On 18 December 2022, agreement was reached between EU lawmaking institutions on the path forward for the EU ETS. The ambitious reforms of the EU carbon market updated the level of emissions reductions targeted through the carbon pricing system and the policy mechanisms through which this goal will be reached. From the previous 43% reduction compared to 2005, the new 2030 goal is to reach 62% reduction under covered sectors.

Formal approval of the December fit for 55-agreement is still pending, likely to be finalized by April 2023, however the details are in place, providing visibility as to how the cap will develop through 2030. To achieve the 62% target, the Linear Reduction Factor will be increased twice, from the current 2.2% to 4.3% in 2024, and again to 4.4% from 2028 onwards. Additionally, the cap will be re-based (lowered) in 2024 and 2026, by 90 million EUAs and 27 million EUAs, respectively. Finally, the frontloading of allowances to finance the acceleration of the green transition under the RePowerEU plan implies a higher intake of allowances to the Market Stability Reserve in the years to come. This again means allowances will be cancelled from the reserve, resulting in an overall tightening of the cap.

With these changes, the cap will decrease much more rapidly, leaving less room for emissions in the years leading up to2030. The effect becomes even more pronounced out towards 2040. With the revised EU ETS framework in place, the cap will reach zero in 2040 – 9 years earlier than under previous rules, illustrated by Figure 1.

Figure 1: The EU ETS cap to zero in 2040

The rapid reduction of annual EUA supply (the cap) spurs the question: will actual emissions follow a similar trajectory and reach zero by 2040?

In short, no. The rapid cap reduction already puts pressure on all EU ETS sectors to decarbonize more rapidly. The shift from energy production fueled by coal and gas to renewables is already well underway – despite the near-term dash for coal spurred by the war in Ukraine. Getting closer to 2030, the room for additional emission reductions in the power sector will be limited, and the bulk of emission reductions will have to come from industry sector abatement in order for the EU ETS sectors to respect the ever-decreasing cap. The future is tight and industrial emissions will have to come down. However, not all emissions that are inherent in industrial processes can be abated. With a cap reaching zero ahead of actual emissions covered by the EU ETS, what flexibility or options exist for industrial installations to continue to meet compliance obligations?

The market stability reserve to the rescue?

First on the list of potential “softening” options is the Market Stability Reserve (MSR). The MSR originated as a tool to ease shocks to the supply/demand balance – both by addressing the oversupply from the past and acting as a stabilizer to ensure the market balance stays within a predefined range. The market-balancing mechanism functions by holding back allowances when the market is oversupplied and injecting allowances when the market is tight. In theory, as the cap begins to quickly tighten the market, the MSR should shift from removing the oversupply (as it is currently doing) to adding volume to the market.

Acting in a cumulatively oversupplied market for some years still, we estimate the MSR to continue to hold back allowances from the auctions for the better part of this decade (see Figure 2). Only towards the end of the fourth trading phase, as the cumulated surplus falls below the lower threshold level of 400 Mt, identified in the legislation as the level when the market balance is too tight to cater for hedging needs, will allowances be released from the reserve. The rules for intake to and release from the MSR are different – and asymmetrical. The release formula stipulates that when the total number of allowances in the market falls below the lower threshold level, 100 Mt will be released annually from the reserve to soften the balance. Note that 100 Mt will have a bigger impact in 2030 with a low annual auction supplies – constituting 12% of the cap in 2030 vs 7% of the 2023 cap.

The MSR currently holds some 2.6 bn allowances, partly filled in a one-off soak-up of old surplus, partly due to the mechanism working on an oversupplied market since its start in 2019, holding back volumes from the auctions equivalent to 24 percent of the accumulated surplus annually. Figure 2 shows how we see the MSR operating going forward – actively holding back allowances from the auctions for the better of the current trading phase. With the surplus falling below the lower threshold in 2030, the reserve will release allowances to the market from 2030 onwards.

A new provision to invalidate allowances in the MSR was introduced at the 2018 ETS review, and further refined in the context of Fit for 55review. In practice this means that the reserve cannot hold more than 400 Mt allowances. We estimate that overall, the some 3.5 bn allowances will be cancelled from the MSR.

This cancellation provision thus effectively limits the role of the MSR when the market gets tight to four years, ie until 2034 when the reserve is emptied. So while the 2.6 bn glut of allowances currently held in the MSR would ease long-term tightness, the new 400 Mt level only allows for additional supply to be added to the market through 2034, after which the MSR will cease to have an impact on the EU ETS. Hence, the MSR will have a very limited role to bridge the gap between the zero-emissions cap and actual industrial emissions.

Figure 2: The Market Stability Reserve at work

New ETS review – easing the burden on EU ETS sectors?

There is no explicit goal in the legislation for the EU ETS to reach zero by 2040, this crossing is a result of extrapolating the 4.4% linear reduction factor beyond 2030, as shown in Figure 1. Currently, the at least 55% emissions reduction goal by 2030 and climate neutrality by 2050 are established in EU Climate Law. The process for setting an intermediate emission target for 2040 is set to kick off with a European Commission proposal mid-2024 (within six months after the Paris Agreement global stocktake in December this year).

The EU ETS should be reviewed to align with the Union 2040 target. By July 2026, the Commission will report and – if it sees fit – put forward a legislative proposal accompanied by an impact assessment how to amend the EU ETS directive in respect of that new target. A “fit for xx%”-legislative package, that is. This implies an opening of the Directive, and all elements, including the cap trajectory could be revisited.

