Greenhouse gas emission allowance trading system

SUMMARY OF:

Directive 2003/87/EC establishing a system for greenhouse gas emission allowance trading within the European Union

WHAT IS THE AIM OF THE DIRECTIVE?

It establishes the European Union (EU) emissions trading system (ETS). This is the cornerstone of the EU’s policy to tackle climate change by reducing greenhouse gas (GHG) emissions in a cost-effective and economically efficient way. It is based on the ‘cap and trade’ principle*.
The original legislation has been amended several times as the system has evolved. The most recent changes were adopted in Directive (EU) 2023/958 and Directive (EU) 2023/959 as part of the EU’s ‘fit for 55’ initiative, which aims to ensure that the EU’s policies are in line with the European Climate Law’s climate goals and commitments under the European Green Deal and the Paris Agreement.

KEY POINTS

The current (fourth) phase of the ETS runs from 2021 to 2030. For this period, the EU has set a new, increased target to decrease GHG emissions by 62% compared to 2005 levels.

The system applies to:

power plants;
a wide range of energy-intensive industrial sectors;
flights within the EU and the European Economic Area (EEA), and departing flights to Switzerland and the United Kingdom;
maritime transport (surrendering obligations will be introduced gradually between 2024 and 2026);
emissions of:
- carbon dioxide (CO₂),
- nitrous oxide,
- perfluorocarbons,
- methane.

A new separate, stand-alone ETS has been set up to cover buildings, road transport and fuels for additional sectors that correspond to industrial activities not covered by the existing ETS.

Allowances

Since 1 January 2005, operators of all activities covered by the legislation must each year surrender an appropriate number of emission allowances to cover their GHG emissions of the previous year (one emission per tonne of carbon dioxide (CO₂); or the equivalent amount of other powerful GHGs).
Annually, the total number of allowances issued in the EU is being gradually reduced: by 1.74% between 2013 and 2020, and by 2.2% between 2021 and 2023. Between 2024 and 2027 it will be reduced by 4.3% per year, and from 2028 by 4.4% per year.
The system of free allowances has been revised to tackle the issue of carbon leakage* by focusing on sectors at risk of relocating their production outside of the EU. In this respect:
- free allowances will be gradually phased out based on higher reduction rates;
- a carbon-border adjustment mechanism (known as CBAM) has been set up (this is a carbon pricing system that applies to energy-intensive products imported into the EU – free allocation in the ETS is being gradually phased out until 2034 for those sectors covered by the carbon-border adjustment mechanism).

Aviation sector

Until the end of 2026, EU carbon pricing will apply to flights within the EU / EEA, and departing flights to Switzerland and the United Kingdom, maintaining the current restricted geographical scope for the international application of the rules. By 1 July 2026, the European Commission must present a report assessing the environmental integrity of the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) set up by the International Civil Aviation Organization. The report must be accompanied by a legislative proposal maintaining or extending the scope of the ETS to departing flights in light of the environmental integrity and ambition of CORSIA in relation to the targets under the Paris Agreement. CORSIA will apply to extra-European flights to and from countries participating in CORSIA.
The updated rules accelerate the implementation of the polluter-pays principle* by gradually phasing out free allowances for the aviation sector with full auctioning in 2026.
From 1 January 2024 until 31 December 2030, 20 million allowances will be reserved as an incentive for aircraft operators to move away from using fossil fuels.

Separate emissions trading system for buildings, road transport and additional sectors

To incentivise emissions reductions in the road transport and buildings sectors – which were not covered by the existing ETS – the co-legislators agreed to establish, as from 2027, a separate but parallel ETS for emissions from fuels combusted in the relevant sectors. Unlike the existing ETS, the so-called ETS2 puts the point of regulation upstream, i.e. on persons liable to pay excise duties on energy (such as tax warehouses and fuel suppliers) and not on the end consumers of fuels. Regulated entities covered by ETS2 should surrender allowances for their verified emissions corresponding to the quantities of fuels they have released for consumption. Although surrendering of allowances under ETS2 will only start in 2028 for 2027 emissions, the monitoring and reporting of emissions will start from 1 January 2025. The allowances in ETS2 will not be fungible with allowances traded in the existing ETS and will be placed on the market only by auctioning (no free allocation). The total number of allowances issued in ETS2 will be reduced annually by 5.10% at the start of the system and by 5.38% from 2028.

Low-carbon funding mechanisms

The Modernisation Fund supports modernising investment projects in the power sector and wider energy systems in EU Member States whose gross domestic product per head at market prices in 2013 was below 60% of the EU average. Three lower-income Member States whose gross domestic product per head at market prices was below 75% of the EU average from 2016 to 2018 have been added.
The Innovation Fund supports the demonstration of innovative technologies and breakthrough innovation in sectors covered by the EU ETS, including innovative renewables, carbon capture and utilisation, and energy storage with a stronger focus on the upscaling of new technologies.
The Social Climate Fund established by Regulation (EU) 2023/955 (see summary) will accompany the introduction of the carbon price in the buildings and road transport sectors and provide dedicated funding to Member States to support the most affected vulnerable groups, especially households in energy or transport poverty and microenterprises.

Role of Member States

Member States are responsible for the following tasks.

Issuing allowances.
Ensuring that operators, aircraft operators, shipping companies and regulated entities monitor and report their emissions annually and surrender a number of allowances equal to their total emissions during the previous calendar year.
Auctioning all allowances not allocated free of charge or placed in a market stability reserve.
Deciding how to use income from the auctions on climate, energy and social purposes.
Providing the Commission with an annual report on the application of the legislation.
Ensuring that allowances can be transferred between installations in the EU and to non-EU countries where the allowances are recognised.
Setting out effective penalties for any breaches of the law.

The Commission:

presents an annual report to the European Parliament and to the Council of the European Union on the implementation of the EU ETS and accompanying climate and energy policies;
has the power to define the technical rules necessary to implement basic legislation;
maintains an independent registry and a transaction log that record the ownership, issuing, transfer and cancellation of allowances.

The European Securities and Markets Authority presents annually an assessment of the functioning of EU carbon markets.

FROM WHEN DO THE RULES APPLY?

Directive 2003/87/EC had to be transposed into national law by 31 December 2003.
The changes introduced with the 2023 revision of Directive (EU) 2023/958 and Directive (EU) 2023/959 on stationary installations, aviation and maritime need to be transposed by Member States by 31 December 2023.
Nevertheless, Member States will need to apply several provisions relating to free allocation only from 1 January 2026.
The deadline for transposition of the rules of the new ETS for buildings, road transport and additional sectors is 30 June 2024.

BACKGROUND

EU emissions trading system (European Commission).

KEY TERMS

Cap and trade principle. The EU ETS works on the basis of this principle. A cap, or limit, is set on the total amount of certain GHGs that can be emitted by the factories, power plants and other installations in the system. The cap is reduced over time so that total emissions fall. The system allows emission allowances to be traded so that the total emissions of the installations and aircraft operators stays within the cap, and the least-cost measures can be taken to reduce emissions.

Carbon leakage. Carbon leakage refers to the situation that may occur if, for reasons of costs related to climate policies, businesses were to transfer production to other countries with laxer emission constraints. This could lead to an increase in their total emissions. The risk of carbon leakage may be higher in certain energy-intensive industries.

Polluter-pays principle. This principle requires polluters to bear the cost of the pollution they cause.

MAIN DOCUMENT

Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC (OJ L 275, 25.10.2003, pp. 32–46).

Successive amendments to Directive 2003/87/EC have been incorporated into the original text. This consolidated version is of documentary value only.