The European Union’s Emissions Trading System (EU ETS) was established in 2005 and includes over 11,000 installations across the European Economic Area, covering around 40% of Europe’s greenhouse gas (GHG) emissions. The EU ETS is a “cap and trade” system, meaning that a cap determines the total amount of greenhouse gases that companies can emit. Under the annually shrinking cap, companies receive or buy emission allowances which they can trade as needed.

Since the beginning, the EU ETS has suffered from a surplus of emission allowances which has led to a price too low to spur a climate-friendly transformation.

The main causes for the insufficient price signal have been an unambitious overall target, the 2008 economic crisis, and the inflow of international credits. Following measures to limit the oversupply and the agreement of a higher EU 2030 climate target,  prices reached new record levels in 2021. Despite having started to provide a meaningful price signal, the EU ETS is still at risk of oversupply and prices have not yet reached levels compatible with the Paris Agreement.

The EU ETS Market Stability Reserve (MSR) absorbs excess allowances off the market and has helped to deal with the past surplus. However, the MSR is currently not fit for purpose to deal with sudden shocks or future surplus.

Moreover, companies that are supposed to pay for their pollution make profits from the EU ETS as a result of the free allocation of emission allowances (see section “Decarbonising European industry”).

The EU ETS will be revised starting in 2021 as part of the EU Green Deal. Carbon Market Watch calls for a steeper emission reduction path, a strengthening of the market stability reserve and an end to free allocation of pollution permits. Furthermore, a one-off reduction of allowances is necessary to ensure that the cap better reflects real emission levels. All auctioning revenues from the EU ETS should be earmarked to deliver further climate action, industrial innovation, just transition and international climate finance.