Emissions Trading System (ETS)

An emissions trading system (ETS), also called a carbon market, is an economic mechanism that puts a price on greenhouse gas (GHG) emissions. By capping total emissions and issuing tradable allowances, it lets the market find the cheapest way to cut pollution while keeping aggregate emissions within a defined limit.

How a cap-and-trade market works

• Cap: a regulator sets a maximum volume of emissions for the covered sectors over a period.
• Allowances: companies must hold one allowance for every tonne of CO2 equivalent they emit. Allowances are auctioned or partly allocated for free.
• Trading: firms that cut emissions below their holdings sell surplus allowances to firms that exceed theirs, creating a single carbon price.
• Declining cap: the limit tightens over time, steadily raising the cost of emitting and rewarding decarbonisation.

An ETS is a market-based, cap-and-trade instrument. It differs from a carbon tax, which fixes the price per tonne and lets the quantity of emissions adjust, whereas an ETS fixes the quantity (the cap) and lets the price move.

Why governments use an ETS

• Internalise the cost of pollution: make emitters pay for climate and health damage.
• Reward innovation: raise the relative attractiveness of clean technology and energy efficiency.
• Raise revenue: auction proceeds can fund the climate transition.

Major systems around the world

• EU ETS: the first and largest carbon market by value, now joined by a separate ETS2 for buildings and road transport (allowance surrendering starts in 2028).
• China's national ETS: launched in 2021 and the largest in the world by the volume of emissions covered, initially focused on the power sector and expanding to heavy industry.
• UK ETS, California and RGGI: established systems in the United Kingdom and North America.

Strengths and limitations

Emissions trading offers flexibility and cost-effectiveness, and systems can be linked across jurisdictions. Its main weaknesses are carbon-price volatility, the risk of carbon leakage where rules differ between regions, and over-generous free allocation that can blunt the incentive to cut emissions. Robust design, a tightening cap and strong oversight are the keys to success.

By putting a price on pollution, an ETS is a central tool for global decarbonization. At Manglai we help companies measure their carbon footprint and understand their exposure to carbon-pricing rules. Discover how Manglai can help you.