Carbon AllowanceEUA
A carbon allowance is a permit to emit a set amount of greenhouse gas — in the EU Emissions Trading System, one tonne of CO₂ equivalent. Total allowances are capped, and companies that emit less can sell spare allowances, which gives carbon a market price.
Governments that want to cut emissions can tax them, or they can cap them and let a market set the price. Emissions trading systems do the second. Each allowance is a right to emit a fixed amount, and because the total is limited, allowances become a tradable commodity with a price that moves with supply, demand and policy.
- Category
- Commodities, Energy and Carbon
- Reading time
- 4 min
- Also called
- Emission allowance, EU Allowance, Carbon permit
- Updated
Carbon allowances in plain words
In a cap-and-trade system, the government sets a limit on total emissions and issues that many allowances. In the EU ETS, one allowance gives the right to emit one tonne of CO₂ equivalent, and allowances are auctioned and can be traded.1
Each year, covered companies must hand in enough allowances to cover their emissions, or face heavy fines.1 A company that cuts emissions can sell its spare allowances or keep them.1
Allowances trade like other commodities, on spot and Futures Contract markets. The UK runs a similar scheme with its own allowances.2
How cap and trade works, step by step
Set the cap
The authority limits total emissions for the covered sectors; in the EU the cap falls every year.1
Issue allowances
Allowances are auctioned or given out free; participants can also buy them on the secondary market.2
Measure emissions
Companies monitor, report and verify their emissions each year.
Surrender allowances
Each company surrenders allowances equal to its emissions.1
Trade the difference
Companies short of allowances buy; those with spare allowances sell or keep them.1
Price emerges
Supply and demand in the carbon market set the allowance price.1
Worked examples
Example 1 — A company that is short
Buy 20,000 allowancesA plant emits 100,000 tonnes of CO₂e and holds 80,000 allowances. Assume a hypothetical price of €70 per allowance.
| Shortfall | 100,000 − 80,000 = 20,000 allowances |
| Cost to buy | 20,000 × €70 = €1,400,000 |
Each allowance covers one tonne, so the shortfall must be bought or the company faces fines.1
Example 2 — A company with spare allowances
€700,000 of spare allowancesA plant holds 100,000 allowances but cuts emissions to 90,000 tonnes. Hypothetical price €70.
| Spare | 100,000 − 90,000 = 10,000 allowances |
| Value if sold | 10,000 × €70 = €700,000 |
Cutting emissions frees allowances that can be sold or kept for later.1
Example 3 — Price risk for a buyer
€200,000 moreA company needs 20,000 allowances later in the year. The price rises from a hypothetical €70 to €80.
| Cost at €70 | 20,000 × €70 = €1,400,000 |
| Cost at €80 | 20,000 × €80 = €1,600,000 |
| Extra cost | €1,600,000 − €1,400,000 = €200,000 |
Because the market sets the price, emitters carry price risk and may hedge it with futures.1
Carbon allowance vs. carbon tax
| Aspect | Allowance (cap and trade) | Carbon tax |
|---|---|---|
| What is fixed | Total emissions (the cap) | Price per tonne |
| What moves | Price | Total emissions |
| Tradable | Yes | No |
| Price risk for companies | Yes | Low — rate is set |
Who uses carbon allowances
Compliance buyers
Power and industrial companies that must surrender allowances.
Hedgers
Emitters locking in future costs with futures.
Traders
Speculators trading price moves driven by policy and energy markets.
Energy analysts
Watching carbon costs that feed into power prices.
Advantages and disadvantages
Advantages
- Caps total emissions directly.
- Rewards companies that cut emissions by letting them sell spare allowances.
- Creates a transparent, traded price for carbon.
- Offers liquid futures for hedging.
Disadvantages
- Prices can be very volatile.
- Policy changes can move prices sharply.
- Rules are complex and differ between schemes.
- Not all emitters or regions are covered.
Going deeper
Read as far as you need. Each level builds on the one before it.
One allowance, one tonne
Beginner
In the EU ETS, each allowance covers one tonne of CO₂ equivalent and can be traded.1
Supply is set by policy
Intermediate
The cap falls each year, so supply shrinks over time.1 Free allocation, auctions and the secondary market decide who holds allowances.2 Watch policy news as closely as Volatility.
Common mistakes
Confusing allowances with offsets
Compliance allowances and voluntary carbon credits are different products.
Ignoring policy risk
Rule changes can move prices more than fundamentals.
Assuming all schemes are linked
EU, UK and other systems have different allowances and rules.
Overlooking leverage
Carbon futures are leveraged and can move fast.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- An allowance is a right to emit a fixed amount of greenhouse gas.
- In the EU ETS one allowance equals one tonne of CO₂ equivalent.
- The cap limits supply and falls over time.
- Companies that cut emissions can sell spare allowances.
- Prices are market-set and can be volatile.
Frequently asked questions
Is a carbon allowance the same as a carbon credit?
Can individuals trade carbon allowances?
What moves the price?
Further learning
- Futures Contract
How carbon allowances are traded forward.
- Hedging
How emitters lock in costs.
- Volatility
Why carbon prices swing.
- Spot Trading
Buying allowances for immediate delivery.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- European Commission. About the EU ETS (opens in a new tab) Checked .
- UK Government (GOV.UK). Participating in the UK Emissions Trading Scheme (UK ETS) (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.