Understanding the EU-ETS

Posted on January 25, 2011 by


The European Union Emission Trading System (EU-ETS) is the largest emissions trading scheme in the world and also a first cap and trade system[1] of CO2started in 2005. Formerly the tradable emission allowances were first used under the United States’ Acid Rain Program, the world’s first cap and trade program. The program, which began in 1995, addresses Sulphur dioxide emissions from utilities. The success of this program helped paved the way for the development of cap and trade programs addressing green house gas emissions, the most notable of which are the European Union’s Emissions Trading Scheme (ETS). Under the EU-ETS, large emitters of carbon dioxide within the European Union must monitor and annually report their CO2 emissions. EU-ETS was enacted before the Kyoto Protocol became legally binding in international and EU law and it would have become operational even if the Kyoto Protocol had not entered into force in February 2005. Although it is inspired by the Kyoto Protocol but it is independent of it.

How does it operate?

The ETS system is divided into trading periods or phases. Allocation of Cap is done by fixing the trading period. The cap for the first period (2005-07) was determined in mid-2005 (Pilot or Trial phase). Cap for second trading period (2008-12) was not finalized until late 2007 and the period after 2012, the European Council has declared that the EU’s greenhouse gas (GHG) emissions will be at least 20 percent lower than the 1990 level by 2020.

Emission allowances: An emissions allowance is an authorization to emit a fixed amount of a pollutant. It is a term commonly used to describe a unit of greenhouse gas emissions (GHG) covered under an emissions trading, or “cap and trade” program. An emissions allowance is sometimes also referred to as a permit. An allowance is a fully marketable commodity that may be bought, sold, or traded for use by entities covered by the program. Currently under EU-ETS, each memberstate decides how many allowances to allocate per trading period based upon criteria established by the European Commission. The member states draw up national allocation plans (NAPs), which the Commission must adopt. The countries, through their NAPs, set the overall emission caps, establish a set number of allowances, and distribute those allowances to the regulated installations within their countries.

The EU ETS is a classic cap-and-trade system. However, it also contains some significant design differences from those reflected in cap-and-trade systems for other emissions that have been implemented in the U.S. The common features are that

1. An absolute quantity limit (or cap) on CO2 emissions has been placed on some 12,000 emitting facilities located in the European Union,

2. Tradable allowances have been distributed to these facilities (typically for free) in an amount equal to the cap, and

3. These facilities must measure and report their CO2 emissions and subsequently surrender an allowance for every ton of CO2 they emit during annual compliance periods. The primary differences from U.S. experience with cap-and-trade mechanisms relate to how the cap is set, the process for allocating emission allowances, banking and borrowing provisions, the monitoring, reporting, and verification procedures, and the linking or off-system provisions.

Cap setting process

There was no initially determined overall limit. No there are separate decisions concerning the total number of European Union Allowances (EUAs) that each member state could distribute to affected installations within its jurisdiction. Each member state proposed a quantity of EUAs, but that quantity was subject to review and approval by the European Commission according to procedures and criteria specified in the EU Emissions Trading Directive.

The main change in EU ETS is that it is a cap within a cap from 2008 on. The Kyoto Protocol, as modified for the European Union (EU15) by the Burden Sharing Agreement (BSA) imposes an economy-wide cap on all greenhouse gas emissions(The EU-ETS includes only CO2 emissions). The sectors (power sector, specified industrial sectors and all combustion facilities with a thermal input of greater than 20 MW regardless of the sector in which they are found including commercial and institutional establishments) included under the EU ETS comprise about half of EU CO2 emissions and about 40 percent of the GHG emissions covered by the Kyoto Protocol. GHG emissions from sources not included in the EU ETS.

Incorporation of Kyoto Mechanism in EU-ETS

An important but less noticed complement to the Emissions Trading Directive is the Linking Directive, which was formally adopted in November 2004. Up to a certain limit, it allows affected installations to comply by submitting qualifying credits for emission reductions accomplished outside of the European Union. The only credits allowed are those created through the provisions of the Kyoto Protocol relating to the Clean Development Mechanism (CDM) or Joint Implementation (JI) and known respectively as Certified Emission Reductions (CERs) and Emission Reduction Units (ERUs). Even so, credits generated by certain CDM activities cannot be used for compliance in the EU ETS, namely, those associated with nuclear power and from CO2 sinks. Interestingly, however, credits generated by non-CO2 GHG emission reduction projects outside the EU are acceptable.

When the Kyoto Protocol came into force on 16 February 2005, the EU ETS had already become operational. Only later, the EU decided to accept Kyoto flexible mechanism certificates as compliance tools within the EU ETS. The “Linking Directive” allow operators to use a certain amount of Kyoto certificates from flexible mechanism (CDM, JI & IET[2]) projects in order to cover their emissions.

How does trading occur?

Notable feature of the EU ETS is that effectively there is no restriction on banking or borrowing of allowances within any given multi-year trading period. Allowances are issued annually but they are valid for covering emissions in any year within the trading period. Moreover, each year’s issuance of allowances occurs at the end of February, two months before allowances must be surrendered for the preceding year. As a consequence, installations can cover shortages in any given year by allowances issued for the next year. This arrangement effectively allows year-ahead borrowing within the trading period.

The Linking Directive allows affected installations to buy KP units but the limit on CER and ERU use in EU-ETS is 10% only (A. Denny Ellerman & Paul L. Joskow). This limit is specified in each member state’s National Allocation Plan (NAP) and it varies among member states and, in some cases, even by sectors within a member state.

Trading analysis: Use of credits or allowances from outside the system for compliance, that is, the use of anything other than the system’s own allowances.In the case of the EU- ETS, the primary sources of such offsets are the project credits created under the Kyoto Mechanism i.e. CDM & JI and known as Certified Emission Reductions (CERs) & Emission Reduction Unit (ERU). The Linking Directive, enacted soon after the Emissions Trading Directive, opened the door to the use of CERs and Joint Implementation credits created by a similar process under the Kyoto Protocol.

In searching of low cost mitigation options: EU ETS will exploit lower cost mitigation options wherever they are located. Since there is no necessary relationship between individual country emissions caps and the geographic distribution of low-cost mitigation opportunities, mechanisms must be found to facilitate the ability of countries with relatively high-cost mitigation options to exploit relatively low-cost mitigation opportunities in other countries.

Post 2008-12: The EU also agreed to three additional important system changes. They agreed to extend the trading period to eight years, tighten the emissions cap so that 21% reductions (Climate Lab Website) would occur by 2020. This creates immense opportunities in the carbon market for developing countries to implement mitigation plans and to facilitate the industrial nations.

Contact Agneya Carbon Ventures for knowing more about the Carbon trading.


1. A. Denny Ellerman & Paul L. Joskow., Massachusetts Institute of Technology .,‘The European Union’s Emissions Trading System in perspective’.

2. European Commission official EU ETS website, Accessed on 2 August 2010


3. Climate Lab Website, Accessed on 2 August 2010