All you wanted to know about Emissions Trading Schemes (ETS) work - a comprehensive introduction

Added: 2026-06-02

[00:00:01]The reality is simple. If you don't understand the fundamentals of an emission trading scheme or ETS, you don't really understand carbon pricing.

[00:00:09]Yet, many decarbonization professionals today still hear terms like carbon pricing, cap and trade, and carbon markets without fully understanding how our emission trading scheme work. As a result, they struggle to follow the debates, assess policy proposals, or understand what is driving carbon prices around the world. If you give me about 20 minutes of your time, by the end of this video, you'll have the foundation needed to understand virtually any ETSs in the world and to follow one of the most important developments in climate policy today. I'm Zana and welcome to the Carbon University. Let's get on with it.

[00:00:48]Here's our road map for today. First, we'll nail down exactly what an ETS is and why governments choose it over other options. Second, we'll look at three distinct types of ETSs because they are not all the same. Third, we'll go through eight key design features that determine whether an ETS actually works.

[00:01:07]Fourth, we'll do a global tour of the major schemes operating right now. And fifth, we'll look ahead at the next generation of ETSs emerging in developing countries. Let's go.

[00:01:19]So, what actually is an emission trading scheme? Here's the core idea. The government says across all the big emitters in our economy, there is a total amount of greenhouse gas we're going to allow. Full stop. That total is the cap. Now, every ton of emissions needs a permit called an allowance.

[00:01:37]Companies get or buy these allowances.

[00:01:39]And here's the clever part. They can trade them. If you cut your emissions, you've got spare allowances. You can sell them. If you're struggling to reduce, you can buy more. So, the market is doing the work of finding where emission cuts are cheapest. Three things make this powerful. One, the poller pays. There's a real financial cost to emitting. Two, environmental certainty.

[00:02:00]The cap is fixed, so you know exactly how much total pollution there will be.

[00:02:04]And three, cost efficiency. Cuts happen where they're cheapest, not where they're most politically convenient.

[00:02:11]That's a genuinely elegant piece of policy design.

[00:02:15]Now, to really appreciate the ETS, let's put it next to its competitors. A carbon tax. It sets a price per ton, but you don't know how much companies will actually reduce. They might just pay the tax and carry on. A regulation like a technology standard forces specific actions, but can be extremely costly and inflexible. Voluntary offsets, no mandatory coverage, so it's patchy at best. The ETS sits in a unique sweet spot. It guarantees the environmental outcome through the cap. It creates a market price through trading. It raises government revenue through auctions. and it gives businesses genuine flexibility in how and when they decarbonize. That combination is why more countries have adopted ETSs than any other single carbon pricing tool. It's not perfect.

[00:03:01]We'll see some of the challenges as we go, but as policy instruments go, it's remarkably versatile, right? Uh section two, types of ETFs.

[00:03:11]Now, here's something that surprises a lot of people. When we talk about different types of ETS, we're not talking about different caps or different trading rules. The underlying mechanism is the same in all of them.

[00:03:23]What changes is this? What happens to the money? When the government auctions off allowances and auctions can raise billions of pounds or euros every year.

[00:03:33]What do they do with that revenue? There are three answers to that question and each one gives you a different type of ETS. Let's look at all three.

[00:03:42]Cap and trade is the original classic model and it's the one most people mean when they say carbon market. Here's the cycle. Government sets the cap.

[00:03:50]Allowances are issued, either auctioned or given free. Companies emit as they do their business. Throughout the year, allowances are bought and sold on carbon exchanges just like any commodity. And at year end, every single covered company must hand in allowances equal to their actual emissions. Exactly. No rounding, no excuses. Short of allowances, buy more or pay a hefty penalty. In the EU, that penalty is a hundred euros per ton. Plus, you still owe the allowances the following year.

[00:04:21]Surplus, bank them, or sell them. The revenue from auctions in this model flows into general government funds. No strings attached. Governments can spend it however they like. That flexibility is politically useful, but it also means there's no guaranteed link between carbon pricing and climate investment.

[00:04:39]That's exactly what the next two models try to fix.

