Mastering the Carbon Market in Europe: A Practical Guide to EU ETS, ETS 2, and Voluntary Carbon Trading

This guide is essential for business leaders looking to navigate carbon trading in Europe. From understanding the EU ETS and ETS 2 to exploring voluntary carbon markets, this article offers insights to help leaders make informed decisions. Whether you’re a seasoned player or new to carbon trading, this guide will provide the tools to succeed in the carbon market landscape.

Table of Contents

• The European Union Emissions Trading System (EU ETS) - A Compliance Market
• EU ETS 2: New Developments and the Fit-for-55 Package
• Carbon Capture, Removal, and Synergies with Carbon Markets
• Voluntary Carbon Markets (VCMs): Are They Worth It?
• Future Trends in Carbon Markets
• Practical Tips for Implementation
• Frequently Asked Questions (FAQ) on Carbon Markets

The European Union Emissions Trading System (EU ETS) - A Compliance Market

The EU ETS is a cornerstone of the EU’s climate policy and the world’s first and largest multinational cap-and-trade system. It covers over 11,000 power stations and industrial plants across 31 countries, operating on the principle of putting a price on carbon to incentivize emission reductions. In the sectors covered by the ETS, in particular electricity and heat generation, iron and steel smelting, cement and lime production, and commercial aviation, emissions have since been reduced by around 35% (2005 to 2019).

Key Components

The system sets a cap on emissions and allows businesses to trade allowances, providing flexibility. As the cap decreases, emissions align with the EU’s climate goals. The system includes sectors such as power, aviation, and heavy industry and is managed by the European Commission. The Market Stability Reserve (MSR) balances supply and demand, ensuring market stability.

Compliance for Businesses

Businesses in the above sectors must hold allowances equal to their emissions or face financial penalties. Accurate monitoring and reporting of emissions are critical to ensure compliance.

EU ETS 2: New Developments and the Fit-for-55 Package

The EU ETS 2 (Phase 4) runs from 2021 to 2030 and is part of the broader Fit-for-55 package, aimed at reducing greenhouse gas emissions by at least 55% by 2030. EU ETS 2 includes several significant updates over EU ETS 1 designed to strengthen the system and expand its coverage.

• Cap Adjustments: The cap on emissions is set to reduce by 62% by 2030 compared to 2005 levels. The Linear Reduction Factor (LRF), which determines the annual decrease in emissions, will rise from 2.2% to 4.3% in 2024 and further to 4.4% in 2028.
• Expansion to New Sectors: EU ETS 2 introduces a new emissions trading system for buildings, road transport, and smaller industrial sectors that are not currently covered by the original EU ETS, launching in 2027.
• Inclusion of Maritime and Aviation Sectors: By 2026, emissions from these sectors will be fully included in the system, ensuring a wider coverage of industries.
• Carbon Border Adjustment Mechanism (CBAM): To prevent carbon leakage, the CBAM will ensure that imported energy-intensive products are subject to the same carbon pricing as those produced within the EU. This will start with emissions reporting in October 2023, with full implementation by 2026. You can read more on CBAM here: CBAM Regulation: Registration, reporting obligations and standard values simply explained.

Historical and estimated future emissions in the ETS II sectors are well above the level covered by allowances - the so-called cap. The planned annual cap reduction is more than five times higher than the historical reduction rates. However, many of the measures in the ‘Fit For 55’ package for the ETS II sectors will only lead to significant emission reductions in the medium term. The
ETS II will probably lead to a considerable shortage of allowances, at least initially - and thus to high CO2 prices. ETS II will also introduce a market stability reserve as a price-dampening measure in the event of major price increases. However, this measure will only have a weak effect and will not be able to significantly dampen a high CO2 price.

Overview of available estimates on CO2 price development in ETS II

Carbon Capture, Removal, and Synergies with Carbon Markets

Carbon capture and storage (CCS) and carbon dioxide removal (CDR) are becoming increasingly interconnected with carbon markets. Carbon compliance markets act as a policy tool and pricing mechanism that can support industrial CCS and CDR projects. These technologies, essential for achieving long-term climate goals, are complementary to emission reductions and have begun to overlap significantly with carbon pricing schemes.

