The limit set on the total amount of greenhouse gas emissions that can be produced by entities covered by the EU ETS.
Every year, the EU sets a limit on the amount of CO2 emissions that can be produced. This “cap” needs to be matched by European Union Allowances (EUA) held by companies. For every tonne of CO2 that they emit, those actors need to surrender one allowance. From a financial perspective, we can think of the cap as the market supply of the asset.
The objective of the EU Emissions Trading System is to reach 62% net emissions reduction below 2005 levels by 2030. However, the pace of the decrease cannot be too brutal, otherwise it may be economically detrimental. Hence, the cap gradually diminishes over time.
Every year, the amount of CO2 that can be emitted is reduced by a fixed percentage, decided by the EU Commission. We call this figure the linear reduction factor (LRF). In 2013, the LRF was set at 1.74% per year. Now, the maximum amount of emissions that can be produced declines at a rate of 2.2% per year. It will increase to 4.3% between 2024 and 2027, and then to 4.4% between 2028 and 2030. In 2013, the cap was set at 2,084 MtCO2e, and in 2023, this figure is 1,486.
Companies need to pay in order to purchase EUAs to match their carbon emissions. They can do so from auctions with a fixed calendar and predetermined rules. However, in order not to hurt economic productivity, some allowances are handed out for free by regulators. Over time, the amount of free permits is decreasing - it will be more and more expensive for companies to pollute. Generally, free allocations are deemed to go to zero by 2030 for most sectors. Steel, aluminum, cement, hydrogen and fertilizers industries will keep be handed in some free allowances until 2040.
