Emissions trading, also known as cap and trade, is a cost-effective way of reducing greenhouse gas emissions. To incentivize firms to reduce their emissions, a government sets a cap on the maximum level of emissions and creates permits, or allowances, for each unit of emissions allowed under the cap. Emitting firms must obtain and surrender a permit for each unit of their emissions. They can obtain permits from the government or through trading with other firms.

The government may choose to give the permits away for free or to auction them.
Firms that expect not to have enough permits must either cut back on their emissions or buy permits from another firm. For a given permit price, some firms will find it easier, or cheaper, to reduce emissions than others and will sell permits. If there are too many such firms in the market, the price of permits, the total number of which is set in advance by the cap, will decline, inducing some firms to reduce their emissions reduction efforts.

Only when the price of permits is just right will the number of permits offered for sale by firms that can reduce emissions at low cost be equal to the number of permits demanded by firms for which emissions reductions are costly. This process of trading ensures there is a unique price for all firms coordinating their activities and drives down emissions to the level allowed under the cap cost-effectively.

Of course, there is no reason to expect that a permit price that clears the market at a point in time will continue to do so in the future. As economic conditions and emitting firms� circumstances change, permit prices will fluctuate, becoming more expensive when demand is high relative to supply (for example when the economy is growing robustly) and cheaper when demand is lower (for example when ample renewable electricity reduces the requirement for thermal generation firms).

Which countries have emissions trading systems?[1]

The European Union emissions trading system, or EU ETS, is currently the world�s largest system. It operates in all 28 EU countries plus Iceland, Liechtenstein and Norway, limiting emissions from more than 11,000 heavy users of energy including power stations and industrial plants, and airlines operating between the ETS member countries. In total, it covers around 45% of the EU�s greenhouse gas emissions.

The World Bank�s State and Trends of Carbon Pricing (May 2018)[2] reports that there are 51 implemented or scheduled carbon pricing initiatives worldwide. These include ETSs in Switzerland, South Korea, and New Zealand and several US states and Canadian provinces, as well as national-level carbon taxes.

China officially launched a major national emissions trading scheme in December 2017 after piloting seven schemes at local government level. It plans to introduce the national scheme first to the energy sector, with full implementation by 2020, to become the largest ETS in the world.

Managing interactions with wider energy transition policies[3]
Carbon pricing policies are implemented alongside a wide mix of other policies that promote clean energy transitions, such as air pollution control, renewable energy deployment, energy conservation, economic restructuring, and energy sector and power market reforms. It is important to understand the interaction of an emissions trading system with these other policies because it can accelerate or hinder clean energy transitions.

Aligning emissions trading systems with national mitigation objectives[4]

Mechanisms that promote both flexibility and certainty of a carbon price are fundamental to ensure that emissions trading systems can respond to unexpected or unintended impacts of domestic companion policies and other external factors, such as an economic crisis.

Emissions trading system is generally embedded within higher-level greenhouse gas mitigation objectives, including those expressed within each country�s nationally determined contribution (NDC) to the Paris Agreement on climate change and long-term mitigation strategies. Some jurisdictions have worked to align the emissions reductions trajectory and cap of their emissions trading system with these mitigation objectives, though in different ways. Setting the emissions trading systems cap with a top-down approach can help better align the trading system with the national mitigation objectives.

In theory, the cost of an emissions trading system allowances creates various levels of incentives for the power sector to reduce emissions, for example by investing in less carbon-intensive power supply, reducing electricity demand or changing the merit order of electricity dispatch in favor of low-carbon power supply.

In practice, however, power markets are often fully or partially regulated, and some power market structures can weaken the carbon pricing signal, reducing the emissions trading system�s effectiveness.

Adapting the design of emissions trading systems to power market structures[5]

Several methods can be used to better reflect the system�s carbon price signal while taking into consideration existing power market regulations. These methods include consignment auctions, covering indirect emissions, consumption charges, climate-oriented dispatch rules, carbon investment boards and pricing committees. Further research and experience will improve understanding of the effectiveness of these options.