Synergies Between Carbon Markets, CCS, and CDR

The role of CDR in carbon markets will continue to grow, and carbon pricing will be a key enabler for (non-fossil) CCS projects. Investing in both emissions reduction and removal strategies is essential to stay aligned with net-zero pathways. However, reduction should always remain the prioity, as I argue here: CO2 Reduction vs. Compensation for Companies.

To add a bit of nuance, fossil CCS (Carbon Capture and Storage) captures carbon from fossil fuel combustion processes and stores it underground, but since it doesn't address emissions from earlier stages, I do not consider this a viable carbon removal technology. Similarly, fossil CCU (Carbon Capture and Use) captures carbon and converts it into valuable products, but emissions from extraction and eventual release of carbon back into the atmosphere, such as through waste incineration, mean it also fails to contribute to meaningful carbon drawdown.

Conversely, CCS technology can help achieve negative emissions when used with methods that extract carbon from the atmosphere. There are both technical and natural approaches, such as Direct Air Capture with permanent storage (DACCS) and the absorption of CO2 in plants combined with bioenergy combustion and permanent storage (BECCS). Considering the overall situation, the limited capacity of storage facilities and resources should be reserved solely for unavoidable emissions, explicitly excluding fossil emissions.

Voluntary Carbon Markets (VCMs): Are They Worth It?

Voluntary carbon markets offer businesses a flexible way to offset emissions through the purchase of carbon credits. However, carbon credit quality is critical to ensuring the integrity of VCMs. According to a whitepaper by Sylvera, not all carbon credits are created equal, and understanding the quality of these credits is essential to making meaningful climate contributions.

Defining Carbon Credit Quality

Sylvera defines high-quality carbon credits based on three core pillars:

• Robust Carbon Accounting: Ensuring accurate and verifiable emissions reductions or removals.
• Additionality: Demonstrating that the project’s impact would not have occurred without the revenue from carbon credits.
• Permanence: Confirming that the CO2 removed or avoided will stay out of the atmosphere for a significant period of time, ideally 100 years.
  
  

Importance of High-Quality Carbon Credits

VCMs have faced challenges due to variability in credit quality, which can undermine the credibility of offset claims. Low-quality credits fail to deliver the climate impact they promise, shaking confidence in the market. Therefore, businesses must focus on purchasing high-integrity credits from reputable providers, that are thiry-party verified.

Practical Guidance for Businesses

When participating in voluntary carbon markets, businesses should:

• Prioritize high-quality credits by evaluating their carbon score, additionality, and permanence.
• Engage with trusted ratings providers, like Sylvera, that offer transparency in their assessment of carbon credits.
• Ensure MRV (Monitoring, Reporting, and Verification) processes are in place to guarantee the integrity of their carbon offset strategies.

Future Trends in Carbon Markets

1. Nature-Based Solutions and Carbon Removal

• There is a growing emphasis on integrating nature-based solutions such as reforestation, soil carbon sequestration, and blue carbon projects (marine ecosystems) into both compliance and voluntary markets. At the same time, technology-driven removals like Direct Air Capture (DAC) are gaining momentum, offering scalable solutions for long-term CO2 removal. Currently though, biochar is the most popular removal method.
• Businesses will need to consider how these solutions fit into their broader carbon strategies, particularly as regulatory frameworks such as the EU Carbon Removal Certification Framework (CRCF) come into force. 

  The CRCF classifies carbon removal into three primary categories: Carbon Farming (e.g., soil carbon and afforestation/reforestation), Permanent Carbon Storage/Removal (e.g., BCR, DACS, ERW, and BECCS), and Carbon Storage in Products (e.g., wood-based construction materials and concrete). All of these categories are evaluated based on "QU.A.L.ITY" criteria - Quantification, Additionality, Long-term Storage, and Sustainability - to guarantee their efficacy. This provisional agreement represents the world’s first such framework and will likely become a global benchmark for carbon removal certification.

