The Carbon Border Adjustment Mechanism (CBAM)
14 min
Level
In this article, we break down what the EU CBAM is, how it works, and what businesses need to do to comply.
ESG / CSR
Industries
MEASURE
ACT
COMFORM
How Does Emission Trading Work?
Level
By Kara Anderson, UK Copywriter, on 12/19/2023
Updated by Kara Anderson, on 04/13/2026
Putting a price on carbon is one of the most practical ways to drive large-scale decarbonization. Rather than just setting rigid rules for every business, emissions trading schemes (ETS) create a market where carbon is treated as a financial asset.
By setting a strict limit on total pollution and allowing companies to buy and sell the right to emit, these systems reward efficiency and penalise high emitters. Today, major frameworks like the EU ETS, the UK ETS, and China’s national market are shifting from experimental policies to the primary drivers of corporate investment in green technology.
In this article, we'll cover:
What emissions trading schemes are and how they work
The world's largest emissions trading schemes and how they operate
How emissions trading is helping economies to decarbonize
What are emissions trading schemes and how do they work?
Emissions trading: A quick overview
At its simplest, an Emissions Trading Scheme (ETS) is a system that turns pollution into a cost of doing business. Often called cap-and-trade, it moves away from traditional one-size-fits-all regulations. Instead, the government sets an overall limit - a cap - on the total greenhouse gases that specific sectors (like power, heavy industry, and now aviation and shipping) can emit.
As this cap is lowered annually, the right to emit becomes a scarce resource, driving up its value and forcing companies to choose: pay to pollute or invest in cleaner technology.
The cap and trade process
The system operates like a specialised financial market, following a strict lifecycle:
Setting the Cap
Regulators determine the total carbon budget for the year. The UK ETS has tightened its cap to align with the 2050 Net Zero target, reducing available permits.
The Allowance System
The cap is divided into allowances. One allowance typically grants the right to emit one tonne of CO₂ equivalent.
Allocation & Auctioning
While some sectors still receive free allowances, most permits are now auctioned, generating revenue for governments to invest in green energy.
The Trade
Companies that emit less than their limit can sell surplus allowances to others that face greater decarbonization challenges.
Example
A paper mill cuts emissions by 20% through efficiency gains. By selling its surplus allowances on the secondary market, it generates direct profit from improved environmental performance.
What about compliance?
Compliance is no longer just a legal hurdle; it is a financial necessity. In 2026, penalties for failing to surrender enough allowances are index-linked and significantly higher than the market price of carbon. Furthermore, companies that fail to comply face 'name-and-shame' public disclosure requirements, which can devastate an ESG rating and deter institutional investors.
The role of the regulator as a market stabiliser
The government doesn't just set the rules and walk away. They manage the Market Stability Reserve (MSR). If the market becomes flooded with allowances and the price of carbon drops too low to discourage pollution, the regulator removes permits from the system. This keeps the carbon price high enough to ensure that business as usual remains more expensive than going green.
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Major emissions trading schemes in 2026
Emissions trading is no longer confined to a few regions - it has become a global standard. While many systems share a similar cap-and-trade DNA, they are tailored to the specific economic priorities of their territories.
🇪🇺 EU Emissions Trading System
Launched in 2005, the EU ETS remains the world’s most influential carbon market, covering over 10,000 installations.
2026 Milestone
Shipping is now integrated, with 70% of emissions covered, moving to 100% next year.
Expansion (ETS2)
Road transport and heating fuels will be priced under ETS2 by 2027/2028.
Impact
Emissions from covered sectors have dropped by ~50% since launch.
🇬🇧 UK Emissions Trading Scheme
Established post-Brexit, the UK ETS mirrors the EU system with stronger local ambition.
Maritime Integration
From July 2026, domestic shipping emissions are included.
Waste & Incineration
Monitoring phase underway; market entry planned for 2028.
Strategic Linking
UK and EU are negotiating to connect their carbon markets.
