EU ETS: Commission publishes proposal for the revised Emissions Trading System

On 17 July 2026, the European Commission published its proposal for a revised EU Emissions Trading System (ETS), presented alongside a new Electrification Action Plan. The proposal follows intense political pressure from Member States for a drains-up review of the EU’s flagship carbon pricing instrument against a backdrop of sustained high energy cost and a populist revival of climate change denial. Consequently, the review is expansive, looking at a recalibrated emissions cap, new direct funding mechanisms to support industrial decarbonisation, revised rules on free allocation, expanded sectoral coverage and the gradual inclusion of municipal waste incineration.

Key takeaways from the Commission’s proposal:

• A slower emissions reduction trajectory. Under the existing rules, the annual rate at which the ETS cap shrinks (the “linear reduction factor” or “LRF”, currently 4.3%, rising to 4.4% from 2028-2030) would have driven the cap to zero around 2040. The new proposal slows that decline: a 3.7% LRF from 2031 to 2035, stepping down to 1.7% from 2036 to 2040. In practice, this means more allowances in the market for longer, giving industry more headroom and time to transition.

• €100 billion to fund industrial decarbonisation. The centerpiece of the proposal is a new Industrial Decarbonisation Bank (IDB). An early-phase “Investment Booster” (funded by 400 million allowances, worth an estimated €30 billion) will begin deploying capital from 2028 on a first-come, first-served basis. From 2031, the IDB will support projects through competitive tools, with the IDB’s total estimated budget reaching €100 billion for 2030-2040. The Innovation Fund will continue alongside the IDB, focusing on innovative projects with higher technological risk that need support to reach commercial maturity.

• International carbon credits are back on the table. The Commission will be empowered to purchase up to 260 million high-integrity international credits to complement domestic emission reductions, effectively reducing the required EU domestic effort from 90% to 85% by 2040. Crucially, there is a fallback: if sufficient high-quality credits are not available, the cap reverts to a 90% domestic trajectory. This is a significant development for the voluntary carbon market – it creates a potential EU-backed source of demand for high-integrity credits and could help drive quality and standardization globally. That said, the provision will face political headwinds and scrutiny during the legislative process given the negative sentiment towards project-based emission reductions from particular environmental groups.

• Free allowances are conditional on decarbonisation. Free allocation will continue beyond 2030 but is now conditional on investment in decarbonisation. From 2031, operators must develop independently verified “Invest in EU Decarbonisation Plans” and invest an amount equivalent to 100% of the value of their free allocation into decarbonisation projects in Europe. For sectors not covered by the Carbon Border Adjustment Mechanism (CBAM) but exposed to carbon leakage, the carbon leakage framework is extended until 2038, with up to 100% benchmark-based free allocation. For CBAM sectors, the phase-out of free allocation has been slowed and extended to 2038. A separate benchmarks proposal aims to increase free allocation to industry by €6 billion for 2026 to 2030. In addition, Member States will be required to spend at least 50% of their national ETS revenues on investments to decarbonize ETS sectors.

• The scope of the ETS is expanding. The proposal addresses scope expansion and reform in four key areas:

  • Carbon removals. In one of the most significant developments in carbon removal policy to date, the proposal integrates 250 million tonnes (Mt) of high-quality permanent domestic carbon removals into the ETS between 2031 and 2040. Only removals certified under the Carbon Removal Certification Framework (CRCF) will be eligible, initially limited to Direct Air Carbon Capture and Storage (DACCS) and Bioenergy with Carbon Capture and Storage (BioCCS), with permanent storage subject to ETS monitoring, reporting and verification rules. The Commission will act as central buyer, purchasing certified removals using revenues from auctioning 250 million additional allowances. This represents a deliberate shift from voluntary carbon markets towards compliance-led demand, and could serve as a blueprint for other emissions trading systems worldwide.

  • Aviation. The proposal extends ETS coverage to all flights departing from an EEA airport and landing in third countries within 5,000 km of the geographical centre of the EU, from 2029. All incoming and departing business jet flights will be covered. Internationally, the proposal continues to implement CORSIA for 2027 to 2035 and introduces a deduction mechanism to avoid double carbon pricing where both systems apply. The Commission will conduct a further assessment in 2032.