  It has however been heavily influenced by the strong agriculture lobby in Europe. Consequently, the CRCF is riddled with emission reduction clauses and carve-outs. This is a significant setback, as emission reductions should not be included in this framework. Carbon reductions must be strictly distinguished from removals! And to state the obvious, the proposed certification framework does not include CCS facilities that capture difficult-to-reduce fossil fuel emissions from industrial processes. These are regarded as greenhouse gas reduction technologies rather than carbon removal.

• Businesses should follow the CRCF closely, as it will shape how removals are accounted for and rewarded in carbon markets, offering new opportunities for those involved in CDR projects.

2. Expansion of Carbon Pricing to New Sectors and Regions

Carbon pricing is expanding to cover new sectors, such as shipping, aviation, and buildings, through frameworks like EU ETS 2. China plans to include cement, steel, and aluminium production in its carbon emissions trading scheme by the end of 2024, potentially covering 60% of the country's greenhouse gas emissions. In other regions, India, Turkey, and Indonesia are all progressing towards implementing carbon pricing schemes.

Practical Tips for Implementation

1. Establish Internal Carbon Accounting Systems

Accurate carbon accounting is essential for managing emissions, meeting compliance obligations, and purchasing offsets. Businesses should invest in internal systems or software that allow them to measure, monitor, and report their emissions.

2. Partner with Carbon Offset Providers

Selecting high-quality carbon offset providers is key to ensuring the integrity of your investment. Look for providers that include transparent rating and MRV mechanisms and align with your sustainability goals. Working with trusted providers also reduces the risk of investing in low-quality or fraudulent credits. I would'n invest in anything below a BBB-rating.

3. Consult with Sustainability Experts

Engaging with sustainability consultants or carbon market experts can provide invaluable guidance, helping businesses develop comprehensive carbon strategies. These experts can advise on compliance requirements, market developments, and investment in innovative carbon reduction projects like nature-based solutions or CCS technologies.

4. Incorporate Carbon Offsetting in Long-Term Business Strategy

Carbon offsetting and removal shouldn’t be a short-term solution. Businesses should embed carbon within a broader, long-term strategy that includes direct emissions reductions and investment in low-carbon technologies. Combining these efforts will enhance your sustainability credentials and prepare your company for more stringent regulations in the future.

Frequently Asked Questions (FAQ) on Carbon Markets

What is a carbon market?

A carbon market is a system in which carbon credits are bought and sold, allowing businesses, governments, and other entities to trade emissions allowances or offset credits. Carbon markets can be compliance-based or voluntary.

What are voluntary carbon markets?

Voluntary carbon markets (VCMs) allow organizations to purchase carbon credits to offset their emissions on a voluntary basis, outside of government-regulated systems.

What are compliance carbon markets?

Compliance carbon markets are regulated by governments or international bodies to meet legally mandated greenhouse gas reduction targets. Examples include the European Union Emissions Trading System (EU ETS) and China’s national carbon market. 

What are carbon credit markets?

Carbon credit markets facilitate the trading of carbon credits, which represent one tonne of CO2 (or equivalent) reduced or removed from the atmosphere. Usually these are emissions trading schemes (cap-and-trade system), like the EU one. A carbon tax sets a fixed price on greenhouse gas emissions, requiring companies to pay a specific amount for each ton of emissions they generate, while a cap-and-trade program allocates a limited number of emissions "allowances" annually.

How do carbon markets work?

In carbon markets, companies are assigned a cap on the amount of CO2 they can emit. If they emit less, they can sell their unused allowances as carbon credits to other companies that have exceeded their cap.

What countries have carbon markets?

Several countries and regions have implemented carbon markets, including:

• European Union: EU Emissions Trading System (EU ETS)
• China: National carbon market
• United States: Regional markets like California’s Cap-and-Trade Program and the Regional Greenhouse Gas Initiative (RGGI)
• Canada: Various provincial systems such as Quebec’s Cap-and-Trade System
• South Korea: Korea Emissions Trading Scheme (K-ETS)
• New Zealand: New Zealand Emissions Trading Scheme (NZ ETS)
• Mexico: Pilot carbon market
• Brazil: Aiming to introduce a market by COP30.