EU Emissions Trading System (EU ETS): Cap-and-Trade, CBAM, and Market Stability

Introduction

The EU Emissions Trading System (EU ETS), established by Directive 2003/87/EC, is the world’s first and largest international carbon market, covering approximately 40% of EU greenhouse gas emissions. Operating as a cap-and-trade system, the ETS sets a declining absolute cap on emissions from covered sectors — power generation, energy-intensive industry, aviation, and, from 2024, maritime transport — and enables participants to trade emission allowances. The system is the cornerstone of the EU’s climate policy architecture, designed to deliver the 2030 emission reduction target of 62% below 2005 levels for ETS sectors, contributing to the overall 55% net reduction under the European Climate Law.

Cap-and-Trade Mechanics

The cap — the total quantity of allowances available in each trading period — declines annually by a linear reduction factor (LRF). Phase IV (2021–2030) applies a 2.2% LRF from 2021, increased to 4.3% from 2024 under the Fit for 55 revision (Directive 2023/959), accelerating emissions reduction in the power and industrial sectors. The 2024 LRF increase reduces the cap by approximately 90 million allowances per year compared to the previous trajectory.

Allowances are distributed through two primary methods: auctioning (the default method from Phase III onwards) and free allocation (transitional and targeted). Auctioning revenues (over €120 billion cumulatively by 2025) accrue primarily to Member States, which must spend at least 100% (new obligation from 2024) of auction revenues on climate and energy-related purposes, including the Innovation Fund and the Modernisation Fund supporting low-carbon investment in lower-income Member States.

Free Allocation and Carbon Leakage

Free allocation addresses carbon leakage — the risk that emission costs drive industrial production and emissions outside the EU, undermining both climate ambition and economic competitiveness. Installations in sectors deemed at risk of carbon leakage receive 100% of the benchmark-based allocation, while less exposed sectors receive 30% declining to zero by 2030. The carbon leakage list (2021–2030) covers 63 sectors, including steel, cement, chemicals, aluminium, and fertilisers.

The benchmarking methodology allocates free allowances based on the average performance of the top 10% most efficient installations in each sector, creating an incentive for decarbonisation while protecting competitiveness. The Cross-Sectoral Correction Factor (CSCF) adjusts free allocation downwards where the total requested free allocation exceeds the maximum available quantity.

CBAM — The Carbon Border Adjustment Mechanism

Regulation (EU) 2023/956 establishes the Carbon Border Adjustment Mechanism (CBAM) , a transitional measure (2023–2025) becoming fully operational in 2026. CBAM addresses carbon leakage by applying a carbon price to imported goods equivalent to the EU ETS price, ensuring that imports face the same carbon costs as domestic production. CBAM initially covers cement, iron and steel, aluminium, fertilisers, electricity, and hydrogen, with extension to downstream products and organic chemicals planned from 2026.

Importers must purchase CBAM certificates at a price linked to the weekly average EU ETS auction price. The carbon price paid in the country of origin may be deducted (Article 9). From 2026, free allocation in CBAM-covered sectors will decline in proportion to CBAM coverage, reaching zero by 2034. CBAM compliance requires quarterly reporting (from 2026) and third-party verification of embedded emissions (from 2027).

ETS II — Buildings and Transport

Directive 2023/959 establishes a separate emissions trading system for buildings, road transport, and additional sectors (EU ETS II), operational from 2027. ETS II places a cap on emissions from fuel combustion in these sectors, applying to fuel suppliers rather than individual households or drivers. The cap declines by 5.1% annually from 2027, with a linear reduction factor of 5.4% from 2028.

To address social impacts on households and small businesses, the Social Climate Fund (Regulation 2023/955) provides €65 billion (2026–2032) for direct income support, energy efficiency measures, and clean mobility, financed from ETS II auction revenues. Member States must submit Social Climate Plans demonstrating how they will use Fund allocations to protect vulnerable households, micro-enterprises, and transport users.

Market Stability Reserve

The Market Stability Reserve (MSR) , established by Decision (EU) 2015/1814 and operational from 2019, addresses the structural surplus of allowances accumulated during Phase II and the economic crisis. The MSR absorbs a percentage of the total allowance surplus into a reserve, releasing allowances when total surplus falls below a threshold. From 2023, 24% of the surplus is placed in the reserve; allowances held in the reserve above the previous year’s auction volume are permanently invalidated from 2023 (the MSR invalidation mechanism , reducing supply by over 350 million allowances).

The MSR has restored carbon price signals: from under €5/tCO₂ in 2017, carbon prices rose to over €80/tCO₂ by 2024, before adjusting to the €60–70 range under macroeconomic headwinds. The strengthened MSR is credited with driving this price recovery and enabling the ETS to function as a credible investment signal.

Aviation and Maritime

Aviation emissions have been covered since 2012 (Phase III), with a linear reduction factor applying from 2021. Following the CORSIA (Carbon Offsetting and Reduction Scheme for International Aviation) agreement, intra-EEA flights remain fully covered, while extra-EEA flights benefit from a time-limited derogation, subject to CORSIA implementation review. From 2024, maritime transport emissions — CO₂, methane, and nitrous oxide — are included in the ETS (gradually phased in: 40% of emissions in 2024, 70% in 2025, 100% from 2026).

Revenue Use and Innovation Support

Auction revenues support the Innovation Fund (over €40 billion to 2030), funding breakthrough technologies in renewables, energy storage, carbon capture and storage (CCS), carbon capture and utilisation (CCU), and net-zero mobility. The Modernisation Fund (€14 billion to 2030) supports ten lower-income Member States in modernising their energy systems and enabling just transition.

Enforcement and Monitoring

Compliance is enforced through a penalty of €100 per tonne for surrendered allowances not covered by verified emissions (Article 16 Directive 2003/87), together with a requirement to surrender the missing allowances in the following year. Member States must ensure independent verification of emissions reports and accredited monitoring plans, with penalties for non-compliance that are effective, proportionate, and dissuasive. The European Commission reviews the ETS Directive every five years, with the next comprehensive review scheduled for 2026.