Im­pact Se­ries: 02-22

The EU Emissions Trading System:
Becoming Efficient


This Kühne Impact Series focuses on the EU Emissions Trading System, a cornerstone of the European Green Deal and Europe’s attempt to reach climate neutrality by 2050.1 We discuss how the system has been developed, creates a price on carbon, and the efficiency of the allocation of emissions allowances. Moreover, we analyze the evolution of the EU ETS prices and discuss the recent substantial volatility in the price of the carbon permits. The experience with the EU ETS has been mixed. However, we believe that recent and expected developments will make the system more resilient and reliable – and can ensure a credible and efficient path to carbon neutrality.

Full Article

Launched in 2005, the Eu­ro­pean Union Emis­sions Trad­ing Sys­tem (EU ETS) was the worldʼs first green­house gas emis­sions trad­ing scheme, and it re­mains the largest. The sys­tem cur­rent­ly lim­its emis­sions from around 10,000 in­stal­la­tions, cov­er­ing emis­sions from the pow­er gen­er­a­tion sec­tor, in­dus­try, and in­tra-Eu­ro­pean flights, amount­ing to about 40% of the EUʼs green­house gas emis­sions. Fur­ther strength­en­ing and broad­en­ing of the EU ETS is a sub­stan­tial part of the so-called “Fit for 55” pack­age, which de­clares the EU ETS as a crit­i­cal tool for re­duc­ing green­house gas emis­sions by at least 55% by 2030 (com­pared to 1990 lev­els), and reach­ing cli­mate neu­tral­i­ty by 2050.2, 3

The EU ETS currently limits emissions from the power generation sector, industry, and intra-European flights, amounting to about 40% of the EUʼs̓ greenhouse gas emissions.

The EU ETS is a so-called cap-and-trade sys­tem. This means that gov­ern­ments set a max­i­mum (“cap”) on the to­tal amount of cer­tain green­house gas­es emit­ted by all in­stal­la­tions cov­ered by the sys­tem over a cer­tain pe­ri­od. Trad­able emis­sions per­mits are then is­sued with­in the cap, and emit­ters bound by the scheme must hold enough per­mits to cov­er their an­nu­al emis­sions. The cap is grad­u­al­ly re­duced to achieve emis­sions re­duc­tions.

The emis­sions per­mits are al­lo­cat­ed for free or sold through auc­tions, and they can be sold and bought as need­ed on a trad­ed mar­ket. Each al­lowance gives the hold­er the right to emit one tonne of car­bon diox­ide (CO2) or the equiv­a­lent amount of oth­er pow­er­ful green­house gas­es (ni­trous ox­ide and per­flu­o­ro­car­bons).

Com­pa­nies face a fine of 100 eu­ros per ex­cess tonne if they emit more than they have cov­ered and must also ob­tain al­lowances to make up the short­fall in the fol­low­ing year.

The development of the EU ETS: 4 phases

In the first trad­ing pe­ri­od of the EU ETS (2005–2007), known as the pi­lot phase, most al­lowances were giv­en out for free and in gen­er­ous amounts. The main rea­son for the over-sup­ply of free al­lowances was an ab­sence of re­li­able emis­sions data, but also to re­duce risks of car­bon leak­age and al­low time for green in­vest­ments.4 The pi­lot phase suc­ceed­ed in es­tab­lish­ing the in­fra­struc­ture for the EU ETS. How­ev­er, as il­lus­trat­ed in Fig­ure 1, the num­ber of al­lowances is­sued ex­ceed­ed the amount of ac­tu­al emis­sions, re­sult­ing in a low price of emis­sions, which even­tu­al­ly reached zero in 2007 (Fig­ure 2).

In phase 2 (2008–2012), the cap on al­lowances was slight­ly re­duced (by 6.5% com­pared to 2005), but the sup­ply of emis­sion al­lowances still ex­ceed­ed the de­mand, re­sult­ing in a con­tin­u­ing low price. The ex­cess sup­ply was part­ly ex­plained by the 2008 eco­nom­ic cri­sis lead­ing to re­duced de­mand for emis­sions. In its third phase (2013–2020), the cap was set to be re­duced by 1.74% per year to re­duce emis­sions by 21% in 2020 (com­pared to 2005). More­over, freely dis­trib­uted al­lowances dropped con­sid­er­ably, and 40% of al­lowances were auc­tioned in­stead.