[00:04:43]So if cappen trade gives revenue to the general pot, Kappen investment says no, let's ring fence it for the energy transition. Every pound or euro raised from auctioning allowances gets reinvested in clean energy, efficiency upgrades, grid infrastructure, lowcarbon innovation. You can literally see the money going from the carbon market into the clean economy. That's powerful for public legitimacy. The EU does this through its innovation fund and modernization fund. billions directed specifically at decarbonization projects. California earmarks a significant share for disadvantaged communities and clean transport. Now, cap and dividend takes a completely different approach. And I think it's the most interesting model from a social policy perspective. Instead of investing the revenue, you give it back equally.

[00:05:32]Every citizen gets the same check, the same dividend regardless of income. Why is that progressive? Because richer households tend to have bigger carbon footprints. So they pay more into the system through higher energy and product prices, but they get back the same dividend as everyone else. The net effect redistributes wealth downwards.

[00:05:52]Canada's climate action incentive payments work on exactly this principle.

[00:05:57]Okay. Section three. This is the heart of the lecture and I want you to really engage with this section because this is where ETSS success or failure is determined. Designing an ETS isn't just passing a law and calling it done. Every single one of these eight design features has to be got right. A cap that's too loose. Carbon price collapses. Too many free allowances.

[00:06:18]Windfall profits for industry. No abatement incentive. Too many cheap offsets. Companies buy their way out instead of actually reducing emissions.

[00:06:27]We've seen all of these failure modes in real schemes. So let's go through all eight. And for each one, I'll explain not just what the design choice is, but why it matters so much.

[00:06:38]First design question, which emissions do we actually cover? And this is where we need to understand the concept of emission scopes. Scope one is the most straightforward. Direct emissions, the stuff that comes out of a company's own chimneys, its on-site boilers, its industrial processes, a steel mill melting ore, a cement kiln, cowsigning limestone, a power station burning gas.

[00:07:00]These are all scope one. Almost every ETSS in the world focuses primarily on scope one because these emissions are measurable, verifiable, and clearly attributable to a specific facility.

[00:07:11]Scope 2 is more indirect. It's the emissions from generating the electricity you bought. In most ETSs, the power station's scope one emissions are regulated and that carbon cost flows through to electricity prices. So, consumers are effectively paying for scope 2 indirectly. Japan is unusual in explicitly regulating scope 2 purchased electricity at facility level and scope three supply chain emissions everything upstream and downstream currently excluded from all mandatory ETSs worldwide.

[00:07:44]Second design feature, which sectors?

[00:07:46]And this is a really practical question because you can't just wave a wand and cover the whole economy on day one. To regulate an emission source, you need to be able to measure it accurately, verify it independently, and enforce compliance. That's easy for a coal power station, large, static, well monitored.

[00:08:04]It's much harder for a million individual cars. So ETSs programs start with the easiest wins. Power generation always comes first. It's the biggest source and the simplest to monitor.

[00:08:15]Heavy industry follows. Steel, cement, glass, oil refining. Aviation gets added as schemes mature. Buildings and transport are trickier. Some schemes cover them through fuel distributors.

[00:08:26]Regulate the companies selling petrol and gas rather than every driver and homeowner. And the general trajectory over time expansion schemes almost always start narrow and widen as administrative capacity and political will develop.

[00:08:42]Third design feature, and this is arguably the most critical one of all, the cap. Because here's the brutal truth. If the cap is too high, the whole system is pointless. You need the cap to be below what emissions would be without the scheme. That's what creates scarcity, which is what creates a price.

[00:08:59]No scarcity, no price, no price, no incentive to reduce. We learned this the hard way in the EU ETS phase 1. The cap was set too high, partly because reliable emissions data didn't exist yet and the carbon price crashed to near zero. Modern best practice uses a top- down approach. Start with the climate target, work backwards. If you need a 55% reduction by 2030, calculate what total ETS emissions must be each year to deliver that and set the cap accordingly. The cap then shrinks yearbyear in a predictable planned trajectory. Certainty is everything for long-term decarbonization investment.

[00:09:38]So the cap declines every year, but by how much? That's what the linear reduction factor and the LRF determines.

[00:09:44]It's a fixed percentage reduction year after year. A steep LRF means allowances get scarcer faster. Scarcity drives up prices. Higher prices make clean investments more attractive sooner. A shallow LRF keeps prices low for longer, which feels more comfortable in the short term, but delays the investment signal that industry needs. The EU made a dramatic decision here as part of its fit for 55 package. It increased the LRF from 1.74% per year to 4.3% per year from 2024. That is a massive acceleration, more than doubling the annual tightening rate. China, by contrast, uses an intensity- based approach. The benchmark improves each year, but total emissions can still rise if output grows. That's a fundamentally weaker environmental guarantee, though more acceptable politically in a rapidly developing economy.

