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Glossary · Energy industry & energy transition

Cap in Emissions Trading

Cap Emissions Trading EU-ETS Carbon pricing certificate trading Climate protection Emissions Budget

The cap is the upper limit in emissions trading. It determines the maximum amount of greenhouse gas emissions that all installations and operators in an emissions trading system may emit together. Technically, this is done through the number of emission allowances issued in a given period. In the European emissions trading system, the EU ETS, each allowance entitles the holder to emit exactly one tonne of CO₂ equivalent. Those covered by the system must surrender a corresponding number of allowances for their verified emissions in a year.

The cap is thus the quantity variable through which emissions trading is steered. In a cap-and-trade system, the state first fixes a quantity, not a price. The CO₂ price then forms on the market. It depends on how scarce the allowances are relative to how cheaply the covered companies can avoid emissions.

Scope of the EU ETS

The EU ETS (often called ETS 1) covers power and heat generation, energy-intensive industry, aviation (since 2012) and maritime transport (since 2024). It applies in all EU member states as well as in Iceland, Liechtenstein and Norway. In Northern Ireland it applies only to electricity generation. There is a common cap for power and heat generation, industry and maritime transport. A separate cap is calculated for aviation.

For buildings, road transport and smaller energy and industrial installations, the EU is creating a separate system, the ETS 2. It has its own cap and addresses fuel suppliers, not individual installations. The ETS 2 was originally to start in 2027. At the end of 2025, the EU postponed the start to 2028. In Germany, the national fuel emissions trading system (Brennstoffemissionshandel) remains decisive until then. Anyone speaking generally about the cap in EU emissions trading should therefore specify which system is meant.

How the cap is set and reduced in the EU ETS

Since 2013, there has been an EU-wide cap for power plants and industrial installations. Previously, member states set their quantities through national allocation plans. The cap falls every year by a linear reduction factor (LRF). This percentage refers to a fixed reference value: the average annual quantity of allowances in the years 2008 to 2012. The cap therefore falls each year by an equal absolute amount and not by a percentage of the previous year's quantity.

Until 2020, the factor was 1.74 percent per year, and from 2021 it was 2.2 percent. With the 2023 reform of the ETS Directive, the cap is meant to reduce emissions of the covered sectors by 62 percent by 2030 compared with 2005. To this end, the factor was raised to 4.3 percent for 2024 to 2027 and to 4.4 percent from 2028. In addition, the cap was reduced twice on a one-off basis (rebasing): in 2024 by 90 million and in 2026 by 27 million allowances. Because maritime transport was added from 2024, the cap was simultaneously increased by 78.4 million allowances. According to the Commission, the cap in 2024 was around 1.386 billion allowances.

A worked example shows what this means: with a cap of around 1.4 billion allowances, each percent corresponds to about 14 million tonnes of CO₂ equivalent. If the trajectory from the 2023 reform were simply extended, expert analyses suggest the cap would fall to zero around 2040.

In July 2026, the Commission proposed flattening the trajectory after 2030: to 3.7 percent per year for 2031 to 2035 and to 1.7 percent from 2036. Under the proposal, international credits would also be counted to a limited extent. This is so far only a proposal and not applicable law. Parliament and Council are still negotiating it.

What happens within the cap: auctioning and free allocation

Member states auction the largest part of the allowances under the cap. A portion is allocated free of charge to industrial sectors. This is intended to protect them against the relocation of production and emissions abroad (carbon leakage). Other parts of the cap are reserved for the Innovation Fund, the Modernisation Fund and the Social Climate Fund. Free allocation does not mean that emissions take place outside the cap. Freely allocated allowances also form part of the limited total quantity. The method of allocation mainly determines who bears which burdens, how competition is affected and how high public revenues are. For the climate effect, the total quantity is what counts first and foremost.

Cap, allowance and CO₂ price

An emission allowance is not a measuring instrument but a tradable right to emit a certain quantity. Actual emissions are measured, reported and verified by independent bodies. Companies must then surrender allowances in the same amount. The cap limits the sum of these rights.

The price results from scarcity, expectations, regulation and the behaviour of market participants. It can rise if a future tightening is expected or if fuel prices make switching from coal to gas more expensive. It can fall if fewer allowances are needed, for example because less coal-fired power is generated, industry is weak or more electricity comes from renewable sources. A high price can indicate a tight cap but is rarely explained by that alone. A low price does not automatically mean that the cap is ineffective. Anyone wishing to assess the effect must consider quantity, price, time profile and the rules of the system together.

