Category: European Union Carbon Market Glossary

Published: 25 July 2015

Last Updated: 12 May 2023

 

European Union Emissions Trading System (EU ETS) is the cornerstone of the European Union's policy to tackle climate change and its key tool for cost-effective reduction of emissions of carbon dioxide (CO2) and other greenhouse gases (GHG) in the power, aviation and industrial sectors.

25 April 2023 ‘Fit for 55': Council adopts key pieces of legislation delivering on 2030 climate targets The new rules increase the overall ambition of emissions reductions by 2030 in the sectors covered by the EU ETS to 62% compared to 2005 levels. 28 March 2022 ESMA Final Report, Emission allowances and associated derivatives, ESMA70-445-38

The EU ETS was launched in 2005 and is the first - and still by far the largest - international system for trading greenhouse gas emission allowances covering over three-quarters of the allowances traded on the international carbon market. The EU ETS operates in the 27 Member States of the EU, Iceland, Liechtenstein and Norway.

In the United Kingdom the EU ETS operated until the end of 2020 (from 1 January 2021 the UK ETS replaced the UK's participation in the EU ETS and the EU ETS Directive applies to and in the UK only in respect of the generation of electricity in Northern Ireland, on the basis the Protocol on Ireland/Northern Ireland). As of 1 January 2020, the EU ETS is also linked to the Swiss carbon market. It regulates emissions from nearly 11 000 power and heat plants and manufacturing installations as well as around 350 aircraft operators flying from/to EEA's airports and from EEA's airports to Switzerland and the UK. It covers around 36% of the EU's GHG emissions (Report of 28 October 2021 on the functioning of the European carbon market, COM(2020) 740 final). EU Member States may add more sectors and greenhouse gas emissions to the EU ETS (opt-in procedure).

The EU ETS works on the 'cap and trade' principle and is a market-based measure where participants are required to monitor and report their emissions and surrender sufficient emission allowances to cover their reported emissions in each year. Emission allowances can be traded to enable abatement to occur where it is most cost effective to do, thereby lowering the overall cost of tackling climate change.

The EU ETS was designed as a quantitative instrument in which a predetermined quantity of emission allowances is released to reach the desired environmental aim, which, under Article 1 of the EU ETS Directive, is ‘to promote reductions of greenhouse gas emissions in a cost-effective and economically efficient manner’ (European Court of Justice in the judgment of 21 June 2018, Republic of Poland v European Parliament and Council of the European Union, Case C-5/16). European Court of Justice assessed in the said judgment of 21 June 2018 that the system “does not intervene directly to set the price of allowances, the latter being determined exclusively by market forces, on the basis of, inter alia, the scarcity of allowances, combined with the flexibility provided by the possibility of trading allowances.”

The price signal created at EU level is supposed to influence the operational and strategic decisions of investors.

 

EU ETS cap

 

A 'cap' is an absolute quantity of greenhouse gases which can be emitted by the factories, power plants and other installations in the system, to ensure the emission reduction target is met. The cap corresponds to number of allowances put in circulation over a trading phase (period). In phases 1 and 2 (2005 - 2012) the EU-wide cap was determined in a bottom-up manner from the aggregated total quantity of allowances laid down by Member States in their National Allocation Plans (NAPs). As from the start of the phase 3, an EU-wide cap is determined by the EU ETS Directive. The 2013 cap for emissions from stationary installations was set at 2 084 301 856 allowances. This cap decreased in each year of the phase 3 by a linear reduction factor of 1.74% of the average total quantity of allowances issued annually in 2008-2012, thus ensuring that the number of allowances that can be used by stationary installations will be 21% lower in 2020 than in 2005. The inherent assumptions were that in 2020 emissions from sectors covered by the EU ETS would be 21% lower than in 2005 and by 2030 the decrease would reach the level of 43%.

