The Revision Of The EU Emissions Trading System

The European Commission (“Commission”) has published its proposal to review Directive 2003/87/EC (“EU ETS Directive”) under the title “proposal for a directive amending Directive 2003/87/EC and Decision (EU) 2015/1814 as regards driving competitiveness and cost-effective decarbonisation”¹, with document reference 2026/0212 (COD). 

The key elements of the proposal are: 

1. alignment of the Emissions Trading System (ETS) cap with the 2040 climate target by reducing the linear reduction factor (LRF) to 3.7% for 2031–2035 and 1.7% for 2036–2040, allowing continued issuance of allowances into the 2040s
2. the introduction of a mechanism under which up to 260 million allowances may be set aside for the Commission by which the Commission may fund its purchase of up to 260 Mt of high-quality, high-integrity international credits, contributing to ETS-sector ambition from 2036 to 2040, while complementing domestic action and resulting in a domestic reduction target of -85% compared to 1990 
3. integration of 250 Mt of domestic permanent carbon removals (BioCCS and DACCS) into the ETS through a Commission purchasing programme, whereby the cap of allowances will be increased by 250 million allowances for auctioning between 2031 and 2040 (with an additional 10 million allowances if the revenues of the aforementioned 250 million auctioned allowances would prove insufficient)
4. reform of the Market Stability Reserve, including a reduction of the intake rate from 24% to 12% and the introduction of dynamic, annually declining parameters 
5. extension of benchmark-based free allocation beyond 2030, with continued support conditional from 2031 on operators establishing verified “Invest in EU Decarbonisation Plans” and investing the equivalent of 100% of their free allocation value in decarbonisation in the EU 
6. a slower phase-out of free allocation for sectors covered by the Carbon Border Adjustment Mechanism (CBAM),² now extended to 2038, but subject to conditions such as adhering to a decarbonisation plan 
7. establishment of the Industrial Decarbonisation Bank (IDB) with an estimated EUR100 billion in funding, whose first phase is the ETS Investment Booster, providing approximately EUR30bn in support through 400 million allowances for 2028–2030, followed from 2031 by a second phase deploying a further 400 million allowances through competitive bidding 
8. extension of the EU ETS geographic scope for aviation from 2029 to flights departing from the EEA and landing at aerodromes in third countries no further than 5,000 km from Frankfurt, as the largest aerodrome in the geographical centre of the Union, with a CORSIA deduction mechanism 
9. extension of the maritime ETS to certain categories of smaller ships (below 5,000 GT but not below 400 GT) and establishment of a Sustainable Maritime Alternative Propulsion (SMAP) mechanism
10. inclusion of municipal waste incineration from 2031 with a phased surrender obligation reaching 100% in 2034.

Importantly, the Commission limited its proposals to ETS1 and does not intend to amend ETS2. As described in the proposal, ETS2 is excluded from the scope of this proposal as it will become fully operational in 2028, its application is due for review by 2029, and any assessment of the feasibility of integrating the sectors under ETS2 into the EU ETS is due by 2031.

The ETS review is being negotiated against a backdrop of heightened concern over industrial competitiveness, energy prices and the cost of decarbonisation. The Irish presidency of the Council of the European Union (“Council”) has indicated that it plans to rapidly move forward, with a view to reach a Council negotiating position in time for a meeting of environment ministers in mid-December, stressing that certainty on the ETS is vital for European competitiveness.³

Market participants should expect continued political pressure on core parameters, including free allocation, CBAM timing, price-stability tools and sectoral scope.

The ETS review is being negotiated against a backdrop of heightened concern over industrial competitiveness, energy prices and the cost of decarbonisation. The Irish presidency of the Council has indicated that it plans to rapidly move forward, with a view to reach a Council negotiating position in time for a meeting of environment ministers in mid-December, stressing that certainty on the ETS is vital for European competitiveness.3 Market participants should expect continued political pressure on core parameters, including free allocation, CBAM timing, price-stability tools and sectoral scope.