In the fourth and on­go­ing phase (2021–2030), the cap on emis­sions de­creas­es at an in­creased an­nu­al lin­ear re­duc­tion rate of 2.2%. Around 57% of the al­lowances are auc­tioned, while the rest is pro­vid­ed for free. The fourth phase is, how­ev­er, ex­pect­ed to be strength­ened as the “Fit for 55” pack­age sug­gests that the re­duc­tion fac­tor will be in­creased to 4.2% in 2024. There is also a push to re­duce the freely al­lo­cat­ed al­lowances faster.5

Efficiently decreasing pollution

The re­duc­tion in emis­sions al­lowances im­plies an in­creased com­pe­ti­tion for the avail­able al­lowances and an in­creased price on emis­sions. This in­creased price be­comes an ad­di­tion­al cost for com­pa­nies, which can be re­duced by de­creas­ing emis­sions, for in­stance, by in­vest­ing in “clean­er” tech­nolo­gies.6 Com­pa­nies with the low­est will­ing­ness to pay for al­lowances are pre­dict­ed to be the first to de­crease emis­sions. Their low will­ing­ness to pay may re­flect that the trans­fer to green­er pro­duc­tion tech­nolo­gies is eas­i­er or cheap­er for these com­pa­nies, i.e., the cost of in­vest­ing in new pro­duc­tion meth­ods is low­er than the price of emis­sions al­lowances when the price of car­bon is rel­a­tive­ly low. By first re­duc­ing emis­sions where the tran­si­tion to green­er pro­duc­tion is least cost­ly, the EU ETS de­creas­es pol­lu­tion ef­fi­cient­ly.7

By first reducing emissions where the transition to greener production is least costly, the EU ETS decreases pollution efficiently.

Source: The Eu­ro­pean En­vi­ron­ment Agency (EEA) and au­thors’ cal­cu­la­tion

Optimal ETS price

The ETS price has in­creased dras­ti­cal­ly in the last few years, from €20/t in 2020 to above €90/t in 2022. In Feb­ru­ary 2022, the Eu­ro­pean car­bon per­mits reached their max­i­mum val­ue at €96.7/t. Dif­fer­ent ex­pla­na­tions have been giv­en for this quick ac­cel­er­a­tion, and they can main­ly be clas­si­fied into two cat­e­gories: changes in pub­lic poli­cies and de­mand-side fac­tors. Specif­i­cal­ly, the fast ac­cel­er­a­tion in prices was dri­ven by the be­gin­ning of phase 4 of the ETS and the an­nounce­ment of the “Fit for 55” pack­age, to­geth­er with par­tic­u­lar­ly cold weath­er in Eu­rope, which caused en­er­gy de­mand to rise, and high­er gas prices, push­ing elec­tric­i­ty pro­duc­ers to switch to more CO2-in­ten­sive pow­er sources.

A ques­tion that might arise is whether the price of the ETS has reached the op­ti­mal equi­lib­ri­um price to in­duce sub­stan­tial CO2 emis­sions re­duc­tions and in­cen­tivize firms to in­vest in green­er tech­nolo­gies. With­out dras­tic in­vest­ments in green­er tech­nolo­gies, the more the cap is re­duced – fol­low­ing the path to­wards car­bon neu­tral­i­ty by 2050 – the more the price of the ETS is ex­pect­ed to in­crease. The only way to sta­bi­lize prices would be if the re­duc­tion in car­bon per­mits al­lo­cat­ed to the mar­ket is matched by a re­duc­tion in the de­mand for al­lowances. Giv­en the high un­cer­tain­ty in green tech­no­log­i­cal progress in the near fu­ture, it is hard to pre­dict how and if this will hap­pen and thus to fore­cast the evo­lu­tion of the ETS prices cor­rect­ly.

The so­cial cost of car­bon (SCC) might, how­ev­er, pro­vide in­sight into what the op­ti­mal price should and will be. The SCC is de­fined as the mar­gin­al cost of the im­pacts caused by emit­ting one ex­tra tonne of green­house gas at any point in time. In 2018, the In­ter­gov­ern­men­tal Pan­el on Cli­mate Change of the Unit­ed Na­tions sug­gest­ed that a car­bon price of $135–$5,500/t in 2030 and $245–$13,000/t in 2050 would be need­ed in or­der to meet the glob­al warm­ing tar­get of 1.5°C set by the Paris Agree­ment. The cost for lim­it­ing warm­ing to 2°C is sug­gest­ed to be about 3–4 times low­er. The wide range of these price pre­dic­tions is a strong sig­nal of the high un­cer­tain­ty about the ef­fi­cient path to achiev­ing car­bon neu­tral­i­ty by 2050.

