Loosen the Cap, or Rethink it? A Deep Dive Inside the EU ETS Review

Image - Alexandre Lallemand

COM(2026) 616 is a Commission proposal issued on 17 July 2026 to reform the European Union Emissions Trading System (EU ETS). While the review praises the step towards sustainable development, stating that the EU ETS “has demonstrated its effectiveness, as ETS sectors have reduced their emissions by over 50% since 2005, while the economy has continued to grow”, it has also been criticised as too generous. According to Carbon Market Watch's windfall-profits brief, energy-intensive companies made over €24 billion in windfall profits from the scheme between 2008 and 2014, while governments lost out on at least €137 billion in foregone auctioning revenue over the same period.

^‍After the scheme’s launch in 2005, the price of EU Allowances (EUAs) plummeted from €30 to under €1 in 2006–07, and to under €3 in 2013. Then the financial crash in 2008 drove investors away and cut industrial output, and with it demand for allowances. Lastly, technical issues, ranging from regulatory loopholes to the over-allocation of EUAs, made the policy lose traction. Despite the EU’s attempts to correct these imperfections, such as tackling over-allocation through the Market Stability Reserve (MSR), extraordinary circumstances (the financial crisis, Covid and the current wars) overshadowed these efforts. Could any policy have 'survived' so many shocks?

Against this backdrop, the Commission has tabled a reform proposal over which experts, policymakers and lobbyists now argue: is it relief for industry or a reasonable policy adjustment – and, either way, is it a viable long-term solution?

I believe the Commission’s proposal is not only, to some extent, a justified loosening of the policy, but fundamentally a lost opportunity to reform a mechanism that remains structurally too rigid to deal with uncertain future demand.

But firstly, what is the EU ETS? The EU Emissions Trading System is a cap-and-trade system. In essence, an artificial market in which industries trade rights to emit CO2 (EUAs). The EU caps the total number of allowances, and firms trade them among themselves. The system aims to reduce greenhouse gas (GHG) emissions, a negative externality, by incorporating the carbon footprint of goods and services into the price mechanism, thereby subjecting it to market incentives.

Trading enables a key beneficial mechanism: firms with low marginal abatement costs (those for which cutting emissions is cheap) have an incentive to invest in cutting their emissions to sell their spare allowances to firms whose abatement costs are higher. In effect, high-cost abaters finance the green transformation of those who can decarbonise cheaply. Such trading makes the system efficient in theory, and the Commission's review credits it with effectiveness in practice.

However, we should not forget that high-to-abate industries incentive to substitute production methods are very low in the short term - EUAs are cheaper. Therefore, EUAs increase their production costs, which tend to pass through to consumers where demand is inelastic. For instance, for oil and gas companies, the possibility and incentive to shift from GHG emissions is low, and the EU ETS solely leads to consumers paying higher petrol prices. The indirect incentive to (due to high oil prices) buy an electric car seems too weak in the short term.

Every year the total number of EUAs is reduced, so total emissions from the covered sectors also fall. The reduction is linear, but increasingly steep: the Linear Reduction Factor (LRF) subtracts a percentage of a fixed reference quantity each year (the average annual number of allowances issued in 2008–2012), and that percentage has been raised in steps: 1.74% (2013–2020), 2.2% (2021–2023), 4.3% (2024–2027) and 4.4% (2028–2030) under current law. Looking at this mechanism, a core tension arises. The supply trajectory is largely predetermined through the LRF, while the factors that drive future demand for EUAs are uncertain - for example depending on technological and economic developments.

However, the review's proposal does not aim to provide more flexibility to manage the mismatch between relatively rigid supply and uncertain demand but proposes another even lower supply trajectory. Therefore, it does not solve the structural issue, while lowering the policy's ambition. The two most significant changes are the following:

1. To lower the LRF from 4.4% (2028–30) to 3.7% (2031–2035) and then to 1.7% or 2.7% depending on whether high-quality international credits are available. This significant reduction of the LRF lowers the pace at which issuance of new allowances fall to zero.

