Emissions trading systems (ETS) aim to reduce greenhouse gas emissions by pricing the pollution of greenhouse gases. From California to China, over 30 emissions trading systems are active worldwide. At the forefront of this movement is the EU Emissions Trading System. Launched in 2005 as the world’s first international ETS, it represents the pillar of Europe’s climate strategy.
With the 2026 EU ETS revision on the horizon, understanding the impact of these policies is more critical than ever. We asked Eva Franzmeyer, doctoral researcher at the EUI Department of Economics, to explain how emissions trading systems work and to share insights from her working paper ‘From Free to Fee: How Emission Permit Allocation Affects Firms’ co-authored with EUI economics researcher Marie Alder and EUI alumnus Benjamin Hattemer. Their study explores a pivotal question: How did the last EU ETS reform affect industrial pollution and firms' economic activity?
For those unfamiliar with the concept, how does an emission trading system work? Can you also explain what changed in the EU Emissions Trading System with the last reform?
An emissions trading system is a market-based policy designed to cut greenhouse gas emissions at the lowest possible cost. Policymakers set a fixed cap on total emissions for a specific period and issue permits equal to that limit. Firms must hold a permit for every unit of pollution they produce. Under an ETS, the government can give out emission rights for free or, alternatively, these rights can be sold to firms. Companies able to reduce their emissions below their allocated allowances more easily do so and sell their excess permits, while those facing high costs to reduce emissions purchase permits instead. This trading system ensures that emissions reductions occur where they are most cost-effective.
The EU Emissions Trading System covers more than 12,000 installations across Europe, primarily in energy-intensive sectors like power generation and manufacturing. The EU ETS has been key in reducing emissions in Europe to date. For many years, the system gave companies a large share of permits for free to prevent carbon leakage—the risk that European firms move production outside Europe if climate policies increase costs at home. To reduce this risk, sectors heavily exposed to international competition—like steel, pesticides, and fertilisers—were protected through free permits.
Over time, however, the EU ETS has become more stringent, with a declining emissions cap and a growing share of permits auctioned rather than allocated for free. Before the last reform—announced in 2018 and implemented in 2021—many manufacturing sectors received almost all their permits for free.
With the reform, the EU introduced a new and stricter rule that based eligibility on a single indicator that combines how polluting a sector is with how exposed it is to international trade. The change created a sharp cutoff. Sectors just above the threshold continued to receive close to 100% of their permits for free, while otherwise very similar sectors just below the threshold lost a large share of free permits. For example, the casting of iron remained eligible for almost full free allocation, while the casting of light metals lost this status and received far fewer free permits. This change led to firms in affected sectors having to buy many more permits on the market.
Did the reform succeed in forcing companies to cut their emissions?
The reform led to a substantial reduction in emissions. Firms that lost access to their free permits cut their emissions by about 9% when the reform was announced. Following its implementation, the reduction went up to over 14%. What makes this result striking is both why emissions fall and by how much.
Standard economic theory predicts that, in a well-functioning ETS, it shouldn't matter whether permits are given away for free or sold. If a firm can cut emissions for costs that are below the market price of emission permits, it may sell its free permit. In any case, emissions reduction depends on the price of permits, not on the allocation of free permits. This theoretical result has been used to justify handing out free permits within the EU ETS for decades. On the contrary, we found out that when firms receive less free emission permits, they cut emissions sharply. Emissions dropped by more than 14% within five years.
Beyond the environment, how did these stricter rules impact the economy? Are European firms remaining competitive while going green?
Our research shows that the implementation of the last EU ETS reform reduced firms’ economic activity—though not immediately.
In contrast to emissions, this effect didn’t happen when the reform was announced, but in the moment firms actually received fewer free emission permits. Revenues and jobs remain unchanged at first because companies initially changed how they produced goods rather than how much they produced.
However, after the reform was implemented, affected firms contracted: Revenues fell by more than 15%, employment declined by about 11%, and total assets dropped by about 10%. These declines are comparable in magnitude to their reduction in emissions, suggesting that firms eventually responded by scaling down their overall activity.
To explain this pattern, our paper develops a theoretical model based on multi-product firms. Firms operate multiple product lines, such as different models of cars, type of fertilizers, or pharmaceutical products, that vary in productivity and profitability. Think of free emission permits as a subsidy that helps cover the basic costs of running a factory. When that subsidy is taken away, a company’s least profitable product lines—the models of a car company that yield only a small profit—become too expensive to keep. Firms shut down their least efficient activities but keep their high-performing ones running. As a result, total output, employment, emissions, and assets decline over time.
Interestingly, these slimming down drives innovation. Because companies anticipated that some of their product lines would become unprofitable and shut down in the future, they started investing in making their surviving products cleaner and more efficient the moment the reform was announced.
A simple example helps clarify this logic. Consider a car manufacturer such as Audi. The company anticipates that, without free permits, its least profitable model (like the A3) will eventually become economically unsustainable and will need to be discontinued. Some customers who would have bought an A3 will likely buy a similar Audi model instead, such as the A4. For consumers, the change is small because the brand, design, and features remain similar. Some customers might switch to another brand, like BMW, but this effect is likely limited. As a result, sales and revenue of the remaining Audi models, like the A4, increase relative to competitors.
In other words, the expected discontinuation of the A3 increases demand and revenues for the A4. Because more units of the Audi A4 are expected to be sold, investments in cleaner production for this model become more profitable. Importantly, firms anticipate these revenue reallocations as soon as the policy change is unveiled. As a result, Audi undertakes the clean-technology investment at the time of the reform announcement, leading to a reduction in emissions well before firm size, employment, or assets adjust.
What are the main takeaways from your research policymakers cannot ignore, especially in view of the upcoming EU ETS revision?
Our findings have broad relevance for policymakers worldwide. As the use of emissions trading systems expands across the globe, understanding how these policies affect firm behaviour becomes increasingly important.
The first key takeaway is that the allocation of free permits matters as it affects both emissions and firms’ economic activity. Policymakers have often thought that permit allocation is irrelevant if the overall emissions cap is fixed. Our study of the EU ETS shows that this principle does not hold in practice. Reducing free permit allocation successfully lowers emissions but also reduces firms’ economic activity, revealing a genuine trade-off between environmental goals and economic outcomes. Allocation rules should therefore be treated as an active policy instrument and carefully designed keeping its impact on firms' production quantities in mind.
The second takeaway concerns how companies react to changes over time. Firms adjust in stages: They initially reduce emissions by improving efficiency without shrinking, and only later reduce scale by cutting output and employment. This dynamic response has important implications for policy design. It points to a role for complementary measures—such as policies that encourage early investment in cleaner technologies—to ease the transition.
Because firms are forward-looking and respond to expected future costs and profits, the timing and sequencing of policy changes are crucial elements of effective climate policy.
Eva Franzmeyer is a doctoral researcher at the EUI Department of Economics. Her PhD thesis entitled ‘Essays on the Effects of Environmental Regulation on Firm Dynamics and Macroeconomic Outcomes’ is supervised by former EUI Professor Edouard Challe (supervisor) and by EUI Professor Russell Cooper (co-supervisor).
Read the paper ‘From Free to Fee: How Emission Permit Allocation Affects Firms’ by Eva Franzmeyer, Marie Alder, and Benjamin Hattemer on SSRN.