Emissions trading

What is emissions trading?

Emissions trading – also known as cap-and-trade - is a way of putting a price on carbon and reducing greenhouse gas emissions in a cost-effective way.

A limit, or cap, is set on the overall level of emissions. Within that limit, participants can buy and sell allocations. The cap ensures the emissions target is met; the trading system helps ensure the cheapest options for reducing emissions are used.

Emissions trading is not a new idea. It has been used in the US since 1995 to tackle acid rain by reducing pollution from power stations. It was included in the 1997 Kyoto Protocol as a way of reducing greenhouse gas emissions. The UK first introduced a voluntary emissions trading scheme for carbon emissions in 2002.

The UK does not believe that an ETS is sufficient to drive the decarbonisation of our economy on its own. We see it as one, important measure, which is accompanied by other policies to reduce emissions from parts of the economy not covered by the ETS.

The European Union Emissions Trading System

The European Union Emissions Trading System (EU ETS) is the world’s first international functioning greenhouse gas emissions trading system. Prior to the mandatory EU ETS, the UK ran a voluntary trading scheme from 2002.

The EU ETS is an essential part of the EU's strategy for fighting climate change. It is the first international trading system for carbon dioxide (CO₂) emissions in the world and has been in place since 2005. The EU ETS was introduced by the EU to help meet its greenhouse gas emissions target under the Kyoto Protocol.

Global carbon market and the EU ETS facts:

• The EU ETS has put a price on carbon emissions and shown that it is possible to trade in greenhouse gas emissions.
• It is the first and biggest international scheme for trading greenhouse gas emissions allowances
• Two-thirds of European businesses included in the scheme have reduced their emissions. Many have made money by doing so
• The EU ETS dominates the global carbon market – itself worth $144bn in 2009 - with a total transacted value of $118bn in 2009, 18% increase from 2008.
• The UK has not experienced significant carbon leakage or job losses through the EU ETS. Quite the opposite: the ETS and our other measures have created substantial numbers of jobs (800,000 in low carbon and associated sectors in the UK alone, expected to rise to 1.2m by 2012).

How does the EU ETS work?

The system is a Europe-wide cap and trade scheme that caps the overall level of emissions allowed. Within that limit, participants in the system can buy and sell allowances as they require. These allowances are the common trading “currency” at the heart of the system.

In practice, this works by each EU member state developing a National Allocation Plan (NAP) approved by the European Commission. This sets an overall cap on the total emissions allowed from all the participants covered by the system. This is converted into allowances (1 allowance equals 1 tonne of CO₂), which are then distributed by EU member states to participants covered by the system.

Since the total number of allowances issued is lower than the number needed for "business as usual" emissions, the cap creates scarcity in the market and generates a carbon price.

At the end of each year, participants are required to surrender allowances to account for their actual emissions. This means they are paying for their emissions using the currency of carbon allowances. They may use all or part of their allocation. Participants can emit more than their allocation by buying allowances from the market. Similarly, an installation that emits less than its allocation, achieved for example by investing in more efficient technology or using less carbon-intensive energy sources, can sell its surplus allowances. The environmental outcome is not affected because the amount of allowances allocated in the system is fixed.

Participants that can reduce emissions cheaply are likely to do so, while participants for whom it would be very expensive will choose to buy allowances instead. In this way, emissions are reduced wherever it is most cost-effective. Emissions trading thus helps lower the cost of combating climate change.

Participants of the EU ETS include electricity generation and the main energy-intensive industries – power stations, refineries and offshore, iron and steel, cement and lime, paper, food and drink, glass, ceramics, engineering and the manufacture of vehicles.
In the upcoming third phase of the EU ETS (running 2013-2020), it is expected that the ETS will cover about 48% of national CO₂ emissions.  The UK uses other policies to tackle those emissions which are not covered by the ETS.

Find out more about EU ETS Legislation and how the EU’s system is working.

Carbon markets around the world

The UK strongly believes that a global carbon market, with tough developed country targets, is the most cost-effective way of reducing emissions.

