Carbon Crunch: Top 5 Developments to Watch in the Upcoming EU-ETS Review

On July 15, the European Commission will present its proposals for overhauling the EU-ETS, the most significant regulatory event since the ‘Fit-for-55’ package was launched in July 2021. Over the following 12-18 months, the Commission’s blueprint will be debated by the EU Council and the EU Parliament. Once a compromise is reached between the three institutions – likely in the second half of 2027 – it will set the operating parameters for the world’s largest and most liquid carbon market well into the next decade. Such is the magnitude of this moment.

So, what are the main changes the Commission is likely to recommend, and how controversial are they likely to be? We see five key topics to watch for, each likely to spark heated debate over the next 12-18 months.

Reducing the Cap Adjustment Trajectory (i.e., Linear Reduction Factor)

First, the Commission is likely to recommend a reduction in the Linear Reduction Factor (LRF), i.e., the rate at which the annual cap declines, from 2031 onwards. Under the current legislation, the LRF declines at 4.3% over 2024-27, and then at 4.4% from 2028, which means that on the current trajectory, the EU-ETS cap is set to fall to zero by 2040. However, given the impact of persistently high energy prices over the last five years on both European industrial competitiveness and consumer affordability, this trajectory is no longer politically viable. As a result, we expect the Commission to propose a lower LRF from 2031 onwards, probably between 3% and 3.4%.

Figure 1 shows how an LRF of 3.4% and of 3% from 2031 would compare with the current 4.4%.

Figure 1: Potential scenarios for the EU-ETS cap* under EU-ETS Review versus current trajectory (Mt)

Source: European Commission, CLIFI; *For fixed installations only (i.e., excluding Aviation and Maritime)

While the implied increase to the total cap under both an LRF of 3.4% and 3% would be significant, it is important to emphasize that, in both cases, >70% of the increase relative to the current cap would accrue beyond 2035. This means that, assuming the Commission proposes the new LRF take effect from 2031, there would not be any meaningful impact on the supply/demand balance in the EU-ETS before 2035 anyway, even assuming a significantly lower LRF of 3%.

As a result, as long as the Commission does not propose an LRF materially below 3%, and that it proposes that the change to the LRF does not take effect before 2031, we think the LRF proposal will be broadly market neutral, as we think a reduction in the range of 3%-3.4% from 2031 is what the market is currently pricing.

Adjusting Market Stability Reserve (MSR) Thresholds & Supply Limit

Second, the Commission may make further changes to the way in which the Market Stability Reserve (MSR) operates beyond those already announced at the EU Council meeting in March. The Market Stability Reserve (MSR) is the EU ETS’s supply-management mechanism that automatically adjusts the total number of allowances in the market based on the overall market surplus, helping prevent excessive oversupply and stabilize carbon prices. Currently, the MSR maintains a maximum supply of 400m and invalidates any excess allowances above that level. At the March Council Meeting, the Commission proposed ceasing invalidation of allowances in the MSR above the 400m threshold from the end of this year, meaning the MSR will start building a larger surplus very quickly. Modeling this change alone, we now project that the MSR will hold 976m EUAs by the end of 2030, versus 400m under the existing policy.

In terms of other changes to the MSR that the Commission might propose, the most significant would relate to the thresholds for withholding allowances from auctions (currently triggered if supply is above 833m, placing 24% of overall supply into the reserve) and releasing allowances back to the market (currently if supply is below 400m). Any proposed reduction of the threshold would be bullish for the market. Still, we think that, combined with an end to invalidation at the end of this year, the current MSR parameters already mean the Commission will have greatly increased flexibility to deal with any future price spikes.

As a result, we think the most likely change the Commission will propose to the MSR thresholds is a reduction in line with whatever revised LRF it ultimately proposes. We do not expect the Commission to propose any change to the current intake rate of 24%, but if it puts forward a reduction to 12% – the original number it suggested when the MSR was first debated in 2017 – then that would be bearish.

Sourcing and Timeline for the Investment Booster

Third, there is the question of the so-called Investment Booster (IB), which will earmark or reallocate auction revenue into clean investment programs (e.g., industrial decarbonization, clean tech deployment, infrastructure upgrades). The Commission has already said it wants to raise €30bn for industrial decarbonization through auctioning 400m EUAs. Still, it is not yet clear where those EUAs will be sourced or over what timeframe the auctioning will take place. In our view, the most likely source of the 400m allowances is the New Entrant Reserve (NER), which currently holds just over 500m EUAs and is a pool of EUAs set aside to allocate for free to new industrial installations or existing installations that significantly expand capacity, helping them cover emissions when they enter or grow within the system.

