The proposed adjustments and expansions in the European Emissions Trading System Review, (ETS), do more than strike a balance between climate ambition and competitiveness. The European Commission is also seeking a better balance between rewarding innovation and giving more time to sectors where emission reduction is most difficult. At the same time, it has added new instruments to keep the ETS effective in the long term and has further expanded CO₂ pricing.
This is necessary. Climate policy gains more support if it allows sufficient flexibility to achieve the goals, keeps costs for European industry manageable, and does not only reward frontrunners. The review also makes a start on negative emissions. These are necessary to offset the last remaining emissions and to ultimately actually remove CO₂ from the atmosphere once net zero has been achieved.
The European Commission faced five challenges during this review.
- It had to determine the CO₂ budget for the fifth ETS period, from 2030 to 2040.
- She also had to, as defined for the EU Climate Law, make room for a limited number of remaining emissions after 2040, because some sectors will not yet be able to reach full zero by then.
- Furthermore, she had to take into account the costs for energy-intensive industries, certainly given the geopolitical situation, tarriff wars and high energy costs.
- At the same time, the ETS had to continue contributing to the EU climate target of a net 90 percent emission reduction by 2040, of which 85% within the EU.
- And finally, the system had to continue rewarding frontrunners.
More head room
All things considered, the Commission has succeeded reasonably well in this. The European Climate Law for 2040, agreed last year, had already provided direction for this. The package is balanced and meets all five objectives. Nor is it a weakening of climate policy. After all, there were no agreements yet regarding the next phase of the ETS after 2030. Therefore, there was no existing phase-out path towards 2040. However, it is clear that the world has changed significantly since the previous ETS revision. The industry is facing high energy costs, geopolitical uncertainty, a shortage of renewable energy and hydrogen, and CO₂ storage that is only really getting underway this year.
Despite these circumstances, European climate policy remains ambitious. The ETS is not weakening, but applies the necessary flexibility and is rather expanding. New sectors are being added, and the system is contributing to the further tightening of European climate policy.
Ad 1) From 2031, the ETS budget will decrease annually by 3.7 percent the so-called Linear Reduction Factor LRF). This year, that budget amounted to just over 1 billion emission allowances. Since the start of the ETS in 2005, emissions from all participants combined have already fallen by approximately 50 percent. The upcoming phase therefore requires substantial reductions once again. These go beyond the regular 1 to 2 percent energy efficiency improvement per year. Companies will really have to continue investing. That 3.7 percent is a compromise. It lies between the current phase-out rate of 4.4 percent and the previously circulating proposal of 3.4 percent. With this, the Commission is opting for a steeply declining ceiling, but with slightly more room than at the current pace. 3.7 percent is roughly 75 million tonne, whereas 4.4 percent removes roughly 89 million tonne.
From 2036, the annual ETS budget will decrease by 1.7 percent. This is related to the expectation that a number of industrial sectors, as well as parts of the air and maritime shipping sectors, will not yet be able to operate entirely without physical emissions in 2040. This concerns so-called residual emissions in hard-to-abate sectors. The 1.7 percent rate is conditional on available high-quality international credits; if they fail, it reverts to 2.7 percent from 2036, with zero around the mid-2040s. The proposed 1.7 percent from 2036 removes roughly 35 million tonne. The ETS budget will then run out around 2046 or 2047.
Ad 2) At the end of last year, the EU had already agreed in the European Climate Law that a limited number of emissions must remain possible under the ETS even after 2040. This requires additional CO₂ headroom, without abandoning the climate goal. This headroom is being sought through, among other things, permanent carbon removal and international carbon credits.
- From 2031, the Commission intends to centrally finance approximately 250 million tonnes of European permanent carbon removals. Examples include BECCS or BioCCS, direct CO₂ capture from the air (DAC). Possibly also biochar, as the EU will follow the EU Carbon Removal Certification Framework (CRCF), that includes biochar as certified permanent storage. These removals can subsequently be converted and auctioned as ordinary emission allowances. Central procurement enables additional public-private financing. This is necessary because the costs of carbon sequestration are often twice as high as the ETS price.
