages (EU port to EU port): 100% of emissions covered
• Outbound voyages (EU port to non-EU port): 50% of emissions covered
• Inbound voyages (non-EU port to EU port): 50% of emissions covered
• Ports of call in EU waters (for ships not calling EU ports): covered proportionally

Fuels covered: CO2 from all fossil fuels. From 2024, methane (CH4) from LNG vessels and nitrous oxide (N2O) are added for future periods.

Estimated annual ETS cost per voyage type (illustrative, EUA = €65/tonne):

• Rotterdam to Hamburg (intra-EU, 30,000 DWT bulk carrier): approximately €30,000-50,000 per voyage
• Shanghai to Rotterdam (50% coverage, 180,000 DWT): approximately €200,000-350,000 per voyage

EU ETS 2: Road Transport and Buildings from 2027

EU ETS 2 is an entirely separate emissions trading system, established by Directive 2023/87/EU as part of the “Fit for 55” package. It will cover CO2 emissions from road transport fuels and heating fuels for buildings.

Key differences from EU ETS 1:

Feature	EU ETS 1	EU ETS 2
Start date	2005	2027
Covered entities	Industrial operators, power plants, shipping	Fuel distributors (fuel suppliers upstream)
Allowances	EUAs	EUA2s (separate instrument)
Price cap	No formal cap (MSR provides indirect constraint)	Price cap of €45/tonne until 2030 if prices spike too fast
Cap trajectory	Decreasing cap with MSR	Separate cap, reduced annually
Social Fund	Not applicable	Innovation and Social Climate Fund financed partly from ETS 2 revenues

EU ETS 2 covers fuel distributors — petrol and diesel suppliers, heating fuel distributors — rather than individual drivers or householders. The carbon cost would be embedded in fuel prices. At €45/tonne (the price cap), this adds approximately €0.10 per litre to petrol and diesel prices.

EU ETS 2 will launch in 2027 (potentially delayed to 2028 depending on economic conditions) with a transitional period. It creates a significant new carbon cost for road transport in Europe and has been politically controversial due to its consumer price impacts.

CBAM: The Carbon Border Adjustment Mechanism

CBAM is one of the most important trade policy developments of the decade. It extends the effective reach of EU ETS pricing to imports of carbon-intensive goods.

Why CBAM exists: If EU manufacturers pay €65/tonne for every tonne of CO2 they emit (through the EU ETS), and importers of similar goods from outside the EU do not pay any equivalent carbon cost, the EU manufacturers face an unfair competitive disadvantage. This is called carbon leakage — production shifts abroad to avoid EU carbon costs, and total global emissions don’t fall.

CBAM sectors:

• Iron and steel (including rebar, beams, wire, rails, tubes)
• Aluminium (including primary, secondary, and some downstream products)
• Cement
• Fertilizers (ammonia, nitric acid, urea, and compound fertilizers)
• Electricity
• Hydrogen

Timeline:

• October 2023 to December 2025: Transitional period. EU importers must report the embedded carbon content of covered imports quarterly. No financial obligation yet.
• January 2026: Full CBAM applies. Importers must purchase CBAM certificates at a price linked to the weekly average EU ETS auction price.

How CBAM certificates work: The importer calculates the embedded emissions in imported goods (using default values if actual production data is unavailable). They then subtract any carbon price already paid in the country of production. They purchase CBAM certificates for the remaining embedded emissions. At year-end, certificates are surrendered to match imported embedded emissions.

Practical example: A UK company exports 1,000 tonnes of steel to Germany. The steel has embedded emissions of 1.5 tonnes CO2/tonne of steel (1,500 tonnes total). The UK ETS price was equivalent to €30/tonne during production. The EUA price is €65/tonne. The CBAM obligation: (1,500 × (€65 − €30)) = 1,500 × €35 = €52,500 in CBAM certificates.

For commodity importers: CBAM is not just a compliance exercise. It changes the landed cost of importing steel, aluminium, cement, and fertilizers from non-EU countries into the EU, shifting the competitive landscape for materials sourcing.

How Companies Comply: Registration, Monitoring, and Surrender

For a company new to the EU ETS, the compliance process involves four steps.

Step 1 — Identify if you are covered: The EU ETS applies to specific types of installation above defined capacity thresholds. An installation operator must check whether their activities are listed in Annex I of the EU ETS Directive and whether their capacity meets the threshold (e.g., combustion installations above 20 MW thermal capacity).

Step 2 — Apply for a greenhouse gas permit: Covered installations must obtain a greenhouse gas emissions permit from the competent national authority (for example, the Environment Agency in England, or DREAL in France). The permit specifies the monitoring methodology to be used for measuring emissions.

Step 3 — Monitor and report emissions: Each installation must follow an approved monitoring plan, record fuel consumption and emissions data, and submit a verified annual emissions report by March 31 each year. The report must be verified by an accredited independent verifier before submission.

