The world’s first international emissions trading system is the EU Emissions Trading System (EU ETS). The European Union became the CO2 market pioneer when it launched the system to put price on carbon in 2005. It is a cost-effective tool for reducing greenhouse gas emissions (GHGs) by setting a cap. That is, the carbon price established by an ETS guarantees that the cap is met at minimum cost. The cap-and-trade principle of EU ETS permits certain GHGs emission allowances under a reduced cap over time where companies receive or buy emission allowances and thereby, they can trade each other when needed. The supply of emission allowances is determined by simply the cap of an Emissions Trading System whereas output and emission intensity levels of regulated entities determine the demand of emission allowances.
All EU countries and EEA-EFTA states including Iceland, Liechtenstein and Norway are in the operation of EU ETS which limits CO2 emissions from power and heat generation, energy-intensive industry sectors including oil refineries, steel works and production of iron, aluminum, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids and bulk organic chemicals and commercial aviation sector. Sometimes companies are incentivised to less emission and penalized for more emissions. The drafted emission trading proposal was submitted to the EU Council of Ministers and the European Parliament in 2001. The Emissions Trading Directive was formally adopted in October 2003 after more than a year of negotiations between the European Parliament and key stakeholders—both industrial and political (European Parliament and Council of the European Union, 2003). Under EU law, such type of trading program would be considered an environmental policy rather than a tax policy. Since it commencement in 2005, the EU climate policy had integrated the policy of decarbonising the economy for attaining sustainable economic prosperity. Thus, the EU ETS scheme is ultimately following its commitment to fulfil the Kyoto protocol.
There are four phases EU ETS, existed in the current time frame. Phase 1 started from 2005 to 2007 as a pilot program not only to establish market price for CO2 but also to build administrative capacity within the EU Commission, within national governments, and within industry, ahead of the Kyoto Protocol's first commitment period (2008–2012). In phase 1, cap on allowances set at national level which only considered CO2 emissions from power generators and energy-intensive industries. There were free allowances to business. Although forward price was above spot price, the supply exceeded demand and consequently market price for carbon was close to zero.
Phase 2 from 2008 to 2012, was designed to incorporate lessons learned from phase 1. The credible installation-level emissions data which was generated by reporting and verification process in phase 1, used to guide its form phase 2. Although the price of EUAs had collapsed in phase 1, the commission raised the limit to let countries auction up to 10 of their allowances in phase 2. This gave a rise EUA futures to 25 euro and it climbed to 30 euro as phase 2 got underway in 2008. In this phase, the cap was lowered and new countries joined: Iceland, Liechtenstein and Norway. The free allocation was reduced and introduced auctions. The penalty for non-compliance was increased from 40 Euro to 100 Euro per tonne
Phase 2 can be coincided with the first commitment period of the Kyoto Protocol. Since January 2012 the aviation sector is covered under the ETS. The demand for emission allowances were depressed due to financial crisis between 2007 and 2012 whereas the supply remained fixed and was further expanded through international carbon credits. This surplus caused a collapse in the price for European emissions allowances (EUA). This particular lessons learned from phase 1 and 2 weakened the political case of ‘grandfathering’ as many firms had earned windfall profits by raising prices while receiving their allowances for free, such as electricity sector.
Phase 3 from 2013 to 2020 started with a biggest change of allocation process that had become centralized under the European commission. This centralized process further strengthened the EU's claim to be able to deliver what is offered in global negotiations. This phase introduced a single EU-wide cap through auctioning the default method of distributing allowances, and harmonized the free allocation rules. This scope was also spread through more sectors and gases. The emission was reduced by 41% in 2020 compared to 2005, though the target was a 21% reduction by 2020. This phase introduced EU-wide cap on emissions and auctioning instead of free allocation.
Phase 4 from 2021 to 2030 is a reform package which is made important changes to shore up and to stabilize price expectations. It accelerated the tightening of the emissions cap, moving from an annual linear reduction of 1.74%–2.2%. The annual free allocation volume continues to decline in line with the overall cap. Thus, more of the revenue from allowance auctions would also be hypothecated to support innovation and modernization. The 2030 target of European Climate Law is to reduce net emissions by 55% by lowering the cap and further extension by including others sectors and improved functioning of the ETS. These goals are align with the legislative proposal in the 'Fit for 55' package.
In earlier phases, the decisions of grandfathering allowances under national regulators were targeting the intense lobbying. The intension of lobbying was to ensure that each firm would have enough allowances to compete but the rent seeking exercise ultimately contributed to crippling system-wide over-allocation (Quirion, 2021). This further depressed CO2 prices and helped to paralyze the EU ETS for many years. As the system lacked the necessary flexibility to address the excess supply of allowances within commitment periods, the longer commitment advises of economists were failed (Grosjean et al., 2016). The political compromise and economic refinement were iterated by many ways and thereby, it was observed fruitful results.