EU ETS annual cap for installations for the years 2013-2020 was as follows (source: Report from the Commission to the European Parliament and to the Council, Report on the functioning of the European carbon market, 23 November 2017 (COM(2017) 693 final, p. 11, Report on the functioning of the European carbon market, 18 November 2020, COM(2020) 740 final, p. 11):

 
Annual aviation allowances put into circulation:

 

According to Article 1 of the Commission Decision (EU) 2020/1722 of 16 November 2020 on the Union-wide quantity of allowances to be issued under the EU Emissions Trading System for 2021, the Union-wide quantity of allowances referred to in Article 9 of Directive 2003/87/EC amounts to 1 571 583 007 for 2021.

From 1 January 2021, the EU ETS Directive applies to and in the UK in respect of the generation of electricity in Northern Ireland, on the basis the Protocol on Ireland/Northern Ireland. As a result, only the emissions from electricity generation in Northern Ireland remain subject to the EU ETS and will be accounted for in the cap (applied from the base period 2008-12). This will determine a reduction of the cap in proportion to the emissions from the United Kingdom that are no longer accounted for.

 

Improvements of the EU ETS in the third phase

 

A major revision of the EU ETS system was agreed in 2009, for the implementation in the third trading phase to run from 2013 until 2020. The overall driver for the 2009 EU ETS reform was to streamline its operating rules through increased harmonisation of its pre-existing parts fragmented by national borders of the EU Member States. This tendency has been expressed, in particular, in the following EU ETS features in the period 2013-2020:

- For the purposes of enhanced predictability and stability, a single, EU-wide cap has been imposed na the allowances' volume, the cap was decreasing by 1.74% annually (in line with the Linear Reduction Factor - LRF), and replaced the previous system of the EU Member States' national caps;

- Open, transparent, harmonised and non-discriminatory auctioning has replaced the free allocation as the default method for allocating emission allowances (the detailed rules are stipulated in the EU ETS Auctioning Regulation;

- The procedures for the free allocation of emission allowances have also been harmonised across the EU and ambitious EU-wide ex-ante performance benchmarks have been introduced (Benchmarking Decision);

- Regulation for monitoring and reporting and Regulation for verification of emission reports and accreditation and supervision of verifiers have been adopted and apply directly in all EU Member States;

- Stricter rules and conditions for the use of international carbon credits in the EU ETS with harmonised limits for their use by operators (for details see here);

- Central electronic Union Registry has replaced the emissions allowances registries run previously individually by the EU Member States. The Central Union Emissions Allowances Registry is governed by a Registry Regulation applying directly in all EU Member States (see the requirements and procedure for opening account with the EU ETS Registry).

Another reform was to change the emission allowances legal status into financial instruments and subject them (along with being already in scope derivative financial instruments or auctioned products based on them) to financial market supervisory system, mainly to the Markets in Financial Instruments Directive and Regulation under the MiFID II package and the Market Abuse Regulation. 

The European Commission in November 2012 proposed a short-term measure to postpone (back-load) auctioning of 900 million emission allowances until 2019 and 2020. The European Parliament and the Council agreed on the proposal in December 2013 and the implementation of back-loading started in March 2014 (more on the EU ETS allowances backloading read here). Subsequently, in January 2014 a proposal to establish a Market Stability Reserve was presented (the legislative process has been finalised with the adoption of the Decision (EU) 2015/1814 of the European Parliament and of the Council of 6 October 2015 concerning the establishment and operation of a market stability reserve for the Union greenhouse gas emission trading scheme and amending Directive 2003/87/EC). On 15 July 2015 the Commission presented a legislative proposal to revise the EU Emissions Trading System in line with the 2030 framework.

 

Coverage of activities, installations and aircraft operators

 

Greenhouse gases

 

In terms of greenhouse gases EU ETS scope was firstly defined in the Directive 2003/87/EC and has been amended by the Directive 2009/29/EC, including some new activities (such as production and processing of non-ferrous metals, some chemicals etc.) and new greenhouse gases (nitrous oxide (N2O) and perfluorocarbons (PFCs)).

 

The EU ETS currently covers carbon dioxide (CO2) emissions, nitrous oxide (N2O) emissions from all nitric, adipic, glyoxal and glyoxylic acid production and perfluorocarbons (PFC) emissions from aluminium production (see Annex I of the Directive which lists the categories of activities to which the ETS currently applies).

