EU ETS Reform – Briefing

Introduction

On 17 July 2026, the European Commission presented its long-awaited proposal for a revision of the EU Emissions Trading System (EU ETS; the Commission’s proposal referred to as the Proposal). The Proposal establishes the legal framework for the fifth trading period (2031–2040) and is intended to align the EU's carbon pricing instrument with the Union's 2040 climate target of a 90% net reduction in greenhouse gas emissions compared to 1990 levels, as set out in the revised European Climate Law. Presented at a time when European industry is struggling with high energy costs and intensifying international competition, the Proposal marks one of the most consequential reviews of the system since its introduction in 2005.

The review concerns the existing emissions trading system (ETS 1), covering power generation, energy-intensive industry as well as parts of aviation and maritime transport. The second emissions trading system (ETS 2) for buildings and road transport, which will become fully operational in 2028, is not part of the Proposal and will be reviewed separately.

European Parliament and the Council are expected to negotiate the Proposal well into 2027. While individual elements may therefore still change, the Proposal sets the framework and direction for the reform – and thus provides companies with a first reliable indication of what to prepare for.

Key changes

1. 1. A slower decline of the cap

Under the current framework, the overall emissions cap decreases annually by a linear reduction factor (LRF) of 4.3% (2024–2027) and 4.4% (from 2028). If extended unchanged into the next trading period, this trajectory would have brought the issuance of new allowances to an end around 2039.

The Commission now proposes an LRF of 3.7% for the period 2031–2035 and of 1.7% from 2036 onwards. Consequently, allowances would continue to be issued well into the 2040s. The Commission justifies the flatter trajectory by reference to the architecture of the 2040 target: as a net target, it may be met in part through international carbon credits and permanent carbon removals (see below 5. and 6.) which reduces the reduction burden placed on the cap itself.

1. 2. A softer Market Stability Reserve

At present, the Market Stability Reserve (MSR) absorbs 24% of the surplus of allowances in circulation once a fixed threshold is exceeded; allowances held in the reserve above 400 million are permanently invalidated. The Proposal – together with a separate amendment to the MSR Decision (COM(2026) 153 final) already tabled in April 2026 – substantially recalibrates this mechanism: the intake rate is to be halved to 12% from 2028, the thresholds are to become dynamic and decrease annually in line with the shrinking cap, and the invalidation mechanism is to be discontinued, so that surplus allowances would be retained as a buffer rather than cancelled.

Taken together with the flatter cap trajectory, these changes increase the supply of allowances available to the market compared to the current framework.

A flatter cap trajectory also implies a more moderate carbon price trajectory than previously anticipated. This is of relevance not only for EU ETS participants, but also for business models that depend on a robust and predictably rising emissions allowance price as a competitiveness factor. For these business models, the reform offers less relief than for compliance-driven industry and may unsettle post-FID investment assumptions.

1. ​​​3. ​​​​Free allocation: extension for conditionality

The most significant changes for industrial operators concern free allocation. Under the current framework, free allocation based on product benchmarks is granted largely unconditionally to sectors exposed to a risk of carbon leakage. For sectors covered by the Carbon Border Adjustment Mechanism (CBAM), free allocation is being phased out entirely between 2026 and 2034 (also see our briefing on the CBAM).

The Proposal modifies this framework in two directions. On the one hand, free allocation and carbon leakage protection are extended through 2040. For CBAM sectors, 15% of the free allocation currently scheduled for phase-out is to be reintroduced from 2028, and the phase-out is stretched until 2038 – correspondingly slowing the CBAM phase-in.

The extension of free allocation is supplemented by a recalibration of the benchmark methodology. The maximum annual benchmark update rate – currently capped at 2.5% – is to be adjusted to 2% in order to track the observed rate of sectoral decarbonisation more closely, rather than a predetermined reduction path. The corresponding implementing acts for 2031–2035 and 2036–2040 will follow at a later stage. In addition, the buffer before the cross-sectoral correction factor applies is increased to 4% of the total quantity of allowances, reducing the risk of pro rata cuts to free allocation across sectors. Both changes tend to increase and stabilise allocation volumes for sectors where decarbonisation is progressing slowly relative to the benchmark. Conversely, installations that have already achieved above-average efficiency gains may see their relative allocation advantage narrow, as the benchmark trajectory converges more closely with the sector average.

