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The European Union Emissions Trading System (EU ETS) operates on the cap-and-trade principle, which is designed to reduce greenhouse gas emissions in a cost-effective manner. Under this system, a limit (or cap) is set on the total amount of emissions that can be emitted by all participating installations. This cap is gradually reduced over time, which helps to decrease overall emissions.

Each installation is allocated a certain number of allowances, where each allowance permits the holder to emit one ton of CO2 (or its equivalent). If an installation reduces its emissions below its allocated amount, it can sell its excess allowances to other installations that are exceeding their limits. This market-based approach incentivizes companies to innovate and improve their efficiency in order to either save on allowances or profit from selling them, thereby promoting a more sustainable approach to emissions management.

By implementing this mechanism, the EU ETS aims to create a financial incentive for businesses to reduce their emissions, ultimately leading to a greener and more sustainable economy.