Price volatility

De­spite the re­cent steady in­crease, the ETS price has also ex­pe­ri­enced some se­vere fluc­tu­a­tions and price falls in the last few months. The day be­fore the Russ­ian in­va­sion of Ukraine, the price of the EU ETS closed at €95.07/t. By March 7, it had slumped to €58.30, al­most a 40% fall. Dras­tic falls in ETS prices are not un­prece­dent­ed. Over a decade ago, dur­ing the 2007–2008 glob­al fi­nan­cial cri­sis, the price of CO2 al­lowances in the EU col­lapsed from al­most €30/t in June 2008 to bare­ly €9/t by the fol­low­ing Feb­ru­ary, only to lan­guish in sin­gle dig­its for the next decade.

How­ev­er, these two col­laps­es were dif­fer­ent. The great re­ces­sion dras­ti­cal­ly re­duced the world­wide (and Eu­ro­pean) eco­nom­ic ac­tiv­i­ty, neg­a­tive­ly af­fect­ing the de­mand for al­lowances. Since there were no good sys­tems to ad­dress the over­hang of al­lowances, this re­sult­ed in de­pressed prices for a decade. The price col­lapse in­duced by the Rus­sia-Ukraine war is a bit more puz­zling. ETS prices usu­al­ly move with en­er­gy prices, but they seem to have de­cou­pled in the last months. Giv­en how much Eu­ro­pean coun­tries rely on Russ­ian gas, one would have ex­pect­ed the price of the ETS to go up, as­sum­ing that elec­tric­i­ty pro­duc­ers would have had to switch to more CO2-in­ten­sive pow­er sources, like coal. But the short-term sell-off of car­bon per­mits had lit­tle to do with longer-term con­sid­er­a­tions. In­stead, it was main­ly due to some risk-off sen­ti­ment. There has been a gen­er­al liq­ui­da­tion of po­si­tions by in­vestors: some traders liq­ui­dat­ed their ETS to meet mar­gin calls in oth­er ris­ing en­er­gy mar­kets; oth­er in­vestors fled into safer mar­kets, fear­ing a po­ten­tial fall­out of sanc­tions on the EU; fi­nal­ly, there have also been spec­u­la­tions that some sell­ers in­clud­ed Russ­ian traders, repa­tri­at­ing as­sets to avoid sanc­tions. These are signs of fi­nan­cial spec­u­la­tions hap­pen­ing in the car­bon pric­ing mar­ket.

The fi­nan­cial spec­u­la­tion, and more pre­cise­ly the re­cent roller coast­er ride of ETS prices, might be detri­men­tal to the ef­fi­cien­cy of the car­bon pric­ing mar­ket. High price volatil­i­ty could re­sult in high un­cer­tain­ty in the over­all cost of pol­lut­ing for in­stal­la­tions cov­ered by the ETS sys­tem, re­duc­ing the in­cen­tive to move to­wards green­er tech­nolo­gies.

The pol­i­cy changes that have sup­port­ed ETS prices to surge last year could also help sta­bi­lize prices go­ing for­ward. For in­stance, the car­bon price has re­cov­ered quick­ly since it reached its low­est point on March 7. The bench­mark con­tract reached €80/t by the end of March – one month af­ter the be­gin­ning of the war – and close to €90/t in May. Two rea­sons that helped the fast re­cov­ery of the ETS price are the Mar­ket Sta­bil­i­ty Re­serve and the long-term pol­i­cy com­mit­ment by EU mem­ber states to reach net-zero emis­sions by 2050. Still, ex­treme price fluc­tu­a­tions can pro­duce harm­ful ef­fects in the short term. Only dur­ing May, the price of the ETS os­cil­lat­ed be­tween a max­i­mum of €92/t to a min­i­mum of €77/t. This sug­gests that the new­ly im­ple­ment­ed in­stru­ments reg­u­lat­ing the car­bon mar­ket seem to be in­ef­fec­tive in sta­bi­liz­ing prices in the short term, even more so if the fi­nan­cial spec­u­la­tion in the ETS mar­ket were to in­crease.

