A working guide to how the cap is set, who has to comply, and what actually moves the carbon price.
The EU Emissions Trading System opened in 2005, the first carbon market of its kind anywhere and still the biggest. It runs across 30 countries: the 27 EU members plus Iceland, Liechtenstein and Norway. The idea behind it is simple enough. Rather than tell each power plant or factory how to cut its emissions, the EU sets a ceiling on the total tonnes the covered sectors are allowed to emit in a year, then lets companies trade allowances among themselves to stay under it at the lowest overall cost.
One allowance, called a European Union Allowance or EUA, carries the right to emit a tonne of CO₂-equivalent. Each year a covered site has to hand back enough allowances to match its verified emissions. A company that cuts its emissions cheaply ends up with spare allowances it can sell; one that finds cutting expensive can buy what it needs instead. The effect is that the cheapest reductions happen first, while the cap still fixes how much pollution is allowed in total.
Worth remembering
The cap is what guarantees the climate result; trading is what keeps the cost down. And because the cap is cut a little more each year, allowances get scarcer and the price tends to climb over time. That is the whole point of the design.
All told, the system covers about 40% of the EU’s greenhouse gas emissions. That takes in power and heat generation and the heavy industries that burn a lot of energy: refineries, steel, cement, lime, glass, ceramics, pulp and paper, and chemicals. Commercial flights within the European Economic Area were brought in from 2012, and shipping joined in 2024. From 2026 the rules for ships also pick up methane (CH₄) and nitrous oxide (N₂O), not just CO₂.
Roughly 10,000 installations and operators are covered in all. One thing the system does not yet reach is the fuel you burn to heat your home or drive your car. Those emissions are being handled by a second, separate scheme called ETS2, which we come to later in this series.
| Sector | What’s Covered | Since |
|---|---|---|
| Power & heat | Electricity and heat generation | 2005 |
| Industry | Steel, cement, refineries, chemicals, glass, paper | 2005 |
| Aviation | Intra-EEA flights (CO₂) | 2012 |
| Maritime | Large ships; CH₄ & N₂O added 2026 | 2024 |
The cap is the hard ceiling on emissions from all covered sites in a given year, written as a number of allowances. Up to 2012 it was stitched together from separate national plans; since 2013 it has been a single EU-wide number. Each year it falls by a fixed percentage of a historical baseline, a rule known as the Linear Reduction Factor, or LRF. So the amount of allowed pollution shrinks on its own, without anyone needing to renegotiate it.
The 2023 “Fit for 55” reform made that annual cut much steeper, raising the LRF from 2.2% to 4.3% a year over 2024 to 2027, and to 4.4% from 2028. On top of that, two one-off reductions took 90 million allowances out in 2024 and another 27 million in 2026. Taken together, these changes commit the covered sectors to emitting 62% less in 2030 than they did in 2005. For 2026 the cap works out at about 1.19 billion allowances for industry, power and shipping, with a separate aviation cap of roughly 25 million.
The practical effect
A steeper LRF simply means fewer fresh allowances turn up each year. If demand holds, that scarcity feeds through into a higher price, which is exactly the signal meant to push companies to invest in cleaner kit.
Allowances reach companies in two ways: through auctions, or for free. Auctioning is now the normal route. Power generators, for example, have to buy almost every allowance they use. The sales run on a shared platform, the European Energy Exchange (EEX), on behalf of most member states, and the money raised goes to national governments, which are meant to spend much of it on climate and energy.
Free allowances haven’t disappeared. They still go to industries thought to be at risk of “carbon leakage”, the worry being that a tough carbon price could just push production, and its emissions, abroad to countries that don’t charge for carbon. The free allocation is set against efficiency benchmarks, so only the cleanest plants get fully covered and everyone else has to buy the difference. This free supply is now being wound down as the Carbon Border Adjustment Mechanism (CBAM) takes over, charging instead for the carbon built into imported goods.
Every operator goes through the same routine each year. They track their emissions under an approved monitoring plan, get the numbers checked by an accredited verifier, report the verified total, and then surrender one allowance for each tonne. The surrender deadline is 30 September. Miss it and the penalty bites: €100 for every tonne you failed to cover, a figure that rises with inflation, and you still have to hand over the missing allowances anyway.
| Step | What Happens |
|---|---|
| 1. Monitor | Track emissions all year under an approved monitoring plan |
| 2. Verify | An accredited third party checks the annual emissions report |
| 3. Report | Submit the verified figure to the national regulator |
| 4. Surrender | Hand back one EUA per verified tonne by the deadline |
Spare allowances can be banked, meaning carried over and used in a later year. That sounds like a small detail, but it is the reason the big surplus left over from the early years still hangs over today’s price. Banking is also why the market looks ahead: what an EUA costs now reflects what traders think the cap will be worth several years from here.
A plain cap-and-trade market can pile up a huge surplus when demand drops, which is what happened after the 2008 financial crisis and sent the EUA price through the floor. The EU’s answer was the Market Stability Reserve, or MSR, running since 2019. Think of it as an automatic valve. When the total number of allowances in circulation, a figure known as the TNAC, climbs above 1,096 million, 24% of that surplus is pulled out of the auctions and parked in the reserve. If it drops below a lower threshold, allowances flow back the other way. (Article 2 in this series digs into the TNAC and how the surplus has moved over the years.)
Between September 2026 and August 2027 the reserve is set to take in roughly 190 million allowances. That is less than the year before, which suggests the surplus the market carried for so long is finally being worked off. Anything the MSR holds above a set ceiling is cancelled outright, so some of that supply never comes back.
The short version
The cap decides how much supply there is over the long run. The MSR smooths out the bumps in between. Between them they try to keep the price firm enough to matter without letting it lurch around wildly.
In May 2026 EUAs changed hands at around €74 a tonne, inside a 2025–26 range of roughly €60 to €95. Over the long run the price comes down to supply and demand: a cap that keeps shrinking on one side, and how much the covered sectors actually emit on the other. Day to day, though, plenty of other things move it. Gas and power prices matter a lot, since they decide whether utilities burn coal or gas. So do the weather, how busy industry is, the pace of MSR withdrawals, and whatever the market expects Brussels to do next.
Because allowances can be held and banked, it isn’t only compliance buyers in the market. Funds, banks and traders hold EUAs too, which adds liquidity and, now and then, some extra volatility. The upshot is that carbon trades much like any other commodity, with spot, futures and options, even though the reason it exists is environmental.
Part 2 traces the EU ETS from its over-supplied 2005 pilot through Phase 4’s “Fit for 55” reforms, the surplus crises, the MSR’s introduction, and the TNAC numbers that have driven supply ever since.
Part 2 — How the Market Has Worked · Part 3 — EU ETS in 2026 · Canadian Carbon Pricing Series
Primary sources for the figures and rules cited above.
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