The European Commission has published a wide-ranging proposal to revise the EU Emissions Trading System (EU ETS) for the period from 2031 to 2040. The review is intended to align the carbon market with the EU’s 2040 climate target, while also responding to concerns around industrial competitiveness, carbon-price volatility, and the need for greater investment in decarbonisation.
The EU ETS is the EU’s principal carbon-pricing mechanism. It operates through a “cap-and-trade” system, under which a limit is placed on emissions from covered sectors, including electricity generation, energy-intensive industry, aviation, and maritime transport. Companies, whether granted free allowances or purchased, must surrender one EU Allowance, or EUA, for every tonne of carbon dioxide equivalent emitted. The total number of allowances reduces over time, creating an increasing incentive to cut emissions. Some industries, such a gas fuelled electricity generation, are not granted a free allowance.
A central element of the proposal is a revision to the Linear Reduction Factor, or LRF, which determines the annual rate at which the overall emissions cap declines. The Commission proposes an LRF of 3.7% between 2031 and 2035, falling to 1.7% from 2036 onwards. This is slower than the 4.4% rate due to apply from 2028 and would allow new allowances to continue being issued into the 2040s. The Commission argues that this more gradual trajectory will give industry additional time to deploy difficult and capital-intensive decarbonisation technologies.
The proposal also includes reforms to the Market Stability Reserve, or MSR. The MSR is designed to address imbalances between the supply of and demand for allowances by removing allowances from the market when there is a large surplus and releasing them when supply becomes too tight. The Commission proposes reducing the rate at which allowances are placed in the reserve, introducing a new lower buffer and gradually reducing the reserve’s thresholds as the overall ETS market contracts. These changes are intended to support market liquidity and reduce excessive price volatility.
Further flexibility would be introduced through permanent carbon removals and international carbon credits. Up to 250 million tonnes of permanent removals, initially focused on technologies such as bioenergy with carbon capture and storage and direct air carbon capture and storage, could be integrated into the ETS. The Commission also proposes purchasing up to 260 million tonnes of high-quality international credits between 2036 and 2040. These measures are intended to provide additional flexibility for hard-to-abate sectors, although they also raise questions about the strength of the domestic carbon-price signal and the extent to which investment may be directed outside Europe.
A major feature of the review is the increased use of ETS revenues to support industrial decarbonisation. The Commission proposes a €100 billion Industrial Decarbonisation Bank, preceded by an ETS Investment Booster before 2030. These mechanisms would support technologies including industrial electrification, storage, flexibility, grid connections, hydrogen and carbon capture. Member States would also be required to direct at least 50% of national ETS revenues towards the decarbonisation of ETS sectors.
Free allocation for industry would continue beyond 2030 but would become more closely linked to investment in emissions reduction within the EU. The phase-out of free allocation for sectors covered by the Carbon Border Adjustment Mechanism would also be extended to 2038.
For the electricity sector, the review presents both opportunities and risks. Greater electrification of industry, transport, and buildings should increase demand for clean electricity and reinforce the need for investment in generation, grids, storage, and flexibility. However, a slower reduction in allowance supply could weaken the carbon-price signal that supports the transition away from fossil generation.
The proposal will now be considered by the European Parliament and the Council. The final outcome will be important in determining whether the ETS can continue to support cost-effective decarbonisation while also providing the investment certainty required for Europe’s energy transition.