The EU ETS – The Basics
The EU ETS (Emissions trading system) works on the fundamental basis of ‘cap and trade’. To put it simply, there is a limit placed on the total greenhouse gas emissions allowed for participants within the EU ETS which is then converted into tradeable permits (credits). These can almost be thought of as ‘tradeable allowances’. These allowances certify the holder to release a specific amount of emissions.
These credits are allocated to members in the system through a mix of allocations and auctions. Even if you do not receive an allocation that covers your total emissions, you can purchase more credits from those who have extra. This means that those businesses who give off higher emissions than others will now have more of a financial burden to cover off their higher level of emissions. Those whos’ emissions are below their allocation are free to sell on their credits – receiving monetary compensation for being emission-friendly.
This system effectively punishes those who’s emissions are too high and rewards those who come in under the limit.
All companies covered by EU ETS are required to report and monitor their emissions every year – surrendering any emission allowances to cover annual emissions. This data helps the cap level to be calculated as accurately as possible.
Over-time, the cap is gradually reduced. Taking into account new research, technology, good practice, and previous emissions data to set a smaller limit year after year. This falling cap should lead to a fall in total emissions year upon year.
EUAs and Carbon Trading
EU Allowances (EUAs) are the main form of currency for the EU Emissions Trading Scheme. Globally, EUA carbon trading is a serious business. Although this ‘currency’ is traded from all across the globe, the majority occurs from within Europe. This is to be expected, however, as EU companies have more of a vested interest in the market. This is compounded by the market trading hours operating to standard European business hours – 7AM to 5PM GMT.
Most of EUA trading happens on exchanges – with the Intercontinental Exchange (ICE) recognised as being by far the most liquid for EUA carbon trading. This is not to say that these contracts aren’t listed anywhere else – contracts are bought and sold on both the Chicago Mercantile Exchange (CME) and NASDAQ.
Historically, annual EUA contracts with the most liquidity settle in December of each year. Good liquidity means tight bid and offer spreads resulting in lower transaction costs for companies that take part in emissions trading.
Annual contracts are not the only contracts available. Although usually associated with less liquidity, spot, monthly, and quarterly contracts are also available to trade. As these contracts are usually less liquid it means that bids and offers can be further apart.
Exchange-listed contracts are actually deemed to be ‘physical’ contracts, meaning the appropriate number of allowances must actually be physically delivered/received by the exchange. Over-the-counter trading is common, although is vulnerable to additional risk. This is because OTC trading encourages companies to contract directly with one another and use bespoke contracts. Although common, the majority of EUA trading still occurs directly on exchanges.
Sectors and Gases covered
It is very easy to expect that all emissions from production are harmful towards the environment. This is not actually true, however.
The EU ETS only really focusses on the ‘damaging’ sectors and gases, focusing particularly on the emissions that can be measured, reported, and (most importantly) verified with high levels of accuracy.
|Gas and Abbreviation||Sector (s)|
|Carbon Dioxide (CO2)||Power generation, heat generation, oil refineries, steel works, iron production, aluminium, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids and bulk organic chemicals, aviation.|
|Nitrous Oxide (N2O)||Production of nitric acid, adipic acid, glyoxylic acids, glyoxal.|
|Perfluorocarbons (PFCs)||Aluminium production.|
For any companies that operate in the industries listed, participation in the EU ETS is mandatory. So, if you operate an aluminium production plant and haven’t signed up yet… I have some bad news for you.
This ‘mandatory participation’ rule is not quite as comprehensive as it first seems. There are exceptions to be made based upon:
- Plant size: Some plants will need to reach a certain operational size before they are legally required to adhere to the EU ETS.
- Government intervention: Some small installations may not be required to sign up to the EU ETS if there are already government measures put in place that cut emissions by an equivalent amount.
- EEA Flights: Although commercial aviation is targeted rather heavily for their emissions – the EU ETS will only be applied to flights between airports located in the European Economic Area (EEA).
Delivered emission reductions
The EU ETS has already caused some quite dramatic results. Although we still have a long way to go, it is impressive to see how this system has caused massive reductions in emissions already.
Between 2005 and 2019, emissions from installations covered by the EU ETS declined by around 35%. Considering this is also set against an overall backdrop of economic growth – this is remarkable.
Also in 2019, the Market Stability Reserve (MSR) was introduced. This has led to a much higher and robust carbon price, which has contributed to a year on year reduction in emissions of 9% in 2019. To add a little more context to this figure, this was helped by a 14.9% reduction in electricity and heat production and 1.9% from industry.
Through the European Green Deal an impact-assessed plan was presented to the commission in September 2020. This plan proposed an increase of reduction targets to at least 55% by 2030. The commission agreed to present new legislative proposals by June 2021 in order to hit this new target. The commission did mention that they would potentially be revising and/or expanding the EU ETS because of this.