Introducing an emissions trading system in the industrial sector could in theory affect economic competitiveness, leading for example to lower investments in industry and job losses. It could also affect the economic competitiveness of internationally traded goods. Industrial production (and associated pollution) might also move to jurisdictions with less stringent environmental controls or emissions reductions requirements, a phenomenon known as �carbon leakage�. All current emissions trading systems address these concerns by including features aimed at reducing the extra costs imposed on some industries.

It is therefore important to have a transparent means of identifying industries with the highest risks of carbon leakage and competitiveness concerns, estimating the associated costs. Free allocation of allowances has been widely used by various emissions trading systems as a way to address competitiveness and carbon leakage concerns for the industrial sector. There exist different design methodologies to allow free allocation of allowances, which require varying degrees of inputs.

The choice of the allocation method is important, as this would determine the amount of allowances that the industrial facility would receive and would impact its emissions trading system obligations. Gradually phasing down free allocation in favour of auctioning can help correct potential market distributional distortions, generate revenue, and increase the mitigation effectiveness of trading systems.

Functioning of EU ETS across borders[6]

Cross-border policy co-operation to implement or harmonize carbon pricing instruments in different jurisdictions is also possible. The EU ETS is the largest international regional carbon pricing initiative. It has gradually extended its geographic coverage over the years and currently operates in 31 countries.

The European Commission promotes international co-operation beyond the boundaries of the EU ETS to link systems and build capacity. A linking agreement between the EU and Swiss emissions trading systems has been finalized. The European Commission has also established strong bilateral co-operation programs with China and Korea on designing and implementing emissions trading systems.

Who issues allowances in the EU ETS?

The accurate accounting of all allowances issued is assured by a single Union registry with strong security measures. The registry keeps track of the ownership of allowances held in electronic accounts, just as a bank holds a record of its customers and their money.

How and where trading is done?

Anyone with an account in the Union registry can buy or sell allowances, whether they are a company covered by the EU ETS or not. Trading can be done directly between buyers and sellers, through several organized exchanges or through intermediaries active in the carbon market. The price of allowances is determined by supply and demand. In 2015, on average 26 million allowances or their derivatives were traded per trading day. This added up to over 6.6 billion allowances or their derivatives, with a total value of around �49 billion.

How allowances are allocated?

Since 2013, auctioning is the default method of allocating emission allowances. This means that businesses have to buy an increasing proportion of their allowances at auction. Auctioning is the most transparent method of allocating allowances and puts into practice the principle that the polluter should pay.

The European Commission (referred to as the Commission) is the only institution with the power to initiate a legislative proposal such as new regulations in the EU ETS or amendments to the EU ETS Directive. The European Council and Parliament can suggest amendments to the legislative proposal, which the Commission can include in an updated legislative proposal. In the end the Council and Parliament both need to approve the proposed legislation before it is adopted. Any new legislative proposals and most amendments to the EU ETS need to follow this co-decision procedure.

For the EU ETS, the Commission has powers of implementation when uniform conditions of implementation are needed e.g. in determining the allocation of free allowances and monitoring, reporting and verification of emissions. These rules are implemented on an EU-level to ensure a harmonized approach between different MSs. The Commission consults MSs prior to the implementation of implementing measures through the Climate Change Committee in which all MSs are represented. With regards to the EU ETS, around 15 decisions and regulations relating to its implementation in areas such as free allocation, monitoring or reporting were examined by Climate Change Committee.

Allocation of allowances

Allocation of allowances is done either by free allocation, where installations receive allowances for free (see Free allocation in the EU ETS), or via auctioning of allowances (see Auctioning in the EU ETS). 5% of the total quantity of allowances is set aside for free allocation to new entrants. Allowances to aircraft operations are allocated in a similar manner (see Aviation). In phases 1 and 2 of the EU ETS most allowances were given out to participants for free. In phase 3 auctioning is the default method of allocation, although free allocations are still handed out, mainly to the industry sector (see How allocation has evolved). A cap has been set on the maximum free allocation to industry, limiting it to approximately 43% of the total phase 3 cap (see Limit on total free allocation: Correction factors).

