What the EU Emissions Trading System is and why it exists

The European Union Emissions Trading System, or EU ETS, is a market-based program that puts a price on carbon dioxide and other greenhouse gases. Instead of setting strict rules about how much pollution each factory or power plant must cut, the EU ETS lets companies buy and sell permits to emit. The system covers large industrial facilities, power plants, and airlines operating within EU member states, plus Iceland, Liechtenstein, and Norway.

The program started in 2005 because the EU committed to reducing greenhouse gas emissions under international climate agreements. Rather than ban pollution outright, the EU decided to make pollution expensive. When pollution costs money, companies have a financial reason to pollute less — either by changing how they operate, investing in cleaner technology, or buying permits from companies that polluted less than allowed.

The EU ETS is the world's largest carbon market by volume and value. It covers roughly 40 percent of the EU's total greenhouse gas emissions, making it one of the main tools the EU uses to meet its climate targets.

Key Takeaways

  • The EU ETS requires large emitters to hold permits for every ton of carbon dioxide they release, and the number of permits shrinks each year.
  • Companies that emit less than their permit allowance can sell unused permits to other companies, creating a market price for carbon.
  • The system covers power plants, factories, and airlines, but not cars, homes, or small businesses.
  • Revenues from permit auctions fund climate and energy projects across the EU, and some money goes to lower-income member states.
  • The EU has tightened the system over time, cutting the total number of permits available and expanding which industries must participate.

How permits and allowances work in the system

At the heart of the EU ETS is the allowance — a permit that lets a company emit one metric ton of carbon dioxide equivalent. Each year, the EU sets a total number of allowances available across all covered sectors. Companies that operate large facilities receive allowances either free or by purchasing them at auction.

At the end of each year, every covered company must hold enough allowances to match the emissions it produced. If a company emitted 100,000 tons of CO2 during the year, it must surrender 100,000 allowances. If it has more allowances than it needs, it can sell the extras. If it has fewer, it must buy them from other companies or face a financial penalty.

The EU reduces the total number of allowances available each year — currently by about 4.2 percent annually, though this rate may increase. As allowances become scarcer, their price typically rises, which pushes companies harder to cut emissions or invest in cleaner processes.

Which industries and facilities are covered

The EU ETS covers large emitters: power plants, oil refineries, steel mills, cement factories, paper mills, chemical plants, and commercial airlines. A facility generally enters the system if it produces more than a certain amount of energy or material. For example, a power plant must be covered if it has a thermal input greater than 20 megawatts.

The system does not cover cars, trucks, homes, or small businesses. Emissions from transport fuels, heating buildings, and agriculture are handled through separate EU policies. However, the EU has expanded the system over time — in 2024, it began including emissions from maritime shipping, and it is preparing to launch a separate carbon market for transport fuels and building heating by 2026.

Within the covered sectors, some companies receive free allowances based on historical emissions or production benchmarks, while others must buy all their allowances at auction. The EU has gradually shifted toward auctioning more allowances rather than giving them away, to increase the financial pressure to reduce emissions.

How the carbon price is set and what it means

The price of an allowance is not set by government decree — it emerges from trading. Companies that need allowances bid to buy them; companies with extras offer to sell. The price fluctuates based on supply and demand, just like a stock price. When the economy is strong and factories run at full capacity, demand for allowances rises and prices climb. When the economy slows, demand falls and prices drop.

The EU ETS price has ranged widely since the system began. In the early years, prices were very low because too many allowances were issued. By 2023, prices had risen to roughly €80 to €90 per ton of CO2, though prices vary month to month and year to year. A higher price makes it more expensive for companies to pollute, so they have stronger incentive to cut emissions or switch to cleaner fuels.

Companies pass some of these costs to consumers — a power plant that pays more for carbon permits may charge higher electricity prices. This is intentional: the EU wants the cost of pollution to be visible throughout the economy, so that consumers also feel pressure to use less energy and buy cleaner products.

