EU Emissions Trading System (EU ETS)

The EU Emissions Trading System, or EU ETS, is the European Union's carbon market. It sets a limit on how much greenhouse gas big polluters can release in total. Companies must hold a permit, called an allowance, for every tonne of carbon dioxide they emit. They can buy and sell these allowances among themselves, so pollution gets a market price.

Why does it exist?

Pollution harms everyone, but a factory usually pays nothing for the carbon it releases. Economists call this a hidden cost. The ETS makes polluters pay for it. Once pollution costs money, companies look for cheaper ways to cut it, such as cleaner fuels or better machines. Because permits can be traded, emissions get cut wherever it is cheapest to do so.

Where did it come from?

The idea of emissions trading came from the Kyoto Protocol (1997), which allowed countries to use market methods to meet climate targets. The EU ETS started in 2005, and it was the world's first major carbon market. It has grown in phases:

• Phase 1 (2005 to 2007): A trial phase.
• Phase 2 (2008 to 2012): Matched the Kyoto Protocol's first commitment period. Aviation within Europe was added from 2012.
• Phase 3 (2013 to 2020): One EU-wide cap replaced national caps, and auctions became the main way to give out permits.
• Phase 4 (2021 to 2030): Much stricter caps under the "Fit for 55" climate plan. Maritime shipping was added from 2024.

How does "cap and trade" work?

Think of it like a fixed number of entry tickets to a cricket stadium.

1. The cap: The EU fixes the total number of allowances (tickets). This cap goes down every year, so total pollution falls.
2. Getting allowances: Companies get some allowances free and buy the rest at government auctions.
3. Trading: A company that cuts its pollution can sell its spare allowances. A company that pollutes more must buy extra ones.
4. Surrender: Every year, each company must hand over enough allowances to cover all its emissions. If it does not, it pays a heavy fine.

The Market Stability Reserve (MSR), which started working in 2019, removes extra allowances from the market when there are too many. This stops the carbon price from crashing.

Key parts and facts

The EU ETS covers about 40% of the EU's greenhouse gas emissions. It covers power plants, heavy industry, aviation within Europe and maritime shipping. Under the current rules, emissions from these sectors must fall by 62% by 2030 compared with 2005. A second, separate system called ETS2, for fuel used in buildings and road transport, was due to begin in 2027.

The EU has postponed it by one year to 1 January 2028. In 2026 the EU also adopted a legally binding target to cut total emissions by 90% by 2040 compared with 1990.

Free allowances and their link to CBAM

For years, the EU gave many heavy industries (like steel and cement) allowances for free. The reason was to protect them from foreign competitors who pay no carbon price. If a carbon price pushes a factory to move its production to a country with weaker climate rules, pollution does not fall. It only moves. This is called carbon leakage.

How does a sector qualify for free allowances?

The EU uses a simple test written in the ETS law (Article 10b of the ETS Directive). It multiplies two numbers for each sector:

• Trade intensity: how much the sector trades (exports plus imports) with countries outside the EU, compared with the size of its EU market.
• Emission intensity: how much carbon dioxide the sector releases for each unit of value it produces.

If the result is above 0.2, the sector goes on the carbon leakage list and gets more free allowances. If it is between 0.15 and 0.2, the EU looks at the sector case by case. The current list covers the years 2021 to 2030.

Now that CBAM puts a carbon price on imports, these free allowances are being removed slowly, between 2026 and 2034. In 2026, industries still get 97.5% of their earlier free share, and this falls each year.

The price of a CBAM certificate is tied to the price of an ETS allowance. This way, an importer pays about the same carbon price as a factory inside the EU. For 2026, the CBAM price is the average ETS auction price of each quarter (each block of three months). From 2027, it will follow the average ETS price of the previous week. Importers can start buying CBAM certificates from 1 February 2027.

Russia's WTO complaint argues that these free allowances act as an export subsidy for EU industry. Its reason: a sector qualifies partly because of how much it trades with the outside world. WTO rules (the Agreement on Subsidies and Countervailing Measures, or SCM Agreement) ban subsidies that depend on export performance. On 25 September 2026, the WTO set up a dispute panel (a group of trade judges) to hear this case, numbered DS639. India and 17 other members joined as third parties.

India's position and Indian examples

India does not have a cap-and-trade system like the EU ETS. Its earlier Perform, Achieve and Trade (PAT) scheme, started in 2012 under the National Mission for Enhanced Energy Efficiency, let industries trade energy-saving certificates. India's new Carbon Credit Trading Scheme (CCTS), 2023, sets targets for how much carbon each unit of output may release (called emission intensity), rather than a fixed total cap.

It covers nine sectors including aluminium, cement, fertiliser, iron and steel, and petroleum refining. The Bureau of Energy Efficiency (BEE) runs it under the Ministry of Power.

Commonly confused concepts

• Cap-and-trade vs carbon tax: A cap-and-trade system fixes the amount of pollution and lets the market set the price. A carbon tax fixes the price and lets the amount vary.
• EU ETS vs CBAM: The EU ETS prices pollution from factories inside the EU. CBAM prices the pollution in goods imported into the EU.
• Absolute cap vs intensity target: The EU ETS uses an absolute cap (a fixed total number of tonnes). India's CCTS uses intensity targets (tonnes of carbon per tonne of product), which allow total emissions to grow as output grows.
• Compliance market vs voluntary market: In a compliance market (like the EU ETS), companies are forced by law to take part. In a voluntary market, companies buy carbon credits by choice, often to meet their own green goals.

Issues, criticism and the way forward

• Low prices in early years: In the first phases, too many free allowances were given out and the price crashed. Reforms like the MSR fixed much of this.
• Free allowances: Critics say free allowances weakened the push to cut emissions and gave windfall profits to some companies.
• Cost for households: ETS2 may raise fuel and heating costs for ordinary families. This is why the EU created a Social Climate Fund and delayed ETS2 to 2028.
• Trade tensions: Linking the ETS with CBAM has led to complaints from trading partners such as Russia and concerns from India and others.
• Way forward: Experts suggest steady tightening of the cap, fair support for poorer households, and linking with other carbon markets so that carbon prices become more equal around the world.

Concepts to Know

• Allowance: A permit that allows a company to release one tonne of carbon dioxide (or an equal amount of another greenhouse gas). Its official name is EU Allowance (EUA).
• Kyoto Protocol: A 1997 international agreement under the UNFCCC that set binding emission targets for developed countries.
• Emission intensity: The amount of greenhouse gas released for each unit of product, for example tonnes of CO2 per tonne of steel.
• Carbon leakage: When production moves from a place with a carbon price to a place without one, or buyers switch to cheaper imports. Pollution then just shifts to another country instead of falling.
• Third party (at the WTO): A country that is not suing or being sued, but cares about the result of a dispute. It can attend hearings and give its views to the panel.
• Windfall profit: A big, unexpected profit that a company did not work for, for example by selling free permits it did not need.