  • Shipping. The proposal extends the ETS to several categories of smaller vessels by lowering the threshold from 5,000 gross tonnage (GT) to 400 GT, covering oil tankers, chemical tankers, gas carriers, LNG carriers, Ro-Pax ships and passenger ships.

  • Waste incineration. The proposal gradually includes municipal waste incineration in the ETS from 2031, with a phased approach: operators will be required to surrender allowances for 25% of verified emissions in 2031, rising to 50% in 2032, 75% in 2033 and 100% from 2034 onwards. Member States may opt out until 2035 if they meet at least two of three conditions: an equivalent national carbon tax, being on track for recycling targets, and being on track for landfill targets.

• Market Stability Reserve (MSR). The proposal modernizes the MSR, adjusting its parameters to a shrinking market post-2030. The intake rate will be reduced from the current 24% to 12%, meaning more allowances remain in the market for longer. This is intended to improve market stability, predictability and liquidity. The reform complements the Commission’s earlier April proposal to stop the automatic invalidation of allowances held in the Reserve.

• Fast-track legislative timeline. The Council and Parliament are targeting political agreement by Q1 2027, with intense debate expected from September 2026 onwards.

For further background

What is the EU ETS?

The EU Emissions Trading System is the world’s first and largest carbon market. It operates as a “cap and trade” system: a cap is set on the total amount of greenhouse gas emissions permitted from installations covered by the system, and companies then either receive allowances for free, or purchase emission allowances they need from Government auctions or in the secondary market. 

The ETS covers CO2 emissions from power generation and heat, energy-intensive industry (including steel, cement, chemicals and refining), intra-EU aviation and, since 2024, maritime shipping. 

A separate “ETS 2” was introduced under the “Fit for 55” reforms to cover emissions from buildings, road transport and small industry, with trading beginning in 2027/2028. 

The overall cap is reduced each year by a “linear reduction factor” (LRF), tightening the supply of allowances over time and increasing the price of allowances, which forces companies to find efficiencies to reduce their emissions. 

In addition, the Market Stability Reserve (MSR) manages the balance of allowances on the market, withdrawing surplus allowances to support price stability and releasing them when scarcity is excessive. 

A border tax is also employed to ensure that activities are not simply exported outside of the EU with finished goods being imported. 

Why is reform of the ETS needed?

The revision takes place against the backdrop of several pressures:

• Competition and cost pressures. Europe’s energy-intensive industries face high electricity and input costs, driven in large part by the EU’s reliance on imported fossil fuels. ETS costs are seen to impose an additional burden not faced by competitors in the United States, Middle East and Asia, fueling a strong political push for the system to support, not undermine, European competitiveness. Consumers are also under significant pressure from energy costs, driving populist narratives across Europe. 

• From carbon price signal to direct investment. The funding needed to facilitate industrial decarbonisation is unavailable from budget constrained EU Governments, so the EU institutions see the revenue raising capacity of allowance auctions as a potential source of financial support that they can direct into projects chosen by them to receive financial support. Implicit in this is that the variability in potential carbon costs reduces the incentive power of the EU ETS as a tool for driving decarbonisation. 

• Carbon leakage and free allocation reform. The existing system of free allocation has shielded energy-intensive industries from carbon costs. CBAM was intended to equalize carbon costs at the border for imported goods but does not support EU exports. For export-heavy industries, the EU ETS therefore remains a strong push to offshore manufacturing. The Commission’s response is to slow the CBAM phase-in and extend the phase-out of free allocation to 2038, while making continued free allocation conditional on investment in decarbonisation.

How Linklaters can help

We have deep expertise across all sectors affected by these reforms. Our multi-disciplinary team advises on the full spectrum of carbon market regulation, emissions trading, CBAM, carbon credit structuring and the financing of decarbonisation projects.

As the legislative process unfolds, we will be tracking developments closely and advising clients on the strategic, regulatory and commercial implications. If you would like to discuss how these proposals may affect your business, please contact any of the authors listed above.

Resources

The ETS Review Package includes:

• ETS Directive proposal

• Proposal on monitoring, reporting and verification (MRV) 

• Proposal revising the heat and fuel benchmarks

• Impact assessment

• Questions and Answers on the ETS review 

• Factsheet on the ETS review

• Press release