Dr. Edwin Woerdman - How the EU ETS Works: Coverage, Allocation, and the Logic of Cap-and-Trade
Introduction
The EU Emissions Trading System is back in the spotlight. Permit prices have moved, energy prices are politically sensitive, and in 2026 the ETS is up for review. But in the public debate, a lot of the confusion comes from the basics: what does the ETS cover, how does it work, and what are the key building blocks?
In this episode, I’m joined by Professor Edwin Woerdman (University of Groningen), a specialist in carbon market regulation and EU climate law and economics.
This is Part 1 of a short mini-series on the EU ETS. We cover the fundamentals:
How Emission Allowances Are Allocated in the EU ETS (~5:00) 3
Why the EU ETS Moved From Grandfathering to Benchmarking (~08:40)
What the Cross-Sectoral Correction Factor Does (~11:09)
How Auction Revenues Are Supposed to Be Used (~13:46)
Why the EU ETS Has Been Effective at Cutting Emissions (~16:00)
Linear Reduction Factor and the 2039 Target of No New Allowances (~22:25)
Why Small Changes to the Linear Reduction Factor Do Not Change the 2050 Goal
Next week (Part 2): we dive into the Market Stability Reserve, price volatility, and why the ETS is being tweaked in 2026.
Note that Professor Woerdman recently published a paper explaining a lot of what we cover in more detail. You can find the paper here: Woerdman, E. and Kotzampasakis, M., ‘EU Emissions Trading System’ (April 01, 2026), EU Climate Mitigation Law, Cheltenham: Edward Elgar Publishing, forthcoming 2027. Available at SSRN: https://ssrn.com/abstract=6633238or http://dx.doi.org/10.2139/ssrn.6633238
Transcript
Arvid Viaene: Hi everybody, and welcome to another episode. There is a lot of debate going on right now around EU climate policy, especially the EU’s Emissions Trading System. The EU ETS was the world’s first carbon market. In episode 11, with Jos Delbeke, we covered how it was created and the challenges it faced early on.
But now, in 2026, the system is up for review again. Recently, emission permit prices have been volatile, energy prices have been sensitive, and there is a lot going on. So there are growing calls to change parts of the system. But I noticed there is also a lot of confusion in the public debate about how the EU ETS actually functions, and I myself am sometimes confused.
So this is part 1 of a short mini-series to build a clear toolkit to understand what is going on. So in part 1, we will cover the fundamentals, what the ETS covers, how the allocation mechanism works, and why the system reduced emissions faster than expected and why 2039 shows up a lot through the linear reduction factor.
So today I’m very happy to have Edwin Woerdman as a guest to do so. Edwin is a professor of markets and regulation at the University of Groningen in the Netherlands since 2018. He is also managing board member of the Groningen Centre of Energy Law and Sustainability since 2007.
He defended his PhD on climate law and economics in Groningen in 2002. Professor Woerdman has specialized in energy and carbon market regulation, concentrating on emissions trading and other tradable rights.
He has published more than 100 articles, chapters, and monographs, including Essential EU Climate Law. Two of his papers on emissions trading appeared in the top 20 most downloaded articles of the Review of Law and Economics.
So, Edwin, welcome to the podcast.
Edwin Woerdman: Thank you so much.
Arvid Viaene: I’m very happy to have you on because, like I said, there’s a lot of confusion right now. I think many people would benefit from having a clear picture of what the EU ETS actually is. For an economist, the concept is simple, but the details are varied, which I think we’ll get to. So maybe let’s start there: what emissions are actually covered by the EU ETS?
Edwin Woerdman: The EU ETS is currently active in the 27 EU Member States plus Norway, Iceland, and Liechtenstein. It has also been linked to Switzerland’s emissions trading system. It covers about 12,000 emitters responsible for approximately 40 percent of greenhouse gas emissions in the EU.
And as you were asking, the system mainly focuses on reducing carbon dioxide emissions. But not only that. Since 2013, it also includes emissions of nitrous oxide from the production of certain chemicals, and emissions of what are called PFCs - perfluorocarbons - from the production of aluminum. And since this year, the EU ETS also covers methane and nitrous oxide emissions from maritime transport.