🇨🇳 China’s National ETS
The world’s largest carbon market by emissions coverage, launched in 2021.
Sector Expansion
Steel, cement, and aluminum are being added to the system.
Policy Shift
Moving from carbon intensity to absolute emissions caps.
🇺🇸 North America
Regional systems continue to expand in the absence of federal pricing.
California Cap-and-Invest
Extended to 2045, funding community decarbonization projects.
RGGI
Virginia has rejoined; model used by other states exploring carbon pricing.
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Are emissions trading schemes successful?
The evidence from the world’s major economies shows that market-based climate policy isn't just a theory - it is delivering significant, measurable results.
🇪🇺 Proving the Model: EU ETS Progress
Verified 2026 data confirms that carbon pricing is driving measurable decarbonization across sectors.
-50%
Emissions reduction since 2005
Energy & Renewables
Solar grew by 24.6% in 2025, overtaking hydropower and accelerating the decline of fossil fuel generation.
Industrial Transformation
Emissions from heavy industry declined by 2.5%, reflecting structural shifts toward cleaner production.
Maritime Success
Shipping emissions dropped ~3% within a year of inclusion, showing rapid response to carbon pricing.
💰 Funding the Transition
Carbon markets generate capital to directly finance decarbonization.
$4.8B
California ETS annual funding (2025–26)
California Cap-and-Invest
Funds high-speed rail, housing, and clean water infrastructure.
UK Decarbonization
Emissions are now 54% below 1990 levels, driven by coal phase-out.
🌍 Global Expansion & Innovation
Success is triggering global adoption and market expansion.
China’s Industrial Shift
Steel, cement, and aluminum sectors added, making it the largest ETS globally.
Power Sector Transformation
Solar surged 24.6% in 2025, overtaking hydropower as EU’s #2 renewable source.
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Navigating the hurdles: Challenges for carbon markets
While emissions trading is a powerful lever for change, its success depends on how regulators and businesses manage a complex set of evolving risks.
Market Volatility and Investment Risk
Unlike a fixed carbon tax, an ETS allows the market to determine the price of carbon. While this ensures economic efficiency, it introduces unpredictability that complicates corporate planning.
Risk
Price Fluctuation
Sudden energy price spikes or industrial shifts can cause allowance prices to fluctuate. This makes it difficult to calculate long-term ROI for major investments such as hydrogen switching or carbon capture and storage (CCS).
Stabiliser
Market Stability Reserve (MSR)
Mature systems like the UK and EU ETS use a Market Stability Reserve as an automated pressure valve. It withdraws allowances when prices are too low and releases them when prices spike excessively.
The Global Rise of Carbon Border Taxes
A major challenge is carbon leakage — where production shifts to countries with weaker environmental laws. Border mechanisms are designed to prevent this.
EU CBAM
Now fully operational, importers of steel, cement, and fertilisers must pay a carbon price aligned with the EU ETS.
UK Framework
Launching in 2027, the UK CBAM mirrors EU objectives but expands scope to sectors like ceramics and glass.
Global Ripple Effect
Australia is exploring a border tax, while the U.S. is considering carbon fee legislation to protect domestic industry.
Ensuring a Just Transition and Public Support
As ETS expands into consumer sectors like transport and heating, energy affordability becomes a central concern.
Challenge
Energy Poverty
If carbon pricing is seen as unfair to lower-income households, it risks losing public support.
Solution
Reinvestment
Governments use auction revenues to fund insulation, EV infrastructure, and public transport via mechanisms like the Social Climate Fund.
Fragmentation vs. International Linking
The global carbon market is fragmented, creating complexity for multinational companies.
Cost
Multiple Systems
Companies operating across regions must navigate different compliance regimes, increasing administrative burden.
Future
Market Linking
Linking systems like the UK and EU ETS would create a unified, more stable carbon price and reduce compliance costs.
How ETS affects your business
Emissions trading has moved out of the sustainability category and into core operations. If you operate in a regulated sector - or buy from someone who does - carbon is now a financial variable you have to manage.