Market Stability Reserve: how the quantity actually available changes

The cap determines how many allowances may be issued. How many of them actually reach the market is additionally controlled in the EU ETS by the Market Stability Reserve (MSR). It is guided by the total number of allowances in circulation, that is, allowances that have been issued but not yet surrendered. If this number is above 1,096 million, 24 percent of it is shifted from future auctions into the reserve. If it falls below 400 million, the reserve releases 100 million allowances for auction.

Since 2023, allowances held in the reserve above the threshold of 400 million have been invalidated. On 1 January 2024 alone, this amounted to around 381 million, and on 1 January 2025 to around 271 million. According to the Council, more than 3 billion allowances in total have been cancelled since this mechanism began. The reserve has thus permanently reduced the total quantity below the statutory cap.

This cancellation rule is being revised in 2026. In April 2026, the Commission proposed abolishing it entirely. The Council, by contrast, wants to suspend it only until the end of 2030 and then reintroduce it with a higher threshold of 800 million. The final rule was not yet settled at the time of editorial close.

Distinction from carbon tax, emissions budget and sector target

The cap distinguishes emissions trading from carbon pricing through a tax. With a tax, the state sets the price per tonne, and the quantity of emissions results from how those affected respond. With emissions trading, the state sets the quantity, and the price emerges in trading. Hybrid forms also exist: the German fuel emissions trading system operates with fixed prices or a price corridor in its introductory phase. It therefore acts more like a price instrument.

An emissions budget usually describes a permissible total quantity over a longer period, for example to meet a climate target. The cap, by contrast, is the concrete quantity limit within a specific trading system. It may fall annually, is linked to reserves and covers only certain sectors. It also differs from national sector targets: the cap limits the emissions of all covered installations together but does not determine which sector or country saves how much. Savings are made where it is economically attractive first within the system.

Why the cap works in the power system

Fossil power plants must cover their CO₂ emissions with allowances. This raises their variable costs, which feeds into the dispatch order of power plants. A coal-fired power plant emits roughly twice as much CO₂ per kilowatt-hour as a modern combined-cycle gas plant. A CO₂ price therefore makes coal-fired power more expensive to a greater extent, and the order may shift in favour of gas. Renewable energy, storage and load shifting reduce the demand for allowances when they replace fossil generation.

However, the cap does not limit the emissions of an individual power plant in a particular hour. A power plant may emit as long as it holds or can buy allowances. Questions of firm capacity, covering the residual load and availability therefore remain. Emissions trading replaces neither grid planning nor rules on security of supply. A declining cap is nevertheless central for investment. It raises the expected costs of fossil generation and makes low-emission alternatives more attractive. However, this works only if companies consider the future price path credible. Political discussions about a flatter trajectory after 2030 or a changed reserve directly influence these expectations.

Common misconceptions

  • "The cap is only a declaration of intent": It becomes binding only when allowances are issued, emissions are monitored and verified, allowances are surrendered and violations are penalised. Without reliable measurement and sanctions, the upper limit would be just a political number.

  • "National climate measures are pointless because of the cap": If a member state shuts down coal-fired power plants, demand for allowances first falls. Whether the allowances thereby freed up are used elsewhere depends on the rules. As long as the reserve absorbs surplus allowances and holdings above the threshold are invalidated, the total quantity is partly permanently reduced. In addition, under Article 12(4) of the ETS Directive, member states may voluntarily cancel allowances. Because the cancellation rule is currently being revised, the effect can only be assessed under the legal status applicable at the time.

  • "Free allowances lie outside the cap": They too count towards the limited total quantity. The only difference is who bears the costs.

  • "Cap and actual emissions are the same": Actual emissions can be below the cap, for example in an economic slump or a rapid roll-out of low-emission technology. Surpluses then arise, which are banked, traded or absorbed via the reserve.

Institutional and economic significance

How high the cap is set is decided by policy, not by technology. It is derived from climate targets, distributional questions and legal requirements. The legislator sets the cap, reduction path, market rules and controls. Companies then decide whether to buy allowances, avoid emissions or change their production. Grid operators remain responsible for safe grid operation, and electricity market rules continue to determine which power plants run and how prices are formed.

The CO₂ price can raise the wholesale electricity price when fossil power plants set the price. At the same time, an effective cap reduces permitted emissions and strengthens low-emission alternatives. What the auction revenues are used for is a separate political decision and is not part of the cap's function. In short: the cap is not a price forecast. It determines how many emissions the trading system still permits at all.

Sources

Related glossary entries

Edited by eCMS on 11.11.2026 16:44

© 2026 Erik Schmidt. All rights reserved. Quotations with a link to the source are welcome.