The Two Efficiencies of Emissions Trading
Arvid Viaene: That is a huge range. And I also wanted to ask you about something you wrote in a paper that I studied for this interview. Before we get into the details, you say that an emissions trading system has two efficiencies. Could you talk about those?
Edwin Woerdman: Yes. In that paper, I make a distinction between first-order efficiency and second-order efficiency goals of emissions trading. You can find that distinction in economic theory. It sounds very fancy, but applied to climate policy it comes down to effectiveness and cost savings.
First-order efficiency concerns the effectiveness with which climate damage is reduced by actually realizing the intended emission reductions. According to economists, effectiveness is part of efficiency. Ineffective climate policy is inefficient because greenhouse gas emissions are not reduced to the economically optimal or socially desirable level to prevent or reduce climate damage. Then second-order efficiency concerns the extent to which the intended emission reductions are realized at the lowest possible cost.
And in the course of our conversation, I hope to explain that the EU ETS meets the first-order efficiency requirement and largely, but only partly, meets the second-order efficiency requirement.
Arvid Viaene: So it is very effective, but only partially efficient in the second-order sense.
How Emission Allowances Are Allocated in the EU ETS
Arvid Viaene: Part of cap-and-trade is that you need permits to trade. So how are those allocated? How does the allocation of emissions work in the EU ETS?
Edwin Woerdman: That is a good question, and an important part of the EU ETS. In the first and second trading phases - so the phases starting in 2005 and the second trading phase running up to 2012 – (respectively) 95 to 90 percent of the allowances were allocated to companies free of charge, based on Article 10 of the EU ETS Directive.
Only about 5 to 10 percent of the allowances were auctioned. So in the beginning there was very little auctioning. That changed in 2013. Since then, 57 percent of the total number of allowances in the EU ETS are auctioned. That applied in the third trading phase and also in the current fourth trading phase, which runs from 2021 to 2030.
Energy producers must purchase all of their emission allowances at auction. The basic idea is that energy companies do not compete on an international product market, so they can pass on most of their carbon costs to electricity consumers. But many energy-intensive industries do compete internationally. They are exposed to competition from non-EU firms in countries without carbon pricing. This can lead to carbon leakage - the unwanted relocation of installations, production, or investments, and therefore emissions to countries without an emissions trading system or carbon tax.
To prevent these leakage effects, exposed industries are included on the so-called carbon leakage list and they receive their emission allowances for free, provided they meet a few additional criteria. The European Commission draws up a new list for every trading phase. The most recent list is from 2019 and applies to the years 2021 to 2030. For the few energy-intensive industries that are not on this list, their free allocation decreases each year and ultimately falls to zero in 2030. And of course, the number of allowances available for free allocation decreases in line with the total emissions cap for the system as a whole.
Arvid Viaene: So for energy-intensive users that are not on the list, by 2030 they receive no more free permits.
Edwin Woerdman: Exactly.
Arvid Viaene: Whereas for those on the list, their allocation still decreases along with the overall cap, but they continue to receive some free permits.
Edwin Woerdman: Exactly. And with the current energy situation, one of the ideas now being discussed is whether to extend or adjust some of these arrangements. But we can come back to that later.
Why the EU ETS Moved From Grandfathering to Benchmarking
Arvid Viaene: Exactly. So that is how much they get for free versus how much they have to buy. Then how does the process work? We had different regimes, right? In the beginning there was a system of grandfathering, and then that evolved. Could you talk more about that?
Edwin Woerdman: Yes, absolutely. Basically, we went from grandfathering to benchmarking. In the first two trading phases, between 2005 and 2012, free allowances were based on grandfathering, which means they were allocated based on historical emissions. This method favors dirtier companies with relatively high emissions. But at the start of the EU ETS, that was considered politically necessary to promote industry acceptance and protect the competitive position of Member States.
Since 2013, however, free allocation takes place on the basis of benchmarking. A benchmark is a carbon standard per unit of production multiplied by the level of production in a base year. This emissions standard - called an ex-ante benchmark in the EU ETS Directive - is determined based on the average emissions of 10 percent of the installations with the lowest carbon emissions per unit of product or energy output in an industrial sector.
So in other words, the relatively clean companies. An advantage of this is that benchmarking favors cleaner companies, which then receive free allowances based on better low-carbon performance.
