After nearly 2 years of negotiations, EU legislators reached a provisional deal on the EU ETS reform under the Fit-for-55 climate policy package this weekend. Most of the provisions have already been priced into the market. However, as you know from our previous posts here and here, there had been uncertainty about some policies, namely the €20 billion funding plan for REPowerEU, which aims to speed up Europe’s transition away from Russian fossil fuels to low-carbon energy sources. Additional upgrades that we've been closely watching include the rate at which the allowance cap would decline (known as the Linear Reduction Factor) and the price control mechanism under Article 29a. All three institutions--the EU Commission, Parliament, and Council--will have to formally sign off on the deal, which is expected to be finalized early next year.

The key updates are listed below.

Higher emissions reduction target: 62% reduction in ETS emissions from 2005 levels by 2030, which is considerably higher than the existing 43% target.

Increased reduction in the annual cap: Changes to the Linear Reduction Factor (LRF), or the annual allowance cap reduction rate, will be implemented in two stages: a 4.3% reduction from 2024-27 and 4.4% from 2028-30. Currently, the cap is reduced at a 2.2% rate annually. Bringing down the cap at a faster rate creates a tightening of supply that should be bullish for EUA prices.

The Market Stability Reserve (MSR) 400-833 EUA million threshold remains unchanged. The MSR helps manage market imbalances by adjusting the supply of allowances by either injecting or releasing allowances depending on how the total number of allowances in circulation (TNAC) falls within the predetermined threshold. If the TNAC is greater than 833 million, then 24% of that total is withdrawn from future auctions and placed into the reserve over a period of 12 months. This 24% intake rate was set to revert back to 12% by 2023, but with the new provisional deal, it's being extended to at least 2023.

Legislators decided to add a component to the upper bound parameter. Rather than the automatic 24% intake rate, there will now be a buffer range of 833-1,096 million. If TNAC is within the range, the quantity of EUAs to be withdrawn from future auctions is instead calculated based on the difference between the TNAC and 833 million level. The lower-bound threshold, which is triggered when the TNAC is less than 400 million, saw no changes. At this level, 100 million allowances are taken from the reserve and injected into the market through auctions.

Another provision related to the MSR, the price-hike mechanism under Article 29a, was also confirmed. The price control mechanism is set to automatically release 75 million allowances from the MSR if, for over six months, the average EUA price is higher than 2.4 times the preceding 2 years. This 2.4x multiple is less restrictive than Parliament's previously proposed 2x multiple and is less likely to be triggered, meaning the MSR is more likely to retain supply than add it.

REPowerEU €20 billion initiative will be funded from 3 sources: 40% will be from frontloaded allowances from auctions in 2023-25, meaning allowances set aside for future auctions will be sold earlier. The remaining 60% will come from the Innovation Fund, which was set up to finance projects aimed at developing innovative technologies that significantly reduce emissions. The Fund receives revenue through the auctioning of allowances, specifically at least 450 million EUAs from 2020 to 2030. To make up for its funding of the REPowerEU plan, the Innovation Fund will be partially replenished by drawing on €2 billion worth of allowances from the MSR.

The Commission's original proposal called for additional allowances to be brought out of the MSR and sold to raise the full €20 billion for the initiative, but this move would have been too bearish for the market. Releasing more allowances from the reserve would have depressed prices and potentially shaken confidence in the EU ETS. The decision to fund through multiple sources is, thus, a much more welcomed compromise.

Implementation of the Carbon Border Adjustment Mechanism (CBAM), which acts as a tariff on foreign companies by requiring energy-intensive producers to pay the EUA price on goods imported into the region, is set to start in 2026. CBAM is significant because it will prevent carbon leakage by establishing a more level playing field across borders and will replace free allowance allocations. It will also indirectly bring more foreign companies into the program as they could potentially hedge the tariffs in the EUA market. It also doubly raises revenues as tariffs and previously free allowances are paid for.

Phase out of free EUA allocations kicks off in 2026 at 2.5% rate but incrementally increases over the years to end free allocations by 2034. The timeline for phasing out is as follows:

2026: 2.5%, 2027: 5%, 2028: 10%, 2029: 22.5%, 2030: 48.5%, 2031: 61%, 2032: 73.5%, 2033: 86%, 2034: 100%

Even with the lower rates in the near term, this phasing out of free allocations will still serve as bullish tightening for the market. Most of the market, at roughly 94% of industrial emissions, is covered by free allowances. Limiting free allowances, in conjunction with the tightened LRF rate for the annual cap, will have a massive tightening impact on the market. It would also leave room for generating greater revenue at auctions, which can then be directed toward innovative projects for decarbonization.

A new, separate “ETS II” introduces carbon pricing to buildings and road transport starting in 2027. The existing EU ETS covers power, industrial, and aviation emissions, so with this new ETS, private and public road transport and building heating emissions will be regulated. They've added other fossil fuel-related emissions from other sectors, such as manufacturing, not covered by the main EU ETS. ETS II will operate independently from the main ETS, but we may see the two combine down the road and have a single carbon price. According to ICIS, EU ETS 1&2 may cover close to 75% of the EU’s total emissions by 2030.

Inclusion of maritime emissions from the shipping sector: gradual introduction of obligations for shipping companies to surrender allowances: 40% for verified emissions from 2024, 70% for 2025, and 100% for 2026. This could be one of the more bullish factors as matching new supply and demand enters the market. While roughly neutral on paper, there will be more participants and more hedging, which could drive price discovery. Further, the new sector does not come with the same "surplus" that exists in the broader market.

Greater climate investments from allowance auctioning:

• The Innovation Fund will grow larger from the inclusion of bringing more industries into the program, such as the shipping sector.
• The Modernization Fund, which provides financing for EU countries with a GDP per capita that's less than 75% of the EU average to upgrade energy-related technologies, will now receive an additional 2.5% of auctioned allowances.
• In 2026, the Social Climate Fund will be formally launched to provide financial support to vulnerable households and will be funded by ETS 1&2.
• 100% of revenue from EU ETS must go toward climate projects compared to the previous >50% requirement.

Overall, the message is clear: The market is expanding, getting stronger, and seeking higher targets. We will be watching for higher prices as the market digests this news.