 

Stationary installations

 

As from the start of the phase 3 of the EU ETS (i.e. 1 January 2013), the sectors with stationary installations covered by the EU ETS are energy intensive industries, including power stations and other combustion plants, with ≥20MW thermal rated input (except hazardous or municipal waste installations), oil refineries, coke ovens, iron and steel, cement clinker, glass, lime, bricks, ceramics, pulp, paper and board, aluminium, petrochemicals, ammonia, nitric, adipic, glyoxal and glyoxylic acid production, CO2 capture, transport in pipelines and geological storage of CO2.

Even though participation in the EU ETS is mandatory, in some sectors only installations above a certain size are included. Moreover, participating countries can exclude small installations from the system if measures are in place that will cut their emissions by an amount equivalent to the amount of emissions which would have been cut had the installations been included in the EU ETS. Participating countries may also add more sectors and GHGs to the EU ETS.

The EU ETS covers about 11 000 power plants and manufacturing installations in all EU Member States, Iceland, Norway and Liechtenstein (Report on the functioning of the European carbon market, accompanying the document Report from the Commission to the European Parliament and to the Council, Climate action progress report, including the report on the functioning of the European carbon market and the report on the review of Directive 2009/31/EC on the geological storage of carbon dioxide of 18 November 2015 (COM(2015) 576 final), p. 5).

 

Aviation

 

The aviation scope of the EU ETS was initially limited to flights within the EEA until 2016 and later extended to 2023. The aviation activities within the initial scope of the EU ETS included all flights from or to an aerodrome situated in the territory of a Member State to which the Treaty applies, with some exceptions as listed in Annex I of the EU ETS Directive. However, in the light of the negotiations within ICAO looking to propose a global market based mechanism for reduction of aviation emissions, this scope has been temporarily reduced and only flights within the EEA are covered.

 

Further reading on EU ETS coverage of aviation, in particular in the light of the CORSIA measure.

 

Table: Key features of the EU ETS across trading phases

 

Key features	Phase 1  (2005–2007)	Phase 2 (2008–2012)	Phase 3 (2013–2020)
Geography	EU27	EU27 + Norway, Iceland, Liechtenstein	EU27 + Norway, Iceland, Liechtenstein Croatia from 1.1.2013 (aviation from 1.1.2014)
Sectors	Power stations and other  combustion plants ≥20MW  Oil refineries  Coke ovens  Iron and steel plants Cement clinker  Glass Lime  Bricks  Ceramics Pulp Paper and board	Same as phase 1 plus Aviation (from 2012)	Same as phase 1 plus Aluminium Petrochemicals  Aviation from 1.1.2014 Ammonia Nitric, adipic and glyoxylic acid production CO2 capture, transport in pipelines and geological storage of CO2
GHGs	CO2	CO2,  N2O emissions via opt-in	CO2, N2O, PFC from aluminium production
Cap	2058 million tCO2	1859 million tCO2	2084 million tCO2 in 2013, decreasing in a linear way by 38 million tCO2 per year
Eligible trading  units	EUAs	EUAs, CERs, ERUs    Not eligible: Credits from forestry, and large hydropower projects.	EUAs, CERs, ERUs   Not eligible:  CERs and ERUs from forestry, HFC, N2O or large hydropower projects.  Note: CERs from projects registered after 2012 must be  from Least Developed Countries

 

 Source of the Table: EU ETS Handbook, p. 18, 19

 

Tradable units

 

There were four types of tradable credits under the EU ETS:

- EU Allowances (EUAs),
- EU Aviation Allowances (EUAAs),
- Certified Emission Reduction (CERs),
- Emission Reduction Units (ERUs).

EUAs are most common units, EUAAs have been created specifically for the compliance of aircraft operators and initially (until 31 December 2020) were allowed to be surrendered only by aviation operators and, hence, enjoyed considerably smaller tradable demand.

Starting from phase 4 of the EU ETS - i.e. as from 1 January 2021- aviation allowances can be surrendered in order to meet the compliance obligations of both aviation operators and stationary installations. International credits, such as the CER and ERU, are no longer eligible for use in phase 4 of the EU ETS.