Power generation sector As a rule, the power generation sector will be subject to 100% auctioning from 2013 onwards. The only exception is free allocation for the modernisation of the power sector in certain Member States as stipulated in Article 10c of the revised EU ETS Directive (see Transitional free allocation for modernisation of the power sector (Article 10c)). Industry and heating sector Industrial (non-power) and heating sectors will receive free allocation based on ambitious greenhouse gas performance benchmarks for a transitional period.

In 2013, 80% of the quantity determined by the free allocation rules for the industrial sector will be allocated for free, decreasing to 30% in 2020, with a view of 0% in 2027. Any sector that it is deemed to face a significant risk of carbon leakage from exposure to non-EU competition due to price on CO2, will continue to receive up to 100% of the quantity determined by the free allocation rules for free throughout the entirety of phase 3 (see Addressing the risk of carbon leakage).

Free allocation in the EU ETS

Free allocation in the EU ETS From phase 3 onwards, a benchmarking approach is used for the free allocation of allowances. The total amount of free allocation each installation should receive is determined by product-related GHG emission benchmarks, to the extent feasible (see What is a benchmark?). Those benchmarks are set at the average emission level of the 10% most efficient installations within each sector.

In this way, installations that are highly efficient should receive all or almost all of the allowances they need to comply with EU ETS obligations. Inefficient installations have to make a greater effort to cover their emissions with allowances, either by reducing emissions or by purchasing more allowances (see Free allocation shifts compliance costs). The same principle is used for free allocation to aircraft operators, but benchmarks have been determined in a different manner (see Aviation). During phases 1 and 2, most allowances in all Member States were given out for free based on historical GHG emissions. This method is known as grandfathering.

This approach has been criticised as rewarding higher emitters while not taking early action into account. In contrast to grandfathering, benchmarking does not have the effect of providing more free allocation to the highest emitting installations. Benchmarking allocates allowances based on their production performance instead of their historical emissions; GHG-intensive installations will receive less free allowances relative to their production compared to highly efficient installations, driving inefficient installations to take action to cover their excess emissions. Therefore, in phase 3 benchmarking was chosen to determine free allocation.

Auctioning in the EU ETS

The auctioning of allowances from the third trading period (2013�2020) onwards (and in the case of aviation, from 2012 onwards) is governed by the Auctioning Regulation (EU Regulation No 1031/2010) which specifies the timing, administration and other aspects of how auctioning should take place to ensure an open, transparent, harmonised and non-discriminatory process (see Auctioning in practice). Any auction must respect the rules of the internal market and must therefore be open to any potential buyer under non-discriminatory conditions (see Auctioning bodies and venues).

Member States are responsible for ensuring that their share of allowances is auctioned (see Distribution of auctioning rights for details). As from phase 3 of the EU ETS, auctioning can either take place on a common auction platform appointed through a joint procurement procedure or on an 'opt-out' auction platform appointed pursuant to a procurement procedure conducted by those Member States.

The joint procurement approach is taken by the European Commission and 25 participating Member States. Germany, Poland and the UK chose to opt-out from the joint procurement procedure and have their own auction platform. The maximum duration for each appointment of auction platform is 5 years. The European Energy Exchange AG (EEX) is the transitional common auction platform for 25 Member States, and is also, separately, the opt-out common auction platform for Germany.

The other auction platform is ICE Futures Europe (ICE), which is the opt-out auction platform for the UK. Poland has so far not listed an opt-out auction platform, so it temporarily uses the transitional common auction platform EEX. Norway, Liechtenstein and Iceland also use the transitional common auction platform. Each bidder may apply for admission to bid at the auction platforms from anywhere in the EU and the EEA-EFTA.

The auction platform must check each application to ensure bidders are eligible to participate under the rules laid down by the Auctioning Regulation and to prevent the auctions being used for criminal activity.

To ensure fair and orderly auctioning, there are two levels of supervision:

• Scrutinising and monitoring by the auction platform itself;
• Supervision by the competent national authority for financial markets of the Member State where an auction platform is located.