2. To keep some free allocation for four more years, extending the finish line from 2034 to 2038. Even though this is a loosening of the policy, it must be considered that the current EU ETS reduction of free EUAs for firms in CBAM sectors is very fast, falling from 97.5% in 2026 to just 39% by 2031, with deep jumps, such as from 77.5% to 51.5% between 2029 and 2030.

According to Jakob Graichen at Germany's Öko-Institut, an independent research institute, “The European Commission's proposal goes too far. Taken as a whole, it will lead to a new surplus of allowances rather than setting out a reliable path to decarbonisation. In fact, modelling by ClearBlue Markets, a carbon-market analytics firm, suggests that the EUA price in 2030 will be 22% lower than under the old trajectory. Consequently, polluting becomes cheaper for firms, which weakens their incentive to reduce emissions.

While in certain dimensions the review loosens regulations, in others it tightens them. For instance, from 2031, 20% of free EUAs will only be released once firms' planned decarbonisation investments have been verified as implemented, while 80% will be released upon submission of an ‘Invest in EU Decarbonisation Plan’. Such conditionality marks a shift away from largely unconditional free allocation. However, these ‘tighter rules’ seem to be outweighed by the loosened LRF, making the policy less effective and pushing back the date at which no new allowances are issued.

Under the original policy, cessation of new allowance issuance would occur in 2040, but the softening of the policy extends the timeline. Since official estimates of when no new EUAs would be issued under the review’s proposal could not be found, the newly proposed LRF rates have been extrapolated to estimate that date. Using the EU ETS's actual 2026 cap and the proposed Linear Reduction Factor rates (COM(2026) 616 for the rates and ICAP for the cap figure), and with the help of Claude (Sonnet 5), it was found that it extends the timeline to roughly 2042 if the credit safeguard fails (reverts to 2.7%), or 2046 if it succeeds (stays at 1.7%). That means the revision likely buys between 2 and 7 compared with the current EU ETS. Therefore, the review’s proposal seems to be closer to relief for industry than to greater stringency. CAN Europe, a leading coalition of environmental NGOs influencing EU policy, argues that extending free allocation to 2038 “rewards delay instead of industrial decarbonisation”, since “free pollution permits were never meant to become a permanent subsidy”.

So, why loosen regulations, reward businesses and delay the date at which no new allowances are issued?

A key reason for the reform is the need to handle the so-called 'ETS endgame' - if the system was born to die at all rather than compensating society for emissions. The ETS endgame is the point, around 2039–2040 under current rules, at which no new allowances would be issued. If emissions fall more slowly than the supply of EUAs, firms will still be emitting when no new EUAs are issued: demand, but no new supply. The Commission wants to avoid such a crisis, since prices tend to become erratic as an exhaustible resource depletes, and firms would rationally start hoarding allowances, driving the cost of polluting to extreme levels.

A valid criticism of the proposal is that industry, having been too slow to reduce its emissions, is rewarded with looser regulation instead of being held to a stricter cap. On the other hand, the shocks of the past two decades may have made reducing emissions harder than policymakers anticipated in 2005. The Commission’s proposal tries to balance protecting industry from excessive carbon costs (the EUA price) against incentivising its transition to net zero.

BusinessEurope, a lobby group representing national business federations from 36 European countries, argued in February 2026, before the review’s proposal: “Businesses are facing increased costs and fierce global competition while the enabling conditions to create a business case for decarbonisation are largely missing. The ETS review must be adjusted to the current challenges and post-2030 context.”

^‍However, while BusinessEurope calls for protection, the EU has actually protected European businesses from import competition by levelling the playing field through the Carbon Border Adjustment Mechanism (CBAM). CBAM matches the carbon costs that EU manufacturers already pay under the EU ETS and charges importers the same - as if it were an import tax. This mechanism allows European firms to maintain competitiveness within the European market but not outside it, where there is no CBAM.