Before 1 January 2021 CERs and ERUs, as the qualifying credits for emission reductions accomplished outside the European Union, were eligible, within certain limits, to be submitted for compliance under EU ETS (however, they needed to be translated into EUAs in order to count for compliance purposes). CERs were obtained through the Clean Development Mechanism (CDM), which allowed emission reductions achieved in less developed country to be credited in a developed country. ERUs were produced through the Joint Implementation (JI) mechanism, which promoted technology transfer between Kyoto Protocol Annex 1 countries.

 

Free allocation

Although in phase 3 of the EU ETS, auctioning was the default allocation method, a significant amount of allowances was been allocated for free to industrial installations (about 43% of the total quantity of available allowances was allocated for free, while the share of allowances to be auctioned by Member States amounted to some 57%). This was to address the risk of carbon leakage - a situation where companies transfer production to third countries with laxer constraints on GHG emissions, which may lead to an increase in their total emissions.

In this regard he following principles applied:

• electricity production was not eligible for free allowances;
• free allowances to manufacturing industry were distributed according to EU-wide harmonised rules;
• the free allocation was based on performance benchmarks to strengthen the incentives for GHG emission reductions and innovation and reward the most efficient installations;
• an EU-wide New Entrants' Reserve (NER) for new industrial installations and installations significantly increasing capacity was established, equivalent to 5% of the total amount of allowances for phase 3.

 

The sectors and sub-sectors deemed to be exposed to a significant risk of carbon leakage are placed on a carbon leakage list (originally the list covered the period 2015-2019, the revised EU ETS Directive prolonged its validity until 31 December 2020). In phase 3, as the demand for free allocation exceeded the amount available, the allocation for all installations under the EU ETS was reduced by the same percentage through the application of a "cross-sectoral correction factor (CSCF)". In 2017, the original CSFC values were revised.

 

EU ETS carbon market

 

The EU ETS carbon market is dominated by derivatives - it is assessed around 85% of trade in allowances involves the use of derivatives: futures, forwards, options, which are subject to EU financial markets regulations. In 2014, the EU ETS total volume traded was 8.33 billion tonnes of CO2 either as spot allowances or derivatives of allowances (total value of EUR 47 billion), where only around 900 million allowances were traded on the spot market (value of about EUR 5.2 billion). EU ETS covers more than 11 000 power stations and industrial plants in 31 countries, around 2 000 intermediaries, traders, organisations and individuals voluntarily participate in the EU ETS.

According to the ESMA Preliminary report of 15 November 2021 (Emission Allowances and derivatives thereof, ESMA70-445-7, p. 6-8):

• in 2020, the EU ETS accounted for almost 90% of the global carbon market value (besides the EU ETS, national or sub-national systems are being operated or are under development in Canada, China, Japan, New Zealand, South Korea, Switzerland, the United Kingdom and the United States);
• at 8.1 billion tonnes in 2020, the total traded volume of emission allowances in the EU was four times greater than the volume traded in North America, the next largest market;
• notwithstanding its continuous expansion the carbon market size is relatively small as compared to, for example, the multitrillion oil and gas markets;
• the proportion of OTC trading activity in the mandatory carbon market is marginal (in contrast to the voluntary carbon credits that are traded OTC);
• hence, as opposed to other derivatives markets, the carbon market is almost entirely traded on regulated markets and cleared in central counterparties (CCPs).

 

Primary market

 

The primary market for emission allowances consists of auctions. 

EU ETS auctions

Entities eligible to participate in emission allowances auctions are compliance entities (companies and aircraft operators who are obliged to participate in the EU ETS), most categories of market participants are also able to participate in (e.g. credit institutions, investment firms, funds, commodity trading firms without compliance requirements), provided that as bidders they meet the relevant admission requirements as set out in the Auctioning Regulation 1031/2010 (Articles 18 and 19) – which guarantees a fair and open access for all auction participants.

The admission requirements of the Auctioning Regulation require, among others:
- all the entities that are not compliance buyers to be established in the EU,
- the opening of an account in the Union registry,
- appointing of at least one bidder’s representative,
- existence of technical arrangements but also compliance with the admission requirements of the auction platforms (e.g. evidence of personal reliability and professional qualification, recognition as a trading participant by the clearing house).