[00:10:37]Fourth design feature, how do you actually get allowances into the hands of regulated companies? There are two routes. Free allocation, you just give them allowances, usually based on historical emissions or industry benchmarks. or auctioning, companies bid competitively and pay market price. Now, free allocation sounds generous, but it's not as benign as it sounds. If a power company gets free allowances, it doesn't mean it has free emissions. The allowance has an opportunity cost the company could have sold it. So, they include the cost in electricity prices, charging customers for a carbon cost they never actually paid. This is the windfall profits problem, and it was massive in early EU ETSs. Auctioning eliminates this completely. You pay for every allowance you use. Full stop. The EU has been methodically shifting from mostly free allocation to mostly auctioning. The power sector fully auctioned since 2013. Industry on a glide path to full auctioning by 2034.

[00:11:35]Directly linked to the introduction of CBAM.

[00:11:39]Fifth design feature trading rules. And this is where the market actually comes to life. Allowances can be bought and sold on organized exchanges or traded bilaterally. The two most important rules are banking and borrowing. Banking means if you have spare allowances this year, you can hold on to them and use them next year or the year after. This rewards early action, smooths price volatility and lets companies plan strategically. Borrowing would mean using next year's allowances to cover this year's emissions. Why is that dangerous? Because if you can borrow freely from the future, the annual cap loses its meaning. You're just pushing the problem forward. Most schemes prohibit it and markets need proper oversight. In the EU, carbon allowances are financial instruments under MYFID 2 subject to transaction reporting and market abuse rules. There's even a market stability reserve that automatically absorbs excess allowances when supply gets too high, like a central bank for carbon.

[00:12:38]Sixth design feature, review periods.

[00:12:41]And I want to make a key point here.

[00:12:43]Reviews are not a sign of weakness.

[00:12:45]They're a sign of intelligent governance. The EU ETS has had four phases since 2005, and each one has been meaningfully different from the last.

[00:12:55]Phase 1 was honestly a bit of a disaster. Cap too high, price crashed.

[00:13:00]Phase 2 hit the financial crisis and was flooded with surplus allowances again.

[00:13:05]Phase three introduced a single EUwide cap and more auctioning. Phase four is a wholesale reform aligned with the EU's elevated 2030 ambitions. Each review incorporated lessons from the previous phase and adjusted accordingly. Climate science evolves, technology changes, economic conditions shift, review periods allow regulators to tighten the cap if climate targets are raised, expand sector coverage as administrative capacity grows, and explore linking with other schemes. Think of it less like changing the rules of the game and more like tuning the engine.

[00:13:39]Seventh and eighth design feature, offsets and their limits. An offset is a carbon credit generated from outside the ETS cap. Please see our video introduction to carbon offsets. If you need more background on what is a carbon offset, a company struggling to reduce its own emissions can buy a verified credit from, say, a forest protection project in Brazil and use it to meet part of its compliance obligation. The appeal is obvious. It's cheaper and gives companies flexibility on how to comply with their obligations. It directs climate finance to local, regional, or international projects with high social, economic, and environmental impact. In particular, if the carbon offset project is in a developing country, for that reason, most ETSs around the world allow for the use of offsets for compliance obligations up to a limit and generally below 10% of the compliance obligations. However, for offsets to play that role, they must represent real emission reductions, avoidance, or removal. Each ETS will set which offsets, if any, can be used, including project types, methodologies, and location. Not all ETSs allow the use of offset. As an example, China and California do allow them, whereas the EU and the UK currently do not.

[00:14:53]All right, we've built the conceptual toolkit, and now we get to use it.

[00:14:57]Section four. Let's travel the world and look at what's actually operating right now. By 2024, more than 30 ETFs are running globally, covering around 8 billion tons of CO2 equivalent annually, roughly 23% of all global greenhouse gas emissions. When the EU ETS launched in 2005, it was the only mandatory ETS in the world. Today, it's a genuinely global phenomenon. We're going to look at six of the biggest and most significant. the EU, the UK, China, Japan, South Korea, and California. Each one is fascinating in its own way, and the differences between them tell us a lot about how carbon pricing interacts with different political and economic contexts.

