The European Union’s emissions trading system (ETS) is making headlines recently. But what is the EU’s carbon market and how does it work?
The ETS is the foundation block for all of the EU’s climate and energy policymaking, as it imposes the polluter-pays principle on most parts of the European economy.
Sectors covered by the ETS must buy enough pollution permits to account for each tonne of carbon dioxide they emit. The number of permits put up for sale is controlled, meaning a price per tonne can be set based on supply and demand.
As the years go by, climate targets become stricter and decarbonisation technologies become more widespread and affordable, the number of permits will be gradually reduced.
Eventually, there will be no permits and no emissions left to price, as if all goes to plan, the EU will have achieved its net-zero goal.
The guiding principle of the carbon market is to make polluting more expensive than investing in greener technologies but its ultimate objective is essentially to make itself redundant.
Power generation, big industrial facilities and flights within the EU are all covered by the ETS. Some of those polluters are granted a certain number of free permits to help them absorb some of the cost of carbon pricing.
The ETS recently expanded to include the shipping sector for the very first time and assessments are currently underway to see whether waste-to-energy facilities and all international flights should also be included.
Building and road transport are not a part of the main ETS but as of 2028 will be covered by their own separate carbon market, which has been dubbed the ETS2. Policymakers are still discussing whether agriculture should be folded into its own mini-market as well.
Switzerland, a non-EU country, also has an ETS and that is directly linked to the EU’s under an international agreement. Talks between the EU and United Kingdom are progressing on brokering a similar cross-Channel arrangement.
The ETS is also closely linked to the EU’s newest climate policy, the carbon border adjustment mechanism (CBAM), a carbon border tax that will impose charges on certain imported goods like steel and iron that do not meet sustainability benchmarks.
Importers of CBAM-covered products will have to buy a certain number of permits, the price of which will be pegged to the weekly average of the ETS price.
In order to make it fair for both domestic and third-party businesses, the free ETS permits will be phased out as CBAM is phased in.
Later this year, the European Commission will review the ETS, which is set to trigger a politically-sensitive debate about the true point of the carbon market.
Some industries claim that the ETS is driving them out of business, although high energy prices and global overcapacity for goods like steel are arguably larger contributing factors.
It has taken the ETS the best part of a decade to start achieving its objectives of effectively pricing emissions and this year will define whether it will kick that mission onto the next level or not.
