What the EU Emissions Trading System Does

The EU Emissions Trading System (ETS) is a market-based program that puts a price on carbon dioxide and other greenhouse gases. Instead of setting strict limits on how much each factory or power plant can emit, the EU issues tradeable permits — each permit allows the holder to emit one metric ton of CO2 equivalent. Companies that emit less than their permit allowance can sell the extra permits; companies that emit more must buy additional permits or reduce their emissions. The system covers about 40% of the EU's greenhouse gas emissions, mainly from large industrial facilities and power generation.

The ETS began in 2005 and operates in phases, with each phase tightening the total number of permits available. This creates upward pressure on the carbon price over time, making it more expensive to pollute and more profitable to invest in cleaner technology. The system now covers the 27 EU member states plus Iceland, Liechtenstein, and Norway.

Key Takeaways

  • The EU ETS sets a declining cap on total emissions and issues tradeable permits that allow companies to emit carbon, creating a market price for pollution.
  • Covered sectors include power plants, refineries, steel mills, cement plants, and other large industrial facilities that emit more than set thresholds.
  • Companies can reduce emissions, buy permits from others, or invest in carbon offset projects to meet their obligations under the system.
  • The carbon price under the ETS has risen significantly since 2020, making emissions reductions more economically attractive to covered businesses.
  • Revenue from permit auctions funds climate and energy projects in member states, with some money directed to support lower-income households.

Which Facilities and Industries Are Covered

The ETS covers large emitters in specific sectors. Power plants that generate electricity or heat are included if they have a thermal input above 20 megawatts. Refineries, steel mills, cement plants, lime kilns, glass production, ceramics, pulp and paper mills, and chemical plants are covered if they exceed certain production thresholds. The system also covers airlines operating flights within the ETS zone, though with some exemptions for flights to and from non-ETS countries.

Small emitters below the threshold for their sector are not covered by the ETS. Instead, many EU member states run their own national emissions trading schemes or carbon tax systems for smaller businesses. A company's inclusion depends on both the sector it operates in and the scale of its emissions — the EU publishes a list of covered installations that updates regularly as facilities expand, close, or change operations.

How Permits Are Issued and Traded

The EU sets a total emissions cap for all covered installations combined, then issues permits equal to that cap. In the current phase (2021–2030), the cap declines by 2.2% each year, meaning fewer permits are available annually. The EU distributes permits through three main routes: free allocation to certain industries, auctions where companies bid for permits, and set-asides for new entrants and sectors at risk of relocating outside the EU.

Once issued, permits can be bought and sold on secondary markets. A company that reduces emissions below its permit allowance can sell unused permits to another company that needs them. This trading creates a carbon price — the market value of one permit to emit one ton of CO2. The price fluctuates based on supply and demand, economic conditions, and expectations about future policy. Since 2020, the ETS carbon price has risen from around €5 per ton to over €80 per ton in some periods, reflecting both tighter caps and increased climate ambition.

Companies must surrender permits equal to their actual emissions each year. If a company emits more than its permits allow and does not buy additional permits, it faces a penalty of €100 per ton of excess emissions (adjusted annually for inflation) plus the requirement to surrender permits retroactively.

How the System Reduces Emissions

The ETS reduces emissions through two mechanisms: the declining cap forces total emissions down regardless of individual company choices, and the rising carbon price makes it economically rational for companies to invest in efficiency and clean technology. A steel mill facing a carbon price of €80 per ton may find it cheaper to install electric arc furnaces or switch to hydrogen than to buy permits indefinitely. A power plant may retire coal units and invest in wind or solar capacity.

Companies can also reduce their ETS obligations by investing in carbon offset projects outside the EU, though the EU has tightened rules on which offsets count. Some sectors, particularly those competing globally, receive free permits to avoid relocating to countries with weaker climate rules — a policy called carbon leakage protection. As the cap tightens, the proportion of free permits declines, pushing more companies toward paid permits and emissions reductions.

Revenue from Permit Auctions and How It Is Used

When the EU auctions permits, the revenue goes to member states. The EU requires that at least 50% of auction revenue be used for climate and energy purposes — funding renewable energy projects, energy efficiency upgrades, public transport, and climate research. Member states have flexibility in how they allocate the remainder, though the EU encourages spending on climate action and supporting vulnerable households affected by the transition.

In 2023 and 2024, auction revenues reached record levels as carbon prices climbed, generating tens of billions of euros annually across the EU. Some member states have used this revenue to fund just transition programs, helping workers and communities dependent on fossil fuel industries shift to new economic activities. Others have directed funds to household energy support, recognizing that higher carbon prices can increase energy costs for consumers.

The Carbon Border Adjustment Mechanism and Future Changes

The EU introduced the Carbon Border Adjustment Mechanism (CBAM) in 2023 to prevent companies from relocating to countries with weaker climate rules and to level the playing field for EU producers. CBAM requires importers of certain goods — cement, steel, aluminum, fertilizers, electricity, and some organic chemicals — to purchase CBAM certificates reflecting the carbon content of those goods. This mirrors the cost that EU producers face under the ETS.

The ETS continues to evolve. The EU has proposed extending the system to maritime shipping and potentially to buildings and road transport in future phases. A separate ETS for buildings and transport is being designed to operate alongside the main system. These expansions would increase the sectors covered and the total emissions subject to carbon pricing, accelerating the transition to a low-carbon economy.

Frequently Asked Questions

How does the ETS differ from a carbon tax?

A carbon tax sets a price per ton of emissions and lets the quantity of emissions fall where it may. The ETS sets a cap on total emissions and lets the price fluctuate based on supply and demand. Both achieve emissions reductions, but the ETS guarantees the environmental outcome while the carbon tax guarantees the price. The EU uses the ETS for large emitters and some member states use carbon taxes for smaller ones.

Can companies outside the EU participate in the ETS?

No, the ETS is limited to installations within the EU and participating countries (Iceland, Liechtenstein, Norway). However, companies outside the EU that export to the EU may be affected indirectly through CBAM, which applies to imports of certain carbon-intensive goods. Non-EU companies can also invest in offset projects that generate credits usable under the ETS.

What happens if a company's emissions drop below its permit allowance?

The company can sell its unused permits to other companies that need them, or bank the permits for use in future years. This creates an incentive to reduce emissions early, since the permits retain value and can be monetized. Banking rules vary by phase, but generally permits can be carried forward to the next year.

Does the ETS cover emissions from cars and home heating?

Currently, the main ETS does not cover cars or home heating directly. Emissions from road transport and buildings are regulated through other EU policies, such as fuel efficiency standards for vehicles and building energy codes. However, the EU is designing a separate ETS for buildings and road transport that would begin in the late 2020s, extending carbon pricing to these sectors.

How is the carbon price determined?

The carbon price emerges from trading on secondary markets where permits are bought and sold. The price reflects expectations about future supply and demand, economic growth, weather (which affects renewable energy output), and policy changes. Major exchanges in Europe publish daily carbon prices, and financial institutions offer futures contracts on ETS permits, allowing companies to hedge their exposure.