For more details as regards the EU ETS primary market see EU ETS Auctioning Regulation.

 

Secondary market

 

The secondary market for emission allowances consists of

(1) contracts with a daily expiry, called “daily futures” or “spot”,

(2) futures with various maturities; and

(3) options on futures.

 

All derivatives have a standardised contract size of 1,000 allowances (i.e. 1,000 tonnes of CO2).

Three European trading venues offer a secondary market on the EU carbon market:
- EEX in Germany,
- ICE Endex in the Netherlands and
- Nasdaq Oslo in Norway.

 

The EU carbon secondary market on ICE migrated in full from the UK trading venue ICE Futures Europe to the Dutch entity ICE Endex in June 2021, and the allowances under the UK ETS are since then available for trading on ICE Futures Europe. Derivatives on emission allowances traded in these trading venues are cleared respectively by ECC AG in Germany, ICE Clear Europe Ltd. in the UK, and Nasdaq Clearing in Sweden. It is to be noted that after the transfer of the trading of derivatives on EUAs in ICE from its UK trading venue to ICE Endex in the Netherlands, ICE contracts remain cleared by ICE Clear Europe in the UK. These CCPs also offer clearing for OTC transactions.Secondary markets play an important role by providing compliance buyers with an opportunity to acquire allowances without taking part in the primary auction. Financial entities are present on the primary market (acting on behalf of their clients) as well as on the secondary market. A comparison of recent data on open interest on the three trading venues EEX, Nasdaq Oslo and ICE Endex shows that the latter accounts for the largest share of the outstanding contracts.

The aforementioned ESMA Preliminary report of 15 November 2021 indicated that almost 45% of the open interest on ICE Endex had been concentrated in December 2021 expiry futures).

ESMA Final Report of 28 March 2022 Emission allowances and associated derivatives (ESMA70-445-38) also shed some light on the secondary emission allowances market. According to this analysis:

- trading in the secondary market between June 2021 and December 2021 averaged EUR 57 billion per month;

- most of the trading in the secondary market takes place through derivative contracts, as many compliance entities seem to take long futures positions with investment firms to acquire emission allowances instead of purchasing them on the spot market;

- large holdings of emission allowances in the trading accounts of investment firms at the EU Registry appear highly correlated with short positions these firms take in emission allowance derivative markets;

- derivative markets are dominated by compliance entities and other non-financials that are holding long positions for hedging purposes and trading with investment firms holding short positions to make a market;

- most of the trading volumes concentrate in the next (front-year) December expiry futures contract, although there are also significant positions in the March expiry of the current year linked to the lifecycle of emission allowances which have to be surrendered by 30 April every year;

- investment firms, credit institutions and compliance entities tend to trade futures across the maturity spectrum, while investment funds and other non-financial sector firms appear to favour trading in futures with a residual maturity of less than one year;

- investment funds and other non-financial sector firms also trade options to a larger extent;

an increase in the relative share of options in total notional volumes traded in late 2021 is a development that warrants monitoring – as do trends in the less transparent OTC market segment.

 

Status of the EU ETS carbon market in the context of financial legislation

 

With MiFID II Directive, emission allowances have become financial instruments under Annex I, Section C (11). In contrast to energy markets, spot markets of emission allowances do not fall under the REMIT. Moreover, despite being subject to weekly and daily position reporting, derivatives on emission allowances do not fall under the definition of commodity derivatives under MiFID II and are therefore not subject to position limits and position management controls. Emissions markets are also subject to the Market Abuse Regulation (MAR).

 

EU ETS evolution in the context of the European Green Deal

 

The climate neutrality to reach the objectives of the Paris Agreement is the central element of the European Green Deal, as set out by:

• the European Commission in Communications of 2018 (COM(2018)773 final) and December 2019 (COM(2019)640 final);
• the European Council (European Council conclusions of 12 December 2019);
• the European Parliament (resolution of 14 March 2019 on climate change and resolution of 28 November 2019 on the 2019 UNClimate Change Conference in Madrid, Spain (COP 25)).

In further communications (COM (2020)80 final and COM (2020) 562 final) the European Commission has proposed a EU-wide, economy-wide net greenhouse gas emissions reduction target by 2030 compared to 1990 of at least 55% and set the stage for this initiative together with other legislative initiatives in the field of climate and energy.

