The EU sets an upper limit (cap) up to which CO2 may be emitted. For every tonne of CO2 that a company emits, it must be able to show an emission allowance, a so-calledEUA (European Union Allowance). An EUA entitles the company to emit one tonne of CO2 into the atmosphere.
The amount of EUAs issued by the EU depends on the amount of the cap. This means that the emission target is determined from the outset by the amount of EUAs issued. The lower the cap, i.e. the fewer EUAs in circulation, the higher the value attributed to an EUA and the incentive to invest in climate-friendly, i.e. low carbon emission technology.
EUAs are tradable, i.e. the price of allowances is determined by the interaction between supply and demand. For companies with low CO2 avoidance costs, it may be advisable to sell surplus EUAs on the market. However, companies whose costs for avoiding a tonne of CO2 exceed the price of an EUA can buy additional allowances on the market. In this way, CO2 is saved exactly where it is possible at the lowest cost from an economic point of view.