The EU Emissions Trading System is the world's largest carbon market by traded value and the system every CBAM number is ultimately derived from. This is how it actually works: the cap, the allowances, the auctions, the free allocation phase-out, the new ETS2 arriving in 2027, and what is still being negotiated right now.
- It is cap and trade at scale. Roughly 10,000 power and industrial installations, plus airlines and shipping, across 30 countries.
- Phase 4 runs 2021 to 2030. The cap shrinks 4.3% a year through 2027 and 4.4% a year from 2028.
- Free allowances for CBAM-covered industries are being phased out between 2026 and 2034, deliberately in step with CBAM's own phase-in.
- ETS2 is a separate system, covering buildings and road transport, launching in 2027 with its own cap and its own price.
- The rules are not settled. A Commission proposal to further revise the system was put forward in July 2026 and has not been adopted.
- What the EU ETS actually is
- A brief history, and why it matters
- How allowances actually get auctioned
- How Phase 4 works right now
- Free allocation, benchmarks and the CBAM phase-out
- Who is actually in this system
- A worked example: what it costs an installation
- Price mechanics and the Market Stability Reserve
- ETS2, arriving in 2027
- What is still being negotiated
- Sources and further reading
- Frequently asked questions
What the EU ETS Actually Is
Strip away the acronyms and the EU ETS is a fairly simple idea applied at enormous scale. The EU sets a hard limit, a cap, on how many tonnes of CO2 the installations and companies it covers can emit each year. That cap shrinks every year. Companies need one allowance for every tonne they emit, and they get those allowances either for free, a shrinking share discussed below, or by buying them at auction. If a company emits less than its allowances cover, it can sell the extra. If it emits more, it has to buy more, from another company or at auction.
That is the entire mechanism: a shrinking supply of permission to emit, priced by the market.
It is the world's first major carbon market, launched in 2005, and it is still the largest by traded value. Everything CBAM does is built to mirror what this system already charges EU producers. That is the whole logic of the border mechanism. It exists so importers cannot undercut EU industry just by emitting somewhere the EU ETS does not reach.
A Brief History, Because the Current Phase Only Makes Sense in Context
| Phase | Years | What defined it |
|---|---|---|
| Phase 1 | 2005 to 2007 | A pilot. Allowances mostly given out free through national allocation plans. The market badly overallocated and prices collapsed toward zero by the end, a genuinely instructive failure. |
| Phase 2 | 2008 to 2012 | Tighter, but overlapped the 2008 financial crisis, which suppressed industrial output and with it demand for allowances. Prices stayed weak. |
| Phase 3 | 2013 to 2020 | The real structural shift. A single EU-wide cap replaced the patchwork of national plans, and auctioning became the default allocation method rather than free handouts. |
| Phase 4 | 2021 to 2030 | The current phase, split into two allocation periods, 2021 to 2025 and 2026 to 2030. |
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Phase 1's collapse is the reason the system has a supply-management mechanism today, and Phase 3's move to auctioning is the reason the price behaves like a market price rather than an administrative fee. Neither of those design choices was obvious in advance.
How Allowances Actually Get Auctioned
Most EU ETS allowances not given out for free are sold through regular auctions on a common auction platform, primarily the European Energy Exchange, running daily or several times a week depending on the allowance type. Bidders include the installations themselves, but also banks, investment firms and other financial intermediaries registered to participate, which is part of why EUA prices behave somewhat like a traded commodity rather than a fixed administrative fee.
Auction revenue does not disappear into general EU budgets. Member states are required to use at least half of it for climate and energy purposes, and a portion is specifically earmarked for the Modernisation Fund and Innovation Fund supporting lower-income member states' energy transitions.
How Phase 4 Actually Works Right Now
The cap shrinks according to something called the linear reduction factor, essentially the percentage the total emissions ceiling drops each year. Under the current legislated rules, that is 4.3% annually from 2024 through 2027, rising to 4.4% from 2028 through 2030. Two one-off rebasing cuts also pulled allowances out of the system entirely, 90 million in 2024 and a further 27 million in 2026, tightening supply beyond just the annual reduction rate.
For Phase 4's second allocation period, 2026 to 2030, free allocation for industrial installations became conditional in a new way. Companies now have to show they have implemented energy efficiency measures, backed by audits or a real energy management system, and the worst-performing installations need an actual carbon neutrality plan to keep receiving free allowances at all.
This is a real behavioural lever, not just a tightening cap. It directly ties free allocation to demonstrated decarbonisation effort, rather than handing it out purely by sector and output.
Free Allocation, Benchmarks, and Exactly How It Connects to CBAM
Free allowances are not handed out arbitrarily. They are calculated against product-specific benchmarks representing the average performance of the most efficient 10% of installations making that product in Europe. An installation more efficient than its sector's benchmark effectively receives a small surplus it can sell; one less efficient falls short and has to buy the difference.
These benchmark values get updated periodically. The current set applies through the 2026 to 2030 allocation period, recalculated from more recent production data than the previous period used, meaning even installations that have not changed anything may see their free allocation shift simply because the benchmark itself moved.
This is the part most directly relevant if you have read anything about CBAM. Free allocation for the sectors CBAM covers, iron and steel, cement, aluminium, fertilisers and hydrogen, is being phased out gradually between 2026 and 2034, deliberately synchronised with CBAM's own phase-in so EU producers never face a period where they are paying more than an import would cost under CBAM. The phase-out starts slowly and accelerates toward the end of the period.
Aviation's free allocation, by contrast, is already fully gone, phased out entirely by 2026 after stepped cuts of 25% in 2024 and 50% in 2025.
