The Specific Carbon Market Trick European Companies Are Using to Avoid Emission Costs

European companies are gaming the EU Emissions Trading System in specific legal ways that reduce the climate policy's effectiveness. Here is exactly how it works.

The EU Emissions Trading System is, in design, the most comprehensive carbon pricing mechanism ever implemented. In practice, it contains specific structural features that sophisticated industrial companies exploit to minimise their compliance costs in ways that technically comply with the rules while substantially reducing the system's climate impact.

The most consequential exploitation involves 'carbon leakage prevention' free permits — allocations given to energy-intensive industries to prevent them from relocating to less regulated jurisdictions. These free permits are calculated based on production benchmarks: a facility that produces a certain amount of steel receives a certain number of free permits based on the average carbon intensity of the most efficient producers in that sector.

The exploitation works through two mechanisms. First, facilities that have already made the efficiency investments that justify the benchmark level receive free permits whose value matches their actual costs — the intended outcome. Facilities that are less efficient than the benchmark receive free permits whose value exceeds their actual carbon cost — a windfall. Second, some companies in sectors eligible for leakage protection have restructured their operations to maximise permit allocation while minimising actual production, essentially earning carbon credit revenue without producing the goods whose production the permits were designed to compensate.

The EU Commission's analysis of the permit system found that between 2012-2022, industrial sectors collectively received free permits worth approximately €160 billion more than the permits they actually needed — a transfer of value from the carbon market mechanism to industrial incumbents that represents the most significant structural subsidy in European climate policy.

The policy correction — the Carbon Border Adjustment Mechanism and the phased elimination of free permits — is moving in the right direction. The pace of correction is slow enough that significant gaming value remains available for several more years, and the industries most capable of gaming the system are the same industries with the most political resources to resist the correction.