On 17th July, the European Commission unveiled its much-anticipated legislative proposal to overhaul the EU’s compliance carbon market, the EU Emissions Trading System (EU ETS).
At a strategic level, the EC’s move aims to improve the EU’s energy independence and industrial competitiveness by cutting dependence on imported fossil fuels and electrifying the emissions-intensive industries. The proposals include reforms to the EU ETS and a broader Electrification Action Plan.
The EC also wants to alleviate the burden on industrial companies by including a less aggressive CO2 emissions reduction trajectory under the EU ETS. It also wants to increase funding for industrial decarbonisation projects and include other flexibility mechanisms, such as allowing the use of international carbon credits in the scheme.
All very sensible-sounding ideas, you might say. But how will these lofty goals actually be addressed through the EC’s proposed legislative changes to the EU ETS?
Let’s examine five of the key components in turn.
Linear Reduction Factor
The Linear Reduction Factor (LRF) under the EU ETS is simply the percentage rate at which the overall ‘cap’ on CO2 emissions shrinks each year. This matters for affected businesses because it represents the strength and speed of the collective carbon reductions that industry will have to deliver over time.
The LRF is currently set at 4.3% for 2024-2027 and 4.4% for 2028-2030. If the 4.4% rate were maintained beyond 2030, the EC estimates that the supply of new allowances would fall to zero by around 2040. It has therefore proposed a new post-2030 trajectory of 3.7% from 2031-2035 and 1.7% from 2036-2040.
The change would keep allowances entering the market into the 2040s and leave more room for residual emissions from hard-to-abate sectors while the EU moves towards economy-wide climate neutrality by 2050.
Market Stability Reserve
The EC also proposed changes that aim to recalibrate the Market Stability Reserve (MSR) under the EU ETS. The MSR is a quantity-based mechanism that withholds surplus carbon allowances if there are too many in the market, preventing the carbon price from collapsing, and releases them if the supply in circulation falls below a certain threshold.
The new rules, if adopted, would mean the MSR’s intake rate would halve from 24% to 12% per year and its thresholds and release volumes would also adjust from 2029, reflecting a shrinking market after 2030.
This would build on the EC’s proposal in April 2026 to scrap a current rule that invalidates allowances in the MSR above a 400 million threshold. This is likely to cause a significant increase in the volume held in the MSR by 2030.
Use of carbon credits
The EC also proposed that carbon credits can play a role in the EU ETS, but with strict controls.
From 2036, the proposal would create an EU-level facility to purchase up to 260 million tonnes of high-quality international carbon credits, financed using up to 260 million EU Allowances (EUAs). This would create additional emissions space within the ETS equivalent to up to 2% of the EU’s 1990 net greenhouse-gas emissions. It would sit within the wider economy-wide flexibility of up to five percentage points proposed for meeting the EU’s 2040 climate target.
The move aims to “allow breathing space in 2036-2040 when the emission reduction in Europe will become more challenging,” the EC said when announcing its proposal.
CORSIA and the EU ETS
Before the EC’s package, expectations had been that emissions from extra-EU flights departing EU airports would be brought under the EU ETS, rather than left under the UN’s Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA).
However, the EC has proposed something less expansive: that emissions from flights heading from Europe to destinations within 5,000 km of Frankfurt airport would come within the scope of the EU ETS from 2029, with a review in 2032. This move is seen as a way to give more time for CORSIA to show its effectiveness at dealing with emissions from international flights.
Most flights departing EEA airports for destinations in the US and China would remain outside the proposed extension because they exceed the 5,000 km threshold.
However, the coverage of the EU ETS for aviation emissions would include major transport hubs in the Middle East such as Dubai, Jeddah, Doha, and Istanbul, representing a significant additional volume of CO2 emissions coming within the scope of the EU ETS.
Funding for decarbonisation
The EC also proposed new tools to provide funding to reduce CO2 emissions across the EU.
These include the Industrial Decarbonisation Bank which will have €100 billion of funding to boost industrial decarbonisation across Europe at scale, and the ETS Investment Booster as the first phase of the Bank, funded with €30 billion for the period 2028-2030.
Member States would also be required to direct at least 50% of their ETS revenues towards specified priority investments, including clean energy and grids, industrial decarbonisation, low-carbon transport, circularity and climate innovation..
Negotiations to follow
It’s also worth underlining at this stage that the EC’s legislative package is just a proposal. It will need to go through the EU’s legislative process which involves detailed three-way negotiations between the EU Parliament, the Member States and the EC, before it can become law.
Expect to see negotiations between MEPs and voting blocs in the EU parliament before a common position can be reached, and then further talks with member states and the Commission before a final package can be hammered out and adopted into law – a process that can take well over a year to complete.
Political and economic realities
Our take on this is that the EC’s legislative proposals reflect the economic realities of the current time. The legacy of inflation and persistently high or volatile energy costs have taken their toll on both households and industrial competitiveness in the EU. These factors have been further compounded by additional energy shocks due to conflict in the Middle East and an ongoing war on Europe’s eastern border.
A long-term electrification of industry can reduce the EU’s dependence on imported fossil fuels and exposure to fossil fuel price volatility further down the line, but the more pressing issue is reducing cost burdens on families and businesses now.
The EC’s move to soften the emissions reduction trajectory under the EU ETS, include more flexibility on the use of carbon credits, and boost funding for decarbonisation represent the need for legislators to balance long-term climate ambition with the political realities of running healthy economies, maintaining jobs and protecting household wealth and industrial competitiveness.
For more detail and analysis on the EC’s legislative proposals, see our June highlight article by guest editor and carbon market analyst Mark Lewis: Carbon Crunch: What to Expect from the Coming EU ETS Review – Carbonwise
To visualise the scale of global emissions reductions needed by 2050, see our Visual Learning: 1.5°C Pathway Emissions – Carbonwise