The role of fi­nan­cial in­sti­tu­tions in the ETS mar­ket has at­tract­ed the at­ten­tion of pol­i­cy­mak­ers and has been ex­am­ined by the Eu­ro­pean Se­cu­ri­ties and Mar­ket Au­thor­i­ty (ESMA). In a re­cent re­port, ESMA high­lights that the num­ber of fi­nan­cial en­ti­ties with lim­it­ed di­rect con­nec­tion to the reg­u­lar func­tion­ing of the ETS mar­ket has grown in re­cent years.8 Specif­i­cal­ly, about 50% of po­si­tions are held by non-fi­nan­cial play­ers as com­mer­cial un­der­tak­ings. While EMSA high­lights that fi­nan­cial in­sti­tu­tions play a cru­cial role in keep­ing the mar­ket for car­bon al­lowances more liq­uid, they have also raised con­cerns re­gard­ing the in­creased in­volve­ment of fi­nan­cial play­ers in the ETS, and its ef­fect on price volatil­i­ty, call­ing for fur­ther in­ves­ti­ga­tion, mon­i­tor­ing, and pos­si­bly lim­it­ing fi­nan­cial in­vestors’ fu­ture ac­cess to the sys­tem. Sim­i­lar views have been ex­pressed by the Eu­ro­pean Par­lia­ment.9

Towards broader coverage, a lower cap and reduced surplus of allowances

Dur­ing its first phas­es, the ex­pe­ri­ence with the EU ETS was mixed, and much crit­i­cism was di­rect­ed at the low price of car­bon emis­sions due to the over­sup­ply of per­mits. As the sys­tem has de­vel­oped and be­come more bind­ing, there are rea­sons to be more op­ti­mistic. Fur­ther re­duc­tions of the emis­sions cap, phase­out of free al­lowances, and ex­ten­sion of the ETS to ad­di­tion­al sec­tors will help en­sure a faster trans­for­ma­tion to­wards car­bon neu­tral­i­ty. The broad­en­ing of the ETS to the mar­itime sec­tor, road trans­porta­tion, and ful­ly cov­er­ing the avi­a­tion sec­tor are es­sen­tial parts of this. More­over, as of 2019, a new in­stru­ment has been in­tro­duced to curb the sur­plus of emis­sions al­lowances, the Mar­ket Sta­bil­i­ty Re­serve (MSR). The ob­jec­tives of the re­serve are twofold: ab­sorb the sur­plus of al­lowances from phase 3; and in­crease the re­silience of the sys­tem, by ad­just­ing the num­ber of al­lowances to be auc­tioned in the fu­ture.10 The MSR has con­tributed to the steady in­crease of ETS prices over the last 2 years, achiev­ing its first ob­jec­tive. The quick re­cov­ery of ETS prices – fol­low­ing the col­lapse in­duced by the Rus­sia-Ukraine war – also showed how the MSR was able to cope with ma­jor shocks by mak­ing the mar­ket more re­silient, in line with its sec­ond ob­jec­tive.

There is a broad con­sen­sus that by re­duc­ing the sur­plus of al­lowances, and thus sta­bi­liz­ing the ETS price, the MSR is a nec­es­sary tool for al­low­ing the EU to reach its emis­sions re­duc­tion tar­get. A main out­stand­ing is­sue is whether the al­lowances in the re­serve will be can­celed at a suf­fi­cient­ly fast pace, rather than stored and used as a fu­ture buffer in a way that will pre­vent the EU from fol­low­ing its emis­sions re­duc­tion tra­jec­to­ry.

Concluding remarks

Cli­mate change pos­es an im­mense threat to our so­ci­eties, and the need to re­duce emis­sions is acute. Putting an ef­fi­cient price on emis­sions is cru­cial to de­crease pol­lu­tion and help com­bat this threat. We be­lieve us­ing a mar­ket-based cap-and-trade sys­tem to cre­ate a price on car­bon can en­sure a cred­i­ble path to car­bon neu­tral­i­ty.
The EU ETS sys­tem re­duces emis­sions by op­er­at­ing on the quan­ti­ty of car­bon al­lowances is­sued. This mar­ket-based mech­a­nism au­to­mat­i­cal­ly cre­ates an ef­fi­cient price for car­bon per­mits to achieve the EU re­duc­tion tar­get. The re­cent de­vel­op­ments of the EU ETS and the fur­ther strength­en­ing pro­posed by the Com­mis­sion will make the sys­tem more re­silient and re­li­able. These pos­i­tive ef­fects can be seen by an­a­lyz­ing the evo­lu­tion of the ETS prices in the last few years.