Under current rules, the EU ETS sectors continue to take a larger share of the emission reduction burden compared to sectors outside the EU ETS. This has been the situation since the start of the system, reflecting the ability and cost of large installations covered by the ETS to reduce their emissions compared with sectors such as households and transport. As climate targets get more ambitious, the harder to abate-sectors will have to contribute more. Reaching agreement on the establishment of a Union-wide instrument - an ETS2 - for these sectors was arguably one of the most significant challenges during the Fit for 55 process. With an overall 2040-target established, the debate will again be a zero-sum game; if the burden on the ETS1 sectors is eased though a laxer linear reduction factor, the effort for the rest of the economy, via ETS2 and member state national climate goals, will have to be strengthened. All in all, we see limited potential for a softened EU ETS cap to be adopted.

Re-entry of carbon credits in the EU ETS?

The EU's 2030 climate ambition is domestic. The requisite emissions reductions should take place on European soil by investing in low-carbon solutions to green and decarbonize the European economy. The idea that investing in low carbon solutions will improve European manufacturers’ competitiveness is at the core of the Green Deal.

In this picture, there is no role for carbon credits or offsets, units issued on the back of emission reduction avoidance or removal of 1 tonne of CO2 equivalent elsewhere. The EU’s approach towards climate credits was not always so restrictive; for compliance with the EUs 2020 climate ambition, both EU member states and EU ETS compliance entities were entitled to use a defined amount of such credits towards national climate goals under the EUs effort sharing chapeau and towards EU ETS compliance obligations. The import of carbon credits issued under the Kyoto protocol’s market-based Clean Development Mechanism (CDM) for use toward EU ETS compliance during the third ETS trading period (2013-2020) was subject to both quantitative and qualitative restrictions.

Partly blamed for the build-up of allowance surplus and sustained low price levels in the EU ETS – though with the financial crisis as the major suspect – use of carbon credits was no longer a viable option politically when the 2030 climate target discussion kicked-off. And, despite political concerns over carbon price levels during the course of the fit for 55 negotiations over the past year, opening for carbon credits was never on the table. When asked about the role of carbon credits, Peter Liese,rapporteur for the EU ETS review file in the European Parliament, said “I am not convinced we should do this if we want to lead by example”.

That said, emitters’ appetite for credits and policy makers’ attitudes towards them may change once the 2040 target discussion gets started - or at least during the subsequent debate on how the EU ETS should deliver towards that target. That process will kick off with a Commission report and potentially a legislative proposal in mid-2026. It will need to account for the sheer magnitude of the challenge, as well as for the changed international framework.

In the era of the Paris Agreement, where all are treated equal in terms of framework (with each country defining its own national climate ambition), Article 6 will structure cooperation to mitigate climate change across borders. Throughout the UNFCCC negotiation process, the EU has advocated for a robust and stringent architecture and recognizes the future role of Article 6 as ambition deepens, as outlined in the 

“While the focus needs to remain on domestically reducing emissions and increasing removals, RECOGNISES the potential of Article 6 for facilitating further ambition to close the gap towards limiting global warming to 1.5 °C (…)”.

Carbon removals and the EU ETS: Not a question of if, but when and how

 2050 climate neutrality target will be met by reducing emissions and increasing removals. Negative emission will have to play a role for all parts of the economy – both for the sectors covered by the EU ETS and for sectors currently not covered by an emission trading system. The revised EU ETS framework which was agreed in December last year briefly mentions the role of removals in the context of the EU ETS. It describes the process and timeline for the discussion and provides a few broad guidelines. The Commission will by 31 July 2026 report, and if appropriate, put forward a legislative proposal on how negative emissions could be covered by emissions trading. This coincides with the timing for the legislative proposal for the EU ETS directive as mentioned above. The legislative text also underlines that any proposal will ensure that removals are not offsetting necessary emission reductions, thus addressing the concerns that removals will be an excuse to continue to pollute.

As one of few emissions trading systems worldwide, the EU ETS currently contains provisions for how to treat Carbon capture and storage (CCS). In short, emissions captured from EU ETS installations and stored safely according to the rules of the CCS directive will be counted as “not emitted”. Whether removals will in a similar manner be directly recognized as an abatement option in the EU ETS, respecting the upcoming rules in under the European carbon removal certification framework (CRCF), or whether removal credits will be treated in a similar fashion as carbon credits (CDM/Article 6) – is only one of the many discussions to be had. What is clear, however, is that one way or another, and, in light of the gap to the zero 2040-cap, sooner rather than later, carbon removals will play a part in the EU ETS. Clarity on that framework cannot be expected until closer to 2030. With lack of economic incentives from the EU ETS, the removal industry will continue to seek finance from various public support mechanisms within Europe and outside, and through private finance via the voluntary carbon market.

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The revised EU ETS framework agreed in December last year spells a steep path to zero emissions for the sectors covered by the EU’s flagship climate instrument. With the new linear reduction factor, the cap reaches zero in 2040. Even with the necessary massive abatement in EUs industry sectors, emissions cannot follow suit. Due to the cancellation provision, the Market Stability Reserve will only to a limited degree come to the rescue with additional supply, and the debate on inclusion of carbon credits from outside EUs borders is bound to resurface once EU policymakers start to discuss the Unions 2040 climate target next year. Negative emissions, via direct inclusion of removals in the EU ETS or through carbon removal credits, will have an important role to play in a 2040 timeframe.

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