ESRS E1: What is the European Union Emissions Trading System (EU ETS)?

ESRS E1: What is the European Union Emissions Trading System (EU ETS)?

1. Introduction

The European Union Emissions Trading System (EU ETS) has become an important tool in Europe's climate policy. It puts a price on greenhouse gas emissions, which means companies must now consider carbon as an environmental concern and also as a financial cost.

The EU ETS works as a cap-and-trade system. This means the EU sets a total limit (or cap) on the emissions allowed from certain sectors, and companies within those sectors must hold enough "allowances" to cover their emissions. One allowance equals one tonne of CO2. Companies can trade these allowances with each other, adding flexibility while keeping the overall emissions within the cap.

In this article you will learn:

✅ How the EU ETS cap-and-trade system works
✅ What’s new in Phase 4 (2021–2030)
✅ How free allowances are changing
✅ The annual compliance process
✅ The financial and strategic impact
✅ What companies must report under the CSRD if they fall under the EU ETS

Reading this will help you understand how the EU ETS works and how it can influence corporate decisions and sustainability strategies.

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2. The basics of cap-and-trade in the EU ETS

The EU ETS sets a yearly cap on emissions from sectors like power generation, steel, cement, chemicals, intra-EU aviation, and (from 2024) maritime shipping. This cap shrinks every year, supporting the EU’s climate targets.

Companies must have a sufficient number of allowances, called EU Allowances (EUAs), to cover their emissions. Each EUA equals one tonne of CO2. If a company emits more than it has allowances for, it must buy more from the market. If it emits less, it can sell its surplus.

The system covers about 40% of the EU’s total greenhouse gas emissions. In Phase 4, the cap is reducing faster than before — by 4.3% per year starting in 2024, and 4.4% from 2028. A one-time cut of 117 million allowances was also introduced to speed up reductions.

Allowances can be saved for future years (banked), but not borrowed from future years. Since 2020, companies can no longer use international carbon offsets.

Example case. Between 2020 and 2021, the UK Environment Agency fined 33 companies over £27 million for failing to comply with climate-related reporting and emissions reduction schemes. Power and energy firms were penalized under the EU ETS for under-reporting emissions or missing reports. Brewing and automotive companies were fined for not meeting voluntary carbon reduction targets tied to tax discounts. Other businesses, including those in insurance and manufacturing, faced penalties under the Energy Savings Opportunity Scheme for skipping mandatory energy audits.

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3. What’s new and important in Phase 4 (2021–2030)

Phase 4 raises ambition and tightens the rules. Key updates include:

• Wider coverage:
  The EU ETS now applies to more sectors. Maritime shipping has been added, and waste incineration might be next. The system also covers more gases, not just CO₂, but also nitrous oxide (N₂O) and perfluorocarbons (PFCs).

• Stricter cap:
  The total amount of emissions allowed under the system is getting smaller. By 2030, the goal is to cut emissions by 62% compared to 2005 levels, making the system tougher and more ambitious.

• No free allowances for power generators:
  Companies that produce electricity can no longer get free carbon allowances. They must now pay for 100% of their emissions.

• Changes for aviation and shipping:
  The rules are changing over time. Aviation will lose its free allowances by 2026, and shipping enters the system in 2025, starting with partial coverage and building up.

• Market Stability Reserve (MSR):
  This is a tool to keep the carbon market balanced. If there are too many allowances, the MSR will take some out of circulation and even cancel them starting from 2023 to prevent prices from dropping too low.

• No offsets allowed:
  Companies can no longer use international carbon credits (like CERs) to meet their obligations. Only EU Allowances (EUAs) are valid now, ensuring all reductions happen within the EU system.

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4. Free allocation: who gets what, and why it’s changing

To help industries compete globally and prevent production from moving abroad (carbon leakage), some companies still receive allowances for free. This is based on