Here the industry has a fair point. While the EU can attempt to lower GHG emissions while protecting industries within the EU, the ETS lowers the international competitiveness of EU firms outside of the EU. That has an undeniable economic cost. To what extent the EU prioritises stronger climate policy at the risk of industries' success, its re-investing abilities and innovation is a value judgement for the EU to make. At the end of the day, the EU cannot force other countries to adopt its policies, nor can it avoid them benefiting from the EU's reduced emissions. A good example of Garret Hardin's 'Tragedy of the Commons'.

Given this protection at home, loosening the EU ETS mainly helps European businesses compete outside Europe, while risking moral hazard: it signals to industry that falling behind will be rewarded. In short, the review is an attempt to avoid the ETS endgame and its potential cost crisis, but its application would extend the issuance of new allowances by an estimated 2–7 years.

More fundamentally, researchers at the Florence School of Regulation (FSR), as part of the LIFE COASE project (Collaborative Observatory for ASsessment of the EU ETS), note: “While decreasing allowance supply may not pose significant issues if demand decreases concurrently, uncertainties surrounding technology development and infrastructure deployment could significantly impact market outcomes. Managing the evolution of supply relative to demand will be crucial in transitioning to a net-zero environment”. In other words, as long as firms' demand for EUAs falls at the same pace as their supply, a shrinking cap need not cause problems. Unfortunately, the factors on which this relationship depends are technology and infrastructure, two variables which are hard to predict. Therefore, a fixed, pre-legislated schedule, which cannot adapt to technology deployment, can hardly be an accurate solution to manage the demand-supply relationship of EUAs.

Furthermore, the FSR argues: “As […] allowances become scarcer, policymakers grapple with the challenge of maintaining fairness amid increasing costs. Adjustments in ETS design, such as implementing holding limits or exploring central carbon banking, offer potential solutions but necessitate further research and careful consideration of their implications”. More broadly, for unpredictable variables, such as technology, economic cycles and extraordinary events such as Covid, a more flexible approach is needed. The reduction of the Linear Reduction Factor is not just loosening the policy but also putting in place a ‘solution’ not flexible enough to be precise, since it cannot consider the main variables forming the demand for EUAs.

More flexible approaches could be rules-based systems (e.g. a price band) or an even more flexible discretion-based organisation, such as a Carbon Central Bank. Maybe a Carbon Central Bank could be a solution to this 'Tragedy of the Commons', helping to manage individuals and firms to compensate society for the use and pollution of our environment. Academics have argued for its potential capacity to manage the supply of EUAs, keeping prices within a reasonable band and acknowledging the trade-offs between competitiveness and sustainability, while still leading to a net-zero Europe.

In fact, BusinessEurope agrees on the need for flexibility, since it recommends to “Introduce flexibilities to ensure long-term viability. According to the Commission’s own estimates, there will still be industrial emissions in 2039 when the current linear reduction factor (LRF) will reduce issuance of new allowances to zero. Firstly, ETS must be adjusted to enable the continued transition after 2040, by modifying the LRF to avoid an ‘ETS Endgame’ in 2040. Secondly, […] The MSR must be made future-proof and adjusted to a new situation where allowances are becoming scarce”. This highlights the need for a more flexible approach. However, BusinessEurope’s ‘flexibility’ refers to relief for industry rather than the flexibility integrated into public policy that allows responsiveness to shocks.

In conclusion, the reduced LRF is not just a looser cap that pushes back the date at which no new allowances are issued, but also too rigid a mechanism that does not consider the most impactful variables, such as technology, economic cycles and extraordinary circumstances. Overall, among the factors that constrained the EU ETS’s success were these unpredictable variables. A more flexible method, such as a Carbon Central Bank, would be able to take these into account. By not being anchored to a fixed calendar, but to the real progress of emitters and the economy, a Carbon Central Bank could lead to the sustainable development the EU aims for.