- ETS operators, shipping companies and aircraft operators can compensate their own fossil emissions with CRCF-certified BioCCS removals that they themselves generate. This compensation mechanism cannot generate negative emissions itself
- In addition, from 2036, the EU intends to centrally purchase approximately 260 million tonnes of carbon credits via Article 6 of the Paris Agreement. By doing so, it aims to prevent double counting. This involves structural cooperation on transition with leading developing countries. This represents approximately 2 percent of European emissions. The EU Climate Act stipulates that 85 percent of the reduction must take place within the EU itself, and a maximum of 5 percent may be achieved via carbon credits. The proposed use of credits is therefore cautious. The remaining 3 percent remains available for non-ETS sectors.
A pilot phase for the financing of carbon credits will start as early as 2031. Through indirect linking, the EU maintains control over costs, quality, and volume of international credits. This is important because international credits are only credible if they are robust and easily verifiable. - The Market Stability Reserve will also continue to play a role. Emission allowances held within it that remain available after auctions will remain usable for longer. This is interesting because actual emissions in recent years have consistently been lower than the ETS budget available under the Paris Agreement. This headroom can therefore remain available, including for free allocation. At the same time, it is quite possible that this headroom will ultimately not be fully needed. From 2028 the intake rate is halved from 24% to 12%, meaning that in the event of a surplus, future intakes will be spread over a longer period.
Central procurement of permanent carbon removals enables additional public-private financing. This is necessary because the costs of carbon sequestration are often twice as high as the ETS price.
And for international carbon credits, through indirect linking, the EU maintains control over costs, quality, and volume
Ad 3) To limit costs for the industry, free allowances are being kept available for longer, and the share of free allowances relative to allowances to be auctioned is increasing.
- Companies that receive free allowances based on an energy efficiency benchmark will retain that right until 2040. But from 2031, all free allocation is made fully conditional upon operators submitting a verified decarbonisation investment plan, with 80% of allowances released upon plan approval and the remaining 20% contingent on demonstrated emissions reductions by the end of each five-year period. Operators relocating activities outside the EU will be required to return allowances received under the relevant provision, directly incentivising investment retention within the EU.
- Additionally, 14 sectors that purchase electricity will receive extra free emission allowances to promote electrification.
- Furthermore, the phasing out of free allowances for CBAM sectors will be delayed until 2038.
- For sectors without their own benchmark, which fall under the default heat benchmark, additional allocation will become available. This corrects an imbalance, as the heat benchmark partly took into account the extensive use of biomass in Scandinavia, whereas that possibility is much more limited in the rest of Europe. This concerns, among others, the chemical industry, certain metals and metallurgy, ceramics, glass, and agri-food processing. The extra capacity comes from the 3 percent emission allowance reserve.
Ad 4) The dwindling ETS budget, the additional headroom through carbon sequestration, and the limited use of international carbon credits must collectively contribute to the European goal of a 90 percent reduction by 2040 – of which 85% within the EU – and climate neutrality by 2050. In this regard, ETS sectors continue to reduce emissions faster than sectors outside the ETS.
Ad 5) ETS remains rewarding frontrunners
- The CO₂ price is expected to remain strong in the long term because the budget continues to decrease. While the phase-out path will be slightly less steep, meaning the price will rise less sharply than with a stricter ceiling, the structural direction remains clear. It is expected that the ETS price could exceed 200 euros per ton in 2035 and 300 euros in 2040. The market also reacted visibly to the review. The ETS price briefly fell below 80 euros on July 17, but subsequently rose again above 86 euros per ton. In the run-up to the review, the market feared that the Commission would consider bringing an additional 400 million emission allowances onto the market without conditions. That did not happen. The proposed linear reduction factor, which determines how the emission ceiling decreases annually, turned out to be stricter than expected.
- Even for sectors receiving extra free allowances, there remains an incentive to reduce emissions. Those who innovate faster can avoid costs or recoup value through the sale of rights. Laggards, on the other hand, are pushed forward, because they are required to invest the saved money in their own site in exchange for free rights.