In addition, for horizontal supervision of all auctions on all auction platforms, an auction monitor will be appointed through a joint procurement procedure involving all the Member States and the Commission. Before the determination of allowances to be auctioned, 5% of the total quantity of allowances is set aside in the New Entrant Reserve (NER) for free allocation to new entrants (see How are allowances allocated?).

If the allowances in the NER are not allocated to new entrants or other eligible parties as specified in the EU ETS Directive, the remaining allowances are distributed over the Member States for auctioning. The distribution will take into account the level to which installations in Member States have benefited from the NER (Article 10a (7) of the EU ETS Directive).

The distribution of the auctioning rights between Member States in phase 3 is specified in Article 10(2) of the EU ETS Directive. 88% of the total amount of allowances that can be auctioned is distributed to Member States based on their share of GHG emissions in phase 1 of the EU ETS. A further 10% of the auctioning rights are divided between Member States with low per capita income receiving a larger share compared to those with high per capita income.

The redistribution of auctioning rights allows the Member States with lower per capita income to generate additional auction revenues that can be used to invest in climate-friendly technologies. The remaining 2% of auction rights are distributed so as to take into account early action, by distributing auctioning rights to Member States which had already achieved a reduction of at least 20% in greenhouse gas emissions by 2005, compared with the reference year set by the Kyoto Protocol.

Nine Member States (Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania and Slovakia) benefit from this second mechanism. Member States that provide some free allocation to electricity producers (based on Article 10c of the EU ETS Directive and see Transitional free allocation for modernisation of the power sector (Article 10c)) have the equivalent number of allowances deducted from their auctioning rights.

Issuing and allocating allowances
In phase 2 the allowances to be issued by the Member States to each installation were specified in National Allocation Plan Tables and held in national allowance holding accounts. In phase 3 the National Allocation Plans were replaced by the National Allocation Tables established in accordance with the National Implementation Measures (NIMs).

The Central Administrator issues all allowances by creating them on the EU total quantity account in the Union registry. The Central Administrator is responsible for transferring allowances for auctioning and free allocation to the appropriate accounts. Member States are responsible for allocating the allowances free of charge. Surrendering allowances EU allowances (EUAs) are valid for surrendering in any year throughout the trading period.

By 30 April of each year, ETS operators are required to surrender in the Union registry a quantity of EUAs equal to the volume of their verified GHG emissions of the previous year. Eligible international credits such as certain CERs and ERUs can also be used up to the maximum allowed limit (see External links: use of international credits). In contrast to phase 2, in phase 3 international credits cannot be directly surrendered.

Only EUAs can be surrendered for compliance, so all eligible CERs and ERUs need to be exchanged for EUAs first. There is a penalty of �100 per tCO2, increasing with EU inflation from 2013, in case of failure to surrender allowances in time. This penalty does not, however, take away the obligation to surrender the required amount of allowances (see Penalties for non-compliance). Deleting allowances Participants can also choose to voluntarily �cancel� allowances, or in other words have them permanently withdrawn from circulation and deleted from the Union registry, without using them for compliance.

This is done primarily as a �voluntary offset� measure or for environmental reasons, namely that deleting allowances will increase the amount of abatement activity that takes place within the scheme. This is based on the reasoning that if the number of allowances in the ETS decreases then the price of the remaining allowances rises, which in turn creates a greater incentive for internal abatement measures.

A specific deletion account exists within the Union registry for this purpose. Transferring allowances Transfer of allowances takes place between EU ETS registry accounts. The transfer instructions are given electronically by the authorised representatives of the seller account, who indicates the amount of units to be transferred and the details of the recipient's account. In general once trades have been confirmed, either Over-The-Counter or on an exchange (see Market oversight), instructions are sent to the Union registry for the physical transfer to take place (also called delivery).

End-Notes:

1. https://taxfoundation.org/carbon-taxes-in-europe-2020/
2. https://openknowledge.worldbank.org/handle/10986/29687
3. https://www.iea.org/reports/implementing-effective-emissions-trading-systems
4. https://www.iea.org/reports/implementing-effective-emissions-trading-systems
5. https://www.iea.org/reports/implementing-effective-emissions-trading-systems
6. https://www.iea.org/reports/implementing-effective-emissions-trading-systems