Arvid Viaene: So we moved from a system where you got permits based on how much you used to pollute, to a system where we look at the most efficient firms and determine allocation based on that.
Edwin Woerdman: Yes. That is how free allowances are determined for the industry. For the sectors that had to buy all of their allowances at auction, like power producers, this does not apply in the same way because they buy their allowances anyway.
What the Cross-Sectoral Correction Factor Does
Arvid Viaene: Another term that comes up in this context is the cross-sectoral correction factor - a very technical term. What does it mean, and what does it do?
Edwin Woerdman: Yes. I always try to come up with more intuitive words for these things. The cross-sectoral correction factor is what I call a “cheese slicer”. I’m from the Netherlands, and we like cheese, so that is the image that came to mind.
The cross-sectoral correction factor was designed to deal with the possibility that the total number of free allowances calculated for companies, based on these benchmarks, would exceed the total EU emissions cap. If that would happen, the correction factor would be applied. That means each company would receive slightly fewer free allowances.
Arvid Viaene: So if the cap had to be 100 allowances, but because of the benchmarking calculations we got to 110, this would bring it back down to 100.
Edwin Woerdman: Exactly. And then the cheese slicer would apply to all those companies. It is quite technical in detail, but that is the basic idea. And what was interesting in recent years is that industries were very worried that this would happen. They were counting on a certain number of free allowances, and then the Commission might come in and say: sorry, if we add everything up, it is too much, so you all get a bit less. That means they would have to buy additional allowances, which is of course an extra cost.
Arvid Viaene: So I see the advantage of benchmarking: it rewards cleaner firms. But the disadvantage is that firms do not always know in advance exactly how much they will get.
Edwin Woerdman: Exactly. Hence the cheese slicer.
How Auction Revenues Are Supposed to Be Used
Arvid Viaene:
Auctioning permits means there is an auction, which also means there are auction revenues. How are those revenues supposed to be used? I think not a lot of people have this front of mind, but there is substantial money generated by this.
Edwin Woerdman: That is true. Previously, EU Member States were urged to use at least 50 percent of their auction revenues for emission reduction and climate adaptation measures and technologies. That includes renewable energy, energy efficiency, carbon capture and storage, and also things like retraining workers in coal regions.
Thanks to the revised EU ETS Directive, this increased to 100 percent from 2023 onward. And it is no longer just a recommendation - it is now a spending obligation. That said, this obligation looks stricter than it is, because in practice Member States were already spending on average more than 75 percent of their auction revenues on climate and energy measures.
Arvid Viaene: Which I find interesting. I was surprised that the number was already that high.
Edwin Woerdman: I was surprised too, to be honest. That number comes from one of the Commission’s reports on the state of the EU ETS. I have not done my own deep dive into what exactly is counted there, but if someone wanted to investigate how that percentage is composed, I would be very interested to see it.
Arvid Viaene: I think that is a really interesting topic in itself - how those revenues are used.
Why the EU ETS Has Been Effective at Cutting Emissions (~16:00)
Arvid Viaene: That brings us to the effectiveness of the system. Since it is a cap-and-trade system, what were the original emission reduction targets, and how were they sharpened over time?
Edwin Woerdman: Exactly. Now we are looking at first-order efficiency - the effectiveness properties of the EU ETS. The EU set itself the goal of reducing total greenhouse gas emissions by 20 percent in 2020 compared to 1990. To achieve this, companies under the EU ETS were required to reduce emissions by 21 percent by 2020 compared to 2005.
What is interesting is that this goal was already achieved in 2014. By 2020, ETS installations had reduced their greenhouse gas emissions by 43 percent compared to 2005. While over the same period, non-ETS sectors such as road transport, buildings, and agriculture had reduced emissions by 16 percent.
The EU ETS thus contributed significantly to the overall 34 percent reduction in total EU emissions achieved in 2020. These figures show that companies in the EU ETS not only stayed below the emissions caps, but even reduced emissions beyond what was required.
Now, I have to add that these extra reductions can be partly explained by the financial crisis of 2008 and the COVID-19 pandemic, both of which reduced industrial activity and energy demand. But these extra reductions also reflect technical and operational improvements, as companies adopted innovative energy-saving or CO2-saving technologies and practices, which enabled them to sell surplus allowances or bank them for future use.