If you’re not great at your months of the year, this is happening in about two months from now. Absolutely something for all of us to keep an eye on.
The Past, Present, and Future of the EU ETS
Phase 1&2 – The Past
The EU ETS was passed into law by the European Parliament in 2003, and set up by October of the same year. The first and second trading phase was heavily monitored and regulated as there were still doubts surrounding overall viability.
Phase 1 (2005-2007) was more of a ‘pilot’ phase than anything else, extensively testing the system for any signs of weakness. Member states were allowed to decide how many EUAs to allocate in total as-well as to each installation in their territory. The initial penalty for non-compliant companies was only 40 Euros per tonne of CO2.
Phase 2 (2008-2012) bas concurrent with the first commitment period of the Kyoto Protocol. The commission learned from their testing during the previous phase that they needed to tighten the boundaries slightly. This was represented by a reduction in total volume of EUAs by 6.5% from 2005, nitrous oxide inclusion into scheme, inclusion of flights within borders of member states, up to 10% of allocations could now be sold onwards, increased non-compliance penalty to 100 Euros per tonne of CO2.
Phase 3 – The Present
We are currently in phase 3 (2013-2020) out of 4, so it seems like we are rapidly approaching the end game. Phase 3 is incredibly different from the previous two phases – with some of the changes outlined below:
- Single EU-wide cap on emissions now applies instead of the previous system of national caps
- Auctioning is the default method for allocating allowances (instead of free allocation), and harmonised allocation rules apply to the allowances still given away for free
- More sectors and gases included
- 300 million allowances set aside in the New Entrants Reserve to fund the deployment of innovative, renewable energy technologies and carbon capture and storage through the NER 300 programme
Phase 4 – The Future
The next trading period that we will be entering into is phase 4 (2021-2028). The legislative framework for this period was revised in early 2018 – largely so that the emission reduction targets agreed upon in the Paris Agreement are hit. The EU committed to massive reductions by the year 2030 and these revisions reflect this.
- Strengthening the EU ETS as an investment driver by increasing the pace of annual reductions in allowances to 2.2% as of 2021 and reinforcing the Market Stability Reserve (the mechanism established by the EU in 2015 to reduce the surplus of emission allowances in the carbon market and to improve the EU ETS’s resilience to future shocks).
- Continuing the free allocation of allowances as a safeguard for the international competitiveness of industrial sectors at risk of carbon leakage, while ensuring that the rules for determining free allocation are focused and reflect technological progress
- Helping industry and the power sector to meet the innovation and investment challenges of the low-carbon transition via several low-carbon funding mechanisms
Overall Market Trends
Don’t worry, we are well aware you can’t read this graph! It’s intentional… Kind of.
All that we wanted to show with this is three things. Firstly, how the market for EUAs crashed during the 2008 financial crisis, the stagnation of price until 2018, and how the introduction of the Market Stability Reserve caused a steady upturn in price.
This is an incredibly important year when it comes to the EU ETS. As we have already mentioned earlier in this article, we are about to enter in the fourth and final phase of the scheme. The transition period is likely to have some form of teething problems – but this does not seem to be a cause for concern.
Why is it so important then…? Well, have a look back to the last three phases and try to see if you can see the link in prices of ECX Futures and policy changes to the EU ETS. The market has been showing great price growth over the last handful of year – largely down to the introduction of market stability reserve. We already know that the next phase of the scheme will include an increase in the pace of annual reduction (limiting supply) and a further strengthening of the MSR.
It doesn’t take a genius to take a guess in which direction the graph above will be heading…
A Final Thought – Price Tracking Paradise
If you find it difficult to follow the graph above – do not fear, there is an online tool that combines up to date market prices for all of our favourite commodities.
If you are at all interested in any of the content in this article, this tool could be of great use to you!
What is the EU ETS?
The EU ETS is the cornerstone of the EUs policy to combat climate change. It operates on the basis of capping total emissions from EU businesses, allocating tradeable permits to release these emissions, and slowly reducing the total amount of permits over time.
What does EU ETS stand for?
EU ETS stands for EU emissions trading system.
What does EUA stand for?
EUA stands for EU allowances.
What are EUAs?
EUA stands for EU allowances, and they are the main form of currency in the EU ETS.
Has the EU ETS actually done anything?
Yes! The EU ETS has reported that between 2005 and 2019, emissions from installations covered by the EU ETS declined by around 35%.
What emissions are covered by EU ETS?
The main emissions covered by the EU ETS are Carbon Dioxide (C02), Nitrous Oxide (N20), and perfluorocarbons (PFCs).