Coverage: Who Is Actually in This System
Around 10,000 power stations and industrial installations across the EU, plus Iceland, Liechtenstein and Norway, fall under the EU ETS, along with airlines flying within the covered area and, more recently, shipping.
Maritime coverage started with CO2 only and is expanding. CH4 and N2O emissions from ships are being added from 2026, with the obligation to surrender allowances for those emissions phased in gradually rather than all at once, and member states cancelling allowances equal to the shortfall between what was surrendered and what was actually verified during the transition years.
A Worked Example: What This Actually Costs an Installation
Take a mid-sized industrial installation emitting 100,000 tonnes of CO2 a year, receiving free allocation covering 60% of that based on its benchmark position. That 60% is a plausible figure for an installation performing close to but not quite at the top decile, and it is illustrative rather than a universal rate.
| Line | Figure |
|---|---|
| Annual emissions | 100,000 tCO2 |
| Free allocation, illustrative | 60%, or 60,000 allowances |
| Allowances that must be bought | 40,000 |
| EUA price used | Approximately €72 |
| Direct annual allowance cost | Approximately €2.88 million |
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That is before any of Phase 4's efficiency conditions or the shrinking free-allocation share in later years are factored in. The number moves every year as the cap tightens and free allocation shrinks further, which is precisely why the linear reduction factor is not just a policy detail. It is the single biggest driver of how this cost curve looks five years out.
Price Mechanics and the Market Stability Reserve
EUA prices in 2025 and 2026 have traded roughly in the €60 to €95 range, sitting around €72 as of April 2026. That volatility is deliberately dampened by the Market Stability Reserve, introduced in 2019 and strengthened in 2023.
When the number of unused allowances in circulation climbs above 833 million, 24% of the surplus gets pulled permanently out of the market and placed in the reserve rather than staying available to buy. When supply runs tight instead, the reserve can release allowances back in.
It is a supply-smoothing mechanism, not a price cap or floor, but it meaningfully reduces the kind of price collapse that wrecked Phase 1, when a genuine oversupply had nowhere to go and prices fell toward zero.
You can track the live EU ETS price on our carbon prices page, which is the same figure the CBAM certificate price is ultimately built from.
ETS2: A Second, Separate System Arriving in 2027
This is genuinely new and worth understanding as distinct from everything above. ETS2 covers buildings and road transport, sectors the original EU ETS never touched, and launches as its own separate scheme in 2027, with its own cap, its own allowances and its own price. It is not merged into the existing EUA market.
Because heating and transport costs land directly on households, not just industry, the EU paired ETS2 with the Social Climate Fund, which will receive up to €65 billion from ETS2 revenues between 2026 and 2032, roughly a quarter of total ETS2 funds, specifically to offset the impact on lower-income households.
To manage the risk of an initial price spike as this new market finds its footing, auction supply is set to decrease by 103.6 million allowances annually from 2029 to 2031, a deliberate frontloading correction rather than a static schedule.
What Is Still Being Negotiated, and This Matters for Accuracy
On 17 July 2026, the European Commission proposed a further, targeted revision of the EU ETS, aimed at industrial competitiveness and the bloc's 2040 climate target. The proposal includes a new Industrial Decarbonisation Bank, continued Innovation Fund and Modernisation Fund support, updated free allocation and CBAM rules, strengthened aviation and maritime coverage, and gradual extension of emissions trading to municipal waste incineration.
As of this writing, this is a proposal, not adopted legislation. Any guide, including this one, describing EU ETS rules should be read with that distinction in mind. This system has changed meaningfully every few years since 2005, and it is in the middle of another negotiation right now.
Sources and Further Reading
- International Carbon Action Partnership, icapcarbonaction.com
- European Commission Climate Action, free allocation, climate.ec.europa.eu
- Carbon Market Watch, EU ETS policy milestones, carbonmarketwatch.org
- Live EUA data, CRBN.CREDIT carbon prices page
Following the EUA price because it sets your CBAM cost?
Live EU ETS settlement data and the published CBAM certificate rate, in one place.
For the border mechanism built on top of this system, see what CBAM is and how the certificate price is set. For what it means in practice for exporters outside the EU, see India's CBAM problem and the free tools built to solve it, or go straight to the India CBAM Center.
Frequently Asked Questions
What is the EU ETS in simple terms?
A cap-and-trade market where the EU sets a shrinking limit on how much CO2 covered companies can emit, and companies buy or sell allowances to stay under that limit.
How is the EU ETS different from CBAM?
The EU ETS prices emissions from production inside the EU. CBAM prices the emissions embedded in goods imported into the EU, calculated to roughly match what an EU producer would have paid under the EU ETS for making the same thing domestically.
How are EU ETS allowances actually sold?
Mostly through regular auctions on a common platform, primarily the European Energy Exchange, open to covered installations as well as registered banks and investment firms, which is part of why the price moves like a traded commodity.
Why is free allocation being phased out?
To push covered industries toward paying the real cost of their emissions over time, synchronised with CBAM's phase-in to prevent EU producers being undercut by imports during the transition.
What is ETS2?
A separate carbon market covering buildings and road transport, launching in 2027 with its own cap and price, distinct from the original EU ETS which covers power and heavy industry.
Is the EU ETS still changing?
Yes. A Commission proposal from July 2026 would further revise free allocation, CBAM integration, and sector coverage. It has not been adopted as of this writing.
A note on this article. EU ETS rules are set by legislation that has been revised repeatedly since 2005, and a further revision was proposed in July 2026 and is not yet adopted. Prices, cap figures and allocation rules above reflect the position as of publication, and the worked installation cost is illustrative rather than a universal figure. This is for informational purposes and is not legal, tax or investment advice.