On the other hand, free allocation is to become fully conditional from 2031: Operators would receive 80% of their free allowances only upon approval of a verified decarbonisation investment plan. The remaining 20% would only be released upon demonstrated emissions reductions at the end of each five-year period. Operators relocating activities outside the EU would be required to return allowances received.

Free allocation would thus change in character – from a largely unconditional shield against carbon leakage to an instrument tied to verifiable transformation efforts within the EU. The precise requirements for decarbonisation investment plans, including the standard of review and the consequences of partial implementation, are to be specified in secondary legislation and therefore remain open for the time being.  

1. 4. Waste incineration joins the EU ETS

To date, waste incineration installations are only subject to monitoring, reporting and verification obligations. The Proposal extends the EU ETS to all installations incinerating or co-incinerating non-hazardous waste with a capacity exceeding 3 tonnes per hour. The surrender obligation is to be phased in gradually from 2031, reaching 100% of verified emissions by 2034. Monitoring, reporting and verification obligations are extended to non-hazardous waste landfills, accompanied by a review clause on a possible future inclusion of landfilling itself.

For the waste management sector – including municipal operators – this entails material cost implications, which may feed through to waste management fees.

The introduction of waste incineration and carbon removals (see below 5.) into the ETS points to a broader regulatory shift: the combination of a new compliance obligation for waste incinerators, direct crediting for CRCF-certified BioCCS removals, and access to the new funding instruments described below creates the pre-conditions for an emerging business model along the chain from waste intake through incineration, carbon capture, certification and revenue generation.

At the same time, waste-to-energy installations supplying district heating remain eligible for free allocation, and carbon capture projects at incineration sites gain access to the new funding instruments.

1. 5. Domestic carbon removals (not yet) to enter the system

For the first time, permanent domestic carbon removals will be partially integrated into the EU ETS and materially funded by the Commission. The EU ETS cap is to be increased by 250 million allowances, to be auctioned between 2031 and 2040, with the revenue used exclusively to purchase permanent removals – bio-energy with carbon capture and storage (BioCCS) and direct air carbon capture and storage (DACCS) – certified under the Carbon Removals and Carbon Farming Regulation (CRCF-Regulation). Notably, the Proposal does not mention biochar carbon removal, although the legal framework for the certification of such removals has been delivered jointly with those for BioCCS and DACCS (Delegated Regulation (EU) 2026/285). In its Impact Assessment, the Commission expresses concerns as regards, firstly, lack of long-term research on release of CO2 from biochar beyond soil application and use in products and, secondly, market effects of the comparatively low price of biochar removal certificates. The purchased BioCCS and DACCS removal units, after all, would not circulate within the market but would "back up" the additionally issued allowances.

Additionally, operators generating CRCF-certified removals of biogenic CO2 in their own installations may offset their fossil emissions directly against these removals. In combination with the inclusion of waste incineration (see below), this creates a genuine incentive for carbon capture at installations with significant biogenic emission shares. However, those certified removals will not lead to a negative emissions balance, nor will those removal units be tradeable like emission allowances. The Proposal likely rules out offsetting of emissions with biochar carbon removals.

The Proposal further addresses non-permanent carbon capture and utilisation (CCU): with waste incineration included in the EU ETS, most re-emissions from non-permanent CCU will become subject to carbon pricing at the end of a products life cycle. For synthetic fuels, a new activity covering their distribution points is to be added to the ETS Directive, so that their emissions are priced when the fuel is placed on the market.

1. 6. Return of international credits

Since 2021, international carbon credits have been entirely excluded from the EU ETS. The Proposal operationalises the limited re-opening agreed in the revised European Climate Law: between 2036 and 2040. Up to 260 million allowances may be set aside from the cap and auctioned, with the revenues used to purchase up to 260 Mt of high-quality international credits under Article 6 of the Paris Agreement – equivalent to roughly 2% of the EU's 1990 net emissions. This constitutes a major subsidy for international carbon removal projects.