1. What Is the EU Emissions Trading System?

The EU Emissions Trading System (EU ETS) is the world's first major cap-and-trade carbon market. Launched in 2005, it covers electricity and heat generation, energy-intensive industry, commercial aviation, and (since 2024) maritime transport, together accounting for approximately 40% of total EU GHG emissions. Now in its fourth trading phase (2021-2030), it is governed by Directive 2003/87/EC⁴ as most recently amended and has been linked to the Swiss ETS since 2020.⁵ Separately, the EU and UK are negotiating linkage of their emissions trading systems. By 2025, covered-sector emissions had been reduced by more than half compared to 2005 levels.⁶

2. Proposed amendments to the EU ETS

On 17 July 2026, the Commission published its proposal for amendments to the EU ETS. The proposed amendments by the Commission cover a broad area of topics of the EU ETS. Below, we provide an overview of the key changes proposed by the Commission and how they affect the current ETS rules.

2.1 CAP TRAJECTORY AND THE LINEAR REDUCTION FACTOR

a. Current framework

Article 9 of the ETS Directive provides that the Union-wide quantity of allowances must decrease linearly each year. The current LRF is 4.3% per annum from 2024 to 2027, increasing to 4.4% from 2028⁷. At this trajectory, total ETS1 allowance supply is expected to approach zero around 2039 or the early 2040s, raising questions about alignment with the 2040 target of a 90% net GHG reduction, provision for residual hard-to-abate emissions, and market functioning as supply diminishes.⁸ The European Climate Law requires the Commission to address these issues but leaves the post-2030 LRF to be determined in the current proposal.⁹

b. Commission Proposal

The Commission proposes to amend Article 9 of the ETS Directive to set the linear reduction factor at 3.7% from 2031 to 2035 and 1.7% from 2036 to 2040. This replaces the current rate of 4.3% (rising to 4.4% from 2028) and allows the continued issuance of allowances into the 2040s, avoiding a trajectory that would have driven the cap to zero around 2039-2040.

The revised trajectory is designed to be aligned with an EU-wide domestic ambition of -90% for the period 2031 2035 and -85% from 2036 to 2040, reflecting the European Climate Law’s provision permitting up to 5 percentage points of international credits from 2036. A proposed new Article 9b provides for allowances to be set aside for the purchase of 260 Mt of high-quality international credits (see further below).

A fallback mechanism is included: if the Commission reports by 31 January 2033 that high-quality, cost-effective international credits are not available, the LRF reverts to 2.7% from 2036, aligning the trajectory with a fully domestic 90% reduction.

2.2 INTERNATIONAL CARBON CREDITS AND ARTICLE 6

a. Current framework

The EU ETS is an allowance-based system in which international carbon credits are not currently recognised as compliance units. In Phases 2 and 3 (2008–2020), Kyoto Protocol credits could be used or exchanged within quantitative and qualitative limits,¹⁰ covering roughly 1.6 billion tonnes of CO₂-equivalent (a factor the Commission identified as contributing to the allowance surplus that depressed prices). Article 6 of the Paris Agreement now provides the framework for international carbon-market cooperation, and the amended 2040 Climate Law permits high-quality international credits to contribute up to 5% of the EU’s 90% net-reduction target, but this operates at the EU target level rather than as an operator-level ETS compliance right. The debate has accordingly been reopened on whether Article 6 credits should be admitted for ETS compliance.

Footnotes

1. Press release available here. 

2. Established by Regulation (EU) 2023/956 of the European Parliament and of the Council of 10 May 2023 establishing a carbon border adjustment mechanism.

3. Ireland kicks off talks on ETS with hope of deal by year end.

4. Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a system for greenhouse gas emission allowance trading, as amended (consolidated version of 5 June 2023), Article 9.

5. Agreement between the European Union and the Swiss Confederation on the linking of their greenhouse gas emissions trading systems, OJ L 322, 7.12.201

6. European Parliamentary Research Service (EPRS), Briefing: “Free allocation in the EU emissions trading system," PE 789.377, July 2026, p. 1. 

7. Directive 2003/87/EC, Article 9, as amended by Directive (EU) 2023/959. LRF of 4.3% from 2024-2027 and 4.4% from 2028.

8. EPRS Briefing PE 782.615, 2026; see also EPRS Briefing PE 785.707, 2026.

9. Amended Regulation (EU) 2021/1119 (European Climate Law).

10. Kyoto Protocol, Articles 6 and 12; Commission Regulation (EU) No 389/2013, Articles 59-61.

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