As far as the timeframe is concerned, we assume that the Commission will propose monetizing the 400m allowances gradually over the five years 2028-32, as 2028 is the earliest date from which the auction process could begin. The Commission has already said that it does not want the auction process for the IB to have a negative impact on prices, and its target of €30bn implies an average auction price of €75/tonne (very close to current levels). Accordingly, we think the Commission will be wary of an accelerated auction process of less than five years, as the higher annual volumes implied by a shorter process would risk crashing the EUA price.

Inclusion of the Aviation Sector

Fourth, there is the question of what to do about the Aviation sector: will the Commission propose that all flights departing the EU be included in the EU-ETS, or will it give the Carbon Offset and Reduction Scheme for Aviation (CORSIA) more time to prove that the global aviation industry can deliver meaningful emissions reductions in line with the Paris Agreement? We think bringing departing flights back under the scope of the EU-ETS would be very difficult to enforce in practice, as it would be opposed by major countries such as the US, China, Russia, and India. Moreover, due to international opposition, certain key EU countries, such as Germany and France, oppose it. Nonetheless, the Commission may, at this stage, propose that all departing flights be included in the EU-ETS as a bargaining chip with the member states on other issues.

Inclusion of Article 6 Offset Credits

Finally, there is the question of whether the Commission will propose allowing a limited quota of Article-6 credits for use in the EU-ETS. Article 6 credits are generated when emissions reductions or removals (e.g., from renewables, methane capture, or reforestation) are verified and authorized under the Paris Agreement, allowing them to be transferred and used by another country toward its climate targets.

Given that the EU has already agreed to allow up to 5% of its 2040 emissions-reduction target to be met via international credits, the Commission may propose that part of this overall quota be allowed for EU ETS compliance entities to use the credits in place of EUAs to meet part of their emissions obligation. However, we think the Commission is philosophically opposed to allowing international credits back into the EU-ETS – Commission spokespersons frequently cite the experience with Kyoto credits over 2008-20 as being negative – and we therefore expect it not to propose any use of Article-6 credits in the EU-ETS.

That said, we think several member states are very much in favor of allowing Article-6 credits into the EU-ETS and that, as a result, this will prove one of the hottest contested elements of the entire EU-ETS Review.

Updated Supply/Demand Model

Taking all of the above into account, we have updated our projections for the EU-ETS supply/demand balances out to 2030. Our updated assumptions now project slightly lower consecutive annual deficits through 2030. However, the average annual drawdown of the accumulated surplus remains substantial at 63Mt per year over 2026-30 (versus 99Mt per year previously).

Figure 2: CLIFI updated EU-ETS annual S/D balances, 2008-30 (Mt)

Source: European Commission, CLIFI

These revised annual balances mean that our projected reduction in the total surplus of allowances accumulated since 2008 – in other words, the total number of allowances in circulation (TNAC) with aviation included from 2012 – is now slightly gentler over 2026-30 (Figure 3). We now have the system-wide cumulative surplus trending down to 537Mt by 2030 versus 404Mt on our previous assumptions, a reduction of 317Mt over 2026-30.

Figure 3: CLIFI updated cumulative system-wide* EU-ETS surplus, 2008-30 (Mt)

Source: European Commission, CLIFI; *This number differs from the TNAC published by the European Commission every year in that it includes the cumulative Aviation balance from 2012, not just from 2024. This explains why the system-wide cumulative surplus is materially lower than the TNAC published by the European Commission.

Conclusion: Time to Buckle Up

We are now set for the most significant regulatory proposal in the EU carbon market for five years on July 15, and then a long-running debate between the three law-making EU institutions over the next 12-18 months, with many complex technical and political perspectives to be balanced before a final outcome is reached at some point in late 2027.

Our updated projections reflect our current expectations of what the Commission is likely to propose in mid-July and how the EU Council and the EU Parliament will then react as the process of reaching a final agreement continues. Given that we continue to project consecutive annual deficits through 2030 and an ongoing reduction in the cumulative surplus, we think our updated numbers are both realistic and constructive for the outlook for EUA prices over the second half of this decade.

However, we also acknowledge that there will likely be some surprises when the Commission makes its announcement on 15 July – there usually are with such significant regulatory updates – and we will therefore make any further updates to our assumptions and projections that might be necessary once the Commission has pronounced.

Carbon Market Roundup

The weighted global price of carbon moved slightly higher over the week, ending at $59.46, up 1.36%. EUAs rose to €81.57, gaining 1.94% on the week, while UKAs moved up to £58.87, up 1.26%. In North America, CCA prices increased to $33.03, up 2.77%, and RGGI allowances climbed to $43.85, up 5.56%. WCA moved lower to $57.50, down 10.71% over the period.