- The ETS is being expanded. Smaller seagoing vessels of 400 to 5,000 gross tonnes will fall under the system.
- International aviation from the EU up to 5,000 kilometers is also included, as are private jets.
- Waste incineration plants are being gradually brought under the ETS by 2034 for the fossil portion of their emissions. This could make CCS in waste incineration more attractive, as capturing the biogenic portion—approximately half of the emissions—can lead to negative emissions. Accounting of non-permanent carbon capture and utilisation (CCU) will be added: majority of re-emissions from non-permanent CCU will become subject to carbon pricing. Synthetic fuels, will be added to the ETS Directive as activity, covering the distribution points for synthetic fuels.
- The Commission is also examining the conditions under which decarbonisation can actually be achieved.
- Simultaneously with the ETS review, an Electrification Action Plan has been proposed, with an indicative electrification target of 46 percent by 2040. Currently, that share stands at around a quarter. According to the Commission, this could reduce European gas imports by more than 70 percent. Furthermore, the aim is to reach 200 gigawatts of storage capacity by 2030 and accelerate the rollout of renewable electricity.
- An Industrial Decarbonisation Bank will also be established, with 100 billion euros in funding. In the first phase, the bank is intended to accelerate investments through an Investment Booster. An estimated 30 billion euros is available for this purpose until 2030 to mitigate investment risks and reward first movers.
- Additionally, Member States will be required to spend 50% of their national ETS revenues on investments in making ETS sectors more sustainable. This could generate more than 100 billion euros in investments before 2030.
All in all, the package remains ambitious and in line with Paris
All in all, the package remains ambitious and in line with Paris. At the same time, it acknowledges that geopolitical and economic circumstances have changed. It is justifiable to utilize the maximum CO₂ margin and create new margin through carbon sequestration and carefully selected international credits. Energy-intensive industries are heavily impacted by high energy costs and international competition. The ETS is intended to make achieving CO₂ targets affordable. This can help green companies, but that is not the goal in itself.
Ultimately, this review is about the final result. To garner broad support, the package contains both more ambition and more margin for emissions after 2039. Particularly attractive is the combination of a less steep linear reduction factor, adjustments to benchmarks, new emission allowances in exchange for permanent carbon storage for hard-to-abate sectors, and limited margin for international carbon credits after 2036.
Of course, much depends on the implementation. Member States must invest, permits must be granted, sustainable technology must become available, and carbon sequestration and carbon credits must be reliable, affordable, and verifiable. If these preconditions are not met, the ETS will remain strict but will become less effective as an investment instrument.
Moreover, by including international credits to a limited extent, the EU ensures that developing countries with which Europe has trade relations, and from which products are also imported, will do more regarding climate policy and CO₂ pricing. This can contribute to a broader international movement, provided the quality of those credits is properly safeguarded.
Trump Card: Price Corridor
Furthermore, the Commission is keeping another trump card up its sleeve. The Market Stability Reserve will remain filled for longer with emission allowances that fall within the initial CO₂ ceiling and with unused reserve allowances. These will not simply be released but could be auctioned off if the CO₂ price rises too high. This could become particularly relevant during periods of scarcity.
This also brings back the discussion regarding a price corridor. A ceiling price can prevent extreme spikes, while a floor price provides certainty regarding the minimum incentive to invest. In the past, about half of the Member States proved open to this. For ETS-2, the system for buildings and transport starting in 2028, the Market Stability Reserve already acts as such a CO₂ price stabilizer.
The ETS review therefore does not just try to please everyone. It attempts to prepare the system for a next, more difficult phase. The ETS remains ambitious but is becoming more realistic regarding the time required by some sectors. It gives industry more leeway but maintains pressure for reduction. It introduces new instruments but tries to retain control over quality and volume.
That is exactly what is needed. The ETS must not only be strict but also workable. Only then will it remain an effective instrument for achieving European climate goals without unnecessarily weakening Europe’s industrial base.