[00:15:40]Let's start with the EU ETS, the pioneer. Launched in 2005, covering about 40% of EU greenhouse gas emissions. Despite a rocky start, it has matured into a genuinely credible tightening carbon market. By 2021 to 2024, prices were consistently in the 50 to 100 per ton range. That's a real price signal changing investment decisions. Phase 4 reforms, the steeper LRF, the phase out of free allocation, the introduction of CBM represent a real step change in ambition. The UK ETS is the interesting younger sibling. When the UK left the EU, it built its own scheme deliberately designed to be compatible with the EU ETS and aligned with the UK's legally binding 2015 net0ero target. The UK ETS covers the same sectors, uses the same auction mechanism, has a similar LRF, but there have been periods of price divergence.

[00:16:35]UK allowances have sometimes traded significantly below EU ones, and there are ongoing discussions about formally linking the two schemes, though post-rexit political dynamics have made it complicated.

[00:16:48]Now, let's go to Asia, home to the world's two largest ETSs by coverage.

[00:16:53]China's national ETS launched in July 2021 and overnight became the world's biggest carbon market by volume, covering around 5 billion tons of CO2 per year. That's more than three times the EU ETS. But, and this is crucial, size is not the same as ambition.

[00:17:12]China's ETS currently covers only the power sector and it uses an intensity based cap. That means a power plant needs to hit an emission rate target.

[00:17:21]But if total electricity generation grows, total emissions can still increase. And Chinese carbon prices are around 6 to€10 per ton. Compare that to 50 to 100 in the EU. The plan is to expand to steel, cement, aluminium, chemicals, and aviation in coming phases. Japan has a more complex layered picture. Tokyo's ETS has been operating since 2010, one of the world's first building sector carbon markets. Japan's new GXES, launched in 2023, starts as a voluntary scheme transitioning to mandatory with a complimentary fossil fuel import levy. Japan also uniquely requires companies to account for scope 2 purchased electricity.

[00:18:05]South Korea launched its ETS in 2015, the first mandatory national ETS in East Asia, beating China by 6 years. It covers 73% of South Korea's national emissions, power, heavy industry, buildings, domestic aviation, transport, and waste. That's genuinely comprehensive. The challenge has been carbon prices, which have generally been lower than needed. Phase 3 is working to address this with more auctioning and broader coverage. California's cap and trade is one of the most sophisticated ETS designs in the world, covering 85% of California's emissions, including the transport sector through fuel distributors. It was linked with Quebec in 2014, creating the first crossber carbon market in North America.

[00:18:51]California has smart market architecture others could learn from a price floor so the price can never collapse to zero. A price ceiling to prevent extreme spikes and strong requirements that auction revenue goes to disadvantaged communities. Clean transportation and natural resource protection. It's cap and trade with social equity built in.

[00:19:11]Here's our comparative table. All six schemes side by side. Let me walk you through the key comparisons. On coverage, California and South Korea cover the highest share of national emissions because they include road transport. The EU and UK cover less because road transport isn't directly in the scheme yet. On cap type, China is the outlier, intensity based. Everyone else uses absolute caps. On price, massive variation. EU and UK are highest, reflecting tight caps and strong institutional design. China is a fraction of European prices. a significant difference in the investment signal being sent. On free allocation, EU and UK are phasing it out. Everyone else still provides substantial free allocation. On offsets, EU and UK phase 4, essentially none. California up to 8% domestic only. The bottom line, ETS is genuinely global now, but there's still enormous variation in ambition. The convergence over time as CBAM creates pressure for equivalent carbon pricing as article 6 links markets together will be one of the defining stories of climate policy in the next decade.

[00:20:18]And that brings us to the final section and honestly the most exciting one. The next chapter of global carbon markets is being written right now in emerging economies. Think about it. India, Brazil, Indonesia, these are among the world's fastest growing emission sources. What they do on carbon pricing over the next 20 years will matter enormously for the global climate outcome. And there are real forces pushing them towards ETS. Their Paris Agreement commitments require meaningful emission cuts. The EU's carbon border adjustment mechanism means that if they export to Europe without domestic carbon pricing, they'll face a border levy, effectively paying for carbon anyway, just to the EU rather than their own government. And there's growing domestic recognition that carbon pricing can fund the clean energy transition they need.

[00:21:06]India, the world's third largest emitter and set to grow. In 2022, India made a landmark move. The energy conservation amendment act created the legal basis for a carbon credit trading scheme.