Carbon as a Direct Expense
Emissions move from an abstract sustainability issue to a direct financial line item.
Under a cap-and-trade system, your emissions are essentially a line item. If your facility goes over its limit, you have to go into the market and buy more permits.
The Financial Risk
If carbon prices spike - as they often do during energy crises - your operating costs can jump without warning.
The Revenue Upside
If you cut your emissions faster than the regulations require, those "spare" permits are an asset. You can sell them to competitors who are struggling to hit their targets, turning your efficiency into a direct cash injection.
Supply Chain and Logistics Costs
Carbon pricing reaches procurement and freight even when your own operations are not directly covered.
Even if your own business doesn't need to report emissions, your suppliers definitely do. This creates a trickle-down cost effect that hits your procurement budget.
Embedded Carbon Costs
Suppliers in sectors like steel, cement, and energy-heavy manufacturing are increasingly passing their carbon costs onto their customers.
Shipping surcharges
With the UK and EU now including ships in their trading schemes, logistics companies are adding carbon surcharges to their quotes. When you're choosing a freight partner, their carbon efficiency now directly dictates your shipping overhead.
Changing the Math on Upgrades
Carbon pricing changes how businesses justify capital expenditure and efficiency investments.
The presence of a carbon price changes the ROI on equipment upgrades. Previously, a new, more efficient system might have been rejected because the energy savings didn't justify the cost quickly enough.
New Investment Logic
Now, you have to add the avoided carbon cost to the equation. Saving 100 tonnes of CO2 isn't just good for the planet, it's 100 permits you don't have to buy. This makes the payback period for new technology much shorter and easier to approve at a board level.
Access to Financing
Carbon performance increasingly affects how lenders and investors price risk.
Banks are under their own pressure to hit green targets, which affects how they lend to you.
Sustainability-linked loans
Many lenders now offer better interest rates to businesses that can prove they are reducing their carbon footprint within an ETS.
Risk profiles
If your business is heavily reliant on free allowances that are scheduled to be phased out, banks may see you as a higher risk. Conversely, being ahead of the curve makes your business much more attractive to investors.
Emissions Trading FAQ
What is the difference between a carbon tax and an ETS?
A carbon tax sets a fixed price on carbon but does not guarantee a specific reduction in emissions. In contrast, an ETS (cap-and-trade) sets a fixed limit on the total volume of emissions, while the market determines the price. An ETS provides environmental certainty through the cap, whereas a tax provides price certainty for businesses.
What are Scope 3 emissions in the context of an ETS?
Most emissions trading schemes currently regulate Scope 1 emissions - those produced directly by a company’s own facilities. However, the costs of an ETS often migrate into Scope 3, which are the indirect emissions in a company’s value chain. For example, when a logistics provider pays for carbon allowances, those costs are passed down to the customer as part of their Scope 3 footprint.
Can companies use carbon offsets to meet their ETS targets?
In most modern schemes, like the UK and EU ETS, companies cannot use international carbon offsets (such as forest conservation projects in other countries) to meet their compliance obligations. Regulators increasingly require internal decarbonization or the use of highly regulated, engineered removals that are specifically recognized within the scheme's framework to ensure high environmental integrity.
How do free allowances work, and are they being phased out?
Free allowances are given to energy-intensive industries at risk of carbon leakage to help them remain competitive globally. However, as mechanisms like the Carbon Border Adjustment Mechanism (CBAM) are introduced to tax imports, these free permits are being systematically phased out. This shift forces companies to bid for all their allowances at auction, increasing the financial pressure to decarbonise.
How does an ETS affect small and medium-sized enterprises (SMEs)?
Most SMEs are below the thermal capacity threshold required for direct regulation under an ETS. However, they are still impacted by shadow pricing, where larger suppliers and energy providers pass their own carbon compliance costs down the chain. SMEs that proactively reduce their energy use often gain a competitive advantage by avoiding these indirect surcharges.
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