The Inception Impact Assessment of 29 October 2020 (Ref. Ares(2020)6081850) envisions the following potential modifications of the ETS Directive for 2021-2030 (phase 4):
- strengthening the EU ETS, while reviewing the Market Stability Reserve in line with the corresponding legal obligation and examine possible amendments to its design; and ensuring continued effective protection for the sectors exposed to significant risk of carbon leakage while incentivising the uptake of low carbon technologies:
- including at least intra-EU emissions of the maritime sector to ensure the sector contributes to the emission reductions needed, in accordance with EU’s international commitment to economy-wide action under the Paris Agreement, and deciding whether to include emissions from other sectors such as buildings and road transport into emissions trading at EU level and assessing if a transitionary system is needed;
- addressing the distributional effects of this transition, by reviewing, as appropriate, the low carbon funding mechanisms and solidarity aspects in the distribution of allowances.

Pursuant to the said document of 29 October 2020, a broad variety of options will be explored, including on:
- the linear reduction factor to meet the higher 2030 target of at least 55%, a one-off reduction of the cap that would put it closer to the actual emissions level, as well as the interaction with the Market Stability Reserve (MSR);
- the parameters for the operation of the MSR, including the predefined range triggering adjustments to annual auction volumes, as well as the percentage rate applied to the total number of allowances in circulation;
- the extension of emissions trading to maritime emissions, potentially emissions from buildings and road transport or all fossil fuels combustion and waste incineration, as well as the interactions with the existing regulatory and non-regulatory framework applicable to these sectors;
- improving support for low-carbon and carbon removal investment and innovation such as carbon contracts for difference e.g. through the existing Innovation Fund.
- the ETS’ contribution to addressing specific distributional and innovation;challenges related to the transition to climate neutrality and its impacts, including the use of auction revenues and the Modernisation and the Innovation Fund;
- carbon leakage provisions, such as free allocation rules and updating emission benchmarks, coherence with a potential carbon border adjustment mechanism, indirect cost compensation.

 

Commission Communication of 17 September 2020 “Stepping up Europe’s 2030 climate ambition Investing in a climate-neutral future for the benefit of our people” (COM/2020/562 final) reads:

„The Commission has assessed carefully the possibility of reinforcing and expanding emissions trading as a tool to achieve greenhouse gas emissions reductions at the EU level.

The Commission sees important benefits in expanding the use of emissions trading in the EU, to deliver in an economically efficient manner an increased climate ambition of 55% greenhouse gas emissions reductions. Emissions trading can achieve greenhouse gas emissions reductions cost‑effectively. Its resulting carbon price internalises the climate externalities and gives consumers incentives to reduce greenhouse gas emissions. It guarantees environmental integrity in the form of the emissions cap and provides a strong price signal that influences daily operational and strategic investment decisions. At the same time, emissions trading raises revenues that can be re-invested in the economy leading to better overall economic outcomes.

As already announced in the European Green Deal, a further expansion of the system could include emissions from road transport and buildings. Already now, the EU ETS directly or indirectly covers around 30% of buildings emissions from heating.
Covering all emissions of fossil fuel combustion and integrating them in the EU ETS would present important benefits in terms of effectiveness and administrative feasibility. The Commission therefore intends to pursue such an integrated approach and will look into incorporating it in its legal proposal by next year June.”

 

CSRD linkage 

 

The content of the EU Emissions Trading Scheme (EU ETS) has been embedded in the Corporate Sustainability Reporting Directive (CSRD) rules - see draft ESRS E1 Climate change, specifically, in draft ESRS E1-6 Gross scope 1 of GHG emission and the percentage of Scope 1 GHG emissions from regulated emissions trading schemes, and ESRS E1-9 Financial effects from material climate-related risks: potential liabilities linked to EU ETS (Draft European Sustainability Reporting Standards, Explanatory note of how draft ESRS take account of the initiatives and legislation listed in Article 1 (8) of the CSRD adding article 29 (b) -5 to the Accounting Directive, EFRAG, November 2022).

 

 

 

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