Step 4 — Surrender allowances by April 30: By April 30 each year, the installation must surrender EUAs equal to its verified prior-year emissions into the EU Transaction Log. The national registry transfers the surrendered EUAs to the European Commission. EUAs can be purchased on the open market (ICE, EEX, or through brokers) if the company doesn’t have enough from its free allocation.

Consequences of non-compliance: Missing the April 30 deadline triggers an automatic penalty of €100/tonne shortfall (indexed to EU inflation), and the shortfall must still be covered in the following year. Persistent non-compliance can result in withdrawal of the greenhouse gas permit, effectively shutting down operations.

For shipping companies, the surrender deadline is September 30 (six months later than industry) to allow for the compilation of verified annual emissions reports covering the January-December shipping year.

Frequently Asked Questions

What is an EU Allowance (EUA) worth?

As of 2024, EU Allowances traded in the range of €50-75 per tonne of CO2. The price reflects market supply and demand, current and anticipated future cap tightness, energy prices (which affect how much fossil fuel is burned in the power sector), and general economic conditions. EUA prices can and do change significantly — they ranged from below €5/tonne in 2013 to over €100/tonne in 2023.

Who has to register for the EU ETS?

Any operator of a covered installation in the EU (or EEA) must obtain a greenhouse gas permit from the relevant national authority and open an account in their national registry (which is part of the European Union Transaction Log). Shipping companies with vessels above 5,000 GT calling EU ports must register with an EU member state authority. Aviation operators flying within the EEA must register with a relevant administering member state.

What happens on April 30 each year?

April 30 is the annual ETS compliance deadline. By that date, every covered installation must have surrendered EUAs equal to its verified CO2 emissions for the previous calendar year. An installation that emitted 100,000 tonnes of CO2 in 2024 must surrender 100,000 EUAs by April 30, 2025. Companies that fail to comply face a €100/tonne penalty plus must still make up the shortfall.

What is the Market Stability Reserve and why does it matter?

The Market Stability Reserve (MSR) is an automatic mechanism that controls the supply of EUAs in the market. When the total number of allowances in circulation exceeds 833 million, the MSR removes allowances from upcoming auctions. This prevents the structural oversupply that crashed EUA prices in Phase 1 and Phase 2. The MSR, activated in 2019, is the primary reason EUA prices recovered from below €5/tonne to above €50/tonne.

What is EU ETS 2 and when does it start?

EU ETS 2 is a separate emissions trading scheme for road transport fuels and building heating fuels, to launch in 2027 (potentially 2028). Unlike EU ETS 1, which covers industrial installations directly, EU ETS 2 covers fuel distributors and suppliers upstream. The carbon cost would be passed through to petrol, diesel, and heating fuel prices. A price cap of €45/tonne applies until 2030. EU ETS 2 has its own separate allowances (EUA2s) and cap trajectory.

How is CBAM different from EU ETS?

EU ETS applies to industrial operators within the EU, requiring them to surrender allowances for their own emissions. CBAM applies to EU importers of specific carbon-intensive goods (steel, aluminium, cement, fertilizers, electricity, hydrogen), requiring them to account for the emissions embedded in what they import. CBAM links to EU ETS pricing — the CBAM certificate price mirrors the EU ETS auction price. Together, they aim to ensure both EU producers and importers face equivalent carbon costs.

Key Takeaways

• The EU ETS is the world’s largest carbon market, operating since 2005 through a cap-and-trade mechanism covering approximately 10,000 installations across power, industry, aviation, and (from 2024) shipping.
• EU Allowances (EUAs) represent the right to emit one tonne of CO2; they are traded on ICE Futures Europe and EEX, with the December futures contract being the most liquid instrument.
• EUA prices collapsed in Phase 1 and 2 due to over-allocation and the 2008-2009 recession; the Market Stability Reserve (active from 2019) corrected structural oversupply and prices recovered to €50-100/tonne.
• Maritime shipping is being phased into the EU ETS: 40% emissions coverage in 2024, 70% in 2025, 100% from 2026 — adding direct carbon costs per voyage for EU-touching ship calls.
• The annual compliance cycle requires companies to monitor emissions, submit a verified report by March 31, and surrender EUAs by April 30; failure incurs a €100/tonne penalty plus the outstanding surrender obligation.
• EU ETS 2 is a separate scheme covering road transport fuels and building heating — launching 2027, with a €45/tonne price cap through 2030 — substantially expanding the EU’s carbon pricing coverage.
• CBAM (Carbon Border Adjustment Mechanism) extends EU ETS carbon costs to imports of steel, aluminium, cement, fertilizers, and hydrogen; full operation from January 2026 means importers must pay for embedded carbon in goods from non-EU countries.
• For trade and supply chain professionals, EU ETS costs are now a material budget line for EU-touching operations — maritime surcharges, materials cost premiums from CBAM, and the trajectory of EUA prices all affect total landed costs.

Related Reading

To deepen your understanding of the topics covered in this article, explore these related guides: the broader policy concept behind cap-and-trade carbon markets, the power sector where EU allowance costs have the most direct impact and how steelmakers face different carbon costs depending on furnace technology.