Notably, operators would not be able to purchase or surrender international credits themselves. Instead, the credits would be acquired centrally through a dedicated EU facility, funded by the auctioning of the set-aside allowances. The Proposal also contains a safeguard: the Commission must report on the international credit market by January 2033. Should credits of sufficient quality and integrity prove unavailable, the LRF would revert to 2.7% from 2036, restoring the full domestic reduction pathway. Whether a sufficient supply of credits meeting the envisaged integrity standards will materialise remains to be seen.

7. A new funding architecture

The Proposal significantly expands the financial support framework of the EU ETS beyond the existing Innovation Fund and Modernisation Fund. From 2028, an Industrial Decarbonisation Bank (IDB) is to be established with an envisaged funding volume of EUR 100 billion. In a first phase (2028–2031), an "ETS Investment Booster" would reserve 400 million allowances to provide fixed carbon premia for verified emissions avoided on a first-come, first-served basis. Support would be conditional on strict completion deadlines, secured by completion bonds.

From 2031, the IDB – equipped with further 400 million allowances – would transition to competitive bidding procedures awarding Carbon Contracts for Difference or carbon premia, under which the level of support is determined by the bids rather than fixed in advance, providing long-term revenue certainty for decarbonisation projects.

In addition, Member States would be required to allocate at least 50% of their emission allowance auction revenues to defined priority areas such as clean energy and grids, industrial decarbonisation and low-carbon transport, with investments incompatible with climate neutrality explicitly excluded.

1. ​​​​​​​8. Aviation and maritime transport

​​​​​​​The Proposal also extends the system's reach in aviation – including an extension to flights to destinations within 5,000 km of the EU from 2029 and the inclusion of business aviation – and in maritime transport, where coverage is extended to vessels between 400 and 5,000 gross tonnage.

1. 9. RFNBO production

The Proposal also has impact on the business cases for production and distribution of renewable fuels of non-biological origin (RFNBO) and low-carbon fuels (LCF). To account for the CO2 emitted during their use, the Commission suggests an upstream approach, including the distribution of RFNBO and LCF (collectively called “synthetic fuels”) into the EU ETS. We will return to this topic in a further article.​​​​​​​

Implications for companies

Even at proposal stage, companies covered by the EU ETS – or newly brought into its scope – should take note of several practical consequences:

• Compliance: Industrial operators will face an additional compliance layer as decarbonisation investment plans are set to become a precondition for free allocation, with a 20% tranche at risk if emissions reductions are not demonstrated. Preparing robust, verifiable plans will require considerable lead time.
• Funding: Operators with decarbonisation projects should assess the new funding instruments at an early stage. The first-come, first-served design of the ETS Investment Booster is likely to reward well-prepared applicants.
• Waste management companies and municipal operators should begin quantifying their exposure and reviewing pricing structures, permits and long-term supply contracts in light of the phase-in from 2031.
• Installations with significant biogenic emission shares – notably in waste-to-energy and bio-based industries – should evaluate the business case for BioCCS under the CRCF framework and its interaction with the funding instruments described above.
• Recalibrating investment models: Companies with long-term carbon price assumptions embedded in investment models, power purchase agreements or supply contracts will need to review these assumptions against the proposed cap trajectory. This applies with particular force to business models whose competitiveness case rests on a robust and rising EUA price.

Conclusion and outlook

The Commission‘s Proposal has prompted a debate on how to assess its implications both for companies and the EU’s climate ambition. Read one way, the package softens the ETS-system: the cap declines more slowly, the MSR withdraws fewer allowances, free allocation is extended, and international credits partially re-enter the system – all of which points towards a more moderate carbon price trajectory than under the current framework. Read the other way, the package tightens the system's transformational logic: free allocation becomes conditional on verified investment plans, relocation triggers an obligation to return allowances, revenues are ring-fenced for decarbonisation, and an entirely new funding architecture is created.

Which of these two readings will prevail depends largely on the legislative process ahead – and on the implementing legislation the Commission intends to table later in 2026, notably on benchmarks and on the purchase of international credits. Companies are well advised to follow legislative developments closely and to prepare for the new conditionality regime at an early stage.

Our EU/COMP team will be happy to advise on all questions relating to the EU ETS reform, emissions trading compliance and the new funding instruments.

​​​​​​​We would like to thank Tammo Eilts for his valuable support in preparing this briefing.