We be­lieve that this sys­tem is ca­pa­ble of de­creas­ing pol­lu­tion ef­fi­cient­ly. How­ev­er, chal­lenges still re­main and in­clude en­sur­ing the ca­pac­i­ty to han­dle po­ten­tial new sur­plus­es of al­lowances, set­ting up a well-func­tion­ing car­bon bor­der ad­just­ment mech­a­nism to avoid car­bon leak­age, and lim­it­ing ex­cess price volatil­i­ty.

  1. In a pre­vi­ous Kühne Im­pact Se­ries we have an­a­lyzed the Eu­ro­pean Green Deal – i.e., the EUʼs at­tempt to trans­form the Eu­ro­pean econ­o­my and make Eu­rope cli­mate-neu­tral by 2050 – and its ef­fect on in­ter­na­tion­al trade and trans­porta­tion. The Eu­ro­pean Green Deal: Trans­form­ing In­ter­na­tion­al Trade and Trans­porta­tion, Kühne Im­pact Se­ries 06/21, avail­able at: https://www.kuehne­cen­­pact_se­ries/2021_12_21-06-21-eu­ro­pean_green_deal.html
  2. Eu­ro­pean Union: Eu­ro­pean Com­mis­sion, Com­mu­ni­ca­tion from the Com­mis­sion to the Eu­ro­pean Par­lia­ment, the Coun­cil, the Eu­ro­pean Eco­nom­ic and So­cial Com­mit­tee and the Com­mit­tee of the Re­gions: ‘Fit for 55’: de­liv­er­ing the EUʼs 2030 Cli­mate Tar­get on the way to cli­mate neu­tral­i­ty, 14 July 2021, COM(2021) 550 fi­nal, avail­able at:­­gal-con­tent/EN/TXT/?uri=CELEX%3A52021DC0550 [ac­cessed 16 No­vem­ber 2021]
  3. The pro­pos­al to amend the ETS con­sists of five el­e­ments: i) a re­duced cap and more am­bi­tious lin­ear re­duc­tion fac­tor for GHG emis­sions, ii) re­vised rules for free al­lo­ca­tion of al­lowances and the mar­ket sta­bil­i­ty re­serve, iii) an ex­ten­sion of the ETS to mar­itime trans­port, iv) a sep­a­rate new ETS for build­ings and road trans­port, and v) an in­crease of the In­no­va­tion and Mod­erni­sa­tion Funds and new rules on the use of ETS rev­enues.
  4. Car­bon leak­age refers to the sit­u­a­tion that oc­curs if, for rea­sons of costs re­lat­ed to cli­mate poli­cies, busi­ness­es choose to trans­fer pro­duc­tion to oth­er coun­tries with less emis­sions con­straints.
  5. Each phase also brought oth­er sig­nif­i­cant changes, such as an in­creased num­ber of par­tic­i­pat­ing coun­tries and an ex­ten­sion of the ac­tiv­i­ties and green­house gas­es cov­ered.
  6. This as­sumes that mea­sures are in place to pre­vent car­bon leak­age.
  7. In prin­ci­ple, the free al­lo­ca­tion of emis­sions al­lowances does not con­tra­dict the ef­fi­cien­cy ar­gu­ment, al­though it does di­rect­ly con­tra­dict the “pol­luter pays” prin­ci­ple.
  8. ESMA: Fi­nal Re­port on the Eu­ro­pean Union Car­bon Mar­ket 28 March 2022, avail­able at:­­lish­es-its-fi­nal-re­port-eu­car­bon-mar­ket
  9. See for in­stance https://en­er­gy­­tions-to-re­form-the-eu-ets-cop­ing-with-price-volatil­ityand-spec­u­la­tion-event-sum­ma­ry/­­­ceo/doc­u­ment/P-9-2021-001871_EN.html
  10. If the to­tal num­ber of al­lowances in cir­cu­la­tion is greater than 833 mil­lion, 24% (12% from 2024 on­wards) of the al­lowances in cir­cu­la­tion will be placed in the re­serve. If, on the con­trary, the to­tal num­ber of al­lowances in cir­cu­la­tion is low­er than 400 mil­lion, then 200 mil­lion al­lowances will be re­leased from the MSR (100 mil­lion from 2024 on­wards). The “Fit for 55” pro­pos­al to re­vise the MSR con­sists of pro­long­ing its cur­rent pa­ra­me­ters to 2030.


Michael Blanga-Gubbay

Senior Research Fellow at the Kühne Center for Sustainable Trade and Logistics at the University of Zurich


Roza Khoban

Senior Research Fellow at the Kühne Center for Sustainable Trade and Logistics at the University of Zurich


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