How revenue from permit sales is used

When the EU auctions allowances, the money goes to member state governments, not to a central EU fund. Each member state decides how to spend its auction revenue, though the EU requires that at least 50 percent go toward climate and energy projects. These projects might include renewable energy infrastructure, energy efficiency upgrades to buildings, or support for workers in coal regions transitioning to new industries.

The EU also created the Innovation Fund, which receives revenue from a portion of auctioned allowances. This fund finances projects that develop and deploy low-carbon technologies — for example, carbon capture equipment, green hydrogen production, or battery manufacturing. The Innovation Fund is separate from national spending and targets technologies that are not yet cost-competitive but could become so with investment.

Additionally, the EU set aside allowances to support lower-income member states through the Modernisation Fund. This fund helps Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Slovakia invest in clean energy and energy efficiency.

The Carbon Border Adjustment Mechanism and its purpose

One challenge the EU faced was that companies covered by the ETS might move production to countries outside the EU where carbon rules are weaker or nonexistent. This is called carbon leakage. To prevent it, the EU introduced the Carbon Border Adjustment Mechanism, or CBAM, which began as a pilot in 2023 and will become mandatory in 2026.

The CBAM works like a tariff on imports. When goods such as steel, cement, or fertilizer enter the EU from countries without equivalent carbon pricing, importers must pay a fee based on the carbon emissions embedded in those goods. The fee is calculated using the EU ETS carbon price. This makes imported goods more expensive if they come from high-emission production, which levels the playing field between EU companies (which pay for emissions) and foreign competitors (which may not).

The CBAM covers cement, steel, iron, aluminum, fertilizers, and electricity. The EU plans to expand it to other sectors over time. Revenue from CBAM fees goes into the EU budget and is intended to support climate action and help lower-income countries adapt to climate change.

How the system has changed and what comes next

The EU ETS has gone through several phases since 2005, each one tightening the rules. In the first phase (2005–2007), too many allowances were issued and the price collapsed. The second phase (2008–2012) reduced allowances and introduced stricter rules. The third phase (2013–2020) moved toward auctioning instead of free allocation and cut allowances faster. The fourth phase (2021–2030) continues cutting allowances and expands the sectors covered.

Looking ahead, the EU has committed to cutting emissions by at least 55 percent by 2030 compared to 1990 levels, and to net-zero emissions by 2050. To reach these targets, the EU is tightening the ETS further — increasing the annual reduction rate for allowances and expanding coverage to maritime shipping and, eventually, to transport fuels and building heating through a separate market.

The EU is also exploring a potential link with other carbon markets outside the EU, such as Switzerland's system. Linking markets would allow companies in different regions to trade allowances with each other, potentially lowering the overall cost of cutting emissions globally.

Frequently Asked Questions

Does the EU ETS cover my car or home heating?

No. The EU ETS covers only large industrial facilities, power plants, and commercial airlines. Emissions from cars and home heating are addressed through separate EU policies, though the EU is creating a new carbon market specifically for transport fuels and building heating that will start in 2026.

What happens if a company doesn't have enough allowances at the end of the year?

The company must buy allowances from other companies to cover the shortfall. If it fails to surrender enough allowances, it faces a penalty of €100 per ton of CO2 (adjusted annually for inflation) plus a requirement to surrender allowances in the following year. Repeated violations can result in facility closure.

Why does the EU ETS price keep changing?

The price changes because allowances are traded like any commodity — supply and demand determine the price. When the economy is strong, factories produce more and need more allowances, so prices rise. When the economy weakens, demand falls and prices drop. Expectations about future policy also affect price.

Can companies outside the EU participate in the ETS?

Only companies operating facilities within the EU, Iceland, Liechtenstein, or Norway are required to participate. However, the Carbon Border Adjustment Mechanism means that companies outside the EU that export goods to the EU must account for carbon costs when their products enter the market.

How much has the EU ETS reduced emissions?

Covered sectors have cut emissions by roughly 35 percent since 2005, though not all of this reduction is due to the ETS alone — other policies and economic changes also played a role. The EU attributes a significant portion of the reduction to the carbon price created by the system.