Global carbon markets have the potential to deliver emissions reductions at low-cost. The 2009 report, “Global carbon trading: a framework for reducing emissions”, by the then-Prime Minister’s special representative on carbon trading, Mark Lazarowicz MP indicated a well-designed carbon market could reduce the costs of emissions reduction by 70% compared to a world where each country acted alone.

In addition to the EU ETS, 35 countries and regions around the world have, or are developing, their own forms of emissions trading schemes. New Zealand and Switzerland have schemes operating now; Korea and Japan are examining emissions trading; and China is considering market based mechanisms in domestic sectors. The Delegation of the EU to Australia and New Zealand has further information on emissions trading around the world in its December 2010 ‘Insight’ publication.

Meanwhile in the US, several states are operating a regional scheme under the Regional Greenhouse Gas Initiative, and, in December 2010, California endorsed the establishment of a cap-and-trade regulation that will allow the state's greenhouse gas emitters to buy and sell emission allowances. Find out more about carbon markets North America.

In Australia, the state-based NSW Greenhouse Gas Reduction Scheme (GGAS) which commenced in 2003, is amongst the first mandatory greenhouse gas emissions trading schemes in the world. GGAS aims to reduce greenhouse gas emissions associated with the production and use of electricity. It achieves this by using project-based activities to offset the production of greenhouse gas emissions.  

Carbon leakage

Carbon leakage - the increase in emissions outside a region as a result of an emission cap in this region – is sometimes raised as a concern of carbon trading.

The European Commission has undertaken extensive research and policy consultation on carbon leakage. Joint research by the Massachusetts Institute of Technology and the PEW Center on Global Climate Change concludes the EU ETS is “working well”.

In September 2010, the UK’s Department of Energy and Climate Change commissioned an assessment to investigate the impact of an increased EU greenhouse gas reduction target on the risk of carbon leakage. The study shows that for those sectors studied, only when both a sector’s trade intensity and carbon cost are moderate to high, is a sector exposed to a large risk of carbon leakage. Equally, it finds that that sectors with low carbon cost and varying levels of trade intensity are at low risk of carbon leakage. The report also suggests the EU’s criteria are “fairly robust” for assessing carbon leakage, but that the thresholds chosen may select too many sectors and do not place enough emphasis on sectors which really are at risk of carbon leakage. Download the report: Assessment of degree of carbon leakage in light of an international agreement on climate change.

Implications of EU ETS on electricity prices

Questions have been raised around the impact of the EU ETS on electricity prices. In particular, there are concerns that the costs of freely allocated CO₂ emission allowances is passed through to power prices, resulting in higher electricity prices for consumers and additional ("windfall") profits for power producers.

It is true that there have been modest increases in business and consumer prices. In the first phase of the ETS, too many emissions credits were given away, which led the price to drop and allowed some industries to gain windfall profits. However, like any new commodity market, we have learnt from these mistakes – for example we are moving to 100% auctioning for the power sector.

Additionally, analysis has also shown that other factors – such as changes in the price of oil and the weather – have affected electricity prices far more than the ETS.

In the face of concerns about higher electricity prices, UK households have actually saved money through energy efficiency. UK programmes promoting energy efficiency upgrades have cost the average household A$57 each year for three years – but brought them savings of A$82 per year for many years to come. Read more about the UK’s supporting consumers through energy efficiency and other programmes.

Related links

The European Commission’s web pages around how the EU is tackling climate change

The UK’s latest news on the EU ETS

The UK’s comprehensive list of EU ETS Legislation 

The UK’s extensive listing of useful research conducted at various stages of the EU ETS

Publication from non-government organization Climate Strategies on insights from the EU ETS with reference to emerging systems in Asia

A VIVID economics report "Implicit price of carbon in the electricity sector" examines 6 major economies including UK and Australia and finds that domestic policies are creating some financial incentive to produce low-carbon electricity and, consequently, an implicit price on carbon.