[00:21:18]India's scheme builds on the PAT mechanism, perform, achieve, and trade.

[00:21:23]Running since 2012 as an energy efficiency trading program, the new scheme deepens and expands this into a proper carbon trading market covering India's most energyintensive industries, steel, aluminium, cement, pulp and paper, petrochemicals and textiles. Like China, India is expected to use intensity based benchmarks rather than absolute caps reflecting the reality that India's economy and energy demand are still growing. A pilot trading phase is expected between 2026 and 2028. And India is also a major potential supplier of international carbon credits under article 6 of the Paris Agreement.

[00:22:00]Getting India's carbon market architecture right isn't just about Indian emissions. It shapes the whole international carbon crediting landscape.

[00:22:10]Brazil, one of the biggest climate policy stories of 2024. Under President Lula, Brazil passed a landmark federal law formally establishing the SBCE, the Brazilian emission trading system, covering oil and gas, steel, cement, chemicals, mining, and pulp and paper from around 2027.

[00:22:29]What makes Brazil's ETS distinctive is the explicit inclusion of ready plus forest credits. Brazil's Amazon and Sado are carbon sinks of global significance.

[00:22:39]If the ETS creates a direct financial reward for keeping those forests standing, that's potentially transformative. Indonesia launched its carbon exchange, idxarbon, in September 2023, the first in Southeast Asia. The mandatory scheme covers power plants above 100 megawatt with plans to expand to oil and gas and industry. Carbon prices are currently very low, but this is a beginning. Like Brazil, Indonesia's tropical forests make it a potential major supplier of forest-based credits.

[00:23:10]And both countries are getting significant technical and financial support from the World Bank and Asian Development Bank.

[00:23:17]Beyond India, Brazil, and Indonesia, there are six more countries worth watching closely. South Africa has had a carbon tax since 2019 and is now consulting on transitioning to a full ETS probably in the late 2020s.

[00:23:32]Turkai is particularly interesting because of its EU candidate status. CBM means Turkish steel and cement exporters face European carbon prices, a very direct economic incentive to build domestic carbon pricing rather than pay the CBM levy to Brussels. Chile has Latin America's most developed carbon pricing framework, a carbon tax since 2017, and a new climate law mandating an ETS transition. Vietnam is developing a pilot ETS starting in 2025 for its booming industrial sector. Singapore is positioning itself as the carbon market hub for Southeast Asia with active article 6 bilateral agreements being negotiated and a carbon tax rising to some of the highest levels in the region by 2030. And Mexico has been running a pilot ETS since 2020 with links to the California Quebec market being explored.

[00:24:23]the common thread, Paris agreement commitments, CBAM economic pressure, and the growing understanding that carbon pricing is a tool for economic modernization, not just a climate burden.

[00:24:35]Let's bring everything together. Five key takeaways from today. One, an ETS is a quantity-based instrument. The government sets the cap, the market sets the price. It delivers environmental certainty and cost efficiency simultaneously. Two, the three types, cap and trade, cap and investment, cap and dividend, share the same cap mechanism, but differ in how revenue is used. In practice, most real schemes blend elements of all three. Three, design is everything. A cap that's too high, too many free allowances, too many cheap offsets. Any one of these can undermine the whole system. The eight design features we covered are the engineering specs that determine whether the scheme delivers real emission reductions. Four, the six major operating ETFs show us both the diversity and the maturity of carbon markets today. EU and UK lead on price and ambition. China leads on volume.

[00:25:28]South Korea and California show us what comprehensive sector coverage looks like. Five. The next chapter is being written in the global south. Carbon pricing is no longer a niche experiment.

[00:25:39]It is the cornerstone of international climate policy.

[00:25:43]And that's a wrap. Thank you so much for your attention throughout this lecture.

[00:25:47]I really hope you found it genuinely useful and that carbon markets feel a lot more approachable. Now, if you want to go deeper, and I really encourage you to, the IAP status report is updated every year and is the gold standard global overview of all operating ETFs.

[00:26:03]The World Bank's state and trends of carbon pricing report is another essential annual read. Both are free.

[00:26:10]Both are excellent. The links on screen will take you straight there. Carbon markets are evolving fast. New schemes launching, existing ones reforming, international linking developing. If you found this training useful, please consider sharing our channel with your colleagues and communities that could benefit from our free best-in-class courses on carbon pricing and carbon markets to help amplify our impact.

[00:26:33]Thank you and see you next time.