The EU initially intended to reduce greenhouse gas emissions by 40 percent by 2030 compared to 1990. For ETS companies, that translated into a 43 percent reduction compared to 2005. But as I just said, the EU ETS already achieved that goal in 2020.
Because climate damage became increasingly severe and visible, and because emissions could be reduced at lower cost than expected - the allowance price was only around 5 euros in the previous decade - the EU tightened its 2030 target to a 55 percent net reduction compared to 1990. That is the Fit for 55 package. As part of this goal, companies in the EU ETS now have to achieve emission reductions of 62 percent by 2030 compared to 2005. And for 2050, the ultimate EU goal was initially an 80 to 95 percent reduction, but that was tightened in the European Climate Law of 2021 to net-zero emissions by 2050, in line with the Paris Agreement to limit global warming to well below 2 degrees Celcius.
Arvid Viaene: That is a lot of targets. But one thing I took away is that the system reduced emissions much faster than many expected.
Edwin Woerdman: Yes, exactly. The 2020 target was achieved well ahead of time, and the ETS-specific reduction target was also already met by 2020. So the system was moving faster than many had initially expected. That is also why the 2030 target could be strengthened. And in my view, that low allowance price in the previous decade was actually a success, not a failure. Many people complained about it, but I think it was a great achievement. The system was meeting the cap at low cost, which is exactly what an emissions trading system is supposed to do. And because it was doing that, it created political room to tighten the cap.
Arvid Viaene: Exactly. If you think of an abatement cost curve, you would expect that in the beginning there are cheaper reductions available. If the system is effective and those reductions are cheap, that is a good thing.
Edwin Woerdman: Yes, very true.
Linear Reduction Factor and the 2039 Target of No New Allowances (~22:25)
Arvid Viaene: One number that comes up often in the current debate is the linear reduction factor. Could you talk about what that is?
Edwin Woerdman: Yes. The linear reduction factor is the percentage by which the emissions cap decreases each year for emitters under the EU ETS.
Arvid Viaene: So given that the long-term target is net zero by 2050, why is the current system often described as having a kind of 2039 endpoint for no new allowance allocations?
Edwin Woerdman: The year 2039 was not so much chosen as a goal in itself. It was the de facto consequence of the increased linear reduction factor. Article 9 of the revised EU ETS Directive stipulates that the emissions cap will be lowered each year to ensure that total emissions continue to decline in line with the European Climate Law. The required annual reduction was 2.2 percent up to 2021. It then increased to 4.3 percent and is set to reach 4.4 percent from 2028 onward. This doubling of the linear reduction factor means a much tighter annual decline of the cap. And the consequence of that is that from 2039 onward, no new emission allowances will be issued.
In the beginning, I do not think that was entirely clear to everyone involved. I was not involved in the negotiations myself, so I did not get to look behind the closed doors, but for many economists and lawyers the 2039 date of no new emission allowances came as quite a surprise and it is now also under discussion.
Arvid Viaene: So it was not that they explicitly chose 2039 as a symbolic target. It is more that they chose a reduction path, and 2039 follows from that.
Edwin Woerdman: Exactly.
Why Small Changes to the Linear Reduction Factor Do Not Change the 2050 Goal
Arvid Viaene: That brings up the natural question. If you slightly soften the linear reduction factor, and that pushes the zero-new-allowances date from 2039 to 2042 or 2043, that still seems consistent with the net-zero-by-2050 goal.
Edwin Woerdman: Yes, I fully agree. The 2050 goal is what we need to keep in mind. Tightening or loosening the reduction path a little bit and moving that date by a few years does not make a huge difference to the climate outcome, as long as we remain committed to net zero by 2050.
If we keep the cap-and-trade structure and the broader target in place, then we are still on the right path.
Arvid Viaene: So that was a walk-through of the building blocks: coverage, allocation, why the ETS delivered big emissions cuts, and how the linear reduction factor creates that “2039” talking point.
Next week, we go one level deeper: the Market Stability Reserve—why it was created, how it affects auction supply, and why the Commission is reconsidering parts of it in the current energy and geopolitical context. We will also discuss why the allocation mechanism of free emissions may not be economically efficient.
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