European emission allowances and an explanation of how they work ?

European emission allowances are an effective means of reducing emissions and are key to achieving the EU's future emissions targets.

Emission allowances are the main instrument of the European Union Emissions Trading Scheme (EU ETS), which aims to reduce greenhouse gas emissions by charging for them.The EU ETS was launched by the European Union in 2005 as the first large-scale greenhouse gas emissions trading scheme (and was the largest of its kind in the world until early 2021, when China's national ETS became operational). In addition to EU countries, it also includes Iceland, Liechtenstein and Norway.

How do allowances reduce emissions ?

Today, power plants and industrial plants emitting greenhouse gases must demonstrate that they have allowances for these emissions to the appropriate extent. One allowance entitles them to emit one tonne of CO2, or an equivalent amount of N2O or perfluorocarbons. Each year the EU issues a certain amount of these allowances (European Emission Allowance, EUA), and this amount (called the "EUA") is the amount of CO2 emitted by the EU.The system thus makes it possible to control and continuously reduce the amount of emissions from the covered sectors.

The EU's emission cap is set at a level that is steadily reduced over the years, in line with the EU's emission targets.

In the English-language literature, the ETS is often referred to as cap-and-trade because it combines a cap on total emissions (cap) with free trading (trade) between individual GHG emitters.

Power plants and other utilities participating in the scheme buy allowances at auction (or can receive them for free, see below) and then trade them freely on an exchange. Their emissions are measured and verified, and if they emit more greenhouse gases than their allowances entitle them to, they are fined (€100 per tonne of emissions) and must also replenish their allowances.

When some power plants or industrial plants have the opportunity to reduce their emissions more cheaply than the price of emission allowances, they face a decision: is it more profitable to innovate and invest in cleaner technologies, or to buy emission allowances at a given price?

The EU is gradually reducing the amount of allowances offered in the next few years (i.e. the maximum amount of emissions allowed). At the same time, the possibility of free trading of allowances ensures that emission reductions are made first in companies where implementation is cheapest. Therefore, we say that the EU ETS leads to achieving emission targets in a cost-effective way.

Emissions trading schemes are a market mechanism that is based on the principle that polluters should pay for environmental damage. These payments incentivise power plants and other operations to reduce their own emissions and at the same time the funds raised can be used, at least in part, to repair the damage caused. Economists refer to this principle as the "internalisation of externalities" (here, an externality is the release of greenhouse gases that polluters have so far burdened nature and society as a whole without having to pay for it). It is precisely the existence of externalities that do not occur in the ideal market model that leads to an unfair advantage for polluters. Emissions trading schemes seek to eliminate this imperfection and to level the market environment.

How much do emission allowances cost?

The price of emission allowances is a key parameter of the whole system.

If it is too low, the polluter can buy the necessary allowances cheaply and the principle of paying accordingly for the pollution caused remains unfulfilled.

But reductions in emissions are nonetheless occurring as the European Union gradually lowers its emissions cap. Fewer allowances in circulation also means a rising price. Since the introduction of the scheme, the price of allowances has been very low in some years, often as a result of a weakening economy (e.g. during the downturn in economic output during the financial crisis in 2008-2009 or at the beginning of the coronavirus pandemic in 2020, but also in 2013-2017 due to a surplus of allowances). In 2020, on average, €25 per tonne of CO2 was paid, and even more than €30 in early 2021. According to estimates by some institutions, a price per tonne of CO2 in 2020 in the range of €33-66 was necessary to achieve the Paris Agreement's targets.2 3 The lower limit of €33 reached the price of a European emission allowance in December 2020. This is a good signal, but not sufficient in itself: in addition to further future price increases, most of the world's greenhouse gas emissions would need to be comparably priced.

Which sectors are included in the scheme?

The scheme mainly covers larger sources in energy-intensive industries (nearly 11,000 installations in total), namely:

• power plants with a thermal input of more than 20 MW,
• oil refineries,
• coking plants,
• iron and steel works,
• cement plants
• and some other industrial production.

In addition, it covers approximately 600 aircraft operators within the European Economic Area (EEA). Collectively, it covers approximately 38 % of the greenhouse gas emissions in the European Economic Area (EU1), and in addition to CO2 emissions, nitrous oxide N2O emissions and fully fluorinated PFCs emissions are also included.

Who receives free emission allowances?

About 43 % of allowances were allocated free of charge between 2013 and 2020, mainly to emission-intensive industries. The remaining 57 % were to be auctioned (however, the actual number of auctioned allowances was lower). Free emission allowances are intended for sectors of the economy where it would be easy to shift production to countries where GHG emissions are not restricted. Thus, if the auctioning of allowances were applied consistently, there could be a drain of production facilities from the EU and an increase in emissions in other countries. The amount of free allowances allocated has been gradually reduced and, for example, electricity generation has not been eligible for free allocation since 2013 (however, some countries, including the Czech Republic, have negotiated an exemption from this rule until 2019).

How is the maximum quantity of allowances determined?

In order to achieve the EU's emission targets in 2020 and 2030, the maximum quantity of allowances has been steadily reduced since 2013. In 2013, 2.1 billion emission allowances were issued and 38 million fewer each year until 2020 - to ensure a reduction of at least 21 % in the sectors covered (compared to 2005).

The reductions will be even faster in the next decade: the original target was to reduce emissions in the EU ETS by 43 % by 2030 (compared to 2005) - this target is now being further adjusted under the Green Deal for Europe.

Where does the EU ETS work well and where does it not?

Benefits

• The EU ETS is a market-based mechanism, i.e. decisions on greenhouse gas emissions are largely left to the producers themselves. Power plants and other installations decide whether to buy emission allowances or invest in reducing their own emissions, depending on the current price. Combined with the limitation of the total quantity of allowances, it is thus possible to achieve the emission targets with low additional costs - and this is the main advantage of the whole system.
• The funds raised from the auctioning of allowances can be used to support innovation and for climate and energy purposes.
• Well-configured ETS systems allow for interconnection with other countries (e.g. the EU ETS is today linked to a similar system in Switzerland and in the future it should also be linked to the emerging UK system). This helps to equalise the price of emissions from different countries and increase the efficiency of the system.
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